Key themes from the Treasury Business Liaison Program - November 2002

The following is a summary of findings from Treasury's business liaison conducted in the last week of October and throughout November 2002.¹

Indications from contacts in the non-farm sectors of the economy are that domestic activity was solid in the December quarter 2002, and the outlook for the year ahead remains positive. However, sentiment has been tempered by the prospect of continued drought, the expected easing in the residential construction sector, and weak global economic conditions.

Treasury greatly appreciates the commitment of time and effort made by the Australian businesses and industry associations that participate in this program.²

Overview

The November business liaison round comprised approximately 80 interviews. The meetings were predominantly conducted in Sydney, Melbourne and Brisbane. This was supplemented by meetings in regional towns in New South Wales and phone interviews with contacts in other states.

Business liaison focused on conditions in the farm sector and developments in the construction sector. Other industries contacted included finance, tourism and accommodation, manufacturing, mining and energy, transport and storage, and retail trade.

Sentiment about business conditions and the outlook remained generally positive in November, but was tempered by:

• A deterioration in current agricultural conditions, particularly for winter crop production, and an unfavourable outlook for summer cropping.
• A softening in the outlook for the residential construction sector, particularly with respect to medium density dwellings and investor activity.
• Further evidence of the impact of weak global economic conditions on the domestic economy.

Aside from the effect of the drought on the farm sector, business liaison contacts indicated that the outlook for economic growth over the remainder of 2002-03 is expected to be solid, although moderating from recent strong growth. Business liaison contacts indicated that investment intentions remain on track (especially for non-residential construction), and that there were signs of continued growth in consumer demand. In addition, contacts indicated that they expected the residential construction sector to ease in the second half of 2003.

Prospects for the farm sector

Meetings with a wide range of agricultural contacts were held during the August and November liaison rounds, which included meetings in rural NSW.

The outlook for most segments of the farm sector deteriorated over the second half of 2002, with the drought becoming widespread across many parts of Australia.

• A number of contacts in NSW reported that the current drought is worse than the 1994-95 drought in terms of water and feed availability.
• The poor outlook reported by contacts for agricultural production in 2002-03 is consistent with previously published official estimates.

Broad-acre crops (both summer and winter), dairy, livestock, and horticulture have been most affected. There was cautious optimism among contacts that the drought will break in autumn of 2003, as recently reported by the National Climate Centre. However, contacts noted their concerns about the potential impact of the drought if it continues into 2003-04.

Crop production

Winter crop production has been badly affected by the drought, and estimates for 2002-03 are beginning to firm as farmers begin the harvest. Significant rainfall going forward will have little to no impact on 2002-03 winter crop production. Many contacts, however, expect a strong rebound in winter crop production if the drought breaks in time for 2003-04.

Contacts were concerned that the prospects for summer crop production appeared poor. They indicated that irrigated summer crops such as cotton were facing extensive water shortages and restricted water allocations. The lack of rain has meant that major head-water storages and dams have not refilled in several key production areas.

The reported outlook for sugar production was uncertain. Some contacts have reported significant downgrades to sugar production, whereas others believe that below average rainfall has not lead to decreased production in areas that traditionally experience excessive wet conditions. Contacts have also reported an increase in diversification away from sugar production to other produce such as macadamias and sweet potatoes.

• In general, the outlook for world sugar prices is pessimistic, stemming from excess supply in the market.

The drought has adversely impacted the horticulture industry, with contacts commenting on water restrictions reducing production and sales in the nursery and garden sector. Some fruit and vegetable production in Queensland has been severely affected.

Livestock

Contacts reported a marked increase in the slaughter of livestock and as such, contacts reported favourable business conditions for abattoirs, with most plants operating at capacity and some scheduled to run throughout Christmas.

• The outlook for beef exports remains positive with signs of recovery in exports to Japan. Contacts expect the Japanese market to fully recover from the BSE scares by the end of 2003.
• In addition, there have been reports of increased interest from Korea and live cattle exports to the Middle East and Asia are also doing well as there are few countries that export live animals.

Contacts have reported a strong jump in feed and water costs. There have been reports of feed costs rising by 30 to 35 per cent. In Victoria, some farmers have been able to agist stock in the south where conditions are better. In NSW, the widespread nature of the drought has meant there are fewer prospects for local agistment. Some contacts have reported an increase in their vet bills of over 300 per cent due to increased stress on animals.

