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Long-run forecasts of Australia's terms of trade

Date

Jared Bullen, Michael Kouparitsas and Michal Krolikowski1

Treasury Working Paper2 2014–01

Date created: May 2014

Date modified: May 2014

Abstract

Australia’s terms of trade rose significantly over the 8 years to 2011-12 following a period of relative constancy over the preceding 40 years. Australian Government fiscal projections from the 2010-11 Budget to the 2013-14 Budget, assumed that beyond the near-term forecast period the terms of trade would fall by 20 per cent over the subsequent 15 years. This approach was silent on when the expected decline would end and the level at which the terms of trade would eventually settle. This paper details the projection methodology underlying the terms-of-trade projection assumption in the 2013-14 MYEFO. In contrast to the earlier approach it provides guidance on the timing of the end of the current expected decline and the associated long-run level of the terms of trade. The centrepiece of the new approach is detailed price and volume forecasting modules for Australia’s major export categories, including global demand and supply models for the three major bulk commodities (iron ore, metallurgical coal and thermal coal). Based on this methodology, Australia’s terms of trade are expected to fall at a more rapid rate than previously predicted in the 2013-14 Budget from 2012-13 to 2017-18 and remain reasonably constant thereafter at a level roughly equal to that recorded in 2006-07. As noted in the 2013-14 MYEFO, there are a number of downside risks to this outlook including uncertainty around the global economy, the nominal exchange rate and non-bulk commodity price forecasts. Applying prudent judgement to the model’s outcome results in a long‑run terms of trade that settles at the level observed in 2005-06 by 2019-20.

JEL Classification Numbers: Q00, F17, E37
Keywords: commodity prices, production cost, mining boom

Jared Bullen and Michal Krolikowski
Macroeconomic Conditions Division
Macroeconomic Group
The Treasury
Langton Crescent
Parkes  ACT  2600

Michael Kouparitsas
Macroeconomic Modelling and Policy Division
Macroeconomic Group
The Treasury
Langton Crescent
Parkes  ACT  2600


1 Jared Bullen and Michal Krolikowski: Macroeconomic Conditions Division, Macroeconomic Group; and Michael Kouparitsas: Macroeconomic Modelling and Policy Division, Macroeconomic Group, The Treasury, Langton Crescent, Parkes ACT 2600, Australia. Correspondence: Michael Kouparitsas, michael.kouparitsas@treasury.gov.au. In preparing this paper we have consulted with industry and Government agencies and would like to thank members of the Bureau of Resources and Energy Economics, the International Energy Agency and BHP Billiton for suggestions and comments on an earlier draft. We also thank Katrina Yu, Alexander Beames, Theresa Farrelly, Cathryn Lee and Diana Hourani for outstanding research assistance, Alistair Peat and Jessica Whelan for outstanding charting assistance and Bryn Battersby, Katrina Di Marco, Simon Duggan, Paul Fischer, David Gruen, David Muller and Oliver Richards for suggestions and comments on an earlier draft.

2 The views expressed in this paper are those of the authors and do not necessarily reflect those of the Australian Government.