Australia
Staff Report for the 2011 Article IV Consultation

In this study, Australia’s economic performance from the onset of the global financial crisis is discussed. A healthy banking system, flexible exchange rate, and robust demand for commodities from Asia are important for good performance. Although recent global market volatility has increased uncertainty about the economic outlook and tilted risks downward, strong commodity demand from emerging Asia underpins Australia’s favorable economic prospects. The importance of tax and structural reforms is emphasized. The Australian Prudential Regulation Authority’s plans are used to undertake stress tests incorporating disruptions to funding markets.

Abstract

In this study, Australia’s economic performance from the onset of the global financial crisis is discussed. A healthy banking system, flexible exchange rate, and robust demand for commodities from Asia are important for good performance. Although recent global market volatility has increased uncertainty about the economic outlook and tilted risks downward, strong commodity demand from emerging Asia underpins Australia’s favorable economic prospects. The importance of tax and structural reforms is emphasized. The Australian Prudential Regulation Authority’s plans are used to undertake stress tests incorporating disruptions to funding markets.

THE RECOVERY AND THE MINING BOOM

1. Australia’s performance since the onset of the global financial crisis has been enviable. It was one of the few advanced economies to avoid a recession in recent years, reflecting its strong position at the onset of the crisis and a supportive macro policy response. The good performance can also be attributed to a healthy banking system, a flexible exchange rate, and robust demand for commodities from Asia, especially China.

2. A recovery is now being driven by a mining boom. Real GDP growth picked up to 2¾ percent in 2010 with private demand and commodity exports beginning to take over from public demand as the main drivers (Table 1, Figure 1). Business profits have risen, especially in mining, as demand for commodities has pushed the terms of trade to 60 year highs (text figure).1 In the first quarter of 2011, however, activity was disrupted by cyclones and floods in Queensland and Western Australia that reduced output, especially exports of coal and iron ore (which comprise about ⅓ of Australia’s exports) (Figure 2). This contributed to a 0.9 percent fall in real GDP in the first quarter (seasonally adjusted, quarter-on-quarter). Real GDP growth rebounded in the second quarter by 1.2 percent (seasonally adjusted, quarter-on-quarter) but coal export volumes have not yet recovered fully.

Table 1.

Australia: Selected Economic Indicators, 2008–12

article image
Sources: Data provided by the Australian authorities; and IMF staff estimates and projections, including the estimated impact of the Clean Energy Future package from 2011/12.

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 2011 are for latest available month.

IMF, Information Notice System index (2005 = 100).

Figure 1.
Figure 1.

Australia: A Recovery Driven by Commodities

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

Figure 2.
Figure 2.

Australia: Trade and the Balance of Payments

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

uA01fig02

Historical Terms of Trade

(1900/01-1999/2000 average = 100)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

Sources: ABS; Gillitzer and Kearns (2005); RBA; and IMF staff calculations.

3. The exceptionally large rise in the terms of trade since 2002 has increased national income and improved the current account balance. Real national income per hour worked has increased by more than 3 percent per annum since 2002, while real GDP per hour worked grew at a much slower pace (text figure). The increase in income from commodity exports was a key factor behind the improvement in the current account deficit to about 2½ percent of GDP in the first half of 2011, well below the average of 4½ percent of GDP for the past 15 years.

uA01fig03

Income and Productivity

(March 1990 = 100)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

1/ Real GDP adjusted for the purchasing power of change in the terms of trade and income accruing to foreigners.Source: ABS.

4. The unemployment rate has fallen to just over 5 percent, but job growth has slowed. Total employment has grown by more than 1 million since early 2007 (about 10 percent), despite the impact of the global crisis. Employment in mining and construction has grown rapidly (text figure). Some mining companies have reported that shortages of skilled labor have slowed construction of investment projects, partly because the projects are concentrated in remote areas of Queensland and Western Australia. Job growth, however, has been weak in manufacturing and some service sectors that are not benefiting from high commodity prices.

uA01fig04

Employment by Industry

(In thousands of persons)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

Sources: ABS; Australian Treasury.

5. Inflation has increased as spare capacity has been used up. Headline inflation reached 3½ percent year-on-year in the second quarter, above the Reserve Bank of Australia’s (RBA) target band of 2–3 percent (over the medium-term). The increase was due in part to disruptions to food supply following the floods in Queensland. However, underlying inflation has also risen, reaching 3 percent on an annualized rate in the first half of the year. Private sector wage growth has picked up to 4 percent year-on-year in the June quarter 2011, and is running well ahead of trend labor productivity growth of 0.9 percent over the same period (Figure 3).

Figure 3.
Figure 3.

