Australia
2007 Article IV Consultation-Staff Report; Staff Supplement; and Public Information Notice on the Executive Board Discussion

This 2007 Article IV Consultation highlights that the lengthy expansion brought the Australian economy to a position of near full employment. Inflation had eased in late 2006 and early 2007, but accelerated in the second quarter. The current account deficit was 5½ percent of GDP in 2006. The trade deficit narrowed, while the investment income balance continued to deteriorate, reflecting large net dividend payments. The Australian dollar has appreciated substantially over the past few years, but does not appear misaligned once the recent terms of trade gains are taken into account.

Abstract

This 2007 Article IV Consultation highlights that the lengthy expansion brought the Australian economy to a position of near full employment. Inflation had eased in late 2006 and early 2007, but accelerated in the second quarter. The current account deficit was 5½ percent of GDP in 2006. The trade deficit narrowed, while the investment income balance continued to deteriorate, reflecting large net dividend payments. The Australian dollar has appreciated substantially over the past few years, but does not appear misaligned once the recent terms of trade gains are taken into account.

I. Economic Developments

1. After a brief slowdown, Australia’s real GDP expanded by 3¾ percent over the year to the first quarter of 2007, while inflationary pressures have moderated. The pace of non-farm GDP growth accelerated, partly reflecting the surging terms of trade (TOT) driven by commodity prices. However, a severe drought sharply reduced output in the farm sector, subtracting about ¾ of a percentage point in GDP growth in 2006/07. Growth has been driven by domestic demand with consumer spending accelerating in the second half of the year, supported by rising employment and real wages (Table 1 and Figure 1). Australia’s lengthy period of expansion has brought the economy to a position of high capacity utilization and tight labor markets. However, both headline and core inflation have eased recently reflecting in part temporary factors, particularly fuel and food prices (Figure 2).

A01ufig01

Real GDP growth

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

Source: Australian Bureau of Statistics.
A01ufig02

CPI Inflation

(Percent change y/y)

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

Sources: Australian Bureau of Statistics and Reserve Bank of Australia1/ Average of weighted median and trimmed mean inflation calculated by RBA.
Table 1.

Australia: Selected Economic Indicators, 2003–08

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Sources: Data provided by the Australian authorities; and Fund staff estimates and projections.

Includes public trading enterprises.

Fiscal year ending June 30, Commonwealth Budget.

Excludes asset sales and other one-off factors; cash basis.

Data for 2007 are for latest available month.

IMF, Information Notice System index (1990 = 100). Data for 2007 are for latest available month.

Figure 1.
Figure 1.

Australia: Real Economic Indicators

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

Figure 2.
Figure 2.

Australia: Inflation and Labor Market Indicators

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

2. The current account deficit remained slightly above 5½ percent of GDP in 2006, reflecting high investment and a strong currency. Historically, Australia has run on average a deficit of about 4½ percent of GDP. In 2006, the trade deficit narrowed, owing to higher export prices and a modest lift in volumes (Table 2 and Figure 3). However, the volume of imports rebounded recently, driven by firming growth in domestic demand, including strong imports of capital goods. The investment income balance continued to deteriorate, reflecting large net dividend payments particularly in the resource sector. Net foreign liabilities increased to over 60 percent of GDP. The private sector accounts for 99 percent of Australia’s net external debt, with 78 percent intermediated by private financial institutions.

A01ufig03

External Current Account Deficit

(Four-quarter average, in percent of GDP)

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

Source: Australian Bureau of Statistics
Table 2.

Australia: Balance of Payments, 2003-2008

(In percent of GDP)

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Sources: Data provided by the Australian authorities; and Fund staff estimates and projections.
Figure 3.
Figure 3.

Australia: External Developments

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

3. Macroeconomic prospects remain favorable. Staff project GDP growth to accelerate above 4 percent in 2007 and moderate slightly in 2008 (Table 3). Growth will continue to be broad based. The global environment is expected to remain supportive, driven by strong growth in major trading partners. Exports are likely to increase as investment in the mining sector becomes productive. The current account deficit should remain stable in 2008 as the balance on goods and services improves, though the income deficit continues to create some drag. CPI inflation is expected to ease further in 2007 to slightly over 2 percent but recover to around 2¾ percent in 2008, within the Reserve Bank of Australia’s (RBA) target band of 2-3 percent.

Australia: Medium-Term Scenario 2006–12

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Sources: Data provided by the Australian authorities; and staff estimates and projections.
Table 3.

Australia: Medium-Term Scenario 2006–12

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Sources: Data provided by the Australian authorities; and staff estimates and projections.

Includes public trading enterprises.

