Australia
2009 Article IV Consultation: Staff Report; and Public Information Notice on the Executive Board Discussion;

This 2009 Article IV Consultation highlights that following a prolonged expansion, reflecting sound macroeconomic policies and favorable terms of trade, global events have slowed Australia’s economic growth well below trend. The turmoil sparked by the collapse of Lehman Brothers in September 2008 had an immediate impact on Australian markets. Executive Directors have commended the authorities for their timely policy response, which has effectively cushioned the impact of the global financial crisis on the Australian economy. Directors have also welcomed the Reserve Bank of Australia’s early reductions in the policy rate.

Abstract

This 2009 Article IV Consultation highlights that following a prolonged expansion, reflecting sound macroeconomic policies and favorable terms of trade, global events have slowed Australia’s economic growth well below trend. The turmoil sparked by the collapse of Lehman Brothers in September 2008 had an immediate impact on Australian markets. Executive Directors have commended the authorities for their timely policy response, which has effectively cushioned the impact of the global financial crisis on the Australian economy. Directors have also welcomed the Reserve Bank of Australia’s early reductions in the policy rate.

I. Introduction

1. Australia was in a strong economic position at the onset of the global recession. Sound macroeconomic policies and structural reforms, together with a stable external environment, delivered 17 years of continuous economic growth. National income was boosted in recent years by a commodity price boom, which pushed the terms of trade to its highest level in more than half a century. The expansion reduced unemployment to historical lows, but put pressure on prices as productive capacity became stretched. The Commonwealth government had eliminated its net debt, and corporate and bank leverage were relatively low.

2. The turmoil sparked by the collapse of Lehman Brothers in September 2008 had an immediate impact on Australian markets. Key commodity prices fell sharply, domestic money markets came under stress, and offshore funding tightened. As a result, the currency depreciated and equity prices plunged.

3. However, the crisis has not hit real activity in Australia as hard as in many other advanced economies. In part, this reflects limited higher-tech manufacturing and robust commodity exports to China.

4. Economic activity was also shielded by the authorities’ timely and significant policy response. Monetary policy remains effective, as large cuts in the policy rate passed through to lending rates, while the sound banking system helped avoid a sharp contraction of credit. The flexible exchange rate has provided a buffer for export incomes. In addition, a sizable fiscal stimulus is being delivered, supporting domestic demand.

5. Nonetheless, the crisis highlighted some vulnerabilities and the near-term outlook remains highly uncertain. Both household debt (at over 150 percent of disposable income in 2008) and short-term external borrowing (at over 50 percent of GDP in 2008) are high by advanced country standards. Unemployment has increased, but less so than in many other advanced countries.

II. The Impact of the Global Crisis

6. The global financial crisis increased spreads and volatility in Australian financial markets. Short-term money market spreads and Credit Default Swap (CDS) spreads for banks and corporates widened significantly in late 2008, but have since recovered some lost ground (Figure 1). A financial stress index, which summarizes market volatility, spiked in late 2008, but has since eased back below levels in Canada, the United Kingdom, and the United States. Equities and the currency fell sharply, as did business and consumer confidence.

Figure 1.
Figure 1.

Australia: Impact of the Global Crisis on Domestic Financial Markets

Money market strains have been less than in the U.S....

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Reserve Bank of Australia.
F1a

...bank CDS spreads widened in early 2009, but have since eased.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Sources: Reserve Bank of Australia; Bloomberg.
F1b

Corporate CDS spreads followed a similar path...

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Bloomberg.
F1c

...the exchange rate depreciated as commodity prices declined.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Reserve Bank of Australia.
F1d

Confidence fell sharply in late 2008 but has since recovered considerably.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Sources: Westpac-Melbourne Institute; National Bank of Australia.
F1e

The stock market also fell sharply in 2008.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Sources: Reserve Bank of Australia; Bloomberg.
F01

7. Economic growth has slowed as a result of the crisis. Real GDP growth eased to 2.3 percent in 2008 and 1½ percent in 2009 Q1 (saar), well below trend (text figure, Figure 2, Table 1). Negative wealth effects from falling equity and house prices, compounded by tumbling consumer and business confidence, led to a contraction in domestic demand. Business investment fell by 23 percent in 2009 Q1 (saar). However, net exports increased as imports declined and export volume growth remained positive in 2009 Q1 because of strong commodity shipments, especially to China. On the production side, manufacturing value added fell sharply, as in many advanced countries, but with manufacturing comprising less than one-tenth of total output, the hit to overall GDP growth was less than elsewhere. Recently, consumer and business confidence measures showed signs of a recovery, but investment intentions remain weak.

