Brian Fallow: Economy struggling to regain balance

The quarterly survey of business opinion from NZIER completes a trifecta of dispiriting reports on the state of the economy over the past three weeks.

First the Reserve Bank's September monetary policy statement delivered a distinctly downbeat view of the economic outlook - one step away from last rites, Westpac called it - and lowered the expected trajectory for interest rates accordingly.

Then the June quarter national accounts recorded growth of just 0.2 per cent, way below economists' forecasts.

And now the Quarterly Survey of Business Opinion (QSBO) presents a reading of the here-and-now which suggests a further loss of momentum in the September quarter - perhaps even to the point of rolling backwards.

Both the Reserve Bank's forecasts and the QSBO do not reflect the impact of the Canterbury earthquake, which in the near term is unequivocally and significantly negative.

The net effect is a picture of an economy which at best has gone sideways over the past six months.

Especially worrying is that this sluggish and torpid level of activity is despite the fact that monetary policy, fiscal policy and the terms of trade are all strongly supportive right now.

True, the bank has begun the process of raising the official cash rate from the exceptionally low level it cut to during the global financial crisis.

But the interest rates which matter - like the average mortgage rate people are paying - are still at cyclical lows and well below longer-run averages.

Likewise no one is suggesting the weak state of business borrowing is because interest rates are too high.

The Government, while talking sternly of fiscal rigour, is running fiscal policy very loose. We are just a quarter of the way through a financial year in which it forecasts a cash deficit of over $13 billion - the famous $250 million a week it is borrowing and injecting into the economy.

Meanwhile prices for export commodities are close to all-time highs. The terms of trade - the ratio of export to import prices - are more favourable than they have been for almost all of the past 30 years.

Yet the economy is treading water. So what's the problem and when will things improve?

The two bits of jargon bandied about most often in this context are "deleveraging" and "rebalancing".

Both are desirable, even essential, in the longer-term, but in the short term they make the going hard for those businesses which are chasing the consumer's discretionary dollar.

Deleveraging is debt reduction and right now is a big factor in households' and farmers' behaviour.

Between 2000 and 2008 household debt climbed from around 100 per cent of disposable income to nearly 160 per cent.

It has subsequently fallen by about 5 percentage points, but remains high by historical and international standards. Household savings rates are still negative.

Meanwhile, ANZ reminds us, the dairy sector's debt has climbed from $12 billion to $29 billion in six years.

So it is not surprising that in the context of a weak labour market at home and a patchy and frail global recovery people are more inclined to reduce debt than increase it.

But as you can't have your cake and eat it, the effect is the disappointingly weak demand evident in the September QSBO.

Retailers, other service providers and builders all reported sales down on the June quarter, well down on what they had expected and well down on their long-run average levels.

A key indicator from the survey, domestic trading activity, makes a striking contrast to what was seen after the next-deepest recession, in the early 1990s.

As the top graph shows, at this stage of the recovery - six quarters after the trough in the cycle - it was still rising sharply in a classical V-shape and had further to go.

This time by contrast the QSBO's activity indicator has drooped, registering minus 15, down from minus 4 in June. It is at a level which, based on past relationships, suggests September quarter GDP was contracting even before the quake.

That is a measure of domestic trading activity. The QSBO does not survey farmers directly, and exporting manufacturers were in positive territory, though only just.

But on the long-desired rebalancing of the economy - a shift from spending to saving, from consumption to investment, from importing to exporting - the Treasury this week sounded a cautionary note.

"Signs of rebalancing towards the tradeable sector which were present earlier in the year have eased recently," it said.

Drought had hit agricultural production and the associated downstream processing activity, and what little growth the June quarter could muster was driven by non-tradeable sectors such as construction and services.

Looking forward, the portents for the tradeable sector are mixed.

Export prices are strong and the impact of drought will fade, but it will be replaced by lamb losses and other casualties of the dreadful spring we have just had.

The low exchange rate with the Australian dollar will assist manufacturers exporting across the Tasman, but the Aussie dollar has strengthened even more against other currencies, including the US dollar.

On the home front the QSBO had a few embers of hope among the ashes of disappointment.

Investment intentions for plant and machinery, and hiring intentions, remain marginally above their long-term averages.

But ANZ economists note that investment in plant and machinery remains nearly 30 per cent below pre-recession peaks. Firms' profitability is under pressure and business credit continues to shrink.

Looking forward, however, they forecast decent growth of around 4 per cent next year.

Not all the income boost from higher export prices will go to debt reduction and fertiliser. Eventually the farmers will go to town.

Rebuilding, repairing and replacing what was damaged in the Canterbury earthquake will stimulate demand, especially in a construction sector with plenty of spare capacity.

And while household deleveraging will remain a constraint, "we struggle to see consumers keeping their wallets perennially shut."

A cyclical rebound in business investment must be on the cards at some point, and there was already evidence of a revival in construction, both residential and non-residential, in the June quarter, albeit from a depressed base.

BNZ economists think people may be underestimating the impact of the tax changes which have just kicked in.

They are broadly designed to assist rebalancing of the economy by taxing consumption more heavily and leaving people with more after-tax income to either save or spend as they see fit.

The income tax cuts are larger than Labour's in October 2008 or National's in April last year, BNZ economist Craig Ebert said.

"They represent a disposable income boost of 2.3 per cent for those on the lowest of incomes, 3.8 per cent for someone on an average income and as much as 6.3 per cent for the very top-end earners."

They will be offset by a GST increase which will push up the consumer price index by 2 per cent.

But that is only a partial offset to the income tax cuts. The Budget estimates the overall tax package, including changes to business and property taxation would reduce Government revenue by nearly $500 million in the year to June next year.