Moody's revises outlook on Western Australia's Aa1 rating to negative

Investors Service has revised the outlook on Western Australian Treasury Corporation's (WATC) Aa1 ratings -- backed by the State of Western Australia -- to negative from stable. At the same time, Moody's has affirmed its debt and issuer ratings at Aa1. WATC's Euro Medium Term Note Programme's (P) Aa1 rating and the Prime-1 ratings on its commercial paper program and short-term issuer rating remain unchanged.

RATINGS RATIONALE

The change in outlook to negative from stable reflects the ongoing deterioration in Western Australia's financial and debt metrics. The state's deficit position -- as measured by the ratio of net lending to borrowing -- is projected to widen, as revenues decline due to the drop in the price of iron ore without corresponding measures to adequately redress the budget deficits. These larger deficits will likely increase the state's debt burden which, although still manageable, is at a higher level than its peers.

The rapid rise in iron ore and other royalties, as commodity prices spiked to record highs in 2013, along with adjustments to the royalty rate, pushed up the state's reliance on this volatile source of revenue to 21.6% of income in FY2013/14 from 8.4% in 2006/07. At the same time, these windfalls fueled a rapid rise in current expenditures, with significant enhancements to healthcare, education and justice services resulting in deficit operations during a period of strong economic growth.

With a near halving of iron ore prices over the past 12 months, along with a reduction in Goods and Services-backed (GST) Commonwealth grants -- due to the lag in the application of the equalization formula -- the state has forecast a record-high deficit equal to 13.8% of revenues for FY2015/16. This level would be considerably higher than the 1.4% forecast last year for FY2015/16, and also higher than the December 2014 mid-year estimate of 4.8% of revenues. This forecast follows an estimated deficit of 11.6% of revenues in FY2014/15, and reflects similar trends. The deteriorating budget results are exacerbated by the lack of financial cushions against adverse movements in commodity prices and exchange rates.

As a result of larger cash deficits in the consolidated government sector, including high levels of capital expenditures, the state's debt burden has risen rapidly. Net direct and indirect debt rose to 99.6% of revenues in FY2013/14, up from a modest 44.4% in FY2007/8. The debt burden is forecast to rise to 122.7% of revenues in FY2015/16 before stabilizing over the medium term and, although manageable, is high compared to its peers.

The state plans to narrow the deficit and return to a balanced position with a surplus equal to 5.1% of revenues by FY2018/19. These improvements assume revenues will rise by 5.6% on average over the next four years, outpacing current expenditures, which are now set to rise by a low 2.5%.

On a positive note, the state has implemented some structural changes to ease the rapid growth in public sector employee costs. Measures include the capping of agency salary budgets to CPI, limiting wage adjustments to CPI, and passing legislation to allow for involuntary redundancies, all of which provide additional tools to dampen current expenditure growth. Furthermore, revenue measures, including a series of upward adjustments to the state's land tax and a change to the payroll threshold, will support lower budget gaps. The state is also planning a series of asset sales that -- while one-off in nature -- could ease the expected accumulation in debt.

Ultimately, however, Moody's thinks that the state will be hard pressed to achieve the much lower level of current spending forecast, unless the government fortifies its commitment to budget improvements. Projections rely on reducing the average rate of spending to 2.5%, and to as low as 1.9% in 2017/18, compared with the 6.2% rate registered over the last four years. This will require very low rises in public sector employee costs and a concerted reduction in the growth rate of spending on healthcare and other social services, which could prove difficult in the context of a still rapidly rising population, albeit at slower rates than in recent years. In particular, an accelerated pace of hospital reform will be critical to lower the state's above-average healthcare costs.

Despite these concerns, the Aa1 ratings remain supported by Australia's strong institutional framework, including the equalization formula that is used to distribute GST-backed Commonwealth grants and which will result in a strong rebound in these grants in FY2017/18 and FY2018/19 to reflect declines in state revenues in FY2014/15 and FY2015/16. In addition, the state retains ample budgetary flexibility, with the ability to raise tax rates or reprioritize its high levels of capital expenditures.

Also, while the state's economy is slowing from very high rates of expansion -- to a rate of 3.25% estimated for FY2014/15 and 2.0% in FY2015/16, down from 5.3% a year over the past five years through to FY2013/14 as mining investments soared -- growth will pick up in coming years as production and exports related to large investments in liquefied natural gas (LNG) and iron ore mines ramp up.

What could change the rating -- Up/Down

If the government is unable to meet its lower expenditure targets, and in the absence of offsetting growth in revenues, that result in ongoing large deficits and higher-than-forecast debt accumulation, there would be downward pressure on the rating. The outlook could revert to stable if the state's budgetary redress plan leads to a balanced position with an associated easing in the debt burden.