Major Factors

Recent Developments

Most Australian states and territories will report weaker budgetary performance during the next few years as a result of the COVID-19 pandemic and its aftereffects. This is primarily because their revenue sources are relatively sensitive to economic and labor market activity. Receipts from payroll taxes, stamp duties, gambling taxes, and other own-source revenues will be lower than previously expected.

Transfers from the Commonwealth government (i.e., the Australian sovereign) will also be written down. In July 2020, the Commonwealth estimated that the national pool of goods-and-services tax (GST) grants shrunk by A$5.2 billion (7.9%) in fiscal year 2020 (i.e., the year ended June 30, 2020) and A$7.6 billion (11.2%) in fiscal 2021, relative to expectations from December 2019.

States and territories have committed tens of billions of dollars to health and emergency economic support measures so far. Together, the weaker revenues and larger expenditure commitments will cause most states and territories to report moderate operating deficits and wider after-capital-account deficits in fiscal years 2021 and 2022.

The financial impact will be uneven. Victoria, Australia's second-most populous state, is emerging from a second lockdown. It will likely see larger revenue writedowns and also need to spend more on economic support. Western Australia, the largest iron ore producer in the world, should outperform, thanks in part to strong mineral royalty revenues. Other rated states and territories will fall somewhere between the two extremes.

Most Australian states and territories have been successful in suppressing the spread of coronavirus to date, compared against their international counterparts. This has allowed them to reopen their economies much faster than initially feared at the onset in March 2020.

We expect operating balances to mostly revert to surplus in the next 2-3 years and after-capital-account deficits to gradually narrow as the national economy recovers. However, the speed and extent to which this fiscal repair transpires could depend on whether states and territories choose to announce new stimulus initiatives in their upcoming budgets.

Delays in annual budgets haven't yet altered our view of institutional transparency. States and territories ordinarily release their annual budgets around the second quarter (Q2) of each calendar year. This year, because of the challenge of forecasting during the pandemic, they collectively postponed their budgets to Q4 or later (see "Checks And Imbalances: Delayed Australian State Government Budgets Will Embrace More COVID-19 Stimulus," published Sept. 7, 2020). Some have released shortened, interim updates. We expect a return to the usual budget schedule from calendar 2021 onward.

Fiscal and monetary policy in Australia are now extremely accommodative. The Commonwealth is delivering large economic support and wage subsidy programs, while the Reserve Bank of Australia (RBA) has lowered its target policy rate to a record low of 0.1% and introduced a government bond purchase program, among other unconventional measures. This will help to keep borrowing costs low and credit markets functional, even in an environment of rapidly rising public debt. On Nov. 3, 2020, the RBA further announced that it would begin a A$100 billion quantitative easing program, of which about 20% (i.e. A$20 billion) is allocated for state and territory bonds.

On April 8, 2020, we revised our outlook on Australia (AAA/A-1+) to negative from stable. We consequently revised our outlooks on the states of New South Wales, Victoria, and Australian Capital Territory to negative, too. This is because we believe no Australian state or territory can maintain stronger credit characteristics than the sovereign in a stress scenario.

Predictability

Frequency and extent of reforms

Australia has a highly stable and predictable governance system, with broad consensus in favor of conservative macroeconomic policy. Reforms are typically incremental, and major reforms are generally only undertaken after a period of lengthy review.

Australia's constitution divides powers between the federal and state governments. The states have plenary powers to legislate on most matters, except a small number in which the Commonwealth has exclusive authority. Many lawmaking powers, in areas such as trade, commerce, and taxation are held concurrently between the federal and state governments, meaning the states are free to make laws so long as they are not inconsistent with Commonwealth law. The tiers of government work together in an approach often described as cooperative federalism. A century of slowly evolving precedent has augmented constitutional rules.

