Currency Outlook

After three years of slowing global growth, Australia and New Zealand will be helped along this year by a stronger global economy. It may not be a global boom, but we expect the US economy to expand by well over 3.5%, Japan by over 2% and Europe by over 1%, while China will continue to crack along at close to 8%. Because of the boom in China and the pickup in both Japan and the US, most of the smaller North Asia and South East Asian economies to which Australia and New Zealand exports will also be doing better.

For Australia and New Zealand the more cheerful global economy not only means that output growth will be well supported, but also that the pattern of growth will change. For the year to June 2004 Australia and New Zealand output growth will be over 4%, in both cases a market improvement over growth to June of last year. In both economies exports will be more important, home-building less important. Exports will account for half of Australian output growth this year, and over a quarter of New Zealand output growth.

Residential construction will account for less output growth than last year, and while exports will pick up over the year, housing construction will fade. Helped by rising employment and incomes we expect consumption to remain strong in Australia and New Zealand, but, challenged by higher interest rates, it will not grow quite as solidly as last year.

Responding to continuing output expansion, real business investment growth will slow to around half last year's rate in Australia and New Zealand, but remain a little above 5%. The economic experience of Australia and New Zealand will by no means be identical this year, though the outcome will be similar. Part of Australia's growth this year is explained simply by recovery from drought. Part of New Zealand's strength is a surge in immigration, which adds to home building and consumption.

Overall retail price inflation remains lower in New Zealand than Australia. When the impact of lower inflation in the tradable sector is excluded, however, Australia and New Zealand have remarkably similar inflation and at a rate which troubles their central banks.

To restrain the growth of borrowing and also to moderate activity as the economies approach closer to full employment, both the Reserve Bank of Australia and the Reserve Bank of New Zealand will raise the cash rate twice more to 5.75%.

The Reserve Bank of Australia and the Reserve Bank of New Zealand will use a similar rationale for the tightening, arguing that while inflation will remain well within the respective targets for the next year, it will pick up as the impact of currency appreciation on import prices fades.

It is quite likely that the tightening will be completed in both economies by mid-year, and in both cases the central banks would now view a 5.75% rate as broadly neutral. We expect bond yields to pick up moderately over the year, largely in response to rising bond yields in the US.

Though we had earlier thought the appreciation of the Australia and New Zealand dollars against the US dollar would run on for several more months, the currencies may well have reached their peaks in the first quarter. This is largely because the US dollar depreciation has slowed as the outlook for US employment (and therefore increased interest rates), mainly against the US dollar rather than the rest of the world.

In the two years from February 2002 to February 2004 the Australian dollar appreciated 47% against the US dollar, half of that percentage against the yen and only 6% against the euro.

The New Zealand dollar shows a similar pattern, appreciating 60% against the US dollar over the period, but only 19% against the euro - and 9% against the Australian dollar. In both cases the currencies appreciated from levels against most currencies which were ridiculously cheap compared to the past 15 years. Because there will still be a wide interest rate premium against the US, Japan and Europe and because Australian and New Zealand exports will be increasing, the currencies will remain quite firm, even though the appreciation will stop.

We expect the Australian dollar will be around US$0.78 at the end of the year, and the New Zealand dollar US$0.68, with the currencies peaking against the US dollar towards the end of the second quarter.

The firm currencies will not help exports, but Australian exports will anyway be increasing because of resumed rural production, while stronger world growth will buoy exports from both economies. In this respect the increasing weight of China in the region, its rapid and sustained growth and its gravitational pull on neighbouring economies is changing the outlook for Australia and New Zealand.

In the last decade the share of New Zealand exports going to China has doubled to 5% and the share of Australian exports going to China trebled to 10%. In both countries exports to China are growing more rapidly than to most other markets.

China displaced the US as Australia's second biggest export destination after Japan in three months of last year, a trend likely to strengthen over coming years. Because most East Asian trade is now between economies in East Asia, because trade with China accounts for most of the growth of that trade, and because East Asia (including Japan) now accounts for a large share of world growth, China's economy will, within a few years, become as important to Australia and New Zealand as the prosperity of the US. The free trade agreement between Australia and the US announced in February will be useful, but it will not define Australia's economic circumstances over the next half century. Its real importance is for trade strategy, not economic growth.

At a time when most of Australia's East Asian trade partners are negotiating preferential trade agreements with each other from which Australia will be excluded, an FTA with the US is a useful chip in a game which, like it or not, Australia is now obliged to play. While the growth outlook for 2004 is quite good, there are risks to which we will remain attentive. These include the trajectory of house prices in Australia, the broader impact of rate rises in both economies, the impact of higher currencies, and the uncertainties of policy changes arising from an Australian federal election likely during the year, and for New Zealand the continuing problem of low labour productivity.