abare.gov.au - Australian commodities – September quarter . volume 15 . number 3 2008

Economic overview

Marina Kim and Jammie Penm

The slowdown in world economic growth is expected to continue through the second half of 2008, with a gradual recovery starting in late 2009. In year average terms, world economic growth is assumed to be 3.9 per cent in 2008, before declining to 3.8 per cent in 2009.

The economic slowdown reflects continued weak economic growth in the United States and the associated slowing in other OECD economies. In contrast, strong growth in the emerging economies is expected to continue, although moderating from the rapid rates of recent years.

In Australia, economic growth is assumed to average 2.75 per cent in 2008-09, compared with 3.7 per cent in 2007-08.

The global economy

The slowdown in world economic growth continues

The slowdown in world economic growth, which began in mid-2007, continued in the first half of 2008. Growth is estimated to have decreased to around 4 per cent on an annualised basis in the first half of 2008, down from 5 per cent in 2007. The slowdown was led by the OECD economies, in particular the United States, with growth also slowing in the emerging economies.

The economic slowdown has so far been milder than previously expected. However, recent indicators suggest world economic growth could slow further in the remainder of 2008. In the OECD economies, business and consumer sentiment have continued to weaken, and growth in industrial production has declined further. There have also been signs of slowing business activity in the emerging economies.

Global financial markets remain volatile

The continued weakness in the US housing sector and the poor performance of the US equity market continue to adversely affect the US financial system and confidence in global equity markets. To date, around US$500 billion has been written down by global financial institutions (Statement on Monetary Policy, Reserve Bank of Australia, August 2008). Although some banks have succeeded in raising additional capital, their balance sheets remain under pressure as credit quality across many loan classes has deteriorated.

As a result, global equity markets have fallen markedly, with weakness evident in both OECD and emerging economies. While the largest declines have occurred in the financial and relevant business sectors, equity prices have also been substantially lower in the industrial and consumer related sectors, reflecting expectations of slower economic growth in the short term.

World stock markets

52 week high a

mid-Sept. 2008

change %

OECD

United States

14 198

10 918

–23.1

Japan

17 489

12 215

–30.2

Euro area

3 937

2 859

–27.4

Australia

6 829

4 818

–29.4

East Asia

China

6 396

2 182

–65.9

Korea, Rep. of

2 065

1 443

–30.1

Chinese Taipei

9 860

6 252

–36.6

South East Asia

Indonesia

2 830

1 870

–33.9

Malaysia

1 516

1 041

–31.3

Philippines

3 874

2 673

–31.0

Singapore

3 831

2 487

–35.1

Thailand

915

647

–29.3

India

20 873

14 324

–31.4

a Highest point between mid-September 2007 and mid-September 2008.

Inflationary pressures persist

Despite the slowdown in world economic growth, inflationary pressures persist in many OECD and emerging economies. Higher food and energy prices have been the main contributors to increased consumer prices in many countries. Global oil prices, for example, have risen sharply over the past year, with the price of the commonly quoted West Texas Intermediate crude oil increasing from around US$70 a barrel at the onset of problems in the US subprime market in August 2007, to a recent high of US$145 a barrel in July 2008, before easing to below US$100 a barrel in mid-September 2008.

Inflationary pressures have been more pronounced in the emerging economies, where food and fuel make up a larger share of consumption baskets. Sustained strong growth in recent years has also reduced the spare capacity available in these economies. In response to increasing inflationary pressures, interest rates have been raised in a number of world economies, including the European Union, the Republic of Korea, Indonesia, the Philippines, Chinese Taipei, Thailand and Viet Nam.

Over the next 12 months, however, inflationary pressures in the OECD economies are expected to ease, mainly as a result of slower economic growth. While inflationary pressures are also likely to decline in many emerging economies, the pace of decline may be more gradual because of continued strong economic growth and the adoption of relatively accommodative monetary and fiscal policy settings. Recent decisions to reduce energy subsidies in several economies, such as China, Indonesia, Malaysia and Thailand, could also contribute to upward pressure on consumer prices in the short term.

