21 minute read
Craig Michaels | Director, Sovereign and Public Finance, Standard and Poor’s Ratings Services
Craig Michaels
Key points:
• The Federal Government was placed on a negative AAA outlook by
Standard & Poor’s in July 2016, which means that there is about a one in three chance of a ratings downgrade over the next year or two. • Commodity prices, wages and inflation, and the political process of budget repair are downside risks for the Commonwealth Budget. • Despite risks, Australia has strong and consistent institutions that help to foster investor confidence.
I plan to give an overview of the economic landscape and, from a ratings agency perspective, how we see the Government’s fiscal environment. If I was to summarise that in one sentence, it would be that the economic environment is pretty good. The fiscal environment facing the Federal Government, in particular, is pretty weak and pretty tough.
If you’re listening to the media, you probably have a fairly downbeat view about the Australian economy, but it is actually going pretty well. Economic activity, or what economists know as GDP, is growing at quite a robust rate of 3.3 per cent over the past 12 months.
Now, when you think about the potential growth of the Australian economy, which most economists think is about 2.75 per cent, about 3.25 per cent is actually a pretty good outcome and all the more remarkable, I think, when you realise that we are still in the midst of the tremendous downturn in mining investment, which was the positive story of the economy a few years ago. Interestingly, the latest data is now starting to show very much the positive impacts on growth of the infrastructure spending that governments, particularly at state level, now have underway.
Overall, I would say that the economic transition from mining investment–led growth years ago, to nonmining growth is happening pretty well. Yes, there are some soft patches, particularly in non-mining business investment, but you would have to say that, overall, it’s happening in a pretty good fashion. And it’s further evidence to us of Australia’s resilient and flexible economy, which we think is a big plus.
The labour market, which people out in the street care more about, is also in reasonable shape. The unemployment rate is at 5.7 per cent. If you think about what’s realistically achievable, the lowest sustainable unemployment rate might be close to five per cent. There is some slack in the economy – there are some unemployed people who could be working and there are people who could be, or would like to be, working more than they are.
But the unemployment rate has clearly peaked from its high mid last year of about 6.25 per cent. Based on the current set of data and a range of indicators, it will probably edge down a little bit further from where it is now over the next six months or so. Australia has a reasonably good, if not fantastic, labour market.
But GDP is a concept, and it’s really a concept that only economists get excited about. Normal people care about incomes, I imagine. I think that’s true of individuals, it’s true of businesses, and it’s also true of governments. Despite the good economic growth that
Craig Michaels
I’ve just been describing, growth in incomes across the economy has been quite weak for quite some time. So, why the disconnect between economic growth, which is pretty robust, and income growth, which is pretty dismal, really?
Fundamentally – most of you will be very familiar with the story – it’s because the prices of the stuff we are selling to the rest of the world – mainly the iron ore that we heard about from Ben Wyatt before, and coal – the prices of those commodities have been falling very quickly since they peaked in 2011. Why is that? Largely, it’s because we’ve been producing more of the stuff.
We have been doing that, and countries like Brazil and Canada have also been doing that. So, in terms of simple supply and demand, a big boost is putting real pressure on prices.
More recently, it’s also because China’s economic growth is starting to slow down a bit, and that’s probably, more recently, what’s been putting more downward pressure on prices. That slowdown in economic growth in China has been more focused on the commodity-intensive parts of its growth story, as well as property and industrial development and infrastructure.
We’re producing stuff, but we’re selling it at much lower prices than we were yesterday. You don’t have to be a genius, or even an economist, to realise that that’s going to put downward pressure on your incomes compared to what they were before, and that’s the state of affairs that we’re in now.
Mining company profits have tanked since the heady days of 2011, and that has taken a direct hit on government revenues, as you know. It has also permeated through the economy more broadly in terms of much lower growth in wages and much weaker inflation. Both of those things also have a significant effect on government revenues because it is incomes and nominal spending – not GDP, which only economists really care about – that governments collect taxes from.
