Better budget should protect rating: HSBC's Paul Bloxham
GUEST OBSERVER
For the first time in some years we expect better estimates of the coming year’s deficit, due to higher commodity prices.
Infrastructure investment plans, including a new Sydney airport and a major national rail project, SME tax cuts and education spending are expected to be the budget highlights.
Rates Strategy: After years of disappointment, the budget should be welcomed by bond investors as it is set to confirm 2016/17 as the peak of government debt issuance
Revenue gets a boost from higher commodity prices.
It has finally arrived. After a run of budgets when the Treasurer of the day has had to announce that the underlying budget deficit was larger than expected, this year we expect a modest improvement.
Rising commodity prices have been the main source of support, as the bounce is expected to have delivered additional tax revenue. However, this positive effect has been partly offset by weaker-than-expected wages growth, relative to the projections in the May 2016 budget, making the overall improvement only modest.
The projected budget deficit is expected to be AUD25bn (1.4% of GDP) in 2017/18 (estimated at AUD28.7bn in December 2016 and AUD26.1bn in May 2016). However, much depends on the government’s assumptions about commodity prices, which we expect to be cautious. As a result, we expect the projected return to budget surplus still will not be forecast to arrive until 2020/21, as previously forecast.
The key policy initiatives in the budget (due to be handed down on 9 May 2017) are expected to be plans for infrastructure investment, including a second airport in Sydney and a new inland rail from Brisbane to Melbourne, a corporate tax cut for small and medium-sized businesses and a boost to education spending. The Treasurer has also announced that, for the first time, the budget will separately report debt that is earmarked for infrastructure from that used for recurrent spending.
With Standard & Poor’s putting Australia on ‘negative outlook’ for its triple-A sovereign rating in July 2016, a key question is whether Australia will get downgraded. With the budget set to look a bit better, an improving nominal economy and signs of some budget reform, we doubt a downgrade will arrive next week.
Our new onshore AUD/NZ rates/FX strategist, Tom Nash, expects the budget to be positive for long-dated government bonds (ACGBs). Even allowing for the infrastructure spend, 2016/17 should mark peak ACGB issuance.
A rare improvement in the budget outlook
Largely thanks to continued strength in commodity prices, we expect the forecast budget deficit for 2017/18 will look slightly better than previously estimated. This would be a marked contrast to Australia’s recent budget history, which since 2009 has featured consistent downward revisions to the budget balance and the predicted return to surplus being pushed ever farther into the future.
There was some rare good news in the December 2016 mid-year fiscal update, when the forecast 2016/17 deficit was revised a touch lower from AUD37.1bn to AUD36.5bn, in response to the lift in commodity prices seen during late 2016. However, the commodity-related boost was expected to be temporary and the projected deficits beyond 2016/17 were expected to be larger than previously forecast (Chart 1).
Since the mid-year update, the strength in commodity prices has proven to be more sustained, especially for iron ore. Although iron ore prices have dipped in recent weeks from over USD90/t to around USD66/t, the mid-year fiscal update assumed a decline from USD68/t at the time to USD55/t by Q3 2017.
Although the assumptions underlying the new budget estimates are expected to once again assume that commodity prices will revert to a lower level, they will probably be a little more optimistic than those used in December. This should deliver a stronger nominal growth outlook and, in turn, better revenue projections (Charts 2, 3 and 4).
As a rule of thumb, a 1 percent increase in nominal GDP lifts government revenue by around AUD3bn. The mid-year update assumed nominal growth of 5.75 percent in 2016-17 and 3.75% in 2017-18. While the former is not much different from our own expectation of around 6 percent, we see scope for the 2017-18 forecast to be revised up to 5.25 percent or above thanks to the continued strength in commodity prices and a likely upward revision to the real GDP growth outlook (Table 5).
Key expected policy initiatives provide signs of fiscal reform
For some time now, the clarion call in our research has been for fiscal policymakers to focus on tax reform and infrastructure investment. As we have pointed out previously, Australia’s new growth engine is exporting services to Asia, including education and tourism, and if Australia is to remain competitive in services exports, better urban infrastructure is needed (see Australia’s broadening economic links to China, 8 November 2016). At the same time, we have noted that Australia’s tax system has become more dependent on taxes that distort economic behaviour, such as corporate and personal income taxes, and that reform of the tax system is needed.
This budget is expected to show some progress on these fronts, although more reform is needed over time. Key initiatives are expected to include:
The government is set to announce that a new government-funded company will be set up to build a second airport in Sydney at Badgery’s Creek at an expected cost of A$5-6 billion. A new inland rail line from Melbourne to Brisbane is also set to be announced, at a cost of A$10-12 billion. These projects are expected to be off the government’s balance sheet, much as the National Broadband Network was funded in earlier years.
The Treasurer, Scott Morrison, has announced that the budget will also, for the first time, split its accounting of new government debt into that used for capital spending, such as infrastructure, and current spending, such as public sector wages. This is a positive development that should allow a clearer assessment of government spending that is investing in future growth prospects and that which is being used for current consumption.
The government is expected to announce a significant boost to spending on primary and secondary education, of around A$19 billion over the next decade (figures as report by the Australian Financial Review on 3 May 2017), adopting an adjusted version of the opposition Labor Party’s previous proposal for a ‘needs-based’ funding model.Tax cuts for small and medium-sized businesses have already been passed by both houses of parliament, but will be part of the budget. Businesses with less than A$50 million in turnover will see the company tax rate cut from 30% to 25% by 2026/27, with the reductions phased in at different rates for businesses of different sizes. The budget is expected to contain a proposal to broaden this to every company by 2026/27.
