Debt an answer, but Moody's hovers

The economy that Victoria's new Premier, Denis Napthine, will be running isn't an east-coast basket case. Given that the next state north is the second-biggest exporter of Australia's second-most-valuable export commodity - coal - you could even argue it's been boxing above its weight.

Victoria has no mining industry to speak of, and is the state most reliant on manufacturers who have been side-swiped by the Australian dollar. Despite that, it has matched NSW for growth in demand in four out of the past five years.

The problem for Napthine and his government is that the odd year out was 2012. To turn around the polls and secure a second term for the Coalition in November next year he needs to turn Victoria's economy around - and as he looks for ways to do so, he faces a tough choice: the growth he needs may not be achievable without bringing the ratings agencies down on Victoria's AAA-rated head.

Victoria matched NSW with demand growth of 1. 6 per cent in 2008, and stayed in touch in 2009 and 2010 despite a rise in the value of the Australian dollar from a post-crisis low of US63¢ to parity. Demand growth in Victoria was 4.1 per cent and 3.5 per cent in those years. In NSW, it was 4.3 per cent and 3.3 per cent.

Ted Baillieu became premier in December 2010, and as his government cut spending in 2011 to begin shrinking a budget deficit that had swollen during the global crisis Victoria continued to grow, by 1.6 per cent compared with 1.8 per cent in NSW.

Last year, however, Victoria fell behind. Final demand rose by another 2.7 per cent in NSW. In Victoria, it fell by 0.3 per cent.

State final demand numbers do not include exports, to other states and overseas. In recent years, they have underestimated growth in the non-resources states that are suppliers of goods and services to the mining boom. Victoria's gross state product (GSP) includes exports, and it rose by 2.3 per cent in the year to June 2012.

Bank of America Merrill Lynch economist Saul Eslake also points out that Victoria's jobless rate does not signal crisis conditions. Since August 2011 it has risen from 5.2 per cent to 5.7 per cent. Unemployment in NSW has edged down over the same period from 5.3 per cent to 5.1 per cent. Unemployment in Queensland has risen a notch from 5.9 per cent to 6 per cent, and in resources-rich Western Australia it has fallen by 4.2 per cent to 4 per cent.

There's no doubt that Victoria's economy decelerated sharply last year, however, and a dearth of new major public projects in the state is part of the problem.

BIS Shrapnel's chief economist, Frank Gelber, briefed bureaucrats about the problem in October last year at an interdepartmental forum hosted in Melbourne by Victoria's Department of Planning and Community Development.

The high Australian dollar was weighing down Victoria's manufacturing sector, and a burst of private sector commercial and residential property development in earlier years had saturated the property market at much the same time as the Baillieu government began to slow down its own infrastructure development, he said. Public sector non-dwelling building declined by 16.7 per cent in Victoria in 2011-2012, and Gelber's firm is predicting that it will fall by another 13.7 per cent in the current year to June.

Construction and property development is a crucial economic multiplier in the economy. It's very difficult for Victoria to post growth while it is in retreat at the same time as the $A is mugging manufacturers, and at the October meeting Gelber's advice was simple. The government should seriously consider increasing debt to finance quality infrastructure expenditure, he said - to support jobs and activity in the near term, but also to support medium-term growth and boost productivity.

That proposition presents a challenge, however. The Baillieu government was tightening the budget purse strings to get out of the red and onto a surplus of more than $100 million in 2013-2014, locking in Victoria's AAA credit rating in the process. Now, it also needs to pump-prime construction activity - not least to get the economy into shape for a November 2014 election.

Victoria's balance sheet could handle a temporary debt blip. The state's public sector debt is expected to rise from 7.5 per cent of GSP to 10.6 per cent of GSP by June 30 2016, but it was 20 per cent in the early '90s, and AAA-rated NSW's debt-to-GSP ratio is expected to rise from 8.7 per cent to 11.8 per cent over the same period.

The ratings agencies are hovering, however. In a review of all the states on Monday Moody's effectively told them that they needed to maintain fiscal settings that will see Victoria budget for a surplus in 2013-2014 and NSW budget for a surplus a year later.

States that wavered from the surplus path and did not "correct slippages" would likely be reviewed for a downgrade, Moody's warned. The threat is obvious, but so too for the Coalition government in Victoria is the threat of an election loss: it will be interesting to see whether fiscal purity, political expedience or some other, hopeful hybrid emerges.

mmaiden@fairfaxmedia.com.au