economics@

The Australian economy:The Australian economy:a posta post--Budget assessmentBudget assessment

Presentation toPresentation toANZ ANZ customerscustomers

Saul EslakeSaul EslakeChief EconomistChief EconomistANZ BankANZ Bank

Hobart, SydneyHobart, Sydneyand Adelaideand Adelaide

1313--1919 MayMay 20052005

www.anz/com/go/economicswww.anz/com/go/economicswww.anz/com/go/economics

2economics@

-15

-10

-5

0

5

10

15

20

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

% change from previous year

(f)

Australia is enjoying its longest run of uninter-rupted economic growth since FederationAustralia is enjoying its longest run of uninterAustralia is enjoying its longest run of uninter--rupted economic growth since Federationrupted economic growth since Federation

Australian real GDP growth, 1901 - 2006Australian real GDP growth, 1901 - 2006

Note: data are for financial years ended 30 June.Sources: Angus Maddison, Monitoring the World Economy 1820-1992; Reserve Bank; ABS; Economics@ANZ.

25 quarters of negativegrowth in this period,

including 6 episodes of2 or more consecutivequarters of –ve growth

3 qtrsof –vegrowthin thisperiod

2 qtrsof –vegrowthin thisperiod

no quarterly data before 1959

3economics@

1

4

7

10

13

16

19

22

2550 53 56 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04

Ranking

AustraliaJapan

New Zealand

US

Australia’s living standards ‘ranking’ among Western countries has thus risen significantlyAustralia’s living standards ‘ranking’ among Australia’s living standards ‘ranking’ among Western countries has thus risen significantlyWestern countries has thus risen significantly

Australia’s ranking among OECD countriesin terms of GDP per capita

Australia’s ranking among OECD countriesin terms of GDP per capita

Note: GDP is in 1999 US$ at PPP exchange rates.Source: Groningen Growth and Development Centre, GGDC Total Economy Database 2005.

4economics@

After 14 years of continuous growth the business cycle is again rearing its headAfter 14 years of continuous growth the business After 14 years of continuous growth the business cycle is again rearing its headcycle is again rearing its headl Output growth increasingly subject to ‘capacity

constraints’– labour shortages, infrastructure ‘bottlenecks’, etc

l Demand rising at a much faster pace than supply– boosted by commodity price gains, government

largesse and (until recently) low interest rates and gains in personal wealth

l Current account deficit largest in over 50 years– despite most favourable ‘terms of trade’ in 30 years

l Productivity growth has slowed sharply– partly reflecting stalled reform agenda

l Scattered evidence of cost and price pressures– though not yet widespread enough to be reflected in

economy-wide indices such as CPI– implies risk to profit margins

5economics@

78

79

80

81

82

83

84

00 01 02 03 04 05

%

Actual (seas. adj. by ANZ)

Trend

Capacity utilization

Sources: ABS; National Australia Bank;Economics@ANZ.

8090

100110120130140150160

00 01 02 03 04 05

'000

Job vacancies

The Australian economy is running into capacity constraints for the first time in 16 yearsThe Australian economy is running into capacity The Australian economy is running into capacity constraints for the first time in 16 yearsconstraints for the first time in 16 years

Labour shortages

2468

1012141618

00 01 02 03 04 05

%

Businesses reporting labour shortages as aconstraint on output

Highest in 26-year history of

this series

Recentlyfallenawayfrom15-yrhigh

Highestin the15-year history of this survey

5.0

5.5

6.0

6.5

7.0

7.5

00 01 02 03 04 05

% of the labour force

Actual

Trend

Unemployment rate

Lowest since Nov 1976

Sources: ABS; National Australia Bank;Economics@ANZ.

6economics@

Demand and income are now both outstripping growth in output – and this now matters Demand and income are now both outstripping Demand and income are now both outstripping growth in output growth in output –– and this now matters and this now matters

‘Demand’ vs ‘supply’

Demand growing at more than double the rate of

growth of supply, at a time when capacity constraints

are becoming more binding

Substantial improvement in the ‘terms of trade’ means that real output growth is

significantly understating real income growth

-4

-2

0

2

4

6

8

91 92 93 94 95 96 97 98 99 00 01 02 03 04

Real % changefrom year earlier

Real

'Supply'(GDP)

(Final domestic)

demand

Note: real gross domestic income (GDI) is GDP adjusted for movements in the ‘terms of trade’ (the ratio of export to import prices). It measures the purchasing power of Australia’s GDP in terms offoreign-produced goods and services.Source: Australian Bureau of Statistics.

