A year ago the federal Budget was delivered against a backdrop of slowly easing international and local uncertainty, which continued to ease through the year as China surged, dragging Asia and us with it, making the forecasts in Wayne Swan’s second Budget irrelevant (in the nicest possible way).

You have to remember that all the Budget gurus a year ago were gloomy and cast doubt on the forecasts in the Budget and warned that things could get worse, which they didn’t.

The Budget was delivered on Tuesday against a backdrop of international uncertainty and a local boom. The gurus were back saying something similar, that it all depends on events offshore, Europe is a big fear, then China. Any bets on what the outcomes will be in a year’s time?

Europe’s woes have taken the eye of critics of all types because it’s the most current and the most spectacular, but for us it’s a relative sideshow.

The real influence on this Budget is China’s voracious appetite for our minerals (helped by improving demand in Japan and the rest of Asia), and the pricing of our exports, which has become very short-term since the Budget was delivered after the changes to contract pricing engineered by BHP Billiton and Rio Tinto, and followed by the rest of the iron ore and coal industries here and around the world.

Budgets are a 12-48-month event (the current and the forward years). Our national income and terms of trade (subject to the changes in the value of the dollar) used to be underwritten by steady volume and prices in annual contracts with changes happening once a year.

Now these coal and iron ore contracts have not only risen in size and value to us and the exporters, but their volumes and pricing have become very short term, quarterly at best, spot prices at worst.

That means on the income side for the economy an important part has become “short” while on the outlays side, we are still “long” in terms of the annual budgets that the government, companies and other groups run. Therefore, our terms of trade will now move much quicker than before, along with national income.

Iron ore and coal have joined gold, oil, copper zinc, etc (but not so much LNG) in being priced in the very short term. But because iron ore and coal prices (as we saw in 2008) have risen so quickly and so high, the dollar amounts are now so large that they influence our terms of trade quicker than other exports.

This means that the rise in prices this quarter could very well be reversed, partly or wholly in coming quarters by a slump in demand in China, Japan or Korea, or a combination of those markets. That exposes Australia, the economy and the Budget to sudden shocks that in previous times could be predicted months ahead when the annual contract pricing changes around April 1 each year for iron ore and coal.

If the federal opposition wanted to get into Budget criticism, this is where it should be concentrating: our export income terms of trade now set asymmetrically to the federal Budget, instead of being roughly in sync.

But the federal opposition’s claims the Budget is built on quicksand with Joe Hockey’s claim there’s no provision for Greece (whatever that means. Is Greece a contingent liability for Australia?) or for the volatility in Europe, completely misses the mark.

Cutting our debt and the deficit faster than normal is the provision for Greece and for the troubles in Europe. A few extra whacks would have been helpful here on the outlays side, but enough has been done. Hockey doesn’t seem to remember that first quarter economic growth here will be weak (which will have him and his leader cackling on about a slowing economy) while the next interest rate rise will see the duo rabbit on about government spending and borrowing driving up rates.

In fact Hockey and Tony Abbott gave no sign of having read last Friday’s Statement of Monetary Policy from the Reserve Bank where the bank forecast:

“The rise in the terms of trade is expected to increase domestic incomes by around 4 per cent this year (although the boost to national income — the income accruing to Australian residents — will be smaller) and nominal GDP is expected to rise by close to 10 per cent over 2010.”

That is the most important forecast for the economy: economies do not get into trouble when national income grows sharply in the year. If nominal GDP is growing by close to 10% towards the end of this year, then there’s a considerable head of steam already in the economy. But it will be influenced by the new system of pricing iron ore and coal contracts.

Europe is a danger to Australia in 2011 through until 2013. That’s when our economy could be wedged by the contractionary nature of budget and spending cuts across the region, from the UK to Greece, Spain and Germany.

Europe is now China’s biggest export market, having gradually replaced the US. China is Japan’s and Korea’s biggest export market, and one of our big two (the other is Japan).

There is a danger that the contraction in Europe in government spending will slow growth next year (and Germany’s biggest market is the rest of Europe), which will in turn slow demand for Chinese and other exporters.

The US won’t be growing strongly enough to pick up any slack from Europe. So our biggest export markets, Japan and China (and to a lesser extent Korea and Taiwan), could take a hit, dropping commodity prices and crimping our terms of trade sooner than the slowdown forecast for later in 2011.

Yesterday’s inflation and house price figures for China were a warning for us (although at 12.8% China’s rise in house prices is still behind Australia’s, so who has the “bubble”?). The 17.8% rise in industrial production in April from a year ago was down on the growth in the first three months, and perhaps a sign of the slowing to come. But that will slow from a very high level, to merely a strong level of output.

Chinese electricity output was more than 21% above a year ago in April. Power once made, can’t be stored in huge amounts if there are no users. It is consumed. That is the best measure of the current strength of demand in China’s economy.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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