Transcript
DR DAVID GRUEN
So it's now my pleasure to call on Chris Kent who's going to talk on the implications for the Australian economy of strong growth in Asia, a topic dear to many of our hearts.
DR CHRIS KENT
Thanks very much David and thanks too also to the co-organisers from Treasury and the IMF and I should start by thanking my co-authors or co-conspirators in this paper, this project, Dr Michael Plumb and Dr James Bishop, who are hiding down there in the audience somewhere; so difficult, technical questions can be directed to them over lunch.
So let me start by stating, I guess, the obvious, but I think it's worth stating, to date, the most obvious effect of the strong growth in Asia on the Australian economy has been the very dramatic, unprecedented, if you like, rise in the terms of trade. Now, that's led to a boom in investment in the resources sector, it's also been associated with a very high level of the exchange rate. There's been, along with this, a reallocation of productive factors, with especially strong growth in employment in resource and resource related activities, and then declining employment in a number of non-resource industries.
So in the paper that we've tabled for this event, what we do is, we try and examine how this process of structural adjustment has gone so far, and then we think a bit about how it might proceed from hereon in. One brief comment is just to say that what we do throughout, and you'll see in a number of the charts, we focus broadly on the mining, or more broadly, resource sector, and we break that part of the economy into two parts, although in the charts we largely group these together, there's the resource extraction activities, if you like, the operational part of the mining and then there's the resource related activity, much of which at the moment is focussed on the investment. So, we focus on the resource sector, we focus on the other tradable sector and then we focus on the non-tradable sector. And just to give you a preview of our key results, I think one of the main points of the paper is to say that the process of adjustment that we've seen to date has been really quite a smooth one, it's also been one, the pattern of adjustment that we've seen has been broadly in line with what you might have thought if you'd put down a model and thought about the theory of what would have happened.
Now, it's very true to say that not all parts of the economy have benefitted equally from this boom in terms of trade, but overall, output growth has been close to trend, unemployment has remained relatively low, and inflation close to target, and that's the sense in which I say the adjustment process has been a relatively smooth one. Now, a key role in all of this is the changes in some important relative prices, most obvious is the real exchange rate, another form of that is the ratio of price of non-traded to traded goods, wages as well, relative wages across industries and indeed across regions. And all of that's happened but without a breakout in wage and price inflation, which is what we've seen in much earlier booms. So that smooth process of adjustment that I've just outlined there, I think, that's been underpinned by a number of things, perhaps first and foremost has been the flexible exchange rate regime we've had in Australia for some time now; I think that's been bolstered too by the inflation targeting regime which has given us low and stable inflation and it's helped to anchor inflational expectations, and then a third element that's important is our more flexible labour market relative to the one that we had in much earlier booms.
We do spend a bit of the time thinking about the future and not just the past, and we're looking now, we can see on the horizon the peak in resource investment and so far the contribution of resource investment to output growth has been very substantial, but that, once we've passed this peak, will turn around. Now, that leaves a gap in terms of a contribution to output growth; some of that gap's going to be filled naturally by an increase in the exports and production of resource commodities. However, to the extent that activity in the non-resource sector requires adjustments in relative prices, then I think it's true to say that the exchange rate would be expected to play an important role there.
So, let me start with taking you through the paper in terms of the key charts. This chart is intended to place the terms of trade shock in its historical context and highlights the point I made earlier that the rise in the terms of trade has really been unprecedented and the key point here is that it's been rising substantially over a period of a number of years, starting from around 2003, and the bottom panel clearly shows that the exchange rate has also appreciated along with the rise in the terms of trade. And what we do in the paper which is not really novel and I notice many others think of it and talk about it in this way, is to think about the process of adjustment to this terms of trade as occurring in three, and it's important they're not distinct, but three overlapping phases. Phase one sees the rise in the terms of trade and it's true to say that by all accounts that appears to be behind us with the terms of trade having peaked in the September quarter of last year. Phase two sees the build-up of investment in the resources sector and then ultimately phase three sees the growth in exports once that extra productive capacity has been put in place. Just to highlight this theme of a relatively smooth adjustment this time around, at least, this chart emphasises that unlike much earlier episodes, so we can go back to the 1950s when we had the Korean war, well, boom, and then later again in the early to mid 1970s, unlike those episodes, this time around, inflation has remained relatively low and stable, but that's not been the case in much earlier booms.
The other thing to remark about the adjustment that we've to date through this episode is the fact that's it's been perhaps all the more remarkable, given the difficulties faced by other advanced economies, now, part of that of course, is helped by what China did after the onset of the GFC, but in Australia, this chart shows that GDP has grown, GDP has grown around trend pace over this episode, unemployment has remained relatively low and inflation has been close to target and actually really quite close to the experience of many other advanced economies.
What this chart does is start to look at the differences across these three parts of the economy; this is highlighting phase two of the adjustment process, the investment boom. So mining investment, you can see here, picked up to a very high rate and that started from around 2003 when the terms of trade started to lift, and it's been ongoing. On the other side of things, other tradable sector has been much softer, particularly of late, and that's in part induced by the high level of the exchange rate. The non-tradable sector has been a little softer of late, as well, compared to its normal behaviour, but I think one of the important points we make in the paper is that this softness in parts of the non-tradable sector relates to other things that go beyond just the high level of the exchange rate and the terms of trade boom, and an obvious one is the general weakness in the housing market and the construction industry and that's occurring outside of mining investment and that's, as I said, it really is not related to the terms of trade boom and the associated high exchange rate.
This chart just splits these sectors again by real output growth, and the story on real output is really quite similar, for resources sector to date, though, this increase in, this higher output
growth has mostly been a story not of resource extraction, not of digging a lot more out, but rather about resource related activity and in particular, resource investment. The digging of wells, the removing of the overburden and the adding of extraction and transport facilities and the like.