Strong upward momentum in oil prices reflects a sluggish supply response against a backdrop of already stretched spare productive capacity. There are widespread market expectations that higher investment costs, together with technological, geological and political constraints, will result in slower than previously expected expansion of oil production and distribution capacity. Therefore, low spare productive capacity and tight market conditions are expected to persist, at least in the short term. Consequently, oil prices are expected to remain sensitive to any news signalling risks of supply disruptions and geopolitical tensions.

Prospects for world economic growth

In preparing this set of commodity forecasts, world economic growth is assumed to decline from 5 per cent in 2007 to around 3.9 per cent in 2008 and 3.8 per cent in 2009, with a gradual economic recovery assumed to begin in the latter year. Although world economic growth in the remainder of 2008 and for 2009 is assumed to be weaker than in recent years, it remains strong relative to historical average growth rates.

In the OECD countries, economic growth is assumed to moderate further in the remainder of 2008, before a gradual recovery begins during 2009. Sluggish growth in the US economy is expected to continue, with economic activity also assumed to slow in Western Europe and Japan. While the recovery is assumed to begin during 2009, the growth momentum is likely to become more evident toward the end of the year.

Despite the assumed slower growth in the OECD countries, economic performance in the emerging markets is expected to remain relatively strong. Although external demand may weaken, the domestic demand in the emerging economies, including higher public sector spending, is expected to provide support for economic growth in the short term.

Risks to the world economic outlook

Currently, risks to the world economic outlook appear to be to the downside. Continued pressures in global equity and financial markets represent a significant downside risk. As financial institutions seek to repair their balance sheets, extension of credit for business investment could remain constrained, potentially dampening the speed of recovery in the OECD economies. At the same time, sustained inflationary pressures in a number of major world economies could limit the scope for accommodative monetary policy to stimulate the economic recovery.

The length of adjustment period for the financial sector, especially in the United States, is likely to depend on stabilisation in the US equity market, while a recovery in the US housing market will help to restore consumer confidence and spending.

The recent sharp rise in oil prices has also contributed to the increase in global imbalances by transferring savings from the oil consumers to the oil producers. In 2007, there were more countries with a current account deficit than five years ago, and the size of the current account deficits also increased as a share of gross domestic product. The increase in current account deficits suggests that any sudden shifts in capital flows could lead to significant volatility in exchange rates and/or interest rates.

In the United States, higher oil prices have overshadowed some of the improvements that occurred in the current account balance over the past few years as a result of the decline in the US dollar and slower growth of the US economy. The US non-oil trade balance is now around 3 per cent of gross domestic product, compared with a high of 4.5 per cent in 2006.
On the upside, demand in OECD and emerging economies might be more resilient than currently assumed, especially if the recent decline in oil and other commodity prices continues and global financial markets stabilise.

Food price inflation

World prices for major agricultural commodities such as grains, oilseeds and many livestock products have risen markedly over the past few years. The world indicator price of wheat, for example, increased by around 74 per cent in nominal terms since mid-2006, while prices for corn, soybeans and major dairy products ( including cheese, butter and skim milk powder) rose by 70 per cent to 140 per cent over the same period. Sharply higher food commodity prices have attracted significant attention from policy-makers in both OECD and emerging economies, raising concerns about global food security and generating debate on appropriate policy responses to increase food production.

Despite widespread concerns about global food price inflation, it is important to note that agricultural commodity prices in real (net of inflation) terms are still well below those in the early to mid-1970s. The fact that commodity prices are mostly reported in US dollars, which have depreciated against most currencies not explicitly pegged to the US dollar, means the percentage increases in commodity prices measured in those currencies are less than the increases measured in US dollars.

Although concerns similar to those currently expressed about food security and resource availability arose in the 1970s, there are now additional factors involved that suggest there may be more reason for concern. The price increases now involve a greater number of food commodities and there are new sources of demand for agricultural commodities, including stronger food demand from fast growing emerging economies, such as China and India, and industrial demand in the form of government supported biofuel production. At the same time, agricultural producers are facing greater challenges in the form of stronger competition for land for urban, industrial and environmental uses. There are also other issues which have the potential to adversely affect agricultural production, including water scarcity and climate change.

These challenges suggest it is now more difficult to achieve a significant increase in global food production in the short term. To overcome these difficulties, it will be important to maintain substantial investment in agricultural research and development, and infrastructure support. Only by lifting agricultural productivity, in particular through higher yields, will a significant improvement in global food supply be achieved.