So, that gets me to the credit rating of Australia. As Brendan mentioned, we put Australia on negative outlook in July, which means that we see about a onein-three chance that we could downgrade the rating over the next year or two.
Why did we do this? The reason we did it is because we see rising risk that the Government won’t be able to achieve its current strategy of getting the Budget back to surplus, or at least balance, over the next few years. And it’s in the context of very significant slippage in the Government meeting all of its targets.
You’ll remember that, originally, the previous Labor Government predicted a surplus budget by 2013, which is now ancient history. And the current Budget projections have the Government getting back to a balanced budget by 2021. That’s eight years of fiscal slippage, and well over a decade since the global financial crisis initially pushed the Government Budget into deficit.
So, there’s a question of fiscal policy credibility here. It’s not that deficits are large or debt is high, but the question is whether the Government still has a credible fiscal path back to balance.
If you compare Australia’s government sector net debt to that of pretty much any other country, Australia does stack up very well. In absolute terms – in our view, anyway – net debt is quite low and, as I said, when you compare it to that of other countries, including AAA countries, Australia’s net debt looks pretty good. Net debt is not our ultimate concern.
Our key concern is that, while the public sector balance sheet is in quite strong shape, the economy’s overall balance sheet, with regard to the rest of the world, is actually very vulnerable. Australia’s level of external debt – debt owed to foreign investors – is extremely high and among the highest when you look at countries globally, and particularly when you compare it to other AAA countries.
Why is there such a high level of foreign debt? Basically, Australia has been borrowing from offshore since European settlement about 200 years ago. We have persistently run account deficits, and that doesn’t seem to be something that’s going to change. And that has led to a very large debt owed to offshore investors; and particularly in the 1990s and 2000s, when we had – at least on the eastern seaboard – a huge boom in house prices that was largely funded by the banks borrowing from those investors and then on-lending to households, which basically went into an unproductive boom in house prices.
So, while there has been a lot of productive investment from that offshore capital, quite a bit of it has gone into unproductive purposes, and it leaves us in a situation where the economy, and particularly the banks, have a high level of debt, a high level of exposure to foreign investors, and, still, a structural current account deficient of around three to five per cent of GDP. And so we are currently, and will possibly always be, going to be reliant on the goodwill and the
Craig Michaels
confidence of foreign investors to continue to fund our current account deficits to fund economic growth.
If that changed for some reason – and we’ve seen over the past 10 years instances where foreign investors do become very jittery about the global environment – and if, at some stage, foreigners are no longer willing to roll over our debt and fund our ongoing borrowing, then the economy will be in for a rude shock. Credit in the economy would dry up, business investment would tank, employment would slump and the Government’s Budget would be hit hard, not just by a collapse in government revenues, but also by the need to spend much more on unemployment benefits and the like.
We could also think of a really nasty scenario where banks’ asset quality collapses and the Australian Government is forced to support the banking system, on top of all of that. Now, I’m talking about what we think is a very low-probability scenario, let me make that very clear. But this is the vulnerability that we do see, given the high level of debt and ongoing reliance on foreign funding.
So, what does that mean? The bottom line for us is that we see very strong and credible public finances as being very important to help offset that external vulnerability, and to help reassure investors in the credit worthiness of Australia as an economy more broadly.
Now, if we look at the Government’s capacity to meet its own Budget targets at this point in time, and get the Budget back to balance by about 2021... if they did that, we’d be pretty comfortable, from a ratings perspective. But we do see at least three areas of risk to the Government achieving its Budget forecasts, hence the negative outlook upon the rating.
The first one is commodity prices and the impact that’s having on Western Australia’s Budget. It’s having a broadly similar effect on the Commonwealth Budget. We’re more pessimistic about the outlook for the commodity prices, particularly iron ore, than the Commonwealth was in its own Budget back in May.
