This study relates Australian household saving more closely to movements in asset market using event study analysis and econometric analysis. In this study, the policy challenges for Australia from rebalancing in China, a temporary growth slowdown in China, and a recession in advanced countries are analyzed. The Globally Integrated Monetary and Fiscal Model (GIMF) is used for policy challenges. The impact of the mining boom on the Australian labor market is also discussed in this paper.

Abstract

This study relates Australian household saving more closely to movements in asset market using event study analysis and econometric analysis. In this study, the policy challenges for Australia from rebalancing in China, a temporary growth slowdown in China, and a recession in advanced countries are analyzed. The Globally Integrated Monetary and Fiscal Model (GIMF) is used for policy challenges. The impact of the mining boom on the Australian labor market is also discussed in this paper.

ii. Policy Challenges for Australia from Rebalancing in China and Downside Risks in the Global Economy1

1. This paper analyses the policy challenges for Australia from three scenarios: rebalancing in China, a temporary growth slowdown in China, and a recession in advanced countries. To analyze these potential policy challenges, we use the Globally Integrated Monetary and Fiscal Model (GIMF) calibrated for six regions of the world: Australia, China, Japan, Emerging Asia, United States, and the Remaining Countries.2 This allows us to study not only the direct linkages between the Australian and Asian economies, but also the indirect linkages in a multi-country framework.

2. The results suggest that Australia is likely to cope with shocks better than other countries or regions. Rebalancing in China would have only a small impact, provided Australia is flexible enough to adjust quickly to a change in the structure of external demand. However, a separate shock to Chinese and global growth will have a sizable impact on demand for commodities and in turn lead to a slowdown in Australia. The impact on real GDP growth in Australia is milder than elsewhere, in part because monetary and fiscal policy has scope to buffer the shock. The simulation also shows the important role that the flexible exchange rate policy plays in helping adjust to the shock.

3. For fiscal policy, a policy implication is that fiscal space should be built during good times when commodity prices are high. The authorities plan to continue to build fiscal buffers, which should allow a discretionary fiscal response over and above the full operation of automatic stabilizers during a downturn. The simulation of a global recession, triggered by a crisis in advanced countries, results in a sizable increase in net public debt in Australia (about 10 percent of GDP) assuming a gradual return to budget surplus. The increase in net public debt would have been even larger if a discretionary increase in spending were assumed, as undertaken following the Global Financial Crisis. In addition, broad-based economic reforms, including those aiming to increase labor participation and flexibility, would facilitate structural adjustment and lower the real cost of shocks (see Chapter III, The Impact of the Mining Boom on the Australian Labor Market).

A. Comprehensive Rebalancing in China

4. As in the China Spillover Report,3 we assume that a successful rebalancing of China’s growth toward private consumption comes about by a comprehensive set of policy measures that includes exchange rate appreciation, financial sector reform, structural reforms, and a stronger social safety net.4 All these measures support private consumption and shift resources from the tradables to the nontradables sector while slowing the build-up of export capacity through private investment.

  • Exchange rate appreciation: The nominal exchange rate appreciates against the U.S. dollar by 20 percent over five years. Because prices in China are sticky, the nominal appreciation translates into a persistent real effective appreciation of about 16 percent over five years.

  • Financial sector reform: Interest rate liberalization will result in a higher cost of capital. At the same time households and SMEs are assumed to get increased access to financial services.

  • Fiscal reform: Government spending is re-oriented toward the social safety net, affordable housing and the provision of health and education services in a way that is neutral for the budget balance. As a result of fiscal and financial sector reform, households save less.

  • Structural reforms: Reforms facilitate a reallocation of capital and labor from the tradables to the nontradables sector.

5. As a result, the model suggests that China’s annual GDP growth rate would fall by 1½ percent and the level of GDP would be about 7 percent below baseline after five years (Figure II.1). However, Chinese consumers enjoy improved terms of trade, which raises their welfare. Domestic demand increases by about 8 percent of GDP while net exports fall. The current account surplus narrows by 4 percent of GDP over five years.

Figure II.1.
Figure II.1.
Figure II.1.

Comprehensive Rebalancing Strategy in China—Impact on Australia

Citation: IMF Staff Country Reports 2011, 301; 10.5089/9781463921934.002.A002

Source: GIMF simulations.

