S&P demands a surplus

For some time I have laboured in the wilderness on the question of bank funding and the national Budget. Indeed I took the AFR to the woodshed last week for its hopelessly political assessment of Budget imperatives. Well, they seem to have listened. From S&P and Fitch via the AFR this morning comes the hard, cold truth about the trap in which the Australian economy is caught:

Federal Treasurer Wayne Swan has been put on notice by ratings agencies to deliver a tough budget next month to protect Australia’s coveted AAA credit standing.

Australia is one of only 14 countries in the world with a top ranking from each of the three major agencies but analysts at Standard & Poor’s and Fitch Ratings are concerned about the banking system’s reliance on overseas funding.

“The AAA rating is pinned on the strength of the government’s fiscal position and if it doesn’t have that, we have less cause to see it as a AAA-rated sovereign, given how weak the banking system is in terms of its external liquidity,” said S&P credit analyst Kyran Curry.

“To be consistent with maintaining a AAA rating . . the government would really need to stabilise its fiscal position as soon as possible.”

Mr Curry said the external liquidity of Australia’s banking system was “quite weak” and the industry was overleveraged.

“If there is stress in the banking system like in Europe, [its] liabilities could migrate on to the government’s balance sheet,” he said.

Fitch Hong Kong-based director Art Woo said banking sector liabilities were always a “potential concern”.

…“The reality is that, if they don’t bring the budget back into surplus, we have to judge why,” Mr Woo said. “Is it because they haven’t put the right measures in place or because you get a cyclical downturn and the revenues don’t come through?”

…“This budget is very important to us,” Mr Curry said. “We will be looking more broadly for the government to demonstrate that it can remain committed to stabilising its debt dynamics over the medium term. This government needs to have a strong balance sheet to offset some of the weaknesses that we see for the sovereign,” he said.

“The main issue is the importance of maintaining a strong balance sheet and running surpluses over the cycle to give the government the sort of flexibility it had pre-2009 to respond should the external environment weaken and present a problem for the banking system, which is highly leveraged.”

…“It’s important that the government stabilises its fiscal position as soon as conditions allow,” Mr Curry said. “We are not necessarily looking for a return of the balance to surplus this year but we would be looking for a continued path to stabilise its fiscal position.”

Don’t be fooled by the AFR’s colourful language. This was an interview, not a formal credit watch move. Nonetheless this is vital to understand for the future direction of the Australian economy and respective asset classes.

Here is how I put it last November:

There are two implications that flow from this. The first goes back to my earlier point about Australians being unable to accumulate more debt because the banks cannot expand their offshore borrowing further without risking downgrades from Moody’s and S&P. The second point is that the state of the Federal budget is now inseparable from the credit ratings of the banks. This means that the Budget must always be straining for surplus, limiting its pro and counter cyclical efficacy. That is, you can forget tax cuts for as far as the eye can see, and any further stimulus packages in times of weakness aren’t going be anywhere near as spectacular as that deployed in 2008, another reason why we are condemned to slow growth.

What this means, of course, is big Budget cuts in May and more slow growth next year and more interest rate cuts.  If we’re lucky, the dollar will fall and boost offshore demand for our goods rather than the banks pressing their luck with more lending. If it were up to me I’d use macroprudential policies to ensure it.

Houses and Holes
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  1. So from this analysis interest rate falls are practically guaranteed. Won’t the interest rate falls be negated by petrol being $2 at the pump?

        • Nope raveswei!

          The inflation is come from Government charges and offshore. Interest rate or fiscal policy here will have little effect on it.
          In the past we have had low inflation despite reckless credit policies. The same factors that brought that about have now been thrown into reverse and will have the reverse effect.

    • Won’t the interest rate falls be negated by petrol being $2 at the pump

      Petrol won’t be $2 at the pump because the RBA cuts rates a few times. Even if the dollar fell to 70c, and crude prices remained constant in US dollar terms, my guess is you wouldn’t see more than a 15% increase in petrol prices. That’s because a lot of the price you pay at the pump is taxes, margins and other costs.

      Besides, an environment where the RBA is forced to cut by 100bps or more implies weak domestic demand, and a weak(er) global economy, both of which will downward pressure on petrol prices.

