will resource boom be derailed by us and eu debt problems

8/4/2019 Will Resource Boom Be Derailed by Us and Eu Debt Problems

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The resources boom bigger than everWill it be derailed by European/US events?

September 2011

Kieran Davies and Felicity Emmett

Economics

Kieran Davies

+612 8259 5171

[email protected]

Felicity Emmett

+612 8259 5835

[email protected]

www.rbsm.com/strategy


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Australia The resources boom vs the sovereign debt crises

Growth: Strong growth likely driven by the resources sector rest of the economy underperforms

Inflation: Inflation pressures still in the system given poor productivity underpins strong unit labour cost

growth

Transmission of the European/US crises: Likely channels are: (1) commodity demand, which issurprisingly resilient so far; (2) bank funding stress, which is limited compared with 2008-09; and (3)

confidence, which is depressed, although it is too soon to tell whether this leads to delayed spending/hiring

Interest rates: RBA on hold given global uncertainty history shows there is some risk of an insurance

cut, but if global spillover is limited, the resources boom points to higher rates next year

Budget: All levels of Government plan to return their Budget to surplus the Commonwealth should be

first, although its target date of 2012-13 is ambitious

Politics: Minority ALP Government could face an early election, which polling suggests it would lose. Notethat, the Liberal/NP Coalition would struggle to secure crucial Green support in the Senate.

Risks: (1) China the authorities could make a policy mistake; (2) households are highly leveraged andthere is a bubble in house prices households may decide to cut gearing, but a spike in unemployment is

probably needed as a trigger

Exchange rate: Averages over parity, supported by central bank buying of bonds and commodity prices


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Table of contents

World activity 4 What if the world doesnt fall apart? 24

World inflation 5 (1) The resources boom 25

Market pricing of monetary policy 6 (2) Inflation 27

Channels for Europe/US to affect Australia 7 (3) Interest rates 33

(1) Commodity demand 8 Other key risks 38

(2) Banking linkages 10 (1) China 39

(3) Consumer & business confidence 13 (2) House prices/leverage 41

Dutch disease 18 Fiscal policy 43

(1) Mining versus the rest 19 Politics 44

(2) Manufacturing 21 Exchange rate 45

(3) Retail sales 22 New Zealand 47

(4) Tourism 23 Appendix 1 - Table of key forecasts 48

Appendix 2 - Structure of the economy 49


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World activity Recovery loses momentum in Q2 and Q3

After a deep recession, the world economy grew strongly, but lostmomentum in Q2, partly in response to the tragic events in Japanand higher energy prices.

Business surveys point to further weak growth in Q3, with someindicators pointing to fresh a risk of recession in the US.

Growth has slowed in Emerging Asia reflecting the withdrawal ofpolicy stimulus and the impact of supply-chain disruptions fromJapan, but growth remains weakest in the major advancedcountries.

-2

-1

0

1

2

3

4

5

6

7

90 95 00 05 10

30

35

40

45

50

55

60

World real GDP (% yoy) World PMI (index)

World PMI

World GDP

30

35

40

45

50

55

60

65

90 95 00 05 10

Surveyed business conditions (index)

World

USA

-40

-30

-20

-10

0

10

20

30

90 95 00 05 10

Industrial production (% 3m annualised)

Advanced economies

Emerging Asia


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World inflation Loose monetary policy supports high commodity prices

Commodity prices have risen sharply on strong Asian demandand loose monetary policy globally.

Further policy easing in the advanced economies would supporthigh commodity prices.

With policy settings still loose in most countries, higher headline

inflation may become embedded in higher inflation expectations.

At this stage, though, market estimates of inflation expectationshave fallen given weaker activity in the advanced nations,although the risk of deflation is not being factored in as it was in2008-09.

-5

0

5

10

15

20

25

30

35

90 95 00 05 10

CPI (% 3m yoy)

World

Developing Asia

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

00 02 04 06 08 10 12 14

US 10-year breakeven inflation rate (%)

Swap

Bond

0

50

100

150

200

250

300

350

400

450

500

90 95 00 05 10

World price index

Manufactured goods

Energy

Food and other raw materials


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Market pricing of monetary policy An emergency rate cut la2008

Global events saw the front end of the yield curve price in anemergency rate cut along the lines seen during the worst point ofthe global financial crisis in 2008-09.

The market has modestly scaled back the expected reduction inrates, but it remains substantial, with about 100bp of rate cuts

priced in over the next twelve months. The market has moved away from pricing in an immediate cut at

the next meeting, but is still expecting most of the reduction inrates to happen this year.

