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 emerging challenges, including slower growth, elevated inflation, and declining housing prices.

The Australian economy grew at a strong pace in 2022. Output increased 4.0% in the first three quarters of the year compared to the same period one year prior. Activity was driven by consumer spending, robust private business investment, and favorable terms of trade. Labor market conditions are very tight. The unemployment rate is at its lowest level in nearly five decades, even as the participation rate reaches new highs. However, growth is set to slow due to high inflation, tighter monetary policy, and weaker global demand. The Reserve Bank of Australia (RBA) has responded to strong inflationary pressures by raising the policy rate by 300 basis points in just eight months, and additional hikes are expected this year. Housing prices are adjusting to higher borrowing costs, although DBRS Morningstar views financial stability risks as contained. The IMF forecasts GDP growth to slow from 3.7% in 2022 to 1.7% in 2023.

Some public finance metrics have deteriorated as a result of the extraordinary fiscal support provided during the COVID-19 pandemic. General government debt is estimated to have increased by 10 percentage points of GDP from 2019 to 2022. Nonetheless, 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 60% of GDP in 2024 and then gradually decline. Even with a higher level of debt and rising interest rates, debt servicing costs are projected to remain at relatively modest levels.

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 there is a sustained deterioration in fiscal policy discipline.

RATING RATIONALE

Fiscal Restraint Aims To Ease Inflationary Pressures And Support Budget Consolidation

The federal fiscal deficit is declining more quickly than previously anticipated, as elevated commodity export prices and an extraordinarily strong labor market have bolstered revenues. The government expects the underlying cash deficit this fiscal year (ends June 30) to come in at 1.5% of GDP, an improvement from the projected deficit of 3.4% of GDP in the April 2022 Pre-Election Economic and Fiscal Outlook. In addition, the government is calibrating fiscal policy in the near term so as to avoid contributing to inflationary pressures. Overall, we view the federal fiscal stance as neutral. Most of the revenue windfall in FY2022-23 and FY2023-24 is being saved, and recently announced policy measures, such as cost-of-living relief, are being targeted and offset with spending cuts elsewhere. The government expects the underlying cash deficit to widen slightly over the next two years to about 2% of GDP, due to normalizing commodity prices, higher spending on the National Disability Insurance Scheme (NDIS), and higher borrowing costs. Over the medium term, spending related to Australia’s ageing population and the energy transition could put additional pressure on fiscal accounts.

The pandemic-related recession and large fiscal response have led to higher government debt. The IMF projects that debt-to-GDP for the general government (which includes the Commonwealth, as well as state, territory and local governments) will increase from 47% in 2019 to 57% in 2022 before peaking at 60% in 2024. The ratio is then projected to gradually decline over the medium term as the fiscal adjustment advances. Although the projected cumulative increase in the debt-to-GDP ratio from 2019 to 2024 is substantial at 14 percentage points, the level of Australia’s debt is still moderate compared to other advanced economies. Debt servicing costs are also expected to remain at relatively low levels, 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.

The RBA Is Tightening Monetary Policy To Curb Elevated Inflation, Leading To An Adjustment In The Housing Market

High commodity prices, supply disruptions, and strong domestic demand have led to high and broadly based inflation. In November 2022, headline CPI increased to 7.3% (yoy). Trimmed mean inflation reached 5.6% (yoy). The recent moderation in commodity prices and improving supply chains may help ease price pressures in the coming quarters, particularly in goods-related sectors. Services inflation, however, could be more persistent, especially since services prices are more sensitive to wages and demand for labor remains very strong. In response, the RBA has increased the policy rate by 300 basis points since May 2022, thereby taking the policy rate to 3.1%. Markets expect the RBA to raise the policy rate another 50 basis points this year, which would put monetary policy in a moderately restrictive stance.

The Australian housing market is rapidly adjusting to higher rates and affordability constraints. The market heated up after the initial shock of the pandemic. Prices nationwide were up 37% in the third quarter of 2022 relative to two years prior. However, housing prices have started to adjust to sharply higher borrowing costs. Price declines are most acute in Australia’s largest cities (Sydney, Melbourne, and Brisbane), while home prices have remained relatively flat in some smaller cities. DBRS Morningstar makes a one category adjustment to the ‘Monetary Policy and Financial Stability’ building block in order to reflect risks associated with the scale and duration of the housing market adjustment.

In spite of risks to the housing sector, financial stability risks 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 is rising but still lower than the average share over the decade preceding the pandemic (2010-2019). Furthermore, a large majority of borrowers have accumulated prepayment buffers in the form of offset accounts or redraw facilities. These buffers have increased markedly since March 2022. 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.

Australia’s Medium-Term 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. Assuming immigration flows gradually return to pre-pandemic levels, Australia’s medium-term growth prospects look strong compared to other advanced economies, although slightly lower than what Australia experienced over the last 30 years. The IMF estimates potential GDP growth at about 2.3 percent.

The main external risk to the growth outlook is a sharp deceleration in China. The challenges associated with unwinding the country’s zero-COVID strategy, combined with the economic fallout of a slowing real estate sector, and the potential escalation of global trade tensions pose risks to China’s outlook. In the near term, further lockdowns and COVID-19 outbreaks in China could weaken external demand and disrupt supply chains, thereby worsening growth and inflation dynamics, including in Australia. In the event of a prolonged 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.

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 narrowed in 2022 due to strong import demand and large primary income payments abroad. DBRS Morningstar expects the current account to return to a modest deficit over the medium term. While the net foreign liability position is high (averaging 45% 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. In the May 2022 federal election, the Labor Party, led by Anthony Albanese, defeated the incumbent Liberal/National coalition. The Labor Party now holds a 77-seat majority in the House of Representatives (out of 151 seats) but needs support from the Liberal/National coalition or crossbenchers in the Senate in order to pass legislation. The Labor government’s policy key priorities include advancing climate policies to cut greenhouse gas emissions, expanding access to affordable childcare, and improving care for the elderly.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

There were no Environmental, Social, or Governance factors that had a significant or relevant effect on the credit analysis.

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-riskfactors-in-credit-ratings (17 May 2022).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments at: https://www.dbrsmorningstar.com/research/408616.

Notes:

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/401817/global-methodology-for-rating-sovereign-governments (29 August 2022). In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-andgovernance-risk-factors-in-credit-ratings (17 May 2022) in its consideration of ESG factors.

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, Reserve Bank of Australia, IMF, Australian Bureau of Statistics, BIS, IMF, World Bank/NRGI/Brookings, 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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