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RESERVE BANK OF AUSTRALIA

Economic Conditions and Prospects

Glenn Stevens
Governor

Address to the Economic Society of Australia (Queensland) 2013 Business Luncheon
Brisbane - 3 July 2013


It is a great pleasure to be in Brisbane once again.

Yesterday the Board, at its monthly meeting, left the cash rate unchanged.

I don't propose to comment about yesterday's decision in particular, or to send any particular messages about the next decision.

Instead I want to step back to look at the broader picture. The economy grew at about its long-term average rate in 2012, but more of that growth was in the first half of the year than the second. According to the latest national accounts, growth in real GDP has been running at an annualised pace of about 2½ per cent over the past three quarters. Our guess is that sub-trend growth will continue in the near term. Consistent with that, the rate of unemployment has tended to increase. Employment is growing – the number of jobs in the economy is at a record high – but not quite as fast as the supply of labour.

Over the past five years, the economy has expanded by about 13 per cent. The corresponding figure for the United States is 3 per cent. For Japan, the Euro area, and the United Kingdom, the figures are negative.

Some of our Asian neighbours and trading partners have also done well, which has certainly helped us. Korea has recorded growth about the same as Australia's (13 per cent), Singapore more (about 18 per cent). And of course China's growth over this period has, despite frequent talk to the contrary, been rather stellar. Chinese GDP has risen by over 50 per cent since early 2008. China's growth over the past year or two has moderated, to be more like 7½ per cent, not the 10 per cent plus seen for some years. Most of the data we are seeing from China are consistent with that pace. This is what the Chinese authorities have been saying they want to achieve.

It's worth noting that while Australia has done relatively well, the economy's average growth rate over the period since the financial crisis erupted in earnest has been only about 2½ per cent. In the preceding decade it had averaged almost 3½ per cent. That was a period in which the rate of unemployment declined from about 7½ per cent to just over 4 per cent. In contrast, the unemployment rate today, while still quite low by longer-run historical standards, at about 5½ per cent, is higher than it was.

There are a couple of points to make here. The first is that Australia's economy was overheating by 2008. Capacity was stretched as the resources sector was in the first phase of its investment build-up while household consumption was still growing briskly and credit growth was still in double digits by the end of 2007. Inflation rose, peaking at about 5 per cent. This was substantially due to domestic pressures, not just international ones (though they were not helping). These were all clear signs that we were not going to be able to keep growing at a pace like that seen in the decade up to 2008. The Reserve Bank had made this point many times, though it was not very popular. While inflation did subsequently abate, this experience showed that if there was to be a very large rise in resources sector activity, other sectors could not continue as they had been doing.

The second observation is that similar declines in rates of growth have been observed in other countries – even the ones which have come through the financial crisis with relative success. Around our region, Korea, Taiwan, Singapore, Hong Kong, New Zealand and Malaysia, although navigating the crisis pretty well, have seen their growth rates decline by at least as much as Australia's. So Australia seems to be part of a broader pattern here. While we have benefitted a lot from China's ongoing emergence in this period, so have those countries.

The fact that no country has managed to return to the sorts of growth seen prior to the crisis is highly suggestive that that growth was to some extent being driven by forces that could not be sustained. Perhaps this has to be a conditioning factor when we think about our own growth aspirations and the way we seek to achieve them.

At this point, we have unemployment at about 5½ per cent, inflation ‘in the 2s’, the banking system is strong and government finances overall sound. Growth is on the slow side, inflation is low. That combination means that we have low interest rates (the lowest for fifty years in fact). Significant structural change is occurring, which is always challenging. But set in context, the macroeconomic data over recent years show a pretty respectable set of outcomes. Those who have memories of the 1970s or 1980s or the 1990s would surely recognise them as such.

Now it has been said that we were ‘lucky’ to have the mining boom, the effect of China and so on. Otherwise, we would have seen much more economic weakness. It's hard to disagree with that proposition as a piece of arithmetic. As a piece of analysis, though, it is incomplete.

It could equally be said that we were ‘lucky’ that the effects of the global economic downturn worked to help reduce inflation in Australia from its peak in 2008 of 5 per cent – which was way too high – to something acceptable. It could also be said that we were fortunate that the sub-prime crisis in the US emerged from early 2007, and not later. Although such lending was less prominent in Australia at that time, it was growing fast and would have become a much bigger vulnerability had it continued at that pace. The fact that things went wrong in the US when they did meant that what was a small problem here stayed small. It could be added that we were lucky that the change in behaviour of households – slower borrowing, more saving – came when it did. For a start, had households continued as they were, they would have become more financially extended, and it is obvious now that that would have been risky. Moreover, this changed behaviour of households has helped us absorb the resources investment boom.

Of course the story is not yet finished. We have to negotiate the downward phase of the investment boom over the next few years, which appears likely to pose significant challenges. How will we meet them?

