Glenn Stevens: Economic conditions
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the American
Chamber of Commerce in Australia Business Luncheon, Melbourne, 13 June 2008.
* * *
Thank you for the invitation to address you in Melbourne today. I read that AmCham is the
largest international chamber of commerce operating in Australia, and has been working to
promote trade, investment and general business links between the United States and
Australia since 1961. Over that period of nearly five decades, the US and Australia have
enjoyed a mutually beneficial trade relationship, enshrined most recently in the Free Trade
Agreement.
During that time, a lot of other shifts have occurred, of significance to us both. In 1961, nearly
a quarter of Australian exports went to the United Kingdom, our number one trading partner.
Trade with China was of inconsequential size. Japan had become a prominent destination for
exports by then, but would go on to become by far our largest trading partner by the end of
that decade, due to the expansion in the mining sector. In 2007, the UK was number six as a
destination. The US was number three (little changed from 40 years earlier). China equalled
Japan in first place for two way trade, and will easily outstrip Japan this year.
Of course, the United States is still far and away the largest economy in the world, and will
remain so for quite a while. Nonetheless, the change in the trade experience of Australia -
and we are hardly alone in that - is an indicator of the way the weight in the world economy
is gradually shifting to the Asian region.
On the financial front, in contrast, Asia remains in many respects underdeveloped, especially
in terms of the prominence of its local-currency capital markets. US capital markets remain
the largest, deepest and most influential, driving developments in stock, bond and money
markets, and their various derivative offshoots, around the world.
That contrast - the increasing economic weight of Asia and the continuing dominance of
American behaviour in financial markets - is in many ways at the centre of the set of
challenges facing Australia, and I suspect other countries, right now. Before coming to that,
however, it is fitting to begin with some remarks about the US economy. I will then talk about
the global economy more broadly, and particularly the effects of the US slowdown on the rest
of the world before focusing particularly on Australia and the current challenges of economic
management that we face.
The United States economy
As you well know, the US economy is struggling with a period of weakness at present.
Growth has slowed to a very subdued pace, and confidence is well down. There continues to
be debate as to whether or not what we are witnessing can be called a recession. In some
respects, this is a rather silly preoccupation because there is no doubt that conditions are
weak, and it is not worth spilling much ink over whether the growth rate is just above or just
below zero. That said, the US economy has, thus far, done a little better than many people
had feared.
Of course the episode is not yet over; a period of adjustment still lies ahead. The epicentre of
this adjustment is the housing sector, where deteriorating lending standards and a
speculative boom in parts of the country a few years ago led to a build-up of excess physical
stock and over-stretched borrowers. Subsequently, the need to work off this overhang has
seen construction rates for new homes fall by half, and prices for established homes in many
major cities decline for the first time in many years. Rising defaults and foreclosures are likely
to dampen prices further. The non-recourse nature of mortgages in some US states is
potentially a destabilising factor as well, since even people who can service a loan have an
incentive to walk away once their equity falls to zero. Tighter credit conditions are a
dampening factor for the US economy more generally, as lenders work to limit risk in order to
repair their own balance sheets.
So the real question is when the preconditions for a renewed expansion will come into place.
It is perhaps a bit soon to conclude that we have reached that point. There are certainly
some helpful dynamics at work: the worst fears of a serious financial collapse have abated
somewhat over the past couple of months, the process of balance sheet repair for key
institutions is well under way, macroeconomic policies have been put into expansionary
mode and initiatives to offer some modest support to the housing market are in train.
Considerable uncertainty, nonetheless, surrounds the outlook for the United States over the
next year or so.
The global economy
What is the effect of this on the rest of the world? In a previous response to this question,1 I
suggested that there are two key channels to consider. The first is trade spillovers, as the fall
in US income means that the US demands less in the way of products from other countries.
The decline in the US dollar also works in this direction. The second potential channel is
financial contagion, with the possibility that other countries may experience the same
financial dynamics as those which have been at work in the United States.
My view was that this second channel was likely to be the more important one in this
episode. The trade channel certainly is working - lower US demand is being felt in weaker
exports to the United States from most parts of the world. But other forces are also at work,
and the strength of some other regions has meant that many export-driven economies,
certainly those in Asia, have continued to record quite solid growth into the early months of
2008. Some of these countries have also developed a good deal of momentum in domestic
per se
demand. So to date, trade has not been the major issue.
But financial exposures to the problem assets were spread around the global system.