Table 1.

Australia: Selected Economic Indicators, 2006-10

article image
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 2009 are for latest available month.

IMF, Information Notice System index (2000 = 100).

Figure 2.
Figure 2.

Australia: Impact of the Global Crisis on the Real Sector

Growth slowed in late 2008 as the global crisis hit…

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Australian Bureau of Statistics.
F2a

…spot prices for two key commodity exports fell sharply in late 2008, and contract prices have reset at lower levels…

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Sources: RBA; Bloomberg; and IMF staff estimates.
F2b

…but commodity export volumes continued to grow.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Australian Bureau of Statistics.
F2c

Manufacturing fell sharply in 2009 Q1, but other sectors continued to grow…

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Australian Bureau of Statistics.1/ Production based GDP year-on-year growth.2/ Average of production, income, and expenditure, year-on-year growth.
F2d

A relatively low share of manufacturing in GDP, has limited the fallout from the global crisis.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: UNIDO database.
F2e

Growth was positive in 2009 Q1 unlike most other advanced economies.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Sources: WEO; and Fund staff calculations.
F1F
Source: Australian Bureau of Statistics.

8. Capacity pressures have abated and inflation has moderated quickly, to within the policy target band. After increasing steadily since 2000, capacity utilization declined sharply over the last year, and the unemployment rate rose by almost 2 percentage points from its trough in early 2008 (Figure 3). Prices have responded quickly, with headline, nontradables, and tradables inflation decelerating markedly. Moreover, upward pressure on tradables prices from currency depreciation was more than offset by lower energy prices and growing spare capacity. Headline CPI inflation, at 1½ percent year-on-year in the June quarter, is now below the Reserve Bank of Australia’s (RBA) target band of 2–3 percent inflation, on average, over the cycle. Inflation expectations reacted swiftly to the sharp turnaround and wage demands showed signs of moderating.

Figure 3.
Figure 3.

Australia: Inflationary Pressures Dissipate

Capacity pressures have eased…

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Sources: Australian Bureau of Statistics and National Australia Bank.
F3a

…and inflation has declined quickly.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Australian Bureau of Statistics.
F3b

Inflation expectations led inflation down…

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Sources: Australian Bureau of Statistics and Reserve Bank of Australia.1/ Melbourne Institute Consumer Inflation Expectations.
F3c

…and private-sector wage growth has started to show signs of moderation.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Australian Bureau of Statistics.
Source: Reserve Bank of Australia.
Source: Reserve Bank of Australia.

9. The RBA cut its policy rate sharply as the outlook weakened. Since September 2008, the RBA reduced the policy rate by 425 basis points to 3 percent. Most of this fall has been reflected in floating mortgage interest rates, which apply to the bulk of Australian mortgages (Figure 4). Business lending rates have also fallen markedly, but by about 150 basis points less than the cash rate.

10. Credit growth has slowed in recent months reflecting both demand and supply factors. Mortgage rate reductionsand a temporary increase in the first-time homebuyers’ subsidy underpinned demand for housing credit, but business and other personal credit growth contracted (text figures). Households and businesses are pulling back on spending plans, while banks have tightened their credit standards. Household debt-to-income has declined slightly since mid-2008, but the household debt-service ratio has fallen further because of the large drop in mortgage interest rates.

Figure 4.
Figure 4.

Australia: Monetary Easing

The policy rate was lowered broadly in line with that prescribed from a simple Taylor Rule…

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Reserve Bank of Australia.
F4a

…and the decline has been largely passed through to mortgage rates…

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Reserve Bank of Australia.
F4b

…unlike the situation in some other countries like the U.S.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Bloomberg.
F4c

Business lending rates also fell.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Reserve Bank of Australia.
F4d

Government bond yields dropped sharply in late 2008, but have risen in recent months.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Bloomberg.
F4e

Real interest rates have declined.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Sources: Reserve Bank of Australia, Melbourne Institute, Bloomberg, and Fund staff estimates.