A range of previously proposed budget measures that have not passed through parliament will also be scrapped. These include cuts to Medicare proposed in the lead-up to the 2016 election as well as cuts to education and welfare spending. These are set to reduce budget savings by around A$8 billion.
Structural budget deficit remains a challenge
Although the stronger commodity price story, along with some fiscal consolidation measures, are expected to make the budget bottom line look a little better, Australia still faces many years of sizable budget deficits. This is because the deficit is structural, not cyclical. That is, the deficit is not the result of temporarily weak conditions in the economy – and so an improvement in economic conditions cannot be relied upon to return the budget to balance (Chart 6).
Interestingly, the Australian Treasury estimates that the structural deficit has been consistently larger than the actual underlying cash balance over the past decade, despite below-trend economic growth. This is mainly driven by the large, budget-positive impact of high commodity prices outweighing the smaller, budget-negative impact of weak GDP growth.
The precise estimates of the structural balance are highly uncertain, as they rely on assumptions about the size of the output gap and the long-run level of the terms of trade. For instance, the IMF’s estimates suggest that Australia’s structural deficit has not been as large as the actual deficit. Nonetheless, regardless of its size, it seems clear that Australia does have a significant structural deficit and that an improvement in cyclical factors alone will not be enough to restore a balanced budget over the long term. Changes to fiscal settings will be needed.
A rating downgrade is unlikely at this stage
Despite ongoing budget deficits (both actual and structural), we do not expect Australia to lose its AAA credit rating. In an international context, Australia’s fiscal position is still strong; in particular, net debt remains low, although it has risen significantly since 2008 (Charts 7 and 8).
With the budget deficit currently around 2 percent of GDP, and expected to narrow further in 2017/18, the government’s debt-to-GDP ratio is also close to stabilising.
The key factors that have been of concern to the major rating agencies have been: a lack of fiscal reform, due to political constraints; Australia’s persistent current account deficit; and high household debt levels, making balance sheets more vulnerable.
The key catalyst for Standard & Poor’s putting Australia on ‘negative outlook’ for its triple-A rating in July 2016, was the close Federal election result and the rating agency’s expectation that this reduced the likelihood of ‘forceful’ fiscal action need to get the budget back to surplus. Since then, commodity prices have lifted, supporting tax revenues, and there are some signs that fiscal reform may be moving the right direction, albeit slowly.
The current account deficit has also narrowed significantly, due to the recent lift in commodity prices, the ongoing rise in commodity exports as new capacity comes on line and continued growth in services exports (Chart 9).
Household debt has continued to rise and is at high levels, which is expected to be a continued point of focus for the rating agencies. At the same time, the prudential regulator, in a coordinated approach with the central bank, has been tightening its prudential settings to reduce the risk entering the financial system.
Rates Strategy: A bullish budget for bonds
After years of disappointment, the 2017/18 Budget is set to be positive for Australian Commonwealth Government Bonds (ACGBs) as it will likely confirm that bond issuance has peaked and fiscal consolidation is back on track. We have previously highlighted fiscal policy as one of the structural factors underpinning our bullish stance on the long-end of the curve (see ‘AUD Rates: Cheap enough’, 30 March 2017).
The Treasury is likely to confirm FY16/17 as the peak for ACGB issuance, despite uncertainty over the funding of infrastructure projects. Mid-year Treasury projections imply a sizeable 24% decline in gross issuance in FY17/18 (to AUD78bn), and a larger 43% decline in net issuance (to AUD44bn) compared to the current fiscal year. We present an alternative scenario in Table 10 that assumes that all of the announced infrastructure spending is funded by debt as well as incorporating our economics team’s estimate of improved revenues. Total bond supply is c.AUD10bn higher over the projection period under this scenario but 2016/17 remains the peak.
While the duration of new ACGB supply is likely to stay high (the weighted average maturity has been 10.6yrs this fiscal year compared to 7.6yrs five years prior) we expect it to be well absorbed. The recent uptick in bid-cover ratios (Chart 11) as well as a continued gradual rise in offshore bond holdings implies a steady demand for duration.
With fiscal consolidation on track, HSBC’s base case is that this budget will not prompt any of the major credit rating agencies to downgrade Australia’s AAA credit rating. Importantly, an improved revenue outlook should give rating agencies more confidence that the public debt-to- GDP ratio stabilises in the near term and declines over the medium term as net bond issuance drops below 2% of GDP (Chart 12).
Australia’s Triple-A rating is positive for bonds primarily because politicians’ commitment to maintaining it encourages strict fiscal discipline. Reflecting this, Australia has the largest underlying fiscal consolidation embedded over the medium term among developed economies, based on the IMF’s standardized methodology (Chart 13). The pricing of credit risk premium is a secondary consideration for ACGBs given there is no real mechanical flow impact associated with a rating downgrade from AAA to AA and arguably yields already reflect a lower rating/ higher degree of sovereign credit risk (e.g. Australian sovereign CDS spreads already trade above the AAA average).
PAUL BLOXHAM IS CHIEF ECONOMIST (AUSTRALIA AND NEW ZEALAND) FOR HSBC.