Australian Federal Budget in Tatters Already


I don’t mean to get all philosophical on you today, but it’s necessary for some context…

I have a general belief that things happen for a reason. There is no such thing as a coincidence. In other words, the universe tells you things in its own subtle way. You can either take heed and make changes, or ignore it and plough on regardless.

I bring this up because the government is clearly ploughing on, regardless of a message coming to it loud and clear…

I’m talking about last week’s federal budget, which I have so far avoided mentioning altogether. Now that things have died down a bit, though, it’s probably time to raise a few important issues.

Or one important issue to be precise. That is, the forecast price for iron ore that underpins the government’s revenue projections over the next few years.

At the mid-year economic and financial outlook, released in December, the government forecast an iron ore price of US$39/tonne. Last week, it upgraded its outlook for iron ore to $55/tonne.

When taking freight costs of around US$5/tonne into account, that equates to a spot price of about US$60/tonne.

The government presumably rationalised the increase on the big rally in the iron ore price in early 2016. A rally that was always clearly unsustainable.

And what happened in the week of the budget’s release, which contained these shiny new forecasts?

The iron ore priced tanked!

As the Financial Review reported on the weekend:

Iron ore posted the biggest weekly loss in four years after China quelled speculation in raw-materials trading and concern increased about whether a recent improvement in demand in the top user will be sustained.

And the falls continued overnight. The price of Qingdao 62% iron ore content was smashed 5.7% to US$55/tonne, following weaker than expected import and export data out of China on the weekend. The price is now down 22% since the 21 April peak and nearly 10% below the government’s forecasts before the new financial year even gets underway.

Is this the cosmos saying that the government’s new budget is in tatters already?

As far as signs go, it looks like a pretty obvious one to me.

Not that the government will take any notice. It’s well within their interests to forecast a strong iron ore price if they can get away with it. According to the Treasury’s numbers, a US$10/tonne price change will add or subtract around $1.5 billion to the government’s tax receipts next financial year, assuming an exchange rate of US$0.77 cents. The sensitivity rises to nearly US$4 billion in the 2017–18 financial year.

Given my strong view that the iron ore price will head to new lows following China’s latest futile stimulus attempts, the government is surely hoping to see the Aussie dollar fall considerably.

As we head into an election, this hideously poor forecasting error undermines the government’s ability to campaign on a narrative of economic competence.

The government simply doesn’t want to have to do anything. It doesn’t want to unwind any of the spending largesse that came with the commodities boom, and it doesn’t want to push a tough reform agenda, however beneficial that might be over the longer term.

It just wants a continuation of the same thing that has driven Australia’s growth for the past few decades. That is; China, low (and always lower) interest rates, rising debt and higher house prices.

But that’s just not going to cut it anymore. In the same way that China’s old growth model is dead, so is Australia’s. Yet the government doesn’t have any other solution other than to jam the numbers into a failed narrative.

The Federal deficit will be around $40 billion this year. Next year it’s projected to be slightly lower but, more than likely, it will come in worse again. Based on current policies and projections for future economic growth (which are way too high), the return to surplus in 2020–21 is a pipedream.

Luckily for the Coalition, they will get to the election on 2 July without these projections being undermined by reality. But it will become a bigger problem down the track. Even a mainstream voice like AMP’s Shane Oliver can see the looming issues Australia faces:

Australia still has a budget deficit problem. Government spending surged 25% between 2006-07 and 2008-09 to combat the GFC and this has never been unwound. We are still spending the proceeds of the boom even though it’s long gone.

While our public debt to GDP ratio is low compared to the US, Europe and Japan, comparing ourselves to a bad bunch may not be wise. And in any case we are a bit different to Europe and Japan which run current account surpluses and so are not dependent on the rest of the world for capital inflow and the US which has the benefit of the US dollar being a reserve currency.

Australia’s sizeable current account deficit of 4% of GDP means we have the classic twin deficit problem that leaves us vulnerable should foreign investor sentiment turn against us.

I’ve been talking about this issue for ages. And it’s only a matter of time before the rating agencies put the government on notice about its AAA credit rating. Once that goes, the cost of borrowing will begin to increase.

It’s a big political risk for this ‘do nothing’ government. Labor will look to exploit the ‘AAA’ issue during this election campaign.

Not that that matters to the government right now. Two-year bond yields are 1.57%, while 10-year bonds are just 2.32%. That’s a very cheap borrowing cost for a government with no plan.

The fall in interest rates isn’t the market rewarding the government with lower borrowing costs. It’s a signal that deflation, lower growth, and a possible recession are coming to Australia later this year.

This confirms that last week’s economic growth projections contained in the budget are wrong already. Despite the cosmos sending ample signs the government’s way, the wilful economic ignorance and incompetence is simply breathtaking.

And this from a government that prides itself on economic management! How dumb do they think we are? Pretty dumb is the answer to that question.

We’ll find out just how dumb on 2 July.


Greg Canavan,

For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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