Australian Federal Budget.

2013/14

A report by Westpac Economics

Corporate directory
Westpac Economics Sydney Level 2, 275 Kent Street Sydney NSW 2000 Australia Telephone (612) 8254 8372 Facsimile (612) 8254 6934 Bill Evans Chief Economist Global Head of Economics & Research Andrew Hanlan Senior Economist Matthew Hassan Senior Economist Huw McKay Senior International Economist Justin Smirk Senior Economist Elliot Clarke Economist Auckland Takutai on the Square Level 8, 16 Takutai Square Auckland, New Zealand Telephone (649) 336 5671 Facsimile (649) 336 5672 Dominick Stephens Chief Economist, New Zealand Michael Gordon Senior Economist Felix Delbrck Senior Economist Nathan Penny Economist London Camomile Court, 23 Camomile St, London EC3A 7LL United Kingdom Telephone (4420) 7621 7061 Facsimile (4420) 7621 7527 James Shugg Senior Economist

This issue was finalised on 14 May 2013 Publication enquiries, Westpac Economics, Telephone (612) 8254 8720, economics@westpac.com.au

Australian Federal Budget 2013/14

Overview
Overview The Government forecasts that the Budget will be back in balance in 2015/16 and in underlying cash surplus in 2016/17, from a weaker than expected 2012/13 starting point of 1.3% of GDP. Revenues are projected to rise by 1.4% of GDP over four years from 2012/13 while expenses will decline by 0.4% of GDP. The improvement in the budget position is appropriately gradual over the four years. Surprisingly for an election year budget, there are few sweeteners besides the big ticket items in education and disability funding reform that have been in the public domain for some time. The likely deficit for the current financial year of $19bn considerably exceeds the forecast in the October Mid-Year Economic & Fiscal Outlook (MYEFO) for a surplus of $1.1bn. Receipts have surprised to the downside, down $16.4bn. New policy decisions cost $2.4bn. A minor positive was a slight underspend on expenditures, of $1.7bn. A weaker than expected starting point for revenue and a downgrading of economic growth prospects for 2013/14 combine to lower expected revenue in 2013/14 by around $17bn. The budget is expected to remain in deficit until 2014/15, which would be the seventh consecutive year of budget deficits. The budget was in surplus for each of the eleven years from 1997/98 to 2007/08, with the one exception of 2001/02. Note that 2015/16 is a slight 'dollar' surplus that fails to register as a share of GDP (0.0%). The Government projects that the budget will return to surplus in 2016/17, forecasting a surplus of $6.6bn, representing 0.4% of GDP. Much of the turnaround can be attributed to the fact that while the funding measures matched to the NDIS and the Gonski reforms are bringing in revenue from 2013/14, substantive outlays on these two very expensive programs are delayed until beyond the traditional four year projection period. Other savings come from attacking loopholes exploited by large corporations, recalibrating carbon related outlays to the diminished carbon price, rationalising some of the middle class welfare that accumulated in the pre-GFC boom years, deferring foreign aid spending targets further, and moving to monthly PAYG instalments for large tax payers. The economic forecasts underpinning the Budget projections appear to be credible, although we consider the risks to be skewed to the downside. Nominal GDP is projected to expand at 5% in 13/14 and 14/15, accelerating to 5% in the following two years. The unemployment rate is expected to rise to 5% in 13/14, remain there in 15/16, before returning to the vicinity of 'full' employment in the out years, at 5%. We disagree with the sanguine outlook for the US and Europe embodied in the 4% forecast for world growth in 2014, but given the Treasury is projecting a supply driven decline in the terms of trade regardless, this is not really a major issue for the plausibility of the projected revenue line. The Commonwealth Government's net debt position remains extremely manageable. Net debt is forecast to reach 11.4% of GDP in 2014/15, and fall to 10.0% by 2016/17. A broader measure of the strength of the Government's balance sheet, net financial worth, was 17.8% of GDP in 2012/13. It is expected to improve to 14.8% by 2016/17. The stock of Commonwealth Government Securities on issue at 30 June 2013 is expected to be $256bn, of which $233bn are Treasury Bonds, $18bn are Treasury Indexed Bonds and the balance Treasury Notes. Net issuance of Treasury Bonds is expected to be $27bn in 2013/14, while for TIBs the figure is $4bn.

12/13 worse than expected ...

... but return to balance forecast by 15/16 ...

... and surplus by 16/17.

Net debt remains manageable.

Outstanding CGS to hit $256bn.

