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In framing the forecasts for the domestic economy the exchange rate is assumed, as is usual practice, to remain unchanged from the average levels reached in recent months, at around US52½c and around 50 against the trade weighted index (TWI). On the basis of these assumptions, the exchange rate would be lower on average in 2001-02 than in 2000-01, and significantly lower than its average level of around US63c and 55 against the TWI in 1999-2000, helping to produce a solid net export performance in the face of slower world growth.
The forecasts take into account the reductions in official interest rates since February 2001. The reductions in interest rates are expected to be supportive of domestic demand, especially residential investment and household consumption spending (in particular, on consumer durables). Although the timing and magnitude of this effect is uncertain, most of the impact from lower interest rates is expected to be felt in 2001-02.
The forecast fall in farm production in 2000-01 largely reflects a combination of very dry conditions in some areas and severe flooding in others. An assumed return to normal seasonal conditions in 2001-02 would see stronger farm production contributing to overall economic growth.
In 2001-02, economic growth in Australia is forecast to be around 3¼ per cent in year-average terms and a strong 4 per cent through the year to the June quarter 2002. Average unemployment rates are forecast to be slightly higher than recent levels at around 7 per cent, with inflation declining relative to 2000-01 and the CAD well below its average level of the 1990s.
Gross national expenditure is forecast to grow at a moderate rate of around 3 per cent in 2001-02, following growth of less than 1 per cent in 2000-01. Residential construction is expected to contribute strongly to growth, with moderate growth in household consumption, business investment and net exports (Chart 2).
Residential construction is expected to grow by around 5 per cent in year-average terms in 2001-02, following a large decline of around 25 per cent in 2000-01, with the turn around supported by recent reductions in interest rates and the Government's more generous First Home Owners Scheme. The recovery in this sector is expected to gather strength as 2001-02 proceeds, with through-the-year growth of around 14 per cent. Modest growth is also expected to resume in non-residential construction, particularly engineering construction, following several years of decline since the recent peak in 1998-99.
Following the weakness in the second half of 2000 and subdued growth expected in the first half of 2001, economic growth is now expected to be around 2 per cent in 2000-01 in year-average terms and around 1 per cent in through-the-year terms.
Chart 2: Contributions to GDP growth
(a) Excluding private sector net purchases of second-hand public sector assets.
Source: Australian Bureau of Statistics (ABS) Cat. No. 5206.0 and Treasury.
Household consumption is forecast to increase by around 3 per cent in 2001-02, a little stronger than the estimate of 2¾ per cent for 2000-01 (Chart 3). This follows a six year period where consumption growth averaged a very strong 4½ per cent per annum.
Chart 3: Annual growth in real household consumption
Source: ABS Cat. No. 5206.0 and Treasury.
Real household disposable income in 2000-01 has been boosted by the income tax cuts and increases in benefits flowing from The New Tax System (after an allowance for the associated increases in indirect taxes). However, the beneficial impact of these tax cuts on consumption expenditure was offset to some extent in the latter part of 2000 by the effects of rising interest rates during 2000 and rising petrol prices. Slower employment growth in 2000-01 also had a moderating effect on the growth in real household income and consumption. In addition, the strong accumulation of wealth experienced over recent years (Chart 4) did not continue to the same extent in 2000-01, with relatively steady share prices, and with house prices declining in some areas and rising less quickly than previously in other areas.
The significant interest rate reductions since early 2001 are likely to give some boost to consumption growth in 2001-02, as will the expected gradual downward trend in petrol prices. On the other hand, subdued employment growth will continue to have a moderating effect on the growth in real household income in 2001-02.
Chart 4: Annual growth in private sector wealth(a)
(a) June 30 estimates.
There are few signs of major imbalances in the balance sheet of the household sector, suggesting that the household sector's net financial position should not act as a major constraint on consumption growth over the forecast horizon. Household borrowing has been strong in recent years, partially reflecting the continuing impact of financial deregulation on the availability of credit and lower interest rates. This has increased the debt-to-disposable income ratio to a little over 100 per cent, close to the average of other developed economies. However, the growth in household debt has been broadly matched by an increase in assets held by households, with the household debt-to-assets ratio showing only a gradual increase over recent years. Further, the household debt servicing ratio remains at a relatively modest level by historical standards (see Chart 5), well below the peak in the late 1980s, and is likely to fall during 2001 in response to recent declines in interest rates.