11. Banks were in a healthy position at the onset of the turmoil. They reported strong profit growth before the crisis hit, with returns on equity of 15–20 percent (Figure 5). A conservative approach by regulators and supervisors meant that banks had relatively low leverage and high capital adequacy ratios, with Tier 1 capital ratios of 7–8 percent in 2007. Moreover, the “four-pillar policy,” which does not allow the four large banks to merge, played a role in limiting risky behavior. Asset quality of smaller banks is somewhat weaker than that of the large banks, but these banks still appear sound.1 Banks had limited exposure to securitized assets and investment vehicles holding structured finance products in Australia and overseas.2

Figure 5.
Figure 5.

Australia: Impact of the Global Crisis on Domestic Banks

Australian banks maintain capital ratios in excess of regulatory requirements…

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Reserve Bank of Australia.
F5a

…profitability has fallen but remains healthy.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Australia Prudential Regulation Authority.
F5b

Impaired assets are low by international standards although they have increased lately.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Reserve Bank of Australia.
F5c

Banks remain exposed to the housing market, with mortgage loans accounting for half of total lending.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Reserve Bank of Australia.

12. Although bank asset quality is declining, capital buffers are being increased. Past due loans and impaired assets have risen, but only to 1½ percent of assets in March 2009, and profitability has fallen, reflecting increased provisioning for bad debt. Most importantly, even in the midst of the crisis, large banks have been able to raise common equity from private investors and strengthen their capital positions in anticipation of further bad loans. This has improved their Tier 1 capital ratios to over 8 percent.3

13. On the liability side, the swift introduction of deposit and wholesale funding guarantees helped maintain confidence in banks. About half of banks’ funding comes from the wholesale market, and access was disrupted after the Lehman collapse. The establishment of wholesale funding guarantees in October 2008 enabled banks to raise $A 140 billion in longer-term funding in the subsequent seven months. However, rollover risks remain. Staff estimate that financial institutions’ short-term external debt (on a residual maturity basis) was about $A 400 billion (35 percent of GDP) in March 2009. The authorities also introduced the Financial Claims Scheme in October 2008 that provided a guarantee for retail deposits up to $A 1 million (see Appendix I for details).

14. The broader financial sector was hit hard by the crisis. Securitization activity fell sharply after the initial turmoil in 2007, and effectively shutdown post Lehman, with very little activity in recent months (text figure). The dislocation of securitization markets resulted in greater concentration of lending with the four large banks. The fall in equity prices reduced returns at superannuation and managed funds, contributing to a fall in household financial assets by more than 60 percent of household disposable income in 2008 (text figure), while general insurers’ profits declined owing to more difficult underwriting conditions.

F5d
Source: Reserve Bank of Australia.
F5e
Source: Reserve Bank of Australia.

15. The government reacted quickly to the crisis by providing a sizable fiscal stimulus and allowing the automaticstabilizers to work—shifting the fiscal balance into deficit. The Commonwealth government ran surpluses of around 1–1¾ percent of GDP in the six years to 2007/08 that, along with asset sales, eliminated its net debt and reduced gross public debt to low levels by advanced country standards (text figure). For 2008/09, an underlying cash deficit of 2.7 percent of GDP is estimated, as the downturn hit tax revenues and the government implemented stimulus measures (Table 2, Figure 6). In addition, states and public corporations continued to increase their investment spending, which pushed the consolidated nonfinancial public sector deficit to 5¾ percent of GDP in 2008/09 (Figure 6).

Figure 6.
Figure 6.

Australia: Fiscal Accounts

A string of surpluses eliminated net debt and improved net financial worth…

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Reserve Bank of Australia.1/ Net financial worth is equal to total financial assets less total liabilities (including superannuation).
F6a

…but the economic slowdown and fiscal stimulus resulted in a large shift in the balance in 2008/09.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

F6b

Revenue fell in 2008/09 as the economy slowed…

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

F6c

…while expenditure rose sharply in real terms.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

F6d

After rising with the terms of trade, corporate tax receipts turned down as activity slowed.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Sources: Australian Bureau of Statistics; and Fund staff estimates and projections.
F6e

State governments also shifted into deficit in recent years.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

F5f
Source: World Economic Outlook; and Fund staff calculations.
Table 2.

Australia: Fiscal Accounts, 2004/05-2012/13 1/

(In percent of GDP)

article image
Sources: Commonwealth of Australia: Budget Strategy and Outlook, 2009-10; and Fund staff estimates and projections.

Fiscal year ends June 30.

Expenditure projections as presented in the Budget Strategy and Outlook, 2009–10, staff projections for revenue and balances.

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.

