Australia: 2013 Article IV Consultation—Staff Report; Press Release; and Statement by the Executive Director for Australia

This 2013 Article IV Consultation highlights that the Australian economy has performed well relative to many other advanced economies since the global financial crisis. A transition phase has now been reached as the terms of trade-driven mining investment boom of the past decade has peaked, and the economy is moving to the production and export phase. Annual growth slowed to 2¼ percent in the third quarter of 2013, below the trend growth of about 3 percent. Inflation remains anchored in the Reserve Bank of Australia’s (RBA) target range.

Abstract

This 2013 Article IV Consultation highlights that the Australian economy has performed well relative to many other advanced economies since the global financial crisis. A transition phase has now been reached as the terms of trade-driven mining investment boom of the past decade has peaked, and the economy is moving to the production and export phase. Annual growth slowed to 2¼ percent in the third quarter of 2013, below the trend growth of about 3 percent. Inflation remains anchored in the Reserve Bank of Australia’s (RBA) target range.

Recent Economic Developments

1. Setting. The Australian economy has performed well relative to many other advanced economies since the global financial crisis. However, a transition phase has now been reached as the terms-of-trade-driven mining investment boom of the past decade has peaked and the economy is moving to the production and export phase. Mining-related investment which accounted for almost half of GDP growth in the past couple of years is expected to drop sharply in the near term (text figure and Annex 4), and a recovery in non-mining investment will be needed to underpin demand and return the economy’s growth rate to trend.

2. Real economy developments. Annual growth has slowed to 2¼ percent in the third quarter of 2013, below the trend growth of around 3 percent. In addition to the slowdown of investment in new mining projects, non-mining investment has been weighed down by excess capacity and an overvalued exchange rate (Box 2, Figure 1). In line with relatively weak consumer sentiment, consumption growth has been modest and the household savings rate has remained above 10 percent, leaving the household debt-to-income ratio stable at around 150 percent. On the plus side mining exports, mainly to China, are growing as new capacity comes on stream and in recent months housing market activity has begun to pick up with building approvals, transactions, and prices increasing (paragraph 8 and Annex 2). Nevertheless labor market conditions have remained soft and the unemployment rate has risen gradually from a trough of 5 percent in mid-2011, in part reflecting the mining sector moving to the less labor-intensive production phase.

Figure 1.
Figure 1.

Australia: Growth Weakened

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Sources: Australian Bureau of Statistics; Westpac-Melbourne Institute; Statistics New Zealand; Bloomberg; IMF, World Economic Outlook; and IMF staff calculations.

3. Inflation. Annual inflation slowed to 2¼ percent in the third quarter, close to the middle of the Reserve Bank of Australia’s (RBA) target band. With the weakening of overall labor market conditions wage inflation has slowed to 2¾ percent, the lowest rate since 2000 (text figure).

4. Monetary policy. In response to weakening demand the RBA has eased the policy rate by 225 basis points since November 2011 to 2½ percent, with the most recent cut in August 2013 (Figures 3 and 4). This has begun to support interest-sensitive spending and asset values. Market lending rates, key indicators of the overall monetary policy stance, are now well below their historical averages. Overall credit growth however has remained relatively subdued.

A01ufig1

Australia: Mining Investment

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Source: ABS; ANZ; and IMF staff calculations.
A01ufig2

Australia: Wage Inflation

(Annual percentage change)

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Source: ABS.
Figure 2.
Figure 2.

Australia: Household Vulnerabilities

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Sources: OECD; Reserve Bank of Australia; Australian Prudential Regulation Authority; Reserve Bank of New Zealand; Eurostat; Federal Reserve Board; Haver Analytics; RP Data-Rismark; and IMF staff calculations.
Figure 3.
Figure 3.

Australia: Inflationary Pressures Moderate

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Sources: ABS; RBA; Melbourne Institute; and IMF staff estimates.
Figure 4.
Figure 4.

Australia: Monetary Stance

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Sources: RBA; and IMF staff estimates.

