Treasurer Joe Hockey faces a squeeze. Photo: Alex Ellinghausen / FairfaxThere is much speculation just now about whether Australia is about to lose its AAA credit rating. It is another headache for Treasurer Joe Hockey as he crafts his second budget. But what exactly is this rating, where does it come from and does it matter? Jonathan Shapiro answers the AAA questions you always wanted answered. What is a AAA (“Triple-A”) rating?
This is a way of rating an entity, usually a government or a company, that wants to borrow money. It gives lenders an easy way of seeing how likely they are to get repaid. Ratings have several grades with AAA being the highest down through to C. Anything below BB is deemed as junk. Australia is one of 12 governments with a AAA rating worldwide Why does it matter?
The higher your rating, the lower your borrowing costs. This is because with a higher rating you are seen as a smaller risk by someone lending you money. When a government or company borrows money, usually through issuing bonds, that debt is then assigned a value based partly on the credit rating. This is important for people who trade bonds. How does it get assessed?
Rating agencies such as Standard & Poor’s and Moody’s will look at your assets and liabilities, your income and your expenses and then decide how able you are to repay any new debt. Governments are usually bolstered by their power to raise new revenue through taxes. Rating agencies work closely with the entities they are rating. Is it an assessment of the health of the economy?
No. It is an assessment of the ability of a borrower to repay money. However, for a government in particular its ability to repay money is linked strongly to the performance of the economy. In a strong economy, income to the public purse is higher and expenses such as welfare are lower. So the rating can be a proxy measure of how strong a nation’s economy is travelling. The credit rating is also an important benchmark for politicians about how prudently they are managing the government’s finances. What would it cost Australia if it was downgraded?
The cost of a credit rating downgrade is hard to quantify, especially for a government. In theory, a lower credit rating should lead to borrowers demanding a higher return for the risk they’re taking. In the case of Australia however, since all its debt is denominated in Australian dollars which it is able to print, it can never technically default. This means Australia’s borrowing costs are determined by expectations of where the Reserve Bank will set the cash rate. Other governments that have lost their AAA ratings such as the US and Japan have actually seen their borrowing costs fall because investors have assumed their central banks would hold official interest rates lower. What else would it impact?
The real impact of a credit downgrade would be borne by other borrowers that the rating agency has assessed to be tied to the health of the government, in particular state governments and banks. This is because both are bolstered by an implicit guarantee from the Australian government. That could mean a downgrade of the federal government could push up costs for other parts of the economy. The banks source a large portion of their funding from international bond investors that would, all else being equal, demand higher rates. The higher the cost of borrowing for the banks, the more they may have to charge for mortgages, for example. Didn’t these rating agencies play a key role in GFC? Why should we listen to them?
The rating agencies were among the key culprits in the financial crisis. Since they are paid by the institutions that they rated, they were conflicted and turned out to be too liberal with their AAA ratings on complex bonds – allowing cautious investors to load up on what turned out to be risky debt. Most of the rating agency failings related to complex structured securities. Their track record is less tainted (but far from perfect) when it comes to assessing company and government risk. Despite their role in the crisis, rating agencies have become more entrenched in the financial system because the volumes of bonds governments and companies have issued since the crisis.