Now, the commodity market is actually doing not too badly as we speak here today, but these things can change very quickly. We have upgraded our commodity prices a little bit over the past couple of weeks compared to where we had them in January. But it’s still about 10 to 15 per cent below the Government’s Budget assumption.
Why is the commodity price market improving a bit at the moment? It’s mainly because China is propping up its economy as only China can through its stimulus measures, to help keep its economic growth broadly in line with the target it has. We think the impact of that on commodity prices is only going to be temporary, and we expect commodity prices to come back down a fair bit by the end of this year and remain reasonably subdued over the next couple of years. That is clearly an important source of downward pressure on government revenues, compared to the latest set of Budget forecasts.
The second area is inflation and wages growth, which I did touch on earlier. It has been very subdued, and when you see the numbers come out each quarter both on wages and inflation, they constantly surprise on the downward side. Wages growth, which is about two per cent per annum, is the lowest it’s been. And both of those things for last financial year are a little bit weaker than what the Government assumed in its Budget projections, and we still think that there is downside risk to both of these things over the next few years. Again, that feeds directly into government revenues.
It’s not just that commodity prices have fallen and that’s feeding through to subdued wage and price pressures in the broader economy. That is true, but it’s also a global phenomenon, and I don’t think anyone’s really got a handle on what is driving this, but it is clear that inflation is very low. In fact, in central banks in many of the major economies around the world – Japan in particular – they are grappling with how to sustain positive price growth. They’re desperately trying to boost growth to ward off the destructive economic forces of outright deflation, which is something that the Japanese are very familiar with now. Even in the United States, where the economy and the labour market are much healthier than they were a few years ago, low wages and low inflation are still problematic.
The third area is the political process of budget repair. This is something that probably gets most of the headlines. Now, given the revenue issues that I just mentioned, we think that if Australia is to retain its AAA rating, the Government and Parliament would need to implement more revenue or more spending measures to improve the outlook for the budget.
Over the past couple of years, in particular, passing legislation to enact savings and revenue policies has proven very challenging, and that’s something that I don’t need to tell this audience. Even now, the Budget assumes savings that have not been passed by the Senate, that have been stuck in the Parliament, if you like, for the last couple of years. They are already baked into the assessment for the Budget, but may or
Craig Michaels
may not ever occur. This is a significant risk, from our perspective – can and will the Parliament pass more savings measures? This is something that we’ll be watching very closely over the next six to 12 months, in particular, to see what they plan and how that pans out.
I want to make the point that we are agnostic about where the ratings should be. We’re not advocating to the Government, or to anyone, that Australia should have a AAA credit rating. We’re not advocating policy measures that the Government or the Parliament should take. We are trying to simply articulate what factors we believe are consistent with Australia having a AAA credit rating.
So, that’s the doom and gloom side, but I want to end on a positive note, because we do see Australia as being very resilient. Even if we do downgrade Australia at some point – and we’re signalling that that is a significant risk – even if we do, Australia would still have a very, very high credit rating. Not the Rolls- Royce credit rating, but still very high. We think that the many factors that have helped Australia to adapt to economic shocks over the past few decades will still be there to serve the economy well.
The first is strong and predictable institutions, which help to foster confidence among local and foreign investors to invest in the economy, and that’s been very important to Australia’s economic success and leading to Australia being one of the richest economies globally. Paradoxically, it is probably a large reason why we do have such a high level of external debt, because we are seen from offshore as an attractive place to invest, in a large part, because of the strength of the institutions that we have here.
We also see the economy as having relatively flexible labour and product markets, which helps the economy to respond to economic shocks. The economy didn’t experience a blowout in inflation during the commodity boom that we have and it hasn’t – so far, at least – experienced a collapse in the economy on the downside of the investment boom. As I said at the start, economic growth is actually quite strong, really.
Australia also benefits from a free-floating currency, and has a deep liquid currency market, which also has typically acted as an economic shock absorber, and we think it will continue to do so. In fact, this was a crucial part of the reason Australia could navigate the positive economic, or incomes, boost to the terms of trade without putting undue pressure on other parts of the economy, because the high currency helped that transition. And right now, we think that it’s helping, too, with a big rise in tourism and education exports playing a significant role in filling the growth gap left by mining investment.
