Australian Government, 2013-14 Budget

Statement 2: Economic Outlook (Continued)

The outlook for the international economy

Global financial market conditions have improved noticeably since late 2012 and global economic activity is expected to gradually strengthen over the forecast period. While acute crisis risks have abated due to policy actions in the United States and Europe, the recovery is fragile and downside risks remain. Many advanced economies face deep‑seated challenges with weak growth, high unemployment and unsustainable public finances. It is likely that the uncertainty surrounding the prospects for a lasting resolution to the euro area's crisis, and the potential for renewed volatility in financial markets, will continue for some time. Growth in a number of advanced economies is also being constrained by their fiscal austerity measures. As such, global growth remains subdued, with the recovery only expected to strengthen noticeably from 2014 onwards.

Global economic growth is expected to gradually improve over the forecast period, as major economies experience a gradual pick‑up in their growth rates. World GDP growth is forecast to be 3¼ per cent in 2013, and 4 per cent in both 2014 and 2015 (Chart 4).

Chart 4: World GDP growth

This chart shows real world GDP growth in year average terms.  Between 1985 and 2012, real global economic growth averaged around 3 ½  per cent. The global economy is forecast to grow by 3 ¼  per cent in 2013, and 4 per cent in 2014 and 2015.

Source: IMF World Economic Outlook April 2013, Thomson Reuters and Treasury.

China's growth outlook remains positive, economic conditions in the United States are looking more encouraging, and the proactive policy stance Japan has taken since late 2012 will help support its growth, especially in the short term. However, the euro area recession has deepened and events in Italy and Cyprus have served as a reminder that the sovereign debt crisis is far from resolved. Unemployment in many advanced economies remains high and a number of these economies (including the United States and Japan) face the challenge of undertaking significant medium‑term fiscal consolidation without undermining their recoveries. In the case of Japan, ensuring a sustainable return to growth will also require an extensive program of structural reform.

The growth of emerging market economies in 2012 was noticeably affected by the knock‑on effects of recessions in Europe and Japan and slow growth in the United States. This was exacerbated by a slowing in domestic demand in some of the emerging market economies, particularly India. Despite the slowdown, growth in emerging Asia has remained relatively robust. The stabilisation in China's growth since mid‑2012 is expected to have continuing spillover benefits to the rest of Asia, as will the improved outlook for the United States.

The economies of Australia's major trading partners are expected to grow at a robust rate over the forecast period, largely reflecting ongoing strong growth in emerging Asian economies. GDP growth in Australia's major trading partners (export weighted) is forecast to be 4½ per cent in 2013 and 4¾ per cent in both 2014 and 2015 (Table 2).

Table 2: International GDP growth forecasts(a)
  Actuals   Forecasts  
  2012   2013 2014 2015
China 7.8   8 7 3/4 7 3/4
India(b) 4.0   5 3/4 6 1/2 6 1/2
Japan 2.0   1 1/4 1 1
United States 2.2   2 2 1/2 2 1/2
Euro area -0.6   - 1/2 1 1 1/2
Other East Asia(c) 3.8   4 1/2 4 3/4 5
Major trading partners 4.1   4 1/2 4 3/4 4 3/4
World 3.2   3 1/4 4 4

(a) World, euro area, and other East Asia growth rates are calculated using GDP weights based on purchasing power parity (PPP), while growth rates for major trading partners are calculated using export weights.

(b) Production‑based measure of GDP.

(c) Other East Asia comprises the Newly Industrialised Economies of Hong Kong, South Korea, Singapore and Taiwan and the Association of Southeast Asian Nations group of five (ASEAN‑5), which comprises Indonesia, Malaysia, the Philippines, Thailand and Vietnam.

Source: National statistical publications, IMF, Thomson Reuters and Treasury.

Economic conditions in China strengthened in the second half of 2012 after the Chinese authorities adopted more accommodative policy settings particularly in relation to credit. Total social financing — a broad measure of new finance activity — surged in the second half of 2012 and has remained strong in 2013. While real activity for the March quarter was weaker than expected given these favourable credit conditions, strong credit growth should provide an increasing impetus to economic activity over the remainder of the year. While this is expected to underpin economic growth of 8 per cent in 2013, a continued muted response in the real economy to the expansive credit conditions would present some downside risk to this forecast.