A good way to begin is to have a reasonable starting point, and we have a better starting point going into this episode than we might have had, or than we have had on other occasions. Had we followed the pattern of previous terms of trade booms, we would have had much more inflation, faster credit growth and more asset price inflation, and more excesses generally. And then, when the terms of trade began to fall, we would have been much more likely to have a very big slump. This was the case in the early 1950s, the mid 70s and the late 70s (Graph 1). In each case domestic excesses arose resulting both from flow-ons from high commodity prices with a fixed exchange rate and policy weaknesses, which then made the ensuing downturn worse.

Graph 1

Graph 1: Inflation Cycles

Click to view larger

It hasn't been that way this time. On this occasion, the resources boom – a bigger one than anything seen for at least a century – was accommodated without a big rise in inflation, or a big run-up in leverage or an unsustainable asset price boom. In fact, for most of the past several years we have had various industries or regions complaining that they had not felt the benefits of the boom. There were actually positive spillovers. But the excesses were not as great as had been the case on other occasions.

Quite evidently one major feature has been a flexible exchange rate, something Australia did not have in previous resources booms. The exchange rate played the role it is supposed to play when the country receives a large expansionary external shock: it rose. It has been correctly noted by other commentators that the real exchange rate has in recent times been at its highest since the float thirty years ago. Indeed, it has been just about as high as any time in the past century. In the broad that is not a total surprise, given that the terms of trade rise and ensuing increase in resources sector investment has been bigger than anything seen in a century (Graph 2).[1]

Graph 2

Graph 2: Real Exchange Rate and Terms of Trade

Click to view larger

Actually, the exchange rate might have been even higher but for the changes in behaviour by households, which have not returned to their earlier spending habits, instead maintaining a saving rate much more in line with longer-run historical norms. Corporations have tended to have a reasonably conservative mindset too, putting an emphasis on reducing debt and maintaining high levels of liquidity.

Had they not done that, all other things equal, we would have had lower national saving, a larger ex ante gap between saving and investment, and a larger current account deficit. Interest rates would have been higher and the exchange rate presumably even higher than it was. Some largely non-traded business areas – retailing or real estate or banking – might have enjoyed an even longer period of households gearing up and spending. I conjecture that some other trade-exposed sectors would have had an even harder time than they did have. Moreover, we would, I think, have been more exposed to the effects of the decline in the terms of trade that we are now seeing.

So the more ‘cautious’ or, more accurately, more prudent behaviour of households, together with some genuine caution by many firms, has been a force that has meant that Australia has accommodated a 100-year high in resource investment. Higher saving by the private sector has helped to ‘fund’ the resources investment boom at lower interest rates, and a lower exchange rate, than might have been the case otherwise. I am not convinced we should lament that performance as much as we seem to do.

That is not to deny that, for many areas of the economy, the exchange rate has been ‘too high’ given the level of costs and productivity in place. But realistically, it is the nature of the shock we experienced that certain high cost or low productivity parts of the economy would struggle with the implications of a big rise in the terms of trade.

In fact, I suspect that many sectors would still have struggled even if the exchange rate had not risen. At a 70c dollar, the resources companies would have had even higher expected profits and an even greater ability to bid for labour and capital. Inflation of wages and prices would have been higher, and in the scramble to keep up many of the same companies that have struggled in recent times would still have struggled. Admittedly, higher inflation might have concealed the problems to some extent, since everyone's nominal revenues would have risen faster, but only for a while. In the end, relative prices had shifted and, at any exchange rate, some sectors were going to find that to their advantage and others to their disadvantage. Moreover, taking the inflationary route would have left a much bigger legacy of problems to come home to roost as the resources boom matured.

That said, the exchange rate was somewhat too high for a period. It is no secret that I, for one, have been surprised that the foreign exchange market has taken as long as it has to reflect the fact that the terms of trade peaked some time ago – nearly two years ago, in fact. In the end, though, market-based exchange rates do eventually adjust – and usually in a less disruptive way than those that are maintained artificially. A flexible exchange rate is an important part of adjustment over all phases of the cycle and it remains a major advantage that we have one. If the economy ‘needs’ a lower exchange rate, it will probably get it.

So I would argue that, as we face the undoubted challenges of the decline in resources sector investment, our starting position is in several important respects a better one than we have usually had at this point of previous episodes of this kind.

Still, a starting point is just that. It is understandable, as we go into this phase, that people will ask ‘where will the growth come from?’ The conventional discussion at present has turned its attention to just this question. Not so long ago people were worried that there were no positive spillovers of the boom, or that there were even, in net terms, adverse effects. Some almost seemed to feel that it would have been better if there had never been a boom. Now suddenly people are worried that there were positive spillovers from the boom after all and that their absence or reversal will be disastrous.

The question of where will the growth come from is one that recurs periodically at moments of uncertainty. Twenty years ago there was an almost despairing pessimism about economic prospects in the wake of what was admittedly a pretty big recession. It was thought likely by many observers that unemployment, then in double digits, would remain so for a long time.[2] In fact, as we now know, we were on the cusp of two decades of good economic performance, at the end of which our country's relative standing for economic management would have improved out of sight. Who predicted that?