Dairy

The short-term outlook for the dairy industry is for production and incomes to fall due to lower world dairy prices and the drought. The drought has impacted significantly on milk production and also led to some slaughtering of dairy cattle, contributing to lower wholesale beef prices.

• According to contacts, milk production volumes in northern Victoria are down 15 to 18 per cent, due to poor pasture conditions.

Contacts noted their concerns about the damaging impact on the dairy industry if the drought continues into 2003-04. This would require a substantial period of re-stocking once the drought breaks and costs associated with this are likely to be significant as cattle prices are expected to rise due to the lack of supply.

• World dairy prices remain weak because of increased subsidies in the US and Europe, and New Zealand (the second largest producer) being able to maintain high production levels.

Wool

One of the main concerns for the wool industry is the declining sheep numbers over recent years. Higher sheep meat prices relative to wool have lead to increased slaughterings, and increasing live sheep exports have also contributed to the declining flock number. As such, concerns about the future wool supply have pushed wool prices to historical highs.

• Contacts in the fine wool industry are fairly positive about general business conditions as they have been able to continue to supply at these higher prices to countries such as Italy. However, some contacts have experienced a fall in the quality of wool produced due to a lack of feed.

Flow-on effects from the drought

Many agribusiness contacts have reported that farmers seem to be better prepared for this drought, with high incomes in the previous year, a supportive exchange rate and lower debt lev
els.

• Contacts reported evidence of farmers having made significant repayments of their term and seasonal debts.
• Contacts have commented on the strong productivity gains in the farm sector, particularly in broadacre cropping. Technological developments such as improved drought tolerant varieties of crops, better rotations and tillage have helped farmers maintain some production.

A number of the larger agribusinesses are diversified, in areas such as insurance and financial services, and maintain a positive medium-term outlook for their business.

Most agribusiness contacts reported they were deferring their farm investment for 2002-03. However, they expected farm investment to rebound strongly when the drought breaks.

• After more than a year of strong activity, most farm machinery companies are expecting low sales over the next few months.

Contacts reported that fertiliser sales have dropped around two-thirds since the onset of the drought. Rural and regional freight volumes have also fallen.

Many regional towns, reliant on the farming industry, are experiencing the effects of the drought, with retail sales slowing since August and poor sales were expected over the 2002 Christmas season.

• The significant decline in agricultural employment was confirmed, consistent with other available data.

Residential construction trends

Contacts in the construction industry indicated that the high levels of residential construction activity in the September quarter, continued into the December quarter.

• Residential building supply manufacturers also noted that material sales were strong going into the December quarter, although these contacts commented that they would expect easing sales in the first half of 2003.

Contacts across most states still expect residential construction to ease in 2003. There were some differences around the timing of the expected decline in 2003, but contacts generally characterised the expected easing in residential construction as a `soft landing'. In addition, several construction related industries expect to benefit from a pick up in non-residential construction.

Overall, there has been a softening in sentiment in the residential sector since the August round. While contacts were still generally positive about prospects for the industry, they felt more assured about the likely decline in activity in the second half of 2003.

• Contacts indicated that extensive media coverage around a possible correction in the residential property market has appeared to discourage some potential investors.
• Contacts continued to report oversupply in medium-density developments in Sydney and Melbourne, noting that these `overdeveloped' segments would be more likely to experience a correction in the near future. Contacts generally felt that the owner-occupier segment was well placed.

Emerging cost pressures in the construction industry

Despite the positive outlook for construction activity, several cost pressures are emerging in the industry, including growing insurance and labour costs.

• Premiums for professional indemnity insurance and some classes of industrial insurance have increased by up to several hundred per cent. Double-digit increases in overall insurance premiums are possible in the next year, from an already high base.
• Margins were reported by some as being tight in the construction sector, with profit being generated through high volumes. Contacts reported that insurance increases will place further pressure on margins going forward, and some cost increases may be passed on to buyers.
• Manufacturers of bulky building and construction materials are running at (or above) capacity at the moment and price increases for some products are anticipated where there is no natural import competition.

The high demand for labour has seen a general tightening in the construction labour force, and several contacts noted that a move to a 36-hour working week has increased spending on overtime payments.

The outlook for business investment

Contacts reported that many business investment plans for 2002-03 and 2003-04 are on schedule. Major investment projects in the mining and transport sectors continue to progress well. On the down side, farm spending is deferred, and some investment is being restrained by international conditions and the poor profitability of foreign parent companies.

