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 in part due to strong health and economic policy responses. Output was already 1.8% above its pre-crisis level by the second quarter of 2021. However, the economy contracted by 1.9% (q/q) in the third quarter as the Delta outbreak led to tighter restrictions in New South Wales and Victoria. High frequency activity and employment indicators point to a rapid recovery in the fourth quarter, but the recent spread of the Omicron variant now presents a headwind to the near-term outlook. New cases are rising quickly, which could impact consumer sentiment and contact-intensive sectors. Nonetheless, DBRS Morningstar expects disruptions due to the Omicron variant to be modest relative to previous outbreaks and that the economy will expand at a robust pace in 2022. Domestic demand should benefit from a strengthening labor market, households’ willingness to draw on their large stock of excess savings, and accommodative policy settings. Moreover, with 78% of the population fully vaccinated and the government shifting to a strategy of living with COVID-19, the likelihood of additional widespread lockdowns appears low. The IMF projects GDP growth of 3.5% in 2021 and 4.1% in 2022.
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 20 percentage points from 2019 to 2023. However, DBRS Morningstar views debt sustainability risks as low. The government entered the pandemic with a healthy balance sheet and a strong fiscal position. General government debt is expected to peak at 67% of GDP in 2023 and then gradually decline as the economy recovers and fiscal deficit narrows. Even with a higher level of debt, debt servicing costs remain very low.
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 there is a sustained deterioration in fiscal policy discipline.
Fiscal Accounts Set To Consolidate But Government Has Space To Provide Additional Support If Needed
Fiscal policy has continued to provide support to the economy amid the recent COVID-19 outbreaks, but policy is set to tighten over the next three years. The fiscal response to the pandemic has been large in scale. The general government deficit widened from 1.2% of GDP in FY2018-19 (the fiscal year starts July 1) to 7.6% in FY2019-20 and 9.1% in FY2020-21. Fiscal relief was largely comprised of income support and wage subsidy programs. While most of the initial pandemic-related measures were phased out by mid-2021, the Commonwealth government provided an additional A$25 billion (1.2% of GDP) in targeted support to workers and businesses adversely affected by the Delta outbreak. This was complemented by additional assistance from states and territories. As a result, the deficit will remain relatively high this fiscal year. The IMF estimates a general government deficit of 8.0% of GDP. However, as the recovery advances and risks associated with the pandemic diminish, fiscal accommodation is set to be withdrawn. The general government deficit is expected to narrow to 4.0% in FY2022-23, 3.2% in FY2023-24, and 2.6% in FY2024-25.
The large fiscal deficits combined with the recession has led to higher government debt. The IMF projects that debt-to-GDP for the general government increased from 47% in 2019 to 62% in 2021. The ratio is expected to peak at 67% in 2023 and then gradually decline. Although the cumulative 20 percentage point increase over a four-year period is substantial, the level of debt is still moderate compared to other advanced economies. Debt servicing costs are also expected to remain low, even after incorporating higher borrowing costs in the coming years. 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 RBA Is Set To Slowly Withdraw Highly Accommodative Monetary Policy As Inflation Firms Up
Trimmed mean inflation increased to 2.1% (yoy) in the third quarter of 2021. This marked the first time that underlying inflation returned to the RBA’s 2-3% target range since 2015. Yet, inflation has been more subdued in Australia so far than in many other advanced economies. This partly reflects declining electricity prices in Australia, the strong recovery in labor supply, and the country’s multi-year wage setting processes. However, inflation will likely accelerate as the labor market tightens and higher housing costs are absorbed. In this context, the RBA has maintained a highly accommodative monetary policy stance, but it is also setting the stage for a gradual withdraw of stimulus. Weekly government bond purchases were lowered in September 2021 from A$5 billion to A$4 billion (bond purchases may come to an end as early as February 2022) and the 3-year yield target was discontinued in November 2021. The RBA has stated that it does not expect to raise the policy rate until inflation is running sustainably within the 2-3% target range, which it does not expect until early 2024. However, markets are pricing in the first rate hike as early as mid-2022.
Housing prices have increased markedly in the context of low mortgage rates and strong household income growth. Residential property prices were up 22% on a year-over-year basis in the third quarter, although high frequency data points to a deceleration in recent months. The gains were greater in detached housing than apartments, partly reflecting the shifting of preferences in favor of greater space. Rising home prices have coincided with rising mortgage credit growth. If sustained at high rates, the growth in housing credit could worsen financial vulnerabilities related to household indebtedness and elevated housing prices.
However, financial stability risks stemming from the mortgage market appear contained. The large Australian banks are well-capitalized with a high level of liquid assets. Strong domestic franchises consistently generate robust profitability. Housing loan arrears are at very low levels and, overall, households appear well-positioned to repay their mortgage obligations. Debt servicing costs as a share of disposable income are low, and the majority of households have accumulated prepayment buffers in the form of offset accounts or redraw facilities. These buffers have increased over the last year. Loan repayment deferrals were offered at the onset of the Delta outbreak but take-up was low. According to the RBA, less than 1% of housing loans were on deferral in August 2021. To further mitigate risks, the regulators in October 2021 increased the interest rate serviceability buffer used in assessing prospective homebuyers’ loan applications by 50 basis points to 3.0 percent.
Omicron Clouds The Near-Term Outlook 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 uncertainty about the pace of recovery in the near term, Australia’s medium-term growth prospects look strong compared to other advanced economies, assuming immigration flows gradually return to pre-pandemic levels. The IMF forecasts average GDP growth of 2.6% per year from 2023-26.
The main external risk to the medium-term growth outlook is a sharp deceleration in China. The challenges associated with the country’s zero-COVID strategy, as well as the economic fallout of a slowing real estate sector and the potential escalation of global trade tensions 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 more than 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. The one-notch adjustment from “Very Strong” to “Strong” in the Economic Structure and Performance building block reflects the risks stemming from potential regional volatility or escalating geopolitical tensions.
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. The surplus increased in 2020 and 2021 as Australia’s terms of trade improved, primary income payments declined, and services imports fell. The surplus reached 3.9% of GDP (rolling 4 quarters) in the third quarter of 2021. DBRS Morningstar expects the current account to return to a modest deficit over the medium term, as commodity export 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 (averaging 50% of GDP over the last five years), risks to balance sheets stemming from currency volatility appear relatively limited and a sizable share of foreign liabilities are in the form of equity.
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. The next Australian federal election is scheduled to take place on or before May 21st. The ruling Liberal-National coalition, led by Prime Minister Morrison, is defending a one-seat majority in the Lower House, while the opposition would need to pick up seven seats to have a majority. Regardless of who forms the next government, there is a consensus across the political spectrum on the basic pillars of macroeconomic policy.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/391018.
All figures are in Australian dollars (A$) unless otherwise noted. Public finance statistics reported on a general government basis unless specified.
The principal methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/381451/global-methodology-for-rating-sovereign-governments (July 9, 2021). Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).
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 the Australian Treasury (Mid-Year Economic and Fiscal Outlook, Budget 2021-22), Reserve Bank of Australia (Financial Stability Review, October 2021), IMF WEO (October 2021), Australian Bureau of Statistics, IMF IFS, Australian Office of Financial Management, BIS, IMF, Bloomberg, World Bank, Social Progress Imperative (Social Progress Index 2021), UNDP, Bloomberg, 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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