Despite near-term pain, flood repairs are set to deliver stronger economic growth in the second half. This clearly shifts market risks in the direction of higher interest rates.

The tragic Australian floods will significantly distort Australia’s growth profile over 2011 and 2012. Broadly speaking we will initially see a substantial fall in economic activity as businesses, farms and mines are disrupted in their capacity to provide services and maintain production levels.

This effect will be somewhat mitigated given that the peak disruption from the floods coincides with the Australian holiday season when many businesses, factories and social service providers such as schools are closed down.

As time passes these service and production facilities will be restored and economic activity levels will return to pre crisis levels.

In addition to activity losses there have also been substantial capital losses. These losses will cover residential properties, commercial and rural properties, and both public and private infrastructure.

As this capital is restored so the economy will receive a boost to economic activity.

Consequently, the broad profile of growth in the Australian economy will see a much weaker than previously expected start to the year followed by a stronger second half.

At this early stage it is impossible to get precise estimates of the key factors – the degree of output loss; the extent of capital loss; the pace of reconstruction activity; the timing of the return to "normal activity levels”; and the level of spare capacity available in the economy.

Of course there will also be substantial interdependencies in this process. For example, the pace of rebuild of the infrastructure will affect the capacity of the economy to return to normal activity levels.

Key assumptions

In arriving at our revised growth profile for 2011 and 2012 we have made the following assumptions/estimates around these issues.

-- The loss to activity in the March quarter will be around $4 billion. By far the largest component of this will be a loss of around $2 billion in coal production (latest industry estimate) due to the infrastructure damage to the coal mines in Queensland. Other activity losses to agriculture; manufacturing; construction and services mainly in Queensland and Victoria will cover the remaining $2 billion.

-- The loss of activity in the June quarter will be about 40 per cent of the activity loss in the March quarter; the loss of activity in the September quarter will be 20 per cent of the loss in the March quarter and there will be no loss by the December quarter. This assumption could be challenged as being overly optimistic as some infrastructure will not be restored by the December quarter. However, we expect by that time businesses and households will have adjusted to find adequate substitutes.

-- There has been a loss of $8 billion in public and private infrastructure – damage to 90,000kms of public roads; 100 schools flooded; rail and bridge damage. This estimate seems to be around current private estimates although the more reliable public estimate will not be released for a few weeks. The rebuilding process of infrastructure is estimated to span the June 2011 quarter to the September 2013 quarter.

-- Industry estimates are that around 15,000 houses will require a total rebuild – slippages will come from inadequate insurance; denied planning permission; and change of living preferences. We estimate that eventually around 13,000 new houses will be rebuilt. In addition there are estimated to be around 20,000 dwellings with some need for renovation/remodelling. We estimate the approximate replacement cost of dwellings as $260,000 per unit and $20,000 per renovation/repair.

-- We expect that the renovation work will begin immediately and continue until the end of 2011. The housing rebuilding will cover the June 2011 quarter to the September 2012 quarter.

-- The fairly rapid housing rebuild program is predicated on the expectation that there is already considerable existing slack in the Queensland’s housing construction sector where the bulk of new houses will be required. Note that the number of residential commencements in Queensland in 2007 was 43,000 compared with around 31,000 for 2010.

-- The pace of the required infrastructure spend will be limited by capacity constraints. Our fairly optimistic estimates envisage $2.5 billion in 2011; $4 billion in 2012; and $1.5 billion in 2013. These restoration projects will be competing for resources with the two new LNG projects (around $30 billion over the next 4 years) announced for the Gladstone area along with expected further mine expansions in the coal industry. Governments do not substantially cut spending on existing infrastructure commitments.

The revised growth profile

-- We now expect GDP to contract by 0.1 per cent in the March quarter 2011, downgraded from our earlier forecast of 1.1 per cent growth.

-- Growth in the June quarter of 2011 is forecast to be 1.9 per cent, upgraded from 0.9 per cent. Even with this higher growth rate, output in the June quarter will remain below that previously expected, notwithstanding the boost from initial rebuilding and renovation activities.

-- Growth in the second half of 2011 will be 4.8 per cent (annualised), upgraded from 3.4 per cent in the original profile.

-- Through the year growth on our revised profile drops from 4.3 per cent in 2011 to 3.3 per cent in 2012 as the rebuilding and renovation projects are wound back.

Fiscal policy implications

As discussed above, we have estimated/assumed that the repair bill is almost $13 billion, of which $8 billion is for infrastructure and the remainder for housing.

