The virtue of modesty

The world economy is now emerging from its worst downturn since the end of the Second World War, which was brought on by the financial crisis of 2007-09. However the effects of the crisis will linger on for some years yet, particularly in what are still commonly referred to as the ‘major advanced economies’ of the United States, Western Europe and Japan. Their financial systems remain fragile. Households have sustained significant losses of wealth, notwithstanding the strong rebound in share prices since March last year. Unemployment may have stopped rising, but remains discomfortingly high. Energy is no longer cheap. And governments in most major Western economies are burdened by levels of public debt which are higher as proportions of national income than at any time since the end of World War II, and with little prospect of growing out of them relatively painlessly as they did in the 1950s and 1960s.

In short, it’s hard to be optimistic about the prospects for the parts of the world to which Australia has traditionally looked for guidance as to where we might be heading.

Fortunately for Australia, these countries aren’t as important to our economic prospects as they used to be. With Asia (excluding Japan) now absorbing more than half of Australia’s exports and those exports comprising a broad range of commodities rather than – as is the case with many other commodity-exporting economies – one or two products, Australia is almost uniquely positioned among ‘Western’ economies to benefit from the continued urbanization, industrialization and rapid economic growth which is likely to occur across Asia over the coming decade.

Moreover, through a combination of good luck and good management, Australia has emerged comparatively unscathed from the global recession of 2008-09.

Australia’s financial institutions were more prudently managed and better regulated than their American and European counterparts and had very little exposure to the ‘toxic’ debt products which wreaked so much havoc on both sides of the North Atlantic. Australia has not experienced a housing ‘bust’, so that with the rebound in the share market since March last year Australians have, in general, experienced much smaller declines in net worth than citizens of other advanced economies. The Reserve Bank and the Australian Government responded promptly and effectively to the heightened risk of recession brought on by the financial crisis, such that Australia ended up being one of a handful of advanced economies to have recorded positive growth in 2009. And although the Government’s response to the financial crisis has pushed the budget into significant deficit, the resulting level of public debt is quite small by international standards and does not represent any material threat to Australia’s medium-term economic prospects. Provided the Government adheres to its commitment to restrain growth in spending to less than 2% per annum in real terms, there should be no need for tax increases in order to return the budget to balance.

Growth in Australia’s economy will pick up this year, led by a strong rebound in housing activity, a renewed increase in resources sector investment (after a lull last year) and higher levels of public sector infrastructure spending. Consumer spending is likely to be relatively subdued, as the effects of last year’s fiscal stimulus measures fade and as interest rates rise a little further. Non-residential building is likely to be quite weak, except for the effects of the Government’s school buildings program. Australia’s trade deficit will continue to widen, with a rebound in imports in response to strengthening domestic demand more than offsetting the likely pick-up in exports. Overall, economic growth should average around 3% this year, up from just under 1% in 2009.

Although the Reserve Bank surprised financial markets by leaving interest rates unchanged at its February meeting, it nonetheless remains probable that interest rates will rise some more this year as economic growth returns closer to its longer-term trend rate and unemployment declines further. Bearing in mind that the margin between the Reserve Bank’s official cash rate (which no-one actually pays) and the interest rates (which borrowers actually do pay) has widened by between one and two percentage points since the onset of the financial crisis, the official cash rate will probably get to 4½% by the second half of the year.

The widening margin between Australian interest rates and interest rates in other financial centres will continue to underpin the value of the Australian dollar, although the currency will also continue to be affected by swings (in both directions) in commodity prices and by mood swings among global investors (with the AUD tending to weaken when global investors become nervous).

Australia’s increasing economic engagement with Asia brings risks as well as opportunities. Although growth rates in Asia are likely to be higher on average than in the rest of the world, they will also be more volatile. That volatility will affect perceptions of Australia’s investment markets, as evidenced by the strong market reactions to the recent tightening of monetary policy in China. The same combination of prudent but flexible macro-economic policies which contributed to Australia’s resilience in the face of the financial crisis will also be important in steering the Australian economy through what will continue to be choppy global waters in the years ahead.