1. This statement contains information that has become available since the Staff Report was circulated to the Executive Board on September 4, 2003. This information does not alter the thrust of the staff appraisal.

2. Real GDP growth in the second quarter of 2003 slowed to about ½ percent (seasonally adjusted annualized rate), compared with growth of slightly more than 2¼ percent in the first quarter. Domestic demand continued to post very strong gains, rising by around 5¾ percent (4 percent in the first quarter). A deterioration in net exports was largely offsetting, reflecting a sharp drop in exports and a rise in imports. Consequently, the current account deficit rose from 5½ percent of GDP in the first quarter to 6¾ of GDP in the second. Recent indicators point to a rebound in GDP growth in the second half of 2003. Retail and motor vehicle sales have surged in the last few months, consumer and business confidence are high, and the unemployment rate fell to 5.8 percent in August, its lowest level in 13 years. Net exports are not anticipated to deteriorate further; indeed, exports are expected to recover as prospects improve for the agricultural sector with an easing in drought conditions. In the first half of 2003, housing prices continued to post rapid gains, rising at an annualized rate of 18 percent.

3. For 2003, GDP is still projected to grow by 3 percent, and it is expected to pick up to 3¾ percent a year over the medium term, in line with the economy’s currently estimated potential growth. CPI inflation is expected to remain in the RBA’s target range of 2-3 percent. Risks to the outlook have become more balanced, with upside risks becoming more prominent given the continued strength of domestic demand and recovery in agriculture from the drought. Although the Australian dollar resumed its appreciation against the U.S. dollar in September, reaching a value of 70 U.S. cents in October, its trade-weighted value has been largely unchanged. At its regularly scheduled meeting in early October, the Reserve Bank of Australia (RBA) decided to continue to leave the target for the cash rate unchanged at 4.75 percent.

4. Data on the budget outcome for 2002/03 released in September indicate that fiscal performance was significantly stronger than previously estimated. The Commonwealth budget recorded an underlying cash surplus of $A 7.5 billion, equivalent to 1 percent of GDP, which is ½ percentage point higher than estimated at the time of the 2003/04 Budget. Cash receipts were $A 2.2 billion higher than previously estimated, due mainly to stronger-than-anticipated company profits. Cash payments were $A 1.3 billion lower, reflecting lower take-up rates across a range of family and community services and education programs, along with some delays in contracted health expenditures. Net debt of the Commonwealth government declined to $A 29.7 billion (3.9 percent of GDP) at end-2002/03.

5. In an assessment of financial system stability published in September as part of its 2003 Annual Report, the RBA concluded that the Australian financial system remains very sound.¹ The financial soundness indicators monitored by the RBA—including asset quality, capitalization, profitability, and market valuation—continue to provide reassuring readings. Asset quality remains robust, with the ratio of impaired to total assets for the banks continuing at the low level of 0.5 percent. At the same time, lending standards—particularly for mortgages to finance investor purchases of housing—have been tightened. Strong lines of defense also are maintained against a deterioration in credit quality, as banks hold general provisions amounting to around 0.5 percent of total assets and aggregate capital of around 10 percent of risk-weighted assets; nonbank deposit-taking institutions have aggregate capital of 14-15 percent. The banks in particular have maintained high levels of profitability by enlarging their asset bases, containing costs, and diversifying income sources. In the period ahead, the RBA saw the main potential source of risk to financial stability as being a substantial correction in the housing market that could impact on the balance sheets of financial institutions through mortgage defaults. A flattening of, or modest reversal in, housing prices was not seen in itself as a cause for concern. The concern would be a sharp jump in mortgage default rates that would trigger a more substantial housing market correction, a scenario that was viewed as more likely to be associated with a deterioration in employment conditions or a sharp rise in interest rates.

6. In a September 8 address, the Chairman of the Australian Prudential Regulatory Authority (APRA) discussed his agency’s stress tests of the housing loan portfolios of Australian deposit-taking institutions. APRA tested the resilience of each individual institution’s mortgage portfolio to a 30 percent drop in housing prices over a one-year period and a probability of default on housing loans of around 3½ percent for deposit-taking institutions as a group, conditions which are far worse than Australia has experienced historically. The tests suggest that such a substantial correction in the housing market would not in itself be cause for undue alarm about the strength and stability of the sector. The capital position of these institutions as a group—though reduced—would not be materially affected, and over 90 percent of them would survive such a shock without breeching minimum regulatory capital requirements. Breeches of minimum capital requirements by a small number of institutions would not be large, and no institution would fail or come uncomfortably close to failing. The tests, nonetheless, drew APRA’s attention to potential shortcomings in information systems and specific improvements that are needed to strengthen risk management policies and capital positions at some individual institutions, and APRA will be working with these institutions to achieve improvements. Where necessary, APRA would raise minimum capital ratios for institutions whose housing lending practices are judged as not being up to standard.