5. Fiscal policy. The budget deficit was reduced from 3 percent of GDP to 1½ percent in 2012/13. The previous government’s goal of returning the budget to surplus last year was held back by slower-than-projected output growth and weaker commodity prices. Revenue fell short of projections as the lower terms of trade together with the persistently strong Australian dollar reduced nominal GDP and dented corporate profitability, with company tax revenue coming in around ½ percent of GDP lower than expected. Capital gains and resource rent taxes were also weak. Spending was somewhat higher than anticipated, exceeding plans by 1¼ percent of GDP.1

6. Recent market and financial sector developments. Aside from some welcome depreciation of the dollar, Australian markets were little affected by the market turbulence following the announcement of prospective Fed tapering in May 2013. The banking system has been performing well, with profitability remaining strong and balance sheets continuing to strengthen (paragraph 17).

Outlook and Risks

7. Near-term outlook. With the drop off of mining investment, growth will likely remain soft in the near term. Growth this year is projected at 2½ percent, rising to its trend rate of about 3 percent by 2016/17. While resource exports will increase, the outlook for the non-resource sector is more uncertain. An accommodative monetary stance could support housing investment, but the soft labor market, excess capacity in the non-mining sector holding back investment plans, and a strong Australian dollar could continue to act as headwinds to overall growth. The near-term risks relative to this baseline scenario are broadly balanced. On the downside the transition to broader-based growth could prove more difficult than currently expected, particularly if the exchange rate were to remain stronger than implied by fundamentals. On the other hand recent indicators suggest that business conditions are beginning to improve and the revival in the housing market could contribute to improved consumer confidence and growth.

8. Housing sector risks. After several years where house prices have lagged income growth and construction has been weak, the recent revival in housing market activity could contribute to near-term growth and begin to help address persistent structural supply shortages but has also boosted house price inflation (Annex 2). To date house price increases have been steeper in Sydney Melbourne and Perth and lower elsewhere. Overall credit growth has remained moderate with many households continuing to prepay mortgages. Looking forward though, against the backdrop of already high house prices and high household debt, there is a risk that rapid house price growth could give rise to expectations-driven, self-reinforcing demand dynamics and price overshooting. In this context there have been some signs that banks have responded to increased demand pressures by increasing mortgage lending to the investor segment of the market (paragraph 20). A sudden house price decline—triggered perhaps by a shock to household incomes or borrowing costs—could reduce consumer confidence and impact overall economic activity. The authorities would need to be prepared to take preventative actions if household credit growth, transactions volume, and prices accelerate.

A01ufig3

Australia: House Price Inflation

(Annual percentage change)

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Source: Australian Bureau of Statistics; RP Data; and ANZ.

9. External risks. Australia’s growth prospects remain exposed to external developments (Annex 1). In particular:

  • A sharp slowdown in growth in China over the medium term and a related sustained decline in commodity prices. Over half of Australia’s exports go to emerging Asia and nearly two thirds are non-rural commodity exports. With the volume of these exports increasing sharply in future years, Australia’s economic outlook will be closely tied to developments in this region. Increases in global supply of Australian export commodities coming on stream are expected to bring about a steady decline in their prices—these projections are built into our baseline scenarios—but a sustained steep decline could have significant implications for Australia’s growth prospects (paragraph 27).

  • Surges in global financial market volatility related to the exit from unconventional monetary policy. An orderly tightening would likely have a positive impact by weakening the exchange rate and supporting the adjustment of the Australian economy. However, a bumpy exit from unconventional monetary policies and renewed international financial market volatility would likely raise the cost of Australian banks’ wholesale borrowing.

The external and domestic risks are closely interlinked. A hard landing in China could reduce demand for Australia’s mineral exports, worsen the terms of trade, reduce household income and trigger a fall in house prices. These interlinked risks could amplify any given shock as collateral effects further weaken consumer demand and growth, and could in turn lead to a market reassessment of Australia’s growth prospects, and negatively affecting banks’ balance sheets.2

10. Policy space to manage risks. The floating exchange rate provides a key cushion against such shocks. The RBA has some room to respond, and the rapid and effective monetary transmission mechanism in Australia would allow for a nimble policy response should these risks emerge. But with the policy rate currently low at 2½ percent, the scope for monetary policy to offset shocks is limited and a sharp deterioration in the economic outlook would call for additional policy responses. As discussed below, Australia’s modest public debt level gives the authorities the scope to allow automatic stabilizers to operate in full and to temper the pace of budget deficit reduction when needed.