      Please stop listening to the MineBot’s spin that a lower AUD means runaway petrol prices. It doesn’t. In 2008-09 the AUD was in the 60s and petrol at the pump was cheaper than it is now.

      • Not runaway petrol prices. Higher petrol prices. And in 2009 the price per barrel was…

        Higher prices for all imported items feeding inflation?

        • ps as we have discussed before, generally I agree weaker global demand lower oil prices – however we have had weaker global demand and persistently high oil prices – it’s a big world and geopolitical risks exist.

        • And in 2009 the price per barrel was…

          I think it bottomed out below USD $40/barrel (which was probably about AUD $67/barrel at the time) compared to today where its approx AUD $100/barrel. Taxes, margins and other costs meant that the price at the pump didn’t fall anywhere near as much as a $67/barrel oil price implies.

          Which proves my point.

          The price at the pump is moderated by taxes, margins, and other costs, as well as currency movements.

      • Again Lorax…we are talking about dropping the dollar realtive to all other currencies. The difference we will make to the world oil market is, by definition, not zero but it must be close to it.
        Do you think the oil price is going back to $38 per barrel because we are dropping our interest rates? Of course you don’t.

        You think all the taxes on fuel are going to be lessened? You aren’t listening to Swannie or indeed taking your own realistic take on the state of things into account.

        We are already headed for high inflation over the next two years. Anything we do to lower rates and the dollar will make it worse.

        Note you know my thinking is to crash the dollar but there is no point in trying to make out that it is some one way road to prosperity.

        • You think all the taxes on fuel are going to be lessened?

          No, but lets say taxes, margins and other costs make up half the $1.50 price you pay at the pump. I’m not sure of the real numbers, but I think that’s roughly right. So 75c is due to the price of crude. Lets say the dollar falls from $1.05 to 70c (a 30% fall) and crude prices stay constant in US dollar terms. 30 percent of 75c is 22.5c, so petrol goes up to $1.75 (ish) not $2.00.

          And that’s completely ignoring the fact that crude prices are likely to be falling in any scenario where the RBA cuts hard and the AUD falls to 70c and local margins will be crunched in such a weak economy.

          So again, all this talk of $2.00/L at the pump because of a weaker AUD is complete nonsense. The only way we’re going to see $2.00/L at the pump in the near term is if the US and China grow more strongly than expected and spare capacity gets crunched. That, or the US attacks Iran or something.

          • According to Wikipedia, excise is 38 cents per litre on unleaded. Add GST and that comes to a shade under 42 cents per litre.

            I don’t buy petrol these days, but the last time I looked it cost about $1.50 per litre, so taxes add up to a bit over a quarter of the total.

            If this seems small, perhaps you’ve forgotten that excise hasn’t been indexed to the CPI for over a decade, so in real terms, it has shrunk quite a bit.

          • Higher Petrol prices would be the perfect opportunity to stimulate the rollout of natural gas infrastructure for motor vehicle consumption. Quicker we become energy independent and free of the singapore market pricing the better.

          • Definitely Bear.

            It is not yet critical if one ignores CAD’s Foreign Debt etc.
            However obviously it will become critical soon enough and we ought get on with it.

            I’m not quite sure how our far-flung population can be brought into the CNG fold because of the storage problems (CNG being about 25% energy content of diesel for a given volume)

          • Thanks Phil…I was about to go check that.
            I think the retail margin in petrol is about 10 cents? (I’m open to correction)
            So, presuming no other feed-back inflation we are looking at $1.90..that’s a lot closer than saying a significant devaluation will have no effect.

            That’s the sort of difficult conundrum we have to deal with and work out how the pain is to be spread around.

          • Ummmm guys, do you think it might cost something to refine crude oil into unleaded petrol?

            So we have 38c/L petrol excise, 10% GST on the retail price, the retail margin, refining costs, refining margins, road transportation costs, shipping costs, and probably half-a-dozen other things I haven’t thought of.

            The price of crude does not account for three quarters of the price at the pump. Not even close!

          • I also concur with The Bear above. Higher petrol prices are not necessarily a bad thing. But being a watermelon, I would say that wouldn’t I!

