Statement 2 (continued)
Key influences affecting the outlook
The Australian economy is going through an extraordinary period of transition, with investment in resources projects shifting from being the key driver of growth towards becoming a significant detractor from growth. The fall in investment, which is expected to happen alongside a further decline in the terms of trade, will lead to a reversal of the substantial shift of labour and capital into the resources sector that has taken place since the beginning of the investment phase.
These influences on the Australian economy are expected to persist for some time. The substantial decline in resources investment is forecast to continue through until at least 2015‑16, while the decline in the terms of trade will likely last longer still. Further complicating the growth outlook is the need to pursue a prudent approach to Australia's fiscal situation over the years ahead in order to help manage the impact of the ageing population and build the capacity to respond to future global shocks.
That said, the economy is forecast to grow only slightly below trend (Chart 1). The household sector is responding to historically low interest rates and wage flexibility is supporting employment growth. The fall in the exchange rate over 2013 is also helping, although further falls would help support the necessary rebalancing of the economy.
Source: ABS cat. no. 5206.0 and Treasury.
Household sector responding to low interest rates
There are clear signs that the household sector is responding to low interest rates. Dwelling sector indicators uniformly point to a pickup in activity, suggesting construction will gain momentum in the near term (Charts 2 and 3), while household consumption is being boosted by recent improvements in wealth. These developments have contributed to an improved outlook for the household sector at a time when household income is being restrained by the soft labour market.
The housing sector is beginning to respond to lower interest rates with a pickup in prices and leading indicators of construction. Rising dwelling prices in mid‑2013 were one of the first signs that the dwelling sector was responding to low interest rates, while leading indicators of dwelling construction began to rise around the same time as the sector responded to the improved returns available from building.
Dwelling investment is yet to reflect the strength in leading indicators, growing by only 1.4 per cent through the year to the December quarter 2013. Liaison suggests this sluggish response is most likely due to the increasing proportion of approvals in medium‑ and high‑density dwellings, which are more complex projects to manage and take longer to plan and complete. This suggests dwelling investment should rise strongly over the near term.
Dwelling investment is forecast to grow by 7½ per cent in 2014‑15 and 5½ per cent in 2015‑16.
The increase in dwelling prices since mid‑2013 has coincided with higher equity prices and generated an 11 per cent rise in household wealth over the year to the December quarter 2013. Rising wealth has encouraged consumption to grow more rapidly than household income, with the (trend) household saving ratio falling from a peak in 2012 near 12 per cent to its current level of around 10 per cent.
Household income is expected to grow more slowly than average over the forecast period, reflecting moderate employment growth and subdued wage growth. However, further gains in household wealth are expected to support a further modest decline in the saving ratio, enabling consumption to grow faster than income.
Notwithstanding this anticipated decline, the saving ratio is expected to remain well above the levels seen in the decade before the financial crisis, which were a reflection of a prolonged period of rising household borrowings. After the crisis, households reduced their demand and appetite for credit, leading to a sharp step‑up in the household saving ratio and a marked slowing in household credit growth. Developments in household consumption will be heavily influenced by how these factors change during the prospective period of moderate income growth.
Household consumption is forecast to grow by 3 per cent in 2014‑15 and 3¼ per cent in 2015‑16.
The resources boom transitioning between phases
Investment in resources projects has passed its peak and is expected to detract significantly from growth over the next three years (Charts 4 and 5). While there is some confidence about the size of the decline in resources investment, the precise timing of the fall remains less certain. The size of the fall is more predictable because of the small number of large Liquefied Natural Gas (LNG) projects that are underpinning the current resources investment profile, and the construction lead time associated with, and the small number and size of, any other projects that might be undertaken in the near term.
Note: Treasury's major resources projects profile is the sum of spending on existing and planned resources projects greater than $2 billion, weighted by their probability of going ahead.
