Australia: Staff Report for the 2015 Article IV Consultation

This 2015 Article IV Consultation highlights that the Australia's economy is now facing a large transition as the mining investment boom winds down and the terms of trade has fallen back. Growth has been below trend for two years. Annualized GDP growth was about 2.2 percent in the first half of 2015, with particularly weak final domestic demand, and declining public and private investment. Capacity utilization and a soft labor market point to a sizeable output gap. Nominal wage growth is weak, contributing to low inflation. The FY2015/16 Budget projects a return to surplus in 2019-20.

Abstract

This 2015 Article IV Consultation highlights that the Australia's economy is now facing a large transition as the mining investment boom winds down and the terms of trade has fallen back. Growth has been below trend for two years. Annualized GDP growth was about 2.2 percent in the first half of 2015, with particularly weak final domestic demand, and declining public and private investment. Capacity utilization and a soft labor market point to a sizeable output gap. Nominal wage growth is weak, contributing to low inflation. The FY2015/16 Budget projects a return to surplus in 2019-20.

Context: The Long Boom Winds Down

After years of rapid growth, Australia’s outperformance is fading with a soft real economy, a maturing financial cycle and slowing potential growth

A strong track record…

1. Australia has outperformed its peers for the past two decades:

  • GDP has grown twice as fast as its peers (averaging 3¼ percent since 1998), without a technical recession for 25 years.

  • Per capita income has grown rapidly and stood at U.S. $61,000 in 2014—among the highest in the world.

  • The fiscal position compares well to advanced economy peers with net debt only 15 percent of GDP compared to 79 percent on average for G20 advanced economies.

2. A boom in global demand for resources and migration have supported growth. From the early 2000s, strong growth in China led to an unprecedented rise in Australia’s terms of trade and a resources investment boom. The resources sector expanded to around 10 percent of GDP, and accounted for close to half of GDP growth in the past three years. Net migration has contributed to a rapidly growing population, at 1½ percent a year, among the highest in the OECD.

3. The strong performance is also the product of sound policies and frameworks. The flexible exchange rate facilitated the shift in resource allocation to the resource sector and contained import price inflation during the investment boom. A flexible labor market helped accommodate the shift in employment to resource and related sectors without undue pressure on wage or price inflation. Credible monetary policy, strong institutions, sound financial sector supervision, and prudent and transparent fiscal frameworks fostered a strong business environment.

A01ufig1

Australia has outperformed

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: Haver Analytics and IMF staff calculations.Note: Area refers to the difference of min and max of real GDP per capita for EU, UK, US, Japan, Canada, and New Zealand.

…but the real economy has hit a soft patch and is facing a large transition…

4. Growth has been below trend for two years. GDP grew by 2½ percent in the year to 2015 Q1, with particularly weak final domestic demand, and declining public and private investment. And a recovery in non-resource investment is only gradually coming through. Capacity utilization and a soft labor market point to a sizeable output gap.

5. The economy is facing the largest swing in the terms of trade for 150 years. The anticipated increase in the supply of resource commodities has been accompanied by sharper than expected falls in prices, in part reflecting slowing growth in China. Resource export volumes have continued to ramp up despite tumbling prices as Australian producers (especially iron ore) are very competitive with low marginal costs. Resource equity prices have fallen back, but since the mining companies have globally distributed shareholdings, the effect on profits is spread between Australia and abroad.

6. With lower terms of trade, the economy has suffered falling incomes and unemployment has risen. Real net national disposable income per capita has been flat or falling in the past four quarters. Unemployment has settled at a decade high of 6 percent (now above major advanced economy peers such as the US and the UK). Employment though has held up better than might have been expected, resulting in weak nominal wage growth, and contributing to low inflation.

A01ufig2

A difficult transition from the mining investment boom

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: ABS; ANZ; and IMF staff calculations.

7. Recent interest rate cuts have yet to fully feed through to the broader economy. With subdued inflation pressure and weakening outlook, the Reserve Bank of Australia (RBA) has cut its already accommodative policy rate by a further 50bps since February. While housing investment has picked up strongly, consumer confidence indicators are around average and investment expectations remain muted. Business conditions and capacity utilization have begun to pick up in recent months. Consumption growth has been moderate, reflecting weak income growth, although the household saving rate has begun to fall back from a high level.

8. The exchange rate has depreciated but is still on the strong side. While iron ore prices have fallen by more than a third and Australia’s commodities prices are down 25 percent since mid-2014, the real effective exchange rate was only 6 percent lower in June. Recent movements appear to be driven by shifts in the global economy—U.S. dollar appreciation, euro/yen depreciation and market volatility due to developments in China and Greece (see Box 1), coupled with still attractive Australian yields. Although the current account deficit narrowed to 2.8 percent of GDP in 2014 as mining-related imports declined, it is expected to widen in 2015 as export prices fall, and the net international liabilities position widens (Box 2 and Annex II).

A01ufig3

Commodity prices fall more than AUS$

(Percent change since June 2014)

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Australian Market Reaction to China and Greece Events

Market reaction to recent Greece/China developments has been relatively muted and in a direction that would help support activity.

  • The exchange rate depreciated further against the U.S. dollar and in nominal effective terms.

  • Long term bond spreads moved in a narrow range.

  • Wholesale markets were unaffected.

  • Ground lost on equities in early June (mainly resources and retail) was largely recouped by late July.

  • The iron ore spot price has fallen back since June. It fell steeply to a low of $44 in early July partly influenced by developments in the Chinese equity market but also because of an inelastic supply response to a seasonal slowing of demand.

