Can the economy dig itself out of an iron ore slump?

While strong iron ore export volumes will underpin real GDP growth over the coming years, a decline in the commodity's value will weigh on income growth, consumption and investment.

A softer outlook for the resource sector presents a considerable challenge for the Australian economy. Of particular note is the fall in iron ore prices, which will prove problematic for the federal government and is set to weigh on spending and employment across Australia.

The Bureau of Resource and Energy Economics, in its publication Resources and Energy Quarterly, has downgraded its outlook for Australian exports for 2014-15. Estimated nominal earnings were revised down by about $14 billion or around 0.9 per cent of nominal GDP.

The bad news though is that the outlook could weaken further on the back of a fairly strong assumption by BREE regarding the iron ore price. Their outlook assumes an average price of US$105 a tonne this year and US$97 a tonne next year.

Iron ore futures have picked up recently to US$95 this morning, but there remains considerable downside risk. With China looking to ease excess capacity while more supply comes online and its residential property market appearing a little shaky, I expect demand for iron ore to soften somewhat compared with expectations over the next couple of years (Why Chinese investment matters to Australia, June 20).

Nevertheless, iron ore trade is expected to rise rapidly and Australia is primed to fill most of that new demand. This should underpin real GDP growth over the next couple of years.

Major iron ore exporters

Graph for Can the economy dig itself out of an iron ore slump?

But there’s a caveat to export growth that is worth consideration. While volumes are anticipated to grow strongly, the value of exports is expected to be far more subdued owing to a lower iron ore price and a declining terms of trade.

That scenario is highlighted in the graph below, which shows that the value of exports is forecast to grow at a slower pace than volumes during 2014-15. The divergence between the two would increase further if the iron ore price is weaker than BREE expects next year.

Australian iron ore exports

Graph for Can the economy dig itself out of an iron ore slump?

So while strong export volumes will underpin real GDP growth, softer export values will weigh on nominal GDP. Although it is normal to focus on real GDP, nominal activity has important implications for the federal budget and the Coalition’s push towards balancing that budget. This is particularly noteworthy given the budget already includes some fairly optimistic assumptions for revenue.

While a lower iron ore price is problematic for the federal government, it can be downright devastating for the Western Australian state government. Its iron ore price assumptions are increasingly ludicrous, leaving a considerable budget black hole.

The broader economic implications are also worth consideration. While real GDP focuses on volumes, there is an important secondary impact of exports via the profit received and the purchasing power it provides.

Leith van Onselen touched on this prior to the March quarter GDP result (Why you should discount today’s GDP result, June 4). He noted that with commodity prices and the terms-of-trade trending lower, growth in real GDP per capita will exceed real national disposable income per capita, which is a measure of activity that adjusts for changes in the terms-of-trade.

Basically our exports will not be able to purchases as many goods as they could when our terms-of-trade was trending upwards and this will weigh on income growth and employment, as well as household consumption and investment.

Recently the outlook for household spending has taken a hit and business investment is set to decline sharply as mining investment collapses. Net exports were the major driver of growth in the March quarter and, despite the softer outlook, should remain that way in the near-term.

But we shouldn’t neglect the impact that lower iron ore prices will have on the Australian economy. Whether it is the budget or export profits or the goods that we can buy with those profits, the iron ore price represents a significant risk to the Australian economy.