Measures of consumer sentiment have been particularly volatile over the last year, with the Westpac-Melbourne Institute index falling by around 15 per cent prior to the introduction of The New Tax System and then rebounding to previous levels, as the uncertainty surrounding the introduction of The New Tax System abated. The consumer sentiment index has trended lower over recent months, although with a significant rebound in May. Nevertheless, it is too early yet for the full impact of lower interest rates to be reflected in the survey responses. It is also noteworthy that retail sales increased strongly in the March quarter 2001 (by around 1.9 per cent in real terms), at a time when measures of consumer sentiment were declining.
An extended period of low consumer sentiment represents a downside risk to the consumption growth forecasts, although the recent reductions in interest rates should be supportive of higher confidence levels.
Chart 5: Household debt servicing ratio
(a) Household (including unincorporated enterprises) debt interest payments as a proportion of household disposable income.
Source: ABS Cat. No. 5206.0.
Following several years of strong growth, dwelling investment is expected to fall by around 25 per cent in 2000-01 in year-average terms, before returning to a positive rate of growth later in 2001.
In 1999-2000, building activity rose strongly to its highest level as a share of GDP in almost 20 years, as home builders and renovators brought forward activity ahead of the introduction of The New Tax System. This bring-forward of activity was unwound in the second half of 2000 which, combined with the effects of higher interest rates, saw activity in this sector decline by around 35 per cent over the September and December quarters of 2000 (Chart 6). This decline in building activity, in turn, contributed to weaker employment and household consumption spending.
In 2001-02, dwelling investment is expected to rebound significantly, with forecast growth of around 5 per cent in year-average terms and around 14 per cent in through-the-year terms. Strong growth is expected to be driven largely by improved housing affordability and by the Government's more generous First Home Owners Scheme. Recent declines in interest rates should see housing affordability improve through 2001. The First Home Owners Scheme, which encourages the construction of new dwellings through the payment of a $14,000 grant to first home buyers, should also provide a targeted, short-term boost to building activity in 2001-02.
There is a greater than normal degree of uncertainty surrounding the timing and extent of the recovery in dwelling investment. The Government's more generous First Home Owners Scheme and the recent reductions in interest rates should provide a significant boost to activity in the sector, although the timing and magnitude of this boost is difficult to assess. Early indications suggest strong interest from home buyers resulting from the First Home Owners Scheme.
Chart 6: Growth in dwelling investment
Source: ABS Cat. No. 5206.0.
New business investment2 is expected to grow by around 5 per cent in 2001-02, following approximately zero growth in 2000-01 (Chart 7). Through the year to the June quarter 2002, new business investment is expected to grow by around 9 per cent. The solid outlook for business investment reflects sound fundamentals: short and long-term interest rates are near historical lows; corporate profitability (despite recent declines) remains around historically high levels as a share of GDP, and is particularly strong in the mining sector which is highly capital intensive; and the decline in the exchange rate over recent quarters will give many Australian industries an important buffer against the effects of slower world growth. Despite the forecast solid increase in business investment in 2001-02, the level of business investment would remain slightly below longer run averages as a share of GDP, following a small fall in 2000-01.
New investment in plant and equipment is expected to grow by around 3 per cent in 2001-02, and a strong 7 per cent through the year to the June quarter 2002, following estimated growth of around 5 per cent in 2000-01. The outlook for investment in plant and equipment is partially underpinned by expected investment in the mining sector. After a couple of very weak years during and immediately following the Asian crisis, conditions in the mining sector are conducive to investment, with record levels of profitability boosted by higher prices for a range of commodities and the decline in the exchange rate. Firms' first investment intentions for 2001-02, as reported in the ABS capital expenditure survey, were quite strong, although early estimates only provide a broad indication of likely outcomes. Allowing for some impact from lower levels of business confidence experienced over recent quarters on realisation ratios applied to investment intentions, the investment intentions data point to solid growth in plant and equipment investment in 2001-02.
