Regional Focus

Australia’s economy faces unique challenges ahead

Published: Oct 2022

With a tight labour market and rising inflation, Australia faces similar economic challenges to the rest of the world. In other respects, however, the country is unique – particularly with its relationship to China.

View of Sydney, Australia

Australia, like the rest of the world, has bounced back from the pandemic and is now facing rising inflation and a need to rein it in – and also avoid a recession. The issues are similar to many other markets around the world, and Australia faces higher inflation, rising interest rates and a harder time for households. This also comes as uncertainty looms over the country’s relationship with China, and how this will impact companies and households.

There are reasons to be optimistic, however, as Australia’s inflation figures have so far not been near the level of other countries. Sarah Hunter, Senior Economist and Partner, Deals Tax and Legal at KPMG, expects the coming months to be difficult for the Australian economy, but not as bad as other markets where recession has been predicted. “I do not expect there to be a recession,” she says of the outlook for Australia. “Slower growth, definitely – but not a recession.”

Hunter comments the challenges that Australia is currently facing are the same as many other developed countries, such as rising fuel prices and supply chain disruptions. “There is a lot of commonality with other countries,” she says.

Also, Australia has experienced – like many other countries around the world – a strong economic recovery after the pandemic. The Australian government supported households and businesses through the lockdowns with social assistance programmes such as JobKeeper and Boosting Cash Flow. Data from the Australian Bureau of Statistics notes that three major strains of COVID-19 had a significant impact on the economy, with discretionary spending being the most impacted. Discretionary services declined as people were unable to go out but spending on discretionary goods increased as people stayed home and shopped online.

Hunter comments that the public health response to the pandemic in Australia was effective. And, despite the severity of the lockdowns, the country has been able to emerge without significant outbreaks of COVID-19. “That public health response appears to be paying dividends” and this includes employment returning to pre-COVID-19 levels.

Now, however, Australia – like many other countries – is experiencing a tight labour market and the unemployment rate is at its lowest level since the 1970s, says Hunter. This tightness is in part due to low levels of immigration as a consequence of the pandemic. Workers were unable to travel to Australia and many of those already in Australia returned home during the pandemic. “That added tension to the labour market,” says Hunter.

Saul Eslake, Economist and Founder of Corinna Economic Advisory, comments that Australia’s inflation rate is lower than other Anglo-Saxon countries. At the time of writing, it was hovering just above 6%, while for other countries – such as the UK – it was around 10%. One difference with Australia, Eslake notes, “Wages have not made any material contribution to the acceleration in inflation.” In the US and UK, for example, wages have been rising at their fastest rate since the 1980s. And in New Zealand, they have been rising at their fastest rate since the 1990s. Anecdotally, however, Eslake is hearing that the wage growth will move up in Australia. One reason, explains Eslake, that the wages haven’t moved up so far is because there is a delay in the bargaining system for wage increases.

Also, the lack of migration has had an impact. “Employers who have come to rely on migrants have been holding out for a resumption of migration when borders reopened,” says Eslake. Australia had some of the tightest borders in the world during COVID-19, and many companies have been waiting for migration to return to pre-pandemic levels as an alternative to paying higher wages. This has been putting pressure on the economy, and also a squeeze on the tight labour market.

Australia’s immigration at net levels is not noteworthy compared to other countries, but as a proportion of its overall population it is. According to the Australian Bureau of Statistics, to the year ending June 2020, there were over 7.6 million migrants living in Australia. In the same period, the country’s population increased by 194,400 people due to net overseas migration. Perhaps what makes Australia unique, though, is that 29.8% of its population was born overseas. This, notes Eslake, means that Australia has the highest proportion of foreign-born people in the world, after Israel.

One issue, with this type of population growth, says Eslake, is that Australia has avoided focusing on training and education as much as it would have done if it was not relying on immigration. That discrepancy has been exposed, however, in the post-COVID-19 world.

Australia is unique in other respects. Eslake explains: “Unusually, for an advanced economy, it is an exporter of commodities and an importer of manufactured goods,” he explains. And this makes it unique in terms of the trading relations it has with other countries.

Australia’s relationship with China is a major contributor to its economy and has been troubled in recent years. Unlike other countries which may have been threatened by the rapid industrialisation of China – because their manufacturing industries lost out to China’s competition – Australia derived an enormous economic benefit because of its commodities exports. This has meant that Australia has become heavily dependent on China, Eslake says, and has not been dependent on another country in this way since the 1950s when Australia referred to Britain as the ‘mother country’.

