WEEKEND ECONOMIST: Growth artifice

The federal government expects the Australian economy to record growth around trend, unemployment to remain near relatively low levels and inflation to be benign.

Real GDP is forecast to rise 3 per cent in 2011-12, with growth of 3.25 per cent in 2012-13 and 3 per cent in 2013-14. Unemployment is expected to drift up slightly to 5.5 per cent by mid 2013 and remain at this historically low level thereafter. Headline inflation is forecast to reach 3.25 per cent in 2012-13, but this includes a 0.75 percentage-point lift from the introduction of a carbon price in July 2012; inflation ex-carbon and underlying inflation are both expected to be well contained at 2.5 per cent.

However, the steady outlook conceals major divergences.

The resources and related sectors are expected to record very strong growth while conditions elsewhere are expected to be much more subdued, with some parts of the economy likely to face challenging conditions.
This is viewed as a structural change with a ‘complex transition' that is not just the result of rapid change in the global economy (i.e. the rise of Asia and associated strong growth in demand for resources) and the high Australian dollar, but also ongoing consumer caution and changing expenditure patterns.

The resource and resource-related sectors – estimated to account for 15 to 20 per cent of GDP – are forecast to average growth of 9 per cent over the forecast period. In contrast, the remaining 75 to 80 per cent of the economy is expected to average sub-par growth of 2 per cent

This divergence is reflected in the views on expenditure.

Household consumption is forecast to grow at 3 per cent year-on-year, a moderate pace – ongoing cautious behaviour is expected to see spending track income growth. Dwelling investment is also expected to be
subdued. After an expected 1.5 per cent rise in 2011-12, public demand is forecast to decline by 0.5 per cent in 2012-13.

Business investment is expected to surge 18 per cent in 2011-12, 12.5 per cent in 2012-13 and a further 8 per cent in 2013-14, spearheaded by mining investment.

New production capacity is also expected to see export growth of 4.5 per cent a year over the next two years, despite the ongoing weight of the high currency on manufacturing and services exports.

The mining investment boom is expected to be impervious to a correction in the terms of trade, which are projected to decline 9 per cent over the forecast period – a sizeable decline, but still to a level close to long-term historical highs. The declining terms of trade are expected to see nominal GDP growth of 5 per cent in 2012-13, a more subdued result than the 8.3 per cent recorded in 2010-11.

Labour markets highlight the complexity of the structural transition underway, with a multifaceted picture of sectoral and sub-sectoral strength and weakness, and an unemployment rate that has remained stable at low levels, despite variations across regions.

These forecasts are broadly consistent with the 3 to 3.5 per cent growth forecast in the RBA's Statement on Monetary Policy, although there are some notable divergences. Near-term growth is expected to be stronger (3 per cent year-on-year for 2011-12 versus the RBA's 2.75 per cent) while growth forecasts for year two are a touch slower (3 per cent versus the RBA's 3 to 4 per cent year-on-year).

It is also notable that the government forecasts assume interest rates "move broadly in line with market expectations” – i.e. likely implying a further 75 to 100 basis points in rate reductions, compared to the RBA forecasts "no rate change” basis. Westpac's forecast is a middle ground with a weaker assessment of 2011-12, a further 50 basis points in easing, and growth at 3.3 per cent in 2012-13.

In the global economy, risks abound. The government is anticipating only a modest slowing of world growth, from 3.9 per cent in 2011 to a forecast 3.5 per cent in 2012, followed by a rebound to 4 per cent growth in 2013.

Our reading of global trends and developments points to the likelihood of a more pronounced slowdown of world growth during 2012. While we are four years on from the global downturn of 2008, the world economy remains fragile.

We expect world growth to be sub-trend in 2012, at around 2.8 per cent.

Growth in the US is sluggish, constrained by fiscal headwinds and household sector deleveraging. China is experiencing a significant cyclical slow-down. Europe is in recession, and a much deeper downturn remains a very real risk.

This global slowdown represents a key risk to the government's budget position. In particular, there is the very real possibility that the decline of global commodity prices, which emerged during the second half of 2012, is sharper than anticipated.

The government is forecasting nominal GDP growth to be a reasonably solid 5 per cent for 2012-13 and 5.25 per cent thereafter.

This factors in a terms of trade decline of 5.75 per cent for the upcoming financial year and a decline of 3.25 per cent for 2013-14 in year-average terms.

If the global downturn does turn out to be sharper and more prolonged than anticipated by most central case scenarios, Australia will suffer a bigger hit to national income. For the government, this means that revenue collections, particularly company tax, are likely to fall short of official forecasts.

A final point: it is worth remembering that the estimates contained in the 2012-13 budget are a function of a number of assumptions.

Changes in these assumptions will impact receipts and payments and as a result, the underlying cash balance. The government gives some guidance on this issue in Budget Statement 3 by discussing the effects of: a 1 per cent reduction in nominal GDP, owing to a permanent 4 per cent terms of trade fall; and a 1 per cent increase in real GDP, due to higher labour productivity and labour force participation.

Against the baseline forecasts, the first scenario is projected to reduce real GDP and employment by 0.25 per cent and 0.5 per cent respectively in 2013-14, and reduce the underlying cash balance by $3.4 billion in 2012-13 and $7.1 billion in 2013-14. The second scenario is expected to result in a 0.75 per cent increase in nominal GDP and a 0.5 per cent increase in employment in both years.

The impact on the underlying cash balance is estimated at $3.3 billion and $4.4 billion for the two years. This analysis provides useful guidance to how modest changes in the underlying assumptions can threaten such a wafer thin surplus.