Note that the entire yield curve is now lower than the cash rate.

0

1

2

3

4

5

6

7

8

9

95 97 99 01 03 05 07 09 11

RBA cash rate (%)

Actual

12-month ahead forecast derived

from the futures and swap markets

(aligned with outcomes)

3.50

3.75

4.00

4.25

4.50

4.75

5.00

Cash 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y

Current interest rate (%)

Term -250

-200

-150

-100

-50

0

50

100

150

200

250

95 97 99 01 03 05 07 09 11

Expected change in the cash rate over the next 12 months

derived from the futures and swap markets (bp)


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Channels for Europe/USA to affect Australia

(1) Commodity demand volumes & prices have held up surprisingly well

(2) Banking linkages no signs of strains at this point

(3) Confidence confidence was already low too early to judge the impact,

but worry most about the effect on jobs


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(1) Commodity demand Asia matters, not Europe and the US

Direct trade links are dominated by Asia, especially China (75% ofexports go to Asia with China at close to 30%). Direct trade linkswith Europe and the US are small (less than 5% of exports each).

Prices and volumes of Australias key commodities of iron ore andcoal have been surprisingly resilient, whereas they collapsed in2008-09.

We expected lower prices as flood-affected coal productionreturned to normal, but prices have been steady to date.

Material weakness in commodity demand would have majorimplications for the growth outlook in Australia and would triggeran aggressive policy response from the RBA.

40

50

60

70

80

90

100

110

120

130

1900 1925 1950 1975 2000

Terms of trade (ratio of export to import prices)

0

5

10

15

20

25

30

35

90 95 00 05 10

Exports of goods by country (smoothed % of total)

China

USA

Euro area-10

-5

0

5

10

90 95 00 05 10

Real GDP (% qoq annualised)

Australia's major trading partners

G3

(USA, Japan

& Euro area)


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Commodity demand Prices and volumes are surprisingly resilient

0

20

40

60

80

100

120

140

160

180

200

00 02 04 06 08 10 12 14

Coal price (USD/t)

Spot price

Australian export price

0

50

100

150

200

250

00 02 04 06 08 10 12 14

Iron ore price (USD/t)

Spot price

Australian export price

0

5

10

15

20

25

30

35

40

00 02 04 06 08 10 12 14

Export volumes (Mn t)

Iron ore

Coal

Queensland floods

0

1

2

3

4

5

6

90 95 00 05 10

Exports (% of GDP)

Iron ore

Coal

Natural

gas


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(2) Banks No funding stress at this point

Bank spreads have widened, although not by as much as they did in2007-09 and for different reasons. That is, bank spreads have widenedonly because funding costs have not fallen as fast as the expected cashrate. In 2007-09, wider spreads were driven by higher outright fundingcosts.

Bank usage of the RBA cash facility hasnt changed much, indicating nostrains on local banks.

Banks have dramatically restructured their liability mix over recentyears, increasing the reliance on deposits and medium-term fundingand reducing the reliance on short-term funding.

Note that European banks have already significantly scaled back theirlending in Australia, with the slack taken up by the major trading banksand Asian banks.

-10

10

30

50

70

90

110

130

150

170

00 02 04 06 08 10 12

3-month BBSW less the expected cash rate (bp)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

03 04 05 06 07 08 09 10 11

Daily repos of private securities with the RBA

by banks ($bn)

Smoothed

Oct-08

2

3

4

5

6

7

8

9

00 02 04 06 08 10 12

Interest rates (%)

3M BBSW

Target cash rate

3M expected

cash rate


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Banks Bank bond yields have fallen although CDS is up

-10

10

30

50

70

90

110

130

150

02 04 06 08 10

3-year bank bond less swap (bp)

0

1

2

3

4

5

6

7

8

9

10

00 02 04 06 08 10 12

Interest rates (%)

3Y bank bond

3M swap

-60

-40

-20

0

20

40

60

00 02 04 06 08 10

3-year AUD cross-currency basis swap (bp)

0

50

100

150

200

250

03 04 05 06 07 08 09 10 11

Average 5-year CDS for the 4 major banks (bp)


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Banks Banks have restructured their funding & Europeans are departing

0

20

40

60

80

100

120

140

160

180

90 95 00 05 10

Bank loan-deposit ratio (%)

0

10

20

30

40

50

60

70

90 95 00 05 10

Global financial crisis &aftermath

Bank funding by type (% of total)

Deposits

Short-term debt

Long-term debt

0

2

4

6

8

10

12

14

16

00 02 04 06 08 10 12 14

Non-financial corporate bank debt by region (% of total corporate debt)

Europe & UK

Asia (incl Middle East& Africa)

USA/Canada

64

66

68

70

72

74

76

78

80

00 02 04 06 08 10 12 14

0

2

4

6

8

10

12

14

16Non-financial corporate bank debt by lender (% of total corporate debt )

Australia -

4 major banks (LHS)

Australia - other banks

(RHS)


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(3) Confidence spillovers Consumers are gloomy

Households have become more conservative over the past fewyears, lifting the saving rate from zero to 10%. This is the biggestturnaround on record and the largest change of any country.

