Economics Australia

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Global Research
Australias economy needs to rebalance from mining to non-mining led growth The process is being made more urgent by the slowdown in China and the fall in commodity prices But we think Australia will avoid a significant downturn or a recession, helped by a weakening AUD

Australias R-word: Rebalancing not Recession

Mind the mining gap

Australias growth has been uneven in recent years; with the mining sector booming, other sectors were held back. As the mining story slows, other sectors need to pick up to support Australias growth (we have been calling this Australias great rebalancing act, 7 December 2012). There are some early signs that rebalancing is gradually happening, although it has been slower than expected. This reflects that it has been hampered by the AUD, which had remained high until recently, and by households that have continued to save more than expected. Asias growth has also been weaker than expected, dampening confidence (see our Asian Economics Quarterly Q3 2013: Asias bitter medicine, 9 July).

10 July 2013
Paul Bloxham Chief Economist, Australia & New Zealand HSBC Bank Australia Limited +61 2 9255 2635 paulbloxham@hsbc.com.au Adam Richardson Economist HSBC Bank Australia Limited +61 2 9006 5848 adamrichardson@hsbc.com.au

We remain optimistic that Australia will pull off its rebalancing, although growth is likely to be below trend this year (2.5%), before heading towards trend next year (2.8%). The RBA may cut rates further to support this rebalancing. Our optimism reflects that: Australias main trading partners are still the worlds fastest-growing economies; there are few imbalances in the local economy; the bulk of the local economy is outside of mining; policymakers still have room to move on the monetary and fiscal policy fronts; and the AUD could fall further if necessary. Key risks are a sharp fall in commodity prices, due to slower Asian growth, or a ramp-up in global commodity supply. However, we remain confident that local policymakers have room to loosen policy and the flexible AUD could provide support in the face of a negative global surprise. While a recession can never be completely ruled out, we think Australias R-word is more likely to be rebalancing.

View HSBC Global Research at: http://www.research.hsbc.com

Issuer of report: HSBC Bank Australia Limited

Disclaimer & Disclosures This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

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Mining slowing, not collapsing

Mining investment is near its peak as a share of the Australian

economy, as fewer new mining construction projects are started

Looking beyond this, the economy will get support from rising

resource exports, as new projects come online

But, unsurprisingly, the overall mining contribution to growth will

be less than it has been in recent years, when it had been an extraordinarily large share of Australias GDP growth story

Mining booms three stages

Australias economy has been supported in recent years by a mining boom. This has been a key reason for the economys outperformance compared with the rest of the developed world. The boom can be thought of as occurring in three overlapping stages (we outlined these in Downunder digest: Reports of the mining booms death greatly exaggerated, 26 July 2012). First, commodity prices rise, boosting incomes. Second, the high level of commodity prices motivates mining companies to invest significant amounts in new capacity. Finally, there is a ramp-up in resources exports as new capacity comes online. The first stage is over, the second stage is winding down, but the third stage is only just ramping up.

Commodity prices have peaked, so the first stage is over

The first stage occurred between 2003 and 2011, with a brief interruption during the global financial crisis in 2008. Thanks to Chinas large boost to government spending after the global financial crisis, commodity prices bounced back in 2009, after a brief and sharp fall in 2008 (Chart 1).
1. Commodity prices have passed the peak, but are still high

Source: RBA

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At the peak, in mid-2011, the average price of the basket of commodities that Australia exports was 370% higher than it was in 2000 in USD terms. Commodity prices have fallen by 27% since then, though they remain historically high, at around 240% above the level they were at in 2000 in USD terms. A significant AUD appreciation between Q1 2009 and Q2 2011 helped Australia to absorb the positive shock to local incomes from the rise in commodity prices, particularly the jump in prices after the global financial crisis. As a result, commodity prices rose by less in AUD terms over recent years than they had prior to the global financial crisis, dampening the impact on local incomes. The first stage boosted Australias income growth most significantly in the mid-2000s. Nominal GDP grew by 8.0% a year from 2004 to 2007 (Chart 2). It slowed to 6.4% between 2008 and 2011, and we expect nominal GDP growth will track below its long-run average in the coming four years, at closer to 5%, as global growth is more constrained and Australias terms of trade are expected to gradually decline. The first stage of the mining boom is over.
2. Nominal GDP is slowing as the commodity price boom is over

