Australia
2012 Article IV Consultation—Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Australia

GDP growth is likely to remain strong, although narrowly driven by a mining investment boom, increasing the economy’s vulnerability to terms of trade shocks. Outside the mining sector, growth is expected to be slow with still weak consumer confidence and a strong exchange rate weighing on business investment. The main risks are external, and include an intensification of the euro crisis and a sharper-than-expected slowdown in China.

Abstract

GDP growth is likely to remain strong, although narrowly driven by a mining investment boom, increasing the economy’s vulnerability to terms of trade shocks. Outside the mining sector, growth is expected to be slow with still weak consumer confidence and a strong exchange rate weighing on business investment. The main risks are external, and include an intensification of the euro crisis and a sharper-than-expected slowdown in China.

Recent Economic Developments

1. Growth. The Australian economy has been growing faster than most advanced countries, benefiting from its trade linkages with Asia, particularly China. Growth accelerated from 2¾ percent in the second half of 2011 to 4 percent in the first half of 2012, driven by private domestic demand and exports (Figure 1, Table 1). However, growth has been uneven with mining-related sectors expanding strongly, in contrast with below-trend growth in other sectors. The high Australian dollar is weighing on trade-exposed manufacturing and tourism, which along with the uncertain global economic outlook is contributing to a broadly pessimistic mood. With cautious homebuyers and weak business confidence, investment growth outside the mining sector is weak.

Figure 1.
Figure 1.

Australia: Growth Driven by Commodities

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

Table 1.

Australia: Selected Economic Indicators, 2009–13

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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, 2012 refers to fiscal year July 1, 2011 to June 30, 2012.

Data for 2012 are for latest available month.

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

2. Household sector. Although survey measures of consumer and business sentiment remained below their long-run averages, household consumption grew in line with solid household income growth (text figure). The household saving ratio seems to have stabilized at around 10 percent after increasing sharply at the onset of the global financial crisis. Household debt has been growing at around the same pace as disposable income, leaving the ratio of debt to income around 150 percent (Figure 2).

Figure 2.
Figure 2.

Australia: Household Vulnerabilities

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

uA01fig1

Consumer Sentiment and Consumption

(Index; Y/Y percent change)

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

Sources: ABS; Melbourne Institute.

3. Labor Market. The labor market has performed well in international comparison, with a low unemployment rate at below 5½ percent. Employment growth has slowed recently, with robust employment growth in mining and parts of the services sector offset by continued job-shedding in the manufacturing sector (text figure).

uA01fig2

Employment by Industry

(In thousands of persons)

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

Sources: ABS; Australian Treasury.

4. Terms of trade and the exchange rate. Australia’s terms of trade peaked in 2011, pushing up the real effective exchange rate further and narrowing the current account deficit to 2¼ percent of GDP. By the second quarter of 2012, the terms of trade had fallen by around 10 percent, driven by declines in spot prices for iron ore and coking coal of 25 and 30 percent respectively (text figure). In recent months, however, the Australian dollar has remained high despite lower export commodity prices and the weaker global outlook, in part related to portfolio reallocations of large reserve holders toward Australian government debt.

uA01fig3

Australia: Real Effective Exchange Rate and Terms of Trade

(2000=100)

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

Sources: ABS; and IMF staff estimates.

5. Carbon price. Australia introduced a price on carbon in July 2012 with the objective of reducing carbon dioxide and other greenhouse gases to at least 5 percent below 2000 levels by 2020. The introduction of the carbon price is not expected to have any significant impact on economic growth but is expected to increase inflation by ¾ percentage points by end June 2013. Low- and middle-income households will be compensated through increases in the income tax free thresholds, and welfare beneficiaries will be compensated for cost of living increase associated with the scheme.1

6. Inflation. CPI inflation has eased with underlying measures of inflation remaining near the middle of the 2-3 percent target band, largely due to the declining tradable goods prices associated with the appreciation of the exchange rate (Figure 3). Wage growth is also moderate, just marginally above its 10 year average in June 2012 with private sector wage growth faster than in the public sector.

Figure 3.
Figure 3.