  2. Um…”macroprudential policies” – I wonder if you could explain this with a few words please for non-experts?

        • Different China Fanboy

          I read it as not adding more money to housing. In other words you want lower rates but need to stop lower rates bubbling housing.

    • I really dont see how the government cannot have their cake and eat it too. They want to lower rates but don’t want to risk pumping further money into housing.

      For example: Why not just impose a % limit on leverage’s. So if interest rates full .5% make it so that on a residential mortgage you can only borrow 90% of the purchase price.

      House prices are dictated by the amount people can borrow. If you limit their leverage then they can’t continue borrowing at high levels.

      Is there something complicated to imposing a leverage restriction >< or is it just sheer laziness…

  3. Different China Fanboy

    on the other hand

    surplus -> recession -> unemployment -> falling house prices -> banks smashed

    so it seems to me hard to imagine a scenario that does not end in tears. A surplus probably brings this on faster though.

    • Yes, it’s a trap. But one of our own making, not S&P’s. We have failed to address the banks post GFC and thus now can only reduce rates at the risk of expanding the very lending that is the problem. Conversely, we can’t loosen the Budget because we didn’t establish a mechanism through which the guarantee is management independently.

      Either way there’s trouble.

    • I don’t think it is axiomatic that recession follows surplus, not with this level of investment pouring into the economy. Unemployment will probably nudge up, but to say that this will usher in a fall in house prices significant enough to ‘smash banks’ is a dubious conclusion.

  4. Deus Forex Machina

    I think that S&P are trying to shine a light on the governments spin about what is going on in the economy and that revenues are up but spending is way through the roof – checkout @barnabyisright on twitter for his latest post.

    Look out for the parameter changes in the budget next month as a cure all as well.

    Australia does not have to be in this position – the Government, whichever stripe it may be – has to stop thinking about nightly and weekly news cycles, neilson polls or even the next election.

    They have to manage this economy not for me but for my kids and my as yet unborn grandkids…the net present value of these very young and yet to be born Australians is not zero and the Government and its agencies have to stop acting like it is zero…

    • Different China Fanboy

      sheesh!! next you’ll be saying that analysis of the economy and government policy is more important that Julia’s arse or Abbott’s speedos. Get with the program is you want to be in the meedya.

    • DFM…respect! I think you’ve said it all here. Likely outcome … not on you life as any sides of the political elite don’t see the world this way. It’s all about staying in power and making your opponent look stupid, and most importantly never be transparent to the people.

      The voting public need to remember that these guys don’t have a performance agreement with us. They can screw up big time and still get their golden pensions and directorships etc.

    • Agreed but there are a lot of things that should be done, but we are kidding ourselves if we think they are likely to happen in the current environment.

      Gillard, Abbott, whoever…useless. Maybe they should look at Ireland and how the legacies of politicians and their families have been destroyed due to their “inaction” in the boom times and the public wake up the root cause of the problems.

      That might spur a little action towards doing the right thing for Australia long term. I won’t hold my breath…

    • drsmithyMEMBER

      They have to manage this economy not for me but for my kids and my as yet unborn grandkids…the net present value of these very young and yet to be born Australians is not zero and the Government and its agencies have to stop acting like it is zero…

      Sounds like evil socialist central planning to me – that’s never going to fly in contemporary politics.

      But I agree 100%.

      • Sounds more like pragmatic economic liberalism to me – let’s hope to hell that flies in contemporary politics.

  5. I dont get how this framework of highlighting the importance of AAA can still be valid in a world where even US/France have lost their AAA with no consequences.

    there is a finite amount of countries where investors can buy quality bonds from, it s not like they are going to put their money in Zimbabwe.

    I am pretty sure only ratings comparison between similar countries matter, following absolute ratings make no sense in reallife.It s all relative.

      • The bigger question is why does anybody still pay attention to ratings agencies at all ? Having held the world’s hand during its long, slow march to the precipice for most of the last decade, it seems the rating agencies are now on a desperate mission to restore a semblance of credibility. No credibility should be granted – not by the BIS, the US, France, and certainly not by our governments. They should be ignored as befits their complete and well-deserved irrelevance.

        You are only wrong in having abandoned la belle France for this culturally forsaken hell pit of bad bread and boorish mining bogans.