Chart 7: Annual growth in new business investment(a)
(a) Excluding net purchases of second-hand public sector assets.
Source: ABS Cat No. 5206.0 and Treasury.
The risks around the outlook for plant and equipment investment in 2001-02 appear to be balanced. On the one hand, slower domestic and world growth may point to a weaker outlook than forecast, particularly if business confidence falls in response to this uncertain outlook. While profits in aggregate have been around historically high levels, there is anecdotal evidence that margins in some sectors may have been affected by the lower Australian dollar, high energy and fuel costs, new tax payment arrangements and weaker demand. On the other hand, relatively low short and long-term interest rates, lower plant and equipment prices as a result of the introduction of The New Tax System, and the potential for investment by the mining and resource sectors over the medium term are supportive of strong investment. There is also some potential for stronger than forecast investment in 2001-02 if business confidence rebounds sharply from its current level.
New investment in buildings and structures is expected to grow by around 6 per cent in 2001-02 and a strong 10 per cent through the year to the June quarter 2002. This follows an estimated decline of 22 per cent in 2000-01, mainly associated with the completion of Olympics-related projects. Strong growth in engineering construction is expected to underpin growth in investment in buildings and structures in 2001-02, as a number of new projects in the mining and resource sectors, and several power generation projects, commence during the year. A stabilisation in the level of non-residential building approvals, commencements and work-yet-to-be-done suggests that activity in this sector may have bottomed, following two years of decline.
Investment in intangible fixed assets (that is, computer software, mineral exploration rights and artistic originals) is expected to grow strongly in 2001-02, although at a slower rate than in 1999-2000 and 2000-01. The outlook for intangible fixed assets is dominated by expected strong growth in software investment, which now comprises over 10 per cent of total new business investment. Some easing in growth of software investment is expected in 2001-02, following the completion of work relating to the new tax arrangements in 2000, and Y2K-related work in 1999.
Private non-farm inventories are expected to contribute around a ¼ of a percentage point to growth in 2000-01. In the first half of 2000, there appears to have been an unanticipated run-down in inventories, especially in the retail sector, as sales were brought forward ahead of the introduction of The New Tax System. In turn, there was some rebuilding of inventory levels in the second half of 2000 as this net bring-forward of sales was unwound. However, after making an allowance for this effect, there appears to have been a modest build-up in inventory levels in the second half of 2000, due to weaker than expected growth in sales.
Private non-farm inventories are expected to subtract around a ¼ of a percentage point from GDP growth in 2001-02, as the modest build-up in inventories in the second half of 2000 is gradually unwound over 2001, and more generally as firms continue to manage down inventory-to-sales ratios to increase profitability. However, there is a risk that the build-up in inventories may be unwound more quickly, especially if the recent falls in business sentiment are sustained.
In 2001-02, real public final expenditure3 is anticipated to grow by around 2¼ per cent in year-average terms, similar to the outcome expected in 2000-01, but well below the 5.6 per cent growth recorded in 1999-2000. The moderation relative to 1999-2000 reflects the winding down of expenditure related to the peacekeeping mission in East Timor; the start-up costs associated with tax reform; and the completion of large infrastructure projects in some States (including the Olympics). This has been partially offset at the Commonwealth level by the new spending initiatives on research and development, roads and defence that are expected to commence in 2001-02.
Growth in consumption at the State level is expected to be steady, with a fall in consumption following the Olympics offset by increased spending on roads and wage costs. An expected fall in State underlying investment reflects the completion of a large number of infrastructure projects in 2000-01 and decreased investment spending in 2001-02.
The CAD is forecast to decline sharply from 5.3 per cent of GDP in 1999-2000 to around 3 per cent of GDP in 2000-01 and 2001-02. The decline in the CAD relative to 1999-2000 is expected to be driven by a stronger trading performance in volume terms, a rise in the terms of trade and a lower NID. At these levels, the CAD would be well below its average level as a share of GDP during the 1990s, and around half its earlier peaks.