Creditrelated losses that have been disclosed by financial institutions around the world to date
amount to something approaching US$400 billion, of which about half is in institutions
domiciled outside the United States. More losses reside in entities outside the core financial
system. So the pressure on balance sheets arising from the decline in credit standards in the
middle of the current decade has extended beyond the US itself, at least to Europe and the
UK. Given the integrated nature of financial markets in the developed world, moreover,
pressure on term borrowing costs for banks has been seen in many places over the past
nine months, even if in a less acute way than observed in the countries at the centre of the
crisis.
These forces are contractionary in nature, and so global growth is widely expected to be
lower in 2008 than the very strong result in 2007. According to the IMF, global GDP growth
will moderate to about 33⁄4 per cent in 2008 and 2009, with slowing concentrated among the
developed economies of North America, Europe and Japan. This forecast embodies a mild
US recession during 2008.
But while this outcome for global growth would be well below the exceptional pace of about 5
per cent seen in 2006 and 2007, it is actually in line with the average rate of growth for the
world economy over the past 15 years. And although the IMF suggested in April that the
short-term risks surrounding this forecast were concentrated on the downside, with a 25 per
cent chance of global recession (which it defines to be global growth at or below 3 per cent),
recent developments do not suggest that those risks are any more likely to be realised than
was the case a couple of months ago.
To date, in fact, the financial developments that have so occupied the minds of developed
world policy-makers have not been as big an issue for many countries in the emerging world,
at least not those most important to Australia. Banks in those cases have not had serious
funding problems, perhaps in part because their own exposures to the bad assets were
minimal. Capital markets, which are less important as avenues of funding than in many
developed economies, have not been a source of significant disruption. Admittedly, share
markets in the emerging economies have declined noticeably, but credit expansion has
continued unimpeded and, as I indicated a moment ago, economic growth appears to have
remained pretty solid.
In fact, around much of the emerging world at the moment, the bigger problem seems to be
neither the near or actual recession of the United States, nor the credit crunch about which
we hear so much in the discussion of the major countries, but inflation. From Asia to Latin
America to Africa, as well as in many of the industrial countries, we are hearing a lot more
about inflation now.
Food price rises loom large in developing countries' consumer basket, so the big rises in
grain prices over the past year have been very prominent. Several potential drivers of these
increases have been nominated. One is the change towards a more protein-intensive diet as
developing countries' incomes rise, which increases demand for grain to feed animals kept
for meat. This is no doubt a factor, but it is a long run trend and there is no evidence that
meat consumption has exploded just in the past year.2 Another is the diversion of some
grains towards production of bio fuels, with up to half the increase in the consumption of
some crops in 2006-2007 going to this source, thus constraining supply available for
additional food production.3 But while this has played a role at the margins, supply
disruptions have arguably been the most important cause of big price rises in the past year.
In particular, supply has been disrupted by adverse weather conditions in key production
areas, for example, the drought in Australia. To the extent that those effects are temporary, it
could be expected that food prices will not continue to rise at the same pace.
Temporary supply factors may, at the margin, also have been at work in pushing up oil prices
of late. In addition, the inflow of financial capital into energy derivatives markets as funds
have expanded their asset universes to include commodities has been a source of demand.
This seems to be what people have in mind when they suggest that oil prices have been
subject to speculative pressure.
But it is surely impossible to avoid the conclusion that most of the trend rise in oil prices over
a number of years now has been due to rising demand by end users. Supply has risen too, in
contrast to what occurred in the OPEC shocks of the 1970s, but it has struggled to keep
pace and the cost of supplying the marginal unit has risen.
The same can be said, moreover, about other resource commodities, including thermal and
metallurgical coal and iron ore - commodities that are very important to Australia as a
producer. Chinese demand for these resources to construct first-world standard cities has
been extremely strong, and has accounted for a large share of the increase in demand over
the past several years. Anyone who visits a Chinese city can see the results. Such visitors
also tend, more often than not, to get a sense that this demand could continue, as a
structural phenomenon, for quite a long time.
At present, there is a strong sense of overheating in the Chinese economy. It would be even
clearer in the statistics were it not for the administrative controls over many prices. As it is,
China's official CPI is rising at close to 8 per cent per annum.
The effect of China on the rest of Asia, moreover, is expansionary. Coupled with fairly easy
monetary policy settings in much of the region, which tends to occur in many emerging
economies when US policy rates are very low because of the importance of exchange rate
considerations to Asian policy-makers, this is likely to limit downside risks to growth in the
short term. It does pose the risk, though, that inflation will continue to pick up. This is not
confined to Asia, either: inflation pressures are evident in much of Latin America and South
Africa, both regions where higher resource prices have delivered a terms of trade gain of
substantial proportions. I would venture a guess, in fact, that the number of countries where
inflation is the major problem greatly exceeds, at present, the number where the predominant
concern is inadequate growth.
