The great fiscal rift between Australia's commodity haves and have-nots shows no signs of narrowing just yet (see chart 1). We expect gross debt to rise across most of Australia's eastern states, in both absolute terms and as a proportion of operating revenues. Iron ore powerhouse Western Australia (AAA/Stable/A-1+) stands alone, with a flat-to-declining debt burden.

Chart 1

Combined, Australia's states and territories (hereafter "states") are closing in on gross debt of A$600 billion as they borrow to finance a historic infrastructure binge--and in some cases to cover operating deficits. All now carry stable outlooks (see table 1), after we downgraded Australian Capital Territory (AA+/Stable/A-1+) in September 2023 and revised the outlook on South Australia (AA+/Stable/A-1+) in August 2023 (see table 2).

This report is part of a global series that examines subnational government borrowing across the world. It is also the latest in an annual series on the Australian states. 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.

Table 1

Table 2

States' Fiscal Fates Are Diverging

The debt hangover from COVID-19 lingers. We estimate that total state debt will pass the next milestone of A$600 billion late in calendar 2024. This projection is consistent with our last report ("Subnational Debt 2023: Australian States Navigate Crosscurrents Of COVID, Coal, And Capex," published on RatingsDirect on Feb. 27, 2023).

The rising sectorwide debt burden masks a striking dichotomy. Strong royalty revenues are fueling bumper cash surpluses for the mineral-rich states of Queensland (AA+/Stable/A-1+) and Western Australia.

It's a turn of events that few saw coming. In June 2020, at the depths of the COVID-19 downturn, Queensland's treasurer stated that "no government in Australia can think of delivering a surplus." Just three years later he presided over the biggest surplus in Australian state history, courtesy of skyrocketing coal prices and a progressive new royalty regime (see chart 2).

Chart 2

Chart 3

Meanwhile, Western Australia (see chart 3) reaps the benefits of two minor miracles. First, the price of iron ore has stayed consistently elevated--above US$100/metric ton for most of 2023--despite a sputtering economy in China, the world's largest steelmaker. Second, changes to the system for distributing federal GST (goods and services tax) grants in 2018 continue to shower the state with revenue, despite its standout finances.

A federal deal in December 2023 assures other states they won't lose out from the 2018 GST reforms during the next half-decade. The Australian government has extended the GST "no worse off" transitional guarantee by three years, to 2030 from 2027. But this deal also kicks the can down the road, in our view, by ensuring that uncomfortable questions about the fairness of the GST system will reemerge in a few years.

At the other end of the spectrum, we expect the populous southeastern states of Victoria (AA/Stable/A-1+) and New South Wales (AA+/Stable/A-1+) to maintain their heavy borrowing streaks. New revenue measures will help but fail to stem the tide of red ink. Victoria implemented a (rather discordantly named) "COVID Debt Repayment Plan" in its 2023 budget in the form of higher payroll and land taxes, while New South Wales will hike coal royalties from mid-2024 onward.

Why The Mushrooming Debt?

The end of the COVID-19 emergency has seemingly given way to a new era of elevated public investment and spending. We see a few common factors behind the rise in state debt:

States are ramping up infrastructure investment (see chart 4).  This is to accommodate a booming population (see chart 5), unclog transit bottlenecks, and facilitate the energy transition. Australia's population reached 27 million in January 2024, two decades earlier than forecast in the nation's first intergenerational report in 2002. Whereas New South Wales and Victoria held their four-year capital budgets steady last year--likely due to capacity constraints--Queensland's June 2023 budget ratcheted up its infrastructure pipeline by a staggering 55%.

The cost of some projects has soared.  For example, Victoria's North East Link has been reassessed at A$26 billion from a budgeted A$15.8 billion in 2019; Sydney Metro West will now cost A$25 billion after an overrun of at least A$12 billion. Australia is an expensive place to build (see chart 6). Contributors to overruns include inflation in the cost of labor and materials, unforeseen geotechnical obstacles, and a tendency by ministers to commit to projects prematurely before they are fully scoped. In several instances, project selection appears motivated by politics instead of firm business cases.

