Glenn Stevens: Producing prosperity
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Committee
for Economic Development of Australia (CEDA) Annual Dinner, Melbourne, 20 November
2012.
* * *
Thank you for the invitation to join you for your Annual Dinner.
Financial markets and policymakers have been living in a more or less continual state of
anxiety for over five years. While it was poor-quality lending in the US mortgage market that
proved to be a key cause of problems, from quite early on it became apparent that European
banks also had serious difficulties, because of their exposure to securities of doubtful quality,
their high leverage and their need to fund US dollar portfolios on a short-term basis. It was in
August 2007 that those acute funding difficulties first became apparent in European markets.
Five years on, US banks have made a lot of progress in working through their asset quality
problems and their capital deficiencies. At times the process was not pretty, but the
US system is in better shape today as a result. US taxpayers have earned a positive return
on the investments in major banks that were made at the height of the crisis.
In Europe progress has been much slower. There are various reasons for that, not least the
sheer complexity of coordinating the process of evaluating and strengthening balance sheets
across so many countries, where the national capacities to assist are so different, and within
the strictures of a currency union. This exacerbates, and in turn is compounded by, the
deterioration in economic conditions in Europe, which feeds back to bank asset quality and
sovereign creditworthiness.
It is perhaps no surprise then that the news seems to have been dominated by the ebb and
flow of anxiety over things like: whether or not the "troika" will recommend further funding for
Greece; whether a national constitutional court will strike down a government's participation
in initiatives that will assist other countries; or whether the populace in a country under
pressure will reach the end of its tolerance for "austerity" - and so on. There is "event risk"
almost weekly. This is the European drama.
Unfortunately, it is, I suspect, set to continue that way for quite some time. Over recent
months financial market sentiment has improved, from despair to mere gloom, as a result of
a number of important steps that have been taken and commitments that have been made. It
is right that this improvement in sentiment has occurred - it recognises the determination of
the Europeans to save the euro, which should not be underestimated. But there is much
more to do, and it will take a considerable time. So while good progress is being made, we
will not, any time soon, see a point at which the "euro problem" can be seen as past. The
world will have to live with euro area anxiety for some years yet as a normal state of affairs.
In the meantime the US economy has continued its slow healing. The US housing sector
has, it would appear, finally turned. Now the election is past, the so-called "fiscal cliff" is
rapidly coming into focus - a new source of event risk. But if one is prepared to assume that
the US political system will not, in the end, preside over an unintentional massive fiscal
contraction next year, the risks to the US economy probably look more balanced than they
have been for a while. An upside surprise would be as likely as a downside one. It would be
fascinating if, in another year, we find ourselves looking back at a US economy that had
outperformed expectations. (There is still of course a critical need for the US to craft a
measured and credible path back to fiscal sustainability. That particular drama could
continue as long as the European one.)
But it is appropriate to turn our gaze to our own part of the world, especially in the
current period of discussion about "the Asian Century". Two years ago, when I last spoke to
CEDA's Annual Dinner, a key feature of my presentation was this chart.1
Graph 1
This evening I can show how the chart looks when updated for two more years of data and
our revised estimates for the near-term outlook. The terms of trade ended up rising further
than assumed two years ago, and have then fallen back from the peak, though the level
recorded in the most recent quarter is about 7 per cent higher than was in the forecast two
years ago.2
The event is sufficiently unusual that we can add one twist to the chart. Instead of a five-year
average, we can show a decade-long average. The chart in fact shows an eleven-year
average, which allows the measure to be centred on the current year. To do this of course
we need to make a five-year-ahead assumption. We have assumed that the terms of trade
decline steadily, at a pace a little faster than implied by forecasts of private analysts. What is
unusual about this event is not just the peak level observed, but the apparent persistence of
high levels. The terms of trade will very likely record over a decade an average level
50 per cent higher than the previous long-term mean. That is a big deal. Even with a more
pessimistic assumption - say that commodity prices fall by twice as much over the next five
years - there is no doubt that this is easily the biggest, and the most persistent, terms of
trade event for a very long time.
Graph 2
Still, the terms of trade have peaked, and will probably have fallen by about 15 per cent by
the end of this year. Further declines over time are likely. So while a high level of the terms of
trade continues to add to the level of national income, we can no longer expect that a rising
growth
terms of trade will be adding to in living standards. We are entering a new phase.
