Can drought lead to a recession in Australia?

May 14th, 2007

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In Can Australia?s deflating property bubble deflate even further?, we asked ?… what external forces beyond Australia?s control may tilt her into a recession?? In that article, we listed ?sustained uptrend in oil prices? as one of the possibilities. Today, we thought of another possibility: drought.

It is obvious that the drought will affect farm output in Australia. Although the farm sector will be severely affected, it is always assumed that it will not pull down the rest of the Australian economy into recession. However, something in the Sydney Futures Exchange gave us something to think about regarding that assumption.

In the last several weeks, electricity futures contracts (expiring all the way to 2011) in the Sydney Futures Exchange have been soaring. The drought was blamed for the declining electricity output?there is not enough water to (1) drive the turbines for hydroelectric plants and less importantly, (2) to cool coal-fired power stations.

If this is going to translate to a sustained uptrend in electricity prices, what will be consequences?

Firstly, electricity is a major input cost for many industries. As this article, Electricity futures shock as turnover quadruples, price doubles, in the mainstream news media said,

Electricity represents 15 to 20 per cent of costs for industries such as paper, cement and steel. The increased cost can be expected to flow through into economy-wide costs in the same way as last year’s oil price increase.

With higher input costs, we can expect them to be passed on to consumers. Also, higher electricity costs can have the effect of curtailing consumer spending just as higher oil prices do. The outcome will be price inflation, which may further pressure the Reserve Bank of Australia (RBA) to raise interest rates. Higher interest rates will definitely be a strain to an already highly indebted nation (see More pain for Australia), especially on the mortgage front (see this news article: Drought powers threat to mortgages).

Please note that we are not predicting that this will happen?we are only saying that this is a possibility. In the meantime, keep an eye on this development.