We’re in the money – Australian budget in surplus in 2018?

The Mathais “the Terminator” Corman was noting something that had slipped under the media and market participants nose, despite the Department of Finance release the week before that the first 11 months of the 2018 financial year.  As usual, our media was more concerned about the bally ho surrounding Senator “Ill say anything I like” Leyonhjelm.

The Department of Finance figures show that the federal government recorded a chunky $9.4 billion surplus in May on its “fiscal balance” measure, with the “underlying cash balance” and “net operating balance” metrics likewise registering surpluses of $4.9 billion and $10.4 billion, respectively.

Importantly, both the net operating balance ($1.9 billion surpluses) and the fiscal balance ($1.1 billion) benchmarks. Only the underlying cash balance remains in deficit ($10 billion). In context, it should be remembered that the May 2017 budget, forecast that Australia’s net operating and underlying cash balances would both suffer large deficits of $20 billion and $29 billion respectively in the 2018 financial year.

Now the budget is $22 billion ahead of these estimates on the net operating balance measure and $19 billion better off on an underlying cash basis. It is possible for the Budget numbers to be a shocker for June but it is unlikely. It is important to remember that way back in 2017 when the Budget was delivered the analysts and rating agencies say the Government was being far too optimistic. Yet the numbers make a joke of the analysts and agencies by about $20 billion in 2018 alone.

As you can see from this graph from investment bank UBS, we’re rapidly approaching 50 per cent.

Why has the economy suddenly improved?

Nuh. Wages growth is still painfully slow, so are improvements in productivity, inflation is below trend despite our absurd energy policy, which makes it cheaper to import gas from Texas than it does from Gippsland and economic growth is tepid.

Normally in the conditions, the economy would be facing recession, but the Reserve bank has been able to handle the hot potato with the interest rate gloves. This is why the Reserve Bank has kept interest rates at a record low for so long and has no plans to raise them any time soon.

Instead, several forces largely outside the Federal Government’s control have shifted the budget balance. Commodity prices have been stronger than forecast while employment growth has been good. Combined, those two factors have delivered much stronger revenue flows.

Importantly, the heavy losses incurred from our big corporations in the aftermath of the financial crisis finally have washed through the tax system and despite the ABC appalling analysis of corporate tax policy, we now discover that have exhausted their losses, corporate tax receipts are now rising.

Despite Emma Alberici’s distorted view of corporate reality it typically, it takes three to four years for tax revenues to get back to normal because companies can use previous years’ losses to reduce tax. If of course, you have a one in a century event like the Global Financial Crisis then it will take longer, let’s not forget the GFC occurred in 2008 – 2009. Anyway, the tax losses are now pretty much are all used up.

It has taken a decade because, just as our banks and property groups began recovering, the resources boom came to a shuddering halt in 2014.

As a result, the budget bottom line is in much better shape than forecast even just a few months ago. The Commonwealth Bank has done some analysis and they think there has been a $10 billion improvement and a further $27 billion over the next three years even without any government initiatives.

Key drivers

CommSec’s Craig James, was on it early when he said this is the “smallest rolling annual deficit for nine years”. “For the 11 months to May the operating balance is almost $2 billion in surplus – over $7 billion better than [the government] expected [only two months ago in its May budget],” James says.

The driver of Morrison’s upside surprise, was predicted by Christoper Joye in the Australian Financial Review when he pointed out in 2017 that better than expected commodity prices, labour market conditions, and overall economic growth would sooth the deficit rash. “Record employment growth and company profits have boosted government revenues while at the same time the government has trimmed its spending,” James explains.

As a result these improvements are likely to compel S&P’s sovereign analyst Kim Eng Tan to consider taking the AAA rating off its “negative outlook” and restoring it to a “stable” footing, which few thought possible 12 months ago.

This is good news for the banks as S&P’s Sharad Jain has flagged that the agency is contemplating upgrading Australia’s economic risk score from 3 to 2 (lower is better), which would lift the credit ratings on the major banks’ hybrids from BB+ to BBB-. It would also improve the ratings on their subordinated bonds to BBB+, which all else being equal should ameliorate their funding costs.

While Aussie house prices have corrected 2.5 per cent from their October 2017 peak (Sydney prices are down 5 per cent), there are no signs of the “credit crunch” imagined by the likes of UBS’s Jon Mott. However, we would not rub this off the strategy board just yet.

According to the Reserve Bank of Australia, housing credit expanded, not contracted, by 0.4 per cent in May and has increased by a handsome 5.8 per cent over the last 12 months. There has been a welcome deceleration in overall housing credit growth in recent years as regulators pushed banks to substantially boost the conservatism of their lending standards since 2014.

