Australia
2008 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Australia

The Article IV Consultation discusses that recently a commodity price boom, driven by robust global demand, has pushed the Australian economy up against capacity constraints. Banks are adjusting the structure of their funding in response to the turmoil, increasing liquidity, and lengthening the maturity of their funding. Executive Directors considered that the sound macroeconomic framework should permit Australia to weather the global downturn and contain inflationary pressures. They encouraged the authorities to take advantage of the positive macroeconomic performance to advance structural reforms.

Abstract

The Article IV Consultation discusses that recently a commodity price boom, driven by robust global demand, has pushed the Australian economy up against capacity constraints. Banks are adjusting the structure of their funding in response to the turmoil, increasing liquidity, and lengthening the maturity of their funding. Executive Directors considered that the sound macroeconomic framework should permit Australia to weather the global downturn and contain inflationary pressures. They encouraged the authorities to take advantage of the positive macroeconomic performance to advance structural reforms.

I. The Economic Expansion and Commodity Price Boom

1. Sound macroeconomic policies and structural reforms in Australia have delivered more than 16 years of economic expansion, but the economy’s productive capacity has become increasingly stretched. The pace of real GDP growth picked up in 2007 to more than 4 percent, driven by a commodity price boom in response to robust global demand for iron ore and coal, especially from China. The commodity price boom has elevated the terms of trade to its highest level since the Korean War and has boosted profits, employment, and wages, which has helped cushion the impact of a severe drought and the global financial market turmoil. However, the boom has pushed up against capacity constraints, with unemployment falling to the lowest rate since the mid-1970s and capacity utilization rising to historic highs in early 2008 (Table 1, Figure 1).

Table 1.

Australia: Selected Economic Indicators, 2004–09

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

Contribution to growth.

Includes public trading enterprises.

Fiscal year ending June 30, Commonwealth Budget.

Data for 2008 are for latest available month.

IMF, Information Notice System index (1990 = 100).

Figure 1.
Figure 1.

Australia: Prolonged Expansion and Commodity Boom Leads to Overheating

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

2. Inflation increased over the past year as resource pressures mounted. The Reserve Bank of Australia’s (RBA) measures of underlying inflation had been running close to the top of its target of “2–3 percent, on average, over the economic cycle” for some years, but rose to almost 4½ percent year on year in June 2008, the highest level in 16 years (Figure 2). The inflation pressures are broad-based, reflecting an increase in tradables inflation and wage growth.

Figure 2.
Figure 2.

Australia: Inflationary Pressures are Widespread

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

3. The RBA responded to the rising inflation by tightening monetary policy. Since 2002, the gradual increase in the policy rate has been passed through into retail rates, but the strength in the economy continued to surprise on the upside through end 2007 (Figure 3). Despite the onset of financial market turbulence last year, which prompted policy easing in many industrial countries, the underlying strength in the economy necessitated a renewed RBA tightening cycle. Between August 2007 and March 2008, the policy rate was increased by 100 basis points to 7¼ percent. In addition, higher funding costs from the global financial turmoil have pushed up lending rates by a weighted average of around 60 basis points more than the rise in the policy rate over the period August 2007–July 2008. Inflation expectations have risen with the jump in food and energy prices, which has muted the impact of the recent increase in the policy rate, with real interest rates now around the average for the past five years. Nonetheless, credit growth has slowed sharply in recent months as tighter credit standards have been applied by financial institutions.

Figure 3.
Figure 3.

Australia: Monetary Tightening

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

4. The Commonwealth’ but the states have begun to run deficits. The Commonwealth government has run surpluses of around 1½ percent of GDP in recent years, which has eliminated its net debt (Figure 4, Table 2). Revenue outcomes have consistently surprised on the upside, driven by the stronger-than-expected economy and buoyancy in corporate tax revenue related to the commodity boom. However, increased spending and tax cuts over the last three years have offset some of the restraint from the automatic stabilizers. In addition, the states have increased capital spending and their budget balance has shifted to a deficit of about ½ percent of GDP in 2007/08.