Budget repair discipline has waned.  Civil service headcount and "cost of living" subsidies are rising as public notions of the role of government expand (see chart 7). Queensland's 2023 budget includes a record A$8.2 billion in subsidies, discounts, and rebates, up 21% year on year. Australia's political history (recall the first budgets of Joe Hockey in 2014 and Campbell Newman in 2012) suggests that voters do not tolerate cost cuts.

Australia's federal model imposes no binding fiscal rules.  This means there are no real constraints on the size of deficits and debt--beyond what the public will abide and what bond markets can digest.

Chart 4

Chart 5

Chart 6

Chart 7

Fiscal Targets Are Somewhat Nebulous

Self-imposed fiscal targets and principles do little to curb growth in debt, in our view. An important difference between the federations of Australia and Canada, on one hand, and many subnational government peers (particularly in Europe) on the other, is that Australian states and Canadian provinces have strong fiscal autonomy (see "Subnational Debt 2023: Fiscal Sustainability Rules Are Put To The Test," March 3, 2023). They are not bound by firm statutory or constitutional budget rules.

Victoria has softened its debt target over the past decade. The target shifted from an explicit reduction in net debt as a share of gross state product (GSP) in its 2014 budget, to a ceiling of 12% of GSP in its 2019 budget, to merely aiming to "stabilize [debt] in the medium term" in its 2023 budget. By the state's own measures (which differ from ours), general government net debt currently stands at about 22% of GSP.

In 2021, Victoria's independent parliamentary budget office noted that fiscal targets "have often not remained in place for a sufficient period to be useful or credible." In 2023, Victoria's auditor-general recommended that the government set specific targets.

Other states' commitments to stabilize or keep debt at "sustainable" levels are similarly vague. Most states aim to achieve an operating surplus (on an accrual basis, at general government level), but this does not restrain growth in debt for capital investment.

Sometimes fiscal targets pull in opposite directions. The latest budget of Tasmania (AA+/Stable/A-1+) features a bold target to achieve fiscal balance over rolling four-year averages, which would imply roughly zero net new borrowing. (Tasmania's own forecasts indicate it won't attain this goal.) But the state's 10-year fiscal strategy also caps gross debt at an unambitious A$20,000 per capita, almost double the current level of A$10,800.

Subnational Deficits Are Eclipsing That Of Central Government

Australia's central government is wary of any new procyclical spending that could fuel inflation. It booked a surprise headline cash surplus in fiscal 2023 (year ended June 30), mostly by banking better-than-expected corporate tax revenues rather than channeling them into new spending.

The states, in contrast, have been slower to repair their budgets following the COVID-19 shock (see chart 8). In part this is a textbook collective action problem. Each state government in isolation has little impact on the macroeconomy, but together they add to inflationary pressures by competing for the same limited pool of engineers, laborers, and tradespeople.

Chart 8

States Will Need Lofty Bond Sales For Years

We estimate net new bond issuance by the states of about A$55 billion-A$60 billion a year (see chart 9). In gross terms, the states will collectively need to market A$90 billion-A$100 billion a year, both to finance upcoming deficits and refinance maturing bullet bonds.

Chart 9

Chart 10

In a striking reversal of fortunes, the states' gross issuance in fiscal 2024 will be almost double the A$52 billion-A$54 billion funding task of the Australian Office of Financial Management (AOFM, the borrowing arm of the sovereign) (see chart 10). Their gross bond sales were just half those of AOFM's in fiscal 2021. Gross issuance across the sovereign and subnational sectors should become more balanced from fiscal 2025 onward, as AOFM bond maturities jump to A$83 billion-A$87 billion from A$36 billion this year.

Our forecasts for states reflect our assumption that they must fund capital works through debt, operating surpluses, or capital grants, rather than fiscal reserves or asset sales. New South Wales, for instance, has mostly drained financial assets in its Restart NSW Fund and Snowy Hydro Legacy Fund.

