Trade dispute: heading down under

The trade war is arguably the biggest downside risk to the global economy. But the good news is Australia has options to respond. 

"If there is a sharp slowdown in China as a result of the trade dispute, Australia will need to forgo its plans to return the budget to surplus.”

In the event there is a slowdown in global and Chinese growth, the Australian economy will be affected in several ways. The two main effects will be a direct impact on gross domestic product through the terms of trade (with implications for fiscal policy) and a weight on business sentiment.

ANZ Research believes it is likely, if there is a sharp slowdown in China as a result of the trade dispute, Australia will need to forgo its plans to return the budget to surplus in order to proactively support the economy. 

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If the global outlook worsens sharply from the trade war, a swift policy response including fiscal stimulus measures would seem appropriate. Furthermore, if conditions worsen, moves from the Reserve Bank of Australia could play an important role. With the official cash rate already closing on its lower boundaries, quantitative easing looms as a legitimate response.

Even with stimulus, a slowing domestic economy would make it hard for business sentiment to remain optimistic and would depress growth further as investment and hiring fell away.

Over and above

Although there is spare capacity in Australia’s labour market, it is the global backdrop which could hasten the RBA toward significant policy easing - even over and above what the market is already pricing in.

The potential costs to the global economy and Australia will rise as more countries are impacted by the trade dispute. China is vulnerable from the direct impacts of tariffs as well as from deteriorating sentiment around business investment.

China has seen an almost continuous decline in trade as a share of GDP since 2007. Despite that decline, China still has significant exposure to the US, which receives more than 22 per cent of its exports.

US tariffs on China are likely to damage growth. ANZ Research estimates the direct effects of the trade war will shave 0.5 percentage points off China’s GDP.

Globally, this means businesses will hold off on investment which in turn will slow other components like consumption and employment. ANZ Research expects the US-China dispute will continue into 2020 and that China’s economic growth will come under pressure.

Decline

The first impact on Australia’s GDP would come from a decline in national income as exports and foreign investment slow.

During a negative global shock, Australia’s terms of trade typically deteriorates through falling commodity prices. Natural resources make up the largest share of Australia’s exports so commodity prices are a key factor in determining the terms of trade - and by extension, the size of the impact on national income.

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The primary impact on natural resource exports is likely to be on the price side, while volumes will be marginally affected.

Falling commodity prices influence the economy beyond lower mining profits. Sectors that support mining activity, such as construction and business, also see profits and wages growth fall. In a cautious global environment, all trade-exposed sectors (like manufacturing, tourism, education) are likely to feel the effect.

On the other hand, falling commodity prices should see some downward pressure on the Australian dollar, which will help offset that impact. Overall, ANZ Research expects to see most trade-related exports fall, as they did during the global financial crisis when export receipts (excluding resources) fell more than 12 per cent.

ANZ Research believes the current risks to Australian GDP are greater than when commodity prices collapsed between 2013 and 2015. During that period forecast tax receipts were written down by around $A125 billion over five years.

No part of the domestic economy is growing strongly enough to maintain momentum for Australia in a world of deteriorating global conditions that includes China slowing. Altogether, fiscal policy will have to be ready to provide additional stimulus, if needed.

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Reducing government spending to offset some of the decline in revenue is likely to exacerbate the situation, leading to an even larger economic slowdown, particularly given the potential size of reductions in government revenue and spending.

With GDP currently growing only 1.8 per cent a year, absorbing falls in tax revenues is also unlikely to be enough. When this response was used in 2013 to 2015, the economy was stronger, driven by construction and the housing boom.

Now, with relative weakness across most key sectors of the economy, ANZ Research thinks additional discretionary spending would be required in the event of a global negative shock - just such a response helped Australia avoid a recession during the GFC. ANZ Research believes the required discretionary stimulus would be well below the roughly 3 per cent of GDP introduced during this time. 

Sentiment

A decline in business sentiment will also hit the Australian economy if the trade war is prolonged. If businesses see the environment as less than favourable, they neither invest nor hire, which shows up in the data.

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Negative business sentiment is harder for the government to offset, particularly in an already relatively weak economy. Previous terms of trade shocks tended to be offset by growth in other sectors.

After the GFC, mining investment and demand for our natural resources remained strong and commodity prices rebounded quickly. When commodity prices fell between 2013 and 2015 the construction and housing sectors helped sustain growth – alongside aggressive RBA rate cuts.

Hayden Dimes is an Economist and David Plank is Head of Australian Economics at ANZ

This article was originally published on ANZ’s Institutional website.