Figure 4.
Figure 4.

Australia: Fiscal Strength and the Commodity Boom

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

Table 2.

Australia: Fiscal Accounts, 2004/05-2011/12 1/:

(In percent of GDP)

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Sources: Commonwealth of Australia: Budget Strategy and Outlook, 2008–09.

Fiscal year ends June 30.

Projections as presented in the Budget Strategy and Outlook, 2008–09.

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

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

The consolidated commonwealth, state, and local governments.

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

Includes Future Fund assets that are kept in cash and debt instruments.

Includes financial and nonfinancial assets and total liabilities, including Future Fund assets and unfunded superannuation liabilities to public employees.

Includes financial assets and total liabilities, including Future Fund assets and unfunded superannuation liabilities to public employees.

5. The current account deficit widened in 2007 to more than 6 percent of GDP, despite the commodity boom (Figure 5, Tables 3 and 4). The trade deficit deteriorated, as export volume growth was constrained by drought disrupting rural exports and bottlenecks in the export supply chain. Imports also grew strongly owing to buoyant domestic demand and an appreciation of the real effective exchange rate (REER). In addition, the investment income deficit increased, reflecting higher interest payments on foreign debt and large dividend payments, particularly from the resource sector. Net foreign liabilities rose to 67 percent of GDP at end-March 2008, mainly owing to an increase in foreign debt, channeled primarily through financial institutions.

Figure 5.
Figure 5.

Australia: Current Account, Commodity Boom, and the Exchange Rate

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

Table 3.

Australia: Balance of Payments, 2004–09:

(In percent of GDP)

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Sources: Data provided by the Australian authorities; and Fund staff estimates and projections.
Table 4.

Australia: Balance of Payments in U.S. Dollars, 2004–07:

(In billions of U.S. dollars)

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

6. Australian banks have weathered the global financial turmoil reasonably well. The four large banks that account for two-thirds of bank assets continued to report strong profits through early 2008, together with adequate capital. While impaired assets are very low (0.2 percent of assets), several large banks have increased their provisioning for bad debts to reflect the potential impact of a downturn and rising interest rates (Figure 6). The large banks have limited low-doc and nonconforming lending, with most of this activity concentrated in the smaller banks and the nonbank sector.1 The smaller banks have a higher impaired assets ratio (around ½ of a percent) than the four large banks, but this ratio is low by international standards. Moreover, the smaller banks remain well capitalized, with the aggregate capital ratio in excess of 10 percent.

Figure 6.
Figure 6.

Australia: The Continued Strength of the Banking Sector

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

7. The turmoil, however, highlighted the vulnerability of Australia’s financial institutions to rollover risk. Sizable short-term funding from the wholesale market, including from offshore, has resulted in an increase in funding costs (Box 1). Some of the smaller financial institutions that relied more heavily on capital markets, particularly securitization, for funding were more affected by the higher cost of funding than institutions that had sizable deposit bases. As a consequence, the availability of home mortgages from these institutions has fallen, especially for low-doc and sub-prime borrowers, and large banks have increased their market share for prime mortgage lending. Corporates have issued fewer bonds because of the turmoil, and instead have approached the banks for funding. This contributed to an increase in financial institutions’ business credit growth in early 2008, but business credit growth has declined in recent months with the increase in interest rates and some tightening of credit standards.

Australian Banks and the Global Financial Turmoil: The Rollover Risk

Australian banks are financially sound, but the global turmoil has highlighted their vulnerability to rollover risk associated with short-term wholesale funding. Wholesale funds account for about 60 percent of total funding of the banking system, and more than 40 percent of wholesale funds come from offshore. Furthermore, about 30 percent of offshore funds and 75 percent of domestic wholesale funds of Australian banks have residual maturity of less than one year. This funding structure makes the banks dependent on a stable international and domestic funding environment, and leaves them vulnerable to increases in the cost of funds and to the protracted loss of access to international short-term debt markets.

