Friday, 08 July, 2016
by Christopher Joye, Updated Jul 8 2016 at 1:05 PM
Australia will likely lose its prized AAA rating and, contrary to the characteristically meaningless rhetoric of the politicians responsible for this outcome, interest rates will rise up to 0.13 per cent annually. But ironically not the rates the government pays – just those used by business, personal and residential borrowers.
None of this will surprise this column’s readers. In May 2015 I argued Australia was racking up the "worst cumulative deficits in 60 years" and did "not deserve an AAA credit rating".
"Worryingly, the cumulative Commonwealth deficits since the GFC have been far deeper than the two other fiscal shocks experienced in the post-war period," I wrote. "And with Treasury consistently missing its forecasts, there can be no confidence of a path back to surplus."
A year later I reiterated the contrarian forecast that with "no credible reforms" and "losses as far as the eye can see", our "AAA credit rating must be on its last legs". "If you thought an unprecedented post-war streak of 11 years of consecutive deficits would stiffen politicians’ resolve to reform, you’d be mistaken: the budget’s underlying cash balance has actually deteriorated."
On Thursday Standard & Poor’s recycled these sentiments, placing the government’s AAA rating on "negative outlook". "Ongoing budget deficits may become incompatible … with a ‘AAA’ rating," the agency warned.
This means there’s a one in three chance S&P could cut the rating within the next two years if it judges "parliament is unlikely to legislate savings or revenue measures sufficient for the [budget] … to be in a balanced position by the early 2020s".
Important for the banks
S&P has actually truncated this traditional timeframe, signalling it may make a decision in the "next six to 12 months" as it "continue[s] to monitor … the success or otherwise of the new government’s ability to pass revenue and expenditure measures through both houses of parliament".
With so few AAA rated countries left (there are only 12, with the UK, US and Japan rated in the AA band), a downgrade will not have material consequences for either the cost of the government’s debt or our ability to source money. This is a relative game, and Australia’s bonds carry higher yields than developed market alternatives and arguably superior credit metrics.
The 1.93 per cent interest rate offered on a 10-year Aussie government bond is far more enticing than the negative (and capital-destroying) returns investors earn on equivalent Japanese and German securities, which has fuelled a strong foreign bid for Down Under debt. There’s also much more room for our rates to fall towards zero, which would furnish speculators with capital gains.
The rating agency action is, however, more important for the major banks, which S&P has likewise put on "negative outlook". Curiously it has not placed Macquarie Bank in the same camp on the basis it’s easier for the government to bail out.
Yet this logic is flawed. In any banking crisis the majors will be prioritised way ahead of the expendable millionaire’s factory, which is not systematically important: Macquarie today is just a global funds management business with a small retail and business bank tacked on.
So if the government can’t balance our books when economic growth is above-trend, the jobless rate is low and monetary policy is providing the most stimulatory rates ever, there’s a decent chance S&P downgrades Australia’s foreign currency rating to AA+ with the consequence the majors’ issuer ratings drop from AA- to A+.
Notches of support
This is because the latter will lose one of their two notches of assumed government support that improve their single "a" stand-alone ratings to AA- in what is an implicit taxpayer subsidy. (Macquarie Bank, which S&P lifts from "bbb+" to A on the presumption it’s also too big to fail, will be unaffected.)
While the majors’ senior bond ratings will fall to A+ (as we previously flagged), their subordinated bond and hybrid ratings will not shift because these securities are not notched up on the back of government support.
This is one reason why I’ve avoided investing in the major banks’ senior bonds since the last budget and feel for those who subscribed for NAB’s US$4 billion deal – the biggest ever by an Aussie bank – a day before S&P’s news.
Our regression analysis implies that a one-notch downgrade will increase the majors’ cost of funds on five-year senior bonds by 0.13 percentage points annually, which will be passed on to borrowers if the oligopolists’ competitors remain missing in action.
One rider is if the Australian Prudential Regulation Authority (APRA) continues to de-lever the major banks’ balance sheets to 15-16 times their equity in line with the regionals. I consider this likely: APRA reaffirmed this week that "Australian banks need to continue to improve their capital ratios", highlighting that their "leverage ratios", which divide equity by assets, are "still below the top quartile" of global peers.
Offset sovereign downgrade
On Thursday Morgan Stanley’s banking analyst Richard Wiles forecast that the majors have to originate another $17.5 billion-plus of "equity", which is directionally consistent with this column’s estimates and those of NAB ($15.4 billion) and CBA ($25-30 billion).
If this happens, S&P says it will upgrade the majors’ stand-alone rating credit profiles one notch, which would offset the sovereign downgrade.
While bank lobbyists would love to convince us that retaining a AA- rating is essential to Australia’s ability to import capital, this is BS.
During the GFC the banks’ funding markets shut tight despite their AA- ratings, which is why they needed government guarantees on their bonds. NAB’s chairman Ken Henry says he expects similar liquidity support in the next calamity. In the meantime APRA should let the banks’ ratings reflect their risk.
Christopher Joye is a director and shareholder in Smarter Money Investments, which manages fixed-income investment portfolios.
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