Net exports are expected to contribute a large 1¼ percentage points to GDP growth in 2000-01, but slower world growth in 2001 will have a significant impact on exports in 2001-02. However, net exports are still expected to contribute around ¼ of a percentage point to GDP growth in 2001-02, reflecting the assumed lower average exchange rate in 2001-02 and the impact of modest growth in domestic demand on imports.
In 2001-02, export volume growth is expected to be a solid 5 per cent, following an estimated 6 per cent growth in 2000-01. These growth rates are only a little below trend, reflecting the impact of slower world growth in 2001 on Australia's export volumes being substantially offset by a lower average exchange rate. Export growth in 2001-02 is expected to be underpinned by strong growth in non-rural commodity exports, reflecting the continued ramp-up of production from recently completed projects.
Farm production is expected to fall by around 6 per cent in 2000-01 due to adverse seasonal conditions. In 2001-02, farm production is expected to grow strongly, by around 7 per cent (well above trend), due to the assumed return to average seasonal conditions. Rural export volumes are not expected to fall by as much as farm production in 2000-01, as stocks - particularly wool and wheat - are drawn down to meet demand. As a result, rural export volumes are not expected to rebound as strongly as farm production in 2001-02.
The impact of slower world growth - in particular in Australia's major trading partners - is expected to be most apparent in lower growth in elaborately transformed manufactures (ETMs) and services exports. However, the lower average exchange rate should partially offset this by providing a boost to Australia's competitiveness, enabling Australian exporters to increase their market share. As a result, both services (abstracting from the Olympics) and ETM export volumes are expected to continue to grow solidly in 2001-02, albeit at rates somewhat below trend.
Import volumes are expected to grow by 4 per cent in 2001-02, up from around zero growth in 2000-01, reflecting strengthening - but still below trend - domestic demand growth and more modest growth in import prices in Australian dollar terms than in 2000-01. Nevertheless, in both years, import volume growth is expected to be well below trend growth rates.
The terms of trade are expected to increase by a strong 4 per cent in 2000-01, to be around the highest level in a decade. Only a slight decline (¾ per cent) from these levels is forecast in 2001-02, despite slower expected world growth. This slight decline reflects a modest fall in the world price of Australia's exports, partly offset by continued weakness in the world price of Australia's imports.
In currency neutral (Special Drawing Rights (SDR)) terms, Australia's non-rural commodity export prices - as measured by the Reserve Bank of Australia's commodity price index - are expected to continue to grow in 2001-02, following strong growth in 2000-01. Underlying this forecast are strong increases in negotiated contract prices for bulk commodities being partially offset by weaker prices for base metals and mineral fuels. Contract prices for steaming coal have recently increased by around 20 per cent in US dollar terms, coking coal by around 11 per cent and iron ore by around 4 per cent.
Some moderation in aggregate rural prices in SDR terms from recent high levels is anticipated, reflecting an expected rise in world agricultural production in 2001-02 (in part driven by the continued high level of agricultural subsidies in developed countries) and continued high levels of world stocks. This points to subdued world prices in 2001-02, particularly for wheat and cotton. Nevertheless, world prices for beef and wool - two of Australia's key rural exports - are expected to increase slightly in 2001-02, building on strong gains in 2000-01, to be at their highest level in two decades in Australian dollar terms. This reflects a relatively tight supply/demand balance in both markets.
In Australian dollar terms, rural commodity prices are expected to remain around historically high levels over the forecast period. While adverse seasonal conditions have seen farm production fall by around 6 per cent in 2000-01, a return to average seasonal conditions is expected to see farm production increase by 7 per cent in 2001-02. The relatively unusual combination of high prices and strong production should see farm incomes increase to historically high levels in 2001-02.
The CAD is forecast to decline sharply in 2000-01, to 3 per cent of GDP, down from 5.3 per cent of GDP in 1999-2000. The decline in the CAD is expected to be driven by a stronger trading performance in volume terms, a rise in the terms of trade and a lower NID. In 2001-02, the CAD is expected to remain around 3 per cent of GDP.
