DBRS Confirms Australia at AAA, Stable Trend

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

The rating confirmation reflects Australia’s strong credit fundamentals amid an improving economic outlook. Spare capacity in the Australian economy is diminishing as output growth gradually picks ups. Accommodative monetary policy and greater public spending on infrastructure are buoying domestic demand. Labor market conditions are slowly tightening. Business investment is firming up. In addition, strengthening global demand and increasing LNG production are supporting export growth. The economy is set to expand 2.9% in 2018 and 3.1% in 2019. Despite the steady growth outlook, household debt continues to rise and remains a source of concern.

The AAA ratings are underpinned by several credit strengths. The Australian economy is diversified, competitive, and highly productive. Public finances are characterized by low levels of debt and substantial financing flexibility. Sound macroeconomic policies enhance the economy’s resilience to adverse shocks. In addition, Australia benefits from highly effective governing institutions and a stable political environment.

Notwithstanding these strengths, Australia faces domestic and external challenges. The key domestic vulnerability is the high and rising level of household debt, which leaves the economy susceptible to income and interest rate shocks. On the external front, a sharp deceleration in China would likely have large negative implications for Australia’s growth outlook, primarily by weakening the terms of trade and reducing demand for service exports.

STRONG GOVERNMENT BALANCE SHEET AND PRUDENT FISCAL MANAGEMENT

Australia’s credit profile benefits from low public debt and a track record of conservative fiscal management. Gross general government debt amounted to 43% of GDP in 2017, a level that compares favorably to most other AAA-rated sovereigns. Public debt ratios are expected to peak this year and then gradually decline as the fiscal adjustment advances and the output gap closes.

Fiscal consolidation is proceeding gradually and on schedule. The federal deficit narrowed to 1.9% of GDP in FY2016-17 (based on the underlying cash balance). The plan calls for the gap to fall to 1.3% in FY2017-18 and return to surplus by FY2020-2021. Consolidation will be partly driven by strengthening cyclical conditions, but structural measures will also support the improvement. The government will likely reaffirm its fiscal strategy when it announces the FY2018-19 Budget in May. DBRS views the commitment to fiscal consolidation positively. Nevertheless, in the event of an adverse shock, Australia has ample fiscal space to provide additional support to the economy without putting stress on the AAA ratings.

AUSTRALIA’S ECONOMIC FUNDAMENTALS ARE SOUND

The Australian economy has outperformed most of its peers for the last two and a half decades. Structural reforms in the 1980s and 1990s helped set the stage for a prolonged period of strong economic growth. From the 2000s, Australia also benefited from rapid growth in China, which drove up global commodity prices and led to a decade-long investment boom. Although growth recently slowed in the wake of a large terms of trade shock, the Australian economy has shown remarkable resilience. From 2013 to 2016, the economy expanded at a compound annual rate of 2.5%, even as capital and labor resources shifted from mining to other sectors of the economy.

The main external risk to the growth outlook is a sharp deceleration in China. As the Chinese economy continues to rebalance toward more consumption-led growth, risks related to rising corporate debt are rising. In the unlikely event of a negative growth shock in China, Australia would principally be affected through the terms of trade channel. Metals, coal, and fuel products account for roughly 60% of Australia’s goods exports, and therefore are exposed to price fluctuations. Spillovers could extend to Australia’s services sector, particularly tourism, education, and healthcare, where China is an increasingly important source of demand.

Exchange rate flexibility has facilitated the economy’s adjustment to weaker terms of trade. The real effective exchange rate depreciated 19% from 2012 to 2015. This led to expenditure switching and improved export competitiveness. The current account deficit narrowed to 1.6% of GDP in the third quarter of 2017. The net international liability position remains stable at 50-60% of GDP, partly reflecting the reliance of Australian banks on external funding. Despite this relatively large net liability position, risks to balance sheets stemming from currency volatility appear limited due to the currency composition of external assets and liabilities as well as natural and financial hedging.