Key macroeconomic assumptions

World

2006

2007

2008

2009

Economic growth

OECD

3.1

2.7

1.3

0.9

United States

2.9

2.2

1.2

0.8

Japan

2.4

2.1

1.0

0.9

Western Europe

2.8

2.6

1.3

0.9

– Germany

2.9

2.5

1.8

1.1

– France

2.2

1.0

0.9

– United Kingdom

2.9

3.1

1.1

0.8

– Italy

1.8

1.5

0.1

Korea, Rep. of

5.1

5.0

4.3

4.2

New Zealand

1.5

3.0

0.7

1.6

Developing countries

7.6

7.8

6.7

6.3

– non-OECD Asia

9.1

9.3

7.7

7.3

South East Asia a

5.9

6.3

5.2

China b

11.6

11.9

10.0

9.3

Chinese Taipei

4.9

5.7

4.3

4.4

India

9.8

9.3

7.7

7.3

– Latin America

5.5

5.6

4.5

3.6

Russian Federation

7.4

8.1

7.5

6.8

Ukraine

7.1

7.3

6.1

4.7

Eastern Europe

6.6

5.6

4.6

4.5

World c

5.1

5.0

3.9

3.8

Industrial production

OECD

3.1

2.5

0.9

Inflation

United States

3.2

2.9

4.0

2.3

Interest rates

US prime rate d

8.3

6.6

5.2

5.0

US exchange rates e

Yen/US$

116

118

107

111

Euro/US$

0.79

0.73

0.68

0.73

Australia

2005-06

2006-07

2007-08

2008-09

Economic growth

3.0

3.2

3.7

2.75

Inflation

3.2

2.9

3.4

3.5

Interest rates g

6.6

6.9

7.7

7.3

Australian exchange rates

US$/A$

0.75

0.78

0.90

0.85

Yen/A$

TWI for A$ h

a Indonesia, Malaysia, the Philippines, Singapore and Thailand. b Excludes Hong Kong. c Weighted using 2007 purchasing-power-parity (PPP) valuation of country GDPs by the IMF. d Commercial bank prime lending rates in the United States. e Average of daily rates. g Large business weighted average variable rate on credit outstanding. h Base: May 1970 = 100. f ABARE assumptions.
Sources:ABARE; ABS; IMF; OECD; RBA.

Australia’s major export markets

The United States

In the United States, gross domestic product, in real terms, is estimated to have increased at an annualised rate of 3.3 per cent in the June quarter 2008, compared with growth of 1.9 per cent in the previous quarter. The main contributors to economic growth in the June quarter were higher consumer spending and a stronger export performance. These effects were partially offset by a decline in residential and other private investment expenditure.

While economic expansion in the United States so far this year has been stronger than previously expected, partial indicators released recently suggest economic growth may slow in the remainder of 2008. Labour market conditions have softened and the equity market remains under significant pressure. Tighter credit conditions, continued weakness in the housing sector and higher energy prices are likely to have an adverse impact on consumption which supported US economic growth in recent times.

Reflecting higher energy and food prices, inflationary pressures in the US economy increased in mid-2008, with the consumer price index rising year on year by 5.6 per cent in July, the highest rate in 17 years. Excluding energy and food prices, inflation increased at a significantly lower rate of 2.5 per cent year on year in the same month. Looking forward, inflationary pressures are expected to moderate over the next few months as economic growth weakens further. The recent decline in world oil and other commodity prices, if sustained, is also expected to dampen inflationary pressures.

In preparing this set of commodity forecasts, economic growth in the United States is assumed to average 1.2 per cent in 2008 and 0.8 per cent in 2009.

Risks around these growth assumptions are weighted to the downside, particularly for 2009. Continued weakness in the financial and housing markets could lead to lower business investment and consumer spending which could slow the pace of economic recovery. On the upside, concerns have been partially alleviated by vigorous policy responses, particularly the provision of liquidity to financial markets. The expected moderation in inflationary pressures should also help to support economic activity.

Given the current economic outlook, the US monetary policy is expected to remain accommodative in the short term. The federal funds rate was at 2 per cent in early September 2008, compared with 5.25 per cent in the same period a year earlier.