Prospects for the non-residential construction sector were reported by contacts to be very solid over the next year, including a substantial pick up in engineering construction and a sound outlook for non-residential building. There is a substantial stock of construction work yet to be done over the next 12 months - consistent with findings from the two previous liaison rounds.

• The outlook for contacts involved in large engineering construction projects, such as mining projects, roads and other infrastructure developments, was particularly positive. Several contacts in these industries have noted record order books in recent months.
• A couple of contacts also noted that they were capitalising on business opportunities in Asia, such as project work flowing from the boom in infrastructure development in China.

The prospects for equipment investment appear sound, boosted by anticipated investment in the aviation sector. The finance sector provided some indications that the prospects for overall business investment remain positive.

Consumer sentiment

Retail contacts were reasonably positive about the outlook for sales going into the Christmas shopping season and for the remainder of 2002-03. Sales of consumer goods linked to the strength of residential construction are expected to moderate in line with an easing in housing activity. Reduced rural income due to the drought is expected to have some impact on regional retail sales in 2003.

Some contacts also noted the possibility of a slight shift in discretionary expenditure away from overseas holidays into increased domestic travel and expenditure on household items, due to international security concerns.

• Contacts noted other risks to the outlook include potential adverse impacts on consumer confidence linked to a possible war against Iraq and negative wealth effects from a sharper than expected correction in house prices.
• Retail finance contacts noted that credit quality remained sound, with low rates of defaults, credit card delinquencies and bad debts.

Motor vehicle manufacturers are generally expecting sound conditions, with the release of several new and updated models likely to boost sales going into 2003.

The impact of international conditions on tourism

The direct impact of international conditions has been highlighted by contacts in the tourism sector. Conditions in the tourism industry have varied over the past 12 months, depending on the exposure that contacts have to the international travel market. Contacts commented consistently that inbound tourism remains weak, but that conditions in the domestic travel market were relatively good in 2002.

Hotel contacts that are highly exposed to international corporate business travel have been worst affected. Contacts were cautiously optimistic about the outlook for the international tourism market, but there is significant uncertainty due to the continued weakness of overseas economies and security concerns.

• International events such as the Rugby World Cup and the Commonwealth Games in 2006 were noted as bonuses for the industry.

On a state basis, concerns remain around the continued growth in capacity in the Melbourne hotel market, but the Sydney market is looking more positive past the short to medium-term as the flow
of new capacity slows.

Views from contacts on the impact of international security alerts and the Bali bombings for outbound tourism were mixed. There was limited anecdotal evidence that outbound tourists may shift their plans to domestic travel.

The expansion of domestic aviation routes was also noted as a positive development for the tourism industry going forward.

Hiring intentions, wages and prices

While November's business liaison confirmed the decline in rural employment, the overall employment outlook and hiring intentions remain sound. Contacts indicated that employment in the construction sector and related industries remains particularly strong.

• Finance industry contacts reported plans to increase their staffing where they were expanding their branch operations. However, consolidation in areas of the financial sector that are heavily exposed to the international economy has lead to office closures and job shedding.
• In broad terms, retailers were planning to keep their staff numbers steady and in line with future store expansions.
• Despite the softness in the tourism sector, overall employment in the industry is expected to remain steady, with normal seasonal fluctuations.

Wage increases are expected to be moderate in the year ahead, offset by expected productivity gains in many cases. Wage increases of around 3 to 4 per cent per annum were anticipated by most contacts, but there were individual instances of additional wage pressures. Most industry contacts indicated that they were not facing any significant skill shortages, with the exception of perhaps the construction industry.

Business contacts continue to report restrained price pressures. Strong competition in many sectors is reported to be keeping margins tight. Nevertheless, some contacts thought price increases were inevitable where rising cost pressures over the past few years had eroded margins.

1 A detailed explanation of the Treasury Business Liaison Program is provided in the Treasury Economic Roundup Spring 2001. Further information is contained in the May/June business liaison summary report in the Winter 2002 Economic Roundup.

2 Summary reports of Treasury's business liaison reflect the views and opinions of contacts. A summary of business conditions reported by liaison contacts is provided for the information of readers. While Treasury's evaluation of the economic outlook is informed by findings from business liaison, a much wider range of information and data is utilised to ensure a rigorous assessment of the Australian economy.