Economics and finance | Australia, Asia

3 February 2014

Storm clouds on the horizon, or plain sailing ahead? Quentin Grafton checks the economic forecast.

For the better part of two decades the Australian economy has been sailing. On a glistening ocean of global growth, terms of trade and fair fiscal weather, the economy has truly had the wind in its sails.

Even when the Global Financial Crisis (GFC) storm blew in, causing many Western nations to flounder in choppy seas, Australia navigated to safety, carried along in the wake of the Chinese boom and stimulus, a depreciated dollar and sensible made-in- Australia monetary policy responses.

But despite the apparent economic success, I’d argue that Australia is like a yacht in a gale—its policymakers can change direction, but only within certain boundaries and only after carefully aligning the sails to take account of the direction and strength of the global winds. Unfortunately, what’s ahead is unlikely to be as good as what we’ve enjoyed over the last ten years.

To understand where we might be headed, we first need to understand what challenges we face.

Australia confronts two types of economic risks and opportunities: the made-in-Australia variety, and global threats Australia cannot influence.

Made-in-Australia: risks and opportunities

The three Ps

A useful framework for understanding the key supply determinants of level and trend in economic performance at a per capita level is the three Ps— Participation in the workforce; Productivity and Prices (terms of trade). Australia has been fortunate that in the 1980s it benefited from a sustained increase in labour force participation, in the 1990s enjoyed a surge in productivity growth and in the 2000s a dramatic increase in its terms of trade.

Over the past three decades Australia has enjoyed solid growth in real per capita incomes. In the decade to 2023 per capita income growth will decline, labour force participation will be static or fall, and the terms of trade will be a drag on income growth.

I expect that only productivity is expected to make a positive net contribution to income growth over the next decade, but this will be at a level below the stellar performance of the 1990s.

Government revenues and spending

Nominal GDP growth, a key determinant of growth in government revenues, has dropped sharply since the boom peaked, declining from eight per cent in 2010–11 to about two per cent in 2012–13.

Slower and lower growth means that the expectations of Australians and the policy settings of the Commonwealth and state overnments need to change from their GFC levels. The most immediate impact, which is already being felt in 2014, is the effect on government revenues and budgets. The bottom line is that current projections are that payments will exceed receipts for the next decade, as will the underlying cash balance of the Australian Government.

Sustainable budgets over the business cycle require much more than reducing the growth in spending. They demand tax and transfer reform. The current tax system disconnects revenue raising from spending responsibilities at the state and federal level and includes many inequities and inefficiencies. A good place to start tax reform is the Henry Tax Review that was released in 2010.

Productivity growth, human capital and infrastructure

Beyond the immediate budget challenge to rein in spending growth, an increase in per capita Australian incomes over the coming decade will depend almost entirely on productivity growth.

Long-term growth in productivity, beyond tax reform, requires special attention to skills, training and education. Higher productivity is needed to justify Australia’s high wages. The challenge is that Australia is not only a high-cost economy relative to developing and emerging economies, but is high- cost compared to major developed economies such as the United States.

By itself, skills and education may not be sufficient to raise productivity growth to the levels of the 1990s, but they are absolutely necessary to ensure higher long-term productivity growth. Without a highly-skilled and productive workforce, Australia will not be able to take full advantage of the so-called Asian century.

Multiple improvements to long-term educational and workforce performance are required. But above all, improved teacher selection, training and pay must be a priority. Recruiting teachers who have some of the lowest entry scores to university, providing them with little specialised subject-matter knowledge and inadequate mentoring and support to learn how to teach has, and will, serve Australia poorly.

Other ways to raise working population capabilities include: curricula that support the fundamentals of numeracy and literacy, high-quality and available vocational learning, life-long opportunities for retraining, and equitable and needs-based funding to ensure high-quality teaching across Australia in both government and non-government schools. Building school gyms, or simply lowering entry or graduation standards at university, are not answers to Australia’s declining educational performance.

The deficiency in Australia’s capital stocks is not so much in physical assets, but rather in its human capital. Indeed, I would argue (and contrary to many commentators) that with the exception of public transportation networks in its faster-growing cities, Australia does not have a deficiency of infrastructure. At an annual average spend of

six per cent of GDP over the past four decades Australia has invested in infrastructure at a rate about 50 per cent greater than its industrialised peers. Further, the enormous past and current private-sector investments in Australia’s resources and energy sectors on infrastructure, and also in the electricity and water utility sectors, show that, when needed, infrastructure can and does get built by the private sector or with private/public sector partnerships. By contrast, the equally important need for Australia to invest wisely in training and education is not being met, at least as judged by our relative educational performance.

House price growth

One significant risk in terms of asset price growth is the housing sector. Australia is not alone in facing these risks, but it has had the most rapid growth in nominal house prices of all developed economies since 1997. While Australia has enjoyed one of the highest increases in real incomes and also population within the OECD during the boom, it ranks one of the highest in terms of price to income ratio, and the household debt to income ratio at about 150 per cent is close to, but not yet at record levels.

