Why a bigger deficit is not all bad

The Federal Government’s financial position continues to deteriorate.

The latest monthly snapshot of Commonwealth finances shows the deficit reached $35.48 billion in the 12 months to December – $763 million larger than was predicted in the Mid-Year Economic and Fiscal Outlook, which came out only a month ago.

It means there is going to be no let-up in the pressure on Federal Ministers to find savings ahead of the election year Budget released on 10 May.

But, promisingly for the Government, the deterioration in the Budget position was largely due to higher-than-expected cash payments than yet another unexpected revenue write-down.

In fact, there are some small signs that the flood of red ink that has drenched the tax revenue columns of Budget for the past few years may be starting to slow.

Gross income tax receipts ($87.6 billion for the financial year-to-date) were a little weaker than forecast in MYEFO ($88.1 billion), but recent jobs growth will spur hope of a strengthening in that revenue stream.

Even more optimistically, company tax receipts reached $30.82 billion so far this financial year – about $750 million more than anticipated in MYEFO.

Of course, this month’s sharemarket plunge might yet cruel this improvement.

Another cause for optimism is that GST receipts were mareginally stronger than expected, reflecting the increased willingness of consumers to shop and firms to invest.

If this improvement in activity, as reflected in the tax revenue figures, is sustained, then hopes that the country is well advanced in its adjustment to the end of the mining investment boom – – aided by the weakening of the dollar – will appear increasingly well founded.

 

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Why the gloomsayers are overdoing it

When national leaders talk up how good things are, it is often taken as a sign that they are about to turn very bad.

So when Barack Obama and Malcolm Turnbull each delivered upbeat speeches in the past week, more than a few pessimists probably took them as vindication of their bleak outlook.

After all, there seems to be plenty to be worried about.

The new year has begun in a flood a red ink on global sharemarkets as China growth fears, weak commodity prices, terrorist attacks and natural disasters have all weighed heavily on investor sentiment.

For those determined in their gloom, the latest update on the Chinese economy suggested additional reason for pessimism. The world’s second largest economy expanded at an annual rate of 6.9 per cent in the last three months of 2015, its the slowest pace in 25 years.

Taken together with the decision by the International Monetary Fund to trim its global growth forecasts for 2016 and 2017 by 0.2 of a percentage point each to 3.4 per cent 3.6 per cent respectively, and the bearish mood would seem to be well founded.

But in striking discordantly upbeat messages about the outlook, Messers Obama and Turnbull are not just handing around warm cups of cocoa.

There are concrete reasons to think the gloom is overblown.

Although a sudden upsurge in economic activity appears as likely as a return by Tony Abbott to the Lodge, there are several pointers – local and international – that suggest optimism is not misplaced.

Most importantly, the US economy – still overwhelmingly the largest in the world – appears well established on a growth path.

If the US Federal Reserve’s much-anticipated interest rate increase late last year did not confirm it, a streak of sustained jobs growth that has seen the unemployment rate halve from 10 to 5 per cent ought to allay doubts.

Yes, many jobs have been part-time or casual, and wage growth is weak. And there are headwinds from the weak oil price, which has kicked the stuffing out of the shale gas industry, and the increasing US dollar, which will weigh on export competitiveness.

But cheaper petrol has also boosted real household income, and the American consumer is back shopping and spending, which in turn is encouraging businesses to hire and invest.

As has been widely recognised for some time now, China is engaged is engaged in a highly challenging phase in its economic and political development.

The investment-led growth model that has powered its expansion for the last 25 years has run its course, and left a massive overhang of excess capacity and troubling debt.

If this was not challenge enough, the central government’s reluctance to loosen its control over the economy is coming back to bite it. As The Economist notes, its current situation of a slowing economy, a semi-fixed currency and increasingly porous capital controls is a volatile combination – if the government loosens monetary policy to boost consumption, it will weaken the currency and encourage even more capital to flow offshore.

Still, the Chinese government has plenty of ammunition if recession threatens – $US3 trillion of foreign exchange reserves and ample room to trim interest rates and devalue the yen.

The gloom about Australia’s prospects is also overstated.