16. The current account deficit narrowed to close to 4 percent of GDP in 2008. The improvement reflected large increases in commodity contract prices negotiated in early 2008 for iron ore and coal exports (Figure 7). These contracts are being renegotiated with prices expected to fall by 30–60 percent, bringing them back to just over 2007 levels. The income deficit declined because of a fall in interest and dividend payments to foreign investors. As a result, the current account deficit narrowed further in 2009 Q1 to less than 2 percent of GDP. Recently, the deficit has been financed by a more balanced mix of equity and debt inflows than in the past five years. Net foreign liabilities stabilized at about 60 percent of GDP over the past two years.

Figure 7.
Figure 7.

Australia: External Developments

The current account deficit narrowed with the deficit in trade in goods and services shrinking.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Sources: ABS Times Series database; and Fund staff estimates.
F7a

Exports and imports declined sharply since mid 2008.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Reserve Bank of Australia.
F7b

Strong demand from China supported exports.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Haver Analytics.
F7c

Capital inflows remain sizeable with an increase in equity inflows.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Australian Bureau of Statistics.
F7d

Net foreign liabilities stabilized at around 60 percent of GDP.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Australian Bureau of Statistics.
F7e

While gross external debt increased to more than 100 percent of GDP.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: ABS Times Series Database.

III. Policy Discussions

17. Discussions focused on the economic outlook and policies to cushion the domestic impact of the global recession and preserve macroeconomic and financial stability. In particular, key topics included:

  • maintaining the appropriate monetary policy stance;

  • delivering the fiscal stimulus and preserving medium-term fiscal sustainability;

  • maintaining financial stability; and

  • reducing external vulnerabilities.

A. The Outlook

18. The near-term outlook for growth is weak. Aggressive policy action is expected to limit the decline in activity to ½ percent in 2009. Staff’s baseline forecast envisages a contraction in domestic demand as external shocks spill over into consumption and investment. Rising unemployment, low asset prices, high debt levels will weigh on household spending plans, despite lower interest rates. As a result, private consumption is projected to be stagnant. Private investment is expected to fall sharply, as corporate profitability is affected by the fall in demand and lower commodity export prices.

19. The recovery will likely be slow. Growth is projected to reach 1½ percent in 2010, led by government spending on infrastructure, as households and businesses continue to deleverage. Output will likely remain below potential in coming years. This will reduce core inflation and raise the unemployment rate to 7½ percent in 2011. The current account is projected to remain in deficit, with net foreign liabilities relative to GDP rising, as Australia will remain an attractive destination for foreign investment, especially in the resource sector.

20. Staff projects a lower level of potential output as a result of the global recession. By 2014, GDP is projected to be about 5 percent lower than implied by the precrisis trend (Figure 8). This loss results from weaker export prospects and higher cost of capital, but it is substantially less than losses projected for most other advanced countries. In part, this reflects high investment in the resource sector in recent years that will increase productivity over the medium-term as projects come on stream. Moreover, despite the fall in export prices this year, the terms of trade is projected by staff to remain more than 40 percent above the average for the 1990s, because of demand for commodities from fast-growing Asian economies.

Figure 8.
Figure 8.

Australia: Potential Output

GDP is projected to be below that implied by an extrapolation of trend growth in 2000–07…

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Fund staff calculations and estimates.
F8a

…as capital’s contribution to potential growth is projected to fall.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

F8b

But the output loss is less than in most other advanced economies…

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Sources: World Economic Outlook; and Fund staff calculations.1/ Latest projections for actual GDP in 2014 as a percentage of an extrapolation of the historical precrisis GDP trend (2000–07).2/ Average excluding Australia.
F8c

…partly because the terms of trade is projected to remain elevated.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: World Economic Outlook; and Fund staff estimates.

21. The risks are evenly balanced, but the outlook is highly uncertain. On the downside, the world economy could take longer to recover, with significant spillovers to Australia through commodity sector incomes, external demand, and international capital markets. Domestically, a sharper-than-expected deterioration in banks’ asset quality, possibly stemming from lower house prices, could constrain credit and deepen the downturn. A high-impact tail risk would be a decline of investor confidence in banks or the sovereign. However, this is highly unlikely given low public debt and Australia’s track record of sound macroeconomic policies. On the upside, a key risk is stronger-than-expected demand from China. A further upside risk is that domestic and foreign economies could be more responsive than expected to the considerable policy stimulus currently in place.

