Speech Aspects of Australia's Economic Situation
Assistant Governor (Economic)
Melbourne Institute Business Economics Forum
I would like to thank the Melbourne Institute for the invitation to take part in this conference. I welcome the Institute's entry into the market for forecasting conferences in Sydney. I have to warn you, however, that it is a pretty competitive market! Hopefully the competition will spur further improvements for the conference-goers.
I will begin with a few brief remarks about the short term, but I then want to lift our gaze to some longer term issues.
The Short Term
It is, of course, a difficult moment to be a forecaster because the course of economies, both here and internationally, has changed a good deal in a short period. In the Australian case, the tone of commentary shifted sharply on the release of December quarter national accounts. The oft-repeated warnings about making too much of one quarterly figure have been largely forgotten in the rush to try to discern what those numbers tell us.
That was inevitable, I suppose, since it was the first quarterly result with a negative sign in front of it for some time. Indeed, it is partly the steadiness of the estimated growth figures in the past eight or nine years something which stands out as unusual compared with longer run history which casts the December quarter into sharper relief. If one looks back through the quarterly data in their current incarnation, with all the accumulated revisions there are a number of quarterly falls in GDP which were not part of the generally accepted "recession" episodes of the early 1960s, mid 1970s, late 1970s, early 1980s and early 1990s. Some of these did signify periods of noticeably slower growth within broader periods of expansion. Others were just the inevitable noise in statistical data. Those with a sense of history are wary of over interpreting a single figure, but would, by the same token, be seeking to extract the genuine signal from the result, and from all the other information which is around.
It should by now be well understood that the recorded overall GDP weakness in the second half of 2000 was due overwhelmingly to the downturn in the housing sector, something which was anticipated in a qualitative sense, but completely unexpected in its size and more importantly its speed. Non-housing aggregate demand has slowed to some extent, but still recorded pretty good growth over the year to December, helped by strong export growth. Simple arithmetic suggests that, if not much else happens, we could expect a fairly early return to quite good rates of GDP growth since, as the housing downswing has now ended, a contractionary influence equal to over 2 per cent of GDP in two quarters will be removed. A recovery in housing, moreover, is obviously on the cards during 2001, given that too few dwellings are now being constructed to satisfy ongoing demand, there is relatively little overhang of dwellings to work off compared with previous episodes, and affordability has improved considerably. Indeed, borrowing for housing purposes continues to be quite strong.
So even making allowance for some indirect effects of the housing downswing through multipliers and so on, a fairly early return to more normal rates of growth in GDP in mid 2001 say is certainly well within the range of possible outcomes. Given the stance of macro economic policies, an undervalued currency, corporate balance sheets in pretty good shape, and two years of the down-phase of the business investment cycle already behind us, rather than ahead of us, the broad macro fundamentals of the economy are strong. So those who are relatively optimistic are not just whistling in the dark.
The difficulty is, of course, that things may not be that simple in the short term if the world economy continues to weaken and/or if confidence at home is further eroded, by the effect on "animal spirits" of the fact of the housing sector weakness itself or by other forces. Hence there is genuine uncertainty about the short-term outlook. That is just the nature of things at such moments, which is why the forecasters' job is so difficult. Beyond the short-term, however, we should have confidence that the broad factors supportive of growth will dominate.
The Medium Term
As important as the short-term path of the economy is, we also have a responsibility to lift our eyes beyond the short-term, and to focus on some important longer-term issues. It is this which I will attempt today. In particular, I want to return to a topic about which I have spoken before, including at an earlier Melbourne Institute conference, namely the structural change in the household sector's balance sheet which has occurred over recent years, and its implications for economic performance. I want to try to develop a linkage between these trends and those in the balance of payments, from the perspective of capital flows.
