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Warren Hogan Chief Economist +61 2 9227 1562 Katie Dean Head of Australian Economics, IIB +61 3 8655 9079 Cherelle Murphy Senior Economist +61 2 6198 5010 Tony Morriss Head of Interest Rates Strategy +61 2 9226 6757 Tony. Zo McHugh Interest Rate Strategist +61 2 9227 1302

ANZ forecasts the Commonwealth budget to be in deficit by around AUD17bn in 2012-13 and around AUD7bn in 2013-14 when it is released at 7:30pm AEST on May 14. These deficits are small relative to GDP at around 1% and % respectively but do represent a deterioration from the small surpluses projected in the October mid-year update. Small budget deficits are expected until 2014-15. The return to surplus that may occur in 2015-16 will require a modest further tightening of fiscal policy supporting the view that expansionary monetary policy will remain appropriate for some time. An earlier return to surplus is very difficult without a notable tightening of discretionary fiscal policy or an AUD decline that outpaces the decline in commodity prices. This is not ANZs expectation, however, as we see the AUD remaining elevated for some time. Net debt is expected to rise only slightly, to a peak of around AUD176bn or an average of around 10.5% of GDP over the coming four years. Further increases in net debt from budget deficits will be partially offset by a low interest burden on this debt, in line with continued low global interest rates. Whilst disappointing, these weaker budget outcomes should not affect Australias coveted AAA (stable) credit rating. The Government and Opposition are both committed to conservative fiscal policy1. The budget balance is likely to continue to improve and debt levels are low by international standards ensuring the Government retains budget flexibility to react to negative shocks. If there were a change in the Governments fiscal strategy to achieve budget surpluses on average over the medium-term, this would not be looked upon favourably by rating agencies. This, however, is unlikely. There are three principles by which we will judge the 2013-14 budget: First, is this an appropriate fiscal setting for the current economic cycle? A further modest tightening of fiscal policy is arguably not inappropriate if Australia is near a peak in the unemployment rate (ie. nearing the beginning of a cyclical non-mining upturn). Fiscal contraction is less appropriate if the labour market outlook worsens and/or downside risks to the non-mining economy rise. Second, do the fiscal settings presented provide a credible path back to balance, and thus Australian fiscal sustainability? The weaker budget outcome this year due to the falling terms of trade and high AUD suggests some structural vulnerability in the budget. Just as the broader economy needs to adjust to a lower terms of trade and a higher AUD, so too does the Government sector. A broadening of the revenue base and/or a reprioritisation of expenditure is required. A Government announcement to deliver the required reforms during an election year would be a welcome surprise. Third, does the budget support long-term structural reform to lift productivity growth?

The Coalition is, however, yet to release its full suite of policies, with few specifics expected until the August release of the Pre-Election Economic and Fiscal Outlook.

Australian Economic Update / 18 April 2013 / 2 of 13

A BUDGET DEFICIT IN EXCESS OF 1% OF GDP IN 2012-13 The Commonwealths budget position is not improving as quickly as anticipated when the October Mid-Year Economic and Fiscal Outlook (MYEFO) was released last year. Monthly Commonwealth financial statements suggest the underlying cash balance was a deficit of around AUD24bn in the eight months to February 2013. This is running behind where it should be in order to meet the projection of a AUD1.1bn surplus for the 2012-13 fiscal year (Figure 1). The Government said in December that this surplus would not be achieved.
20 10 0 -10 AUD bn -20 -30 -40 -50 -60 Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun
2007-08 2008-09 2009-10 2010-11 2011-12 2012-13
MYEFO est. 2012/13 AUD1.1bn

Sources: Minister for Finance and Deregulation and ANZ

The February Commonwealth Financial Statements suggest the deterioration in the budget balance, relative to the MYEFO forecasts, is due almost entirely to weaker revenue growth. The statement reports that, yearto-date: Revenues are currently running around 3% below MYEFO projections; and, Expenses are a little below MYEFO expectations (i.e. better than), by around 0.3%.