22. The authorities broadly agreed with staff’s views on the near-term outlook and risks, but they considered staff’s medium-term growth projections too pessimistic. The latest official projections (May 2009 Budget) show a faster recovery, with growth reaching 4½ percent by 2011/12 and a smaller permanent output loss in the medium term. They argue that potential growth will not fall significantly given the absence of a domestic banking crisis, robust demand for commodities, and high immigration expected over the next few years.

B. Monetary Policy

23. Staff and the authorities agreed the current stance of monetary policy is appropriate, as earlier cuts in the policy rate will continue to support domestic demand. The RBA has kept rates on hold in recent months given the substantial fiscal and monetary stimulus in train and signs of a recovery in consumer and business confidence. The policy rate is currently below that implied by a simple Taylor Rule and staff’s forecast for inflation in 2010 is just under 2 percent.

24. If the outlook for growth and inflation worsens, staff and the authorities concurred that there is ample scope for further cuts in the policy rate. A downside scenario of lower global demand and higher risk premia on Australian assets would spill over to the domestic economy through weaker commodity prices, growth, and inflation (Box 1). In this scenario, a cut in the policy rate and a depreciation of the currency would ease financial conditions and cushion the impact on Australia.

Australia: Slower World Recovery

The IMF’s Global Integrated Monetary and Fiscal Model (GIMF) has been used to estimate the impact on Australia of a slower-than-expected world recovery. In this scenario, shocks to investment and consumption are used to proxy an intensification of the global financial crisis. The shocks reduce growth in the world outside Australia by roughly 2 percentage points in each of the first three years. This weaker growth is assumed to increase home bias in investment and consumption goods outside Australia. Smaller shocks to investment and consumption are also applied to Australia. In addition, the scenario assumes a temporary increase in Australia’s currency risk premium of almost 200 basis points, with half of that flowing through to Australian market interest rates.

The shock reduces the level of real GDP in Australia by 3 percent after three years. In addition to the direct impact of weaker external demand, slower world growth reduces commodity prices by roughly 20 percent, lowering private incomes and weakening domestic demand in Australia. However, the impact on the Australian dollar price of commodities is buffered by depreciation in the real exchange rate. With weaker growth reducing inflation, the policy rate declines by almost 300 basis points. In part, the large policy rate cut is necessary because a portion of the cut is not passed through to lending rates owing to a rise in the risk premium. Assuming that nominal government spending remains at baseline, but that revenues decline with nominal GDP, the fiscal balance moves into deficit for five years, driving government debt up by almost 7 percent of GDP at its peak.

F8e

In Percent or Percentage Point Deviation From Baseline

Real Output

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

F8f

Commodity Prices and Exchange Rate

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

F8g

Interest Rates and Inflation

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

F8h

Government Balances

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Source: Global Integrated Monetary and Fiscal Model simulation.

25. The authorities agreed with staff on the need to be more cautious than normal in tightening in view of the fragile state of the global economy. Although the risk of deflation is more limited in Australia than elsewhere, the associated output costs could be severe. Therefore, the return of the cash rate to neutral should wait until there are clear signs that a sustainable recovery is underway.

26. The monetary transmission mechanism has not been impaired in Australia and staff and authorities considered that unconventional monetary policy measures are unlikely to be needed. Nonetheless, staff suggested that the authorities consider how such measures could be implemented if required. Some measures have been taken already to help resuscitate residential mortgage back securities (RMBS) and asset backed commercial paper (ABCP) markets, with government planning to buy about $A 8 billion in RMBS securities.4

27. The authorities and staff agreed that the inflation-targeting framework provides a robust nominal anchor. Over the last several years, which witnessed the largest boom in Australia’s commodity prices in half a century, wage growth remained relatively stable, suggesting well-anchored medium-term inflation expectations. Moreover, the flexibility embodied in the target of 2–3 percent inflation, on average, over the cycle has allowed the RBA to take a wide range of factors into account, and thereby contain the buildup of potentially destabilizing imbalances. In particular, the RBA noted that the tightening of monetary policy in 2003 was partly in reaction to the sharp increase in house prices, owing to concerns about wealth effects, and that the tightening had been more effective in containing house price inflation compared with some other advanced economies (text figure).

C. Fiscal Policy

28. With low public debt and a transparent medium-term fiscal policy framework, the authorities were able to deliver a sizable fiscal stimulus—above the G20 average. Discretionary measures taken since September 2008 include 0.8 percent of GDP in 2008, 2.9 percent of GDP in 2009, and 2 percent of GDP in 2010. The measures centered on temporary transfers to almost 40 percent of the population and temporary increases in infrastructure spending (text figure). In addition to policy measures, the weaker outlook for growth and commodity prices is projected to shift the Commonwealth fiscal balance to a deficit of about 4¾ percent of GDP in 2009/10 (Figure 9).