‘Income’ vs ‘output’

-4

-2

0

2

4

6

8

91 92 93 94 95 96 97 98 99 00 01 02 03 04

Real % changefrom year earlier

Real

'Output'(GDP)

Real gross domestic income

(GDI)

7economics@

Terms of trade*

80

90

100

110

120

130

140

60 65 70 75 80 85 90 95 00 05

2002-03 = 100

Real

*The ‘terms of trade’ is the ratio of export to import prices. Source: Australian Bureau of Statistics.

-8

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

60 65 70 75 80 85 90 95 00 05

% of GDP

Real

-8

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

60 65 70 75 80 85 90 95 00 05

% of GDP

Real

Current account deficit the largest in over 50 years despite best terms of trade in 30Current account deficit the largest in over 50 Current account deficit the largest in over 50 years despite best terms of trade in 30years despite best terms of trade in 30

Current account balance

Deficit larger than 7% of GDP for first time since 1951-52

Terms of trade more favourable than at any time since mid-1970s

commodities boom

8economics@

The worsening current account deficit reflects volumes, not prices The worsening current account deficit reflects The worsening current account deficit reflects volumes, not prices volumes, not prices

Export and import prices (in US$)

Export and import volumes (as % of GDP)

90

95

100

105

110

115

120

125

130

135

140

91 92 93 94 95 96 97 98 99 00 01 02 03 04

Index (4-qtr movingaverage; 2002-03 = 100)

Real

Imports

Exports

Note: Exports and imports are of goods and services.Source: Australian Bureau of Statistics; Economics@ANZ.

12

14

16

18

20

22

24

26

91 92 93 94 95 96 97 98 99 00 01 02 03 04

% of GDP (4-qtrmoving average)

Real

Imports

Exports

9economics@

-2

-1

0

1

2

3

4

5

6

94 95 96 97 98 99 00 01 02 03 04 05

% change from yearearlier (trend)

Real

Australia

US

Productivity went backwards last year – in absolute and relative terms Productivity went backwards last year Productivity went backwards last year –– in in absolute and relative terms absolute and relative terms

Productivity (output per hour worked)

70

72

74

76

78

80

82

84

86

88

64 68 72 76 80 84 88 92 96 00 04

%

Australian productivity relative to United States

Sources: ABS; Groningen Growth and Development Centre (University of Groningen,Netherlands, and the Conference Board); Economics@ANZ.

10economics@

This is the point in the business cycle where mistakes are common, and costlyThis is the point in the business cycle where This is the point in the business cycle where mistakes are common, and costlymistakes are common, and costly

l Allowing wages to grow faster than justified by productivity in a tight labour market

– much less of a risk now that centralized wage fixation is dead

l Failing to allow the Reserve Bank to raise interest rates before inflation has begun to accelerate

– not a serious risk now that the RBA is ‘independent’

– although persistent government criticism of recent rate increases reminds us why this is important

l ‘Giving away too much’ of the revenue dividend in spending increases and tax cuts

– still a significant risk (as demonstrated in 2004)

Three policy mistakes have traditionally been made atthis stage of the business cycle -

11economics@

In 2004 Federal outlays grew 10¾% in real terms – the fastest in over 20 years In 2004 Federal outlays grew 10¾% in real In 2004 Federal outlays grew 10¾% in real terms terms –– the fastest in over 20 years the fastest in over 20 years

* ie, excluding payments to State & local governments.Source: ABS, quarterly national accounts; Economics@ANZ.

Government outlays (excl. defence and interest)

-5

0

5

10

15

20

74 77 80 83 86 89 92 95 98 01 04

Federal own-purpose*

State & local

Real % change from previous year

12economics@

All of which calls to mind these words of Adam Smith, the founder of economics …All of which calls to mind these words of Adam All of which calls to mind these words of Adam Smith, the founder of economics …Smith, the founder of economics …

“It is the highest impertinence and presumptionin kings and ministers to pretend to watch overthe economy of private people, and to restrain their expense …

… They are themselves always, and without anyexception, the greatest spendthrifts in thesociety”

Adam Smith, The Wealth of Nations (1774)Book Two, Chapter 3, p. 442

13economics@

Two criteria on which to assess the 2005-06 BudgetTwo criteria on which to assess the 2005Two criteria on which to assess the 2005--06 06 BudgetBudget

l Is it ‘appropriate’ for the current stage of the business cycle?