This is not so much because of the "end of the mining boom". As a matter of fact, talk of the
"end of the mining boom" has been somewhat overhyped. The "boom" is not so much ended
as simply evolving, as these events would be expected to. Thoughtful commentators have
already pointed out on a number of occasions that there are three phases to the "boom".
The first was the rise in prices - something that began as far back as about 2004. The peak
in prices was more than a year ago now. The Reserve Bank began noting that prices had
declined in our monthly interest rate announcements in October 2011. But relative prices for
natural resources are still high. At this point, the terms of trade are down to the "peak" seen
in the September quarter of 2008, which was of course a fifty-year high.
The second phase of the "boom" is the rise in resource sector physical investment. This is
aimed at taking advantage of expected high demand for iron ore, coal, natural gas and other
commodities over the medium term, at prices which are attractive relative to costs of
production, including the cost of capital. The peak in this build-up lies ahead. It has, for some
time, been our expectation that it will occur in 2013 or 2014; that expectation seems to be
firming up. The actual level of the peak is probably going to be a bit lower than we thought
six months ago, in view of the somewhat lower, and more variable, prices for iron ore and
coal observed in recent months.
But it's worth putting that downward revision into perspective. For fifty years, resource sector
investment was typically between 1 and 2 per cent of GDP, with cyclical peaks at about
3 per cent (Graph 3). The uncertainty now is over whether it will peak at closer to 8 per cent
of GDP than 9 per cent. What isn't uncertain is that either number is very high by any
historical standard.
Graph 3
It's also worth observing that, in any episode of this nature, there will always come a point
when some potential projects, conceived at the time when prices were at their highest and
when costs were about to start mounting quickly as well, have to be shelved. Actually, if
projects that rely on extremes of pricing and optimism can be shelved before they get too far,
that is preferable to having them continue. More generally some important parts of the
resources sector have now reached a point where the costs of further expansion in capacity,
relative to those that might be expected elsewhere in the world, are a much more important
factor in investment decisions than they were a couple of years ago.
The third phase of the "boom" is when the capacity to extract and export higher quantities of
resources is actually used. This phase has begun for iron ore but it is mostly still ahead of us,
especially for gas. The main uncertainty is really over the prices that will be achieved as
higher supply - and not just in Australia - comes on stream. Such uncertainty is, and always
has been, part and parcel of the business of investing in resource extraction.
Perhaps what people have found a little unnerving over the past year is that as the prospect
of rising supply of key natural resources gets closer, and prices have declined from their
peaks, the Chinese economy has been in transition to slower growth. It was inevitable that
China would slow to some extent, from the very rapid pace seen for much of the past
decade. The signs it needed to do so were quite evident: increasing general price inflation,
escalating property prices, doubts about the process of credit growth and credit risk
management, and so on. But just how big a slowing was occurring? For much of this year,
that was the question that people have been trying to answer. My assessment is that the
slowdown has been more material than had been expected a year ago, but not disastrously
so. There are some signs that the moderation may have run its course, though further data
are needed before such a view could be offered with confidence.
So the Chinese economy has not crashed. But neither is it likely to return to the sorts of
double-digit percentage rates of growth in real GDP, and 15 per cent growth rates for
industrial production, that we saw for some years. People expecting that to resume are likely
to experience disappointment.
These trends are entirely consistent with two propositions that we have advanced over the
past several years. The first was that China's economy would have an important and
increasing weight in the regional and global economies. China's economy is nearly three
times the size it was a decade ago. One corollary of this is that even "moderate" growth in
China is quantitatively significant. If China grew by, say, "only" 7 per cent in 2013, that would
add more to global GDP than the 10 per cent growth recorded in 2003.3
The second proposition was that China, like all economies, has a business cycle. It is
affected by what happens elsewhere in the world, and by its own internal dynamics, including
the decisions of its policymakers. Swings in China's economic performance are increasingly
affecting Australia's economy and that of the region - and the world. Hence the focus on
monthly data reports from China these days in our business press, in addition to the focus on
the Chinese political situation. The Chinese "purchasing managers index" is now as keenly
awaited, and is as potentially market moving, as the original US PMI measure, known these
days as "ISM".4
There is some tentative evidence that Chinese data "surprises" have become
increasingly influential in driving movements in Australian financial prices such as the
exchange rate and share prices.
Turning then to Australia, two years ago I noted that we could not know how much of the rise
in the terms of trade would be permanent, and that there was therefore a case to save a
good proportion of the additional national income until it became clearer what the long-run
prospects might be. In a manner of speaking, we have, as a community, done something like
that. The marked rise in the rate of saving by households in 2008 and 2009 has been
sustained. Corporations have also increased their saving considerably over the past five
years, opting to repay debt and lower their gearing ratios.