Chart 8: Contributions to the current account deficit
Source: ABS Cat. No. 5302.0 and 5206.0 and Treasury.
The NID is forecast to remain a little below 3 per cent of GDP, despite a continued (albeit more moderate) build up in Australia's net foreign liabilities as a share of GDP. This outcome reflects lower Australian and world interest rates, and the significant narrowing in the difference between the yield on foreign investment in Australia and the yield on Australian investment abroad over recent years. Recent trends in the NID are discussed in more detail in the Centenary edition of the Economic Roundup.
Employment growth in 2001-02 is expected to be slower than in recent years at around 1 per cent in year-average terms and around 1½ per cent through the year. This largely reflects the lagged effects of slower overall economic growth in 2000-01, particularly the downturn in the labour intensive construction sector (Box 2).
Employment in the construction sector declined by around 55,000 in total over the December 2000 and March 2001 quarters, with likely flow-on effects to other sectors, including employment in parts of the manufacturing sector involved in the production of building materials. These effects are expected to be reversed gradually as the construction sector recovers during the course of 2001-02, with the turn around likely to be most apparent in the second half of the year.
Chart 9: Unemployment rate
Source: ABS Cat. No. 6202.0 and Treasury.
The unemployment rate is expected to increase slightly from recent levels, to average around 7 per cent in 2001-02 as a whole and in the June quarter 2002. Monthly data are likely to vary significantly around these averages. Recent falls in the various job vacancy series suggest that weak employment outcomes are likely over coming months, which is expected to put some upward pressure on the unemployment rate. However, as in previous short periods of slower GDP growth (identified by the circled periods in Chart 9), the increase in the unemployment rate is expected to be relatively small and quite brief. Continued moderate growth in wages will help to limit the extent and duration of the rise in unemployment. Prospects are sound for a resumption of the downward trend in unemployment over the medium term as the construction sector recovers, overall economic growth strengthens and the benefits from earlier labour market reforms and more general microeconomic reforms, including taxation reform, continue to accrue.
Productivity growth (on a heads basis) is forecast to reach a cyclical low in 2000-01 before rebounding solidly in 2001-02 to 2¼ per cent. Some of the factors likely to influence the medium-term trends in productivity are discussed in Budget Paper No. 1, Statement 4.
Industries in Australia differ markedly in terms of their labour intensity and therefore their levels of labour productivity (Chart 10). For example, mining accounts for around 5 per cent of total output, but employs just 1 per cent of the workforce and therefore has a high level of labour productivity (output of around $300,000 per person employed in the industry) and is relatively capital intensive. In contrast, construction is relatively labour intensive with levels of labour productivity (output of around $50,000 per person employed in the industry) a little below the economy-wide average.
Chart 10: Labour productivity by industry(a)4
(a) The chart shows average levels of productivity over the years 1996-97 to 1999-2000.
Source: ABS Cat. No. 5206.0 and 6203.0.
In 2000-01, as the composition of economic activity shifted away from relatively labour intensive industries such as construction, and towards relatively capital intensive industries such as mining, the impact of the slower overall economic growth on the labour market was more pronounced. As the construction industry recovers during 2001-02, this effect will be unwound gradually.
Wages have continued to grow at a moderate pace in 2000-01, consistent with slower economic and employment growth and the moderate increase in unemployment. Importantly, there has been little evidence to date of widespread wage increases in response to price changes following the introduction of The New Tax System.
Average earnings growth on a national accounts basis (AENA) is expected to be a moderate 3½ per cent in 2000-01. Abstracting from the increase in the superannuation guarantee charge on 1 July 2000, AENA is expected to grow by 3 per cent in 2000-01.
In 2001-02, growth in AENA is expected to increase to 3¾ per cent, as economic growth strengthens and is reflected in slightly firmer labour market outcomes as the year progresses. The forecast incorporates the recent `Living Wage Case' decision.
