15 Sep 2016

Maintaining our AAA status is of utmost importance

The following op-ed was published in the Australian Financial Review on Thursday 15 September, 2016.

Since the election, much has been written about whether Australia can maintain its AAA status, what it might mean if it is lost, and how important it is to maintain it.

Clearly there are concerns about both the “politics of reform” and the fiscal outlook.

By global standards, Australia’s economy is performing as a true AAA economy. However, because our savings pool falls short of the investments we make in the likes of housing and business, Australia’s households and businesses rely on foreign savings to fund part of our growth.

This makes Australia, and its banks that facilitate the foreign funding, susceptible to disruption in global funding markets.

To offset the private sector shortfall, ratings agencies like to see Australia’s public sector running a strong fiscal position and balance sheet.

While public sector net debt generally remains low, recent attempts to rein in the deficit have been frustratingly unsuccessful. And that clearly has weighed on the patience of rating agencies. And now the “politics” are such that many worry about whether any progress will be possible over the life of the new Parliament. If Australia was to lose its AAA status, much would depend on why.

A downgrade owing to a significant slowdown in the economy is a very different scenario from one largely based on concern about budget repair and politics.

The exchange rate, and the cost/availability of funding, would be very different in these two scenarios. Traditionally, analysis of the cost of losing a sovereign rating is couched in terms of the increase in the cost of funding for the sovereign. However in a world of negative interest rates, a downgrade is unlikely to mean much for the cost of Australian bonds.

Australia, with its still strong economy, positive yields, relatively low unemployment still looks a very attractive investment to foreign investors.

And Australia is, already, a relatively high interest paying AAA. Hence the comparatively high value of the $A. Rather the mechanism in Australia’s case this time would, almost certainly, be via its flow on implications to the banking sector.

A downgrade in the sovereign rating (by say one notch) will see the banks’ ratings (given its sovereign’s implicit support) similarly downgraded. That will in the first instance increase the banks cost of offshore wholesale funding.

While estimates vary, most see a notch downgrade for the banks – from AA to A – as increasing funding costs by between 10 and 20 points.

While Australian big banks only draw around one-third of their funding from foreign wholesale markets, the result would clearly be an increase in the cost of funding – albeit a mild one. That would be separate to the impact of increased (regulatory) liquidity and capital costs which are already independently increasing costs and reducing bank profitability.

Where the real problems escalate would be a downgrade followed in time by a downturn in the local economy. In those circumstances, bank funding opportunities would shrink significantly. It is much easier to raise funds as a AA rated institution – especially in a crisis.

Some might say that “supply would be available at a price”. However, that ignores the fact that Australian banks are already large drawers on foreign funding markets – and there are limits to investors’ appetite. In short the real prospect is that in a crisis there would be a “supply” problem – not just a “price” issue.

That in turn, would see credit rationing at a time when the economy was already weakening. In many ways that was exactly what the government was trying to avoid as the global financial crisis struck.

While not forecasting another GFC, it is likely that as a AA rated country with single A banks, Australia’s finance sector would act as an accelerator of any local downturn – rather than, in the past, where it has tended to act as a moderator.

History shows that recessions involving financial stress always last longer and are more severe than “traditional demand oriented” slowdowns. Australia’s early 1990s recession hit Victoria and South Australia – both states where local financial institutions got into trouble – significantly harder than elsewhere.

The rating agencies have been more nuanced than many realise. While Moody’s has fully restored the Australian rating to AAA stable, it has left Australian banks on negative outlook.

S&P, on the other hand, still has both the sovereign and banking sectors on negative outlook. The cost of doing little on the fiscal and policy front should not be underestimated. While we do not currently see a recession looming, the risks are not zero.

Geopolitical risk is high and could quickly turn a reasonably stable outlook on its head. Nor is the Australian outlook without clouds.

In the next 12 to 18 months, we see GDP growth of around 3 per cent underpinned by LNG exports and the property. However by the end of 2018 we are expecting little more than 2 per cent growth as the impact of these special factors wane.

Once a sovereign rating is lost it traditionally takes a long time to retrieve it – in Australia’s case around 15 years. That makes now the time to support growth by more targeted long-term investment in productivity enhancing initiatives.

A move to a more credible fiscal outlook is crucial, as is enhanced structural reform. All sides of politics need to cooperate more in this endeavour to avoid unexpected – but predictable – accidents. In that context there is a case for separating out the capital account side of the public sector balance sheet from the consumption side – with the latter in surplus but more scope to run the capital account into deficit.

There has never been a better time for politically neutral infrastructure investment.

It is unlikely to get much cheaper in real terms, and by 2018 it is likely the economy will need it. Finally, unless productivity and labour supply enhancing initiatives are pursued more vigorously, there is a real risk that the natural or trend growth rate will slip from around an estimated 2.5 per cent to below 2 per cent.

That leaves less room for error for policymakers

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