Australia: Inflationary Pressures Eased

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

7. Monetary policy. The Reserve Bank of Australia (RBA) has lowered the policy rate by 150 basis points since November 2011, with the most recent cut in October 2012. Initially, when inflation moderated at the end 2011, the RBA moved to remove a mildly restrictive monetary policy stance. During 2012, as the outlook for the global economy deteriorated accompanied by a slightly weaker domestic outlook for 2013, and with projected inflation consistent with the target, the RBA shifted to an accommodative monetary policy stance. Interest rates for borrowers, a key indicator of the overall stance, are now slightly below their medium-term averages.

8. Fiscal policy. The 2011/12 underlying cash deficit came in at 3 percent of GDP, about 1½ percentage points higher than forecast in the 2011-12 Budget, due to both weaker receipts and higher expenditure. Structural factors have kept receipts as a percent of GDP below pre-crisis levels and have also contributed to receipts falling short of projections by 0.9 percent of GDP during 2011/12. High levels of mining sector investment and associated depreciation deductions have dampened growth in mining company tax receipts relative to profit growth. Changing consumer spending patterns away from the retail sector towards services have lowered retail company tax receipts. Furthermore, lower house and equity price growth rates, especially compared with pre-crisis rates, lowered capital gains tax receipts. Payments during 2011/12 exceeded forecasts by 0.6 percent of GDP mainly due to payments related to natural disasters and the accelerated transfer payments to households and businesses as compensation for higher energy costs following the introduction of carbon price.

Outlook and Risks

9. Near-term outlook. The outlook for Australia remains favorable, buoyed by still-high growth in China accompanied by strong commodity demand which is supporting Australia’s export earnings and driving a mining investment boom. We project growth of around 3¼ percent this year, broadly in line with trend. New natural resources-related investment, dominated by liquefied natural gas projects, is expected to reach a record level (text figure). On the other hand, with an appreciated Australian dollar, uncertain global environment, and sluggish housing construction, investment outside of the resources sector is likely to remain weak in the near term. The impact of the authorities’ deficit reduction plan, discussed below, is expected to be buffered by strong mining-related growth. Inflation is projected to increase slightly as the effects of earlier currency appreciation decline and with the introduction of carbon pricing, yet is projected to remain consistent with the authorities’ target band.

uA01fig4

Total Private Capital Expenditure

(In billions of Australian dollars)

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

Source: ABS.

10. Vulnerabilities and risks. Fundamentals have improved since the global financial crisis; household and business balance sheets have strengthened and banks have reduced their use of foreign funding. Nevertheless, vulnerabilities remain. Risks are tilted to the downside (Appendix 1):

  • The impact of a financial and economic fallout from an intensification of the European debt crisis and a hard landing in emerging Asia, especially China, could be compounded by a sharp decline in commodity prices.

  • Turmoil in the international financial markets remains a concern as Australia’s banks will continue to rely on overseas wholesale funding.

  • Domestically, despite a recovery in the household savings rate and a recent softening of house prices, high household debt coupled with elevated house prices remains a vulnerability. A potential fall in commercial real estate prices is also a risk.

Many of the above risks are closely linked, and the importance of the resources sector to Australia’s near-term outlook makes it vulnerable if a downside global scenario materializes. For example, a hard landing in China would reduce demand for Australian mineral exports, worsen terms of trade, reduce household income, and could trigger a fall in house prices. This in turn would weaken consumer demand and growth, and negatively affect banks’ balance sheets.

11. Policy space to manage risks. The authorities have the monetary and fiscal policy space to respond to near-term shocks, with monetary policy serving as the first line of defense. The RBA has the scope to lower interest rates and loosen monetary conditions to help buffer against a downside scenario. As evident during the global financial crisis, the free-floating Australian dollar provides an additional cushion against external shocks, including disruptions to offshore funding and negative terms of trade shocks, with widespread hedging by banks insulating bank balance sheets from fluctuations in the exchange rate. The authorities would also be able to provide emergency liquidity support to banks, a measure which proved effective when wholesale markets shut down in the wake of the 2008 crisis. Moreover, Australia’s modest public debt gives the authorities scope to delay their planned return to surplus in the event of a sharp deterioration in the economic outlook.

