S&P declares surplus fail, endorses AAA anyway

So, the cat is out out the bag. Australia’s ever-disappearing surplus has been wiped out by S&P, which has declared that:

Australia will record a budget deficit of $20-25 billion this year.

The agency has slashed its earlier estimate of a $1 billion surplus.

S&P’s senior director of sovereign ratings Tan Kim Eng says the cut is mainly due to global economic problems.

“Firstly the export sector is not doing as well as initially expected, commodities exports have not been as strong, on the other hand expenditures are rising,” he said.

But the analysis is part of some good news, with the agency re-affirming Australia’s AAA credit rating. But to be honest, reading the rationale you have to kind of wonder why. The list of risks S&P cites is long and kind of scary. The full text is below but the following two paragraphs capture what I mean:

Mr. Curry added: “The stable rating outlook reflects our view that Australia’s public finances will continue to withstand potential adverse financial and economic shocks, and our belief that the country’s consensus in favor of prudent budgetary policies will remain. Moreover, our base-case scenario assumes that fiscal consolidation will continue, and that the general government debt burden will remain low and on a declining trajectory.”

We could lower the ratings if external imbalances were to grow more than we currently expect, either because the exchange rate no longer adjusts to terms of trade movements, the terms of trade deteriorates quickly and markedly, or the banking sector’s cost of external funding increases sharply. Such an external shock could lead to a protracted deterioration in the fiscal balance and the public debt burden. It could also lead us to reassess Australia’s contingent fiscal risks from its financial sector.

That reads to me like a gigantic “get into surplus or else” statement. Moreover, this is the first time I’ve seen a ratings agency connect the contingent fiscal risks from the banks, ie the guarantees, with the rating. Such guarantees tend to exist in some ratings nether region, often ignored for decades at a time. To throw that up in a context of fiscal deterioration is a monumental threat.

Anyway, for today it’s all good, as the dunderheads say.

The unsolicited ratings on the Commonwealth of Australia ref lect Standard & Poor’s Ratings Ser vices’ view of the country’s ample fiscal and monetar y policy f lexibility, economic resilience, public policy stability, and a financial sector that appears to be sound. We believe these factors demonstrate Australia’s strong ability to absorb large economic and financial shocks, such as the global recession in 2009. These strengths are moderated by Australia’s high external imbalances, dependence on commodity exports, and high household debt, all of which weigh on its growth prospects.

The Australian economy perfor med relatively well in the fiscal year ended June 30, 2012, as mining exports and private investment in mining and liquefied natural gas of fset weaknesses in domestic consumption and export sectors exposed to the high Australian dollar, such as education, tourism, and manufacturing. Yet considerable risks remain for Australia’s growth prospects, prosperity, and credit quality. These stem from its growing dependence on trade with China. If demand for Australia’s resources were to weaken, this could lead to a range of disorderly dislocations in its economy, including in its labor and property markets. However, while strong demand for its commodities continues–from emerging Asia, and particularly China–we believe Australia’s economic prospects remain favorable (see “Weaker China Trade Threatens To Take the Wind Out Of Australia’s Economic Growth Sails,” published March 12, 2012, on RatingsDirect on the Global Credit Portal).

In our view, Australia’s overall economic resilience ref lects decades of str uctural refor ms, wages restraint, and a national savings rate of roughly 25% of GDP. However, we believe that Australia’s financial sector relies more heavily on external savings than do banking systems in other highly rated sovereigns. This ref lects Australia’s heavy external borrowings to partly fund investment in its mining sector and lending for residential real estate. Despite recent private-sector deleveraging, including by households, we believe that subdued demand for credit against the backdrop of a still-high debt burden will constrain domestic consumption growth over the next three years as the government withdraws fiscal stimulus. That said, we expect that the robust outlook for commodity prices, allied with a strong pipeline of mining investment, will under pin a return to trend GDP growth of 3.5% by 2015.

Although Australia’s public finances have worsened as a result of the global recession, the deterioration has been more contained than for most ‘AAA’ rated peers, whose steep deficit increases have been more pronounced and may well persist for longer. We estimate that Australia’s general government (federal, state, and local) will record a deficit of 2.5% of GDP in 2012, and return the balance to sur plus in 2015. We estimate that the general government debt burden will rise by 1.3% of GDP to 23.4% in 2012.