Holding these relativities constant, produces an underlying cash balance estimate for 2012-13 of around AUD13bn (0.8% of GDP). 2 This, however, appears a little too optimistic when we consider how revenues and expenses are tracking relative to 2011-12, particularly on the expenses side. Revenues are currently 7.2% above 2011-12 levels (year-to-date). This is below the 10.5% increase in revenues projected for 2012-13 in the MYEFO.

The underlying cash balance is equal to receipts less payments less Future Fund earnings. Our workings throughout this note assume no change in Future Fund earnings relative to the MYEFO forecasts. At MYEFO, the sale of spectrum was expected to boost Government receipts by around AUD4bn in 2012-13. We now expect weaker market conditions will reduce these receipts, while some of the payments from telecommunications companies have also reportedly been deferred until 2013-14.

Australian Economic Update / 18 April 2013 / 3 of 13

Expenses are currently 2.2% above 2011-12 levels (year-to-date). This is well above the 0.7% decline in expenses that was projected for 2012-13 as a whole at MYEFO.

Assuming these relativities hold for the rest of this fiscal year produces a budget deficit estimate of AUD28bn (1.9% of GDP) for 2012-133. Accurately forecasting a budget outcome is fraught with difficulty given the potential for the Government to shift the timings of payments and receipts to suit political and other motives. The natural vagaries of the profit and economic cycles can also push these figures around. Taking a mid-case scenario, our assumptions for 2012-13 are: Receipts are 4% weaker than MYEFO. This is broadly in line with current YTD tracking relative to MYEFO, but allows for further impacts of a higher AUD relative to MYEFO. Whilst it assumes around a 45% uplift in revenues for the rest of this financial year, this is not atypical given April is one of the biggest months for tax collections. Payments fall as expected at MYEFO (-2.1% from 2011-12).

Adjusting for the Future Fund earnings and the adjusted timing and revenue from the sale of spectrum, these assumptions imply a budget deficit of around AUD16.6bn (1.1% of GDP) for 2012-13 (Figure 2).

3 2 1 % of GDP 0 -1 -2 -3 -4 -5 60 64 68 72 76 80 84 88 92 96 00 04 08 12 16

MYEFO forecast

ANZ forecast

Sources: MYEFO and ANZ

Of course, there are the usual caveats around this forecast, with numerous upside and downside risks. On the upside (i.e. assisting a smaller deficit), revenue could be boosted by, amongst other things, an uptick in mining tax receipts in H1 2013 following the improvement in iron ore prices in Q4 2012, whilst expenses could be constrained by additional discretionary spending cuts. We see the balance of risks causing a larger deficit. These risks include (a) failure of company tax revenues to match the usual seasonal pick up in April (when around 17% of payments are collected) because of ongoing pressure on profits from the
3 Note, this simple working makes an adjustment for expected earnings from the Future Fund and for the sale of spectrum2.

Australian Economic Update / 18 April 2013 / 4 of 13

higher AUD and the possibility of lower commodity prices, among other factors4; (b) the temptation to implement new spending, which is not fully offset ahead of the election period; (c) a further rise in the unemployment rate (the MYEFO forecasts are based on a stable unemployment rate of 5% in the June quarter compared to a 5.6% rate in March); and, (d) one-off spending pressures e.g. natural disaster funding and greater-than-expected asylum seeker arrivals. SIGNIFICANT CONTRACTIONARY FISCAL POLICY WOULD BE REQUIRED FOR A RETURN TO SURPLUS IN 2013-14 Returning the budget to surplus over the next couple of years now looks more difficult without very strong economic growth forecasts (unlikely) or an explicit tightening of fiscal policy (new revenue measures and/or very significant savings). Two major new policies, the National Disability Insurance Scheme and the Gonski Education reforms, which are expected to cost several billion dollars each per annum and are expected to be funded out of new savings, further challenge the speed at which the budget deficit can be reduced. The Prime Minister announced at the weekend that the education reforms, as they stand, would cost AUD9.4bn over the next six years and only AUD520m of that (over four years) has been offset so far by associated spending cuts. The expected deterioration in the budget balance in 2012-13 considerably worsens the starting point for the budget in 2013-14. This is because tax receipts lag nominal GDP growth5. Scenario analysis in the MYEFO showed that a 1% reduction in nominal GDP growth in 2012-13 that was driven by a weaker terms of trade would reduce the underlying cash balance by AUD2.8bn in 2012-13 and AUD6.7bn in 2013-14. Comparing ANZs nominal GDP growth forecasts with those printed at MYEFO for 2012-13 (Figure 3) suggests the starting point for the 2013-14 underlying cash balance is already AUD8.4bn lower. Admittedly, this may be an overestimate of the hit to the budget because not all of the current weakness in revenues reflects a weaker terms of trade; some of it is also due to lower real GDP growth.