The Authorities’ Views

12. The authorities broadly agreed with staff on the outlook and balance of risks, expecting the key growth drivers in the near term to be resources investment, related commodity exports, and household demand. They view the main risks to the economy as linked with external developments, including disruptions to European financial markets, the threat of sharp fiscal contraction in the United States, and a fall in Chinese growth momentum. A fall in commodity prices remains a vulnerability, but with many projects–of which approximately 70 percent are LNG and are associated with long-term supply contracts–already under construction or committed, the investment outlook is likely to be resilient to cyclical commodity price declines. They also pointed to relatively weak growth in some parts of the economy–the strong dollar is placing pressure on the non-mining traded sector and the uncertain external environment is weighing on domestic confidence–but noted that household demand remains robust and that the effects of earlier reductions in the cash rate were still working through the domestic economy. The authorities acknowledged that despite recent improvements related to rising incomes and softening in house prices, some metrics of housing affordability are still low by historical standards. They viewed this, however, as consistent with fundamentals reflecting both supply constraints in major cities and high demand from population growth on top of the one-off increase in equilibrium prices resulting from past disinflation. Given this, they do not see a major house-price correction as a stand-alone risk.

Near-Term Challenge: Keeping the Economy on an Even Keel

13. Monetary policy. Staff viewed the RBA’s monetary policy stance as broadly appropriate, given the sizeable fiscal adjustment and the absence of inflation pressure, and factoring in higher bank funding costs, the appreciated exchange rate, and modest overall lending growth.2 Analysis by staff suggests that the cash rate is compatible with inflation gradually rising to the mid-point of the RBA’s 2–3 percent inflation target in 2013 (Figure 4). This projection is premised on wages rising broadly in line with productivity and the RBA’s inflation target.

Figure 4.
Figure 4.

Australia: Monetary Stance

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

14. Fiscal policy. The government has made returning to surplus by 2012/13 a major policy priority. To reach this target, the government expects a rebound in receipts by 1½ percent of GDP and plans cuts in spending by about the same amount (Figure 5, Table 3). About 1 percent of the adjustment is achieved through expenditure restraint across a broad range of discretionary categories. Most of the adjustment in receipts will occur as receipts catch up with output growth (about ¾ percent of GDP), rather than changes in tax rates. Some of the other increases in receipts, such as those related to the introduction of minerals taxation (paragraph 19), are unlikely to affect investment decisions in the short run. These factors should help mitigate the impact of the planned deficit reduction on aggregate demand. In addition, unlike many other advanced economies, Australia’s monetary policy space is still sizable and output is close to trend. These conditions suggest that the fiscal multiplier could be lower than in other countries undergoing fiscal consolidation, mitigating its negative impact on output. Given this and the nature of the fiscal adjustment, staff estimates that the contractionary impact of this budget will be less than would be suggested by the headline deficit reduction of 3 percent (Box 1).

Figure 5.
Figure 5.

Australia: Fiscal Stance

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

Sources: Australian Bureau of Statistics; and IMF staff estimates and projections.
Table 2.

Australia: Medium-Term Scenario, 2009–17

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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, 2012 refers to fiscal year July 1, 2011 to June 30, 2012

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

Table 3.

Australia: Fiscal Accounts, 2009/10–2017/18 1/

(In percent of GDP)

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Sources: Commonwealth of Australia 2012-13 Budget and Mid-Year Economic and Fiscal Outlook; and IMF staff estimates and projections

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.

15. Macroeconomic policy-mix. Staff supported the authorities’ move toward a policy-mix that combines a tighter fiscal policy with an accommodative monetary policy stance, which will help ease pressure on the exchange rate. The fiscal consolidation is consistent with a policy setting where monetary policy plays the primary role in managing demand. The RBA’s high degree of credibility and the rapid monetary policy transmission in Australia allows monetary policy to react quickly and flexibly to changing economic circumstances. Staff supported the authorities’ strong commitment to a freely-floating exchange rate. The government’s planned fiscal consolidation will produce a desirable reduction in net government debt.

