Rising dollar squeezes budget outlook as debt pressure grows

WHEN Christian Porter delivers his inaugural budget next Thursday, it will provide the first real insight into the treasurer’s economic and financial priorities.

Mr Porter will attract close scrutiny in at least two ways: what specific measures will be taken to deliver a good 2011-12 outcome; and, perhaps more importantly, what strategy will he articulate to deal with longer-term challenges.

Arguably the greatest challenge the treasurer faces is finding ways to meet the state’s long-term infrastructure needs while controlling state debt.

The pressure on state debt was highlighted by the mid-year budget review, which projected that Western Australia’s net debt would soar to $19.9 billion by June 2014, on a no-policy-change basis.

That was close to the $20 billion debt ceiling the government had previously set, and was one signal the state had little room to move when it came to cutting taxes or lifting spending.

The forward estimates in this year’s budget could look even worse, because of the strength of the Australian dollar.

Every US 1 cent increase in the $US/$A exchange rate cuts $58 million off annual revenue, according to a sensitivity analysis in the budget papers.

Since last year’s budget, the $A has risen by about 15 US cents, so that immediately cuts $870 million off projected annual revenue.

This may be partly offset by changes to other parameters.

Each $US1 per tonne increase in the price of iron ore adds $32 million to annual revenue.

Similarly, each percentage point increase in wages or employment adds $26 million to payroll tax.

Another key variable is WA’s share of GST grants; the state government estimates WA’s share will decline to just 4.9 per cent of the national pool by 2013-14. That is down from 7 per cent in 2010-11 and about 10 per cent if the grants were allocated on a simple per-capita basis.

All of these variables help to explain the challenge that is inherent in preparing budget forecasts.

The dramatic rise in the $A, to short-lived highs around US110 cents, makes forecasting particularly difficult.

The Department of Treasury & Finance gets around the forecasting challenge by assuming that key variables like the exchange rate and commodity prices return to their long-run average over the four-year forward estimates period.

Hence, in the mid-year budget review released in December, the dollar was tipped to gradually weaken to about US80 cents in 2013-14.

Chamber of Commerce & Industry WA chief economist John Nicolaou questions the merit of Treasury’s methodology.

“That standard practice you’d need to call into question now,” Mr Nicolaou said. “The global forces that are driving the dollar and iron ore prices are long-term forces, they aren’t temporary shocks.

“That makes it more likely the exchange rate will stay high rather than revert to the long-run average.”

Mr Nicolaou also questions the dramatic clump in GST grants forecast by Treasury.

“Its hard to imagine it would ever be allowed to get that low,” he said.

Challenging times

Subject to all of these qualifiers, Treasury’s mid-year review estimated the state would achieve a budget surplus (i.e. net operating balance) of $758 million in the year to June 2011.

In the two following years, the budget surplus was tipped to stay around $1 billion, before weakening again, on a no-policy-change basis (see graphic).

That’s a pretty healthy starting point for the government, but less comforting was the projected increase in net debt to $14 billion by June 2011 and $19.9 billion by June 2014.

The higher debt is driven by state government borrowing (which sits outside the calculation of the net operating balance) to fund its capital works program.

Mr Nicolaou is under no illusions about the task facing the treasurer.

“It’s one of the more challenging environments that the government has faced,” he said.

This includes structural problems, particularly on the revenue side.

Weak consumer spending is eroding GST revenue, and WA’s falling share of GST grants compounds the problem.

The weak housing market also flows through to stamp duty receipts.

The offsetting factor is the strength of mining royalties and payroll tax.

On the expenditure side, Mr Nicolaou said spending growth was still too high in WA.

“We have a public sector that is too big and too expensive, and requires genuine structural reform,” he said.

The Department of Education illustrates the problem.

It is projected to exceed its approved spending limit in 2010-11 and “it appears unlikely that corrective measures will avoid this outcome,” the mid-year review concluded.

Mr Nicolaou is urging the government to look at the size of the public sector.

