The outlook for the domestic economy (continued)
Business investment
Businesses are in a good position to undertake additional investment expenditure. Business profits have been strong across most sectors (especially in mining), capacity utilisation is at high levels and the Australian dollar prices of many investment goods have been falling over recent years.
New business investment is forecast to grow by 6 per cent in 2005-06, and remain at a very high level in real terms, having increased by almost 40 per cent in the three years to 2003‑04 (see Chart 6). However, falling prices for business investment, particularly for imported machinery and equipment, have meant that nominal business investment has remained broadly constant as a share of nominal GDP.
The mining sector has been an important contributor to business investment over recent years. Data from the Australian Bureau of Statistics’ Survey of New Capital Expenditure and Expected Expenditure (CAPEX) shows that mining sector investment has been running above A$2 billion a quarter for more than two years, compared with a little above A$1 billion a quarter at the beginning of the decade. Mining sector investment should remain high for some time yet, given strong world demand for commodities.
Investment in non-dwelling construction is expected to grow by around 2 per cent in both 2004‑05 and 2005-06. These forecast growth rates represent a moderation from the very strong growth in this category in recent years. Increasing commercial office vacancy rates, a slower rate of commencement of new infrastructure projects and increasing prices for steel and cement will restrain growth in non-dwelling construction. Nevertheless, continuing work on a number of large projects, and supportive conditions for business investment more generally, will help to hold non-dwelling construction at its current high levels.
New machinery and equipment investment is also forecast to remain at high levels in 2005‑06 with forecast growth of 7 per cent. The first estimate of investment intentions for equipment, plant and machinery in 2005‑06 from the CAPEX survey was 5.2 per cent higher (in nominal terms) than the equivalent estimate for 2004-05. Initial estimates of investment intentions can provide only a broad indication of likely outcomes. Nevertheless, the CAPEX expectations provide early support for continued strong growth in 2005-06.
Chart 6: Growth in new business investment
Source: ABS Cat. No. 5206.0 and Treasury.
Inventories
Changes in inventories are forecast to contribute ¼ of a percentage point to GDP growth in 2005-06, primarily through growth in private non-farm inventories. Despite a positive contribution to growth from inventories, the inventories to sales ratio is expected to fall further in 2005‑06 as strengthening export growth boosts overall sales.
Farm and public authority inventories (including the inventories of privatised marketing authorities) are expected to fall in 2004-05, following lower grain production in 2004, and then remain broadly unchanged at this level in 2005-06.
Public final demand
Public final demand is forecast to increase by 3¾ per cent in 2005-06, after expected strong growth of 6 per cent in 2004-05. Public investment expenditure has grown strongly over 2004. In 2005-06, growth in public investment expenditure is expected to slow, as is growth in public consumption.
Net exports and the current account
Net exports
Net exports have made a significant detraction from GDP growth over the past three years. Strong growth in gross national expenditure and a high exchange rate have supported import growth in recent years, while export growth has been subdued (see Chart 7). Net exports are expected to detract a further 1 percentage point from GDP growth in 2005-06, an improvement from previous years.
A number of shocks to the economy in the first half of this decade have acted to constrain export growth. The 2002‑03 drought and subsequent dry weather conditions affected rural exports, the slowdown in the world economy in 2001 and 2002 weighed on manufactured and service exports, and various health and security concerns have affected international travel and business. The increase in the exchange rate since 2002 has also reduced the price competitiveness of Australian exports.
In volume terms, export growth still remains below what could be expected for this stage of the world economic cycle. An important part of the explanation for this relatively weak growth in export volumes is the long lead times on investment in the mining sector (see Box 2). Around A$20 billion has been invested in new production and transportation capacity in the mining sector over the past two years alone, but non‑rural commodity export volumes have remained broadly flat.
Chart 7: Growth in exports
Source: ABS Cat. No. 5206.0 and Treasury.