The Authorities’ Views

16. Monetary Policy. In its early October monetary policy announcement and, in discussions during the mission in September, the RBA noted that with inflation projected to remain consistent with their target and in light of a softening outlook for the global economy and slightly weaker domestic growth prospects, there was some scope for a more accommodative monetary policy stance. As a result of moves since late last year, interest rates for borrowers are a little below medium-term averages but the impact of these reductions has not, as yet, been fully felt.

17. Fiscal Policy. The authorities expressed the view that the impact on the economy of the return to surplus was significantly lower than the change in the headline fiscal position this year—subtracting ¾ to1½ percent from GDP growth–and in the context of an economy growing at around trend, and with adequate monetary policy space, did not present a policy challenge. Moreover, it is consistent with the government’s medium-term fiscal framework. During the crisis they provided a strong fiscal impulse with the commitment to unwind fiscal support once the crisis was over and growth had returned to trend. Returning to surplus and maintaining fiscal discipline would therefore be important for sustaining investor confidence in the strength of Australia’s public finances and signaling the government’s commitment to maintaining its fiscal strategy. The authorities acknowledged a risk that achieving the surplus could be jeopardized if revenue were to fall short, in part if the economy underperformed relative to projections. If a major shock hits the economy, the authorities agree that they have the fiscal space to respond.

Household Saving and Fiscal Multipliers

Australia’s household saving as a share of GDP began increasing in 2005 and then increased sharply as the global financial crisis began to unfold. Household saving ratio (household savings to household disposable income) also rose by more than 5 percentage points in 2008-2009. Since then both ratios seem to have stabilized at levels above the pre-crisis averages.

The sharp increase in household saving in 2008-2009 reflected both slower growth in private consumption and a temporary boost to household income, with a significant contribution from the cash transfers paid to households as part of the government’s fiscal stimulus package during the crisis (fiscal stimulus averaging about 2 percent of GDP a year in 2009-2011). Meanwhile household interest payments declined by more than 30% between the third quarter of 2008 and the first quarter of 2009, largely due to monetary policy easing. As Australia’s economy was in a relatively strong position at the onset of the global financial crisis, the rapid deployment of fiscal and monetary stimulus measures helped buffer the negative impact of the crisis on household income and private demand.

As suggested in the IMF Fiscal Monitor (April 2012), the size of fiscal multipliers can vary significantly by the underlying state of the economy – the multipliers tend to be larger in downturns than in expansions as the crowding out effect between public and private spending is less applicable when there are excess capacities in the economy. Given that Australia’s economy is close to potential, the contractionary impact of the current fiscal consolidation is likely to be smaller than in other countries undergoing similar fiscal adjustment but with large negative output gaps, and the impact could also be mitigated by Australia’s still-sizable monetary policy space. These results are broadly in line with those suggested by the Global Integrated Monetary and Fiscal (GIMF) model simulations.

Going forward, Australia’s household saving ratio is likely to decline modestly as interest rates normalize and household sentiment improves. But the saving ratio will remain above the pre-crisis levels as the persistently strong capital gains in household assets in the 1990s and 2000s, which allowed households to enjoy rising wealth with low rate of saving, are unlikely to be repeated in the near future.

uA01fig5

Australia Private and Government Saving

(In percent of GDP)

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

Source: OECD.
uA01fig6

Australia Household Saving Ratio

(In percent)

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

Source: ABS.

Medium-Term Fiscal Policy

18. Fiscal Strategy. The government’s fiscal strategy has remained unchanged since first developed in 2008-09. It 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 (23.7 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. This strategy is projected to yield small surpluses which gradually increase from ¼ percent of GDP in 2013/14 to 1 percent of GDP in 2015/16. As a result, net commonwealth debt, already low by international comparison (Figure 6), will fall from about 10 percent of GDP in 2012 to zero by 2020/21. Outside the Commonwealth budget, the States and Territories also anticipate a gradual reduction in expenditure over the medium term, in part through public sector wage control measures, to maintain their reputation among international bondholders for fiscal discipline in the face of lower projected GST revenues.

Figure 6.
Figure 6.

