Public borrowing is set to soar in most advanced economies. In Australia, both the federal government and the states and territories (hereafter "states") will record unusually large cash deficits this year, with the possible exception of iron ore-rich Western Australia. Outstanding commercial term debt on issue by the states surged past A$330 billion around August 2020 (see chart 1). This will reduce buffers at the 'AAA' and 'AA+' level.

In "Checks And Imbalances: Delayed Australian State Government Budgets Will Embrace More COVID-19 Stimulus," published Sept. 7, 2020, we described how state governments have committed tens of billions of dollars to emergency support measures this year. There is more red ink to come. Upcoming annual budgets will likely contain new initiatives, to be paid for with debt.

When a second wave of infections forced Victoria, Australia's second-most populous state, into a new lockdown and unprecedented curfew in August 2020, the state's chief health officer described the strategy as one of "shock and awe." The demand for fiscal loosening will be greatest in Victoria.

Chart 1

The Reserve Bank Of Australia Has Entered The Fray

Even against a backdrop of rising bond supply, yields have plumbed historic lows. This will keep the states' debt-servicing costs very manageable. Crucially, the Reserve Bank of Australia (RBA) has committed to ensuring that markets for state government bonds--sometimes known as "semi-government" securities, or simply "semis"--remain functional.

We think the RBA might expand its unconventional policy toolkit in the coming months, if the post-coronavirus recovery appears fragile or uneven. Central banks in other advanced economies have active purchase programs for state, provincial, and municipal government bonds. These purchases are mostly in secondary markets, but in some countries they're in primary markets, too.

A unique confluence of factors is driving public debt higher. Even prior to the onset of COVID-19 we had expected debt to climb, as east-coast states plan large forward infrastructure pipelines. The COVID-19 crisis--and associated restrictions on commerce and mobility--is hammering tax receipts, and the shortfalls will need to be bridged with debt. Federal policymakers are piling pressure on the states to deliver even more infrastructure stimulus during the next two years. Public sentiment could be turning, too. In an August 2020 survey by Per Capita, an Australian think tank, 48% of respondents supported government borrowing for long-term investment. This was up 15 percentage points on the figure recorded just six months earlier.

Australian states entered 2020 on a comparatively stable footing. Their high credit ratings are supported by wealthy and diversified economies, robust financial management, and strong institutional settings. In this report, we set out our views on the implications of higher debt for state credit ratings. We also examine liquidity and contingent liabilities.

Australia's States Entered The Crisis From A Position Of Relative Strength

Seven states, as well as their wholly owned central borrowing authorities, have issuer credit ratings of 'AAA' or 'AA+' (see table 1). This places them at or near the very top of our global ratings scale. Our negative outlooks on New South Wales, New South Wales Treasury Corp., and Australian Capital Territory mirror that on the Australian sovereign. The outlook on Australian Capital Territory also reflects downward pressure on its stand-alone credit profile (see "Australian Capital Territory 'AAA/A-1+' Ratings Affirmed; Outlook Negative," published Sept. 10, 2020). In table 1, the institutional framework is evaluated on a scale of '1' to '6', with '1' being the best possible score; other factors are assessed on a scale of '1' to '5.'

The ongoing lockdown in Victoria is taking a toll on its economy and state finances. Victoria and Treasury Corp. of Victoria are on CreditWatch with negative implications. This signifies at least a one-in-two likelihood of a downgrade within a few months.

Table 1

The assessments at greatest risk in table 1 are those for debt burden and budgetary performance. Debt stocks are climbing for most states, and some will inevitably tip into a weaker bracket. We expect operating and after-capital-account balances to worsen substantially in fiscal 2020-2021 (i.e., the year ending June 30, 2021), and possibly beyond, too. Importantly, we will assess whether this deterioration is structural in nature or likely to unwind in future years.

Our measure of states' internal liquidity could dip on the back of large after-capital-account deficits. However, states are sitting on hefty piles of cash, having completed a lot of prefunding in the second quarter of 2020. Access to external liquidity remains a key strength. It should ensure that our overall liquidity assessments remain supportive.

In our view, states benefit from strong public institutions and professional civil services; comprehensive budget processes, notwithstanding the risks we flagged in our last report; limited pension liabilities; and conservative handling of debt and liquidity. However, we could lower our financial management assessment on states that fail to present plans consistent with medium-term fiscal discipline. For instance, we've previously highlighted that Victoria allowed its public servant wage bill to grow at a rapid pace during the past few years. As such expenses tend to be inflexible, this leaves its operating budget more exposed in a downturn.