Consumers are anxious given a string of natural disasters, theexperience of the US/European consumer, fears about the carbontax and soft equity and house prices. Even with solid jobs growthand solid wages growth we are assuming that household savingrises further to around 15% of income. Note that there has also beena structural shift away from retail goods to services (eg, the boom inoverseas travel) and buying from overseas internet retailers.

Supply constraints are still an issue, but housing demand hasweakened, partly because of a slump in migration and an absence offirst home-buyers. Measures of financial stress remain low and the

key there remains unemployment.

-4

-3

-2

-1

0

1

2

3

90 95 00 05 10

Surveyed consumer confidence (detrended index)

Roy Morgan weeklyconsumer confidence

WMI monthly

consumer

confidence

-1

0

1

2

3

4

5

6

7

90 95 00 05 10

Real consumer spending (% yoy)

-6

-4

-2

0

2

4

6

8

10

12

90 95 00 05 10

Real household income (% yoy)

Total household income

Wages


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Consumer caution Consumers are saving more

-5

0

5

10

15

20

25

60 70 80 90 00 10

Household saving rate (%)

Latest available estimates

Estimates as first published0

10

20

30

40

50

60

90 95 00 05 10

Consumer survey - "Wisest place for savings" (% of respondents)

Pay off mortgage

Bank deposits, etc

-20

-15

-10

-5

0

5

10

15

20

90 95 00 05 10

Real household wealth (% yoy)

-4

-2

0

2

4

6

8

10

12

90 95 00 05 10

Household bank deposits (% of household assets) /

Term deposit rate less cash rate (pp)

1Y term deposit rate less cash rate

Household deposits


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Consumer caution Financial stress depends on unemployment

0

5

10

15

20

25

30

35

40

45

80 85 90 95 00 05 10

Mortgage payments on a new loan (estimated % of household income)*

* assumes lowest available interest rate, 20% deposit and 25 year term

0

2

4

6

8

10

12

90 95 00 05 10

Bank residential mortgage arrears (% of loans)

US

Australia

0.00

0.05

0.10

0.15

0.20

0.25

0.30

90 95 00 05 10

Mortgage reposessions (smoothed annualised % of households)

New South Wales

Mainland states

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

0.50

90 95 00 05 10

Bankruptcies, debt arrangements etc (annualised % of households)

Bankruptcies, debt

arrangements, etc

Bankruptcies excluding small business


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Consumer Housing supply is constrained, but demand has weakened

-5

0

5

10

15

20

25

90 95 00 05 10

National house prices (% yoy)

0

50

100

150

200

250

300

350

400

450

500

50 60 70 80 90 00 10

Annual change in the population and the housing stock ('000)

Change in the housing stock

Change in the population

400

420

440

460

480

500

520

540

560

580

600

08 09 10 11 12

Capital city house price - distribution of median prices ($'000)

Top 20% of

the market

Bottom 20% of

the market

Middle 60% of

the market

0

1

2

3

4

56

7

8

9

10

90 95 00 05 10

Home loans written each month ($bn)

Other home-buyers

First home-buyers

Investors

Increase

in a Govt

subsidy


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Business Need to watch if companies freeze hiring plans

Surveyed business confidence and conditions have both fallen toaround average levels. Usually business confidence tracksconsumer confidence more closely, so it is surprising that it hasntfallen by more. Business confidence can also be influenced byshare prices.

Need to watch if companies decide to delay hiring staff. The

hours worked data are poorly measured, but show some signs ofthis in that hours worked have risen as employment has beensofter, suggesting firms are working their existing employeesharder rather than putting on new staff.

