Rob Brooker Head of Australian Economics

2010/11 Budget Commentary & Economic Overview Rob BrookerHead of Australian Economics

Overall reaction to the Budget • This is very much a budget aimed at repairing the medium term fiscal outcome: surplus returning 3 years early in 2012/13 • Deficit reduction involves policy tightening together with strong growth • Overall budget decisions broadly neutral over 4 year period • But really around $2bn p.a.early, neutralised by resources tax kicking in fully in 2012/13. • Monetary & fiscal policy now aligned • Economic forecasts appear credible

Revenue/savings mostly known beforehand • Miners super profits tax: $9 bn • PBS reduced drug prices: $0.5 bn • Tobacco excise: $1.3 bn • ATO increased compliance (especially GST): $0.5 bn

Likewise spending/reduced taxes • Lower corporate tax rate (SME fast track): $2.3 bn • Small business depreciation: $1.0 bn • Superannuation concessions: $1.9 bn • Discount on interest income: $0.5 bn • Health: $1.7 bn • Training & infrastructure fund: $0.8 bn • Resource exploration tax offset: $0.7 bn

How credible.. • Politics • Clearly lot depends on super profit tax • Issues include at what rate (Govt bond rate hard to defend) and will it be retrospective • Govt linking it to other measures • Low-income & related super concessions • Infrastructure fund • Cut to company tax rate • Will it get through the Senate??

Credibility • Economics • Forecasts • we find the forecasts credible • Govt sees fiscal stimulus withdrawn from 2011/12 • That is we see tighter fiscal policy taking around 2% from GDP • But no scope for pre election spending if want fiscal repair • But fiscal position of Australia relatively remarkable • Net debt to peak at 6% and moving down thereafter

Looking at the Budget from the policy viewpoint (Structural Surplus deficit) • Tightening starting in 2010/11 • Much more in 2011/12 • Budget repaired by 2012/13

On forecasts • We were surprised by the extent of the tightness implied in the public sector numbers • We actually reduced our domestic forecasts a touch But locally we still expect stronger growth – coming earlier due to terms of trade and investment • In 2010/11 we expect 4% vis a vis Govt’s 3 ¼% And better unemployment • Global forecasts very similar

Resource super profits tax • Extractive industries taxed differently • Susceptible to ‘super profits’ (profits > needed to invest) • Shifts tax from production to profit • Marginal mines currently pay royalties (deductible from RSPT) • Fiscal stabilisation case • But uncertainty • How to calculate ‘super profit’? • How does it affect project evaluation?

Global Economy : Key Messages • It is now clear that global growth has returned • But it is very varied by region • China very strong and Non Japan Asia has bounced back • USA also surprising – with potential upside risks • Japan also improving from a very low base • Europe still very disappointing – with growth downgrades • New twist is sovereign risk – which would have dangerous and large effects if allowed to develop • EURO/IMF package of E750bn should calm markets • But growth prospects very poor

The latest estimates suggest Chinese GDP increased by around 3% in Q1 2010 implying growth still accelerating – currently 11.9% y/yAnd heavily driven by secondary industry (i.e. big users of coal / iron ore)

The strongest “V” has been in Non Japan Asia (ex China). China strength and increased global trade the key drivers. While China off its peaks production still robust. Indian production strong and accelerating.

Key fundamentals - USA • High unemployment will act as a headwind • As will the withdrawal of stimulus (fiscal and monetary) • But traditional drivers of growth are equally powerful unless something else intervenes • Real rate are very low and fiscal pump priming large • Equity markets are up substantially • House prices are stabilising / turning up • Currency is low • And lags to falling oil prices • Most likely risk (outside Europe) is commercial property

Going forward…..model underlines why upside risk in 2010But beyond near term growth not expected to continue to accelerateCommercial property a risk on downside • Model based on - real rates - house prices - equity markets - oil prices - currency - credit crunch

European issues: The Problem child • Growth seems to have stalled – with domestic demand negative in late 2009 • Unemployment very high and falls in house prices substantial (especially outside large economies) • Some of the smaller Europeans have pump primed to such a large extent that doubts arise about ability / willingness to implement sufficiently tight policies to put fiscal position back on sustainable path • Greece, Italy, Ireland, Spain and to a lesser extent UK • Markets nervousness rampant • But package seems large enough to settle nerves in the short run. But growth stalled and prospects poor.

So adding up gives global growth of around 4¼% in 2010 and 2011.But key message is very different across regions – with gap widening.Australia well placed re MTP growth – now up 5% in 2010

Economic forecasts (a) Through-the-year growth rate

Where are we now. Business confidence still strong but back from excessively strong readingsAlso signs in recent months of larger falls in retail, construction and transport as rates bite and Govt stimulus passes.

Australian business activity – as measured by business conditions – easing back a touch but still reasonable. Main slowing recently was in sales especially retail transport and construction.

That said overall the survey is still suggesting that domestic demand is still travelling at around 4% Recent slowing would be welcomed by the RBA.

Key factors driving higher growth prospects • Better major trading partner growth (5% in 2010) • Faster start to year with high confidence levels and new orders • Critically extra income in the economy from commodity price increases. As reflected in our term of trade.

The strength of the labour market has important flow on effects to income and housing prices and wealth • The strengthening in hours worked and lower unemployment • While higher rates and the end of the first home owners boost will slow the housing market, their impact is more than offset by lower unemployment • On housing critical issues are • Population growth: currently near 2% • Interest rates: to rise significantly • The degree of over / under building: currently under built by around 50000 per annum • Unemployment: Prospect of significant falls very important • Debt really only a big issue if unemployment rises and / or rates go too high.

Higher capacity, confidence and incomes likely to see investment strengthen significantly in 2010. Business still wary but intentions are improving. Mining projects – especially Gorgon – will add further. Business investment to increase by 15% in both 2010 and 2011. Models point to some upside risk

For 2010 forecasts are for growth of 3 ¼ % - stronger (3 ½ %) Dec / Dec Qtr. For 2011 expect even stronger growth at 4 % • GDP (fiscal years) • 2 ¼ % in 2009/10 • 4 % in 20010/11 • The strength of the forecasts are underlined by expected growth in domestic demand of 5¼% in both calendar years.

The strength of the growth forecasts points to employment growth of around 3 ¼ per annum. Even with stronger partipation that could see unemployment fall to 4 ½% by end 2010 and 4% by end 2011.

On short term interest rates dynamics… • RBA currently on hold looking at the world (Europe) and the impact of what it has already done • We see cash rates moving up to 5¼% by end 2010 – which would, in an environment of higher bank spreads, be a touch on the tight side of neutral. • While every RBA meeting is “potentially live” depending on data, we have pencilled in rate rises in August, September and December. • Moving into 2011 we expect rates to rise to 6% which is above current market pricing and would be the best part of ¾% above neutral

Rob Brooker Head of Australian Economics