Australia
2010 Article IV Consultation: Staff Report; and Public Information Notice on the Executive Board Discussion

The impact of the global crisis was milder in Australia than in other advanced economies owing to strong demand from Asia and decisive policy responses. Australian banks were resilient to the global crisis, and the labor market was flexible in the face of the shock. The exit from fiscal stimulus is appropriate as is the recent review of the tax system. Banks could adopt riskier strategies and require vigilance. The exchange rate is overvalued but will dissipate as interest rates in other advanced economies eventually normalize.

Abstract

The impact of the global crisis was milder in Australia than in other advanced economies owing to strong demand from Asia and decisive policy responses. Australian banks were resilient to the global crisis, and the labor market was flexible in the face of the shock. The exit from fiscal stimulus is appropriate as is the recent review of the tax system. Banks could adopt riskier strategies and require vigilance. The exchange rate is overvalued but will dissipate as interest rates in other advanced economies eventually normalize.

I. What Explains the Resilience of the Australian Economy to the Global Crisis

1. Australia was one of the few advanced economies to escape recession in 2009 (text figure). This reflected growing links with Asia, including strong demand for commodities from China and India, a prompt and significant macro policy response to the global crisis, a healthy banking sector, and a flexible exchange rate (Table 1, Figure 1).

Table 1.

Australia: Selected Economic Indicators, 2007–11

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

Contribution to growth.

Includes public trading enterprises.

Fiscal year ending June 30, Commonwealth Budget. For example, 2011 refers to fiscal year July 1, 2010 to June 30, 2011 which the Australian Government’s budget papers denote as budget year 2010.

Data for 2010 are for latest available month.

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

Figure 1.
Figure 1.

Australia: Resilience to the Crisis

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

2. Australia was in a strong position at the onset of the global recession. Sound macroeconomic policies and structural reform secured 17 years of continuous growth. Unemployment was at historical lows and inflation expectations were well-anchored.

3. Exchange rate flexibility provided a buffer. The Australian dollar depreciated sharply at the onset of the crisis as commodity prices fell and risk aversion jumped. Subsequently, the currency appreciated in real effective terms by 35 percent between March 2009 and September 2010, as commodity prices recovered and interest rate differentials widened (Figure 2). Australian financial markets have also largely recovered from the global crisis.

Figure 2.
Figure 2.

Australia: Exchange Rate and Financial Market Developments

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

4. Monetary policy reacted promptly. In response to the global crisis, the Reserve Bank of Australia (RBA) cut its policy rate from 7¼ percent to 3 percent over the seven months to April 2009. The transmission of monetary policy was very effective, in contrast with some other advanced economies, as the cuts were largely reflected in mortgage and business lending rates.

5. Fiscal policy also supported activity. The Commonwealth government ran budget surpluses of around 1-1¾ percent of GDP in the six years before the crisis that eliminated its net debt. With considerable fiscal space, the government reacted quickly to the global crisis by providing a fiscal stimulus of 4⅓ percent of GDP in the two years to June 2010, above the G-20 average (text figure). The operation of the automatic stabilizers, in particular the decline in revenue, together with the stimulus, shifted the budget into an underlying cash deficit of about 4 percent of GDP in 2009/10 (Table 2).

Table 2.

Australia: Fiscal Accounts, 2005/06-2014/15 1/

(In percent of GDP)

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Sources: Commonwealth of Australia: 2010-11 Budget; and IMF staff estimates and projections.

Fiscal year ending June 30.

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.

uA01fig01

GDP Growth, 2009

(Year-on-year percentage change)

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

Sources: WEO; and IMF staff calculations.
uA01fig02

Estimated Cost of Discretionary Measures

(In percent of GDP, relative to 2007 baseline)

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

Source: IMF staff estimates.

