Ratings On Commonwealth of Australia Affirmed At AAA/A-1+ On Sound Fiscal Performance Primary Analyst: Kyran Curry (Melbourne) Secondary Analyst:

Kim Eng Tan (Singapore) Overview Australia has high fiscal flexibility, supported by a soundly performing economy and financial system. The countrys high reliance on external savings and commodity income to fund growth are key vulnerabilities. We have affirmed the ratings on Australia at AAA/A-1+, and the outlook remains stable. Rating Action On Sept. 23, 2011, Standard & Poors Ratings Services affirmed its unsolicited AAA longterm and A-1+ short-term sovereign credit ratings on the Commonwealth of Australia. The outlook remains stable. Rationale The unsolicited ratings on Australia reflect Standard & Poor's view of the country's ample fiscal and monetary policy flexibility, economic resilience, public policy stability, and its sound financial sector. We believe these factors demonstrate Australias strong ability to absorb large economic and financial shocks, such as the global recession in 2009. These strengths are moderated by Australia's high external imbalances, dependence on commodity exports, and high household debt and emerging fiscal pressures associated with its aging population. The Australian economy performed relatively well in the year ended June 30, 2011, as very strong mining exports and private investment in mining and liquefied natural gas offset weakness in household consumption and temporary economic weakness associated with natural weather disasters. We believe the economy has favorable prospects for sustained growth while there remains strong demand for commodities from emerging Asia, particularly China (see "Uncertain Global Outlook Threatens To Derail Australia's Economic Recovery," published Sept. 12, 2011, on RatingsDirect on the Global Credit Portal). In our view, the Australian economys overall resilience, including to the global downturn in 2009, reflects decades of structural reforms, wages restraint, and a sound savings rate. However, Australia has what we consider to be strains on its financial sector compared to other highly rated sovereigns, reflecting its heavy external borrowings to partly fund investment in its mining sector. Although there has been private-sector deleveraging in recent years, including by households, we believe that the high debt burden will constrain growth in domestic consumption over the next three years as the government withdraws fiscal stimulus. That said, we predict that the robust outlook for commodity prices, allied with a strong pipeline of mining investment, will underpin a return to trend growth of 3.5% by 2013. Although Australias public finances have worsened as a result of the global recession, the deterioration has been more contained than for most AAA rated peers, whose steep deficit increases have been more pronounced and may well persist for longer. We estimate that Australias general government (including federal, state, and local governments) will record a