Investment boom plateauing, so the second stage is ending, too

In response to the high level of commodity prices, mining companies increased their investment in the resources sector. In 2008, this saw engineering construction contribute about 1ppt to Australias GDP growth and provide significant support for the economy in the face of the global financial crisis. This was a big deal at the time, but there was significantly more to come. The global financial crisis of 2008-09 temporarily disrupted progress, but the ramp-up in investment that followed in 2011 and 2012 was much larger than the previous boost. It was led by a substantial pick-up in the construction of Liquefied Natural Gas (LNG) projects in Australia. In 2011 and 2012, engineering construction grew by around 40% a year and contributed over half of all GDP growth in the economy. This is despite the mining sector (including the sectors immediately downstream from the mining investment boom) accounting for less than 20% of the overall economy (Chart 3).
3. Mining investment contribution slowed after the boom

Source: ABS Source: ABS, HSBC estimates

This stage of the mining story is now slowing. We believe this should not be a surprise, given the extraordinary pace of growth in mining investment over the past couple of years. For

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investment to continue to grow would have required more and more new (and larger) projects to enter the pipeline. This would have been unrealistic, in our view. Indeed, because Australia has been doing so much investment, the cost of new investment has risen substantially as companies have been competing for labour and capital, which has also discouraged new investment proposals. Mining investment is set to peak as a share of the Australian economy this year. The precise timing is difficult to determine due to the lumpy nature of these large projects. A guide to the likely timing of the peak is the Australian capital expenditure survey, which aggregates responses from firms about investment spending plans. The RBA has also provided its own forecasts, based on publicly available information, as well as its own confidential liaison. Both, the last set of available RBA forecasts and the numbers from the last capital expenditure survey suggest that mining investment will plateau over the coming year, rather than peak and fall sharply (Chart 4).
4. Investment should plateau, but not plummet

Third stage is yet to come, as the export boom is just ramping up

The third stage of the mining story is only just ramping up. Of the three key commodities in Australias resources story, iron ore and coal exports have already begun to ramp up, while LNG has yet to pick up strongly. However, the large driver of the forthcoming increase in resources exports is expected to be LNG (Chart 5). After all, around three-quarters of the capacity build in recent years has been to produce LNG. Government estimates based on capacity under construction suggest that exports of LNG will rise by around 400% between 2014 and 2018.
5. Massive ramp-up in resource exports is just starting

Source: Australian Treasury

Putting it all together

Adding up the overall mining story suggests we have passed the peak of the positive contribution of mining to Australias economic growth, but there is likely to be modest support for growth yet to come. This slowdown is expected because the first and second stages of the mining boom are likely to have provided a larger boost to growth than the expected boost from the third stage. In real terms we expect the mining sector will continue to make a modest contribution to overall GDP growth. This is mostly because resources

Source: ABS, RBA, HSBC estimates

Beyond this period, we expect mining investment will fall and be a drag on economic growth. However, this does not imply that mining is necessarily an overall drag on the economy. After all, this capacity has been built for a reason to boost Australias resources exports.

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exports are a much larger share of GDP than mining investment: so while mining investment is set to decline in coming years, we expect this to be more than offset by a rise in resources exports (Chart 6).
6. Mining sector should contribute positively in real terms

but to edge downwards over the next couple of years (Chart 7). Clearly, this is an important assumption and we discuss the risks in the final chapter, below.
7. Commodity prices to cycle around a new higher mean

Source: ABS, HSBC estimates Source: ABS, HSBC estimates

But this is not the full story. A large part of the boost to the economy from the mining run-up in recent years came from rising commodity prices (stage one of the mining boom). If there was a large fall in commodity prices, this would be a drag on the nominal economy. That is, the run-up in commodity prices boosts incomes, but a fall in prices would work in the other direction. Much depends on the commodity price outlook. We remain of the view that commodity prices will not fall back to the low levels of the 1980s and 1990s. We discuss this view in detail: Commodities and the global economy: Are current high prices the new normal?, 8 August 2012. In short, we expect the shifting composition of global growth towards the emerging world means global growth is now more commodity intensive as these economies have substantial infrastructure requirements. However, we do expect commodity prices have passed their peaks, which means that they are now a modest drag on income growth. Our working assumption for Australias terms of trade is that they remain structurally high. We expect them to cycle around a new higher mean than in the past,

With this working assumption for the terms of trade, we believe that the mining sectors nominal share of the Australian economy is likely to edge downwards in the next few years, although it is expected to remain significantly higher than it was in the 1990s and early 2000s (Chart 8). In broad terms, this shift in Australias economy matches the shift in the composition of global growth to being more driven by emerging economies. For Australia, the investment share is forecast to fall, but this is expected to be largely offset by a rise in export values.
8. In nominal terms, mining is expected to edge downwards

Source: ABS, HSBC estimates

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Overall, our central view remains that mining is slowing, not collapsing, with the forthcoming fall in mining investment expected to be more than offset (in real terms) by a rise in exports, as new capacity comes online.

