This article appeared in the November 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Can our economy weather problems in the US, Europe and potentially China?

Photo of Janu Chan By Janu Chan, St George Bank

It has been quite a year so far: major natural disasters at home, including floods and cyclone Yasi, and abroad with devastating tsunami and earthquake in Japan, and another earthquake in New Zealand. Add to this mix a growing sovereign debt crisis in Europe and the US fighting to prevent recession. In the meantime, China's economy continues to grow strongly.

These factors all have had significant implications for Australia and certainly complicate the overall picture of where our economy is headed.

(Editor's note: Don't miss Janu Chan's presentation on Australia's economic outlook at ASX Investor Hour in Sydney on December 13. Watch Investor Hours on the ASX website in coming weeks for more details.)

Economic data domestically has been mixed and showing divergence across different areas of the economy, giving rise to the terms "patchwork" and "multi-speed" economy. Australia continues to benefit from high commodity prices. Although they have weakened in recent months, commodity prices remain at high levels. The mining sector is the obvious beneficiary, but business investment is also booming. Investment intentions in the mining industry are very strong as miners race to meet demand. There are also flow-on effects to spending on infrastructure and other business services, and a boost to government revenue through taxes, including income tax.

There are also areas of weakness in the Australian economy. Caution by consumers is weighing on retailers and contributing to a softer residential housing market; and exports apart from resources, such as manufacturing and tourism, are being squeezed by the high Australian dollar. Overall there has been a decline in business confidence and business conditions over the past year, and it is being reflected in softer growth in jobs and credit growth.

Being a small, open economy, Australia's economic outlook also hinges on developments overseas. The greatest uncertainty is whether European leaders will be successful in containing the sovereign debt crisis and if solid growth in China can stay on track, given the weak growth outlook for Europe and the US.

Here are three key international issues and what they mean for Australia:

1.    Trouble simmers in Europe

A sovereign debt default by Greece or a large writedown of debt is looking increasingly likely so that Greece's debt levels can come down to a manageable level. But this is likely to lead to a need for some form of recapitalisation for European banks, to prevent a banking crisis (Editor's note: a recapitalisation by injecting additional funds into European banks will help them deal with the significant risk of Greece defaulting on its borrowings).

The other major risk is the contagion effect on other troubled indebted countries in the Eurozone (e.g., market concerns about Greece affecting borrowing costs for the larger economies of Italy, Spain and Portugal). These countries have seen their bond yields soar, compounding the difficulties in consolidating their public finances. Italy, in particular, is in the spotlight. It has the third-largest bond market and exposure to it is widespread.

While markets continue to face heightened volatility as they await action from eurozone leaders, economic growth in the region is stalling under the weight of austerity measures to reduce government debt, and stresses in the banking sector. Confidence has weakened considerably, which can have a negative impact on spending and growth. There are also growing calls by analysts and the International Monetary Fund for the European Central Bank to cut interest rates to boost growth.

2.    The other eye of the storm - the US

There has been a loss of momentum in the US economy and fears of a double-dip recession have emerged. To date, evidence of a recession has yet to surface and we believe one can be avoided. That being said, growth is likely to be sub par for some time. Any form of monetary stimulus from the US Federal Reserve (quantitative easing or bond-buying programs) will continue to have limited impact on the economy while demand for borrowing is low and there is a reluctance to lend.

US President Obama's proposed US$447-billion jobs package could provide a boost to growth and jobs, but the policy is facing stiff opposition from Republicans. There also remains the challenge for fiscal policy to achieve a balance between supporting short-term growth and reducing the deficit over the longer term.

In our opinion, the greater risks to the global economy come from Europe. The IMF recently downgraded world growth forecasts to 4 per cent for 2011 and 2012, but expects growth to remain above the long-term average. Ongoing sovereign debt woes from Europe suggest there are further downside risks to these forecasts.

3.    Can China keep growing quickly while US and European growth is weak?

Growth in Asia generally remains robust and although there are signs of slowing economic activity in China, annual growth there in the third quarter was still solid at 9.1 per cent.

Chinese authorities are welcoming signs of moderation in growth because inflation in China remains uncomfortably high. Chinese authorities have been tightening policy since October 2010 through increasing interest rates and banking requirements.

There are fears China will undergo a significant slowdown such as that during the global financial crisis. There is a risk that weaker demand from the US and Europe will dampen export demand and thus growth in Asia, although activity in the US and Europe is not expected to weaken as much this time around. On the upside, the Chinese Government has a close handle on the economy: stability is a key priority and it can quickly implement policies to offset slower exports.

What this means for Australia

Australia remains vulnerable to overseas developments, but there are many reasons to be optimistic about the outlook.

  • There has been strong growth in incomes and unemployment is low. Thus, although consumers have tightened their belts, they still have the means to spend.
  • There is plenty scope for monetary and fiscal policy to provide support to the economy if needed. Government debt is very low and, unlike many other advanced economies, there is potential to lower interest rates to boost growth.
  • Australia is also cushioned by weaker global growth, given the Australian dollar tends to depreciate in tandem with lower growth, which helps exporters.
  • Our banking sector is well capitalised and the banks have improved their liquidity and funding positions since the GFC. They have reported little direct exposure to sovereign debt in distressed countries and have not seen the same short-term funding difficulties as during the GFC.

Recent domestic partial indicators have improved, including employment and retail sales. Despite heightened volatility in financial markets, sentiment for consumers and business has recovered partially, encouraged by the prospect of a weaker Australian dollar and possible rate cuts from the Reserve Bank.

Meanwhile, surveys indicate that investment intentions remain healthy, and the recovery in coal exports, which were hit hard by the floods early in the year, still has much further to run. On balance, we expect economic activity to remain firm over the medium term after posting a solid rebound in the second quarter this year.

About the author

Janu Chan is an economist at St George Banking Group.

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