From CBA's Chief Economist, Michael Blythe, who is one of the best in the business...
2010/11 Budget – initial views
* The underlying Budget deficit for 2010/11 is put at $40.8bn (2.9% of GDP) vs the $57.1bn (4.4% of GDP) deficit now expected in 2009/10.
* The improved economic backdrop allows a faster return to surplus (in 2012/13, 3 years sooner than previously thought).
* The economy is expected to grow at 3¼% in 2010/11 and 4% in 2011/12.
* The Budget adheres to the GFC exit strategy and the medium-term fiscal framework.
* But fiscal settings are a little out of kilter with short-run cyclical requirements.
* The rapid return to surplus and a peak government debt level of 6.1% of GDP provides a degree of protection against the current bouts of global risk aversion.
* Financial markets were largely unmoved by the Budget.
* Smaller deficits imply a lower financing task.
The big picture
The 2010 Budget was framed against a much different backdrop from that in 2009. Expectations of a nasty recession that was going to decimate the Budget proved unfounded. And recovery has been sooner and more forceful. The income skew in the recovery has magnified the impact on fiscal aggregates. As a result, near term deficit projections have been scaled back. And the Budget is expected to return to surplus in 2012/13, three years sooner than previously anticipated.
The no-frills, fiscal conservatism theme promoted in recent weeks runs through the Budget. Fiscal initiatives were largely limited to measures already announced and the government’s response to the Henry tax review. The main new proposals revolve around simplification of tax returns, a renewable energy fund, some extra spending on rail infrastructure and some further health initiatives (adding to spending and reducing costs). The main “surprise” was the decision to introduce a 50% discount on interest income. Such a reform had been mooted in the Henry tax review but was not included in the government’s response released nine days ago.
Budget forecasts show an economy quickly returning to trend (GDP growth at 3¼% in 2010/11) and beyond (4% growth in 2011/12). Growth at this pace underwrites a firm labour market backdrop, although progress in winding back unemployment is slow. The economy rapidly approaches full capacity in this scenario so inflation risks are increasing. Nevertheless, Budget forecasts show inflation tracking along at 2½%pa from 2010/11 onwards.
The Budget’s economic activity forecasts look reasonable for an economy facing a terms-of-trade-driven income boom. But we would regard the accompanying price figuring as at the low end of the range of likely outcomes. The broad growth backdrop is similar to that sketched out by the RBA in last week’s Statement on Monetary Policy. But the inflation numbers are clearly lower than the RBA forecasts.
Beyond 2012/13, economic growth returns to a trend-type 3%pa. This assumption represents a shift from the 2009 Budget when a more extended period of above-trend growth was assumed. Together with 2½%pa inflation, these new GDP growth assumptions have probably reduced revenue growth in the out-years. There may be scope for some further improvement in the Budget bottom line at a later date.
Scoring the Budget
Fiscal policy was set for a recession. Having dodged the recession bullet, fiscal settings need to be “normalised” in much the same way that the RBA has normalised interest rates. The wisdom of designing a stimulus response that worked quickly and then unwound is now apparent. But more remains to be done.
The short-term exit strategy from the GFC stimulus involves:
· saving revenue gains,
· capping real spending growth at 2%pa; and
· paying for new spending with cuts elsewhere.
The close correlation between revenue projections and nominal growth does suggest that most of the revenue gains have been allowed to flow through to the bottom line. The spending cap is met. But the fiscal effort is a middle-of-the-road type outcome compared with previous fiscal consolidation efforts. Other measures of real spending – such as government own purpose consumption spending – suggest a slight slippage towards the end of the projection period.
Some new spending is funded by tax measures rather than savings (eg health/tobacco excise, superannuation/Resource Super Profits Tax). And the government has dipped into the contingency reserve to support its claim that all new spending measures have been offset by a reprioritisation of other policies (although to be fair this is standard procedure). The deferral of the Carbon Pollution Reduction Scheme has also helped.
The medium-term fiscal framework involves:
· achieving budget surpluses, on average, over the medium term;
· keeping the tax take, on average, below 2007/08 (23.6% of GDP);
· improving Government net financial worth over the medium term.
These objectives are largely satisfied in today’s Budget. Surpluses return and net worth improves marginally. But the Budget numbers do rely on robust growth early on and an extended period of high commodity prices to do most of the work. There is also some tendency for the big ticket spending proposals to have delayed start dates while savings measure are more up front. The revenue share is kept below the 2007/08 target level. The task is, however, made easier by ABS revisions to the size of the economy. The 2007/08 GDP level was revised up by $50bn over the past year - allowing an extra $12bn of revenue to fit under the cap.
So the Government has essentially delivered on its policy approach. But a case can be made that more should be done.
The fundamental policy issue is the commodity boom and its income impact on an economy running close to full capacity. The tension between income, spending and production is where the inflation risks lie. There is a perceived demand management issue and a resource allocation issue for policy makers to resolve.
The demand management issue relates to the Budget’s place in the economic cycle. Short-term stimulus measures were unwound by early 2010. The change in the underlying Budget balance over the two years to 2011/12 – a reasonable proxy for the degree of fiscal effort – is equivalent to 3½% of GDP. But the full impact of longer-run infrastructure measures is yet to be felt. And today’s Budget actually boosted infrastructure-related spending. OECD estimates suggest that infrastructure spending has a larger impact on economic activity than other policy measures. Some commentators argue that there is a risk of fiscal policy becoming pro-cyclical.