Household Balance Sheets and Spending
As is well known, households have borrowed at a pace not previously seen over the past decade. This reflected both supply and demand factors. On the supply side, there was the willingness of banks to lend to a sector which has always been seen as a very good credit risk. Competition to lend increased and margins declined. On the demand side, there was the enhanced capacity of households to service much larger loans, as a result of the structural decline in nominal interest rates which accompanied the return of low inflation. Essentially, the level of mortgage rates in the past few years has been about half that of the period a decade earlier, while the ratio of gross debt to annual household income has approximately doubled. As a result, the share of gross household income being used for debt service is quite similar to what it was a decade ago.
On the assets side of household balance sheets, there has been a corresponding increase. Indeed, household leverage the ratio of debt to assets has changed relatively little. The rise in wealth, measured either in gross or net terms, has been quite remarkable and, superficially, bears more than passing resemblance to what has occurred in some other English-speaking countries, notably the United States and the United Kingdom. In the Australian case, the rise was relatively more concentrated in the appreciation in the value of the dwelling stock than it was in the US, where share prices figured much more prominently, arithmetically and certainly psychologically. It is worth noting as well that, in the Australian case, there can't be much doubt that the prolonged period of low interest rates facilitated at least some of this appreciation.
These gains in wealth, combined with the relatively low cost and easy availability of credit, for some time appear to have facilitated a rise in consumption spending by households ahead of the gains in current income, observable as a decline in the household saving rate as conventionally measured. This process was most marked in the US, but was also seen, in a somewhat less pronounced fashion, in Australia. Recent research at the Bank suggests that part of the observed strength in consumption spending in 1998 and 1999 might be ascribed to the "wealth effect" in operation at those times, though our models of this process are far from definitive. Likewise, the wealth gains appear to have paused, for the time being at least, in 2000 which may have had some role in bringing about the slower pace of consumption growth of late, though disentangling that effect from all the others in operation, such as the GST, the Olympics, the rise in energy prices and so on, is well-nigh impossible. In the accompanying chart, I should make clear that the volatility in wealth just recently is a result of effects of changing composition in the sample of house prices used, while the net decline in the wealth-to-income ratio over the past year or so is due entirely to a rise in the denominator of the ratio, household disposable income.
So the story of wealth gains, borrowing behaviour and the effects on consumption and saving is, in my view, an integral part of the cyclical dynamics at work driving demand growth in recent years. Something which has perhaps had less attention has been the counterpart to this in the balance of payments. Let us look at that for a moment.
The Balance of Payments
From a trade viewpoint, it is well known that the current account deficit widened after the Asian financial crisis, as exports weakened very sharply. Subsequently, that is since the middle of 1999, the current account deficit has halved, and has reached its previous cyclical low point of around 3 per cent of GDP. Export receipts have grown extremely quickly, as volumes have improved, and the decline in the exchange rate has added to prices in A$ terms. The exchange rate-driven price rise in exports is of course, given back on the imports side, but Australia's terms of trade have risen over the past year a genuine income gain and have recovered all of the Asian crisis fall and more. In fact, in late 2000 they stood at their highest level for about ten years.
In saving-investment parlance, there is an interesting contrast between the most recent current account cycle and the one at the end of the 1980s. Table 1 gives some figures. These are as ratios to nominal GDP, between approximate peaks and troughs in the current account balance.
|Current Account||General Government||Other||Investment||Statistical Discrepancy|
|Current account widenings|
|June 1987 September 1989||2.7||1.8||0.9||0.9||4.1||0.2|
|March 1997 September 1999||2.7||0.5||3.1||2.6||2.9||0.3|
|Current account narrowings|
|September 1989 March 1992||+3.3||6.1||3.5||2.6||8.6||0.7|
|September 1999 December 2000||+2.9||+1.0||3.4||+4.5||3.0||+1.1|
The Asian crisis saw Australian saving decline, as our spending remained strong while income weakened. Government saving was increasing, as a result of fiscal consolidation in 1996 and the effects of the strength of overall economic activity on revenues. But the current account deficit rose. Sound familiar? It was such a combination in the late 1980s which effectively showed that the simple twin deficits notion was a bit too simple. On that occasion, even though both government and private saving rose, private investment spending boomed.
