States on edge: further credit downgrade threats loom amid fiscal strain

The ACT’s credit rating was downgraded to AA by rating agency Standard and Poor’s (S&P) last month due to significant budget deficits and a large capital spending pipeline. Sound familiar? The news was easy to miss but doesn’t dilute its importance.

The Federal Budget projects deficits for the next decade, but the Commonwealth’s debt burden is just one part of the story. The fiscal discipline of our state and territory governments is another critical, yet often overlooked, issue that is leading to unprecedented debt levels across the country. Governments must focus on the future by implementing prudent fiscal policies. 

If expansive spending agendas continue, Australia risks credit rating downgrades – both at a state and federal level – meaning higher borrowing costs, exacerbating the debt burden. This has serious socio-economic consequences for future generations.

Not only will they inherit the burden of paying for this debt, but there will be no room to invest in their own priorities or solve future problems. And if Australia faces another crisis, state governments won’t have the fiscal capacity to support the economy like they did in 2020, leaving future generations in an even worse position. The snowball gets larger. The debt spiral continues.

All governments must take proactive measures to address these challenges now. Tough budget choices must be made. Debt levels are forecast to keep growing in the three years to 2029. General government gross debt is projected to reach over $720 billion for the states and territories combined, in addition to the $1.2 trillion of federal government gross debt. By FY29, that would be nearly $67,000 of government gross debt for each person in Australia.

Rising state debt

Not only are state credit ratings at risk of a downgrade, but rising state government debt could also put pressure on Australia’s overall credit rating. Australia is one of only 10 countries to hold the highest credit rating available, AAA, from all three major ratings agencies.

Why does this matter? Credit rating downgrades signal decreased confidence in governments’ fiscal management, leading to higher borrowing costs and compounding the debt burden for states and territories. It can also affect broader confidence across the Australian business sector and our ability to attract foreign investment.

Victoria has already felt the impacts of a double notch downgrade to AA by S&P in December 2020. The downgrade and higher volume of debt issuance led to Victoria’s interest costs rising. This is the state’s lowest credit rating since 1992 and the lowest rating of any Australian jurisdiction, until the ACT’s recent downgrade last week.

Prior to this, Victoria held the prestigious AAA credit rating for 18 years. In essence, investors demand a higher return on Victoria’s debt given the rise in their perceived credit risk compared to that of the Australian Government and the other states and territories.

Western Australia had to walk the difficult path of record-high net debt, losing its coveted AAA credit rating in 2013. It took the state nearly a decade to regain it by cutting agency budgets, selling assets and enforcing a strict public sector wages cap. And that was with the help of high commodity prices and a bigger share of GST.

Rather than acting as a warning sign, WA’s experience seems to have been ignored. WA is the only state currently rated AAA. New South Wales, Queensland, South Australia, and Tasmania are in the downgraded AA+ club, and the ACT now finds itself in the AA club along with Victoria.

Queensland has the largest projected operating deficits of the states and territories totalling $25 billion over the forecast period. On a per capita basis, Queensland’s public sector gross debt is not far behind Victoria’s in FY29. ‘Waning fiscal discipline’ was highlighted in S&P’s outlook downgrade for Queensland to ‘negative’ – which means that its rating may also be lowered. Insert flashing red light here!

In the eyes of credit rating agencies, Victoria has failed to make a concerted effort to get its spending under control – continuing to push ahead with its record high infrastructure program, particularly its flagship Suburban Rail Loop project.

Victoria is currently sitting on a ‘stable’ outlook, but this push to spend, despite total public sector gross debt forecast to hit over $290 billion by FY29, poses the real threat of another downgrade. This would further increase the $10.5 billion interest bill expected in FY29 and consume a larger portion of government revenues, leaving less money available for essential public services such as healthcare and education.

Public sector debt projections

But the bad news doesn’t stop there. NSW total public sector gross debt projections are not far behind, at just over $250 billion by FY29 which is likely why NSW has been put on ‘negative’ outlook, along with Tasmania.

The trajectories for Tasmania and the Northern Territory don’t look dissimilar, although their nominal debt levels are lower compared to the bigger states, as a share of the economy their total gross debt burden is the highest at 54 per cent and 43 per cent respectively.

There’s no doubt that state and territory governments are juggling a multitude of structural and spending pressures. But higher interest rates, precipitated by a credit rating downgrade, would only exacerbate the debt burden and reduce fiscal flexibility.

Governments must focus on the future by implementing prudent fiscal policies, reducing unnecessary spending, and paying down debt. Only then can they mitigate the real risks of credit rating downgrades, ensuring a more stable and prosperous future – one where future generations do not need to pay for our mistakes.