The Budget: No Inflation-Buster

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This story features LENDLEASE GROUP, and other companies.
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By Greg Peel

It is agreed that the biggest problem facing Australia at the moment is inflation. While a little bit of inflation is a good thing, an overdose can destroy an economy by eroding corporate earnings, personal incomes and superannuation and generally make striving for success seem like a forlorn waste of effort. Inflation is affected by both international and domestic issues, with a lot more emphasis being placed on the former in a more globalised economy. Inflation can be tackled by adopting both monetary and fiscal measures.

China and other emerging economies have proven a two-edged sword for Australia, or more directly rising commodity prices have provided both benefits and problems. The benefits lie in a commodity-rich economy being able to grow its terms of trade (the balance of export receipts and import payments) thus ensuring a strong economy and an abundance of income, all down to China and friends significantly increasing demand and therefore prices for our products. But that same demand-shift has meant higher prices for energy and food, which directly hits the pockets of working Australians.

More recently, the subprime mortgage crisis has set in train a global credit tightening process which has forced banks to increase their lending rates.

The Reserve Bank of Australia began raising rates in recent years to offset the effect of a surging, China-led economy and to pre-empt any significant rise in inflation. In more recent months the RBA has had to raise the cash rate more urgently as global inflation has run out of control. The intention is to slow the rate of economic growth and ease consumer demand. While Australian commodity producers are receiving exponentially more for resources such as oil, coal and iron ore, it is smaller businesses and individuals who have to offset the brunt of this windfall.

The global credit crisis has also had its effect, but were it not for independently increased bank lending rates the RBA would doubtless have raised rates further by now.

The RBA is holding up its side of the bargain in fighting inflation, but the RBA cannot act alone. Without fiscal support from a responsible government, the RBA would be forced to counter inflation even more strenuously. It is in this environment that the Rudd government has brought down its very first federal budget.

The headline number was a budget surplus of $21.7bn, or 1.8% of GDP, expected for fiscal year 2008-09. This was in line with economists’ expectations. In order to fight inflation, the government needs to run a surplus. A surplus suggests more income and less spending, and spending is what pushes prices up. However, such a surplus also reflects a surge in income that is providing a lot more money for the private sector to spend. So what the government does with that surplus is very important. The Rudd government inherited an economy that has been booming and is running out of spare capacity, the highest inflation level in 16 years and the highest population growth in 18 years.

By all accounts, this was a fairly benign, safe, workman-like budget. Exactly the sort of budget one might expect from a new government that is finding its feet and not yet willing to upset the applecart. What it wasn’t, however, was an “inflation-busting” budget, certainly not to the extent the government hinted it would be. All up, economists suggest it was a largely neutral budget where inflation is concerned. If anything, it probably even leans towards stimulatory in ensuing years.

There was a little bit of Robin Hood going on, but not as much as might have been expected. The wealthy were hit on a couple of fronts that will probably be annoying, but then only a small proportion of Australians will thus be annoyed. There were a myriad of spending cuts, all of which added up to nothing particularly material. All up savings will total $7bn, but spending will total $5bn. A total saving of $2bn is nothing spectacular.

The $6bn in tax cuts promised in the election remained, as expected. Tax cuts provide a potential to increase consumer spending, and this has been the result following the Howard government tax cuts of recent years – another reason why the RBA cash rate is where it is today. However, the evidence now suggests Australia has overcome its addiction to new toys and big houses, and it is more likely the tax cuts will find their way into paying off debt – mortgage, credit card – or simply be saved to cover high petrol and food bills rather than squandered on wide-screen TV. If that is the case, then the tax cuts will not be inflationary.

What will be inflationary is the level of government spending made available through the building and infrastructure fund ($21bn), education fund ($10bn) and health fund ($11bn). The government intends to employ the proceeds of these funds immediately, and dip into capital for approved projects sooner rather than later. In short, the government intends to start spending.