Fiscal year basis ending June 30.

Underlying cash balance equals receipts less payments, and excludes Future Fund earnings.

Assuming the sale of the government’s remaining shareholding in Telstra.

4. The short-term risks to the outlook appear to be on the upside, while the medium-term risks are balanced. A recent pickup in housing starts, recovery in rural income with the easing of the drought, and a lift in natural resource export volumes could lead to faster growth and pressure on inflation. The medium-term risks are evenly balanced and stem mainly from external developments, although risks from the recurrent droughts and household balance sheet consolidation remain. If the global economy slows significantly, for example owing to a possible financial turbulence, commodity prices could fall deeper and more rapidly than assumed, reducing exports, dampening investment, and slowing growth. On the other hand, commodity prices could continue to outperform expectations as they have for the past several years. This could present challenges including upward pressure on an already stretched economy.

A01ufig05

RBA Commodity Prices and Market Forecasts

(Index)

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

Source: Reserve Bank of Australia and Access Economics

II. Policy Discussion

5. In view of Australia’s strong macroeconomic and policy performance, including external stability, this year’s consultation discussions were streamlined. The policy priorities remain to foster economic growth, maintain price stability, strengthen the financial system, and enhance productivity through structural reforms. Given the robust fiscal position and the favorable outlook—partly because of the improvement in the TOT—there now exists an exceptional opportunity to achieve these goals. With the upcoming Federal election, however, it will be important to keep economic policy from deviating from its medium-term objectives. Discussions focused on the appropriate macroeconomic policies in light of limited spare capacity and the strategy to manage the long-term challenges related to growth.

A. Appropriate Policy Settings in a Full Employment Environment

6. The challenge for policymakers in the near term is how to guard against upside risks. Both fiscal and monetary policy are well-positioned to deal with downside risks, especially with a very strong fiscal position. The authorities need to be mindful, however, of upside risks by keeping aggregate spending in line with the economy’s productive capacity without adding to inflationary pressures and by building capacity.

7. Monetary policy has remained supportive of economic activity while ensuring low and stable inflation. The RBA appropriately raised the official interest rate by 25 basis points three times last year to 6¼ percent, in view of the tight capacity utilization and a build-up of inflationary pressures (Figure 4). However, recently the RBA considered that the evidence from producer and consumer price indices indicated that inflation had moderated. Also, the surging value of the Australian dollar has helped dampen prices. In view of a relatively short policy effectiveness lag in Australia, staff concur with the RBA that this easing of inflationary pressures has allowed further time to assess the need for further tightening.

A01ufig06

Nominal Interest Rates

(In percent)

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

Source: Reserve Bank of Australia
Figure 4.
Figure 4.

Australia: Financial Market Indicators

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

8. However, if signs of inflationary pressure were to reemerge, this would call for a prompt policy action. Key concerns to the inflation outlook relate to the ongoing strength in domestic activity, household credit, and wage outcomes. The RBA is monitoring these developments, and Governor Stevens has stated publicly that the political calendar would not influence the monetary policy decisions.

9. The Australian dollar has been appreciating substantially over the past few years, but does not appear misaligned once the recent TOT gains are taken into account, especially if these gains are permanent. The recent appreciation partly reflects the surge in the TOT (40 percent in the last 4 years) and strong capital inflows, encouraged by the differentials on interest rates along with the perception that these differentials are likely to persist for some time.1 The available estimates for the overvaluation of Australian dollar’s real effective exchange rate (REER) range from 1 percent according to an RBA model (which is based on the TOT changes so far) to 9 percent according to two of the CGER estimates that take into account the projected partial reversal of the TOT gains over the medium term.2 Based on this, the staff believes that there is no significant misalignment of the exchange rate.

A01ufig07

REER and the Terms of Trade 1/

(March quarter 1995 = 100)

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

Source: Authorities and Fund Staff estimates.1/ REER using RBA trade weights.
A01ufig08

REER: Actual and Model 1/

(March quarter 1970 = 100)

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

Source: Reserve Bank of Australia1/ REER using RBA trade weights.

10. The RBA’s general approach is to let market forces determine the exchange rate. They noted that the currency appreciation has played a valuable role in easing inflation pressures directly through lower import prices, and indirectly by switching expenditure to imports when capacity utilization was high. The RBA has taken advantage of the relatively high Australian dollar to accumulate a modest amount of additional reserves, with negligible effect on the foreign exchange market.

