Who cares. Deficits are irrelevant…
Overview
• On Aug. 3, 2020, the State of Victoria declared a “state of disaster” in response to rising cases of COVID-19, triggering additional lockdown measures that we expect to severely hit economic activity. • There is an increasing possibility that we will lower our long-term rating on Victoria within the next few months if the situation deteriorates, such as the state being unable to control the latest outbreak or if the state’s fiscal recovery is likely to be delayed beyond our expectations. • We are consequently placing our long-term rating on Victoria on CreditWatch with negative implications. • We aim to resolve the CreditWatch within the next few months as more details become available about the fiscal effect of the latest lockdown and greater clarity emerges about the government’s policy direction and ability to control the latest outbreak. Rating Action
MELBOURNE (S&P Global Ratings) Aug. 5, 2020–S&P Global Ratings today placed its ‘AAA’ long-term rating on the Australian State of Victoria on CreditWatch with negative implications. At the same time, we affirmed our ‘A-1+’ short-term rating on Victoria.
CreditWatch
We expect to resolve the CreditWatch listing within the next few months, when there is greater clarity about the fiscal effect of the latest lockdown, the government’s policy direction, and the government’s ability to control the latest outbreak.
We expect to lower our long-term rating on Victoria if we consider its fiscal repair would be delayed beyond our base-case expectations. This could occur if the COVID-19-related economic contraction is more prolonged or severe than we currently expect. This may also come if our view is that the state’s financial management is weakening.
We would lower our rating if we were to take a similar action on Australia.
We expect to remove the ratings from CreditWatch negative if we gain confidence that an economic recovery and the state’s financial management capability will support Victoria’s fiscal metrics to recover, notably through delivering operating surpluses and reducing its debt burden relative to operating revenues within the next two years.
Rationale
The State of Victoria on Aug. 3, 2020, declared a “state of disaster” in response to rising cases of COVID-19. The magnitude of the second wave of infections has triggered additional lockdown measures and is likely to hit the state’s finances hard. This is a material deviation from our previous base case that could delay fiscal repair beyond our expectations.
There is significant uncertainty over COVID-19’s effect on the state’s economy and fiscal accounts. Victoria has been less successful in containing the pandemic than other Australian states, and is likely to suffer a longer and more severe hit to the economy and government finances as a result.
There is an increasing possibility that we will lower our long-term rating on Victoria within the next few months, when we have greater clarity of the fiscal effects of the latest lockdown, the government’s policy direction, and the government’s ability to control the latest outbreak.
The current lockdown and strict border closures with all other states will hit the Victorian economy substantially more than we previously expected. This will have a flow-on effect on government finances, placing significant pressure on the state’s fiscal position and ‘AAA’ rating. We believe the latest lockdown will significantly curtail activity in all sectors of Victoria’s economy for the remainder of calendar 2020 and potentially beyond, raising the unemployment rate to levels not seen in decades. It will also result in a large number of businesses permanently closing and a drastic reduction in the state’s population growth in the immediate future.
We nevertheless believe the economy remains structurally wealthy and diverse on a global scale, and Victoria’s very strong financial management is ensuring liquidity coverage is comprehensive during this period of disruption. Underpinning our rating is an extremely supportive and predictable institutional framework.
We expect the state’s budgetary performance and debt burden will weaken further in the next few years, before improving in fiscal 2022. The main hit to the state’s finances is primarily via a drop in revenues, though we expect the state’s expenditure will increase as the economic fallout continues. Victoria is providing significant support to individuals and businesses as a result of its lockdown measures, which we believe will result in large operating deficits in fiscal years 2020 and 2021. Further support packages could be announced as a result of the second lockdown and revenues could take much longer to recover than we forecast. Combined with the state’s record infrastructure program, this will drive large after-capital account deficits and debt levels to record highs.
Economic recession and spending initiatives are weighing on Victoria’s fiscal metrics
The COVID-19 pandemic and government response are weighing heavily on Victoria’s operating revenues, especially conveyance duties and payroll tax, as well as goods and services taxes (GST). Operating expenditures will increase relative to the state’s previous budget as the government responds to the pandemic with higher health spending as well as support for individuals and businesses. Revenues are likely to fall further, and expenses could rise more, given the latest lockdown on all nonessential businesses. Employee expenses meanwhile continue to grow. This limits the government’s ability to respond further, given the rapid rise in employee expenses in recent years. We forecast operating deficits of about 3% of operating revenues in 2020 and 11% of operating revenues in 2021. We expect operating margins to begin recovering in 2022, reflecting improved economic conditions, though significant uncertainty remains.