The fall in commodity prices has been steep, but so was their rise. As Rod Sims recently pointed out in The Australian Financial Review, the current dominant market narrative of a “collapse” in commodity prices is underpinned by a short-term view. From a historical perspective, they are more accurately depicted as returning toward their long-term average.

Pessimists also point to soft wages growth and a weakening housing market as causes for concern.

But the country is generating sufficient jobs to edge the unemployment rate lower – it fell to 5.8 per cent in December – setting a firmer base under pay rates and raising the prospect of an eventual consumption-boosting lift in household incomes as spare capacity shrinks.

And although capital gains in housing have slowed as some of the heat has gone out of the property market, sentiment toward buying shows signs of picking up.

On the question of whether now was a good time to buy a dwelling, the Westpac-Melbourne Institute Consumer Sentiment Index found a sharp improvement in mood. The index jumped almost 14 per cent this month to 113 points – the highest reading since May last year and only a little below the level of a year ago.

Westpac chief economist Bill Evans says the reading should be treated with some caution, but nevertheless “ma be signalling some improving optimism in the housing market”.

This interpretation is supported by a jump in house price expectations following a plunge in the second half of 2015.

Late last year, Reserve Bank of Australia Governor Glenn Stevens estimated the economy was “roughly half way” through the decline of resources investment, and a rebalancing in the sources of growth was underway – a process that will be greatly aided by the falling currency.

Economic commentary often exudes an unjustified air of certainty.

But the sharemarket’s current bloodletting, but a focus on this has tended to blot out some of the more positive big picture developments occurring.

This is one of those seemingly rare occasions when it may pay to heed the message of political leaders.

 

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Why what happens in Washington matters in Canberra

Among the economic indicators Treasurer Scott Morrison needs to keep an eye on, the US labour market should be toward to the top of the list.

As the US Federal Reserve begins to gradually edge up its funds rate, Chair Janet Yellen has indicated the tightness of America’s market for workers will be an important factor in shaping the central bank’s thinking on how quickly to proceed with tightening monetary policy.

The state of the US labour market matters because as it gets tighter, so the bargaining power of workers is likely to increase and wages rise, helping force inflation up.

The higher inflation goes, the more the Federal Reserve will feel compelled to raise interest rates.

This matters for Australia because the higher official US interest rates rise, the greater the downward pressure on the Australian dollar (though this relationship should not be overstated).

As the Australian economy tries to establish sources of growth outside the boom-and-bust resources sector, a lower dollar helps by making exports and locally-made goods and services more competitive.

In the past year, the $A-$US exchange rate has slipped down more than 10 cents to 71.2 cents, a far cry from the above-parity levels reached earlier this decade, when massive mining investment was sucking in huge amounts of capital.

Given that the US unemployment rate has already dipped to 5 per cent, it might come as a surprise that the Federal Reserve has only just begun to increase interest rates.

But behind the headline number, data shows that many of the jobs created in the last few years have been casual or part-time. This suggests that there is considerably more slack in the labour market than a 5 per cent unemployment rate would ordinarily imply.

Recent soft income growth underlines the point. In the year to September, US wages grew by 3.66 per cent, virtually half the long-term average of 6.33 per cent.

This is being reflected in consumer spending – US retail sales grew by a modest 1.7 per cent in the year to November.

The Federal Reserve held off embarking on a tightening cycle until it was confident that the US recovery from the global financial crisis was well-established, so its decision earlier this week to raise interest rates, even by a meagre amount, is seen as a vote of confidence in the world’s largest economy.

As he contemplates the sea of red in the Commonwealth’s financial accounts, Scott Morrison can only hope that this is the case.

Despite his bizarre denialism on the matter, the Federal Government does indeed have a revenue problem. Collapsing commodity prices and soft income and corporate tax collections account for a lot of the deterioration in the Budget position.

And the government’s own forecasts suggest there is not going to be a quick turnaround. Earlier predictions that the economy would expand by 2.75 per cent this year have now been pared back to 2.5 per cent, and next year it is expected to grow by 2.75 per cent rather than 3.25 per cent.

Estimates of business investment, household spending, the terms of trade and private final demand have all been downgraded.

As Reserve Bank of Australia Governor Glenn Stevens observed last month, a rebalancing in the sources of growth is underway, but it is a little rockier than might have been hoped for.