6. Australian banks were resilient to the global crisis. Banks have remained profitable with adequate provisioning and sound asset quality, as nonperforming loans rose to less than 2 percent of assets (Figure 3). Capital adequacy has improved to about 12 percent, after banks raised private capital. The “four pillars policy,” which does not allow the four large banks to merge, together with sound regulation and supervision, played a role in limiting risky behavior before the crisis and helped maintain stability, with the Council of Financial Regulators coordinating the response of the main regulatory agencies to the global crisis. In addition, the government’s Guarantee Scheme for Large Deposits and Wholesale Funding for banks introduced in late 2008 helped maintain access to funding. The guarantee was withdrawn for new liabilities in March 2010 as market conditions had normalized.

Figure 3.
Figure 3.

Australia: A Healthy Banking System

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

7. The labor market proved to be flexible in the face of the shock. Many employers reduced hours worked rather than laying off staff, given their recent experience of skills shortages. This resulted in a sharper fall in hours worked than employment, and tempered the increase in the unemployment rate, which peaked at less than 6 percent in mid-2009. Employment and hours worked have since rebounded.

uA01fig03

Employment Growth

(Year-on-year, in percent)

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

Sources: Haver Analytics, IMF staff estimates.

A. The Mining Boom and the Beginning of Exit from Stimulus

8. A mining boom is underway, as commodity prices have rebounded. Prices for key exports, such as iron ore and coal, are expected to remain high in the near term, based on strong demand from China and India. Private sector investment in mining in recent years has risen, which, combined with public investment and a pickup in household consumption, underpinned activity in the first half of 2010.

uA01fig04

Real Capital Expenditure

(In billions of Australian dollars, 2007/08 SA)

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

Source: Australian Bureau of Statistics.

9. Early signs of Inflation pressure are starting to emerge. While core inflation fell below 3 percent y/y in June 2010 and wage growth moderated, spare capacity is beginning to be used up with the unemployment rate falling to just over 5 percent (Figure 4).

Figure 4.
Figure 4.

Australia: The Re-Emergence of Inflationary Pressures

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

10. Monetary accommodation has been withdrawn. In late 2009 it was evident that the economy was recovering and the RBA started to withdraw monetary stimulus, raising the policy rate to 4½ percent in six steps, the most recent in May (Figure 5). The increases in the policy rate have flowed through effectively to both mortgage and business lending rates which have returned close to their 10-year averages. With considerable uncertainty about the global economic outlook, the RBA has kept policy rates on hold in recent months.

Figure 5.
Figure 5.

Australia: Withdrawing Monetary Stimulus

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

11. Credit growth is showing signs of recovery. The sharp slowing in credit growth following the onset of the crisis was driven by falls in business and personal credit. Mortgage credit growth, while slowing, remained positive, reflecting the introduction of government incentives for first time home buyers and the quick pass through of policy rate reductions into mortgage rates. More recently, personal credit growth picked up, although business credit continues to contract.

12. Strong commodity demand helped reduce the current account deficit (Tables 3 and 4). The current account deficit fell to 3⅓ percent of GDP in the first half of 2010, as iron ore and coal exports picked up, and dividend and profits payments declined. Net external liabilities have risen over the past few years to about 60 percent of GDP by mid-2010.

Table 3.

Australia: Balance of Payments, 2005–09

(In percent of GDP)

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

Australia: Balance of Payments in U.S. Dollars, 2005–09

(In billions of U.S. dollars)

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Sources: Data provided by the Australian authorities; and IMF staff estimates.
uA01fig05

Credit by Sector

(Seasonally adjusted, Y/Y percentage change)

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

Source: Reserve Bank of Australia.
uA01fig06

Current Account Balance

(Annual, in percent of GDP)

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

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

II. Outlook and Risks

13. The outlook is favorable. Real GDP growth is projected at 3–3½ percent in 2010 and 2011, with private investment in mining and commodity exports taking over from public demand as the main driver of growth (Table 5). The output gap is expected to close in mid-2011. Despite rising mortgage rates, household consumption will be supported by strong income growth, buoyed by the recent rebound in employment. The terms of trade is expected to rise to historic highs in late 2010, driving a mining boom that is likely to be long lasting, given increasing ties with fast-growing emerging Asia (Box 1). The current account deficit is projected to narrow in the near-term to less than 2½ percent of GDP, due to the jump in the terms of trade. However, the deficit is forecast to widen to about 6 percent of GDP over the medium term, mostly reflecting higher investment in the resource sector, including on LNG projects.1

Table 5.