And finally, it’s the central bank, the Reserve Bank of Australia (RBA), that we see as having a high degree of credibility and independence. No doubt we’ll see a smooth transition to the new Governor. Even though interest rates are now down to a record low of 1.5 per cent, there is, unlike in many major economies, still some room to cut interest rates if that became necessary, even before we start to talk about what at least used to be known as unconventional monetary policy tools.
As I alluded to before, there are a lot of central banks around the world now that would look at the RBA with some envy because of its positive interest rates and room to cut them if necessary, instead of being in the midst of massive bond-buying programmes and even – I still struggle to get my head around this, to be frank – negative interest rates.
To finish, Australia is in a robust position in terms of its medium- and long-term prospects. The economy is, we think, very resilient to shocks. But in the meantime, government revenues and spending will remain in a very challenging position, at least for the next few years.
Craig Michaels is a Director in the Sovereign and Public Finance Ratings group at Standard & Poor’s Ratings Services. Based in Melbourne, Mr Michaels is the lead analyst for sovereign credit ratings on Australia, New Zealand and other Pacific countries, as well as ratings on a number of Australian and New Zealand sub-sovereign governments.
Prior to joining Standard & Poor’s, Mr Michaels was a senior economist at ANZ Banking Group, with a focus on the Australian economy and financial markets. Before this, he was a senior economist at the Victorian Treasury in Melbourne, responsible for economic and revenue forecasting, economic modelling, and providing micro-economic policy advice.
Mr Michaels holds an honours degree in chemical engineering, a Bachelor of Commerce and a Postgraduate Diploma in Economics from the University of Melbourne.
ALSTOM BRINGS GLOBAL EXPERTISE TO AUSTRALIAN RAIL EXPANSION
A strong customer focus and long-term commitment are central to its strategy.
Alstom Australia’s world-class expertise in rail systems is helping to drive this country’s rail renaissance, and is creating jobs for local communities.
The Australian operation is part of Alstom SA, a global pioneer in integrated rail solutions, and an acknowledged leader in its field. The French group operates in more than 60 countries, employs 31,000 people and had the equivalent of $15.5 billion worth of orders in 2015–16.
Alstom’s sole focus is now rail – having sold its energy business to General Electric in November 2015 – and it is best known for a comprehensive portfolio that includes record-breaking TGV high-speed trains, tilting Pendolino trains, modern Citadis trams, high-tech Metropolis metro trains and world-leading signalling technologies.
Alstom Australia’s Managing Director, Mark Coxon, says the business adapts the company’s rail expertise to this market. ‘Alstom prides itself on listening to customers, taking a local focus, and making a long-term commitment to its markets. We strive to offer the best of both worlds to customers: access to Alstom’s leadership in rail systems, with a very strong Australian focus,’ says Coxon.
Alstom’s proud Australian history dates back more than 100 years. It manufactured diesel/electric locomotives in Brisbane in the 1940s and 1950s, and acquired the Ballarat workshop in the 1990s from the Victorian Government.
Alstom has since supplied more than 500 X’trapolis rail cars to Public Transport Victoria (PTV). Its Ballarat operation has helped Victoria to develop its skills in rolling stock manufacturing, renovation and maintenance – and it has secured an important industry for the community.
Alstom was awarded a contract to supply 22 six-car Metropolis trains and communication-based train control (CBTC) signalling for Sydney Metro Northwest. This project includes Australia’s first fully automated, driverless train.
In February 2015, Alstom, as part of the ALTRAC Light Rail consortium, was awarded the contract for the Sydney CBD and South East Light Rail project. It is responsible for the integrated light rail system, which includes the design, delivery and commissioning of 60 coupled Citadis X05 trams, power supply equipment, signalling systems and 15 years of maintenance. In another Australian first, the project includes 1.2 kilometres of wirefree operations.