Australia: Rising Inflationary Pressures

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

6. Households remain cautious, however, as they rebuild their balance sheets. Household spending growth slowed since the crisis and saving rose to more than 10 percent of household disposable income in early 2011, the highest level in nearly 25 years. The jump in the saving rate appears to be attributable to households rebuilding their net worth after a decline during the global financial crisis. Households also appear to be offsetting part of the fall in government saving in recent years.2 Consumer confidence has weakened as house prices have fallen, inflation has risen and employment growth has slowed (text figure). Household debt has stabilized at about 150 percent of disposable income.

uA01fig05

Consumer and Business Confidence

(Survey data, SA)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

Sources: Haver; Westpac-Merlbourne Institute; National Australia Bank

7. Macroeconomic stimulus is being withdrawn. The RBA began to raise its policy rate in late 2009, earlier than central banks in other advanced economies. The policy rate has been held at 4¾ percent since November 2010, because of uncertainty regarding the global outlook and the impact of natural disasters on activity. Nonetheless, monetary conditions have tightened further with the appreciation of the exchange rate over the past year. The exit from fiscal stimulus began in 2010, as the recovery gained traction. However, fiscal consolidation has been complicated by natural disasters that contributed to a wider-than-expected budget deficit of 3½ percent of GDP in 2010/11.

8. Recent global financial market volatility has had some impact on Australian markets. The increase in global risk aversion in recent months has led to a depreciation of the Australian dollar by 5–6 percent in nominal effective terms from its recent peak in late July. However, the real effective exchange rate remains just below the highest level since the Australian dollar was floated in 1983, supported by the strong terms of trade (text figure). Stock prices have fallen in recent months and credit default swap spreads have risen for Australian banks, but not as much as for U.S. and European banks (Figure 4). Financial markets are now expecting a cut in the RBA’s policy rate over the next year as they have become more pessimistic about the global outlook, but a recent Reuters survey of local analysts suggests a small increase in the policy rate over the next year.

Figure 4.
Figure 4.

Australia: Financial Market Indicators

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

uA01fig06

Australia: Real Effective Exchange Rate and Terms of Trade

(2000=100)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

Sources: ABS; and IMF staff estimates.

OUTLOOK, RISKS, AND SPILLOVERS

9. The economic outlook remains favorable, despite the global financial market volatility in recent months. Real GDP growth is projected at almost 2 percent for the calendar year 2011 and 3⅓ percent for 2012, on the back of strong demand for commodities and a sharp rise in private investment in mining. For 2013 and beyond, real GDP growth is likely to be around the potential rate of around 3⅓ percent, supported by the positive outlook for fast-growing emerging Asia. The demand from Asia is reflected in the construction of several large iron ore and liquefied natural gas projects, which could raise private business investment to 50-year highs in coming years. The unemployment rate should continue to fall gradually to 4¾ percent by 2012. With capacity constraints emerging in the labor market and the output gap expected to close by year end, underlying inflation is likely to rise gradually. The external current account deficit is expected to narrow to 2¼ percent of GDP in 2011—due to the jump in the terms of trade—before progressively widening to about 6⅓ percent of GDP in the medium term, reflecting the increase in investment and a fall in saving. This assumes that the real effective exchange rate remains at its current level, even though staff project the terms of trade to decline by about 10 percent over the next five years.

10. The recent global financial market volatility has increased uncertainty about the near-term economic outlook, and the risks to staff’s growth projections are tilted to the downside:

  • On the downside, a key risk is that the global recovery stalls or Asian growth falters in the near-term, impacting demand for commodities. Contagion from the euro area periphery and uncertainty about progress toward fiscal consolidation in the United States could also destabilize global funding markets. On the domestic front, a fall in house prices, which appear overvalued by 10–15 percent (Box 1), could hurt consumer confidence further and depress consumption growth.

  • On the upside, investment in the resource sector could be larger than expected, boosting growth and pushing up wages and inflation. Also, households may become more confident as the boom progresses and reduce their current high level of saving.

11. The favorable Australian outlook should have positive spillovers for New Zealand and the Pacific Islands. Staff analysis suggests that economic shocks to Australia are transmitted almost “one-to-one” to New Zealand, given the strong trade and financial links.3 There is also a positive correlation between growth in Australia and the Pacific Islands given the links through trade, tourism, and remittances (text figure). In addition, the planned increase in Australia’s official development assistance to 0.5 percent of Gross National Income over the next few years is expected to support growth in the Pacific Islands.

uA01fig07

Australian and Pacific Islands: Real GDP Growth, 2000-2010

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

*PICs: Fiji, Kiribati, Marshall Islands, Micronesia, Palau, Papua New Guinea, Samoa, Solomon Islands, Togo, and Vanuatu.Source: IMF staff estimates.

House Price Assessment

Real house prices rose by 130 percent in the last 20 years in Australia—faster than most comparators. However, unlike many comparators, Australia’s house price increase growth has occurred in the context of strong growth in population and household income and relatively subdued growth in housing supply. As of June 2011, real house prices have fallen by 5 percent (year-on-year) since the peak in mid-2010.