A01ufig4

Australian Market Reaction to Recent China/Greece Events

A$/US$

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

A01ufig5

Australia: AUS/US 10-Year spread

(Basis points)

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

A01ufig6

Australia All Ordinaries Index relative to S&P 500 Index

(Index, June 1, 2015=100)

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

A01ufig7

Australia Iron Ore Spot Price Index

(USD/DMT)

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

External Sector Assessment

Australia has run a current account deficit for much of its history and has a negative IIP position. Official reserves are relatively small at 4½ percent of GDP, but with a strong commitment to a floating exchange rate there is less of a need for reserves and banks’ external liability positions are either in domestic currency or hedged. Previous external sector assessments have pointed to an external sector position that is moderately weaker than warranted.

A01ufig8

Current Account Balance and IIP

(% of GDP)

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Source: IMF, World Economic Outlook.

Since the summer of 2014 a confluence of large external shocks have affected the current account outlook—(1) sharply falling commodity export prices and terms of trade, (2) a decline in oil prices, and (3) large bilateral exchange rate movements for the U.S. dollar, euro and Yen, all with different effects on the current account:

  • Lower commodity export prices are partly offset by the continued ramp up in export volumes resulting in a moderate decline in export values. Since the profits from Australian resource companies are globally distributed, the net income deficit stays at around 2 percent of GDP.

  • Lower oil prices have a mild positive effect on the trade balance (net oil imports of 2 percent of GDP). But LNG prices have also declined as they are linked to the oil price with a lag. Over the medium term as Australia becomes a larger exporter of LNG, this effect will begin to dominate.

  • Bilateral exchange rate movements. The Australian dollar has depreciated sharply against the U.S. dollar but by a smaller amount in nominal and real effective terms (down 9 percent from a recent peak). While this should help boost the competitiveness of non-resource exports—and there are signs that services exports are picking up—the real exchange rate still looks high relative to the decline in the terms of trade.

  • Lower mining investment is contributing to a fall in capital goods imports and together with the depreciation should moderate import growth.

In 2015 the current account deficit is expected to widen to 3½ percent of GDP as the fall in resource exports outweighs the other developments. Over the medium term the current account deficit should remain contained at around 3½ percent of GDP as the trade balance narrows and the income deficit widens as global interest rates normalize and mining income accruing to foreign investors rises. The main effects on the domestic economy are reflected in the increase in the net exports contribution and the positive effect on rebalancing of growth from the lower exchange rate (see Outlook).

Staff assess that the external sector position remains moderately weaker and the real exchange rate moderately stronger than warranted by fundamentals. Model-based approaches in the IMF’s External Balance Assessment for 2014 together with the trends through to May 2015 suggest that the real exchange rate appears overvalued by 0-15 percent and the current account is sustainable and looks around 0-1½ percent weaker than implied by medium-term fundamentals and desirable policies globally and domestically. The depreciation since June has narrowed the exchange rate gap a little. The strength of the Australian dollar may reflect the attractiveness of Australian assets with continued strong capital inflows, likely related to a global search for yield, and extraordinary monetary easing in the major advanced economies. Policy tightening in other advanced economies or monetary easing in Australia could result in a further depreciation, which would narrow the external imbalance and support the transition to non-resource based growth.

9. Fiscal consolidation has become more difficult and public debt is rising, albeit from a low level. Lower export prices and weak wage growth are denting nominal tax revenues and unemployment is adding to expenditures. This together with a lack of political support for some measures (changes to family benefits and smaller measures amounting to 0.4 percent of GDP by 2017/18) is making consolidation targets difficult to achieve. The national deficit is estimated at around 3 percent in 2014/15, broadly unchanged from 2013/2014. The May 2015/16 Budget projects a return to surplus in 2019-20. Public debt has been rising since the global financial crisis, although it remains substantially lower than in most advanced economies (Figure 5).

…and the financial cycle is maturing

A01ufig9

The path to consolidation is more difficult

Consolidated General Government Fiscal Balance (% GDP)

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: ABS, Commonwealth and State/Territory Treasuries, IMF staff estimates and projections.

10. The financial and real sectors are at different stages of the cycle. The output gap and the financial cycle have diverged since the peak of the mining investment boom in 2012. Low interest rates have helped push up asset prices and more interest sensitive sectors whereas the real economy has softened.

  • In line with global developments, long-term bond yields have fallen over the past eighteen months, notwithstanding some reversal since April.

  • Equity prices have continued to rise driven by financials, and despite the fall back in the resources sector.

  • House prices are booming in Sydney, but the picture varies greatly across the country. Overall house price inflation is close to 10 percent, but is around 16 percent in Sydney (Box 3).

  • The commercial and property development sectors, which are highly cyclical, are now turning down.

A01ufig10

Stylized cycle: high asset prices/soft real economy

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

11. There are no signs of a generalized credit boom. Overall credit growth has continued at a moderate pace, picking up to 5.9 percent (y/y) in June. While credit to GDP is rising, this reflects weak nominal growth rather than rapid credit growth. However, housing credit is rising at a faster pace, 7.3 percent in June, led by investor credit at 10.9 percent, and accounting for almost half of all housing credit growth.

Are Australian House Prices Overvalued?

International comparisons persistently signal warnings. The level of real house prices and the house price to income ratio is high relative to the OECD average (though similar to other buoyant markets). House price inflation picked up to 7-10 percent in 2014-15—driven by rapid increases in Sydney and to a lesser extent Melbourne (prices in the resource states have fallen back in recent months). While foreign investment in real estate has increased, the main driver has been local investor lending and interest-only loans. Sydney house price to income ratios are much higher than for other cities at around 7—similar to Auckland, London, Stockholm and Vancouver.