Non‑resources businesses are waiting before investing
Investment by non‑resources businesses remains subdued. While interest rates remain low and business confidence is higher than it was a year ago, conditions remain difficult, as reflected in low levels of capacity utilisation and business surveys. Not surprisingly, given these circumstances, the latest CAPEX data point to only a modest increase in investment in 2014‑15. This is consistent with reports from Treasury's business liaison which suggests firms are reluctant to invest until they have a clearer sense that demand is improving.
The scale and timing of the anticipated recovery in non‑resources business investment is the predominant source of uncertainty affecting the outlook. Consistent with the CAPEX data, the outlook for 2014‑15 remains subdued, with growth likely again to be below trend. However, there are some positive signs including a rise in approvals for non‑residential building over 2013. Non‑resources investment is forecast to pick up in 2015‑16 as firms start to respond to improving demand and existing levels of spare capacity are absorbed, with GDP growth returning towards trend (Chart 5).
Source: ABS cat. no. 5204.0, 5206.0 and Treasury.
Overall new private business investment is forecast to fall by 5½ per cent in 2014‑15 and 3½ per cent in 2015‑16. The fall in resources investment is reflected in the forecast for new engineering construction, which is expected to fall by 13 per cent in 2014‑15 and 20½ per cent in 2015‑16. The recovery in non‑resources investment has influenced the forecast for new non‑residential building investment, which is expected to remain flat in 2014‑15 and grow by 5 per cent in 2015‑16, and the forecast for new machinery and equipment investment, which is expected to fall by 2 per cent in 2014‑15 and grow by 7 per cent in 2015‑16.
Resources exports continue to grow
The strong rise in resources exports over recent years is expected to continue over the forecast period as capacity in the resources sector continues to come on stream. The volume of non‑rural commodity exports is forecast to grow by 8 per cent in 2014‑15 and 9½ per cent in 2015‑16.
Large expansions in iron ore infrastructure are mainly complete and production will build up to designed capacity over the next two years. Coal export volumes are also expected to rise, although both metallurgical and thermal coal producers are under pressure from low prices and higher costs which saw Australian producers move from predominantly the bottom half of the global cost curve to the top half over the past five years. Impediments to driving down costs will exacerbate the pressure associated with weak prices and could result in mine closures and job losses.
To date, coal mine closures have been limited, with many producers bound by contractual arrangements with infrastructure providers that require some payment for transport regardless of the volume of coal actually transported. Under these arrangements, many producers are maximising their production to reduce average unit costs. This situation raises uncertainty around the outlook for coal exports, particularly if price weakness continues and as contracts with infrastructure providers expire.
Exports of LNG are expected to grow significantly by 2015‑16 as the more advanced LNG projects begin production. By 2015‑16, the value of LNG exports is expected to be roughly double its current level. This would see it surpass both thermal and metallurgical coal, currently Australia's second and third largest exports by value. Continued robust growth is also expected beyond the forecast years as additional projects come online, with Australia likely to overtake Qatar to become the world's largest LNG exporter before the end of the decade.
While these projects are already in the construction phase, considerable uncertainty remains over exactly when they will begin exporting, and how quickly they can ramp up to full capacity. A number of projects have already experienced cost overruns and have delayed expected start‑up dates. The unique properties of individual gas fields and technological differences between conventional and unconventional gas extraction will also likely affect gas flow rates and the ability to reach the project's stated capacity.
Projects that fail to meet their production targets may need to purchase gas from established gas sources, either in Australia or overseas, to meet contractual obligations to foreign customers. Shortfalls are most likely to occur on the East Coast gas network, which will have implications for domestic gas users in the form of higher prices and more difficulty in securing long‑term supply agreements. Restrictions on the spread of new gas extraction technologies are likely to make this problem more acute.
Notwithstanding significant drought in Queensland, New South Wales and parts of South Australia and Victoria, rural exports are forecast to decline only marginally in 2014‑15. Exports are expected to recover in 2015‑16, assuming a return to average seasonal conditions.