House prices appear overvalued by about 10–15 percent as of June 2011, using a combination of simple metrics and models:

  • The price-to-income ratio suggests an overvaluation of about 15 percent compared to its long-term average (text table and figure). This is based on the Australian Property Monitors data which include all residential property nationwide, including non-urban areas.1

  • The price-to-rent ratio also suggests an overvaluation of about 15 percent. This is based on data from the Real Estate Institute of Australia and RP Data Rismark, which includes houses and apartments.

These simple ratios, however, have shortcomings in assessing misalignments. The ratios ignore structural changes such as the fall in nominal mortgage interest rates since the 1990s and do not take account of strong population growth or the increasing scarcity of land close to urban centers. Moreover, the 20-year average used as a benchmark is an imperfect proxy for the equilibrium house price.

Model-based estimates indicate that house prices are overvalued by about 10 percent, from a medium-term perspective.2 The model uses a nationwide series that covers all residential properties (the RP Data Rismark) and takes into account demographics, mortgage interest rates, and the terms of trade as a proxy for future income, in line with Tumbarello and Wang (IMF WP/10/291).3 The model suggests that a 10 percent fall in the terms of trade could result in an 8 percent fall in real house prices over the medium term.

uA01fig08

House Price-to-Income Ratio

(1990 = 100)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

Sources: OECD database. For Australia based on APM, ABS house price measure.
uA01fig09

House Price-to-Rent Ratio

(1990 = 100)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

Sources: OECD database. For Australia based on REIA and RP Data Rismark house price measure.

Australia: Deviation of House Prices from Long-term Average

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Sources: RBA; Australian Property Monitor; REIA; and RP Data Rismark.
uA01fig10

Australian Housing Price-to-Income Ratios

(Median house prices, disposable income per household, sa)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

* Excludes Darwin and Hobart.Sources: Reserve Bank of Australia; APM.
1 The price-to-income and price-to-rent ratios, according to the OECD database, suggest a much larger overvaluation of 25–35 percent compared with the average for the past 20 years. However, these measures are based on the Australia Bureau of Statistics (ABS) series which has several shortcomings. The ABS house price series covers only detached houses in capital cities, where prices have increased faster than in non-urban areas, and excludes apartments and row houses. The ABS price-to-rent ratio series includes only rents for detached houses. A broader measure that includes apartments—which are a growing share of the housing market—shows much higher rental yields.2 Based on assumptions for the terms of trade, demographics, and mortgage rate through 2016.3 The model does not take into account supply side factors, such as local government regulations on land use. Changes to these regulations would affect land prices.

The Authorities’ Views

12. The authorities broadly agreed with staff on the outlook and balance of risks. They were alert to the potential impact on the Australian economy from continued global uncertainty or a significant disruption to global growth. They pointed out that while the medium-term growth outlook for the Australian economy remained strong, the substantial divergence across sectors was likely to persist. They noted that the extent and duration of adjustment to the high real exchange rate and cautious household spending behavior are key uncertainties. They also noted some upside risk to investment in the mining sector, given the conservative nature of their current projections.

THE NEAR-TERM MACROECONOMIC POLICY MIX

13. Staff agreed with the monetary policy stance taken over the past year, which has helped anchor medium-term inflation expectations. Financial conditions are mildly restrictive at present. Mortgage and business lending rates are above their average level for the past 15 years and the elevated exchange rate is helping contain inflation pressures (Figure 5). Moreover, credit and asset price growth remain subdued.

Figure 5.
Figure 5.

Australia: A Mildly Restrictive Monetary Stance

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

14. Staff advised that if the recovery remains on track, further increases in the policy rate are likely to be needed to contain inflation pressures from the impact of the mining boom on the wider economy. Staff analysis suggests that, in the absence of further tightening, underlying inflation would rise above the RBA’s 2–3 percent inflation target band in 2012. Importantly, the RBA should guard against inflation expectations becoming anchored at too high a level.

15. On fiscal policy, the authorities remain committed to achieving a surplus by 2012/13 (Table 3, Figure 6). To this end, a temporary income tax levy and offsetting expenditure measures have been introduced to meet the costs of disaster relief and reconstruction in Queensland.4

Table 2.

Australia: Medium-Term Scenario, 2008–16

article image
Sources: Data provided by the Australian authorities; and IMF staff estimates and projections, including the estimated impact of the Clean Energy Future package from 2011/12.

Contribution to growth.

Includes public trading enterprises.

Fiscal year basis ending June 30. For example, 2012 refers to fiscal year July 1, 2011 to June 30, 2012 which the Australian Government’s budget papers denote as budget year 2011.

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

Data for 2011 are for latest available month.

Table 3.

