Australia, compared to other advanced nations, has enjoyed a stellar economic run in recent decades.
It’s now been over 26 years since Australia experienced a technical recession — defined as two consecutive quarters of negative GDP growth — helped by past reforms, strong population growth and, of course, the rise of China as a global economic superpower.
Although there’s still some debate, to many, the current stretch of uninterrupted growth is the longest for an advanced economy on record.
That amazing statistic has ensured that there’s been no shortage of commentators who think Australia’s economic luck will soon come to an end, suggesting that a degree of complacency has crept in with economic growth increasingly reliant on debt, housing, population growth and commodity demand from China, rather than other areas such as productivity growth and further economic reforms.
However, for all the bears that continue to circle the Australian economy, it continues to defy the doomsayers.
But what, as it heads towards its 27th consecutive year of consecutive growth, could end this record run? For all the success that’s been seen in the past, at some point, Australia will almost certainly experience an economic downturn.
It’s something that Gareth Aird, Senior Economist at the Commonwealth Bank, has obviously been thinking about recently, producing an excellent report on what, in his opinion, are the biggest risks facing the Australian economy right now.
It’s an interesting mix of ideas that he’s collated, looking at both external and internal threats that could upend the economy.
From an external perspective, rather than geopolitics, Aird says the largest threat comes from a collapse in commodity prices.
Commodity prices fall sharply
Australia continues to be heavily reliant on commodities for its resource revenue. And a huge chunk of our exports go to China. As such, the biggest threat to commodity prices is a slowdown in China that would lead to lower investment growth or possibly a fall in investment. Such a slowdown could occur it if the Chinese authorities accept a lower level of output growth for the sake of financial stability given the rapid build-up of corporate debt. It could also happen if a greater emphasis is placed on delivering growth through services rather than investment. And it could of course come via a China hard landing. In any event, commodity prices get hit and that would have implications for the Australian economy.
Under such a scenario, Aird says that a 40% fall in commodity prices would see Australia’s terms-of-trade fall by 30%, a scenario the would likely see the AUD fall to the low-to-mid US 50 cent level.
The subsequent decline in national incomes would hurt the household sector through higher unemployment and a likely decline in income levels, says Aird. It would also hit government revenues, limiting the ability of policymakers to respond as the budget position deteriorates.
So not a great scenario, and one that Australia has little control over unfortunately.
As for the largest internal risk facing the economy, it’s likely one that you have heard before, even if you’ve been in a bomb shelter for the past ten years or so.
A collapse in Australian house prices
The single biggest risk to the domestic outlook looks to be a sharp correction in dwelling prices. In our view, this carries a greater risk to the real economy than it does to financial stability given the banking system is well capitalised.
The risk of a material correction in dwelling prices looks higher now than it has been for a long time given the incredible lift in dwelling prices over the past five years, mortgage rates are probably unlikely to go lower and indeed can’t go much lower, household debt to income is at a record high and dwelling supply is in the process of lifting quite significantly in some jurisdictions.
If a housing downturn was to take place, Aird says it’s economic impact would be determined by just how large it is.
“A soft correction in dwelling prices would probably have no material negative impact on the labour market. But there is a risk that a hard correction in prices of 20% or more would lead the economy into a downturn via the wealth effect,” he says.
“Since income to one person comes via the spending of another, there is a risk that falling home prices leads households to put the brakes on spending which ultimately drags consumption and employment growth lower.”
Outside of the housing market, Aird says the outlier risks from a domestic perspective also include a policy mistake from the Reserve Bank of Australia (RBA).
RBA hikes rates too fast too quickly
We consider a policy mistake by the central bank to be a risk to the economy given how much debt the household sector is carrying. Specifically, if the RBA hikes too early it could derail the improvement in the labour market that has been underway over the past two years. The record level of debt being carried by the household sector means that interest payments as a share of income will rise quickly if and when rates move higher
We consider a policy mistake to be a risk because the RBA has been overly bullish on wages and the consumer over the past five years. The apparent bias in their forecasts towards a lift in wages and consumer spending means there is a risk that they hike too early if/when wages growth starts to rise.
While few disagree that the next move in Australian interest rates will likely be higher than lower, most expect the RBA to hold fire until at least late next year or longer given the fragility of the household sector given debt levels and ongoing weakness in income growth.
The other main internal risk, says Aird, is one that Australia may get to see from afar given the recent change in New Zealand’s government.
A change in immigration policy
A material reduction in net migration to Australia would increase the risk of a fall in dwelling prices as well as weigh on total output growth and negatively impact the construction sector. But it would also likely put upward pressure on wages growth by reducing the pool of workers in many occupations. In that context, it’s not so much a downside risk, but rather one that would see a shift in the economic outlook that would have both winners and losers. From a policy perspective it’s about assessing whether there is a net societal benefit.
While Aird notes that both of Australia’s major political partners support maintaining a high permanent migrant intake every year, he says that there’s a risk that one of the major parties opts for a different policy stance as has been recently seen in New Zealand.
“A change in immigration policy cannot and should not be ruled out in Australia,” he says.
So, in Aird’s opinion, there’s four plausible risks facing the economy economy, some greater than others.
So how are policymakers placed to deal with any potential threat that may eventuate?
In contrast to prior periods, Australia is looking a little vulnerable at this current juncture given official interest rates are already at the lowest level on record while the government is still running large budget deficits.
That limits the ability of rate cuts or fiscal spending to stimulate the economy is and when it needs it, potentially exacerbating the impact of any potential downturn.
Put simply, households are maxed out on debt, businesses rely upon households and the government will not be able to splash the cash as seen in immediate aftermath of the global financial crisis.
It’s easy to see why some see Australia as looking a little vulnerable right now, even with a noticeable improvement in parts of the economy this year.
It also helps explain why the Australia Recession 2018 advertisements keep popping up in your browser, continuing the pattern seem each and every year since the global financial crisis.
So after assessing the potential risks facing the Australian economy, what does Aird think will eventuate?
As opposed to other more bullish and bearish commentators, he thinks the next few years will be pretty uneventful for the economy.
“CBA’s base case for the economy over the next two years is a benign one. It is broadly similar to the RBA’s forecast profile for the economy which is also not dissimilar to the consensus view,” he says.
“In 2018, most of the key components of the economy are expected to contribute to growth, with dwelling investment the exception.”
Aird sees GDP growing 3% next year, above its potential trend level of 2.75%, helping to slowly build wage and inflationary pressures. However, he admits that’s unlikely to lead to a near-term rate hike from the RBA, suggesting that it “still looks a long way off.”
Boring, right? But given the alternative scenarios and vulnerable position the economy is currently in, it’s likely that a majority will hope plays out.