The depreciation of the exchange rate over 2013 has created better conditions for exporters, but the exchange rate remains high by historical standards. This strength stands in sharp contrast to the historical tendency of the exchange rate to move together with the terms of trade. Exporters will benefit from the improved outlook for growth in our major trading partners. The already lower exchange rate is likely to support modest growth in non‑commodity goods exports, which are forecast to rise by 3 per cent in 2014‑15 and 3½ per cent in 2015‑16. Services exports improved over 2012‑13, ending a period of weakness that began around the financial crisis, buoyed by higher tourism arrivals, particularly from China and South‑East Asia, a trend that is expected to continue. Services exports are forecast to grow by 3 per cent in both 2014‑15 and 2015‑16.
Total exports are forecast to increase by 5½ per cent in 2014‑15 and 7 per cent in 2015‑16.
Over the forecast period, imports of capital goods are expected to decline as construction on LNG projects winds down. Imports of consumption goods are forecast to grow reflecting near trend consumption growth and the elevated exchange rate, but at more moderate rates than the average of the previous decade. Total imports are forecast to grow by 2 per cent in 2014‑15 and 2½ per cent in 2015‑16.
The terms of trade are expected to continue to decline
After holding up during the second half of 2013, iron ore and coal prices have fallen sharply since the beginning of 2014. The decline has been due to weaker demand for steel, a period of negative sentiment around China's economic growth prospects, as well as rising global supply, in particular due to recently built capacity coming on line from Australia.
Iron ore prices are expected to fall further in 2014‑15 and 2015‑16, reflecting further growth in global supply and slower growth in demand for steel. Metallurgical coal prices are expected to rise slightly over the forecast period as global supply growth slows, while thermal coal prices are forecast to remain stable (Charts 6 and 7).
LNG export prices are expected to increase over the forecast period as the new contracts associated with projects that are starting up come into force. As most LNG contract prices are tied to global oil prices, there is some uncertainty over future price movements. Global supply developments, particularly the potential for gas exports from the United States, will also have important implications for global gas prices. While this is unlikely to have a large impact on current LNG projects, which have long‑term contractual arrangements, additional US supply to the Asia‑Pacific region would affect the feasibility of new or expanded operations in Australia.
Over the longer term, it is also possible that LNG exports from the US may be directed across the Atlantic, given a renewed focus on energy security in Europe following events in Ukraine. This would reduce potential supply in the Asia‑Pacific and could support prices in the region.
The weak outlook for commodity export prices is consistent with the medium‑term projections based on a bottom‑up framework outlined in MYEFO as described in Treasury Working Paper 2014‑01,1 which sees a falling terms of trade until 2019‑20. The terms of trade are expected to fall by 6¾ per cent in 2014‑15 and 1¾ per cent in 2015‑16 (Chart 8).
Source: ABS cat. no. 5206.0 and Treasury.
The current account deficit is forecast to widen from 3¼ per cent of GDP in 2013‑14 to 4 per cent of GDP in 2014‑15, before narrowing slightly to 3¾ per cent of GDP in 2015‑16, driven mainly by changes in the trade balance.
While export volumes will rise, further expected weakness in export prices implies that the trade balance is likely to return to a modest deficit over the forecast horizon. Further, as the economy transitions from the investment to the exports phase of the mining boom, Australia's net income deficit is expected to widen due to the high degree of foreign ownership in Australia's resources sector.
Fiscal consolidation continuing
The measures in this Budget improve the budget bottom line over the forecast period and beyond. Over the forecast period, the timing and composition of the new policy decisions mean that the faster pace of consolidation in this Budget does not have a material impact on economic growth relative to the 2013‑14 MYEFO, including because the fiscal multipliers associated with infrastructure spending are larger than those for the measures having a direct impact on households and businesses. Fiscal consolidation, at both Commonwealth and State levels, is one of the forces acting on the economy taken into account in the setting of interest rates by the Reserve Bank of Australia.
