Fitch retains negative outlook on Australian AAA

Via Fitch:

Fitch Ratings has affirmed Australia’s Long-Term Foreign-Currency Issuer Default Rating (IDR) at ‘AAA’ with a Negative Outlook.

KEY RATING DRIVERS

Australia’s rating reflects its strong institutions and effective policy framework, which supported nearly three decades of economic growth prior to the coronavirus pandemic and helped limit the severity of the current shock. The Negative Outlook reflects uncertainty around the medium-term debt trajectory following the significant rise in public debt/GDP caused by the response to the pandemic.

The Australian economy has weathered the pandemic well compared with peers. Fitch estimates real GDP contracted by 2.8% in 2020, against a ‘AAA’ median contraction of 3.8%. This performance reflects successful virus containment and an effective fiscal and monetary response consistent with a policy framework that has underpinned the economy’s resilience to shocks over the medium term.

We forecast the economy to expand by 3.8% in 2021 and 2.7% in 2022, driven by robust consumption as households draw down high accumulated savings from government relief measures. Policy settings are set to remain accommodative, although we project the bulk of fiscal stimulus has now passed. Risks remain tilted to the downside, reflecting the possibility of additional and broader lockdown measures to contain any resurgence of the virus. Vaccine rollout, set to begin this month, should gradually ease these risks over the year and support domestic sentiment.

The closure of international borders, which we expect to persist until late-2021, has dampened inward migration, an important growth driver. Migration should gradually recover as borders reopen, and with no serious labour market scarring anticipated, we expect potential growth to return to pre-pandemic levels by around 2023. Rising trade tensions with China have not had a significant macroeconomic effect on Australia, but this remains a risk over the medium term, given the country’s considerable export dependence on the Chinese market, at 40% of total goods and 20% of total services exports.

The government has implemented large fiscal stimulus, with about AUD251 billion (12.5% of GDP) in direct pandemic-related economic support over five years, announced since March 2020. Roughly AUD175 billion of this had already been dispersed through to December 2020, with the bulk of the spending coming through the government’s JobKeeper wage subsidy programme, which has been tapered since October and will expire in March 2021.

We estimate a general government deficit of 12.7% of GDP in the fiscal year ending June 2021 (FY21) on a government finance statistics basis, up from 7.3% in FY20; this compares with a calendar year 2020 ‘AAA’ median deficit of 4.9%. The federal government deficit will reach 9.1% of GDP under our forecasts and state deficits will widen considerably. Our deficit estimates are modestly narrower than those set forward in the government’s Mid-Year Economic and Fiscal Outlook and state budgets due to our more positive view of Australia’s strong labour-market performance and high commodity prices. We forecast the general government deficit to fall to a still-high 6.4% of GDP in FY22 (2021 ‘AAA’ median: 2.8% deficit), as the bulk of fiscal stimulus rolls off. State governments also see only gradual consolidation, as they increased planned infrastructure spending to help support the recovery.

Core to our rating assessment is the medium-term trajectory of the debt ratio; we expect general government debt to rise to 62.9% of GDP by FYE22 (2022 ‘AAA’ median: 42%), from 41.8% at FYE19, as a result of the large fiscal stimulus. Our debt dynamics forecasts show general government debt/GDP reaching the mid-60s in FY23 and turning slightly downward from FY24. The government has announced its intention to turn its fiscal objectives towards stabilising and reducing gross and net debt ratios once its target of an unemployment rate comfortably below 6.0% is achieved. The federal government has demonstrated recent fiscal prudence, but this comes in the context of a steady rise in general government debt from 21.9% of GDP when Fitch upgraded Australia to ‘AAA’ in 2011.

Australia’s labour market appears to be on a stable path to recovery, supported by the JobKeeper programme and the economic rebound. The unemployment rate fell to 6.4% in January 2021, from a peak of 7.5% in July 2020, and the participation rate has returned to pre-pandemic levels. The expiration of JobKeeper at the end of March could temporarily pause the ongoing labour-market recovery, but we forecast the positive momentum to persist, with unemployment averaging 6.2% in 2021 and 5.6% in 2022.

Australia’s current account swung into surplus in the past two years, reaching 2.5% of GDP in 2020 based on our estimates (2019: 0.6%), from a persistent deficit since the 1970s,buoyed by strong commodity prices, reduced tourism imports and declining income payments. We forecast the surplus to moderate to 1.3% of GDP in 2021 as commodity prices recede, returning to a deficit of 0.3% in 2022 as the opening of international borders drives a recovery in tourism imports.

