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Lower budget deficit to protect AAA rating

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A likely improvement in the budget outlook thanks to last year’s surprise mini-boom in commodity prices is expected to shield Australia’s coveted triple-A rating from a downgrade, even as infrastructure spending looks set to rise.

Economists are tipping the budget deficit for 2017-18 to come in around $25 billion, or well below the $28.7 billion projected in December’s mid-year budget review, a welcome change from years of downward revisions.

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The lower deficit won’t be down to tough fiscal reform, though, but comes courtesy of strong rises in the prices of key exports iron ore and coal, which are boosting nominal GDP as well as delivering additional tax revenue.

“With the budget set to look a bit better, an improving nominal economy and signs of some budget reform, we doubt a downgrade will arrive,” said HSBC chief economist Paul Bloxham.

It looks like Treasurer Scott Morrison will once again be able to dodge the bullet of a ratings downgrade. It looks like Treasurer Scott Morrison will once again be able to dodge the bullet of a ratings downgrade. Photo: Alex Ellinghausen

The main change from the mid-year review is the likely upward revision of next financial year’s nominal growth forecast, which translates into a higher tax intake. HSBC said that as a rule of thumb, a 1 percentage point increase in nominal GDP lifted government revenue by about $3 billion. 

“We see scope for the 2017-18 forecast to be revised up to 5.25 per cent (from 3.75 per cent) or above thanks to the continued strength in commodity prices and a likely upward revision to the real GDP growth outlook,” Mr Bloxham said.

Standard & Poor’s put Australia on ‘negative outlook’ for its triple-A rating in July 2016, warning that the government’s worsening fiscal position made a downgrade a one-in-three possibility over the following two years. It’s so far the only one of the big three rating agencies to threaten a downgrade.

However, the budget is now expected to remain on track for a modest surplus by 2020-21 and with net debt remaining low in an international context as well as a lower current account deficit, S&P is seen as less likely to follow through with its threat.

The federal government is set to ramp up infrastructure spending. The federal government is set to ramp up infrastructure spending. 

This comes despite the government’s plans to ramp up infrastructure spending for projects such as the Badgerys Creek airport in western Sydney, a Melbourne-to-Brisbane inland railway or the Snowy Hydro scheme.

Much of the additional capital spending to fund infrastructure is likely to be off-budget equity injections into non-financial public corporations, classified by Treasurer Scott Morrison as “good debt” that will improve Australia’s productivity in the long term.

Good debt as opposed to bad debt for recurring spending will for the first time be presented separately in the budget, a differentiation most economists have welcomed.

But rating agencies are likely to see through the Treasurer’s move, as they tend to focus on the quantity, rather than quality, of debt.

When assessing the credit rating, the agencies will make judgments about the nature of the off-budget spending and if it assists, or hinders, the government’s ability to repay its debt, said ANZ economist Cherelle Murphy.

“The critical point is that the government’s increased spending, both ‘on budget’ and ‘off budget’, will not be so large to threaten a projected return to surplus sometime near the end of the forward estimates or shortly thereafter,” she said.

Investors have in general been relaxed about a potential loss of the highest rating, with NAB chief financial officer Gary Lennon last week noting the impact of a downgrade – which he considered “inevitable” – would be small, as it had mostly been priced into markets.

“​While our global investor base does not seem perturbed by a downgrade to AA+, no government wants that to happen on their watch,” said TD Securities Asia-Pacific chief macro strategist Annette Beacher.

One area where investors are likely to feel the repercussions of an improving budget position is the fixed-income market.

Mr Bloxham said the budget should be bullish for bonds as it would confirm that issuance of government paper had peaked in 2016-17, while fiscal consolidation was back on track.

“The recent uptick in bid-cover ratios as well as a continued gradual rise in offshore bond holdings implies a steady demand for duration,” he said.

Looking further ahead, Citi economist Josh Williamson said the government’s pledge to return the budget to surplus by 2021 would come into sharper focus this year as that financial year would now form part of the official forward estimates.

But the government faced a difficult challenge to reach that target given it had ruled out several large revenue-raising options, and the political difficulty of cutting spending.

“The government is quite hamstrung,” he said. “It is going to be a small-target budget, they are going to have to thread the needle.”

Mr Williamson said large changes to the economic underpinning of the budget were unlikely, although there was a small chance GDP could be revised upwards.

“We don’t have any problems with any of their macro-economic assumptions,” he said.

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