The PEFO built on shifting sands

Global economic uncertainties, carbon pricing assumptions, optimistic MRRT forecasts, terms of trade doubts – this Pre-Election Economic and Fiscal Outlook is a rubbery beast.

Given that Chris Bowen issued his economic statement less than a fortnight ago, there was never any realistic possibility that the Pre-Election Economic and Fiscal Outlook from Treasury and Finance would have materially different numbers or assumptions. It didn’t.

That the numbers haven’t changed doesn’t make them any more appealing or certain. The forecast deficits over the next two years still total $54 billion and while the budget is projected (rather than forecast) to return to surplus in 2016-17, the departments make it very clear that those projections are riddled with uncertainties.

As the PEFO said, the forecasts and projections are based on an expectation that the Australian economy will transition away from resource investment-led growth towards more broadly-based growth "although this transition may not occur as smoothly as forecast".

That transition was needed, the department said, to deliver sustained economic growth – which says that if it doesn’t occur there won’t be sustained economic growth.

Global economic uncertainty and the questionmarks over the rate at which growth will settle in China’s economy as its new leadership grapples with their own attempted transition from export and investment-led growth to a greater emphasis on consumption means that trying to forecast commodity prices and Australia’s terms of trade over the next four years with any precision is, as the departments essentially acknowledged, a near-impossible task.

The budget outcome is quite leveraged to changes in the terms of trade, with a 1 per cent decrease in nominal GDP due to a fall in the terms of trade estimated to swell the budget deficit by $3 billion this financial year and $5.9 billion in 2014-15.

It’s also quite leveraged to assumptions about future carbon prices. The "carbon pricing mechanism", an emission trading system linked to the price of European permits, is forecast and projected to raise $16.4 billion over the next four years, with the price estimated at $6.20 in 2014-15, $12.50 in 2015-16 and $18.90 in 2016-17 on its way to $38 in 2019-20.

The departments say, however, that for every $1 change in the price in any year the underlying cash balance would change by about $160 million in 2014-15 and $220 million in 2015-16 or 2016-17. The European prices have been around $6 in recent weeks.

One puzzling line item in the PEFO is a revision up, relative to the economic statement, in forecast and projected receipts from the Minerals Resource Rent Tax.

While the increments are small – an extra $50 million, to $850 million, this financial year and an extra $100 million, to $1.1 billion, in 2014-15 – over the four years they have added almost $500 million of extra revenue and result in the MRRT being forecast to generate almost $6 billion over the forward estimates period.

We know that the biggest and most profitable miner of the most profitable commodity, iron ore, paid no MRRT last year – indeed, Rio Tinto was refunded a provisional $74 million payment it had made. The other commodity covered by the tax, coal, is suffering from low prices and high costs and most of the sector is either under water or only marginally profitable.

The Rio result last week demonstrated that the big increases in volume flowing from the massive investments made over recent years don’t compensate for the lower prices – Rio’s iron ore business’ earnings in the half-year to June were about $US700 million lower than the previous year’s.

In the absence of a sharp rebound in iron ore and coal prices, which appears unlikely given the outlook for weaker growth in demand and rising supply over the next few years, those MRRT forecasts and projects appear quite optimistic.

At a practical level, the rubbery nature of the PEFO numbers shouldn’t complicate the Coalition’s costings of its election promises, although it could make life difficult for the next treasurer, whether it’s Chris Bowen or Joe Hockey, in framing future budgets if the forecasts prove overly optimistic.

The Opposition would have known that there would be no material differences between the assumptions in the economic statement and the PEFO.

While there will inevitably be a debate about whether or not Hockey has properly funded Tony Abbott’s policies, the PEFO does confirm that Labor’s legacy of accumulated deficits will be around $275 billion, which ought to be a powerful argument that the Coalition can use to compare the fiscal credibility of the government against its own record in government.