Public final demand, which captures the direct economic impact of public sector consumption and investment by all levels of government, is forecast to grow moderately, as governments pursue budget consolidation. New public final demand is forecast to grow by 1½ per cent in 2014‑15 and by 1 per cent in 2015‑16. These forecasts represent a significantly smaller than average contribution to overall growth from public demand.
Incentives provided through the $5 billion Asset Recycling Initiative by the Commonwealth Government for state governments to reinvest the proceeds of privatisations into new productivity‑enhancing infrastructure, along with $3.7 billion of additional investment for road projects and the $2.9 billion Western Sydney Infrastructure Plan, are expected to boost construction activity from 2015‑16. This will enable states to employ construction capacity that will be freed up as investment in the resources sector winds down. Governments can also fund projects beyond the finance generated by privatisation and Commonwealth assistance.
Investment in national infrastructure adds immediately to economic activity and can also lift the long‑term potential output of the economy, particularly by allowing businesses to expand to exploit the better transport, communications or energy solutions available.
Weakness in the labour market leading to subdued wages
Participation in the labour market can be affected by structural and cyclical factors. The change in the population's age structure as the `baby boomers' reach retirement age is exerting downward pressure on participation. The downward pressure is due to the increasing proportion of the population in older age groups that have low participation. At present, this pressure is being predominately offset by other structural factors not related to ageing, including increases in the participation rate for many specific age groups, particularly over 60s. However, the negative structural effect due to ageing is expected to start dominating by the end of the decade.
The fall in the participation rate over the past three years has been driven not only by ageing but also by potential employees giving up the search for work, given weak employment demand and scarce job opportunities. This phenomenon, the discouraged worker effect, is associated with a cyclical downturn in the labour market and is consistent with sub‑trend demand across the economy.
That said, there has been a significant pickup in employment growth and job vacancies have improved since the start of the year. While the turnaround is encouraging, there remains significant spare capacity in the labour market. In trend terms, the employment to population ratio continues to decline, and the unemployment rate would be markedly above its current rate of 5.8 per cent if the participation rate had not fallen significantly over the past three years.
Source ABS cat. no. 6202.0 and Treasury. Trend participation is derived from a disaggregated analysis of age and gender specific participation rates as outlined in Treasury Working Paper 2014‑022.
Over the forecast period, the participation rate is expected to decline from its current rate of 64.7 per cent to 64½ per cent in the June quarters of both 2015 and 2016, reflecting the expectation that employment growth will not be strong enough to entice discouraged workers to resume their job search (Chart 9). However, an improvement in job vacancies and advertisements in early 2014 indicates that there are upside risks.
A number of measures in the 2014‑15 Budget support participation and economic growth: the Restart initiative for over‑50s; the tightened unemployment benefit arrangements for under‑30s; changes to eligibility for Family Tax Benefit Part B; and the Paid Parental Leave scheme.
Employment growth is forecast to be 1½ per cent through the year to the June quarters of both 2015 and 2016 reflecting sub‑trend GDP growth across the economy. This forecast is on an aggregate basis and employment will vary across industry sectors. Based on the employment and participation rate forecasts, the unemployment rate is forecast to be 6¼ per cent in the June quarters of both 2015 and 2016 (Chart 10), although positive labour market developments since the start of the year suggest the unemployment rate could peak at a lower level.
Source ABS cat. no. 6202.0 and Treasury.
Recent wage growth has been very subdued, consistent with the current spare capacity in the labour market. The wage price index grew by 2.6 per cent through the year to the December quarter 2013, its weakest growth since the series began in 1997.
Wage flexibility is an important adjustment mechanism. As was seen during the financial crisis, slower wage growth allows employers to maintain higher staff levels, particularly at a time when business income is expected to come under pressure from the declining terms of trade. It will also encourage non‑resources sectors to employ more of the labour that will be freed up as major resources projects are completed.