MONETARY STIMULUS SUPPORTS CYCLICAL RECOVERY AMID GROWING FINANCIAL IMBALANCES

Expansionary monetary policy is supporting economic activity amid weak inflation pressures. The Reserve Bank of Australia has left the policy rate unchanged at 1.5% since August 2016 and has not signaled any intention of tightening in the near term, unlike monetary authorities in some other advanced economies. Headline inflation came in at 1.9% in 2017, slightly below the RBA’s target range of 2-3%. Subdued inflation reflects spare capacity in the economy as well as increased competition in sectors such as retail. Inflation is expected to gradually pick up this year as demand conditions strengthen. Market-based measures of inflation expectations are in the middle to low end of the target range.

While monetary stimulus is helping achieve price stability, it is also contributing to the buildup of financial imbalances. National housing prices have been rising at a rapid rate since 2012 on the back of supply constraints, population growth, and low interest rates. Rising home prices have coincided with rising mortgage debt. The share of household debt to disposable income increased from 171% in 2012 to 210% in September 2017. Although aggregate household leverage (debt as a share of net wealth) has not increased over this period and low mortgage rates continue to support affordability, the high level of household debt creates economic vulnerabilities. In particular, high indebtedness could amplify income and interest rate shocks on the real economy by forcing borrowers, particularly those with limited savings, to cut back on consumption.

Financial stability risks stemming from the mortgage market, however, appear contained for now. The regulators have introduced measures to slow mortgage credit growth, particularly in riskier segments of the market, and bolster bank resilience to shocks. The Australian banking system is well-capitalized with excellent asset quality. Strong domestic franchises and efficient cost structures generate consistently robust profitability. Moreover, banks have improved their funding profiles since 2008 by shifting from wholesale to more deposit funding.

INSTITUTIONAL QUALITY IS STRONG

Australia’s political environment is a fundamental strength of the sovereign credit profile. Australia is a stable liberal democracy with effective public institutions. The country is characterized by strong rule of law, a sound regulatory environment, and low levels of corruption. According to the World Bank’s Worldwide Governance Indicators, Australia ranks highly compared to other advanced economies in most areas of governance.

RATING DRIVERS

The Stable trend reflects DBRS’s view that Australia has a high capacity to absorb shocks and cope with pending challenges. However, the ratings could experience downward pressure over the medium term if a large shock were to substantially weaken growth prospects and fiscal outcomes, thereby resulting in a sustained deterioration in public debt dynamics.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the AAA to AA (high) range. The main points discussed during the Rating Committee included: recent housing market dynamics, risks stemming from high household debt, and Australia’s linkages with China and the risks associated.

KEY INDICATORS

Fiscal Balance (% GDP): -2.7% (2016); -2.2% (2017F); -1.8% (2018F)
Gross Debt (% GDP): 41.0% (2016); 42.6% (2017F); 43.4% (2018F)
Nominal GDP (USD billions): 1,262 (2016); 1,390 (2017F); 1,482 (2018F)
GDP per capita (USD thousands): 51.7 (2016); 56.1 (2017F); 58.9 (2018F)
Real GDP growth (%): 2.6% (2016); 2.2% (2017F); 2.9% (2018F)
Consumer Price Inflation (%, eop): 1.4% (2016); 1.9% (2017F); 2.3% (2018F)
Domestic credit (% GDP): 203.7% (2016); 199.2% (June 2017)
Current Account (% GDP): -2.9% (2016); -1.9% (2017F); -2.5% (2018F)
International Investment Position (% GDP): -57.5% (2016); -53.8% (September 2017)
Gross External Debt (% GDP): 113.0% (2016); 106.5% (September 2017)
Governance Indicator (percentile rank): 93.9 (2016)
Human Development Index: 0.94 (2015)

Notes:
All figures are in Australian dollars 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. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include the 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 considers the information available to it for the purposes of providing this rating to be 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 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.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Michael Heydt, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Co-Head of Sovereign Ratings – Global Sovereign Ratings
Initial Rating Date: July 31, 2014
Last Rating Date: March 31, 2017

Information regarding DBRS ratings, including definitions, policies and methodologies, is available on www.dbrs.com.