Australia: Comparison of Fiscal Outlook

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

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

19. Tax Policy. Staff supports the recent tax initiatives. Following a comprehensive review of the Australian tax system in 2010 (Australia’s Future Tax System), the authorities implemented on July 1, 2012 a number of tax reforms that include a minerals resource rent tax (MRRT), a broadening of the base of the petroleum resource rent tax (PRRT), and a carbon price with a transition to emissions trading over time. Staff welcomed the introduction of the MRRT and broadening of the base of the PRRT and continues to support the carbon price, which is well-designed along FAD recommendations and intended to be fiscally neutral.

20. Fiscal Policy Management. While monetary policy is expected to be the main demand management tool in the medium-term, fiscal policy can, nevertheless, play a role in responding to economic shocks. In this regard, staff recommended that the automatic stabilizers be allowed to move fully in both directions. Staff noted that the growing importance for the economy of mining exposes government revenue, more than in past years, to swings in commodity income.

21. Medium-term fiscal challenges. Over the medium-term, the authorities are facing an increase in expenditure commitments, primarily related to aging and health care costs, which together are estimated to increase public expenditure by over 3 percent of GDP by 2030. With revenue currently well below the government’s cap of 23.7 percent of GDP–around 21.0 percent of GDP in 2011/12 –there is some room to accommodate the higher spending needs through increases in revenue. Even so a re-prioritization of spending would likely be needed to accommodate the additional commitments and produce budget surpluses if the revenue ceiling is maintained. A sustained shock to the terms of trade would add to these challenges.3

The Authorities’ Views

22. The authorities agreed with staff on the role of automatic stabilizers in fiscal policy management. They acknowledged the medium-term budgetary challenges. They noted that the revenue ceiling is based on 2007-08 receipts and as such reflects temporary factors that contributed to unusually high receipts in the pre-crisis period, namely, high capital gains taxes boosted by surging asset prices, rapidly rising commodity prices, rapid credit growth and a low household savings rate. Moreover, structural changes to the tax base that have taken place during the recovery from the crisis, such as shifting consumption patterns, lower asset price growth and higher depreciation deductions, are likely to persist. As such, the authorities do not expect the revenue ceiling to be a binding constraint over the next several years if the current tax policy framework is maintained. The authorities’ strategy for managing the public sector proceeds from increased mining exports does not envisage accumulating assets in an earmarked sovereign wealth fund—unlike other commodity producing countries with such funds, the share of Australia’s mining sector in the economy (projected to increase to around 10 percent of GDP) and its contribution to public revenue will still remain limited even after the expansion, and minable resources are expected to be long-lasting rather than temporary. Instead, the authorities plan, in the first instance, is for the tax proceeds to contribute more generally to the gradual reduction in gross public sector debt, which provides for equivalent outcomes as a formal fund.

Safeguarding Financial Sector Stability

23. Resilient financial system. Banks are highly profitable with a return-on-equity in line with the pre-crisis average (Figure 7). Asset quality remains good and the ratio of nonperforming loans to total assets continues to inch downward from the post-crisis peak (text figure). Although the Australian banks remain amongst the most highly rated globally, there were some rating actions in the last 12 months with S&P downgrading all four major banks in December 2011, a well-anticipated move that was driven by revised methodology. Fitch also downgraded three major banks earlier this year, citing risks posed by banks’ reliance on offshore wholesale funding. Bank credit default swaps spreads are above pre-crisis levels yet below those for European banks (Figure 8).

Figure 7.
Figure 7.

Australia: Banking System Developments

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

Figure 8.
Figure 8.

Australia: Financial Market Indicators

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

uA01fig7

Asset Quality: Non-performing Loans

(In percent of loans by type)

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

1/ Impaired assets.Source: Reserve Bank of Australia.

24. Funding. Since the financial crisis, reflecting lessons learned and the changing regulatory environment, banks have shifted toward more stable funding sources facilitated by combination of strong overall deposit growth and slower credit growth. Reliance on wholesale funding has been reduced and deposits now currently meet more than 50 percent of banks’ funding requirements. Much of the decline in wholesale funding has been driven by declines in domestic short-term debt further improving the stability of banks’ funding–the share of short-term debt has fallen from a peak of over 30 percent to about 20 percent. Legislative changes in October 2011 permitted Australian banks to issue covered bonds and since then the major banks have used around one-quarter of their covered bond issuance capacity. So far this year, covered bonds accounted for about one-third of banks’ bond issuance, with the remainder unsecured. The increased competition for deposits has pushed up the spread of deposit to money market rates, and, together with a move to more stable funding sources, contributed to higher funding costs.