We anticipate the after-capital account balance to record very large deficits of about 20% of total revenues in 2020 and 26% of total revenues in 2021. The state is in the middle of a record infrastructure program, including roading, rail crossing removals, and public transport initiatives. The government has announced its intention to further boost infrastructure spending to support the weakening economy.
Reflecting Vitoria’s very weak fiscal outlook and changing accounting standards, we expect its debt burden will rise substantially during this year. We forecast total tax-supported debt to reach 122% of operating revenues in 2021, up from 70% in 2018. Victoria’s debt burden is likely to plateau at around 117% as operating revenues recover.
Adding to Victoria’s reported total tax-supported debt is its early adoption of new accounting standards in 2019 and 2020, which record operating leases and service concessions as debt. These items account for about A$17 billion, or 20%, of the state’s total tax-supported debt in 2023.
We adjust Victoria’s reported debt figures to nullify the A$6.5 billion central banking system. We classify the system as an internal transfer between government accounts. Victoria’s interest expenses remain low, despite rising debt burden, at 3.6% of operating revenues between 2019 and 2021, because of the low interest-rate environment. We also believe Victoria’s contingent liabilities are small compared with its peers and we believe that only a small portion, if any, is likely to crystallize.
In our opinion, the state’s liquidity coverage is comprehensive, reflecting its internal debt-servicing ratio, access to external liquidity, and potential Commonwealth support. The state’s debt-service coverage ratio is about 122% of its upcoming debt maturities and interest costs.
We consider the state to have strong access to external liquidity. The Australian states utilize a well-developed capital market for their funding. In March 2020, the Reserve Bank of Australia began purchasing Australian Government Securities and securities issued by the state and territory central borrowing authorities in the secondary market. It is targeting yields on three-year government securities of around 0.25% to help lower funding costs across the economy. Victoria historically has had no difficulty in accessing Australian and international markets, and we expect that this will continue. We also expect the Commonwealth to provide support, if needed, as it did during the 2008-2009 financial crisis, when it provided a guarantee of Australian state government debt for a fee, though Victoria didn’t take up this offer.
Latest COVID-19 outbreak will delay economic recovery, but not structurally lower the state’s economic wealth
We believe Victoria’s economy will contract substantially this year. Uncertainty surrounding the COVID-19 pandemic and government policy direction is weighing heavily on consumer and business confidence, consumption, and investment. The latest lockdown is shutting nonessential businesses across the state for at least another six weeks. This will have a significant economic effect on the state and weaken the state’s fiscal outlook. It will result in unemployment soaring and a substantial increase in the number of businesses permanently closing.
The inability to control the number of COVID-19 cases relative to other Australian states will also weigh on economic activity via domestic and international border closures and a drastic slowing of population growth. Victoria’s population has grown rapidly in recent decades, driven by international migration. The Australian Treasury has forecast the country’s migration intake will collapse by more than 80% in 2021 compared with 2019.
Despite the downturn, we expect Victoria will retain its considerable economic strength on a global scale. This remains a structural feature of the state. We view the economy as very wealthy in an international context, with a well-diversified economy. A large services sector, previously high-ranking livability, and a large infrastructure pipeline should support the state’s long-term economic outlook.
In our opinion, Victoria’s financial management practices are very strong in a global context. In response to the current pandemic fallout, the state has announced over A$9 billion in government support for the economy, including supporting businesses and jobs, improving health facilities, and infrastructure projects. The state was the first in Australia to update its 2021 funding plan to incorporate assumptions about the crisis at a time of great uncertainty. Victoria continues to display a high level of financial transparency, sophisticated debt and liquidity management, and forward-looking financial planning.
However, the implementation of base expenditure reviews, of which the state was looking to gain efficiencies and target savings to fund expenditure, have been deferred by at least six months. We believe the state’s commitment toward costs savings is important because it should alleviate some pressure on the budget that was building before the COVID-19 pandemic. This was because the government allowed operating expenses–namely employee expenses–to grow relatively fast compared with its peers. We believe these expenditures are inflexible and difficult for governments to reduce as seen with recent wage outcomes during the pandemic.
While we consider that Australia’s institutional framework is one of the strongest in the world and underpins our ratings on Victoria, there is a degree of structural imbalance between revenue powers and expenditure responsibilities. The Commonwealth government raises the bulk of revenue, while the states and territories have significant expenditure responsibilities, including in the politically sensitive areas of health and education.
We believe Victoria, along with the other Australian states and territories, does not have substantial budgetary flexibility. This is because under Australia’s institutional framework, the Commonwealth collects about 80% of government revenue and passes on a proportion of this to the states. Current transfers from the Commonwealth represent more than 40% of Victoria’s revenues and are primarily untied GST receipts, which are under pressure for soft consumption expectations.
S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.
Get in there and buy the bonds, RBA!
