ANZ RESEARCH

AUSTRALIAN ECONOMICS NSW IN FOCUS

NSW RECOVERY MAY UNDERPIN THE TRANSITION FROM MINING BOOM 7 AUGUST 2013 CONTRIBUTORS
Warren Hogan Chief Economist +61 2 8037 0063 Warren.Hogan@anz.com Cherelle Murphy Senior Economist +61 2 6198 5010 Cherelle.Murphy@anz.com Dylan Eades Economist +61 2 8037 0074 Dylan.Eades@anz.com

In recent months, the New South Wales economy has shown signs of genuine recovery and is now outperforming the rest of Australia. This comes after a decade when the NSW economy underperformed with its share of national output slipping by around 4 percentage points to 31% in 2012. This note examines whether the early signs of an upturn in NSW, Australias most populous state, are likely to continue. Examining NSWs economic outlook not only assists our understanding of around one third of Australias economy but also provides some insight into how smoothly Australia might transition from the mining investment boom to a more broad based growth story. There remains much uncertainty around the outlook for the Australian economy at the moment. However, we conclude that there are a number of reasons why NSW may grow at an above average rate and play a central role in leading the national economy in the transition to stronger non-mining growth over the next few years. The improved NSW outlook contrasts with the more negative outlook in the mining states and in Victoria, where an overhang of housing construction is likely to weigh on growth. It also contrasts with NSWs own recent history. During the early 2000s IT bust and global financial crisis, the NSW economy slowed more sharply than the rest of Australia and employment growth was weaker. We also examine the relationship between the US business cycle and the NSW economy concluding that a strong relationship still exists due to linkages related to financial markets, financial services and the headquartering of multinational firms in Sydney. Our analysis suggests that although China is increasing its influence on the national economy, the US economy remains a major driver of the NSW cycle.
FIGURE 1: NSW AND US GDP GROWTH
6 5 4 Forecasts

Annual % change

3 2 1 0 -1 -2 -3 -4 NSW US

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Sources: ABS, Bloomberg, ANZ

Australian Economic Update / 7 August 2013 / 2 of 16

A DECADE OF UNDERPERFORMANCE COMES TO AN END From 2000 until 2012, the NSW economy grew more slowly than the rest of Australia, at an average annual rate of 2.1% compared to 3.5%. Figure 2 below shows NSW economic growth, proxied by state final demand plus net exports, was weaker on average than the rest of Australia through most of this period. The NSW economy and employment growth were more heavily impacted by the bursting of the tech bubble in 2000-01 and the global financial crisis around 2007-09. These downturns were relatively more severe than the rest of Australias. This is likely due to the over-representation of the financial and insurance services industries and IT, media and telecommunications industries in NSW.
FIGURE 2: THE LOST DECADE
8 6 4 2 0 -2 -4 87 89 91 93 95 97 99 01 03 05 07 09 11 13
New South Wales New South Wales, decade average Australia (excluding New South Wales) Australia (excluding New South Wales), decade average

Sources: ABS, ANZ

Another reason for underperformance in NSW was the slowdown in dwelling investment which slipped as a share of domestic demand in NSW much more than in other states and territories from around 2005 (Figure 3). This followed a period of strong activity in the late 1990s, where NSW and in particular Sydney, led the national housing boom of 1998-2003.

Annual % change in state final demand plus net exports (trend)

Australian Economic Update / 7 August 2013 / 3 of 16

FIGURE 3: NSW DWELLING INVESTMENT AS A SHARE OF DOMESTIC DEMAND VERSUS REST OF AUSTRALIA
8

7
Dwelling investment as % of state final demand

3 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
New South Wales Australia (excluding New South Wales)

Sources: ABS, ANZ

NSW business investment, while continuing to grow, slipped relative to the rest of Australia as a share of state final demand (Figure 4). NSW has not participated in the mining investment boom to the same degree as Western Australia, Queensland and the Northern Territory although coal mining is still an important contributor to the state economy.
FIGURE 4: NSW BUSINESS INVESTMENT AS A SHARE OF DOMESTIC DEMAND VERSUS REST OF AUSTRALIA
21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
New South Wales Australia (excluding New South Wales)