With the economy poised between the drag caused by tumbling resources investment and support coming from a nascent recovery in non-mining activity – particularly services – now would seem a bad time to be adding to the weight on activity by cutting into government spending.

To his credit, Morrison has so far eschewed the sort of bloodletting Joe Hockey pursued in his first Budget.

But the cuts he has outlined – crackdowns on welfare ‘rorts’ and the axing and reduction of bulk billing incentives for pathology and diagnostic imaging services, in particular – make little economic sense.

Both sets of measures, collectively worth more than $2 billion, will mean consumers have less money to spend.

As the country’s experience through the GFC has shown, this is significant. Arguably the most effective measure taken by the Federal Government when the GFC hit in late 2008 was to deposit money directly into the bank accounts of millions.

While much of this money was saved, enough was spent to keep shop tills ticking over, shielding thousands of retail and services sector jobs.

This was especially the case among lower-income households, where a higher proportion of income has to be spent rather than saved.

The bulk of Morrison’s cuts will fall on just such households.

At a time when retailers and service providers are trying to find their feet after several years of lacklustre conditions, this is hardly helpful.

Such unhelpful tinkering by governments all too common.

Economists often lament that government interference prevents an economy’s ‘automatic stabilisers’ (floating currency, swings in tax collections and welfare payments) from working effectively, making a difficult situation far worse.

But it is totally unrealistic to expect governments in such situations to do nothing – after all, they have usually been elected on a platform to ‘do something’.

As Ross Gittens suggests, they could do much worse than to devote their energies into devising a path to surplus that kicks in once a recovery is established, and to work out how to better handle future prosperity.

 

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For interest rates, the only way is down

People might complain about mixed messages coming from the US Federal Reserve, but the same cannot be said about the Australia’s Reserve Bank at the moment.

The message from RBA Governor Glenn Stevens was about as unambiguous as a central banker can get: if there is to be a change in official interest rates in the next little while, the only direction will be down.

Mr Stevens highlighted the dovish sentiment currently prevailing at the central bank at the moment to the 2015 Economic and Social Outlook Conference in Melbourne today.

“Were a change to monetary policy to be required in the near term, it would almost certainly be an easing, not a tightening,” he said, adding that “an accommodative [monetary policy] stance will be appropriate for some time yet”.

But those hoping the RBA might be inclined to offset recent mortgage rate hikes by the big banks with a rate cut of its own are set to be disappointed.

Mr Stevens said that the recent increases had only partially reversed the decline in mortgage rates enjoyed by owner-occupiers this year, and those most affected were investors – a segment of the market policy makers will be happy to see cooled off a little.

Overall, the increases have been equivalent to half a 0.25 percentage point increase in the official cash, and have taken back just a quarter of the interest easing that has occurred since the start of the year, Mr Stevens said.

The RBA does not seem fussed by such a marginal tightening. The governor pointed out that “this increase is from the lowest rates that any current borrower will have ever seen”.

Change is happening

The central bank has also sought to bring some perspective to discussion about the country’s economic prospects, particularly the short-term growth path.

Mr Stevens said that the country had navigated the after-effects of the biggest terms of trade boom in 150 years reasonably well, managing to continue to grow despite the big plunge in mining-related investment.

Promisingly, he thought the country was about halfway through the decline, and the “headwinds” it was causing were currently about as intense as they were going to get.

The rebalancing of the economy away from resources-led growth toward other drivers of expansion, particularly burgeoning services activity, is, Mr Stevens said, well underway.

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Hackneyed penalty rates debate sells nation short

When politicians and business leaders talk about the need for flexibility, it is usually preceded by the word “labour”, and often comes down to cutting penalty rates, leave arrangements and other worker entitlements.

Which is what makes the contribution by Reserve Bank of Australia Deputy Governor Philip Lowe particularly refreshing.

While Lowe sees a flexible labour market as contributing to the overall adaptability of the economy, it is only but one part of the picture.

Instead, in his speech to the CFA Institute conference, the senior RBA official seen as a front-runner to head the central bank when Glenn Stevens retires, emphasises the importance of a freely-floating exchange rate, financial innovation, robust competition, incentives for innovation and investment in education as critical to the flexibility of the economy.