Admittedly, government saving has been lower for a time, for countercyclical purposes,
though that is now scheduled to rise as well. For the nation as a whole, the fact that the
current account deficit has been lower on average in the past few years than in the period
from 1985 to 2005, at the same time as the share of business investment in GDP has been
exceptionally high, indicates that national saving has been higher. In fact it has been at its
highest share of national income since the late 1980s.
This change can be seen as a sensible response to an unusually high level of the terms of
trade. Something else has also been at work, though, in household behaviour. I have spoken
about this before but it bears saying again, because it is fundamental to understanding the
current economic situation.5 After a period in which high levels of confidence,
macroeconomic stability, easy availability of credit and rising asset values saw Australian
households borrow more and save less, households have over recent years changed their
behaviour in respect of spending, saving and borrowing. They have gone back towards what
was once considered as "normal".6
This really had nothing to do with the resource boom. But it has had important implications
for some key business sectors. Financial institutions are finding that growth in credit is now a
single-digit number, not a double-digit one as it had been for so long. Businesses that in the
earlier period of optimism derived earnings from high rates of turnover in asset markets -
real estate agents, stock brokers, for example - face challenges, given that turnover is now
greatly reduced.
The retail sector now faces different consumers. It is not actually that consumers have no
income to spend, nor that their confidence levels are that low, nor that their saving rate is that
high. Measures of confidence that date back to the 1970s show it to be roughly at its long-run
average. The household saving rate as measured by the Australian Statistician, at just over
10 per cent, is not, in fact, high in the broader sweep of history (Graph 4).
Graph 4
To be sure, confidence was persistently very high for years up to 2008, and saving was very
low - even falling to about zero, as measured, at one point. But that period was unusual. I
don't think it will return. Moreover consumers are much more knowledgeable about prices as
a result of information technology, and have at their disposal ways of responding to that
information that a decade or more ago they did not have. This is putting pressure on retail
business models, on wholesaling and distribution, and also on segments of the retail property
sector.
Given that the change to household behaviour was probably inevitable, the income boost
from the terms of trade arrived at a rather fortuitous time. It helped to accommodate a rise in
household saving and a slowdown in the build-up of debt in a fairly benign fashion. The
weakness of some other parts of private demand, and openness to imports with a high
exchange rate has also meant that a very large expansion in mining investment has been
accommodated without overheating the economy overall. As it was, total real private final
demand in Australia rose by 6 per cent in 2011/12, well above trend.
With the peak in the investment phase of the mining boom now coming into view, the
question naturally arises as to how the balance between the various types of demand in the
economy will unfold. Mining investment will contribute less to growth in domestic demand in
the current fiscal year than it did last year, and less again next year. Working in the other
direction, it is likely that export volume growth will begin to strengthen as the capacity being
installed in the resource sector is used. That would show up as GDP growth, though it may
be predominantly reflected as higher measured productivity rather than generating a large
volume of extra employment.
The question will be whether other areas of domestic demand start to strengthen. Many
households have made progress in reducing debt burdens. At some point that might be
expected to lead to such households feeling more inclined to spend. But a complex
interaction of factors - asset values and expectations about job security to mention two - will
be at work in ways that are not amenable to accurate short-term forecasting. Overall, our
assumption is that consumption will probably continue to grow at about trend pace, in line
with income.
Public demand is scheduled to be subdued as governments seek to return budget positions
to surplus. The near-term outlook for business investment spending outside the resources
and resource-related sectors is subdued, judging by currently available leading indicators. In
most cycles, it takes time for this sort of investment to turn; this episode looks like no
exception. The exchange rate may also have some role in helping the needed re-balancing.
While it's not surprising that the Australian dollar has been very strong given the terms of
trade event we have had, it is surprising that it has not declined much, at least so far, given
that the terms of trade peaked more than a year ago. A lower exchange rate would, of
course, need to be accompanied by a pace of growth of domestic unit costs below that seen
for much of the past five years, in order to maintain low inflation.
One area of stronger potential demand growth is dwelling construction, which has been
unusually weak. It is not clear, actually, that the degree of weakness has been adequately
explained. Various explanations have been offered - interest rates too high, housing prices
falling, zoning restrictions, planning delays, construction costs, lack of "confidence", all have
featured. At present, at least some of the pre-conditions one might expect to be needed for
higher construction seem to be coming into place. Interest rates have declined, dwelling
prices seem to have stopped falling, rental yields have risen, and the availability of
tradespeople is assessed as having improved. We have, moreover, seen a rise in approvals
to build. So there is some evidence of a turning point, albeit a belated one.