Australia: Fiscal Accounts, 2007/08–2014/15 1/

(In percent of GDP)

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Sources: Commonwealth of Australia 2011-12 Budget; and IMF staff estimates and projections, including the estimated impact of the Clean Energy Future package from 2011/12.

Fiscal year ending June 30.

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

Net lending (+) / borrowing (-), i.e. the fiscal balance, is equal to revenue less expenditure.

The consolidated Commonwealth, state, and local governments.

Receipts exclude earnings of the Future Fund.

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.

Figure 6.
Figure 6.

Australia: On the Path to Consolidation

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

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

16. Staff commended the authorities’ commitment to consolidation to increase fiscal space and support monetary policy. The planned consolidation is faster than in many other advanced economies and is more ambitious than earlier envisaged, with an adjustment of about 3½ percent of GDP in the Commonwealth’s cash balance over the next two years (Figure 7). If the growth outlook improves, staff advised saving higher-than-expected tax revenue to avoid overheating and take pressure off the exchange rate.

Figure 7.
Figure 7.

Australia: Comparison of Fiscal Outlook

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

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

17. If global financial markets become severely disrupted or world growth falters, macroeconomic policy is well positioned to respond. The exchange rate would likely depreciate, limiting the fall in commodity prices in Australian dollars and providing stimulus to the noncommodity tradable sector. The RBA has ample scope to cut the policy interest rate and provide liquidity support to banks, which proved effective in the global financial crisis. There is also fiscal space to delay the return to surplus and, if needed, to take temporary discretionary measures, given the low level of Commonwealth government net debt (6 percent of GDP).

The Authorities’ Views

18. In discussions with the mission in late July and in its two subsequent post-Board statements, the RBA said that it remained concerned about the medium-term outlook for inflation. It emphasized that monetary policy was exerting a degree of restraint, including through the exchange rate. The Board considered in August whether the outlook warranted further policy tightening. On balance, it judged that it was prudent to maintain the current setting of monetary policy, particularly in view of the acute sense of uncertainty in global financial markets. In discussions with the mission, the RBA agreed that there is considerable policy space to react to a downside scenario.

19. The authorities reiterated their commitment to fiscal consolidation. The Budget forecasts a return to surplus in 2012–13, despite the impact of the natural disasters earlier in the year. The emphasis on expenditure control was key to achieving this goal and they pointed out that the pace of consolidation was faster than in previous episodes. They agreed with staff that the fiscal position was strong enough to accommodate a sharp downturn in global growth.

HOW TO MAKE THE MOST OF THE MINING BOOM OVER THE MEDIUM TERM?

20. The mining boom is expected to be long lasting, given the favorable prospects for sustained growth in emerging Asia. However, there could be bumps along the road. A key policy challenge for economic policy is to facilitate the movement of resources to mining and related service sectors in order to raise household incomes, while containing economy-wide wage pressures. Moreover, the greater importance of mining may amplify the business cycle and raise the economy’s exposure to swings in commodity prices. To make the most of the boom, reforms should enhance the flexibility of the economy so that it can adjust to the structural changes taking place.

A. Medium-Term Fiscal Policy

21. The government’s fiscal strategy envisages three pillars: achieving budget surpluses, on average, over the medium term; keeping taxation as a share of GDP below the 2007-08 level on average (23½ percent of GDP); and improving the government’s net financial worth over the medium term. To achieve this aim, the government is committed to limiting spending growth. In particular, while the economy is growing at or above trend, real spending growth, on average, will be capped at 2 percent annually until surpluses are at least 1 percent of GDP.

22. The mining boom provides an opportunity to put Commonwealth government finances in a stronger position to deal with future shocks by reducing debt and building funds for a rainy day. Therefore, staff advised targeting a budget surplus of more than 1 percent of GDP, on average, for the period beyond 2013/14, while the mining boom continues to support growth. Although Australia’s public debt is relatively low, larger fiscal buffers would give greater scope to spend during a downturn to support income and jobs. Staff noted that lack of scope for fiscal and monetary policy to react in other countries may mean that a global downturn would have a sizable impact on Australia, implying a need for larger buffers than in the past.5 Moreover, a further strengthening of the Commonwealth government balance sheet should continue to contain economy-wide debt-servicing costs. This will be important given the likely upward pressure on global interest rates from sizable sovereign borrowing by other advanced economies in coming years.

23. Staff recommended allowing the automatic stabilizers to operate fully in both directions. The growing importance for the economy of mining exposes government revenue to swings in commodity income. This would motivate running sizable surpluses during upswings to avoid overheating. These surpluses should be larger than in past upswings when they were limited to about 1¾ percent of GDP. Conversely in a downturn, sizable but temporary deficits would be appropriate. The impact of a large fall in commodity income on the budget could be presented to the public to build support for running sizable surpluses during good times. Staff estimates suggest that a permanent fall in the terms of trade of 30 percent could reduce nominal GDP by 6 percent relative to the baseline (assuming that the exchange rate depreciates by 15 percent) and worsen the budget balance by 2 percent of GDP.

