Friday, September 21, 2012

Straight talk from the IMF about that surplus: we might have to postpone it

Who could it have been talking to?

The Treasurer and the International Monetary Fund are at odds over whether the budget should return to surplus this financial year.

The Fund has used its latest report on Australia to raise the prospect of abandoning the planned surplus saying the authorities had “scope to delay their planned return to surplus” should the economic outlook deteriorate sharply.

Treasurer Wayne Swan will tell a business breakfast in Sydney this morning he intends to return to surplus regardless, saying although the task “is made harder by a fall in commodity prices” a surplus is “still our best defence against the current global economic volatility and sends a clear message that we are committed to responsible fiscal policy”.

However the IMF believes Australia’s reputation is not at risk, describing its public debt as “modest” and saying it has “monetary and fiscal space” to respond to shocks.

It has upgraded its forecast for Australian growth this year from 3 to 3.25 per cent but warns “risks are tilted to the downside”.

“For example, a hard landing in China would reduce demand for Australian mineral exports, worsen terms of trade, reduce household income, and could trigger a fall in house prices,” it says.

The Fund paints a picture of an economy increasingly at the mercy of international markets saying “the increasing share of the mining sector in the economy implies Australia will be exposed more to volatile commodity prices, not only upward but also downward, as in recent months”.

While the floating dollar can help cushion the national economy it “offers little help” to regional economies and the industries that suffer the most at the hands of international markets.

The IMF says investment outside of Australia’s resources sector is likely to remain weak for some time and that the rest of the economy will soon face the challenge of absorbing mining industry workers made redundant as the boom comes off its peak.

Mr Swan will tell this morning’s breakfast he is an optimist about China.... He will say his talks there have convinced him much of its slowdown is deliberately engineered.

“We really just need to keep things in perspective,” he will say. “China is now 40 per cent larger than in 2008 so its growth rate can be 20 per cent lower for it to make the same contribution to global growth.”

“It’s like Usain Bolt easing off a bit at the end of the 100 meters because he’s 10 meters in front and has already smashed the world record.”

The Fund’s Asian head of mission Masahiko Takeda told reporters yesterday Australia had the ability to respond to both a deeper decline in Asian growth and a worsening European situation. ‘‘Australia has policy space to mobilise,’’ he said, noting that for the moment Australian policies struck a good balance between cutting debt and supporting growth.

Its monetary and capital markets chief Dr Cheng Hoon Lim said ‘stress tests’ showed Australia’s banking system could withstand a five per cent drop in economic growth and 35 per cent slide in house prices.

Mr Swan said the Fund had “lauded” Australia’s strong fundamentals and bright outlook. His speech this morning will concentrate on the United States saying the biggest threat is “the cranks and crazies that have taken over the Republican Party”.

In today's Sydney Morning Herald and Age

IMF Concluding Statement Australia


Thanks Craig [Meller] for that introduction.

AMP has certainly pulled together a great event working with Peter Maher and John Brogden from the Financial Services Council.

Today’s a good opportunity to just step back and have a chat about where the global economy is going and what that means for Australia.

I want to talk about Europe, the US, Asia then Australia in that order.

The way I see it, we’re now clearing some of the major hurdles in the global recovery but we have a long way to go and the finish line is still well-off in the distance.

We should take heart from a couple of the most encouraging weeks in the world economy for some time and that’s cause for cautious optimism.

On the flip side, the two biggest risks to the global outlook are Europe and the fiscal cliff in the United States.


In Europe, three events recently had the potential to tip the balance.

In a rare coup for the optimists among us, each fell the right way and together with developments in the US have helped support confidence.

Mario Draghi delivered a potential game-changer.

The ECB’s announcement of further measures to stabilise Spanish and Italian sovereign bond markets was essential.

We should acknowledge Draghi’s determination to do everything he can within his mandate to preserve the euro. Someone had to step up.

It was a necessary step, but certainly not sufficient.

For the first time in a long, long time the Europeans did something that made us think they’re capable of sorting this thing out.

Two other key events bought them further breathing space - the German Constitutional Court did not rule against the European Stability Mechanism and the Dutch people elected a pro-euro government.

We now need Europe’s political leaders to use this window of opportunity to take further decisive action to stabilise the path of Europe’s troubled economies.

More fundamentally, despite the steps taken in the last couple of weeks, it remains the case that the European project is only half-finished.

We admire Europe’s ambition in seeking to bind itself together so that it may never again tear itself apart through pan-European military conflict and political upheaval.

