Bye, bye AAA:
Fitch Ratings has affirmed Australia’s Long-Term Foreign-Currency Issuer Default Rating (IDR) at ‘AAA’ and revised the Outlook to Negative from Stable.
KEY RATING DRIVERS
The Negative Outlook reflects the significant impact the global coronavirus pandemic has on Australia’s economy and public finances. Growth will fall sharply in 2020 and government spending in response to the health and economic crisis will cause large fiscal deficits and a sharp increase in government debt/GDP. The ‘AAA’ rating reflects the sovereign’s strong institutions and effective macroeconomic policy framework, which has supported a long record of stable economic growth prior to the current exogenous shock.
Fitch forecasts GDP to contract by 5% in 2020, driven by a plunge in economic activity during the second quarter due to virus containment measures. While these measures have effectively curbed the spread of the virus, they also constrained household consumption and reduced business sentiment and investment. We expect a gradual economic recovery to begin in the second half of 2020 and forecast GDP to grow by 4.8% in 2021. Domestic restrictions are now being eased, but border controls are likely to remain in place for some time, constraining international tourism and student service exports.
Risks are tilted to the downside given uncertainties around the spread of the coronavirus domestically and globally. A resurgence of cases in Australia could lead to the re-imposition of domestic restrictions. The global outlook could also be worse than we currently forecast if the emergence from current lockdown measures is slower than we anticipate or if there is a second wave of infections. Australia’s exports would be particularly affected if China’s recovery were to falter. International and bilateral trade tensions with China also pose risks.
The forecast GDP contraction will end a run of 28 consecutive years of economic growth. An effective and flexible policy framework, along with strong net migration, have underpinned a record of stable economic growth in the face of considerable external, financial, and commodity price shocks. The authorities have launched substantial fiscal and monetary policy stimulus, in response to the current shock, which should soften the shock and support the economic recovery.
The government has announced three fiscal packages totaling AUD194 billion (about 10% of GDP) in direct spending over the next four years (heavily front-loaded) to cushion the impact of the coronavirus shock by providing income support to households and businesses. Central to these measures is the AUD130 billion JobKeeper programme, scheduled to expire in September, which provides wage subsidies to incentivise firms to retain their employees. In addition to the direct fiscal spending, the Commonwealth government has allocated AUD20 billion in loan guarantees for SMEs and AUD15 billion to the Australia Office of Financial Management to invest in structured finance products. States and territories have also announced fiscal stimulus measures of about AUD12 billion (0.6% of GDP) through tax relief and cash payments.
Fiscal deficits are set to swell at both the Commonwealth and state levels as a result of the discretionary fiscal measures and economic contraction. We forecast the general government deficit to rise to 6.9% of GDP in the fiscal year ending June 2020 (FY20) and to 9.0% in FY21 from 1.2% in FY19. Higher expenditures are the key driver of the fiscal deterioration, rising to about 44% of GDP in both FY20 and FY21 from 37% in FY19. Revenues are forecast to decline as a share of GDP beginning in FY21 due to lagged effects of the weak economy and modestly lower iron ore prices.
Fitch forecasts Australia’s gross general government debt to jump to 58.2% of GDP by FYE21 from 41.9% at FYE19 on the back of the wider fiscal deficits. This stands well above the current Fitch forecast ‘AAA’ median of 44% of GDP in 2021. Relative to other advanced economies, most of Australia’s fiscal support is on-balance sheet, which drives a more severe decline in fiscal metrics, but limits contingent liabilities related to loan guarantee programmes. Beyond FY21, Fitch forecasts lower fiscal expenditures and narrower deficits, leading to a debt/GDP ratio of just above 60% by end-FY24. The authorities have demonstrated a recent commitment to fiscal prudence, but this comes in the context of a rise in the debt level from 21.9% of GDP when Fitch upgraded Australia to ‘AAA’ in 2011.
