The Long Transition…

From Bloomberg yesterday afternoon:

“The Australian economy continues to transition from the investment phase to the production phase of the mining boom despite a downward revision to the real GDP growth forecast,” [Federal Treasurer Scott] Morrison said in a statement Monday. “Exports and household consumption are expected to support growth.”

Pardon the muffled laughter.

If the economy is still transitioning to the production phase, we can only wonder what has been in all those ships leaving for China.

We could have sworn Australia had exported tens of millions of tonnes of iron ore to China throughout the 2000s.

Really, if the transition is still happening, either we’re about to witness the biggest resources boom in the history of mankind (even bigger than the 2000s boom) or…it’s not really transitioning at all.

It’s already transitioned. It’s downhill from here. A recession is coming.

How debt grows…and grows

The comments from Treasurer Scott Morrison relate to the prospect of ratings agencies downgrading Australia’s AAA credit rating.

As the Bloomberg report notes:

Australian Treasurer Scott Morrison forecast a slightly narrower deficit this fiscal year and retained a projected return to surplus in 2021 as he bids to stave off a credit rating downgrade.

The underlying cash deficit was predicted to be A$36.5 billion ($26.7 billion) in the year through June 30, compared with a A$37.1 billion shortfall forecast in May. In the ensuing three years, however, deficits are expected to widen by almost A$11 billion more than May projections. Morrison also cut the fiscal 2017 growth estimate to 2 percent from an earlier 2.5 percent forecast.

Most humorously:

Two months before that election, Morrison projected the books would return to balance by 2021. S&P wants to see evidence that will be achieved, noting the budget has been in deficit since 2009 and a previous Labor government pledged a surplus would be achieved in 2013. That forecasts was eventually ditched at the end of 2012.

We can only assume the current surplus pledge will be ditched in 2020…regardless of which party is in power.

In case you’re not sure, a quick lesson on government finances.

A deficit is when a government spends more money than it takes in through taxes. If a government spends $400 billion, but only raises $350 billion in taxes, it has a deficit of $50 billion.

That’s easy. The question, then, is: How does the government pay for all of its spending? It issues debt. In this example, the government would have to raise $50 billion in debt to pay for its spending.

Here’s the problem: Unless the government starts with a clean slate, not only does it have to issue debt to cover that year’s shortfall, it also has to issue new debt to pay for current debts that will fall due that year.

This is what makes it so difficult for a government to pay off its debts. Even just one bad year can throw a proverbial spanner in the works.

Let’s say that, in our example, the government did have a clean slate — that the $50 billion deficit was its first deficit, and its first debt.

In order to get back to square one the following year, the government’s spending would have to either remain at $400 billion, while it’s tax revenues increased to $450 billion (up from $350 billion the year before), or it would have to fall to, say, $350 billion, while it’s tax revenues increased to $400 billion.

Those are just a couple of examples. The point is, whatever the outcome, in order to repay the debt in a single year, tax revenues need to be $50 billion higher than spending.

And that doesn’t even include interest expenses.

Of course, the reality is that when a government goes into debt, it’s due to a major economic shock. The result of that shock is that government spending tends to increase due to welfare payments, stimulus measures, and so forth.

At the same time, the government’s tax revenues tend to fall because fewer people are working, companies are making less in profits, and taxable spending tends not to rise as fast as government spending.

It explains why the Aussie government is in this position…


Source: Australian Office of Financial Management
[Click to enlarge]

…in debt to the tune of $464.79 billion.

That’s up from a net debt position of close to zero 10 years ago.

Be clear: We’re not making a call on whether this is the fault of the Labor Party or the Coalition. Our position on this has been consistent.

For those who think the government wouldn’t be in this mess if the Coalition had been in power in 2008, think again. The Coalition would have had an even better excuse than the Labor Party to take the nation into debt. It could have claimed that this was the ‘rainy day’ they had saved for.

It may not have stimulated the school-hall-building industry, or the home-insulation industry, but it would have stimulated something. Make no mistake about that.

But, whatever. There is only one direction for the Australian economy — and that’s down…into recession.

Credit rating down…interest rates down too?

If the ratings agencies cut Australia’s credit rating, that’s bad news, and is sure to lead to higher interest rates, right?

Err, not so fast. In a vacuum, you’d think so.

When the ratings agencies knocked the US’ credit rating down, interest rates actually fell.

Why?

Simple. It’s because investors expected the downgrade and the worsening economic picture to result in more stimulus. They figured the central bank would have to cut interest rates, in order to encourage people and businesses to borrow…and to make it cheaper for the government to borrow.

Could that happen here? Australian interest rates have soared in recent months. But that has had more to do with the prospect of higher interest rates in the US.

The chart below is the Aussie government 10-year bond yield.


Source: Bloomberg
[Click to enlarge]

The Reserve Bank of Australia (RBA) Cash Rate currently stands at 1.5%. Most investors now seem to think that the rate won’t fall any further from here.

Don’t count on it. A slide into recession, the loss of the AAA credit rating, and the incentive for the government to go further into debt could just result in the RBA cutting rates even further.

Regards,

Kris Sayce,
For Markets and Money

Editor’s Note: This article was originally published in Port Phillip Insider.

Kris Sayce
Kris Sayce, dubbed the ‘Jeremy Clarkson of Australian finance’, began as a London finance broker specialising in small-cap stock analysis on London’s Alternative Investment Market (AIM). Kris then spent several years at one of Australia's leading wealth management firms. A fully accredited advisor in shares, options, warrants and foreign-exchange investments, Kris was instrumental in helping to establish the Australian version of the Markets and Money e-newsletter in 2005. He is currently the Publisher, Investment Director and Editor in Chief of Australia's most outspoken financial news service — Money Morning.

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