25. Vulnerabilities. The banking system is large, highly concentrated, and interconnected. The four major banks are systemic, with broadly similar business models, and their reliance on wholesale and off-shore funding, although below pre-crisis levels, still represents a risk. Residential mortgages are the banks’ single largest asset but household debt is high and house prices are elevated. These are long-standing structural issues that will remain key sources of risk over the medium-term. Stress testing indicates that the major banks are adequately capitalized and are likely to withstand severe macroeconomic shocks, but would require the assistance of the RBA to withstand an extreme funding shock. Net foreign liabilities of the banks amount to almost 25 percent of GDP. Although predominately in foreign currency, these positions are hedged and counterparty risk is limited. The banking sector faces the prospect of slower credit growth as businesses and households continue to deleverage, and could take on riskier strategies in an effort to return to pre-crisis credit and profit growth rates.

26. Financial sector reform. Capital ratios are increasing and the banks are well-placed to meet Basel III capital requirements and Australian Prudential Regulation Authority (APRA)’s accelerated timetable for implementation (Box 2). Total capital has increased, largely due to dividend reinvestment plans and higher retained earnings which boosted Tier 1 capital. Banks have shifted the composition of their portfolios towards assets with lower risk weights, such as mortgages and government bonds. Holdings of liquid assets have increased as banks also prepare to meet Basel III liquidity requirements (Figure 7).

Progress towards Implementing Basel III Reforms

Under APRA’s accelerated schedule, Australian banks will be required to meet the minimum Basel III capital requirements from January 2013 and the Basel III capital conservation buffer beginning January 2016. Australian banks have made good progress and are well-positioned to meet these new requirements. Total capital ratios have improved, with a greater increase in Tier 1 capital ratios, as banks chose to run-off holdings of Tier 2 instruments no longer eligible under Basel III. Immediately following the global financial crisis, new equity issuance increased banks’ capital. However, more recently, capital has been accumulated organically through retained earnings and dividend reinvestment plans. Relatively low asset growth and a slight shift toward lower-risk assets has also improved banks capital ratios.

The liquidity of banks’ balance sheets has steadily improved since the financial crisis: in March 2012 liquid assets were 10 percent of total assets up from 6 percent in March 2007 (text figure). The composition of the banks’ liquid asset portfolios has also changed significantly. Banks have substituted holdings of short-term bank paper for Commonwealth Government Securities (CGS) and semi-government securities which are now one-third of liquid assets compared with 6 percent in March 2007.

A key element of the Basel III liquidity reforms is the liquidity coverage ratio (LCR) which is designed to ensure that banks have adequate high-quality liquid assets—defined by APRA as cash, central-bank reserves, CGS and semi-government securities–to meet the outflows associated with a 30 day stress scenario. 1/

However, Australia faces a shortage of such high-quality liquid assets. In particular, a long-period of prudent fiscal policy has resulted in a low supply of CGS relative to the size and liquidity needs of the financial sector. In addition, overseas demand for CGSs is high with a sizeable share held by non-residents, including by institutional investors that tend to hold assets to maturity, further reducing the depth of the CGS market. Other Basel III reforms, such as collateral requirements for derivative contracts, are expected to further increase the demand for high quality liquid assets.

With some other countries also facing a shortage of high-quality liquid assets, the Basel III framework allows for alternative approaches. The RBA and APRA have adopted one of these approaches, a committed liquidity facility, where banks can establish a secure liquidity facility with the RBA, for which they are charged an ongoing fee. The facility is designed to cover any shortfall between a bank’s holdings of high-quality liquid assets and the LCR requirement. However banks are required to hold more high-quality liquid assets and cannot solely rely on the facility to meet the LCR.

