The Australian Budget review: A change in the fiscal landscape

Matthew Peter ,Chief Economist

Scott Morrison’s 2017/18 Budget seeks to reframe Australia’s fiscal landscape. Gone are over $13 billion of unlegislated and unpopular zombie budget cuts from the Abbott/Hockey era. Given the difficulty in passing spending cuts, the Budget relies on tax hikes to pay for the zombie measures (via the Major Banks Levy and Medicare levy).

The Government is seeking to meet Labor half-way on health and education, with the re-indexation of Medicare payments and Gonski 2.0. The Budget also opens the possibility of negotiation around various tax policies such as the Medicare Levy and the Budget Repair Levy with a greater chance of compromise and progress than has been the case over the last four years.

The Budget also pursues a significant $75 billion infrastructure program. In addition, it proposes a new funding model, with the potential for a clear line-of-sight between a government-based build-and-operate phase and a transfer phase to the private sector.

The Budget is fiscally responsible. Economic projections appear reasonable, although are slightly more optimistic than QIC’s. While growth and wage forecasts are slightly higher than QIC’s and consensus forecasts, we estimate that our softer view on the economy deteriorates the Budget by around $6 billion over the four years of the forward estimates (i.e., 2017/18 to 2020/21). This means that in that in the final year of the forward estimates (2020/21) the Budget surplus would be $6 billion instead of $7.4 billion, as projected by Treasury. This differential between Treasury and those implied by the consensus of Australian forecasters is well within tolerable range of error.

Over the course of the forward estimates, the Budget deficit is projected to fall from its current level of -$37.6 billion to -$2.5 billion in 2019/20, before reaching a surplus of $7.4 billion in 2020/321. Net debt peaks at 19.8% of GDP in 2018/19 before gradually drifting lower. Ratings agencies have shown support for the Budget. Moody’s and Fitch have noted the budget is consistent with Australia’s AAA rating, while it appears that Standard & Poor’s will hold off on commenting on Australia’s sovereign rating until its review in July.

However, no Budget is without its shortcomings. The Budget noticeably failed to adequately address the housing affordability issue, hampered by backbench resistance to adjustments to negative gearing and capital gains tax.

While the levy on major banks strikes a popular chord, the prospect of ongoing conflict between the government and the pillars of Australia’s banking sector, combined with the arbitrary nature of the shift in policy has the potential to erode the confidence of foreign investors. With a shaky AAA rating (notwithstanding the overall endorsements from Moody’s and Fitch), a burgeoning level of household debt and the risk of a major housing market downturn into an already sluggish economy, it is of increasing importance for Australia to present itself as a beacon of financial stability.

On a more positive note, the government’s infrastructure program, while modest, opens the door for a more rational approach to much needed infrastructure spending. Infrastructure spending can benefit the economy in three important ways.

First, when the infrastructure becomes operational, it facilitates efficiencies in economic activity. Without continual renewal and development of our infrastructure, we run the risk of reducing our competitiveness in international markets.

Second, in a weak economy, spending during the construction-phase of the project tends to soak up unutilised and under-utilised resources, delivering a multiplier impact on the economy. In our analysis of infrastructure spending, we find a multiplier of 1.4 for transport infrastructure projects such as those proposed by in the Budget. This means that for every $1 spent on the construction of infrastructure a further spending of $0.40 is created in the economy, as industries along the supply chain are stimulated and as additional income growth also stimulates general spending in the economy.

Third, additional economic growth increases the government’s tax base generating a growth dividend for the Budget. While reasonably modest at $75 billion spread over 10 years, our simulations of the impact of the government’s infrastructure program is that it will generate around 25 basis points of additional real GDP growth over the four years of the forward estimates; enough to close the gap between Treasury’s economic forecasts and the forecasts of the median Australian forecaster reported by Consensus Economics. In addition, our simulations show that it will generate a Budget growth dividend of between $3 billion and $5 billion over the four years of the forward estimates.