Impact on Australia

6. Rebalancing toward domestic demand in China is mirrored by rebalancing toward external demand in the rest of the world. Nevertheless, global GDP remains about ¾ percent below baseline after five years, as structural adjustment in the global economy takes more than five years to complete. Commodity revenues in Australia remain little changed as the lower demand from China is largely compensated for by higher demand elsewhere.5 The gain in competitiveness leads to an increase in noncommodity exports of goods and services and the current account improves by about ¾ percent of GDP after five years. Real GDP is modestly higher, however, nominal GDP falls ¾ percent below baseline because of lower terms of trade. Government revenues from commodities are lower while government expenditures change little. As a result, the public debt to GDP ratio increases, though not by much.

B. One Year of Slower Growth in China—the Role of Policy Flexibility in Major Economies

7. In this tail risk scenario, we assume a decline in investment drives a slowdown in China, possibly because of problems in the real estate market or some financial market disturbances.6 GDP growth falls to around 6 percent for one year and the level of real GDP returns to baseline after five years, with 1 percent higher-than-baseline growth in each of the four years following the growth shock.

8. We assume no large discretionary fiscal policy response from the Chinese authorities. If the Chinese authorities were to respond as they did following the Global Financial Crisis, by increasing public spending on infrastructure, it would likely cushion the impact of the slowdown on demand for commodities.

A02ufig01

China: Real GDP returns to baseline

Citation: IMF Staff Country Reports 2011, 301; 10.5089/9781463921934.002.A002

A02ufig02

..and so do external balances...

Citation: IMF Staff Country Reports 2011, 301; 10.5089/9781463921934.002.A002

A02ufig03

... as well as commodity prices.

Citation: IMF Staff Country Reports 2011, 301; 10.5089/9781463921934.002.A002

9. Lower growth in China leads to a persistent fall in global commodity prices by about 13 percent (Figure II.2). While this hurts commodity exporters, it benefits commodity importers and reduces the impact of slower Chinese growth on the global economy.

Figure II.2.
Figure II.2.

One Year of Lower Chinese Growth—The Role of Policy Flexibility

(First year impact)

Citation: IMF Staff Country Reports 2011, 301; 10.5089/9781463921934.002.A002

Source: GIMF simulations.

Policy flexibility

10. The impact on the global economy is mitigated by automatic fiscal stabilizers in Australia and other countries. However, with limited fiscal space, many advanced countries may not have the policy flexibility to let automatic stabilizers work fully. To illustrate the role of fiscal stabilizers, two scenarios were run: one in which automatic stabilizers are allowed to work fully (full policy flexibility) and another where automatic stabilizers are reduced in Europe, Japan, and the United States (limited policy flexibility).7 In Japan and the United States, policy interest rates are at the lower bound and cannot be reduced. China’s renminbi is assumed to be pegged to the U.S. dollar.

11. Australia suffers a terms of trade shock. The size of the impact, however, depends significantly on the degree of policy flexibility elsewhere.

  • With limited policy flexibility elsewhere, Australia’s terms of trade falls by about 10 percent in the first year, relative to baseline. The impact of the fall in global commodity prices on the terms of trade is partly offset by a fall in the price of commodity imports, including oil. With full policy flexibility in advanced countries, the fall in Australia’s terms of trade would be cut by two-thirds.

  • Real GDP falls by about ¾ percent relative to baseline, because of lower demand from China and the negative impact of the Chinese shock on global demand. However, with policy flexibility in advanced countries the fall would be less than ¼ percent. The reduction in commodity prices amplifies the negative impact on nominal incomes, with nominal GDP falling by 2½ percent in the case of limited policy flexibility (1½ percent with full policy flexibility).

  • Government revenue in Australia falls directly, through a decline in resource taxes and company income taxes, and indirectly through lower economic activity. We assume public expenditure is reduced gradually to balance the budget. As a result, transitory deficits add to public net debt which rises by about 3 percentage points of GDP over two years.

12. A depreciation of the Australian dollar helps buffer the shock, as do cuts in the policy interest rate. The exchange rate depreciation redirects exports to non-commodities and reduces imports. The contribution of net exports to GDP growth in real terms improves. However, the depreciation is not strong enough to fully offset the impact of lower commodity prices on the nominal trade balance, which worsens by about 1½ percent of GDP. Because about half of private earnings from commodities accrue to foreign shareholders, the drop in the current account balance is smaller than the decline in the trade balance.