Australia has a large net external debtor position, which we estimate reached about 59.0% of GDP in 2020, against a ‘AAA’ median 18.2% net creditor position. However, Australia’s exposure to external financing risk from a sharp shift in capital flows appears low, particularly as banks have reduced their reliance on short-term external funding since the 2007-2008 global financial crisis. This was demonstrated by their limited liquidity pressure during the 2020 market volatility. Superannuation funds have accumulated equity holdings abroad, which also contributes to the broader improvement in Australia’s net international investment position.

Household debt, at 180% of disposable income at September 2020, is among the highest of ‘AAA’ rated sovereigns and remains an economic and financial stability risk in the event of a sustained labour market or interest rate shock. However, most mortgage holders have exited pandemic-related loan deferral programmes offered by banks, with only 2% remaining in deferral as of end-2020, from a peak of 11%. Households also further built up mortgage offset and redraw accounts during 2020, helping mitigate risks. Sustained low interest rates improve debt-servicing capacity, but could exert upward pressure on house prices and debt levels.

Australia’s banking system, which scores ‘a’ on Fitch‘s Banking System Indicator, is well positioned to manage the current shock, with modest asset-quality deterioration to date due to government-support measures for households and businesses. Business insolvencies are at historic lows, but are likely to rise slightly as fiscal support measures are withdrawn. Capitalisation buffers are sufficient for banks’ current rating levels. Sound prudential regulation and stronger underwriting standards improved the resilience of bank balance sheets entering into the shock.

ESG – Governance: Australia has an ESG Relevance Score 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) have in our proprietary Sovereign Rating Model. Australia has a high WBGI ranking at 93.4, reflecting its long record of stable and peaceful political transitions, established rights for participation in the political process, strong institutional capacity, effective rule of law and a low level of corruption.

RATING SENSITIVITIES

The main factors that could, individually or collectively, lead to negative rating action/downgrade are:

– Public Finances: Failure to put general government debt/GDP on a stable or downward trajectory over the medium term; for instance, from an absence of a sufficient post-pandemic fiscal consolidation strategy.

– Macro: 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.

The main factors that could, individually or collectively, lead to positive rating action/upgrade:

– Public Finances: Confidence that debt/GDP will be stabilised or placed on a downward trend over the medium term.

– Macro: Evidence that policy measures have helped keep medium-term growth potential relatively unchanged following the pandemic shock.

SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)

Fitch‘s proprietary SRM assigns Australia a score equivalent to a rating of ‘AA+’ on the Long-Term Foreign-Currency IDR scale.

Fitch‘s sovereign rating committee adjusted the output from the SRM to arrive at the final Long-Term Foreign-Currency IDR by applying its QO, relative to SRM data and output, as follows:

– Macroeconomic: +1 notch. We have introduced a positive notch adjustment to offset the deterioration in the SRM output from the GDP volatility and growth variables, which reflect a substantial and unprecedented exogenous shock that has hit the majority of sovereigns. We believe that Australia has the capacity to absorb the pandemic shock without lasting effects on its long-term macroeconomic stability and that the shock, which we believe will be temporary, would otherwise add excess volatility to the rating.

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 Long-Term Foreign-Currency 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 or not fully reflected in the SRM.

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit [https://www.fitchratings.com/site/re/10111579].

KEY ASSUMPTIONS

– The global economy performs in line with Fitch‘s Global Economic Outlook – December 2020 at www.fitchratings.com/site/re/10145707

– Fitch forecasts an average iron ore price of USD75/tonne in 2021 and USD70 in 2022 (62% Fe CFR China reference).

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG CONSIDERATIONS

Australia has an ESG Relevance Score of ‘5’ for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch‘s SRM and are therefore highly relevant to the rating and a key rating driver with a high weight.

Australia has an ESG Relevance Score of ‘5’ for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in Fitch‘s SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight.

Australia has an ESG Relevance Score of ‘4’ for Human Rights and Political Freedoms as the Voice and Accountability pillar of the World Bank Governance Indicators is relevant to the rating and is a rating driver.

Australia has an ESG Relevance Score of ‘4’ for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver for Australia, as for all sovereigns.

Not that it remotely matters anymore in the age of QE.

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