Sources: ABS, ANZ

But recently there has been a turnaround. Over the past year, the NSW economy appears to have grown at a faster pace than the rest of Australia. Activity in NSW (as measured by state final demand plus net exports) is above its trend rate, while the rest of Australia has slowed to below its trend rate as shown in Figure 2. A similar pattern is seen in employment growth, with NSW growing faster than its

Business investment as % of state final demand

Australian Economic Update / 7 August 2013 / 4 of 16

trend rate while the rest of Australias employment growth has slowed. As Figure 5 highlights, the net 83,500 jobs created in NSW (in trend terms over the year to June) was greater than the net job gains to the rest of the country.
FIGURE 5: CHANGE IN EMPLOYMENT LAST 12 MONTHS, BY STATE
Tas NT (trend) ACT (trend) SA Qld WA Vic NSW -20 0 20 40 60 80 Change in employment over latest 12 months (sa, 000s) 100

Sources: ABS, ANZ

This has not been reflected in the NSW unemployment rate, which rose to 5.4% in June, from a low of 4.7% last year. But higher unemployment is mostly due to a rising participation rate as shown in Figure 6. The improvement has been unique to NSW and suggests that a brightening economic outlook is encouraging workers to seek jobs. Similarly, the employment to population ratio, which fell throughout the country in the aftermath of the GFC has started to recover in NSW only.
FIGURE 6: PARTICIPATION RATE, BY STATE
69 76

67

74
Participation rate, trend, %

Participation rate, trend, %

65

72

63

70

61

68

59 05 06 07 08 AUST Tas 09 10 11 12 NSW WA (RHS) 13 05 06 07 VIC ACT (RHS) 08 09 10 11 QLD NT (RHS) 12 13 SA

66

Sources: ABS, ANZ

Australian Economic Update / 7 August 2013 / 5 of 16

Another positive labour market development particular to NSW in recent months has been a fall in workers who were working less than 35 hours a week for economic reasons (ie. because they have been stood down or are on short time due to insufficient work). In all other states, there has been a rise in the numbers of workers in this category.
FIGURE 7: SHORT ON HOURS FOR ECONOMIC REASONS, BY STATE
30 90

25

75

20

60
000s

000s

15

45

10

30

15

0 96 97 98 99 00 01 02 QLD 03 04 SA 05 06 WA 07 08 09 10 11 12 13 NSW Victoria Tasmania

0 Australia (RHS)

Sources: ABS, ANZ

The early signs of recovery in the NSW state economy are encouraging, particularly recent labour market developments. Indeed, we expect the outperformance of the NSW economy to continue for several reasons. As shown below in Figure 8, ANZs forecasts highlight that we expect the NSW economy is the most likely to pick-up and perform above its decade average, even though growth is likely to remain below the actual rates of the mining states (which should benefit from strong resource export volumes in the coming few years).
FIGURE 8: ANZ GROSS STATE PRODUCT FORECASTS
7 6
11-12 12-13f 13-14f 10 yr average
6.7

5.5 5.0 4.25 4.4 4.5

5 4 3
2.1 2.25 4.0 3.5 3.25 2.5 3.5 3.25

Per cent

2 1 0

2.0

2.0

2.3 2.0 1.75

2.4

1.5 1.25 0.5 0.0

Share of - economy 1.7% - population 2.2%

TAS

SA
6.3% 7.3%

ACT
2.2% 1.7%

VIC
22.2% 24.8%

NSW
30.7% 32.1%

QLD
19.3% 20.1%

WA
16.3% 10.8%

NT
1.2% 1.0%

Sources: ABS, ANZ

Australian Economic Update / 7 August 2013 / 6 of 16

The main reasons for our optimism about NSW are: NSW demonstrates closer correlation with the US economy than the rest of Australia and the US economy is recovering. This is in contrast with our other major growth driver, China which is slowing, albeit from higher growth rates. We see a more positive outlook for the financial and insurance services industry in Australia compared to recent years, which we believe is in part a direct consequence of the recovery in US economy and stronger demand for housing and related finance. Nearly 45% of Australias financial and insurances industry is based in NSW. The benefits of a lower interest rate environment are filtering through the NSW economy, particularly to housing construction which is also gaining momentum from pent-up demand following several years of underinvestment. The NSW Governments recent windfall gains from leasing the ports of Botany and Kembla plus its plans to privatise or lease a number of other significant assets and sound budget management have facilitated a number of large-scale transport infrastructure projects. More are likely. Partly offsetting these will be lower capital spending by the recently heavily-capitalised electricity sector. Falling commodity (especially coal) prices are likely to deter new major project developments, but with only 3% of its economy dependent on mining, NSW will not feel the effects as much as WA and Qld.