-50

-40

-30

-20

-10

0

10

20

30

40

90 95 00 05 10

NAB business survey - business confidence & conditions (net balance)

Business conditions

Business

confidence

-4

-3

-2

-1

0

1

2

3

4

5

6

00 02 04 06 08 10 12 14

Employment & total hours worked (% yoy)

Employment

Hours worked

-3

-2

-1

0

1

2

3

4

5

00 02 04 06 08 10 12 14

-30

-25

-20

-15

-10

-5

0

5

10

15

20Employment (% yoy) NAB business survey - employment (index)

NAB employment

(leading by 6 months)

Employment


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Dutch disease

(1) Mining versus the rest the rest of the economy is actually growing

(2) Manufacturing struggling before the resources boom

(3) Retail sales Australians take to the internet & head overseas

(4) Tourism an exodus of Australians


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(1) Dutch disease The non-mining sector is actually growing

Contrary to popular perceptions, the economy outside the miningsector is actually growing.

This is true regardless of whether you adjust GDP to excludeeither: (1) mining production; or (2) mining net exports andinvestment.

The same also holds if you exclude mining from totalemployment.

-3

-2

-1

0

1

2

3

4

5

6

7

90 95 00 05 10

Real GDP (% yoy)

GDP

Excluding mining production

-3

-2

-1

0

1

2

3

4

5

90 95 00 05 10

Total employment (% yoy)

Exluding mining


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The benefit of the boom for the rest of Australia

$1 in export earnings = 25c on domestic services

+ 15-20c on government taxes/royalties

+ 10c on domestic wages bill

+ 5-10c on domestic share-holders

+ 35-45c in offshore returns

which => a 55-65c boost to the domestic economy


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(2) Dutch disease Manufacturing has been in decline for decades

60

70

80

90

100

110

120

1950 1960 1970 1980 1990 2000 2010

60

70

80

90

100

110

120

130

140Manufacturing output (index) Real exchange rate (index)

Manufacturing

Real exchange rate

0

5

10

15

20

25

1900 1920 1940 1960 1980 2000

Production (% of GDP)

Manufacturing

Mining

0

5

10

15

20

25

80 85 90 95 00 05 10

Manufacturing exports and estimated domestic sales ($bn real)

Exports

Estimated domestic sales

0

5

10

15

20

25

30

70 75 80 85 90 95 00 05 10

Manufacturing employment (% of total employment)


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(3) Dutch disease Retail sales struggling to compete on many fronts

Retailers have been soft for some time as they have lost marketshare because of: (1) a shift to spending on services; and (2)Australians buying goods from overseas internet retailers.

The increase in spending on services includes double-digit growthin overseas travel. The Bureau of Statistics also believes it maybe underestimating spending on telecommunication services.

There are no hard statistics on overseas internet purchases, butusing survey and overseas data we put the loss in market share atabout 5% of sales.

-2

0

2

4

6

8

10

00 02 04 06 08 10 12 14

Real consumer spending by type, excluding autos (% yoy)

Spending on

services

Retail goods

0

10

20

30

40

50

60

70

80

90

100

04 05 06 07 08 09 10 11 12

0.55

0.65

0.75

0.85

0.95

1.05

1.15

1.25

Weekly google searches from Australia

for "free shipping" (index)AUD per USD

AUD

Searches

0

100

200

300

400

500

600

90 95 00 05 10

Australians taking overseas holidays to see family/friends

or for a vacation (Smoothed '000 per month)


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(4) Dutch disease Tourism is small, but suffers from a high dollar

-10

-5

0

5

10

15

20

25

30

90 95 00 05 10

Domestic accommodation revenue (% yoy)

Sydney

Olympics

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

1998 2000 2002 2004 2006 2008 2010

Tourism output (% share of financial-year GDP)

0

2

4

6

8

10

12

14

16

18

20

1998 2000 2002 2004 2006 2008 2010

Nominal tourism output (% yoy)

Sydney

Olympics

0

100

200

300

400

500

600

700

80 85 90 95 00 05 10

Overseas arrivals and departures (smoothed '000)

Australians travelling

overseas

Overseas tourists arriving in Australia


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What if the world doesnt fall apart?

If the fall-out from global events is limited, then the resources boom

should see higher inflation re-emerge as the main problem with higher

interest rates to follow

(1) The resources boom still in full swing

(2) Inflation poor productivity and looming skill shortages

(3) Interest rates hikes back on the agenda


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(1) Resources boom Mining underpins the boom in investment

0

1

2

3

4

5

6

7

8

60 70 80 90 00 10

Non-residential construction (% of GDP)

Work done

Unfinished work

-20

-10

0

10

20

30

40

50

80 85 90 95 00 05 10

Nominal business investment (% yoy)

Implied by the Capex Survey

0

5

10

15

20

25

00 02 04 06 08 10 12

Business investment pipeline (% of GDP)

Committed projects

Projects under

consideration

7

8

9

10

11

12

13

14

15

16

80 85 90 95 00 05 10

-10

-5

0

5

10

15

20

25

30

35

Business investment

(% of GDP)

Business debt (% yoy)

Debt

Investment


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Resources boom - Major investment projects in Australia


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(2) Inflation Pressure still in the system

The general picture that one gets from [our] analysis [of the 2005-09 period]

is that underlying inflation in Australia was slower to pick up than suggested

by the historical relationships, but when it did eventually pick up, it did so

more quickly, and by a larger amount, than suggested by these relationships.