Australia: Medium-Term Scenario, 2008–15

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

Contribution to growth.

Includes public trading enterprises.

Fiscal year basis ending June 30. For example, 2011 refers to fiscal year July 1, 2010 to June 30, 2011 which the Australian Government’s budget papers denote as budget year 2010.

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

14. The main risks relate to the global outlook and, in the near term, are tilted largely to the downside. If the global recovery stalls and Chinese demand for commodities declines, Australia’s terms of trade could fall sharply. In addition, concerns about fiscal sustainability in Europe could disrupt global financial markets and push up the cost of capital for Australian borrowers (Box 2). On the domestic front, a fall in house prices and deleveraging by highly indebted households could negatively impact private consumption and slow the recovery. An upside risk is that the mining boom may have a larger-than-expected impact on output and inflation.

Australia: Increasing Ties with Emerging Asia and Australia’s Growth Potential1

The destination of Australia’s exports has shifted dramatically from advanced economies to fast-growing emerging Asia. Over the past two decades, exports to China and India grew by almost 20 percent per annum in U.S. dollar terms while exports to the U.S. and Germany grew by just 3–4 percent annually. As a result, China overtook Japan as Australia’s top export destination in 2009. If this trend continues, almost half of Australia’s exports will head to China and India by 2015.2

Strong commodity demand from emerging Asia has pushed Australia’s terms of trade to near historical highs. The gain in the terms of trade has been stronger in Australia than in other commodity producing countries since 2003.

Increasing ties with fast-growing emerging Asia is expected to continue supporting Australia’s growth potential. Strong demand from Asia would boost investment and capital accumulation in Australia, enhancing production capacity. Partly reflecting this, staff analysis suggests that Australia’s potential growth over the medium-term is expected to be high relative to other advanced countries.

Australia: Major Mechandise Export Destinations

(In percent of total)

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uA01fig07

Terms of Trade, Goods and Services

(2000=100)

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

uA01fig08

Trading Partners’ GDP Growth 1/

(In percent)

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

1/ Weighted by average trade exports of 2006-08 to all partner countries.
uA01fig09

Medium-Term Potential Per Capita Growth

(In percent)

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

1

Based on “Potential Growth of Australia and New Zealand in the Aftermath of the Global Crisis” by Y. Sun, IMF WP/10/127.

2

Assuming Australia maintains its market share of the projected growth in China and India’s imports in the range of 20 percent per annum in U.S. dollar terms for 2010–15.

Authorities’ Views

15. The authorities agreed with staff’s economic outlook, although they viewed the risks as more balanced. They noted the downside risks from market concerns about the fiscal outlook for some European economies. They also pointed to the risk that the pickup in private demand in Australia may not occur as quickly as expected and drive the recovery when public investment is contracting. The authorities, however, expect strong demand for mineral exports to continue to support the recovery, given urbanization and industrialization in emerging Asia.

III. What is the Right Pace of Exit from the Policy Stimulus?

A. Monetary Policy

16. Staff supported the removal of monetary stimulus since late 2009, given the improvement in the economic outlook. Staff also noted that keeping policy rates on hold since May 2010 was appropriate, in light of increased uncertainty about prospects for the recovery. With lending rates in Australia close to ten-year averages and economic activity responding quickly to cash rate adjustments, the RBA has scope to wait for the outlook to become clearer.

