Australia exports what the world wants. As a major producer of coal, gas, and iron ore, we see the country as a rare beneficiary of the global surge in commodity prices sparked by the Russia-Ukraine war and China's post-COVID reopening. We anticipate Australia will dodge recession in 2023. But the road ahead is not without obstacle.

Nominal interest rates have surged. Property prices are falling. The global backdrop is gloomy. Australia's states and territories ("states") are closing in on gross debt of A$540 billion, as they borrow more to finance infrastructure investment. Our outlook bias on Australia's states is slightly negative (see table 1).

Subnational Government Debt To Climb

The fiscal scars and debt overhang from COVID-19 linger. In line with our last report ("Local Government Debt 2022: Australian State Debt To Breach Half A Trillion Dollars," published March 8, 2022), we estimate that total state debt topped A$500 billion in late 2022 and will pass the next milestone of A$600 billion around 2024 (see chart 1).

The rising sector-wide debt burden masks a geographic divide. Strong royalties are fueling bumper cash surpluses for the minerals-rich states of Queensland and Western Australia. Meanwhile, we expect the populous southeastern states of Victoria and New South Wales to continue their heavy borrowing streak.

This report is part of a global series that examines subnational government borrowing across the world. It encompasses the seven states rated by S&P Global Ratings. Together, these rated entities account for 98.7% of Australia's GDP. We exclude the unrated Northern Territory.

Chart 1

Table 1

Commodities: Record Royalties

We slightly revise down our projected debt trajectories for Western Australia and Queensland relative to 12 months ago. Prices for energy commodities are high (see chart 2); Australia-China relations are thawing; and there is relative strength in the U.S. dollar (in which most commodity exports are invoiced). Together these factors are proving a major boon.

Chart 2

Elevated prices translate into impressive royalty receipts (see chart 3). Queensland's bottom line will also benefit from a new progressive coal royalty structure, implemented from July 1, 2022, that lifts the marginal royalty rate to as high as 40% when the per-metric ton coal price exceeds A$300 (approximately US$215). This new structure renders its budget much more sensitive, both on the upside and downside, to fluctuations in global prices (see chart 4).

Between June and December 2022, Queensland revised up its forecast royalty take for fiscal 2023 by a remarkable A$5.8 billion to A$13.4 billion, which would be more than five times the figure reported for fiscal 2021.

Chart 3

Chart 4

Rocketing energy prices are not without drawback. Increases in electricity costs are dampening confidence and adding to a perceived "cost-of-living crisis." Under a national Energy Price Relief Plan, announced in December 2022, New South Wales and Queensland agreed to set a temporary ceiling on the price of coal used for domestic electricity generation at A$125 (US$90) per metric ton. We believe this policy will have little impact on royalty collections as the ceiling doesn't apply to the vast majority of coal produced for export.

Housing: What Goes Up Must Come Down

Falls in revenue from property transfer duties (also known as stamp duties or conveyancing duties) weigh on our near-term outlook for state revenue. New South Wales for example, forecasts a 36% year-on-year drop in transfer duty receipts in fiscal 2023, while Victoria forecasts a 22% drop.

States are exposed to volatility in both sale prices and transaction volumes. Property prices are moderating, particularly in Australia's east-coast cities, after an atypical run-up fueled by cheap money during the lockdown years (see chart 5).

Home values slumped 8.9% between April 2022 and January 2023, according to a five-city composite index produced by CoreLogic. With owners hesitant to sell into a down market, the number of transactions is also declining (see chart 6). Prices in Perth, Western Australia, are holding up better, since they have tracked largely flat over the past decade.

Chart 5

Chart 6

The correction may have further to run. The Reserve Bank of Australia's (RBA) breakneck 325 basis points of interest rate hikes, over 10 months through February 2023, is yet to fully transmit into higher mortgage rates. Variable-rate mortgages account for two-thirds of outstanding housing credit. Of the remaining 35% of mortgages carrying fixed rates, about two-thirds are due to expire by the end of 2023 and roll over into much higher rates. The monetary policy transmission mechanism is potent in Australia.

Our house view assumes a peak-to-trough average price correction of about 15%-20%. We see risks to this assumption as roughly balanced, with downside risks from a possibly higher terminal cash rate set against upside risks from stronger inbound migration.

Infrastructure: No Running Out Of Road

Ambitious capital investment plans (see chart 7) are the main driver of the states' upcoming borrowing needs. The states are collectively budgeting a vast A$319 billion (13.8% of GDP) of infrastructure investment over fiscal years 2023-2026. This is roughly equal to the total direct economic and health support that Australia's central government says it committed to responding to the COVID-19 pandemic up until its May 2021 budget.

Infrastructure spending is politically attractive. Elected officials get to announce projects they say will bust congestion and shorten commuting times. An added bonus is that such spending isn't counted in the "net operating balance" figures most closely scrutinized by the media. New South Wales's treasurer speaks of being part of "an infrastructure government," while his Victorian counterpart proclaims infrastructure spending commitments more than quadruple the size of that state's previous administration.

