Australia’s credit rating: Cause for concern?

The best time to lose a AAA rating

Damian Wood, Spectrum Asset Management

Spectrum sees a greater than 50% chance of at least one agency downgrading the Australian sovereign in the next 12 months.

The good news is there has never been a better time to lose a ‘AAA’ rating. Global bond investors are starving for income. Around $US10 trillion of sovereign bonds are generating negative yields. Many will be willing to look past a slight deterioration in credit strength just for a marginal pick in returns.

Longer term, though, it does pose some key risks. Firstly, the risk of a downgrade comes after 24 years without a recession. How will Australia’s ratings endure tough economic times? Spectrum’s view is not very well. More downgrades could follow if Australia’s economy contracts.

Secondly, Australia’s banks borrow around $600 billion from abroad. Many foreign bond investors take comfort that the Australian government has the will and the capacity to financially support our major banks should the need arise. The problem comes if a recession hits which is likely to coincide with a jump in bad loans. The double whammy of weakening implicit sovereign support with an increasing risk of need for that support will make that $600b more expensive to rollover. That’s the easy part for banks to handle. The real risk is that it will make it more difficult to refinance. In the worst-case scenario the banks would be at risk of a liquidity crisis.

Time to fix the plumbing

Angus Coote, Jamieson Coote Bonds

We don’t see [any potential downgrade] being a huge issue in the longer term as long as there is a resolve to fix the plumbing and improve the budget going forward…. In previous cases of downgrades (UK most recently down two notches from AAA by S&P) bonds actually rally hard. This was the case in USA, France and NZ.

Confidence is the key

Jonathan Rochford, Narrow Road Capital

What is important is that the Australian attitude to running deficits year after year with no real prospect of balancing the budget on the horizon must change. If the global economy continues to slow, or if China’s debt bubble collapses we would be in a very bad position to respond with fiscal stimulus.

In the short term a downgrade wouldn’t mean much to our economy. However, Australia is a net debtor nation and as such we remain reliant upon the confidence of global investors. If we see another financial crisis it is possible that international investors reassess our economy, particularly the exposures to property, banks and mining. Each of these sectors suffers substantially during recessions. A recession with higher unemployment and problems for these sectors could cause a loss of confidence in the ability of governments and banks to repay their debts and problems with rolling over existing debts.