Australian Banks’ Liabilities:

(Percent of total)

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Sources: APRA; RBA

The global turmoil resulted in a sharp increase in funding costs in both domestic and offshore debt markets. The spread between the 3-month bank bill rate and the overnight index swap (OIS) rate averaged around 50 basis points in March–July 2008, compared to the average of 10 basis points in recent years. Furthermore, credit default swap spreads for the major Australian banks widened sharply during the same period, also indicating a higher cost of funding.

Despite the turmoil, the large Australian banks have maintained access to wholesale markets to refinance themselves and to finance growth in their assets, albeit at significantly higher spreads. In addition, they have been attempting to improve their liquidity, by attracting more deposits and issuing short-term securities to one another (increasing the supply of eligible securities that can be used for repos with the RBA).

Banks are also attempting to change their funding structure, by issuing longer-term securities domestically and offshore, in particular through private placements of one-year extendible bonds in the United States and through issuance of yen-denominated “samurai” bonds for the first time. However, changing the maturity profile has been costly, as investors globally are demanding high premia for term funding. As a result, the share of offshore wholesale funding has fallen by only 1¼ percentage point over the period June 2007–May 2008, to 25½ percent of total liabilities, and the debt structure of Australian banks remains predominantly short term.

uA01fig01

Bank Bill and Overnight Index Swap Rates

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

Source: Bloomberg.
uA01fig02

Credit Default Swap (CDS) Spreads:

(5-year, average of four largest banks)

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

Source: Bloomberg.

II. How to Reduce Inflation and Sustain Economic Performance?

8. Discussion focused on the policies needed to reduce inflation associated with the commodity boom and to maintain financial stability in the face of the global financial market turmoil.

A. Where is the Economy Heading?

9. Baseline. The staff and authorities agreed that activity is slowing, and that the outlook is more uncertain than usual because of large countervailing forces. Growth in real domestic demand has begun to ease with the tightening of financial conditions, higher energy and food prices, and a sharp decline in confidence (Figure 7). However, the dampening effect of tighter credit conditions and slower trading partner growth is being cushioned by an 80–240 percent jump in annual contract prices for the key exports of iron ore and coal, that will increase the terms of trade by 20 percent in 2008/09, and cuts in personal income taxes.2 Staff’s baseline forecast is that real GDP will grow below trend for the next two years, easing domestic capacity constraints and returning CPI inflation back within the target band over the period (Table 5). The current account deficit should narrow to 4¼ percent of GDP in 2009 due to slower domestic demand growth, the jump in export prices, a rebound in rural exports, and mining sector capacity coming on line.

Figure 7.
Figure 7.

Australia: Stock Market and Confidence Indices

(Percent)

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

Sources: Reserve Bank of Australia and National Australian Bank.
Table 5.

Australia: Medium-Term Scenario, 2007–13

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

Contribution to growth.

Includes public trading enterprises.

Fiscal year basis ending June 30. Projections through 2012 are as presented in the Budget Strategy and Outlook, 2008–09. For 2013, staff projections are used.

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

10. The staff viewed the balance of risk to growth is tilted toward the upside and that the risks on inflation were clearly on the upside.

  • Upside Risks. Growth could exceed expectations, owing to the recent jump in commodity prices, sizable immigration flows, and the increase in state infrastructure spending (Figure 8). These factors could offset the impact of weaker consumer and business confidence and support domestic demand. On inflation, the risks are clearly on the upside. Capacity constraints, especially in the mining and housing sectors, could push wage and CPI inflation higher than envisaged.

  • Downside risks. On the domestic front, activity could slow significantly if the tightening in credit conditions apparent in the sharp fall in credit growth in recent months has a greater-than-expected impact on domestic demand. In addition, farm output may not rebound from the drought as projected. On the external front, a global slump could weaken export demand and reduce commodity prices, although the one-year contracts for iron ore and coal would delay the impact on the economy. Further international financial turmoil could tighten credit conditions, leading to a sharper-than-expected slowing in global activity.

Figure 8.
Figure 8.