We don’t doubt the emotional commitment at the heart of the euro.

But Europe’s leaders must accept that the economic structure they sought to build lies incomplete.

A monetary union standing alone remains structurally unstable.

It must be reinforced by the strong foundations of a fiscal union, and the supporting pillars of a banking union and political union.

The answer – the only answer – lies in more Europe, not less.

Of course, this is a reform story that will span decades, not months.

It requires more political courage among Europe’s leaders than they’ve shown to date – to take difficult decisions in the long-term interest of their people.

That’s what leadership is about – forsaking the politically easy, populist road, in favour of the more challenging but more sustainable path towards prosperity for the future.

There’s been too little of this in Europe up to now.

Here in Australia, we have rich and proud history of leaders who have set aside their political interests to take decisions in the long-term national interest.

Whether it was floating the dollar, bringing down the tariff wall, abolishing centralised wage fixing, or introducing compulsory super.

Or in our case the carbon price, MRRT and more.

We’ve stumped up and pushed forward when the times called for it.

Europe has much of this nation building task still ahead of it.

As they bind their countries closer together, European policymakers must continue their efforts to support economic growth and job creation, and recapitalise their banking system.

They must do this while they implement a credible medium-term framework to reduce excessive sovereign debt levels and boost competitiveness through structural reform.

There is little doubt this will be a very long and painful adjustment with bouts of volatility in global financial markets along the way.


So Europe’s obviously the first key risk to the global outlook, but there’s another on the other side of the Atlantic.

In the United States, we are reminded again of the price paid by the community when hard decisions are delayed.

It’s been just over twelve months since the venomous partisan debate over the United States’ legislated borrowing limit and fiscal trajectory led to S&P stripping the US of its prized AAA-rating after 70 years.

Despite President Obama’s goodwill and strong efforts, the national interest was held hostage by the rise of the extreme right Tea-Party wing of the Republican Party.

The consequences were grave.

S&P said at the time that the downgrade reflected its view that:

“the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges”

S&P cited: “the difficulties in bridging the gulf between the political parties over fiscal policy”.

These are words of warning to politicians the world over.

There can be few things more alarming in public policy than a political movement which was genuinely prepared to see the US Government default on its obligations in order to score a political point.

Fast-forward to today, against the backdrop of a very close presidential campaign, and global investors are once again keenly focussed on political gridlock in the US.

As is well known, a ‘fiscal cliff’ looms early in the new year threatening to derail the still moderate recovery in the US.

The Congressional Budget Office estimates that currently legislated spending cuts and tax increases amount to a fiscal consolidation worth around 5.1 per cent of GDP in the 2013 calendar year.

This would tip the US economy back into recession – the CBO estimates the US would contract at an annual rate of 2.9 per cent in the first half of 2013.

To give you an idea of the counterfactual, the CBO estimates that if US lawmakers removed the scheduled contraction in full, the US economy would likely grow somewhere in the order of 4.4 per cent in 2013.

With the world watching, it is imperative that the US Congress resolve an agreement to support growth in the short term.

In a throw back to a year ago, global markets are nervously watching the positioning of hardline elements of the Republican Party for signs that they will dangerously block reasonable attempts at compromise.

Let’s be blunt and acknowledge the biggest threat to the world’s biggest economy are the cranks and crazies that have taken over the Republican Party.

Of course, Congress must outline a credible medium-term plan to assure markets that the US can put its budget back on a sustainable footing over time, building its fiscal strength to respond to future challenges.

Last week, Moody’s confirmed it would likely join S&P in downgrading the US from AAA if the US Congress does not outline a credible plan for reducing its debt levels over time.

But Moody’s observed that unless this was achieved without a “large, immediate fiscal shock – such as would occur if the so-called fiscal cliff actually materialized” its ratings outlook would likely remain negative.

Here in Australia, of course, the grass is so much greener.

Our net debt is around one-tenth the level of the major advanced economies as a percentage of GDP, and we’re coming back to surplus before every single one of these economies.

Getting the budget back into surplus is made harder by a fall in commodity prices, but it’s still our best defence against the current global economic volatility and sends a clear message that we are committed to responsible fiscal policy.

It gives the RBA maximum room to cut official interest rates – as it has with the equivalent of five rate cuts in the past year or so, supporting businesses and supporting households.

This recognises that monetary policy should play the primary role in managing demand in the current circumstances – consistent with its medium term inflation target.

So in the US as in Europe, we’ve seen political gridlock, excessive public debt, and no room to move on interest rates – leading the US central bank to respond with unconventional monetary policy.

