Australia's AAA Emergency

MELBOURNE — Yesterday, we talked about the big picture narrative being one of rising US interest rates and a reversal of long term capital flows. The biggest casualty of this narrative is emerging markets. Capital is flowing out of their economies, putting pressure on currencies, interest rates and budgets.

Yesterday, the ratings agency Standard & Poors downgraded Brazil’s credit rating to junk status, which will put even more pressure on the beleaguered country. Big pension funds and institutional money are in most cases not allowed to hold ‘junk bonds’, and so they will have to sell out. This will increase capital outflows and put more pressure on the currency.

As the Financial Times reports:

‘Worries over the Chinese economy, a slump in commodity prices and the implications of the Federal Reserve hiking interest rates have battered EM currencies in recent weeks.

‘Brazil is in the thick of the EM squall, but its problems are exacerbated by economic and political problems, including a sizeable capital accounts deficit and the government’s struggle to stick to its austerity agenda.’

Hmmm, that all sounds familiar. Where have I heard these problems before?

What other country has a huge reliance on iron ore, has economic and political issues, a sizable current account deficit and struggles to keep the budget deficit under control?

You guessed it… Australia!

But we have an AAA credit rating. Brazil’s status is junk. Why the big difference?

Well, Australia has a few things going for it that Brazil doesn’t. For a start, we’re not in recession. Over the past two quarters Brazil suffered a 2.6% contraction in GDP. Their government debt-to-GDP ratio is nearly 60%, interest rates are around 14%, and they have a current account-to-GDP ratio of 4.17%. In addition, Brazil suffers from capital outflows.

In case you’re wondering, none of this is very good.

Australia on the other hand has a government debt-to-GDP ratio of 28.6% (sourced from trading economics) and low official interest rates of 2%. But based on our latest current account deficit blow out of nearly $20 billion for the June quarter, our current account-to-GDP ratio is a hefty 4.76%.

The difference is that we have foreign capital coming into the country to finance the deficit. Brazil suffers from outflows…which is why its currency, the real, is plummeting and interest rates are so high.

One area where Australia outdoes Brazil is in gross foreign debt. This is the total amount we owe to foreigners. Australia’s gross debt level is $1.81 trillion, or around US$1.267 trillion. Brazil’s, on the other hand, is just US$340 billion.

There are clearly differences between Australia and Brazil. But what makes one country a solid, unquestioned AAA credit rating and another classified as ‘junk’.

In a word, confidence. The confidence of our creditors ensures that interest rates are low and government borrowing remains low by international standards.

The fact that our economy is keeping its head above water no doubt helps on this front. But our economy is relatively strong because low interest rates sparked a housing construction boom and household spending remains healthy. And creditor confidence helps keep interest rates low.

This is why it’s so important for Australia to avoid a recession. Recessions are bad for confidence. If we were to enter a downturn, would our creditors keep sending money our way?…enough to allow the RBA to keep cutting rates to promote whatever type of growth it can muster?

It’s an interesting question. I’m not trying to suggest that Australia will join Brazil in junk bond status anytime soon. But I am saying that our AAA credit rating is under threat. We have massive household debt combined with rising government debt levels. A recession would immediately blow out the budget deficit and put the credit ratings agencies on notice.

The AAA rating is vitally important for Australia. Our banks, the financiers of the housing boom, borrow at favourable rates because of this rating.

Recently, I spoke to a mate who works for a Chinese real estate development company. He told me that part of the reason for the large Chinese capital flows into Australia was to take advantage of the AAA rating. That is, buy assets in an AAA rated country. Take those assets to a bank and borrow against them. The cost of doing so is much cheaper than in non-AAA rated countries, which allows investors to leverage their returns on equity.

My guess is that when Australia loses its AAA rating (not if, but when) it will have a massive impact. The RBA will have less room to manoeuvre on interest rates and our dollar will plummet. The confidence of our creditors will wane.

There are only nine other countries in the world that hold AAA ratings from the three main credit ratings agencies. All of them, except for Australia and Canada, run current account surpluses, which means they’re not relying on creditors to finance their standard of living.

I said it was a matter of when, not if, Australia loses its AAA credit rating. That’s because our politicians absolutely refuse to make any structural changes that would improve their long term finances.

The path to a budget surplus only exists in make-believe forecasts. It doesn’t exist in reality. It may take a couple more years, but Australia is on the path to lose its most powerful economic weapon…its AAA credit rating. As Vern Gowdie argues here, it’s the ‘End of Australia’.

Regards,

Greg Canavan
for The Daily Reckoning, Australia

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