Another quantities graph thinking about employment, and again, it really mirrors the patterns that I've just shown in investment and output. Most of the employment growth, though, in the resource sector to date has been related to this resource related activity, the resource investment that I've spoken of. Among other things, that includes a number of activities that I don't think people normally associate with a mining sector putting in a lot of investment, things like a number of professional services such as legal and accounting work, just to name one. Anyway, if we add the resource extraction employment and the resource related activity employment together, another chart in the paper which I haven't shown here, shows that that's roughly doubled to about 10% of all employment, the share of employment roughly doubled to about 10% of all employment since about the mid-2000s.
Moving on to wages and prices, what this chart does is show you that there was a generalised stepping up in the average pace of wage growth across all of these industries after 2003, but by far and away the largest increase, not surprisingly, was in mining and mining related employment, while wages growth was weakest in the other trade exposed industries and by cumulating these differences from an initial starting point, which is done here in this chart, you can see the move in relative wages cumulating over time. And indeed it's this change in relative wages that's been one of the mechanisms that's encouraged labour to move from the other tradable sector including industries like manufacturing and so on, broadly towards mining and mining related activity and the ability of wages to rise in one part of the economy but not in all parts, has been one thing, has been an important feature of the recent adjustment and that has been helped by the move away from centralised bargaining, and in that sense, this is the sense in which I'm suggesting that the labour market is much more flexible compared to much earlier episodes of terms of trade booms in this country. And finally, on this point, I think well anchored inflation expectations have also no doubt played a role here.
I think perhaps this is one of my favourite charts in the paper, for a number of reasons, but one, because I'm always a fan of thinking carefully about different ways to think about the exchange rate. This is, another key part of the adjustment process has been a shift in relative prices; this chart shows the ratio of non-traded to traded prices across the economy and of course, economists often refer to that as just another measure of the real exchange rate. Now, it's normally the case that non-traded prices tend to increase faster than traded prices, that's the standard behaviour that we can see, and you can see that in the trend line that we've drawn here, that just, is a linear trend that fits that ratio from 1982 up to 2003, just when the terms of trade boom comes along and starts to gain some real length, and the remarkable thing is, right at that time, of course, this ratio starts to rise much more rapidly than it has in the past. Now, underlying that ratio, of course, what's happened is trade prices have been held down by the very substantial nominal exchange rate appreciation. And then non-traded prices have been rising more rapidly over this period than they had in the past and that just reflects an increase in domestic cost pressures. So, despite these significant relative price changes, aggregate inflation has really not been much above its earlier average that we had seen prior to the boom in the terms of trade.
Let me just spend a minute to think briefly about what lies ahead, and we're also part way through this phase, which is the production and export side of things, phase three. So we've seen already an increase in the production and exports in the resource sector. These data, these projections, are actually not ours, but they're those of the Bureau of Resource and Energy Economics, these are the ones they made in July. Now, despite what you read in the papers this morning, and I thought the most important news out of yesterday's report, because we knew what prices had been doing, we see prices on a daily basis on commodity prices, but I thought the news out of the update that we provided to these numbers the other day, is that there hasn't been a very big downward revisions to volumes from their latest numbers, so these were for their June, yesterday's release was updated one quarter and they didn't see a big drop in these numbers, so much so that I haven't bothered to update this chart.
Anyway, what the charts show is that we've already seen a rise in coal exports, the rise in iron ore has been larger still, and then I think the take away for me on this chart is that the long building phase, it really takes a long time to put in place the infrastructure for these big LNG operations, that long phase means that the exports of that commodity are expected to pick up very substantially, but only starting in 2015. So, commodity prices, it's true, overall have been expected by us to decline, they've certainly declined rather sharply in recent times, but volumes are expected to increase significantly. So, of course, the extra production capacity in Australia and elsewhere around the globe, that's indeed the reason why we and others expect commodity prices to come off somewhat from where they have been.
Just a brief comment on what's been happening to exports outside the resource sector, these have obviously been affected by the high level of the exchange rate as well as a number of other developments, not the least of which is the global financial crisis. Now, I think we can clearly see that in the sharp fall away in manufactured exports; there was a tightening in the student visas, that's weighed on service exports for a while now, but the other point that's made in the paper and I don't have the chart here today, is that for each of these export categories, for manufacturing, for services, for rural exports, the share going to China has been rising very strongly over recent years, perhaps not so surprising.
Let me just wrap up, then. To restate, that the strong growth in Asia has seen a substantial increase in both the demand for and a sustained run up in the prices of commodities and that's to the significant benefit of the Australian economy. Now, prices have come off their peaks of late, but they remain high compared to the past 150 years. All of this has led to a significant adjustment for us in Australia's economy, for some parts of the economy that adjustment has been a very difficult one, there's no doubt. But the key point of the paper I think we're trying to make is that the economy overall, from a macro economic perspective, the adjustment's been a remarkably smooth one. Now, investment in the resource sector has moved to record highs over a number of years and is still expected to have a little further to run to reach the peak as a share of GDP; there's been a significant reallocation of productive resources aided by changes in relative prices and relative wages, but, as I've stated before, output has been growing around trend, unemployment has remained relatively low, inflation close to target. There have of course been other factors at work, and I've mentioned the GFC, and I've mentioned the weakness in housing markets, those are two that come to mind, but the key to all of the overall smooth adjustment process, I think has been the flexible exchange rate combined with low and stable inflation and well anchored inflation expectations, and a relatively flexible operation of the labour market, and those things have helped to bring about this smooth adjustment. And I think it's true that those same factors would be expected to play a
very important role in the adjustments that lie ahead of us. So, I'll stop there, David, thank you.