What happens when Australia loses the AAA?

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Speculation is mounting that S&P will strip Australia’s AAA rating. To my mind, this throws up a strange paradox.

One on hand, what is the point of S&P if it does not? Australia’s fiscal outlook has thrown out the medium and long-term commitment to surpluses which constitute a key plank of AAA.

On the other hand, who cares? Ratings have never been less relevant as the age of MMT gets underway. 

So, for me, the fate of the AAA is largely an academic discussion anyway. Enjoy it. Westpac with the note:

• Australia’s AAA S&P sovereign rating has come under renewed surveillance since last week’s Federal Budget. The central concern is the fact that the budget pays little heed to post-pandemic fiscal repair, but rather is a big spending budget aimed at generating accelerated economic growth and employment outcomes. The resultant rise in the forward debt profile is the predominant focal point, with Net Debt as a % of GDP rising throughout the 4 years of estimates and projections, peaking at 40.9% in FY2025. Despite the welcome windfall that has improved this year’s bottom line by $161bn, from FY2023, the government is forecasting larger deficits than previously, with no surplus in sight. That has led some commentators to argue that this is a breach of the Charter of Budget Honesty which commits governments to “achieving budget surpluses, on average, over the economic cycle”. It will also be a major negative from S&P’s perspective.

• In the following pages, we outline the S&P methodology as a starting point in assessing what is crucial to the ratings outlook. Having established what the S&P methodology is, and Australia’s starting point within them, we can then more clearly assess potential ratings actions. In summary, our current thoughts are:

– Debt Burden: When assessing this aspect of the rating, it is important to note that S&P had actually improved its score for this metric from a 3 following last October’s Budget to a 2 as at the end of March 2021 (refer page 9). That would have been an acknowledgement of the aforementioned rapid improvement in this year’s deficit. However, the threshold to maintain a score of 2 is GG Net Debt as % of GDP of 30-60% and GG Interest Expenditure as % of Revenues between 5-10% on average over the current and next 2 or 3 years. From the Budge, we can calculate these ratios as 35.75% and 3.97% respectively. On those numbers, the current score of 2 remains in place. So, while the market tends to focus strongly on the debt piece, it is not likely to be the large swing variable, on purely quantitative metrics, that might at first glance be the case. And given the fact it is combined with Fiscal Performance & Flexibility within the overall Fiscal Assessment, it has less impact on the overall score than might be assumed.

– Fiscal Performance & Flexibility: This metric looks at the average change in GG Net debt as % of GDP over the current and the next 2 or 3 forecast years. The score from the budget is 3.93%, so that would imply a score of 3 for this measure. That would be the worst case scenario, however, as there is some scope for uplift given the governments large liquid asset holdings and ability to increase its revenues quickly. Even so, this is the main risk to the Fiscal Assessment. If it has no uplift, then, averaging with Debt Burden would put the score for this assessment at 2.5 and push the overall Flexibility & Performance Profile to 2.8 which is cusp AA+ (refer page 8). While that may sound ominous, as a comparison, after the October Budget this score was a 3, definitely in the AA+ range. So there has been some improvement!

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How? It is down to an improved External Assessment:

– External Assessment: Historically, S&P has assigned the worst possible score of 6 to this factor. The weak External Assessment has been due to Australia’s historical dependence on global funding to compensate for a deficit of domestic savings relative to investment opportunities. While this remains the greatest source of vulnerability for Australia’s sovereign credit rating, it has certainly lessened recently, as the current account has moved significantly into surplus and maintained that surplus over a number of years. As a result, the score from S&P on this factor has improved from 6 to 5. That provides some buffer against the deterioration in the Fiscal Assessment.

– Political Fiscal Rectitude or “Will”: We think this can be the swing variable in the consideration as to whether or not the AAA rating is lost. In July 2016, when S&P first put Australia’s sovereign rating on “negative outlook”, the main reason was that Australia had been slow to return to budget surplus. It was seen as a “shot across the bough” to politicians struggling to improve the budget balance. The politicians were seen to get their act together and the situation had improved sufficiently by September 2018 for the outlook to move back to “stable”. However, the impact and response to COVID-19 saw a return to a “negative outlook” in April 2020. That implies a one in three chance of a notch downgrade over the 2 years following the shift. At the time, S&Ps rationale was around the “substantial deterioration of the government’s fiscal headroom”, however they also expected the deterioration to be “temporary” and commented that it does “not represent a structural weakening of fiscal performance.”

Whether that is still their view will be key to whether or not they act on the “negative outlook”.

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– S&P have previously stated that “there is strong bipartisan support within parliament to achieve sound fiscal outcomes during the economic cycle…We believe Australia is more willing than its peers to raise revenue to achieve budget outcomes.” Again, they may no longer share that view. So that certainly makes it hard to argue that there will be sufficient improvement to avert a downgrade within the timeframe of the negative outlook assessment.

– Conclusion: So far, we have highlighted some of the quantifiable aspects of S&Ps ratings methodology. In so doing, we have noted that the indicative rating is actually slightly improved relative to last October’s update, due to an improved External Assessment. Whether that is sufficient to stave off a downgrade will once again come down to S&Ps subjective assessments with regard the factors in their credit rating framework and their own forecasts relative to the government’s budgeted position.

– In the end, we think that the biggest influence on whether or not S&P choose to shift their rating will come down to whether they are confident that the current political considerations around fiscal repair are appropriate. If they were to take a similar stance to previous years, then a downgrade would be almost certain. However the postpandemic world is a different place. And focusing on achieving budget surpluses on too tight a time frame would, in our view, be counter-productive to the ultimate creditworthiness of the sovereign and the aim of the debt rating.

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– There are some significant positives to consider that in our view, should stave off any immediate move to downgrade the sovereign rating:

• First, by exhibiting the flexibility, resilience and institutional processes necessary to offer a targeted stimulus, maintain social cohesion and underpin the health and job security of its citizens, the sovereign has demonstrated some of its strengths over the past year.
• In addition, in the same way that the current fiscal year has had a significant windfall relative to expectations, there are some reasonable expectations that a similar outcome is possible in future years. Foremost to these is the built-in benefit if the Iron Ore price were to remain significantly above US$55/t throughout the coming fiscal year.
• Also, the government is making a concerted effort to generate jobs and maintain strong economic outcomes via a stimulatory budget. Should they achieve those goals, then some of the deterioration in the fiscal performance as currently projected will not become the reality. An early use of policies to reduce debt would have been at the expense of allowing the economy to operate at its potential. Any return to sustained full employment would see significant budget repair, although the public sector is still likely to cycle around much higher debt ratios than we saw before the advent of COVID.
• Global comparisons matter, and debt metrics have deteriorated by a greater extent in other developed economies and their own debt ratios are also unlikely to return to pre COVID levels any time soon.

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.