Figure 9.
Figure 9.

Australia:

Large budget deficits are forecast…

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

F9a

…delivering a sizable stimulus.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

F9b

Expenditure jumps in the near term, but real growth is constrained over the medium term.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

F9c

State deficits also widen.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

F9d

The authorities project a return to surpluses in 2015/16. The staff project a later return to surpluses, based on lower GDP growth assumptions.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Sources: Australian Bureau of Statistics; and Fund staff estimates and projections.
F9e

Net debt is projected to rise over the next 4–5 years before declining thereafter.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

F8i

29. Staff commended the quick implementation of fiscal stimulus and noted that the shift into deficit was justified in current circumstances. Staff estimates suggest that the stimulus will raise real GDP by about 3 percent relative to baseline in 2009 and 2010, before dissipating in outer years.5 The transfers to households had an immediate impact on activity that helped underpin confidence. The increase in public investment will continue to support activity in the near term, while addressing infrastructure shortfalls. The stimulus payments to state governments are also in line with the Commonwealth and State governments’ reform agenda that focuses on investing in education, health and transportation infrastructure to raise productivity while harmonizing regulations across states.

30. Staff and authorities agreed that, given low public debt, there is scope for further fiscal stimulus, if the outlook for growth weakens. However, staff advised that monetary policy should be the first line of defense, as it remains effective and because additional fiscal stimulus would increase government debt further. If growth were slower than expected in the near-term, automatic fiscal stabilizers should be allowed to work fully. Staff analysis suggests that the impact on growth is highest for public investment spending. However, transfers targeted to low-income households have a faster yet still large impact, and could be the most suitable measure if a prompt demand impetus is required.

31. The authorities’ reaffirmed their medium-term fiscal strategy that focuses on three objectives:

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

  • keeping Commonwealth tax revenue as a share of GDP, on average, below the 2007/08 level (24.6 percent); and

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

32. The government has adopted a deficit exit strategy consistent with its broad medium-term fiscal objectives. Once GDP is growing above its trend rate, the authorities intend to take action to return the budget to surplus by limiting real growth in spending to 2 percent per year and allowing tax receipts to increase through fiscal drag. Based on the authorities’ growth projections, the underlying budget balance would return to surplus by 2015/16 and remain in surplus through 2019/20. As a result, Commonwealth government net debt would peak at almost 14 percent of GDP in 2013/14 before falling below 4 percent of GDP by 2019/20.6 The authorities consider that the increase in net debt is prudent in the current economic circumstances, as net debt is projected to remain low relative to both the peak of the past 40 years (18½ percent of GDP) and to other advanced economies.

33. Staff welcomed the authorities’ fiscal strategy and the intention to return to surpluses in the medium term. Staff projects a return to surpluses by 2017/2018, assuming a lower GDP growth rate than the authorities but that their spending plans are maintained. On this basis, staff projects Commonwealth government net debt to be peak at about 15 percent in 2013/14 before falling to 10 percent of GDP by 2019/20. While the staff’s projected increase in debt is somewhat higher than projected by the authorities, it is less than expected for many other advanced countries. This would leave Australia in an enviable fiscal position by international standards (Figure 10).

Figure 10.
Figure 10.

Australia: Comparison of Fiscal Outlook

Australia’s change in the budget balance is broadly in line with other advanced countries.

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.A001

Sources: World Economic Outlook; and Fund staff estimates and projections.
F10a
Sources: World Economic Outlook; and Fund staff estimates and projections.
F10b
Sources: World Economic Outlook; and Fund staff estimates and projections.
F10c
Sources: World Economic Outlook; and Fund staff estimates and projections.

34. Staff welcomed plans to contain expenditure and allow tax receipts to increase, but noted that further fiscal adjustment may be needed. The current global environment implies considerable uncertainty about Australia’s medium-term prospects. If trend growth or the terms of trade are not as high as assumed, government revenue would be negatively impacted. In such circumstances, further fiscal adjustment would be needed to return to surpluses at a horizon consistent with the government’s medium-term objective. In particular, the growth of real spending would need to be constrained below the 2 percent annual rate envisaged in the budget, once growth has recovered. Staff advised that if revenue is higher than currently expected, the authorities should strive for an earlier return to surpluses.