C. A Recession in Advanced Countries

13. This scenario represents the tail risk of a confidence crisis triggered by high sovereign debt in advanced countries, particularly Europe. It assumes higher risk premiums on government bond rates (75 basis point area wide) and a risk premium on the exchange rate, leading to a real effective exchange rate depreciation in the Remaining Countries block. A permanent deleveraging by private households and a two-year discretionary reduction in the fiscal deficit are also assumed (1¾ percent of GDP). In the United States, households deleverage as well, but no discretionary fiscal tightening was assumed. Government bond rates rise in all countries, except China.

14. As a result, advanced economies enter into a recession led by a decline in investment. Global GDP falls by about 3 percent (Figure II.3). China’s output declines most, hit by the reduction in imports in advanced countries directly and a related fall in investment. International commodity prices fall by about 25 percent. The terms of trade in commodity export countries worsen, and improve in those countries which are net commodity importers. Lower commodity prices support consumption in the latter countries.

Figure II.3.
Figure II.3.

Global Recession—Impact on Australia

Citation: IMF Staff Country Reports 2011, 301; 10.5089/9781463921934.002.A002

Source: GIMF simulations.

15. Macroeconomic policy flexibility is assumed to be limited in most advanced countries. Automatic fiscal stabilizers in Europe and the United States are reduced to ⅓ of their OECD estimates, and no fiscal space is assumed to be left in Japan. Again, in Japan and the United States, policy interest rates are at the lower bound and cannot be reduced and China’s renminbi is assumed to be pegged to the U.S. dollar.

16. GDP in Australia falls too, but by less than in the other regions, despite a large decline in commodity prices. This is largely due to a strong policy reaction and a flexible exchange rate and sizeable foreign ownership in mining companies.

  • Policy interest rates are reduced by more and earlier than elsewhere and the exchange rate depreciates against all other countries except the Remaining Countries block (Europe). Real net noncommodity exports improve and mitigate the impact of the worsening commodity balance on the wider economy.

  • Automatic fiscal stabilizers in Australia are allowed to work fully by keeping expenditures on the planned path while temporarily absorbing shortfalls in government revenues, including from commodities, in a larger fiscal deficit. Net debt rises by about 10 percent of GDP after five years. This cushions the blow to domestic incomes and demand.

  • Mining profits are squeezed, as commodity prices fall. However, a large share of foreign ownership limits the impact on the domestic economy and the current account. Nevertheless, lower profits depress investment in Australia.

References

  • International Monetary Fund, 2011, People’s Republic of China: Spillover Report for the 2011 Article IV Consultation and Selected Issues, IMF Country Report No.11/193.

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  • Kumhof, Michael, Douglas Laxton, Dirk Muir, and Susanna Mursula, 2010, The Global Integrated Monetary and Fiscal Model (GIMF) - Theoretical Structure, IMF Working Paper No. 2010/34, http://www.imf.org/external/pubs/ft/wp/2010/wp1034.pdf

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1

Prepared by Juan Jauregui and Werner Schule. The paper greatly benefited from assistance by D. Muir and discussions with seminar participants at the Australian Treasury Department and the Reserve Bank of Australia.

2

See Globally Integrated Monetary and Fiscal Model (GIMF) - Theoretical Structure, 2010, IMF Working Paper No.10/34.

3

See People’s Republic of China: Spillover Report for the 2011 Article IV Consultation and Selected Issues, IMF Country Report No. 11/193.

4

In GIMF, these policies were implemented through shocks to the exchange rate target, households’ rate of time preference, investment, sovereign and bond premiums, and productivity shocks in the tradable and non-tradable sectors. People’s Republic of China: Spillover Report for the 2011 Article IV Consultation and Selected Issues, IMF Country Report No. 11/193.

5

The commodity basket in GIMF includes energy, minerals, and agriculture commodities, while Australian commodity exports to China are mainly iron ore and coal, which represent a larger input share in Chinese output than elsewhere. The simulations are therefore likely to underestimate the negative impact of rebalancing in China on the demand for Australia’s key commodities.

6

Implemented as a temporary shock to investment.

7

Automatic fiscal stabilizers are calibrated in GIMF to reflect those estimated by the OECD.

Australia: Selected Issues
Author: International Monetary Fund