Statement by Mr. Christopher Y. Legg, Executive Director, and Ms. Susan Bultitude, Advisor to Executive Director, on Australia October 5, 2011

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.

My authorities are monitoring closely the deteriorating external environment, very conscious of the prospect for a sustained period of global weakness and the downside risks this poses for the Australian economy. Heightened global financial volatility and uncertainty are compounding domestic pressures associated with a two speed economy, weighing on confidence in non-mining sectors. A significant increase in household saving – in many ways a positive development – is also constraining retail activity. Non-mining related growth is forecast to be weak, and we have witnessed a small upturn in unemployment in August, to 5.3 percent.

My authorities remain committed to preserve, and optimize, the considerable policy room they have available to respond to external instability. Recent improvements in both household and banking sector balance sheets will also help to buttress the domestic economy. More generally, a combination of factors continues to underpin the Australian economy’s resilience: a continuing commitment to sound policy and regulatory frameworks; a proactive and cautious approach by the prudential regulator; the adaptability supported and fostered over many years by structural reform and exchange rate flexibility; as well as the advantages of close integration with a fast growing Asian region. After widespread damage and disruption associated with devastating floods and cyclones across wide areas of Australia earlier this year, GDP recovered strongly, by 1.2 percent, in the June quarter.

The benefits of proximity to emerging Asia are most obviously manifested in the unprecedented mining boom now driving growth. Australia’s terms of trade are currently at 140 year highs. Mining investment is expected to reach record highs as a share of GDP over the next two years, rivaling that for the rest of the economy, notwithstanding the fact that mining production accounts for only around 9 percent of GDP. These developments are posing significant adjustment challenges for the Australian economy. However, the mining boom is a manifestation of a broader, long-term phenomenon, namely the transformation of Asia, with profound implications for the pattern of global production and consumption. The policy challenge in Australia is to maintain the right policy settings – both macroeconomic and structural – to ensure the economy benefits fully from the opportunities this transformation will bring.

Fiscal Policy

My authorities remain committed to returning the budget to surplus in 2012–13 and beyond, to re-build policy buffers and make room for the mining-related investment boom. The 2011–12 Budget projected that government net debt would peak at around 7 percent this year and decline to zero by 2019–20.

This involves a commitment to a significant adjustment effort, of the order of 4 percent of GDP in the space of 2 years. At the same time, revenue is likely to be less responsive to growth than during the first phase of the mining boom, from 2004 through 2007, including as a result of the impact of growing mining sector depreciation expenses as a proportion of mining sector profits and the sector’s larger overall share of the economy. The Government’s planned Minerals Resource Rent Tax will improve the sector’s contribution to the budget. A Temporary Flood and Cyclone Reconstruction levy has also been imposed to help offset the costs of these natural disasters. But a significant part of the burden of this consolidation will necessarily fall on expenditures, and the 2011–12 Budget identified significant savings from reforms to a wide range of family benefits, income support including reforms to encourage greater participation, health, education, and defense programs. Real growth in spending is expected to average only 1 percent over the forward estimate period.

My authorities consider that the existing fiscal strategy – budget surpluses on average over the medium term, taxation as a share of GDP kept below the level for 2007–08, and a commitment to improve the government’s net financial worth over the medium term – continues to provide a sound basis for sustainability. In operationalizing this strategy, the Government has committed to keep real expenditure growth below 2 percent per annum, once the budget returns to surplus and until the surpluses are at least 1 percent of GDP, while the economy is growing at or above trend. My authorities acknowledge Staff’s recommendation regarding the desirability of allowing automatic stabilizers to operate fully in both directions, and note the arguments in favor of building larger fiscal buffers beyond the return to surplus. The need to manage the implications for aggregate saving of demographic trends is well understood. However, the benefits of greater insurance against cyclical risks in what may be a more volatile environment, would need to be weighed against the costs of significantly larger surpluses.

We welcome Staff’s endorsement of Australia’s strong budgetary institutions, its support for the establishment of a Parliamentary Budget Office, and the observations made regarding the scope for further fine tuning.

Monetary Policy

The Reserve Bank of Australia continues to assess carefully the outlook for growth and inflation. At its September meeting, the RBA Board judged that it was prudent to maintain the current stance of monetary policy, with the cash rate having been unchanged at 4.75 percent since November 2010. While the Board remained concerned about the medium-term outlook for inflation, most financial indicators suggested that monetary policy had been exerting a degree of restraint.