This is a much broader picture than the current hackneyed focus on industrial relations, and it opens up many more fruitful avenues for action and reform.

The wrongheadedness of the “IR-only” focus underlined by the fact that, by and large, current labour market arrangements seem to be serving the country fairly well.

As Lowe says, during the resources boom there was little spill-over from huge wage increase in the mining sector, while in the subsequent slowdown flexible work hours and weaker wage growth have helped limit unemployment.

“From a cyclical perspective, the labour market has proved to be quite flexible, and things have worked reasonably well,” he says.

In its recent assessment of the nation’s workplace relations, the Productivity Commission similarly thought the IR system was in need of repair, rather than replacement.

“Contrary to perceptions, Australia’s labour market performance and flexibility is relatively good by global standards…Strike activity is low, wages are responsive to economic downturns and there are multiple forms of employment arrangements that offer employees and employers flexible options for working,” the Commission reported.

Not that everything is rosy.

The Productivity Commission was critical of the Fair Work Commission’s “legalistic” approach to award determination, and suggested the need for an “enterprise contract” as a mid-way point between enterprise agreements (unwieldy for small businesses) and individual arrangements. It also said that at the moment it is too easy for employers to dodge punishment for sham contracts and exploiting migrant workers.

But overall the Commission supported, with some caveats, the minimum wage, penalty rates, Australia’s “idiosyncratic” awards system and enterprise bargaining.

Lowe’s speech suggests there are other areas that demand greater attention.

He says maintaining a flexible financial sector will be crucial in ensuring business is able to grab opportunities as they emerge. To achieve this, regulations will have to strike a judicious balance between supporting financial innovation while protecting investors.

Competition policy needs to ensure that businesses harnessing new technologies do not face unfair barriers to entering the market, and that the tax and legal systems – as well as community attitudes – provide incentives for innovation and entrepreneurship.

In education, Lowe says, “continual improvement in our human capital will hold us in good stead”, and has urged the need to strike a balance between developing specific technical and professional skills and encouraging general learning.

Many may quibble about what is on, and not on, Lowe’s list, but it opens things up a much more fruitful debate about what needs to be done to make sure the country is best-placed to take advantage of future opportunities as they arise.

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Will the China trade deal really deliver $billions?

