Election 2016 - Does Australia get downgraded?

Angus Coote

In our view its a very bad outcome for Australia. At the very moment the country needs political stability, especially with whats going on overseas, we get exactly the opposite. This turmoil will not be resolved for a week or so and the uncertainty will have an ongoing effect on business and consumer confidence, especially if it turns out that we indeed have a hung Parliament. The ratings agencies are going to hate this. They will likely come out in the next week or so to send a shot across the bow that the Sovereign will be downgraded unless there is a cohesive plan to reduce the ongoing deficit circus. With the prospects of a slim majority at best, or ahung Parliament at worst,we just do not see this happening. Australia will most likely be downgraded to AA+ after the 2017 budget is delivered. The real question is does this matter?

In a world where the reserve currency (USD) and a host of former AAA stars have been downgraded to AA+ (France, UK, NZ) we dont see this 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. There are a couple of reasons for this. Without going into too much detail the main is that Reserve Managers (Central banks, the biggest buyers of bonds globally) used to only be able to buy AAA rated bonds. But when the USA (reserve currency) was downgraded in 2011 reserve managers changed their trust deeds to be able to take AA+ paper given that the reserve currency, and biggest beneficiary of reserve allocation, had now been downgraded. Prior to this it would have been far more serious being slapped with AA+.

The second reason for bond yields falling (rallying) on a downgrade is that bond investors assume the economy will slow further and that the Central Bank (in our case RBA) would have to cut rates aggressively to take up the slack. This sees the AUD fall and bonds rally significantly.

Should the ratings agencies cut Australia to below AA+ this would pose more significant problems for funding costs. This however is (thankfully) a long way off and may never happen (hopefully).

The real issue is with the banks....

The Australian banking sector has the benefit of a AAA rated Sovereign and the implicit assumption that if things get bad the Government will step in should a problem arise (think Goverenment Guarantee in 2008). If the Sovereign gets downgraded then so too do the banks. At last count the banks are funded roughly 30% in offshore capital markets. End result is higher borrowing costs and either higher mortgage rates or lower banking margins (we're tipping the former)


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