  6. Agree re the ratings agencies, Botswana has the same credit rating as Japan.

    The money is on huge defence cutbacks in the budget, which makes sense on the outsourcing our defence to the yanks via the bases and drones etc.

    • To be a bit contrary, it sounds like Botswana has a very healthy economy and its public debt is only 5.1% of GDP (Japan’s is 233%).

      “Since independence, Botswana has had the highest average economic growth rate in the world, averaging about 9% per year from 1966 to 1999. Growth in private sector employment has averaged about 10% per annum over the first 30 years of independence.”


    • Botswana is a stable representative democracy, services comprise the majority of its economy, its population is young and urbanized, it has a respectable GDP per capita of $14,000, it is growing at +6% a year, and its public debt stands at 20% of GDP.

      Japan is dying. There 2.6 people working for every one retiree. A little after 2050 there will be roughly one person working for every one retiree. It’s public debt already stands at well over 200% of GDP. Currently it borrows more money each year than it raises in tax revenue. There is only so long this ponzi can be supported by the current account, especially now that Japan insists on importing all of its energy.

      It’s not unreasonable that Botswana would be viewed in a comparable light. Unless you’re Botswanan, in which case I imagine you’d resent the comparison.

  7. What are the direct implications for the banks if the Government’s AAA rating were to drop a notch or two?

    Given the ‘implicit’ government guarantee the banks enjoy – which the ratings agencies openly admit gives the banks an additional 2 notches on the ratings ladder – does this mean that the banks’ ratings will drop across the board as a result?

    And so the cost of their wholesale funding rises?

    • yes, just a little is the quickest answer. And they will also likely see a drop in deposit growth from the surplus drive, if exports do not accelerate from here, so overall funding pressures will squeeze the banks even further.

      It will take a little more than telling staff to work on weekends – but saying its not the weekend – to save the banks profitability…

  8. Jumping jack flash

    They’ve wiggled the interest rate lever so much it’s fallen off.

    “What this means, of course, is big Budget cuts in May and more slow growth next year and more interest rate cuts.”

    I really can’t see how anyone would benefit from lower rates, except the banks of course, from not passing cuts on.

    With a recovering US, (so far) isn’t that going to place downward pressure on the dollar in itself? Low rates are something we do not need in this case.

    • Yep!

      The question for anyone proposing lower interest rates is what economic decision making do they think this will encourage.

      Sure people with large mortgages can pay down faster but that is no comfort to harvey norman

      No point in making investment decisions on the back of jerry rigged teaser rates.

      No one will crank up their credit cards because the rate is lower ( not that the banks ever lower those rates anyway)

      Hmmm whats left?

      Borrow to speculate on assets!

      Again bullwinkle

      Try to stop that with macroprudential regs – what then is the point.

      Low interest rate policy is a mugs game.

  9. “Mr Curry said the external liquidity of Australia’s banking system was “quite weak” and the industry was overleveraged.

    “If there is stress in the banking system like in Europe, [its] liabilities could migrate on to the government’s balance sheet,” he said.”

    Can the S&P get more explicit than that? Yet the Treasury and the RBA keep insisting our banks are well managed and well regulated.

    • I couldn’t agree more Mav.

      Whether we like it or not our banks debt is going to migrate to the treasuries bottom line.

      As Different China Fanboy said the required Federal government surplus is merely the first step down a road of recession, unemployment and the end of credit bubble that has existed for decades. I don’t say this lightly the government and the Australian public have painted themselves into a corner and now this is the only reasonable option left open to us.

    • Yes and that is easy to acheive.

      Rezone lots of land, cut the paperwork to a minimum, fund development costs with bonds repaid by rates instead of fat front loaded charges.

      Builders start building low cost housing.

      More Jobs and fewer people entering debt servitude

  10. Is there a list of who still trusts the rating agencies? If not, why are they rating in the first place?

  11. The bent Wall Street based ratings agencies (who we all know were all complicit in the GFC) have put a noose around the Federal Government necks because bank “liabilities could migrate on to the government’s balance sheet”.

    If the entire “Surplus” issue is driven by a “highly leveraged banking system” then should there be more public discussion about the risk that these ratings agencies are “ potentially concerned” about so much that they’re forcing government budget policy???