17. Should the recovery proceed as expected and downside risks dissipate, staff advised that monetary policy will need to be tightened further to contain inflation pressures generated by the impact of the mining boom on the wider economy. In determining the magnitude of the additional tightening, the RBA will need to consider two key factors. First, given the high level of household indebtedness, domestic demand is likely to be more responsive to interest rates than in the past. Second, with inflation projected to remain close to the top of the 2–3 percent target band, the RBA needs to guard against inflation expectations becoming anchored at too high a level.

18. If world growth falters or global markets come under severe stress because of concerns over European sovereign debt, the RBA is well positioned to respond. It has ample scope to cut the policy rate and provide liquidity support for banks, which proved effective in the recent crisis.

The Potential Impact on Australia of the European Sovereign Debt Turbulence

The IMF’s Global Projection Model (GPM) has been used to estimate the potential impact that Europe’s sovereign debt crisis could have on the global economy’s major regions. Two scenarios are considered. The first is that the direct impact is largely concentrated in Europe with slower activity reflecting the fiscal consolidations required to stabilize financial markets, a mild increase in the Euro area risk premium, and a moderate increase in financial stress. Spillovers outside Europe are limited to trade effects. The second scenario entertains the possibility that global financial markets could become severely disrupted because European fiscal consolidation plans are viewed to be either not credible or not sufficient. The impact on the major world regions under these two scenarios are presented in the table.

These scenarios are used in a small open economy model of Australia to estimate the potential impact that Europe’s sovereign debt crisis could have on Australia’s macro outlook.1 The impact on Australia is mild due to the space for policy to respond and the importance of emerging Asia, which is less affected than other regions.2 However, the output effect is longer lived in Australia because of the impact of commodity prices, which remain below baseline for an extended period due to the persistence in the shock to the level of world demand.

Impact of Euro Area Turbulence on GDP Growth GPM Simulation Deviations from Baseline

(Percent or percentage point)

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Impact of Euro Area Turbulence on Australia FPAS Simulation Deviations from Baseline

(Percent or percentage point)

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1

The reduced form-model, the Forecasting and Policy Analysis System (FPAS), describes the behavior of Australia and its relevant rest-of-world. It is an estimated model that includes reactions functions for both monetary and fiscal policy and also incorporates commodity prices.

2

The GPM countries/regions impacts are weighted using Australia’s trade weights to calculate the GDP impact on Australia’s external sector.

Authorities’ Views

19. The RBA agreed that if the downside risks to the outlook diminished and further inflation pressures emerged, the policy rate would need to be raised. They will continue to monitor domestic and external developments closely and set monetary policy to achieve an average rate of inflation of between 2 and 3 percent over the cycle. The authorities were concerned that global market disruptions could arise with some frequency over the next few years. They noted that such disruptions may pose some challenges for monetary policy in Australia, but the flexible exchange rate and removal of earlier monetary policy stimulus has put them in a strong position to respond to a downside scenario.

B. Fiscal Policy

20. The government’s strategy to exit fiscal stimulus is projected to return the budget to a surplus of 0.2 percent of GDP by 2012/13. With above trend growth forecast, the government intends to achieve this goal by:

  • allowing tax receipts to increase through fiscal drag as the economy recovers, while keeping the tax-to-GDP ratio below the 2007/08 level of 23.6 percent on average;

  • holding real growth in government spending to 2 percent or less per year until the budget returns to surplus. Once the budget is back in surplus, the government will retain a 2 percent real cap on spending growth, on average, until the budget surplus is at least 1 percent of GDP, currently projected for 2015–16.

21. Staff supported the pace of withdrawal of fiscal stimulus, if the economic recovery proceeds as expected. The exit from the stimulus, which began in 2010, sees Commonwealth government net debt peaking at 6 percent of GDP in 2011–12 (Figure 6). The fiscal adjustment is faster than past consolidations in Australia and exit plans in most other advanced economies (Figure 7). In the event of a downside scenario, staff noted that Australia’s fiscal position provides ample scope to allow the automatic stabilizers to operate, and, if needed temporary discretionary measures to be introduced.

Figure 6.
Figure 6.

