From punchbowl to prudence

The March quarter national accounts show Australia's terms of trade fell about 1% in trend terms compared with the December quarter. Are official terms of trade forecasts for 2012-13 to 2014-15 optimistic?

Historically, Australia's terms of trade peaks have been sharp: fast increases followed by fast declines. So far, this has been the case in the run-up to the mid-2011 peak and the subsequent decline (see Chart). The official forecasts out to 2014-15 imply the decline will suddenly slow markedly. Beyond 2014-15, this continues. The terms of trade are projected to decline by about 1.3% per annum over a 15-year period, finally settling at 2005-06 levels. This is still higher than the last peak during the 1973-74 commodity boom. Is this projection too slow and too little?

Sources: ABS, 2013-14 Budget Papers, Geoff Carmody & Associates estimates.

The 2013-14 Budget forecasts a fall in Australia's terms of trade of 7.5% in 2012-13. If the terms of trade in the June quarter equal the March quarter level, the 2012-13 decline would be around 10.75% (in trend terms). Assuming a 2% decline in the June quarter, the 2012-13 decline would be over 11%.

The Budget forecasts a terms of trade fall of only 0.75% in 2013-14. For this, and assuming the June quarter trend result equals the March quarter result, the terms of trade must increase above the March quarter level, on average, for every quarter in 2013-14.

From its trend peak in mid-2011, the average quarterly decline in the terms of trade has been 2.5%. Trend terms of trade declines averaging 2% in each of the next five quarters would result in a 7.3% decline in 2013-14. Continuing that assumption for 2014-15 would see the Budget forecast terms of trade decline of 1.75% revised down to 7.75%.

Such forecast revisions have big implications for our economy and Commonwealth Budget. If they reflect larger reductions in Australia's commodity export prices, forecast nominal GDP growth is affected. The Budget forecasts nominal GDP growth of 3.25%, 5% and 5%, respectively, in 2012-13, 2013-14 and 2014-15. Larger declines in the terms of trade could slash these forecasts, reducing or even eliminating the forecast gap between nominal and real GDP growth.

Using the Budget papers sensitivity analysis, such downgrades of the official terms of trade forecasts could wipe out any improvements in the underlying cash Budget deficit in coming years – or even reverse them.

Given falling terms of trade, why has the $A has remained at historically high (post-float) levels?

Of itself, a fall in the terms of trade implies nothing about the exchange rate.

Falling terms of trade mean our export prices in $A fall relative to import prices in $A. A depreciation of the $A means $A prices for our exports can increase (especially for contracts denominated in foreign currencies like the $US). But it also increases import prices measured in $A. The net effect on the ratio of export prices to import prices in $A – the terms of trade – is not clear.