Federal budget: $19.4bn deficit in 2012/13

4 2 0 -2
-3.3

Decomposing the 2013/14 deficit

$bn 40 20 0 -20 -40 -60 5 0 -5 -10 -15 -20 MYEFO
19.5 0.7 18.0

% of GDP
$bn (rhs)

Underlying cash balance % of GDP (lhs)

$bn
+2.2
Sources: Budget papers, Westpac Economics

Sources: Treasury, ABS, Westpac Economics

Govt f/cs to 16/17

-4 -6 1981/82

-4.1

-4.2

1991/92

2001/02

2011/12

Parameters

Net Policy

2013/14 estimate

Australian Federal Budget 2013/14

Budget 2013: the themes

Fiscal policy: the path to surplus The Government has charted a return to surplus in 2015/16 and 2016/17 with $44bn in savings over four years more than covering $13bn in major new initiatives over the same period. The Budget is projected to swing from an $18bn deficit in 2013/14 to an essentially balanced $0.8bn surplus in 2015/16 and a $6.6bn surplus in 2016/17. Savings The largest saving comes from a % increase in the Medicare Levy dedicated to funding the national disability insurance scheme, DisabilityCare Australia. Increased funds from the levy arrive well before the scheme ramps up with $7.3bn raised by 2015-16 vs $0.3bn in disability scheme spending. Other major savings come from: tightening up on corporate tax ($4.2bn over 4yrs); scrapping carbon tax compensation ($3.4bn); extracting a 1.5% and 1.25% efficiency dividend out of higher education ($2.6bn); cancelling the family tax benefit part A increase ($2.5bn); tightening eligibility for the baby bonus and halting indexation on family payments ($2.4bn). A further 40% of identified major savings comes from deferring a rise in foreign aid, health spending measures, payment changes for large taxpayers, reduced R&D incentives, cost recovery on import processing and other. Protecting the corporate tax base The Government is looking to shore up its revenues by closing a variety of tax loopholes exploited by multinationals and large corporates. These include: profit shifting structures that load debt onto Australian entities; tightening up on tax concessions for exploration; improving the foreign resident capital gains tax regime; closing loopholes around offshore banking units and the consolidation of business entities; preventing dividend washing or dividend double dipping exploitation of franking credits; and increasing ATO surveillance. The combined effort is expected to generate a $1.5bn a year uplift in revenues by 2015/16. Education the Gonski reforms A new school funding system that will see a $9.8bn boost to education spending over the next 6yrs. The new model aims to ensure better funding for schools catering to students from disadvantaged backgrounds. However, the reforms depend on state governments opting in so far NSW is the only major state to do so. Within the 4yr fiscal horizon, the new system and continued support of disabled students is forecast to cost $3.1bn. Increases in early childhood education, alternative pathways and additional places for postgraduate and sub-bachelor courses also total $1.2bn over 4yrs. DisabilityCare Australia The Governments major social initiative, a national disability insurance scheme, will be phased in from July 2013, with coverage ramping up in the last year of the fiscal forecast. Over the 4yr fiscal horizon and the following 3yrs, the combined cost is forecast to be $19.3bn. Again the scheme relies on buy-in from the states/territories. WA and NT are the only states that have signed up at this stage. Support for youth, homelessness and an increase in the income free area for Newstart recipients has also been targeted with an additional $0.9bn over 4yrs. Infrastructure The major projects are rail (Brisbane Cross River Rail; Melbourne Metro), highways (Bruce Highway), motorways (Sydney, Brisbane; Melbourne; and Adelaide) plus regional projects (Swan Valley bypass; Midlands Highway) scoped to be worth $2.9bn in total over 4yrs. But the major projects are conditional on state funding and a stipulation of no toll roads. Industry innovation Industry support via innovation precincts, Australian Industry Participation, Future Fellowships to attract and retain researchers, and an alternative pathways programme for apprenticeships & trade qualifications, totalling $0.5bn over 4yrs. Defence A $0.8bn increase in expenses from 2013/14 over the 4yr projection reflects growth in Defence funding, including support for the priorities outlined in the 2013 Defence White Paper.

Australia: public net debt remains low

50 40 30 20 10 0 -10 -20 1971/72
Sources: Treasury, ABS, Westpac Economics

General government, net debt

$bn
Govt f/cs to 16/17

% of GDP

Federal Government

250 120 200 100 150 100 60 50 0 -50 -100 40 20 0 80

% of GDP; 2012

12 10

Source: IMF, budget papers, Westpac Economics

Net debt, $bn (rhs) % of GDP (lhs)

Peaks 10.3% 85/86 18.1% 95/96

Australian Government including 2014/15 f/c

80 60 40 20 0
Germany

Canada

1981/82

1991/92

2001/02

2011/12

France

Spain

Italy

UK

Aus

US

NZ

Australian Federal Budget 2013/14

Budget 2013: key figures

2011/12(a) GDP Nominal GDP Unemployment (Jun qtr) 3.4 5.0 5.1 2012/13 3.00 3.25 5.50 2013/14 2.75 5.00 5.75 2014/15 3.00 5.00 5.75 2015/16 3.00 5.25 5.00 2016/17 3.00 5.25 5.00

Cash balance, $bn * % of GDP Revenue, % GDP Expenses, % GDP % chg, real #

43.4 2.9 22.4 25.2 4.8

19.4 1.3 23.0 24.2 3.2

18.0 1.1 23.5 24.5 4.3

10.9 0.6 23.9 24.4 2.2

0.8 0.0 24.3 24.0 1.4

6.6 0.4 24.4 23.8 1.9

Net debt, $bn % of GDP

* Underlying cash balance; # deflated by CPI Sources: ABS, Budget papers, Westpac Economics