Box 2: Mining capacity constraints |
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| Global demand for commodities has increased more than expected over recent years, while resource production has increased only modestly. As a result, commodity prices have increased dramatically. Chart A: Commodity prices and Australian mining investment
Source: ABS Cat. No. 5204.0 and RBA (original data). The limited initial supply response reflects the large fixed costs inherent in mining projects. These costs mean that mining operations and supply chains are most profitable when operating close to capacity. Hence, there is often little spare capacity to meet an unexpected increase in demand. Australian mining investment has surged following the increase in commodity prices since 2000 (Chart A). The resulting increase in output has already begun to lift export volumes (Chart B). There is still further productive capacity to come on stream, with resource exports expected to increase by a further 15 per cent by June 2006. |
Chart B: Iron ore and coal export volumes
Source: Unpublished ABS data and Treasury (original data). Some infrastructure constraints emerged as mining output increased. In vertically-integrated production and transport chains, such as in the iron ore and liquefied natural gas industries, these constraints are being addressed in tandem with increases in output. In cases where ownership of the production and transport chain is more fragmented, such as in the coal industry, infrastructure investment has tended to lag increases in production, leading to some bottlenecks. Strong global demand and sustained high prices will encourage an increased supply of resources from Australia and the rest of the world. The interplay between rising global demand and supply makes predicting the future course of commodity prices particularly difficult. However, the mining sector is likely to be a significant contributor to national income in coming years. |
The additional production flowing from new investment in parts of the mining sector has so far been outweighed by falling production for other commodities. Production in some of Australia’s mature oil fields off Western Australia and in Bass Strait, for example, has fallen sharply over the past two years. This situation is expected to be redressed to some degree in 2005‑06 as a significant expansion of capacity in areas such as liquefied natural gas and iron ore is brought into production.
After growing strongly in the late 1990s, export volumes for rural goods have not grown over the first half of this decade. The 2002‑03 drought had a major impact on rural production. Grain production recovered strongly in 2003, but fell slightly in 2004. The production of livestock and some water-intensive crops has still not fully recovered from the drought. On the assumption of average seasonal conditions, rural exports are forecast to grow modestly in 2005-06.
Manufactured exports have grown more strongly, on average, than commodity exports in recent years. However, manufactured export growth has still been considerably below the average rate recorded through the 1990s. The maturing of some of Australia’s manufactured export industries and the upward movement in the exchange rate since late 2001 explain some of this slowdown. The increasing quality and diversity of the goods produced by some newly industrialising countries, such as China, is also leading to increased competition and significant movements in the prices of some internationally-traded manufactured goods. It is difficult to predict precisely how Australia’s exporters of manufactured goods will respond to these challenges, but a modest strengthening in manufactured export growth is expected in 2005-06.
Service exports have been broadly flat in recent years, partly reflecting the impact of a rising exchange rate and health and security concerns for international travel. Growth in service exports is expected to strengthen in 2005‑06 in response to favourable world economic conditions.
Growth in imports is forecast to be 8 per cent in 2005-06, marginally slower than in 2004-05. Falling import prices and strong growth in all of the components of gross national expenditure have supported import growth in recent years. Slower growth in gross national expenditure over the forecast period will contribute to slower import growth.
The terms of trade
The terms of trade are expected to increase substantially in 2005-06, largely reflecting the convergence of strong world demand for commodities and relatively low growth in commodity supply. The exchange rate is broadly unchanged from the start of 2004, so the recent prices received for commodities in Australian dollars have generally tracked the price movements on world markets (usually expressed in US dollars). Continuing falls in import prices are also expected to support growth in the terms of trade.
In 2005-06, the terms of trade are forecast to increase by 12¼ per cent, after growth of 7.0 per cent in 2003‑04 and expected growth of 9¾ per cent in 2004-05. This exceptional period of growth will take Australia’s terms of trade to their highest level in 50 years.
In the late 1990s, the world supply of commodities grew strongly. Uncertainty around world economic developments, particularly following the Asian financial crisis in 1997, saw commodity prices fall to their lowest level in more than two decades in US dollar terms. This led commodity producers to reduce their investment in new capacity, notwithstanding the structural increase in global demand associated with the rapid growth in China and elsewhere. The sentiment of the time was reflected in the very strong interest in ‘new economy’ industries at the expense of ‘old economy’ industries such as mining.
Demand for commodities was relatively subdued in the following years, with most of the world’s economies entering a period of subdued growth in 2001 and 2002. But some economies, most notably that of China, continued to grow strongly and increase their demand for commodities throughout these years. As the United States and, to a lesser extent, the rest of the world entered a period of stronger economic growth in 2003 and 2004, the demand for commodities quickly outstripped supply. As a result, commodity prices began to increase sharply.
Australia has benefited from these strong increases in world commodity prices and this is evident in the higher terms of trade. The prices for coal and iron ore, in particular, have increased substantially in recent rounds of contract negotiations with Japanese and Chinese buyers (see Box 3).
It seems unlikely that world commodity prices will be sustained at these levels indefinitely because the present high prices substantially exceed the cost of new production. Consequently, a large amount of investment in mining projects is already underway around the world, including in Australia. Continuing high commodity prices will encourage more investment. While the planning and construction lead times on mining projects are typically very long, meaning that supply responses typically lag demand changes, it is likely that the world supply of commodities will increase in 2005‑06 and future years. For example, over the next three years, world production of iron ore is expected to increase by around 20 per cent.