– does it further add to demand, and hence risk putting additional upward pressure on interest rates

– or does it allow ‘automatic stabilizers’ to take some of the heat out of demand

l To what extent does it lay down markers for renewed economic reform?

– how will the government take advantage of its enhanced legislative position post 1 July?

– how does it address the ‘supply-side’ constraints which are now impeding growth?

– to what extent does it use revenue windfalls to ‘grease the wheels’ of genuine reform, rather than just currying favour with (particular groups of) voters?

14economics@

Key assumptions and influences on the 2005-06 forecastKey assumptions and influences on the 2005Key assumptions and influences on the 2005--06 06 forecastforecast

Growth drivers

l World economy continues to grow ‘above trend’

l Oil prices average ‘remain broadly unchanged’

l ‘Normal seasonal conditions’ in rural areas

l A$ averages around TWI 64 (~US76¢)

l Interest rates ‘remain around current levels’

Assumptions

l Acceleration in exports as major resources projects come on stream

l Continued growth in business investment to lift production capacity

l More subdued growth in consumer spending

l A very mild decline in housing activity

l Slower growth in imports

15economics@

Treasury expects the world economy to grow a little more slowly than last yearTreasury expects the world economy to grow a Treasury expects the world economy to grow a little more slowly than last yearlittle more slowly than last year

Real GDP growth (%)

88½9.59.3China

44¼5.13.8World

54¾5.84.3Other East Asia

21¼2.61.4Japan

21½2.10.9Euro area

3½3½4.43.0US

2006200520042003 l Unbalanced pattern of growth, exacerbating current account imbalances among major economies …

l … and heightening the risk of ‘disruptive adjustments’ to exchange rates and interest rates

l Continued high and volatile oil prices – could feed into higher inflation expectations

Major risks(according to Treasury)

16economics@

Treasury’s forecasts for Australian economic growth have been revised downwardsTreasury’s forecasts for Australian economic Treasury’s forecasts for Australian economic growth have been revised downwardsgrowth have been revised downwards

Real GDP growthl Forecast for 2004-05

lowered from 3% to 2%

– requires 0.7% growth in March and June quarters

l 2005-06 growth revised down from 3¼% to 3%

– implies an acceleration in growth ‘through the year’ from 2% to about 3¼%

l Much in line with ANZ forecasts

– 2¼% in 2004-05 and 3% in 2005-06

l GDP growth projected to slow to 3¼% in 2008-09

– initial impact of retire-ment of baby boomers

0

1

2

3

4

5

02-03

03-04

04-05

05-06

06-07

07-08

08-09

% changeDownwardrevisions

Source: Budget Paper No. 1, Budget Strategy and Outlook2005-06, Statement 3.

17economics@

However forecasts of nominal GDP (which is what drives revenues) have been revised upHowever forecasts of However forecasts of nominalnominal GDP (which is GDP (which is what drives revenues) have been revised what drives revenues) have been revised upup

Nominal GDP growthl While projections for real growth have been revised down …

l … forecasts of nominalGDP growth have been revised up for 2005-06

– higher commodity prices will add 2% to nominal GDP in 2005-06

– commodity prices are then assumed to ‘return to their long-run average level’ over the next two years, cutting nominal GDP growth

0

1

2

3

4

5

6

7

8

02-03

03-04

04-05

05-06

06-07

07-08

08-09

% change Upwardrevision

Source: Budget Paper No. 1, Budget Strategy and Outlook2005-06, Statement 3.

18economics@

Note: Charts show real p.c. changes for financial years ended 30 June.

