When the economy runs dry

With real economic growth currently running at less than 2% and inflation nudging 4%, the last thing the Australian economy needs is another severe drought. However, with the lack of winter and spring rains across much of the continent, the drought is now of a magnitude to materially constrain economic growth and put further upward pressure on inflation.

The drought's economic impact

During the 2002/03 drought, some 100,000 rural sector jobs were lost. This represented around 25% of all agricultural employment and highlights the magnitude of the economic and social impact that a severe drought can have on rural communities.

While the impact is heavily concentrated in rural areas, the general Australian economy is far from being immune to the drought's affect. Although representing just 2.7% of the economy’s total output, rural production levels are far more volatile than the balance of the economy. Swings in rural output can be significant enough to noticeably impact on aggregate economic growth.

As can be seen on the chart above, the 2002/03 drought saw rural output fall by 25%. Indications are that the current drought will be more severe than that of 2002/03. The Australian Bureau of Agricultural and Resource Economics expect this year's winter crop production levels (including wheat, barley and canola) to fall by 35%. The Bureau also estimates that the drought will detract 0.7% from the economy's overall economic growth rate.

This impact on economic growth may well be more noticeable than that which took place in 2002/03. Prior to the downturn in rural production in 2002/03, Australia's economic growth rate was a healthy 4.6%. This time around though, the economy is expanding at a far more modest 1.9%. Therefore, the scope for the drought to drag economic growth down to a level that starts to seriously impact on variables such as corporate sector profits may now be more significant.

Food prices to rise

Perhaps the most noticeable impact of the drought on those living in non-rural locations will be an increase in the price of many food items. With the quantity of agricultural output declining, prices are likely to be higher. The recent experience with bananas highlights how dramatic the price movements can be in response to shortages in agricultural produce.

Food prices have already been on the increase over the past year. Fruit prices have jumped 93% (largely due to bananas), while vegetable prices are 9% higher. There may, however, be some shorter-term decline in meat prices as farmers are forced to bring livestock to slaughter early due to the insufficient availability of feed (see chart below).

With food representing some 15% of the Consumer Price Index basket that is used to measure inflation, rising food prices can have a significant impact on general inflation. Given the Reserve Bank's intent on maintaining inflation between 2% and 3% in the medium-term, the additional food-related inflationary pressure may increase the likelihood of higher interest rates. Higher food prices, and possibly higher interest rates, will act to reduce household sector purchasing power and further dampen the prospects for increased economic growth.

Rural export income to fall

Although in longer-term decline, agricultural items, particularly meat and cereals, still make up a significant proportion of Australia's export income. The following table shows the contribution that various categories of goods make to the economy's export receipts.

Luckily, booming mineral commodity prices combined with the recent upturn in mining sector investment has significantly brightened Australia's export prospects. However, the economy is still running a significant trade deficit and a decline in revenue from rural exports makes the trade position more vulnerable to a correction in mineral commodity prices.

International finance markets anticipate that growth in export income will significantly improve Australia's trade deficit income over the next year. Any detraction from these expectations could put downward pressure on the Australian dollar. While a lower Australian currency would be good news for farmers (as it lowers the price of their output on world markets), the resulting increase in import costs may further add to the upward pressure on inflation and interest rates.

Implications for investors

The Australian economy is less reliant on the rural sector now than it has ever been. Hence, it is important that investors do not overreact to the potential implications of the worsening drought. Apart from those investors who have specific agricultural investments, the drought should be viewed as just one of many potential influences on the short to medium-term outlook.

However, leaving all other potential influences to one side, the drought is generally negative for Australian investments. A lowering in economic growth and increase in inflationary pressures creates an environment less conducive to company profit growth and equity returns. Similarly, the prospect of higher inflation and interest rates, adds risks to any longer-term fixed interest or property holdings that may be part of an investment portfolio.

The drought provides a good example of a country-specific risk that investors should always try and diversify against by having a good spread of international investments to accompany home country exposures.

Summary

1. Recent forecasts by the Australian Bureau of Agricultural and Resource Economics confirm that the severity of the drought has increased significantly in recent months.

2. All things being equal, the drought can be expected to lower economic growth, increase inflation, widen the trade deficit and put downward pressure on the Australian currency. It may also increase the prospect of higher interest rates.

3. For investors, the drought could have some negative implications for domestic equity, property and fixed interest investments and highlights the value in having an investment portfolio with international diversification.

By Brad Matthews, Hillross Economist