deficit of 4.4% of GDP in 2011, and to return its balance to surplus in 2013, despite the weaker-than-forecast budget balance in 2011 as a result of the natural disasters. We estimate that the general government debt burden will rise by two percentage points of GDP to 21.3% in 2011. In view of our forecast of a deficit of 2.5% of GDP in 2012, we project that Australia's general government debt burden will peak at 22.6% of GDP in 2012, before trending lower as the deficit shrinks further. This level of government debt is considerably lower than that of other 'AAA' sovereigns. Moreover, we believe that Australias resilient economy, strong balance sheet, and the government's cheap access to capital market funding give the sovereign a higher debt-bearing load capacity. That said, we believe that Australias private sector debt levels are among the highest of any rated sovereign and are a key vulnerability. The federal government has outlined a two-year fiscal consolidation program from 2011 worth A$52.9 billion (3.8% of GDP), more than half of which is expected to come from keeping average real growth in spending of about 1% over the forward-estimates period. This represents one of the fastest consolidation programs among AAA rated sovereigns. The governments intention is to maintain expenditure restraint through a 2% annual cap on real spending growth, on average, until surpluses are at least 1% of GDP, while the economy is growing at or above trend. We believe this commitment will be supported by strong bipartisan political and community backing for conservative public finances, as well as stable political consensus on fiscal, monetary, and exchange-rate policies. As for other advanced sovereigns, Australia faces significant long-term age-related spending pressures on health, pensions, and aged care. In this respect, Australias longer-term fiscal consolidation will benefit from the continued build-up of assets to fund government pension obligations, of which the central government's unfunded component was well below most 'AAA' rated peers, at an estimated A$129.5 billion (9.3% of GDP) at June 30, 2011. Although Australia's public sector finances are not strained, private-sector balance sheets-particularly in the banking system--carry a high level of external liabilities. These liabilities were an estimated 217.8% of current account receipts in 2011, reflecting current account deficits associated with banks external borrowing to fund lending for domestic residential housing and businesses (about 57% and 32% of financial system lending, respectively). An expected widening in Australia's current account deficits to about 4.5% of GDP by 2014 (from 2.4% in 2011) partly reflects a boost in export capacity from higher private investment in the mining sector. We expect this widening to be financed through foreign direct investment (which has funded about 43% of Australias current account deficits on average over the past five years), retained earnings, and long-term debt. Australia's gross external financing requirement (the current-account balance plus amortization of long-term external debt plus stock of short-term external debt) was about 209% of current-account receipts in 2011, but we note that this measure remains well below highly related peers. In our opinion, the risks associated with Australia's high private-sector external debt are manageable because of the countrys soundly performing financial system, a large degree of foreign currency debt hedging, and an actively traded currency (see "Australias External Debt Is A Weakness But The Credit Risk Is Ameliorated, And Here Are Nine Reasons Why," published Sept. 23, 2010). Although we consider that loan loss provisions of the Australian banking system are likely to remain low by international standards, lending growth and profit margins in the sector may be dampened by cautious consumer sentiment, intensifying competition for retail deposits, and more financially onerous regulatory requirements.

Nevertheless, we expect that the credit profile of Australia's banking sector to remain sound, supported by the banks' conservative risk appetite and good capitalization, and the country's sound economic outlook (see "Australia Banking Outlook: Credit Slowdown And Margin Pressures Are Likely To Dampen Earnings Growth, published June 1, 2011). Furthermore, we observe that Australia has an independent monetary policy with a freefloating currency that allows external imbalances to adjust. The Australian dollar is also the fifth-most actively traded currency in the world. A large portion of the nation's external debt is denominated in Australian dollars, while much of the remainder finances companies with revenue in foreign exchange or is hedged. In summary, we view Australia's financial and capital markets as well developed and supportive of the rating. Outlook The stable outlook reflects our view that Australia's public finances will continue to withstand potential adverse financial and economic shocks, and our belief that the country's consensus in favor of prudent budgetary policies will remain in place. Moreover, our basecase scenario assumes that fiscal consolidation will continue, and that the general government debt burden will remain low and on a declining trajectory. Conversely, the ratings could be lowered if, against our expectations, there is a protracted deterioration in the fiscal balance, leading to persistent growth in the public debt burden. A weakening in the external environment, or in the credit metrics of the financial system, may lead to a lowering in the ratings given Australias high reliance on external savings and commodity income to fund growth. Over the longer term, Australia's aging population will continue to present a challenge to public finances. Although Australia is well ahead of most peers in reducing these intertemporal imbalances, continued commitment to pre-funding age-related spending will be required to ensure the long-term sustainability of government finances. Related Criteria And Research Government Rating Methodology And Assumptions, June 30, 2011 Asia-Pacific Sovereigns Are Not Immediately Affected By The U.S. Downgrade, But Long-Term Consequences Could Be Negative, Aug. 7, 2011 Asia Pacific's Top 40 Banks Navigating Rough Waters Well -- For Now, June 27, 2011 Inflation Is Biggest Risk To Stable Outlook For Asia-Pacific Banking Sector, June 6, 2011 Australia Banking Outlook: Credit Slowdown And Margin Pressures Are Likely To Dampen Earnings Growth, June 1, 2011 Banking Industry Country Risk Assessments, Sept. 8, 2011 Asia-Pacific Sovereigns: Is The Positive Rating Trend On Hold?, Sept. 20, 2011.