Statement on Monetary Policy – August 2006 Foreign Trade and Capital Flows

Commodity prices and the terms of trade

After strong rises in the terms of trade through 2004 and 2005, there was a further modest increase in the first half of 2006. The rise of over 30 per cent in recent years has lifted the terms of trade to around their highest level in 50 years (Graph 27). This increase mainly reflects sharp rises in the prices of Australia's major commodity exports, which have taken the RBA's index of commodity prices to around its highest level since the series began in 1982 (Graph 28). During the most recent three months, commodity prices were volatile, particularly for gold and base metals, with a sharp increase until mid May, a decline through to mid June, and a subsequent recovery. Overall, the index increased by 1.3 per cent over the three months to July and is up around 7 per cent since the end of 2005 (Table 10).

The increase in the commodity price index during 2006 has largely reflected a 40 per cent increase in base metals prices. Nickel and copper prices rose especially strongly over the past three months, with the nickel price boosted by a pick-up in global stainless steel demand and the copper price supported by low global inventories. Speculative activity and higher portfolio allocations to commodities have also supported base metals prices and contributed to the recent high level of price volatility.

Benchmark contract prices for coking coal and iron ore for the 2006/07 year (beginning April) have now been settled, but steaming coal contract prices are still being negotiated. Iron ore contract prices were settled at a 19 per cent premium over the 2005/06 prices (which were 72 per cent higher than prices in the previous year), underpinned by expectations of strong growth in Chinese steel production. In contrast, coking coal contract prices fell by around 18 per cent, due to expectations that recent high prices are bringing forward a significant global supply response. These are yet to be reflected in the commodity price index, but assuming an eventual modest fall in steaming coal contract prices, the new contracts should leave the overall commodity price index broadly unchanged. (For further details on these commodities, see ‘Box C: Commodity Contract Prices and Trade’, May 2006 Statement on Monetary Policy.)

Rural commodity prices were flat over the past three months, as higher prices for wheat and wool were offset by lower sugar and cotton prices. The price of wheat increased as weather conditions continue to weigh on the outlook for the 2006/07 world crop. The price of sugar fell, on expectations of an increase in global production in the coming year.

Given the outlook for the various commodities, Australia's terms of trade are expected to remain at around their current historically high level over the coming year. Looking further ahead, an increase in the global supply of resource commodities is expected to put some downward pressure on commodity prices which, when combined with moderate growth in import prices, is likely to result in an easing in the terms of trade. Nonetheless, commodity prices are likely to remain at significantly higher levels than the averages seen over the past decade or so.

International trade

Recent trade data have been volatile, with the monthly deficit fluctuating between $0.4 billion in February and $2.3 billion in May (the most recent monthly data available). This volatility was mainly caused by temporary export supply disruptions and the timing of several large import items.

The value of exports increased by 14 per cent in the three months to May compared with the same period a year earlier. This mostly reflected the impact of higher commodity prices. The growth of export volumes was subdued, due to capacity constraints and temporary supply disruptions, including the severe cyclone season in Western Australia that impeded shipments of iron ore, oil and gas early in the year (Graph 29). Nonetheless, some recovery in export volumes appears to be underway.

The value of resource exports declined by 2 per cent in the three months to May compared with the previous three months, but is up by 21 per cent compared with the same period last year, primarily reflecting the large increases in resource commodity prices. Looking ahead, the record number of projects either recently completed or in the final stages of construction is expected to underpin a solid expansion in resource export volumes in the second half of this year. For example, the Darwin LNG compression plant that started operations in February will eventually increase LNG shipments by almost 25 per cent, projects in the Pilbara will likely boost the volume of iron ore exports in late 2006, and the first exports from the Enfield oil project are expected in August. High metals prices have also improved the feasibility of smaller mining projects, particularly for gold, while coal exports are benefiting from recent efforts to ease transport constraints throughout the supply chain. However, some projects may be delayed due to ongoing shortages of labour and essential mining equipment, such as tyres for trucks.

Rural export earnings have increased solidly in 2006 so far, after falling by around 3 per cent over 2005; the trade data show a 7 per cent increase in the three months to May compared with the same period last year. Although shipments of meat and wool declined, cereal exports increased sharply and are expected to remain strong in the next few months.

Manufactured goods export earnings increased by around 2 per cent in the three months to May compared with the same period last year. Manufactured exports are expected to continue to grow at only a moderate rate due to intense competition from developing countries and the relocation of some operations offshore. However, prospects remain better for those manufacturers exposed to the resources sector. Services exports are also being constrained by international competition, although they have grown solidly so far this year, partly reflecting a pick-up in education exports. International demand for travel services appears to have been largely unaffected by Cyclone Larry, which hit northern Queensland in late March.

The value of imports increased by around 13 per cent over the year to the three months to May, partly reflecting the large increase in world oil prices. The volume of total imports grew by 6 per cent over the year to the March quarter, a pace much slower than the 10–15 per cent rates recorded over the previous three years, in line with the slower growth of consumer spending (Graph 30). Volume growth over the year was driven by a 25 per cent increase in capital imports, due to the strength in machinery & equipment investment, while imports of consumption and intermediate goods increased only slightly. Recent data indicate the value of imports increased strongly in April and May but fell in June; both prices and volumes are expected to have increased solidly in the June quarter.

In real trade-weighted terms, the Australian dollar is about 14 per cent above its post-float average, and has been broadly flat for more than a year (Graph 31). Accordingly, while the relatively high level of the exchange rate continues to restrict activity in some trade-exposed sectors, particularly manufacturing, this effect is likely to have been more than offset by the stimulus to the overall economy from the stronger terms of trade.

Current account

The current account deficit narrowed to 5.8 per cent of GDP in the March quarter, compared with 6.0 per cent in the December quarter (Graph 32). With the trade deficit widening slightly to 1.9 per cent of GDP, the overall narrowing of the current account deficit was driven by a decline in the volatile net income deficit (NID) to 3.8 per cent of GDP (Graph 33). This mostly reflected lower net payments on equity in the March quarter. Nonetheless, the level of the NID remains high, due to increases in interest payments on Australia's foreign debt and dividend payments on equity investments in Australia over recent years. The strength in the latter mainly reflects the strong increase in the profitability of mining companies.

Capital account

The strength in spending, especially business investment, relative to income in recent years has been accompanied by strong demand from foreigners for claims on Australian assets. Consequently, the stock of net foreign liabilities has increased, and reached 60.5 per cent of GDP in the March quarter. At a component level, the increase in the stock of net foreign liabilities in recent years has reflected a run-up in debt liabilities, with the level of net equity liabilities broadly tracking sideways. Indeed, almost the entire net capital inflow to Australia since 2000 has been for the purchase of debt securities, particularly asset-backed securities and bonds issued by financial companies, which have largely funded lending for housing (Graph 34). Gross foreign equity investment in Australia has remained buoyant, but this has been more than offset by substantial equity investment offshore. The available evidence for the June quarter suggests that debt inflows have remained strong, particularly borrowing by financial intermediaries (see the chapter on ‘Domestic Financial Markets and Conditions’ for more details).