24. Stronger fiscal consolidation would also put the budget on a firmer footing to deal with some of the long-term pressures from aging and rising health care costs (text figures). Staff welcomed the reform agenda of the Council of Australian Governments to improve coordination and efficiency in the health care sector, including the development of nationally consistent performance indicators for patient care.

uA01fig11

Public Health Spending: Projected Increases Over 2010-30

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

Source: IMF Fiscal Monitor database.
uA01fig12

Pension: Projected Increases Over 2010-30

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

Source: IMF Fiscal Monitor database.

25. While budget institutions are operating well, the quality of the institutional arrangements could be improved further. The proposed establishment of a Parliamentary Budget Office is welcome, and steps to ensure that a greater share of expenditure is covered in the annual budget process would enhance the quality of spending decisions (Box 2).

The Authorities’ Views

26. The authorities agreed with the need to improve the fiscal position over the medium term, noting that the budget is forecast to return to surplus in 2012–13 and real spending growth will be limited to 2 percent a year, on average, until surpluses are at least 1 percent of GDP. However, they considered that revenue improvements from the mining boom could not be expected to contribute to building surpluses at the same rate as previous occasions. They noted that revenues are not expected to grow as strongly as in the 2003–04 to 2007–08 mining boom, given the already very high level of commodity prices. If revenues surprise on the upside, they would allow these revenue improvements to flow through to improve the budget position, consistent with the government’s fiscal strategy. While larger buffers would help cushion against commodity income shocks, achieving these buffers would limit the scope for reducing taxes and thereby addressing the associated deadweight losses for the economy.

Budgetary Institutions Supporting Fiscal Consolidation1

Australia’s strong budgetary institutions have operated successfully both in times of fiscal strength and stress. Australia is an international pioneer in many areas of budgetary reform including: the development of three-year forward estimates, the Expenditure Review Committee which reviews expenditure proposals, the introduction of accrual accounting and outcome frameworks, and the publication of an Intergenerational Report. This Box discusses some enhancements to the quality of existing institutions that would support fiscal consolidation.

Staff welcomes the proposal to create a Parliamentary Budget Office (PBO). Comparable institutions have been established in Canada and the United Kingdom with the objectives of improving fiscal transparency and providing an independent view on the government’s fiscal policy. The Australian PBO’s proposed functions include costing political parties’ election commitments and providing independent analysis to parliament on fiscal policy and the financial implications of policy proposals. While most of the focus has been on its role in costing election commitments, it is equally important that the PBO develop its capacity to provide independent fiscal analysis.

A significant portion of the Australian Government budget is subject to a greater degree of lock-in, making fiscal consolidation potentially more difficult. Up to 30 percent of expenditure is approved by the parliament each year through the annual budget process. The remainder is subject to “special” or standing appropriations where authority for expenditure continues beyond the three-year estimates period until it is annulled or amended by the parliament. This includes most entitlements and benefits programs, such as pensions, but also some other discretionary spending. The balance between “special” and “annual” appropriations should be reviewed, with the aim of reducing the share of expenditure under “special” appropriations.

Budget decisions should be focused on the annual budget to uphold fiscal discipline. The government has also taken decisions on spending and saving proposals outside the annual budget process. While this approach provides flexibility and helps maintain discipline, it does not improve the government’s ability to make strategic decisions, including on trade offs and reallocations across departments. This is best achieved when decisions are made in the context of the annual budget.

1 Prepared by Ms. Curristine, FAD, following a staff visit to Australia in July 2011.

B. Tax and Structural Reforms

27. Tax and structural reforms will play a key role in allowing Australians to take full advantage of the mining boom. Labor force participation has risen in recent years, in part reflecting government initiatives, but the mining boom is increasing the demand for labor. Meeting this demand will require not only raising labor supply, but also facilitating the movement of labor across industries and regions.6 Productivity growth in Australia has slowed over the past decade, and the elevated level of the real exchange rate is generating pressure for efficiency improvements in the nonmining tradable sector.

28. The review of the tax system released in May 2010 provides a blueprint for tax reform. Staff welcomed the progress already made in adopting many of its recommendations, which include reducing the company tax rate, taxing some mineral resource rents, taking steps to reduce effective marginal tax rates for low-income earners, and reducing the complexity of the tax system. Staff supported the proposed introduction of a carbon price as a transition to a permits trading system to mitigate greenhouse gas emissions (Box 3). Part of the revenue raised from the tax will be used to assist low- and middle-income households by increasing the tax-free threshold to $A 18,200. This should boost labor force participation and relieve an extra 1 million Australians from the need to lodge an income tax return.