We explore each of these drivers below and point out where there are also downside risks. NSW CORRELATION WITH THE UNITED STATES ECONOMY Over the past three decades Australian GDP has shown a strong correlation with the US economy. In recent years however, this appears to have lessened while Australias correlation with China has increased. The impact of the GFC on the US economy and the China led mining boom are the main reasons for this. Our analysis suggests that the NSW economy has maintained a strong correlation with the US economy through this past decade despite the rising correlation with the Chinese economy at the national level. As shown in Figure 9 the long-term correlation (10yr rolling) between the Australian economy (ex. NSW) and the US has gradually declined from around 0.35 in the late 1990s to 0.15 in the past five years. For NSW the correlation is now higher than in the late 1990s at over 0.40.

Australian Economic Update / 7 August 2013 / 7 of 16

FIGURE 9: 10-YEAR ROLLING CORRELATIONS WITH THE US

0.6 Australia (excluding NSW)-US 0.5
10-year rolling correlation

NSW-US

0.4

0.3

0.2

0.1

0 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Sources: Bloomberg, ABS, ANZ

There is certainly evidence to suggest the NSW correlation with the US (GDP), is stronger than the rest of Australias correlation with the US economic cycle.
FIGURE 10: NSW AND US GDP GROWTH
6 5 4 Forecasts

Annual % change

3 2 1 0 -1 -2 -3 -4 NSW US

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Sources: Bloomberg, ABS, ANZ

Our forecasts indicate that the US economy is on the verge of a sustained expansion following a weak and patchy five years. While our point forecasts have growth of around 3% for the US economy in 2014 and 2015, our analysis of the risks suggests these are firmly to the upside. Given this historical correlation, our outlook for the US is supportive of continued expansion for the NSW economy. One reason this may be the case is because of NSWs exposure to the financial and insurance industries (see section below). There are also a large proportion of multinational companies headquartered in NSW, which may mean US economic conditions and confidence have a relatively large impact in NSW.

Australian Economic Update / 7 August 2013 / 8 of 16

Despite the rise of China and the importance of Chinese economic activity to Australia, the US economy is still an influential force. Much of the economic impact operates through the NSW economy via financial and confidence linkages. In our view, this boost to NSW from a stronger US economy will create positive spillovers to the surrounding state economies of Queensland and Victoria over time. Indeed, a potentially important factor in Queenslands difficult recent history has been the soft NSW economy. FINANCE AND INSURANCE SERVICES POTENTIAL Around 45% of Australias financial and insurance services are based in NSW including key financial markets and major international banks. The industry has grown rapidly over the last 30 years and now contributes around 14% of NSW gross value added, which is more than any other single industry.
FIGURE 11: NSW INDUSTRY STRUCTURE, 2002 AND 2012
Financial and insurance services Ownership of dwellings Manufacturing Professional, scientific and technical services Health care and social assistance Construction Transport, postal and warehousing Wholesale trade Public administration and safety Education and training Information media and telecommunications Retail trade Mining Administrative and support services Accommodation and food services Utilities Rental, hiring and real estate services Other services Agriculture Arts and recreation services 0 NSW 2002 NSW 2012 2 4 6 8 10 12 14

% of Gross Value Added, 2011-12

Sources: Bloomberg, ABS, ANZ

Financial and insurances services were significantly impacted by the GFC. Employment in this industry has only just recovered to be around the level recorded in early 2007. While Australias financial institutions have weathered the GFC in a relatively strong position, many international banks have been shrinking, including in Australia. There is further room for upside in this industry following the recovery in the US economy and especially its financial services industry, lead by the improvement in financial market activity which is likely to filter through to confidence more generally. An improvement in the housing cycle, which we discuss more fully below, will also lift demand for finance and insurance services (due to increased demand for housing and related finance). A downside risk however comes from the business sector with business confidence and investment subdued at present. This is not suggestive of a pick up in demand for credit from the business sector. A stronger US economy and rising financial asset

