OREANDA-NEWS. Fitch Ratings has affirmed Australia's Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDR) at 'AAA'. The Outlook is Stable. Australia's senior unsecured foreign- and local-currency bond ratings are also affirmed at 'AAA'. The Country Ceiling is affirmed at 'AAA' and the Short-Term Foreign Currency IDR at 'F1+'.

KEY RATING DRIVERS
The affirmation of Australia's sovereign ratings reflects the following factors:

- Australia's 'AAA' rating is underpinned by the economy's high income, strong institutions and effective governance. The free-floating exchange rate, credible monetary policy framework, low public debt and growing recognition of the Australian dollar as a reserve currency allow the economy to adjust to changing economic conditions.

- GDP growth of 2.5% in 2015 was marginally slower than a year earlier, but still outpaced the median of 1.8% for 'AAA' rated sovereigns. A thriving services sector and strong residential investment is helping the economy rebalance away from mining-driven growth, although a recovery in non-mining investment remains elusive. Fitch expects low interest rates to continue fuelling consumption growth, resulting in GDP growth of 2.6% in 2016. Residential investment growth could decelerate from the current fast pace over the next two years, but should be partly offset by a pickup in state infrastructure investment. Increasing production of natural gas and greater spending on education and tourism from non-residents should support export growth. Fitch expects a smaller drag on GDP growth from falling mining investment in 2017, helping push GDP growth up to 2.9%.

- Australia depends more on primary commodity exports, particularly to China, than 'AAA' peers. Exposure to Chinese households through the service sector and capital flows is also increasing. A severe slowdown in China, although not Fitch's base case, could have a widespread negative economic impact. Other downside risks to Fitch's economic forecasts include continued weakness of non-mining business investment and a sharper than expected property market slowdown. Maintaining the recovery in iron ore prices year-to-date could result in an upside risk to Fitch's forecasts.

- Despite resilient GDP growth, a sharp fall in the terms of trade has weighed on nominal income growth, reducing tax revenues and slowing the expected pace of fiscal consolidation. As such, the government does not expect an underlying cash surplus until the fiscal year ending June 2021 (FY21). Fitch estimates Australia's gross general government debt (GGD) at 34.5% of GDP in FY15, still 9.1pp below the 'AAA' median of 43.6%. However, the difference has narrowed from 24.5pp in FY11, when Australia's Foreign-Currency IDR was first upgraded to 'AAA'. Fitch projects the GGD ratio to peak in FY17 should the budget deficit narrow in line with Fitch's baseline scenario. However, a negative economic shock without offsetting policy actions could lead to further deterioration in public finances.

- Fitch considers Australia's external finances a longstanding structural weakness, with the largest net external debt relative to GDP in the 'AAA' rated category. Net external debt, including derivatives, increased to 61.0% of GDP in 2015 from 54.4% in the previous year. This is higher than the previous 2009 peak. Fitch expects the current account deficit to narrow only slightly from 4.6% of GDP in 2015 over the next two years and for net external debt to continue growing. A diversified pool of foreign investors willing to lend to Australian entities in local currency, sophisticated currency hedging and maturity mismatches in the financial sector are helping mitigate some of the external liquidity risks arising from Australia's debt position and reduces the economy's vulnerability against a sharp depreciation in the Australian dollar. However, a sustained reallocation of capital flows away from Australia by foreign investors could raise financing costs and put downward pressure on economic growth.

- The Australian banking system is one of the strongest globally on a standalone basis, based on Fitch's Banking System Indicator (BSI) scoring mechanism. Fitch expects banking sector balance sheets to continue strengthening, with solid capitalisation and recently tightened underwriting standards offsetting slower profit growth and modest asset-quality pressures. However, household debt, at 184.6% of disposable income at end of September 2015, is high relative to peers and makes up the majority of banking system lending assets. Low interest rates, high mortgage offset account saving levels and a stable unemployment rate is helping maintain debt sustainability. But a sharp economic downturn, particularly one accompanied by widespread unemployment and a sudden reversal of house prices after two years of strong growth, could lead to banking sector losses and a higher risk that support is required through the sovereign balance sheet. Fitch considers such a scenario a tail-risk and assumes house price growth will moderate to 2% in 2016 from 8% in 2015.

RATING SENSITIVITIES
The Outlook is Stable, as Fitch does not currently anticipate developments that pose a high likelihood of a rating change. However, future developments that could individually or collectively result in a ratings downgrade include:

- A sustained widening of the fiscal deficit without remedial policy actions, leading to continued upward trajectory of the general government debt-to-GDP ratio.

- A negative external shock, such as a continued rapid decline in the terms of trade following a severe slowdown in China. This could lead to a sharp increase in the current account deficit and/or a sustained reallocation of foreign capital.

- A sharp economic downturn, which could also be triggered by external events, leading to widespread household defaults, banking system distress and the materialisation of contingent liabilities on the public balance sheet.

KEY ASSUMPTIONS
-The global economy performs broadly in line with Fitch's Global Economic Outlook, particularly China, which has become a key destination for Australian exports. Fitch expects the Chinese economy to grow by 6.2% in 2016.

- Fitch assumes an average iron ore price of $45 per tonne in 2016 and 2017, $50 per tonne in 2018 (62% Fe CFR China reference).