Can the increase in house prices be explained?

  • The housing market and financial system have changed significantly over the past two decades with a shift to low inflation, low nominal interest rates and financial liberalization which loosened credit constraints. Households’ borrowing capacity increased and they moved to a higher steady state level of indebtedness and higher house prices relative to incomes.

  • Supply side constraints may also keep prices high. Although Australia is big, much of the country is remote and the population is concentrated in a few cities where there are geographical or other barriers to expansion. Population growth has also been much more rapid than for other OECD countries, whereas housing investment as a share of GDP is only at OECD average levels. Supply bottlenecks also reflect planning issues and transport restrictions.

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Supply is constrained… Big country but much of it remote

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Image sourced and modified based on: Families in Regional, and Remote Australia, Institute of Family Studies, Factsheet March 2011, Jennifer Baxter, Alan Hayes and Matthew Gray. Data Sources: Accessibility Remoteness Index Australia 2006 GISCA, The University of Adelaide, Australian Government Geoscience Australia and Bureau of Statistics.

Are high and rising prices a problem? There has been no generalized credit boom and lending standards are generally high (and being tightened), so financial stability risks seem contained. The run-up in house prices has also not been accompanied by a construction boom (unlike Ireland and Spain). But with already high debt and house prices, rapid house price inflation raises the risk of a sharp reversal, which would damage the macroeconomy.

Do models point to overvaluation? Estimating overvaluation is inherently difficult. Rather than relying on one model, staff used four different approaches.

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House price valuation: fundamentals and supply

Index

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

  • Statistical filter. Deviations from an HP filter suggest overvaluation of about 5 percent.

  • Fundamentals. The standard model used in the Fund, estimated since the early 2000s, with fundamental explanatory variables—affordability, incomes, interest rates, and demographics—estimates overvaluation of around 15 percent and equilibrium growth rates around 3-4 percent.

  • Including supply factors. A model using similar long-run fundamentals, but adding credit and the housing stock to take into account supply constraints, points to an overvaluation of around 8-10 percent.

  • User costs. Estimates of user costs (whether it is more expensive to own than to rent) suggests that renting is about as costly as buying a house based on average real appreciation since 1955 (Fox and Tulip, 2014). However, this estimate is highly sensitive to interest rates and expectations of future house price appreciation. Using a plausibly lower expected appreciation term results in an overvaluation of 10-19 percent.

Bottom line: House prices are moderately overvalued, probably around 10 percent. The problem is concentrated in Sydney and is fuelled by investor credit and interest only loans. Current rates of house price inflation imply rising overvaluation.

A01ufig13

House price valuation: user costs (%), Fox and Tulip (2014)

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

12. Buoyant housing investor lending has prompted regulatory action. The Australian Prudential Regulation Authority (APRA) adopted a gradual and targeted approach and advised banks in December 2014 that it would focus on higher risk mortgage lending (interest only and high loan to income or value ratios), reining in growth of investor lending above 10 percent a year, and strengthening loan serviceability tests (by increasing interest rate buffers and floors). Failure by banks to take action would trigger more intense supervisory action, potentially including additional capital requirements. The Australian Securities and Investments Commission (ASIC) is reviewing whether mortgage lenders’ interest-only lending complies with their responsible lending obligations. Banks have responded since mid-2015 by reducing discounts on investor lending, curtailing high loan to value ratio loans and tightening interest only lending, though these are yet to be reflected in lending data given preapproval lags of 2-3 months. Separately, in response to the findings of the Financial System Inquiry, APRA announced that capital adequacy requirements for large banks using the internal risk based ratings approach would be increased (see Box 7).

13. Political setting. The Liberal-National coalition is more than half way through its term in office with the next federal election due by January 2017. The coalition has a majority in House of Representatives but not in the Senate.

Outlook And Risks: Negotiating a Difficult Transition

“We are now witnessing the largest fall in the terms of trade since records began…,”

Treasurer Hockey, December 2014

A. Outlook: A cyclical pick up; but weaker medium-term prospects

Medium Term Forecasts (calendar year) 1/

article image

Data sources: Staff projections, RBA Monetary Policy Statement (May 2015), Treasury Budget 2015 (May 2015), and Consensus forecasts from Consensus Economics Inc. (June 2015).

Fiscal year; e.g. 2015 represents FY 2014-15.

Annual average for IMF, Treasury, and Consensus; end of period for RBA.

14. Growth should pick up through 2016.

  • Net export volumes rise despite lower commodity prices. In the baseline with growth in China moderating to a safer and more sustainable rate, Australian iron ore producers continue to ratchet up export volumes, as they remain competitive even at current lower prices and can displace less competitive producers. LNG exports also come on stream, with Australia set to become the world’s largest exporter. And services exports improve with the lower exchange rate.

  • Investment contributes to growth in the short run. Though resource investment is scaled back further, residential investment continues to grow and business investment gradually turns around as improvements in business confidence and rising capacity utilization feed through. The recovery is supported by strong corporate balance sheets, the weaker exchange rate, historically low interest rates and contained wages pressure.

  • Consumption growth remains restrained in the near term with low wage growth, and more muted income expectations—as the financial cycle matures and house price inflation slows. But it improves further ahead, underpinned by rising confidence, a drawdown of the savings ratio from high levels, and a pickup in income growth following the stabilization of the terms of trade.