It may be that the slowing in growth in train in the major countries will lead to energy prices
and some other commodity prices moderating. On the other hand, the forecast moderation in
global growth is taking it back only to about average pace. With the bulk of new demand for
energy and resources coming from countries which are yet to show much sign of cyclical
slowdown, and whose energy intensity of demand is continuing to increase secularly, any
near-term softening in these prices might only be modest.
Hence the fact that the low level of interest rates in the major countries results, de facto, in
the setting of monetary conditions being pretty easy in many developing countries as well, is
starting to raise warning flags among observers who can see inflation pressures already
building. This could pose some quite difficult choices for policy-makers, particularly in the
emerging world, over the next year. Longer term, of course, the likely ongoing growth in
demand for energy by developing countries will surely pose major adjustment challenges for
the rest of us.
The Australian economy
The external environment certainly poses some big, and very immediate, challenges for an
Australian economy which has experienced a long expansion and largely used up its
reserves of spare capacity. The forces at work from abroad pull in different directions, to an
extent seen on few occasions in the past.
On the one hand, the seriousness of the sub-prime credit crisis, and the associated weak
outcomes being experienced in the US, and thought to be in prospect in the UK and some
parts of Europe, are well understood by Australian households and businesses. The financial
turmoil of the past nine months has also seen a market-driven tightening of financial
conditions in addition to that which resulted from the tightening of monetary policy.
Combined, these developments are having a dampening effect on demand. Households
have, over recent months, adopted a more cautious attitude to borrowing and spending, the
evidence for which is a string of flat results for retail sales, and a significant decline in the
flow of new loan approvals for housing. Credit approvals to businesses have also declined
significantly. While this partly reflects the winding down of a process of rapid reintermediation
that had been occurring as businesses turned to their banks and away from capital markets
around the turn of the year, total business funding has slowed. In short, things are happening
that suggest a moderation in growth in domestic demand is occurring, signs of which were
beginning to appear in the national accounts data released last week. At this stage,
inevitably, the extent and likely duration of the moderation remains uncertain.
There is not much uncertainty, though, about the need for a moderation. Inflation increased
over 2007, and in underlying terms reached the highest rate for 15 years or more. It is true
that it was boosted by the international rise in oil and other commodity prices, but Australia's
inflation rate has risen more than most of those in our usual peer group when measured on a
comparable basis. It is also pretty clear that strong domestic factors were at work, with
growth in local demand at a pace exceeding, by a large margin, any plausible estimate of the
economy's long-run potential growth rate for output, at a time when capacity was already
tight. Had not the rise in the exchange rate occurred over the past couple of years, moreover,
the Australian dollar prices of energy and other raw materials (as well as other tradeable
goods and services) would be even higher.
So inflation has picked up, and needs, over time, to be reduced. Reductions of inflation
usually require a period of slower demand growth, and this episode is no different.
At the same time as we are seeking this moderation in domestic spending, the rise in
resource prices that is occurring courtesy of strong demand abroad has complex effects on
the Australian economy. Since Australians pay world prices for their petroleum products, the
rising global oil price adds to costs for businesses and consumers. This is inflationary in its
immediate impact, though it also acts as a brake on spending on other goods and services,
unless people are prepared to reduce saving or borrow to sustain that other spending at
previous levels. Other things equal, this brake dampens inflation impulses in those other
areas.
Terms of Trade - Selected Countries
Percentage change, 2002-2007
_____________________________________
Chile 78
Russia* 64
Australia 42
forecast for Q3 2008 67
Norway 38
Argentina 21
Canada 19
South Africa 13
Mexico 4
Turkey 4
Indonesia 1
United Kingdom 0
France -2
Germany -2
Italy -2
United States -6
Korea -13
Japan -22
But other things are not equal. Australians also receive higher incomes as a result of higher
resource prices. As shareholders they experience higher profits. Employees in the resource
sector, as well as in the construction sector or the various areas that supply goods and
services to mining, are receiving larger pay packets. Governments are receiving higher
revenue flows, which in some cases they will spend, at least in part. So in net terms, this
terms of trade effect is expansionary. In the normal course of events, it would add more to
demand than the higher commodity prices would take out.
With the rises in bulk commodity prices taking effect now, Australia's terms of trade will rise
by about 20 per cent, on top of the very substantial lift that has occurred over the past
several years. Since 2002, the total rise in the terms of trade will, by the end of this year, be
of the order of 65-70 per cent. Some other countries are also experiencing significant terms
of trade rises. But few will have seen anything bigger than Australia's over a five-year period.
