Part 3: Fiscal Strategy and Outlook (continued)
Attachment A: Sensitivity of the balance sheet to economic and fiscal risks
Consistent with the medium‑term fiscal strategy, this MYEFO places emphasis on the strength of the Government's balance sheet. This section supplements the analysis of Australia's fiscal sustainability in Part 3, and discusses the resilience of our balance sheet to adverse economic and fiscal shocks. The baseline case and the downside scenario are analysed:
- Baseline case: discussion of how current economic and fiscal risks may impact the balance sheet.
- Downside scenario: discussion of how significant but remote economic and fiscal downside risks may impact the balance sheet.
A strong balance sheet provides the Government with the flexibility to respond to adverse fiscal and economic risks, and is an indicator of fiscal sustainability. Fiscal risks refer to developments or specific events that are unpredictable in both timing and magnitude, which result in a significant increase in Government payments. This includes events such as emergency defence or foreign aid requirements and natural disasters. These payments generally result in an erosion of existing budget surpluses and/or higher government borrowings. Economic risks refer to economic shocks, such as a financial crisis, that result in a fall in GDP, employment, wages and therefore tax receipts, and increased payments, for example for unemployment benefits. These effects generally result in lower receipts and higher payments, eroding surpluses or widening deficits and resulting in higher levels of net debt.
This analysis focuses on the impact of large risks eventuating and the impact to the balance sheet and fiscal sustainability in broad terms.
Baseline case
The estimates contained in MYEFO are based on forecasts of the economic and fiscal outlook. Risks that have a probable chance of materialising are already taken into account in the financial statements. Australia holds AAA credit ratings from all three rating agencies, and the balance sheet is strong given current economic conditions.
There are a number of existing contingent liabilities and assets that are not included in the Financial Statements on the basis that they are currently assessed as unlikely to occur, but under certain and potentially extreme circumstances they could crystallise in the future. These contingencies include loan guarantees, warranties, indemnities, uncalled capital and letters of comfort, and are outlined in Appendix C: Statement of Risks.
Downside scenario
If fiscal or economic risks come to fruition, the strength of the balance sheet is called upon as it will need to respond to the initial shock to the economy or the budget. In a large economic shock, the Government will likely be pressed to intervene in a riskier environment by drawing down assets, issuing more debt and/or providing guarantees to give certainty to the market. This poses a challenge to the Government and tests the ability and strength of the balance sheet to support economic activity and so ameliorate the impact of the shock on businesses and households.
A higher level of payments necessitating higher borrowings
When economic conditions deteriorate the budget position can decline significantly as receipts fall and payments increase. This can lead to an erosion of existing budget surpluses and/or an increase in borrowings to fund these additional payments. The section below discusses how a number of fiscal and economic risks increase payments if they materialise.
A deterioration in economic conditions and economic activity is usually signalled by a fall in demand for labour and for goods and services. Eventually excess supply in product and labour markets will generate falls in wages and domestic prices, and the quantity of labour employed and goods and services exchanged. The decline in wages and employment will lead to a fall in personal income tax receipts. Weak labour market conditions would also lead to lower household consumption and falls in GST receipts. The fall in nominal GDP (driven by falls in domestic prices and the level of goods and services exchanged) reduces revenue raised from company tax. At the same time a higher unemployment rate would lead to increased expenditure on income and other Government support payments. To fund this deterioration in the Government's fiscal position, assets would need to be run down or borrowings would need to increase through the issuance of more Commonwealth Government Securities (CGS).
During an economic downturn, increases in payments could be funded by an increase in CGS issuance thereby increasing the liability. This would lead to higher interest payments until the Government begins to repay its debt.
A weakened economic environment also increases the likelihood of contingent liabilities on the balance sheet (for example, guarantees) crystallising or defaults on government loans, resulting in higher liabilities and an increase in payments.
Appendix C provides further detail on contingent liabilities, contingent assets and other fiscal risks. Information on contingent assets and liabilities is also provided in the Australian Government's annual consolidated financial statements and in the annual financial reports of departments and non‑budget entities.