35. Although government debt is projected to remain relatively low, several factors argue for continued prudence. While the probability is extremely low, the government may need to assume additional debt on behalf of the banks should they be unable to rollover their significant short-term external liabilities. Guarantees on banks’ deposits and wholesale funding as well as state-government debt, presents an additional, although again similarly low probability risk. Relatedly, servicing government debt could become more expensive if increased global supply drives up sovereign debt yields, as seen in recent months. Returning to lower debt levels would put Australia on a firmer footing to respond to future shocks. Looking further out, while some pension and health care reform has been included in the budget, remaining longer-term pressures from aging and rising health care costs argue for more policy action.

36. State governments are projecting higher cash deficits and increased debt levels. Staff noted that this highlights the importance of maintaining fiscal restraint at the Commonwealth level over the medium term, given the new guarantee of state debt.

37. The authorities reiterated their commitment to maintaining debt at prudent levels over the medium term. They considered that the downside risks to revenue were limited, but stated that they would cut expenditure if necessary to achieve their medium-term fiscal objectives. Should revenue exceed budget projections, they would save excess revenue to return to surpluses earlier than envisaged.

D. Domestic Macro-Financial Linkages and Preserving Financial Stability

38. The linkages between high household debt and bank balance sheets are a key domestic vulnerability. Australian household debt is relatively high by advanced country standards and staff analysis suggests that house prices are overvalued by 0–20 percent.7 A fall in house prices and a jump in unemployment could lead to further household deleveraging and an increase in bank’s impaired assets. In turn, higher provisioning for losses could constrain bank credit growth and deepen the downturn. However, the risks of a sharp fall in house prices is limited given strong immigration flows and improved affordability because of lower mortgage rates. Moreover, less than 10 percent of owner-occupiers with mortgages belong to the high risk group—those with a debt-service ratio over 30 percent and a loan-to-value ratio greater than 80 percent. Staff’s preliminary analysis suggests that potential further losses from a sizeable downside shock that would increase mortgage and corporate defaults sharply would not reduce large banks’ capital below the regulatory minimum.8

39. Staff commended the Australian Prudential Regulation Authority (APRA) for regularly stress testing the banking sector and advised that banks be required to undertake more extreme stress tests than in the past. The tests should be undertaken jointly with their subsidiaries, to assess vulnerability of their capital and liquidity positions to a sharp jump in unemployment, a drop in house and commodity prices, and a disruption to wholesale funding.9 Prudential judgment should be used to assess adequacy of banks’ capital buffers, in light of stress tests, and capital requirements raised if necessary.

40. The authorities reiterated their commitment to continue monitoring and stress testing banks’ capital position. They noted that banks are now required to conduct regular stress tests under Basel II. Moreover, a recent mission from the IMF’s Monetary and Capital Markets Department gave a very positive assessment of Australia’s Basel II implementation (Box 2).

Australia: Basel II Implementation

The Australian Prudential Regulation Authority (APRA) implemented the Basel II framework in 2008. The major banks, representing nearly 70 percent of banking industry assets, adopted the advanced approaches for credit, market and operational risk. At the request of the authorities, an IMF mission from the Monetary and Capital Markets Department visited Sydney in May 2009 to assess Basel II implementation. This box summarizes the assessment of the mission.

The mission found that APRA followed a rigorous process in implementing the Basel II framework. APRA has allocated sufficient resources prior to the Basel II start date and the outcome has been robust implementation. The mission noted that adequate resources will be needed to ensure that banks continue to meet these requirements on an ongoing basis.

The authorities adopted a more conservative approach in several cases than required by the Basel II framework. Most importantly, a 20 percent loss given default (LGD) floor was adopted for residential mortgages that comprise over half of the large banks’ loans, which is higher than the Basel II 10 percent floor. In addition, higher risk weights were required for certain residential mortgages under the standardized approach. Moreover, reduced risk weights, which are permissible in the Basel II framework’s standardized approach, have not been introduced for retail lending. Furthermore, banks’ capital requirements under the advanced approaches continue to be subject to the 90 percent floor of the Basel I capital requirement, instead of the 80 percent floor applicable in the second year. APRA has also exercised caution in other choices regarding the framework, such as requiring banks using the advanced approaches to hold capital against interest rate risk in the banking book.