In the late 1990s widening of the current account, by comparison, business investment rose, but by somewhat less than a decade earlier, and to a noticeably lower level as a share of GDP. As a consequence, there is little sign either of over-investment in physical capital, or excess debt in the corporate sector, quite a difference to a decade ago (and hence part of the story of "no imbalances" that the Governor has talked about). The really striking trend in the late 1990s episode was that even though government saving rose by more than had been the case in the late 1980s, private saving actually fell sharply, largely as a result of the fall in household saving.
As a rough generalization, we could say that, compared with the late 1980s, the late 1990s current account widening was relatively less about financing an investment boom and more about facilitating strength in private consumption spending. I do not say this in any pejorative sense: that confidence to spend, sustained by wealth effects, was something which helped the economy weather the Asian crisis in much better shape than most expected. Australians were temporarily able to lower their saving rate and draw on foreign saving because their fundamental position was good, and global capital markets were looking for alternative avenues to invest funds after the Asian crisis hit.
Since mid 1999, the imbalance between saving and investment has declined. Private sector investment has declined, but national saving has trended upwards as a share of GDP, despite a decline in government saving in the most recent couple of quarters, due partly to the tax cuts from 1 July 2000. Gross private sector saving in total has increased, more than making up the decline in the 199799 period, facilitated to some extent most recently by the income tax cuts. The earlier decline in the household saving rate has not continued: household consumption growth has declined, and the expansion in consumption has been approximately in line with income growth. Corporate saving has improved because of relatively high levels of company earnings, much of which is retained.
Several differences with the narrowing of the current account in the early 1990s are obvious. On that occasion, as the economy went into a deep recession, saving fell which is normal in recessions but investment fell much more steeply. In the current episode to date, investment has fallen by less, and saving has risen.
The Longer Term
So these shifts in private saving behaviour have been an important part of the recent developments in the balance of payments and the economy as a whole. But in addition to their cyclical dimensions, they may have some longer-term structural significance as well. I suspect we should be viewing the decade-long trends in household finances as indicating a structural adjustment to a new equilibrium position, and not as secular trends which could be expected to continue over a very long period, at least not at the same pace. With an aggregate ratio of debt to annual income of just over 100 per cent, Australian households are now very much within the international pack, as opposed to being a long way below it, as they were ten years ago. At some stage, surely this pace of debt accumulation will lessen, as households reach a new balance sheet position more in line with what they desire, but were unable to reach for various reasons in the past.
I am not going to predict exactly when this might occur, nor am I going to launch into a sermon about the evils of debt and say "this can't go on". I have considerable sympathy for the dictum that if something can't go on, it won't. Nor is there anything particularly wrong with what Australian households have done, and if anything the surprise is that it did not happen earlier.
Nonetheless, if what we have observed in the past five or ten years is the bulk of a one-time structural adjustment, surely that means that, a decade from now, we will not be here talking about a further rise in debt and wealth of the same order of magnitude. In the interim, assuming that my way of thinking about this issue is the right one, we will see some adjustments. What will they be?
For a start, we will probably see a return to somewhat higher rates of saving out of current income. It is surely unlikely that a saving rate so low will persist indefinitely. Things like the rising superannuation guarantee charge will help the saving rate move higher to some extent anyway, but if wealth stopped rising much faster than income, and households were less inclined to take on additional debt, we would be much less likely to see consumption gains run ahead of income. That is, the downward trend in the household saving rate through the 1990s would lose one of its major drivers. It may be that such an adjustment has already begun, given that the saving rate has apparently stabilized in the past year or so, in contrast to its counterpart in the United States. It is probably not sensible to make too much of this yet, as short-term movements in the measured saving rate are volatile, and prone to revision. Nonetheless, this apparent change in trend may bear watching.
