Fitch Ratings affirmed Australia's triple-A sovereign debt rating, but warned surging house prices hold the potential to destabilise the country's banks.
With Treasurer Joe Hockey set to announce the government's first budget in mid-May, Fitch is anticipating substantial spending cuts to underpin a medium-term plan to reduce public debt.
The government "hasn't announced any concrete measures yet, but the budget is likely to include significant spending cuts," Fitch said in an internal report obtained by The Wall Street Journal.
The resource-rich economy is expected to continue growing at a pace below its long-term average of around 3 per cent in coming years, as the end of a decade-long mining investment boom acts as a headwind to activity.
"The end of the mining investment boom that supported growth over the past years has now set in and there are still substantial uncertainties surrounding the outlook," Fitch said.
The ratings agency also warned that if house prices in Australia continue to rise at their current pace, it could at "some stage impact gross domestic product growth and bank balance sheets."
Still, the country's banks are strong.
"The banking sector remains resilient. Major banks' capital holdings are currently rising and their profitability is expected to remain solid through 2014, providing a buffer to absorb a possible asset quality deterioration," the agency added.
Fitch's warning on housing comes as house price gains accelerate, fanned by record-low interest rates.
House prices jumped by a record 2.3 per cent in March from February, lifting home values in half of Australia's major cities to record levels. Home prices in Australia's capital cities have risen by nearly 11 per cent over the past year; in Sydney, the country's largest market, they are up nearly 16 per cent.
The Reserve Bank of Australia has indicated recently its growing concern about the pace of house-price increases.
RBA Governor Glenn Stevens told a Brisbane audience yesterday that even a modest overheating in housing markets can have long-term negative consequences for economic growth.
"Overdoing it on housing on the way up is usually followed by a fairly extended period of working off the problems," Mr. Stevens said.
Kieran Davies, chief economist at Barclays Australia, said the concern over house prices is justified as household debt in Australia has reached a record high.
"The RBA would be concerned by the exuberance in housing," Mr. Davies said.