In June 2020, the prime minister announced a new National Federation Reform Council (NFRC) to replace the former Council of Australian Governments (COAG). A National Cabinet, comprising the prime minister and state and territory first ministers (i.e., premiers and chief ministers), forms the center of NFRC. The Council on Federal Financial Relations, which consists of treasurers from each jurisdiction, continues in operation and will report to the National Cabinet. On Oct. 23, 2020, the National Cabinet agreed to recommendations of an independent review that include rationalizing the number of ministerial councils and forums, which stand at about 50. The objective is to reduce bureaucracy and red tape.

It is too early to say if these new arrangements will achieve their stated aims. Past attempts at reform have had mixed results. For instance, the 2008 Intergovernmental Agreement on Federal Financial Relations sought to consolidate the number of federal-state funding arrangements, but the number grew again in subsequent years.

We believe recent reforms to Australia's system of horizontal fiscal equalization will help to mitigate the budgetary volatility faced historically by some states and territories. In late 2018, the Commonwealth legislated perhaps the most significant reforms since the introduction of the GST in 2000. The legislation established a permanent relativity "floor" of 70 cents per person per dollar of GST, rising to 75 cents from fiscal 2025. This roughly means that no state or territory will receive less than 70%-75% of the GST that is paid by its residents to the national pool. The changes also included some technical adjustments to the benchmark for equalization, to ensure that the fiscal capacity of all states and territories is raised to at least the equal of New South Wales or Victoria, whichever is higher.

The reforms were considered necessary because the preceding half decade had seen great volatility in relativities. For instance, in Western Australia, the effect of a mining boom (and its subsequent end) saw that state's relativity fall to as low as 30 cents per person per dollar of GST. Because of lags built into the GST distribution formula, the fall in relativity followed a collapse in mineral royalties, prolonging the damage to Western Australia's budget.

The Commonwealth has promised that no state or territory will be worse off as a result of the changes. To ensure this, it will make around A$9 billion of additional contributions to the national pool over a 10-year period.

The reforms were enacted only after lengthy deliberations, which included a review by the independent Productivity Commission. It should be noted that the reforms help protect states and territories from declines in their relativities, but not from reductions in the size of the national GST pool itself, which are driven by economic conditions.

We do not anticipate other substantive changes to federal-state financial relations. We believe the Commonwealth would seek consensus before proposing any changes to, for example, the rate and base of the GST. New South Wales has commissioned its own independent review of federal-financial relations, which issued a draft report in July 2020. The draft recommendations include abolishing state stamp duties, otherwise known as transfer duties or conveyance duties, in favor of a broad-based land tax. We believe the recommendations would require strong political fortitude to implement.

State and territory governments prepare annual budgets that contain detailed, four-year forecasts, known as "forward estimates," on a cash and accrual basis. Budgets are produced at general government, public corporation, and consolidated level. Infrastructure Australia and similar state and territory bodies help inform longer-term infrastructure decisions.

Ability of LRGs to influence or oppose reform

We believe Australia's states and territories have some power to individually and collectively soften the negative consequences of reforms through the National Cabinet and other intergovernmental forums, as they did under the former Council of Australian Governments. Substantive changes to the framework of federal-financial relations generally only occur when there is broad consensus.

Australia is one of the oldest federations in the world. All six states have their own constitutions. The Commonwealth government has no power to amend states' constitutions; they can only be amended by individual states.

The Commonwealth can, however, override legislation of the two mainland territories: Australian Capital Territory and Northern Territory. This is because the territories were created by the Commonwealth under self-governing acts. However, in matters economic and fiscal there is virtually no difference between the powers of the states and the territories, and hence we assess them as operating under the same institutional framework.

The states have equal representation in the Australian Senate, the upper house of the bicameral federal parliament. There are 12 senators from each of the six states and two from each of the mainland territories. In theory, this design gives the smaller states strong powers to ensure that their interests are not dominated by those of the more populous states.

Revenue And Expenditure Balance

Overall adequacy of revenues to cover expenditures needs

Taxation powers are concentrated at the Commonwealth government level. While the Commonwealth is responsible for social welfare and the age pension, states and territories deliver most high-cost public services, including health and education. The level of vertical fiscal imbalance is relatively high in Australia compared with other federations, and is partly offset by significant downstream intergovernmental transfers. States and territories rely on the Commonwealth for around 36% of their operating revenues on a nonfinancial public sector basis (chart 1).