2012-13 2013-14 MYEFO ANZ MYEFO ANZ Nominal GDP 4.0 2.8 5 4.9 Real GDP 3.0 2.8 3.0 2.9 Terms of trade -8.0 -10.0 -2 -0.5 5 5.7 5 5.7 Unemployment rate CPI 3.0 2.9 2 2.1 3 3.2 3 3.5 Wage price index Exchange rate TWI 75 78 75 79 1.02 1.04 1.02 1.05 Exchange rate AUD/USD Unemployment rate is for the June quarter CPI and wages are through-the-year growth to the June quarter Exchange rates are year averages

Sources: ABS, MYEFO and ANZ

A more useful way to consider the likely budget position in 2013-14 and beyond is to consider the expected balance under different revenue and

At MYEF0, the exchange rate was assumed to be a trade weighted index of around 75 and AUDUSD around 1.02, compared to averages of 77.6 and 1.039 respectively in 2012-13 to date. This is because company tax instalment rates for Year 1 do not tend to be adjusted until after a company has lodged its tax return for Year 1, which is typically not done until six months after the end of Year 1.

Australian Economic Update / 18 April 2013 / 5 of 13

expense growth scenarios. This provides a more meaningful top down analysis of how fiscal policy needs to respond to the new reality of lower nominal GDP growth. Below we outline the underlying cash balance for the forward estimates period based on three different scenarios for expenses and revenues growth (Figure 4). We consider scenarios that would be consistent with (a) very tight fiscal policy; (b) moderately conservative fiscal policy; and, (c) explicit fiscal policy slippage (Figure 5).
FIGURE 4. UNDERLYING CASH BALANCE (AUDBN) THREE SCENARIOS SCENARIO 1 SCENARIO 2 SCENARIO 3 MYEFO TIGHT FISCAL POLICY CONSERVATIVE LOOSE FORECASTS 2012-13 -16.6 1.1 2013-14 4.0 -6.8 -14.0 2.2 2014-15 19.0 -3.6 -18.8 3.3 2015-16 37.8 2.1 -21.9 6.4
Source: ANZ



We expect the Governments most likely course of action will be along the lines of Scenario 2. That is, the Government will limit expenses growth in order to present the budget returning to surplus at the end of its forward estimates period. This scenario analysis demonstrates that a return to surplus in the forward estimates period is not possible unless either (a) revenue growth significantly outpaces nominal GDP growth (unlikely without new revenue measures being put in place); or, (b) expenses growth is limited to 1.5%-2% per annum in real terms. The latter (which we assume will be the Governments course of action) means a slightly tighter fiscal policy than the Governments previous policy settings. Previously, the Government had committed to cap real expenses growth to 2% pa over the cycle, but in the three years 2013-14 to 2015-16, had only planned to keep expense growth to this low level in the middle year, 2014-15. STARTING POINT IS CRUCIAL Scenario analysis also highlights how crucial the starting point for this budget cycle is to the possibility of being able to report a surplus. This is due to the lags involved in revenue collection. If our forecasts for the 2012-13 underlying cash balance (-AUD16.6bn) prove to be too optimistic, the path back to surplus will take longer than four years unless there is a very notable tightening of discretionary fiscal policy. Figure 6 below applies our scenarios to a more pessimistic 2012-13 underlying cash deficit of AUD20bn. It shows that a return to surplus by 2015-16 is not possible under our middle or conservative fiscal policy framework. We would emphasise however that a return to surplus by a certain point in time has never been an economic imperative as much as a political one. First, the difficulty of forecasting means the Governments forecasts beyond the current year often prove to be some way out. Second, a plan for an improvement in the budget position and a return to surplus over the medium term is all we would like to see for fiscal settings to be appropriate in the current setting. The difference between a 0.1% of GDP surplus and 0.1% of GDP deficit is almost nil in terms of its impact on the economy.