15. Inflation stays in line with the RBA’s target of 2-3 percent. Inflation expectations are well anchored. Tradables inflation rises as the effects of the exchange rate depreciation pass through and oil prices stabilize. But non tradables inflation remains relatively contained, dampened by weak wages growth.

16. But Australia’s outperformance is likely to fade in the medium term. Medium-term potential growth is likely to be around 2½ percent rather than the 3¼ percent of the past, bringing per capita GDP growth back to the advanced economy average of around 1 percent.

17. The financial cycle is likely to decelerate. The policy rate is expected by markets to eventually begin rising, while inflation remains well anchored in line with the target of 2-3 percent. Banks are likely to raise capital ratios (Box 4). Growth of lending for housing, the bulk of total lending, is likely to slow as house price inflation moderates partly in response to higher interest rates. This, combined with high household debt, and fiscal consolidation picking up, may all slow the closing of the output gap.

A01ufig14

Growth outperformance ending

(Real GDP per capita annual growth, %)

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

A01ufig15

Potential output growth is slowing

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Macro-financial Outlook

With a large financial sector, high household debt, and much of household wealth in housing, assessing Australia’s economic outlook requires integrating macro-financial variables into the macroeconomic framework.

  • House prices. The baseline projection is for a soft landing, with house price inflation slowing to a sustainable 3-4 percent, based on medium-term fundamentals. This implies no change in the estimated overvaluation and housing market risks thus remain heightened.

  • Household debt. Projected increases in house prices would raise nominal household debt, but income growth should gather pace, resulting in the debt ratio initially rising before falling gradually.

  • Credit to the private sector is assumed to grow as a weighted average of house price increases and business investment. This results in slightly slowing growth. However, combined with deposits staying broadly constant as a share of GDP, this results in no further reduction in banks’ use of wholesale funding.

  • Bank balance sheets. Slower growth in risk-weighted assets is expected to reduce profitability somewhat. Following the increase in mortgage risk weights in 2016 (see paragraph 13), the CET1 capital dips to 9 percent but then rises to around 10 percent through profit retention. Further increases could be achieved by reducing dividend payout ratios.

Historical relationships between house prices, credit, and activity help check the consistency of macro projections. For example:

  • Credit and activity: Historically, credit and GDP have shown a strong positive relationship, which appears to have flattened recently. The projections are based on this flatter relationship. The projections for private consumption and household credit, as well as non-housing investment and business credit, are in line with recent historical relationships.

  • House prices and activity: The projected path of dwelling investment and house prices is somewhat higher than implied by the recent past, but it broadly reflects the current strong momentum in housing construction and record high housing approvals. The private consumption growth forecast is also somewhat stronger than suggested by recent experience and reflects a continued gradual moderation of the current high household savings rate.

  • House prices and credit: The growth of housing credit (for owner occupied houses) is projected in line with what recent house price inflation and housing credit growth would suggest.

A01ufig16

Rising interest rates, moderating house price growth

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

A01ufig17

Household debt ratio rises then falls

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

A01ufig18

Credit/GDP relation has shifted

(% growth)

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

B. Risks Skewed Downwards: Payoffs from Active Policies

18. Housing and China risks loom. While Australia’s overall vulnerabilities are low, several distinct downside risks could interact and exacerbate the impact on the economy (Risk Assessment Matrix).

A01ufig19

Downside risks could interact

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

  • Persistently weak domestic demand. Non-resource demand could be slower to pick up (for example, due to a weak transmission of monetary policy to consumer demand and business investment) and further terms of trade falls could entrench slower growth, higher unemployment and fiscal deficits, especially if there is reform inertia, and in a scenario where there are global deflationary forces and/or falling house prices.

  • Housing market hard landing. Current efforts to rein in riskier property lending might not be sufficiently effective. Against a backdrop of already high house prices and household debt, this could give rise to price overshooting and excessive risk taking. A sharp correction in house prices, possibly driven by Sydney, could be triggered by external conditions (e.g., a sharper slowdown in China or a rise in global risk premia, Box 5) or a domestic shock to employment. This might have wider ramifications if it affects confidence. The house price cycle could be amplified by leveraged investors looking to exit the market and a turning commercial property cycle. Though currently small, investors in self managed superannuation funds that have added geared property to their fund portfolios would also be adversely affected in a downturn. In a tail scenario, APRA’s stress tests (Box 8) suggest banks would probably face ratings downgrades/higher offshore funding costs and would likely resist capital ratios falling into capital conservation territory by sharply tightening credit conditions, thus transmitting and amplifying the shock to the rest of the economy.

Balance Sheet Risks—Housing and Foreign Borrowing

The composition of an economy’s assets and liabilities can help to illustrate likely resilience to financial shocks and identify vulnerabilities. It can also highlight the main transmission channels of risk. For Australia the key issue is:

  • Net liability position with the rest of the world. Throughout its history Australia has been a capital importer with an overall net liability position with the rest of the world. This reflects very high private investment relative to a savings rate that is already high by international standards. As a result, the net liability position has ranged from 50 to around 60 percent of GDP since 1994. This could give rise to vulnerabilities were the rest of the world to become much less willing or able to lend to Australia. However, these vulnerabilities are substantially mitigated as most liabilities are Australian dollar denominated whereas the majority of foreign assets are in foreign currency, leaving Australia with a net foreign currency asset position. The banking sector, which has a net foreign currency liability position, is fully hedged. The balance sheet would thus improve rather than worsen in the face of a sudden Australian dollar depreciation.