29. Going forward, staff recommended continued tax reform. A priority should be to remove inefficient taxes such as state stamp duties (including on home sales that discourage worker mobility) and insurance taxes. Moreover, there is scope to improve work incentives by further reducing effective marginal tax rates and to encourage investment by reforms to business tax. While tax reform entails difficult political choices, options to replace the lost revenue from these reforms include more reliance on a consumption-based tax,7 reforming land taxes,8 and broadening the coverage of the minerals resource rent tax beyond coal and iron ore.

30. On broader structural reforms, staff welcomed the steps taken to raise labor participation and invest in skills training, which should help workers improve their mobility and income prospects. The 2011/12 budget introduced several measures to increase labor supply. These include reducing marginal tax rates for single parents, phasing out tax breaks for dependent spouses under forty years old, and increasing childcare support. Work requirements and wage subsidies are being expanded for disability beneficiaries and the long-term unemployed, while pensioners will be able to work more hours without losing income support. Further steps in this direction could raise labor participation. Vocational training is also being expanded. In other areas, the current favorable economic outlook provides a window of opportunity to push ahead with the Council of Australian Governments’ reform agenda, including in the areas of education, infrastructure, and harmonization of business regulations. In addition, the government should resist pressures to prop up declining industries.

Carbon Pricing and the Emissions Trading Scheme

Australia plans to introduce a price on carbon in July 2012. An Emissions Trading Scheme (ETS) will be established to progressively reduce carbon dioxide (CO2) and other greenhouse gases to at least 5 percent below year 2000 levels by 2020. Around 500 large emitting companies will be required to purchase and surrender a permit for each metric ton of emissions produced.

Initially the permit price will be fixed at $A 23 per metric ton of CO2 equivalent, but after July 2015 will be determined by market trading. Permits will be allocated for free to emissions-intensive and trade-exposed industries and electricity generators to help them transition to carbon pricing by assisting them to meet part of their liability.

The ETS has a number of attractive features. Pricing policies (emissions trading and emissions taxes) are the most effective and cost-effective policies for reducing emissions. The ETS is comprehensive, covering major industrial sources such as power generators and gas producers. Emissions from fuel used in light passenger-vehicles are not covered. However, an effective carbon price will be levied on fuel used in aviation, off-road, and by some businesses through the fuel excise system.

The majority of emissions allowances will be auctioned. Estimates by the Australian Treasury suggest that the sale of permits and application of a carbon price will raise receipts of $A 18.2 billion over the three years to 2014/15 (about 0.3 percent of annual GDP on average for the three years). Treasury modeling shows that the scheme would increase the level of the Consumer Price Index by about 0.7 of a percentage point in late 2012.

Low- and middle-income households will be compensated through income tax cuts and transfer payments. The tax free threshold will be increased and welfare beneficiaries will be assisted with the increase in the cost of living associated with the scheme. Further assistance will be given to businesses affected by the scheme and to encourage investment in green technology. Overall, the compensation exceeds the revenue generated from the scheme. As a result, an increase in the cash budget deficit of about $A 4.1 billion is projected by the Australian Treasury for the four years to 2014/15, which is less than about 0.1 percent of annual GDP (on average for the four years).

The Authorities’ Views

31. The authorities noted that a number of important tax and structural reforms are being implemented. They emphasized that they have been working toward reducing effective marginal tax rates, including through tripling the tax free threshold from $A 6,000 to $A 18,200, reducing income support payment withdrawal rates, and increasing income support free areas. The authorities added that further progress in this area generally involves a fiscal cost. The authorities pointed to the significant number of other tax reform measures that also build on recommendations from the tax review, including cutting company tax and providing tax relief and simplification for small business. Measures will also reduce complexity in the system, through a higher tax-free threshold, optional standard personal tax deductions, and simpler depreciation for small business. They noted the discussion of the inefficiency of state taxes such as stamp duties. The government is opposed to the option of raising consumption taxes. On structural reforms, the government’s tax reforms are designed to get a better return for Australia’s nonrenewable resources and reinvest this in business tax cuts, infrastructure, and superannuation savings to enhance the competitiveness of the broader economy.

HOW TO SAFEGUARD FINANCIAL SECTOR STABILITY?

32. Banks were resilient to the global crisis, mainly because of sound regulation and supervision. Prudential rules, often tighter than the minimum international standards, such as higher loss-given-default assumptions, together with a pro-active approach to supervision, helped maintain a healthy and stable financial sector. Moreover, the Council of Financial Regulators played a key role in coordinating the response to the global crisis. Staff welcomed the government’s confirmation that the Financial Claims Scheme will be a permanent feature of the financial system. The scheme currently guarantees deposits with banks and other deposit-taking institutions of up to $A 1 million. The cap is being reduced to $A 250,000 in February 2012, but will still cover around 99 percent of deposit accounts in full.