RBA Assistant Governor (Economic) Lowe


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Wages are back to normal, but with no productivity offset

Wage pauses/freezes are behind us and wages are back growingat a 4-5% pace on a variety of measures. As unemployment fallsfurther we see wages remaining strong and picking up further.

The problem for many companies is that productivity performanceis poor, such that there is no productivity offset to higher wages(poor productivity is apparent across a range of productivity

measures and is weak across industries).

-4

-2

0

2

4

6

8

10

90 95 00 05 10

GDP measure of wage rates & nominal unit labour costs (%yoy)

Nominal unit labour costs

Wages

0

1

2

3

4

5

6

90 95 00 05 10

RBA inflation target

Consumer expected inflation over the next 12 months (%)

1800

1900

2000

2100

2200

2300

2400

2500

2600

90 95 00 05 10

Index of labour productivity

Trend


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Skill shortages Likely to emerge late 2011/early 2012

Business surveys suggest skill shortages are likely to emergelater this year/early next year (there are already reports ofshortages in the resources sector).

Unemployment continues to trend lower and the supply of labouris growing more slowly as net overseas migration has slumped(fewer people are arriving and more Australians are leaving).

The reduced supply of labour is important because foreign-bornworkers have accounted for about two-thirds of the growth inemployment over the past year.

0

10

20

30

40

50

60

70

80

70 75 80 85 90 95 00 05 10

NAB business survey - labour as a significant constraint (% of firms)

0

2

4

6

8

10

12

90 95 00 05 10

Unemployment rate (%)

Total

Excluding those unemployed for a year or more

-80

-60

-40

-20

0

20

40

60

80

100

70 75 80 85 90 95 00 05 10

ACCI/WBC manufacturing survey - availability of labour (net balance)

Harder to get

Easier to get


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Skill shortages Population growth has slumped

0

50

100

150

200

250

300

350

70 80 90 00 10

Annual change in net overseas migration ('000)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

80 85 90 95 00 05 10

Working age population (% qoq annualised)

-4

-3

-2

-1

0

1

2

3

4

5

6

90 95 00 05 10

Employment (% 3M yoy)

Total employment

Contribution to employment

growth from people born overseas


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Inflation Likely to breach the RBAs target band

Underlying inflation has troughed at 2% and is likely to reachthe top of the RBAs 2-3% target band by the end of this year (it isalready above 3% on an annualised basis in the first half of2011).

The higher dollar is having a restraining effect on inflation, but thetighter labour market and higher inflation expectations are driving

inflation higher.

This is evident in two RBA inflation models: (1) an expectations-augmented Phillips Curve model; and (2) a mark-up model ofinflation. These models suggest inflation is likely to be around 3%or higher over the next couple of years.

0

1

2

3

4

5

6

7

8

90 95 00 05 10

Underlying inflation (% annualised)

ActualRBA Phillips Curve model

prediction

0

1

2

3

4

5

6

7

90 95 00 05 10

0

2

4

6

8

10

12RBA underlying inflation (% yoy) Unemployment (%)

Unemployment

Inflation

0

1

2

3

4

5

6

7

90 95 00 05 10

0.4

0.5

0.6

0.7

0.8

0.9

1

1.1

1.2

RBA underlying inflation (% yoy) AUD per USD

AUD

Inflation


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RBA inflation models Sub-5% unemployment points to >3% inflation

An unemployment rate in the 4s is inconsistent with the 2-3% target band, assuming no change in the exchange rate

Predicted annual underlying inflation based on Phillips Curve model (%)

Breakeven inflation rate:

2% 2% 2% 2% 3% 3% 3%

Unemployment rate:

4% 3.5 3.6 3.8 3.9 4.0 4.2 4.3

4% 3.2 3.4 3.5 3.7 3.8 4.0 4.14% 3.0 3.2 3.3 3.5 3.6 3.7 3.9

4% 2.8 3.0 3.1 3.3 3.4 3.6 3.7

5% 2.7 2.8 2.9 3.1 3.2 3.4 3.5

5% 2.5 2.6 2.8 2.9 3.1 3.2 3.3

5% 2.3 2.5 2.6 2.8 2.9 3.1 3.2

5% 2.2 2.3 2.5 2.6 2.8 2.9 3.0

6% 2.1 2.2 2.3 2.5 2.6 2.8 2.9

0

1

2

3

4

5

6

7

8

90 95 00 05 10

RBA trimmed mean CPI (%qoq annualised)

Actual

Mark-up model

prediction

0

1

2

3

4

5

6

7

90 95 00 05 10

-4

-2

0

2

4

6

8

10RBA trimmed mean CPI (% yoy)

Unit labour costs

Underlying inflation

Nominal unit labour costs (% yoy)


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(3) Interest rates The RBA may take out insurance

The RBA has cut in response to confidence shocks

-50bp in Dec 1987 after the Oct 87 stock market crash (started to raise rates in April 1988)

-25bp in Dec 1998 after the Aug/Sep 1998 Russian debt default/LTCM crisis (started raising rates

in Nov 1999)

-25bp in Oct 2001 after 9/11 (it cut again in Dec 2001 before hiking in May 2002)

At this point, though, there are periods of tremendous turbulence when I think it is a very good thing for

policy to just sit still, if it can, rather than add to that turbulence by starting to change our settings.

RBA Governor Stevens, Parliamentary testimony


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Interest rates Reports of Board tension

Reports of tension between Bank staff, who are more worried about inflation, and the

private-sector Board-members.

Leaked cable reporting tension between the Treasury, who wanted more aggressive

action, by cutting rates towards zero, in 2009 than the RBA.

Former Board-member ANU Professor McKibbin has called for: (1) replacing private-

sector board-members with more expert representation; and (2) excluding the Secretary to

the Treasury.


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Interest rates No change this year, hikes in 2012 cuts need big spillovers

The RBA has seen higher-than-expected inflation and weaker-than-expected growth, although the latter largely reflects thetemporary impact of natural disasters in Queensland.

We see no change in rates over the rest of this year, although aninsurance rate cut is possible. We forecast higher rates with5.5% by the end of 2012 assuming limited fall-out from

European/US events. A reversal would likely happen if: (1) bankfunding froze up; (2) commodity demand slumped; and/or (3)lower confidence led to weaker activity and higher unemployment.

Financial conditions are generally on the tight side of neutral. Thereal exchange rate is high and credit growth is low (although thisis partly because companies are using retained earnings to fundinvestment). Surveyed lending standards for companies haveeased, though, while banks have trimmed mortgage rates.

0

2

4

6

8

10

12

14

90 95 00 05 10


%

Cash rate

RBA

forecasts

Underlying inflation

0

1

2

3

4

5

6

7

90 95 00 05 10


Underlying inflation (% yoy)

Actual inflation

Rolling year-ahead RBA inflation forecast

-3

-2

-1

0

1

2

3

4

5

6

7

90 95 00 05 10

Real GDP(% yoy)

GDP growth as first reported

Rolling year-ahead RBA GDP forecast


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Interest rates Financial conditions generally on the tight side

40

50

60

70

80

90

100

110

120

130

80 85 90 95 00 05 10

AUD real exchange rate (index)

-5

0

5

10

15

20

25

30

35

80 85 90 95 00 05 10

Total private-sector credit (%6m annualised)

-20

-10

0

10

20

30

40

50

90 95 00 05 10

Surveyed lending standards (net balance of respondents

reporting tighter standards)

Manufacturing

(ACCI/WBC survey)

All business

(NAB survey)

4

5

6

7

8

9

10

00 02 04 06 08 10 12 14

Mortgage interest rates (%)

Standard variable

Discounted variable3Y fixed


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Interest rates A Taylor rule scenario analysis points to higher interest rates

If the resources boom remains intact, inflation points to higher ratesCalibrated Taylor rule - Cash rate = 2% real rate + inflation forecast + *(inflation forecast RBA 2% target) + *output gap

Inflation forecast (%):

Output gap (%) 1 1 1 1 2 2 2 2 3 3 3 3 4

-2 1 2.1 2 2.9 3 3.6 4 4.4 4 5.1 5 5.9 6

-1 2 2.6 3 3.4 3 4.1 4 4.9 5 5.6 6 6.4 6

Flat 2 3.1 3 3.9 4 4.6 5 5.4 5 6.1 6 6.9 7

1 3 3.6 4 4.4 4 5.1 5 5.9 6 6.6 7 7.4 7

2 3 4.1 4 4.9 5 5.6 6 6.4 6 7.1 7 7.9 8

Market pricing of a big rate cut => low inflation and/or high unemploymentInflation forecast (%):