There could be upside (i.e., lower debt issuance) to our forecasts if New South Wales suspends or reduces future so-called contributions into the NSW Generations Fund. The state has budgeted for these to recommence in fiscal 2025 after a temporary pause.

Borrowing Costs Bite Into State Budgets

We assess that debt serviceability is manageable, for now, and won't erode creditworthiness. This is because most state debt (86%) is in the form of fixed-rate domestic bonds (see chart 11). State borrowing authorities (sometimes known as semi-government issuers, or "semis") locked in low borrowing costs at longer tenors during the cheap money era of 2020-2021. They also have comparatively little short-term debt (e.g., commercial paper or promissory notes) to roll over (see chart 12).

But even with these advantages, interest costs are beginning to sting. The weighted average life of states' debt portfolios stands at just four to seven years (see chart 13). This means they must refinance a wave of upcoming bond redemptions, in addition to funding future cash deficits, at higher market interest rates. Yields surged sharply over 2022-2023 (see chart 14), in line with global reflation and market consensus that policy rates could stay higher for longer.

Chart 11

Chart 12

Chart 13

Chart 14

Rising interest expenses threaten to crowd out other public spending. On our measures, interest costs will soon consume more than 5% of operating revenue for the mainland eastern states (see chart 15). Sectorwide interest expenses topped A$14.3 billion in fiscal 2023, a figure that exceeds Western Australia's annual public health budget. Deficit states will borrow merely to meet interest outlays, creating a vicious feedback loop.

Chart 15

Setting aside the rising debt impost, we assess that states prudently manage their treasury risks. Borrowing authorities aim to develop large, liquid, benchmark bond lines at regular intervals across the yield curve. Currency risk is minimal: only a tiny volume of foreign-currency long-term bonds is on issue (about A$3 billion), all swapped back to Australian dollars--though borrowing through Euro-commercial paper programs can be substantial. In 2023, TCorp executed its first Uridashi issuance.

The presence of a large, ready-made buyer base in the form of domestic banks helps to keep a lid on spreads between the various semis. Banks must hold semi or (lower yielding) sovereign government bonds to meet liquidity coverage ratio regulations. And market liaison suggests that the smaller state issuers pay little so-called illiquidity premium, with some investors instead seeking out their scarcer paper for diversification.

Labelled Bonds Get The Green Light

We anticipate that green, social, and sustainable (GSS) bonds will remain a small but meaningful component of states' debt issuance programs in coming years. This will stem from an ongoing desire to showcase environmental and social credentials and the emergence of new issuers.

While the three large eastern states (New South Wales, Victoria, and Queensland) are seasoned thematic issuers (see chart 16), Western Australia has recently joined the GSS club, launching an inaugural 10-year green bond in June 2023. The Australian government, through AOFM, has also committed to issuing its first-ever green bond between April and June 2024.

Chart 16

In February 2024, the A$34.5 billion subsovereign GSS market ballooned by 66%. SAFA retroactively labeled all bonds (about A$23 billion) first issued from July 2018 onward as sustainability bonds (not shown in chart 16). SAFA also plans to issue the first new bond under its budding sustainability bond framework in the first quarter of calendar-2024.

From Windfalls To Wind Farms

We assess GSS issuance as being neutral to marginally positive for credit quality. Outstanding GSS bonds trade roughly in line with benchmark secondary yield curves. GSS bonds have also diversified states' investor bases by bringing new and arguably less flighty pools of money into the fold. Such bonds often align with states' inherent responsibilities in areas such as mass transit, renewable energy, and public housing.

In Queensland, the coal royalty bonanza is helping to fund an enormous A$19 billion investment over four years into new wind, solar, storage, and electricity transmission infrastructure.

Australia's state debt dichotomy is a timely reminder that creditworthiness need not correlate with so-called sustainability characteristics. Our high credit ratings on Australia's states derive strength from many factors beyond their mineral riches. These include strong institutions and governance, a wealthy and diversified national economy, and deep and liquid financial markets.

Appendix

Chart 17

Editor: Lex Hall

Design: Evy Cheung

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