Australia’s AAA Rating on the Rocks

Australian debt credit

Before diving into today’s Markets and Money, I wanted to let you know about some exciting changes ahead in 2017.

Starting on Tuesday, 3 January — our first new edition following the holiday break — I will be writing for our sister publication, Money Morning. Along with co-editor Sam Volkering, I’ll continue to call it like I see it, bringing you all of the latest news and investment insights you’ve come to expect. You’ll also notice that I will focus more on the markets and individual Aussie stocks next year, and less so on macroeconomics.

That means you will no longer see me leading off here at Markets and Money. Don’t worry, though. We’ve got a great editor lined up to fill my shoes here.

To follow me at Money Morning, you can simply click here. We’ll take care of the rest. I hope to see you over at Money Morning in the new year.

With that out of the way, we move on to market news.

Aussie stocks are set for a flat start to kick off the week, following on from Friday’s trading session in the US. Thanks to a pullback in the US dollar, oil prices jumped a couple of percent, while gold put in a lacklustre bounce.

But the focus today won’t be on the market as much as it will be on the government. Today sees the release of the government’s ‘mid-year economic and fiscal outlook’, which is basically an update on the budget position.

While not expected to contain much in the way of new information, it will be an excuse to continue the debate about whether Australia can maintain its AAA credit rating.

The ratings agencies have previously told the government that, unless they get the budget back on a credible path to surplus, they can expect to lose the coveted AAA rating.

According to the Financial Review, that doesn’t look like it’s happening…

The government signalled on Sunday that Australians should expect weak wages growth and a softening economy will cause a fresh deterioration in the budget outlook, which some analysts have said could reach as much as $18 billion over four years.

While the deficit for 2016–17 is expected to come in around $37 billion, as forecast in the May budget, economists and the government said a crunch in profit growth and shortfalls in income tax revenues means there will be further writedowns. These are expected to overwhelm any benefits from higher commodity prices over the last six month.

“What we have also said is that the recent increases in commodity prices are not enough to offset the effect of lower wage inflation in particular on income tax receipts and the lower growth in company profits more generally,” Finance Minister Mathias Cormann said.

This is surprising. Commodity prices — and iron ore prices in particular — have done very well this year. Higher commodity prices means a higher terms of trade, which is good for government revenues.

But the government is saying that this is not enough. Because of low wages growth, the government isn’t benefitting from higher income taxes. And because spending increases are ‘baked into the cake’, the boost from higher commodity prices isn’t enough to cover the higher spending bill.

That in itself will be a concern for the credit rating agencies. As I’ve pointed out here many times before, the problem with Australia’s spending is that it is locked in; it also increases year on year.

For example, welfare spending accounts for around 40% of all government spending. That compares to around 18.5% on healthcare spending, and around 8.7% on both defence and education spending.

I support the existence of a welfare state. A wealthy nation should have a system that supports those on the margins.

But the targets for welfare reforms are usually the unemployed and those on a disability pension. Yet these two welfare payments represent 7.8% and 2.9% of government spending respectively.

On the other hand, the age pension accounts for 16% of total government spending, which is only just below the nation’s healthcare bill.

Spending on pensions (and other welfare benefits) is indexed. It goes up each year, regardless of the government’s revenues. This is the issue with the budget. Spending goes up each year, whereas revenues simply don’t increase as much. And when that happens, the budget blows out.

Regarding the age pension, once again, I have no problem with a society providing for retired workers. But Australia’s demographics suggest that this will be a continuing problem as the population ages. It means that more taxpaying workers will be required to support our ageing society.

That means reform is inevitable. It makes no sense to make full pension payments to retirees sitting on multi-million-dollar properties.

It might make sense to the recipient, but it doesn’t make sense for the nation.

Australia spends more on the age pension than it does on educating our youth. This doesn’t make sense, either. We need to spend more on genuinely long-term productivity-enhancing programs like education, and less on age pension payments.

Again, I’m not suggesting cutting payments for those in need. I’m suggesting including the family home in the pension assets test where the value exceeds a certain level. The use of reverse mortgages, or something similar, could easily provide access to equity in the home, so cash flow wouldn’t be a problem in the event that the age pension faced cuts or outright termination.

This will not be a popular measure. Which is why the government won’t suggest it. It will hit the Liberal supporter base.

And it’s not necessarily popular with you, either. When I’ve suggested tackling welfare payments previously, I’ve received responses saying that ‘I’m off track,’ and that ‘the government should take on tax-avoiding multi-nationals instead’.

That’s fine; they should. But doing so isn’t going to make a huge difference to the budget. The budget needs genuine reform — not tinkering around the edges.

But tinker is all governments have done for years now. This tinkering — and lack of real action — has got us to where we are now…at risk of losing our AAA credit rating.

But this might not be as big a deal as the media is beating it up to be. Tomorrow, I’ll discuss what the potential loss of our AAA credit rating means for both interest rates and the Aussie dollar.

One final thing before I leave you today: As I mentioned earlier, this will be my last week at the helm of the Markets and Money. As of next year, I’m moving over to our sister publication, Money Morning. Like the Markets and Money, it’s a free daily publication. If you want to follow me over at Money Morning, please do. You can sign up here.

Regards,

Greg Canavan,
For Markets and Money

PS: Our colleague Callum Newman recently interviewed former News Corporation and Fairfax journalist Michael West.

You can hear the interview on Callum’s podcast, The Newman Show. As Callum told me, West talks about how newspapers are dead, business journalism is a joke in Australia, and no one takes on big end of town.

It’s sure to be an interesting episode.

To subscribe via iTunes, go here.

To subscribe via Stitcher, go here.

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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