Companies pursuing tax breaks often end up with contrived, complicated and opaque corporate structures that bog them down and bear only passing relation to how they actually operate.
It is increasingly the same in international trade.
With the conclusion of a preferential trade deal with China earlier this week, Australia is now signatory to 16 bilateral and plurilateral trade agreements, almost all of them negotiated in the last 15 years.
It is part of a regional trend.
Across the Asia Pacific, there has been a frenzy of deal making. At the turn of the century there were 51 preferential trade deals in the region. By earlier this year, their number had swollen to 215, with a further 60 under consideration.
The quality and comprehensiveness of these deals vary widely, and each is weighed down by rules and annexes that can run to thousands of pages setting out rules and exclusions.
Even the Korea-Australia Free Trade Agreement signed late last year, considered to be one of the higher-quality deals around, runs to 1700 pages and covers more than 4000 product-specific rules.
These deals come with sales pitches that typically claim they will deliver staggering riches.
For example, the Centre for International Economics – on commission from the Department of Foreign Affairs and Trade – has calculated that the triumvirate of Australia’s bilateral deals with Japan, China and Korea will, collectively, boost Australia’s exports by 11.7 per cent (almost $17 billion) by 2035 and create an additional 178,000 jobs.
Such gains, if realised, should not be sneezed at.
But there are reasons to be more than a little sceptical about these claims. Aside from the challenges of anticipating what the economy will be like in 20 years’ time (how many in 1995 would have imagined that a business based on sharing photos and pithy one-liners would grow into one of the world’s biggest companies), there is the question of how much trade that might go elsewhere will end up channelled to these three markets because of these trade deals.
But perhaps the biggest question of all is how much businesses will avail themselves of the opportunities contained in these agreements, and at what cost.
Tariffs may be cut to zero, but that means nothing unless businesses take advantage. And by pursuing the opportunity in one market, attention invariably shifts from others. Then there is the competition for domestic producers from cheaper imports, and the associated benefits that are likely to accrue to consumers.
Experience both in Australia and internationally shows that, despite all the hype, businesses are poor at taking advantage of preferential trade agreements.
An Economist Intelligence Unit study found that, across east Asia, less than third of eligible firms used concessions provided by trade deals, and a survey of Australian companies by the Australian Chamber of Commerce and Industry in late 2013 found that in almost all instances their understanding of Australia’s trade agreements was low – more than half said they didn’t understand them at all, and a further fifth used them but did not comprehend them.
A lot of this is due to complexity.
To take advantage of preferential agreements, exporters have to negotiate a thicket of rules about where components are made, how products are assembled, variable tariff rates and other technical details.
Working out how to take advantage of a trade agreement can be a huge undertaking for a company, particularly if it is small or operates in multiple markets.
Ultimately, if it is too hard and costly to use, businesses will just avoid using the concessions provided in trade deals.
ACCI warned in a submission to a parliamentary inquiry, “Australia may have the best trade agreements in the world, but they are wasted if the Australian Government does not follow through and ensure that…businesses know how to use them”.
Ultimately, the complicated web of preferential trade deals may hinder as much as help trade.
An exporter may find that in shaping their products and operations to take advantage of opportunities in one market, they fall foul of regulations in another.
The sum total may be a nest of complex and cross-cutting rules that are incompatible with one another and stymie attempts at setting uniform international standards.
But to try to assess bilateral trade deals in economic or commercial terms is to miss the point.
These are primarily political documents, a de facto form of diplomacy and strategic positioning.
It cannot be a coincidence that, after a decade of wrangling, the Australia-China FTA was concluded late last year in the shadow of the US-led Trans-Pacific Partnership Agreement, which has been seen as part of efforts by Washington to ‘ring-fence’ Beijing as the rivalry between the two powers intensifies.
Unfortunately, these political games have real consequences for international trade, distorting the flow of goods and services and skewing the commercial playing field.
For evidence, you only need to look at the genesis of the Australia-Korea FTA. Business groups backed the deal for fear that competitors in the US, Europe, Canada and New Zealand were stealing a march in the battle for market share because their governments had already struck FTAs with the Koreans.
The beggar thy neighbour logic of preferential trade agreements creates a world in which governments must endlessly chase trade deals for fear of being left at a disadvantage, all the while creating rules and incentives that create inefficiencies and clog up commerce.
But in this game of double-jeopardy, it is one thing to know what is going on, another altogether to do something about it.

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Weak jobs, weak budget

Forget Tony Abbott’s boasts about how many jobs have been created since his government was elected.
The facts are that the labour market is weak, and the incentive for business to put on more staff is low (though the ANZ job ads survey out early this week indicated employers are increasingly looking to hire).
Not only has the unemployment rate (6.4 per cent last month) jumped to its highest point in almost 13 years, the average hours worked each week is stuck around a record low 31.7 hours.
In practice, it means there is plenty of scope for employers to bump up the hours of existing staff before they need to start thinking of hiring someone extra.
Today’s labour force figures simply reinforce Reserve Bank of Australia warnings that the growth outlook is underwhelming – the central bank expects the economy to have expanded by just 2.25 per cent in the 12 months to June this year, and doesn’t expect any major improvement until into 2016.
There are some positives. The exchange rate is hovering around $US0.76, interest rates are at a multi-decade low of 2.25 per cent, petrol prices have tumbled in recent weeks and consumer sentiment has jumped.
But the improved outlook of households is likely to be short-lived as worries about job security and political turmoil in Canberra drag on confidence.
Altogether, it is not a great time to be framing a federal budget, with little reason to think that the huge slowdown in revenues from company and personal income tax will be reversed any time soon.
If ever the nation needed to have a serious conversation about broadening the tax base and reigning in tax expenditures (which were worth $113 billion in 2009- 10 alone), this is the time.
As Stephen Bartos noted in testimony to the inquiry into the establishment of the Parliamentary Budget Office, “tax expenditures are the unloved orphan of fiscal scrutiny, paid little attention and not well understood and analysed”.
It is time to change that.

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