The Reserve Bank of Australia (RBA) implemented sizeable monetary stimulus to facilitate lending and financial market liquidity and functioning. In March, the RBA cut the policy rate twice by 25bp to 0.25% and announced a yield target of 0.25% for the three-year government bond. The RBA also implemented an AUD90 billion Term Funding Facility, which provides banks with three-year funding at 0.25% to support lending to SMEs. Fitch does not expect a change to the policy rate through 2021. Inflation is forecast to remain well below the RBA’s 2%-3% target band, averaging 1.2% in 2020 and 2021.
Fitch expects the unemployment rate to rise to an average of 8.0% in 2020 from 5.2% in 2019, before gradually declining to 7.1% in 2021. The JobKeeper programme will help contain the potential spike in the unemployment rate from the coronavirus shock, but measures of underemployment, hours worked and participation will be affected more greatly.
Household debt, at 186.8% of disposable income in 4Q19, is among the highest of ‘AAA’ rated sovereigns and poses an economic and financial stability risk. In the event that the current shock proves more persistent or leads to a structurally weaker labour market, households’ ability to service their debt could become impaired. A six-month mortgage payment holiday limits near-term risks and many households have prepaid their mortgages or maintain offset accounts, which provide a buffer for debt servicing.
Australia’s banking system, which scores ‘a’ on Fitch’s Banking System Indicator (lowered from ‘aa’ after the downgrade of four large banks in April 2020), is relatively well positioned to manage the current shock. Fitch expects deterioration in bank asset quality and earnings due to weak economic performance and lower interest rates. Capitalisation will be affected by weaker asset quality, but buffers remain sufficient at current bank rating levels. Sound prudential regulation and the strengthening of underwriting standards have improved the resilience of bank balance sheets. Funding and liquidity is supported by the RBA’s liquidity management and support measures, limiting near-term pressures.
Net external debt remains among the highest within the ‘AAA’ category at 57.9% of GDP in 2019. However, we view Australia’s exposure to potential external financing risks from a sharp shift in capital flows as relatively limited. Australian banks have generally relied on external funding, but were able to meet much of their external funding needs early in the year and domestic liquidity support combined with strong deposit inflows and slower loan growth limits the need to access these markets in the near term. Banks have considerably reduced their reliance on external wholesale funding since the global financial crisis. The RBA also established a swap line of USD60 billion with the US Federal Reserve to relieve possible US dollar liquidity pressures, but the take-up on the swap line since early-May amounted to just USD1 billion.
Australia posted a current account surplus of 0.6% of GDP in 2019, its first full-year surplus since 1973, on the back of historically high terms of trade. Fitch forecasts a return to a slight deficit of 0.2% of GDP in 2020 and 0.7% in 2021 as the terms of trade recede from their recent highs. This is well below the deficit of 6.7% of GDP in 2007, before the global financial crisis.
ESG – Governance: Australia has an ESG Relevance Score (RS) of 5 for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) has in our proprietary Sovereign Rating Model. Australia has a high WBGI ranking at 92.5 percentile, reflecting its long track record of well-established rights for participation in the political process, strong institutional capacity, effective rule of law and a low level of corruption.
SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)
Fitch’s proprietary SRM assigns Australia a score equivalent to a rating of ‘AAA’ on the Long-Term Foreign-Currency (LT FC) IDR scale.
Fitch’s sovereign rating committee did not adjust the output from the SRM to arrive at the final LT FC IDR
Fitch’s SRM is the agency’s proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch’s QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
– Failure to put general government debt/GDP on a downward trajectory over the medium term, for instance from an absence of a sufficient post-coronavirus fiscal consolidation strategy.
– Economic or financial sector distress resulting from impaired household debt-servicing ability, for instance from a structural deterioration in the labour market or substantial decline in housing prices.
Factors that could, individually or collectively, lead to positive rating action:
– Confidence that debt/GDP will be placed on a downward trend over the medium term.
– Evidence that policy measures have made economic performance more resilient than we forecast through the global coronavirus shock or that medium-term growth potential is relatively unchanged following the shock.
S&P already has us on negative watch, Moody’s next!
Not that it matters anymore.