The main transmission channels are:

  • Banks’ use of external funding. Households could be vulnerable in the face of a foreign funding induced shock; especially given a high level of household debt, much of which is at a floating interest rate—higher funding costs would likely be passed on by banks to households which may stretch the capacity to repay though currently households have mortgage buffers (two years debt service).

  • Other financial institutions. The growth of superannuation funds is increasing households’ exposure to changes in equity wealth, and away from other, possibly more stable, forms of saving (e.g. bank deposits).

  • Non financial corporate sector has a net liability position with other sectors and with the external sector but has a small net foreign currency asset position. Large private non financial corporations (global resource sector conglomerates) typically finance themselves abroad and profits are globally distributed.

  • Strong public balance sheet with a small negative net financial worth. The government is a AAA borrower, and borrows in domestic currency. The public sector, RBA and the Future Fund have net foreign currency asset positions.

Balance Sheet Matrix

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  • Two key external risks could trigger or amplify these risks.

    • China. A sharp growth slowdown accompanied by market volatility, and/or fall in property investment, could lead to a further large fall in demand for Australia’s commodity exports. Over half of Australia’s exports go to emerging Asia and nearly two thirds are non-rural commodity exports. An unexpectedly sharp fall in iron ore prices could reduce prices below production costs, and further dent incomes and growth. It would also likely dent foreign investment in Australian property and other markets, adversely affecting prices.

    • Tighter or more volatile global financial conditions. An orderly QE exit in the United States would likely have a positive impact on Australia by weakening the exchange rate and fostering the recovery of the non-resource sector. However, a bumpy exit, or Euro Area turbulence could raise volatility and wholesale funding costs, and this could be amplified by low market liquidity. This could be passed on to mortgage lending costs, resulting in a real estate downturn.

19. These are partly offset by upside risks. With supportive monetary policy, possibly accompanied by productivity-enhancing reforms, business investment and domestic demand could pick up more than in the baseline, creating virtuous feedback loops with the labor market, household confidence and spending. A sharper decline in the real exchange rate could boost export competitiveness and improve investment prospects. Growth in middle-income Asia could also turn out stronger than expected, adding to demand for Australian services exports.

20. There is policy space to cushion downside risks. Targeted prudential actions could potentially help to engineer a soft landing of the housing market similar to in the early 2000s. Should downside risks materialize, the RBA has scope to ease policy further and low government debt allows more supportive fiscal policy, including through discretionary recurrent stimulus if needed. Foreign exchange intervention could also be employed in times of market dysfunction as it was during the global financial crisis.

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Spillovers

21. Risks could potentially spillover to neighboring economies. New Zealand is Australia’s most important trade and financial partner, and is vulnerable to a sharp slowdown in Australia’s economic prospects. Australian bank subsidiaries make up 90 percent of New Zealand’s banking system. As subsidiaries rather than branches however, New Zealand banks are 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 access to offshore wholesale funding. Statutory obligations underpin cross-border cooperation between the two countries, strengthening regulatory and supervisory oversight. With a common labor market, net migration between the two countries is also important—and as Australia has slowed, net migration to New Zealand has turned positive.

22. Trade and financial linkages would also result in spillovers to the Pacific Island Countries (PICs). Spillover channels vary across the PICs. Australia accounts, on average, for 20 percent of PICs’ trade, while tourist arrivals from Australia account for about 50 percent of total arrivals in Fiji and Vanuatu. Remittances from Australia represent around 35 percent of the total in Fiji, Samoa, and Vanuatu. Financial linkages are also important with the PICs’ banking sector dominated by Australian banks. Australia is also by far the largest aid donor—and its aid budget has been reduced—as well as the largest foreign investor.

Authorities’ Views

23. Economic conditions were in place to generate a gradual strengthening of growth supported by highly accommodative monetary policy settings. The economy was considered to have performed solidly in the context of an unprecedented fall in the terms of trade and the associated waning of the resources investment boom. The recent decline in the exchange rate would help the transition to stronger and more balanced growth although a further depreciation would assist. Weak income growth was weighing on domestic demand, although moderate wages growth was also supporting employment and the economy’s growth transition. The timing of the anticipated strengthening of growth in the non-mining economy was uncertain and the authorities viewed the possibility of a sharper than expected slowdown in China as the main external risk, while noting that the floating exchange rate plays a key role in cushioning the economy against such shocks.

24. Housing prices were rising but the risks should not be overstated. Accommodative monetary policy had supported strong demand for housing, raising house prices and increasing dwelling construction, contributing to the economy’s transition to broader-based growth. Rapid house price growth was concentrated in Sydney and only limited market segments of Melbourne, but there was no evidence of widespread oversupply and most mortgage holders had accumulated sizeable repayment buffers. The coordinated policy actions announced by APRA in December 2014 were taking effect (see paragraph 50). There remained policy space to respond to risks that materialize—and it would be used actively if needed to contain the likelihood of an adverse event.

Policies to Re-Energize Growth

Reinvigorating the outlook requires policymakers being on the front foot to enable Australia to make the most of its considerable potential. This means:

  • Sustaining aggregate demand in the shorter term through the resource cycle transition

  • Lifting productivity in the longer term to sustain strong income growth

  • Building resilience and reducing the macroeconomic and financial vulnerabilities that could throw the transition to broader-based growth off course

A. Sustaining Aggregate Demand Through The Resource Cycle Transition

“Monetary policy alone can’t deliver everything we need and expecting too much from it can lead, in time, to much bigger problems”

RBA Governor Stevens June 2015

Context

25. The sizeable output gap and the large structural transition of the economy call for supportive aggregate demand policies. Inflation pressures are weak and the demand outlook is subdued against a backdrop of higher unemployment and lower income growth. The exchange rate also appears still on the strong side when compared with the steep fall in the terms of trade.

