Much more defence spending required to properly protect Australia

Christopher Joye

Coolabah Capital

In the AFR I write that unable to control Australia after decades of unprecedented espionage and propaganda, and having had scant success forcing us to bend the knee following an equally unparalleled economic coercion campaign, China is now attempting to militarily encircle us.

The Chinese Communist Party has sought to lay the ground-work to establish bases, runways, naval ports, and close military ties with most countries situated to our north and north-east, including Fiji, Papua New Guinea, Samoa, the Solomon Islands, Timor Leste, Tonga, Vanuatu, and, further afield, the tiny nation of Kiribati.

The dark non-democratic shadow being cast over Australia by a one-party communist dictatorship desperate to cauterise all perceived threats to its existence calls into question the relatively modest “official” defence spending plans unveiled in this week’s Commonwealth Budget.

While defence’s 2.1 per cent share of GDP is an improvement over the tiny 1.6 per cent Australia spent back in 2012 – the lowest level since the 1930s – the truth is we need to radically increase our military investments if we are serious about protecting ourselves in the event of major power conflicts. The most pressing near-term existential risk is of course war over Taiwan.

The budget did not account for Australia’s $100 billion plus commitment to acquiring nuclear-powered submarines under the new AUKUS alliance nor any other game-changing acquisitions, such as the potential purchase of B-21 stealth bombers. Australia desperately needs asymmetric capabilities that project themselves far beyond our borders to deter prospective foes, including larger fleets of weaponised drones, vast stores of long-range ballistic missiles, advanced unmanned under-sea vehicles, and the conversion of our amphibious assault ships into mini aircraft carriers via vertically launched F-35s (and drones) as the US and others are now doing.

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A responsible government that can make tough security decisions in the face of pressure from China and its proxies, and further circumvent the interminable procurement ineptitude of Australia’s defence department, would boost military spending by 50 to 100 per cent. This means that there may not be much downside risk to the $156 billion of debt issuance (via bonds and bills) anticipated by Tuesday’s Commonwealth budget. In particular, the revenue upside that would otherwise be realised when actual budget outcomes debunk the crazy assumptions that underpin the forecasts, such as absurdly low iron ore, coking coal and thermal coal prices, may be offset by substantial unaccounted defence spending.

The arguably much more interesting fiscal upside emerges when one considers the State, as opposed to Federal, budgets, which are on track to record huge beats over deficits predicted as recently as their mid-year updates in December.

On Wednesday, NSW released its monthly budget data for February, which revealed that it was remarkably close to being in balance (or producing a surplus) despite the challenges wrought by Omicron and the floods. This is, in fact, the second month in succession that NSW has come close to a surplus. January’s result was even more astonishing given that Omicron allegedly stifled much of the economy.

Our chief macro strategist, Kieran Davies, who was formerly director of forecasting at the Commonwealth treasury, concludes that NSW’s budget deficit this financial year is likely to be at least $5 billion smaller than what was projected in December as a result of revenue surprises and lower costs. This is despite conservatively assuming the floods will cost NSW $5-$6 billion.

The $5 billion smaller deficit also ignores the fact that the Commonwealth will pay for 75 per cent of the floods once the State submits its compensation claim. Allowing for the Commonwealth’s share of expenses, NSW’s budget deficit would be $8.5-$9.5 billion smaller than the official estimates.

Of course, we don’t know exactly when the Commonwealth’s money will hit NSW’s coffers. The looming Federal election could convince it to accelerate payments into this financial year, as has happened in the past. Alternatively, the Commonwealth cash might arrive next financial year.

Irrespective of what occurs, NSW is likely to issue up to $10 billion less public debt next financial year compared to previous estimates. Further improvements in the budget performance over coming months could raise this figure again.

Now consider the other States and Territories. They are all benefiting from much higher than budgeted revenues via resources royalties, payroll tax, GST receipts, stamp duties, and land tax. Outlays also appear to be skinnier than their assumptions. States like Victoria, which do not have to wear the cost of the tragic floods, should be realising even larger gains than NSW and Queensland.

Notwithstanding this outlook, Treasury Corporation of Victoria has issued $4.5 billion more debt than its official funding task required at this juncture to get ahead of its curve. If one assumes Victoria beats its budget estimates by a similar margin to NSW, it is possible that Treasurer Tim Pallas will have $10-$15 billion less debt to issue next financial year.

NSW Treasurer Matt Kean would also likely be considering further drawing-down on the circa $15 billion that will be left in NSW’s Debt Retirement Fund after he repays the first $11 billion of debt he proposed to buy-back last year. This would be smart given the explosion in NSW’s government debt from $38 billion in 2018 at the time the Debt Retirement Fund was created to more than $109 billion today.

This debt burden is becoming much more taxing to service due to the huge spike in long-term interest rates: NSW’s cost of borrowing 10-year money has more than doubled from 1.5 per cent in August 2021 (when this column argued it should reduce its debt) to 3.3 per cent today.

In December 2021, the States and territories expected to issue about $84 billion in total debt during the 2023 financial year. A historically low 4 per cent jobless rate, resurgent wages growth, robust consumer spending, record savings, surging commodity prices, and elevated house and land prices are coalescing to deliver a positive revenue shock while ameliorating costs.

Combined with the fact that the States have generally over-issued debt in this financial year because they did not anticipate the upside revenue surprises, issuance in the next year could fall below $65 billion. And this is before we factor in mounting delays to infrastructure spending.

In a recent research study, Kieran Davies analysed actual versus forecast budget infrastructure capex outcomes for the past couple of decades across the larger States. He found a pattern of State treasuries systematically overestimating the speed with which they can roll-out infrastructure programs, which are typically 10 per cent slower than projected. In more recent years, roll-out speeds have slowed substantially further (eg, to 20 per cent in Victoria and Western Australia) because of supply-side blockages and difficulties accessing skilled labour.

In recognition of these constraints, the NSW infrastructure minister, Rob Stokes, revealed during the week that several multi-billion dollar infrastructure projects will be delayed because "volatility in cost of materials, equipment, and the shortages in skilled labour means it’s really not the right season to commence more mega projects immediately". That seems sensible.

Assuming infrastructure spending is between 10-20 per cent slower than State budget forecasts, Davies concludes that debt issuance in the 2023 financial year will be reduced by another $8-$16 billion. Coupled with the revenue upsides and extra pre-funding highlighted above, total State debt supply could in practice be as low as $55-$60 billion, or 40 per cent less than many market estimates.

This may be one reason why interest-rate hedged State government bonds, which are one of our preferred asset-classes, were arguably the best performing investment-grade assets globally over February and March. And make no mistake, March was a truly horrific month for markets.

Here in Australia, the benchmark AusBond (Fixed-Rate) Composite Bond Index lost a record 3.75 per cent, which was its worst month in 33 years.

For years we have warned of this coming bloodbath, precipitated by an inflation shock that would force long-term interest rates radically higher. In Australia, the 10-year government bond yield has jumped by more than 180 basis points from 1.1 per cent in August last year to 2.9 per cent in March.

The one silver lining is that as long-term interest rates and credit spreads reset higher, investors are finally accessing decent income. And when the Reserve Bank of Australia finally lifts rates, cash will eventually become king again. 

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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