Alstom’s signalling capabilities were reflected in its successful supply, installation and testing of Australia’s first European Train Control System (ETCS) Level 2 signalling in New South Wales in June 2016.
Alstom is also successfully suppling, testing and commissioning its SmartLock 400 interlocking signalling system for the Melbourne and Brisbane suburban networks, and is supplying additional X’trapolis train sets for Melbourne’s suburban rail network.
National expansion is a priority. ‘Alstom is working hard to build a larger presence beyond Sydney and Melbourne as other capital cities upgrade their rail networks in coming years,’ says Coxon. ‘Australia has outstanding potential to transform its urban and regional transportation networks through rail.’
Coxon says that Alstom’s capability to deliver integrated rail systems – from high-speed trains to metros, tramways, maintenance, rail modernisation, and infrastructure and signalling solutions – is an asset. ‘Our ability to design, implement and maintain rail assets provides a wholeof-system solution. Project risk is reduced because customers are not dealing with multiple suppliers, or suppliers who outsource work. Alstom does everything inhouse and brings in specialists from its global network for projects as needed.’
Alstom’s leadership in rail technology is another key capability. ‘Clients know [that] when they use Alstom products they are accessing state-of-the-art rail technology that is being successfully implemented worldwide,’ says Coxon.
Alstom’s proven ability to transfer rail knowledge and help governments to develop local rail industries is another strength. An Alstom joint venture company in South Africa developed a new manufacturing operation there to supply 600 trains, sourced from 65 per cent local content. Similar investments have been undertaken in India and Brazil.
Alstom’s deep experience in large public-private partnerships (PPPs) also benefits customers, says Coxon.
To learn more about Alstom Australia, visit www.alstom.com.au/australia.
TOP GUNS ON TRACK IN RAIL
Nova Systems, a cutting-edge Australia-based technical consultancy company founded in the aviation, space and defence sectors, is now building an impressive track record in rail.
All industries are unique, but each share a common desire to embrace new approaches that will make us more competitive and successful. Existing technologies that have been proven in other sectors can really deliver improvements. Nova Systems has built its 16-year engineering brand around integrating and tailoring these technologies into existing businesses and operations.
By drawing upon its extensive experience of autonomous systems, big data analytics, communications, test and evaluation, complex systems integration, and systems and safety assurance, Nova Systems is ideally placed to provide innovative solutions for the challenges facing the rail sector as it advances towards fully connected, intelligent transportation systems (C-ITS) that interface with increasingly complex and autonomous rail vehicles.
With constantly growing populations, the global rail market is under increasing pressure to reduce congestion and cost of rail, while also improving the safety and efficiency of the transportation of passengers and cargo.
Simultaneously, governments, rail manufacturers, operators and maintainers are constantly searching for innovative ways to reduce costs or simply use the data that they already have to make real improvements.
Formed in 2000, Nova Systems has become the country’s largest independent provider of systems engineering and test consultancy services to the Australian defence and aerospace industries. Today, Nova Systems’ innovative skills and expertise are being used by the rail sector as it advances in the complex world of interconnectivity and intelligent automation.
The need to reduce costs and improve safety, ease of use and efficiency of transportation systems also drives the demand for improved automation, communication and interoperability between vehicles and infrastructure, which, in turn, leads to the introduction of innovative and disruptive technologies into already complex operating environments.
Through whole-of-systems thinking, independent technical integration and systemised innovation, Nova Systems is leading the design, engineering and delivery of complex, safety-critical systems that are vital to future rail networks and next-generation rail transportation.
The challenges facing businesses in the rail industry today are similar to those in the oil, gas and aviation sectors. It is possible and necessary to learn from one another and tailor our approaches to each industry. The big advantages of collaboration are significant, but it takes courage to take the initial steps into unfamiliar areas. Nova Systems has the experience and strong partnering relationships to successfully deliver on the potential of new technological advantages and collaborative approaches.
