Rising state debt threatens Australia’s AAA credit rating amid mounting deficits

Imagine for a minute you are Treasurer Jim Chalmers, responsible for a massive $700 billion Budget and all of a sudden you are facing a dramatic rise in interest payments on Government debt.

It would be a shocking concern but the really tough bit to take would be if you had absolutely no control over the reason for the hike – high and rising state government debt in Victoria and NSW.

This is actually not a far-fetched scenario and could happen fairly soon as ratings agencies react with alarm at the rapid and sticky rise of state debts since the Covid pandemic.

Despite two successive Budget surpluses at the Federal level, global ratings agency Fitch has confirmed that rapidly rising state government debt fuelled by massive infrastructure spending in Victoria and NSW is putting Australia’s overall credit rating at risk.

What makes the situation even worse is that the Federal Government’s forward estimates now predict that it will be running Budget deficits from here on for at least a decade.

Could the coveted AAA rating disappear?

The sharp rise in state government deficits and debt is adding to medium term pressure on Australia’s coveted AAA credit rating according to Fitch and are becoming much more important when it comes to assessing Australia’s overall fiscal position.

Unlike many countries such as most of Europe, in which non-national governments are restrained by national or European Union borrowing limits, Australian states have no real limits on how much they can borrow and spend.

It is not too hard to see why the ratings agencies are so worried.

As Fitch analyst Jeremy Zook points out, state gross debt has risen steadily from about 7% of GDP in 2018-19 to more than 15% in 2024.

If we can believe budget forecasts, which have a habit of being optimistic, state gross debt is set to rise to a staggering total of just under 20% of GDP by 2028.

That means that despite Federal Government surpluses, these elevated levels of state debt have kept the overall level of government debt in deficit – something that will get worse as the Federal Budget also slips into deficit in coming years.

State debt still rising

Mr Zook said rising state deficits were becoming increasingly important in Fitch’s assessment of Australia’s overall fiscal position and are likely to be slow to fall.

Indeed, it will be 2028 before state debts start to return to pre-pandemic levels as a series of infrastructure projects continue to pump up debt.

Ratings agency S&P Global has previously warned that state debt was on track to hit $800 billion by 2028 – triple its pre-pandemic level.

As you might expect, the main population states of Victoria, NSW and Queensland account for the vast bulk of the infrastructure spending, although Victoria deserves a special mention for exceptional spending well above what the population would suggest.

Victoria the debt champion

That has led to Victoria having the nation’s lowest credit rating of AA after it was downgraded a full two notches during the lockdowns.

That poorer rating, compared to AA+ for most other states and AAA For Western Australia, also bumps up the cost of debt servicing, which is why Victoria’s auditor general forecast that the state’s gross state debt would reach $228 billion by 2028.

Indeed, S&P numbers predict Victoria is set to overtake NSW as the most indebted state in outright dollar terms, despite being 25% smaller than NSW.

Apart from potentially reducing Australia’s overall credit rating, the high levels of state debt have also helped to push government spending to a record 27.3% of GDP in the June quarter and potentially held interest rates higher for longer by prolonging inflation.

Household income falling fast in Victoria

The Victorian government has been fighting off negative assessments with a recent in-depth analysis by independent economist Saul Eslake concluding that Victorian household income had dropped below that of Tasmania for the first time.

Data compiled by PinPoint Macro Analytics shows that real household income in Victoria has nosedived since 2019 compared to other Australian states, as well as the US and OECD averages.

Real household income in Victoria has dropped by 6.5% since 2019, while the rest of Australia declined by 2.2%.

US household data grew by 8% over that time and the OECD average was up 6.3%.

PinPoint chief economist Michael Blythe said Victoria had been particularly damaged by its extensive pandemic lockdowns, low office attendance and a flatlining property market.