11. Potential Outward Spillovers. With Australia as its most important trade and financial partner, New Zealand is vulnerable to a sharp slowdown in Australia’s economic prospects.3 Beyond the trade linkages, Australian bank subsidiaries constitute 90 percent of New Zealand’s banking system (Figure 11). As subsidiaries rather than branches, however, New Zealand banks are financially ring-fenced, do not rely on their parents for funding, and are well-capitalized with substantial liquidity buffers, although they would likely suffer indirect reputational effects from financial stress in the parent which could affect their access to funding from global wholesale markets.4 Statutory obligations underpin cross-border cooperation between the two countries, improving regulatory and supervisory oversight.

Figure 5.
Figure 5.

Australia: Fiscal Stance

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Sources: Commonwealth of Australia 2013–14 Mid-Year Economic and Fiscal Outlook, 2013–14 Budget; ABS; and IMF staff estimates and projections.
Figure 6.
Figure 6.

Australia: Comparison of Fiscal Outlook

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Sources: Commonwealth of Australia 2013-14 Mid-Year Economic and Fiscal Outlook; ABS; IMF, World Economic Outlook; and IMF staff estimates and projections.
Figure 7.
Figure 7.

Australia: Banking System Developments

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Sources: RBA; APRA; and IMF staff calculations.
Figure 8.
Figure 8.

Australia: Financial Market Indicators

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Sources: Bloomberg; RBA; Credit Suisse; and IMF staff calculations.
Figure 9.
Figure 9.

Australia: Trade and Balance of Payments

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Sources: ABS; RBA; and IMF staff calculations.
Figure 10.
Figure 10.

Australia: External Vulnerability

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Sources: ABS; IMF, International Financial Statistics, World Economic Outlook; Haver Analytics; EconData; WB-IMF-BIS-OECD Quarterly External Debt Statistics; and IMF staff estimates.
Figure 11.
Figure 11.

Australia: Interconnections and Spillovers

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Sources: ABS; APRA; RBA; IMF, Direction of Trade Statistics; BIS; and IMF staff calculations.

12. Authorities’ views. Recognizing the risks to the domestic economy, the authorities have recently revised down near-term growth projections (currently in line with staff’s). They argued that the sustained reduction in policy rates should continue to support growth in interest-rate sensitive sectors—indeed, recent house price developments had been a not unexpected consequence of this policy, and are providing a boost to housing investment which has been structurally weak for some time. They noted that there has been some increase in mortgage lending, although overall household leverage has not picked up, suggesting that the housing sector has not yet become a near-term risk. Nonetheless they are closely monitoring the situation and believe they have the tools for a targeted and proportionate response to any emerging risks (paragraphs 21 and 22). The strength of the Australian dollar will be a key factor for growth prospects, and in this regard an early exit from unconventional monetary policies abroad is likely to contribute to a lower value for the Australian dollar, which would help facilitate an adjustment to broader-based growth. On the other hand, Australian assets’ relatively high credit ratings make them attractive to foreign investors, and there is a risk that shifts in portfolio preferences could result in capital inflows and put upward pressure on the Australian dollar. The authorities continue to regard a slowdown in China over the medium term and a related fall in commodity prices as the main external risk to the Australian economy. They emphasized the role the floating exchange rate provides as a cushion against such shocks.

Policies to Sustain Growth

13. Monetary policy. Staff views the RBA’s monetary policy stance as broadly appropriate. Inflation is within the target range and inflation expectations remain well anchored. With growth currently on the soft side, the real exchange rate still strong, and efforts to reduce the budget deficit likely, monetary policy should remain accommodative and act as the primary macroeconomic tool for managing aggregate demand in the near term.

14. Fiscal policy. Australia’s fiscal position compares well to its advanced economy peers, although debt has increased in the aftermath of the global financial crisis (Annex 5). The government considers it a priority to return the budget to surplus to preserve its favorable standing with external creditors against the background of relatively high overall net foreign debt (paragraph 23). To this end, the government has announced the broad aim of returning the budget to a sustained surplus, building to a 1 percent of GDP surplus by 2023/24. A more detailed framework will be established when the government announces its fiscal strategy in May. The government has also pledged to scrap the carbon tax and the mineral resource rent tax which will reduce revenue by about ¼ percentage point of GDP compared to total budget revenues from the mining sector of around 2 percent of GDP. Staff supported the broad aim of improving the budget position over the medium term, which would help rebuild fiscal buffers and increase the policy scope to deal with adverse shocks, but cautioned that it should be done in a way that does not disrupt growth prospects in the near term.

