Wednesday 24 May 2017
AAA – safe for now
Wednesday 24 May 2017
In our January article titled “Australia’s AAA rating, going going…?” we discussed the Mid-Year Economic and Fiscal Outlook (MYEFO) and the potential implications for Australia’s sovereign rating. Following the outcomes of the May budget now is a good time to re-assess our analysis.
Broadly speaking, the latest budget has been well received by economists as it contains increased spending for infrastructure, education and healthcare as well as tax reform, generating additional revenue and plausible growth forecasts. Importantly for Australia’s AAA rating, the return to budget surplus is not only affirmed but increased.
Looking at the detail, it is clear that the strong growth in commodity prices last year has benefitted the economy and flowed through to stronger nominal GDP growth forecasts. Gross Domestic Product (GDP) growth for the 2016 calendar year was 6.1%, representing the strongest growth rate since 2011. GDP growth forecasts in the budget for the current financial year of 6%, and 4% for the following two financial years have also helped improve the deficit position by $5.9bn over that period.
In addition, new revenue raising measures are expected to contribute over $20bn over the forecast horizon. The most notable measures are a new bank levy and an increase in the Medicare levy. They are expected to contribute $6.2bn and $8.2bn respectively.
The positive development here from the perspective of the ratings agencies is that the return to surplus by the 2020/21 financial year is affirmed in the budget forecasts and actually increased. The forecast was revised up to a surplus of $7.4bn with an improvement in the deficit in 2019/20 to -$2.5bn from the MYEFO forecast of -$10bn. This should give the ratings agencies some comfort given the consistent downgrading of revenue forecasts in successive budgets since we first entered deficits around the time of the financial crisis.
Source: Australian budget paper, Commonwealth Bank of Australia
This budget appears to be a relatively friendly one in terms of the rating impact, with Moody’s immediately affirming the rating and S&P subsequently reaffirmed Australia's AAA credit rating but have retained the negative outlook. As such the government’s ability to pass the budget measures will be key as to whether the rating agency does eventually act on this outlook. Regardless, we would anticipate the impact on bond yields and currencies to be largely muted beyond a knee jerk reaction. This is due to global precedents for downgrades for countries such as the United States and the United Kingdom where bond yields are lower now than they were at time of downgrade. Furthermore, the number of countries who maintain the AAA rating has fallen to 12 in 2016, from 19 in 2010. As such, much of the global investing community have adjusted to lower ratings in their mandates meaning a downgrade is unlikely to result in forced selling.
In terms of the impact of the budget on supply for bond markets, it is marginal relative to what was presented in the MYEFO. The Australian Office of Financial Management (AOFM) have announced gross issuance for the 2017/18 financial year of $80bn, around half of this amount going to bond maturities. This compares to $92bn having been issued financial year to date, representing a reduced borrowing requirement.
*Based on forecasts for FY2017 and beyond.
The broader macro implications of this budget appear at first glance to offer a further rebalancing of the Australian economy. We would expect banks to pass on the cost of the levy to their customers. This would either be through fees or further increases in mortgage rates. This, combined with other policies around housing and new taxes for offshore buyers would be expected to slow the appreciation in house prices. Along with the Medicare levy, these measures should work to slow consumption further and its contribution to growth while infrastructure and other spending measures should work to offset this drag. At the margin we expect the budget to help tilt growth further from consumption towards capex and potentially improve productivity in the Australian economy. This would give the RBA some scope to further cut interest rates, however the bar to action on this front is high given the already elevated housing market. That combined with the supply profile should pressure interest rate curves steeper.
Overall, our initial assessment remains, that the AAA rating is likely to be retained for now but the negative outlook is unlikely to go.
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