Treasury expects investment and exports to lead growth while household spending easesTreasury expects investment and exports to lead Treasury expects investment and exports to lead growth while household spending easesgrowth while household spending eases

Housing

-5

0

5

10

15

20

03 04 05 06

% change

Business investment

0

3

6

9

12

03 04 05 06

% change

0

2

4

6

03 04 05 06

% change

Consumer spending

0

2

4

6

03 04 05 06

% change

Public spending

0

2

4

6

8

03 04 05 06

% change

Exports

0

3

6

9

12

15

03 04 05 06

% change

Imports

Source: Budget Paper No. 1, Budget Strategy and Outlook2005-06, Statement 3.

19economics@

Employment growth will slow, leaving the unemployment rate at around 5%Employment growth will slow, leaving the Employment growth will slow, leaving the unemployment rate at around 5%unemployment rate at around 5%

Employment growth

0.0

0.5

1.0

1.5

2.0

2.5

3.0

03-04

04-05

05-06

06-07

07-08

08-09

% changeUpwardrevision

Baby-boomersstart to retire

Unemployment rate

5.00

5.25

5.50

5.75

6.00

6.25

6.50

01-02

02-03

03-04

04-05

05-06

% (June qtr)

Source: Budget Paper No. 1, Budget Strategy and Outlook2005-06, Statement 3.

20economics@

Inflation expected to accelerate towards the top of the Reserve Bank target rangeInflation expected to accelerate towards the top Inflation expected to accelerate towards the top of the Reserve Bank target rangeof the Reserve Bank target range

‘Headline’ inflationl ‘Headline’ inflation to rise from 2½% in 2004-05 to 2¾% in 2005-06

– reflects higher petrol prices in near term

l Reserve Bank expects inflation to reach 3% by end-2006

l Wages growth to accelerate from 3¼% to 4% in 2004-05

– combined with slower productivity growth, implies higher unit labour costs

– and lower profit margins

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

02-03 03-04 04-05 05-06 06-07

% change

Source: Budget Paper No. 1, Budget Strategy and Outlook2005-06, Statement 3.

21economics@

Current account deficit will narrow only slightly Current account deficit will narrow only slightly next year despite improvement in terms of tradenext year despite improvement in terms of trade

Current accountbalance

l Deficit to narrow from $56bn (6½% of GDP) in 2004-05 to $48bn (5¼% of GDP)in 2005-06

l Exports to grow 7%– driven largely by resources exports

as major investments come on stream

l Import growth slows to 8% (from 10% in 2004-05)

– in line with slower growth in domestic demand

l Terms of trade* to rise another 12¼%

– highest level in 50 years

l Net income deficit will widen further

– driven by higher profit payments by foreign-owned mining companies

-60

-50

-40

-30

-20

-10

0

01-02 02-03 03-04 04-05 05-06

$ bnRevision

* Ratio of export to import prices. Source: Budget Paper No. 1, Budget Strategy andOutlook 2005-06, Statement 3.

22economics@

The Budget ‘gives away’ about threeThe Budget ‘gives away’ about three--quarters of quarters of the Government’s revenue windfallthe Government’s revenue windfall

-3.5-1.1-1.0-0.9-0.4Less Future Fund income†

8.5

-10.7

12.6

7.6

07-08

-37.8-11.2-9.4-5.8-0.7‘Policy decisions’

9.3

12.2*

9.2*

08-09

51.712.610.73.8‘Parameter variations’

43.87.98.99.2As at May 2005

23.95.74.56.2As at December 2004

Total06-0705-0604-05

Reconciliation of Mid-Year Review and Budget estimates of the ‘underlying’ cash balance ($ bn)

Note: ‘Parameter variations’ are changes in spending or revenue projections arising from changes in economic assumptions, changes in the revenue yield from particular taxes, ‘slippage’ in implementation of policy decisions, etc. * Based on ANZ guesstimates of what the December 2004 projection of the 2008-09 surplus would have been. † Excluded from surplus. Source: Budget Paper No. 1, Budget Strategyand Outlook 2005-06, Statement 2.

23economics@

Government is raking in cash from rising commodity prices and strong employmentGovernment is raking in cash from rising Government is raking in cash from rising commodity prices and strong employmentcommodity prices and strong employment

‘Parameter revisions’ to estimates of revenuesfor the years 2004-05 to 2007-08

-4

0

4

8

12

16

Individualincome tax

Companyincome tax

Indirecttaxes

Other taxes Non-taxrevenues

May 2004 - Dec 2004 Dec 2004 - May 2005

$ billion

Note: ‘Other taxes’ includes FBT, superannuation funds taxes, petroleum resource rent tax, agricultural levies. ‘Non-tax revenues’ includes interest and dividends from Reserve Bank, Telstra etc. Sources: 2004-05 and 2005-06 Budget Papers, Statement 5.

