Thursday, March 31, 2016
Don't be fooled by the burst of optimism following the December quarter national accounts.

Growth during the year of 3% was greeted by the markets as though all our problems have been solved. They haven't. Growth remains slow, and will remain slow for some years yet.

The saving grace is that the lower dollar is speeding economic transition and recovery, and any sustained rise would be damaging.

We should be grateful for slow growth. It could have been a lot worse. Other resources-exporting countries have fallen into recession, but we haven't. Strong exports growth, further boosted by LNG projects coming on stream, is offsetting much of the impact of falling resources investment.

Recovery is coming first in the dollar-sensitive export and import-competing industries. For a decade, those industries languished because of the high dollar which came with the resources boom. Now, the lower dollar is already boosting activity. And this is just the beginning.

The green shoots are appearing in tourism, education services for overseas students, agriculture, finance and business service.

Even manufacturing, where we will still lose motor vehicles and white goods operations as a result of decisions made when the dollar was closer to parity, is seeing offsetting demand in enterprises that have hung, reducing costs and are now lean and extremely efficient. Now they are starting to get orders from clients, many of whom had sourced from offshore while the dollar was high.

Gradually these emerging operations will underwrite growth in manufacturing production and investment. The lower dollar will stimulate employment and incomes. And the dollar sensitive industries will be the first to invest.

However, there are dangers in the current burst of optimism, particularly given the rebound in resources prices.

The rebound in the dollar above US75c is concerning. Should it go much further it will affect competitiveness and hence improvement in these industries.

The question is: will the security and popularity of Australia as an investment destination take the dollar too high and impede the structural change required for transition from a mining investment-driven economy to more balanced growth? Could we be too popular for our own good?

How low does the dollar need to be? Ideally, on our modelling, Australian industry is competitive in a broad band between US58c and US70c. But I'd settle for US70c-US75c.

I'm not comfortable with anything above US80c. But I don't think we'll go there. Given the volatility of exchange rates, those could be famous last words.

In terms of past behaviour, the dollar is driven by resources prices and interest rate differentials.

Firstly, I don't expect a really strong, sustained rebound in commodity prices. The problem for resources is supply not demand. I'm not so worried about China and world growth. The reality is that, given the sheer quantum of investment, supply has caught up to demand. And that will keep prices low for a long time yet.

Secondly, interest rate differentials will narrow as US Fed rates rise, albeit slowly, and Australian cash rates don't follow. There is a buffer between Australian and US short rates that will allow the Reserve Bank to set Australian cash rates in relation to domestic policy considerations. And, given the weak economy, they're likely to keep rates low for some time yet.

Our modelling has the dollar going down to around US71c. And that's roughly where I expect the dollar to settle in the short to medium term. From the point of view of competitiveness and the strength of the economy, I'd prefer the dollar to go lower. I think, and certainly hope, the current rebound is an aberration.

The level of the dollar will underpin recovery in the trade-exposed industries and drive the speed of transition to balanced growth. It will determine how quickly we come out of this soft period.

This article originally appeared on www.theaustralian.com.au/property.
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