The drought - is our economy wilting?

Australia is in drought. While this is nothing new, it does come very soon after the drought of 2002. This time around, the rural community has had little time to recover.

Droughts impact many aspects of the economy. Rural production, employment, exports, economic growth, inflation and the sharemarket are all affected.

In this issue of the Big Picture, we look at what economic impact the current drought may have.

The two main indicators of drought are its geographic spread and the degree of dryness. The map below shows the areas of Australia that are currently experiencing drought conditions.

Impact on economic growth

Droughts have been costly to the Australian economy over time. They impact directly on economic growth through the loss of rural production and indirectly through lower spending by rural communities.

In recent decades the size of the rural sector has fallen as a percentage of the overall economy. In 1960 the rural sector made up 20% of Australian economic output (Gross Domestic Product) but by 2006 it made up only 2.5%. The chart below shows the declining share of the sector in the economy while the bars show the drought years.

The rural sector’s declining size reduces the impact of a drought on overall Australian economic growth. Despite this, the sector’s absolute size and its importance for exports means that a severe drought still has a significant negative impact on Australia’s economic growth.

The Australian Bureau of Agricultural and Resource Economics (ABARE) has forecast a 35% reduction in the value of farm production in 2006-07 due to the drought, with farm output forecast to fall by 20% over the same period. Much of the expected decline in farm production will be due to a sharp fall in wheat production, with the worst affected areas being the wheat belts of NSW and Western Australia.

Based on ABARE forecasts, the Reserve Bank of Australia expects the drought to directly subtract around 0.5% from economic growth in 2006/07. Indirect effects then shave off another 0.2% to 0.3%. If the economy was going to grow at 3.0%, a drought brings that back to 2.3%.

With the drought in mind, Federal Treasury forecasts economic growth of 2.5% in 2006-07. On the assumption of a return to average seasonal conditions in 2007-08, it forecasts economic growth of 3.75% for 2007-08. This may prove to be optimistic.

Helping to soften the impact of the drought will be factors such as drought assistance packages and the Federal Government’s large budget surplus.

The large fiscal surplus should enable increased emergency funding. Such drought assistance helps farmers to smooth income and assists in reducing the flow-on effects from the drought into the wider economy.

Impact on employment

Just as the agricultural sector has declined in relation to the wider economy, the proportion of workers employed within that sector has also declined.

In 1986, 6.1% of employed persons were working in agriculture and farming. By 2006, this had fallen to 3.5%.

The chart below shows the decline in employment within the sector. The orange bars represent drought years.

During the drought in 2002-03, the proportion of all workers employed in the sector fell from roughly 5.0% to 4.0% The current drought could produce a similar reduction in employment, putting further pressure on economic activity in rural areas.

Helping to offset the impact of this potential reduction in rural employment is the low level of unemployment across the broader economy. The national unemployment rate of 4.6% is at 30 year lows. Any unemployment caused by the drought could be offset by job creation in other sectors.

Impact on exports

Exports contribute to economic growth. When exports weaken, economic growth tends to recede unless there is an offsetting reduction in imports.

When rural production falls, rural exports tend to fall. The chart below illustrates this relationship. It measures percentage changes in rural production and rural exports. Inventories or stockpiles of rural products such as wheat and wool do dampen the relationship.

Rural exports have fallen as a proportion of total exports. In 1976, rural exports made up around 40% of all Australian exports. In 2006, they made up around 13%. While a reduction in rural exports is significant it does not have as large an impact on the overall economy as occurred several decades ago.

Impact on inflation

Droughts can have a short term impact on inflation but their longer term impact on inflation has been minimal.

In the short term, wheat prices and the cost of foodstuffs dependant on irrigation tend to rise. Offsetting this is an initial reduction in the price of meat as livestock is slaughtered. Meat prices then rise as shortages occur.

Assisting to keep inflation in check is the ability to import food products that are in short supply. It should also be noted that the contribution of raw material prices (eg for sugar cane) to final retail food prices is small; hence the impact on inflation is subdued.

The Reserve Bank of Australia expects the net effect on inflation from the current drought to be fairly small over the coming quarters. As such it should have direct little impact on interest rates.

Living in a material(s) world

For the past few years Australia has experienced a resources boom. This strong demand for materials is ongoing and is well supported by a robust Chinese economy and by solid global economic growth. The resources boom has helped to offset the negative impact of the drought upon the wider economy and it is probable that some labour will drift from the rural sector to the mining sector.

What about the sharemarket?

A number of companies listed on the stock exchange have strong links with the agricultural sector. They face difficult times and their earnings will be under pressure. However they comprise a very small portion of the market and the overall impact is likely to be small.

And in the end

Droughts are a regular feature of the Australian climate and impact adversely on the Australian economy. This impact has declined over time as the size and structure of the economy has changed.

For those involved in the rural sector the impacts of the drought are severe and require assistance and understanding. Governments will continue to play a role in providing emergency funding and in encouraging the effective use of land and water.

by Hans Kunnen, February 2007