Australian Economic Update / 18 April 2013 / 6 of 13

Deficits of up to AUD7bn are less than % of GDP. Third, the composition of the surplus matters more than the size. For example, if spending is stripped from the foreign aid budget to achieve surplus forecasts, this will have low multiplier effects on the economy and a vastly different impact than if the surplus is achieved by cutting welfare benefits (which have a high multiplier effect on the economy).
2012-13 2013-14 2014-15 2015-16 SCENARIO 1 TIGHT FISCAL POLICY 0.2 15.1 33.8 SCENARIO 2 CONSERVATIVE -20.2 -10.6 -7.6 -2.0 SCENARIO 3 LOOSE -17.8 -22.9 -26.2 MYEFO FORECASTS 1.1 2.2 3.3 6.4

Source: ANZ

STRUCTURAL REFORM NEEDED Importantly, most of the deterioration in the budget position reflects a weaker economy, rather than an explicit loosening of fiscal policy. This is because the deterioration largely reflects weaker revenue growth (due to weaker profits growth, not policy changes) and not stronger-than-expected expenditure growth. Nevertheless, the failure of the budget to recover as quickly as the Government anticipated highlights more than just cyclical weakness. The scenario analysis presented above, which demonstrates the fiscal constraint required for a return to surplus, reveals the structural weakness of the budget. The ability of the budget to grow its way out of deficit (i.e. for revenues to recover sufficiently from an upturn in the economic cycle to drive the return to surplus) has been constrained by a weakening in the terms of trade to, arguably, a more normal level and compounded by the enduring strength of the AUD. Figure 7 below illustrates the extent to which the current projections, which feature a higher terms of trade, drive the projected return to surplus. The 2012-13 terms of trade forecast is represented by the pink dotted line, which is well above the dark blue actual path of the terms of trade. Figure 8 meanwhile illustrates the still very large gap between revenues and expenses. It shows how slowly revenues are recovering, and hence the pressure on expenditures to weaken to close the gap. It also shows the step down in receipts (as a share of GDP) that have occurred given nominal GDP growth is normalising as the terms of trade normalises.

Australian Economic Update / 18 April 2013 / 7 of 13


120 forecast 110 100 90 Index 80 70 60 50 40 90 93 95 98 01 04 06 2004-05 2006-07 2008-09 2010-11 2012-13 09 12 14 Terms of trade with ANZ Forec ast 2005-06 2007-08 2009-10 2011-12

Sources: ABS, ANZ and Commonwealth Treasury


28 27 26 25
% of GDP


24 23 22 21 20 19 18 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15
Receipts - ANZ forecast Payments - ANZ forecast Receipts - MYEFO forecast Payments - MYEFO forecast

Sources: MYEFO 2012-13 and ANZ

This is also demonstrated by Figure 9 (below) which shows the weakening of the Governments tax receipts, relative to the economy. This followed the income tax cuts in the last half of the previous decade when the terms of trade boom commenced.

Australian Economic Update / 18 April 2013 / 8 of 13


Sources: ATO, MYEFO 2012-13 and ANZ

This analysis does not suggest the Australian budget is seriously structurally impaired. Nevertheless, just as the broader economy needs to adjust to a lower terms of trade and a higher AUD, so too does the government sector. This will require more than just a promise to cap expenditure growth until the budget returns to balance, especially given the coincident impact on expenditure as the population ages. It is also worth highlighting that demographic developments will mean expenditure pressures are higher (e.g. in aged care) and revenues are likely to grow more slowly (as there are fewer people paying taxes). Figure 10 below shows that the population over 65 (traditionally the older end of the non-working age population) will grow by around 140% over the next forty years, while the working age population will grow by only around 40%. Health spending is also likely to continue to weigh on the budget for these reasons as medical technology continues to advance. These projections have been well-documented in recent Intergenerational Reports from the Government and other sources6.