24economics@

Projections of company tax collections have been sharply revised upwardsProjections of company tax collections have Projections of company tax collections have been sharply revised upwardsbeen sharply revised upwards

Company tax collections – forecast and actual

25

30

35

40

45

50

55

00-01 01-02 02-03 03-04 04-05 05-06 06-07 07-08 08-09

Latest estimates* 2001 Budget 2002 Budget

2003 Budget 2004 Budget

$ billion

*Latest estimates are actuals up to 2003-04, and May 2005 Budget projections for 2004-05 and beyond.Sources: Budget Papers 2001-02 through 2005-06, Statement 5,and Economics@ANZ calculations.

$14bn

$12bn

25economics@

60

70

80

90

100

110

120

130

140

150

86 90 94 98 02 06

2002-03 = 100

Government is raking in a huge tax windfall from booming commodity pricesGovernment is raking in a huge tax windfall from Government is raking in a huge tax windfall from booming commodity pricesbooming commodity prices

Non-rural exportcommodity prices (in A$) l As an example, the

government will collect an estimated A$990mn* from BHP-Billiton this year solely as a result of the 71.5% increase in contract iron ore prices

l Based on ABARE estimates of increased resources export earnings, the government could rake off an additional $4.2bn in 2005-06 from resources exporters

* Based on estimates by ANZ Credit Research and Economics@ANZSources: RBA; Economics@ANZ.

26economics@

If the government had ‘banked’ its ‘parameter variations’, surpluses would have If the government had ‘banked’ its ‘parameter If the government had ‘banked’ its ‘parameter variations’, surpluses would have variations’, surpluses would have

How the 2005-06 Budget was put together

0

5

10

15

20

25

2004-05 2005-06 2006-07 2007-08 2008-09

December 2004 forecast

May 2005 Budget projections

$ billion

'No policy change' projections

*

* ANZ estimate of 2008-09 surplus projection as at 2004-05 Mid-Year Review. Source: Budget Paper No. 1, Budget Strategy and Outlook 2005-06, Statement 2,and Economics@ANZ calculations.

‘Parameter variations’ (mainly revisions to revenue forecasts)

2005-06 Budget decisions

27economics@

The past two years have seen the biggest budget ‘give-aways’ in historyThe past two years have seen the biggest budget The past two years have seen the biggest budget ‘give‘give--aways’ in historyaways’ in history

Impact of policy decisions on the Budget ‘bottom line’ over rolling four-year periods*

-50

-40

-30

-20

-10

0

10

20

30

1996-97

1997-98

1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

$ billion 1998 electionand tax reform

2001election

2004election

* rolling four-year periods begin with the financial year prior to that for the Budget in question, eg. for 2004-05 includes the years 2003-04 through 2006-07, etc. Sources: Budget Paper No 1, Statement 2 (or equivalent), 1996-97 through 2005-06, andEconomics@ANZ calculations.

28economics@

Budget surpluses of $15-20bn would not have been unprecedented by historical standardsBudget surpluses of $15Budget surpluses of $15--20bn would not have 20bn would not have been unprecedented by historical standardsbeen unprecedented by historical standards

Underlying budget balance as a pc of GDP

-5

-4

-3

-2

-1

0

1

2

3

4

60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

% of GDP Surplus projectionswithout 2005-06

Budget measures

*Sources: Budget Paper No 1, Statement 13 and Economics@ANZ calculations.

29economics@

Tax cuts totalling $26bn over four yearsTax cuts totalling $26bn over four years

-1,250-340-320-300-290Abolition of 3% tariff on business inputs

-205-100-70-35..Tax treatment of ‘black hole’ expenses

-4-35-73538Other

Net reduction in revenues ($mn)

-8,305

-65

-75

-990

-6,700

08-09

-26,149-7,662-6,675-3,472Total

-230-65-50-50Non-resident capital gains tax reforms

-295-75-75-70Increase in mature-age worker tax offset

-2,515-875-650..Abolition of super surcharge

-21,650-6,250-5,600-3,100Income tax cuts

Total07-0806-0705-06

Note: figures in this table are in accrual, not cash, terms.Source: Budget Paper No. 1, 2005-06, Statement 5.