147.3 10.0

161.6 10.6

178.1 11.1

191.6 11.4

191.2 10.8

185.7 10.0

Major policy initiatives in Budget 2013

AUDbn Spending measures Road & rail infrastructure New school funding model Disability care Early childhood education Youth & homelessness Key health services Defence Industry innovation Disaster recovery & farm finance Seniors support Total Savings measures Medicare levy increase for NDIS Protecting corporate tax base Funding school plan Family payment increase canned Other family payment changes Scrapping carbon tax compo Deferring increased foreign aid Tightening up on health spend Other revenue measures Other Total 0.0 0.1 0.1 0.6 0.2 0.2 0.0 0.2 0.1 0.7 2.1 11.6 4.2 2.6 2.5 2.4 3.4 1.9 1.7 3.1 10.7 44.2 ppt increase to fund DisabilityCare Australia Fundamental reform addressing 'profit shifting', 'dividend washing' etc. Uni efficiency dividends, scholarships now loans, cap on edu tax deductions Scrapping increase to FTB Part A 'Baby bonus' reduced and rolled into FTB A, freeze on supplement indexation Future compensation now contingent on carbon price forecast rising >$25.40 Target of 0.5% GDP now to be met in 2017/18 instead of 2016/17 Raise threshold for extended safety net, realign benefits, phase-out tax offset PAYG mthly for big taxpayers, R&D incentives cut, import processing charges Accounts for nearly a quarter of total savings measures 0.0 0.5 0.0 0.6 0.4 0.2 0.6 0.1 0.1 0.0 2.6 3.1 3.0 1.9 1.2 1.0 0.9 0.8 0.5 0.5 0.1 13.0 Bruce Highway, Syd/Bris/Melb motorways, Swan Valley bypass Gonski reforms & support for disabled students Central reform of this budget: $19.3bn over 7 years from 2012/13 Early child edu, post-grad, alternative pathways & future fellowships Youth in transition, homelessness, increase income free Newstart Changes to PBS new & amended listings, cancer care Defence operations & procurement Industry innovation precincts & industry participation Natural disasters, insurance affordability, drought reform & farm finance Housing, policy research & keeping seniors connected 13/14 4 yrs Comment

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

Australian Federal Budget 2013/14

Forecasts: the Government & Westpac

Economic growth to be sub-trend ... The Government expects that the Australian economy this year and next will expand at a pace a little below trend, that unemployment will move a little higher, and that inflation will be well contained. In addition, with the terms of trade trending lower, nominal GDP growth will also be below trend. This is a less upbeat outlook than described by the Government in the October Mid-Year Economic & Fiscal Outlook (MYEFO). Real GDP growth is forecast to be 3.00% in 2012/13, slowing to 2.75% in 2013/14, with trend growth judged to be around 3.2%. While the growth forecast for this year is as in MYEFO, the figure for 2013/14 has been downgraded by 0.25%, largely reflecting a scaling back of business investment. Nominal GDP growth is forecast to be 3.25% this year, downgraded from 4.0% in MYEFO, and 5.00% in 2013/14, lowered from 5.5%. A number of headwinds continue to impact the economy, at a time when the mix of growth is shifting from mining investment towards exports and more robust conditions across the nonmining sectors. This rebalancing of growth will be challenging and the transition is unlikely to be smooth, notwithstanding a boost from low interest rates. Growth will be constrained by a high dollar, households' desire to pay down debt and weak public demand. The international backdrop remains uncertain. The Government expects world growth to strengthen to 4.0% in 2014, from 3.25% this year. However, we see the risk that global conditions disappoint, forecasting world growth to slow to 3.1% in 2014, from 3.3% this year. The international backdrop remains a key risk to the budget position. The terms of trade is trending lower, declining an estimated 7.50% this year and edging 0.75% lower in 2013/14. With our weaker world view, we anticipate a somewhat larger fall in the terms of trade next year, down 2.0% Consumer spending is forecast to expand by 2.5% in 2012/13, constrained by a weak start to the year, improving to a still modest 3.0% in 2013/14. A housing construction recovery is underway, following a 3.6% contraction in 2011/12. However, this cycle is likely to be mild given households' diminished appetite for debt and a scaling back of government incentives for first home buyers. Housing is forecast to rise this year and next, by 0.5% and 5.0%. Business investment is a potential swing factor. Mining investment is set to peak, but remain high by historical standards. The timing and strength of an upswing in non-mining investment is particularly uncertain given the high dollar, global fragilities and a lack of business confidence. Total business investment is forecast to rise by 10.5% in 2012/13 and by 4.5% in 2013/14. We see the risk that overall business investment is broadly flat next year. Unemployment is expected to move a little higher, with the Government forecasting a rise from 5.5% in June 2013 to 5.75% by June 2014. This remains relatively low by comparison with recent decades. ... suggesting risks skewed to the downside. In summary, the risks to the Government's forecasts are tilted to the downside in our view. International conditions may be more challenging than anticipated, the domestic housing recovery may disappoint, and non-mining business investment may be slow to improve. Westpac Economics forecasts real GDP growth to be 2.9% in 2012/13 and 2.4% in 2013/14, and nominal GDP growth for the two years to be 3.0% and 4.0% respectively.