There is nothing wrong with what the government is targeting the funds for. Australia’s economic growth is being hampered by a decade of insufficient attention to roads, rail and ports – a lack of capacity which is crimping our ability to get our abundance of resources to those in the emerging world who desperately want them. We are years behind the rest of the world in terms of our broadband speed, and that is hampering business. We have a skills shortage in those sectors where the money can be made, forcing us to bring in immigrants when there aren’t enough houses to put them in. We have a hospital system in crisis, despite being one of the wealthiest per capita nations on earth.

Unfortunately as the government spends money in these areas in the short term, the effect will be inflationary. There will specifically be an even greater demand for materials and labour in a market which is already short, and the government will find itself competing with the private sector for both.

However, in the longer term the investment will be disinflationary, as increased capacity, a greater number of skilled workers, and a more efficient health system will improve productivity. In others words, it will ultimately cost less to produce the same dollar of output. In this sense the Rudd/Swan package does show the sort of longer term vision the two have been touting. The budget is a more responsible one, commentators suggest, than previous budgets. But to cut the Howard team some slack, no one, but no one, ever saw China coming.

The budget will not, however, go anywhere towards relieving the immediate inflation problem. But nor will it exacerbate inflation drastically, although 2009 is shaping up as being the recipient of budget stimulus. The RBA will still need to battle inflation as stringently as it has been doing, but it should not have to turn the screws even more tightly simply as a result of the budget.

In other words, we’re back to where we started in the short term. Further interest rate increases are still a very real possibility. The government is projecting a lower rate of economic growth and a lower inflation rate ahead than the RBA currently suggests. For the budget to not become inflationary, those projections need to be right.

Whatever the case, we are still held to ransom by the vagaries of the outside world. There is little agreement on whether the oil price will rise or fall from here. There is little agreement as to whether we are in a commodity bubble or not. There is little agreement as to whether the US will suffer a hard or soft economic landing, or as to whether China will be affected by what happens to the US economy either way. The RBA has upgraded its inflation expectations a number of times in the last few months. It is impossible to make accurate predictions on what may happen in the future.

It is thus of limited value to look into years head on the basis of what’s happening today. For all we know spending on infrastructure might be a quick way to create a lot of white elephants if the Chinese economy suddenly implodes. While this is very unlikely to happen, hands up who saw the subprime crisis coming? We may also be stuck with a lot of immigrants and university graduates with all the skills that are no longer required. Those sorts of lags are commonplace.

Nevertheless, the budget is upon us today and it will have immediate ramifications. For the share market, there are winners and losers.

The winners are any company involved in construction, such as Leighton ((LEI)), Lend Lease ((LLC)), United ((UGL)), Downer ((DOW)), Transfield ((TSE)), WorleyParsons ((WOR)), Macmahon ((MAH)), Cardno ((CDD)) and Boom ((BOL)).

Material producers also come out ahead, such as BlueScope ((BSL)), OneSteel ((OST)), Adelaide Brighton ((ABC)), Boral ((BLD)) and CSR ((CSR)), although the last two have overriding problems offshore.

Telcos will benefit from broadband spend (but who can say which ones?)

The tax cuts may help the retail names, such as a Harvey Norman ((HVN)) or a JB HiFi ((JBH)), but not if the money is saved and not spent.

The reduction in withholding tax over three years will prove beneficial for fund managers who invest offshore, such as Platinum ((PTM)), but more generally will provide an impetus for more offshore investment into the local market in general.

Changes to private health insurance will hit the Healthscopes ((HSP)) and Ramsays ((RHC)) of the world.

Spending on anything green – renewables, water, clean coal etc – will clearly benefit those companies involved in such projects.

The lack of inflation-busting should be an overall negative.

Having said all that, the question is: did we not know about or anticipate this anyway? We’ve known about health and we’ve known about tax cuts and we could have bet safe money on infrastructure and greenness, and broadband’s an old one as well. We have also been taking higher inflation, and thus higher interest rates, in our stride since the stock market bottomed out (at least for now) in March.

In other words, it’s fair to say the budget is rated Neutral.

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