Economic assessments are less likely to move. These speak to a state's gross state product, growth prospects, industry concentration and volatility, and socioeconomic profile. After nearly three decades of growth in Australia, a sharp but temporary downturn shouldn't materially shift our views.

Larger Deficits Imply Greater Borrowing Needs

Deficits will be enlarged because of both discretionary stimulus spending and a slump in tax receipts and other revenues. Charts 2 and 3 illustrate the point. In chart 2, we compare forecasts from Queensland's September 2020 COVID-19 Fiscal and Economic Review with those from its last midyear update, in December 2019. In chart 3, we compare medium-term forecasts from Australian Capital Territory's August 2020 Economic and Fiscal Update with those from its February 2020 budget review.

Chart 2

Chart 3

Federal transfers, in the form of goods-and-services tax (GST) grants, will decline on the back of a smaller national pool. Australia's July Economic and Fiscal Update (JEFU) reported that the GST pool has shrunk by A$5.2 billion (7.9%) in fiscal 2019-2020 and A$7.6 billion (11.2%) in fiscal 2020-2021, relative to expectations at the time of a midyear update in December 2019.

Grants to each state will be affected by tweaks to revenue-sharing relativities following the Commonwealth Grants Commission's March 2020 methodology review. In the medium term, the second Victorian lockdown--which commenced after JEFU--will further drag on national consumption and GST receipts. It will likely result in an increase in Victoria's relativity (i.e., relative share of the pool), to the detriment of other states.

States' own-source revenue bases tend to be sensitive to economic activity. Payroll tax collections, the single-largest own-source revenue item, will be soft. All states have included payroll tax waivers or deferrals in their economic support packages. Wages paid via the federal JobKeeper scheme are exempt from payroll tax. Stamp duties, otherwise known as conveyance or transfer duties, will plunge on the back of limp transaction volumes in the property market, relative to previous budget forecasts.

Other, smaller revenue lines will also drop. Fees and taxes related to motor vehicle use--including stamp duties, registration fees, weight taxes, and traffic fines--will be down as people stay home or defer purchasing new cars. Gambling revenues could decline in areas where casinos and electronic gaming devices are inaccessible, or forced to operate at reduced capacity.

All Quiet On The Western Front?

Western Australia may outperform. Its budget position is buoyed by a lofty seaborne iron ore price, which hit a six-year high in August 2020. The price is supported by strong steelmaking demand from China and mine closures in other countries, particularly Brazil. Western Australia is the largest iron ore exporter in the world, accounting for 37% of global supply in 2019.

Chart 4

While the state's May 2019 budget projected iron ore royalties of A$5.4 billion for fiscal 2019-2020, its September 2020 annual report showed that actual receipts beat this figure by A$2.2 billion. As the spot price has generally stayed above price assumptions (see chart 4), further upward revisions are likely. Western Australia receives about A$85 million in additional revenue a year for each US$1 per ton increase in the spot price.

A back-of-the-envelope calculation suggests the state would have received an extra A$650 million across July and August 2020 alone, relative to expectations in December 2019. The weaker Australian dollar through the first half of 2020 also helps: the state collects an additional A$122 million for each US1 cent fall in the $US/$A exchange rate, assuming production volumes are in line with forecasts.

The prospect of additional Chinese infrastructure stimulus is an upside risk. A prolonged global downturn, which would curtail demand for Australian minerals and energy, is a key downside risk. Importantly, the danger to Western Australia's budget is lessened by GST distribution reforms in 2018 that set a floor for grants to Western Australia at 70% of its population share. We note these reforms protect the state from any fall in its relative share of the national GST pool, not declines in the size of the pool itself.

Gross Public Debt Is Growing Quickly

In response to widening budget gaps, outstanding state bonds on issue surged by about 19% in fiscal 2019-2020 (see chart 1). New South Wales Treasury Corp. led the way. It commenced the fiscal year with a gross funding task of A$13.3 billion, upsized its target to A$17 billion in December 2019, and following the onset of the pandemic raised its target to A$27.8 billion.

