ADDRESS TO
AUSTRALIAN CHAMBER OF COMMERCE AND INDUSTRY
ANNUAL DINNER

WEDNESDAY, 1 NOVEMBER 2006

7.30PM

ACCI and its members play an important role in shaping Australia’s economy and representing the views of business to government. I would like to thank you for that contribution, including your contribution to public policy debates. I would like to take this opportunity to once again thank ACCI’s Chief Executive, Peter Hendy, for his effort in co-authoring, with Dick Warburton, the International Comparison of Australia’s Taxes. This document is a valuable resource. We have circulated this report to all the members of the OECD and suggested they might like to use it as a model to benchmark their own tax systems.

Overview

I’ve been asked to share a few thoughts with you tonight about economic developments in China and I will focus on what they mean for Australia and what they mean for the globe. Whilst the story of the re-emergence of China is positive for both I will sound a note of warning.

Before I come to China, however, it is important that I fix a picture in your mind of Australia’s economy.

Australia is a country of 20 million people with very high per capita income. We have 0.3 per cent of global population but 1.0 per cent of global GDP (in PPP terms).¹ Our population is around 1/65^th that of China but our per capita GDP is around 4 times. Our population is around 1/15^th of that of the United States (the world’s largest economy) which has per capita GDP around 1/3^rd higher than Australia. Agriculture comprises around 3 per cent of our economy and almost 17 per cent of total exports. Mining makes up around 5 per cent and around 40 per cent of total exports. The bulk of GDP in Australia is comprised of services, such as retail, property and business services, communications, finance and insurance, and utilities, which is around 64 per cent of GDP. Services exports are around 23 per cent of total exports.

China’s economic re-emergence

Beginning in 1978, China embarked on a major programme of economic reform, which has dramatically transformed its economy from one that was centrally-planned and closed to trade to one that is market-orientated and increasingly open to trade. The Chinese economy has grown by about 10 per cent a year for over 2 decades, an impressive performance.

Combined with China’s huge population of 1.3 billion people — this rapid growth has seen China emerge as the world’s second largest economy behind only the United States (in PPP terms). China’s share of world GDP has increased from 3.4 per cent in 1980 to 15.4 per cent in 2005. Over the last 5 years, China has contributed almost three times the amount the United States has contributed to world growth.

China’s rapid development, the movement of people to cities and its rising living standards are leading to a huge increase in China’s demand for housing and infrastructure, such as roads, electricity, and water and gas connections. For example, over the past quarter century, China’s electricity-generating capacity has increased almost tenfold while the length of the road network has doubled.

These factors have contributed to a construction boom and led to a rapid increase in China’s demand for construction materials. And because this demand has outpaced the growth in China’s production of construction materials, China’s imports of many commodities and raw materials have risen substantially in recent years.

As a result, Chinese demand is now having a dramatic effect on a range of globally-traded commodities. For example, China now accounts for over 40 per cent of the world’s seaborne trade in iron ore and around one-quarter of the world’s consumption of copper, aluminium and nickel.

Reflecting its rapid integration into the global economy, China has emerged as the world’s third largest trading nation, behind the United States and Germany. Between 1980 and 2005, China’s share of world trade has grown from around 1 per cent to almost 7 per cent, and this share is rising rapidly.

Nevertheless, in per capita terms, China is still a relatively poor country and at an early stage in its ‘catch-up’ growth phase — the process by which developing economies typically move towards the technologies, economic structures and, eventually, the living standards of developed economies.

Per capita GDP in China — a good proxy for living standards — reached US$7,000 in 2005 (in PPP terms), which is almost sixteen times the 1980 level of around US$450.

China may continue to grow at around its recent average rates for quite some time. In fact, on plausible assumptions, China may overtake the United States to become the world’s largest economy within a decade (in PPP terms).

The path of Chinese development has been similar to other East-Asian success stories of earlier decades. China’s growth and rapid industrialisation has been accompanied by high domestic saving, massive investment in infrastructure and the shift of low-cost labour from farming to more productive sectors of the economy. Key drivers of these economic developments have been China’s openness to trade and foreign direct investment and the adoption of more market-friendly economic policies.

China’s economic success has not come about simply because of an abundance of low-cost labour. Many other countries also have vast reserves of low-cost labour. It is openness, private entrepreneurship, trade, investment and skills that has enabled China to capitalise on its comparative advantage in low-cost manufacturing to emerge as one of the world’s key hubs for the final assembly of manufactured and electronic goods.

Of course, past growth outcomes are by no means a guarantee of future success.

China’s reform process will only become more demanding as its economy becomes larger and more sophisticated. For instance, China will need to press ahead with further financial sector reforms in the years ahead — a process that experience shows can be difficult to implement smoothly.

Further, China’s comparative advantage in manufacturing will lessen as wages rise, and as other low-cost emerging markets, such as India and Vietnam, benefit from the adoption of similar economic policies. China will need to move beyond low value-added assembly.

