One more MYEFO outlook for the road

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From Bill Evans at Westpac:

• The Treasurer will release the Federal Government’s MidYear Economic & Fiscal Outlook (MYEFO) on Monday, December 19.

• In the May Budget, the budget position was projected to edge into surplus in 2020/21, to around $4bn to $5bn. On our figuring, with a $6bn deterioration in the bottom line by 2019/20, the projection that the budget will be in surplus by 2020/21 hangs in the balance.

• The broader economy has deteriorated materially since the May 2016 Budget. Output contracted in the initial quarter of the 2016/17 financial year, declining by 0.5%, the sharpest quarterly fall since the GFC. We see this surprise as having the greatest impact on the budget estimates. • Against that, commodity prices, particularly for coking coal, have surprised to the high side. We see the spike in prices as being temporary. The revenue boost from higher prices will act to cushion the hit from weakness across the broader economy. A key uncertainty is the extent of tax losses being carried forward in the coal industry, which will act to limit the near-term boost to revenue.

• For the 2016/17 year, we expect real GDP growth to be downgraded by 1ppt to 1.50% from 2.50%. Nominal GDP growth is revised up 1ppt to 5.25% from 4.25%, boosted by higher commodity prices. • By 2019/20, the size of the nominal economy is now expected to be around 1.25% smaller than assumed at Budget time.

• The budget deficit for 2016/17 deteriorates by around $3bn relative to Budget time, widening to $40bn. The boost from higher commodity prices cushions the budgetary hit from broad based economic weakness. • The deficit narrows from this weaker starting position, to $12bn in 2019/20, a $6bn deterioration on Budget time.

• Across the four years, the budget deterioration is $18bn. Net debt is $29bn higher in June 2020 than at Budget time, in part due to an $11bn weaker outcome for 2015/16.

Economic outlook/forecasts

We set out the key economic growth forecasts in Table 1, comparing those in the May 2016 Budget with our expectations for MYEFO.

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There will be significant revisions – across output, employment, wages, the terms of trade and nominal GDP. Keep in mind that the initial two years are forecasts, while the final two are projections.

For 2016/17, we expect real GDP growth to be lowered by 1ppt to 1.50% from 2.50%, with the 3.00% figure for each of the following years to be unchanged. We accept those growth forecasts and projections as reasonable. However we are less comfortable with the projected increases in the Wage Price Index growth rates of 3.25% in 2018/19 and 3.50% in 2019/20 when employment growth is projected to slow to 1.25%.

Wage income growth will be cut by a full percentage in 2016/17 and by ½ppt in the following year, with downgrades split evenly between employment and wages growth.

The terms of trade will be revised sharply higher for the current year to reflect the jump in commodity prices, followed by a reversal spread over the following two years. We have assumed that MYEFO will forecast a rise in the terms of trade of around 12% for 2016/17 (with upside risk), followed by falls of 3% or more in the following years.

Turning to specific commodity prices for the 2016/17 financial year we expect the following (noting that all prices are year average, in US$/t, free on board): iron ore will be upgraded from $55 in the Budget to around $62 in MYEFO; coking coal increased from $91 to around $170 or higher; and thermal coal lifted from $52 to around $70.

Spot prices for these key commodities have lifted to levels considerably higher than these year average figures. Coking coal has climbed from around $90 at the start of 2016/17 to around $260 currently. Iron ore has increased over this period from the low $50s to be approaching $80. Thermal coal has moved from around $60 to $85. We expect the year average MYEFO assumptions / forecasts to be quite conservative given the uncertainties around how quickly prices will unwind from current highs.

Nominal GDP growth will be upgraded in 2016/17, potentially by 1ppt to 5.25%, with possible upside risk. This upgrade is despite weaker wages growth and emphasises the importance of the terms of trade for Australia’s nominal GDP. We note that there are risks surrounding this forecast given the uncertainty as to how quickly higher coal prices feed into export earnings and hence the terms of trade – with trade data to October pointing to surprisingly slow pass through.

Nominal GDP growth is downgraded in the following two years reflecting weaker wages growth and commodity prices reversing recent strength.

Notably, the size of the economy in 2019/20 is around 1¼ppt smaller on the revised profile than at Budget time.

Budget deficit revisions

We set out the key budget forecasts in Table 2, comparing those in the May 2016 Budget with our expectations for MYEFO.

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Note that the budget outcome for the 2015/16 financial year was a deficit of $39.6bn, 2.4% of GDP, in line with the Budget forecast of $39.9bn.

Weaker than expected conditions across the broader economy will dent revenues. Real output and wage incomes are 1ppt lower than expected in 2016/17. The rule of thumb suggests that this will add upwards of $5bn to the annual budget deficit.

For iron ore, the budget papers indicate that a $10 increase in the price adds $1.4bn to the budget bottom line in the initial year. We’ve assumed a price upgrade of $7.

On coal, the impact of higher prices is far less certain. The concern is around the carry forward of tax losses partially or largely offsetting the immediate impact of the spike in coal prices. We have no way of quantifying the current stock of tax losses across the industry. We have assumed only a modest revenue boost – potentially in the order of $1bn.

We see negligible impact on the budget from policy measures. Some existing policy measures, which are already factored into the estimates, have passed the Senate, with some compromises – such as the Omnibus Bill. Mid-2016, the Parliamentary Budget Office suggests that there were then around $8.5bn worth of savings measures (over four years) stuck in the Senate. Most of these measures were introduced in the 2014 Budget. Further slippage on these will adversely impact the near-term budget numbers.

Taken together, we expect the budget to deteriorate by around $3bn in 2016/17 edging up gradually to $6bn in 2019/20. The cumulative deterioration over the four years is $18bn.

Of note, the deficit for 2019/20 is revised from $6bn to $12bn, a $6bn deterioration.

On this profile, the return to budget surplus in 2020/21, as expected in the May 2016 Budget, is less certain. The Budget projected a surplus for 2020/21 of 0.2% of GDP – which we can infer implies a surplus of around $4bn to $5bn, representing an improvement of around $10bn in 2020/21.

With the starting point, on our figuring, now expected to be a deficit of $12bn in 2019/20 the projection that the budget will be in surplus by 2020/21 hangs in the balance.

Public debt

The net public debt profile will shift a little higher to reflect the budget deterioration. Even so, debt levels remain manageable in the current very low interest rate environment and based on current policies and current economic forecasts.

The outcome for 2015/16 was net public debt of $296.4bn, 18.0% of GDP.

This was $10.7bn above the Budget forecast of $285.7bn, 17.3% of GDP.

In addition to this revised starting position, our figuring has the budget deficit deteriorating by $18bn across the four years. This has net debt climbing to $384bn, 19.5% of GDP, by June 2020, a $29bn deterioration from the May Budget forecast of $355bn, 17.8% of GDP.

If that’s the outlook MYEFO delivers then we should downgraded. There is not way that the terms of trade or nominal growth will deliver those outcomes.

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.