For those that don’t know, over the weekend Moody’s stripped the UK of its AAA rating.
Does the UK downgrade matter to Australia? In the short term it may add to some of the upwards pressure on the Australian dollar as one less AAA nation is on offer to global capital (although its been well-telegraphed so probably not).
And on the surface, Australia does not have a lot in common with its erstwhile UK parent. Government debt in the UK is some 85% of GDP versus 24% here. GDP growth has been chronically weak since 2010 whereas Australia has been below trend but decent. The UK is exposed to Europe’s slow growth whereas Australia is exposed to Asia’s high growth. The UK has its cash rate at zero, Australia still has room to cut.
On the other hand, both run current account deficits but Australia’s is much larger as percentage of GDP and both have households with debt in the 150% of disposable income range. And that is the main reason why the UK’s experience is not as distant as we might think, especially as we head into the end of the mining boom.
Moody’s rationale underlines why:
The main driver underpinning Moody’s decision to downgrade the UK’s government bond rating to Aa1 is the increasing clarity that, despite considerable structural economic strengths, the UK’s economic growth will remain sluggish over the next few years due to the anticipated slow growth of the global economy and the drag on the UK economy from the ongoing domestic public- and private-sector deleveraging process. Moody’s says that the country’s current economic recovery has already proven to be significantly slower — and believes that it will likely remain so — compared with the recovery observed after previous recessions, such as those of the 1970s, early 1980s and early 1990s. Moreover, while the government’s recent Funding for Lending Scheme has the potential to support a surge in growth, Moody’s believes the risks to the growth outlook remain skewed to the downside.
The sluggish growth environment in turn poses an increasing challenge to the government’s fiscal consolidation efforts, which represents the second driver informing Moody’s one-notch downgrade of the UK’s sovereign rating. When Moody’s changed the outlook on the UK’s rating to negative in February 2012, the rating agency cited concerns over the increased uncertainty regarding the pace of fiscal consolidation due to materially weaker growth prospects, which contributed to higher than previously expected projections for the deficit, and consequently also an expected rise in the debt burden. Moody’s now expects that the UK’s gross general government debt level will peak at just over 96% of GDP in 2016.The rating agency says that it would have expected it to peak at a higher level if the government had not reduced its debt stock by transferring funds from the Asset Purchase Facility — which will equal to roughly 3.7% of GDP in total — as announced in November 2012.
More specifically, projected tax revenue increases have been difficult to achieve in the UK due to the challenging economic environment. As a result, the weaker economic outturn has substantially slowed the anticipated pace of deficit and debt-to-GDP reduction, and is likely to continue to do so over the medium term. After it was elected in 2010, the government outlined a fiscal consolidation programme that would run through this parliament’s five-year term and place the net public-sector debt-to-GDP ratio on a declining trajectory by the 2015-16 financial year. (Although it was not one of the government’s targets, Moody’s had expected the UK’s gross general government debt — a key debt metric in the rating agency’s analysis — to start declining in the 2014-15 financial year.) Now, however, the government has announced that fiscal consolidation will extend into the next parliament, which necessarily makes their implementation less certain.
Taken together, the slower-than-expected recovery, the higher debt load and the policy uncertainties combine to form the third driver of today’s rating action — namely, the erosion of the shock-absorption capacity of the UK’s balance sheet. Moody’s believes that the mounting debt levels in a low-growth environment have impaired the sovereign’s ability to contain and quickly reverse the impact of adverse economic or financial shocks. For example, given the pace of deficit and debt reduction that Moody’s has observed since 2010, there is a risk that the UK government may not be able to reverse the debt trajectory before the next economic shock or cyclical downturn in the economy.
Fair enough. If Australia were in a position to be judged on similar metrics to the UK, that is, we could grow government debt to 85% of GDP before being downgraded then we’d have lot’s of scope to survive economic shocks. But that is not the case.
Even with government debt at 24% of GDP, ratings agencies have already warned consistently that the national Budget must reach surplus “across the cycle” meaning that so long as economic weakness passes sufficiently for the Budget to reach surplus the AAA rating is secure.
Why don’t we have the leeway of the UK? The reasons are manifold. First, we are much smaller and more vulnerable to the vicissitudes of global markets. Second, the Pound is an older and deeper reserve currency, and is home to a global financial centre, enabling the central bank to print money for long periods of time without risking capital flight. Third, the UK is still a powerful strategic country, with large influence in geopolitical affairs. Finally, the UK has more savings than we do and can fund investment internally with greater ease.
These factors add up to greater leeway in the maintenance of national solvency.
Australia’s capacity to absorb shocks without facing credit rating pressure is more limited that the UK’s on a couple of fronts. We can lower interest rates further but the historical response of a jump in credit growth faces two problems. It will either be limited by APRA and its insistence that new credit must funded by deposits or the banks will borrow more offshore and will be downgraded for raising their liquidity risk. Either way, if mining fades, so does growth.
Alternatively, the government does have the leeway to borrow and spend for a while. Sensible spending on infrastructure would be good, so long as it was matched in the private sector by deleveraging.
But even this approach has its limits. Infrastructure can support growth and competitiveness but it does not solve the issue. And if it runs for long, the sovereign would still be downgraded and the banks along with it. My estimate is that the budget could double its current debt load before downgrade. But it may well happen earlier if credit rating agencies can see no turnaround in budget dynamics.
The only real solution is attracting investment to boost output, especially in export industries, to keep growing.
Australia is in its own version of the UK pincer described by Moody’s. Slower moving and perhaps less inevitable. But with higher stakes if it closes.