The headline consumer price index rose 3.6 percent through the year to the June quarter 2011, of which food prices (mostly fruit and vegetables) accounted for 1.0 percent. Inflation is expected to fall back below 3 percent in early 2012 as the effect of temporary weather-related events reverse.

The Exchange Rate and External Stability

The flexibility of the Australian dollar continues to be key to managing the impact of the mining boom alongside instability in global financial markets. The exchange rate has responded to heightened external risks, depreciating by around 12 percent in recent weeks. This follows a period of sustained appreciation through to July 2011, of around 24 percent since the last Article IV consultations and by more than 70 percent since the low following the collapse of Lehmans. Overall, the strength of the Australian dollar has helped to ease pressure on inflation and monetary policy while facilitating the re-allocation of resources to the mining sector. Nevertheless, recent adjustments in the exchange rate are relevant to the Staff’s finding that the Australian dollar may have been overvalued, by the order of 10-20 percent, and market expectations of a depreciation (of around 6½ percent over two years) referred to by staff.

As the Staff Report notes, Australia’s current account deficit (CAD) is expected to widen on the back of historic levels of investment associated with the mining boom. The authorities’ commitment to fiscal consolidation, alongside measures further to increase private saving to address looming demographic pressures, such as the planned increase in the minimum superannuation contribution from 9 percent to 12 percent of salaries, will bolster domestic saving. Nonetheless, additional external resources will be required to take full advantage of the higher demand for Australia’s commodities. The underlying policy imperative remains to improve the flexibility and allocative efficiency of the economy, to ensure that resources are being used productively.

Financial Sector and Household Balance Sheets

The Australian banking system continues to improve its financial position, with strong encouragement from the Australian Prudential Regulation Authority (APRA). As described in the Staff Report, banks have shifted away from short-term borrowing towards longer-term funding and deposits in recent years, and they hedge their foreign currency exposures.

APRA has a well-established stress testing program which it continues to develop. Upcoming projects include testing across a wider range of funding shocks, and working closely with the New Zealand authorities on trans-Tasman crisis management, under the auspices of the Trans-Tasman Council on Banking Supervision. APRA will also be working closely with the Monetary and Capital Markets Department over the coming year to conduct stress tests as part of Australia’s FSAP.

APRA continues to adopt a conservative and robust approach to the application of Basel III in Australia. It is within this context that APRA has taken the view that it remains premature to increase the capital requirements for domestic systemically important financial institutions ahead of an international consensus being reached. Australia’s experience has been that, at the margin, effective supervision and risk management, rather than additional regulatory capital per se, are the keys to maintaining a healthy financial system,

The financial position of Australia’s household sector is also improving, with the household saving rate reaching 10½ percent of disposable income in June 2011 – a level on par with saving rates seen in the mid 1980s. This has been accompanied by a reduced appetite for most types of debt, an increase in debt repayments (including early repayments of scheduled debt) and an easing of household credit growth. These shifts in saving behavior partly reflect a return to more traditional patterns of saving and borrowing in recent years, after household spending had grown more quickly than income for a decade or so as nominal interest rates declined and credit became more widely available.

While the housing market remains in a position of undersupply, house prices have continued to soften, unwinding some of the strong growth experienced in recent years. However, the softening remains relatively modest, with house prices falling by around 2 to 2½ percent over the year to the June quarter. Taken together, the solid income growth and softening in house prices have contributed to an orderly decline in the ratio of prices to income, which is now consistent with the average level of the past decade.

Structural Reform

The long-term adjustment pressures associated with the emergence of Asia, and domestic demographic trends, underscore the importance of continuing efforts to lift workforce participation and – crucially – to enhance productivity. My authorities recognize the need to reverse the recent decline in multifactor productivity, and the 2011–12 Budget outlined a strategic approach to this challenge, building on a commitment to continued macroeconomic stability with a focus on enhancing flexibility and well targeted investments in skills and human capital, public and private infrastructure, and innovation. Legislation to establish a price for carbon, and transition towards an emissions trading scheme, has been introduced into Parliament, aiming to ensure the least cost means of adjusting to climate change. The compensation package for the introduction of a carbon price includes a number of significant tax reforms, while the Tax Forum, scheduled for October 4–5 in Canberra, will be an opportunity to build further momentum for significant tax reform, drawing on the broad ranging recommendations in the 2009 Report on “Australia’s Future Tax System,” with the potential to improve resource allocation and labor mobility. And, there is an ambitious agenda of productivity reforms in the growing health and education sectors, in cooperation with the States.