Home / Credit rating OK, but fiscal policy a drag: is there a better budget mix?

by Matthew Peter (Chief Economist) and Jimmy Louca, CFA (Senior Economist)
On the heels of a sharp public reaction to last year’s budget, the Federal Government’s prescription this year focused on growth and assistance for low-to-middle income earners. There was a small expansion in the deficit but the budget is still projected to return to surplus by 2019-20. In our view there is not much good news, but also no real bad news. Here is our analysis.
The deficit was contained by continuing to push for health and pensions savings, dropping the proposed paid parental leave scheme and making a back-loaded child care package (beginning in July 2017) conditional on the Senate passing upfront cuts to other family benefits.
Despite some predictions of a post-Budget credit downgrade, credit agencies re-affirmed Australia’s AAA status.
Rating agencies assess sovereign credit based on a combination of institutional, economic growth and monetary policy factors, as well as the external position and fiscal flexibility.
We estimate that Australia scores highly on the first three factors, given strong laws and governance, stronger economic growth relative to comparable peers, a floating exchange rate and credible monetary policy. However, a weaker external position (foreign debt and current account deficits) affords Australia less wriggle room on fiscal metrics.
In particular, we estimate that maintaining gross (federal and state) government debt as a share of GDP below 30 per cent and maintaining a falling budget deficit over a three-to-four-year window are two criteria needed to maintain the AAA rating.
The Budget passed this test, projecting the deficit to narrow over the forward estimates (FES) and the net federal government debt-to-GDP to peak just 0.8 percentage points (ppts) higher than MYEFO at 18 per cent in 2016-17. We estimate this rises to 21 per cent including State/local Government debt – still some distance from the 30 per cent ‘ceiling’.
A small business kick-start
Our modelling shows that the budget’s small business package could lift employment by 10,000 jobs over the coming two financial years. That, however, would be an increase of less than 0.1 per cent of total employment.
Of course, the outcome could be higher if the package does significantly boost business confidence.
We estimate that a large confidence-induced multiplier could potentially double the impact, but that would still only add another 0.1 per cent to total employment.
While a step in the right direction, it’s unlikely to be an economic game-changer.
The budget certainly avoided the damaging impact to consumer confidence of last year, when in May 2014 the monthly gauge of consumer sentiment collapsed 6.8 per cent. By contrast, sentiment lifted 6.4 per cent after this Budget.
Fiscal policy to still weigh on growth
However, fiscal policy will remain a drag on Australian growth for around the next six years.
The path of the budget over 2014-15 to 2015-16 is for a reduction in the deficit of $6 billion or ½ ppt of GDP from $41.1 billion to $35.1 billion. That is, the federal government impost on the economy over the next financial year is still ½ ppt of GDP.
Over the four years of the FES, the fiscal headwind remains, on average, ½ ppt of GDP. Adding in state government fiscal consolidation plans increases, this headwind grows to almost ¾ ppt of GDP per annum.
Such a drag from the public sector would require the private sector to overcompensate by growing 4 per cent per annum to reach trend GDP growth (around 3¼ per cent) over this period. That’s a tall order given the slump in mining investment. It also explains why interest rates are not expected to rise anytime soon.
An opportunity for fiscal easing
We believe a case can be made for short-term fiscal easing combined with a medium-term plan for reform that does not threaten the AAA rating.
We modelled a short-term expansion of the Budget over 2015-16 and 2016-17 through $10 billion of infrastructure investment and a delay of $10 billion of currently proposed savings measures until 2017-18 (Figure 1).

However, to build confidence the budget must not be allowed to deteriorate permanently: the government must legislate now for the introduction of savings measures in 2017-18.
Infrastructure stimulus would be looked upon favourably by rating agencies (given returns are likely to be higher than current low borrowing costs), while staged savings also address debt metrics and achieve a return to surplus.
Moreover, infrastructure expands the capacity of the economy, provides strong multipliers and helps to absorb construction and engineering workers transitioning from the mining industry.
Our modelling of such a policy shows that it could help break the run of below trend growth by pushing 2015-16 GDP to 3.2 per cent from a sub trend 2.8 per cent rate we currently expect (Figure 2).

The policy also breaks the trend of rising unemployment, with the unemployment rate falling from mid-2015, rather than drifting above 6.5 per cent (Figure 3).

A better policy mix
The budget strategy we modelled also promotes a better macro policy mix. By bearing some of the stimulus load, fiscal policy reduces the pressure on monetary policy and hence over-reliance on lower cash rates to deliver economic stimulus.
Our modelling suggests the RBA could pause at a 2 per cent official cash rate and begin raising rates from mid-2016, rather than cut to 1.75 per cent and hold rates at emergency levels through 2016, as would be the case if the Government follows through on its near term Budget tightening (Figure 4).

A better policy mix would promote a more balanced economic recovery; less centred on housing and less at risk of creating a boom-bust, house price cycle.
For financial markets, less downward pressure at the short end of the yield reduces downward pressure on mortgage rates and thus would curb the potential for excessive investor risk taking.
We also find that the credible medium term plan for fiscal consolidation anchors the longer end of the yield curve. Well anchored longer run interest rates support equity valuations, which respond positively to the improved economic and jobs outlook.
Public-sector debt in our scenario peaks at around 23 per cent, still well below 30 per cent, while the deficit has an improving trajectory from 2016-17.
A mix of near term fiscal easing combined with less monetary policy stimulus can boost economic growth back to trend, result in more balanced growth with less risk to asset prices and contribute to lower unemployment.
Combined with a credible path for longer-term structural reform, this could be achieved without threatening Australia’s AAA sovereign credit rating.
 
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