Australian Budget Observer Update

Update from our New Zealand and Australia Chief Economist Paul Bloxham:

PRESS RELEASE

Australian Budget Observer Update
Significant fiscal retrenchment projected

As expected the government is projecting a massive budget swing as it continues to forecast a surplus by next year, despite fiscal slippage this year. The implied fiscal contraction is the largest since the 1950s (-3.1% of GDP). At the same time, growth is forecast at about trend this year and next, despite falls in the terms of trade. The projections seem to implicitly assume RBA rate cuts. We remain sceptical that the RBA would move on the basis of budget projections alone, given recent fiscal slippage. But, if achieved, these budget plans would put downward pressure on RBA rates, much as the government hopes.

Facts
- The government projects the budget balance to be –$44.4bn (-3.0% of GDP) in 2011/12, +$1.5bn (+0.1% of GDP) in 2012/13 and +$2.0bn (+0.1% of GDP) in 2013/14. This implies a massive fiscal contraction this coming year.

- This compares with estimates at the November 2011 mid-year update suggesting a budget balance of –$37.1bn (-2.5% of GDP) in 2011/12, +$1.5bn (+0.1% of GDP) in 2012/13 and +$1.9bn (+0.1% of GDP) in 2013/14.

- Net debt is forecast to peak at 9.6% of GDP this year, before falling to 9.2% of GDP in 2012/13 and 7.3% by 2015/16.

- GDP growth is forecast to be 3.00% in 2011/12, 3.25% in 2012/13 and 3.00% in 2013/14 (versus the RBA’s forecasts for 2.75%, 3-3.5% and 3-4%, respectively).

- CPI inflation is forecast to be 1.25% in 2011/12, 3.25% in 2012/13 and 2.50% in 2013/14.

- The terms of trade are forecast to rise by +3.25% in 2011/12, before declining by -5.75% in 2012/13 and -3.25% in 2013/14

- Nominal GDP is forecast to be +5.50% in 2011/12, +5.00% in 2012/13 and +5.25% in 2013/14 (versus the November 2011 update forecasts for +6.25% in 2011/12 and +5.00% in 2012/13).

- The unemployment rate is forecast to edge up to 5.5% in 2012/13 and 2013/14.

Implications
Tonight’s budget had few surprises, with most of the salient points published ahead of time in the press. As widely expected the government has stuck by its projections for a small surplus next year, after significant fiscal slippage means the current year’s budget deficit slipped from -$A37bn to -$A44bn. The projected fiscal contraction is a massive -3.1% of GDP this year. At the same time, the economic forecasts are for around trend growth this year and next. If achieved, this would put downward pressure on RBA rates, much as the government hopes. But we doubt the RBA would move on the basis of the budget projections alone, given the recent history of fiscal slippage.

Before we go any further, it is worth reminding ourselves that Australia’s fiscal position is very strong compared with the bulk of the developed world. With current net government debt of 9.6% of GDP, Australia’s triple AAA sovereign rating seems secure.

We also agree that it is an appropriate goal for the government to be aiming to balance the budget on average. But timing is also important. On the government’s own forecasts, the terms of trade have peaked and are expected to fall further over the forecast horizon. With nominal GDP having risen very strongly in 2010/11, driven by the rising terms of trade, it would have been more reasonable to expect to achieve budget surplus during that period.

In continuing to aim for a budget surplus in 2012/13, but having achieved very little of the needed fiscal unwind to get there so far, the hard work has been left to the end. In this way, the imperative for achieving a budget surplus by 2012/13 has become more political than economic. It seems unlikely that a milder fiscal unwind, taking longer than planned, would have a material impact on the government’s cost of funding or sovereign rating. And indeed, given the recent history of fiscal slippage, we may yet get to test this hypothesis.

Leading into an election year in 2013, the government’s position is to use the projected surplus as a political tool to indicate that they are economically responsible and to argue that the tight fiscal position will allow the RBA to cut rates further. Lower interest rates help to support incumbent parties in elections in Australia, much as higher interest rates hinder them.

Having had a downside surprise on revenue growth in 2011/12 the government has needed to make some adjustments to net spending to still be on track for a surplus by 2012/13. That is, there was fiscal slippage this year, just as there had been in earlier years. In 2011/12 fiscal slippage is apparent in lower than expected GST and capital gains tax revenues amongst other things. To offset this slippage, adjustments have come in the form of spending deferrals (particularly in defence), increased taxes on high income households and a number of accounting adjustments. The government has also reneged on previous plans to cut the corporate tax rate, which was proposed in conjunction with the negotiations for the mining tax. The mining tax still goes ahead, but estimates of revenue have been reduced to $A6.5bn (0.2% of GDP per annum) over the next two years.

In the end the main drivers of whether the budget surplus will actually be achieved depends on the performance of the economy and the calibration of that performance in terms of its impact on tax revenue and spending. The government is expecting real GDP to grow by 3.25% in 2012/13 and 3.00% in 2013/14. In nominal terms, growth is expected to be 5.50% in 2012/13 and 5.25% in 2013/14. A number of factors will test the plausibility of these GDP forecasts. There are the ever present global risks, as well as the risk that the pulse of growth in Australia is already lower than expected. In addition, the fiscal contraction itself will subtract from growth – though only to the extent that it occurs.

On an assumption of constant RBA rates, the projected scale of fiscal contraction and trend GDP growth seems a stretch. But the question is what will slip? If recent years are a guide, fiscal slippage is the most likely adjustment to this outlook. Though there is a clear downside risk to RBA rates.

At the same time as preaching austerity, the Budget also announced further spending programs. In particular, further compensation to low-income earners to offset the impact of the introduction of the carbon tax, which is implemented from 1 July this year.

Bottom line
Given fiscal slippage over the past year, the government has announced some spending deferrals, reneged on previously proposed corporate tax cuts and made other accounting changes to maintain the surplus projections.

Budget projections imply a massive fiscal contraction to get back to budget surplus over the coming year, but also assume trend economic growth. If the projections come about, they do imply downside risk to RBA rates.

But there is also significant risk of fiscal slippage, given recent history of this.

ends

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