Australia: Upside Risks From Mining and Migration

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

11. The authorities viewed risks to the outlook for growth to be more balanced than the staff. For growth, household spending may fall more than expected as consumer sentiment has declined sharply in face of higher fuel prices and mortgage rates. The authorities agreed that there is an upside risk to inflation, stemming from the extraordinary jump in the terms of trade.

B. Appropriate Macroeconomic Policy Settings

Monetary Policy

12. The staff advised that a firm monetary policy stance is vital for keeping medium-term inflation expectations well anchored. With underlying inflation the highest in more than a decade, containing inflation presents a challenge. The risk that wage inflation will rise further if CPI inflation persists at current levels calls for the RBA to maintain a tight policy stance until it is clear that inflation will abate. Reducing inflation back within the target range will require a significant easing in domestic demand growth. Further tightening may be necessary if the global financial market turmoil eases and business and consumer confidence rebounds. In particular, the slowdown in the United States may not be as severe as projected or the knock-on effects to the region may be limited (Box 2). With the risks to inflation on the upside, the RBA should be prepared to tighten quickly if leading indicators suggest that domestic demand will not slow as expected or the outlook for inflation deteriorates.

The Potential Impact on Australia of a U.S. Slowdown

Two models have been used to estimate the potential impact of a U.S. slowdown: the IMF’s Global Economy Model (GEM), calibrated to include Australia, and an estimated small model of Australia and the United States. The analysis is done in several steps. The first step looks at the trade impact alone coming from weaker U.S. import demand and the appreciation in the Australian dollar resulting from lower U.S. interest rates. The second step attempts to add the potential impact that could come through other channels such as financial market linkages and expectations. This is done by using the correlation between U.S. GDP and Australian GDP from the small model (see charts) to calibrate correlated shocks to private consumption and investment demand outside the United States. The third step holds the monetary policy rate in Australia unchanged for the first year.

uA01fig03

Output Correlations:

(Percent of deviation from baseline)

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

The simulated impact of the trade effect alone is small (Scenario 1). In 2008, GDP and inflation in Australia fall by 0.2 percent, allowing a 50 basis point easing in the policy interest rate. The impact dissipates quickly with the economy back to baseline by 2010. The total potential impact based on the small model, however, is larger (Scenario 2), reflecting the historical correlation. If the policy rate in Australia is not changed in the first year in response to the slowdown, inflation falls by roughly 1.5 percentage points by the second year (Scenario 3). Given the current rate of CPI inflation in Australia, such a decline would return inflation to the top end of the RBA’s 2–3 percent target.

Because the estimation period for the small model starts in the early 1990s, the correlation between Australian and U.S. GDP may be overstated. Over the period, Australia has become more integrated with emerging Asian countries. As a result, the total simulated effect should be thought of as an upper bound on what might occur.

The Impact on Australia of a U.S. Slowdown:

(Percent or percentage point deviation from baseline)

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Source: GEM simulations.

13. The authorities agreed that a firm monetary policy stance was necessary. They noted that the sequence of changes to the cash rate since August 2007, other adjustments by lenders in response to the rise in funding costs, and tighter credit standards have combined to produce financial conditions that were tight. The authorities considered that this tightening was already resulting in slower growth in domestic demand. Moreover, they believed that the tightening to date would be sufficient to reduce growth to below trend for the next two years thereby easing capacity pressures and reducing inflation to less than 3 percent by end-2010. They indicated that if the expected moderation in domestic demand does not occur or if expectations of high ongoing inflation begin to affect wage and price setting they would not hesitate to tighten policy further.

14. The authorities remain fully committed to the inflation-targeting framework, which has been subject to some public criticism in recent months. Several academics have argued that inflation targeting is not well suited to dealing with negative shocks such as the global increase in energy and food prices. The authorities have emphasized publicly that there is no reason to believe that this shock cannot be handled by sensible implementation of the RBA’s inflation-targeting framework. The staff and authorities agreed that the benefits of the framework can be illustrated most clearly when there are large shocks to inflation. Despite the pickup in short-term inflation expectations, the absence to date of a notable acceleration in wage inflation demonstrates that the RBA’s inflation target has helped to anchor medium-term inflation expectations.