It is reasonable to expect that the vast bulk of infrastructure costs will be met by the public sector – but not all, with the private corporation QR National owning a chunk of the rail network.

Housing reconstruction costs will be largely met by the private sector, with the majority of damaged homes being insured (key industry estimates are more encouraging in this regard than some of the media coverage). Standing arrangements mean that the commonwealth Government will cover 75 per cent of the public sector’s contribution.

Our figuring is that the public sector contribution will be around $7.5 billion ($7 billion for infrastructure and $0.5 billion for housing) and the private sectors will be around $5 billion ($1 billion for infrastructure and $4 billion for housing). For the commonwealth, the reconstruction cost will be in the ball park of $5.5 billion, on top of which there is financial assistance to families and business that would lift the total financial cost to around $6 billion.

The floods also have revenue implications for the commonwealth. The disruption to output in the first quarter will dent revenues in 2010/11. However, the rebound in activity will be a plus in 2011/12 as will the lift in global commodity prices triggered by the tightening of global supply conditions.

To some extent the commonwealth budget already provides for the cost of natural disasters. In the 2010/11 financial year the budget, as at the Mid Year Review (MYEFO) included $577 million for natural disaster relief – it is unclear to what extent that money has already been allocated. In the 2011/12 year and in the 2012/13 year the Contingency Reserve is $2.4 billion and $3.1 billion respectively.

This Reserve is an allowance that provides for, among other things, a tendency for expense estimates of existing programs to rise. Even so, some of the Contingency Reserve could be drawn down to meet the cost of this unforeseen natural disaster.

As for the timing of the commonwealth’s expenditure commitments, we expect most of the $6 billion of payments to households, businesses and the Qld and Victorian governments (to meet the cost of reconstruction) to be made this financial year and in the 2011/12 year. Although our growth profile assumes that around $4 billion will be spent in 2012/13 the commonwealth’s payments to the states are typically made before expenditure and that could be comfortably made in 2011/12. The government’s most recent estimates are for a combined deficit in 2010/11 and 2011/12 of $54 billion. An additional $6 billion would only represent a 10 per cent increase in that combined deficit.

This is a significant point, as the commonwealth government’s commitment is to return the underlying cash budget to surplus in the 2012/13 financial year. The impact on the surplus in the 2012/13 year, forecast in MYEFO to be $3.1 billion, would be the servicing cost of the additional debt – which on our figures is in the order of just $0.3 billion.

Implications for markets

Our previous view under the "pre flood” growth profile was that we could expect one rate hike in the June quarter of 2011 with no follow through until 2012. The stronger growth profile in the second half of 2011 adds upside risks to this outlook.

The key will be the impact on the labour market from the stronger demand growth through 2011. The Reserve Bank will be nervous given that the economy now enters a year when we now expect through the year growth to increase from 2.8 per cent in 2010 to 4.3 per cent in 2011. The unemployment rate starts the year near the RBA’s estimate of the NAIRU (5 per cent) although we expect the rate to pick up a little in the near term as the participation rate recovers from the sharp dip in December. Faster demand growth implies faster employment growth and a lower unemployment rate. This higher growth rate would imply a reduction in our forecast for the unemployment rate by year’s end from 4.8 per cent to 4.6 per cent.

Further, in their December commentary the RBA noted that commodity prices had been stronger than previous expectations.

Developments since then lead us to believe that any newly installed Bank terms of trade forecast from December is probably already out of date. As a direct impact of the floods, coal prices have moved rapidly higher, with some estimates indicating that coking coal prices could triple in the short term. Away from the floods, iron ore and base metals prices have been independently strong. These developments are clear upside risks to policy.

Until many of the uncertainties outlined above become clearer the Reserve Bank is likely to hold steady. In fact we expect that the first rate hike this year is likely to be delayed by a couple of months until the September quarter. However, if the growth profile starts to evolve along the lines we envisage then interest rate risks move to the upside and market pricing, which currently only envisages one more rate hike in 2011, is way too complacent.

These revised growth forecasts are our best shot at a very uncertain picture. At this stage we are maintaining our expectation of only one more rate hike this year until the outlook becomes clearer but this revised growth profile and the recent boost to the terms of trade indicate that risks have now moved clearly in the direction of higher rates.

For the markets, the Reserve Bank Statement on Monetary Policy, to be released on Friday, February 4, will provide an insight into the Bank’s own reaction to the floods with both inflation and activity forecasts to be updated in the Statement.

Bill Evans and Andrew Hanlan are Westpac's Chief Economist and Senior Economist, respectively.

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