July 24, 2006	Monday	Jumadi-ul-Sani 27, 1427

Australia

Australia’S economic performance shows mixed trends. The benefits of the mining boom have to date been narrowly based. Much of the rest of the economy — including retail, manufacturing, dwelling construction and large parts of the rural sector — through the south east is performing below trend. These sectors are struggling against a variety of headwinds, including higher interest rates, higher petrol prices, the end of the house price boom, the strong A$ and intense competition from offshore. The net result is that the overall pace of economic activity is relatively subdued.

These variations in the performance of industry sectors are also producing a marked disparity in regional patterns of growth. Those regions of Australia, which are most able to leverage off the resources boom – Western Australia, the Northern Territory and Queensland - are recording very high rates of growth. In contrast, the south eastern seaboard – New South Wales, Victoria, South Australia and the Australian Capital Territory – are growing at about half the pace of the boom states, in large part because they lack significant mining sectors. NSW remains the most poorly performing state across a range of indicators. It is the only state where residential house prices have fallen substantially since the end of 2003 (down 8 per cent); dwelling construction approvals have fallen to the second lowest level since monthly statistics were first collected in the early 1980s; and the NSW budget is now in serious deficit. Tasmania continues to record solid rates of growth.

Economic tempo: The good news is that the economic tempo will pick up through 2006 as the soft sectors regain momentum. Dwelling construction will lift from mid year as the current under building phase leads to a further tightening of rental markets. Household spending will strengthen as employment growth is renewed and as additional government tax cuts and spending flow through. The manufacturing sector will see an easing in offshore competitive pressures as the A$ continues to trend down. The drag from the external sector will also lessen as export volumes increase. Growth in 2006 is projected at 2.9 per cent, up from 2.5 per cent in 2005, with a further acceleration to 3.8 per cent in 2007.

Following a weak second half of 2005, due to a subdued export performance and weak dwelling investment, economic activity is now strengthening again. With business investment remaining buoyant and export volumes eventually picking up, output is likely to accelerate in 2006 and 2007 to about 3 and 3½ per cent, respectively. The recent monetary tightening should be sufficient to counter emerging inflationary pressures. Despite tax windfalls related to the commodities boom, the general government surplus is expected to fall slightly. Any further unexpected windfalls through 2006-07 should be allowed to accumulate in higher surpluses rather than add to demand.

The global boom seems set to continue in 2006, which means Australia’s resource boom will continue also. There are risks, to be sure, but overall it is not clear that the risks are rising.  Indeed, there is the prospect that the world economy is in a “sweet spot” and that slower growth in, say, the USA and China might be offset by faster growth in Japan and (more surprisingly) in Euroland. The key to continued global boom is that various “imbalances” remain under control.  Inflation is the most general imbalance, and rising inflation has brought other global boom-times to an abrupt end.

Productivity: With the price of many goods and services pegged by rising productivity, the excess liquidity raised asset prices, including the prices of houses, commodities and shares, all cases in which strong demand has coincided with relatively fixed supply. This asset price inflation — especially house price inflation in the developed nations — is a major imbalance with the potential for a sharp reversal to induce recession. Consumers have been spending more on the basis of growing wealth, particularly in the form of housing wealth. So far at least falls in house prices have been modest and consumption has continued to grow in the developed nations.

The IMF is forecasting global growth of 4.9 per cent in 2006 and 4.7 per cent in 2007. Australia’s terms of trade has risen 34 per cent since December 2001 and is now the highest for over 30 years (since March quarter 1974). This will be the peak in this cycle. With commodity prices easing back from their highs, and with less downward pressure on import prices as Asian inflation continues to swell, we forecast 2006 will see the peak in the terms of trade in this cycle.

Consumer: Spending by consumers has steadily decelerated since mid 2005, reflecting higher petrol prices, the cumulative effects of higher interest rates, and the dragging effects of the end of the house price boom. The direct impact of higher fuel prices is clear, with the volume of spending on the operation of motor vehicles declining by 6.6 per cent over the year. Consumption of cigarettes and tobacco was also down. In contrast, sales of new motor vehicles (as distinct from their operation) rose 3.3 per cent, although there was a dramatic shift away from large passenger vehicles and large SUVs towards smaller and more fuel efficient vehicles. Spending in mining and building and structures will continue to increase strongly, but it is anticipated there will be reductions in investment in manufacturing and other industries, with the decline showing through in spending on equipment, plant and machinery. After several years of very strong growth, business investment looks likely to plateau at a high level in 2006-07.

Employment growth lost momentum in the second half of 2005 as the softer pace of household spending and dwelling construction hit home. The unemployment rate edged up to 5.3 per cent in early 2006, but then returned to the 30-year low of 5.0 per cent in March. The employment growth will remain subdued in the first half of the year, with the unemployment rate likely to edge up to around 5½ per cent by September. From there, the progressive acceleration in economic activity will lift employment growth, and the unemployment rate will settle back to around or a little below 5 per cent through 2007.

Although employment growth has slowed, the labour market remains tight. Wages growth remains higher than in recent years, with the Wage Price Index rising by 4.2 per cent over the year to the December quarter, although there are signs wages growth has peaked for now. Wages growth is expected to remain robust through 2006, with the possibility of a further acceleration from late 2006 as the unemployment rate resumes its downward track.

Trade: Australia’s terms of trade has risen 34 per cent since December 2001 and is now the highest for over 30 years (since March quarter 1974). This will be the peak in this cycle. With commodity prices easing back from their highs, and with less downward pressure on import prices as Asian inflation continues to swell, we forecast 2006 will see the peak in the terms of trade in this cycle. Trade accounts show slow improvement. Trade accounts have been very volatile in recent months, swinging from an all time high deficit of $2.5bn in January to a three and a half year low of $0.6bn in February.

This trade volatility reveals a slow improvement in trade flows, mainly due to increased export prices and volumes of heavy commodities. More generally, non-resource exports – rural, services and manufacturing – remain flat, with the strong A$ cited as contributing to a lack of competitiveness. Having said that 2006 is shaping up as a much better year for exports, resource exports will strengthen further as new capacity comes on line; rural exports will improve as supply rebuilds after the drought; and manufacturing and services exporters will get some relief from a weaker A$ which should allow for some building of volumes.

On the imports side there remains an underlying bullishness even after adjusting for imports of civil aircraft and fuel products. This is because domestic demand has not slowed much. Household consumption and dwelling investment have eased, and that has been reflected in a slowing in consumption imports. However, business investment is very strong and is being fed by increased imports of capital goods and intermediate goods. Import growth will ease over the next two years as the investment boom matures and in response to a lower A$. Exports will strengthen, but in volume terms will still be adding less to growth than is subtracted by imports.

Current account: The chief disappointment is that the current account deficit (CAD) will stay high both in A$ terms and as a percentage of GDP. The trade balance comprises only about one third of the CAD; the remaining two thirds is the net income deficit, which is the outflow of capital required to service Australia’s net international liabilities. The servicing burden has been rising in recent years, both because the stock of net international liabilities has been rising and because the cost of servicing these liabilities has been increasing in line with higher global interest rates and increased dividend outflows (the latter in particular reflecting the high profits of mining companies). The CAD is forecast to remain at around six per cent of GDP in 2006 and 2007.

Headline CPI inflation remains near the top of the RBA target zone, rising by 2.8 per cent over the year to the December quarter 2005. The various measures of core inflation remain more muted at 2.6 per cent or lower. Rebound in household spending will pressure domestic inflation One bit of good news is that domestic price pressures have eased a touch in response to weaker domestic demand through 2005, although they remain at a high level.