Michael Stutchbury, Economics editor May 28, 2009
THE 37 per cent price cut forced on Rio Tinto for its iron ore sales to Japanese steel mills illustrates Wayne Swan's budget trouble.
Two weeks ago, this column signed off by asking why a key Treasury chart suggests the budget is now in deep "structural" deficit. Surely the deficit should be mostly "cyclical" amid a recession? Surely it will naturally swing back into surplus when the economy and tax revenue recovers?
Afraid not. It's all about the boom-bust in Australia's terms of trade -- the ratio of the prices we get for our exports to the prices we pay for our imports.
The budget's structural position is supposed to measure what the headline budget bottom line -- next year forecast at a $57.6billion deficit -- would be if the economy was operating at normal capacity.
Until now, Treasury has resisted publishing such estimates, arguing in 2005 that this would require complex and possibly misleading "output gap" calculations about how far the economy is operating from its full capacity through the ups and downs of the business cycle.
At the same time, it reassuringly pointed to "a significant structural improvement in Australia's fiscal position over the past few years", according to these very same sorts of estimates from the International Monetary Fund and the Organisation for Economic Co-operation and Development.
But Treasury reversed course in this month's budget, publishing estimates of the budget's structural position. In doing so, it broke from IMF and OECD methodology to instead rely on a medium-term assessment of the terms of trade outlook. The results aren't pretty. "Based on these estimates, the structural budget balance deteriorated from 2002-03, moving into structural deficit in 2006-07," the budget papers state. "This shows that the actual underlying cash balances (that is, surpluses) in previous years were primarily the result of the strength in Australia's terms of trade ..."
Houston, we have a fiscal problem. The graph shown here, drawn from Reserve Bank governor Glenn Stevens's speech last week, illustrates how the sudden surge in China's demand for resources from around 2002 sent prices for Australia's iron ore and coal exports skyrocketing. At the same time, China ramped up its exports of cheap manufactured goods. For each tonne of exported iron ore or coal, Australia could buy many more imported flat-screen TVs. Australia's 60 per cent terms of trade surge was the biggest in living memory -- and bigger than in comparable commodity exporters such as Canada. The big thing we've relearned about Australia in this boom is how swings in the price of our export commodities drive national income -- and hence the budget bottom line. The latest boom added a cumulative $260 billion to nominal gross domestic product over the five years to 2008-09.
This showed up in higher corporate profits, dividends, share market gains, housing prices and job growth. And that supercharged the government revenue harvest from company taxes, capital gains taxes, personal income taxes and, for the states, mining royalties and stamp duties.
Along with other forecasters, Treasury repeatedly underestimated the latest terms of trade boom. The unexpected revenue bonanza financed tax cuts and spending increases -- such as on middle-class welfare. But it still left enough to deliver a string of windfall surpluses, which appeared to guarantee the budget's underlying structural soundness.
By Wayne Swan's first budget, Treasury had become taken by the idea that Australia's commodity export prices had been structurally elevated by a China boom that would last for decades. Its previous conservatism gave way to forecasts of further big terms of trade gains. After delivering scheduled tax cuts, Swan's first budget figured that revenue would rise $17.3 billion over 2008-09. That was budgeted to finance a $12.7 billion increase in government spending while leaving an extra $4.9 billion to add to the surplus.
Swan didn't know it at the time but, in fact, the budget already was structurally in the red. Fiscal policy had been spending the terms of trade bonanza as if it was semi-permanent rather than transitory. Swan's first budget simply sent fiscal policy into deeper structural deficit. This was exposed only months later, when commodity prices slumped, followed by the Wall Street financial crisis. Swan's second budget forecasts a 13.25 per cent terms of trade slump next financial year along with a collapse in corporate tax and capital gains tax receipts.
The budget further assumes that the terms of trade will gradually slide by another 15 per cent over the decade from 2013-14. That will keep a lid on tax revenues, making it harder to return to budget surplus by 2015-16.
The good news is that by the end of this year the terms of trade are still likely to be 40 per cent higher than the average in the 1980s and '90s. Rio Tinto's 37 per cent iron ore cut only partly retraces last year's 85 per cent contract price spike. National income will be permanently raised, but not by as much as previously banked on.
If only we had stashed away more of that extraordinary one-off revenue boom, we would be much better placed now to ride through the recession and hitch back on to the Chinese recovery.