Statement on Monetary Policy – August 2009 Domestic Economic Conditions

The global recession has had a significant effect on the Australian economy, although growth has been stronger than in most other advanced countries. The latest available GDP data suggest that the economy contracted slightly over the six months to the March quarter, compared with the significant falls in output in many other countries (Graph 32). More recent indicators, including private-sector surveys and information from the Bank's liaison program, suggest some modest strengthening, with consumer and business confidence having bounced back after the steep falls of late last year (Graph 33).

The initial estimates suggest that real GDP increased by 0.4 per cent in the March quarter, following a decline of 0.6 per cent in the December quarter (Table 7). Interpreting these data has, however, been made difficult by the unusually large gap between the different measures of GDP, which suggests that the initial estimates are subject to more uncertainty than usual (Graph 34). Looking through the measurement difficulties, and taking into account the many partial indicators of economy activity, it appears that there was a small contraction in the economy in late 2008 and early 2009. In any event, real gross domestic income has been substantially weaker than real GDP, reflecting the significant decline in the terms of trade over this period.

As has been the case in many other countries, both business and dwelling investment have fallen noticeably over the past couple of quarters. In contrast, Australia's export performance has been surprisingly strong, underpinned by a pick-up in Chinese demand for resources and a rise in farm output. Household consumption has also been stronger than in many other countries, supported by the fiscal stimulus and the significant falls in mortgage rates. Another factor supporting GDP growth in Australia, relative to other advanced economies, has been faster growth in the population, with the working-age population increasing by around 2 per cent over the past year, compared with an average increase in the G7 economies of roughly ½ per cent (Graph 35).

Household sector

In contrast to most other developed economies, indicators of household activity in Australia have been fairly resilient over the past year. Retail sales and the housing market have been quite buoyant since late 2008 and there has been a significant rebound in consumer sentiment, particularly over the past few months. The main exception has been household purchases of motor vehicles, which have trended lower over the past year.

The volume of retail sales increased at an annualised rate of around 6 per cent in the first half of 2009 (Graph 36) and consumer sentiment has recovered noticeably, to be back at or above long-run average levels. These developments appear to reflect a number of factors including some recovery in household wealth and a boost to household incomes from monetary and fiscal policy measures. After falling by 10 per cent over 2008, household net worth has increased in the first half of 2009, with both housing and equity prices rising (Graph 37). In addition, household incomes have been boosted by budget measures, in particular transfers amounting to around $20 billion (2¾ per cent of annual household disposable income) to low- and middle-income households between December and May. Many indebted households have also benefited from the significant decline in mortgage rates since September 2008. The reduction in interest payments is estimated to be equivalent to nearly 5 per cent of disposable income, though, at the aggregate level, this has been partly offset by a reduction in receipts on household deposits.

In addition to the stimulus provided to household spending, the boost to households from fiscal and monetary policy measures has allowed some consolidation of household balance sheets. While new housing loan approvals have increased significantly over the past year, housing credit growth has been little changed, suggesting that repayments by the household sector have increased (Graph 38). Credit card repayments have also risen over the past six months, with particularly large payments in December and April, suggesting some households used the government transfers to pay down credit card debt (Graph 39).

Nationwide dwelling prices have increased since the beginning of the year, and have largely recovered the falls experienced in 2008 (Table 8). Prices have generally increased in all capital cities for both houses and apartments. Prices in the less expensive suburbs have risen, reflecting the boost to housing accessibility from increased grants for first-home buyers (Graph 40). However, prices have also increased in the more expensive suburbs, after significant falls over 2008. This is consistent with activity in residential auction markets, where auction clearance rates in Sydney and Melbourne are well above their long-run average levels.

Spending on housing construction has been weak, but is expected to pick up over the remainder of this year. Demand for new housing is being stimulated by low mortgage rates and the temporary increase in grants to first-home buyers. Information from the Bank's liaison program indicates that home builders generally expect a significant increase in construction activity in the second half of the year, consistent with survey-based measures, such as the AIG-HIA Performance of Construction Index and the Master Builders Association survey. Conditions in the housing sector are discussed further in ‘Box D: The Expected Pick-up in the Home-building Sector’.

Business sector

There have recently been some encouraging signs in the business sector, following the significant deterioration in conditions and expectations in late 2008. In a range of business surveys, measures of business confidence have improved from very low levels around the start of the year. Firms have also reported that actual business conditions have picked up considerably in recent months, to be back at more normal levels (Graph 41). Capacity utilisation has also levelled out, after falling sharply in late 2008 and early 2009. While it is too early to tell whether these positive trends will persist, it is encouraging that the improvement is evident across a range of surveys, such as the monthly NAB and AIG surveys, and is reasonably widespread across industry sectors and states.