15. Consistency of the fiscal projections. Achieving and sustaining a surplus over the next decade will be challenging in light of current social spending commitments. Staff’s analysis shows that achieving a surplus would require either an increase in revenue or sizeable cuts in projected spending (Box 1). Early decisions on policy changes required to ensure the medium-term consistency of fiscal policy goals would help to preserve policy flexibility.

16. Authorities’ views. While recognizing relatively weak near-term growth prospects, the authorities expected private demand outside the mining sector to increase at a faster pace, though they pointed to the considerable uncertainties around the outlook. The RBA had not ruled out further interest rate cuts, but emphasized that the effects of the reduction in policy rates already made are still being felt. They also noted that foreign exchange intervention remained part of the policy toolkit, although more recently used only at times of market dysfunction. The government is expected to soon articulate its fiscal strategy in more details. To achieve the aim of returning to and maintaining a budget surplus, sizeable cuts in projected spending would be required. Important for this would be the recommendations of the National Commission of Audit’s Review of the efficiency and effectiveness of expenditure and of spending pressures over the medium term.

Medium-Term Fiscal Consistency

The Government has committed to delivering a surplus of 1 percent within the next decade. Achieving this looks difficult on current spending plans without a large increase in budget revenue or a cut in spending or a combination of both.

Identifying spending pressures

Long run spending projections are discussed in the latest 2010 Intergenerational Report (published every 5 years by the Treasury). Around 40 percent of government spending is directed to health, age-related pensions and aged care, disability, and education (here referred to as “social spending”). Spending on these areas is projected to increase significantly over the Report’s 40-year horizon. Rising health costs account for around two-thirds of the overall increase. Some policy and legal changes—in education and the second round of private health insurance in particular—have been made since the Report was published which affect the composition of spending pressures, although the outlook remains broadly the same.

To assess the consistency of the government’s fiscal targets over the next decade, we do a simple exercise of applying the Intergenerational Report’s expenditure growth models and projections for social spending to see how this might affect overall spending. Specifically, health and disability spending are expected to increase over the next decade by ½ percent of GDP each, and education, assistance to the aged and pensions by 0.2 percent each.

These spending trends imply that if other “non-social” spending were to be held at its current level as a share of GDP, overall expenditure would reach 26½ percent in ten years. If tax revenue is held at its average level over the last decade, the resulting budget deficit in 2023/24 would reach 2 percent of GDP. Reaching the government’s budget surplus target would thus require cutting spending by around 3 percent of GDP, either by reducing net non-social spending or by putting in place policy measures to contain increases in social spending (figure).

A01ufig4

Expenses by Function

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Sources: Commonwealth of Australia Budget Papers; and IMF staff estimates and projections.

The National Commission of Audit

The government recently established the Commission as an independent mechanism to review and report on the performance, functions and roles of the Commonwealth government. Among the main objectives are to identify areas of unnecessary duplication between the activities of the Commonwealth and other levels of government, to identify areas or programs where Commonwealth involvement is inappropriate, no longer needed, or blur lines of accountability, and to improve the overall efficiency and effectiveness with which government services and policy advice are delivered.

The Commission will report to the Prime Minister, Treasurer, and the Minister for Finance with both phases of the audit due by the end of March 2014. The recommendations are expected to inform the decisions presented in next budget. The established priorities are meant to allow savings conducive to improving the medium-term fiscal position.

Financial Stability and Macro-Financial Risks

17. Background. Australia’s banking sector has strengthened in the aftermath of the global crisis. Asset quality remains good, the ratio of non-performing loans to total assets is low and continues to decline from its peak, and return-on-assets is in line with the pre-crisis average. Capital adequacy has improved and is well above the Basel III capital requirements; APRA had its framework in place in January 2013. Banks have shifted toward more stable funding sources, as strong deposit growth has outpaced moderate credit growth—reliance on offshore wholesale funding has been reduced and is of longer maturity, and deposits now meet over half of banks’ funding requirements and the share of short-term debt has fallen below 20 percent (text figure). This has reflected a post-crisis change in banks’ funding strategies and an increase in the deposit base related to the recent jump in the household savings rate. Banks’ external liabilities remain fully hedged to exchange rate and maturity risk.

