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Much Ado About Commodity Prices
  • The mining boom has masked Australia’s weakening budget fundamentals. With windfall revenues from mining taxes, governments of both persuasions have committed to high levels of expenditure under the assumption that revenue would continue unabated. But as history shows, no boom lasts forever. Australia’s terms of trade are in decline and the prospect for further decline is real. This will have significant consequences for the upcoming May Federal Budget and necessitate some hard choices by a government with little political capital to risk.

 

Canberra, We Have A Problem

  • The IMF indicates that Australia has suffered from a 3% structural deficit of the national income in each year since 2009, with the deficit equivalent to $48.5 billion in 2014 alone. As the graph below shows this deficit has largely emerged in response to the GFC when the Labour government implemented a successful stimulus response to stave off the sort of negative effects that plagued other parts of the world.
  • Interestingly, the graph also highlights that the deficit has been improving in recent years and is expected to improve into the mid-term. This improvement can be connected to fiscally conservative policies the former government introduced and the current government is trying to consolidate and extend. However changes in indexation arrangements for pensions, making it harder to get benefits, or tightening eligibility for health care cards does not tend to bode well with the community, so the operative word here is ‘trying’. Indeed, much of the 2014 Budget has either not been passed or significantly watered down. Accordingly the forecast improvements set out below are far from guaranteed.

 

 

How Bad Are We Talking?

  • This is troubling for the Government as they continue to watch commodity prices, and the terms of trade, decline. Long reliant on the tax and royalty revenues accrued through the mining sector (which was a whopping $22.7 billion in 2013 alone) any decline will further exacerbate the deficit.

 

 

  • The graph below outlines estimates by Deloitte Access Economics, Treasury and the Parliamentary Budget Office (PBO) of further falls in the terms of trade. While there are significant variations between them, even their more conservative figures should be sobering evidence of the risks posed to the Budget by further worsening.

 

 

  • In an effort to better understand the ramifications Deloitte developed four hypothetical scenarios, outlined in the graph below:
    • Scenario 1 looks at a fall in terms of trade by 4% (which essentially matches Treasury’s existing scenario analysis);
    • Scenario 2 indicates the effect of a ‘typical’ real economy slowdown, in which employment, profits, private consumer spending and import volumes are one annual standard deviation lower than expected;
    • Scenario 3 examines a fall in the terms of trade back to the level seen in 2002-03, with that fall playing out gradually over the four year forward estimates period; and
    • Scenario 4 combines scenarios 2 and 3 to look at a fall in the terms of trade back to 2002-03 levels combined with a real economy slowdown.

 

 

  • In short, none of these scenarios look good for the Budget. It is clear that if a drop in the terms of trade facilitated a broader decline in economic activity the Budget would worsen rapidly. In today’s terms this would increase the deficit by almost $30 billion on top of the $11.5 billion forecast in the mid-year budget update. Net debt would also expand by an extra $118 billion. A total unwinding of commodity prices would involve an estimated $18 billion drop in company taxes in 2017-18 alone and another $12.5 billion hit to income tax revenue.

 

Hard Choices

  • Such massive revenue shortfall cannot be rectified by bracket creep or a lift in capital gains. Deloitte is arguing vociferously for the implementation of ‘hard choices’ which is simply code for an erosion of the welfare system. As the Abbott led government has discovered, such ‘hard choices’ are largely unwanted within the community. Attempts to cut Medicare or further deregulate university funding have been rebuffed, as consumer confidence has waned in response to moderating wage growth and increasing unemployment.
  • While the Government continues to prosecute the case for these ‘hard choices’ on the basis of un-sustainability, they have also demonstrated their readiness to address issues on the revenue side with the publication of a report on the tax system. What is interesting about the report is that in an apparent budgetary crisis the government continues to make the case for lowering income and company tax rates (due to competitive and complexity concerns) and further make the case for an increase in the GST. Whether the global economy has eroded the capacity of governments to tax or not, it is clear that the windfall gains from high commodity during the Costello budget period have dried up. There is simply not enough revenue now coming in to support current and future spending promises.

 

Conclusion

  • Given the large increases in global supplies of commodities and weaker demand from China, it is clear that commodity prices will remain at subdued, or possibly lower levels. This will have profound consequences on the Federal budget. Australian voters have made it clear however that they will not accept asset sales or cuts to vulnerable groups as means to address the structural deficit. Treasurer Hockey is now only weeks away from delivering his second Federal Budget, which follows a maiden effort which was highly unpopular and remains largely unimplemented. His last budget may have almost cost him his job, but this one will cost Australians a lot more if real changes are not implemented. Good luck Joe.

 

This update does not constitute financial advice and should not be relied upon as such. It is intended only to provide a summary and general overview on matters of interest and it is not intended to be comprehensive. You should seek professional advice before acting or relying on any of the content.

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