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Growth should continue to rebalance

As mining slows, we expect the other sectors, which account for

around 80% of the economy, to take over as drivers of growth

Some of the interest rate-sensitive sectors of the economy,

including housing, have already started to lift

The recent AUD depreciation should help rebalance growth, as it

makes the trade-exposed sectors more competitive

Non-mining was held back

The non-mining sectors of the Australian economy have generally been held back in recent years to make way for the mining boom. Above-neutral interest rates in 2011 were part of the story, as they held back the household sector. The other key factor holding back the non-mining sectors had been the high AUD. Until mid-April 2013 the AUD had been around 30-year highs on a trade-weighted basis, despite falls in the terms of trade through last year, which typically should see the AUD decline. Official data make it difficult to track conditions in the mining versus non-mining sectors on a timely basis, but it is possible to come up with estimates using annual GDP numbers and a technique developed by the RBA. We use this method in Chart 9, which shows clearly that growth in the non-mining sectors of the Australian economy has been well below average in the past few years as the mining sector has been the main driver of growth.

9. Growth in the past couple of years was uneven

Source: ABS

Given the slowdown in the mining sector this year, other sectors of the economy need to pick up and take over as drivers of local growth. Importantly, over 80% of Australias economy is not directly exposed to the mining boom. The bulk of the Australian economy is services, as is the case in most developed nations (Chart 10). Many of these sectors are interest rate and exchange rate sensitive and there are already signs that conditions are gradually improving in these sectors, given the low RBA cash rate. The recent

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fall in the AUD is expected to provide further support for exchange rate-sensitive sectors.
10. The bulk of the economy is services, not mining

Australias powerful policy tools, 13 January 2012), in contrast to many other developed economies where conventional policy options are no longer available. Estimates suggest that a 100bps cut in the cash rate boosts GDP by +0.9%, chiefly through higher household consumption and dwelling investment (Chart 12).
12. Australias cash rate setting is powerful

Responses to 100 bp Cut in Cash Rate

% 8 6 4
Source: RBA

Impact after 6 quarters

8.7

2 0

0.9

0.5 Household Consumption Dwelling investment

Rates right for rebalancing

Monetary policy settings are currently primed to lift the non-mining sectors of the economy. The RBA has already delivered 200 basis points of cuts in the past two years, which have largely been passed through into lower borrowing costs for businesses and households (Chart 11). The cash rate is at its lowest level in over 53 years and mortgage rates are 120bps below average.
11. Mortgage rates are now at well below neutral levels
% 12 10 8 6 4 2 0 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
Cash rate Effective mortgage rate

GDP (expenditure)
Source: HSBC estimates

In addition to the role of interest rates, the currency is also likely to support a rebalancing of the Australian economy. The AUD has fallen significantly in recent months. During the mining investment boom, the exchange rate appreciation played a buffering role, dampening the positive shock to local incomes and spreading the benefits of high commodity prices by boosting the purchasing power of households over internationally produced goods, services and assets, effectively pushing local demand offshore. As mining investment cools, the exchange rate will likely again play its traditional buffering role. A lower exchange rate should help to rebalance production towards the domestic economy. A lower currency improves the competitiveness of Australias exporters and relative price shifts encourage greater consumption spending within Australia, while the tourism and education sectors will also get a boost from a lower exchange rate.

Variable mortgage rates and nominal cash rate

Source: RBA

Our empirical modelling suggests that cash rate changes typically have a significant impact of growth in Australia (see Downunder digest:

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This mechanism was somewhat stymied in late 2012 and early 2013 as the AUD remained around 30-year highs (Chart 13), despite commodity prices having fallen through 2012.
13. Australias great shock absorber is working again

14. Housing prices have risen over the past year

Source: RP-Data-Rismark

Housing construction rising

As well as a lift in house prices, housing construction has also begun to rise from low levels. Building approvals have picked up since their trough in early 2012, with annual growth in building approvals currently sitting at 6% in trend terms (Chart 15).
15. Housing construction is gradually lifting

Source: RBA

To some degree, the AUD was being artificially held up by capital flowing to Australia in search of an alternative safe haven to the US bond market. Since mid-April the AUD has depreciated and has moved back towards commodity price levels. Australias shock absorber is once again working to support the rebalancing of growth in the economy.

Evidence of rebalancing
Housing market is lifting
A key channel through which low interest rates are expected to lift the economy is the impact on new household borrowing. A recent solid rise in housing loan approvals provides evidence that monetary policy is getting some traction. The rise in housing lending is reflected in a lift in activity in the established housing market. National housing prices have risen by 5% since their trough in May 2012 (Chart 14).