... slowing to 2.75% in 2013/14 ...

... as headwinds persist.

Global outlook a risk.

Housing recovery to be mild ...

... and business outlook uncertain ...

Australian economic conditions

% ann 8 6 4 2 0 -2 Dec-98
Domestic demand GDP
Westpac forecasts

Australian growth mix

% ann
f/cs end '14

4 8 3 6 4 2 0 -2 2 1 0 -1 -2

ppts cont'
updated: May 13

contributions to GDP growth

ppts cont'

4 3 2 1 0 -1

2012f

2013f

2014f

Westpac forecasts

GDP growth, average: 3.5%, 1998 to 2007 2.5%, 2008 to 2014

Sources: ABS, Westpac Economics

* includes housing

Sources: ABS, Westpac Economics

-2

Dec-02

Dec-06

Dec-10

Dec-14

Consumer* Mining inv.

Business investment

Net X

GDP

Australian Federal Budget 2013/14

Economic forecasts Australia

Actual Government (year average) Westpac (year average)

2010/11(a) Private consumption Dwelling investment Business investment* Private demand* Government* Final demand Stock contribution ppts GNE Exports Imports Net exports contribution ppts GDP Nominal GDP Employment (Jun qtr) Unemployment rate (Jun qtr) Participation rate (Jun qtr) CPI (Jun qtr) WPI (Jun qtr) Terms of trade Current account, % of GDP 3.6 2.2 8.0 4.1 1.9 3.6 0.6 4.3 0.3 9.7 1.7 2.4 8.5 2.2 5.0 65.5 3.5 3.9 20.6 2.4

2011/12(a) 3.2 3.6 20.8 6.2 2.1 5.3 0.1 5.2 4.7 11.8 1.3 3.4 5.0 1.2 5.1 65.3 1.2 3.7 0.5 2.7

2012/13 2.50 0.50 10.50 4.00 0.50 3.00 0.0 3.00 7.00 5.00 0.50 3.00 3.25 1.25 5.50 65.0 2.50 3.50 7.50 3.50

2013/14 3.00 5.00 4.50 3.50 0.0 2.75 0.0 2.75 6.50 6.00 0.00 2.75 5.00 1.25 5.75 65.0 2.25 3.50 0.75 3.75

2012/13 2.6 0.5 10.0 4.2 2.5 2.7 0.1 2.5 6.0 1.7 0.9 2.9 3.0 1.2 5.6 65.2 2.4 3.3 8.5 3.3

2013/14 3.0 4.7 0.0 2.4 1.0 1.7 0.1 1.6 5.7 2.5 0.8 2.4 4.0 0.9 6.1 65.0 2.9 3.3 2.0 2.9

* business investment and government spending adjusted to exclude the effect of private sector purchases of public sector assets.

2012(a) World growth 3.2

2013

2014

2012(a) 3.2

2013 3.3

2014 3.1

3.25

4.00

Macroeconomic variables recent history

2012 Monthly data Employment 000 Unemployment rate % WestpacMI Consumer Sentiment Retail Trade %mth Dwelling approvals %mth Private sector Credit %ann Trade balance AUDbn Jun 27.3 5.3 95.6 1.1 2.2 4.4 0.90 Jul 16.4 5.2 99.1 0.7 22.3 4.2 1.52 Aug 4.5 5.1 96.6 0.2 13.4 4.1 1.99 Sep 23.4 5.5 98.2 0.5 9.7 4.0 2.14 Oct 0.5 5.4 99.2 0.1 3.0 3.8 1.85 Nov 21.5 5.3 104.3 0.2 0.0 3.5 2.29 Dec 1.3 5.4 100.0 0.5 1.3 3.6 0.66 2013 Jan 12.3 5.4 100.6 1.3 2.0 3.6 1.14 Feb 71.7 5.4 108.3 1.3 3.0 3.4 0.11 Mar 31.2 5.6 110.5 0.4 5.5 3.2 0.31 Apr 50.1 5.5 104.9

