Australian state and territory government (hereafter, states) budgets are on a path to recovery after the initial COVID-19 shock. We expect the states' fiscal positions will benefit from the continued rollout of vaccines and the associated upswing in the national economy as it opens. The reopening of international borders will also help as migrants, workers, students, and tourists gradually return. Fiscal challenges remain, however. We anticipate record infrastructure spending and lower revenue streams over the next decade.

The overall outlook bias has improved relative to 12 months ago. We have only had one rating action this year--on Western Australia, where we revised the outlook to positive from stable. This reflected Western Australia's budgetary outperformance compared with its domestic and global peers. The state is benefitting from elevated royalty revenues and growth in tax receipts, and its economy is rebounding strongly after the quick containment of the coronavirus in the first half of 2020. Additionally, it is the only state whose debt ratio we expect to gradually decline even as infrastructure investment rises.

In calendar year 2020, fiscal deterioration resulted in a shift in our rating spectrum for the states: there were 13 negative rating actions. States are rated between 'AAA' and 'AA', with a mixture of positive, stable, and negative outlooks. Prior to the crisis, states were rated between 'AAA' and 'AA+', all with stable outlooks.

Table 1

In 2020-21, Australian states experienced better fiscal outcomes compared with their 2020-2021 budgets. This was predominantly due to states' early success in managing COVID-19 and the opening of their economies earlier than assumed last year. This led to a flurry of economic activity, boosting property, consumption, and payroll taxes. Still, most states have posted record deficits and escalating debt levels, borne from the initial shock of the pandemic, compared with financial positions prior to the outbreak.

The two most locked-down states throughout the pandemic, Victoria and New South Wales (NSW), are unlikely to regain 'AAA' credit ratings in the next few years. In 2021, we affirmed these ratings at 'AA/Stable/A-1+' for Victoria, and 'AA+/Stable/A-1+' for NSW. Victoria continues to display structurally weaker budgetary metrics and a higher debt burden relative to domestic peers. The rating on it is the weakest among Australian states. NSW's debt burden is rising, although we believe there is sufficient headroom for this within the 'AA+' rating.

Risks remain regarding the fiscal recovery of South Australia and the Australian Capital Territory (ACT) from the COVID-19 shock. In 2021, we affirmed our ratings on South Australia and ACT, with negative outlooks (see "Australian Capital Territory ," published on RatingsDirect on Nov. 29, and "South Australia," published on RatingsDirect on Aug. 30, 2021). However, we see risks these could be delayed beyond our current base case, underpinning the negative outlooks. The outlooks were revised to negative in 2020.

Queensland and Tasmania have emerged from the pandemic with relatively unscathed credit quality because they have benefitted from fewer lockdowns and COVID-19-related hits to their economies. Both states' economies have remained relatively open since the initial national lockdown in April 2020. This has supported their budgets in contrast to most domestic peers. Further, Queensland and Tasmania had more headroom at the 'AA+' rating level than other states, such as Victoria, NSW, South Australia, and ACT had within the respective ratings.

The Pandemic's Impact Stretches Into 2022, With Budgetary Performance Improving Soon After

The impact of COVID-19 will continue to squeeze states' operating balances in the 2022 fiscal year (ends June 2022) before recovering in 2023. We expect the consolidated operating deficits across all states to improve to 2.1% of operating revenues in 2022, compared with a deficit of 8.9% in 2021. States achieved operating surpluses of 6.9% in 2019, a figure that won't be achieved until beyond 2024. The pandemic-induced recession led to a drop in revenue receipts and an increase in health and stimulatory expenditure across all states.

State revenue sources, such as payroll taxes and stamp duties, improved compared with previous 2020-21 budget estimates. National consumption substantially outperformed everyone's expectations. The NSW and Victoria budgets did not factor in the delta wave in their 2021-2022 budgets. They will therefore be weaker than the forecasts contained in their June quarter budgets. In contrast, we accounted for these outbreaks and the associated costs in our rating outcomes in August 2021. We see adequate headroom within our respective ratings to absorb the deteriorations in their budgets. Victoria's budgetary performance will substantially underperform other states over the next few years.

Outside of the lockdowns in NSW, Victoria, and ACT, we expect these positive revenue trends will continue to benefit budgets in fiscal 2022 and beyond (see chart 1). This trend will narrow operating deficits and enlarge Western Australia's surplus. Western Australia's improved operating position benefitted from soaring iron ore prices, favorable distribution of federal grants, and tight operating expense control. Western Australia's fiscal metrics are by far the strongest of all the states.

Chart 1

The pandemic-induced fiscal hit to the states has been enormous. In a bid to protect their residents' health every state suffered shocks. Government-imposed lockdowns that sought to suppress the pandemic came at great economic and fiscal cost. We believe the fiscal and economic damage would have been more severe and more prolonged had governments failed to act swiftly to suppress the outbreak. Indeed, most states recorded smaller operating deficits in 2021 compared with what they expected in last year's budgets, and our forecasts.

