Treasurer Scott Morrison today released the Midyear Economic and Fiscal outlook (MYEFO) document revealing a modest deterioration in the state of the federal Budget. Revenue projections have been downgraded along with the expected rates of growth in the economy, and government spending is projected to remain stubbornly high above 25% of the economy. The government, however, is sticking with the 2020-21 timetable for the return to surplus, which looks even more heroic than before given the slippage since the budget was released back in May.

MYEFO predicts larger cumulative deficits over the forward estimates period to the tune of around $10 billion. For 2016-17, the projected deficit actually is marginally lower at $36.5 billion (2.1% of GDP) than at budget time but, as had been widely-expected by economists, the projected deficits in the out-years have blown out. Treasury still expects a deficit of $10 billion in 2019-20, up from an expected shortfall of $6 billion back in May. As a result, public debt now is projected to peak slightly later than before at 19% of GDP in 2018-19.

Much of the deterioration is due to recent economic developments and changes in Treasury’s underlying assumptions. The drag on tax revenue from weakness in economic growth (the economy unexpectedly shrank in Q3), sluggish corporate profits, softer than expected jobs growth, and record-low wages growth has more than offset the boost to company tax collections from higher commodity prices. Meanwhile, the government’s efforts to restrain spending remain a work in progress, with key savings measures stalled in the Parliament.

Treasury’s economic growth forecasts have been pared back to 2% for the current fiscal year (from 2.5% in the Budget), but are only slightly slower over the forward estimates. Treasury still expects 3% growth in real GDP later in the longer term estimates period, and the unemployment rate forecast is unchanged. The revised forecasts for key commodity prices assume higher prices in the near term, relative to the Budget estimates, but progressively lower bulk commodity prices over time.

On the basis of the latest fiscal slippage, Australia’s coveted AAA credit rating is under greater threat than before, albeit at the margin. Australia is one of a small group of countries still to be rated AAA by all three major ratings agencies – the group includes Singapore, Canada, Switzerland and Germany. Loss of the top credit rating inevitably would trigger downgrades for the top-rated state governments (NSW and Victoria) and, by extension, the Australian banks. State governments cannot have superior credit ratings than the federal sovereign.

The immediate result of a downgrade most likely would be higher domestic interest rates, because a better return would be needed to attract offshore investors to “risker” investments. Commercial banks’ funding costs would rise, an additional impost that quickly would be passed on to market interest rates, including for home mortgages. The silver lining would be that AUD probably would be lower in this environment, a benefit to the economy that the Reserve Bank had been trying to engineer for some time.

The ratings agencies gave the government until the 2017 Budget to demonstrate that the plan for the return to surplus by 2020-21 was on track (although S&P had put Australia on negative outlook), but will be disappointed by today’s announcement. The government still has a plausible plan for the return to surplus, but the state of the public accounts clearly has moved in the wrong direction since the budget. The journey back to surplus, therefore, is slightly longer than before.

Some economists expect a ratings downgrade to be announced as early as today. This looks unlikely but, on the current trajectory, the loss of the highest ranking is all but inevitable. Without further significant remedial action, it seems only the timing of the downgrade is uncertain. Australia’s last credit rating downgrade was as far back as the “banana republic” days of 1986, and the AAA rating was restored by all three ratings agencies only in 2011. History tells us then that, once lost, it is hard to get it back.

There were some minor policy measures announced today, including new funding for a crackdown on the so-called “black economy” and for regional skills training. The Treasurer also announced the abolition of the asset recycling fund with the states.

MYEFO – Fending off a ratings downgrade
 

MYEFO – Fending off a ratings downgrade