Q&A: What's in store for Australia's economy as 2016 kicks off?

We sat down with Economist Robert Hill to find out more about the outlook for the Australian economy in 2016. Here’s his view on what’s in store for Australia.

Question: What’s the outlook for Australia’s economy this year?

Answer: Overshadowing Australia’s outlook is global commodity prices, which are inextricably linked to demand from China. The MYEFO revision surely took the effects from China’s slowdown into account, which has largely been responsible for the 10% downgrade to government receipts in 2015–2016.

Unemployment is decreasing, alongside an increasing employment rate. This is certainly positive news, however, when one takes a look at the data, some questions arise. This increasing participation rate is almost solely due to more women entering the work force. This is of course a good sign, however, it may not lead to an increase in wages, as due to certain workplace barriers, women are often underemployed or paid less than their male counterparts. Furthermore, the underutilization rate remained roughly steady in 2015, and has not followed a downward trend like the unemployment rate. These factors suggest that although unemployment is falling, a rise in wages may not be just around the corner.

Business investment has plummeted, and has been particularly impactful in regions such as Western Australia and Queensland. As these regions lose jobs, some workers will move to bigger South Western cities looking for work. This has already been observed as mining states have seen as decline in population growth since the peak of the mining boom. The catch is that wages will not shift equally into the cities. Mining is a capital-intensive sector, and an extra worker hour in mining produces more output than an extra hour in the household service sector. This is another reason why even though employment looks to be improving slightly, increased wages and consumption may not follow suit. 

A reduction is unemployment is good news on a number of levels, including social cohesion etc. However, from a growth perspective, higher employment generally translates into increased income from higher wages as demand for labor grows. This propels consumer demand, and boosts economic growth. However if the increase in wages is limited, the effects of the decreased employment on growth may be somewhat muted. Also, wages tend to rise alongside increase in expectations of inflation, which are currently relatively subdued.

Q: What is FocusEconomics’ outlook for the Australian economy in 2016? 

A: There is no doubt that China, Australia’s largest trading partner, will present some headwinds to growth for Australia. However, things could be worse. The AUD is likely to remain at its depreciated level over 2016, which will keep Australian exporters competitive even as global demand in 2016 falls.

At home, the country is continuing along its path towards rebalancing growth. The services sector is likely to continue its momentum and expand over the next year. According to the Reserve Bank of Australia (RBA), 2014/15 was the first period in six years in which the service exports contributed more to growth than iron ore exports. Business and consumer surveys have indicated an improvement in household and business services, which indicate that this field could become even more important in the coming year. The sharp decline in mining investment has impacted business services, and this impact will continue to be observable as data for 2015 rolls in. However, the non-mining service sector will also be supported by the RBA’s accommodative monetary policy well into 2016, as the RBA does not appear to be in a hurry to tighten its policy stance.   

The rebalancing process may be underway, however it does not yet appear commensurate with the decline in the resource sector, and has hence resulted in the recent downward revisions to growth.  The Focus Economics Consensus Forecast panelists expect GDP growth to accelerate from an estimated 2.3% in 2015 to 2.6% in 2016 and 2.9% in 2017.

Q: What direction are iron ore prices likely to go?

A: China’s appetite for steal is has driven iron prices in the past, however as the expansion of Chinese urban areas slows, so too does the demand for steel and its iron ore precursor. The spot price for iron has fallen to historical lows in the beginning of December, marking an almost 40% decrease since December last year, a spectacular fall even relative to most other commodities such as benchmark crude prices. Even if, as some analyst predict, prices rally, iron is highly unlikely to recover but a fraction of the losses incurred since last year. 

Q: What’s the outlook for the mining industry in 2016?

A: The good news is, because large scale mining extractions projects have drawn to completion, Australia has recently expanded its iron production capacity, and is able to produce iron, and other resources at a relatively low costs. Although the terms of trade has fallen, export volumes have not. This has given Australia a chance to capture more of the global market share for iron. This should prolong the lifespan of low cost mining operations in Australia, and provide some back up for the transitioning economy. The bad news is that this is not likely sustainable to the same extent over the long term. Aussie mining companies have suffered drastic market decapitalization in 2015 and investors in the sector have been shaken.

Q: Could continued slumping ore prices affect Australia’s credit ratings?

A: As commodity prices are expected to remain low, major mining companies will likely refrain from further investment in the Australian outback, or even begin to divest. The waning importance of the mining sector however will likely not be drastic enough to jeopardize Australia’s AAA credit rating, as thanks to the government’s commitment to fiscal consolidation, and strong growth in the service sector, government finances will not be drastically impacted.

Q: How will the weakening Aussie Dollar affect the country's economy? 
A:
The AUD has fallen almost 12% year to date, and although this may seem significant by Australian standards, it’s a smaller decline that other resource intensive advanced economies such as Canada and Norway, indicating a relative unresponsiveness of the AUD to commodity markets and monetary policy expectations in the U.S. This also suggests that the AUD will remain at its current level for some time. This could give Australian exporters the confidence to count on an Australia price advantage well into the coming year, and may even pave the way for increased business investment. This could conflate with increased export volumes to provide a sizable boost to GDP growth in the coming year.

The weak AUD will likely have a more immediate impact on exports, as well as property markets. Tourism, and other service exports have already picked up this year, and manufacturers will likely also see a break in 2016.  The timing and magnitude of the fed’s second rate hike will test global currencies, including the AUD, and although strong fundamentals should keep the AUD from experiencing extreme volatility, some downward pressure is to be expected if the Fed moves according to, or quicker than, its proscribed path of rate increases.

Q: Apart from the commodities sector, what's the outlook for other economic sectors and how will those affect the country's growth in 2016? 

A: Indicators of Business confidence have come in strong recently, and according the monthly business sentiment index published by the National Australia Bank, business conditions have been above their long run average for the past year, and look to remain strong going forward thanks to moderate inflation, loose monetary policy and a boost to exporters from the low AUD. Business confidence however has not responded to these improved conditions as of yet. This is likely due to uncertainties surrounding global macroeconomic events, not domestic concerns, and should abate as business begin to take advantage of the accommodative conditions.

As mentioned earlier, the last year was the first in several years in which the service sector contributed more to growth the mining sector. We can expect this to also be the case next looking ahead as the sector grows quicker than the economy as a whole. China is slowing, however it is still one of the fast growing countries in the world, and a burgeoning Chinese middle class will look to Australia as a picturesque holiday destination, or as a place to send their children to university. Such factors will provide support to growth and are part of the reason growth is expected to pick up over the course of the next two years.

Q: Does Australia have any good strategies for diversifying the economy?

A: In December, Prime Minister Turnbull announced the country’s National Innovation and Science agenda, as an answer to slowing worker productivity and relative lack of research and development (RND) spending, and research collaboration in comparison to other OECD nations. This agenda includes a new entrepreneur class visa, tax breaks for investors, changes to bankruptcy laws, and a reduction in capital gains taxes for startups. These measures should work to diversify the economy in the future, and help to pivot away from resource intensive growth.

At this early stage, it is difficult to quantify what impact this agenda will have on growth, or on economic diversification. Critics point out that this agenda is too little too late, in the sense that it is long overdue and does little more than to help Australia catch up to the rest of the world, as opposed to making it a global leader in RND. Indeed, placing too much emphasis on startup is risky, as it is notoriously difficult to predict which will succeed, and generally, only relatively few will take off. Nonetheless, the New Prime minister has signaled that he is aware of Australia’s shortcomings in this field, and is taking the initiative, particularly in comparison to his predecessor who, pushed ahead with expansions in the mining sector as late as mid-year 2015.

Date: January 10, 2016


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