33. Banks have remained sound. Bank profits have recovered and the return on equity for the major banks is now around pre-crisis levels (Figure 8). Capital adequacy has improved, driven both by increases in capital and declines in risk-weighted assets. Common equity as a share of tangible assets has also risen to nearly 5 percent for the four large banks. The ratio of nonperforming loans to total assets has decreased slightly from a peak of 1.7 percent in March 2010. Banks have made significant changes to the structure of their funding. Their loans-to-deposits ratio has fallen by more than 10 percentage points since early 2007 to less than 120 percent in mid-2011, and their share of funding from short-term debt has fallen to just over 20 percent (on an original maturity basis).

Figure 8.
Figure 8.

Australia: Banking System Developments

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

34. Challenges remain, however. Banks may be tempted to take on riskier strategies in an environment of structurally lower credit growth. Household debt remains high (150 percent of disposable income, Figure 9) and a downside scenario of slower growth and a fall in the terms of trade, could lead to an increase in bad loans, although current arrears are modest. In addition, concentration in the banking sector has increased in the wake of the crisis with the assets of the four large banks now comprising about three-quarters of total bank assets. The government recently introduced a package to encourage competition among financial institutions. This included the removal of exit fees on bank mortgages, which has contributed to an increase in mortgage refinancing.

Figure 9.
Figure 9.

Australia: Household Vulnerabilities

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

35. The Australian Prudential Regulation Authority (APRA)’s sound supervisory and regulatory approach has been commendable, but continued vigilance is needed to maintain financial stability. The government should ensure that APRA’s capacity keeps pace with emerging risks and the evolving international norms. APRA’s proposed early implementation of Basel III is welcome. In a recent discussion paper, APRA proposed that banks will be required to hold a minimum 4.5 percent Common Equity Tier 1 ratio and a 6 percent Tier 1 capital ratio from January 2013. APRA has also proposed introducing a capital conservation buffer of 2.5 percent from January 2016. Moreover, APRA will maintain its current conservative requirements for determining risk-weighted assets.

36. Staff supported APRA’s plan to undertake more comprehensive stress tests of banks than in 2009/10, including stress tests incorporating a disruption to funding markets.9 Staff also welcomed progress on contingency planning for liquidity and solvency problems at systemically important banks, including for the New Zealand subsidiaries. The Trans-Tasman crisis management exercise with New Zealand should help identify possible challenges in a banking crisis.

37. While continued strong bank supervision is the key to maintaining financial stability, staff also encouraged the authorities to consider higher capital requirements on banks that are systemically important in the domestic market, taking into account the currently evolving international standards. The large market share of the four banks in the domestic market implies that they are perceived as too big to fail and pose a potential fiscal risk (Box 4). Analysis of the appropriate capital requirements could be undertaken over the next year (including using stress tests) in the context of discussions in the Financial Stability Board and the 2012 update of the Financial Sector Stability Assessment with the IMF. More robust capital levels for systemically important banks would be beneficial, particularly in times of market uncertainty.

38. Macro-prudential oversight has played a role in maintaining financial stability. The Council of Financial Regulators (CFR), comprising representatives from the RBA, APRA, the Treasury, and the Australian Securities and Investments Commission, has maintained a focus on systemic risks as part of financial sector regulation. For example, in 2004, APRA raised capital requirements on some types of mortgage lending in response to weakened credit standards in the sector. Looking ahead the authorities see a potential role for a countercyclical buffer, in line with international proposals.

Australia’s Large Banks

Australia’s four large banks account for about 75 percent of total banking sector assets and more than 80 percent of mortgage lending. Banking concentration increased in the wake of the global financial crisis, as the RMBS market became dislocated making it harder for nonbank lenders to compete, two smaller banks were taken over by two of the larger banks in 2008 (both approved by Australia’s competition regulator), and several foreign-owned banks exited the Australian markets.

The assets of the four large banks comprise about 180 percent of GDP, around the average for a selection of advanced and emerging market economies (text figure). Subsidiaries and branches of the four major banks also control 90 percent of the assets of New Zealand’s banking sector. Given their size, any distress among these banks could have a sizable impact on the financial sector and the real economy in both countries. Moreover, they may be perceived by the markets as too big to fail, which implies they could pose a potential fiscal liability.

uA01fig13

Banking Sector Assets for Selected Countries

(Four largest banks as a percentage of these banks’ home-country GDP, end 2010)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

Sources: Bankscope, Banks’ Annual Reports, IMF staff calculations.