The pace of the pick up in economic activity and the timing of its impact on the labour market represent a key source of uncertainty around the wages outlook.
While the introduction of The New Tax System does not appear to have influenced wages growth to date, there remains a residual risk to wages over the forecast period (for example, if union campaigns were to be successful). Recent enterprise bargaining data indicate that the proportion of employees covered by agreements that include inflation-related clauses has increased. However, there is no rationale for higher wages to compensate for the price effects of The New Tax System, given the significant personal income tax cuts and increases in benefits contained in the package.
In 2000-01, `ongoing' inflation (that is, inflation excluding the impact of The New Tax System) is expected to be around 3¼ per cent in both year-average and through-the-year terms. The increase in `ongoing' inflation relative to the 1999-2000 outcome of 2.4 per cent in year-average terms largely reflects the effect of the increase in petrol prices over calendar year 2000.
The New Tax System is expected to increase the CPI by around 2½ per cent through the year to the June quarter 2001, with this effect having been felt largely in the September quarter 2000. Taking together the estimates of `ongoing' inflation and the impact of The New Tax System, the CPI is expected to increase by 6 per cent in year-average terms in 2000-01 and by 5¾ per cent through the year to the June quarter 2001.
The CPI increased by 1.1 per cent in the March quarter of 2001. This higher than expected outcome largely reflected the effect of flooding in northern New South Wales and southern Queensland on fruit and vegetable prices and the effect of increased world demand for Australian meat products. The sharp rise in fruit and vegetable prices is likely to be at least partly reversed in coming quarters as supply returns to more normal levels. There were also the usual seasonal increases in the price of education, pharmaceuticals and childcare. Petrol prices fell 3.7 per cent in the quarter, in response to lower world oil prices and the Government's decision to reduce excise on petrol (and abolish indexation) in early March. Looking through these influences, the CPI increased by a moderate 0.6 per cent in the March quarter, following the very low increase of 0.3 per cent in the December quarter.
Inflation is forecast to decline in 2001-02, with the headline CPI rising by around 2 per cent in both year-average and through-the-year terms. The abolition of Financial Institutions Duty (FID) and other elements of The New Tax System will put downward pressure on consumer prices in 2001-02 and the forecasts also incorporate an allowance for a slight easing in petrol prices in line with an expected downward trend in world oil prices. Wages growth is expected to remain moderate, at around 3¾ per cent, helping to ensure that growth in labour costs remains well contained. The inflation forecasts also make an allowance for some impact on consumer prices of the decline in the Australian dollar over recent quarters.
Measures introduced as part of The New Tax System (including the abolition of FID and stamp duty on marketable securities from 1 July 2001, as well as the early introduction of input tax credits for motor vehicles) are expected to reduce the CPI by between a ¼ and a ½ of a percentage point in both year-average and through-the-year terms. Leaving aside this effect, `ongoing' inflation is expected to be around 2¼ per cent in the year to the June quarter 2002.
A number of key uncertainties surround the inflation outlook, particularly for 2001-02. If world oil prices or the value of the Australian dollar differ substantially from their assumed levels, this could pose risks to the inflation forecasts on both sides. The inflation forecasts are also based on the historical pass-through from exchange rates into the CPI. However, in recent years, exchange rate movements appear to have had less impact on the CPI than was the case on average over recent decades. If this reduced pass-through from the exchange rate to the CPI were to continue, inflation could be lower than forecast.
2 Private sector net purchases of second-hand public sector assets can have a significant impact on estimates of business investment and public final demand, despite the fact that these asset purchases have no impact on aggregate economic activity. Accordingly, the forecasts of new business investment abstract from these transactions.
3 The forecasts of public final expenditure abstract from private sector net purchases of second-hand public sector assets - see footnote 2.
4 The following industries are aggregations of `similar' ABS standard industry classifications: distributional services include wholesale trade, retail trade and transport and storage; business and investment-related services include finance and insurance, and property and business services; consumer services include accommodation, cafes and restaurants, cultural and recreational services, and personal and other services; and human capital services include government administration and defence, education, and health and community services.