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

The AAA rating reflects Australia’s diversified and highly productive economy, strong public sector balance sheet, and highly effective governing institutions. In 2019, the Australian economy lost momentum due to weaker growth in household consumption and a downturn in residential investment. Extreme drought conditions and the ongoing bushfires also contributed to the slowdown. Nevertheless, the labor market has demonstrated resilience, with robust job growth and an unemployment rate near 5 percent. Domestic demand growth is expected to gradually accelerate on the back of income tax rebates, expansionary monetary policy, and a stabilizing housing market. The economy is projected to expand 2.3% in 2020 and 2.6% in 2021.

Although DBRS Morningstar sees limited near-term risks to Australia’s ratings, risks to the economic outlook are skewed to the downside. 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. Key domestic vulnerabilities include high household debt and elevated housing prices. High debt could amplify income or interest rate shocks by forcing some borrowers to pull back on consumption and investment. A large correction in the housing prices could generate adverse wealth effects and thereby dampen domestic demand. In addition, the bushfires could act as a drag on near-term growth by damaging tourism and agriculture prospects and dampening consumer confidence.

RATING DRIVERS

The Stable trend reflects DBRS Morningstar’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 RATIONALE

Strong Public Finances Support The AAA Ratings

Australia has low public debt and a track record of conservative fiscal management. Public debt has increased substantially over the last decade, but the current level is still moderate compared to other highly-rated countries. Gross general government debt in 2019 is estimated at 42% of GDP. The ratio is expected to remain stable in 2020 and then gradually decline over the medium term amid robust fiscal results, moderate economic growth, and low interest rates.

The Australian government is in a strong position to deliver fiscal support the economy, if needed. The federal budget (based on the underlying cash balance) was balanced in FY2018-19 and is expected to reach a surplus of 0.3% of GDP this year. Some additional resources could be required to deal with the bushfires and likely reconstruction efforts, but the government anticipates modest surpluses to continue over the medium term. In DBRS Morningstar’s view, the federal government has ample fiscal space to deal with these immediate challenges and respond to other potential adverse shocks 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. The Australian economy continued to show resilience in the wake of a large terms of trade shock from 2012 to 2016. The economy expanded at a compound annual rate of 2.5% over the last six years, even as capital and labor resources shifted from mining to other sectors of the economy, especially services.

The main external risk to growth 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 pose 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 Australia’s services sector, particularly tourism, education, and healthcare, where China is an increasingly important source of demand, and potentially the local real estate market.

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 mid-2019 amid weak import demand and high iron ore prices. If iron ore prices normalize as global supplies are restored, the current account could return to a modest deficit position in the coming year. Exchange rate flexibility has helped the economy adjust to changing global conditions. The real trade-weighted exchange rate has depreciated 10% since late 2017, thereby supporting export competitiveness. 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.

Expansionary Monetary Policy Aims To Boost Growth And The Housing Market Is Recovering

The Reserve Bank of Australia is delivering expansionary monetary policy amid a negative output gap and below-target inflation. Since June 2019, the central bank has lowered the policy rate three times to 0.75% and has signaled additional easing may be needed. Headline inflation came in at 1.8% (year over year) in the fourth quarter of 2019, slightly below the RBA’s target range of 2-3 percent. Subdued inflation reflects spare capacity in the economy as well as increased competition in sectors such as retail. Inflation is expected to pick up only gradually as the output gap narrows over the next few years.

Housing market conditions stabilized in the second half of 2019 following a 12-18 month adjustment. Resale activity and housing prices are now recovering, not only in Sydney and Melbourne but also across most other capital cities. While the risk of a larger correction in prices in the near term has diminished, the pace of the recovery, if sustained, could intensify affordability concerns. Residential construction activity will likely need to pick up to satisfy rising demand, driven by a growing population, and avoid strong supply-constrained price increases.

The key domestic vulnerability is the high level of household debt. The ratio of household debt to disposable income has been relatively stable over the last two years as credit growth to households has slowed. Nevertheless, the level (186% in September 2019) is high by international and historical standards. In addition, most mortgages in Australia are variable-rate, which means that borrowers are exposed to rising interest rates. Although low rates look set to continue in the near term and most households appear well-positioned to make their debt repayments, some borrowers could be forced to pull back on consumption if rates rise quickly or the labor market weakens. The overall impact of such a scenario would likely be a more pronounced slowdown in growth.

Financial stability risks stemming from the mortgage market appear contained for now. Mortgage credit growth has slowed, particularly in riskier segments of the market. The Australian banking system is also well-capitalized with strong asset quality. Strong domestic franchises and efficient cost structures generate consistently robust profitability. Mortgage loan arrears have increased in Western Australia and the Northern Territory but remains low on a national level. Moreover, the average dynamic loan-to-value ratio for the domestic mortgage portfolio of the four major banks was around 52% as of end-FY19. The high level of collateralization provides a large buffer against a correction in housing prices.

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.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments.

Notes:
All figures are in Australian dollars (AUD) 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, which can be found on the DBRS Morningstar 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 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.

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