Will the net effect of these developments mean that aggregate demand rises roughly in line
with the economy's supply potential over the next couple of years, or will a significant gap
emerge? That is the question the Reserve Bank Board is trying to answer every month when
it sits down to decide the stance of monetary policy.
As of the most recent meeting, as the minutes released earlier today show, the Board felt
that further easing might be required over time. The Board was also conscious, though, that
a significant easing of policy had already been put in place, the effects of which were still
coming through and would be for a while. In addition, the latest inflation data, while not a
major problem, were a bit on the high side, and the gloom internationally had lifted just a
little. So it seemed prudent to sit still for the moment. Looking ahead, the question we will be
asking is whether the current settings will appropriately foster conditions that will be
consistent with our objectives - sustainable growth and inflation at 2-3 per cent.
Over the long run, though, the bigger question, for all of us here tonight and in the business
and policy making community generally, isn't about the monthly interest rate decision. The
big question is: what is the sustainable growth rate of the economy? Beyond its role of
preserving the value of money, monetary policy can do little to affect that sustainable growth
rate. Moreover, the initial contribution of rising mineral prices to our standard of living has
now run its course. To be sure, a higher capital stock devoted to extracting resources at high
prices, assuming they continue, will make its contribution for many years - to the extent that
Australians own some of that capital, work with it or receive tax revenues. But the biggest
contribution to growing living standards will be what it has always been other than in periods
(usually not long-lived) of exceptional luck, and that is productivity performance. I noted two
years ago that while our terms of trade are handed to us, for better or worse, by international
relative prices, the efficiency with which we work is a variable we can actually do something
about.7
For some years there had been evidence of a slowing in productivity growth, beyond the
unusual factors clearly at work in a couple of sectors (mining and utilities). The most recent
data on productivity show signs of a pick-up in the year 2011/12, which is encouraging
(Graph 5).
Graph 5
It is much too soon to conclude that a new, stronger trend is emerging - in this field much
longer runs of data are needed. In my opinion, the accelerated structural change we are
seeing in the economy for various reasons is likely to result in some improvement in
productivity performance. But the most that can be said, at this stage, is that the data are not
inconsistent with that hypothesis.
At this point when talking about productivity, I usually become circumspect. One reason is
that I know that people might ask what we might do to improve productivity performance, and
I am acutely aware that the improvement has to be delivered in enterprises all around the
country - the ones associated with CEDA and millions more. Productivity does not rise
simply because of exhortation or official pronouncements.
As for policy measures, at a meeting in Brisbane earlier this year, I said:
The Productivity Commission has a long list of things to do. My answer to what
we can do about productivity is: go get the list and do them.8
That comment elicited some attention. The Chairman of the Productivity Commission was, I
am led to understand, inundated with media demands for "the list" and had to explain that it
didn't quite exist in that form. But Chairman Gary Banks has very kindly drawn one together,
in his final public speech at the end of a very distinguished tenure in that position.9 His list is
a rather more complete one than mine. In fact it is a set of lists, under three headings: things
that affect incentives, things that affect capabilities and things that affect flexibility. What was
perhaps most striking was the comment in the conclusion that no single policy offered the
secret to success.
To quote:
Rather, what is needed is an approach to "productivity policy" that embraces both
the drivers and enablers of firm performance, and is consistently applied. That in
turn requires policy-making processes that can achieve clarity about problems,
reach agreed objectives and ensure the proper testing of proposed solutions
(including on the "detail" and with those most affected). The beneficial and
enduring structural reforms of the 1980s and 1990s are testimony to the value of
these policy-making fundamentals. Good process in policy formulation is
accordingly the most important thing of all on the "to do list", if we are serious
about securing Australia's future productivity and the prosperity that depends on
it.10
It couldn't have been better put.
As the "mining boom" moves from its second to its third phase over the next year or two, the
world economy will continue to present its own challenges. Australia will, as always, need to
adapt to the changing circumstances. Looking much further ahead, to "the Asian century",
our opportunities are large. But to grasp them, that same adaptability, combined with a clear
focus and steadiness of purpose will be key. We need to produce our sought after prosperity;
it won't just come to us. All of us have our role to play, CEDA and its members included. I
wish you every success.