China

After growing rapidly over the past few years, economic activity in China moderated in the first half of 2008. Real gross domestic product grew at a year on year rate of 10.1 per cent in the June quarter 2008, compared with 10.6 per cent in the previous quarter and an average of 11.9 per cent in 2007.

While disruptions from natural disasters, such as the earthquake in Sichuan province and floods in southern China, had an adverse effect on economic growth, the export performance has also slowed to a year on year rate of 21.9 per cent in the first half of 2008, compared with an average of 25.7 per cent in 2007.

China’s domestic demand appears to have remained relatively strong, with retail sales increasing year on year by 23.3 per cent in July 2008 and industrial production expanding by 14.7 per cent in the same month. Fixed assets investment, in nominal terms, rose by 26.3 per cent in the first half of 2008, slightly higher than in the same period a year earlier. Reflecting smaller increases in food prices, the consumer price index rose year on year to 4.9 per cent in August 2008, compared with a peak of 8.7 per cent in February.

Against this backdrop, economic growth in China is assumed to average 10 per cent in 2008, before declining to 9.3 per cent in 2009.

Risks to China’s short-term economic outlook are broadly balanced at this stage. On the downside, the slowdown in world economic growth, continued volatility in the global financial markets and domestic inflationary pressures could adversely affect the country’s growth prospects. On the upside, domestic demand could be more resilient to weaker external demand. There is also a distinct possibility China would provide a fiscal and monetary stimulus to support economic growth, should it begin to slow markedly. Indeed, China cut its benchmark interest rate by 27 basis points to 7.2 per cent in mid-September 2008 in an attempt to support economic growth.

Japan

After a strong growth of 3.2 per cent on an annualised basis in the first quarter of 2008, Japan’s economy contracted by 2.4 per cent in the second quarter of 2008. The decline in economic activity in mid-2008 was mainly a result of lower exports and consumer spending.
Partial indicators released recently suggest economic growth in Japan is likely to remain relatively weak in the next few quarters. Industrial production declined in the first half of 2008 and consumer sentiment deteriorated, with higher material costs and falling profits also weighing on corporate sector confidence.

Weaker export growth as a result of the global economic slowdown is a key risk to Japan’s economic outlook. Emerging markets in Asia, including China and South East Asia, have become a major destination for Japan’s exports, while the importance of the United States and Western European markets has declined. Therefore, Japan’s future export performance is linked to the economic growth prospects in emerging Asia.

Lower domestic demand is another source of downside risk to Japan’s economic outlook. Higher food and energy prices and slower wage growth could have a greater dampening effect on consumer spending than currently expected.

Economic growth in Japan is assumed to be around 1 per cent in 2008 and 0.9 per cent in 2009. This compares with growth of 2.1 per cent in 2007.

Non-OECD Asia

Despite recent volatility in the financial markets, economic growth in non-OECD Asia (excludes Japan and the Republic of Korea) remained relatively buoyant, although there have been signs of slowing economic activity more recently.

In India, for example, economic growth weakened from the rapid rates of recent years. Real gross domestic product increased by 7.9 per cent year on year in the June quarter 2008, following growth of 8.8 per cent in the previous quarter. While the increased infrastructure spending supported economic expansion, manufacturing growth moderated in the past few months.

Despite the slowdown in industrial production, wholesale price inflation exceeded 12 per cent year on year in August 2008. In response to increased inflationary pressures, the Reserve Bank of India has raised interest rates three times since June 2008 to reach a seven year high of 9 per cent.

The recent tightening in monetary policy, higher inflation and slower external and domestic demand are likely to weigh on growth over the next few quarters. Economic growth in India is assumed to decline from 7.7 per cent in 2008 to 7.3 per cent in 2009.

Other regional economies in non-OECD Asia have been largely unaffected by the problems in global financial markets, with export growth supported by intra-regional trade and shipments to Europe at the time of weaker demand from the United States. However, export performance is expected to slow over the coming quarters as higher fuel prices and global financial market difficulties reduce the demand from Europe and regional demand decelerates because of higher inflation and interest rates in many economies.

For non-OECD Asia as a whole, economic growth is assumed to average around 7.7 per cent in 2008, before easing to 7.3 per cent in 2009. This compares with growth of 9.3 per cent in 2007.