According to figures from the Reserve Bank of Australia, 36.5% of Australia’s exports go to China, which far outweighs the relationship it has with other countries. Japan comes in second, accounting for 10.4% of Australia’s exports, then the United States with 6.2%, South Korea with 5.6%, India at 3.9% and the EU at 3.8%. The bulk of these exports are resources (68.7%), followed by agriculture (11.3%), services (9.8%) and manufacturing (7.6%).

The dependence of Australia’s economy on China has come to the fore since 2020 when diplomatic relations began to unravel. Geoff Raby, a former Australian ambassador to China, writing for a GLG, puts the relationship between the two sides in a broader context. He points to wider structural forces at play and how Australia shifted its view of China. He describes this as a shift from a position of strategic cooperation to one of competition. And more broadly, Australia chose to strongly align its geopolitical and strategic policies with the United States.

Australia-China relations began to deteriorate when Australia banned the Chinese technology company Huawei from being a provider on its 5G network, citing national security concerns. Australia further enraged China by demanding an investigation into the origins of the pandemic and China’s responsibility. China responded with trade penalties, including tariffs on wine and a ban on importing coal from Australia.

In recent months, there have been signs the relationship between the two countries is improving, but there are still many issues that need to be resolved.

“There are still uncertainties,” with the Australia-China relations, says Weihuan Zhou, Associate Professor in Law and Justice at the University of New South Wales. He explains there was a window of opportunity with Australia’s new prime minister and government. And there were signs of improvement when the two foreign ministers met, for example, which was a significant development as there had not been any diplomatic connection for more than two years, explains Zhou. But the situation in Taiwan has cast uncertainties over the current state of the relationship.

Australia is in the unique position of relying on the United States for its security but being economically dependent on China. With Taiwan, Australia could find itself stuck in the middle between two superpowers, but this situation is no different from its role in other political issues between US and China in the Asia Pacific region, notes Zhou.

Australia needs to ally itself with the United States for its security, but as yet, it has not been able to decouple its political and security interests from its economic interests. “As yet, there are no concrete policies that actually do this,” says Zhou.

He notes that at the beginning of the trade tensions in 2020, there were calls for Australia to take a more diplomatic approach that would balance its security interests (with the US) and its economic interest (with China). “We have not seen an immediate and clear policy that could achieve that balance,” says Zhou.

The disagreements centre on a few fundamental issues, says Zhou. The areas of sensitivity, he notes, are typically with high level issues that are of concern for China, such as Taiwan, Hong Kong and human rights.

There have been signs, however, that the frosty relations have been thawing. Dr Jennifer Hsu, Research Fellow, Public Opinion and Foreign Policy Program, Lowy Institute, comments that the change of Australia’s government in May 2022 marked a new point. Li Keqiang, the Premier of the Chinese State Council, for example, sent a note of congratulations when Anthony Alabanese became the Australian prime minister. She notes that the language used by Australia has become less confrontational and there have been a few high-level diplomatic meetings. After meeting with her counterpart in June, Australian Foreign Minister Penny Wong commented that it was a ‘first step’ in stabilising the relationship between the two sides.

Hsu notes that the caveat to expecting a better relationship is the current situation in Taiwan. The tensions in the Taiwan Strait – between the US and China – may be a ‘sticking point’ to whether Australia can get its relations with China back on track. Regarding the outlook for the next year or so, Hsu expects things to improve and there has been ‘chatter’ that the ban on Australian coal may be lifted.

Such easing of trade restrictions will likely have a positive impact on corporates that do business in Australia. As those companies keep an eye on the developing relations at an international level, they will also be paying close attention to matters at home. Interest rates, for example, have started to rise and they are expected to continue this trajectory. Eslake notes the central bank’s raising of interest rates represents Australia’s “most rapidly tightening of monetary policy since 1994.” This, however, he notes is still very low by historical standards. Eslake expects that the cash rate will rise further and will be 2.5% by the end of 2022. Meanwhile the financial markets have been pricing the rate to peak at around 3% or 3.5% in 2023. “That would still be relatively low by historical standards, but households are carrying record debt,” says Eslake. This could in turn impact spending power and have a knock-on effect for companies that primarily sell to consumers, he notes.

Also, Australian companies and the multinational corporations that do business in Australia are likely to be affected by global market conditions. While Australia may not be heading for a recession itself, many other countries will be, which may also have a knock-on effect for Australia.

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