A01ufig5

Australia: Banks’ Funding 1/

(Domestic books; in share of total)

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

1/ Adjusted for movements in foreign exchange rates.2/ Includes deposits and intragroup funding from non-residents.Sources: APRA; RBA; and Standard & Poor’s

18. FSAP findings. The IMF’s 2012 Financial Sector Assessment Program (FSAP) found Australia’s financial system to be sound and well managed. Stress test scenarios suggest the financial system is resilient to a range of solvency shocks, although a severe shock would make major inroads into these banks’ capital buffers requiring recapitalization efforts, and central bank support would be needed in the event of a liquidity shock.5 Recognizing this latter risk, APRA will be introducing Basel III liquidity standards in 2015 ahead of the Basel committee’s deadline. Progress is being made on many of the recommendations of the FSAP to further bolster financial system stability, including higher loss absorbency for systemically important banks, stress testing, and intensifying the supervision of liquidity (see Text Table, page 18). The government announced that there would be a wide-ranging Financial Sector Inquiry which is aimed at fostering an efficient, competitive and flexible financial system. It will report in November 2014 and is likely to cover some aspects of the FSAP recommendations.

Text Table.

High-Priority FSAP Recommendations

article image

19. Key macro-financial risks. The four major banks are systemic with broadly similar business models and, though reduced, reliance on wholesale funding is still high and continues to pose some rollover risks. Residential mortgages account for a large part of banks’ assets, a sector that is vulnerable to price fluctuations and household leverage is still high. These are longstanding structural issues that will remain sources of risk over the medium term. In a tail event of a sharp increase in global financial market volatility, banks’ wholesale funding costs would rise and would likely be passed on to corporate and households. While monetary policy could still respond, its scope would be reduced. In these circumstances fiscal policy may need to provide support. Given Australia’s modest public debt, there is space to respond to a significant shock (see annex 5).

20. Mortgage market developments. Household credit growth has remained moderate, rising broadly in line with incomes, with the recent pick up in lending concentrated in investor loans (Annex 2, paragraph 7). The increasing popularity of property investment among self-managed superannuation funds, although still a small segment of the mortgage market, has further stimulated demand for investor loans which, for tax purposes, are typically interest-only loans. This helps to explain why the proportion of mortgage approvals that are interest-only increased by about 2½ percentage points over the past year to nearly 40 percent. Loans to investors are around a third of total housing mortgages, and the proportion of high loan-to-value mortgage approvals is also around one third. Overall, households are currently using the low interest environment to pay down principal and build up substantial mortgage buffers. Nonetheless, APRA and RBA recently cautioned banks about need to maintain tight lending standards.

A01ufig6

Australia: Private Sector Credit Growth

(Annual percentage change)

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Source: Reserve Bank of Australia.
A01ufig7

Australia: Mortgage Repayment Buffers 1/

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

1/ Data are backcast before December 2010 to adjust for a reporting change by one bank.Source: RBA.

21. Regulatory and supervisory framework. The authorities’ framework seeks to address these financial sector vulnerabilities (Annex 2, paragraphs 11 and 12). Conservative risk weights give Australian banks higher quality capital than most of their advanced country peers. In addition there are features of the Australian regulatory, supervisory, and legal approach to property lending that differ from other advanced economies which would help to limit the impact of a sharp decline in house prices on the financial system. Higher household savings rates and an increase in principal prepayments have allowed households to build large mortgage buffers (text figure). The full recourse nature of lending provides an incentive for continued repayment and lending standards are tightly enforced with a strong regulatory focus on the borrowers’ ability to service their loans. A banking system dominated by only four banks and close cooperation between the RBA and APRA enables swift communication and enhances the effectiveness of prudential tools should risks emerge. Overall, Australia’s regulatory and supervisory framework is likely to have contributed to the low level of non-performing mortgage loans sustained over the past decade.

