End of boom not a canary in coalmine
Last week's downgrading by the International Monetary Fund of world economic growth by 0.25 per cent to 3 per cent in the current year triggered speculation of worse times ahead for the Australian economy. This reaction to a modest reduction in the world's growth prospects is excessive and needs to be treated with scepticism.
The latest IMF assessment confirms that the European economies are likely to remain in recession and the Chinese economy is slowing. But fundamentally, the Australian economy still has a strong and sound base with manageable debt burdens and a well functioning financial system.
It's now obvious the resources boom is coming to an end, bringing falling commodity prices due to emerging oversupply and reduced demand. Nevertheless, while new investment is being discouraged and high-cost producers shut down or reduce output, Australia has an automatic safety valve to reduce the adverse impact on the economy.
Our freely floating exchange rate reduced the inflationary and expansionary effect of the resources boom on the economy. By appreciating in value to the extent it did, the returns to producers in Australian dollar terms were significantly reduced because all major commodity prices are denominated in US dollars. Now with overseas investors repatriating some of the investments which helped it appreciate, the Australian dollar is falling and could well fall further.
The extent of the fall could even be larger than the fall in commodity prices in US dollar terms. Because of political turmoil in Egypt, the price of oil has risen in US dollar terms, increasing the return to domestic producers in Australian dollar terms. While this is bad news for consumers because of the resulting flow through to petrol prices and the cost of living, it's an excellent example of the assistance provided to the economy by a falling currency.
The other important consideration is that the Reserve Bank still has scope to reduce the official short- term interest rate and now looks likely to do so. The money market is expecting that the bank will reduce interest rates in August, much earlier than previously expected. A further reduction in Australian interest rates will increase incentives for foreign investors to reduce their Australian exposure, thus putting further downward pressure on the dollar.
For share investors, further falls in interest rates will increase the attractions of owning shares providing high dividend yields allowing for the value of franking credits. This is a likely explanation for the recovery of the share market this week even when our growth prospects are being talked down. As long as the dollar depreciates by as much as commodity prices fall, the end of the mining boom is unlikely to result in a recession in the overall economy.