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Global Research

Macro Australian Economics

Downunder digest
Australias powerful policy tools
Australias structural story remains intact, with the baked in mining investment boom supporting growth this year But a cyclical global downturn is now in progress and Australia is not entirely immune Unlike other developed nations, however, conventional policy tools will be effective in supporting the Oz economy

Conventional policy will work

Few developed nations can currently claim that conventional policy tools are still effective in responding to a cyclical downturn. Interest rates are close to zero in the US and Japan and heading in that direction in Europe. Fiscal policy has also reached the end of its useful capacity, with fiscal retrenchment now required across the developed world. Tellingly, HSBCs recent global economic outlook described the government debt situation as the arithmetic of doom (When the wheels fall off, 21 December 2011). Indeed, with interest rates at such low levels, monetary and fiscal policies start to seem like the same thing. If the government cant spend, via issuing bonds, the central bank is left to buy bonds. Unconventional policies, such as QE, are the remaining policy levers. Not so in Australia. Unlike many developed economies, which are sailing in uncharted waters, Australia is still in a place it has been before: with the cash rate at 4.25%, budget deficit of 2.5% of GDP (in 2011/12) and net public debt of around 9% of GDP. As a result, Australias conventional policy options are still available. And the tools at policymakers disposal are powerful, particularly the lever at the hands of the RBA. We expect the rate cuts from late last year, and further cuts in early 2012, will see a mild rebalancing of growth in 2012. Remember, the weakest sectors have been the interest-rate sensitive ones housing and retail sales. We expect these sectors to stabilise in 2012. With the government planning to unwind its fiscal deficit in 2012/13 by the largest amount in over 40 years (a 2.6ppts contraction of GDP) there is significant scope for fiscal slippage despite political resistance. Plus, low levels of government debt leave scope for an emergency fiscal package if the economy were to slow a lot more than expected. Then theres the exchange rate. The AUD typically acts as a significant shock absorber for the economy both on the way up and down. However, with Australia retaining a strong sovereign rating and Aussie bonds in high demand, it does beg the question as to whether the AUD would help out as much in a global emergency, as it has done in the past.

13 January 2012
Paul Bloxham Chief Economist HSBC Bank Australia Limited +612 9255 2635 paulbloxham@hsbc.com.au Luke Hartigan Economist HSBC Bank Australia Limited +612 9084 2993 lukehartigan@hsbc.com.au 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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Rate cuts will support interest-sensitive industries

The structural story for Australia is a strong one, and is well known. The mining investment boom is largely baked in and is expected to contribute two-thirds of GDP growth in 2012. But a global cyclical downturn is in progress and Australia is not immune. Importantly, however, a number of the weaker sectors of the economy are also the ones that are most interest-rate sensitive. And rates are coming down. Indeed, the RBAs cash rate is a powerful tool. This stems from the fact that over 85% of all mortgages are at variable rates. The potency of Australian monetary policy was on awesome display after the Lehman failure, in late 2008/early 2009. The RBA cut the cash rate by 425bps in seven months and gave back 5ppts of disposable income to households in that short period. And while some may argue that not all of the rate cuts may be passed on by the banks as they face increased funding costs the RBA sets policy based on effective rates, not the cash rate itself, so monetary policy will work. With household debt at 150% of disposable income and interest payments 11.5% of income, the 50bps of cuts, so far, have boosted incomes by around 0.75ppts. Another 50bps cut (as we expect) sees a total boost of 1.5ppts. Measuring the impact of rate changes on an economy is tricky. Most models suffer from what econometricians call endogenity (in short, its hard to isolate the effect on the economy of rate changes from other effects). Approaches for dealing with this vary and none are foolproof. The most popular is an empirical technique called a Structural Vector Autoregressive model (SVAR), which looks at correlations between variables, allowing the user to assess the impact of changes in one variable on others. Guided by a published RBA SVAR model we estimate that a 100bp cut to rates would boost GDP by around 0.9ppts over 18 months. At the sector level, changes in rates have a noticeable effect on housing and a consumer spending. We estimate that a 100bps cut would boost housing construction activity by around 9ppts and consumption by 0.5ppts over 18 months. The impact of rate cuts on consumption is greater for durable goods, so this could support retail sales, which have a greater durable component. This is a powerful tool that can be used to support the economy. Of course, the fact that the cash rate is still at 4.25% means there is plenty of room to move if needed. Also working in Australias favour is that households have already done significant balance sheet repair, with the saving rate around a 20-year high for the past three years. Lower rates will encourage less saving, and thus a boost to household spending.