Australia: Exit From Fiscal Stimulus

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

Sources: Australian Bureau of Statistics; and IMF staff estimates and projections.
Figure 7.
Figure 7.

Australia: Comparison of Fiscal Outlook

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

Sources: WEO, IMF staff estimates.

22. Although public debt is projected to remain very low by advanced country standards, returning quickly to budget surpluses as the authorities intend would put Australia in a stronger position to deal with future shocks. The increased supply of sovereign debt worldwide could eventually put significant upward pressure on funding costs. Maintaining low Commonwealth net debt levels will help contain debt-servicing costs associated with the private sector’s external debt and increased public saving could help contain the current account deficit.

Authorities’ Views and Plans

23. The authorities emphasized that their projected return to surplus by 2012/13 reflects a strong commitment to spending restraint. They noted that their cap on annual real spending growth of 2 percent (in years when the economy is growing above trend) is well below average annual real spending growth of 3¾ percent in the ten years prior to the global crisis. They agreed on the benefits of reducing public debt and project Commonwealth net debt to return to zero by 2018/19.

IV. How Should the Mining Boom be Managed?

24. The mining boom is expected to be long lived, but brings with it vulnerabilities to which policy will need to respond. Staff analysis suggests a significant dividend for Australia from continued growth in emerging Asia, even with a rebalancing of the drivers of Asian growth toward the non-tradable sector.2 Sound management of the boom in Australia could permanently raise household incomes, but facilitating a shift of resources to the mining sector without giving rise to inflationary pressures presents a key challenge. Moreover, the growing dependence on mining may amplify the business cycle as the economy will be more vulnerable to swings in commodity demand and make government revenue more volatile.

25. The framework laid out in the Charter of Budget Honesty requires fiscal policy to contribute to moderating cyclical fluctuations in economic activity and maintain Commonwealth Government debt at prudent levels. The current government’s strategy is to achieve budget surpluses on average over the medium-term, to help moderate the pro-cyclical impact from the terms of trade. However, during the upswing in commodity prices from 2004–2008, budget surpluses were limited to only 1¾ percent of GDP, with cuts in personal taxes and increases in spending providing a fiscal stimulus during this period.

26. Staff advised allowing the automatic fiscal stabilizers to operate fully. Faster than expected Asian growth can quickly place significant capacity pressures on the Australian economy. Although the exchange rate would adjust and monetary policy react, allowing the automatic stabilizers to operate fully would help avoid potential overheating. To this end, staff recommended saving revenue windfalls. In addition, this would build a buffer against a sharp fall in commodity prices and permit the automatic stabilizers to operate fully during downturns.

27. Because of the growing importance of commodity prices for the budget, staff suggested preparing downside scenarios where the terms of trade return quickly to the long-run average. The budget projects the terms of trade to fall gradually by about 20 percent over the next 15 years as supply comes on stream and settle about 30 percent above the average of the past 20 years. Analyzing the impact of a sharper fall in commodity prices than currently assumed in the budget would illustrate the importance of running larger surpluses during the good times to strengthen the fiscal position.3 A stronger sovereign balance sheet would provide more fiscal space to cushion the impact should the terms of trade deteriorate sharply. Moreover, it would put the budget in a better position to deal with some of the long-term pressures from aging and rising health care costs (Box 3).

28. Tax reform can also play a key role in allowing Australia to take full advantage of the mining boom. Staff welcomed the recent review of the tax system, as it provides a comprehensive blueprint for tax reform issues (Box 4). The planned introduction of the mineral resource rent tax (MRRT) in 2012 is a step in the right direction and is to be accompanied by a cut in the company tax rate from 30 to 29 percent, to encourage investment. While the MRRT strengthens the automatic stabilizers in the budget, staff noted that it is less effective in that regard than the original proposal of a super profit tax. Consideration should be given to broadening the coverage of the MRRT to other mineral resources beyond iron ore and coal. Another objective of tax reform should be to facilitate the reallocation of resources so that Australia can fully benefit from improved terms of trade. Staff advised more reliance on consumption-based taxes. This would allow for the elimination of inefficient taxes that impede labor mobility (including stamp duties at the state level) and make room for reductions in federal personal income taxes that would encourage increases in labor supply and saving.