Subdued wage growth is expected to continue until the spare capacity in the labour market is absorbed. The wage price index is forecast to grow by a still subdued 3 per cent through the year to the June quarters of both 2015 and 2016.
Consumer price inflation is forecast to remain contained over the forecast period. Subdued wage growth will help keep unit labour costs down and contribute to lower inflationary pressure. The removal of the carbon tax is expected to reduce the headline Consumer Price Index (CPI) by ¾ of a percentage point and the underlying CPI by ¼ of a percentage point over the year to the June quarter of 2015 compared to what it would have been with a $25.40 carbon tax. Headline inflation is forecast to be 2¼ per cent through the year to the June quarter of 2015 and 2½ per cent to the June quarter of 2016. Underlying inflation is forecast to be 2¼ per cent through the year to the June quarter of 2015 and 2½ per cent to the June quarter of 2016.
Outlook for nominal GDP remains weak
Nominal GDP growth is expected to remain well below its 20‑year average over the forecast period, largely reflecting further declines in the terms of trade and subdued domestic price growth.
Below average nominal GDP growth is generating weak income growth over the forecast period. This is reflected in weak growth in company gross operating surplus, corresponding to low output prices, and weak growth in compensation of employees, corresponding to low wage growth. Nominal GDP is forecast to grow by 3 per cent in 2014‑15 and 4¾ per cent in 2015‑16 (Chart 11).
Source: ABS cat. no. 5206.0 and Treasury.
International risks are more balanced than previously, although still to the downside. Advanced and emerging market economies continue to deal with legacy issues from the financial crisis. Ongoing financial fragilities remain and the search for yield may see new risks emerge in some markets. The process of normalising US monetary policy may cause financial market volatility and may trigger a reassessment of some emerging market economies with pre‑existing domestic vulnerabilities.
New risks include the resurfacing of geopolitical tensions, which may also affect vulnerable emerging market economies, and are not without the potential for wider implications.
Another emergent risk to the outlook for the euro area is the persistence of very low inflation outcomes, which may cause inflation expectations to drift down and raise the possibility of area‑wide deflation. This risk adds another layer of complexity for policymakers in managing an already weak and uneven recovery. Other risks include the lingering weaknesses in the financial system, the handling of the asset quality review of euro area banks, concerns with budget sustainability, and the ongoing official assistance to some member countries.
In China, there are downside risks around managing both the economy's financial sector — including shadow banking activities and high rates of leverage in some sectors — and the reform initiatives to help rebalance the economy and move up the production chain.
In the United States, there is a risk that recent weak data could reflect more than just temporary or weather‑related factors. In the other direction, with many of the factors holding back the recovery having abated, US growth could be stronger than expected. Japan will need to balance the needs of its recovery with charting a path towards budget consolidation over the medium‑term. The effective implementation of structural reforms to boost Japan's growth potential presents an upside risk to the medium‑term outlook.
Domestic risks are evenly balanced. The household sector is clearly responding to low interest rates. Although business investment intentions remain weak, a further improvement in domestic or external demand could provide the necessary incentive for firms to upgrade their plans. Non‑resources exports have been subdued for an extended period under the influence of the strong exchange rate. A weaker exchange rate, which is historically an outcome associated with a declining terms of trade, would benefit exporters and import‑competing sectors in general and result in a better balance between the exchange rate and the level of interest rates than is currently the case.
Balancing these upside risks, the fall in resources investment is likely to be lumpy, while the associated rise in exports also has uncertain timing. Together, these effects could generate short‑term weakness in GDP. Many trade‑exposed sectors continue to battle against a still‑elevated exchange rate, while a further softening of the labour market would have repercussions for household consumption. Finally, while a further large increase in house prices would support economic activity in the near term, it would also raise concerns about whether prices could be sustained at that level and whether policy might need to respond.