Source: ABS

Dwelling investment has the potential to be a key contributor to growth over the next few years as a number of factors lend support to the sector (see Downunder digest: Australias housing pick-up, 19 March 2013). Mortgage rates are at low levels and the recent rise in house prices will likely encourage further investment in housing construction, as development returns rise. In

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addition, we have been through a period of underinvestment in housing, as construction has slowed in recent years. Coupled with continued population growth, demand for new housing is likely to remain robust (Chart 16).
16. Strong growth in dwelling investment is expected

17. Interest paid has fallen, boosting disposable income

Source: ABS, HSBC estimates

Source: ABS, HSBC estimates

A rise in dwelling investment will, however, not be enough. Household consumption also needs to lift if Australias growth is to rebalance and head back towards its trend pace.

However, we have yet to see a significant rise in household spending. Despite the 200 basis points in cuts that the RBA has provided, the saving rate has remained elevated (Chart 18) and consumption has yet to rise substantially. We still expect a pick-up in household consumption in coming quarters, and we have been somewhat surprised that this has not already occurred.
18. Household saving has remained stubbornly high

Rebalancing has been slower than expected in some areas

Consumer should revive
Policy should be effective in boosting household consumption. The cut in policy rates has already provided a lift to disposable income. With around 90% of households on floating mortgage rates, the drop in the cash rate has seen required mortgage payments ease (Chart 17). Higher housing construction should also see a rise in consumption, supporting demand for durable goods to fill new houses. The rise in housing prices is also helping to lift household wealth, as around three-fifths of Australian household assets are the value of houses (see Downunder digest: Australias consumer revival, 23 April 2013).

Source: ABS

A number of factors may have weighed on household spending activity. In particular, conditions in the labour market remain loose, constraining household sector confidence. Continued weakness in global activity has also likely added to household cautiousness (Chart 19). Households appear to be continuing to repay debts ahead of required rates, constraining their

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willingness to spend. Continued household cautiousness is a downside risk to our forecasts.

19. Consumer sentiment dipped, after lifting in early 2013

Businesses have also held back on hiring recently. The unemployment rate is currently around 5.5%, while jobs growth has only averaged around 24,000 a month since the beginning of 2013, which is not quite enough to match the increase in the labour force. This has seen the unemployment rate gradually drift higher since the middle of 2012 (Chart 21). With the unemployment rate above the full employment level, wage growth has been subdued, and an elevated unemployment rate is a factor holding back household confidence.
21. Labour market remains loose, subduing confidence

Source: Thomson Reuters Datastream

Businesses still unhappy

Business confidence has remained subdued, despite the loosening in financial conditions that has been delivered recently (Chart 20). Political developments are likely to be playing a role, with uncertainty over post-election policies an election is due before 30 November 2013 complicating the outlook for Australian firms.
20. Business confidence has remained subdued

Source: ABS

Source: Thomson Reuters Datastream

Looking forward, policy settings are expected to be effective in boosting employment. A lower AUD coupled with lower borrowing costs should see business confidence begin to improve which should see firms committing to greater levels of hiring. After tracking broadly sideways in recent years, there are already some signs of improvement in employment in the more exchange rate-sensitive industries of the Australian economy (Chart 22). A lower exchange rate should see increased activity and employment in industries such as tourism, retail and manufacturing.

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22. Some rebalancing is occurring in the labour market

24. Net outbound flow of tourists is levelling out

Source: ABS

Source: ABS

Tourism expected to recover

The tourism industry is also expected to recover. There are some early signs of improvement, reflecting a strong rise in tourist arrivals from Asia, particularly China, as the expanding Asian middle classes can afford to travel abroad and are coming to Australia (Chart 23). Chinese arrivals have risen by 85% over the past three years or so. These trends are expected to continue.
23. Chinese arrivals into Australia are picking up strongly

Few structural impediments to prevent rebalancing

Part of our optimism about Australias rebalancing prospects reflects that we dont think the overall economy has substantial structural imbalances. Indeed, inflation and wages have eased in the broader economy in the past couple of years, despite the mining boom. There are few signs of asset price misalignments. In general, there have been few signs of irrational exuberance in the Australian economy in recent years. Importantly, it is therefore only growth that is the increment of change that has been uneven in recent years, not the overall level or structure of the economy. For this reason, it is only growth that needs to rebalance, not the overall economy. This situation makes Australia different to some other economies that are seeking to rebalance, where the imbalances are in the structure of their economies.

Source: ABS

The number of Australias departing for international trips is also expected to level out in coming months as the lower AUD discourages international travel (Chart 24).