A01ufig09

Ratio of Foreign Reserves Assets to Imports

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

Source: Reserve Bank of Australia

11. External debt continues to rise. Net external liabilities reached 60 percent of GDP in 2006, and are projected to increase further as high current account deficits are expected to persist over the medium term (Figure 5). The high deficits are primarily due to high domestic investment, which reflects attractive investment opportunities in Australia, including vast reserves of natural resources. There is little reason to believe that a sudden reversal of the current account balance is bound to occur in the future. Nevertheless, staff raised questions about external stability implications of high and rising external debt.3

A01ufig10

Net Foreign Liabilities

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

Source: ABS Times Series Database
Figure 5.
Figure 5.

Australia: External Debt Sustainability: Bound Tests1/

(Gross external debt in percent of GDP)

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.3/ One-time real depreciation of 30 percent occurs in 2007. This scenario assumes foreign exchange hedging covers 79 percent of foreign currency debt, consistent with the findings of a survey by the Australian Bureau of Statistics, as reported in “Australia’s Foreign Currency Exposure and Hedging Practices,” RBA Bulletin, December 2005.

12. The RBA argued that the growth in foreign liabilities was not a threat to external stability as liquidity and currency risks are contained. In particular, borrowers are predominantly highly-rated banks, and survey evidence shows that a significant portion of this external debt is either denominated in domestic currency or hedged, while foreign currency assets exceed foreign currency liabilities. Also, Australia has a number of features that tend to make it relatively resilient to external shocks, including deep financial markets that are open and transparent attracting foreign participation. Furthermore, the RBA argued that the projected rise in net foreign liabilities over the medium term need not indicate an exchange rate misalignment as it is partly driven by high expected returns on investments, especially in the resource sector. Staff concurred with the RBA’s assessment, but cautioned that debt sustainability also depended critically on the sound macroeconomic framework and sustained implementation of structural reform, which are underpinning Australia’s very favorable investment climate.

13. The fiscal position of the Commonwealth is strong and Australia is well placed to deal with the long term fiscal challenges. The Commonwealth government has recorded surpluses in 9 of the last 10 years, and net government debt was eliminated in 2006. Like in most OECD countries the major long-term fiscal challenge relates to pressure from impending demographics. However, Australia is relatively well prepared for an aging population as it has a flat rate and means-tested public pension, an increasing share of elderly relying on occupational pensions, and has established a “Future Fund” to build up assets to pay for future pension liabilities of government workers.

A01ufig11

Commonwealth Government

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

Source: Australian Treasury

14. The fiscal position remains strong this year. The underlying cash surplus for 2006/07 (fiscal year ending June) is estimated at 1.3 percent of GDP, higher than budgeted, partly reflecting revenue gains from rising TOT and a solid labor market. The 2007/08 Budget targets continued surpluses, despite further personal income tax cuts and a number of new spending initiatives. The underlying surplus is projected to decline slightly to 1 percent of GDP, and to remain at that level in the medium term (Table 4 and Figure 6). The budget appears supportive of long-term objectives, as many of the new initiatives are focused on increasing labor participation and boosting productivity. This fiscal stance is also consistent with the objectives of Australia’s medium-term fiscal strategy to maintain budget balance over the course of the economic cycle and to maintain budget surpluses when growth prospects are sound.

Table 4.

Australia: Fiscal Accounts, 2003/04–2010/11 1/

(In percent of GDP)

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Sources: Commonwealth of Australia: Budget Strategy and Outlook, 2007-08.

Fiscal year ends June 30.

Projections as presented in the Budget Strategy and Outlook, 2007-08.

Accrual data are reported on a consistent basis with Government Financial Statistics (GFS).

The fiscal balance is equal to revenue less expenses less net capital investment.

The 2006/07 balance includes a A$ 5.6 billion deposit by the New South Wales government into their Liability Management Fund to meet future superannuation contributions. Excluding this transaction, the aggregate state/local cash deficit for 2006/07 is 0.1 percent.

The consolidated commonwealth, state and local governments.

Underlying cash balance equals receipts less payments, and excludes earnings of the Future Fund.

Includes financial and non-financial assets and liabilities, including unfunded superannuation liabilities to public employees.

Figure 6.
Figure 6.

Australia: Fiscal Indicators 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

Source: Australian budget for 2006/07.1/ Revenue, expenses, and fiscal balance are on accrual basis.2/ Fiscal balance is equal to revenue less expenses less net capital expenses.3/ Data for fiscal balance of state territories and total public sector debt are available to 2009/10 and 2007/08; respectively.