Should the government have gone harder and scaled back some of this infrastructure spending? There is no universal agreement. But a number of studies suggest that public investment complements private investment and helps promote productivity. One study, for example, found that for the US economy a 1% rise in the stock of public capital raised private-sector capital productivity by 0.4%. This outcome implies very high returns on public sector investment. Similar estimates have been derived for Australia. The main Australian study concluded that a 1% rise in the general government capital stock increases private productivity by about 0.4%. A strong case exists to push on with this spending and ignore cyclical issues.
The resource allocation issue relates to making room in the economy for what looks like an unstoppable resources boom.
Aspects of the recovery have significant funding requirements (infrastructure, business capex and housing). Governments (Federal and State) will remain net borrowers for the next few years. So our reliance on lending by the rest of world is set to rise sharply. Potential implications include:
· a larger current account deficit – bringing with it risks to the AUD and interest rates;
· a high leverage to the global recovery and exposure to shifting risk appetite;
· a need for the household sector to do some of the heavy lifting by reducing net borrowing.
Higher interest rates are one way of shifting resources from households to other parts of the economy. But the tax cut due 1 July and other developments (eg rising wealth) are working in the other direction.
One message is the dangers inherent in making fiscal decisions well in advance of their implementation. This Budget follows a similar path. The cut in corporate tax rates, for example, takes effect in 2013/14 and the increase in the superannuation guarantee is not fully in place until 2020.
From a broader perspective, however, history shows no clear correlation between tax cuts (or size of the cut) and the ensuing trend in consumer spending. There are periods when quite large cuts were followed by slowdowns in consumer spending growth (eg 1982/83, 1989/90). On other occasions, relatively small tax cuts were followed by a significant acceleration in consumer spending (eg 2003/04). This lack of correlation suggests that underlying economic trends are more important in determining the impact of tax cuts. If the economy is in good shape and households are “relaxed and comfortable”, then it is likely that the money will stimulate spending. If households are uncertain or cautious, the money may end up being saved or used for balance-sheet repair.
The three variables that influence longer-run economic developments are population, participation, productivity. Policy makers do have a tendency to claim all measures will support these longer-run aims. Many of the Budget proposals do, however, tick the right boxes. The focus on training, education, superannuation and infrastructure spending is attractive.
Recent developments in Europe highlight the fragile nature of the recovery in financial market confidence. But Australia’s fiscal position is extremely sound. Budget surpluses return by 2012/13 and public net debt set to peak at 6.1% of GDP in 2011/12. Ratings agencies have confirmed Australia’s AAA status. Peripheral economies like Australia will always suffer during periods of risk aversion. But a vastly superior fiscal position means a degree of market discrimination favouring Australia should be evident over the medium term.
Financial markets
The return to surplus is occurring faster than previously expected. As such, the total borrowing requirement is also shrinking.
The government has suggested that there will be $56bn of Coupon CGS issued in 2010/11 and $4bn of index linked issuance. The working pool of Treasury notes is also expected to drop by $1bn to $10bn. The new net issuance is likely to drop even faster. Although the Government is forecasting $60bn of bond issuance, there will also be $20.4bn of maturities. The net issuance of CGS will likely fall from $50.2bn in 2009/10 to around $39.6bn in 2010/11. We now look for the peak of (bond) debt to be about $195bn in 2012/13. Alternatively, if Treasury notes are included, total borrowings are likely to be around $205bn at the peak in 2012/13.
We expect the reduction in net issuance and the increasing demand for bonds to result in widening bond-to-swap spreads. The sources of increased demand for bonds are well known. For example, APRA liquidity rules and increases to superannuation. We believe the composition of issuance will play a factor too. Despite the total borrowings each year remaining relatively constant, the growing maturity profile means that net issuance is falling.
The Government has introduced a large number of measures aimed at boosting the domestic savings rate and to make it easier for credit to flow between borrowers and lenders.
The measure which has received most emphasis from the Treasurer is the 50% discount on interest earned. However, it only applies to the first $1000 of interest income. This really is unlikely to affect the savings decisions of Australians in any meaningful way, in our view. As admitted by the Treasurer in his press release $1000 represents a return of 6% on $16,666.67. Although this will, at the margin, assist banks to increase their deposit bases we cannot see the measure changing savings behaviour greatly. We believe the cap of $1000 interest is just too small. It should be noted that the definition of “interest income” is still subject to consultation, but appears to be intended to be read fairly broadly. The Treasurer’s press release mentions deposits, bonds, debentures and annuities. If the measure increases the deposits held at banks it will lower bank funding costs. To the extent the new 50% discount encourages savings it may also increase bond scarcity if the savings are directed towards Government bonds (we do not expect this to be large).
The Government has also announced significant reductions to the Interest Withholding Tax paid by Financial Institutions in a variety of circumstances. Interest withholding tax is frequently mentioned as a complication for bank funding but again is unlikely to significantly alter funding decisions. It will definitely not affect short-term decisions as the first cut in IWT is not until 2013-14. Also, the Government has announced a simplification of the product disclosure rules for companies that wish to borrow money directly from retail lenders.
We are not sure that any one of these measures will “solve” the domestic banks funding needs. Australian banks are likely to continue to need to borrow significant amounts from offshore wholesale markets. However, the Government has shown significant intent and has introduced a number of measures aimed at easing the funding task of banks. And. At the margin, the measures will increase the attractiveness of Australia as a financial centre.
Regards
Michael Blythe Chief Economist