1. Interest payments are a significant share of income

2. Modelling shows rates are an potent tool

Measures of Household Finances

Percent of disposable income
% % %

Responses to 100 bp Cut in Cash Rate

Impact after 6 quarters
8.7 8 6 4

12

150 Interest expense (LHS)

10

120

90 Household debt (RHS) 2 60 0 0.9 0.5 Household Consumption Dwelling investment

4
90 92 94 96 99 01 03 05 08 10 90 93 95 97 99 02 04 06 08 11

30

GDP (expenditure)
Source: ABS; RBA; HSBC estimates

Source: RBA

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3. The housing market is a key beneficiary of lower rates

4. household consumption also gets a boost

Dwelling Approvals & Interest Rate Changes

Year-ended change
% Dwelling approvals (LHS)
40 -40 -80 %

Consumption & Debt Servicing Interest Costs

Year-ended change
12 % 10 8 6 4 Consumption (LHS, nominal) -160 -140 -120 -100 -80 -60 Interest costs (RHS, inverted, shifted 6 quarters) % -40 -20 0 20

2 0 -2

-40

Official cash rate (inverted, RHS) shifted 6 months

40

-4 -6

-80 80 1993 1995 1997 1998 2000 2002 2004 2006 2008 2009 2011

-8 40 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
Source: ABS; RBA

Source: ABS; RBA

Fiscal policy room to move

The government current plans suggest a return to budget surplus by 2012/13. This will require a significant amount of heavy lifting this year, with a fiscal unwind that would subtract 2.6ppts from GDP in 2012/13 needed. This would be the largest fiscal contraction in a single year in at least 40 years. This quite ambitious plan for fiscal unwind has helped to protect Australias very strong sovereign debt position and is likely to be (at least implicitly) supporting the availability of international funds to local banks (albeit the cost of these funds has risen). Importantly, however, slippage in the plans to return to budget surplus is a key risk, particularly if global growth were weaker than currently expected. On the flip side of this argument, however, there is still room for the fiscal position to provide more support for the economy if needed this year, and still head back to surplus somewhere down the track. Low levels of government debt also allow significant scope for emergency support if required.

AUD shock absorber

Finally, the exchange rate is a key part of the Australian economic armoury. A depreciation of around 30% on a trade-weighted (TWI) basis during the Lehman episode provided significant support for the

5. Government is forecasting a large fiscal unwind

Fiscal Policy Stance
Percentage of nominal GDP % 3 2 1 0 -1 -2 -3 -4
Contractionary Expansionary
F/C

6. Government debt is very low by world standards

General Government Gross Debt

Percent of GDP
% 3 2 1 0 -1 -2 -3

% 250

European Countires

Other Advanced Countires

%
250

"Fiscal Impulse"

Greece 200 150 100 50 Ireland 0 90 94 98 02 06 10 14 91 95 99

Japan
200 150

France Germany

Italy

US
100

Underlying cash balance

-4 -5

UK Spain Australia

50 0

-5 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011

03

07

11

15

Source: Australian Treasury

Source: IMF

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economy in the early period of the global financial crisis. In fact, our modelling suggests a modest 10% depreciation of the real TWI boosts the economy by 0.1-0.2ppts over two quarters. A key risk this year is that the exchange rate might behave differently. The global search for lower risk assets, and their limited supply, has seen high demand for AAA-rated assets, supporting the AUD. In the face of a larger global slowdown, a concern for Australian policymakers may be that the AUD might not depreciate as much as previously, and thus might provide less support. However, some of this could be offset by lower RBA rates than otherwise, which would close the interest rate differential and may see further depreciation. At some point this argument is somewhat circular, though it is fair to say that the AUD may not provide as much protection as in the past. Our currency strategists are forecasting that the AUD drifts down to 95 cents by end 2012, which is still well above the AUD/USD post-float average of around 75 cents.

