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Australia: Outperforming the Global Economic Recovery?

By Jim Johnson

On the face of it, international conditions couldn’t be much worse for Australia’s economy. The global economy was already mired in a rare synchronous recession when terrorist attacks on the U.S. dealt a blow to business and consumer confidence worldwide. Japan, Australia’s largest trading partner, is now in the midst of its third technical recession in the last decade. The slowdown and the additional injection of uncertainty have put further downward pressure on the prices and volumes of several of Australia’s commodity exports, and caused the Australian dollar to temporarily slump to new lows on trade-weighted basis.

As was the case in 1998, however, when the Asian economic crisis led to widespread discounting of Australia’s economic prospects, we think its performance will prove more resilient than the consensus of current forecasts. In fact, were it not for the global economy’s malaise, we’ve little doubt that Australia would be seeing quite robust growth in 2002.

Can Australia avoid recession? We’re confident it will. The downside risks to Australia’s performance in 2002 stem primarily from global economic forces. We expect these forces will slow Australia’s growth in 1H02, but not cause an economic contraction. Here’s why.

First, Australia’s momentum in 2001 was considerable: its economy expanded at a 4% pace in the first three quarters of 2001, compared to a flat performance from the U.S. and growth of 1% in the Euro Area. While the economy will likely slow in the first half of 2002 (to perhaps a 1% to 2% annualized rate), we doubt that even a significant decline in export volumes would be sufficient to offset this domestic momentum.

Recent history supports this view: Australia weathered a much more serious decline in its exports volumes during the Asian economic crisis of mid-1997 to early 1999 with real growth averaging 4.7% over that period. Moreover, that global slump centered on Asia, the destination of much of Australia’s exports, whereas the current weakness is centered in the U.S., where Australia sends only about 10% of its exports.

Can this domestic momentum continue? Although there’s some risk that a prolonged global slump could erode the domestic outlook if the labor market weakens substantially, the latest data on investment intentions, consumer confidence, and credit growth suggests that the economy is still in good shape. Businesses have revised up substantially their planned investment spending for 2001-02 in the two latest surveys, suggestive of about a 6% expansion in nominal terms from the prior year. The Westpac/Melbourne Institute survey of consumer confidence rose 3.4% in November, partly offsetting its 9% fall in October. The rebound is all the more remarkable since the survey was conducted just prior to the Federal election and just after news of a sharp rise in the jobless rate. RBA credit measures have shown bank lending to be growing at still healthy clip, underpinned by housing finances. While the housing boom is expected to wane over the coming year -- presenting some downside risks to growth -- we do not expect a substantial fall.

In addition to growth momentum, we also see the value of the currency and the stance of monetary policy supporting the economy’s continued expansion. The Australian dollar was at extremely competitive valuations in early 2001, and remains so today despite a significant widening in interest rate differentials in favor of the $A. Policy interest rates, for example, are currently 250 bp higher in Australia than in the U.S. (they were 25bp lower in Australia at the start of the year). Despite that, the $A/USD exchange rate remains 6.5% below its average level in December 2000, while the trade-weighted A$ index is off 2.1% over the same period.

The Reserve Bank has been well aware of the risks that the global slump posed for Australia in 2001. The RBA has been easing policy since February 2001, paring its Cash Rate by a cumulative 200 bp, including two 25-bp cuts since the events of 11-September. Likely the RBA will make at least one more 25-bp move in 1Q in response to the global economic outlook. With inflation at the mid-point of the RBA’s 2% to 3% in the September quarter, it seems a safe assumption that the RBA will remain focused on the downside risks to growth emanating from the U.S. and Japan.

Not only do we believe that Australia will avoid recession in 2002, but there’s a good chance that its currency and financial markets will outperform those of other industrialized nations in the recovery that is widely expected in 2H02.

Although there may be additional volatility in 1H2002 (until the global recovery becomes more certain), the Australian dollar should be supported by three significant factors in the medium-term: interest rate differentials, Australia’s better performance on growth (both in the year to date and, we assume, in 2002), and the continued improvement in its terms of trade. That last factor, which has been boosting Australia’s national income since 1999, is a function of the continued decline in the prices of manufactured goods, particularly high-technology items. The slide in information, communications and technology equipment prices has helped to restrain the upward price pressure on imports overall that has come in the wake of the currency’s depreciation. As a result, the implicit price deflator for Australia’s basket of imports has risen by less than that of its exports, yielding a rise in its national income (and standard of living). This experience is a sharp departure from the nation’s experience during the Asian economic crisis, when Australia’s terms of trade fell sharply with the slide in commodity prices. Looking ahead, while a global recovery holds the prospect of a cyclical improvement in Australia’s export prices, the same can’t be said for prices of manufactured goods — particularly technology items.

Longer term, the Australian dollar’s prospects are quite good. In a speech delivered in late November, David Gruen of the RBA’s Economic Research Department made a compelling case for the long-term outlook for the Australian dollar (the speech is available on the RBA’s website, www.rba.gov.au). Dr Gruen argued that the forces that have brought about the decades-long trend decline in the currency should be abating in the years ahead. He cites the RBA’s commitment to inflation targeting, the improvement in the nation’s terms of trade, its labor productivity growth, and the stabilization in its ratio of foreign liabilities to GDP as factors which should arrest if not reverse the trend decline in the various measures of Australia’s exchange rate.

To conclude, while we can’t rule out the possibility that the global economic slump will get worse before it gets better, Australia’s prospects remain better than that of just about any other industrialized nation. With the currency at competitive levels and monetary policy likely to remain accommodative, Australia is poised to outperform in the global economic recovery.