RDP 2013-03: Implications for the Australian Economy of Strong Growth in Asia 1. Introduction

Strong economic growth in the Asian region, particularly in China, over the past decade or more has had important macroeconomic and structural effects on the Australian economy. Most obvious has been the rise in the terms of trade to historically high levels (Figure 1), an appreciation of the exchange rate, a surge in resource investment, and a reallocation of factors of production, with employment growing strongly in resource and resource-related activities and declining in a number of non-resource industries.

Growth in Asia is providing many benefits for the Australian economy. The commodity-intensive nature of this growth has pushed bulk commodity prices to a high level, which is supporting significant investment in the productive capacity of the Australian resource sector and is expected to continue to support the production and export of resources, as well as employment, incomes, tax revenues and wealth. The appreciation of the exchange rate has lowered the cost of many imported goods for Australian consumers. While not all parts of the economy have benefited from this change in relative prices, for the economy as a whole the process of adjustment has proceeded much more smoothly than has been the case in previous terms of trade booms; over the past eight years, inflation has remained within the target range, or not too far from it, and growth has generally not been too far from trend (Figure 2). This is perhaps all the more notable given the difficult circumstances internationally over recent years, with incomes in Australia growing faster than in most other advanced economies and the unemployment rate remaining relatively low. In part, this reflected the relative strength of the Chinese economy through 2009 and 2010 that benefited Asia and pushed Australia's terms of trade to new highs after they dipped during the height of the global financial crisis.

The relatively smooth adjustment of the economy overall, at least to date, has certainly not been the norm in previous booms. A key contributor to the good performance of the macroeconomy through the current boom has been the flexibility of the exchange rate. The high nominal exchange rate has acted as a timely mechanism for facilitating the reallocation of labour and capital across industries. Of course, this process is not a painless one. It entails significant pressures on many trade-exposed industries that have not benefited from higher product prices but have faced higher wages (at least in foreign currency terms) and a softening in demand.

As well as promoting the reallocation of labour and capital across the economy, the high exchange rate has been one of the means by which Australian consumers have been able to benefit from high commodity prices, by directly increasing their purchasing power over imports. Indeed, the purchasing power of the average wage has risen in all major industries since the terms of trade began to rise in 2003/04, despite upward pressure on the prices of non-tradable goods and services during the boom.^[1] For some industries, such as mining, construction and professional services, the real (consumer) wage has grown quite strongly, while growth in real wages has been more subdued, yet still positive, in rental, hiring & real estate, retail and manufacturing.

Another feature of this terms of trade boom is the greater extent of foreign ownership of the resource sector, with some estimates suggesting that foreign ownership is around four-fifths (Connolly and Orsmond 2011). In addition, the imported content of the current boom in resource investment has been high. Both of these factors mean that the expansionary effect of the boom is less than is implied by the extent of growth in investment and profits in the resource sector.

The adjustment process through the current episode has also been helped by inflation expectations remaining well anchored and greater flexibility in the labour market relative to earlier terms of trade booms. The combination of the high exchange rate, a record of low and stable inflation and a relatively flexible labour market means that while demand for labour, and the growth of wages, has increased in the resource sector, this has not led to a significant increase in wages in Australian dollar terms across the economy as a whole. This was not the case in earlier terms of trade booms.^[2]

The smooth adjustment to date suggests that the economy is reasonably well placed to deal with further adjustments that lie ahead. One aspect of this is that the resource boom is expected to turn from one of strong growth in resource investment to one of strong growth in the production and exports of resources. Given that many resource projects employ more labour during the construction and investment phase than during operations, this means that the demand for labour in the resource sector is likely to ease after the peak in investment. Another feature of the adjustment is the decline in the terms of trade from its peak. Indeed, this is already under way, with commodity prices having peaked in late 2011 and forecast to decline further over time as the global supply of commodities gradually increases relative to demand. As with the expansionary phase of the boom, a flexible exchange rate would also be expected to help the economy adjust to both anticipated and unanticipated developments, such as a path of the terms of trade that varies substantially from that which is expected. Similarly, the path of resource investment, in particular the timing and magnitude of the peak in investment, and the demand for, and supply of, labour in the resource sector are also subject to a degree of uncertainty.

In terms of the path of the terms of trade, an important unknown is the extent to which the growth in the demand for commodities, which has been very strong over recent years, might ease over the longer term as the emerging economies in Asia mature. For example, the rate of urbanisation in Asia, which has driven much of the demand for iron ore and coal, is expected to eventually slow and then stabilise^[3] (although demand for non-resource commodities such as food and fibres is likely to increase as populations and incomes grow). Also, the typical pattern of economic development suggests that activity in emerging Asia is likely to become less focused on the production and consumption of goods over time and relatively more focused on the production and consumption of services. While such a transformation might appear to be disadvantageous for countries like Australia that have hitherto focused on supplying these economies with commodities, it may be that Australia is able to benefit from such a shift. Indeed, some Australian service industries, such as education and tourism, have already experienced an increase in demand from Asia, notwithstanding the high level of the exchange rate. Moreover, incomes still have a long way to grow in much of the Asian region to reach levels recorded in the advanced economies. And rising incomes in this large part of the global economy will be relatively advantageous for Australia, in part because the distance from Australia to the region is much less than the distance from Australia to most other advanced economies, but also because of its well-developed and relatively open services sector.

In the remainder of this paper we examine the implications for the Australian economy of strong growth in Asia, particularly in the context of the large increase in the terms of trade since the mid 2000s. Specifically, we examine developments in three broadly defined sectors: the resource sector, the ‘other tradable’ sector and the non-tradable sector. Section 2 presents a theoretical framework that describes how a small open economy might be expected to adjust to a boom in commodity prices. Within the context of this theory, Section 3 then discusses sectoral developments in the Australian economy through the three (overlapping) phases of the resource boom: the increase in the terms of trade; the surge in resource investment; and the subsequent growth in the production and exports of resources. Section 4 concludes.

Footnotes

The purchasing power of the average wage is calculated by deflating average weekly earnings in each industry by the household final consumption deflator. [1]

See, for example, Battellino (2010). [2]

See, for example, Berkelmans and Wang (2012). [3]