“It requires some very brave reforms,” he said.

The government has achieved some progress in terms of controlling spending.

After rising by an average of 12.2 per cent per year over the two years to June 2010, government spending is projected to rise by 6.6 per cent this financial year.

Mr Porter has also announced a new round of voluntary redundancies this year, targeting 400 public service positions, with an up-front cost of $40 million and ongoing salary savings of $29 million.

Genuine reform

Mr Nicolaou said the government needed to implement genuine structural reform, and suggested it revisit the Economic Audit Report it commissioned soon after winning power.

“That was a really important piece of work. What’s been disappointing from CCI’s perspective is that the findings of that report haven’t been acted on in a timely manner,” he said.

There are a couple of areas where the government has been signalling change is on the way.

One is that electricity and water tariffs will increase, moving closer to ‘cost-reflective’ levels. That will allow the government to reduce the operating subsidies paid to its water and power utilities.

While this is pleasing to economic rationalists, it has also caused enormous political flak for the government, which has been hammered by the opposition over rising utility charges.

Labor’s economic spokesperson, Michelle Roberts, said last week that a predicted 5 per cent increase in electricity charges, along with other increases, meant the average WA household would have paid an extra $1,000 on bills in just three years.

“Last year, Mr Barnett apologised to Western Australians for his savage 46 per cent increase in electricity bills, yet there is now every indication he will slug them with another 5 per cent increase,” she said.

Mrs Roberts claimed Western Australians were paying for the Barnett government’s lack of budget discipline.

“This government is increasing electricity and water bills to service state debt,” Mrs Roberts said.

“The Barnett government has a debt problem and is doing nothing other than slugging householders to fix it.”

A second area where Premier Colin Barnett has signalled change is increased funding for the not-for-profit sector, to help it be more competitive and effective in delivering government services.

This is the only policy development where the government has embraced the recommendations of the Economic Audit report.

Overall, Mr Nicolaou is keen to see the government act on three fronts – cutting recurrent spending, which will provide scope to cut taxes, especially payroll tax, and boost infrastructure investment.

He said WA had a poor track record on the taxation front and repeated CCI’s long-standing call for payroll tax relief, over and above the $100 million one-off rebate announced last year.

“Payroll tax is a very real cost, especially for medium-sized businesses. Other states in a much worse financial position have been able to provide relief,” Mr Nicolaou said.

Mrs Roberts said the Liberals had failed to deliver the tax cuts promised before the state election.

Infrastructure spend

In regard to infrastructure, Mr Nicolaou said it was critical that the government kept on spending to support the state’s overall growth.

“There is a danger of being overly conservative. Investment in infrastructure to address bottlenecks is needed now,” he said.

The state government has budgeted to spend a record $7.6 billion on capital works in the current financial year, on top of the previous record of $6.8 billion in 2009-10.

The big-ticket items include the Fiona Stanley Hospital, the Binningup desalination plant, Perth Arena, and expansion of the Ord River irrigation area.

There is no shortage of future projects to consume the government’s capital works budget, with none more topical than a major new sporting stadium to replace Patersons Stadium at Subiaco.

Other priority projects include the new children’s hospital, the Oakajee port development, the Perth waterfront development, the Gateway roads project around Perth airport, and upgraded electricity infrastructure to the Mid West.

Just like the private sector, the government faces unrelenting pressure to contain the cost of its big projects.

Some, like Perth Arena, have already suffered cost blow-outs and there is talk of more cost increases at the Perth Arena and Gateway projects.

The government has turned to the private sector to fund a handful of infrastructure projects, namely a new prison at Kalgoorlie, a new car park at the QEII Medical Centre, and the Mundaring water treatment plant.

The new children’s hospital was also earmarked as a public private partnership, but the government chose to use an iron ore royalties windfall to fund the project itself.

With so much pressure on state finances, it will be interesting to see whether the government embraces a larger role for the private sector in future.