Victoria’s debt-laden budget and fragile AA credit rating are under threat from the escalating conflict in the Middle East, analysts warn, as the war triggers infrastructure cost blowouts in an election year.
The global fuel shock is upending economic assumptions baked into the Victorian budget as the war pushes up expenses – including for fuel, steel, concrete and bitumen – on Big Build projects such as the North East Link and Suburban Rail Loop.
Premier Jacinta Allan has conceded Victoria is not immune to escalating global pressures but maintains the state is on track to deliver an operating surplus this year, as economists warn the fiscal strain could be the most severe since the 1990s financial crisis.
S&P Global Ratings analyst Rebecca Hrvatin said that while the state’s rating remained stable for now, any major increase in expenses compared with current expectations posed a downside risk.
“If high oil prices, rising inflation and supply chain disruptions persist, Victoria’s operating balances would likely weaken and its infrastructure pipeline could face renewed pressure, including cost overruns and project delays,” she said.
Treasury sensitivity analysis shows Victorian net debt will balloon by an extra $1.67 billion by 2028 if interest rates stay just 1 percentage point above 2025 projections. While the May 2025 budget assumed the 3.85 per cent cash rate would fall, it has instead risen to 4.1 per cent.
Inflation has also outpaced expectations. While the budget forecast CPI at 2.75 per cent through 2026-27, federal Treasurer Jim Chalmers this week suggested inflation could reach the “mid to high fours.”
Treasury modelling shows that while higher consumer prices initially boost tax revenue, the rising cost of providing government services eventually outpaces income. A 1 per cent increase in expected CPI would result in a $327 million increase in expenses this financial year alone.
The state’s mid-year financial report published this month said Victoria was still on track to post a $710 million surplus for the full year, as the state’s net debt rose above $160 billion. But economists say even these figures are now likely to be optimistic.
David Hayward, RMIT emeritus professor of public policy and the social economy, likened the current budget volatility to Victoria’s financial crisis of the early 1990s, noting that the state was again facing high levels of debt while interest rates were racheted up to combat global inflation.
“Up until the calamitous Middle East situation, the budget was looking stronger than it had been for a while, and I think this will undercut this,” Hayward said.
He said it was an unusual time as the federal government would be trying to slow the economy, which would mean higher unemployment.
“If you’re a state government running to an election, the last thing you want is that to happen,” Hayward said.
Asked about the effect of global instability on state finances and infrastructure projects, Allan said Victoria was not immune from supply chain threats. “We are the only government, federal or state, on the eastern seaboard to be delivering an operating surplus this financial year, and the recent budget updates confirmed that position,” she said last week.
The government has recently focused on cost-of-living sweeteners with minimal budget impact, such as expanding prescribing powers for GPs and pharmacists, and mandating free building and pest inspection reports.
But Hrvatin said high oil prices and rising inflation could embolden the government to increase cost-of-living support in the lead-up to the November election – further increasing expenses.
“Rising interest rates would result in higher interest expenses, potentially requiring difficult trade-offs to be made,” she said. “This could also impact the government’s ability to respond to future shocks within the AA credit rating.”
Price rises are already being felt across the construction industry, creating further concern about cost blowouts on the state government’s Big Build.
The price of bitumen – which is made from refined crude oil – has risen about 50 per cent since the start of the war, according to the Australian Flexible Pavement Association, the peak road construction industry group.
Chief executive Tony Aloisio said that price rise, along with higher prices for diesel – which is used for everything from asphalt production to hauling materials and operating rollers – would lead to the cost of laying asphalt jumping 15 to 20 per cent.
“For a project like the North East Link, we’ll be talking about millions of dollars of extra costs that will come along,” he said.
Independent economist Saul Eslake said that if the fuel shock continued, it would result in higher long-term interest rates, which would hit Victoria hard because of its high debt.
“In additional to issuing new debt to finance deficits it’s going to run in the years ahead, it also has to refinance maturing debt that was almost certainly borrowed at much lower interest rates four or five years ago,” he said.
Eslake said that in the absence of spending cuts or higher taxes, the budget would be in somewhat worse shape than the budget review published just before Christmas, and warned against increased spending in an election year.
He warned of further cost overruns across Big Build sites, noting the government appeared determined to press ahead as surging fuel prices drove up the cost of essential raw materials and logistics.
The closure of the Strait of Hormuz – a shipping channel carrying 20 per cent of global oil supplies – has driven Brent crude to nearly US$110 a barrel. The 50 per cent price surge since the start of the war last month marks a level not seen since the aftermath of Russia’s 2022 invasion of Ukraine, when soaring energy costs and disrupted supply chains contributed to significant blowouts across Victorian infrastructure projects.
Trent Wiltshire, research and development manager at construction industry consultant Rider Levett Bucknall, said the oil price shock was already hitting transport costs and would eventually flow through to major material inputs such as steel and cement.
“We have already seen the conflict have an impact on contract negotiations between builders and developers – both sides are cautious about the impact on costs,” he said.
Wiltshire said construction costs were already being driven higher by a shortage of workers, which would be exacerbated as preparation for the Queensland Olympics picked up.
Housing and Suburban Rail Loop Minister Harriet Shing said the government was working to make sure it had the fuel it needed across all major project sites, including the rail loop.
“Obviously, large-scale machinery requires fuel to operate, and we know that our fuel markets are under significant pressure in Australia and globally,” she said.
Opposition Leader Jess Wilson said Labor’s “financial mismanagement” had left Victoria badly exposed to external shocks.
“Higher inflation and interest rates will only mean poorer servicers, higher taxes and place Victoria’s dire financial position under even greater pressure,” she said.
Paul Norris, a senior director at Fitch Ratings, said the state’s massive infrastructure pipeline had heightened its exposure to global supply chain disruptions, warning that cost inflation could “challenge fiscal outcomes and squeeze budgetary flexibility”.
While Fitch’s base case does not yet assume a material hit to Victoria’s credit metrics, Norris cautioned that a prolonged disruption remained a key downside risk.
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Daniella White is a state political reporter for The Age. Contact her at da.white@nine.com.auConnect via X or email.
Patrick Hatch is transport reporter at The Age and a former business reporter.Connect via X or email.