DBRS Confirms Australia at AAA, Stable Trend

DBRS, Inc. (DBRS) confirmed the Commonwealth of Australia’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA. At the same time, DBRS 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 with substantial financing flexibility, and highly effective governing institutions. The Australian economy has largely rebalanced following the 2012-16 terms of trade shock and the output gap is closing. The unemployment rate at 5% is at its lowest level since 2011. Business investment is gradually firming up. Although the economy appears to have lost some momentum in the second half of 2018, Australia is expected to sustain moderate rates of growth in 2019 and 2020. Against this supportive economic backdrop, there are clear signs that the housing market is cooling. Housing prices in Sydney and Melbourne are declining in response to increasing housing supply, tighter lending standards, and softer demand from foreign buyers. While the rebalancing of supply and demand could dampen economic activity in the near term, it should also ease overheating concerns and improve affordability over time. Federal elections are scheduled for this year. DBRS expects sound macroeconomic policymaking to be sustained through the electoral cycle.

Although DBRS sees limited near-term risks to Australia’s ratings, risks to the economic outlook are skewed to the downside. 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. At the same time, adverse wealth effects stemming from a larger-than-expected correction in housing prices could further dampen domestic demand. 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.

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 RATIONALE

Strong Public Finances Support the AAA Ratings

Australia has low public debt and a track record of conservative fiscal management. Gross general government debt amounted to 41% of GDP in 2018. While the public debt ratio has increased substantially over the last decade, the current level is still modest compared to other highly-rated countries.

The budgetary position is also improving on the back of strong growth and tight spending control. The federal deficit narrowed to 0.5% of GDP in FY2017-18 (based on the underlying cash balance) from 1.9% the previous year. The government anticipates that the gap will fall to 0.3% FY2018-19 and then return to a surplus in FY2019-20. In addition to better fiscal results, the government is allocating significantly more resources to infrastructure investment, which should support the economy’s productive capacity over the medium term. DBRS views the commitment to fiscal sustainability positively. 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 2017, 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, 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.

Exchange rate flexibility helps the economy adjustment to changing global conditions. As Australia’s terms of trade weakened from 2012 to 2015, the real effective exchange rate depreciated 19%, which assisted in dampening imports and boosting non-commodity exports, particularly services. The current account deficit is at a moderate level. The net international liability position is high but has remained stable at 50-60% of GDP, partly reflecting the reliance of Australian banks on external funding. Despite the 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 Growth While Macroprudential Measures Aim to Contain Financial Risks

Expansionary monetary policy continues to provide support to the economy amid weak inflation pressures. The Reserve Bank of Australia has left the policy rate unchanged at 1.5% since August 2016 and has signaled a neutral bias toward any future rate changes. Headline inflation came in at 1.8% in 2018, 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 as the output gap narrows.

Although monetary policy remains accommodative, the housing market is cooling in response to tighter macroprudential measures and greater housing supply. Residential property prices in Sydney and Melbourne, which experienced rapid appreciation from 2012 to 2017, have declined over the last 12-18 months. Housing markets in other cities also appear to be cooling, albeit to a lesser extent. The price adjustment is partly driven by several years of strong residential construction activity, which is leading to greater housing supply. This should help rebalance the market and improve affordability.

The key domestic vulnerability is the high level of household debt. The ratio of household debt to disposable income increased from 173% in 2012 to 199% in September 2018. At the same time, most mortgages in Australia are variable-rate, which means that borrowers are exposed to rising interest rates. Although low rates continue to support affordability and most households appear well-positioned to manage higher rates, some borrowers could be forced to pull back on consumption if rates rise quickly. Some recent homebuyers and interest-only borrowers could even experience financial stress. The overall impact of such a scenario would likely be a more pronounced slowdown in growth.

However, 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 excellent asset quality. Strong domestic franchises and efficient cost structures generate consistently robust profitability. Not only do most households appear well-positioned to repay their mortgage obligations, but the average dynamic loan-to-value ratio for the domestic mortgage portfolio of the four major banks is around 50%. This provides a large buffer against a correction in housing prices. In addition, the Banking Royal Commission, which submitted its final report in February 2019, is not expected to have a materially adverse effect on banks’ balance sheets.

Institutional Quality is Strong

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. Moreover, there is consensus on the broad pillars of macroeconomic policy among the main political parties. With federal elections this year, DBRS expects policy continuity through the electoral cycle.

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 include 1) Australia’s near- and medium-term growth outlook, 2) developments in the housing market, and 3) the outlook for external demand.

KEY INDICATORS

Fiscal Balance (% GDP): -1.9 (2017); -1.4 (2018F); -1.1 (2019F)
Gross Debt (% GDP): 40.8 (2017); 40.5 (2018F); 40.7 (2019F)
Nominal GDP (USD billions): 1,380 (2017); 1,428 (2018F); 1,464 (2019F)
GDP per capita (USD thousands): 55.7 (2017); 56.7 (2018F); 57.2 (2019F)
Real GDP growth (%): 2.2 (2017); 3.2 (2018F); 2.8 (2019F)
Consumer Price Inflation (%, eop): 1.9 (2017); 1.8 (2018); 2.5 (2019F)
Domestic credit (% GDP): 154.6 (2017); 153.9 (Dec-2018)
Current Account (% GDP): -2.6 (2017); -2.8 (2018F); -3.1 (2019F)
International Investment Position (% GDP): -53.7 (2017); -50.2 (Sept-2018)
Gross External Debt (% GDP): 108.6 (2017); 108.5 (Dec-2018)
Governance Indicator (percentile rank): 93.4 (2017)
Human Development Index: 0.94 (2017)

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. 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 primary 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 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 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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