This is most evident in lending to property investors, which was flat in May and has risen by only 2 per cent over the last year, which CBA’s Kristina Clifton says is “the slowest pace of investor credit growth on record”. While housing credit growth will continue to soften, it is not going to contract as sharply as UBS’s Jon Mott warned.

The RBA seems to believe that any additional tightening in lending standards is likely to be modest, which is interesting because talk to any mortgage broker and they will tell you, getting loans approved is getting more difficult. Indeed one young mortgage broker told me that the “banks” are now saying that if you spend more than a third of your income on a mortgage you are going broke. Well, that comes as no shock to old staggers and by old I mean you had to be in finance before about 1990. Before the mid-1990’s, the quick calculation was a third, then credit loosened up.

Crucially, the normalisation in housing credit growth towards the rate of change in national incomes is precisely what credit rating agencies have wanted to see. Aussie housing has been heinously expensive for some time, and we desperately needed an orderly mean-reversion in valuation fundamentals, which is exactly what is happening.

Does that mean our debt will start to fall?

Short answer: Nuh. It’s like a shrinking mortgage, interest is still payable on the outstanding balance. So, as we keep clocking up deficits, our debt continues to rise.

In fact, our total government debt, from federal, state and local governments, is forecast to hit just shy of $1 trillion within the next two years, around 48 per cent of GDP. Which is pretty bad considering when John Howard left office the federal debt was close to zero.

While a trillion dollars is relatively tame compared with other developed nations, we face a number of unique challenges our peers do not.

1. Our concentrated export sector. We largely rely on one country, China, to whom in essence we sell two commodities, iron ore and coal, so we are horribly exposed to China. China has a massive debt problem, with government debt now around 260% of GDP and a great wall of debt in its shadow banking system which the Reserve Bank of Australia estimates at USD 7 trillion or in simpler terms 60% of GDP. As a result of the Reserve Bank to sound several warnings in the past month, that a sharp slowdown in China, emanating from its debt problems, would be acutely felt here.
2. The second challenge is that, while our government debt is still relatively manageable, our private sector debt and particularly that of households, is not. It recently shot to $2.466 trillion, almost 200 per cent of disposable income, among the highest in the world. This mountain of debt that the Reserve Bank hands tied with interest rates. A sustained rate hike could push large numbers of Australians to the brink and jeopardise the economy’s financial stability.
3. The third problem is that much of our good news on employment has been driven by population growth. It may have boosted the economy and lifted government tax receipts but now we have to build the infrastructure and that costs money.

So what’s wrong with tax cuts?

One way to help ease the debt burden of our households would be to hand out some tax cuts.

If the Rudd Government experiment of 2008 is a guide, when taxpayers were handed the cash splash with cheques in the mail designed to boost consumption during the Global Financial Crisis, the punters split the proceeds between lashing out on extra spending, usually on the pokies and repaying debt.

The problem with doing that now, however, is that, unlike 2008, we are not facing a crisis, at least not yet. And just when some windfall revenue looks to have provided an opportunity for repairing our national balance sheet, the geniuses in Canberra are spending it. The more prudent approach would be to accelerate debt repayment.

That would deliver the Federal Government some much-needed ammunition if chill winds begin blowing on the global economic front, but the voters dont like that, given they have supported economic foley that through the pursuit of unsustainable energy policies, a national disability scheme that is unfunded, an education system that needs more money despite diminishing returns and so on. Tax cuts look sound because at least the prudent punter can pay down their debt or increase contributions to super. Super is outside the claws of bankruptcy, and in the event the banana republic arrives, you can declare yourself bankrupt, send your banker jingle mail and withdraw to a beach.

Speaking of banks, what about

Bank funding costs

Well if Australia’s credit ratings were to improve then you’d expect funding costs to fall, but then again the dollar is falling because the interest rate between the US interest rates is now higher than Australia’s.

So beware the out-of-cycle interest rate hikes as the banks recover elevated funding costs wrought by a hike in the short-term price of money. On this note, there has been much debate as to why these short-term funding costs spiked in Australia at the end of the June quarter, but not in the US or anywhere else.

This has created a pattern whereby both unsecured and secured borrowing costs for Aussie banks have leapt at the end of the December, March, and June quarters.  There are many and varied explanations but in short, the Australian Banks, borrow short term and lend long, so they are dependent on the availability of credit.

The reality is that the banks are being short squeezed on credit, there has a significant increase in demand for Australian dollars by offshore players. Secured lending rates have climbed and the punters willingness to invest in bank deposits have fallen. No surprise 2.75% for a 7-month term deposit is not exactly compelling, is it?

In addition, the Bank for International Settlements says reduced liquidity and increases execution costs; and the fact that budget surpluses are resulting in the government depositing much more money with the RBA, which is buying overseas assets it hedges back into Australian dollars creates yet more demand for local currency and puts upward pressure on short-term rates.