In view of our forecast of a deficit of 1.1% of GDP in 2013, we project that Australia’s general government debt burden will remain about 23% of GDP in 2013, before trending lower as the deficit shrinks further. This level of government debt is considerably lower than that of other ‘AAA’ sovereigns. That said, we believe that Australia’s private sector debt is among the highest of any rated sovereign and remains a key vulnerability.

The federal government outlined a three-year fiscal consolidation program (starting 2009-2010) worth A$56.3 billion (4.3% of GDP). More than half of this is expected to come from keeping average real growth in spending to about 1% over the outlook period (2012-2015). This is one of the fastest consolidation programs among ‘AAA’ rated sovereigns.

The government intends to contain its spending by placing a 2% average annual cap on real spending growth until sur pluses are at least 1% of GDP, for as long as the economy grows at or above trend. We believe this conservative stance on public finances has strong bipartisan political and community backing and we also observe stable political consensus on fiscal, monetar y, and exchange-rate policies. Like other developed sovereigns, Australia faces long-term age-related spending pressures on health, pensions, and aged care. In this respect, Australia’s longer term fiscal consolidation will benefit from the continued build-up of assets to fund government pension obligations, of which the central government’s unfunded component was well below most ‘AAA’ peers at an estimated A$138.5 billion (9.3% of GDP) at June 30, 2012.

Although Australia’s public sector finances are not strained, its private-sector balance sheets–particularly in the banking system–car r y high external liabilities. Net of liquid assets, these were an estimated 224% of cur rent account receipts (CARs) in 2012. Australia’s banks have been a principal channel to fund the countr y’s cur rent account deficits.

This external bank debt has helped fund lending for domestic residential housing and businesses (about two-thirds and one-quarter of financial system lending, respectively). We expect Australia’s cur rent account deficits to widen to about 5% of GDP by 2014 (from 2.4% in 2011) partly due to higher private investment in the mining sector, which should eventually help boost export capacity. We expect this widening will be financed mainly through foreign direct investment (which funded 71% of Australia’s cur rent account in 2011 and is expected to fund around 65% in 2013) and supplemented by long-ter m debt cor porate external debt. Australia’s gross external financing requirement (the cur rent account balance plus amortization of long-ter m external debt plus stock of short-ter m external debt) was about 225% of CARs in 2012, which is high compared with peers.

In our opinion, the risks associated with Australia’s high private-sector external debt are manageable because of the strength of its financial system, the large degree of foreign cur rency debt hedging, and an actively traded currency.

Although we believe banking system loan losses will likely remain low by international standards, cautious consumer sentiment, intensifying competition for retail deposits, and stricter regulator y requirements may continue to dampen

lending growth and profit margins in the sector. Nevertheless, we expect the credit profile of Australia’s banking sector Australia will remain sound, supported by the banks’ conser vative risk appetite and good capitalization and the economy’s sound outlook generally (see “We Still Call Australia Home: Banks Down Under Likely To Retain Domestic And New Zealand Focus,” published July 30, 2012 and “Banking Industr y Countr y Risk Assessment Update: August 2012,” published Aug. 2, 2012).

Further more, we obser ve that Australia has an independent monetar y policy with a free-f loating cur rency that historically has allowed external imbalances to adjust. The Australian dollar is also the fifth-most actively traded currency in the world. A large portion of the nation’s external debt is denominated in Australian dollars, while much of the remainder finances companies with revenue in foreign exchange or is hedged. We view Australia’s financial and capital markets as well-developed and supportive of the rating.

Outlook

The stable outlook ref lects our view that Australia’s public finances will continue to withstand potential adverse financial and economic shocks, and our belief that the countr y’s consensus in favor of pr udent budgetar y policies will remain. Moreover, our base-case scenario assumes that fiscal consolidation will continue, and that the general government debt burden will remain low and on a declining trajector y.

We could lower the ratings if external imbalances were to grow more than we cur rently expect, either because the exchange rate no longer adjusts to ter ms of trade movements, the ter ms of trade deteriorates quickly and markedly, or the banking sector’s cost of external funding increases shar ply. Such an external shock could lead to a protracted deterioration in the fiscal balance and the public debt burden. It could also lead us to reassess Australia’s contingent fiscal risks from its financial sector.

Over the longer ter m, the aging population will continue to present a challenge to the public finances. Although Australia is well ahead of most peers in reducing these intertemporal imbalances, continued commitment to pre-funding age-related spending will be required to bolster public sector savings and ensure the long-ter m sustainability of government finances.