Public debt on issue, at all levels of government, has eclipsed A$1 trillion for the first time. Government bond markets in Australia had been torpid for the two decades leading up to the global financial crisis (see chart 5). Debt has since risen, most conspicuously at the Commonwealth level. The trajectory is set to continue.

Chart 5

Chart 6

States often complete their annual funding tasks several months before the end of each fiscal year. Part of the debt swell in the second quarter of 2020 therefore reflects issuers taking advantage of favorable market conditions to get a headstart on their anticipated funding needs for fiscal 2020-2021. We expect states to report elevated holdings of cash on their June 30, 2020 balance sheets, which will help buttress internal liquidity and fund imminent spending.

Most state borrowing authorities will announce large funding tasks when budgets are finally published in the coming weeks. Some have released early guidance. Treasury Corp. of Victoria has upsized its anticipated task for fiscal 2020-2021 to A$20 billion-A$24 billion, above previous expectations of A$10.2 billion. Queensland Treasury Corp.'s gross funding requirement is A$21 billion.

How Debt Is Defined And Measured Matters

Our credit rating assessments are based on the "nonfinancial public sector" (NFPS, or the "total territory" in the case of Australian Capital Territory). This perimeter includes both the "general government sector"--not to be confused with the concept of general government under our sovereign criteria--and public nonfinancial corporations. The latter are sometimes referred to as public trading enterprises, and include rail operators, ports, and energy and water utilities.

Our preferred measure of debt is gross NFPS tax-supported debt, which differs from outstanding commercial debt as shown in charts 1 and 5. However, the two measures tend to move in the same direction. Borrowing authorities raise money in capital markets and onlend it to state government entities.

Our metrics are different to those commonly employed by the states themselves. Government officials tend to focus on the ratio of net debt to gross state product. Where these ratios are low, or negative, officials may perceive that they have substantial borrowing "headroom." Our metric is the ratio of gross debt to operating revenue. In our view, state debt burdens are already at midrange levels (see table 1).

Our concept of tax-supported debt includes debt-like financial liabilities, such as the present value of lease commitments. One complication is the introduction this year of a new Australian accounting standard, "AASB 1059 Service Concession Arrangements: Grantors." AASB 1059 affects the timing of recognition of assets and financial liabilities for arrangements in which a private operator provides public services on behalf of a state, predominantly through social infrastructure public-private partnerships (PPPs). This may have the effect of increasing reported NFPS gross debt earlier in the lifecycle of a project than under previous accounting standards.

There may be small movements in intergovernmental debt. These loans are minor, at a few billion dollars nationwide. The Commonwealth waived A$158 million of Tasmania's housing-related loans in fiscal 2019-2020. In November 2019, Australian Capital Territory repaid a A$900 million Asbestos Eradication Scheme loan from the Commonwealth, after securing cheaper replacement debt from the market.

The Investor Base For State Government Debt Is Reasonably Diverse

Australian banks hold around half of all semi-government bonds (see chart 6). Australian Commonwealth government bonds (ACGBs) and semis qualify as highly liquid assets under the Australian Prudential Regulation Authority's liquidity regulations.

A recent increase and extension of the RBA's Term Funding Facility (TFF) could help banks to absorb further bond supply. The TFF provides low-cost funding to the banking system for three-year terms at a fixed rate of 0.25%, which is below the three-year yields on semis. Funding is extended under repurchase ("repo") transactions for which semi-government securities are eligible collateral, with very small haircuts.

The presence of offshore investors is sizable. This may partly reflect favorable yield differentials relative to other highly rated issuers. Queensland Treasury Corp. offers some bond lines in the U.S. to qualified institutional buyers under the Securities and Exchange Commission's rule 144A. Overall, though, the share of nonresident ownership of semis is lower than for ACGBs. Offshore investors may be more familiar with, or have a preference for, holding sovereign over subsovereign names. Australian dollar assets comprise about 1.5% of the world's official foreign exchange reserves.

States Manage Currency, Interest Rate, And Refinancing Risks Conservatively

We believe Australian states prudently manage their treasury risks, helping to support their high credit ratings. Currency risk, for example, is negligible, as almost all state borrowing is conducted in Australian dollars. Only the larger treasury corporations have multicurrency euro medium-term note (EMTN) and euro commercial paper (ECP) programs, and issuance is small relative to Australian-dollar funding. Following tax changes in 2008, the states no longer have "global exchangeable bond" programs.