Western Europe

Economic activity in Western Europe weakened in the first half of 2008, with an estimated year on year growth of 1.5 per cent, compared with growth of 2.6 per cent for 2007 as a whole. Consumer and business sentiment declined markedly in response to financial sector instability and the impact of higher oil prices on real disposable incomes. A significantly higher value of the euro and a weaker export demand also had an adverse effect on economic performance.

The effects of economic slowdown are not felt equally across Europe. Economic growth in smaller European countries such as Austria, the Netherlands, Sweden and Switzerland continued to be well above trend. This is in contrast to the performance of the major regional economies, including Germany, France, the United Kingdom and Italy. In France, for example, the economy expanded by 1.1 per cent year on year in the June quarter 2008. While marginally higher annual economic growth of 1.4 per cent was achieved in the United Kingdom in the same quarter, economic activity in Italy remained largely unchanged, compared with the same period a year earlier.

Recent indicators point to continued weakness in economic activity, at least in the short term, with higher oil prices and weaker equity markets beginning to have an impact on investment and consumption growth. There are considerable market concerns about the possible impact of the current US economic slowdown on the economic performance in Western Europe.
Economic links between Western Europe and the United States remain significant. The traditional trade link is important, although stronger trade with Asia, emerging Europe and the Middle East has reduced the importance of the United States as an export market. Financial sector linkages appear to be the main source of spillovers in the current environment. Exposure to the US subprime mortgage market has already strained commercial banks and credit markets in a number of regional economies. As a result, credit conditions are tightening and downside risks to economic growth are rising, with significant potential impacts on domestic demand.

Largely because of higher energy and food prices, consumer price inflation in the euro area was 3.8 per cent on an annual basis in August 2008. Inflationary pressures are expected to decline in 2009 in response to assumed weaker economic growth and slower food and energy price increases. Continued inflationary pressures may constrain the European Central Bank’s ability to stimulate economic growth through more accommodative monetary policy, at least in the short term.

Economic growth in Western Europe is assumed to average 1.3 per cent in 2008, before easing to 0.9 per cent in 2009.

Economic prospects in Australia

After an extended period of strong growth, the Australian economy grew at a more moderate pace in the first half of 2008. Real gross domestic product rose by 0.3 per cent in the June quarter 2008, following growth of 0.7 per cent in the previous quarter. For 2007-08 as a whole, economic growth reached 3.7 per cent. This compares with growth of 3.3 per cent in 2006-07.

The slowdown in economic growth was largely driven by lower domestic demand, particularly household consumption. Partial indicators released recently suggest growth in domestic demand could continue to ease. The unemployment rate rose to 4.1 per cent in August 2008, compared with a low of 3.9 per cent in early 2008. Retail sales have been weak over the first six months of 2008 despite the increase of 1.4 per cent in July 2008 from the previous month.

Australia’s trade account, seasonally adjusted, recorded a surplus of $559 million in the June quarter 2008, compared with a deficit of $7.3 billion in the previous quarter. The current account deficit, seasonally adjusted, was around $12.8 billion in the June quarter 2008, following a deficit of $19.8 billion in the March quarter.

While continued strong demand for Australian commodities is expected to provide support for economic growth, domestic demand is likely to moderate further over the next few quarters. Given the effect of these two opposing forces on the Australian economy, economic growth in Australia is assumed to average 2.75 per cent in 2008-09.

Assuming average seasonal conditions, the volume of farm production is forecast to increase by 10.5 per cent in 2008-09. The volume of crop production is forecast to expand by 22.8 per cent, while livestock production is forecast to fall slightly by 1.4 per cent in 2008-09. For minerals and energy, the volume of mine production is forecast to increase by 6.8 per cent in 2008-09.

Inflation

Limited spare capacity and continued strong growth in demand have contributed to an increase in Australia’s inflation rate. The consumer price index rose by 1.5 per cent in the June quarter 2008, compared with 1.3 per cent in the previous quarter. On an annual basis, Australia’s consumer price index was 4.5 per cent higher in the June quarter 2008.

Given the outlook for easing domestic demand, inflationary pressures are assumed to decline gradually. For 2008-09 as a whole, Australia’s inflation rate is assumed to average around 3.5 per cent, compared with 3.4 per cent in 2007-08.

