Budget increases funded by cuts

Economists expect debt to hit 32pc of GDP by 2015. Photo / Thinkstock

Thursday's Budget will be sold as a tough Budget for tough times.

Speeches by the Finance Minister Bill English and Prime Minister John Key indicate its overarching narrative will be along these lines:

The economy has some serious structural weaknesses that need to be addressed.

But it has also been hit by two very big shocks in the space of three years - the gravest global financial crisis of the post-war era and earthquakes that have inflicted greater physical destruction, relative to the size of the economy, than the disaster that struck Japan.

In both cases these shocks hit when the economy was either already in recession or as near as makes no difference.

All this has laid waste the Government's accounts at a time when the international financial markets, on which our low savings rates make us especially reliant, are intolerant of the combination of rapidly rising Government debt and high levels of international debt.

This requires a fiscal belt-tightening, so for the first time in many years there is no new money on the table.

Any spending increases ministers want to undertake will have to be funded by cuts elsewhere.

That compares with an allowance of $1.1 billion for new operating initiatives in the two previous Budgets and around $2 billion a year under the previous government.

But the imperative of "setting out a credible path back to fiscal surplus" will be aided by a strong economic recovery, underpinned by record high commodity export prices, very loose monetary policy and the need to make good $15 billion worth of damage to Christchurch.

English has indicated that the operating deficit for the 2010-11 year, before valuation gains and losses, will be around $16 billion, or 8 per cent of gross domestic product, up from $11 billion forecast last December.

Three-quarters of the way through the year it stood at $10.2 billion.

The direct costs to the Crown of the earthquakes, which have already accrued and have to be booked up front, are estimated to be $3 billion in the current year and $2.5 billion next year.

In addition, the Treasury will revise down the forward track for GDP and therefore tax revenue - partly because of the earthquakes but mainly, it admits, because it overestimated the strength and pace of the underlying economic recovery.

"Achieving a zero net increase is even more difficult than it may sound," said Westpac chief economist Dominick Stephens.

"Operating costs naturally rise from year to year, due to wage increases and general inflation. A freeze on spending in nominal terms translates to outright cuts in real terms."

Foreshadowed policy changes to KiwiSaver tax credits and Working for Families would not deliver the cost savings needed to deliver a "zero Budget" in the coming fiscal year, to June 2012, Stephens said.

The Government has said it will seek an electoral mandate for the changes. The election is still six months away so the earliest the KiwiSaver tax changes are likely to take effect is April next year.

And the Government has indicated changes to Working for Families would be phased in over an extended period.

ASB economists estimate health and eduction will get between $600 million and $800 million in new spending, which will have to be matched by spending cuts elsewhere.

"We expect that net core Crown debt will increase to 32 per cent of GDP by 2015, compared to 28.5 per cent expected at the December forecasts," they said in a Budget preview.

"However, net core Crown debt does not include agencies outside of the core Crown operations such as the Super Fund, EQC and ACC. Given the Super Fund and ACC have made gains of $5 billion relative to December forecasts, the increase in net Crown debt will be less pronounced."

Ratings agency Standard & Poor's noted after the February quake that net Government debt had been forecast to peak at a level only half the median for AA-rated sovereigns and was a plus for the credit rating.

ASB expects the subsequent increase in the net debt profile to be tolerated by the rating agencies. The additional debt had arisen from a one-off event and would be largely used to fund infrastructure, rather than a blowout in operating spending.

"This should leave rating agencies comfortable that the underlying fundamentals of New Zealand's ability to repay debt remain intact, and the plan to return to surplus over the coming years is credible."

BUDGET 2011: RED INK

* Operating deficit for 2010-11 year around $16b or 8 per cent of GDP

* This is up from $11b forecast last December

* Costs to the Crown of the earthquakes are $3b this year and $2.5b next year