And China will need to address the many challenges associated with the rapid ageing of its population. The one-child policy means that China will face one of the most significant ageing effects of any society in the next generation. China may well grow old before it has grown rich. China will face a unique set of policy issues; not least because many of the institutions that support retired people in the developed world, such as pensions and superannuation, are still undeveloped in China. The effects of ageing in China will be largely felt in the period 2015-2050. In the meantime the continuing shift of its vast pool of rural labour to more productive sectors will drive continuing growth.

China is also grappling with rising income inequality — particularly between the emerging middle classes in booming eastern cities, such as Beijing and Shanghai and poorer rural areas in the centre and west of the country. Future growth will depend critically on maintaining political and social stability through the ongoing process of economic transition that will invariably benefit some groups, and some parts of the country, more than others.

These are essentially domestic challenges. But as China’s share of world output continues to grow, its actions will increasingly affect other economies. There is, in consequence, an important international dimension to China’s policy challenges.

The Australian Economy and challenges

China’s impressive economic performance has led to a rapid increase in global demand for resources, and substantial increases in their prices. Australia’s non-rural commodity prices are currently over 85 per cent higher than their average for the 1990s. At the same time, increased supply of manufacturing goods from China and other low-cost economies has led to lower import prices. As Australia is a net exporter of resources and a net importer of manufactures, this development has led to a very significant increase in our terms of trade.

The increase in resource prices has driven record profits for mining companies. Over the last 3 years, the mining sector has invested around $37 billion. This year alone investment by mining companies increased by almost 80 per cent. This investment in mining capacity will lead to increased capacity in the years to come.

That the Australian economy is responding positively to the large stimulus engendered by the rapid increase in resources prices demonstrates the significant improvements in our policy frameworks.

Well-anchored macroeconomic policies, as well as flexible product and labour markets, combined with a sound financial system have enabled Australia to absorb this large shock with relatively little macroeconomic disruption.

Comparing the current terms of trade boom with the 1970s boom illustrates this point. During the terms of trade boom of the 1970s, inflation nudged 18 per cent, Australia experienced a period of unsustainable wages growth and the unemployment rate more than doubled. The pain caused to businesses, through lower profitability, and households, through higher rates of unemployment, was not short-lived. It took many years to unwind.

There is little doubt that centralised wage fixing was a major cause of this disruption, with wage increases in resource-related sectors spilling over to a broader economy that simply couldn’t afford to pay. By comparison, while recent wage increases have been relatively large in industries associated with the jump in resource prices, these increases have not generated broader and unsustainable wage rises in the wider economy.

In some quarters, there appears to be a view that the current resources boom will last forever. The current conditions are the result of the rapid increase in demand from China, which was not anticipated by the mining industry, and the long lead times between new investment and increased capacity.

The current prices have generated huge new investment, investment that will increase global supply that will rise to meet demand and return prices to more ‘normal’ levels. It is not just Australia that has experienced a high increase in investment. It is not just Australia that is increasing supply capacity. Other countries such as Brazil, Indonesia and Russia are doing the same.

As a result, we would expect the current high prices to unwind over future years. While the RBA non-rural commodity price index (in $A terms) rose in October, the index has been broadly flat since May. The prices of steaming coal have been flat, while the price of coking coal has fallen. Oil prices, which are not in the RBA commodity price index, have fallen by around 24 per cent since August.

Budget forecasts are that key resource prices will fall back to average long-run levels over the forward estimates. But while we have assumed that key resources prices fall back toward their long-run average levels, we have not assumed that they will fall below long run averages, even though that has been the experience in the aftermath of past mining booms. This is the outlook that we see for the 5 per cent of GDP that is comprised by mining in the years ahead – increased production but on moderating prices.

Agriculture

Let me now turn to another part of the economy – this is the 3 per cent that is comprised by agriculture.

Only 3 years ago we endured the worst drought in 100 years and for some that drought has not ended.

This year the rainfall deficiency unfolded later in the cropping cycle than the 2002-03 drought, as a result the crop forecasts have been successively downgraded.

In preparing its latest forecast last week, ABARE has forecast wheat production to fall by around 62 per cent to 9.5 million tonnes in 2006-07.  This would be the smallest harvest since the 9 million tonnes produced in 1994-95. 

Prior to the 2002-03 drought, agricultural incomes were $13.1 billion, the highest on record.  As we enter this drought, agricultural incomes are around $8.7 billion.  This drought will also severely affect Australia’s sheep and cattle farmers who, following the 2002-03 drought, had been rebuilding their herds and flocks.

During the 2002-03 drought, farm GDP fell by around 25 per cent, and the direct impact was a 0.8 percentage point subtraction from GDP growth.  Rural exports fell by almost 13 per cent.  This year we are expecting farm GDP to fall by around 20 per cent and rural exports to fall by around 9 per cent. You would expect a commensurate detraction from GDP. This year drought will cut economic growth below its long term average.

