This statement presents the economic forecasts that underlie the budget estimates.
The Australian economy has remained resilient over the past year despite a weak world economy and the most extensive drought in Australian meteorological records. While the economy should continue to grow in 2003-04, the pace is likely to be a little below trend. Non-farm economic growth is expected to slow, although a rebound in farm production is likely to boost overall economic growth if the drought breaks. Solid employment growth should see the unemployment rate remain around current levels and inflation is forecast to decline to around the middle of the 2-3 per cent target band. World economic growth is likely to remain weak in the near term, although a subdued recovery is in prospect in 2004. Nonetheless, there is still a substantial possibility of a further deterioration in global conditions, which poses a significant downside risk to the domestic outlook.
In 2002-03, economic growth in Australia is forecast to be 3 per cent in year-average terms, unchanged from the forecast presented in the Mid-Year Economic and Fiscal Outlook 2002-03 (MYEFO). Despite the drought, the Australian economy has been one of the developed world's top-performing economies over the past year.
In 2003-04, economic growth is forecast to be 3¼ per cent in year-average terms, with slower growth in non-farm production likely to be more than offset by a rebound in farm production. Employment growth is likely to slow, after very strong growth in 2002-03, with the unemployment rate remaining around 6 per cent over the coming year. Inflation is forecast to decline to around the middle of the target band. The current account deficit (CAD) as a share of GDP should narrow a little as the pace of domestic demand eases and global conditions gradually improve through the year.
The forecast slowdown in non-farm production growth in 2003-04 follows a period of robust growth. Despite weakness elsewhere in the world, non-farm GDP grew by nearly 4 per cent through the year to the December quarter 2002, with strong growth in domestic demand, particularly investment spending, offsetting weak external demand. Growth in consumption and business investment is likely to ease a little over the next year while dwelling investment is expected to contract. Nevertheless, still-solid growth in domestic demand and a gradual recovery in external demand should underpin solid growth in the non-farm economy.
The expected rebound in farm production should provide a boost to overall economic growth in 2003-04. Although the farm sector typically produces around 3 per cent of the economy's output, production should increase substantially if the drought breaks. The drought is estimated to have directly reduced economic growth by nearly 1 percentage point in 2002-03. If rural conditions improve, the recovery in farm production should contribute around ½ to ¾ of a percentage point to economic growth in 2003-04.
Despite the positive domestic outlook, the performance of the Australian economy over the next year will be heavily influenced by international developments. After a protracted period of weakness, and despite substantial policy stimulus, a sustained global recovery has not yet taken hold. The most likely outcome is a gradual improvement in the global economy with world growth expected to be around 3 per cent in 2003, rising to around 3½ per cent in 2004. Trading partner growth is expected to be around 2½ per cent in 2003 and 3 per cent in 2004.
Tempering this outlook, however, is a confluence of pre-existing, and some new, downside risks to the international economic outlook. There are economic risks around growth prospects for the major economies, and financial risks around financial systems in Japan and Europe and financial markets more generally. On top of this there are geopolitical risks around the situation in the Middle East and North Asia and, more recently, risks associated with the spread of Severe Acute Respiratory Syndrome (SARS). While conditions may improve quickly once some of the current uncertainty dissipates, many of the pre-existing international risks will remain. Many of these risks are due to deep-seated structural problems in the major economies, so it is likely that it will take some time before they abate. Until then, they cloud an otherwise healthy outlook for the Australian economy.
Domestically, the outlook continues to be underpinned by solid, albeit moderating, domestic demand. Household consumption looks set to grow solidly, although slower than over the past year. Solid employment growth and real wage increases should continue to support household income growth. Incomes in rural areas, which declined sharply in 2002-03, should rebound in the coming year. Strong increases in wealth in recent years, easier access to finance and low interest rates should provide additional support for household spending. However, the pace of wealth accumulation and household borrowing, which has supported strong consumption growth, is expected to slow after the rapid expansion during the past few years.
Dwelling investment is expected to weaken in 2003-04 following a period of strong growth. While the low interest rate environment remains supportive of dwelling construction, oversupply in some markets and easing expectations of capital gains from housing investment should see a return to more sustainable levels of dwelling construction activity over the coming year. Spending on alterations and additions should partially offset some of the decline. An expected easing in capacity constraints in the building industry should allow pent-up demand for renovations to be met.
The outlook for business investment remains positive, although ongoing global uncertainty has tempered the outlook. Balance sheets are generally sound, profitability and cash flows are solid, interest rates are low and, despite recent falls, confidence has held up well against the unsettled global backdrop. Investment has been subdued over the past few years and relatively high levels of capacity utilisation now point to the need for further investment to meet increased demand. Business costs have increased in recent months with the run-up in oil prices. However, other cost pressures, including wages, generally remain contained, underpinning healthy rates of return.
Although investment intentions have eased a little in recent months, businesses still plan a solid increase in plant and equipment investment in 2003-04. The outlook for non-dwelling buildings and structures investment is very strong with several large investment projects now underway or ready to commence. Notwithstanding this, business investment is likely to be sensitive to global economic developments and the level of uncertainty surrounding the outlook. Further deterioration in the international environment could see investment plans downgraded.