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

Australian Federal Budget 2013/14

Housing outlook
Housing sectors sluggish recovery to continue Australias housing sector will be called on to do much of the heavy lifting through the transition from mining to non-mining led growth particularly during the initial stages. While its becoming clearer that a housing upturn is underway, the slow response to rate cuts, an uneven performance across segments and states, and ongoing headwinds from fragile consumer sentiment, soft labour markets and households focus on debt reduction all suggests the upturn will continue to be restrained compared to previous cycles. The upturn has been very slow to come through. Benchmarking to previous interest rate cycles shows just how disappointing the response to the RBAs policy easing has been. Chart 1 shows that up until March, the response from finance approvals had been the worst in 30 years and that, despite recent gains, the broader response from dwelling prices continues to undershoot previous cycles by a wide margin. That said, there are signs that the pick-up has gained more momentum in 2013. Auction markets, the most timely gauge of activity, have sparked into life with clearance rates in the key Sydney and Melbourne markets surging to over 70% in May. This is a particularly strong performance for Sydney which historically has seen prices rise at double-digit annual rates when when auction clearance rates are sustained at these levels. The latest pick-up is also starting to show through in housing finance approvals. However, the detail here and on prices reveals a very uneven performance by segment and state. Segmentwise, approvals are up strongly for upgraders (+27%yr) and investors (+21%yr) but very weak for first home buyers (FHBs, 5%yr). Some of the weakness in FHB approvals is due to state government policy changes that had seen buyers bring forward purchases. However, even allowing for this the degree of weakness the number of approvals to FHBs touched record lows in February is still extreme. Across the states, NSW and WA are seeing strong gains, particularly for investor finance with rental yields notably firmer in Sydney and Perth. However Vic, Qld and SA are seeing much milder upturns. Its a similar story with prices. The positive price momentum is well established in Sydney and Perth, but is patchier (though improving) in Melbourne. Weak price growth in SA and some further slight slippage in prices in Brisbane is a concern. Looking ahead, we expect this uneven price recovery to continue both this year and next. Sydney and Perth will continue to lead the way although the mining slowdown and a stretched starting point for affordability are expected to become more of a constraint in the west. Despite the solid start to 2013, the Melbourne market will tend to under-perform, particularly as a large pipeline of dwellings currently under construction comes onto the market (including 20,000 units approved for inner Melbourne over the last 2yrs). Brisbane, which has been the weakest market over the last 3yrs, is expected to remain soft near term but improve a little in 2014. Queensland has seen persistently higher mortgage arrears rates in recent years which seems to have been a factor in the weakness in some sub-markets including the Gold Coast and Brisbanes southern fringes. Lower rates should see these pressures ease. Meanwhile low levels of building will see supply shortages, already apparent in rental markets, put upward pressure on prices. Note that while prices may continue to follow a patchy recovery path, gains look well anchored. The Westpac-Melbourne Institute Consumer House Price Expectations Index has surged since the start of the year indicating a strong consensus expect prices to rise over the next year. That points to buyers being unlikely to delay purchase in expectation of lower prices in the future and sellers being unlikely to accept low ball price offers. Again though, there are significant variations across the states. Overall, we expect prices nationally to rise about 5% in 2013 with growth slowing to 3% in 2014. Construction-wise, we expect dwelling investment to rise 4.4%yr in both years. While the cumulative 8% gain in prices and 9% rise in construction may look good compared to the last few years, both are lacklustre compared to previous upturns which would have seen double-digit annual growth at this stage. A fundamental reluctance on the part of buyers to stretch themselves financially is expected to be the biggest ongoing constraint. Though clearly positive, the housing sectors contribution to growth looks unlikely to be vigorous enough to single-handedly sustain momentum in the broader economy as the drag from the mining sector starts to come through.

The current recovery ...

... has been slow to form ...

... and despite a quickening in early 2013 ...

... is uneven across segments ...

... and states

We expect more of the same ...

... as price expectations show gains wellentrenched ...

... but consumer caution to remain an ongoing restraint

Australian Federal Budget 2013/14

Housing outlook
Chart 1. Chart 2.

Housing upturns compared

170 160 150 140 130 120 110 100 90 80 70
Sources: ABS, RP Data-Rismark, Westpac Economics

Auction markets spark into life

dwelling prices index
2008-09 1996-97 1987-88

index

finance approvals

*index based to 100 in month prior to first mortgage rate decline

2001-02 2011-12 1990-93 1983-84

170 160 150 140 130 120 110 100 90 80

4 3 2 1 0 -1 -2

st. devns

auction clearance rates

Sydney (14%) Melbourne (20%) Brisbane (2.5%) Adelaide (6%) Perth (0.5%)^

st. devns

4 3 2 1 0 -1

12 15 18

70 12 15 18 months

-3 May-03

*seas. adjusted by Westpac, smoothed figures show avg proportion of properties sold via auction (i.e. vs private treaty)

*standard deviations from long run avg

Sources: APM, RP DataRismark, Westpac Economics

-2 -3

May-07

May-11

May-03

May-07

May-11

Chart 3.

Chart 4.

Value of finance approvals by segment, state

12 10 8 6 4
5% +21% +15% +8%

Consumer house price expectations positive

12 10 % 100 80 60 40 6 4 20 0 -20 2 0 -40
net % expecting house prices to rise
Sources: Melbourne Institute, Mortgage Choice (Australia 2004-08), Westpac Economics

$bn
'upgraders'* investors FHBs
year to Mar

by state^
NSW Qld SA
^incl. investor finance

$bn

%
Australia* NSW Australia* SA Vic Qld WA

Vic WA
+19%

100 80 60 40 20 0 -20 -40 -60

+27%

2
*ex refinance
Sources: ABS, Westpac Economics

+19% +5%

0 Mar-03 Mar-06 Mar-09 Mar-12 Mar-03 Mar-06 Mar-09 Mar-12

-60 Dec-04

Dec-07

Dec-10

Dec-04

Dec-07

Dec-10

Chart 5.

Chart 6.