Bottom line
A number of the sectors of the economy that were weakest in 2011 are highly interest-rate sensitive, so they can be pump-primed using monetary policy in the face of the impact of the global downturn. Our central case is that conditions in these industries including housing and retail improve in 2012 in response to rate cuts. There still remains significant scope for fiscal support albeit not as much as in 2008/09 and the exchange rate would provide a buffer if growth was weaker than expected (although there is some risk that the AUD may be stickier than in the past due to demand for triple AAA rated Australian bonds).

Appendix how the model works

Following Lawson and Rees (2008) we estimate a structural vector autoregressive (SVAR) model of the Australian economy using their identifying restrictions as a guide (see restriction matrices below). We focus on the following variables: An index representing GDP for Australias major trading partners weighted by export share (MTP), the RBAs commodity price index (AUD terms, RCOM), Real GDP (seasonally adjusted, GDP), real Household consumption (seasonally adjusted, CON), real Dwelling investment (seasonally adjusted, DWELL), Trimmed Mean CPI (), Official Cash rate (quarter average, OCR) and the real Trade weighted index published by the RBA (RTWI). All data are quarterly and enter in logs besides Trimmed Mean CPI and the Official cash rate which are in percentage points. SVAR (1) includes GDP, while SVAR (2 & 3) include GDP less V (CON or DWELL).

Identifying restrictions for SVAR (1)

Identifying restrictions SVAR (2 & 3)

1 b 2 ,1 b3,1 BX t = 0 0 b6 ,1

0 1 b3 , 2 b4 , 2 b5 , 2 b6 , 2

0 0 1 b 4, 3 0 b 6, 3

0 0 0 1 0 b6, 4

0 0 0 0 1 b6 , 5

0 MTPt 0 RCOM t 0 GDPt 0 t b5, 6 OCRt 1 RTWI t

1 b 2 ,1 b3,1 BX t = b 4 ,1 0 b 6,1 b 7 ,1

0 1 b3, 2 b4, 2 b5, 2 b6, 2 b7, 2

0 0 1 0 b5 , 3 0 b7 , 3

0 0 0 1 b5 , 4 0 b7 , 4

0 0 0 0 1 0 b7 , 5

0 0 0 0 0 1 b7 , 6

0 MTPt 0 RCOM t 0 GDPt Vt 0 Vt t 0 b6 ,7 OCRt 1 RTWI t

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1. HSBC's forecasts for Australia and New Zealand _______ Year-average ________ 2011e 2012e 2013e %* 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 Cash rate (end period) NEW ZEALAND GDP Consumption Govt consumption Investment Final domestic demand Domestic demand Exports Imports GDP (% quarter sa) CPI Unemployment rate Labour price index Current A/C (%GDP) Cash rate (end period) ___________________________Year-ended ____________________________ Q311 Q411e Q112e Q212e Q312e Q412e Q113e

2.0 3.5 1.6 6.8 -1.6 16.0 -7.4 4.0 4.3 -1.5 11.4 3.6 2.4 5.1 3.7 -2.2 14.2 4.25

3.4 2.7 1.9 9.2 1.0 17.1 -6.7 4.3 4.1 10.3 12.8 3.1 2.6 5.4 3.4 -3.9 -6.5 3.75

3.5 2.6 2.8 6.9 6.1 8.5 1.5 3.9 3.9 10.6 10.8 3.2 2.8 5.1 3.6 -4.8 -4.8 4.25

2.5 3.8 0.9 9.2 -2.9 21.9 -10.2 4.6 4.7 0.8 13.8 1.0 3.5 2.4 5.2 3.6 -1.6 13.2 4.75