Moreover, areas of the economy that we often don't think about have proven to be major drivers of – and participants in – that growth. Over the 21 years to mid 2012, real GDP rose by about 100 per cent. Only 3 percentage points of that 100 per cent came from manufacturing. The largest contributions came from financial services (13 percentage points), mining (10 percentage points), construction (9 percentage points), professional services (8 percentage points) and health care (7 percentage points). The number of jobs in the economy has increased by around 50 per cent over the same period, with around two-thirds of this increase attributable to household and business services of various kinds. Within these sectors, health care (around 9 percentage points) and professional services (around 7 percentage points) have made particularly notable contributions.

In other words, most of the time the answer to the question ‘where will the growth come from’ is that only part of it will come from the old traditional areas, and a fair bit of it will come from new things, often things of which we are only dimly aware. That is, in fact, the nature of a dynamic, evolving economy.

Turning to the current conjuncture, it can be observed, in conventional expenditure accounting terms, that some key areas are well placed to expand once they have the confidence to do so. Non-mining business investment, for example, as a share of GDP has been unusually weak – it is not much above its recession lows of the early 1990s. Many companies, rather than extending themselves, have been financially conservative over recent years and are sitting on very substantial sums of cash. It's hard to believe that this configuration will not change at some point over the next few years.

Likewise, dwelling investment has been low for an unusually long period, with at least some households intent on reducing debt, thereby strengthening balance sheets. Households have accumulated a good deal of cash as well over recent years. Meanwhile, population growth is quite solid and it has been picking up a bit of late. If anything, we will need to build more dwellings than we have been over recent years. Meanwhile, interest rates are low, dwellings are more ‘affordable’, and finance approvals for housing purchases have risen by 16 per cent over the past year. So there are ‘fundamentals’ that favour a pick-up in these sectors.

Of course, we have to add two things. The first is that no-one can pretend to be able to fine tune this ‘handover’, to guarantee that the non-resources sectors strengthen, on cue, by just the right amount. We have, in fact, had a few handovers over the past five years – from private demand to public in 2009, then to mining investment subsequently. Now we are looking back to household dwelling spending, non-mining investment (and exports). Previous handovers have occurred, largely successfully. That doesn't guarantee the next one will, though it does mean that we shouldn't assume that it won't occur.

The second thing to say is that much depends on ‘confidence’ – that intangible thing that is hard to measure and very hard to increase. We are talking here about confidence that the future will be characterised by growth, that there will be customers for products, that innovations are worth a try, and so on. That confidence seems pretty subdued right now.

To the extent that subdued animal spirits reflect global issues, which they must to some degree, there is not a great deal we can do about it beyond tending to our own national affairs as diligently as possible.

More generally, while there are various ways policy measures can damage confidence, there is no simple policy lever that can be quickly pulled to improve it. Rather, confidence-enhancing conduct of policy involves having well-established and understood frameworks, and acting consistently with those frameworks over time.

The Reserve Bank, for its part, has a well-established monetary policy framework. Guided by this, we will be able to continue to do our part, consistent with our mandate, to assist the transition in sources of demand that is needed. We cannot fine-tune it – no-one can promise that – but we will do what can reasonably be done.

The conduct of other policies likewise needs to be principled and consistent. Notwithstanding the difficulties of achieving a budget surplus in any particular year, which will always be hostage to what happens in the economy and the vagaries of forecasting, there remains a strong commitment to fiscal responsibility in Australia across both sides of politics, even if there are different views about how to achieve it. The importance of that commitment will, if anything, be heightened in the future, given that significant challenges exist over the medium term in funding government initiatives that the community appears to want.

Consistency in other areas that have a bearing on costs and productivity is also important. My assessment is that at the level of enterprises, efforts to improve productivity have been stepped up under the pressure of the high exchange rate and structural change. But we should still be asking whether there are things in the way of faster improvement. Is the combination of regulatory structures of various kinds – however well-meaning and valid in their own terms – imposing unnecessary and excessive costs of compliance, or creating undue complexity for business?

At a previous presentation in Queensland, when asked about this, I made reference to the Productivity Commission's ‘list’. The list is a substantial one. The good side of that is that there are many things that can be done to foster the improvement in living standards we all seek.

Conclusion

We have continued to live in interesting times. Major challenges have been faced, but significant ones lie ahead. No-one can pretend that things will be simple and easy. But, by the same token, prudent policies, within the right frameworks and coupled with private initiative responding to the right signals, can – if we are prepared to accept their requirements – provide Australians with reasons for confidence about the future.


Endnotes
  1. In addition, that has occurred at a time when in major money-centre jurisdictions we have seen not just the lowest interest rates in decades, but in some cases in five centuries.
  2. With unemployment high, it was regarded as pretty daring when the Reserve Bank released a document called ‘Towards Full Employment’ in 1993, which argued that cyclical recovery could reduce unemployment from 11 per cent at least as far as 8 per cent, after which structural reforms would be more important. It seems we were too conservative.