15. Although, the government’s management of additional revenue resulting from the TOT boom has been prudent, the main concern in the near term is to avoid the additional stimulus to the economy. Recent surpluses were used to repay government debt or saved through the Future Fund. Lately, as some of the TOT gains began to appear permanent, the argument for spending part of the increased revenue became more convincing. In addition, with Australia’s fiscal position already very strong, running large budget surpluses has become more difficult to explain to the public. In light of this, the government has used part of the increased revenue for needed expenditures and tax cuts, thereby transferring part of the stimulus from the boost in the TOT to other parts of the economy. The staff recognized that increases in spending and/or reductions in taxes have been done in a manner consistent with the government’s medium-term objective of raising potential growth, but considered it important to balance this against short-term implications for aggregate demand. Staff suggested that this year’s expenditure be kept to the current budget plan, even if revenues run ahead of projections.

16. Another stimulus that raises concern comes from the States. The States are collectively forecasting a fiscal deficit of around ½ percent of GDP in 2007/08. This constitutes a reversal of the surplus position that the States have been in until 2005/06 (Table 4).4 The States point to the need for infrastructure improvements as the main reason for the recent deterioration in their budgets. The catch up in infrastructure spending comes at a time when there is already strong competition for human and capital resources from the private sector. As a result, this is putting more pressure on resources and could begin to bid up prices.

B. Australia’s Challenge: Making the Good Times Last

17. Long-term fiscal sustainability has improved, reflecting reform efforts. The second Intergenerational Report (IGR) published in April 2007 shows that the fiscal position has improved since 2002, mainly by accumulating surpluses, eliminating net debt and establishing the Future Fund to provide for unfunded liabilities. Nevertheless, the long-term financing gap is forecast to reach 3½ percent of GDP by 2047. The projected rise in healthcare cost is the predominant contributor to the gap. A range of measures have been put in place to better control spending on health, such as the Pharmaceutical Benefit scheme, but further efforts will be needed. Continued attention to the efficiency and effectiveness of spending will be key to preserving long-term fiscal sustainability.

A01ufig13

Projected Primary Balances in IGR1 and IGR2

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

18. Australia has shown that comprehensive market reforms can have a large payoff in terms of macroeconomic performance. The staff agrees with the authorities that this is the right time to push forward with the implementation of additional measures needed to spur efficiency and further enhance productivity and income growth. It is important to make progress on the National Reform Agenda (NRA), which was adopted last year as a follow-on to the earlier successful National Competition Policy reform program. The NRA aims at boosting competition in the areas of transport, energy, and infrastructure; reducing the regulatory burden imposed by the three levels of government; and improving human capital. The greater focus on human capital and competition and regulatory reform is consistent with staff research on productivity, which shows that Australia’s strong productivity performance over the past 16 years was aided by the wide range of labor and product market reforms (Tables 5 and 6).

A01ufig13a

Labor Productivity

(1990 = 100)

Citation: IMF Staff Country Reports 2007, 314; 10.5089/9781451802177.002.A001

Labor Productivity defined as Real GDP/EmploymentSource: World Economic Outlook 2007
Table 5.

Productivity Performance of Australian Industries

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Source: Thierry Tressel (2007), “Does Technological Diffusion Explain Australia’s Productivity Performance?” Forthcoming IMF Working Paper.
Table 6.

The Impact of Structural Reforms on Australia’s Productivity Performance

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Source: Thierry Tressel (2007), “Does Technological Diffusion Explain Australia’s Productivity Performance?” Forthcoming IMF Working Paper.

The impact of structural reforms on MFP is estimated in a panel of OECD countries over the period 1980-2003.

Industries that use Information and Communication Technology (ICT) intensively are: paper & publishing, machinery & equipment N.E.C., manufacturing N.E.C., wholesale and retail trade, financial intermediation and business services

Industries that produce ICT goods are electrical & optical equipment, and post & telecommunications

Traditional industries include agriculture, mining, a subset of manufacturing industries, transport, utilities, construction, and hotels & restaurants

19. Maintaining the environment is important for current and future growth. The government is reducing the greenhouse emissions signature of the Australian economy and plans to introduce a new emissions trading system. Given the increasing scarcity of water, the authorities are appropriately investing funds in a comprehensive plan to increase water use efficiency and address overallocation of water entitlements to provide greater water security for communities, industry, and the environment.

20. Sustained growth requires a sound financial system. Australia’s financial system is healthy, profitable, and well placed to cope with shocks. Supervisory authorities are alert to potential vulnerabilities, including heavy reliance on international capital and wholesale markets for funding, cross-border vulnerabilities with the banking system in New Zealand, and large exposure of banks and other lenders to households. With household debt and debt servicing approaching 160 and 12 percent of disposable income and house prices picking up again, household finances need to be closely monitored (Table 7).5 So far, however, the incidence of defaults on mortgage loans remains low. The sub-prime loan market in Australia is very small, and is dominated by specialized non-bank institutions. Nevertheless, given the experience of other countries, the Australian Prudential Regulation Authority (APRA) is appropriately maintaining supervisory efforts to ensure banks’ awareness of the risks arising from “low doc” and high loan-to-value ratio loans.

