- The latest GDP figures indicate that the Australian economy picked up over the first half of 2017;
- But by historical standards, economic growth is currently soft;
- One of the reasons for weaker economic activity is that Australia’s potential growth rate is now lower, partly reflecting an aging labour force;
- The economy is graded a C+, but with the possibility that it will be doing better over the next 6-12 months.
For some time I have been giving the Australian economy a C+: it is doing Ok but with the potential to do so much better. The latest exam results for the Australian economy are out, with the release of the latest GDP figures. So it is time to see whether that grade needs to be updated.
We know the facts, that the Australian economy grew at a bit over 2% annualized pace in the first half of 2017. But how to judge this number? Before doing that analysis it is worth looking at a range of other information to gauge how accurately the GDP numbers reflected the state of the domestic economy. The previous quarter’s GDP numbers were surprisingly low but this partially reflected the impact of poor weather. More generally, the Q1 GDP numbers appeared to understate the economy’s strength given the evidence available from a range of other indicators.
An examination of these other indicators suggests an economy that is doing Ok. Hours worked in the economy has grown by over 2% over the past year, historically a pretty decent pace. Business confidence is at 9-year highs, although consumers are not feeling as great.
The GDP numbers appear to be providing a reasonable read, so what mark should the Australian economy receive? One benchmark to use is to compare the latest GDP reading with Australia’s historical growth performance. This benchmark does not make for good reading. Growth over the year to June quarter 2017 is well below the average growth rates achieved in each of the decades over the past fifty-plus years. It is even below the rates achieved in the current decade, the weakest growth decade.
Another benchmark that could be used is to compare Australia’s GDP performance against that of global peers. Maybe the weaker performance of the global economy is making life difficult for the Australian economy. Low growth numbers by the Australian economy should be expected compared to China, India and Indonesia (although has recently outperformed South Africa and Brazil). But Australia’s growth performance over the past year has been below the numbers achieved in many other high-income countries (although the performance of the domestic economy over the past three years has been relatively stronger).
As the international comparison highlights, different countries grow at different rates depending upon where they are in their own economic cycles and stage of economic development. So perhaps an even more pertinent benchmark is how the domestic economy is growing relative to its potential. A country’s potential economic growth is essentially the sum of how fast the labour force is growing plus the growth of productivity of that labour force.
Judging an economy’s potential is always a little tricky. The OECD (the club for high-income economies) is one body that attempts such calculations (although it’s results are not dissimilar to other estimates). And the OECD figures indicate that Australia’s potential growth has declined since the GFC, partly reflecting a slowing in the growth of the labour force (partly due to an aging population). This is an international phenomena, particularly for higher-income economies (although labour force growth in countries such as China and South Korea is also slowing sharply). When compared to its potential economic growth, Australia’s recent economic performance looks more reasonable.
Reasonable, but not good. Given the Australian economy has underperformed potential growth for much of the past ten years, there is ample room for a period of outperformance (which would allow for a decline in the unemployment rate). Australia can also improve its potential growth if it boosted its rate of productivity growth.
The good news is that productivity growth is doing Ok, currently travelling around its long-term average. Australia’s productivity performance is benefitting from the substantial capex spend (notably in mining).
But to maintain (or improve) productivity growth it will be necessary to keep up investment spending in worthwhile projects. The concern was that business capex spending fell sharply post the mining investment boom as firms were uncertain about the economic outlook. But there have been better signs recently, including in the most recent GDP figures. The overall level of investment in the Australian economy is still well above the rates typically seen between 1960-2000 boosted by the current sizeable infrastructure spending.
While the rate of investment spending is important, it is worth keeping an eye on how that investment is being funded. Concerns about the stability of the economy would be raised if a large proportion of domestic investment was sourced from offshore (particularly if it was from debt with short-term maturities). One measure of the proportion of funding sourced from offshore is the size of the current account deficit (which mathematically is equal to the difference between domestic investment and saving). The current account deficit is currently at its narrowest level since the late 1970s, indicating that the elevated level of national investment is being largely funded from domestic sources.
Another important benchmark of sustainability is whether the GDP numbers have been boosted by excess borrowing. Particularly concerning would be if the borrowing was used to fund consumption. We will not get complete information on the level of borrowing in the economy until the Financial Accounts are released at the end of this month. In the meantime, one indicator to watch is movements in the credit to GDP ratio. That ratio had started to rise again reflecting the impact of the very low level of interest rates encouraging more borrowing. But the ratio also rose because of the low growth of national income. But the credit-to-GDP ratio has moderated since the start of the year reflecting both some slowing in the rate of credit growth and a rise in national income growth.
Of course just using the credit to GDP ratio has its limitations. For example, the moderation of the credit to GDP ratio would hide the ongoing rise of the ratio of household debt to income, something that has increased the vulnerability of many consumers.
Overall, Australia’s current rate of economic growth has been disappointing from both a historical perspective and when compared to the performance of international peers. But a key factor behind the weaker economic performance has been a reduction in Australia’s potential growth rate. The good news is that the Australian economy looks likely to grow faster than its potential over the next 1-2 years, reducing the unemployment rate. Productivity growth rate looks reasonable, although further reforms to boost productivity would be worthwhile to boost the potential rate of economic growth. While aggregate borrowing levels appear reasonable, rising leverage amongst many household is a concern.
Overall, I have maintained a C+ rating for the Australian economy. There has not been enough of a reduction in the unemployment rate to justify a better mark. But there are more promising signs that further improvement in the economy is possible than there have been for some time. If the improvement that is forecast is delivered, a better grade for the domestic economy is probable over the next 6-12 months.
We live in interesting times.