Philip Lowe: Investment and the Australian economy
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the CFA
Australia Investment Conference, Melbourne, 24 October 2013.
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I would like to thank Gareth Spence and Leon Berkelmans for valuable assistance in the preparation of this talk.
I would like to thank the CFA Institute and CFA Societies Australia for the invitation to speak
this afternoon.
I would also like to acknowledge the work that the CFA and its members have done in
promoting the integrity of capital markets and the provision of ethical investment advice. Over
recent years we have seen too many ethical lapses in the global financial services industry
and the bonds of trust between investors and institutions have been strained. Strengthening
these bonds is critical to the financial services sector playing its important role in promoting a
strong and vibrant global economy. I wish you all the best in pursuing this important task.
Confidence is also, of course, an important factor influencing business decisions to invest
and to expand. Indeed, a lack of confidence has been one of the factors holding back
investment in many countries over recent years. So given that this is the CFA's Australia
Investment Conference, I thought it appropriate to focus my remarks today on the topic of
investment. I would first like to spend time discussing recent investment trends in Australia,
particularly the investment outcomes in the non-mining sector. I would then like to look
forward and discuss what the outlook might hold.
Recent developments
It is worth starting off with the global context.
As you are no doubt aware, over recent years the Australian economy has performed much
better than the economies of most other developed countries. We avoided a recession during
the global financial crisis, although growth has been below average recently. Our banks have
remained sound. Public debt levels are comparatively low. The Reserve Bank has not had to
expand its balance sheet massively. And inflation has been close to target. Very few other
countries can make such claims.
But my focus today is the story on investment.
Since 2008, the developed economies have been in an investment drought. Indeed, the four
years from 2008 to 2012 saw the lowest level of investment, relative to GDP, in the
developed economies for many decades (Graph 1). For the world as a whole, investment
has also been very low.
In Australia, the investment picture is very different. Rather than experiencing an investment
drought, we have had an investment boom, particularly in the private sector. Recently,
business investment peaked at over 18 per cent of GDP, its highest level in more than
50 years (Graph 2). And the nation's overall capital stock (including both private and public
capital) has been expanding at around 5 per cent per annum, the fastest rate of increase
since the early 1970s. In contrast, in some other developed economies, the level of
investment has barely been enough to offset the depreciation of the existing capital stock.
The reasons for this difference are well understood. Most of the advanced economies have
been dealing with the fallout of the severe banking and debt problems of the late 2000s. In
contrast, we avoided these problems and have been benefiting from the growth in Asia. This
growth has pushed up the prices of many commodities, which has encouraged investment in
the extraction of Australia's natural resources, particularly iron ore, coal and natural gas. This
investment has boosted our resource exports, and will provide an important source of
national income for many years to come.
This aggregate picture, however, hides some large differences across sectors. Mining
investment has been extraordinarily strong; last year, it was equivalent to around 8 per cent
of GDP, which is much higher than in any previous mining boom, at least for over a century
(Graph 3). In the non-mining sector, however, investment has been quite weak. Indeed, as a
share of nominal GDP, non-mining private business investment is currently around
3 percentage points lower than its average over the period from 2005 to 2008 and it is not
much above levels seen in the early 1990s recession. And if we take into account public
investment, which is also low, then total non-mining investment, as a share of GDP, is below
the trough that was recorded in the early 1990s. In this sense, the profile for non-mining
investment in Australia is not dissimilar to the profile for overall investment in many of the
developed economies.
This weakness in investment outside the resources sector is widespread across industries.
According to the most recently available Australian Bureau of Statistics (ABS) data, in 16 of
the 18 individual non-mining industries, the level of investment (relative to GDP) is at, or
below, the average level of investment for the years from 2005 to 2008. The two exceptions
are the utilities sector, where there has been significant private investment in electricity
distribution and water supply, and agriculture, which has benefited from high global food
prices.
The low level of overall non-mining investment has occurred despite corporate balance
sheets being in generally sound shape and firms having significant holdings of liquid assets.
It has occurred despite financial institutions reporting that they are willing and able to lend.
And it has occurred despite lending rates being at record lows for both large and small
businesses (Graph 4).
So the obvious question is: why is this happening? As usual, there is no single answer, but I
would like to highlight four factors.
The first is a technical point, but a relevant one nevertheless.
The investment figures I have quoted are for nominal investment relative to nominal GDP.
Most of the time, this provides a reasonable guide as to what is going on. But over recent
years, the price of capital equipment has fallen markedly, partly due to the appreciation of the
exchange rate, which has reduced the price of imported goods. The lower prices mean that
for a given amount of capital spending, the economy obtains more units of capital. As a
result, while total non-mining investment as a share of GDP is lower than it was in the
recession of the early 1990s, the non-mining capital stock is increasing a little more quickly
than it was at that time. In a sense, we are getting more bang for our buck.
The second, and ultimately more important factor, is the exchange rate.