26. Monetary policy is accommodative, and could become more so. While the policy rate is at an historic low at 2 percent, it remains high in real terms compared to peer countries with similar output gaps and the neutral rate may well have fallen. Further rate cuts would, however, stoke house price inflation and already high household debt levels may restrain the impact on consumption while heightening financial stability concerns.

27. Fiscal policy is imparting a substantial negative impulse. The combination of tightening by the States and the Commonwealth implies that the national cyclically-adjusted balance improves by some ¾ of a percent of GDP on average over the next three years. The envisaged tightening by the Commonwealth budget relies on historically strong revenue (reflecting bracket creep) and low spending growth (including on account of some as yet unlegislated budget measures).

A01ufig20

Policy rates higher than elsewhere

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Staff Views

28. Monetary policy should remain accommodative and could loosen further if the recovery falls short of expectations, provided financial stability risks remain contained.

  • Asymmetric risks for monetary policy—inflation expectations are well anchored and core inflation and growth appear more likely to under- rather than over-shoot. A weaker exchange rate would also help the recovery and the external position.

  • Housing market risks should be firmly addressed by prudential policy. While credit growth and the housing market overall do not appear substantially overheated, there are clearly specific areas of concern relating to the Sydney housing market, and to investor and interest-only lending. This calls for a targeted prudential rather than a blunt monetary policy response. Indeed, APRA is already taking targeted measures which could be built upon if needed (see Building Resilience).

  • Policy tradeoffs. Cutting rates if the recovery disappoints would provide insurance against a sharper slowdown, though it may require a steeper tightening once the economy gathers steam. By contrast, keeping rates higher than warranted by output and inflation should only be considered if financial stability risks become broad based—with overheating of both credit and housing indicators—and if prudential policy is insufficient to contain risks. Then “leaning against the wind’ might be appropriate as part of a broader prudential strategy to rein in financial stability risks. The benefits would need to be weighed against the output costs and the risk of policy reversals. Similarly, prudential measures aimed at building the resilience of the financial system should be implemented in a gradual manner to minimize the effects on growth.

  • Timely high frequency data are important for policy to be able to react quickly to changing conditions. The quality of the labor market data could be enhanced and the lack of monthly consumer price inflation data is a key gap that the Australian Bureau of Statistics should fill.

29. Slowing the pace of fiscal consolidation. A small surplus should remain a longer-term anchor of fiscal policy and a credible, though gradual medium-term consolidation path should be maintained. But, staff assesses the planned pace of consolidation nationally (Commonwealth and states combined) as somewhat more frontloaded than desirable given the weakness of the economy, the size and uncertainty around the transition from the mining investment boom and the possible limits to the effectiveness of monetary policy.

Substantial fiscal consolidation in the next 3 years

article image

30. Boosting public investment. Raising public investment (financed by borrowing, thus reducing the pace of deficit reduction) would support aggregate demand, take pressure off monetary policy, and insure against downside growth risks. It would employ resources released by the mining sector, catalyze private investment, boost productivity, could ease housing supply bottlenecks and would take advantage of record low interest rates. Net public investment in Australia is higher than in advanced OECD peers, but has subtracted from growth in recent years, and the public capital stock is projected to fall as a percentage of GDP over the medium term. At the same time, Australia is well positioned to benefit from public infrastructure investment—with efficient processes, an output gap, accommodative monetary policy and fiscal space allowing debt financing. These are key factors for maximizing the short- and long-run benefits with little effect on the debt to GDP ratio, as outlined in the WEO (October 2014).

31. Careful coordination would be needed. Boosting public investment in the short term is difficult given inherent lags, and thus calls for strong governance to ensure there is no waste. As most public investment is carried out by states and territories who face borrowing constraints, this requires coordination between different levels of government and broader federal support. Greater focus in budgeting on the national fiscal stance, on strengthening the operating balance (which excludes capital spending) rather than the overall balance, and on increasing the public capital stock, could help frame the debate. A strategy could include:

  • Small as well as large projects. Broadening the scope of investments supported by the Commonwealth, for example, to a wider range of projects, including repairs and maintenance.

  • A pipeline. Continuing to establish a pipeline of quality larger projects with transparent cost-benefit analysis, such as that being prepared by Infrastructure Australia. Broad political support for such a pipeline would reduce uncertainty and boost confidence.

  • Guarantees. In addition to direct funding arrangements, the Commonwealth could consider guaranteeing states’ borrowing for additional investment—this would keep the accountability with the states, but reduce their concerns about credit ratings and would not affect the Commonwealth’s deficit.

32. Nonetheless, restoring a small budget surplus in the longer term is appropriate and should remain a fiscal anchor. Australia’s low public debt is a critical buffer against potential external and domestic shocks and helps sustain the country’s AAA rating, and the strong ratings of its banks. Indeed, additional measures may be required to ensure the envisaged consolidation of the recurrent budget stays on track.

Authorities’ Views

33. The authorities agreed that growth was likely to continue at a below trend pace in the near term but improve as the economy rebalances.