Rental yields close to mortgage rates

13 12 11 10 9 8 7 6 5 4 3 Mar-93 Mar-99 Mar-05 Mar-11 Mar-93 Mar-99 Mar-05 Mar-11
Sources: RP Data, REIA, Westpac Economics

Dwelling prices: uneven recovery to continue

%pa 13 12 11 10 9 8 7 6 5 4 3 110
*all dwellings, Dec 2002 = 100

%pa
Sydney Melbourne Brisbane
investor boom WBC f/c

index 260 210 160

Australia Melbourne Sydney Brisbane
Westpac forecasts

index
Australia Perth Adelaide

Adelaide Perth

*median rent on 2bdrm unit as % of median unit price

260
Westpac forecasts

WBC f/c

210 160 110

Sources: RP Data-Rismark, Westpac Economics

60 Dec-02

60 Dec-07 Dec-12

Dec-07

Dec-12

Dec-02

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

Australian Federal Budget 2013/14

Australian interest rates

Our long held target of 2.75% ... We expect that the Reserve Bank will complement its May rate cut of 25bps with a follow up cut of 25bps in the near future perhaps as early as June to bring rates down to 2.5%. Rates are expected to eventually bottom out at 2% by the first quarter of 2014. In May last year we forecast that the low point in the cash rate cycle would be 2.75%. At the time the Consensus view was around 3.253.5%. We have held our view consistently since then while emphasising clear downside risks over the last six months. With the Reserve Bank cutting the rate to our target level on May 7 it was appropriate to quantify those downside risks. The Governor gave us clear encouragement that a further move in the near term is likely. The final paragraph of the statement makes the following point: The Board has previously noted that the inflation outlook would afford scope to ease further, should that be necessary to support demand. At todays meeting the Board decided to use some of that scope. Our interpretation of this wording is that the door has been left open for another move as early as June. Certainly we expect that over the course of the next month it will become clear that business investment intentions are soft, both business and consumer confidence are fragile and credit growth continues to remain subdued. While we accept that the labour market is also a critical influence on Bank thinking, we do not believe that the volatile monthly employment reports can totally offset the clear picture that is emerging around the broader economy. Indeed, the Reserve Bank opined in its recent Statement on Monetary Policy (SOMP) that the unemployment rate would continue to rise through to mid 2014. The commentary in the Governors Statement and the SOMP suggests that success in boosting demand so far has been mixed and there is no clear indication that the Bank expects a quick resolution. Recall that the last time rates were around these levels 2009 monetary policy was being complemented by fiscal policy both domestically and offshore; the exchange rate; and the upswing in the mining sector all helped to restore demand in the aftermath of the global financial crisis. In the current environment, monetary policy is effectively acting alone. The really key new development over the last few weeks has been evidence of an even lower than expected trajectory for inflation. In its SOMP the Reserve Bank points out that a key factor behind the low inflation has been margin pressure for Australian companies partly associated with the presence of online vendors. Australian companies have been forced to cut overheads; contain wage pressures; and negotiate lower rents. We have also always argued that our assessment of the global economy is more subdued than the consensus. The IMF is expecting 4% world growth in 2014 we are at 3.1%. For Australias terms of trade, the peak to trough decline in the 2011/12 period was 17%, while we forecast a 2013/14 decline in the region of 10%. We have long maintained that from a world growth perspective, 2014 will feel like 2012. The threat of a disruptive event in Europe remains ever present. The US story does not convince us. We confidently expect that the US Federal Reserve will persist with its quantitative easing policy through most of 2014. China has already begun the process of recalibrating its monetary and real estate policy settings and the support it received from the export sector in Q1 is already receding. Indian domestic demand is flagging badly and the required policy support has not been adequate. Japan is something of a bright spot, but its gross acceleration will far exceed the net from a global growth perspective as it takes back market share. After the next cut which we expect in the near future we expect the Bank will be patient and wait to assess the impact on domestic demand of the low rates. However by the end of the year it will have become clear that further stimulus will be required to offset the impact of a softening world economy while the response to the low rates in the domestic economy will be disappointing. We anticipate that two further rate cuts will be required, one in the December quarter of this year and one in the March quarter of next year. That would see the cash rate bottom out at 2.00% from its current 2.75%. Having driven rates down to that level we expect policy to remain on hold through the remainder of 2014.

... was reached in May ...

... as the RBA rightly saw fit ...

... to use some of the scope ...

... provided by low inflation.

With our 2.75% target achieved ...

... we now choose to quantify ...

... the downside risks on rates.

Expect a trough in early 2014 ...

... at an even 2%.

10

Australian Federal Budget 2013/14

Australian interest rates

Chart 1. Chart 2.

RBA cash rate, 3 year swap

% 8 7
3yr swap
Sources: RBA, Bloomberg, Westpac Economics

Fixed Rates turn sharply time to contain risk now

%
weekly average

6 8 7 6 5 4 3 4 5

2009

2013

Cash rate

3yr swap Cash rate

6 5 4 3 2 May-02
updated May 2013

4
f/cs

3
Source: Bloomberg, Westpac Strategy

2 May-06 May-08 May-10 May-12

2 Jan Apr Jul Oct

May-04

Jan

Apr

Jul

Oct

Chart 3.