22. Authorities’ views. The authorities emphasized that should an acceleration in housing price inflation become a risk, their intensive supervisory approach gives them the tools to respond in a more targeted and less distortionary manner than through a more formal macroprudential policy framework. In particular, APRA’s supervision involves continuous monitoring and oversight of regulated entities’ behavior to ensure that they comply with prudential standards, are in a sound financial condition, and maintain effective governance and risk management systems. APRA follows a proactive and risk-based approach under which regulated entities that pose greater risks receive more intensive supervision. APRA generally prefers to adopt a suasion approach when it identifies weaknesses in lending standards, with communication with management and boards central to the approach. However, APRA can and does also impose prudential capital requirements beyond the minimum requirements of the Basel framework for individual authorized deposit taking institutions with higher risk profiles. The authorities also pointed to a wide range of legal powers that enable direct action where there are threats to financial stability. Coordination between authorities is conducted through the Council of Financial Regulators which includes the Treasury and the Australian Securities and Investments Commission (ASIC) as well as APRA and the RBA. The authorities highlighted this framework’s success in helping cool the housing market following the large run up in house prices in the early 2000s (Annex 2, paragraph 10).

Assessing External Stability

23. Current Account and external debt. Australia has run current account deficits for most of its history, with deficits averaging around 4 percent of GDP in the last three decades. This has reflected a structural saving-investment imbalance with very high private investment relative to a saving rate which is already high by advanced country standards, resulting in net external liabilities of around 55 percent of GDP (Annex 3). Looking forward, as imports related to mining investment decline and mining export capacity comes on stream, the trade balance should turn to surplus, offset by a widening income account deficit as global interest rates normalize and mining income accruing to foreign investors’ increases. On net the current account deficit is currently expected to remain below 4 percent of GDP over the medium term, stabilizing Australia’s net foreign liability position as a share of GDP. The stock of external debt has become more stable over the past several years—the decline in short-term offshore borrowing by banks and increased foreign holdings of long-term public debt have lengthened the maturity profile, and a major portion of resources sector investment has taken the form of less volatile foreign direct investment.

24. Exchange rate. Despite some recent depreciation the real exchange rate, currently in the range of 89 cents to the U.S. dollar, is 5–10 percent above the level predicted by Australia-specific factors from a medium-term perspective (Box 2). There are a number of factors contributing to the current high level of the Australian dollar, including the substantial capital inflows to fund the mining sector investment, the gap between domestic and foreign interest rates, and portfolio allocation towards Australian dollar assets by foreign institutional investors. If these factors were to ease, possibly triggered by exit from unconventional monetary policies by major advanced economies, the exchange rate would likely depreciate further, supporting the transition of the economy towards more balanced growth. Budget deficit reduction should help take pressure off the dollar over the medium term by boosting national savings, and additional steps to encourage private saving such as the planned increase in the superannuation contribution rate will also help.

External Sector Assessment

Despite the recent depreciation the real effective exchange rate remains elevated and is still around 20 percent above the long run average since 1983. The current account deficit narrowed somewhat in 2013 as mining investment has begun to decline from the record levels reached this past year.

Model-based approaches in the IMF’s External Balance Assessment (EBA)1 suggest that Australia’s real exchange rate at the end of 2013 appears overvalued by 5–10 percent and the current account looks around ½ to 1½ percent of GDP weaker than implied by medium-term fundamentals and desirable policies domestically and globally, although the current account gap can be partly attributed to the mining investment boom. These estimates are, however, subject to considerable uncertainty. Cross-country panel regressions indicate that terms of trade gains and Australia’s positive interest rate differentials vis-à-vis other advanced countries have contributed to the high levels of the dollar in recent years. That part of the overvaluation not captured by the fundamental factors may be related to short-term factors including strong portfolio inflows, especially to the official government debt market since 2009.

Staff’s assessment is also sensitive to projections of household saving behavior in the long run. The household saving ratio has remained above 10 percent after the sharp increase in 2008–2009 (figure), and growth in household consumption over the past year has been below its long run average, consistent with soft labor market conditions and relatively modest growth in household income. At the same time there has been relatively strong growth in household net worth, driven by higher equity and housing prices. In this regard much will depend on whether the post-crisis increase in household savings represents a structural break from past behavior. If the household saving ratio were to fall closer to pre-crisis levels, the current account deficit would widen which would imply a larger overvaluation of the exchange rate.

A01ufig8

Household’s Net Saving Rate

(In percent of household’s net disposable income)

Citation: IMF Staff Country Reports 2014, 051; 10.5089/9781475555097.002.A001

Source: ABS.
1 See 2013 Pilot External Sector Report and External Balance Assessment Methodology.