29. Other structural reforms will be needed to improve the supply response and address infrastructure bottlenecks in the face of the boom. Reforms underway aim to reduce inconsistent and unnecessary regulation and restrictions on competition across Commonwealth, State and Territory governments. In addition, the Commonwealth government is investing in education and promoting effective regulation and more efficient use of existing infrastructure, and more transparent frameworks for new infrastructure investment decisions.

Authorities’ Views

30. The authorities agreed that the mining boom will test the economy’s capacity and note that adjustments have been made so that fiscal policy is playing a key role in managing the boom. They saw merit in staff’s advice to save stronger-than-anticipated revenue in the upswing. They noted that this advice is broadly consistent with the government’s strategy of achieving budget surpluses, on average, over the medium term and improving the government’s net financial worth. The government’s other objective of keeping Commonwealth tax revenues as a share of GDP, on average, below the 2007/08 level (23.6 percent of GDP) may constrain the increase in revenue. However, given that this objective is defined as an average over the medium term it would not present a substantial constraint in the near-term. In strengthening the government’s fiscal strategy from balance to surpluses over the cycle, they also pointed to the political challenges of running larger surpluses than in the past, given pressure to cut taxes when revenue growth is strong. They agreed that analyzing downside scenarios from a sharp fall in the terms of trade may help build political support for larger surpluses to strengthen the government’s balance sheet. But they raised concerns about how to manage public assets once Commonwealth net debt is reduced to zero. On tax reform, the authorities noted that increasing consumption taxes would be difficult, as they are perceived as regressive. Further, the government has a clear policy that the GST rate will not be increased or the base broadened.

Fiscal Pressures from Aging and Rising Health Care Costs

The “Intergenerational Report 2010” published by the Australian Treasury notes that an ageing population presents significant long-term risks for the economy and the sustainability of government finances. The report projects that government spending on health, age-related pensions and aged care could rise by 5.3 percent of GDP by 2049–50 from the projected low point in 2015–16. Rising health care costs are the largest contributor to this increase, accounting for around two-thirds of the overall increase.

Health: The very high growth rates projected for health spending underscore the need for health reform. The Intergenerational Report emphasizes the need to adjust spending to obtain better value for money rather than simply cutting the budget. In April 2010, the Council of Australian governments, with the exception of Western Australia, reached an agreement on significant reforms to the health system—the establishment of a National Health and Hospitals Network—with a view to improving the delivery and the sustainability of the health system.

Pensions: The government will progressively increase the retirement age from 65 to 67 years beginning in 2017 and revise the means test arrangement to better target the pension to those that are most in need. The government also boosted pension payments, with savings made in other areas of spending. The combination of savings measures means the pension reforms will be fully offset by 2020–21. Nonetheless, government spending on age-related pensions is projected to increase from around 3 percent of GDP in 2009/10 to around 4 percent of GDP in 2050.

While pension and health care reform already undertaken are important steps, further policy action will be needed to contain the public share of costs in these areas. In addition, measures to raise labor force participation and productivity, such as those discussed in the tax review, would help address pressures on the budget.

Australia’s Tax Policy Reform

Australia’s tax review report was released on May 2. The review is designed to provide a framework for policy debate over the next few decades.

The five principles or core criteria underlying the tax reform proposals include:

  • Equity: the system should be progressive and reduce differences in compliance costs across tax payers;

  • Efficiency: the tax system should minimize efficiency costs by reducing the number of inefficient taxes—many of which are levied by the States; and maximize its capacity to generate revenues;

  • Simplicity: the system should be more transparent and be easier to comply with;

  • Sustainability: on the tax side, the system must be able to meet the revenue needs of the government without recurring to inefficient taxes. On the transfer side, the cost of the system needs to be predictable and affordable in the light of demographic pressures Australia faces. Both must be flexible enough to respond to changing policy challenges and consistent with environmental sustainability; and

  • Policy consistency: tax and transfer policy should be consistent among the States, and across levels of government, as well as consistent with governments’ broad policy objectives.