The mission pointed to few areas where APRA could build on initiatives already underway to enhance its supervision of banks’ risk management. APRA should continue to undertake increasingly complex work, such as drill down reviews of banks’ economic capital models and stress testing practices. The mission recommended increased Pillar 3 disclosures by second-tier banks and a re-assessment of the operational risk approach applicable to their operations.

41. The planned introduction of new liquidity guidelines is welcome. Recognizing the increased importance of liquidity and rollover risks associated with short-term liabilities, banks have started to increase medium-term funding. However, liquidity positions should continue to be based on prudentially enforced liquidity guidelines. The stability benefits of strengthening liquidity positions and reducing rollover risks justify likely increases in funding costs.

42. Staff underlined the importance of further crisis preparedness planning, especially for liquidity or solvency problems in major banks in Australia and New Zealand. Staff welcomed ongoing close cooperation with New Zealand authorities, including the visit by APRA to New Zealand in February 2009 for on-site credit book inspections of the large banks. Most importantly, a framework is being developed for resolving stress in an Australian or New Zealand bank.

43. Exit strategies from policy measures introduced during the financial crisis are, appropriately, being considered. Staff recognized that the risk-pricing element of the wholesale funding guarantee provides a natural exit strategy once markets normalize. The authorities plan to review options for guarantees to retail deposits, including changes to the new Financial Claims Scheme that covers deposits of less than a million dollars. Key recommendations of the 2006 FSAP have been implemented, as summarized in Appendix II.

E. Australia’s External Vulnerability

44. A range of indicators suggest that the currency is broadly in line with fundamentals (Box 3). The fall of the exchange rate from mid 2008 to early 2009 was driven by a decline in commodity prices and the loosening of monetary policy (Figure 11). The currency is free floating and fluctuates considerably because of the importance of commodity exports. The authorities agreed that the currency is broadly in line with fundamentals.

Australia: Equilibrium Real Effective Exchange Rate

Staff estimates suggest that the Australian dollar is broadly in line with fundamentals. These estimates are based on the macroeconomic balance (MB) approach, the equilibrium real exchange rate (ERER) approach, and the external sustainability (ES) approach.

The MB estimates suggest that the equilibrium current account deficit is about 4½ percent of GDP, reflecting relatively high population growth. Staff’s projected current account deficit is broadly in line with the norm. This implies a small undervaluation of about

Exchange Rate Assessment: Baseline Results 1/

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Sources: IMF staff estimates.

All results are expressed in percent.

Staff projection of the underlying CA/GDP in 2014.

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

Overvaluation is assessed relative to the average for June 2009.

Based on an assumed nominal growth rate of 5.5 percent.

The ERER estimates suggest a small overvaluation. The model attempts to explain the Real Effective Exchange Rate (REER) on the basis of the terms of trade, relative productivity, and relative government consumption. Using an estimate of the June 2009 level for the REER as the base, the equation suggests an overvaluation of about 5 percent in 2014, assuming a weakening of the terms of trade in 2009.

The ES approach implies an overvaluation of less than 10 percent assuming that net foreign liabilities (NFL) stabilize at the norm estimated by the model of about 46 percent of GDP over the medium-term. However, the predicted NFL is mainly explained by the fixed effect, which casts doubt on the model. A smaller overvaluation of less than 5 percent would result if we assume NFL stabilizes at the end-2008 level of 60 percent of GDP.

The estimates are subject to considerable uncertainty, as shown by the wide range of the confidence intervals. Further discussion of the models and the uncertainty surrounding the analysis is presented in the IMF Working Paper (WP/09/07), Australia and New Zealand Exchange Rates: A Quantitative Assessment, by H. Edison and F. Vitek.

Figure 11.
Figure 11.

Australia: Exchange Rate Developments

The exchange rate depreciated in 2008 as the RBA cut the policy rate…

Citation: IMF Staff Country Reports 2009, 248; 10.5089/9781451802207.002.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.
F11c
Source: Bloomberg.1/ Chicago Board Options Exchange volatility index.

45. Staff forecasts the current account deficit to be around 3½ percent of GDP in 2009. The trade deficit is expected to narrow slightly in 2009, as the decline in the terms of trade is offset by lower imports and continued strong commodity export volumes. The income balance is projected to narrow by about ½ percent of GDP in 2009 because of lower interest and dividend payments. The current account deficit is forecast to be around the lower end of the norm of 4–5 percent of GDP over the medium-term, assuming that the terms of trade remains well above the average of the past 10 years (Table 3).

Table 3.

Australia: Medium-Term Scenario, 2008-14

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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 basis ending June 30.

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