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

Commodity prices and the terms of trade

Australia's terms of trade rose sharply over 2005, and they are likely to have increased by a further 2 per cent in the March quarter (Graph 37). They have increased by more than 30 per cent over the past three years, and are probably now just above the peak in the early 1970s, to reach their highest level since the wool boom of the early 1950s. This dramatic upswing has been mostly driven by substantial rises in the prices of Australia's commodity exports, supported by strong growth in the global economy. The RBA index of commodity prices (ICP) increased by 6 per cent over the three months to April, and by 26 per cent over the year, to be at its highest level since 1982, when the series commenced (Graph 38 and Table 9).

Although there has been broad-based strength in commodity markets, the most recent increase in the ICP has been mainly driven by the exceptional strength in base metals prices. The base metals index increased by 22 per cent over the three months to April. The recent rise partly reflected higher global portfolio allocations to commodities and speculative demand, particularly in the case of the 15 per cent run-up in the month of April. However, fundamental factors such as robust global demand, supply disruptions and low inventory levels are also supporting prices, particularly for copper and zinc.

Contract prices for coal and iron ore for the 2006/07 year (beginning April) had not been settled at the time this Statement was being finalised in early May. However, based on forecasts of price settlements, the new contract prices should be broadly neutral in aggregate for the ICP. (For further details, see ‘Box C: Commodity Contract Prices and Trade’.) Rural commodity prices rose by 3 per cent over the past three months, reflecting higher prices for sugar, wheat and wool. The price of sugar has been supported by high oil prices and an expected supply shortfall in 2006, which has been exacerbated by crop damage in Queensland from Cyclone Larry. Sugar prices are related to those for oil because of sugar's role in ethanol production, a substitute for petrol.

The terms of trade are likely to remain strong over the coming year. In the June quarter, expected increases in iron ore contract prices, as well as the sharp increases in metals and fuel prices through April, are likely to more than offset falls in contract prices for coal. Further ahead, expansion in global supply capacity for resources will probably, over time, tend to put downward pressure on their prices. Together with moderate growth in import prices, this is likely to result in some cyclical weakening in the terms of trade in due course. However, for at least the next year or so, the terms of trade are expected to remain at exceptionally high levels.

International trade

The subdued growth in Australia's export volumes over 2005 has in part been a signal of tight supply capacity. As a consequence, the 17 per cent increase in export earnings over the year was almost entirely due to rapid growth in resource export prices, which lifted resource export earnings by 40 per cent (Graph 39). Growth in resource export volumes was relatively sluggish, partly because of a number of episodes of disruption to coal, oil and LNG exports. Similarly, resource export volumes look to have fallen in the March quarter, due to precautionary shutdowns and some delays to resource export operations due to cyclones in Western Australia. These disruptions added to the recent volatility of monthly trade data and highlight the sensitivity of mining production when the industry has little spare capacity. Nonetheless, strong world demand and expansions in production capacity make for a positive growth outlook for resource export volumes over the remainder of 2006. In particular, shipments of LNG from the new Darwin compression plant commenced in February, and additional LNG shipments from the North-West Shelf are due to have commenced in the June quarter.

Earnings from manufactured exports increased by around 8 per cent over 2005, mostly reflecting solid growth in volumes in the middle of the year. More recently, export volumes appeared to have been relatively soft in early 2006. Strong global demand for raw materials has benefited resource-related manufactured exports, but reduced competitiveness with imports has encouraged some firms in the automotive sector to shift manufacturing operations offshore. Rural export earnings fell by around 3 per cent over 2005, as higher prices only partly offset broad-based falls in export volumes. The overall outlook for rural exports in 2006 is nonetheless positive, given above-average global prices, the large winter crop harvest in late 2005, and early indications of a large increase in summer crop production in 2006. The value of services exports increased solidly in January and February, to be 5 per cent higher over the year. The staging of the Commonwealth Games will have provided a boost in the March quarter. However, as noted in previous Statements, services exports are being dampened by declining average visitor expenditure and the increasing competition from foreign airlines.

The demand for imports slowed noticeably over 2005, in line with the more restrained pace of domestic spending (Graph 40). However, import volumes appear to have risen solidly in the March quarter, to be around 8 per cent higher over the year. Trends across the components of imports have been broadly consistent with the recent pattern of domestic spending; the value of capital goods imports increased by around 20 per cent over the year to March, in line with the favourable conditions for machinery & equipment investment. Fuels & lubricants imports have surged since the beginning of 2006, partly because some of the LNG production in the Timor Sea is being treated as an import before being re-exported.

Some categories of imports have been boosted, and some types of exports reduced, by the elevated level of the exchange rate in recent years. Compared to the level of the terms of trade, however, the exchange rate is much lower than earlier relationships would have suggested (Graph 41). This implies that, notwithstanding effects on areas of manufacturing, the exchange rate is not providing much of an offset to the stimulatory effects of the terms of trade on the economy as a whole.

Current account

The net income deficit (NID) widened to 4.2 per cent of GDP in the December quarter 2005, the highest level in over a decade (Graph 42). While there has been a rise in interest payments on debt owed abroad, the bulk of the recent movement reflects strong profitability of enterprises operating in Australia, mainly in the resources sector. Since the resources sector has a relatively high degree of foreign ownership, some of these higher profits accrue to foreign investors, and are thus recorded in the balance of payments statistics. With business investment rising strongly over the past couple of years, but corporate and government saving also increasing, the national saving–investment gap appears to have changed little. The total current account deficit remains around 6 per cent of GDP (Graph 43).

Capital account

Strong demand from foreign investors for Australian assets has driven continued strong gross capital inflows in recent quarters. Given the net inflow of capital of around 6 per cent of GDP during the past year, Australian net foreign liabilities in nominal terms have risen as a ratio to GDP. Relative to the value of Australia's private-sector wealth, however, net foreign liabilities are little changed since the late 1990s, at slightly below 20 per cent. This ratio has been broadly stable in recent years at a lower level than in the first half of the 1990s (Graph 44).

Within the total net capital inflow, gross foreign equity investment into Australia has been strong for some time, and was underpinned in the December quarter by foreign interest in share floats by several Australian companies. However, this was largely outweighed by substantial direct equity investment offshore by Australian entities, which resulted in almost the entire net capital flow into Australia over 2005 being accounted for by the debt component. Available data for the March quarter are suggestive of debt inflows having been increasingly concentrated in borrowings by financial intermediaries, especially via offshore bond issues, where these highly rated borrowers have been able to raise funds at attractive rates (see the chapter on ‘Domestic Financial Markets and Conditions’ for more details). In contrast, offshore bond issuance by non-financial businesses was much lower than the average of recent years, both in gross terms and adjusting for maturities.