Australian Economic Update / 7 August 2013 / 9 of 16

prices suggest that we may be at a low point for confidence. There may be some improvement in these indicators after the election once there is certainty about the countrys political future, particularly if a majority government is established. HOUSING CONSTRUCTION UPSWING Past interest rate cuts by the RBA and pent-up demand for housing as well as policy measures from the State Government are gaining traction in the NSW residential housing market. Dwelling investment and building approvals have been picking up and house prices in Sydney have risen beyond their 2010 peak (the only other capital city where house prices have risen to new records is Darwin). NSW housing turnover has also increased with auction clearance rates rising significantly. High housing prices could help to stimulate further activity, especially in the investor sector as property returns become more attractive. Figure 12 below comparing population growth and housing starts shows the extent of under building in NSW in recent years, which has lead to significant undersupply of housing stock.
FIGURE 12: HOUSING STARTS VS POPULATION GROWTH, NSW
100 80 60 40 20 0 -20 -40 -60 -80 Housing Starts Population Growth 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Sources: ABS, ANZ

The NSW Government has specifically sought to address the undersupply of housing by doubling the first home owners grant to AUD15,000 but restricting it, and stamp duty concessions, to new housing with a value of less than AUD650,000. (The 201314 Budget said the number of first home owner grants was more than 60% higher than a year ago suggesting that these policies have been initially successful in attracting this segment back to the market). It has also used the proceeds of Government building sales to fund infrastructure around new housing lots and increased its planning budget to focus on facilitating housing in suitable locations. We expect there is further growth in housing construction ahead given pent-up demand and improving affordability. Indeed, there is still a significant gap between the movement in the cash rate and dwelling approvals as below in Figure 13. Moreover, given general softness in the economy and an absence of inflationary pressure, we think the Reserve Bank is likely to keep interest rates at multigenerational lows for the foreseeable future.

% deviation from long run average

Australian Economic Update / 7 August 2013 / 10 of 16

FIGURE 13: NSW RESIDENTIAL BUILDING APPROVALS VS RBA CASH RATE

6
Dwelling building approvals, 000s per month

Cash rate, inverted

3 GST introduction 2

1 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 NSW dwelling building approvals, trend (LHS) RBA cash rate, inverted (RHS)

11

Sources: ABS, RBA, ANZ

PUBLIC SECTOR INVESTMENT The 2013-14 NSW budget dedicated most of the AUD4.3bn proceeds attained from the long-term leases of Port Botany and Port Kembla to transport infrastructure. The projects currently planned include the North West Metro-Rail Link and WestConnex Road Project. Partly offsetting this will be lower investment by the recently highly capitalised electricity sector.
FIGURE 14: UPWARD REVISION TO NSW PUBLIC INVESTMENT PLANS IN 2013-14 BUDGET
12 10 8 forecast

AUDbn

6 4 2 0 2008 2010 2012 2014 2016

General government infrastructure spending as at Dec 12 General government infrastructure spending as at Jun 13

Sources: NSW Budget Papers, ANZ

But we are likely to see more public sector investment slated for coming years. Treasurer Baird has announced the sale of the State's largest power producer, Macquarie Generation, which could raise AUD1.6-AUD2bn. This is in addition to other electricity generation businesses and the lease of the Port of Newcastle. The proceeds from these will be at least partly be spent on state infrastructure (although in practice

Australian Economic Update / 7 August 2013 / 11 of 16

they pay off debt first), continuing the Governments policy to utilise its assets for the productive good of the economy. If the NSW Government is successful in attaining a mandate to sell NSWs electricity transmission businesses following the 2015 election, as it plans to do, the likely funds would be substantial (reports suggest around AUD30bn) and further infrastructure plans would likely follow. The outlook for NSW public sector investment is much more positive than in other states, where constrained fiscal conditions and less ambitious asset sales plans exist. As was demonstrated in the Victorian state economy over the past two decades a period of well targeted and sustained urban infrastructure spending can be a major positive force for investment more generally in the local economy. The opening up of new transport corridors and the upgraqding of existing infrastructure can led to new residential, commercial and retail investment in those locations. A meaningful pick-up in construction activity will create jobs and boost confidence across households and businesses. LIMITED EXPOSURE TO MINING NSW mining is dominated by the coal sector, and coal prices have fallen sharply since late 2011 (in line with most other Australian commodity prices), deterring new developments beyond current commitments. But with only around 3% of its economy dependent on mining, we expect NSW will be much less negatively affected by falling commodity prices than WA, NT and Queensland. Similarly, the labour market consequences will not be as harsh with absolute levels of mining employment in NSW below those in WA and Queensland.
FIGURE 15: INDUSTRY SHARE FROM MINING
WA NT QLD SA NSW VIC TAS ACT 0 5 10 15 20 25 30 35 40

