Shall we pull the fiscal or monetary lever?

For the first time in many months, nobody is talking about the RBA in a rates meeting week. Ironically, the silence accompanies a context which has made a shift in monetary polcy more likely than at many previous meetings this year. The global economy is unequivocally slowing, recession talk in Europe and the US is now mainstream, as is the fallout that includes slowing Chinese growth. In Australia, the labour market has clearly made a turn for the worse, leaving behind the important 5% level for the time being. House prices are sliding very consistently and not all that slowly either. The stock market has been smashed for two months and is down some 20-odd per cent and metals prices have been monstered (though not the bulks). As well, the inflation bogey has been put back in its box as the flood-related surge in first half prices passes, and the ABS offers a helpful hand by rejigging its CPI basket.

Interest rate markets haven’t missed the point. They are pricing the likelihood of rate cuts highly.

I guess the reason nobody wants to mention the war today is that the ugly sister of macoeconomic mangement, fiscal policy, is hogging the headlines via the Tax Summit. Though with the government shutting the outcomes down in advance, especially on the subject of whether or not the nation should aspire to run a Budget surplus next year, there is even greater reason to expect monetary easing to offset gathering economic weakness. It is this last reason that makes rate cuts inevitable, in my view.

Consider, last Friday there were two events that had reference to the position of the national Budget. The first, which dominated the headlines, was Treasuer Swan’s announcement that the final Budget deficit figures for the 2010/11 year was a deficit of $47.7 billion, some $2 billion better than expected. This has left us with a public debt to GDP ratio at 22% (according to the IMF).

The second, far more important, event was roundly ignored by the media. New Zealand was stripped of its AAA soveregin rating stripped by Fitch.

New Zealand’s public debt to GDP ratio is projected to be around 32% this year but, according to Fitch:

Public finances have traditionally been a rating strength for New Zealand relative to ‘AA’ rated peers but the deterioration experienced over the past three years has eroded that strength. The debt/GDP ratio of 46% in 2011, although below the ‘AAA’ median of 57%, is similar to the ‘AA’ median of 43% and the ratio of debt-to-revenues has risen in line with the ‘AA’ rating median to 122%. The general government revenue-to-GDP ratio has also become more volatile at 4.9% compared to the ‘AA’ rating median of 3.9%. Additionally, as non-residents hold more than half of New Zealand’s marketable government debt, the sovereign’s own funding conditions may not be isolated from any materialisation of risks in external finances, although Fitch stresses that the risk of such a downside scenario remains remote despite the downgrade.

I don’t know where Fitch’s higher public debt/GDP figure comes from. It is some 12% or so above the New Zealand Debt Management Office projections and those of the IMF. Anyways, the important point for today’s argument is that New Zealand has suffered a sovereign downgrade despite what appears to be a relatively decent public debt profile. And the reason why is clear:

The downgrade partly reflects Fitch’s view that the sustained shift in the domestic savings/investment ratio required to narrow the deficit sustainably is unlikely within the forecast period. New Zealand remains in the club of advanced economies with high household indebtedness – around 150% of household disposable income, similar to levels in Australia (157%) and the UK (159%), and above the US (116%). Unlike the UK and US, New Zealand has seen no meaningful reduction in this ratio since 2008. Fitch acknowledges that the government has implemented policies designed to facilitate a shift in savings, including raising KiwiSaver contribution rates, but the agency cautions that changing deep-seated behaviour is likely to be difficult.

While a sustained strengthening in household savings could address New Zealand’s external indebtedness, such a development – even if it emerged – could make for a period of weaker growth, unless accompanied by renewed structural reforms. Historical experience shows that private consumption growth in New Zealand has been well-correlated with house price moves. The economy’s five-year-average real GDP growth rate of 0.7% compares unfavourably with median average growth rates of 1.1% and 1.4% for ‘AA’ and ‘AAA’ range credits, respectively. Adding to risks over the medium-term outlook, official data indicates that the productivity performance of New Zealand’s economy weakened over the 2000s. Average incomes remain moderate by ‘AA’ standards and even further below the ‘AAA’ median.

So, the New Zealand sovereign is being downgraded owing as much to the economy’s overall dependence upon external financing to fund a structual current account deficit, housing dependency and indebtedness, as well as lack of competiveness.

Take mining out of the picture and that is Australia.

Now, we don’t, of course, take mining out of the picture. But there is a very important lesson in the New Zealand experience that must colour the way the Australian government thinks about its fiscal position. That is, that the Budget is the key stone in the arch that supports Australia’s externally funded and rather unstable edifice of household debt. By that I mean the implicit guarantee that it provides the banks’ offshore borrowings, which Moody’s has declared contributes to a two notch ratings uplift to the banks.

Whilst the Tax Summit is full of admirable proposals for immediate spending and long term savings to cover the structural deficit that arrises from the aging population, nobody I can find is talking about the risk associated with an imminent slowdown in Chinese consumption of our bulk commodities. If China does slow and the iron ore price falls for a sustained period, the damage to the Budget will be very significant. I can only estimate how big, but here’s some context to give you an idea, as I wrote some months ago:

After flat revenues between 2000 and 2003, the next four years saw Federal corporate tax revenue rocket from $37billion to $66billion. I have been unable to disaggregate mining but its a fair bet that that is where much of the growth came from.

…BHP and Rio alone grew their tax bills from a combined $2.2 billion in 2003 to $14.8 billion in 2008 (though not all of this was in Australia):

Iron ore makes up just shy of 50% of BHP’s profit and a much higher still proportion for Rio. The hit to the Budget will be very big when iron ore falls.

So, ask yourself, is it prudent for the Federal government to contemplate fiscal loosening in the midst of unparalleled terms of trade when the outcome of any sustained slowdown in Chinese demand will be a big hole in revenues just as pressure mounts of the banks external funding (as the pricing of Australian bank CDS currently suggests).

Fact is, the ratings agencies will not look kindly upon any sustained expansion of the Australia’s public debt/GDP ratio. And any downgrade would flow through automatically to bank funding costs, threatening a very unpleasant outcome.

In conclusion, for the time being, I do not expect the Federal government to loosen fiscal policy (nor should they). The RBA should and will loosen monetary policy first.

Not yet mind you. They need another month or two of crappy employment data.