25. Authorities’ views. The authorities agreed that the current account deficit is likely to be lower in the period ahead than in the past decade, as the investment phase of the mining boom comes to an end and mining sector export volumes increase, though this outlook is subject to a degree of uncertainty. The authorities reiterated their strong commitment to a freely-floating exchange rate, emphasizing the role it has played in maintaining macroeconomic stability and containing external vulnerabilities—in contrast to past mining booms, the floating exchange rate has helped the economy to absorb a sharp increase in terms of trade without leading to an overheating domestic economy and a spike in inflation. Like staff, they expressed some surprise during consultations that the exchange rate had remained high despite the decline in the terms of trade, although it has depreciated more recently. Going forward, a lower level of the exchange rate would help balance growth in the economy. They noted that despite the level of net foreign liabilities, the economy as a whole has a net foreign currency asset position, and so a nominal exchange rate depreciation would strengthen Australia’s overall balance sheet.

Role of the Mining Sector and Shift to Broader-Based Growth

26. Resource investment boom and export prospects. Australia’s terms of trade strengthened to an historic high in 2011 driven by record high global prices for key Australian exports such as coal and iron ore, reflecting strong demand for steel in China (Annex 4). In response mining investment has risen from about 2 percent of GDP in 2002 to more than 8 percent of GDP expected last year. Investments in coal and iron ore drove the early pick up but more recently liquefied natural gas projects (LNG) have increased to meet rising global demand for energy. This year’s peak in investment will be followed by a sharp rise in mining export volumes as investment projects bear fruit—volumes of non-rural commodity exports including coal, iron ore and LNG are projected to grow by more than 30 percent in the next five years. As a result, total mining production’s share in the economy, currently about 10 percent of GDP, could rise by several percentage points over the next several years. Available resource deposits are large and are likely to remain for decades with an increased role of mining as a structural feature of the economy going forward.

27. Sensitivity to terms of trade shocks. The increased resources exports will make the economy more sensitive to terms of trade shocks. However, several factors should help mitigate the direct effects of a decline in the terms of trade. Export volumes for most mining sector projects are relatively inelastic to modest declines in prices, given their competitively low marginal production cost. The floating exchange rate can help buffer shocks by depreciating when the terms of trade fall, making other tradable goods and services more competitive. Since the mining companies have globally distributed shareholdings, the effect on profits will be spread between Australia and abroad. The indirect effects however could be large. The impact of a faster-than-anticipated decline in the terms of trade on nominal output would affect budget revenue more broadly. Income for sectors servicing the mining sector would also be reduced. The impact on domestic and foreign confidence, although difficult to predict, could be significant—consumer confidence would likely be affected and falling profit margins in the economy’s most dynamic sector could lead financial markets to reassess more generally Australia’s prospects and increase the country’s borrowing costs. The Treasury’s sensitivity analysis suggests that absent a depreciation, a permanent fall in terms of trade around 4 percent would cause a fall in nominal GDP of ¾ to 1 percent and decrease the underlying budget cash balance by around ¼ percent.

28. Long-run growth. Robust income growth over the past decade has been supported in large part by the unprecedented increase in the terms of trade, which as it unwinds, is likely to detract from income growth going forward. This implies that a significant pickup in labor productivity will be needed to maintain growth in living standards over the coming decade (Annex 4, Box). While productivity in the mining sector should improve as the investments begin yielding results, this will not be enough to maintain current levels of per capita growth, and productivity growth in other sectors will also need to rise. Since Australia has already benefited from sizeable productivity improvements following substantial structural reforms in the 1990s, finding further scope for improvement will not be easy. A shift to broader-based growth would be helped by making the most of the opportunities offered by a growing Asian middle class, which could support demand for Australia’s services exports—in particular health, education, tourism and professional services.

29. Authorities’ views. The authorities agreed that the greater role of mining in the economy had increased Australia’s exposure to terms of trade fluctuations. Australia’s terms of trade have declined by almost 20 percent from their historic peak in 2011, and are expected to decline further over the coming years as global mining capacity increases. For this reason, the government’s medium-term budget revenue projections are based on a significant decline in the terms of trade. They emphasized that despite increased mining exports, the sector will still play a smaller role in Australia’s economy than the service sector, particularly with respect to employment. Finding ways of improving multifactor productivity is regarded as essential for maintaining growth in living standards going forward, and they agreed that this will be challenging. Addressing infrastructure bottlenecks is a key priority, and enhancing the framework for the selection and prioritization of infrastructure projects based on rigorous cost-benefit analysis, and including more involvement by the private sector, would help allow for spending on infrastructure consistent with the government’s deficit reduction goals.