There is an obvious contrast with the United States, whose terms of trade have fallen by
about 6 per cent over the same period, owing to the importance of energy imports to that
country. The strongest contrast, though, is with countries such as Japan or Korea, which,
unlike the US, have no significant resource endowments of their own.
Turning back to Australia, the effect of the 65-70 per cent increase in the terms of trade over
five years has been to lift the purchasing power of our GDP by around 13 per cent. In the
terminology of the national accounts, this is the boost to real gross domestic income or real
GDI. Of course, our resources sector has significant foreign ownership, so a significant part
of the gains accrue to foreigners and the boost to the real income of Australian residents is
not as large. Over 2008, the boost to real GDI is estimated at around 4 per cent, with the
boost to national income somewhat less than this, but still substantial.
The expansionary terms of trade shock occurring now obviously would have the potential,
absent some other adjustment, to be seriously destabilising.
By design, certain features of our macroeconomic policy framework help to handle the shock.
A higher exchange rate plays a very valuable role in dampening the expansionary impact,
lowering prices for traded goods and services and spilling some demand abroad. In the year
ahead, the Government has said that the so-called "automatic stabilisers" in the Federal
Budget, which refers to the feature that the tax system withdraws more income from the
economy the faster it grows, will be allowed to operate, which is also helpful.
It falls to monetary policy to play its proper restraining role as well, dampening private
demand not only because inflation has already picked up, but seeking to head off further
problems that could easily emerge given the expansionary effects of the terms of trade. This
is why a tight monetary policy setting is essential. It is why the Reserve Bank has lifted
interest rates, even as the Federal Reserve was reducing them.
Not only does the overall pace of demand growth need to slow, but we are having to accept
a change in its composition. There is a major process of investment going on, by businesses
as well as by governments. Business investment is at very high levels relative to GDP, and
businesses in aggregate say they intend to increase investment further next year.
Governments at the State level intend a substantial infrastructure spend as well, though the
experience of the current year is that they are having trouble implementing their plans
because of the demands already being made on the engineering construction sector.
In most economies, it is usually not possible, and certainly not prudent, to try to have a
consumption boom at the same time as an investment boom. Of course, Australia can and
does access the savings of foreigners to fund additional investment - a process of running a
current account deficit - so we do not have to finance the totality of the additional investment
ourselves. This is something not unknown to the US economy either (in fact, it has been a
common feature of most of the Anglophone market economies over the past decade).
But even so, there are probably sensible limits here. Practically speaking, domestic
consumption, together with housing demand, and some areas of business investment not
linked to the resource sector, is being asked to make some room, for some period of time, for
the rise in other forms of investment that will sustain higher incomes and living standards in
the future. Given that the economy is pretty fully employed, total investment levels are
already high, the nation's call on net capital inflow from abroad is over 6 per cent of our GDP
and inflation is already 4 per cent, it is difficult to see any serious alternative to an adjustment
of this nature.
To try to absorb the expansionary terms of trade impact without any macroeconomic policy
restraint is not really an alternative at all. In such an inflationary scenario, I expect that we
would still find that the resources sector and the parts and regions of the economy that
benefit most directly from its flow-on effects would attract additional labour and capital, and
become proportionately larger in the national economy over time. Other sectors and regions
would, proportionately, still diminish in size. The process would simply be less efficient: the
price signals for resource allocation that are pretty clear at present would be more difficult to
detect under conditions of higher inflation. Indeed, that is one of the problems high inflation
brings. This course would also leave the rest of the economy with the legacy of embedded
high inflation, commensurately higher nominal interest rates and so on. That would be
harmful for living standards over time. As such, allowing it to occur would be a policy
mistake.
Conclusion
Both the United States and Australia face significant economic challenges. For the US,
dealing with the fall-out of the financial excesses of the earlier years looms large at present.
This is not made any easier by the simultaneous lift in global commodity prices, which raises
consumer prices but, in the US, also dampens economic activity. For Australia, the financial
fall-out has been less severe, mainly because participation in the earlier excesses was so
much smaller, while the very large change in prices for mineral and energy resources is the
most expansionary external shock to affect the economy for 50 years or more. It has
occurred at a time when the productive capacity of the economy has already been stretched
by the long expansion. Hence, the prospect of inflation has presented a larger and more
immediate danger to us than it has, thus far, to the US.
One way or another, the near term continues to present challenges on both sides of the
Pacific, as the two respective economies adjust to the shocks hitting us. But both of these
economies are pretty adaptable. There is no reason why, with sensible policy frameworks,
competitive and innovative firms, and capable and industrious workforces, they should not
continue to prosper over the long term.