While some commentators argue that there are imbalances, we disagree with many of these arguments. First, in our view, Australia does not have a housing bubble. Second, while household debt levels are fairly high, they have been broadly stable for the past seven years and household debt is fairly well allocated to households that can afford to service it. Third, the mining investment that has been

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undertaken is, in our view, an appropriate allocation of capital, given our outlook for resources demand as emerging economies continue to drive global growth. Finally, inflation has been low across the economy, which is another sign that there have been limited excesses as a result of the mining boom.

25. Australian dwelling prices similar to other countries

No housing bubble
We have long held the view that Australia does not have a housing price bubble (see Downunder digest: Australian housing outlook positive, 12 July 2012, and Australias place in the world, 15 March 2011). While Australian house prices are fairly high, they are high for structural reasons that reflect underlying economic fundamentals. These include that supply is low relative to demand for housing, partly reflecting urban structure and zoning restrictions. These constraints limit the quantity of well located housing in Australian cities and these supply impediments are only resolved slowly. Solid population growth and low housing construction suggest that there is an undersupply of housing in Australia. A sharp fall in housing prices would be necessary to establish that Australia has a housing bubble, and we see a sharp fall as highly unlikely. It is worth keeping in mind that while Australian housing prices are fairly high, they are at comparable levels to a range of similar economies. The Australian house price-to-income ratio is similar to Belgium, the United Kingdom, New Zealand and Canada, and only a slightly above the level in Italy and Germany (Chart 25).

Source: RBA

Household debt well allocated

While aggregate household debt is fairly high in Australia, the key to assessing vulnerability is to look at the allocation of this household debt. In Australias case, household debt is well allocated to households that are likely to be able to continue to service it. The bulk of debt is held by wealthy households, with a limited number of highly indebted and financially vulnerable households. Around 75% of all household debt is held by the highest 40% of income earners (Chart 26).
26. Most of the debt is held by wealthy households

Household Debt by Income Group

%

50 40 30 20 10 0 Lowest
Source: RBA

Highest

Micro survey data show that Australia also only has a small proportion of mortgages with very high loan-to-valuation ratios, high servicing burdens and low incomes. In 2011, only around 15% of indebted owner-occupiers had a housing

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gearing ratio greater than 80%. The subset of households that also had high debt servicing ratios of greater than 50% of their incomes was low, at 3.5% of all mortgages. Even within this group, almost half report in surveys that they have built up some buffer by being ahead on their mortgage repayments. Australia also never had sub-prime loans and has a full recourse mortgage system, which encourages households to only take on debts they can afford. Australians have taken the opportunity to consolidate their balance sheets somewhat in recent years, with debt-to-income ratios stabilising and household saving rising (Chart 27). This implies that the quantity of new and inherently more risky lending growth has been modest, with households holding more mature loans and many of them well ahead on their debt repayments.
27. Household debt has been steady since 2006

A run-up in the prices of Australias natural resources saw firms build up productive capacity in Australia with mining capital allocated based on the medium-term outlook for resources demand. As such, rather than an irrational bubble, the mining investment boom provides both an initial boost to growth and improves the medium-term prospects for Australian activity, through providing a sustained increase in Australian resources production. While there have been substantial cost overruns in many of Australias mining construction projects, much of this has reflected that Australia has been trying to do an extraordinary amount of work in a relatively short period of time. This has meant demand for skilled labour and capital in the mining industry has risen well ahead of available supply and driven up costs. Likewise, as mining investment is now slowing down, there are already early signs that many of those costs are falling. The bottom line remains that Australia is a low-cost producer of a range of commodities, even if it has been a high-cost investment destination in recent years. As we move into the production phase, Australia is expected to continue to have an absolute advantage in the production of most commodities. We discuss this topic further in the risks chapter, below.

Inflation is low
Source: ABS, RBA

Mining capital well allocated

During any boom in a sector of an economy, there are risks of a sharp correction if expectations run ahead of fundamentals. In our view, however, rather than a misallocation of resources, the mining investment boom appears to represent a rational response to the price signals provided by the market.

Despite a mining boom, Australias inflation and wages growth has been subdued. Overall inflation is currently at the bottom end of the target band (Chart 28). Most mining booms in Australias history saw inflation rise rapidly, leaving policymakers with less flexibility to respond after the boom had ended. This time around, inflation is low, which is also a sign that there have been few excesses in the broader economy as a result of this mining boom.