China's economic growth is expected to ease marginally to 7¾ per cent in both 2014 and 2015, in line with China's evolving medium‑term growth potential. This lower, though still robust rate of growth reflects a view that the Chinese authorities will promote a pattern of economic growth that moves away from the very high rates of investment seen in the past. The prospects for more moderate growth also reflect the fading benefits of past reform and opening‑up policies, and the projected easing in the growth of China's urban labour supply. Despite the expected moderation in Chinese growth, China's economy has grown by more than 40 per cent since 2008, and so China will continue making a very substantial contribution to global growth.

The risks to the outlook beyond the near term centre on the Chinese Government's ability to manage the difficult transition to a more sustainable pattern of growth. This includes addressing the growing pressures from the rapid growth in investment, which has been increasingly tilted towards investment projects with low rates of return. These pressures have seen growing indebtedness among local governments and signs of capital misallocation. Added to these internal risks for China are continued downside risks from the ongoing uncertainty among advanced economies. Nevertheless, the Chinese Government still has sufficient policy space to shelter the economy from any short‑term adverse impacts.

Economic conditions in the euro area have deteriorated further. Forward‑looking indicators for the core economies of Germany and France imply that activity remains weak at best, and the euro area periphery remains in deep recession. Economic sentiment and credit growth remain weak, unemployment continues to reach new euro‑era highs, and ongoing fiscal austerity and private sector deleveraging will continue to drag on growth.

In contrast to the recessionary conditions in the euro area's real economy, the region's financial markets have calmed somewhat in recent months. Nevertheless, recent developments in Cyprus and Italy serve as a clear reminder that risks remain and that the crisis in the euro area is far from resolved. The widespread public reaction in many euro area countries to prolonged fiscal austerity and structural change highlights the large implementation risks the euro area faces to put in place the reforms needed to produce a lasting resolution to the crisis. The initial proposal for the official assistance program for Cyprus contained a levy on all depositors in Cypriot banks, including deposits insured under European law. While the levy on insured depositors was subsequently withdrawn, it still may have undermined confidence across the euro area, and created uncertainty about whether bank depositors in other troubled euro area economies could face similar measures. The eventual bail‑in of uninsured bank depositors in Cyprus, and conflicting views over the design of a banking union, further point to the difficulty of coordinated euro area decision making in implementing the reforms necessary to resolve the crisis.

Given the ongoing deterioration in economic activity, and the range of policy challenges in restoring economic growth, recovery in the euro area is expected to be delayed and weaker than previously anticipated. Euro area GDP is forecast to record its third calendar year of negative growth since the onset of the global financial crisis five years ago, with a contraction of ½ of a percentage point in 2013, before returning to modest growth in 2014 and 2015.

Fiscal issues continue to dominate the outlook in the United States. Congress came to an agreement on 1 January to avoid the majority of the 'fiscal cliff', averting a sharp fiscal tightening that would likely have pushed the economy back into recession. However, automatic expenditure reductions, which were initially delayed to 1 March, were subsequently allowed to be implemented in their entirety and will drag on already subdued growth. The independent non‑partisan Congressional Budget Office estimates that GDP growth in 2013 would be roughly 1½ percentage points faster if not for the fiscal tightening currently being enacted. Accordingly, the United States economy is forecast to grow at 2 per cent in 2013, before picking up to 2½ per cent in both 2014 and 2015.

Abstracting from fiscal policy developments, the United States economy has held up reasonably well, with clear signs of underlying strength in the private sector economy. Private consumption and business investment — which have traditionally been key drivers of growth — have been solid over much of the past year. The housing sector continues to gather momentum with house prices consistently rising over the past year, and construction activity picking up strongly in late 2012. The housing sector could thus provide a welcome upside to growth prospects. A further positive sign is the improvement in the labour market, with employment growth over the past several months being relatively strong.

While the United States is expected to continue its gradual recovery, it faces a key near‑term risk from the need to raise the federal government's legislated debt ceiling. If the debt ceiling is not raised in a timely manner this may trigger a re‑emergence of financial market turbulence and may damage growth prospects for the United States and the global economy. While there have been positive developments in the labour market, unemployment levels are still elevated, and the long‑term unemployed still account for around 40 per cent of total unemployment.

