Is AAA a curse for the Australian economy?

Exiting the AAA club - which has dwindled to just nine countries - would relieve the Australian government of its hard-fought struggle to retain the rating at any cost,  pave the way to break the political gridlock and spur investment in infrastructure projects such as roads, trains, utilities and ports.

" [Australia’s] sovereign rating. It is not an end in itself – particularly if the costs of maintaining are greater than those of losing it."
Narayanan Somasundaram, Economics & finance reporter

A clutch of economists and institutions including the International Monetary Fund are calling on the country to follow the UK and US in using infrastructure stimulus amid low borrowing costs.

Meanwhile, with currency and bond markets have already begun to price in a credit downgrade and peripheral impacts on the nation’s lenders at best minimal, the downside could be shallower than the headlines suggest.

So are we to ignore the ratings agencies, headlines and spend on infrastructure? Possibly. There is too a considerable difference between dropping from AAA to AA – which is still considered investment grade – compared with dropping from the As to the Bs.

Many government and statutory funds are explicitly prevented from investing below the A line so such a move has much more dramatic consequences than AAA to AA.

But a further complication is the sovereign rating is not just of concern to sovereigns: most investors (and the ratings agencies) layer the sovereign rating over the credit ratings of individual firms.

In all but the rarest of cases, no company can have a higher rating than the country in which it is domiciled. That hierarchy cascades.

If Australia drops from AAA, it would be expected many firms – and especially the banks which raise the most debt – would see consequent reviews.

While again some analysts argue that wouldn’t be dramatic, it would inevitably raise the cost of funding for the economy, either directly or via higher funding costs in the banking system.

An argument to wear those costs assumes a government spending burst far outweighs the pain the government may inflict on the economy - which saw its first quarterly decline since 2008 in the September quarter - in striving to maintain the sovereign rating, economists said.

Australia’s economy shrunk 0.5 percentage points in the September quarter, shocking investors and economists.

A case in point is the state of New South Wales, the fastest-growing in the country and one which has boasted business investment of 10 per cent annually for the past three years and the state with the most infrastructure investment.

There is multiple case studies of economies which came out better after the loss of the AAA in this cycle. The closest example to home is Queensland, which lost the rating in 2009 and still saw its borrowing costs drop. Internationally, the same occurred in the UK and US.

HARDLY BUOYANT

Australia’s economy, while resilient, is hardly buoyant.

“Despite our expectation that recession will be avoided and that growth will bounce back, growth is still likely to be fragile and constrained,” Shane Oliver, head of investment strategy and economics at AMP Capital said.

“In an ideal world now would be a time for some fiscal stimulus focused on infrastructure spending.”

At a more granular level, ANZ economists concur on the overall outlook but with different conditions in the different states.

“Overall economic growth remained broadly unchanged over the year to November,” Giulia Lavinia Specchia and Jo Masters in the latest ANZ Stateometer.

“In NSW, momentum continues to slow, although the rebound in the housing sector is partially offsetting the drag from a weakening labour market. Victoria’s economic growth was little changed and still above trend in November, but momentum continues to slow.

The report noted increasing commodity prices and export volumes were providing support in Australia’s mining states.

“That said, activity in Queensland and Western Australia continues to expand at well-below trend rates, with high spare capacity in the labour market weighing on the index and keeping momentum subdued,” it said.

With such an outlook, government investment in productive assets like infrastructure would be a positive – the risk being that spending may impact the budget forecast and hence the ratings agencies’ views.

S&P Global Ratings placed Australia on ‘negative outlook’ in July in response to the wafer-thin election majority for the Turnbull government. S&P felt pressing through fiscal policy moves would prove even tougher than in previous years.

Two months before the election, the Treasurer Scott Morrison estimated the budget will be balanced in 2021, a target he reaffirmed in the mid-year economic review last month.

While the government has managed to pass more than A$10 billion in savings through cuts in areas such as climate change funding, pension and family benefits, there are still opportunities to lift non-mining investment, which has struggled to emerge despite 11 rate cuts by the central bank since late 2011.

The government’s largest bet - a proposed corporate tax cut to alleviate the cost pressures on firms and push them to increase spending - is facing significant challenges and there other measures are yet to emerge.

SHRINKAGE

The September quarter shrink was one of the only four quarterly contractions in the past quarter century. A second three-month slump is unlikely – especially given an unexpectedly high trade surplus in the latest data - thanks in part to higher commodity prices. Still the economic travails are a sign for lawmakers to wake up to ensure 26 consecutive years of growth continues.

Both the International Monetary Fund and the Organisation for Economic Co-Operation and Development late last year recommended Australia should use low borrowing cost to boost infrastructure spending. That may help the country protect against a global downturn and lift economic output and revive tax receipts, they said.

The OECD estimated Australia had the capacity to increase deficits by half a percentage point of GDP and increase spending over two years on infrastructure before doubts about debt sustainability and the nation’s ability to access funding markets crept in.

A sentiment that resonates with economists including AMP's Oliver and Macquarie's James McIntyre, who say with record low government debt globally, Australia can afford to spend. Household debt at one and a quarter times of GDP is at the other end of the spectrum and it they who need to save now.

"Fiscal policy in Australia remains caught between domestic political concerns around the credit rating and the broader need for supportive macro policies," McIntyre said. "The retention of Australia’s credit rating has broadly won the day.”

“Net debt remains on track to peak below 20 per cent. In our view, a threshold for concern for Australia would be something close to 30 to 35 per cent, which is below the standard advanced economy 60 per cent threshold reflecting our larger primary production sector and linkages to China."

Still, not everyone agrees infrastructure is the answer.

ANZ’s chief economist Richard Yetsenga has warned the argument is often too simplistic.

“The current argument seems to be for a more expansionary fiscal position led by infrastructure, to try to spark a recovery at a time when the bond market is offering financing on historically ‘cheap’ terms,” he said.

“The problem is this argument only considers one side of the issue: the funding side. If the bond market is offering super-low yields, presumably it is pricing even lower nominal growth over the period ahead. It's cheaper to borrow, in other words, because the return we expect on any investment should also be lower.

“In this case there is no reason for having a particular focus on infrastructure. Better roads, public transport or logistics infrastructure are always desirable but there is no ‘gimme’ at present for why they should be a particular imperative just because rates are low.”

The same can be said for the focus on the sovereign rating. It is not an end in itself – particularly if the costs of maintaining are greater than those of losing it. The caveat being ratings agencies focus only on explicit debt levels, not on what that debt is being used for, nor its expected return over time.

Fiscal investment may still be a net positive for the economy but it wouldn’t stop a downgrade.

Narayanan Somasundaram is an economics and finance reporter formerly with Bloomberg.