Economy in good shape to ride out commodity price downturn

The importance of the business investment cycle to Western Australia’s economy cannot be stressed highly enough.

Although business investment directly accounts for about 17 per cent of state final demand over time, it can range between as low as 13 per cent when investment is in the doldrums (as it was as recently as the early part of this decade) and as high as 22 per cent when business investment is booming, as it was in the late 1990s (not coincidentally, just before the most recent bust).

Moreover, it is not unusual for business investment to account for more than half the growth in WA’s SFD, or alternatively to strip three percentage points or more from real growth in the local economy’s bottom line.

Business investment accounts for about 11 per cent of the rest of Australia’s domestic final demand, so is of far less direct importance to most other states’ economies.

It is no coincidence that household consumption, which accounts for around 60 per cent of GDP nationally, was sluggish in WA relative to other states when business investment was last in a cyclical downturn.

It also is no coincidence that booming growth in the high-wage jobs that go with strong growth in business investment in turn is now underpinning strong growth in consumption in WA relative to the rest of the nation.

Nevertheless, even in booming WA, growth in household consumption will not return to the heady days of 2003 and last year – the RBA would not allow that to happen.

As reparation of household balance sheets continues, more so in other states but WA as well, employment and income growth, rather than extraction of equity locked up in the family home, will drive consumption.

WA’s export oriented, capital intensive economy derived, and continues to accrue, disproportionately significant benefits from low and stable long-term interest rates (in turn because so too is inflation low and stable) and a competitive exchange rate.

Sure, the Australian dollar has recently overshot rural commodity prices, but it has not followed non-rural commodity prices to their record highs, even when you look at the base metals component of the RBA’s index of commodity prices, which excludes coal and iron ore, both of which enjoyed massive price rises earlier this year.

The viability of the big-ticket resources projects that dominate WA’s business investment would inevitably be compromised either by a sharp appreciation in the Australian dollar – for instance if the US dollar resumes its slide, and/or if longer-dated bond yields rise sharply. The latter is also most likely to be sourced out of the US if bond yields rise sharply over there. The US bond market has threatened several times to incur a major bout of sustained selling (ie higher yields) but the absence of anything more than a modest up-tick in key measures of inflation have limited the extent of any damage so far.

But it is still a risk that overhangs global financial markets nevertheless, particularly while the oil price continues to hover in the $US60-$70 range.

As a major net energy exporter, WA’s economy is better placed to withstand a downturn in the general commodity price cycle than when iron ore, gold, nickel and alumina collectively dominated the profile of mineral production.

Nevertheless, to the extent – and it clearly is significant – that China is the major reason why most industrial commodity prices and the oil price are high at the same time. Then not even WA’s booming oil and gas sector will be able to prevent a sharp slowing in the state’s broader economic growth if China literally chokes on the pollution caused by its rampant industrialisation.

Maybe India will fill the void if and when China slows markedly, perhaps during its eventual transition to what will surely one day be the world’s biggest consumer market.

Robust business investment and accelerating population growth are doing no harm to WA’s now booming housing market, which lagged most other states until last year, but now is roaring ahead despite supply bottlenecks.

As long as business investment remains strong, the next downturn in the dwelling construction cycle is some way off, and will then only be mild – but it is still, and always will be, a highly cyclical industry.

WA’s housing market would probably take even another 50 basis points of cash rate increases in its stride, but the overstretched eastern seaboard markets would struggle to withstand even one more tightening of monetary policy. So one of the rest of Australia’s points of vulnerability is working in favour of the WA housing market.

The RBA is well aware of the risk of raising the cash rate once too often too soon, so unless actual, as opposed to prospective, inflation breaks higher by the end of this year, the central bank should be in no hurry to look to a higher cash rate.

Nevertheless, there is a more than negligible risk of at least a modest acceleration in key measures of inflation (including wages growth), so a bit more tweaking of monetary policy cannot be ruled out.

Despite a multitude of potential risks to the durability of the global economy in 2006, they are just that – risks that would probably have far reaching (and damaging) consequences for the WA economy if one or more were to crystallise.

But the probability of that occurring has not been deemed high enough thus far to stop business investment in its tracks, and neither should it be.

WA’s SFD is still growing at an annual clip of around 5 per cent, but in the context of mature business and dwelling investment cycles, even a slowing to around 4 per cent would still be considered a solid outcome that would be expected to generate robust employment and aggregate income growth. • Alan Langford is chief economist at BankWest.