The Fed last week delivered on market expectations for another round of quantitative easing – in fact surprising on the upside with an open-ended program and the promise of very low rates even longer into the recovery.

The numbers involved are staggering. Consider this.

Even before QE3 – as it’s known – the total nominal value of unconventional monetary policy undertaken by the Fed so far – at over US$2.5 trillion – is around 75 per cent greater than the size of the Australian economy in 2011-12.

Of course Ben Bernanke doesn’t think he can bridge the ‘fiscal cliff’ or that QE3 will be a panacea – but like Draghi he’s willing to do what it takes within his mandate because the politicians aren’t stepping up.

Just like Draghi, Bernanke has mounted a strong defence of his actions to defuse the ideologically-driven criticisms of the political class – in his case, ultra-hawkish section of the Republican Party.

It’s pretty clear why.

Many American businesses are sitting on the sidelines reluctant to invest or hire new workers against the backdrop of uncertainty created by the impending ‘fiscal cliff’ and risks flowing from Europe.

Bernanke seems rightly troubled by the very real destruction of skills flowing from unacceptably high levels of unemployment, particularly long-term unemployment.

I couldn’t have agreed with Bernanke more when he said recently at Jackson Hole that:

“The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.”

This point is fundamental.

Human and economic outcomes are two sides of the same coin – our people are our most important resource, and our economy is there to enhance the prosperity of our people.

Of course, a self-sustaining recovery in the United States will take time - but I've got a lot of faith in the world’s largest economy.

It’s a dynamic and innovative economy with a spirit of entrepreneurship that’s unique among nations.

It’s a place that’s been built on ideas and hard work to make them a reality, and it will continue to be so in the years and decades to come.


But with the global economic outlook still uncertain, driven in particular by risks flowing from major advanced economies in the Northern Hemisphere, you wouldn’t want to be anywhere but here.

Let’s just have a think about why.

Despite continued global volatility and enormous structural change, the foundations of our economy are rock-solid.

There can be no clearer display of our strength and resilience than the incredible 21 consecutive years of growth that we have achieved, confirmed recently in the June quarter national accounts.

This means Australia has now achieved more straight years of economic growth to date than the G7 economies combined over this period.

Through the year to June, we also recorded above-trend growth of 3.7 per cent, faster than every major advanced economy.

Our economy is now 11 per cent bigger than at the end of 2007 – streets ahead of the major advanced economies.

Over the same period we’ve seen the US expand only modestly by 1.8 per cent, while France has contracted by 0.5 per cent, Japan by 1 per cent, the UK by 4.2 per cent and Italy by a massive 6.3 per cent.

Even the best performing G7 economy – Canada – has only been able to achieve growth of 4.4 per cent, well less than half that of Australia.


Let me turn now to the outlook for China.

There’s been a lot of talk recently about the pace of Chinese growth – with markets forensically examining each monthly data point for evidence that China is slowing too fast or not speeding up fast enough.

So I say this very clearly – I am an optimist about China.

Setting aside the limitations of monthly data, I can tell you I was just up there recently meeting with the leadership and I think there are very good reasons to be optimistic about China's prospects.

Yes, China’s growth has moderated, but this partly reflects a very deliberate move to more sustainable growth, together with the impact of ongoing weakness in Europe on Chinese exports.

Chinese policymakers have got substantial policy flexibility to respond and they’ve said this repeatedly in recent weeks.

And when it comes to China’s growth rate, we really just need to keep things in perspective; China is now 40 per cent larger than in 2008 so its growth rate can be 20 per cent lower – 8 per cent versus 10 per cent back then – for it to make the same contribution to global GDP growth.

It’s like Usain Bolt easing off a bit at the end of the 100 meters because he’s 10 meters in front and has already smashed the world record.


Yes, the recent moderation in China’s steel demand has contributed to the decline in commodity prices, and as we forecast in this year’s Budget, our terms of trade peaked in September quarter last year.

We also know there are other pressures, not assisted by such decisions as the Newman Government’s decision to jack up royalties which the industry loathes because they hit smaller players hardest.

But we also expect our terms of trade to remain at high levels over the medium term, underpinned by the long term growth story in our region.

And as RBA Assistant Governor Christopher Kent reminded us this week, we’re only part of the way through the current mining boom, which can be characterised as three overlapping phases.

A boom in prices, then investment, and then in exports.

And while we’ve passed the peak in prices, the second and third phases still have a way to run.

