The Fiscal Windfall
May 10, 2006
Gerard Minack (Sydney)
The key to the 2006-07 Federal budget is the surprisingly bountiful economic cycle.
Look at how the estimates for the 2006-07 budget balance have progressed: in last year's budget the surplus for 2006-07 was expected to be $7.9bn. Since then, the Government has taken decisions (tax cuts and spending increases) that reduced the surplus by $12.8bn. In other words, the Government blew all the expected surplus, plus some. And yet it now actually expects the surplus to be $10.8bn. The reason the Government could spend almost $13bn and still lift the surplus is because the economic cycle — largely the boom in company profits — added $15.5bn (over 1.5% of GDP) to the surplus. Some of this was known before last night’s Budget speech. Nonetheless, the new news tonight, which includes $6.6bn in personal tax cuts, was probably at the upper end of forecasts. The personal tax cuts amount to around 0.7% of GDP. The total discretionary loosening of fiscal policy is around 1.1% of GDP. One important issue will be how much of the tax cuts are spent. Surprisingly, the tax cuts were slanted to upper-income earners, although no one completely missed out on the largesse, and superannuants. This may moderate the immediate impact on consumer spending. However, if there is a quick-flow through to spending, it would increase the chance of another RBA rate increase. I wouldn't make another RBA move a base-case assumption, but I'd now rate a September quarter move as a one-in-three risk. This budget should offer some short-term support for retail stocks. Economic Forecasts Four noteworthy features of the Treasury's forecasts: First, the stronger GDP growth expected for 2006-07 (3¼% from 2½% expected for this financial year) is due solely to higher export volumes. Domestic demand growth is expected to slow to 3½% from 4% in 2005-06. Consumer spending is expected to revive a little, but remain below trend. Second, business investment is expected to slow, to 8% growth from 14% in the current financial year. This may surprise many, but it's exactly how I see things — the investment boom of the past few years is not about to collapse, but it is clearly showing signs of slowing. Third, and most worrying, Treasury expects the current account deficit to widen next financial year: to 6¼% of GDP, from 6% this year. This is a surprising outcome. At the top of a once-in-a-generation commodity price boom, Australia is still running a completely unsustainable external deficit. Finally, the Treasury lowered its estimate of long-term sustainable GDP growth by 25 basis points (to 3¼%) because of the slowdown in workforce growth due to ageing of the population. Demographics start to bite! For most investors, this budget will solidify the consensus view that nothing untoward is about to unsettle the equity market's seemingly sound fundamentals. I'm not so sanguine, but the near-term risks to growth probably have moderated a little, such is the extent of the fiscal stimulus. Bigger picture, this budget reminds me of America's irrational fiscal exuberance in the late 1990s. Remember the $4 trillion 10-year budget surpluses? Within a couple of years those projections had become multi-trillion deficit forecasts. In Australia's case, the bubble in our forecasts is only partly commodities (Treasury actually assumes commodity prices fall over the next few years). The bigger windfall comes from non-mining company tax revenues. And in this setting to have the external deficit we have is even more remarkable — it implies that the private sector is running an unprecedented cash-flow deficit. Most of this remains a household sector problem. Ultimately, we believe this will end badly, but, it seems, not imminently.
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25bps Rate Cut After April's Inflation Deceleration
May 10, 2006
Deyi Tan (Singapore) and Denise Yam (Hong Kong)
25bps rate cut: After hinting strongly it was likely to cut interest rates in this meeting, the Central Bank pushed through a 25bps cut today. This brings the benchmark rate down to 12.5% from 12.75% previously. Another rate cut in June? This rate cut is likely predicated on the Central Bank’s estimate that 1Q06 growth has slowed whilst inflationary pressures subsided slightly in April by 0.3%-pt to 15.4%. In our view, growth concerns appeared to have trumped inflationary concerns in this decision. Whilst we agree that 1Q economic growth has likely slowed, it is not obvious to us that the deceleration in inflationary pressures would necessarily continue in May. On the inflation front, the rate cut could be slightly premature. In our view, another 25bps rate cut in June 6 will depend on whether May inflation (out on June 1) slows further or at least stabilizes. From this angle, another cut in June does not seem a done deal. Forward inflation trajectory: We maintain our view that inflation will mostly decelerate in steps through the year primarily on changes in base effects as fuel prices revise. On the more micro month-to-month variations in inflation numbers, we believe the only benign factor now is the strengthening currency. However, risks might be tilted to the upside from unsubsidized industrial oil prices and rising oil price forecasts. Industrial oil prices revised by an average 9% MoM in May. The currency has appreciated by a lesser 2% so far. 1Q06 GDP growth likely slowed to 4.5%YoY: 1Q06 growth to be released on May 15 has likely slowed to 4.5% YoY by our estimate. Consumer spending likely faltered. Proxies such as the retail sales index contracted 21.3% YoY in Jan-Feb (vs +1.6% YoY in 4Q05). Meanwhile, consumption credits by commercial banks expanded at a slower 29.9% YoY in 1Q06 (vs +36.7% YoY in 4Q05). On the investment front, our proxies showed that whilst fixed investment appeared to have accelerated, destocking likely continued. External balance has likely improved as imports contracted on the back of slower raw materials intake.
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