Exchange rate

After rising strongly in the first half of this year, the Australian dollar has been depreciating since mid-July 2008, both against the US dollar and on a trade weighted basis. The Australian dollar was trading around US80c and TWI 63 in mid-September 2008, compared with US98c and TWI 74 in mid-July 2008. In the first three months of 2008-09, the Australian dollar is estimated to have averaged around US90c and TWI 70.

A key factor contributing to the recent depreciation of the Australian dollar has been the rise of the US dollar against most other major currencies. For example, the US dollar was trading around 0.70 euro in mid-September 2008, compared with 0.63 euro in mid-July 2008. Recent movements in the US dollar have been affected by weaker growth in some of the major world economies – both the euro area and Japanese economies have weakened markedly since the June quarter 2008.

Another factor which has placed significant downward pressure on the Australian dollar is the financial market expectations of an easing in Australia’s monetary policy. In early September 2008, the Reserve Bank of Australia lowered its benchmark interest rate by 25 basis points.
Interest rate differentials between Australia and other major world economies are expected to continue affecting the value of the Australian dollar. Given the recent weakening in economic growth and the prospects for easing inflationary pressures, Australia’s prime lending rates are assumed to decline from an average of 7.7 per cent in 2007-08 to 7.3 per cent in 2008-09.

In contrast, US interest rates are not expected to change markedly in the short term - prime loan rates were around 5 per cent in mid-2008 – leading to a narrowing of the interest rate differential between the United States and Australia.

In preparing this set of commodity forecasts, the Australian dollar is assumed to average US85c and TWI 67 in 2008-09. This compares with an average of US90c and TWI 70 in 2007-08.

There is considerable uncertainty surrounding the short-term outlook for the Australian dollar. This is because movements in the Australian exchange rate can be significantly influenced by changes in financial market sentiment, leading to strong volatility in the Australian exchange rate.

For example, over the past 12 months the Australian dollar has appreciated from US82c and TWI 66 in early September 2007 to a high of US98c and TWI 74 in mid-July 2008, before depreciating to around US80c and TWI 63 in mid-September. Since its floating in December 1983, the Australian dollar has had an average annual fluctuation range of more than US10c.

Commodity export prices up sharply in 2008-09

The index of unit export returns for Australian commodities, in aggregate, is forecast to rise by 38 per cent in 2008-09, following an increase of 6 per cent in 2007-08. This forecast rise mainly reflects the effects of significantly higher energy and mineral prices.

For farm commodities, however, the index of unit export returns is forecast to fall by 2 per cent in 2008-09, after rising by 10 per cent in 2007-08. The effects of forecast lower world indicator prices for wheat, wool and dairy products are expected to offset forecast higher world cotton, sugar, coarse grain and oilseed prices.

For mineral and energy commodities, the index of unit export returns is forecast to increase by around 47 per cent in 2008-09, compared with a rise of 5 per cent in 2007-08.

The significant increase forecast for 2008-09 largely reflects the effects of higher negotiated contract prices for coking coal, thermal coal and iron ore and forecast higher world prices for crude oil, aluminium and gold.

Unit returns for energy exports are forecast to rise by 86 per cent in 2008-09, compared with an increase of 13 per cent in 2007-08. Unit export returns for metals and other minerals are forecast to increase by 20 per cent in 2008-09, after remaining largely unchanged in 2007-08.

Commodity export earnings continue to set new records

Earnings from Australia’s commodity exports are forecast to be $213.7 billion in 2008-09, compared with an estimated $148.7 billion in 2007-08 (a rise of 44 per cent).

For farm commodities, export earnings are forecast to be around $30 billion in 2008-09, an increase of 9 per cent from $27.5 billion in 2007-08. Agricultural commodities for which export earnings are forecast to be higher in 2008-09 include wheat, barley, sugar, wine, pulses, canola, sorghum and lamb.

For forest and fisheries products, export earnings are forecast to be around $3.9 billion in 2008-09, 2 per cent higher than earnings in 2007-08.

The value of Australia’s minerals and energy exports is forecast to rise by 53 per cent to be around $180 billion in 2008-09. This compares with an estimated $117 billion in 2007-08. For energy commodities, export earnings are forecast to increase by 98 per cent from $45.3 billion in 2007-08 to $89.7 billion in 2008-09. For metals and other minerals, export earnings are forecast to rise by 25 per cent to $90.1 billion in 2008-09.