The recent downgrading of Western Australian state government debt by ratings agency Moody’s (following a similar step by Standard and Poor’s last year) leaves New South Wales and Victoria as the only Australian states with a AAA credit rating. The responses have been predictable. The WA opposition called on the Treasurer to resign, while business groups called for a program of asset sales to restore the “prized” AAA rating. But what does a AAA rating mean, and is it a sensible goal for governments to pursue?
A credit rating is not a seal of approval for the quality of government in general. As the example of NSW shows, a government can be riddled with corruption and still hold a AAA rating on its debt. By contrast, New Zealand, which routinely tops ratings for governmental transparency and freedom from corruption, has a rating two grades lower at AA.
Even when the focus is narrowed to economic management, there is little correlation between credit ratings and economic performance. India has been booming for the last two decades, while Japan has stagnated, but Japan still has a higher credit rating.
Credit ratings have a single purpose: to assess the probability that the interest and principal on a bond will be paid in full and on time. A government can be well or poorly run, provide excellent or terrible public services; none of this matters to the credit rating as long as the ratio of debt to revenue capacity remains low.
Credit ratings originate in the corporate sector and reflect a conflict inherent in the very structure of a corporation. Corporate managers have a fiduciary obligation to advance the interests of their shareholders, but also a legal obligation to honor their debts to bondholders. In some respects, these obligations reinforce each other. Wasteful spending and bad investment decisions will harm both shareholders and bondholders.
When it comes to risk, however, the interests of shareholders and bondholders are opposed. A risk that pays off, yields higher returns to shareholders but gives no extra return to bondholders. On the other hand, a risk that turns out badly enough to send a company into liquidation means that both shareholders and bondholders lose their money.
So a AAA rating is great for bondholders, but not so good for shareholders. In theory, this should all even out. The AAA rating means a lower rate of interest, which should exactly offset the reduced risk of default. The classic analysis of the corporate finance problem, by Franco Modigliani and Merton Miller, reached a stronger conclusion: the value of a company is unaffected by the choice between bond and equity financing.
In reality, however, the profits foregone through the conservative financing needed to secure a AAA rating outweigh the benefits of lower rates of interest on debt. For that reason, all but a handful of corporations have abandoned AAA ratings. Of the 500 leading corporations listed by Standard and Poor’s in the US, only three have AAA ratings.
A government is not a corporation, but it faces the same problem of being accountable to multiple stakeholders with conflicting interests. The primary responsibility of governments is to the citizens who elect them, but it is neither possible nor desirable to ignore economically and socially important interest groups, including businesses, trade unions and, most relevantly in the current context, bondholders.
The possibility that an Australian government will default on its debt is remote. The closest we ever came was during the Great Depression, when the Lang government in NSW refused to make interest payments to (primarily British) bondholders. The Commonwealth stepped in to make the payments, and Lang was dismissed by the state governor and defeated at a subsequent election.
Though it is unlikely in Australia, overseas experience shows that when governments default on their debt, citizens usually suffer significant hardship. So it makes sense for governments to manage their finances carefully, to ensure they have plenty of reserve capacity to manage adverse shocks. However, governments have many other concerns, just as important or even more so: they must invest in infrastructure, protect public health, provide education services, deal with natural disasters and so on.
For bondholders, by contrast, these other concerns are of no interest; the only risk that matters is that of default. So, just as with private corporations, there is a conflict between the interests of bondholders and those of other stakeholders, most importantly citizens. Bondholders will always prefer a AAA rating, but that may not be the best choice for citizens.
Also as with private corporations, the interest rate saving associated with a AAA rating may not be sufficient to offset the cost of the measures needed to achieve and maintain such a rating. An upgrade of one step in credit ratings is typically associated with an interest rate reduction of 0.2 to 0.4 percentage points (in the jargon of financial markets, 20 to 40 basis points). On a debt of $50 billion, comparable to that of NSW, that saving would be worth $100 million to $200 million per year. But the policies often advocated to secure or maintain AAA ratings, such as public-private partnerships and privatisations may cost far more.
To take just one illustrative example, the failed privatisation of Port Macquarie hospital, undertaken by the Greiner government in the early 1990s, cost the NSW public around $50 million a year, until the hospital was eventually taken back into public ownership. That’s just one regional hospital. The losses incurred through bungled toll road projects, largely borne by road users, are incalculably larger.
For governments, as for households and businesses, low debt levels are a good thing if they can be obtained easily. But forgoing economically and socially valuable investments, or selling assets at less then their true value, in pursuit of a higher credit rating is not fiscal prudence, it is economic mismanagement of the highest order.