Table 7.

Australia: Indicators of External and Financial Vulnerability, 2002–06

(In percent of GDP, unless otherwise indicated)

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Sources: Authorities data and Fund staff estimates.

Tier I capital includes issued and fully paid common equity and perpetual non-cumulative preference shares, and disclosed reserves.

21. Prudential supervision by the APRA and market conduct supervision by the Australian Securities and Investments Commission are well established. Supervisory authorities have endorsed the key recommendations of the Financial Sector Assessment Program (FSAP) (Table 8). It is especially encouraging that the authorities are working on formalizing the framework for failure resolution and crisis management despite the favorable financial environment. The proposed Financial Claims Compensation Scheme is a useful element of this framework.

Table 8.

Financial Sector Assessment Program: Key Recommendations and Update on the Progress of Implementation1

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Source: IMF Staff.

A detailed discussion and a full list of recommendations can be found in the Financial System Stability Assessment (IMF Country Report No. 06/372).

III. Staff Appraisal

22. The strong recent performance of the Australian economy is likely to continue with short-term risks tilted on the upside. Staff project that growth will accelerate above 4 percent in 2007 and that core inflation will stay around 2½ percent, well within the target band. The main risk is the possibility that growth could surprise further on the upside, owing to the recovery of rural income with the easing of the drought and a pickup in resource export volumes.

23. The RBA has ably balanced growth and inflation risks, including by keeping rates on hold since November. The staff support this “wait-and-see” policy, as recent data suggest there is little urgency to raise interest rates, and welcome the RBA stance that the political calendar will not have any bearing on the bank’s decision to move interest rates.

24. Fiscal policy is appropriately focused on medium- and long-term objectives. Australia’s fiscal position is strong and the 2007/08 budget targets continued surpluses, even with further personal income tax cuts and a number of spending initiatives. The main concern is fittingly dealing with possible additional revenues stemming from further terms of trade gains. Given the current economic situation and prospects staff urge the government to continue exercising fiscal restraint.

25. The market-oriented exchange rate policy is appropriate. While the Australian dollar has appreciated substantially over the past few years, the exchange rate does not appear to be misaligned once the recent surge in the terms of trade is taken into account. The currency appreciation has played a valuable role in easing inflation pressures directly through lower import prices, and indirectly by switching expenditure to imports when capacity utilization was high.

26. The authorities are pushing forward with the implementation of additional measures needed to spur efficiency to enhance productivity and income growth, thus preparing Australia to face the challenges of population aging. The National Reform Agenda, which was adopted last year, aims at boosting competition in the areas of transport, energy, and infrastructure; reducing the regulatory burden imposed by the three levels of government; and improving human capital.

27. The financial sector is well positioned to cope with shocks and support sustained growth. Australian banks are well capitalized, and asset quality remains high by any standards. At the same time there are a number of potential risks, including heavy exposure of banks to highly indebted households, which warrant close monitoring of household finances. Staff welcome the proposed Financial Claims Compensation Scheme as a useful element of the failure resolution framework.

28. It is proposed that the next Article IV consultation with Australia take place on the standard 12-month cycle.

1

Unlike New Zealand, the carry trade is small relative to aggregate capital flows in the Australian market. So the risk from an unwinding of carry trade is negligible.

2

For a description of an RBA exchange rate model see Stone, et al (2005), “A Small Model of the Australian Macroeconomy: An Update,” RBA RDP 2005-11. The CGER estimates of overvaluation are 9 percent (equilibrium real exchange rate), 9 percent (macroeconomic balance approach), and 18 percent (external sustainability approach).

3

Potential vulnerabilities stemming from Australia’s current account deficit were extensively discussed in IMF Country Report 06/373, which concluded that the deficit appears to be sustainable although risks from the resulting debt require careful monitoring and management.

4

In aggregate, the States eliminated net debt in 2001/02 and up to 2005/06 had run fiscal surpluses in five of the previous seven years. The strong fiscal performance at the state level was partly due to the widespread adoption of medium-term fiscal policy frameworks.

5

Stress tests performed during the FSAP indicated that banks are highly resilient to changes in interest rates.

Australia: 2007 Article IV Consultation-Staff Report; Staff Supplement; and Public Information Notice on the Executive Board Discussion
Author: International Monetary Fund