Chart 4.

Unemployment rate set to peak mid 2014

66.5 %
unemployment rate (lhs)

World growth WBC forecasts slowdown

%
peak 6.25% mid 2014

9
World

2012 (%ann) 3.2 2.2 -0.6 7.7 3.6

2013 (%ann) 3.3 1.7 -0.5 8.0 2.5

2014 (%ann) 3.1 1.6 -0.5 7.8 2.3

65.5

7 64.5 5 63.5
Forecasts to Dec 2015

US Europe China Australia

62.5 Mar-97

Sources: ABS, Westpac Economics

Mar-01

Mar-05

Mar-09

Mar-13

Chart 5.

Chart 6.

Durables inflation domestic margin pressure

average annualised inflation since Q1 2011
Household electrical items

Underlying inflation to stay low despite carbon tax

4 %yr
Westpac's estimate of the Carbon Price RBA core inflation

%yr
Sources: ABS, Westpac Economics Target band

Toys, books & leisure goods

3
Consumer prices
Forecasts

Motor vehicles & parts

Import prices

Furniture

1
Source: RBA

Textiles, clothing & footwear

-12

-9

-6 ppts

-3

0 Mar-11

0 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

11

Australian Federal Budget 2013/14

Australian dollar
Lower interest rates ... The Reserve Bank lowered interest rates at the May 7 meeting. The Governors statement once again pointed out the unusual elevated level of the exchange rate given that export prices and interest rates have fallen markedly over the last 18 months with the exchange rate remaining relatively steady. Unease around the Australian dollar was undoubtedly a key factor behind the decisions to move Australian rates more into line with global markets. The detailed arguments behind our decision to forecast a terminal cash rate of 2.00% (or more correctly, the fact we have now quantified the downside risks on Australian interest rates we have been openly discussing for some time) are set out overleaf. With this lower RBA rate profile there is some modest room for further moderation in the fair value of AUD, which puts downward pressure on our forecasts. Our June 2014 target has been lowered one cent to 96, and we have decided to treat the current spot (1.011.02) as the likely average for the coming quarters. It is the latter judgement that is most different to the view we put forth a month ago. The RBA can contribute to the lowering of fair value by delivering on the rate cuts we envisage, while maintaining a credible easing bias throughout, thereby narrowing the 2 year swap spread that has proved to be the most reliable interest rate related predictor of the exchange rate over time. However, the key to a more significant fall in the currency is a more marked reduction in the over valuation premium the degree to which spot exceeds our baseline estimate of fair value which is something that lies essentially outside the RBAs influence. Our views on advanced country growth indicate that global capital flows, and by extension foreign exchange markets, will continue to be heavily influenced by aggressive unconventional monetary policy in the G4 economies. There is clear evidence that a policy framework characterised by central bank balance sheet expansion leads to higher exchange rates for those countries where conventional policy settings are still in place. One such indicator is the rising wedge between swap spreads and cross exchange rates where one of the parties is a QE jurisdiction and the other is a conventional monetary arbiter. While the Australian dollar has lost a little ground in recent days it is not far removed from the 810 overvaluation relative to fair value that has opened up since late 2010. It is our view that the gap will remain substantially in place this year. Next year our forecasts for the currency envisage the gap between spot and fair value will close gradually, but will remain material at around 56. There is actually nothing new in that assessment. The profile for the Australian dollar we published last month, which had incorporated a steady cash rate of 2.75% (with downside risks reflected in our yield curve forecasts), a softening world economy, periodic financial stress episodes and lower commodity prices, saw AUD back at 97 by June next year, partially due to a gradual narrowing of the overvaluation premium. We have long maintained that from a world growth perspective, 2014 will be reminiscient of 2012. For Australias terms of trade, the peak to trough decline in the 2011/12 period was 17%, while we forecast a 2013/14 decline in the region of 10%. Commodity markets have been perturbed by the soft data coming out of China in recent times (Chinese Q1 GDP came out during the gold and base metal selloff of mid April, but it was not the initial catalyst). We consider the Chinese outlook on page 20. We are inclined to discount the GDP figures as an errant reading and maintain our views that a) activity will firm in Q2 and Q3, and b) the cycle will roll over entering 2014, as tighter policy settings infiltrate more fully. The bulk commodity price profile we derive from this picture (including a view on the distinct seasonality at play) is a classic year of two halves, with the first half broadly up and the second broadly down. Ergo, commodity price support for fair value, that has been evident since late last year up until a few weeks ago, will soon be heading more decisively the other way. A further factor in this story is the financing of the current account. Over the last few years, external financing has been dominated by heavy foreign buying of Australian public debt and direct equity stakes in resource projects, offset by lower demand for offshore borrowing from Australian financials. This mixture of flows is higher quality than that of yesteryear. However, public deficits are narrowing and the resource sectors requirement for foreign capital will be considerably reduced in coming years. It is arguable whether the high quality financing thesis was ever truly grasped by the market, so a gradual change may not impact sentiment that much. Even so, if inflows become less stable as private portfolio debt begins to replace direct equity and public borrowing, fair value and the gap between spot and fair value would decline, unless the mining export payoff was large enough to cover the difference.

