The Upside from Australia’s Coming Credit Downgrade

The Upside from Australia’s Coming Credit Downgrade

There clearly isn’t much going on in the world right now. The business pages are awash with news about Monday’s budget update and the potential effect on Australia’s AAA credit rating.

The main take-away is that the budget will deteriorate by $30 billion over the four years of forward estimates, thanks to weaker than expected company and personal income tax receipts.

Contributing to the deterioration, the government decided not to factor higher commodity prices into the forward estimates. They believe the recent rally is not sustainable.

The Financial Review reports:

‘…the Treasurer opted to treat the surge in prices for iron ore and coal since the May budget as highly dubious.

Had he not done so, this year’s mid-year economic and fiscal outlook would have had its credibility in tatters the moment it was printed.

Resources industry figures have been warning for months that the recent gains in iron ore and steel making coal aren’t likely to last. At best, they’ve giving the economy and the mining companies that benefit most a temporary reprieve from a longer-term shift towards a falling terms of trade.

Maybe that’s right. But if you ever needed a contrarian sign that iron ore and metallurgical coal prices will remain higher than most people expect, this is it.

Anyway, the upshot of all this budget guesswork is that Australia’s AAA credit rating is under threat. I’d say it’s only a matter of time before we lose it…probably following the announcement of the next budget in May.

But this won’t be a big deal immediately. In fact, by the time the ratings agencies finally announce it, the market will have already factored it in.

It’s already happening right now, as I’ll show you in a moment.

While I say it won’t be a big deal immediately, the loss of credit worthiness will be a big deal at some point. That is, it will matter when we need it most. During the next credit crisis — whenever it hits — Australia will feel the full force of the downgrade.

But because that day of reckoning isn’t in sight, no one really cares about it. The market certainly doesn’t. It’s rallying at the prospect!

In the short term, the loss of the AAA credit rating won’t see interest rates head higher, and it won’t cause banks to increase their home loan rates. Therefore, it won’t crash the housing market, either.

But what it will do is hurt the Aussie dollar, and that is already happening.

Have a look below at the chart of the Aussie dollar versus the greenback. In the last few days, the Aussie has gone from just over 75 US cents, to 73 US cents.

That’s quite a sharp fall. It’s now at the lowest point in seven months.

Source: Optuma
Click to enlarge

The way I see it, this is the market beginning to adjust to a credit downgrade.

Many people think a credit downgrade means higher interest rates. That is, because Australia is seen as a higher-risk borrower, it will have to pay a higher rate of interest to compensate lenders.

But the world of international finance doesn’t necessarily work like this.

Australia borrows from the rest of the world to maintain its standard of living. We have a net foreign debt position of around $1 trillion, and we add to it each year (by around $40–50 billion) in the form of our current account deficit.

Most of this debt is held by the private sector (households) — not the government. And most of this household debt makes its way to Australia via the banks. When you take out a loan to buy a house, for example, a bank borrows a chunk of this loan from overseas markets.

This borrowing happens every day. Lenders know what’s going on. They will price in a credit downgrade when lending to Aussie banks well before the ratings agencies make it a formality.

But they won’t do so by demanding a higher rate of interest. They will get their return in another way…

That return will come in the form of a weaker currency.

Let me explain…

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A currency is simply a price, determined by the supply and demand for that currency. If the supply of a currency is maintained (via demand for loans from the banks) — but demand weakens because foreigners aren’t so keen to keep lending — the ‘price’ (the exchange rate) will drop.

A weaker exchange rate has the effect of increasing the purchasing power of foreigners’ currencies. Looking at the Aussie/US exchange rate above, the fall over the past week has just increased the purchasing power of US-dollar lenders by around 3.5%.

In other words, Aussie assets just got 3.5% cheaper for US-dollar lenders. That’s effectively a ‘harmless’ return to foreigners; a return to compensate them for lending to what is becoming a higher-risk borrower.

Imagine what would happen if foreign lenders jacked up interest rates by 3.5%! It would be carnage. Asset prices would collapse, and everyone would lose.

International finance doesn’t work like that. It’s far more subtle.

For a precedent, check out the UK. It lost its AAA credit rating following the Brexit vote. Interest rates didn’t rise, but the currency — the pound — plummeted. In other words, the adjustment occurred via the currency markets, not the interest rate market.

Expect the same thing to occur in Australia. In fact, you can see it happening before your eyes. The Aussie is falling. It’s a loss of national wealth happening on a very subtle level.

On the plus side, a weaker dollar is just what the RBA was hoping for. It provides stimulus to the economy without the RBA having to cut interest rates, something they are loath to do with household debt levels so high.

Why do you think the stock market has ‘shrugged off’ the potential loss of the AAA rating? Because a weaker dollar — whatever the reason — is good for the market as a whole.

The message for investors is this: Don’t stress about the coming credit downgrade. It will be good for stocks, and it’s yet another reason not to keep too much of your portfolio in depreciating cash.


Greg Canavan,
Editor, Crisis & Opportunity

PS: Our colleague Callum Newman recently interviewed former News Corporation and Fairfax journalist Michael West.

You can hear the interview on Callum’s podcast, The Newman Show. As Callum told me, West talks about how newspapers are dead, business journalism is a joke in Australia, and no one takes on big end of town.

It’s sure to be an interesting episode.

To subscribe via iTunes, go here.

To subscribe via Stitcher, go here.


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Greg Canavan

Greg Canavan

Greg is the Managing Editor for Money Morning. He helps investors preserve their wealth over the long term using a method known as value investing. Lucky for Money Morning readers, he imparts some of this knowledge on them three times a week with editorial spots.

Greg Canavan is a feature Editor at the Money Morning and is the foremost authority for retail investors on value investing in Australia.

He is also the Editor of Crisis & Opportunity. An investment publication designed to help investors profit from companies and stocks that are undervalued on the market. Greg is the former head of Australasian Research for an Australian asset-management group and has appeared on CNBC, Sky Business’s ‘The Perrett Report’ and Lateline Business. He has written articles for The Sydney Morning HeraldThe Australian and Greg’s aim is to help you create a portfolio of stocks based on sound, proven, investing principles. His system for identifying stocks trading beneath their ‘intrinsic’ value combines a big picture understanding of the financial markets with a thorough valuation analysis of individual securities.

Greg’s method of investing is not about taking huge risks and rushing into big positions. He investigates highly profitable companies trading at a reduced premium to their net asset value, or ‘equity’ value as he puts it – and passes that research on to his subscribers to incorporate into their financial plan as they see fit.

With Greg’s help, you can implement a long-term wealth building strategy into your financial planning, be better prepared for the tough financial challenges ahead and stop making the basic, costly mistakes that most private investors make every time they buy a stock.

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