The near‑term outlook for Japan has also become more positive in recent months. The new Japanese Government has brought with it a more flexible approach to fiscal policy. Monetary policy has also become much more stimulatory. The Bank of Japan has announced an aggressive unconventional monetary policy response, with the intention of using asset purchases to double the size of its balance sheet and achieve a new inflation target of 2 per cent within two years. The Bank of Japan's measures aim to put an end to 20 years of deflation and help spur an economic recovery. It will need to be complemented by much‑needed and broad‑ranging structural reforms, with further reforms due to be announced by the Japanese Government mid‑year. The substantial depreciation of the yen over the past several months, while a source of contention, will also support Japan's growth.

India's economy experienced a marked slowdown over the course of 2011 and 2012, reflecting a variety of domestic structural constraints, such as persistently high inflation, and widening fiscal and current account deficits, as well as weaker global growth. While growth in the Indian economy is expected to recover noticeably over the next two years, the extent of the recovery is likely to be impeded somewhat by various supply‑side constraints, which may deter a stronger upswing in investment. A key downside risk to the outlook for India is the country's current account deficit, which could become unsustainable if capital flows reverse under unfavourable global or domestic circumstances.

While a number of Asian economies experienced a slowdown in 2012 due to weaker external conditions, the ASEAN‑5 economies, particularly Indonesia, have continued to record strong growth driven by domestic demand. The highly trade‑exposed Newly Industrialised Economies (NIEs) such as Korea and Taiwan were significantly affected by the subdued global environment in 2012. Looking ahead, the expected pick‑up in global economic activity should see growth in the NIEs rebound over the forecast period.

Overall, forecasts are for a continuation of below‑trend global growth this year before improving to around trend rates in 2014. Risks to the outlook, while more balanced than in 2012, are still tilted to the downside, with the euro area sovereign debt crisis the key risk to the global recovery.

The actions of the European Central Bank (ECB) continue to ease financial pressures in troubled euro area economies. However, on its own the ECB's actions cannot improve the region's medium to long‑term growth prospects. With the euro area's recession deepening, the European populace is increasingly weary of enforced austerity, economic stagnation, very high unemployment and deep structural reforms. The prospects for European governments implementing the measures necessary to resolve the crisis and restore growth remain highly uncertain. While clearly a challenge, further progress will need to be made on achieving a fiscal and banking union and on structural reforms if the euro area is to return to growth. Given ongoing uncertainty about the prospects for such reform, the threat of contagion from the euro area sovereign debt crisis is likely to persist.

With Europe's sovereign debt crisis and the debt ceiling debate in the United States both far from resolved, the current state of relative calm in global financial markets could easily be disrupted. The periodic bouts of financial market volatility since the global financial crisis (Chart 5) are a reminder that confidence remains fragile with significant downside risks to the global economic outlook. With many advanced economies under significant fiscal constraints, and policy actions by major advanced economy central banks already very accommodative and unconventional, there is very limited space to respond to any further negative shocks to the global economy.

Chart 5: Financial market volatility expectations

Chicago Board Options Exchange Market Volatility Index (VIX)

This chart shows market expectation of financial market volatility spiked in during the global financial crisis, and also subsequently in 2010 and 2011. Expectations of volatility have moderated recently.

Note: The VIX shows the market's expectations of volatility in the S&P 500 index over the next 30 days.

Source: Bloomberg.

Indeed, the unconventional monetary policy actions being undertaken may themselves carry risks. The size of the stimulus being implemented by the Bank of Japan, while warranted by circumstances, necessarily involves risks including to financial stability and capital flows. The Bank of Japan is also undertaking this stimulus in an environment of unprecedented levels of Japanese public debt, with the IMF projecting Japan's net public debt to exceed 150 per cent of GDP towards the end of the decade. The Japanese Government needs to put in place an integrated growth package to ensure monetary and fiscal stimulus feeds into sustained improvement in the real economy.

In China, there are risks around how the authorities manage the difficult transition to a new growth model, which will require a formidable set of reforms including to China's financial system and, more broadly, the way in which capital is allocated across the economy. However, so far China has managed the transition reasonably well, and China has a proven capacity to support growth in the event of a more substantial slowdown.

The relative stability of global oil prices since the start of 2013 is consistent with a global outlook that remains relatively subdued in the short term, and with oil supply in both Organisation of Petroleum Exporting Countries (OPEC) and non‑OPEC countries being maintained. However, if political tensions in the Middle East escalate, a sharp rise in oil prices could occur. A significant and sustained oil price shock would pose an additional risk to an already uncertain global economic outlook.

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