Second, we could see, associated with this picture, a structural decline in the current account deficit, which has averaged about 4½ per cent of GDP for the past twenty years. If households saved more of their incomes while governments and companies behaved much as they have in recent years, that would be the result. Now that is a big if, of course, as experience with the "twin deficits" hypothesis of old tells us: ceteris paribus does not hold in the real world very often.
Investment rates are below average at present, so in time we could expect that investment will rise. But so will government saving, on currently known policies at least. Hence if household saving rises as well, we could well find that a rise in investment activity could be accommodated without as large a widening in the current account deficit as was the case in other cycles. There will still be cyclical movements, of course, but I would contend that we might find that the average current account position in the next ten years could be noticeably smaller than in the past two decades.
This hypothesis is necessarily somewhat speculative, but we can find some support for it by reverting for a moment back to the perspective provided by the trade accounts. The size of the current account deficit in late 2000, at around 3 per cent of GDP after the Olympics effect had passed, was about the same as in early 1992. But the economy was in a stronger cyclical position in the latter episode, notwithstanding the weakness in the second half of 2000. In 1992, recovery from a deep recession was under way but it was weak initially, and in fact the unemployment rate continued to rise, and reached its peak in late 1992. Put in very crude terms, a 3 per cent of GDP current account deficit in 1992 was a result of the import compression associated with a very weak economy with an unemployment rate approaching 11 per cent. In 2000, a current account deficit of about the same size occurred in an economy which had an unemployment rate of below 7 per cent. I would concede that the world economy was in better shape in 2000 than in 1992, but in fact Australian export performance in 1992 was quite good. The difference appears to lie more on the imports side. Overall, trying to make an allowance for the state of the business cycle, a good case can be made that the external accounts are in better underlying shape than they were a decade ago.
Nor is it this improvement likely to be completed yet. Were the exchange rate to remain anywhere near the recent low levels and that is not a forecast! the adjustment to trade volumes would in due course probably be considerably greater than we have yet seen. After all, a good deal of the exchange rate decline is relatively recent, and even for the earlier fall, the apparent effect on final prices to the consumer seems to have been much more muted than was expected. That would in turn probably mean that the effects of the relative price changes on economic behaviour are only in their early stages, though some changes must be under way because someone, somewhere, has absorbed those exchange rate changes, and their behaviour is presumably not unaffected by having done so.
So from several perspectives, I would argue that there are things happening which have the makings of quite a substantial shift in the shape of Australia's external accounts over the decade ahead. This is a tentative hypothesis. As usual in economics, it is too soon to know for sure. In the short-term, cyclical swings will still dominate slowly shifting trend developments, so depending on your view of the outlook for the Australian and world economies over the coming year, one could make a case for either a diminishing or growing current account deficit over that horizon.
But there are at least some grounds to think that we may be in the early phase of what will turn out to be a major structural change in the shape of the external accounts. If so, the nature of discussion about the balance of payments could change a lot in the years ahead.
This measure of wealth uses a dwelling price series sourced from the Commonwealth Bank. In the June quarter, it appears that first home buyers, whose typical purchase tends to have a price lower than the average, tended to be absent from the market, but returned to it in the September quarter, to take advantage of the First Home Owner Grant. This had the effect of raising the median price recorded in the June quarter, and lowering it in the September quarter, relative to what would have otherwise been seen. 
Some commentators have noted that the rise in export volumes as recorded in the national accounts in the latest four quarters is a relatively modest 5.9 per cent. But this comparison is affected by two things: a lumpy item in the December quarter of 1999 (a frigate), and the effect of climatic events on rural exports more recently. Net of the frigate and re-exports of gold, non-rural exports rose by nearly 13 per cent in real terms over the four quarters to December 2000. This is a very strong result. 
The dates I have chosen are in some cases not the exact moments for the peaks and troughs in the current account, since I have tried to conduct the analysis with an eye to minimising the movement in the statistical discrepancy between the expenditure based aggregates and those derived from the income accounts. This keeps the movements in the various aggregates a little more comparable, while keeping reasonably close to the trough-to-peak and peak-to-trough movements in the current account.