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28. Inflation is in the lower part of the RBAs target range

Source: ABS

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Risks and challenges

Australia is highly dependent on Asia, given that 70% of its

exports go there, which means weaker Asian growth is a key risk

Despite the mining slowdown, we see Australia as unlikely to have

a significant downturn, given our outlook for Asia and because policymakers have room to move to support growth if needed
The challenge for policymakers is managing the economy in the

wake of the mining boom, which would have been easier if more had been saved or productivity-enhancing reforms occurred earlier

China and Asia

Australias relative success in recent years can be partly attributed to its strong ties to Asia. Around 70% of Australias exports go to Asia and commodities constitute the bulk of these exports. As we set out in the first section, Australias mining boom has been a key driver of its recent strong economic performance.

Commodity demand
A sharper downturn in Asia, which sees a fall in commodity demand, is a key downside risk to Australias outlook. For further discussion of the risks to the Asian growth outlook see: Asias bitter medicine, 9 July 2013.

Chinas current slowdown presents some risk in this regard. In the short run, there is some risk that Chinas current focus on faster reforms sees less fixed asset investment than we currently forecast (see Hongbin Qu, China: Faster reform, slower growth, 19 June 2013). However, our mediumterm view remains positive. In our view, China has significant infrastructure yet to build in the medium term, which should support medium-term demand for commodities (see Hongbin Qu, China Inside Out: Yes, China still needs infrastructure, 5 October 2012). The infrastructure story also extends beyond China to across the Asian region. Countries where there is significant infrastructure yet to be built include India, Indonesia and the Philippines (see Ronald Man, Bridging the gap, 20 May 2013). While China is approaching similar levels of per capita steel consumption as the West, India, for example, has barely started (Chart 29).

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29. Steel consumption ramp-up in India is yet to come

The LNG outlook is also more stable as all seven LNG projects currently under construction have forward sold LNG on long-term contracts to various Asian nations.

Commodity supply
Another risk for Australia is that the significant global investment in the resources sector in recent years leads to a glut of supply, which puts downward pressure on commodity prices. Our central view remains that there is only enough supply of commodities due to come online to meet demand at prices that are well above their 1980s and 1990s levels (see Commodities and the global economy: Are current high prices the new normal?, 8 August 2012). But there is a risk that more supply comes online and suppresses prices. While this is a credible risk, it is important to keep in mind that Australia is a low-cost producer of a broad range of commodities. As such, in many cases Australia would continue to export rising quantities of commodities, even if the prices were lower than expected. For iron ore, which is Australias largest commodity export, the large producers are very low on the global cost curve (Chart 31). The same applies for many of the large coal producers, although not all.
31. Australian iron ore at the low end of the cost curve
R e a l (2 0 1 0 ) C a s h C o s t s (U S D /t ) 140 120 100 80 60 40 20 0 0 600 1,200 1,800 Vale Rio BHP Chinese producers

Source: RBA

Importantly, much of Australias recent investment has been in capacity to produce LNG, and thus energy. Over three-quarters of the resources investment boom in Australia has been in capacity to produce LNG. Australia is therefore set to become a large global energy producer. The prospects for energy demand are promising, with a number of Asian developing economies still at very low levels of per capita energy consumption. Chinas energy consumption is still at low levels relative to developed economies and India is at very low levels (Chart 30). Japan is also in the process of substituting nuclear power generation, having shut down 48 of its 50 nuclear power plants following the March 2011 nuclear disaster at Fukushima.
30. Energy consumption is still low in China and India

Cumulative Costed Production by Company

Source: AME, HSBC estimates

Source: RBA

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US shale gas
For LNG, a significant possible threat to supply is from US shale gas. However, as we noted above, the LNG story should be more stable than other commodities as the product is forward sold on long-term contracts. Australias domestic economy is also somewhat protected by the high foreign involvement in the mining industry. Australias mining sector is 80% foreign-owned and the concentration of foreign involvement in the LNG sector is even more highly concentrated. Australias seven major LNG projects are being built by consortia of global multinationals, including Chevron, Exxon, Mobil, Shell and Conoco-Phillips. When the resources boom was ramping up, the leakage of demand offshore was a source of local angst, as it meant less support for local demand. Likewise, as the mining story slows, foreign involvement should be a source of some comfort, as it has a risk-sharing effect.

probability of a recession in any one year is around 20% of course this means that there is an 80% chance of no recession in any year.
32. Australia has had six technical recessions in 52 years