While I am cautious enough not to claim there is a ‘boom’ that inevitably implies a bust, the recent growth in the national median house price of nine per cent in 2013 (14 per cent in Sydney) is a concern, especially when it is about three times greater than nominal wage growth. Should the house price growth spurt continue for much longer there will be an overshoot that will likely create an ‘overhang’. Given that Australia’s major banks borrow about 30 per cent from offshore capital markets, any rapid fall in house prices would pose a dilemma for the big four banks and would likely result in an Australian-made credit crunch.

The risk is that if Australia were to continue its historically low interest rates the housing price surge would continue. The challenge remains to ensure low interest rates are in place to support economic growth and to depreciate the Australian dollar while trying to maintain price stability. Successfully achieving all of these policy objectives simultaneously while avoiding a housing price boom, and in the midst of competitive devaluations from key trading partners, is a ‘big ask’ of any central bank.

Global risks and opportunities

Asset prices

The GFC is not, and cannot be considered ‘over’, until the policy settings implemented over the past five-and-a-half years return to ‘normal’.

Currently very high equity prices do not reflect the prevailing risks but, if prices were to fall sharply, it could trigger another global economic downturn. This disconnect between asset prices and global risks is identified by the IMF, and others, and is a real indication that the world economy is not yet built on solid foundations. Should another downturn occur, the ability of developed economies to respond has become greatly diminished because of the conversion of private debt to sovereign debts and fiscal stimulus as a direct result of the GFC.

While some important measures have been implemented since 2008 to reduce financial risks in the global banking sector, long-standing trade imbalances remain.

Credit and liquidity factors are the most important cause of severe recessions. If the liquidity ‘tap’ stops, or even starts flowing at a slower rate, those countries dependant on international capital inflows for domestic loans and credit, such as Australia, could be squeezed.


Rapid credit growth in China itself represents another global risk. Business and household debt levels have increased in proportional terms by 60 per cent in the past six years and at 200 per cent of GDP is larger than the debt level in Japan in the late 1980s. Fortunately, Chinese authorities are aware of the risks and since June 2013 have responded by changing the policy levers to constrain credit. Such rebalancing, should, over time, support greater levels of consumption and help China maintain sustainable growth rates, albeit at levels well below the past two decades.

The challenge for Australia is that rebalancing the Chinese economy to proportionally less investment and more consumption will impose costs on resource exporters.

China has undertaken annual infrastructure investment equivalent to about 13 per cent of GDP since the mid-1990s, its annual growth in expenditures in 2013 on transport was over 20 per cent (annual growth was less than five per cent in 2011), and it already has the highest proportional and actual spend on infrastructure in the world with an already sufficient infrastructure stock at 76 per cent of GDP. So it seems likely that its infrastructure spending will decline in proportional terms by 2020.

Reduced investment and infrastructure spending as a proportion of GDP will accelerate expected declines in the price of some of Australia’s most valuable exports: iron ore and metallurgical coal. China now accounts for close to 40 per cent of our merchandise trade, so structural adjustments by China will have an impact on Australian exports well beyond the decline in commodity prices.


Australia’s income levels are based on trade. It is advantaged by location as Australia is placed in the fastest growing part of the world: Asia and the Pacific.

As a result of decades-old policies that have allowed migrants to come to Australia on the basis of their skills, rather than ethnicity or background, Australia now has a diverse and multicultural population with strong ties to Asia. Australia’s geographical proximity, its sizable Asian diaspora, and also long-standing diplomatic relationships with the

region, provide Australia with export opportunities, especially in tourism, education, financial services, technology services, and also agriculture. While important, the growth potential in any one of these sectors alone as China restructures will not likely substitute for expected declines in commodity prices and reductions in capital investments in the Australian resources and energy sector.

What opportunities that are available can be enhanced by additional free trade agreements, provided they give greater market access to Australia’s agricultural and services sectors.

Boom or bust?

It seems unlikely that the older generation of working Australians will ever again enjoy the size of the decade plus boom Australia has just experienced. It would seem, therefore, that Australia must ‘trim it sails’ in terms of its policy levers to ensure government spending and revenues converge, not diverge, so that when conditions get worse governments can respond effectively to manage negative shocks.

Like a competitor in the Sydney-Hobart race, Australia must compare itself with its peers. This demands that Australia has a sailing plan, but one sufficiently responsive that if conditions and our competitors change, it can alter course. If Australia’s terms of trade are in decline and labour force participation is static, it must have a coherent and useful plan to increase productivity growth to have rising per capita incomes. Such a plan must be pragmatic and be responsive to what works. It should not be based on unsupported assertions, but use empirical evidence and cross-country comparisons to support policy interventions.

Finally, Australia must navigate its way to avoid rocks and be prepared should the gale become a storm. The recent history of what happened to the US and the global economy when regulators were ‘asleep at the wheel’ should make Australia doubly vigilant to avoid its own home-made credit crunch and to take advantage of its currently growing economy to become more resilient to unexpected shocks.

Australia is not the sole master of its own destiny, but neither can it simply hope for the best or bet on its famed luck. Australia will navigate less friendly economic conditions in the years ahead to 2020.

Inaction or the wrong sort of actions, will make Australia more vulnerable and greatly increase the chances of a ‘hard landing’ for its economy.

Timely and effective action will be the difference between dropping anchor in the port of prosperity, or being lost at sea.

This piece was first published in Asia and the Pacific Policy Society’s magazine, Advance in March 2014:

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