The Commonwealth distributes the money that it collects from GST to states and territories in the form of untied grants. The Commonwealth Grants Commission (CGC), an independent agency, determines the annual distribution of grants based on a formula that takes into account each jurisdiction's population and fiscal capacity. The CGC periodically conducts reviews of its distribution methodology; the most recent review occurred in March 2020. The Organisation for Economic Co-operation and Development assesses Australia as having one of the strongest systems of horizontal fiscal equalization among all federations.

States and territories also receive tied grants from the Commonwealth that are earmarked for specific areas of service delivery, such as health and education. The Commonwealth can set the terms and conditions of such grants.

Australian states and territories on average run modest operating surpluses of 5%-10% of operating revenues, but occasionally incur operating deficits. Most will incur moderate operating deficits in fiscal 2021 because of the COVID-19 shock.

States and territories are responsible for substantial infrastructure delivery in areas such as roads and public transport, hospitals, schools, prisons, social housing, and utilities. This generally leads to after-capital-account deficits (chart 2) that are funded through borrowing in capital markets. The most recent Commonwealth budget, on Oct. 6, 2020, announced a few billion dollars of new capital grants to help accelerate state and territory infrastructure stimulus in response to the COVID-19 recession.

Some states and territories in recent years have leased or sold public assets and reinvested the proceeds into new capital works. The Commonwealth incentivized this "asset recycling" by offering, through its Asset Recycling Initiative, a financial contribution of up to 15% of the sale price of certain assets over 2014-2019. In the years in which major transactions took place, some states recorded strong after-capital-account surpluses and accumulated financial assets, which they will use to fund future infrastructure spending. We believe further asset recycling is unlikely in the near future, except perhaps in New South Wales. In several states, governments were elected on the promise of no future privatizations.

State and territory own-source revenue bases are somewhat narrow and inefficient. The constitution gives the Commonwealth government exclusive power over customs and excise duties. The Commonwealth is also the sole collector of personal income tax and company tax. Some states, most notably Western Australia, derive a significant proportion of revenues from mineral royalties. In some revenue lines, such as payroll taxes, competition between states and territories has generally kept a lid on revenue growth.

Most states and territories have only a moderate degree of fiscal flexibility. As noted above, they have a relatively high degree of reliance on Commonwealth transfers. In addition, the fees and charges levied by state-owned enterprises, such as electricity and water utilities, are usually set by independent economic regulators. The biggest component of operating expenditure is public sector salaries (chart 3). However, states and territories generally have large capital investment programs, and have substantial discretion to postpone or reprioritize infrastructure projects as needed.

Chart 1

Chart 2

Chart 3

Chart 4

In a reversal of recent performance (chart 4), we now expect systemwide tax-supported debt, as a proportion of operating revenue, to climb by around 50 percentage points during the next few years. The debt burden had roughly plateaued in the lead up to the COVID-19 pandemic, but we were expecting it to rise because several states and territories, particularly along the east coast of Australia, have large forward infrastructure pipelines.

Most states and territories will now need to borrow to plug revenue shortfalls, and are likely to expand their infrastructure programs even further as a countercyclical fiscal response. This new capital investment will be largely debt funded (see "Shock And Ore: Surging Debt To Test Australian States," published Sept. 29, 2020).

On a global basis, we view Australian state and territory debt burdens as being midrange. Entering the COVID-19 crisis, they were generally lower than those of Canadian provinces and comparable to German states. Interest expenses in the future are likely to remain manageable, at below 5% of operating revenues. Market yields have fallen to historic lows, and we expect them to remain low for the foreseeable future.

We include in our measure of tax-supported debt the net present value of leases. Note that the introduction in 2019 of a new Australian Accounting Standards Board (AASB) standard, AASB 16-Leases, removed the distinction between operating leases and capital leases, resulting in an uptick in reported gross debt. Australia appears to be ahead of most other jurisdictions in its local implementation of IFRS 16-Leases. The ongoing rollout of another standard, AASB 1059-Service Concession Arrangements: Grantor, might see some debt-like financial liabilities recognized earlier on some states' balance sheets.