Some of the Government's large guarantees are those introduced during the Global Financial Crisis. As described below, even a large deterioration in conditions would be unlikely to trigger some of these guarantees.
The Guarantee Scheme for Large Deposits and Wholesale Funding is applicable to certain liabilities covered by the guarantee. As at 5 December 2014, total liabilities covered by the Guarantee Scheme were estimated at $2.5 billion. Government expenditure would only arise in the unlikely event that an institution failed to meet its obligations with respect to a commitment that was subject to the guarantee and the guarantee was called upon. In such a case, the Government would likely be able to recover any such expenditure through a claim on the relevant institution.
The Financial Claims Scheme provides depositors of authorised deposit taking institutions (ADIs) and policyholders of general insurers with timely access to their funds in the event of a financial institution failure. In relation to ADIs, payments are capped at $250,000 per account holder per ADI, and a mechanism exists to make payments to eligible beneficiaries with a claim against a failed insurer. ADI deposits eligible for coverage under the scheme were $732.4 billion at 30 June 2014, increasing only slightly from an estimated $722.8 billion at 31 December 2013, reflecting overall deposit growth in the financial system. Initial amounts available to meet payments and administer the scheme are $20.1 billion per institution. In the unlikely event of a failure, any payments made under the Financial Claims Scheme would be recovered through a liquidation of the failed institution. Any shortfalls would be recovered through a levy on the industry.
The IMF has analysed and tested the financial strength of Australian banks in its Financial Stability Assessment Programme Report 2012. The report found that Australia's financial system is sound, resilient, and well‑managed, and that the major banks are conservatively run and profitable. The IMF concluded that if necessary, given Australia's modest public debt, there is space for both monetary and fiscal policy to respond to a significant shock.2
The guarantee of State and Territory Borrowings, also introduced in response to the considerable financial market turbulence in the Global Financial Crisis, only applies to outstanding securities for New South Wales and Queensland covered by the guarantee before it closed on 31 December 2010. As at 31 October 2014, the face value of guaranteed securities was $13.3 billion. While the risk of default of either government is remote, if a significant economic event were to cause a default by either or both governments, the Commonwealth is likely to be able to recover its guarantee payments through a claim on the relevant state or territory at a future date.
In addition to payments resulting from shocks to the economy, natural disasters are highly unpredictable and are outside the Government's control. They can pose devastating consequences on the Australian community and result in large unexpected increases in payments for disaster aid and recovery funding. While the Government's current balance sheet strength is able to provide capacity for further borrowings without putting at risk existing spending programmes and Australia's debt sustainability, if a natural disaster occurs in conjunction with a significant economic downturn, the burden on the Government's finances would put further pressure on the budget.
A fall in the strength of the balance sheet
In addition to an increase in borrowings, certain balance sheet items are required to be recorded at market value and the market valuation of these items make them susceptible to significant economic downturns as prices fluctuate. As a result market movements may have temporary impacts on the strength of the balance sheet.
The Higher Education Loan Program (HELP) is the largest asset on the balance sheet, in terms of individual programs, and represents the net present value of expected loan repayments and therefore future sources of funds. The HELP asset was $25.1 billion at 30 June 2014 and is projected to grow to $30.6 billion in 2014‑15 and $52.0 billion by the end of the forward estimates. This growth is largely a result of improved access to student loans and students paying a greater share of the cost of their education. A slow‑down in wages growth as a result of a deterioration of economic conditions may lead to slower loan repayments meaning the government cannot repay its debt as quickly.
The investments of the Future Fund are also susceptible to market changes. The Future Fund's investments are estimated to be around $104.5 billion at 30 September 2014. However, if the Future Fund were to experience negative returns on its investments due to an external financial market shock, its value could fall substantially.
As at 5 December 2014, market value of CGS on issue was $388 billion. Movements in interest rates impact upon the market value of the Government's CGS liability. For example, lower interest rates that may be used to stimulate the economy will contribute to a higher market value of the liability.
2 IMF's Australia: Financial Stability Assessment Programme Report, February 2012.