Ratings agency Fitch has affirmed Australia’s prized AAA credit rating but downgraded its outlook to “negative” from “stable”, citing the impact to the economy and public finances from the COVID-19 pandemic.

Fitch said it expects Australia’s economic growth will fall sharply in 2020 and government spending in response to the health and economic crisis will cause large fiscal deficits and a sharp increase in government debt.

It forecast the $2 trillion economy to contract 5 per cent this year driven by a plunge in economic activity during the second quarter due to virus containment measures.

“While these measures have effectively curbed the spread of the virus, they also constrained household consumption and reduced business sentiment and investment,” Fitch said.

It expects a gradual economic recovery to begin in the second half of 2020 affirmed Australia’s rating but said a downgrade is possible in the absence of a fiscal consolidation strategy or if there is economic or financial sector distress.

Fitch said fiscal deficits are set to swell at both the federal and state levels as a result of the discretionary fiscal measures such as the $130 billion JobKeeper wage subsidy program and economic contraction.

It forecast government deficit to rise to 6.9 per cent of GDP in 2019/20 and 9.0 per cent in 2020/21, from 1.2 per cent in 2018/19.

Fitch’s move follows a similar action by S&P Global Ratings in April, when it downgraded outlook on Australia from stable to negative as a result of the government’s stimulus measures.

Federal Treasurer Josh Frydenberg said Fitch’s action is a reminder of the importance of maintaining medium term fiscal sustainability.

“Our measures are temporary, targeted and proportionate to the challenge we face and will ensure Australia bounces back stronger on the other side, without undermining the structural integrity of the Budget which Australians have worked so hard to restore,” he said in a statement.