... will help bring fair value down ...

... but while QE persists ...

... so will AUD over valuation ...

... although we expect the gap ...

... to narrow from 810 now ...

... to around 56 in 2014.

12

Australian Federal Budget 2013/14

Australian dollar
Chart 1. Chart 2.

Australian dollar to fall but retain QE premium

1.20 1.10 1.00 0.90 0.80 0.70 0.60 0.50
Includes WCFI+BI commodities index, 2 year swap spread, and NFD to GDP.

Commodity prices will fall through 2014

700 600 500 400 300 200 100 Mar-07
Sources: Westpac Economics, Bloomberg, ABS. Bulks includes iron ore and coal. Exchange traded includes rural, crude oil, base metals and gold.

USD
Fair value band AUD/USD actual & forecast
Sources: RBA, Westpac Economics

USD

1.20 1.10 1.00 0.90 0.80 0.70 0.60 0.50 0.40

index
Bulks* (lhs) Exchange traded* (rhs)

index 350 300 250 200 150 100 Mar-13

0.40 Jan-91

Jan-95

Jan-99

Jan-03

Jan-07

Jan-11

Mar-09

Mar-11

Chart 3.

Chart 4.

Chinese construction cycle slowdown coming

40 %yr
Sources: CEIC, Westpac Economics.

Europe: Unemployment continues to rise

30 25 20 %
France Italy

%yr 3mma

unemployment rate

30 25 20 15 10 5

30

Spain Netherlands

20

15 10

10
%yr 3mma

5
Source: Eurostat

0 Jan 05

Jul 06

Jan 08

Jul 09

Jan 11

Jul 12

Jan 14

0 1995 1997 1999 2001 2003 2005 2007 2009 2011

Chart 5.

Chart 6.

Major central banks are committed to QE

50 40
ECB Fed BOJ

US unemployment falls due to part. rate, not jobs

50 40 30 6 20 4 10 0
Unemploment rate (lhs) Participation rate (rhs) Employment-population ratio (rhs)
Sources: Ecowin, Westpac Economics

%GDP
Sources: Ecowin, Bloomberg, CEIC, Westpac Economics
Indicative forecasts

%GDP

12 10 8

68 66 64 62 60 58 56 54

30 20 10 0 Jan-08

2 0 1970

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

1980

1990

2000

2010

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

13

Australian Federal Budget 2013/14

Financial forecasts Australia

Interest rate forecasts
Latest (14 May)
Cash 90 Day Bill 3 Year Swap 10 Year Bond 10 Year Spread to US (bps)
Sources: Bloomberg, Westpac Strategy.

Jun13
2.50 2.55 2.80 3.20 120

Sep13
2.50 2.55 2.80 3.40 120

Dec13
2.25 2.30 2.75 3.25 115

Mar14
2.00 2.10 2.65 3.10 110

Jun14
2.00 2.10 2.75 2.85 105

2.75 2.81 2.89 3.21 129

Currency forecasts
Latest (14 May)
AUD vs AUD index* USD USD forward^ JPY EUR NZD CAD 100 0.9966 na 101.36 0.7674 1.2071 1.0069 100.0 1.01 0.99 99 0.78 1.22 1.02 98.7 1.00 0.99 97 0.78 1.19 1.02 97.8 0.99 0.98 95 0.78 1.16 1.02 95.8 0.97 0.98 92 0.79 1.14 1.02 94.6 0.96 0.97 90 0.79 1.14 1.01

Jun13

Sep13

Dec13

Mar14

Jun14

GBP CHF DKK SEK NOK ZAR

0.6511 0.9532 5.7197 6.5807 5.7772 9.1367

0.67 0.95 5.80 6.76 5.90 9.19

0.66 0.95 5.82 6.79 5.94 9.17

0.65 0.95 5.83 6.81 5.95 9.15

0.64 0.94 5.86 6.84 6.05 9.12

0.63 0.95 5.86 6.85 6.06 9.10

SGD HKD PHP THB MYR CNY IDR TWD KRW INR

1.2364 7.7346 41.02 29.57 2.9869 6.1254 9708 29.72 1108 54.41

1.24 7.84 41.21 29.80 3.01 6.22 9827 29.88 1106 54.65

1.22 7.76 40.45 29.18 2.95 6.13 9652 29.35 1090 53.51

1.21 7.69 40.21 29.06 2.94 6.07 9571 29.11 1083 53.09

1.18 7.53 39.21 28.30 2.86 5.92 9336 28.37 1053 51.70

1.16 7.45 38.63 27.84 2.82 5.83 9199 27.92 1035 50.86

*Nominal trade weighted index, with latest data compiling the base. Weights from Reserve Bank of Australia. A reading above (below) 100 indicates a rise (fall) in the AUD. ^Approximate market forward price for AUD/USD, not a forecast. Sources: Bloomberg, Westpac Economics.

14

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