Export growth should pick up in 2003-04, underpinned by continued, albeit weak, economic growth in Australia's major trading partners and a rebound in rural exports in line with the expected recovery in rural conditions. Import growth is likely to remain solid next year, but should slow as domestic demand growth moderates. Net exports are forecast to subtract ¼ of a percentage point from growth in 2003-04, after subtracting around 2¾ percentage points in 2002-03. Despite weak export prices, the terms of trade is likely to continue to rise, benefiting from falling prices of imported manufactured goods, including information and communication technology goods.
The current account deficit as a share of GDP is forecast to narrow marginally in 2003-04, following substantial widening in 2002-03. Stronger export growth, slightly slower import growth and an expected increase in the terms of trade should underpin the narrowing. Nevertheless, with the Australian economy expected to continue to grow solidly in the face of weak global conditions, the current account deficit is likely to remain at relatively high levels for another year.
The outlook for inflation remains moderate, with the CPI forecast to increase by 2¼ per cent through the year to the June quarter 2004. With wage increases expected to remain steady and productivity growth solid, labour costs should remain subdued. Global weakness also should help contain inflation pressures. With temporary price pressures from the run-up in oil prices and the drought, headline inflation is expected to remain at around the top of the target band in the near-term. However, domestic demand growth is slowing and underlying price pressures are subdued. Together with the recent appreciation of the exchange rate and expected lower oil prices in coming months, this should see inflation decline to around the middle of the medium-term target band by the end of 2003-04.
Employment growth is expected to slow in 2003-04, following very strong growth in 2002-03. Slower employment growth is expected in the retail sector and in the labour-intensive construction industries, where employment growth has surged over the past year. Rural employment should slowly recover if the drought breaks. The unemployment rate is forecast to average around 6 per cent in the June quarter 2003 and remain around that level over the next year.
Uncertainties surrounding the outlook have increased since MYEFO, particularly on the international front. Increased uncertainty and risk aversion have exacerbated underlying structural risks around an already weak and fragile global economy and financial markets. This has increased their vulnerability to further shocks. It is possible that global uncertainty will quickly dissipate and that the substantial policy stimulus in place in the US and elsewhere will see a substantial global recovery sooner than currently expected, providing a fillip for the Australian economy. On balance, though, the bulk of the international risk is on the downside.
Domestically, the risks are more balanced, although the possibility of adverse external developments coming on top of a slowing non-farm domestic economy provides a sombre backdrop to the outlook. Consumption remains robust, but any sustained deterioration in sentiment or a protracted period of slower growth in income or wealth could cause spending growth to slow as households move to consolidate their financial position. Dwelling investment also could decline more sharply than expected if the economic climate deteriorates and investors adopt a more conservative investment position. Business investment and employment are particularly sensitive to global and domestic economic developments and to the level of uncertainty surrounding the outlook.
Export growth could be weaker than expected if global growth falters, the exchange rate appreciates further, or other factors, such as health and security concerns, adversely affect global trade. It is also possible that the drought will not break evenly. Large parts of the country are still experiencing severe drought conditions and the timing, extent and pattern of the rainfall may not allow the expected recovery in farm production this year.
On the upside, the economy has already successfully weathered a protracted global slowdown, the drought and war in Iraq. Income growth is solid and wealth has continued to rise, despite the long downward adjustment in equity markets. Households and businesses have looked through some of the current uncertainties and have continued to consume and invest solidly. If a solid cyclical global recovery takes hold, structural problems notwithstanding, and the drought breaks as appears likely, the economy could grow strongly next year. In addition low interest rates could moderate the downturn in dwelling investment. If low inflation and low interest rates are further capitalised into house prices, wealth accumulation could provide further support for consumption. Petrol prices, which have been a drag on the economy this year, could fall significantly, also boosting economic growth. Together, these factors provide some upside possibility to the otherwise predominantly downside risk.
On balance, with solid fundamentals and supportive policy settings, the most likely outcome is that Australia's economy will continue to grow solidly despite the weak international backdrop, particularly if a gradual world recovery proceeds as expected. Nevertheless, the real and significant risks to Australia's growth prospects should not be discounted.
Table 1: Domestic economy forecasts(a)
- Percentage change on previous year unless otherwise indicated.
- Calculated using original data.
- Chain volume measure.
- Excluding transfers of second-hand asset sales from the public sector to the private sector.
- Percentage point contribution to growth in GDP.
- For presentational purposes, forecast changes in inventories held by privatised marketing authorities are included with the inventories of the farm sector and public marketing authorities.
- The estimate in the final column is the forecast level in the June quarter 2004.
- Average non-farm compensation of employees (national accounts basis).
Source: Australian Bureau of Statistics (ABS) Cat. No. 5206.0, 5302.0, 6202.0, 6401.0, unpublished ABS data & Treasury.