Budget circles on a doubtful dollar

As Wayne Swan set out to sell his budget on Wednesday morning the Australian dollar dipped below US99¢ for the first time in 11 months. It was US105¢ a month ago, and has averaged US103¢ in the past year. Its fate and the economy's are entwined regardless of who is running the country after the September election.

In the budget that Swan handed down on Tuesday, Treasury assumes, as it has in the past, that the $A will remain at recent average levels (US103¢) and that the trade-weighted index of exchange rates will also be stable. It also forecasts that by 2014-15 the terms of trade that measures the relative strength of export and import prices will have declined by 9.8 per cent from its peak in 2011-12.

These assumptions sit beneath budget forecasts for nominal GDP growth of 5 per cent in the next two financial years and a return to a cash surplus in 2015-16, but quantitative easing and China's growth path are big wildcards.

The budget downgraded expected tax revenue in the four years to 2015-16 by $61 billion compared with the midyear update last October, and a decline in corporate profits for an unprecedented five consecutive quarters is the wellspring.

Mining profits were down 20 per cent in 2012 as commodity prices fell, and non-mining profits rose by only 0.9 per cent, well below an annual average increase of 14.1 per cent in the decade before the global financial crisis. It reflects "pressures from the sustained high Australian dollar", Treasury says, "with firms absorbing costs by squeezing profit margins at the same time as they pass on lower import prices to consumers".

The recent decline in the value of the $A will ease the pressure on Australian companies if it is sustained. The currency peaked at US110¢ on July 27, 2011, slipped below US103¢ on May 6 this year, went below parity on budget eve, and fell below US99¢ on Wednesday to be 11 per cent below its 2011 high and almost 4 per cent down in nine days.

It could go lower - hedge fund operator George Soros is among those said to be betting it will - but there are several scenarios, and they are not all good for the economy.

The best one is for a sustained slide in the value of the $A that occurs independently of Australia's terms of trade, or, more accurately, without another slide in commodity prices that influence the terms of trade. The pressure on profits outside the resources sector would ease, mining company profits would hold up, and the predicted $61 billion revenue shortfall would prove to be pessimistic.

It could happen if another key driver of the value of the $A, quantitative easing, weakens. The currencies of economies pursuing QE fall as QE expands the amount of money in circulation and pushes down on interest rates, and the $A's recent weakness is the flip side of a rising $US as economic data feeds speculation that America's $US85 billion-a-month QE program is nearing conclusion.

US growth that lays the ground for QE to be withdrawn also supports commodity prices, and minutes of Fed rate-setting meetings this year confirm that the timing of a progressive withdrawal of QE is being debated inside the Fed.

At the behest of Japan's new Abe government, the Bank of Japan last month announced a quantitative easing program of its own. At $US75 billion a month it almost matches the Fed's for size, and seeks to double Japan's money supply in two years and kill deflation. Even if the Fed signals soon that it is ready to begin unwinding its QE stimulus, Japan's QE campaign will continue to push up on non-QE currencies, including the $A.

The $A and the terms of trade could also both fall if, for example, QE retreats in the US and growth in China also weakens, dragging down commodity prices. Higher non-mining profits and tax revenue would then be offset by lower income and tax revenue in the resources sector. Budget outcomes would depend on the mix.

The third and worst scenario is a double whammy: commodity prices and the terms of trade fall, and the $A stays high; mining profits fall, and the squeeze on non-mining companies continues. It might happen if China's demand falls and America's QE program runs for longer than expected, or if Japan's QE program fills the gap the Fed leaves.

Goldman Sachs' Australian economist Tim Toohey expects a heavier fall in the terms of trade than the budget predicts, and says if the $A also stays strong, the tax revenue shortfall through to 2015-16 could blow out to $150 billion.

Bank of America Merrill Lynch economist Saul Eslake expects a 13.8 per cent decline in the terms of trade through to 2014-15, and weaker nominal GDP growth and bigger deficits unless the $A also falls.

The budget forecasts are up in the air until it's clear where the $A and commodity prices are headed.

mmaiden@fairfaxmedia.com.au