 

Table 1: Financial market movements, 4 – 11 May 2017

 

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,394.4

0.2%

US

2.39%

3.3 bps

US Dollar Index (DXY)

99.62

0.8%

Nikkei 225

19,961.6

2.7%

Japan

0.05%

3.3 bps

USD-JPY

113.86

1.2%

FTSE 100

7,386.6

1.9%

UK

1.16%

4.3 bps

GBP-USD

1.289

-0.3%

DAX

12,711.1

0.5%

Germany

0.43%

3.8 bps

EUR-USD

1.086

-1.1%

S&P/ASX 200

5,878.3

0.0%

Australia

2.65%

1.1 bps

AUD-USD

0.738

-0.4%

 

Economic Update  

United States

Labour market continues to tighten in the US

  • Conditions in the US labour market continue to tighten, with a strong rebound in non-farm payrolls over April (211k compared to 79k in March). Average hourly earnings picked-up over the month (0.3% compared to 0.1% in March), while the unemployment rate continues to trend lower (down to 4.4% from 4.5%).

 

Euro area / United Kingdom

Bank of England flags that a rate hike may be needed sooner than markets think

  • The Bank of England’s Monetary Policy Committee (MPC) left the Bank Rate at 0.25% in its May meeting earlier in the week.
  • In its accompanying inflation report, the BOE revised its 2017 growth forecasts down from 2.0% to 1.9%) due to the softness seen in Q1, but revised up their 2018 (1.7% from 1.6%) and 2019 forecasts (1.8% from 1.7%). Furthermore, the BOE raised their 2017 inflation forecast (2.5% from 2.4%), but lowered their medium-term forecasts (2018: 2.6% from 2.7% and 2019: 2.2% from 2.5%).
  • Interestingly, the BOE noted that should its forecasts pan out, they may need to hike rates sooner than currently expected in the market, which is for the first hike in 2019. Furthermore some members noted that “it would take relatively little further upside news on the prospects for activity or inflation for them to consider that a more immediate reduction in policy support might be warranted.”
  • In our view, the BOE remains overly optimistic on the UK growth outlook and we expect rates to remain unchanged until 2019. 
  • Emmanuel Macron has become France’s next President, convincingly beating the anti-EU Marine Le Pen (Macron received 66.1% of the vote to Le Pen’s 33.9%). The strong performance by Macron has helped ease fears that Europe is following the path of the US Presidential election and UK’s EU referendum last year.

China / Japan

Inflation edges higher in China

  • China’s headline inflation rate rose from 0.9% to 1.2% in April. While inflation remains subdued in China, it is largely due to a sharp 3.5% fall in food prices over the past year. The non-food inflation rate edged up from 2.3% to 2.4%, consistent with firming underlying inflationary pressures in China.
  • Growth in international trade slowed in China in April, with export growth (8% y/y from 16.4% y/y) and import growth (11.9% y/y from 20.3% y/y) slowing over the month. Overall, it appears that tighter domestic policy has started to weigh on activity in the Chinese economy and we expect that growth peaked in Q1 with a modest slowdown expected over the remainder of the year.

 

Australia / New Zealand

Australian retail sales continue to disappoint

  • RBNZ keeps rates unchanged at 1.75% and kept its neutral policy stance unchanged. 
  • Retail sales values remain sluggish in Australia, dropping 0.1% in March. This is the third monthly fall in retail sales in the past four months. Over the quarter, retail sales volumes rose a very weak 0.1%. 
  • Dwelling approvals fell heavily in March (-13.2%) after remaining surprisingly resilient in the first two months of the year. Dwelling approvals have now dropped to a 198K annualised rate close to the lows seen in October last year. Looking ahead, we expect approvals to continue to trend lower given the excess supply emerging in most housing markets across the country.

 

Sources: Thomson Reuters, Bloomberg, FactSet, ABS.

 

 

 

 

 

 

 

 

 

 

 

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