Chart 7

States routinely under-deliver relative to budget. The total sector-wide underspend was about 14% in fiscal 2022, and particularly large in the Australian Capital Territory at 35%. Projects invariably stall because of shortages of raw materials and skilled labor, complicated planning rules, legal or contractual disputes, and unforeseen environmental conditions.

We expect these conditions to persist, meaning shallower but more prolonged growth in public debt than what states forecast. In a December 2022 report, Infrastructure Australia (a statutory body) warned: "[It] is no longer a question of if a project will slip, but more likely when, by how long and at what cost."

The size of the infrastructure pipeline varies widely across states. We think, for example, that Tasmania will struggle to execute. Its four-year capital budget is equivalent to 25.5% of gross state product, or almost three times the size of Western Australia's at 8.6%.

Relatedly, we doubt nominal infrastructure spending will peak in fiscal 2025 as implied by the yellow line in chart 7. We previously hypothesized that changes to office work patterns, rising interest rates, and price inflation could alter the cost-benefit calculus of transport megaprojects. So far, though, only a small handful of tunnel, rail, and stadium plans have been scrapped.

Many instead have been rescheduled, as states recalibrate to an overstretched construction industry. The 14% underspend last year was matched by states consequently adding 15% to their fiscal 2025 capital plans.

Some states have lofty aspirations beyond the current decade. These include Victoria's Suburban Rail Loop (SRL) and Queensland's hosting of the 2032 Summer Olympics. While the first stage of SRL, dubbed SRL East, is budgeted at A$30 billion-A$34.5 billion through 2035, Victoria's independent Parliamentary Budget Office estimates that the entire two-stage project (including SRL North) will have a capital cost of A$125 billion through 2085.

Meanwhile, we do not expect recent flooding events to shift the dial. This is because, given market capacity constraints, capital expenditure on reconstruction is likely to displace rather than add to other projects (see "Bigger Flood And Fire Tests Lie Ahead For Australia," published Jan. 16, 2023). States also benefit from a generous safety net in the form of the federal Disaster Recovery Funding Arrangements.

Fiscal Management: Budget Repair On A Tightrope

Budget repair discipline has waned a little, in our view. This appears in part due to the timing of state elections, in Victoria in November 2022 and New South Wales in March 2023.

Charts 8-10 show changes in revenue and expense projections for New South Wales, Victoria, and South Australia since their November 2020 budgets, which were produced at peak pandemic pessimism. At each consequent annual budget or interim update, parameter variations have mostly been net positive. However, revenue surprises were channeled into new spending announcements. Parameter variations reflect changes outside of a government's direct control, such as improving tax receipts on the back of an economic rebound that beat both states' expectations and ours.

Chart 8

Chart 9

Chart 10

Chart 11

In contrast, the Australian sovereign rolled out only modest new measures in its past two budgets (chart 11). It banked most of the revenue windfall.

The central government is wary of pro-cyclical spending fueling inflationary pressures. In November 2022, the federal treasurer cited estimates that spending A$57 billion of revenue upside in fiscal 2023 would have added 0.5 percentage points to inflation. With the states' total nonfinancial public sector cash deficit tallying close to this figure (A$48 billion last fiscal year; see also Appendix B), a back-of-the-envelope calculation suggests they too may be adding almost 0.5 percentage points to inflation.

To be clear: fiscal consolidation for the states is still occurring, just at a more leisurely pace than might be expected given the strong economic hand Australia has been dealt. Some of the new discretionary spending appears sorely needed: to address well publicized strains on state-owned public hospitals, for example. But ratings could be at risk if expenditure control deteriorates, which would signal weakening financial management.

On the other hand, we think state governments have generally struck pragmatic middle ground in recent wage negotiations, despite the threat of strikes. Self-imposed caps have long kept a lid on salaries for public servants--the largest component of states' expense bases. Some states have recently offered sign-on bonuses, COVID-19 appreciation payments, or similar one-off sweeteners to avoid baking in large recurrent pay increases.

Bond Issuance: A Downshift After Elevated Pandemic-Era Borrowing

We estimate that net new bond issuance by the states will moderate to about A$50 billion-A$55 billion a year (see chart 12). The smaller financing task is partly because of substantial borrowing in advance undertaken last fiscal year by the likes of Treasury Corp. of Victoria.

We assume TCV will again prefund, smoothing its issuance task over fiscal years 2023 and 2024. Market guidance for issuance in fiscal years 2025 and 2026 seems slightly pessimistic, given projected narrowing in the sector-wide cash deficit.

Chart 12

We see the balance of risks tilted to the upside--i.e., toward lower borrowing requirements. Upside risks include:

• Likely under-delivery on states' capital budgets (as noted above);
• Outperformance in royalty revenues due to conservative price assumptions adopted by state treasuries;
• The possibility of new privatizations or similar monetizations; and
• Drawdowns on state-owned sinking funds to buy back bonds on-market.