I said earlier that agriculture makes up 3 per cent of GDP but the huge variation has a significant impact on GDP. This is because most of GDP is comprised of services which are much less volatile than agriculture. Volatile areas such as agriculture and mining move the overall GDP figure significantly even though they are a small proportion of it.

In difficult economic circumstances, people naturally look to governments to do something – to ameliorate the present harm, and to do what they can to provide for them in adversity.

The Australian Government is doing a lot to assist farmers and others directly affected by the drought. But when we ask what we can do to provide better protection from future adversity, one thing stands out above all others, and that is water reform.

Water reform

The drought should focus our attention on water reform. It is clear something needs to change.

Infrastructure and improved water conservation measures are part of the solution, but they are not the complete story. A key step to securing sustainable water supplies and achieving an appropriate balance between the needs of the community, industry and the environment is establishing an effective, fully functioning national market for water.

With a fully functioning national market for water, there would be no need to ration water in this country.

The price signals created by markets would provide incentives for water to be transferred to where it adds the most value; encourage investment in water-efficient technology and cost effective infrastructure where it is needed; and also allow for water to be secured for the environment.

Furthermore, markets would provide us with the flexibility to better adapt to future crises, such as from prolonged drought.

While some ‘temporary’ trading is already taking place, we have a long way to go before we have a fully functioning market.

In 2004 COAG agreed to the National Water Initiative, which set out the reforms needed to improve the way that water is managed in Australia. These include the introduction of market based pricing for water; the development of entitlement trading systems; separating land and water titles; and the provision of water for environmental purposes.

The States have a less than stellar track record on delivering reform. Many of the actions required under the National Water Initiative were agreed by COAG way back in 1994.

Achieving these reforms will require commitment from all levels of government.

G-20

China is the second largest economy in the world. It is not a member of the Group of 8 (G8) industrialised economies that meet regularly to co-ordinate policy. To bring the new emerging economies into forums for discussion and co-ordination we need more representative fora.

The Group of 20 Finance Ministers and Central Bank Governors (G-20) recognises the increasingly important role of developing countries in the world economy. With representatives from the key industrialised economies — including the United States, Japan and Germany — and the key emerging market economies — such as China, India, South Africa and Brazil — the G-20 represents the balance of economic influence in the 21st century.

In a few weeks time, I will Chair the annual meeting of the G-20 in Melbourne. It is the most important economic summit ever to be held in Australia. Through our membership of the G-20, and particularly as 2006 host, Australia has a valuable opportunity to influence global economic policy and further develop strong bilateral relationships with key economic and strategic partners around the world, including China.

Our meeting in Melbourne takes place under the theme of ‘Building and Sustaining Prosperity’. The agenda reflects the key challenges confronting global economic policy-makers, including energy security. I have earlier described how China’s development has moved world energy and commodity markets. China is naturally interested in securing supplies which are necessary to continue that growth.

Energy security – how to get it and how to guarantee it has become a critical international issue. We do not want a race between competing powers to lock-up resources. We want to establish open, transparent and liquid global markets that will facilitate investment and cross-border trade.

Securing a reliable and affordable supply of resources is essential to promoting strong and sustainable global economic growth and development. And to avoiding instability and conflict.

Demographic change is also an issue before the G-20. This is appropriate given the magnitude of the demographic transition facing all G-20 countries. And the demographic redistribution of global population will affect global economic prospects and the energy demands. We need to prepare for the world as it will be in the future.

The broad membership and informal but effective nature of the G-20 make it the ideal forum to tackle these important challenges. And global economic forums must include the new economic powers.

Conclusion

Our Government is in extremely strong financial shape. We have eliminated net debt. We have begun making provision for liabilities that were never funded before. And we need to do this as the demographic change bears down upon us.

Some people have made foolish claims about the effects of recent prices in the resource sector. For example, Mr Beazley’s claim that it has resulted in $160 billion in extra tax was out by a factor of ten. But the prices have been beneficial in income and revenue terms. We must now begin to prepare for the fact that over time they will return to more normal levels. And we must prepare for the real challenges ahead – drought, urban water shortages, population ageing and relentless international competition.

The China story has been good for Australia and good for the globe. To continue its impressive economic development China will need significant further reform. The re-emergence of China has forced re-adjustment to our economy and should force some re-adjustment to the international economic architecture. Australia has a big part to play there as well. We are leading efforts through G-20 to bring the significant global players into discussion to improve outcomes for the global economy and we should be preparing for the globe as we will find it in the decades ahead.

¹ Throughout the speech international comparisons of GDP are done on a Purchasing Power Parity (PPP) basis. This is the preferred basis for comparing the relative size of economies because it uses a conceptually appropriate approach to estimating prices in both the traded and non-traded sectors of the economies, in contrast to comparisons based on market exchange rates.

Address to Australian Chamber of Commerce and Industry Annual Dinner [.pps, 58KB]