An increasing world supply of commodities should place downward pressure on commodity prices over time. The timing and extent of any such price adjustment is very difficult to predict. Since contract prices are typically struck before the beginning of the Japanese financial year on 1 April, any substantial adjustment is unlikely to occur before the June quarter 2006. However, there is a risk that Australia’s terms of trade will fall over the medium term from their historical highs in 2005-06. This, in turn, carries significant implications for the budget projections for 2006‑07 and beyond, particularly with respect to company tax collections from the mining sector. See Box 7 for a discussion of commodity prices and the budget projections.
Box 3: Booming commodity prices |
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| Recent contract negotiations have locked in strong US dollar price increases in 2005 for some of Australia’s key bulk commodity exports. In particular, hard coking coal prices are up by 120 per cent, iron ore prices are up by 70 per cent and steaming coal prices are up by 20 per cent. Largely because of these export price increases, the terms of trade are expected to increase by 12¼ per cent in 2005-06, to be at their highest level in 50 years (Chart A). Chart A: Terms of trade
Source: ABS Cat. No. 5302.0 and Treasury. Assuming no change in the exchange rate, these commodity price increases will add approximately 2 per cent to nominal GDP in 2005-06. This additional income will benefit a number of sectors in the economy. |
Mining companies will receive higher revenue, boosting their profits. Mining company shareholders (including superannuation funds) will also benefit, either from higher dividend payments or, if companies retain their earnings, stronger capital gains. Higher prices, if sustained, will also support higher capacity utilisation and stronger investment in the mining industry with the effect of boosting production and exports. As a result, suppliers of goods and services to the mining industry will also benefit from stronger earnings. Although the mining sector is not labour intensive, employment may also increase modestly. Governments will also benefit from higher royalties and company taxation. Higher commodity prices are expected to reduce the trade deficit by around 2 per cent of GDP. However, foreign investors in the Australian mining sector will receive some of the income generated by the higher commodity prices. Higher dividend payments and repatriated earnings of foreign investors are expected to widen the net income deficit component of the current account by around 1 per cent of GDP. Thus, the increase in the net income deficit will partially offset the reduction in the trade deficit, with the overall current account deficit reduced by around 1 per cent of GDP. |
The current account
The current account deficit (CAD) has remained relatively high as a proportion of GDP in recent years, largely reflecting an increase in the trade deficit since 2001‑02 (see Chart 8). As discussed in the net export section, export growth has been subdued in recent years, while import growth has remained robust, in line with strong growth in gross national expenditure. Australia’s CAD is financed by an offsetting capital account surplus, the components of which are examined in Box 4.
An important influence on movements in the CAD over the forecast period will be the boom in commodity export prices. The net income deficit will increase as higher export prices result in higher profits being paid to foreign investors in the Australian mining sector, but this will be offset by the positive impact of higher prices on the trade deficit.
Chart 8: Current account balance
Source: ABS Cat. No. 5302.0, 5206.0 and Treasury.
The CAD is forecast to narrow to 5¼ per cent of GDP in 2005‑06 from an expected 6½ per cent of GDP in 2004-05. Higher commodity prices will contribute to this improvement in the CAD (see Box 3).
| The balance of payments consists of the current account (goods, services and income transactions between Australia and the rest of the world) and the capital account (flows of funds between Australia and the rest of the world that are required to finance current account transactions). A country that invests more than it saves records a current account deficit (CAD). This is financed by an inflow of funds from the rest of the world, which is recorded as a capital account surplus. The net lending framework decomposes the economy’s financing requirements between the household, corporate and public sectors. The net lending framework for Australia is presented in Chart A. Negative figures indicate a requirement to borrow from other sectors or from the rest of the world. Since 1996-97, the government sector has become a small net lender on average, making a positive direct contribution to the current account balance. Private corporations have also become small net lenders in recent years, as companies have funded investment from profits rather than borrowings. Almost all of the recent increase in the CAD is attributable to the household sector. In other words, households have been borrowing from other sectors and, ultimately, from the rest of the world, via the banking system. |
Chart A: Net Lending
Source: ABS Cat. No. 5204.0, 5302.0 and Treasury (original data). |
Box 4: The balance of payments and net lending (continued) |
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The increase in households’ net borrowing is partly a result of higher household wealth (from higher house prices), leading households to invest more and save less. Higher investment and lower saving is also a response to a more stable and resilient economy with sustained employment growth and low inflation. In a stable economy, households may choose to hold a lower level of precautionary savings than in a volatile economy. |
In addition, deregulation of financial markets, combined with low inflation, has lowered borrowing costs. This has allowed households greater flexibility to spread their consumption and investment decisions over time. The outlook for 2005‑06 is for GDP growth to rebalance away from domestic to external sources. Accordingly, while the corporate and government sectors are expected to remain net lenders, the household sector’s net borrowing is expected to decrease in line with easing dwelling investment and consumption. |