The overarching objective of tax reform is to promote stronger long-term growth by increasing workforce participation—through appropriate design of tax incentives and transfers—and productivity—through higher business investment, especially in infrastructure.

The main recommendations of the tax review included:

  • introducing a rent tax on nonrenewable resources;

  • cutting the company tax rate from 30 percent to 25 percent over the medium term to increase business investment, including FDI;

  • reducing the complexity of personal income tax, including by introducing a high tax-free threshold with a constant marginal rate for most people; removing stamp duties that are by nature inefficient taxes on land that discourage residence mobility and replacing them with a broad-base land tax;

  • enhancing taxes on consumption (excluding the GST) and broadening the consumption tax base. A broad-based cash flow tax could be used to finance the abolition of other taxes, including the payroll tax and inefficient State consumption taxes, such as insurance taxes;

  • promoting higher workforce participation through improving support for quality child care, and building clear work incentives into the levels of income support payments.

The government has endorsed some of the recommendations, including introducing a mineral resource rent tax on iron ore and coal and cutting the company tax rate from 30 to 29 percent in 2012.

V. How to Maintain Financial Stability and Address Banks’ Domestic Vulnerabilities?

31. Given the relatively good performance of banks in the face of the crisis, staff expressed concern that they may be emboldened to take on riskier strategies. The global crisis highlighted the need for banks to hold strong capital and liquidity buffers and for supervisors to encourage banks to carefully manage their risks.

32. A key risk is banks’ exposure to household debt of more than 150 percent of households’ disposable income. As in many other countries, household debt has risen over the past decade leading to an increase in debt servicing costs. Household net wealth has also risen, but this was mainly because of a large increase in house prices, which staff analysis suggests are mildly overvalued (Figure 8).4

Figure 8.
Figure 8.

Australia: Household Vulnerabilities

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

Sources: RBA; RBNZ; Eurostat; OECD; Haver; and IMF staff calculations.

33. A number of factors, however, limit potential losses from banks’ exposure to households.5 First, exposure to high-risk mortgages is small, as less than 10 percent of owner-occupiers had mortgages with loan-to-value ratios higher than 80 percent and debt-service ratios greater than 30 percent. Second, debt is mainly held by higher income households, with households in the top two income quintiles holding almost three quarters of household debt (Text Figure). Third, the Australian Prudential Regulation Authority’s (APRA) intensive supervision and prudential rules guide banks toward a conservative assessment of risk, including by setting a floor of 20 percent for losses given default on residential mortgages (Text Figure).

uA01fig10

Indebted Households, 2006

(Share of household debt held by income quintiles)

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

uA01fig11

Loss Given Default on Residential Mortgages

(Percent)

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

Sources: Banks’ disclosure statements and IMF staff estimates.1/ 3 largest banks.2/ 4 largest banks.3/ 2 largest banks. Reporting dates 4Q 2008 and 4Q 2009.4/ 3 banks. Reporting dates 4Q 2008 and 4Q 2009.

34. APRA’s recent stress tests also suggest that banks are resilient to large but plausible shocks. APRA regularly conducts stress tests, most recently in 2009/10 in cooperation with the Reserve Bank of New Zealand and the New Zealand subsidiaries of Australian banks. A three year macroeconomic scenario was used for the tests, assuming a global economic downturn that results in a 3 percent contraction of real GDP in Australia in the first year, followed by a V-shaped recovery. The scenario also assumed a rise in the unemployment rate to 11 percent, a fall in house prices of 25 percent, and a fall in commercial property prices of 45 percent. The results suggest that none of the banks would have breached the 4 percent minimum Tier 1 capital requirement of the Basel II framework. The weighted average reduction in Tier 1 capital ratios from the beginning to the end of the three-year stress scenario was 3.1 percentage points.

