Surplus by 2020/21 on track, but at an estimated 0.1% GDP: Bill Evans and Andrew Hanlan

GUEST OBSERVATION

The economic growth forecasts have undergone a number of revisions to reflect two major surprises since May, namely: conditions across the broader economy are weaker than anticipated; and commodity prices have spiked temporarily.

The economic growth forecasts are optimistic in our view. Real GDP growth of 2.0% for 2016/17, downgraded from 2.50%, requires a quick return to solid growth, averaging 0.8% per quarter for the rest of the year.

In addition, the medium-term economic projections err on the optimistic side.

From 2018/19 to 2022/23 real GDP growth is assumed to be 3.0% each year, a little faster than potential, judged to be 2.75%.

The thinking is that spare capacity is gradually absorbed, closing the output gap by the end of 2022/23.

The terms of trade are projected to remain flat at around its 2005 level from 2019/20. Nominal GDP growth is assumed to be 5.50% over the long-run (described in a Treasury working paper in 2014 but not specifically mentioned in MYEFO).

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1) The real GDP growth profile for the four years 2016/17 to 2019/20 is: 2.0% (downgraded by 0.50%); 2.75% (downgraded by 0.25%); 3.0% and 3.0%. The Australian economy began the 2016/17 financial year on a weak note, with output contracting by 0.5%, the sharpest quarterly decline since the GFC.

2) Nominal GDP growth profile is: 5.75% (upgraded by 1.50%); 3.75% (downgraded by 1.25%); 4.25% (downgraded by 0.75%); and 4.50% (downgraded by 0.50%). Notably, the size of the nominal economy is 1.0% smaller at the end of 2019/20 than assumed at budget time. Inflation and incomes are softer than anticipated reflecting the weaker conditions across the broader economy.

3) The terms of trade jumps a forecast 14% in 2016/17 (upgraded from 1.25%) on the spike in commodity prices, followed by a 3.75% decline in 2017/18 (downgraded from 0%) as commodity prices retreat to more sustainable levels. There is considerable uncertainty around the timing / speed of commodity price adjustments.

The iron ore price is assumed to decline from its recent average of US$68 per tonne FOB through the March and June quarters of 2017 to reach $55 in September 2017. The budget assumed a year average price of $55.

The coking coal price is assumed to be US$200 per tonne FOB in line with the December quarter contract price, before declining through the September and December quarters of 2017 to $120 in March 2018. The Budget year average price was $91.

Thermal coal prices are assumed to remain at $62 per tonne FOB, up from $52 at budget time.

4) Labour market forecasts have been downgraded to reflect the soft start to the 2016/17 year. Employment growth has been lowered by 0.5% this year and 0.25% next year, while wages growth has been lowered by 0.25% this year and next.

See table 2 below for details.

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The 2016/17 budget deficit forecast is effectively unchanged from that in May, while the cumulative deficit for the four years to 2019/20 has deteriorated by $10.3 billion (with net savings of $2.5 billion partially offsetting $12.8 billion in slippage due to the weaker forecasts).

The medium-term projections have the budget returning to surplus in 2020/21, as assumed in May, although the size of the surplus has been trimmed from 0.2% of GDP to 0.1% of GDP.

Policy decisions had little net impact on the budget position, with a net saving of $2.5 billion, back-loaded over the two out years.

Revisions to the economic growth forecasts (including parameter variations more generally) cost the budget $12.8 billion over the four years, including a saving of $0.5 billion in the current year. Receipts are $30.5 billion lower than at Budget time over the four years, partially offset by a $16.5 billion undershoot on payments.

Critically, as noted above, the size of the nominal economy at end 2019/20 is 1.0% smaller than assumed at Budget time.

Of the $30.5 billion hit to receipts over the four years, key impacts include: individual income tax collections, down $18.3 billion due to weaker wage and employment outlook; company tax down $5.9 billion with weaker non-mining corporate profits only partially offset by higher mining profits from stronger commodity prices over 2016/17; and lower GST collections, down $5.3 billion.

On the payment side, weaker wages growth and lower inflation help to contain expenditure growth.

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Bill Evans is chief economist with Westpac.

Andrew Hanlan is senior economist with Westpac.