15. Recent steps to improve the transparency of monetary policy decision making should enhance public understanding of monetary policy decisions. Since December 2007, the RBA has published a statement explaining the board’s interest rate decision at the conclusion of every policy meeting, regardless of whether the cash rate is changed. This is followed two weeks later by the release of detailed meeting minutes.

Exchange Rate and External Stability

16. The appreciation of the Australian dollar in recent years has been driven by the higher terms of trade and positive interest rate differentials. The stronger exchange rate has eased inflation pressures directly through lower import prices, and indirectly by switching expenditure to imports as domestic capacity became stretched.3 The staff estimate that the currency was about 10 percent above its long-run equilibrium level as of June 2008 (Box 3 and Figure 9). The staff and the authorities agreed that the overvaluation of the exchange rate is temporary, owing to cyclical reasons. Over time, the currency is expected to fall back toward equilibrium as the RBA reduces the cash rate once it is clear that inflation will moderate. However, with a portion of the improvement in the terms of trade likely to be permanent, the currency is expected to remain above its average for the last 10 years.

Australia’s Equilibrium Real Effective Exchange Rate

Staff estimates suggest that the Australian dollar was overvalued by about 10 percent as of June 2008.1 These estimates are based on the macroeconomic balance (MB) approach, the equilibrium real exchange rate (ERER) approach, and the external sustainability (ES) approach. The desk methodology is outlined in Appendix I.

The baseline MB estimates suggest an overvaluation of 7–9 percent over the medium term, while the overvaluation in 2008 is about 6½ percent. The estimates are subject to significant uncertainty, as shown by varying the projected underlying current account deficit and changing the elasticity of the current account balance with respect to the REER. Plausible sensitivity analysis suggests that the overvaluation is about 2–22 percent.

The baseline ERER estimates suggest an overvaluation of 7–12 percent. The models attempt to explain the REER on the basis of the terms of trade, relative productivity, and relative government consumption. An important determinant is the terms of trade, with the 42 percent improvement over the past five years contributing to an increase in the equilibrium REER of about 15 percent. The overvaluation in 2008 is estimated at 10 percent, which narrows slightly to 7 percent by 2013 as the terms of trade is expected to rise.

The ES approach implies an overvaluation of 11 percent, if we assume that net foreign liabilities stabilize at their March 2008 level of 67 percent of GDP. A larger overvaluation would result if we assume that net foreign liabilities stabilize at their average level for the past 10 years of 55 percent of GDP.

Exchange Rate Assessment: Baseline Results 1

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Source: Fund staff estimates.

All results are expressed in percent and CGER estimates based on April 2008.

Staff projection of the underlying CA/GDP in 2013.

Based on a semi-elasticity of the CA/GDP with respect to the REER of-0.16.

Overvaluation is assessed relative to June 2008.

Based nominal GDP growth rate of 6.4 percent.

MB Approach: Sensitivity Analysis1

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Source: Fund staff estimates.

REER overvaluation is expressed in percent.

Staff projection of the underlying CA/GDP in 2013.

uA01fig04

ERER Approach

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

1 The corresponding equilibrium value of the RBA’s real trade weighted index (TWI) is 128–135, assessed relative to an estimate for June 2008 of 145. This estimate is based on real TWI data for March 2008 updated with TWI data through June 2008. The nominal TWI index was at 73.4 as of end-June.
Figure 9.
Figure 9.

Australia: Expected Interest Differential and the Exchange Rate

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

Sources: Reserve Bank of Australia; Bloomberg; and Fund staff estimates.1/ Nominal exchange rate.2/ Spread between bank bill 90-day futures rates in Australia and trade-weighted average of 90-day future rates in the United States, New Zealand, Euro Area, Japan, and United Kingdom.

