Cheer up, the budget might fare better than we think

May 11, 2015

By Stephen Koukoulas

29 April 2015

Despite the doom and gloom, Joe Hockey could well deliver a budget deficit profile significantly below what was predicted, writes Stephen Koukoulas.

In next month’s budget, Treasurer Joe Hockey could well deliver a budget deficit profile significantly below the one outlined in the December 2014 Mid-Year Economic and Fiscal Outlook.

The reasons are simple – the labour market is performing more strongly than was assumed in the MYEFO, the iron ore price may have found a floor around $US50 a tonne, and the Australian dollar is close to 10 per cent lower than was assumed.

For the record, the MYEFO was estimating the budget deficit to be $40 billion in 2014-15, $31 billion in 2015-16, narrowing to just $11 billion by 2017-18.

For 2015-16, the deficit could be about $5 billion lower because of better-than-forecast economic and market conditions, while the 2017-18 budget balance could be close to surplus, depending on the spending and revenue measures that will also be included in the budget in May.

To the labour market first.

The MYEFO painted a picture of weak labour market conditions for 2014-15. Employment was forecast to rise by just 1 per cent while the unemployment rate was assumed to be 6.5 per cent in the June quarter 2015.

There are now nine months of labour force data for 2014-15 and barring some calamity, these forecasts are going to be easily beaten. Even with no increase in employment in the last three months of 2014-15, annual employment growth will be about 0.7 per cent higher than the MYEFO forecast. If employment rises by an average of 17,500 a month for the next three months, which merely matches population growth, employment will be a quite spectacular 1 per cent higher than forecast. That is more than 100,000 extra people with a job, paying income tax and spending in the shops and effectively helping to narrow the budget deficit.

Impressively, the unemployment rate was 6.1 per cent in March, which is well below the MYEFO forecasts, signalling lower welfare payments from the budget.

The MYEFO was forecasting the wage price index to rise by 2.5 per cent through the year to the June quarter 2015, and while data is currently only available for the first six months of the financial year, the current “run-rate” fits with exactly that forecast. In other words, while wages growth is presently subdued, it appears to be no worse than was plugged into the MYEFO budget spreadsheet.

In other favourable news for the budget, the price of iron ore seems to have found a floor. Just last week, Mr Hockey suggested the forecast for the iron ore price in the budget could be as low as $US35 a tonne. Since he made that comment, the price has moved higher and is a little over $US60 a tonne as output cuts and market consolidation have impacted.

According to Treasury analysis, each $US1 a tonne for the iron ore price is worth an estimated $250 million a year to the budget bottom line. If Treasury assumes a $US60 a tonne level the bottom line of the budget improves by about $6.25 billion a year over the forward estimates compared to an assumption of $US35.

MYEFO assumed an iron ore price of $US60 a tonne, with the Australian dollar at $US0.84. In other words, that is an Australian dollar price of just over $70 a tonne. At current levels of $US58 tonne and an exchange rate at $US0.78, the Australian dollar price of iron ore is now about $74 a tonne, about $4 a tonne higher and a boost of in itself just under $1 billion a year to the budget. It is actually a positive issue for the budget now.

In addition to aiding the bottom line of iron ore producers, the lower Australian dollar is also a fillip for other exporters and for firms competing with low cost importers. It is a net boost to activity and inflation to have the currency 10 per cent lower than assumed just four months ago.

Also helping the budget bottom line is the certainty now of RBA dividends to the government over the next few years. The RBA is not only cashed up with the $8.8 billion Mr Hockey gave it, but the lower Australian dollar will boost its earnings and allow it to give to the government several billion dollars a year for the next few years.

The bottom line is that there is nothing in the economic parameters to suggest the overall bottom line of the budget will be any worse than assumed at MYEFO – that is, the deficits should actually be smaller than was forecast because of the relative strength of the labour market and the lower Australian dollar, which has more than offset any issues with the fall in the iron ore price.

What may be challenging is the big spending policies of the Abbott Government, which have shown spending to GDP levels rising to levels above the long-run average.

If the budget deficit is in fact wider when the numbers are revealed on budget night, it is likely that the fiscal deterioration will be the result of changes to policy settings rather than because of any economic or market shock, which are actually better than assumed when MYEFO was put together.