Source: ABS, HSBC

Risk of recession is low

Some commentators have started to note that as the mining investment boom comes to an end, the risk of a recession in Australia is increasing. Even the newly appointed Prime Minister Rudd and his Treasurer Bowen are noting risks of a recession, which is a significant shift in rhetoric from that of the previous leadership who were more upbeat about economic prospects. While a recession can never be completely ruled out, we remain of the view that a recession is unlikely in the next couple of years. A starting point for making an assessment about the probability of recession is to look at Australias history. In the past 52 years, Australia has had ten years when it was in a technical recession a period, which begins with two consecutive quarterly falls in GDP (Chart 32). Using this historical experience implies that the

Importantly, we dont see the chances of a recession as significantly higher than normal. To see a much greater chance than normal means arguing that there are significant imbalances that need to correct which, as we have argued above, we do not see. Or, that there are reasons to think that policymakers would be unable to respond effectively to a downturn which also seems unlikely in Australias case. As we have noted above, the RBA has room to move on interest rates if required and the exchange rate could depreciate further to act as a shock absorber against negative foreign shocks. The governments relatively strong balance sheet also offers a line of defence for the economy. Net public debt is low, particularly in comparison to other advanced economies around the world (Chart 33). At the same time, the government remains on a path of consolidation and the fiscal deficit is relatively small (-1.3% of GDP). The government could provide support for growth with fiscal stimulus if necessary.

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33. Public debt is very low, so fiscal policy has room to move

Challenges for policymakers

Managing a smooth end to the mining investment boom is the key challenge facing Australian policymakers. This would have been made easier if more had been done earlier, when commodity prices were rising. In particular, it is disappointing that Australias government budget remains in a structural surplus despite recent years of strong nominal GDP growth on the back of rising commodity prices. Policymakers are considered to have failed to take full advantage of the mining boom in terms of improving Australias fiscal position (though, as we noted above, government debt is still low by global standards). The kick the economy got from rising commodity prices has discouraged a hard look by policymakers at productivity-enhancing reforms. Indeed, there has been little progress made in productivity-enhancing reforms, which can be thought of as another form of saving or institutional investment. Both of these were key risks that we were concerned about when asked whether Australia had a resources curse (Does Australia have a resources curse? The challenges of managing a mining boom, 18 August 2011). For businesses, recent political developments have also made the tax and regulatory environment uncertain, which is likely to be a drag on confidence. The current government has had a minority in the lower house, which has limited its capacity to legislate. A recent change of leadership of the current government and the forthcoming federal election, which is required to occur before 30 November 2013, may have added to local political uncertainty.

Source: IMF

Of course, a recession can never be completely ruled out. A recession can occur if there is a significant downside surprise, which happens quickly and catches policymakers off guard. The speed of adjustment matters a great deal. This is one of the reasons why we do not expect the end of the mining investment boom to cause a recession because it is widely forecast to occur, which means markets and policymakers have time to respond. The likely driver of a recession would be a negative surprise from abroad probably a sharper-than-expected downturn in Asia. Of course, a downside surprise from abroad would also motivate a response from overseas policymakers. In Chinas case, our Chief China economist remains of the view that China is highly unlikely to have a hard landing because Chinese authorities still have plenty of ammunition to shore up the countrys economy if needed. In particular, he notes that China has a fiscal surplus that has totalled RMB960bn in the first five months, leaving Chinas fiscal accounts in a healthy position. He sees the risk that GDP growth falls below 7% as remote (Hongbin Qu, China Inside Out: Will the cash crunch lead to a hard landing?, 26 June 2013).

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Given low levels of government debt and a fairly flexible economy, these issues are not expected to be too detrimental to Australias growth prospects though it is fair to say Australias does face some structural issues that should have been dealt with when incomes were growing strongly. In the short run, we believe Australias major economic challenge is a lack of confidence. Australias great rebalancing relies on businesses outside of the mining sector and households being confident enough to make investments and spend, and non-mining businesses confident enough to hire. Despite already low interest rates, confidence has remained surprisingly subdued in the first half of 2013. There have been a number of reasons for this, including the mining slowdown, worries about growth in China, the high level the AUD maintained until recently, and local political issues leading to policy uncertainty. With limited help from other policymakers, the central bank is left with the bulk of the burden of managing the transition from mining investment-led growth to growth supported by the non-mining sectors. To manage this, the RBA has already cut its cash rate to its lowest level in 53 years to support rebalancing, but until recently the high AUD was keeping financial conditions tight, despite the rate cuts. The recent fall in the AUD will help support Australias great rebalancing. The falling AUD is also an upside risk to inflation, though at this stage it is largely offset by a loose labour market, which is continuing to put downward pressure on local wages growth. The next move in interest rates is highly dependent on where the AUD settles. Current market pricing suggests another cut is likely in coming months.

