DBRS Morningstar Confirms Australia at AAA, Stable Trend

DBRS, Inc. (DBRS Morningstar) confirmed the Commonwealth of Australia’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA. At the same time, DBRS Morningstar confirmed the Commonwealth of Australia’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

Australia’s AAA ratings are underpinned by the country’s considerable fundamental strengths, including its diversified and highly productive economy, sound macroeconomic policy frameworks, and highly effective governing institutions. The Stable trend reflects our view that Australia’s credit fundamentals remain very strong despite the economic and health fallout from the pandemic.

The Australian economy has weathered the COVID-19 shock better than most other advanced economies. This is at least in part due to strong health and economic policy responses. Notwithstanding a second wave in the state of Victoria from June to September, the country has had a comparatively low number of COVID-19 cases. National output rebounded strongly in the third quarter, even as Victoria imposed tighter restrictions. Economic momentum appears to have been sustained through the end of the year, supported by the easing of restrictions in Victoria, an improving labor market, and greater consumer confidence. The OECD expects GDP to contract by 3.8% in 2020 and then expand by 3.2% in 2021 and 3.1% in 2022. We think the economy could outperform this forecast, particularly given positive developments on the vaccine front and the high level of pent-up stimulus in the system.

However, there are also downside risks to the outlook. In the near term, economic prospects will depend in large part on the evolution of the virus: additional outbreaks or delays in vaccine distribution could impede the recovery. Escalating trade tensions with China could also have a negative impact on growth prospects. Over the medium term, there is the potential for economic scarring. The longer it takes to recover from the COVID-19 shock, the greater the risk of firm insolvencies, high unemployment, and low business investment, all of which could weaken the medium-term growth outlook.

The government has responded to the pandemic by delivering an extraordinary level of fiscal and monetary policy support. Large income transfers and low borrowing costs have mitigated the adverse effects of the shock on private sector balance sheets. Overall, we view the policy response positively. Some public finance metrics have deteriorated as a result of the support. General government debt-to-GDP is expected to increase by 29 percentage points from 2019 to 2023. However, Australia has space to provide temporary stimulus of this size while maintaining the AAA ratings. Debt servicing costs are manageable given the low interest rate environment, and the government entered the crisis in a strong fiscal position and with a healthy balance sheet. Public debt at the general government level is expected to peak at 75% of GDP in 2023 and then gradually decline as the economy recovers and fiscal stimulus measures are unwound.

RATING DRIVERS

The Stable trend reflects our view that a downgrade of the ratings is unlikely in the near term. Australia has a high capacity to absorb shocks and cope with pending challenges. However, the ratings could be downgraded over the medium term if the COVID-19 shock has much deeper and longer-lasting effects on the economy’s growth potential than currently expected, or there is a sustained deterioration in fiscal policy discipline.

RATING RATIONALE

Australia Has Space to Provide Temporary Fiscal Support While Maintaining the AAA Ratings

The government responded quickly to the COVID-19 shock with large-scale fiscal relief. The response included allowing the full operation of automatic stabilizers as well as discretionary measures. The federal fiscal position shifted from a balanced budget in FY2018-19 (the fiscal year starts July 1) to a deficit of 4.3% of GDP in FY2019-20, and is expected to reach 9.9% for FY2020-21. Fiscal relief has been largely comprised of income support and wage subsidy programs, both of which have mitigated the downturn and bolstered household balance sheets, thereby putting the economy in a stronger position to recover once the pandemic passes.

As the health outlook improves, the government aims to transition from providing pandemic-relief to delivering fiscal stimulus. The Budget 2020-21 includes income tax cuts for households, temporary tax incentives for businesses to invest and hire, and plans to bring forward planned infrastructure projects. The government says it will retain a stimulative fiscal stance until the unemployment rate falls comfortably below 6 percent, which is not expected until 2023. Once the unemployment rate has reached the threshold, the fiscal strategy will shift to gradual budgetary consolidation, with the objective of stabilizing and then lowering the debt-to-GDP ratio. In October 2020, the IMF projected that the general government deficit would increase from 10.1% of GDP in 2020 to 10.5% in 2021 and then decline to 6.2% in 2022. However, given the emerging signs of a strong recovery, we think fiscal outcomes will likely outperform these forecasts. The upside risk accounts for the one-category uplift in the “Fiscal Management and Policy” building block assessment.

The large fiscal deficit combined with the recession is leading to higher government debt. The IMF projects that debt-to-GDP for the general government will increase from 46% in 2019 to 60% in 2020 and then peak at 75% in 2023. Although the increase is substantial, the level of debt in 2023 is still moderate compared to other advanced economies. Moreover, debt servicing costs are manageable, particularly in the current environment of low interest rates. The nominal yield on 10-year government bonds averaged just 0.9% over the last 10 months. In addition, the government balance sheet is in good shape with regards to implicit liabilities. The low level of unfunded pension liabilities puts the public sector in a comparatively strong position to manage pension costs over time. This last factor accounts for the one-category uplift in the “Debt and Liquidity” building block assessment.

The Reserve Bank of Australia (RBA) Moved Aggressively to Support the Economy and Financial Markets

The RBA has responded to the COVID-19 shock with a mix of conventional and unconventional policy tools. In addition to cumulatively cutting the policy rate by 65 basis points to 0.1%, the RBA has provided forward guidance that the policy rate would not increase until inflation is running sustainability within the 2-3% target range (which is not expected for three years), established a three-year government bond yield target which is currently set at 0.1%, and announced it will purchase A$100 billion in government bonds over a six-month period in order to reduce yields at the longer end of the curve. To provide liquidity to the markets, the central bank also introduced a term funding facility, which has provided cheap three-year funding to financial institutions, and expanded repo operations. The overall policy response has been effective at lowering borrowing costs across the economy and at ensuring that financial markets are functioning smoothly.

