The simplest way to think about the Aussie economy is that it is driven by dirt and debt. Our commodity exports (led by iron ore) provide the income, which allows us to borrow and speculate on housing. Of course, low interest rates have assisted Australia in achieving the highest household debt levels in the world. In turn, interest rates are so low because of the commodities bear market that occurred from around 2011 to late 2015.
Australian Economy in recent times
As commodity prices fell, so did Australia’s national income. The Reserve Bank of Australia responded to this price fall by lowering interest rates from 4.75% in November 2011 to 1.5% in August 2016. This had the effect of setting off a housing construction and price boom. Rising house prices (via the wealth effect) encouraged consumers to keep spending. Consumption represents nearly two-thirds of economic growth, so this spending kept the economy healthy through the commodity price downturn.
Aussie Economic Risks
The biggest risk for the Aussie economy isn’t a house price collapse, as everyone fears. That will be a symptom of the problem, rather than the problem itself. The biggest risk is a sharp downturn in China’s economy. This will send iron ore prices and other commodity prices plunging back down again. A prolonged downturn in commodity prices will reduce Australia’s income growth. Given Australia’s high debt levels, falling incomes would spook our foreign creditors. This could lead to a plunging Aussie dollar, as foreigners hold back on extending loans to Australia.
So how bad is the Australian Economy?
Australia owes more than $1 trillion (net) to foreign lenders. So if they consider us a higher-risk destination to invest due to a weaker Chinese economy and plunging commodity prices, that could lead to a sharp slowdown and recession. Falling house prices would follow. This is a worst case scenario, but not out of the question if China encounters its own debt crisis.