% industry share from mining

Source: ABS, ANZ

WHERE DO WE SEE REASONS FOR CAUTION? There has been a sharp fall in the AUD which we expect to drift lower over the next year. The recent depreciation can be explained by a few factors but largely reflects a lagged response to lower prices for Australias exports, an actual/expected slowing in domestic growth and concerns about slower growth in China. In our view, the AUD should fall to a cyclical low point in 2015 of around USD0.84. The lower AUD means

Australian Economic Update / 7 August 2013 / 12 of 16

financial conditions are easier and should start to assist the rebalancing of growth by assisting the export and import competing industries that have recently suffered. These include manufacturing, tourism and international education; all industries of some importance to NSW. But they have become a smaller share of the NSW economy over the last 10 years. Any decline in the AUD will have a less positive impact than in the past. Relative to Victoria, South Australia and Tasmania which are more heavily reliant on these industries, AUD depreciation will have a less stimulatory effect to NSW industry 1. (On the other hand if the AUD appreciates again the economy is more insulated from the impact than in the past or relative to others states.)
FIGURE 16: NSW INDUSTRY COMPOSITION COMPARED TO REST OF AUSTRALIA
Financial and insurance services Ownership of dwellings Manufacturing Professional, scientific and technical services Health care and social assistance Construction Transport, postal and warehousing Wholesale trade Public administration and safety Education and training Information media and telecommunications Retail trade Mining Administrative and support services Accommodation and food services Utilities Rental, hiring and real estate services Other services Agriculture Arts and recreation services 0 2 4 6 8 10 12 14

NSW

Average other states

% of Gross Value Added, 2011-12

Source: ABS, ANZ

We do not see an immediately bright future for private business investment spending, which has been particularly weak in recent years. Critical to a sustained expansion in the NSW economy will be a turn around in non-mining investment. There is scant evidence of this yet, although as discussed throughout this paper many of the building blocks of a recovery in business confidence and investment are being put in place.

1 We recognise this is a broad simplification of the impact of the AUD on the NSW economy.

Australian Economic Update / 7 August 2013 / 13 of 16

FIGURE 17: NSW BUSINESS INVESTMENT

5 Business investment (deviation from 5-year average) 3

% of GDP

-1

-3

-5

Source: ABS, ANZ

90

92

94

96

98

00

02

04

06

08

10

12

Consumption growth has been soft and retail sales growth has been growing at a below trend rate since 2011. This is likely due to weakness in employee compensation, which has shown no signs of rising in line with better labour demand in the state. This may be short lived however if improvements to labour demand translate to wages.
FIGURE 18: REAL COMPENSATION OF EMPLOYEES
16 14 12 10
Annual % change

Australia (excluding NSW) compensation of employees NSW compensation of employees

8 6 4 2 0 -2 -4 -6

86

88

90

92

94

96

98

00

02

04

06

08

10

12

Source: ABS, ANZ

Australian Economic Update / 7 August 2013 / 14 of 16

Appendix 1: NSW FACT BOX

Annual GSP AUDbn (2011-12) Share of economy % (2011-12) Population (Dec 12) Share of population % (Dec 12) Share of employment % (av. 2012-13) CPI %y/y (Mar qtr) Unemployment rate %, sa (Jun) Employment %y/y (Jun) Operating budget balance AUDbn (2013-14) 446 30.7 7,348,899 32.1 31.5 2.8 5.5 3.5 -1.9 Net debt AUDbn (2013-14) Government Premier Leader of opposition Treasurer 2014-15 budget Next election S&P's credit rating Moody's credit rating 15.7 Liberal-National since 2011 The Hon Barry O'Farrell MP Mr John Robertson MP The Hon Mike Baird MP June 2014 28 March 2015 AAA (Negative) Aaa (Stable)

Sources: ABS, NSW Budget Papers, NSW Parliament, S&P, Moodys, ANZ

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