As I have talked about on previous occasions, Australia's floating exchange rate regime has
played an important role in stabilising the Australian economy.1 The appreciation of the
Australian dollar since the mid 2000s is perhaps the single most important reason why the
Australian economy has digested a boom in mining investment without overheating and
without developing the imbalances that typically accompany such booms.
That is the good news. But in playing this stabilising role, there is also a downside. The
exchange rate appreciation has taken pressure off domestic capacity by making it cheaper
for Australians to buy imported goods and by reducing the competitiveness of firms in export
markets. In so doing, it has reduced the return on capital in those traded sectors that are not
benefiting from high commodity prices, and thus reduced the incentive to invest. This is
perhaps most obvious in the manufacturing and tourism sectors, where the level of
investment, as a share of GDP, is very low by historical standards (Graph 5). Indeed, in
these industries, the current rate of investment is at, or below, the depreciation of the existing
capital stock. The low level of investment in the manufacturing sector is particularly
noteworthy, as manufacturing has historically accounted for around one-fifth of total
nonmining investment.
The third factor that I would like to discuss is the general lack of confidence by business. This
lack of confidence can be seen in the various business surveys over recent years and has
been clearly apparent through the Reserve Bank's regular program of meetings with firms
across the country (Graph 6). This reported lack of confidence is consistent with firms being
uncertain about the future and risk averse in their decision making.
So the logical question here is: why has business confidence and the willingness to take risk
been so subdued?
Again, there is no single answer. But many of the businesses that we have talked with over
the past couple of years have cited the uncertainty associated with the structural changes in
the economy, including as a result of the high exchange rate. They have also cited the
political environment, particularly the previously hung parliament. And they have cited an
increased regulatory burden. While we cannot be sure, it is likely that each of these factors
has affected the willingness of some firms to expand. A common message from business
has been that they thought it was worth waiting a while to see how things worked out before
they made decisions that were costly to reverse. In the parlance of economists, the "option
value" of waiting has been high.
Beyond these Australian-specific factors, I suspect there is also a deeper global factor at
work - and that is the legacy of the financial crisis. Recall that prior to the crisis, there was
the Great Moderation. During that earlier period, the additional compensation that
businesses required for taking a risk was quite small. Confidence was high and volatility was
low. The financial crisis changed all this. It reminded us all that bad outcomes were possible.
And since then, the frequent news about the problems in the euro area and the possibility of
political stalemate preventing the US government from meeting its financial obligations have
only served to reinforce this idea.
This scarring from the financial crisis is still with us and I suspect it will be with us for some
time yet. It not only helps to explain why investment is weak outside the resources sector in
Australia, but also why investment is very low in many advanced economies despite
generally healthy corporate balance sheets, very low interest rates and large-scale
quantitative easing by central banks.
While recently we have seen some return to risk taking in financial markets, potential owners
of real capital in the developed economies have not yet been prepared to step forward in
significant numbers and take a risk. Consumer demand has been soft and businesses have
wanted to wait and to see what happens. They have felt more comfortable leaving their
money in bank accounts earning very low rates of interest, rather than taking the chance and
investing in new capital. This change in corporate attitudes is, I suspect, one of the enduring
but underappreciated consequences of the financial crisis. At the aggregate level, the
Australian economy has been shielded from its effects by developments in the resources
sector, but some areas of the economy are clearly feeling the impact.
Finally, a fourth factor that has had an effect on the overall level of investment in Australia is
the change in household spending behaviour. Unlike in earlier years, growth in household
consumption is no longer running ahead of growth in household income. The step-down in
the rate of growth of retail spending in particular has reduced pressure on capacity and
affected rents for retail properties. There has also been some reassessment of the
appropriate model of retailing. The result can be seen in the ABS's estimates of total
investment in the retail industry which, as a share of GDP, is at the lowest level for many
years (Graph 7). The ABS data also suggest that there has been some flow-on effects to
investment in the wholesaling industry, which is also at quite a low level.
So, in summary, the high exchange rate, uncertainty, risk aversion and the changes in
household spending behaviour have all weighed on non-mining investment over recent
times. As a result, non-mining investment has made little contribution to growth in the overall
economy (Graph 8). This is at a time when mining investment is no longer increasing, with
the mining boom transitioning from one based on investment to one based on production. As
best we can tell, mining investment declined over the past year, while net exports rose
strongly due to lower capital imports and the higher production of bulk commodities made
possible by the earlier investment.
Looking forward
So having looked back at what has happened so far, I would now like to look forward.
Over the period ahead, the level of mining investment is likely to decline substantially as
existing projects are completed. The exact profile remains difficult to determine, but it would
not be surprising if mining investment, relative to GDP, declined by 3 percentage points or
more over coming years.
A decline of this magnitude should be manageable, just as the earlier rise was manageable.
It will, however, require a further rebalancing of the economy. As part of this rebalancing,
exports are set to grow strongly, particularly when the large LNG projects come on line.