Note that the financial metrics discussed in this section, and which form the basis of our credit rating assessments, are based on nonfinancial public sector cash accounts. Charts 1-4 are based on data covering all states and territories except Northern Territory, for which we do not assign a credit rating.

Fiscal Policy Framework

States and territories are not restricted by any statutory or constitutional rules on borrowing, and they are not required to achieve balanced budgets. The Commonwealth does not exert control over their financial performance.

Each state and territory determines its own fiscal strategy, which is usually articulated in the annual budget or charter of fiscal responsibility. All have some form of self-imposed fiscal targets, which generally revolve around delivering operating surpluses (at general government level, on an accrual basis), keeping net debt at sustainable levels, and/or closing unfunded pension liability gaps over time. We anticipate that these targets will be revised in light of the COVID-19 recession.

In some jurisdictions, targets are expressed numerically. In South Australia, for instance, operating expenditure growth (at general government level) should be limited to trend growth in household income, which stood at 4.5% per annum as of the 2019-2020 budget. In Western Australia, public service wage increases are currently capped at A$1,000 per annum. In some other states and territories, there is simply a soft target to achieve operating surpluses on average over the medium term. Only New South Wales enshrines its fiscal targets in legislation, but there are no penalties for noncompliance.

Government officials generally judge that it is acceptable for long-lived infrastructure to be financed with debt, rather than recurrent revenues, to promote intergenerational equity.

Extraordinary Support

On Nov. 3, 2020, the RBA announced a quantitative easing program. It plans to purchase around A$20 billion of state and territory government bonds on the secondary market over the next six months, which should help to lower their borrowing costs. This follows a separate program, which took place between March and May 2020 and saw the RBA purchase around A$11 billion of such bonds to support market functioning. In allocating its bond purchases across the various states and territories, the RBA will be guided by the stock of each jurisdiction's debt outstanding and relative market pricing.

There are no formalized bailout procedures for states and territories in Australia. However, the Commonwealth government demonstrated its willingness to provide extraordinary support by offering to guarantee state and territory debt, for a fee, during the financial crisis of 2009-2010 (see "Ratings On Commonwealth Of Australia, State Governments Unaffected By Temporary State Borrowing Guarantee," published March 25, 2009). This measure was effective in quickly alleviating capital market strains. The guarantee offer was voluntary and time-bound, and only two states chose to sign up. We think the Commonwealth would step in again, if needed, to support states and territories in a future stress scenario.

The new 2020-2025 National Health Reform Agreement provides a funding guarantee to all states and territories to ensure that no jurisdiction is left worse off, in terms of healthcare funding, as a result of the COVID-19 pandemic. At the height of the first wave of infections in March 2020, the states and territories and the Commonwealth quickly agreed to a 50%-50% shared funding deal to cover health services provided in state-run public hospitals, primary care, aged care, and community health expenditure.

Intergovernmental lending between the Commonwealth and the states and territories is small, and rare. In 2015, the Commonwealth provided a A$1 billion concessional loan to Australian Capital Territory to help fund a buyback and demolition scheme for homes affected by loose-fill asbestos. The loan has since been fully repaid.

The Commonwealth's response to natural disasters, such as the major floods and cyclones in Queensland in 2010-2011, is another example of limited extraordinary support. Its Disaster Recovery Funding Arrangements, which replaced the previous Natural Disaster Relief and Recovery Arrangements, provide for the Commonwealth to fund 50%-75% of the assistance to individuals and communities and restoration of essential public assets.

Transparency And Accountability

Transparency and institutionalization of budgetary process

Transparency is a key strength of Australia's institutional framework. Each state and territory publishes at least a comprehensive annual budget, a midyear review, and an annual report. Budgets provide four years of fiscal forecasts. Public corporations produce their own annual financial statements and statements of corporate intent.

