Why AAA Credit Ratings Matter

Hands holding money - Australian dollar (AUD) banknotes - money raising, funding & consumerism concept

If you read or hear the same words over and over, it wouldn’t be long before they ceased to have any meaning. After surviving one of the longest election campaigns ever — and still going — I know that’s probably not going to come as news to you.

Repeat anything enough and it easily becomes a meaningless slogan. But as empty as these slogans can sound, the unfortunate thing is that it doesn’t make some of them any less real. Yes, some slogans are pure drivel. But others underline an issue that affects everybody.

One phrase that has become another slogan is ‘debt and deficit’. Even typing those words is enough to cringe, as though they’re part of just another election soundbite. The problem is, though, that whoever is able to form government, it’s the one issue that’s not going to go away.

Debt and deficit are inextricably linked — the only way to fund a budget deficit is by borrowing money. While a lot of economic rhetoric gets lost in theory and jargon, the money raised, and paid out, by governments is very much real. Without sufficient receipts, the unfunded spending can only be financed by debt.

And if you add up the string of forecast deficits ahead — regardless of whether you look at figures provided by any of the major parties — you can quickly see that we have a lot more borrowing ahead. That’s pretty clear. But much less clear is how any government is going to stem the flow, particularly with the make-up of the new Senate.

Credit ratings matter

As one of only 10 countries in the world with the coveted AAA rating, we are no doubt the envy of many. However, in light of the stalled election result, the three main ratings agencies — Standard & Poor’s (S&P), Moody’s and Fitch — have all come out to warn us about the impact of uncertainty, including that of prolonged deficits.

While the credit rating directly affects the cost of borrowing, it’s important to remember that it’s not something that happens very often.

If you take S&P, they’ve downgraded our rating twice since 1975. First, in 1986, and then again in 1989. Similarly, Moody’s downgraded it in 1986 (a few months earlier than S&P), and again in 1989 — also a few months prior to S&P’s change.

While the increased borrowing costs that come with a downgrade are tangible, there is also something less tangible about a downgrade. It’s proof that the economy isn’t working as we’d like.

The lack of confidence can find its way into the rest of the financial markets, as other institutions eventually pay more to fund their operations. Although Australian banks enjoy a record high deposit base — 64% of the Commonwealth Bank’s [ASX:CBA] funding comes from its customers — the rest needs to be sourced elsewhere. That is predominantly offshore, where a rating downgrade on government paper can flow into the cost of other institutions’ borrowings.

A rating downgrade is not a knockout blow. What it is, though, is another layer of cost on top of an already struggling economy.

How to get it back

After those downgrades in the 80s, it was the time it took to get the higher rating reinstated that became the real issue. From when S&P downgraded Australia’s rating to AA in October 1989, it took until May 1999 to get the AA+ back — around nine-and-a-half years. It then took until February 2003 to get back to AAA, the highest rating available.

In other words, from losing the AAA rating, it took 17 years to get it back.

If you take a look at the following graph, it shows the balance of the budget as a percentage of GDP. As you can see, above the horizontal ‘zero’ line means a budget surplus; below is a deficit.

Source: RBA and Australian Treasury
[Click to open in new window]

What is immediately apparent is that surpluses aren’t easy to achieve. There is a lot more pain below the line than the joy of the surpluses above it.

Also apparent is the years when these two upgrades took place, which I’ve circled in red. The budget was well in surplus before the ratings agencies reinstated our AAA rating.

If you look to the right side of the graph, you’ll see a vertical line that represents the 2016/17 budget position. This is where the kick-off really begins. And it brings me back to the earlier point about the Senate. The budget needs to get through both Houses of Parliament before the numbers can become real.

And of course, the bars to the right of that line are projections. It’s going to take a lot of political manoeuvring and clout to get the budget anywhere near these.

But for the real drivers of the economy — employment and wages growth — it’s the lack of certainty that will impact business confidence. Businesses will try and maintain profits by cost-cutting (not revenue growth), which will do nothing to promote employment growth.

If one of the agencies does put Australia on ‘negative watch’, it’s not a forgone conclusion that a downgrade will follow. It might take up to 18 months for this to happen. But without a meaningful cut in spending, a downgrade could become inevitable.


Matt Hibbard,
For The Daily Reckoning

Matt Hibbard

Matt Hibbard

Matt Hibbard is Port Phillip Publishing’s income specialist. While most investors focus on making money in the short term, Matt takes a different view. He’s focussed on how you can invest today to grow wealthy in 10 or 15 years’ time. You can find more of Matt’s work over at Total Income where he’s hunting down the next generation of companies that could pay you more each year than you initially invest.

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