Victorian budget surprises with debt issuance downgrade on underlying strength

While media reporting on Victoria's budget has been confusing, it has surprised the market, investors and analysts with material downward revisions to the size of the budget deficit in both this 2021-22 financial year (FY22) and in the next 2022-23 year (FY23). While Coolabah had the most aggressive forecast in the market for these deficit revisions, the size of the improvement in the current FY22, which was $4.2 billion, is double our ~$2 billion estimate and four times bigger than projections published by Adept Economics (see here). The improvement in FY23 is more modest at just $0.4 billion, which with rounding sums to a circa $4.5 billion total reduction in Victoria's budget deficit over FY22 and FY23. This has allowed Victoria to announce a big reduction in its FY23 debt issuance program, which has been reduced from the $25.8 billion originally announced in May 2021 to only $21.3 billion for FY23 today (at the mid-year update in December it was reduced to $23.6 billion). This implies that total state government debt issuance for FY23 is likely to be much lower than official and market estimates: in December, official estimates across all the states and territories totalled about $84 billion in FY23, while the market was anticipating $90 billion or more. Assuming similar budget improvements across all states, Coolabah retains its contrarian forecast for a very large reduction in official debt issuance in FY23 to somewhere in the $65 billion vicinity with further downside risks if NSW chooses to draw down the $15 billion of available capital left in its Debt Retirement Fund ($11 billion of which is already been used for debt reduction).

Two budgets: only one is important

There is a huge lacuna in sell-side research with no analysts publishing independent forecasts for the state budgets, which means investors and the market rely heavily on the state estimates. Coolabah spends a lot of time trying to secure superior insights into the path of both federal and state budgets, and we have been predicting for the last 2 years that state budgets would very materially outperform official estimates, as has generally been the case.

One key complexity when it comes to budget analysis is differentiating between the narrow "general government" budget numbers and the much broader "non-financial public sector" budget results. The latter public sector numbers represent the entire consolidated budget, including state-owned non-financial corporations. It is the public sector budget, not the general government budget, that analysts, the market, and investors should be focused on, although this distinction does sometimes confuse even the sell-side.

Big upside surprises on Victorian revenue

The budget reported an improvement in the state finances, reflecting a stronger-than-expected economic recovery and delays to capex spending, as we had predicted (see our research on infrastructure delays here), although the extent of the improvement was tempered by increased spending on public services (the increased spending on services includes more spending on health, with the government facing an election in November). 

The stronger recovery is also evident in the reasonable economic forecasts, comprising stronger growth and wages/inflation and lower unemployment, where the main risks to the outlook reflect ongoing uncertainty around COVID and the eventual impact of higher interest rates. 

The profile for the narrower general government cash deficit improved in each year of the forecast horizon with stronger revenue and lower capex more than offsetting increased spending on government services. The deficit for 2021-22 improved by $2.9bn to $25bn, while the deficit for 2022-23 narrowed by $1.1bn to $13.2bn, with the deficit ranging between $10bn and $16bn over the three subsequent forecast years.

The more important, and much broader, non-financial public sector deficit also improved in each year of the forecast horizon for the same reasons as the general government sector, albeit with more volatility. The deficit for 2021-22 improved by $4.2bn to $28bn, while the deficit for 2022-23 improved by $0.4bn to $16.4bn, with the deficit ranging between $13bn and $20bn over the three subsequent forecast years (the still-high deficit reflects a large investment programme).  

Devil in the Detail with Victoria's Debt Issuance Requirements

The combined $4.5 billion total reduction in Victoria's budget deficit over FY22 and FY23 has allowed it to announce a large reduction in its FY23 debt issuance program, which has been significantly reduced from the $25.8 billion originally announced in May 2021 to only $21.3 billion for FY23 today (at the mid-year update in December it was reduced to $23.6 billion). 

One devil in this detail is Victoria appears to have a policy of pre-funding a lot of the next 12 months of bond maturities as part of its official debt issuance program. While Victoria appeared to have issued very precisely the amount of debt in the current FY22 that was required by its official funding task, and had therefore not superficially engaged in pre-funding, TCV announced last night that the state had already, in fact, pre-funded $8.6 billion of FY23's requirements. This continues a pattern we have observed in past financial years, with very large completed pre-funding programs that are not otherwise easy to reconcile.

In the FY23 budget, there is a $6bn increase in Victoria's borrowing needs despite a $0.4bn decrease in the public sector cash deficit. Combined with the improvements in the FY22 deficit compared to official forecasts, it appears that Victoria is once again embedding in its FY23 funding task enough pre-funding to allow it to refinance forward 12 month maturities. 

All of this implies that total state government debt issuance for FY23 is likely to be much lower than official and market estimates; in December, official estimates were $84 billion in FY23, while the market was anticipating $90 billion or more. 

Assuming similar budget improvements across all states, Coolabah retains its contrarian forecast for a very large reduction in official state debt issuance in FY23 to somewhere in the ~$65 billion vicinity with further downside risks if NSW chooses to draw down the ~$15 billion of available capital left in its Debt Retirement Fund ($11 billion of which is already been used for debt reduction).

Victoria is establishing a Future Fund with the aim of repaying COVID-related debt.

Another important development is that Victoria is following NSW's lead by establishing a Future Fund that will be managed by VFMC, with the seed capital coming from asset sales and later investments sourced from land sales and a portion of budget surpluses once net debt stabilises. The fund is expected to reach $10bn, where the “initial investment and future returns will be used to repay COVID-19 borrowings”. 

This fund is clearly an effort by Victoria to replicate the success of NSW's novel Debt Retirement Fund (DRF), which, as noted above, has been applied in an unprecedented fashion to reduce NSW's debt by $11bn initially with at least a further $15bn available in the DRF for future debt repayment should NSW decide to draw-down on it.