Staff Appraisal

30. Outlook. The Australian economy has reached a transition phase as the terms-of-trade-driven mining investment boom of the past decade has peaked and the economy is moving to the mining production and export phase. Mining-related investment is expected to drop sharply in the near term and a recovery in non-mining investment will be needed to underpin demand and return the economy’s growth rate to trend.

31. Risks. The recent revival in housing market activity is welcome as it could contribute to near-term growth and begin to help address persistent structural supply shortages, but the authorities will need to be prepared to take actions should credit growth and transactions volume pick up sharply to prevent an unsustainable acceleration in house price inflation. The main external risks include a sharp slowdown in growth in China over the medium term and the risk of a surge in global financial market volatility. The authorities have both monetary and fiscal policy space to react if the outlook deteriorates.

32. Monetary policy. Monetary policy should remain accommodative—inflation is within the target range, growth is currently on the soft side, and the real exchange rate is still strong. Monetary policy should act as the primary macroeconomic tool for managing aggregate demand in the near term.

33. Fiscal policy. The government’s aim to return the budget to surplus in the coming years will help rebuild fiscal buffers and increase the policy scope to deal with adverse shocks, but will be challenging in light of current social spending commitments. Cuts in projected spending and/or increased revenues are likely to be needed, and early decisions on policy changes required would help preserve policy flexibility.

34. Financial sector. The banking sector is sound, balance sheets have strengthened over the past year, and stress tests show the major banks would be able to withstand a sizeable shock to output, terms of trade, rising unemployment, and a fall in property prices. The banks remain exposed however to highly leveraged households and rollover risks associated with short-term offshore funding needs. The authorities’ intensive supervisory framework should allow for a targeted response if house price inflation becomes a risk, and there are features of the Australian regulatory and supervisory approach to property lending which would limit the impact of a sharp decline in house prices on the financial system.

35. External stability. Increasing mining exports should improve the trade balance, and the current account deficit should settle at a level that stabilizes Australia’s net foreign liabilities. Prospects for both near-term growth and external sustainability will depend on whether the exchange rate, which currently looks moderately overvalued, moves consistently with Australia’s fundamentals going forward. In this regard monetary policy tightening by major advanced economies would help weaken the dollar and support the transition toward more balanced growth.

36. Medium-term growth prospects. The increased role of the mining sector will make the economy more sensitive to terms of trade shocks. The floating exchange rate will play an essential role in buffering shocks by depreciating when terms of trade fall, making other tradable goods and services more competitive. The key challenge going forward will be finding ways of increasing productivity to maintain growth in Australia’s living standards. Addressing infrastructure bottlenecks in a manner consistent with the government’s deficit reduction goals is a priority.

37. It is recommended that the next article IV consultation be held on the standard 12-month cycle.

Table 1.

Australia: Selected Economic Indicators, 2010–2014

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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. Projections are provisional based on the 2013/14 MYEFO, and will be updated after the 2014/15 Budget is released.

Fiscal balance equals revenue less expenditure, and expenditure includes net capital investment.

Data for 2013 are as of November.

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

Table 2.

Australia: Medium-Term Scenario, 2010–2018

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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. Projections are provisional based on the 2013/14 MYEFO, and will be updated after the 2014/15 Budget is released.

Fiscal balance equals revenue less expenditure, and expenditure includes net capital investment.

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

Table 3.

Australia: Fiscal Accounts, 2010/11–2018/19 1/

(In percent of GDP)

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Sources: Commonwealth of Australia 2013–14 Mid-Year Economic and Fiscal Outlook, 2013–14 Budget; and IMF staff estimates and projections

Projections are provisional based on the 2013/14 MYEFO, and will be updated after the 2014/15 Budget is released.

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 level comprises the Australian Commonwealth, state, territory 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.

Table 4.

Australia: Balance of Payments in U.S. Dollars, 2010–2018

(In billions of US dollars)

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

Australia: Balance of Payments, 2010–2018

(In percent of GDP)

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