In the June quarter, business investment as a per cent of GDP reached its highest point in 40 years at 17.1 per cent, and we expect it to rise further over the next year or so.

That’s why I have to laugh when I read ideologues in our print media try and write about sovereign risk. It’s absurd.

We’ve got a half a trillion dollar pipeline in the mining sector alone, with more than $260 billion at advanced stage.

These are projects which are largely locked in already.

Just this week we had the RBA say that:

“given the large LNG and other mining investment projects already under way, the staff still expected there to be a substantial increase in resource investment over the next year or so.”

While the Bureau of Resources and Energy Economics said:

“High levels of mining investment are expected to continue for some time to come. Significant expansions to iron ore and coal production capacity are also underway, and will contribute to solid growth in resource export volumes over the foreseeable future”

So we’re sitting in the right part of the world at the right time, at the dawn of the Asian Century.

We’re witnessing a structural change in the global economy, with a massive shift of economic weight to our region.

Of course it’s much broader than just China – it’s countries like India, Indonesia, Vietnam, Thailand and Malaysia.

But the industrialisation and urbanisation of China is a long-term trend as powerful as any the global economy has ever seen.

And there is still a very long way to run.

Although it has already lifted many millions out of poverty, China’s GDP per capita today is still only one-fifth of the average of advanced economies.

By 2025, it is projected to still only reach around 50 per cent.

China still has enormous capacity for deepening its capital stock through investments in productive infrastructure.

Consider this: China and the US are roughly equal in land mass.

But China’s rail lines are still only just over one third the length of those in the US.

According to the Reserve Bank, there is also a long way left to run on China’s path towards urbanisation:

Over the next two decades, China’s urban population is expected to increase by 42 per cent, so that by 2030 around 7 in 10 Chinese will live in urban areas.

But by 2030, China still won’t have caught up to Australia with our urbanisation rate of nearly 90 per cent.

The peak steel requirement for Chinese residential construction is not expected to be reached until around 2023 – a decade from now.

All of this means, in the Reserve Bank’s view that:

“Australia is well placed to retain its position as the largest supplier of iron ore to China in the coming years, particularly given the relatively low cost of extraction of iron ore”

I’m really optimistic about the role that Australia can play in the global transformation I’ve been talking about, not just as passenger but as a driver of the Asian Century.

It’s not only about digging things up and shipping them off.

Across the Asia-Pacific, the ranks of the middle class are swelling at something like 110 million people a year. That’s a figure that should have ambitious Australian entrepreneurs champing at the bit.

By the end of the decade, there are will be more middle class consumers in Asia than in the rest of the world combined.

It won’t just be the biggest production zone in the world, it will be the biggest consumption zone too.

Just think of the enormous opportunities this will mean for Australian industry to get up the value chain and deliver the complex consumer durables and sophisticated services Asia’s middle class will demand.

So it’s not hard to understand why Australia is seen as one of the most attractive investment destinations in the world.

We are increasingly seen as safe haven for global investment – with solid growth, low unemployment, healthy consumption, record investment and contained inflation.

With our strong public finances, we are among a rapidly diminishing pool of AAA-rated sovereign investment opportunities.

We’ve got a AAA-rating from all three global rating agencies for the first time in our history – we’re one of only seven sovereigns to achieve this with a stable outlook.

In fact, just this week S&P strongly endorsed our responsible fiscal strategy by reaffirming Australia’s gold-plated AAA credit rating.

S&P confirmed the Government’s strong fiscal discipline, underpinned by low public debt, as well as our public policy stability and economic resilience amid ongoing global uncertainty.

With the world economy so uncertain, it’s no wonder our 10 year bond yields are currently at around 60 year lows.

Having the AAA credit rating from the three main agencies is a bit like having the Brownlow, the Norm Smith and the flag all in one season.

Another really important factor in all of this is our world-class financial system, built on our decisive action during the global financial crisis.

As well as our efforts to boost its strength since then through measures to build a deep and liquid corporate bond market, and allow the issuance of covered bonds.

We’re a capital hungry country – and international investors bring their money down here because they know we deploy their capital productively and for high returns.

But we take none of this for granted.

While our productivity levels are among the top dozen in the world, it’s well understood that we’ve experienced a decade-long structural decline in productivity growth.

That’s why we’re so focused on the Asian Century White Paper which we’ll be releasing shortly and which will marry up the domestic productivity agenda with all of the other pathways to ensuring we are the biggest beneficiaries of the Asian Century.

I look forward to talking with you about that paper, the global economy more generally, and all the associated issues in the months and years to come.


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