Statement on Monetary Policy – November 2006
Australia is presently being affected by a serious drought. Recently, it has intensified in many agricultural districts and the outlook for the farm sector has deteriorated significantly. The current drought follows a severe one in 2002, with the persistence of dry conditions making the present period exceptional by historical standards. At this stage, farm output is forecast to fall by around 20 per cent in 2006/07 and directly subtract around one-half of a percentage point from GDP growth; this is similar to previous major droughts, but somewhat less than that in 2002, with livestock production currently expected to be less affected than grain. Allowing for flow-on effects to the rest of the economy, the total impact on economic growth should be slightly larger. The reduced supply of farm produce is also likely to place upward pressure on some prices, though the price effects in aggregate are likely to be relatively small.
The nature of the drought
The Bureau of Meteorology records two main indicators of the severity of drought: its geographic spread and its degree of dryness. Geographic spread is gauged by the proportion of land with rainfall in the lowest 10 per cent of historical experience. The degree of dryness is gauged by mean rainfall in a given period compared with historical experience. While it is usual to consider these indicators across the whole country, when assessing the economic implications of the drought, it is more instructive to focus on rainfall deficiencies in major agricultural districts and water storage areas. Rainfall data compiled by the Bureau of Meteorology are examined for the prime agricultural districts in eastern, southern and western parts of the country.1
When the share of prime agricultural land with a rainfall deficiency this year is compared with that in each previous year, the current drought ranks well behind others – in particular, the severe droughts at the time of Federation, in the 1940s, early 1980s and in 2002. However, it follows a drought in 2002 that was extremely severe, limiting the scope for recovery in growing conditions and water storage. One way the Bureau accounts for the persistence of dry conditions is to look at five-year average data; on this basis, the area of agricultural land recording a rainfall deficiency in the current drought is exceeded only by the drought of the mid 1940s (Graph 34).
Mirroring these developments, it is also the case that mean rainfall this year is not as low as in many previous droughts. However, looking at five-year average data, mean rainfall over the period to September was the lowest on record. Furthermore, it was accompanied by a steady increase in average temperature, which now exceeds what the Bureau deems to be normal by close to one degree.2 This is reducing sub-soil moisture and increasing the evaporation of surface water.
With the Bureau indicating that current weather patterns are probably being caused by an El Niño event, spring and summer are likely to be drier than average, and rainfall deficiencies will probably become more acute. In combination with high average temperatures, this is likely to further deplete stored water, which is already at critically low levels, having not been fully replenished from the previous drought. This is especially so in New South Wales, Victoria, and southern Queensland (Graph 35). But while drought conditions are acute in areas where most agricultural activity and water storage takes place, some pastoral areas in northern Australia have experienced a significant increase in their average rainfall over the past decade, including more recently.
Based on the latest Australian Bureau of Agricultural and Resource Economics (ABARE) forecasts of farm production and information from other organisations, the Bank estimates that farm output is likely to fall by around 20 per cent in 2006/07 (Graph 36). This expected decline is somewhat less than in the 2002/03 drought, owing to a smaller fall in livestock production than previously. With output in the farm sector accounting for a little less than 3 per cent of total production, the drought will directly subtract around one-half of a percentage point from growth in GDP in the current financial year. This will reflect a reduction in agricultural supply rather than of demand in the economy.
Much of the expected decline in farm output reflects a sharp fall in crop production, particularly wheat (Graph 37, Table 9). The biggest fall in wheat production is forecast to occur in New South Wales, which is especially drought-affected, though a substantial fall is also expected in Western Australia, which is the largest wheat-producing state. However, with wheat inventories at relatively high levels, rural exports are not expected to decline by as much as production.
In contrast to crop production, overall meat and livestock production is likely to be little affected by the drought. Meat production should be boosted initially, as farmers in drought-affected regions increase slaughter rates in response to rising feed costs. However, offsetting this effect, livestock production is likely to fall, as farmers tend to breed fewer livestock during droughts. In addition, declining sheep numbers and falling wool yields owing to the drought are expected to result in wool production falling by around 7 per cent in 2006/07.
Real farm incomes are expected to decline substantially to around their lowest level since 1994/95 as farm costs are unlikely to fall by as much as production (Graph 38). While spending on feed for livestock is set to be much higher (with grain and hay prices rising sharply), expenditure on other activities (such as cropping and maintenance) is likely to fall, given the failure of crops or the decision in some cases not to plant. The prospective fall in real farm income will further increase the ratio of rural debt to income.
However, a number of schemes will enable some smoothing and supplementation of rural incomes. The Farm Management Deposit (FMD) scheme smooths farmers’ disposable incomes by allowing them to make deposits when earnings are high and withdrawals when earnings are low, thereby paying a lower tax rate. FMDs are currently at high levels, reflecting deposits by grain growers following the large harvests of recent years and earlier strength in cattle prices (Graph 39). With the onset of drought and the prospect of falling income, farmers in all states have begun drawing on these deposits; noticeable draw-downs have been made by grain farmers and those in mixed farming, though intensive livestock producers, who are very reliant on stored water, are also drawing on FMDs. Furthermore, Exceptional Circumstances Relief Payment is being provided to farmers in severely drought-affected areas, with a key aspect of these relief payments being interest rate subsidies.3 And state governments are providing assistance, mainly in the form of transport subsidies for the movement of water, fodder and stock (and in the case of Victoria, rebates on water bills to irrigators).
In addition to these direct effects on the farm sector, the drought is likely to have a significant effect on other industries that supply inputs to the farm sector or distribute farm output. These effects are likely to be concentrated in rural communities. More generally, there will also be flow-on effects to the rest of the economy as farmers’ consumption and investment spending is reduced, though the greater ability of farmers to smooth income than in earlier droughts may partly mitigate these effects. Accounting for these indirect effects, the total effect of the drought is likely to reduce GDP growth by around three-quarters of a percentage point in 2006/07. While the real effects of the drought will be significant, the overall effect on consumer prices is likely to be less pronounced. In fact, historically, the net effect of droughts on the CPI tends to be relatively small, as discussed in the chapter on ‘Inflation Trends and Prospects’.
- Specifically, these are wheat, wheat-sheep and high-rainfall zones. Areas of central and northern Australia are excluded, even though they comprise pastoral districts, as the data do not readily identify pastoral districts separately from desert in some cases. However, rainfall is not deficient in these areas at present.
- The Bureau of Meteorology uses the average of temperatures from 1961 to 1990 as the benchmark from which it judges temperature anomalies.
- Exceptional Circumstances are declared in regions where the effects of an event (usually drought) are deemed sufficiently rare (once in 20–25 years) and severe to warrant special assistance. The event must restrict farm income over a prolonged period for a significant number of farmers in an area. The event cannot be predictable or part of an industry re-structuring process.