2.6 3.7 1.0 9.6 -1.1 21.3 -9.6 4.8 4.4 1.1 13.3 0.9 3.7 2.5 5.3 3.4 -2.2 8.8 4.25

4.0 3.4 1.1 9.1 -0.4 19.6 -10.0 4.5 4.4 10.4 13.9 0.6 2.8 2.4 5.4 3.3 -3.1 1.1 3.75

3.3 2.8 0.8 11.9 0.5 23.7 -9.4 4.9 4.0 9.9 13.4 0.7 2.6 2.3 5.5 3.3 -3.8 -6.8 3.75

3.2 2.2 2.7 7.8 1.2 13.3 -3.5 3.8 3.8 10.5 12.0 0.9 3.4 2.7 5.4 3.4 -3.0 -10.5 3.75

3.3 2.3 2.8 7.9 2.9 12.9 -3.5 4.0 4.0 10.3 12.0 1.0 3.6 2.8 5.3 3.5 -3.3 -9.1 3.75

3.5 2.4 2.8 7.7 5.2 10.9 -1.0 4.0 4.0 10.6 11.5 0.8 3.6 2.8 5.2 3.6 -3.3 -6.6 4.00

2.0 2.2 2.3 3.5 2.5 2.3 2.1 6.0 4.3 6.5 1.9 -2.8 2.50

2.8 2.1 2.6 10.2 4.0 4.2 2.8 6.6 2.7 6.0 2.7 -5.5 3.00

3.3 2.1 2.8 11.0 4.3 4.3 5.7 8.3 3.0 5.5 3.2 -4.8 4.00

2.4 2.6 2.5 3.8 2.8 2.2 3.3 6.8 0.8 4.6 6.6 2.0 -3.7 2.50

2.3 2.6 1.8 0.9 2.1 0.9 1.8 1.3 0.6 2.8 6.3 2.1 -5.6 2.50

2.0 2.2 2.0 5.6 3.0 3.7 1.6 5.9 0.6 2.7 6.2 2.3 -5.5 2.50

2.9 2.4 2.8 10.1 4.2 4.2 2.7 6.0 0.9 2.5 6.1 2.6 -5.1 2.50

3.0 1.9 2.8 11.9 4.3 4.3 2.9 6.8 0.9 2.7 5.9 2.8 -5.6 2.75

3.3 1.9 2.8 13.1 4.6 4.6 3.9 7.6 0.9 2.9 5.7 3.0 -5.8 3.00

3.5 2.6 2.8 2.0 4.7 4.6 1.5 2.0 0.8 2.9 5.6 3.1 -5.6 3.25

Source: ABS; HSBC forecasts; RBA *unless otherwise specified

Reference

Lawson, J. and D. Rees. (2008) A sectoral model of the Australian economy, Reserve Bank of Australia Research Discussion Paper 2008-01

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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 Luke Hartigan

Important Disclosures
This document has been prepared and is being distributed by the Research Department of HSBC and is intended solely for the clients of HSBC and is not for publication to other persons, whether through the press or by other means. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other investment products mentioned in it and/or to participate in any trading strategy. Advice in this document is general and should not be construed as personal advice, given it has been prepared without taking account of the objectives, financial situation or needs of any particular investor. Accordingly, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to their objectives, financial situation and needs. If necessary, seek professional investment and tax advice. Certain investment products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. Investors should consult with their HSBC representative regarding the suitability of the investment products mentioned in this document and take into account their specific investment objectives, financial situation or particular needs before making a commitment to purchase investment products. The value of and the income produced by the investment products mentioned in this document may fluctuate, so that an investor may get back less than originally invested. Certain high-volatility investments can be subject to sudden and large falls in value that could equal or exceed the amount invested. Value and income from investment products may be adversely affected by exchange rates, interest rates, or other factors. Past performance of a particular investment product is not indicative of future results. Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues. For disclosures in respect of any company mentioned in this report, please see the most recently published report on that company available at www.hsbcnet.com/research. * HSBC Legal Entities are listed in the Disclaimer below.

Additional disclosures
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