Output gap (%) 1 1 1 1 2 2 2 2 3 3 3 3 4

-2 1 2.1 2 2.9 3 3.6 4 4.4 4 5.1 5 5.9 6

-1 2 2.6 3 3.4 3 4.1 4 4.9 5 5.6 6 6.4 6

Flat 2 3.1 3 3.9 4 4.6 5 5.4 5 6.1 6 6.9 7

1 3 3.6 4 4.4 4 5.1 5 5.9 6 6.6 7 7.4 7

2 3 4.1 4 4.9 5 5.6 6 6.4 6 7.1 7 7.9 8


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Other key risks

(1) China the biggest medium-term uncertainty

(2) House prices / household leverage the perennial favourite likelyneeds materially higher unemployment to pop the bubble but there

could be a conscious deleveraging


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(1) China China may overdo it in trying to contain inflation

0

5

10

15

20

25

90 95 00 05 10

China - policy interest rate (%) and required reserve ratio (%)

Required reserve ratio

Policy interest rate

0

5

10

15

20

25

90 95 00 05 10

China - real GDP (% growth)

Annualised quarterly growth

Annual growth

-5

0

5

10

15

20

25

30

90 95 00 05 10

China - CPI (% yoy)

Excluding

food

-20

-10

0

10

20

30

40

90 95 00 05 10

China - production (%3m yoy)

Steel

Electricity


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China Australia is heavily exposed

0

10

20

30

40

50

60

70

1900 1925 1950 1975 2000

Exports by country (% of total exports of goods)

UK

Japan

China(plus HK)

India

0

2

4

6

8

10

12

1900 1925 1950 1975 2000

Exports by country (% of Australia's GDP)

UK

Japan China(plus HK)

India

0

5

10

15

20

25

30

35

Singapore

Malaysia

Korea

Thailand

Philippines

Chile

Vietnam

SaudiArabia

Kuwait

Iran

Australia

Japan

SouthAfrica

Israel

NZ

Indonesia

UAE

Belgium

Argentina

Germany

Exports of goods to China and HK as a share of each country's GDP (%)

0

1

2

3

4

5

6

1900 1925 1950 1975 2000

Exports by country and mining investment (% of Australia's GDP)

Mining investment

Exports to China

(plus HK)


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(2) House prices & leverage Households are the Achilles heel

0

50

100

150

200

250

300

350

400

450

500

Australia Germany USA UK Japan

1980 1990 2000 2010

Economy-wide debt (% of GDP)

0

20

40

60

80

100

120

Germany Japan USA UK Australia

1980 1990 2000 2010

Household debt (% of GDP)

0

50

100

150

200

250

Australia Germany UK USA Japan

1980 1990 2000 2010

Public-sector debt (% of GDP)

0

50

100

150

200

250

USA Australia Germany UK Japan

1980 1990 2000 2010

Corporate debt (% of GDP)


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House prices & leverage Prices are out of line with the fundamentals

0

5

10

15

20

25

30

90 95 00 05 10

Residential mortgage debt (% 3m annualised)

0

20

40

60

80

100

120

140

160

180

50 60 70 80 90 00 10

Household debt (% of annual household income)

Australia

US

20

40

60

80

100

120

140

90 95 00 05 10

House prices (June-07 = 100)

Australia

China

Euro

area

USA

0.0

0.5

1.0

1.5

2.02.5

3.0

3.5

4.0

4.5

5.0

50 60 70 80 90 00 10

Existing house price (multiple of annual household income)


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Fiscal policy A forecast return to a small surplus

A large range of small cuts and the resources boom drive theBudgets return to a small surplus in 2012-13. Legislation is yet topass for the carbon and mining taxes, which commence in July2012.

The forecast turnaround in the Budget is one of the biggest onrecord and implies fiscal policy will be a large dampener on

growth, although history shows that it is very hard to accuratelypredict where the Budget will end up.

An early return to surplus poses a different set of challenges tothose faced by other countries, with the Government keepingenough bonds on issue (12-14% of GDP versus the OECDaverage of 100%). Political support for a macro stabilisation fundis still lukewarm at best. -5

-4

-3

-2

-10

1

2

3

4

5

60 70 80 90 00 10

Underlying cash Budget balance (% of GDP)

Government

forecast

-8

-6

-4

-2

0

2

4

90 95 00 05 10

Commonwealth plus State Budget balance (% of GDP)

Smoothed

0

5

10

15

20

25

90 95 00 05 10

Bonds on issue (% of GDP)

Commonwealth

Government

State Governments


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Politics Minority ALP Government could face an early election

The minority ALP Government relies on 1 Green, 1 ex-Green, and2 ex-National Party (two other independents support the LiberalParty). The Greens control the Senate.