APRA intends to adopt the counter-cyclical capital buffer as part of its implementation of the Basel III reforms. However, it is likely to go beyond the Basel Committee on Banking Supervision (BCBS)’s proposed benchmark–the de-trended ratio of credit to GDP–as its guide to deploy the buffer. Any such decisions are likely be made in consultation with the Reserve Bank of Australia, be based on a wide array of data, and with additional capital serving as a complement to other prudential tools.

uA01fig8

Tier 1 Capital Ratio

(In percent of Risk-Weighted Assets)

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

1/ Other risk includes market risk, operational risk, equity risk, interest rate risk in the banking book and other assets.Sources: Banks’ Disclosure statements; IMF staff calculations.
uA01fig9

Bank Liquid Assets

(In billions of Australian dollars)

Citation: IMF Staff Country Reports 2012, 305; 10.5089/9781475561357.002.A001

Sources: ABS; APRA; RBA.
1/ Further draft revised liquidity standards are expected to be released by APRA at end 2012.

27. Financial Sector Assessment Program (FSAP). Staff reiterated the recommendations from an FSAP update conducted over the past months4. To further bolster financial system stability, higher loss absorbency for systemically important institutions may be desirable, as part of a multi-pronged approach, that includes supervision and recovery and resolution planning. The FSAP mission identified room for improvement in certain areas of supervision, recommending greater depth and intensity in APRA’s supervision of liquidity risk through more time allocated to formal on-site review, and that Australia Securities and Investments Commission (ASIC) be given more resources and flexibility over its operational budget. The FSAP mission recommended that the RBA develop macro-financial stress tests which could enhance its ability to identify and monitor emerging systemic risks and APRA devote more resources to stress testing. To ensure that the banking industry bears at least part of the cost of bank failures, the FSAP mission recommended that the authorities re-evaluate the merits of an ex ante funded deposit insurance scheme. While banks are making efforts to change funding structure, the FSAP mission stressed the importance of encouraging banks to continue to lengthen the maturity of offshore funding and increase their domestic funding.

The Authorities’ Views

28. The authorities broadly agreed with the staff assessment of financial sector vulnerabilities. They acknowledged that banks are heavily exposed to household debt and that house prices are high by historical standards but, as discussed above, they do not see a fall in house prices as a stand-alone risk and note that other kinds of bank lending have proven to be more important drivers of losses in many countries over recent years. Moreover, stringent under-writing standards, based on serviceability rather than collateral, improve the resiliency of bank balance sheets to declines in house prices, consistent with the results of recent stress testing. Significant prepayment buffers–funds that borrowers can draw on to stay current with their loan, amounting to over 10 percent of the outstanding stock of housing loans and equivalent to about 18 months payment–further mitigate the risk to the banking sector of significant stress in the housing market or a sharp increase in unemployment. Improvements in banks’ funding profiles have reduced the macroeconomic vulnerability to bank funding stress that would arise if the global funding markets become closed to all banks, regardless of individual strength. Due to their relative strength compared with banks in other countries, Australian banks were able to take advantage of periods of relative financial market calm earlier this year to move ahead of their annual funding targets.

29. The authorities welcomed the main conclusions of the FSAP and noted that the process involved good, robust, and constructive discussions. Overall, they agreed with the assessment that the Australian financial system was resilient through the global financial crisis; the banks are well-capitalized, profitable, and well-positioned to implement Basel III capital reforms; and with the assessment of vulnerabilities, risks and mitigating factors identified during the FSAP process. In terms of the recommendations, the authorities emphasized the importance of intensive supervision as a tool for mitigating risks created by large, systemic banks. They will consider next steps on higher loss absorbency following G-20 endorsement of the Basel Committee’s recommendations for domestic systemically important banks (D-SIBs).

Assessing External Stability

30. Current account. The current account deficit is projected to widen to 4 percent of GDP in 2012 as import volumes pick up, especially for capital goods (Figure 9, Table 5). Over the medium term, assuming a constant real exchange rate, the deficit is projected to reach 6 percent of GDP as investment in the resources sector reaches its peak, increasing mining-related imports by about 2 percent of GDP, and the terms of trade and interest rates on external borrowing normalize. The resources sector investment is financed by new foreign investment and retained earnings rather than through borrowing from domestic banks, and will expand export capacity in the future.

Table 4.

Australia: Balance of Payments in U.S. Dollars, 2007–17

(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, 2007–17

(In percent of GDP)

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