In the near term, however, the level of business investment is likely to decline further given the sharp scaling back of firms' spending plans in response to the deterioration in the outlook for the world and domestic economies in the latter part of 2008. Businesses investment fell by 6 per cent in the March quarter, with a number of indicators suggesting a further decline in the June quarter and continued weakness over the remainder of 2009 (Graph 42).

The area of greatest weakness is likely to be the private non-residential construction sector, where the value of building approvals fell by a further 3 per cent in the June quarter, to be around 50 per cent lower than its peak in mid 2008. According to the Bank's liaison with businesses, this partly reflects the difficulties that commercial (and some residential) property developers are having accessing finance. The weakness also reflects softening demand for office and retail space. The deterioration in office market conditions has been most pronounced in the Perth and Brisbane markets, which were tightest prior to the current downturn (Graph 43). Office vacancy rates have increased since the beginning of 2008, but nevertheless remain below the average of the past two decades. Nationwide office capital values in the June quarter were estimated to be 23 per cent below their peak in late 2007, although sales volumes have been low, making it difficult to measure price movements accurately.

The Bank's liaison indicates some moderation in the scale of firms' planned cuts to investment spending over the past three months. This is consistent with recent private-sector business surveys that have reported that firms were less pessimistic about their investment intentions in the June quarter than they were during the previous six months. In part, this may reflect the tax credits introduced for business, particularly small businesses, which provide tax deductions for new tangible depreciating assets, such as machinery and equipment. Private-sector surveys suggest that around a third of small businesses have increased their investment in response to this tax concession, with motor vehicle deliveries to businesses rising by 27 per cent in May and June but then falling by 12 per cent in July (Graph 44). Another factor supporting the outlook for business investment is the gradual improvement in financial conditions, with the ACCI-Westpac Survey of Industrial Trends suggesting some easing in the financing constraints facing firms, although, as noted above, some sectors of the economy continue to face difficulty accessing finance.

While aggregate capacity utilisation has fallen significantly, it remains well above levels of previous downturns. Indeed, with the recent rebound in demand from China, some mining firms are now almost back to full capacity. Although mining investment is likely to decline somewhat over the coming year – due to the fall in the amount of new projects that were commenced over the first half of 2009 – further increases in petroleum exploration and the recovery in energy prices and demand for bulk commodities could significantly boost investment spending in the medium term, especially in the LNG and iron ore sectors. As a result, although there will be some near-term decline in investment from its historically high share of the economy (Graph 41), the medium-term outlook remains strong.

More broadly, notwithstanding isolated areas of weakness, the overall financial health of the business sector remains strong. After rising through 2008, corporate insolvencies have levelled out in the first half of 2009. Business profits have declined reflecting the more difficult trading environment, but larger businesses have continued to shore up their balance sheets by raising equity and paying down existing debt (for further details, see the ‘Domestic Financial Markets’ chapter). In addition, there has been a shift in the sources of debt financing, with a pick-up in debt issuance in capital markets largely offsetting a decline in intermediated credit. Overall, total business funding has continued to expand, albeit at a slower rate than occurred in the past few years.

Government budgets

Australian Government and state budgets released since the start of May indicate that fiscal policy has exerted significant stimulus over the past year and that there will be some additional stimulus in 2009/10 (Table 9). In total, the general government (Australian plus state) deficit is budgeted to increase from 3.9 per cent of GDP in 2008/09 to 6.4 per cent in 2009/10, before narrowing in future years (Graph 45). The expected widening of the deficit in 2009/10 reflects both policy decisions and the automatic stabilisers (the impact of the weaker economy on the budget). In addition, state government trading enterprises plan to increase capital expenditures significantly in 2009/10. Total capital expenditure by the state public sector (including both public trading enterprises and the general government sector) is expected to rise by $13 billion, equivalent to 1.1 per cent of GDP in 2009/10, including significant investment in schools and public housing as part of the Australian Government's fiscal stimulus measures.

Farm sector

Most rural areas have had a good start to the winter cropping season, with a near-record area planted with wheat. However, the Bureau of Meteorology is predicting a hotter and drier-than-average spring in eastern Australia cropping regions, reflecting the emergence of an El Niño weather pattern. Based on information from the Australian Bureau of Agricultural and Resource Economics (ABARE) and other rural agencies, a wheat crop of around 22 million tonnes is expected in 2009, up modestly from the 2008 crop, and farm output is expected to rise by around ½ per cent in 2009/10. Below-average rainfall over the first half of 2009 continues to result in historically low inflows into the Murray-Darling system, with irrigation water allocations from this system remaining at low levels.

External sector

Despite the sharp slowing in the world economy and the accompanying decline in global trade since late last year, Australia's exports have held up remarkably well to date. This is in stark contrast to many of Australia's major trading partners, which have seen falls in export volumes of 10 per cent or more over the same period (Graph 46). Australian export volumes are estimated to have increased slightly in the June quarter, after growing by around 2 per cent over the six months to the March quarter. The relative strength of Australian exports reflects a strong recovery in Chinese demand for resources, a recovery in rural exports following the larger wheat harvest in 2008, and resilience in service exports, offset by weakness in manufactured exports (Graph 47).