Most issuance is in fixed-rate, nominal domestic bonds. State borrowing authorities aim to develop large, benchmark bond lines across the yield curve. They commit to maintaining a minimum amount outstanding in these bond lines, to support secondary market liquidity. For the smaller states, building benchmark curves could be easier as supply ramps up, and the liquidity premium could decline. Some of the larger states transact in their own bonds through buybacks and switches. States may also issue parcels of debt via private placement.

There is a smaller quantum of floating-rate bonds, to meet demand from public corporation clients and certain investors for these products. More recently, some states have issued green or sustainable bonds; we will discuss these in a subsequent report. Many states have actively sought to extend the duration of their yield curves, which should help to mitigate refinancing risk.

Central Bank Action Has Been Critical To Supporting Market Functionality

The RBA has been instrumental in maintaining an orderly market for ACGBs and semi-government securities. We expect it would intervene again in the future, if needed, to support stability.

March 2020 saw severe dislocation and whipsawing prices in the markets for ACGBs and semi-government securities. According to RBA research, this was driven by investors raising cash to reduce leverage or meet redemptions, by a reduction in demand as some investors tightened their risk limits, and by an inability of bond dealers to absorb large, one-sided flows. Similar strains were experienced all over the world, even for U.S. treasuries. Bid-offer spreads widened significantly, as did the spreads of semis over ACGBs.

In response, the RBA in March 2020 established for the first time a program of long-dated asset purchases in the secondary market. Purchases are outright, out to a maturity of 10 years, and are not sterilized. There are two components to the RBA's program:

• Purchases of ACGBs to target a three-year yield of around 0.25%, the same as the cash rate target. This is a form of yield curve control.
• Purchases of semi-government securities, with no explicit yield or quantity target, to "help facilitate the smooth functioning of Australia's bond market" (see chart 7).

Chart 7

Feedback from market participants indicates that trading conditions have now reverted to close to pre-crisis territory. The RBA resumed purchases of ACGBs in August 2020, but hasn't reentered the semis market. Its balance sheet expanded by about A$100 billion between March and July 2020, a much smaller increase than that of many other advanced economy central banks (the U.S. Federal Reserve's balance sheet ballooned by US$3 trillion over the same period, about twice as much on a GDP proportional basis.) The RBA's A$11 billion in holdings of semi-government bonds represent around 3% of the total quantum of semis on issue.

In its September 2020 board minutes, the RBA reiterated that it stands ready to purchase bonds if there is a recurrence of market dysfunction. In testimony before parliament, the RBA's governor offered strong implicit backing, saying: "I have no concerns at all about the state governments being able to borrow more money at low interest rates. The Reserve Bank is making sure that's the case." The RBA has also opened the door to "consider how further monetary measures could support the recovery."

We aren't aware of any legal constraints on further measures. In contrast, many emerging market central banks face constraints or even bans on bond purchases, according to the Bank for International Settlements.

We maintain our view that Australian states benefit from deep and liquid capital markets. The turmoil of March 2020 hasn't altered our opinion, as it was short-lived and quickly remedied. In our external liquidity assessment we also don't differentiate between the "big four" borrowers--Queensland, New South Wales, Victoria, and Western Australia--and the smaller states.

In 2009-2010, the 'AAA'-rated Australian sovereign offered a voluntary guarantee scheme to the states. The two largest issuers, New South Wales Treasury Corp. and Queensland Treasury Corp., participated. Although unlikely at this point, given the RBA's intercession, we think the Commonwealth would step in again to offer a guarantee if needed. This adds further weight to our view that Australian states have strong access to external liquidity.

Borrowing Costs Are Historically Low

Semi-government yields are at their lowest since Australian federation (see chart 8). This should ensure borrowing costs remain manageable even as debt climbs. For example, in our most recent credit rating report, we forecast that Australian Capital Territory's interest expenses would remain roughly flat at below 4% of its operating revenues during the next few years.

Chart 8

Chart 9

In times of heightened risk aversion, some investors may prefer to hold sovereign paper. We note that spreads between semis and ACGBs have tended to widen during periods of stress (see chart 9). They widened significantly during the global financial crisis, to over 120 basis points. There can also be differences between 'AAA' and 'AA+'-rated names. During the 2010 European sovereign debt crisis, nine-year generic spreads between the bonds of New South Wales (AAA) and Queensland (AA+) reached 60 basis points, according to research by New South Wales Treasury.