  • The RBA noted that with an output gap, subdued labor costs and inflation expected to remain in line with the target of 2-3 percent on average, there was scope for further policy easing in the period ahead if required. But there was also a limit to the extent to which monetary policy could fine tune growth prospects. Exchange rate developments would also be key; a lower real effective exchange rate was likely to be needed to achieve balanced growth. An exit from unconventional monetary policies in the U.S. could contribute to a lower Australian dollar and help facilitate adjustment.

  • The government emphasized that a return to a budget surplus remained a priority to preserve its favorable standing with external creditors. The 2015/16 budget already planned a slower withdrawal of fiscal stimulus than the previous budget. They were also mindful that challenges were looming in light of social spending commitments over the longer term which could limit the scope for easing the pace of consolidation. They concurred that addressing infrastructure bottlenecks was a key priority and funding of high quality infrastructure projects was a key focus. They also pointed to substantial existing planned investments, including the national broadband network, with total general government investment over coming years expected to remain above levels of the 1990s and early 2000s. The authorities’ Asset Recycling Initiative and Northern Australia Infrastructure Facility provided scope for additional investment in high priority infrastructure projects as they are identified, while meeting the government’s medium-term fiscal strategy.

B. Lifting Productivity and Income Growth

“We are in our 24th consecutive year of economic growth. We cannot take for granted another decade of economic growth, we have to earn it.”

Treasurer Hockey, December 2014

Context

34. The drivers of growth—1990s structural reforms and the mining investment boom—have now waned. Maintaining the same growth rate and rise in incomes will be challenging.

  • While population growth will continue to support output growth, labor force participation is likely to decline. The participation rate has fallen back from a peak in 2010 to 64.7 percent in 2014-Q4 and is expected to decline slightly over the medium term as aging pressures emerge.

  • Productivity has lost ground. Australia, like other economies, benefited in the 1990s from the global impact of technological progress in information and communications technology and the effect of Australia’s structural reforms came through. Though better than the OECD average, growth in output per hour has slowed since the mid 2000s and a productivity gap has opened up against best-performing peers.

A01ufig21

Labor participation has declined

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Source: Haver Analytics and IMF staff calculations.
A01ufig22

Some lost ground on productivity

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: OECD Productivity Database, and staff calculations.
A01ufig23

With a slowdown in TFP

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: ABS 16-Market Sector Gross Value Added (GVA) based MFP and GVA data; and IMF staff calculations. Contributions to GVA-based MFP growth are calculated by weighting sector MFP growth by share in gross value added.
  • Slower productivity growth partly reflects the long investment lags for mining. Since the early 2000s, mining investment, the impact of drought on agriculture and utilities, and high profits in mining which led to the mining of marginal deposits, resulted in a slowdown in total factor productivity growth. Productivity in the mining sector is rising as exports come on stream. But this is likely insufficient to maintain per capita income growth—productivity growth in other sectors will need to rise (Box 6).

Income Growth Likely to Slow

Australia’s potential growth is likely to be lower than in the past. Based on a standard production function framework, potential growth is estimated to slow to 2.8 percent over 2016-17, further declining to 2.6 percent over 2018-2020, driven by moderate input and slowing TFP growth (see Selected Issues Paper “Sustaining Income Growth in Australia” for details). This is slower than the estimated historical average of around 3.2 percent over 1990-2014.

As a result, income growth will be weaker. Gross domestic income growth (adjusting for terms of trade movements) is projected to slow from an average of 3.5 percent over 1990-2014 to 2.8 percent in the medium term. Raising gross domestic income growth to its historical average would require TFP growth between 1½ - 1¾ percent on average, nearly 80 percent more than the baseline projection

The distance from the efficiency frontier shows scope to improve efficiency and boost TFP. For example, bridging half the TFP gap between U.S. and Australian TFP levels across sectors over 10-15 years would imply potential growth in the 3-3¼ percent range. Recent IMF research also shows that improved cross-sector allocation of inputs in advanced economies could boost TFP levels on average by 7-9 percent assuming optimal adjustment over 10 years.

A01ufig24

Disposable income growth will weaken significantly

(Real net national disposable income per capita growth; average)

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Source: ABS data; and Staff calculations.

Staff Views

35. To sustain growth at the rates of the past, TFP growth needs to accelerate. It would need to reach about 1½ percent per year (almost double staff’s baseline projections) to maintain GDP and per capita income growth in line with historical trends over the medium term. This requires an ambitious reform agenda.

36. Low hanging fruit already harvested. Raising TFP will not be easy as Australia has already benefited from sizeable productivity improvements following the 1980-early 2000s reforms. While there are no clear game changers, the distribution sector, covering both transport and domestic trade, suggests most scope for catching up to the global TFP frontier. The Competition Policy Review recommended many reforms to strengthen competition and improve efficiency, including in human services and the retail sector. Improving infrastructure investment would relieve bottlenecks, as would reducing housing supply constraints (which critically require more responsive planning and zoning). The recent trade agreements should also help.

A01ufig25

Scope to raise TFP in some sectors

Comparative TFP Levels by Sector (Normalized; 100 - frontier)

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: IMF SDN/15/03; from EU KLEMS, GGDC Productivity Level database.

37. Though politically challenging, fiscal reforms can help raise potential growth substantially and generate revenue. A recent IMF study estimated the per capita growth impact of previous fiscal reform episodes could be around ¾ percentage points on average, though it is difficult to disentangle the effects of fiscal from other types of reform initiated at the same time. The Tax and Federation Reviews provide the opportunity to craft a package to boost labor supply and investment which should include the following interconnected elements:

  • Shifting toward more efficient and simple taxes. Key goals would be to prevent a large share of individual taxpayers from facing higher tax rates through unchecked bracket creep (which would affect those on lower and middle incomes most); reduce the corporate tax rate to international levels; and eliminate stamp duties and minor taxes. This would be paid for by broadening the base of the goods and services tax (GST)—receipts from which are low by international standards—and possibly raising the rate, while at least fully compensating those on lower incomes through lower income taxes and higher transfers, as well as increased reliance on a broad-based real-estate tax and excises.

