Economic impact of the Queensland floods

02 March 2011

The Queensland floods could cut GDP growth over 2011 by half a percentage point and boost inflation by half a percentage point. In the short term, the negative impact on activity should prevent further monetary policy tightening and as a result we no longer expect that the RBA will raise interest rates in Q1. However, the higher inflation profile will keep a tightening bias very much in place.

Certainly monetary policymakers will adopt the view that the greatest contribution they can make is to keep the overall economy growing at a sustainable pace with moderate inflation, as that will enable State and Federal Governments to enact the recovery plans that are sorely required.  Of course, it goes without saying that the greatest cost of this disaster is the loss of lives and the pain and suffering which the floods have caused.

Estimating the impact of the flooding on GDP growth

In thinking about the flood devastation in Queensland, it is useful to consider the several ways in which economic activity will be affected.  

First, there is the temporary disruption to activity itself, as production that would have taken place -- construction work, mining, shopping -- was interrupted.  While this is important, it is easy to overestimate what impact it will have on GDP growth.  For example, if we make the extreme assumption that no activity in Queensland took place for 1 week, then this would result in Queensland's GDP falling by 8 per cent in the March quarter and Australia's GDP falling by 1.5 per cent.  Over 2011 as a whole, growth would be trimmed by just 0.4ppts.

But that is an extreme assumption.  First, Queensland is the most decentralised state in Australia, and Brisbane only accounts for half of Queensland production.  Second, many sectors of the economy including health, most areas of the public service (including police, ambulance, fire etc), communications, media and education haven't experienced a fall in output.  Third, for some sectors that have been affected -- such as grocery retailing -- the floods are more likely to have affected the timing of spending rather than the overall amount of spending, as people still have to eat.  So the direct temporary disruption to activity caused by the flooding will likely only have a modest effect on GDP growth -- probably less than a quarter of a percentage point.  In our view, however, this is the wrong place to look for the real effects on the economy.

The second way in which the floods could affect activity is by the damage to infrastructure itself.  If the supply of electricity or water was disrupted for an extended period, then factories and shops would have to close down even if they were fortunate enough to have escaped the flood devastation.  Similarly, if rail or port infrastructure was badly damaged, it could force coal production to cease even if the mine was operational.  The coal sector could be currently running at just 20 per cent of capacity and it will probably take 3 months before full coal production -- and shipments -- have resumed.  And, of course, if there is further heavy rain -- which is a distinct risk -- then this timetable will be pushed back further.

This is potentially more significant than the first effect for two reasons.  First, because the disruption to activity could be sustained over a much longer period (and so the impact on GDP much larger).  Second, because the Australian economy is much more dependent on growth from the mining sector.  Recall that the Reserve Bank of Australia has been deliberately trying to make room for the mining boom by raising interest rates and dampening household spending.  At the same time, government fiscal policy has become contractionary.  This has meant that the Australian economy is extremely dependent on the mining sector.  Coal accounts for about 20 per cent of mining production and so even with iron ore production remaining okay, a loss of production in this sector would mean that there is no remaining engine to drive growth in Q1.

Third, the floods will have a large impact on rural production.  Heavy rains in south-eastern Australia in recent months had already reduced the quantity and quality of the wheat harvest; however, the Queensland floods will have a greater impact on fruit and vegetable production, cotton growing and have some impact on the beef sector.  Again, this impact will be more enduring than simply the March quarter.  Last, the flooding could also delay the commencement of investment projects, meaning that business investment could be much weaker than expected in 2011H1.

The impact on profits and inflation

The floods obviously undermine the profitability of some companies, such as those firms in the insurance sector which are exposed to Queensland property.  And, initially, some spending will be diverted so that while sales at hardware stores may kick higher as people try to repair their homes, sales of televisions and overseas holidays fall.  Again, the temptation will be to view this as 'swings and roundabouts' with the aggregate impact on profits only moderate.  And for large companies with strong balance sheets that may well be true.  That is, while profits in the insurance sector will take a hit, profits in the retail sector may ultimately rise as people spend their insurance pay outs and people start replacing their cars etc.

While there is an element of truth in this view, we think it understates the potential effect of the flooding particularly for smaller businesses.  First, while the loss of income for a week or two may not sound too significant, for many firms in Queensland, which had already been struggling with a softening economy, the loss of cash flow could be crippling.  In effect, it could be the straw that breaks the camel's back.  Tourism operators, for example, that had been struggling to cope with the impact of the high A$ and have been affected by flooding, may now think it is a good time to take the insurance payout and leave the industry rather than try to struggle on.

The flooding will also push up prices.  Besides higher food costs, transportation costs are likely to increase as may insurance costs.  Governments may introduce 'temporary' levies to help fund the cost of repairing damaged infrastructure.  And the cost of skilled tradespeople is also likely to surge as everyone starts trying to find a plumber or a carpenter to repair damaged properties. Again, for those firms that are unable to pass on these costs, profits will take a hit.

The rebuilding phase

Of course, while the GDP data don't capture the destruction caused by the flooding, they are boosted by reconstruction.  This is one reason why natural disasters can sometimes appear to have a surprisingly small impact on growth.  To be precise, repairs -- such as patching up a roof -- are not considered by the Statistician to be 'production' and so do not boost GDP growth.  But if a house is completely destroyed and is replaced, the new dwelling will boost GDP growth.  This might seem like an arcane point, but it is important in thinking about some of the claims floating around that "$10 billion will need to be spent on reconstruction".  Even if that is true, if half of this reflects repairing damaged property, then it will not be reflected in stronger GDP growth.  Of course, for a building materials firm this distinction is irrelevant as demand for those building products will still rise.
That said, it is also important to note that much of the reconstruction will not be an incremental increase in spending, but will displace other spending that would otherwise have occurred.  That is, instead of building a new highway, the government will divert that money to repairing an existing one.  And finally, it should be remembered that the reconstruction process will likely take some years to complete, which also dampens the positive impact on GDP in any one year.  What took 3 days to destroy, may take 3 years to rebuild.  The bottom line is that rebuilding will boost growth in the second half of 2011, but this impact will likely be modest.

Implications for policymakers

To summarise the impact of the flooding.  The flooding could cut GDP in Q1 by half a percentage point and maybe a little more, but will then add modestly to growth in the second half of 2011 as the rebuilding phase kicks in.  Inflation in Q1 could also be boosted by half a percentage point due to higher food prices.  But while the surge in food prices will likely be reversed in late 2011, that could be offset by increased building costs, insurance costs and the possibility of additional levies.  In our view, the greatest risk to the economy stemming from the Queensland floods is the potential impact on those businesses which had been struggling prior to the flooding, due to the high A$, weak tourism and soft property markets.

So how should policymakers react to this combination of weaker growth but higher inflation?  In the short term, we think the negative impact on growth will dominate.  We had been expecting the RBA to lift interest rates twice in the first half of 2011 in order to remain ahead of the curve.  However, with the possibility that the economy may shrink in Q1, we now expect the RBA to keep rates steady until May.  This said, the higher inflation outlook means that the RBA's tightening bias remains very much in place.

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