For other arms of policy, we believe the focus ought to be on lifting Australias productivity growth, which has been weak recently. Tax and regulatory reform ought to be high on the policymakers agenda and be a key part of the discussion in the lead-up to this years election. Infrastructure is also a key issue as congestion is acting as a key constraint on Australias productivity growth.

Australias R-word
In our view, Australias R-word is rebalancing, not recession. Given our outlook for the global economy and Asia in particular, and Australias current policy settings, a rebalancing of Australias growth is far more likely than a recession. Asias infrastructure build-out has many years to run yet and its energy demand is still low and set to rise rapidly. We remain cautiously optimistic about our outlook for the Australian economy for three key reasons. First, despite a slowdown in Asia, Asian economies are still expected to be the fastest-growing economies in the world and Australias strongest ties are to Asia. Second, Australias mining story is slowing down, not collapsing, with the ramp-up in resources exports yet to come. Finally, Australias interest rates and currency are both now supportive of a rebalancing of Australias growth; and, in our view, Australias economy does not have obvious structural imbalances that constrain its ability for growth to rebalance. We expect a period of below-trend growth in 2013, but for growth to head towards trend in 2014. We believe the RBA may need to deliver further stimulus to support growth, but it is also possible that the AUD depreciates sufficiently to obviate the need for further rate cuts.

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Forecast table
HSBCs forecasts for Australia _______ Year-average _______ 2012 2013 2014 %* AUSTRALIA GDP Consumption Govt consumption Investment - Dwelling - Business - Public Final domestic demand Domestic demand Exports Imports GDP (% quarter sa) CPI** Trimmed mean** Unemployment rate Labour price index Current A/C (%GDP) Terms of trade Budget balance (%GDP) Capital city house prices Private sector credit USD/AUD (end period) 90 day bank bill rate Cash rate (end period) __________________________Year-ended___________________________ Q113 Q213e Q313e Q413e Q114e Q214e Q314e

3.6 3.3 3.1 8.7 -3.8 16.5 0.7 4.7 4.7 6.0 6.4 -1.8 2.3 5.2 3.6 -3.9 -10.4 -3.0 -0.7 3.8 1.04 3.19 3.00

2.5 2.2 0.6 -0.3 5.0 -0.2 -4.3 1.2 0.7 7.6 -0.3 -2.4 2.3 5.5 3.2 -2.4 -2.9 -1.5 4.9 3.8 0.90 2.80 2.50

2.8 2.9 2.1 3.0 9.4 -0.6 9.8 2.8 2.8 6.6 7.0 -3.0 2.8 5.4 3.5 -2.5 -0.9 -1.0 5.9 6.6 0.86 3.30 3.00

2.5 2.0 0.5 0.9 2.7 2.3 -5.8 1.1 0.3 8.1 -3.2 0.6 2.5 2.2 5.5 3.2 -2.2 -6.2 -2.6 3.2 1.04 3.30 3.00

2.6 1.9 -0.5 1.5 5.6 1.4 -2.0 0.6 0.4 8.0 -1.3 0.7 2.7 2.2 5.5 3.0 -2.4 -6.1 -4.2 3.2 0.96 3.05 2.75

2.5 2.3 0.8 0.6 5.6 -1.6 4.2 1.3 0.6 8.4 1.0 0.7 1.9 2.3 5.5 3.1 -2.5 -0.8 -6.7 3.9 0.94 2.80 2.50

2.7 2.6 1.8 -2.9 6.1 -2.5 -11.9 1.9 1.6 6.1 2.2 0.7 2.6 2.3 5.5 3.2 -2.4 2.1 -6.2 4.9 0.90 2.80 2.50

2.9 2.8 1.8 3.8 8.7 1.6 7.2 2.9 3.0 6.5 7.4 0.8 2.9 2.6 5.4 3.3 -2.4 -0.4 -7.3 6.1 0.89 2.80 2.50

2.9 2.9 2.1 3.7 10.2 0.1 10.4 3.0 3.0 6.1 7.0 0.7 2.9 2.8 5.4 3.4 -2.4 0.0 6.2 6.8 0.88 2.80 2.50

2.8 3.0 2.2 2.6 10.3 -1.8 11.5 2.7 2.7 6.7 6.8 0.6 3.1 2.8 5.3 3.5 -2.6 -1.0 5.2 6.8 0.87 3.05 2.75

Source: ABS, RBA, HSBC forecasts *unless otherwise specified **includes the effect of the carbon tax from Q312

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Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Paul Bloxham and Adam Richardson

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Additional disclosures
1 2 3 This report is dated as at 10 July 2013. All market data included in this report are dated as at close 09 July 2013, unless otherwise indicated in the report. HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner.

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Disclaimer
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Global Economics Research Team

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