The news that Australia has regained a AAA credit rating from Standard & Poors sounds good, but what does it mean?
The direct benefits of a higher credit rating are quite small. Typically, a one-step upgrade reduces the interest rate on new bonds by about 20 basis points (0.2 percentage points) Hence, for a gross debt of $50 billion, the total benefit would be around $100 million per year, and this would only be realised when the entire outstanding debt had been rolled over at the new, lower rate. Such a gain could easily be outweighed by marginal timing variations in the issuing of new debt.

In view of the small direct benefits of a credit upgrading, the emphasis placed on credit ratings in the Australian policy debate must be attributed primarily to the view that credit ratings represent an impartial judgement of the soundness or otherwise of fiscal strategy. In general, it is true that policies that tend to have a favourable (or unfavourable) impact on the fiscal sustainability of government policy will also have a favourable (or unfavourable) impact on credit ratings. For example, the introduction of unfunded expenditure programs, or cuts in taxes that are not matched by expenditure savings will tend to reduce credit ratings.

However, this argument does not apply in all cases. Credit ratings are designed specifically to inform and protect the holders of government debt. Policies that specifically improve the position of holders of government debt will be viewed favourably by credit rating agencies even if they are harmful to the state as a whole. In particular, reductions in the level of debt will tend to improve credit ratings even if they are financed by inefficient taxes and charges or by the sale of income-earning assets at inadequate prices. The imposition of inefficient taxes and charges will tend to discourage investment and employment while the sale of income-earning assets at inadequate prices will reduce the net worth of the public sector and, ultimately, the capacity to provide public services, even though both measures may improve credit ratings.

Similarly, a government will generally improve its credit rating by forgoing investment opportunities, even if the investments have an expected rate of return well above the cost of capital. The same is true for corporations, and it is one reason why very few corporations now seek to maintain a AAA rating – the cost in terms of foregone investments exceeds the benefits.

Corporations that do maintain a AAA rating are generally involved in financial activities where such a rating is required by regulation or where a short-term loss of confidence could prove fatal. Confidence is important to governments too. However, the availability of the taxing power means that there is no real danger of a run on government debt until finances get in really bad shape – far below the AA levels that have provoked concern in Australia.