Victoria intends to establish a "Future Fund" from the proceeds of its VicRoads modernization transaction, which raised A$7.9 billion in the second half of 2022. Victoria joins New South Wales and Queensland in establishing debt retirement funds.

Interest Rates: How Times Have Changed

It wasn't long ago that Australian regulators were instructing market participants to prepare for the possibility of negative interest rates. Some states even amended their bond documentation, adding a clause stipulating a minimum interest rate of zero. How times have changed.

We assess that rising borrowing costs are manageable without erosion in creditworthiness. Yields surged sharply over 2022 (chart 13). This was in line with global reflation and the central bank tightening policy and ending quantitative easing (which had included the purchase of A$57 billion of state government bonds over 15 months).

However, most state debt is in the form of fixed-rate domestic bonds. States locked in low borrowing costs at longer tenors during the peak pandemic issuance period.

Spreads to Australian Commonwealth government bonds have also widened since the start of the pandemic but are broadly in line with pre-pandemic averages.

Chart 13

Chart 14

State borrowing authorities (sometimes known as semi-government issuers, or "semis") aim to develop large, "benchmark" bond lines at regular intervals across the yield curve. Most semis plan to further extend their fixed-rate benchmark curves, with issuance to be concentrated in the 10- to 15-year range. In choppy markets they prioritize a flexible approach to issuance, using a mix of tenders, syndications, and reverse enquiry, and avoiding being active in volatile periods around key data releases.

There is a smaller quantum of floating-rate, inflation-linked, and retail bonds outstanding. They meet demand from public corporation clients and certain investors for these products. The share of floating-rate bonds ticked up three percentage points in fiscal 2022 (see chart 14), with several jumbo syndications bought mostly by domestic bank balance sheets.

Green Bonds: Greenlit

We anticipate that Australian states will issue or tap more green, social, and sustainable (GSS) bonds in coming years. This will be spurred by larger eligible asset pools; a heightened desire to showcase environmental, social, and governance (ESG) credentials; and refinancing of GSS maturities due around 2024-2025. The three largest states are already seasoned ESG-themed issuers (chart 15).

Chart 15

We assess GSS issuance as being neutral to marginally positive for credit quality. Outstanding GSS bonds appear to trade roughly in line with, or slightly inside (i.e., at a "greenium" to), benchmark secondary yield curves. GSS bonds have also diversified investor bases of states by bringing new and arguably less flighty pools of money--particularly "real money" asset managers--into the fold.

We assign identical issue credit ratings to GSS bonds as to states' other unsecured debt instruments. They rank equally, and coupons and principal repayment are not linked to performance of the underlying eligible assets.

GSS bonds often align with states' inherent responsibilities in areas such as mass transit, renewable energy, and social housing. States have "longlisted" large project and asset pools that could be earmarked against future use-of-proceeds bonds.

Western Australia Treasury Corp., which hasn't previously issued in GSS format, has signaled it will consider a benchmark-type GSS bond this fiscal year. In contrast, South Australian Government Financing Authority says it will focus on promoting whole-of-government ESG commitments rather than labelled bonds.

Investor Base: Domestic Banks To Remain Linchpin Investors

We expect demand for semi-government securities by Australian bank balance sheets (i.e., treasury desks) will help fill the void left by the RBA. To meet liquidity regulations, banks must purchase more state and sovereign bonds to hold as high-quality liquid assets (HQLA). These will be needed to replace surplus exchange settlement balances, as banks repay A$188 billion of drawdowns on the central bank's Term Funding Facility through mid-2024. The bank bid also benefited from the phasing out of the RBA's Committed Liquidity Facility to zero at end-2022 from A$136 billion at end-2021.

Banks already hold about half of all semi-government debt on issue (see chart 16). Bank demand helps keep spreads between higher- and lower-rated semis (and between semis and sovereign) relatively contained, given HQLA regulations are ratings-neutral.

The central bank assesses that banks can hold about 35% of total outstanding Australian sovereign and semi-government securities for liquidity purposes without unduly affecting market functioning.

Chart 16

The presence of foreign investors in the domestic market is sizable. Australian names appeal to many investors because of their higher yields (relative to high-grade opportunities in other countries), credit quality, and geographic diversification.

Overall, though, the share of nonresident ownership of semis is lower than for Australian sovereign bonds. International investors may be more familiar with sovereign over subnational names. Australian-dollar assets comprise about 1.8% of the world's official foreign exchange reserves.

Appendix B

Table 2

Editor: Lex Hall

Designers: Halie Mustow, Evy Cheung

Related Research

• Bigger Flood And Fire Tests Lie Ahead For Australia, Jan. 16, 2023
• S&P Global Ratings' Metal Price Assumptions: Lower Prices And Higher Costs Start Squeezing Profits, Nov. 2, 2022
• Institutional Framework Assessment: Australian States And Territories, May 5, 2022
• Local Government Debt 2022: Australian State Debt To Breach Half A Trillion Dollars, March 8, 2022