Upheaval in financial markets: Impact on State finances a mixture of good and bad

Australia, and Western Australia in particular, is well positioned to cope with the fall-out from the current global financial upheaval given that our banking system and its regulation is extremely robust by world standards.

However, concerns that a world recession could occur reinforces the need for the WA Government to get its forward finances in order.

The immediate impact of the current market volatility on WA's financial position is a mixture of good and bad.  Some of the effects are counter-balancing and can serve to improve the bottom line for State revenues in the short term.

Since the Pre-election Financial Projections Statement (PFPS) was published, spot prices for a range of commodities, including oil, have fallen on the back of world economic fears and the risk of a slowing in demand for commodities.

The oil price is currently about $US97 per barrel, which compares with the pre-election assumption of $US134 per barrel.  As a general rule, each $US1 per barrel change in the price of crude oil reduces petroleum royalties by $5million per year.  While prices of base metals (eg. nickel, copper, zinc) have also fallen significantly. These metals account for less than 10 per cent of total royalty income.

Exchange rate movements - another critical factor - can be expected to act as a buffer against weaker commodity prices.  The value of the Australian dollar has fallen from an assumed US95.5 cents at the time of the PFPS to about US80 cents today.  Each US1.0 cent fall potentially adds more than $30million to annual royalty collections.

In the short term, contractual price arrangements for the State's key iron ore and LNG exports to Asia will also act as a buffer.   In terms of direct financial implications for WA, the concern lies more in the medium-term impact of global economic conditions on iron ore price negotiations and the possible flow through of lower oil prices to LNG.

Weaker realised commodity prices can also be expected to flow through to the broader WA (and national) economies, potentially delaying a recovery in the property market and associated tax revenues, which have been tracking below those expected at the time of the PFPS.  Consumer confidence and associated GST revenues may also be impacted.

Nonetheless, strong internal investment in China should help to insulate exports and growth in WA from the worst of a global economic down-turn.

Investments of the Public Bank Account (PBA)

As part of the framework of managing State finances, the Treasurer has responsibility for the management of the PBA. The balance of this account is invested on behalf of the Treasurer by the Western Australian Treasury Corporation (WATC).  Currently, the value of these investments is about $4billion.

The investment is managed under investment and credit policies, approved by the Treasurer, that seek to ensure that the moneys are not placed in risky investments.  The credit policy adopted for managing the investment of the PBA is based on the credit ratings assigned by Standard & Poor's and Moody's credit rating agencies.  The flexibility exists within these policy documents to reduce credit limits to entities in the face of geo-political or systemic risk.

In response to the recent increase in systemic risk arising from the 'sub-prime crisis', the WATC and Department of Treasury and Finance (DTF) implemented a more cautious approach to applying credit limits including, for example, reducing the PBA's exposure to investments that are placed on a 'negative credit watch' by either of the credit rating agencies, rather than waiting for a formal credit rating downgrade. 

The WATC and DTF continue to closely monitor the situation in financial markets and will take any further action considered necessary to manage changing risk profiles.

Insurance Commission of WA

As at June 30, 2008, ICWA had net assets in excess of $800million and no material debt. It has no direct exposure to American International Group (AIG) but does have exposure to Lehman Brothers and Merrill Lynch which is estimated at a combined 0.25 per cent (approximately $7.5million) of its total investment portfolio.

Indirectly, the instability in the domestic and international markets can have varying effects on the remainder of the ICWA portfolio and it is difficult to make any predictions at this early stage.

Government Employees Superannuation Board

GESB manages $2.35billion on behalf of the State and this includes some 5,000 securities - a very large and diverse portfolio of equity and fixed income securities.

In recent times, the values of underlying securities have moved in line with the overall global market sell-off and tightening credit conditions. All asset classes have been affected including cash, bonds, property and equities.

The direct exposure to Lehman Bros, AIG, Babcock and Brown and HBOS is approximately $8.9million. Importantly the positions in specific securities represent very significant underweight holdings.

The indirect exposure of GESB's investment portfolio on behalf of the State will be subject to the same volatility as ICWA and it is too early to speculate on the impacts.