35. Despite the good results from the stress tests, staff advised the authorities to remain vigilant to emerging risks. Staff recommended explicitly including funding risk in future scenarios, given banks’ sizable short-term external debt. Staff welcomed the authorities’ efforts to improve banks’ own stress testing capabilities, and suggested that APRA review assumptions regarding probability of default and loss given default in light of recent experience in Australia and elsewhere. Potential risks in the mortgage sector should be examined carefully, especially given high household debt, house price overvaluation, and potential volatility from the mining boom. Staff supported APRA’s pro-active approach to supervision, including its intention to extend stress testing beyond the banking system to other financial institutions such as insurance companies.

36. Staff welcomed progress in contingency planning for liquidity and solvency problems. APRA now closely monitors banks’ liquidity and funding plans and the planned Trans-Tasman crisis management exercise with New Zealand is an important step to identify possible challenges in a banking crisis.

Authorities’ Views

37. The authorities agreed on the need for continued vigilance. On the stress tests, aggregate results have been published, but the authorities see no need to publish individual results given the high level of confidence in banks. The authorities are committed to adopting international enhancements to the quality and quantity of capital held by financial institutions, which is currently being developed by the Basel Committee on Banking Supervision. They noted that Australian banks are unlikely to require significant increases in capital to meet the enhanced requirements as they are already well capitalized, with common equity comprising a significant proportion of tier-one capital.

VI. Addressing External Vulnerability

38. Australia’s main external vulnerabilities arise from its relatively high net external liabilities, sizable short-term external debt, and projected widening of the current account deficit. Staff projects net external liabilities to increase to about 64 percent of GDP in 2015, as the current account deficit widens to 6 percent of GDP.

39. Disruptions in global capital markets could put significant pressure on Australian banks because of their short-term offshore funding. Short-term external debt for the whole economy remains sizable at 46 percent of GDP in mid-2010, and has not changed significantly since the onset of the global crisis (text table). The short-term external debt comprises almost half of gross external debt and is largely held by financial institutions.6 A disruption to external funding, such as a pullback by European banks, could raise the cost of capital for Australian banks.7

40. A number of factors mitigate the vulnerabilities. While net external liabilities are relatively large, gross assets and liabilities are relatively small (text figure). In particular, both gross external debt (99 percent of GDP in mid-2010) and short-term debt are smaller than in many other advanced economies (Figure 9). Moreover, currency risk associated with the debt is limited given that more than 40 percent is in Australian dollars and the bulk of the remainder is hedged. In addition, 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.

Figure 9.
Figure 9.

Australia: External Vulnerability

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

Sources: IFS, WEO, Haver Analytics, WB-IMF-BIS-OECD Joint External Debt Hub, and IMF staff estimates.

Australia: External Debt

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Sources: Australian Bureau of Statistics and Fund staff estimates.
uA01fig12

Foreign Investment Position (2009)

(In percent of GDP)

Citation: IMF Staff Country Reports 2010, 331; 10.5089/9781455208333.002.A001

Sources: IFS, WEO, ABS, CEIC and IMF staff estimates.

41. The flexible exchange rate also provides an important buffer. A disruption to global funding markets would likely lead to a depreciation of the Australian dollar, as occurred after the Lehman collapse in 2008. Such a depreciation would reduce the U.S. dollar and Euro funding required to meet banks’ desired Australian dollar funding. Also, the relatively small holdings of foreign currency denominated assets by Australian banks would limit banks need for foreign currency funding.

42. To reduce rollover risk further, staff advised that APRA encourage banks to rely more on medium and long-term funding. APRA has already taken steps in that direction, including by issuing a discussion paper on liquidity risk in September 2009. The paper emphasizes stress testing and defined a three-month “market disruption” scenario that mainly