Australian resource export volumes are estimated to have been broadly flat over the three quarters to June, although values have declined by nearly 30 per cent, with prices bearing the adjustment rather than volumes. The strong recovery in the Chinese economy and particularly China's demand for resources has been an important part of the resilience of Australian resource export volumes. For example, Chinese steel production has risen by 20 per cent since the end of last year, to be around 5 per cent above its mid-2008 peak, which has boosted demand for iron ore and coking coal. Consistent with this, Australian iron ore exports picked up strongly in the March and June quarters, with China's share of Australia's iron ore export volumes rising to 80 per cent (Graph 48). Coking coal exports have also risen in the June quarter, underpinned by stronger exports to China and India. China's share of Australian coking coal exports has risen to 28 per cent in June – from less than 1 per cent in 2008 – as Chinese steel mills have substituted away from more expensive domestic sources of coal. There are also some tentative signs that demand is recovering elsewhere, with exports to Japan and South Korea increasing modestly towards the end of the June quarter. While strong demand from China helps explain much of the resilience of Australian resource exports, there have also been some other factors at work, such as an expansion of LNG supply with the ramping up of production at the North West Shelf's fifth compression plant.

Rural export volumes have risen by nearly 20 per cent over the three quarters to June, reflecting the recovery in rural production following a return to more normal seasonal conditions in 2008. Wheat exports have more than doubled over this period as the relatively large 2008 wheat crop has been exported. Service exports have also held up comparatively well and are estimated to have risen by 4 per cent over the three quarters to the June quarter. This has reflected continued solid growth in travel services, which includes education services.

In contrast, the volume of manufactured exports is estimated to have declined by around 15 per cent over the three quarters to June, led by sharp falls in transport equipment exports. This is broadly consistent with the experience in other economies, but in Australia manufactured goods account for only around 20 per cent of total merchandise exports compared with 80 or 90 per cent for many countries.

Import volumes appear to have been broadly unchanged in the June quarter, after falling by 7 per cent in each of the December and March quarters, the sharpest falls in import volumes since 1975. The recent moderation appears to have been led by a modest rise in consumption imports, broadly consistent with growth in household consumption; the rise in the Australian dollar since the start of the year has also lowered the cost of imported goods. After a significant depreciation over the second half of 2008, associated with a weakening in commodity markets, the real exchange rate has appreciated in recent months (Graph 49). It has now reversed much of the earlier depreciation, to be 6 per cent lower than its mid-2008 peak. In contrast to consumption imports, capital imports appear to have fallen further in the June quarter, consistent with ongoing weakness in machinery and equipment investment.

With import values having declined by more than export values, the trade surplus widened in the March quarter, to its highest level since 1973. However, the trade balance is estimated to have been a small deficit in the June quarter, reflecting the fall in export prices and the terms of trade (Graph 50).

Labour market

Conditions in the labour market have softened this year, with unemployment increasing and employment being broadly flat. In July, the unemployment rate stood at 5.8 per cent, around 13/4 percentage points above its trough in early 2008 (Graph 51). The level of employment is 0.2 per cent below its peak in late 2008. Thus far, though, the fall in the number of employed persons has been smaller than expected.

However, total hours worked have declined more noticeably than the level of employment (Graph 52). Flexibility in the labour market has allowed many firms and their workers to modify working conditions as an alternative to layoffs. This has enabled many firms to reduce the number of hours worked by employees in a bid to reduce labour costs while holding on to workers; as a result, average hours worked have fallen for both full-time and part-time employees in recent months. There has also been a shift in the composition of employment, with full-time employment declining by around 2 per cent since its peak in mid 2008, while part-time employment has risen by more than 4 per cent in trend terms over the same period. A significant proportion of the fall in full-time employment is accounted for by the manufacturing industry, which employs a relatively large proportion of full-time workers and has traditionally been quite cyclically sensitive (Graph 53).

Labour force participation has remained relatively close to its historical high in recent months, despite the weakening of the labour market. In previous downturns the participation rate has tended to fall as discouraged workers exit the labour force when employment prospects diminish. While the absence of any significant fall in participation to date may reflect longer lags in the current episode, the participation rates of married women and persons aged 55 or more have risen. In the latter case, it appears that some older workers may be delaying retirement due to the significant loss of wealth in 2008.

While conditions in the labour market are likely to weaken further in coming months, some forward-looking indicators are suggesting that the pace of deterioration may ease. Measures of hiring intentions in business surveys have risen from their lows in recent months, and this is consistent with the Bank's liaison with firms, which points to a pick-up in the number of firms expecting to increase employment in the next year (Graph 54). Aggregate job advertisements, as reported by ANZ Bank, have continued to fall, though at a slower pace than in early 2009.