There will also be slower growth in imports of capital goods as projects are completed. But
these adjustments on the trade side will not be enough, by themselves, to ensure that growth
in output and employment is satisfactory. This means that other forms of spending will need
to pick up.
One of these other forms of spending is residential construction, and the modest rise that is
underway here is a welcome development. Some lift in consumption growth is also expected,
although a return to consumption growth faster than income growth for an extended period is
unlikely. It would also be unwelcome given the relatively high levels of existing household
debt.
So this means that a pick-up in non-mining investment is an important part of the story in the
return of the Australian economy to trend growth. Indeed, our expectation is that this will take
place, with growth in non-mining investment predicted to pick up to at least high single-digit
rates within the next couple of years.
This is, of course, a forecast and there is the usual wide range of uncertainties. These
include uncertainty as to the appropriate steady-state capital-output ratio for the economy
and the associated investment ratio. These important structural variables are influenced by a
whole range of considerations, including the rate of total factor productivity growth,
population growth, the rate of depreciation and the industry structure.
But from a more cyclical perspective, there are a number of factors that support the outlook
for a steady pick-up in non-mining investment. The three factors I want to list - and they are
clearly interrelated - are some depreciation of the exchange rate, an improvement in
business confidence and the very low level of interest rates.
While the Australian dollar has appreciated over the past couple of months, on a
tradeweighted basis, it is around 8 per cent lower than the peak in April this year. It is still too early
to see the impact of this on investment, although the depreciation has improved prospects in
some areas of the economy. In particular, there are parts of the tourism and manufacturing
industries where the outlook is now a bit more positive, especially for firms that had earlier
responded to the high exchange rate by doing whatever they could to make themselves
more competitive. The more positive outlook in the tourism industry is also being supported
by the steadily increasing number of visitors from China.
This depreciation of the Australian dollar since April is a welcome development, and a further
depreciation would be helpful in rebalancing growth in the economy. Ultimately, floating
exchange rates adjust to the relative returns on capital across countries. When investment in
Australia was very high and rising, and investment elsewhere in the world was very weak
and falling, it was not surprising that the Australian dollar was at quite a high level. This was
a textbook response to an investment boom. But the textbook would also predict that as the
mining investment boom in Australia unwinds and, hopefully, investment in the developed
economies picks up, some realignment of the relative value of the Australian dollar would
occur. This process has started, although it has been interrupted recently, partly due to the
changed outlook for US monetary policy. Whether we will see a further realignment remains
unclear, but, from today's perspective, a lower value of the Australian dollar would assist in
lifting investment and activity in the sectors that have been constrained during the years of
the mining investment boom.
The second factor on my list is an improvement in business confidence over recent months,
which is evident in a graph that I showed earlier (Graph 6). This improvement is also
apparent in our discussions with businesses, and there has also been a lift in consumer
confidence. These are positive developments. Just as a lack of confidence about the
economy can be self-fulfilling, so too can be a recovery in confidence. If businesses are
prepared to spend, jobs tend to get created, incomes tend to rise and people see
opportunities where previously they saw none.
So an important issue here is whether this improvement in confidence will be sustained. A
fair amount depends upon international events. If global growth is in line with most
forecasters' central outlook, it is quite possible that confidence, both overseas and in
Australia, will be sustained at a higher level than it has been in recent times. There are,
however, a range of things that could go wrong, with the latest wrangling over the US debt
ceiling providing just the latest example of developments that damage confidence.
But beyond international events, domestic policy choices also matter. Business confidence
- and thus the preparedness to take risk - is likely to be higher if the policy environment is
predictable and there is strong commitment to ongoing reform to make markets work well
and to boost productivity. Ensuring that regulation is fit for purpose is also important. So too
is ensuring that the general business environment promotes innovation. These are all difficult
areas to get right, but doing so is key to creating an environment where business is confident
enough to take a risk, buy some new capital, hire a new worker or expand their operations.
The third factor on my list is the low level of interest rates. The impact of these low rates is
evident across a range of indicators and it has further to run. In the housing market, prices
and turnover have risen and, as I noted earlier, dwelling investment is increasing. There are
also signs of an increased appetite for borrowing, most notably among those purchasing a
property to rent out. More generally, households seem prepared to move out a little along the
risk spectrum in an effort to increase their expected returns.
These developments are creating new business opportunities. So too is the steady growth in
the Australian population, which remains considerably faster than in almost all other
advanced countries; at the current pace of growth in five years' time, the population will be
around 10 per cent higher than at present. When businesses are deciding today whether to
take advantage of these opportunities, they face a low cost of borrowing and finance is
available for sound projects. In time, this should underpin a rise in investment across a range
of industries.
Of course, none of this is locked in. But, together, a lower value of the Australian dollar, an
improvement in business confidence and low interest rates provide the basis for our outlook
of a gradual lift in the non-mining economy over the next couple of years.
Thank you very much for listening and I look forward to your questions.
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BIS central bankers' speeches
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BIS central bankers' speeches
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BIS central bankers' speeches
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BIS central bankers' speeches