17. The widening of the current account deficit in recent years and the buildup in foreign debt has increased external vulnerability. The recent global financial turmoil highlighted the rollover risks associated with the sizable short-term foreign debt (Figure 10). Looking ahead, the current account deficit is projected to narrow in 2009 to about the estimated norm of 4–4½; percent of GDP and then widen somewhat over the medium-term as commodity prices ease from the peak in 2008/09. These projections are based on the assumption of a constant REER at June 2008 levels, and a depreciation of the REER to equilibrium would narrow the current account further. In turn, this would slow the accumulation of external liabilities and help to contain vulnerability.

Figure 10.
Figure 10.

Australia: Foreign Debt, March 2008

(As percent of GDP)

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

Source: Australian Bureau of Statistics.

18. The staff and authorities agreed that there are a number of factors mitigating the external vulnerability. These include the limited currency risk associated with the foreign debt, the sound banking system, and the strong economic policy and financial supervision frameworks. About 40 percent of gross foreign debt is in Australian dollars, with half of the remainder in U.S. dollars. Survey data suggests the bulk of the foreign-currency-denominated debt is hedged against currency risk. Moreover, less than 10 percent of the gross debt is with the public sector, leaving most of the debt with financial institutions (Table 6). Australia’s current account deficits largely reflect high investment rather than low saving, and should be sustainable as long as investment leads to growth in export capacity.4

Table 6.

Australia: Indicators of External and Financial Vulnerability, 2004–08:

(In percent of GDP, unless otherwise indicated)

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Sources: Data from authorities and Fund staff estimates.

Data are for latest available month.

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

Fiscal Policy

19. Fiscal policy, focused on medium-term sustainability, delivered a sequence of surpluses that eliminated Commonwealth net debt. This leaves Australia with an enviable fiscal position by international standards. The new Labor government aims to maintain a conservative fiscal strategy by focusing on three objectives:

  • achieving budget surpluses, on average, over the medium term;

  • keeping tax as a share of GDP, on average, below the 2007/08 level (currently estimated at 24.7 percent); and

  • improving the government’s net financial worth over the medium term.

20. In the near term, the authorities stressed that the latest budget places priority on helping to fight inflation and reprioritizing spending to build capacity. The 2008/09 budget slows the pace of growth of Commonwealth government expenditure and forecasts an increase in the underlying cash surplus to 1.8 percent of GDP. This stance is slightly contractionary, with the staff’s estimate of the structural balance increasing by ¼ percent of GDP, broadly in line with the change in the underlying cash surplus (Figure 11). The budget saves about half of the revenue surprise from the jump in the terms of trade and higher nominal GDP.5 The remainder of the revenue surprise helps fund personal income tax cuts targeted at lower income earners. Some other tax increases and expenditure cuts finance new initiatives for health, education, climate change, and housing. Beyond 2008/09, spending is projected to pick up and the underlying cash surplus is expected to fall slightly over the next four years.

Figure 11.
Figure 11.

Australia: Fiscal Forecast

Citation: IMF Staff Country Reports 2008, 312; 10.5089/9781451802191.002.A001

21. The surpluses for 2007/08 and 2008/09 will be saved in three new funds for infrastructure, health, and education to finance capital spending. About 3 percent of GDP will be contributed to the funds, depending on the final budget outcomes and spending from the funds is included in the budget. The funds are a means to constrain spending revenue from the commodity boom in the near term, by saving for infrastructure spending over the medium to long term.

22. The staff advised that further fiscal restraint may be needed. The staff encouraged the authorities to identify areas where additional spending cuts can be implemented and to save any positive revenue surprises to assist monetary policy, until it is clear that inflation will decline. Given the uncertainty about how much of the increase in commodity prices will be permanent, saving the additional revenue in the near term may avoid sharp changes in taxes and spending in the future. Moreover, state governments are expected to run deficits and increase infrastructure spending, offsetting restraint at the Commonwealth level.

23. The authorities stated that if inflation pressures persist they would take the necessary action to support monetary policy. They noted that the next budget would offer another chance to constrain spending and direct it toward areas that are more productive, such as education, health, and infrastructure. They also emphasized that they are committed to saving any further positive revenue surprises in 2008/09. If there is a positive revenue surprise in the 2009/2010 Budget and inflation remains high, the authorities indicated that they would maintain tight controls on spending.