We believe the planned 2013 edition of the Intergenerational Report has been put on hold. The new Parliamentary Budget Office is expected to outline the structural budget position by June 30, which may spark debate on the issue and how the structural deficit can be addressed.

Australian Economic Update / 18 April 2013 / 9 of 13


65+ Working age (15-64) 0-14


20 Total population (millions) 40% 15


140% 5 34%

0 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

Sources: ABS and ANZ

A modest broadening of the revenue base and/or a reprioritisation of spending is therefore likely to be required for a number of reasons. The Government has tackled some of its medium-term expenditure pressures in recent years, for example, reducing access to the private health insurance rebate by means-testing it, reforming the Pharmaceutical Benefits Scheme and most recently by reducing tax concessions for high income superannuation recipients. But more change of this nature is required to counter medium-term fiscal pressures. A Government announcement to deliver another slab of the required reforms during an election year would be a welcome surprise. NET DEBT TO RISE TO AROUND 11% OF GDP The expected deterioration in the budget relative to the last update in October 2012 means Australias net debt position is now likely to peak at around 11% of GDP, a little higher than the previously estimated peak of 10% (Figure 10). Limiting the extent of the rise in the net debt position is the continued downward pressure on global yields, which is likely to reduce the average interest rate paid on Australian debt, at least in the short term. Indeed, we would highlight this as the main risk to our projections.

Australian Economic Update / 18 April 2013 / 10 of 13





% of GDP


-5 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016

2012-13 2013-14 2013-14 2013-14

MYEFO Budget - ANZ projections Budget - ANZ projections optimisic scenario Budget - ANZ projections pessimistic scenario

Source: Commonwealth Treasury and ANZ

Despite this likely slight increase in Australias net debt position, this measure of external vulnerability remains low by global standards (Figure 12).
100 90 80 70 % of GDP 60 50 40 30 20 10 0 Australia Advanced economies 2013 2014 Emerging economies G-20 Advanced G-20 Emerging




Sources: IMF and ANZ

IMPLICATIONS FOR BOND MARKETS The deterioration in the budget position will require greater issuance of Commonwealth Government Securities (CGS) over coming years compared with the budget update in October last year. The numbers are not large and will not bring the AUD300bn debt ceiling into play based on the current outlook. Our new projection for Commonwealth bonds on issue is below in Figure 13.

Australian Economic Update / 18 April 2013 / 11 of 13


350 Total Securities on Issue (AUD '000 M) Debt Ceiling Total CGS projected in October 2012 Total CGS with projected deficit 200







0 95 97 99 01 03 05 07 09 11 13 15 17 19

Sources: AOFM and ANZ

This projection may trigger some cautionary headlines from rating agencies on the apparent slippage in budget discipline over the out years. As argued above, this is not related to a blowout in expenses but rather exogenous factors constraining revenue growth. The general sovereign debt metrics remain very strong as can be seen by the comparison of net debt to GDP relative to other major economies. Australias public sector net debt position needs to be better than its high rated peers, however, given the rating agencies continued concerns about Australias current account and external (economy-wide) debt. The profile means we are looking at the maintenance of a deep and liquid CGS market over the medium-term. This should ensure ongoing investor interest in CGS, which continue to offer the highest yields for a AAA (stable) rated market. The Australian Office of Financial Management (AOFM) should easily manage the increased call on markets. We would expect to see a continued focus on raising the extra funds via longer-dated issuance considering investor demand for high quality sovereign bonds and historically low global interest rates that are a function of extraordinary policy settings in the developed world. In reported comments this week, Opposition Treasury spokesman Joe Hockey said the party would issue bonds with a duration of 40-50 years if the party were to win Government7. We will also be interested in any new developments around the financing of infrastructure investment via CGS in the budget. The current low level of interest rates and numerous calls for infrastructure improvement in Australia would suggest there is ample opportunity for the Commonwealth to work with the states on this issue. Of course, the productivity gains that may come from infrastructure investment would have to be balanced against increased indebtedness (and managed within limits that would maintain the AAA rating). The Opposition has said it will ask the AOFM to examine an Infrastructure Partnership Bonds scheme to lift private investment should they win Government in September.

Hockey proposes bonds up to 50 years, Australian Financial Review, 11 April 2013, p11.

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