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What drives growth from here?

Wednesday, 25 September 2013

The new Australian government faces some big economic challenges.

Spending on new mining projects is falling and this could reduce Australian GDP by as much as 1%. Even as new mining projects start later in the decade the total investment is not going to be as much as we’ve seen in recent times. What replaces the mining capex boom and how should the government encourage new drivers of jobs and construction? These are the questions facing the new government elected on a platform of fiscal discipline and spending restraint.

In the absence of a pickup in other sectors of the Australian economy the result is likely to be slower growth and an increase in unemployment. The post election honeymoon could quickly be replaced by falling confidence if unemployment heads above 6% in 2014.

I’m not suggesting a recession, but the economy could soften nevertheless. There’s no ticking time bomb such as a property bubble, or an imminent equity market crash, that would cause a recession. Even though US equity markets have been pushed to record highs by funds generated through Quantitative Easing, the Fed should be able to unwind that in an orderly fashion.  House property prices remain elevated but if there was ever going to be a price crash that time has passed.

There are four factors (rays of hope, if you like) that will help to mitigate the effects of the mining retreat. The first is a fall in the Australian dollar. Exporters would benefit because the $AUD price of Australian exports would fall, earnings should increase, and the government should receive more tax. One downside to a lower dollar is higher import costs leading to inflation. But higher inflation is a long way off, wage push forces are under control, and the economy has spare capacity.  

Industries which gain from a lower dollar include agriculture, mining, tourism, hospitality and property (through sales to overseas buyers). Also businesses which compete with cheaper imports benefit such as retail and building materials. The Australian dollar has experienced a reasonable downwards correction since May reaching as low as $US0.87, However recent recovery to as high as $US0.95 is a cause for concern. Until the $AUD falls below $US.80c both the RBA and Treasury would probably consider it too high. Another interest rate decrease to cause an outflow of funds and reduce the exchange rate is a real possibility.

The second factor is the long awaited upturn in residential construction. How this plays out is still uncertain, but prospects have greatly improved through low interest rates, and a consumer confidence boost from the change in government. Sydney auction clearance rates above 80% and rising house prices (see chart) show that the market (in Sydney at least) is on the move. Unfortunately this is slow to translate into a solid upturn in construction activity (see chart). Some commentators are warning of a housing price bubble, but that seems premature. Residential construction is the one area of the economy set to grow now and there are substantial multiplier effects which feed through to the rest of the economy including the building, insurance, finance, and retail sectors. 

The prospects for commercial construction are more mixed. Currently cities such as Perth and Brisbane have a high occupancy of mining companies and the industries that service them. With the wind down many of these white collar jobs will no longer be required. Falling occupancy would push the commercial sector into a position of oversupply causing a correction in leasing costs and discouraging new construction with a year or two. Sydney and Melbourne with their focus on finance and insurance should do better.

The third factor is infrastructure. Because state governments are finding it harder to finance projects and bring their budgets into balance this sector is falling (see chart). The new federal government has promised to increase infrastructure expenditure mainly through the provision of roads. However the extensive planning and engineering lead times necessary will push any increase in infrastructure spending out to later in the decade.