Many states and territories release quarterly or monthly financial updates at general government level. All of the states have independent debt management offices that are staffed by professionals with deep expertise in capital markets. Some states have independent parliamentary budget offices, and some produce long-term "intergenerational reports." Actuarial investigations of state and territory superannuation liabilities (i.e., defined-benefit pension liabilities) are conducted on a regular basis.

The Australian system ensures a clear delineation between elected ministers and the public service. The roles and responsibilities of each are defined by legislation. Budgets are generally scrutinized by parliamentary committees through "estimates" inquiries. Most government agencies are subject to freedom of information laws. Every state and territory has some form of independent integrity or anticorruption commission, though their powers and capacities vary. Government departments publish independent budget updates prior to each state or territory election.

In 2020, following the delay in annual budgets, most state and territory parliaments passed temporary supply bills to ensure the continued funding of government operations. Some also passed legislation to broaden the executive's emergency spending authority, in the form of a "treasurer's advance" or similar mechanism. The postponement of budgets was highly unusual, and followed a decision by the Commonwealth to also postpone its own budget. Some states and territories published interim fiscal or economic updates.

Disclosure and accounting standards

The states have adopted a uniform presentation standard, with both cash and accrual accounting. Annual reports and budgets are presented for multiple perimeters of government, including the core government ("general government"), the nonfinancial public sector, and the total state or territory, inclusive of publicly owned corporations. The latter also publish their own annual reports.

All states and territories prepare financial reports in accordance with Australian accounting standards and interpretations as issued by AASB. Since Jan. 1, 2005, these include the Australian equivalents to International Financial Reporting Standards.

Control levels and reliability of information

Each state or territory's auditor-general is responsible for auditing its annual financial statements and evaluating the performance and delivery of government programs. Auditors-general are statutory officers of parliament, and they assess whether accounts are true and fair. The auditor-general's report must be included in annual reports.

Annual reports are released in a timely fashion, generally within 3-4 months of fiscal yearend, though we expect there will be some delays in 2020 due to uncertainties caused by the pandemic. Some states and territories release unaudited quarterly or monthly reports, too.

Trend

The trend for the Australian states and territories' institutional framework is stable.

We expect the sectorwide debt burden to rise, and many states and territories will report historically large operating and after-capital-account deficits in the 2021 fiscal year. We don't assess this to be a structural change. Revenue-expenditure imbalances should generally narrow over the next few years as Australia begins its climb out of recession. We assess the Australian subnational institutional framework to be one of the strongest in the world and consider a change during the next few years to be unlikely.

Related Criteria

• Methodology For Rating Local And Regional Governments Outside Of The U.S., July 15, 2019

Related Research

• Institutional Framework Assessments For International Local And Regional Governments, Nov. 6, 2020
• Shock And Ore: Surging Debt To Test Australian States, Sept. 29, 2020
• Checks And Imbalances: Delayed Australian State Government Budgets Will Embrace More COVID-19 Stimulus, Sept. 7, 2020
• Comparative Statistics: Asia-Pacific Local And Regional Government Risk Indicators, July 29, 2020
• COVID-19: Fiscal Response Will Lift Local And Regional Government Borrowing To Record High, June 9, 2020
• Ratings History List: Asia-Pacific Local And Regional Government Ratings Since 1975, May 29, 2020
• Australia Outlook Revised To Negative As COVID-19 Outbreak Weakens Fiscal Outcomes; 'AAA/A-1+' Ratings Affirmed, April 8, 2020
• COVID-19: Emerging Market Local Governments And Non-Profit Public-Sector Entities Face Rising Financial Strains, April 6, 2020
• Australian State Ratings Depend On Fiscal Discipline And Quick Economic Rebound, April 1, 2020
• Default, Transition, and Recovery: 2018 Annual International Public Finance Default And Rating Transition Study, Aug. 19, 2019
• Ratings On Commonwealth Of Australia, State Governments Unaffected By Temporary State Borrowing Guarantee, March 25, 2009