The elevated level of underemployment in the economy will likely restrain inflation over the next few years. However, with interest rates expected to remain low, it will be important to monitor for the potential buildup of financial risks over time.

Price dynamics in the property market amid the pandemic have been mixed. In terms of commercial property, vacancy rates for retail and office spaces rose last year, particularly in city centers, as people increasingly shopped online and worked from home. On the other hand, demand for industrial space has fared comparatively well. The impact of the virus on residential markets is also differentiated, reflecting restricted mobility and shifting preferences in favor of lower density areas. Housing prices in smaller cities and suburban areas have increased over the last six months, while prices in the large cities like Sydney and Melbourne have been less buoyant or slightly declined. Looking ahead, the overall housing market will balance the supportive impulse coming from lower mortgage rates with the dampening demand effects of a soft labor market and lower immigration due to COVID-related restrictions.

Household balance sheets in aggregate have improved during the pandemic. High household indebtedness may pose a macroeconomic vulnerability in the event of a large income shock or rising interest rates. However, during the pandemic, total household disposable income actually increased in the second and third quarters as income support programs more than offset lost wages. With lower borrowing costs and reduced spending options, households built up savings and paid down debt. However, the shock has not been felt evenly across society. Although balance sheets in aggregate look better than before the crisis, workers that lost their job may experience financial distress, particularly when income transfer programs expire.

The Australian banking system has weathered the pandemic well so far and is in a strong position to support the recovery. The major banks are well-capitalized with a high level of liquid assets. The latter, combined with the provision of liquidity by the central bank, helped banks withstand financial market dislocations in the early weeks of the shock. In general, strong domestic franchises and efficient cost structures generate consistently robust profitability. In FY20, higher impairment charges driven the by economic downturn hit bank earnings, but underlying profitability was relatively resilient. Moreover, accommodative actions from the regulator have enabled the banks to provide loan payment deferrals to households and small- and medium-sized businesses impacted by the pandemic. Outstanding loans covered by payment deferrals peaked in June at A$274 billion (10.1% of household and SME loans) but declined to A$60 billion (2.3%) in November as economic conditions improved. While the full extent of the deterioration in asset quality will become more evident as income support programs wind down and loan deferral periods expire, banks have a strong earnings capacity to absorb potential credit losses.

Uncertainty About the Pace of Recovery But Post-Pandemic Growth Prospects are Comparatively Strong

The Australian economy has outperformed most of its peers in terms of growth for the last two and a half decades. The drivers of growth have been multifold. Structural reforms in the 1980s and 1990s helped set the stage for a prolonged period of expansion. From the 2000s, Australia benefited from rapid growth in China, which greatly increased demand for Australian goods and services and fostered a decade-long investment boom. Another major contributor was strong population growth, which averaged 1.6% over the 15 years preceding the Covid-19 shock. While there is considerable uncertainty about the timing and pace of recovery, Australia’s medium-term growth prospects look strong compared to other advanced economies, assuming travel restrictions are lifted and immigration flows gradually return to pre-pandemic levels. The IMF forecasts average GDP growth of 2.6% per year from 2023-25.

The main external risk to the medium-term growth outlook is a sharp deceleration in China. As the Chinese economy continues to rebalance toward consumption, the buildup of corporate debt and the escalation of global trade tensions could present risks to the outlook. In the unlikely event of a sharp slowdown in China, Australia would principally be affected through the terms of trade channel. Metals, coal, and fuel products account for roughly half of Australia’s exports, and therefore are exposed to price fluctuations. Spillovers could extend to education and tourism service exports. In addition, escalating trade tensions between Australia and China could negatively impact the outlook. China has imposed restrictions are some Australian goods, which has created material headwinds for certain sectors. However, China has not yet put tariffs on Australia’s major commodity exports, such as iron ore, which are key inputs for China’s heavy industries.

Australia’s external accounts appear broadly in line with economic fundamentals. Australia has been a perennial net importer of capital for decades, but the current account shifted to a small surplus in 2019 amid high iron ore prices and weak import demand. This trend continued in 2020. The surplus reached 1.9% of GDP (rolling 4 quarters) in the third quarter of 2020. We expect the current account to return to a modest deficit once iron ore prices normalize and import demand strengthens. Exchange rate flexibility has helped the economy adjust to changing global conditions. While the net foreign liability position is high at about 50% of GDP, risks to balance sheets stemming from currency volatility appear relatively limited and a sizable share of foreign liabilities are in the form of equity. The positive adjustment in the Balance of Payments section of the scorecard reflects these mitigating factors.

Australia’s Strong Institutional Quality Supports the AAA Rating

Australia’s political institutions are a fundamental strength of the sovereign credit profile. Australia is a stable liberal democracy with effective governing institutions. The political environment is characterized by strong rule of law, a sound regulatory environment, and low levels of corruption. In the May 2019 federal elections, the incumbent Liberal-National coalition won an outright majority in the Lower House, although it still needs cross bench support in the Senate to pass legislation.

ESG CONSIDERATIONS

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/372671.

Notes:
For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

All figures are in Australian dollars (A$) unless otherwise noted. Public finance statistics reported on a general government basis unless specified. The federal fiscal balance is reported on an underlying cash basis, which is the headline balance net advances excluding investments in financial assets for policy purposes.

The principal methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (July 27, 2020)

Generally, the conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are monitored.

The primary sources of information used for this rating include Australian Bureau of Statistics, Reserve Bank of Australia, Australian Treasury, Australian Office of Financial Management, IMF, BIS, UNDP, OECD, World Bank, and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.

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