Cullen saving the big guns for next year

By BRIAN FALLOW economics editor

When chief financial officer Michael Cullen reports on the finances of New Zealand Government Ltd on Thursday he will foreshadow a healthy profit but no increase in dividends.

The usual trickle of spending increases, often made to look larger by highlighting the cumulative increase over four years, is in the throes of being drip-fed out.

But in the context of a $40 billion Budget and a $4 billion surplus it is chickenfeed.

The ammunition built up by two years of strong economic growth and fiscal self-restraint by the Government is to be kept in the arsenal until next year's Budget.

When it does see the light of day it is likely to be aimed at fiscal relief for those on low and middling incomes, not through lower tax rates but via more liberal Family Support provisions and adjustments to the benefit system to ease the transition from welfare to work.

That is next year's story, but it raises the question: why wait?

One reason is that a fiscal stimulus now might get in the way of the monetary policy easing that is already under way.

In a speech to Canterbury manufacturers on Thursday, Cullen said that when the Reserve Bank cut interest rates last month it noted that international influences were starting to slow things down, but that the domestic economy was still relatively robust.

"If I try to stimulate that relatively strong domestic economy further through fiscal means there is a real risk that all I do is complicate and frustrate any interest-rate easing that might be in the pipeline."

Another key reason is uncertainty. A Budget surplus is the difference between two very large numbers, revenue and expenditure, and it does not take much change in either to make a big difference to the bottom-line balance.

Three-quarters of the way through the current fiscal year the Government has received $679 million more in tax than it expected six months ago. On the other side of the ledger, subsidies and transfer payments, like Family Support, have cost $302 millon less than forecast.

Budget numbers are driven by forecasts of real and nominal growth in the economy, which are inevitably attended by a margin of error.

The Treasury's forecast of real GDP growth in the year ahead of a Budget are on average out by 1.3 percentage points and are as likely to be too high as too low. Its two-year view tends to be about 1.8 percentage points out.

So when Cullen tells us on Thursday that the economic growth forecast for the year to March 2004 has been revised down from the 2.5 per cent expected last December to 2 per cent, we can be fairly sure it will turn out to be somewhere between 0.7 and 3.3 per cent.

Half a per cent less real growth would translate to at least 1 per cent less nominal growth, the kind that matters for revenue forecasts, which in turn should cut at least $400 million off next year's surplus, which was put at $3.8 billion in December.

But that would only unwind a $500 million positive surprise in the current year.

A slowdown in growth was already expected as the tailwinds which had pushed the economy to expand about 8 per cent over the two years to March 2003 - favourable weather, export commodity prices and exchange rates - veered around to become headwinds.

But that is not all.

In Thursday's speech Cullen said the present environment was one of the most unpredictable we have encountered since the stagflation and Third World debt crises of nearly 25 years ago.

"We face a future dominated by the longest global bear market in 50 years, weak investor confidence, uncertainty about the post-Iraq war reconstruction, pessimistic forecasts about returns to dairying, Sars [severe acute respiratory syndrome], questions about the cost and supply of electricity, worries about the
exchange rate, the effects of dry conditions in some parts of the country and frost in other parts."

But he said the future was uncertain rather than wholly negative.

"By way of example, a post-war reconstruction may well see commodity prices rise and petrol prices fall as Iraq pumps more oil and buys the items it needs for reconstruction.

"Equally, continued instability may have the opposite effect.

"The world economy could remain subdued or it could finally get some traction now that there is more certainty about Iraq. Sars may slow Asian tourism here, but other tourists may divert from Asian destinations to New Zealand ones."

Another key area of uncertainty is how much of the projected Budget surpluses can be counted on to last.

Any permanent adjustment to the fiscal settings, whether on the spending or the revenue side, should be out of the structural or durable part of the surplus, as distinct from the cyclical, temporary part.

The tricky part is to tell where the structural surplus ends and cyclical surplus begins. It is like pouring beer too fast. It has to stand for a while before it is clear where the beer ends and the head of froth begins.

Some of the $4 billion surplus (technically the operating balance before revaluations and accounting changes) expected for the year to next month will reflect an economy growing at a rate about 1 percentage point faster than it can sustain.

Deutsche Bank chief economist Ulf Schoefisch thinks that by the end of the coming fiscal year, that is by June 2004, the positive output gap will have worked its way out and we will see a surplus that does not need to be adjusted for cyclical influences.

A consistent theme of Cullen's stewardship has been the need to run fiscal policy in a genuinely Keynesian, countercyclical way - banking surpluses when economic times are good to avoid the need to tighten the belt during a downturn.

Keynesian management got a bad reputation in the 1980s, he concedes.

"The first [reason] was that Governments had tried to be more proactive, in particular deliberately stimulating the economy on the downside by increasing spending.

"The problem was that it was difficult to recognise turning points, the expenditure taps could be too slow to turn on and often the increases in spending were not temporary but structural," he told the Auckland Labour Party conference this month.

"The second problem was that while Governments were happy to spend more on the downside, they were less willing to moderate their spending on the upside. Thus structural imbalances leading to rising debt and inflation became characteristic of many countries."

Instead of falling into that trap, Cullen has insisted on rigorous fiscal discipline over the past couple of years, which has seen the ratio of gross debt to GDP fall to 29.1 per cent (in Friday's figures) and net debt to 13.6 per cent. Both figures are more than 5 percentage points lower than the ones he inherited four years ago.

The pay-off is a better credit rating and lower debt-servicing costs, which have fallen from 7 per cent of Government spending in 1999 to 5.6 per cent last year.