Contingent Liability Risks Are Coming To The Fore In Some States

Some states may face substantial contingent liabilities from litigation and other risks. We may adjust our debt burden assessments on states in cases where such contingent liabilities are large or at high risk of materialization. We present some examples below.

Western Australia's royalty bonanza sets it apart from other states, for now. However, a legal skirmish between the state government and mining company Mineralogy Pty. Ltd. is an emerging hazard. The dispute relates to development proposals for the Balmoral South iron ore project that were rejected by the state under a previous administration.

In August 2020, the state parliament passed legislation to void any damages that might be awarded under arbitration. Public details are scant, but Western Australia's September 2020 annual report indicates a compensation claim of around A$28 billion. For context, this is roughly 60% of annual NFPS operating revenue. The showdown, according to legal analysts, will likely wind up in the High Court, Australia's final court of appeal.

In Victoria, there is the possibility of class action lawsuits against the state government. Litigants are reportedly seeking compensation for losses suffered by Victorian businesses and workers under lockdown. This could take many years to work through the justice system.

As noted previously, our credit rating assessments are based on states' NFPS metrics. In some states, the central borrowing authority onlends money to public entities that sit outside the NFPS perimeter, such as local councils or public universities. We may treat these debts as contingent liabilities, though we generally consider the risk of materialization of losses to be very low. Some states have also offered various loan guarantees as part of their economic survival packages, though the sums involved are relatively small.

Our Coronavirus Assumptions

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The current consensus among health experts is that COVID-19 will remain a threat until a vaccine or effective treatment becomes widely available, which could be around mid-2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Related Research

• Australian Capital Territory 'AAA/A-1+' Ratings Affirmed; Outlook Negative, Sept. 10, 2020
• Checks And Imbalances: Delayed Australian State Government Budgets Will Embrace More COVID-19 Stimulus, Sept. 7, 2020
• Australian Treasury Corp. Of Victoria 'AAA' Rating Placed On CreditWatch Negative After Similar Action On State. Aug. 5, 2020
• Australian State Of Victoria 'AAA' Rating Placed On CreditWatch Negative On Pandemic Lockdown Uncertainty, Aug. 5, 2020
• Comparative Statistics: Asia-Pacific Local And Regional Government Risk Indicators, July 29, 2020
• COVID-19: Fiscal Response Will Lift Local And Regional Government Borrowing To Record High, June 9, 2020
• New South Wales Treasury Corp. Outlook Revised To Negative After Similar Action On State; 'AAA/A-1+' Ratings Affirmed, April 8, 2020
• New South Wales Outlook Revised To Negative After Similar Action On The Sovereign; Ratings Affirmed, April 8, 2020
• Australia Outlook Revised To Negative As COVID-19 Outbreak Weakens Fiscal Outcomes; 'AAA/A-1+' Ratings Affirmed, April 8, 2020
• Australian State Ratings Depend On Fiscal Discipline And Quick Economic Rebound, April 1, 2020
• Default, Transition, and Recovery: 2018 Annual International Public Finance Default And Rating Transition Study, Aug. 19, 2019
• Public Finance System Overview: Australian States and Territories' Institutional Framework One Of The Strongest In The World, Nov. 11, 2018

External Sources

• Richard Finlay, Claudia Seibold, and Michelle Xiang, "Government Bond Market Functioning And COVID-19," Reserve Bank of Australia, Bulletin, September 2020
• Emma Dawson, "The Per Capita Tax Survey 2020," Per Capita, Sept. 15, 2020
• Reserve Bank of Australia, Minutes of the Monetary Policy Meeting of the Reserve Bank Board, Sept. 1, 2020
• House of Representatives Standing Committee on Economics, Review of the Reserve Bank of Australia Annual Report 2019 (Second Report), Proof Committee Hansard, Aug. 14, 2020
• Yavuz Arslan, Mathias Drehmann, and Boris Hofmann, "Central Bank Bond Purchases In Emerging Market Economies," Bank for International Settlements, Bulletin No. 20, June 2, 2020
• New South Wales Treasury, 2019 Pre-Election Budget Update, March 5, 2019
• David Lancaster and Sarah Dowling, "The Australian Semi-Government Bond Market," Reserve Bank of Australia, Bulletin, September 2011