Several states are incurring record cash deficits after infrastructure spending (see chart 2). This is because of discretionary stimulus spending and a slump in tax receipts and other revenues. Budgetary performance assessments are at their weakest point for many states. For 2022, we project that consolidated after-capital account deficits will be about 15% of total revenue. Thanks to the anticipated economic recovery and associated improvement in revenues over time, we expect this deficit to reduce to average about 10% in 2024. This remains larger than in the past. The consolidated state after-capital account was in balance between 2014 and 2019, aided by large asset transactions and privatizations. At the height of the crisis, consolidated after-capital account deficits peaked at 24% of total revenues in 2021.

Chart 2

Capacity Constraints Will Limit Infrastructure Plans

Most states have announced record infrastructure plans. This investment is aimed at supporting jobs and the economy. New capital grants announced in the May 2021-2022 Commonwealth budget will partly fund some of this investment. We believe total spending on infrastructure will struggle to reach A$260 billion between fiscals 2022 and 2024 because of capacity constraints and inevitable delays through planning, permits, and unexpected issues such as geotech risks, contractor disputes, and lockdowns. This is notably below the A$285 billion presented in states' budgets.

Chart 3

Additional capital plans will stretch the capacity of industry and government. This is because even before the pandemic struck, states were gearing up for an infrastructure boom (see "Australian State Finances Face A$140 Billion Blow," Dec. 14, 2020). If this spending were to remain elevated while states are running weak operating positions, such that a state's already record levels of after-capital deficits were to become entrenched rather than temporary, then downside risks to credit ratings would grow.

Delays will provide some relief to fiscal deficits but could mean economic growth may fail to attain state forecasts. Our ratings and financial forecasts incorporate lower-than-budgeted infrastructure spending by states, taking into consideration these expected capacity constraints.

Record Debt Levels Notwithstanding Expected Fiscal Improvements

State debt is rising rapidly to fund large cash deficits. Total tax-supported debt at the non-financial public sector level, which includes government-owned corporations, will reach record levels. Combined total tax-supported debt will reach 159% of operating revenues in 2024, up from 83% in 2019. Total tax-supported debt for the nonfinancial public sector, including leases and service concessions, will more than double to A$588 billion in 2024, from A$270 billion in 2019 (see chart 4). NSW and Victoria are the main drivers of this growth.

Chart 4

The ability of states to stabilize debt levels and consolidate their fiscal positions varies. We anticipate Victoria's debt levels will rise the most, with debt more than tripling from 2019. Most other states will more than double their debt during the same period. In stark contrast, Western Australia's debt is likely to reduce to 79.6% of operating revenues in 2024 from 90.5% in 2019, aided by strong iron ore royalties and higher GST revenues.

In our view, interest costs will remain manageable at less than 4% of revenues during this period. While yields are rising, they remain very low in historical terms. The low-interest-rate environment eased yields across all state bond issuance. The Reserve Bank of Australia (RBA) has launched three rounds of quantitative easing and is currently purchasing A$4 billion of bonds a week, of which 20% is allocated to state and territory government paper. On Nov. 2, the RBA announced its intention to continue purchasing A$4 billion of bonds until at least mid-February 2022. It also announced its intention to abandon its yield curve target of 10 basis points for debt maturing in April 2024.

Additionally, Australian local banks have been told to reduce their reliance on the Committed Liquidity Facility (CLF) to zero by the end of 2022. The CLF was formed to enable banks to meet a liquidity stress scenario for 30 days by holding enough high-quality liquid assets. Winding down the CLF will likely cause banks to look toward government securities to meet their liquidity stress scenario requirements, thereby boosting demand.

This intervention and the ease with which states are issuing debt into the market support our view of their liquidity. This is occurring even as internal debt service coverage ratios temporarily weaken and states fund record deficits.

Related Research

• Global Ratings List: International Public Finance Entities 2021, Oct. 13, 2021
• S&P Global Ratings Metal Price Assumptions: Choppy Markets Drive Erratic Moves, Oct. 11, 2021
• Institutional Framework Assessments For International Local And Regional Governments, Oct. 7, 2021
• Economic Outlook Asia-Pacific Q4 2021: Growth Slows On COVID-19 And Rising China Uncertainty, Sept. 27, 2021
• Default, Transition, and Recovery: 2020 Annual International Public Finance Default And Rating Transition Study, Sept. 15, 2021
• Comparative Statistics: Asia-Pacific Local And Regional Government Risk Indicators, Sept. 1, 2021
• Non-U.S. Local Governments: To What Extent Did Sovereign Support Offset The Pandemic Downdraft?, July 19, 2021
• Local And Regional Governments Midyear Outlook 2021: Sovereign Support And Market Access Anchor Credit Quality, July 15, 2021
• Local Government Debt 2021: The Pandemic Takes More Of The Shine Off Large Developed Regions' Credit Quality, March 25, 2021
• Local Government Debt 2021: Infrastructure Needs Will Boost Borrowing In Developed Markets, March 25, 2021
• Local Government Debt 2021: Global Borrowing To Hit $2.25 Trillion, March 25, 2021
• Institutional Framework Assessment: Australian States And Territories, Nov. 9, 2020