30economics@

Income tax changes will substantially reduce the Income tax changes will substantially reduce the number of taxpayers subject to the top ratenumber of taxpayers subject to the top rate

After Budget changes(from 1 July 2006)

Before Budget changes

47%

42%

30%

15%

Tax bracket

125,001

$70,001

$21,600

$6,001

Thresh-hold

200,000

800,000

6,100,000

1,800,000

No of taxpayers

2.2

9.1

68.3

20.0

%

7.3650,000$80,001*47%

7.8700,000$63,00142%

64.55,800,000$21,60030%

20.41,800,000$6,00117%

%No of taxpayers

Thresh-hold

Tax bracket

Source: Dr Neil Warren, University of Sydney; The Australian, 14-15 May 2005 p. 4.

31economics@

Business tax changesBusiness tax changes

l Abolish 3% tariff on imported business inputs with no locally manufactured substitutes

– Cost to revenue of $1¼ bn over 4 years

l A range of “black hole expenses” (including pre-business costs) to become deductible or included in cost base of assets for CGT purposes

– $205mn over 4 years

l Application of CGT to non-residents to be limited to direct or indirect holdings of Australian real property and similar assets (eg mining rights) and branch assets – ie no CGT on shares, etc

– $230mn over 4 years

l Abolish foreign loss and foreign tax credit quarantining rules

– $50mn over 4years

32economics@

The Budget contains net new spending The Budget contains net new spending initiatives totalling $11.2bn over four yearsinitiatives totalling $11.2bn over four years

-497-161-150-135-51Medicare safety net

-1,046-330-304-279-133PBS changes

878286190200202Solomon Islands

-386-163-150-94-39‘Efficiency dividend’

Net increase in spending ($mn)

2,835

1,317

..

125

724

1,037

08-09

377224351Iraq commitments

5,4801,6621,569992Other

11,1173,2013,0412,040Total

490125125115Tsunami relief

2,571713703431Family tax benefits

3,2501,113928172Welfare to work

Total07-0806-0705-06

Note: figures in this table are in accrual, not cash, terms.Source: Budget Paper No. 1, 2005-06, Statement 6.

33economics@

Sale of remaining government stake in Telstra will Sale of remaining government stake in Telstra will boost headline surpluses in outboost headline surpluses in out--yearsyears

‘Underlying’ and ‘headline’ cash surpluses

0

5

10

15

20

25

2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

'Underlying' 'Headline'

$ billion

Assumes Telstra soldin three instalments

at average shareprice of $5.25

Source: Budget Paper No. 1, Budget Strategy and Outlook2005-06, Statement 2.

34economics@

-60

-30

0

30

60

90

120

150

180

96 97 98 99 00 01 02 03 04 05 06 07 08 00-10

-5

0

5

10

15

20

25

30

Net debt Unfunded super Net debt as % GDP (right scale)

$ bn

Government could be ‘debtGovernment could be ‘debt--free’ even without free’ even without selling the remaining stake in Telstraselling the remaining stake in Telstra

Net debt and unfunded superannuation

Source: Budget Paper No. 1, Budget Strategy and Outlook2005-06, Statements 2 and 10.

35economics@

Details of the ‘Future Fund’Details of the ‘Future Fund’

l Purpose is to ‘hold’ surpluses for use in defraying future unfunded superannuation liabilities

– to commence with an initial contribution of $16bn, with proceeds of Telstra sale ($33.88bn), future surpluses and re-invested earnings added

– aim of offsetting superannuation liability by 2020

– Fund to be administered by independent authority (no political interference in asset allocation)

– to be invested in a ‘broad range’ of financial assets

– income from fund excluded from underlying surplus

l However there’s no guarantee that all future surpluses, or all the proceeds of the T3 sale, will be deposited in the ‘Future Fund’

– the National Party is likely to demand spending on rural infrastructure, etc., as its price for agreeing to the sale of the remaining government stake in Telstra