Basel III will require banks to hold more and higher-quality capital and introduces global liquidity and funding standards. The Australian banks are making good progress toward meeting these new requirements. Capital adequacy has improved, and the quality of bank capital in Australia is high, as it is mainly common equity. While the headline ratio of common equity to risk-weighted assets is lower than for other large banks, the risk-weighted assets numbers are not directly comparable across countries (text figure). APRA’s requirements for computing risk-weighted assets likely imply that risk-weighted assets are higher than for comparable banks in other countries. For example, staff estimates suggest that if the Australian banks applied a loss given default assumption for residential mortgages of 10 percent (the Basel II minimum), rather than the 20 percent minimum required by APRA, their common equity to risk-weighted assets ratio would rise by almost 1 percentage point. APRA also makes other conservative assumptions that increase risk-weighted assets.

uA01fig14

Tangible Common Equity to Risk-Weighted Assets, 20101

(Four largest banks, in selected countries)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

Sources: Bankscope, IMF staff calculations.1Red bars represent the four large Australian banks (Australia and New Zealand Bank, Westpac, Commonwealth Bank, and National Australia Bank).

The structure of the funding of Australian Banks has further improved, with a higher share of retail deposits and long-term wholesale funding as well as a reduced share of offshore funding. Staff estimates suggest that the Net Stable Funding Ratio (NSFR) has improved for three of the four large banks over the past three years. By end 2010, staff estimates show that Australian banks were at or just below the average level for a selection of large banks.

uA01fig15

Where the Four Large Australian Banks Stand vis-à-vis the NSFR

(in percent)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

Sources: Bankscope; Banks’ Annual Reports; and IMF staff estimates.
uA01fig16

Net Stable Funding Ratio, 2010

(Four largest banks, in selected countries)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

Sources: Bankscope, IMF staff calculations.

The Authorities’ Views

39. The authorities agreed on the importance of continued rigorous supervision including ongoing stress-testing. They emphasized that intensive supervision and close cooperation between regulators are keys to maintaining financial stability. The authorities noted that their proposed Basel III minimum capital requirements are stronger than the global minimum. International standard-setters are yet to finalize additional loss absorbency requirements for global systemically important banks and no decision has been taken on whether these will apply to a broader group of systemically important banks, and if so, how this will occur. Hence, the authorities’ view is that it is premature to consider any extension of these requirements to any Australian banks at this stage. The authorities are also well advanced in their development of proposals to implement the Basel III liquidity requirements.

ASSESSING EXTERNAL VULNERABILITY

40. Relatively high net external liabilities and a projected widening of the current account deficit are vulnerabilities. Net external liabilities fell from a peak of 62 percent of GDP in 2009 to about 57 percent of GDP in mid-2011, largely because of a fall in gross external debt (text figure). Most of this fall was due to lower private sector gross external debt, and an increase in private sector assets held abroad. The latter reflects, in part, an increase in retained earnings in the mining sector. At the same time, public sector gross external debt has risen as a result of budget deficits. Although gross external debt is low by advanced country standards, net external liabilities remain relatively high (Figure 10). Moreover, staff project net external liabilities to increase to 68 percent of GDP in 2016, as the current account widens to 6⅓ percent of GDP by 2016.

Figure 10.
Figure 10.

Australia: External Vulnerability

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

Sources: ABS; IFS; WEO; Haver Analytics; EconData; WB-IMF-BIS-OECD Joint External Debt Hub; and IMF staff estimates.
uA01fig17

Foreign Debt Level: Liabilities

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 300; 10.5089/9781463921941.002.A001

41. The projected widening of the current account deficit should be manageable as it is driven in large part by investment to increase export capacity. For instance, investment in large LNG projects is expected to treble to 3 percent of GDP in 2013–14 and boost total exports by 3–4 percent. Much of the investment in the mining sector is expected to be financed through foreign direct investment, retained earnings, and long-term debt.

42. The expected increase in the current account deficit also reflects a projected decline in the national saving rate. Staff analysis suggests that demographics would put downward pressure on private saving over time, as a growing share of the population would draw on its savings to fund retirement. This underlines the need for fiscal consolidation to raise public saving, as well as tax reform to remove distortions to saving and investment decisions (as outlined in the recent tax review).10 The planned gradual increase in the compulsory superannuation contribution paid by employers, from 9 percent to 12 percent by 2019/20, is welcome as it may help raise national saving, with some studies showing its effectiveness in that regard over the past 15 years.11

43. While financial institutions (mainly banks) have reduced their external borrowing, disruptions in global capital markets could still put pressure on their funding. Financial institutions external borrowing has fallen from a peak of 70 percent of GDP in 2008, to less than 60 percent of GDP in mid-2011 (Tables 6 and 7). Short-term debt (mostly issued by banks) has also declined, but remains sizable at 42 percent of GDP (on a residual maturity basis). Funding from European banks was just over US$300 billion at end 2010, about ¼ of gross external debt. If offshore funding markets were disrupted, the cost of bank funding would likely rise.

Table 4.

Australia: Balance of Payments in U.S. Dollars, 2006–16

(In billions of U.S. dollars)

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Sources: Data provided by the Australian authorities; and IMF staff estimates.
Table 5.

Australia: Balance of Payments, 2006–16

(In percent of GDP)

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