24. To the extent that the improvement in the budget balance is structural, associated with permanently higher commodity prices, there should be scope to reduce taxes or increase spending over the medium term. Staff analysis suggests that a combination of lower labor and capital income taxes, along with increased public investment, will generate the largest economic gains.6 The gains from other options such as lower consumption taxes or higher public consumption are not as large. Despite the expected structural improvement in the medium term, significant long-term fiscal challenges remain, particularly in the area of healthcare spending, and early adjustments will be key to preserving fiscal sustainability.7

25. The authorities noted that there would be scope to reform taxation and increase spending in priority areas, if the recent gains in commodity export prices prove to be permanent. The budget projections assume some easing in commodity prices over the medium term from the record levels forecast for 2008/09. Nevertheless, in recent years the authorities have been surprised by revenue on the upside, and commodity prices may not ease as expected. The authorities made it clear that any changes in taxes and spending would be consistent with the new government’s medium-term fiscal objectives, thereby further strengthening the fiscal position.

C. Dealing with the Global Financial Market Turmoil

26. The RBA responded promptly and fittingly to the domestic impact of the global financial market turmoil. The RBA provided the necessary liquidity support to banks through exchange settlement accounts and increased the range of securities accepted for repo lending in late 2007, including residential-mortgage-backed securities. Since then, many banks have securitized mortgages and are holding them on their books as a contingency measure in case they need to obtain liquidity from the RBA.

27. The Australian Prudential Regulation Authority (APRA) also reacted in a timely and appropriate manner. APRA intensified its monitoring of asset quality, capital adequacy, and the liability structure of banks. In the context of Basel II, APRA is working with large banks on stress tests, which include extreme scenarios such as the loss of access to offshore credit markets for an extended period.

28. In addition, banks are adjusting the structure of their funding in response to the turmoil. They are increasing liquidity as well as lengthening the maturity of their funding and diversifying the sources. However, the banks have found it costly to extend the maturity because of higher interest rates for term funding and have made limited progress in reducing the rollover risk associated with their short-term wholesale funding. Staff analysis using extreme stress test scenarios applied to the large banks suggests that they could suffer a significant fall in profits from an increase in funding costs associated with loss of access to offshore markets for 90 days, but that their capital would remain adequate.8

29. The introduction of new liquidity guidelines should further encourage banks to reduce their rollover risk. APRA plans to introduce liquidity guidelines with a focus on improved disclosure and stress testing. The aim should be to encourage banks to reduce the risk of disruptions from restricted access to wholesale markets by diversifying their funding sources, lengthening the maturity of their funding, and holding sufficient liquidity. The staff advised that requiring banks to publish more detail on the maturity structure of their funding, especially from offshore markets, would impose additional discipline.

30. Banks are exposed to households, but appear resilient to an increase in default rates on mortgages. Households have become increasingly indebted, with debt reaching almost 160 percent of disposable income and debt-servicing costs at about 14 percent of disposable income. As more than half of banks’ loans are mortgages, banks’ asset quality would likely deteriorate with a large increase in interest rates, rise in unemployment, or fall in house prices. Staff analysis show that a very large increase in default rates (to 10 percent of all housing loans) would be required to reduce capital ratios of the four major banks below 8 percent.9 Moreover, staff estimates suggest that house prices are only moderately overvalued (5-15 percent) and that continued strong immigration and household income growth could increase equilibrium house prices.

31. The failure resolution and crisis management framework is being strengthened, as recommended in the 2006 Financial Sector Assessment Program (FSAP). The proposed Financial Claims Scheme is a key element of legislation to be introduced to parliament, and it would provide depositors of a failed authorized deposit taking institution

32. with early access to their funds.10 In addition, the interdependence of the Australian and New Zealand banking systems underscores the importance of the planned work on the practical aspects of coordination of crisis management. Good progress has also been made on a number of other FSAP recommendations (Table 7).

Table 7.

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).