An ALP MP is being investigated by Fair Work Australia and NSWpolice for alleged misuse of credit cards whilst a union official. Ifcharges were brought and if there was a criminal conviction with a

sentence of 1 year or more, then this would force a by-electionand then likely a general election.

Also, 1 independent may withdraw his support for the ALP if thereare no reforms to poker machines by May 2012.

The ALP is very likely to lose the next election - polls show thelowest primary vote support for the ALP since Australia split fromEngland in 1901. The next election is due Aug-November 2013.

50

60

70

80

90

100

110

120

130

140

150

80 85 90 95 00 05 10

Consumer confidence (smoothed index)

Coalition

voters

ALP voters

0

10

20

30

40

50

60

1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011Election year

ALP primary vote in Federal elections, plus in the latest opinion poll (%)

NSW split

from Federal ALP

Latest

opinion

poll

0

10

20

30

40

50

60

90 95 00 05 10

Newspoll survey - primary voting intentions (smoothed %)

Liberal/NP

ALP


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Exchange rate Strong fundamental support

Despite market wobbles associated with concerns over globalgrowth and European sovereign debt, the Australian dollar hasheld onto the strong gains made over the past few years andremains well above parity with the USD.

It continues to be supported by the record high terms of trade,which reflects ongoing strength in bulk commodity prices, as well

as wide interest rate spreads.

The RBA, though, remains tolerant of a higher exchange rate,comfortable with the stronger currency taking some of the heatout of the economy.

Our expectation is that the AUD will continue to trade above paritygiven that the Federal Reserve has committed to keeping rateslow until 2013.

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

80 85 90 95 00 05 10 15

AUD (US dollars)

40

50

60

70

80

90

100

110

120

130

80 85 90 95 00 05 10 15

AUD real exchange rate and the terms of trade (Index)

REER

ToT

-6

-4

-2

0

2

4

6

8

10

80 85 90 95 00 05 10 15

Aus-US 2yr bond spread (%)


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Exchange rate Bond buying by central banks matters most

-4

-2

0

2

4

6

8

10

12

90 95 00 05 10

Net foreign purchases of Australian

bonds (rolling annual % of GDP)

-4

-2

0

2

4

6

8

10

12

90 95 00 05 10

Net foreign purchases of Australian

equities (rolling annual % of GDP)

0

10

20

30

40

50

60

70

80

90 95 00 05 10

Foreign ownership of domestically-issued bonds,

excluding cross-holdings and bonds held by the

RBA and AOFM (% of each total)

Banks

State

Commonwealth

-40

-20

0

20

40

60

80

100

120

00 02 04 06 08 10 12 14

Foreign holdings of Commonwealth bonds (% yoy) and

central bank reserves held in "other" currencies (% yoy)

Total overseas holdings

of Commonwealth bonds

Central bank reserves held in "other" currencies


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New Zealand RBNZ forecasts steep interest rate rises

GDP growth is set to accelerate from around 3% at end-2011 tonearly 5% by end-2012 as the economy gets a boost from therebuilding effort post the earthquakes.

Headline inflation will drop back towards 2.5% by end-2011 as theimpact of tax increases drops out of the calculation, while inflationlooks set to nudge down to around 2% by end-2012.

The RBNZ is forecasting steep rate rises in 2012 and 2013 andhas said that it could hike this year. We expect the first hike tocome in December, returning the cash rate from 2.5% to a pre-disaster level of 3% (the window for a September hike seemsclosed by extreme volatility in global markets). For 2012, we seemore hikes and are factoring in a 4% cash rate by the end of theyear. 0

1

2

3

4

5

6

7

8

9

10

00 02 04 06 08 10 12 14

Interest rate (%)

Cash rate

March MPS projection

for 90 day bills

June MPS projection

for 90 day bills

0

1

2

3

4

5

6

00 02 04 06 08 10 12 14

CPI (% yoy)

Actual

June MPS

projection

March MPS

forecast

-6

-4

-2

0

2

4

6

8

00 02 04 06 08 10 12 14

Real GDP (% yoy)

Actual

Excluding rebuild

June MPS

forecast


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Appendix 1 Key forecasts


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Appendix 2 Structure of the economy


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will resource boom be derailed by us and eu debt problems

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