36economics@

4.0

4.5

5.0

5.5

6.0

6.5

01 02 03 04 05 06

% pa

90-day bill yield

Cash rate

Official interest rates on hold in the near term but likely to rise further eventuallyOfficial interest rates on hold in the near term Official interest rates on hold in the near term but likely to rise further eventuallybut likely to rise further eventually

Short-term interest rates l The Reserve Bank now sees less upside risk to inflation than it did in February

l .. and (largely on the basis of business surveys) it thinks demand pressures may now be easing …

l It considers the March rate hike could have ‘a larger impact … than has typically been the case in the past’

l The Reserve Bank is always reluctant to draw linkages between fiscal and monetary policy

l Nonetheless, the size of the ‘give-aways’ in this Budget means another rate rise is a distinct possibility

Sources: Datastream; Economics@ANZ.

37economics@

0.45

0.50

0.55

0.60

0.65

0.70

0.75

0.80

0.85

01 02 03 04 05 060

50

100

150

200

250

300

350

400

450

500US¢

Australia-US90-d interest

rate spread (right scale)

Basis points

A$-US$(left scale)

0.50

0.55

0.60

0.65

0.70

0.75

0.80

0.85

01 02 03 04 05 0690

100

110

120

130

140

150

160

170

180US¢

RBA US$ commodityprice index (right scale)

2002-03 = 100

A$-US$(left scale)

A$ is likely to fall substantially as interest rate spreads narrow vis-à-vis the USA$ is likely to fall substantially as interest rate A$ is likely to fall substantially as interest rate spreads narrow visspreads narrow vis--àà--vis the USvis the US

Interest rate spreadsCommodity prices

Traditional ‘fundamentals’ and the A$Traditional ‘fundamentals’ and the A$

Sources: Datastream; Reserve Bank of Australia; Economics@ANZ.

38economics@

0.45

0.50

0.55

0.60

0.65

0.70

0.75

0.80

01 02 03 04 05

10

15

20

25

30

35

40

US¢

VIX index (right scale)

Index (inverted)

A$-US$(leftscale)

Any increase in ‘risk aversion’ on the part of Any increase in ‘risk aversion’ on the part of global investors would also weaken the A$ global investors would also weaken the A$

Note: The VIX index is a measure of US stock market volatility based on prices of options on S&P500 futures. Sources: Datastream; Economics@ANZ.

Equity market volatility

0.45

0.50

0.55

0.60

0.65

0.70

0.75

0.80

01 02 03 04 05

50

100

150

200

250

300

US¢

Spread betweenyields on A-ratedcorporate and3-5 year US Treasury bonds(right scale)

Basis points (inverted)

A$-US$ (left scale)

Credit market spreads

Measures of investor risk aversion and the A$Measures of investor risk aversion and the A$

39economics@

Some important reforms in the budget, but no Some important reforms in the budget, but no ‘big bangs’‘big bangs’

l Genuine attempt to increase labour force participation by those currently on welfare benefits

– with some additional ‘stick’ for those for whom monetary incentives alone are not sufficient

– can’t be dismissed as just a cost-saving measure

l Substantial increases in thresholds for top income tax rate ‘neutralizes’ it as a political issue for now

– although loopholes, distortions, exemptions and complexity of the tax system remain untouched

– in no way does this constitute genuine tax reform

l Some worthwhile tax reforms for business– although again no wide-ranging reform

l Some measures to address skill shortages and infrastructure bottlenecks

– but no comprehensive productivity growth agenda

40economics@

An election year budget An election year budget -- 2½ years before the 2½ years before the next election? next election? l The government is rolling in cash -

– ‘no-policy-change’ revenue projections for the four years to 2007-08 have been revised upwards by $37bn since December, and by a total of $64bn (8%) since last year’s Budget

l The Government is ‘giving back’ $38bn of this windfall (most of it in the form of tax cuts) -

– the ‘give-aways’ in this Budget are the second largest on record (after last year’s effort)

– these bring the total ‘give-aways’ in the last 18 months to $103bn over four years (2¾% of GDP)

l From an economic management standpoint the government should have ‘banked’ the windfall revenue gains – but it obviously wasn’t politically prepared to defend surpluses of $20bn per annum

l But the policy measures in the budget will further stoke demand, putting additional pressure on rates