  • Reducing incentives for potentially excessive financial investment in housing. As the Financial System Inquiry notes, the concessional treatment of capital gains tax in real estate and the exemption of owner-occupied housing for the calculation of the Age Pension incentivizes overinvestment in housing and negative gearing, significantly pushing up demand and real estate prices. This is reinforced by the deductibility of interest payments and maintenance expenses for rental properties from taxable income from other sources (though rental income is taxed). Reducing the concessional treatment of capital gains and the deductibility of housing investment losses from other taxable income (which facilitates negative gearing), and capping the exemption of owner-occupied housing for the calculation of the Age Pension would likely improve housing affordability and financial stability.

  • Ensuring fairness. Australia’s system of superannuation savings incentivizes retirement saving where contributions and earnings are taxed, but at concessional rates, and pension payouts are tax-free. The system is complex and disproportionately benefits higher-income earners. Aligning tax rates on contributions closer to personal income tax rates would reduce concessions for higher earners and enhance revenue and could improve housing affordability and financial stability. Adjusting pension policies in particular would need careful calibration and phasing.

A01ufig26

Australia has low VAT revenue

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: OECD, Deloitte.
A01ufig27

Investor Housing Is Boosting House Prices

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: APRA, RBA, IMF estimates.

38. Adjusting federal-fiscal relations. Federal-state fiscal relations will likely need to be adjusted to facilitate the tax reform. There are many options—one could be for states to receive higher GST revenue and autonomy in return for greater spending responsibilities. This could also help increase spending efficiency. More generally, greater coordination of the fiscal policy stance between the Commonwealth and States could facilitate macroeconomic management.

Authorities’ Views

39. Achieving a return to strong nominal income growth would require continued focus on productivity enhancing reforms. The Treasury projected potential growth at close to 3¼ percent a year, supported by strong population growth, a rising participation rate, and an assumption that labor productivity growth in line with historical experience. Total factor productivity growth was likely to pick up now that the export phase of the mining boom had been reached. However ongoing effort to deliver productivity enhancing reforms would be required to achieve the growth rates in national income achieved in the past. The comprehensive reforms of the 1980s-early 2000s made a major contribution to Australia’s past productivity performance and, the productivity gap in some sectors relative to the global frontier offered scope for catch up. Over the longer term, external demand for goods and services from a rising middle class in Asia would help boost potential growth. Recently concluded free trade agreements with China, Japan and Korea would help as well. Unlike other economies, where multifactor productivity growth was inhibited following financial system dislocation, this was not the case for Australia. Nonetheless, declines in global productivity growth would have implications for Australia, further highlighting the importance of domestic reform efforts to sustain growth in living standards.

40. The authorities thought that competition, tax, workplace relations and federal relations reforms could play an important role in raising economic efficiency. There were review processes currently underway examining these issues. Any changes to the tax and superannuation system would also need to have regard to Australia’s already highly-progressive tax and welfare arrangements and ensure that they take account of investment decisions people have already made in good faith on the basis of existing policy.

C. Building Resilience

“[Banks’] capital levels should be raised to ensure they are unquestionably strong. Evidence from banks, regulators and others suggests that Australian banks are not in the top quartile of large internationally active banks. Regulatory changes in other countries may further weaken the relative position of Australian banks.”

Financial System Inquiry final report, November 2014

Context

41. Australia’s financial system weathered the global financial crisis well, aided by flexible monetary policy, a strong fiscal position, and prudent supervision. The major banks are highly rated and profitable compared with peers. Recent performance has been strong with a low level of non-performing loans, a decline in funding costs and reliance on external borrowing, and higher capital ratios.

42. But the financial system faces long-standing structural vulnerabilities. The four major banks are systemic with broadly similar business models. As a capital importer, exposed to terms of trade shocks and with a still relatively high proportion of offshore wholesale funding (though significantly reduced since the GFC and at extended maturities), the economy is vulnerable to changes in international investor sentiment. Residential mortgages account for a large proportion of banks’ assets and household leverage is high.

43. The rise in capital ratios of the major four banks may not be a reflection of lower financial stability risks. Since 2008, as in many other countries, much the improvement in capital ratios for large banks (with internal risk based ratings) has been driven by a shift in banks’ loan books toward housing and a lowering of mortgage risks weights. This has led to a wide divergence between the risk weights attached to mortgages between the big and smaller banks. It may also encourage lending for housing rather than to business.

44. The Financial System Inquiry (FSI) concluded that more should be done to strengthen the system’s resilience. The Inquiry (Box 7) argued that Australia needed to be better placed than other economies given its structural vulnerabilities, with a strong public balance sheet remaining a critical backstop, and the banks should have unquestionably strong capital levels and sufficient loss absorbing capacity to mitigate risks.

A01ufig28

Higher capital ratios reflect housing and risk weights

Banks tier 1 capital ratio, changes in risk weights and proportion of mortgage lending

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

The Financial System Inquiry

The Inquiry published its findings in December 2014. Key recommendations included:

  • Set capital ratios such that Australian banks are “unquestionably strong”. The Inquiry argued that this would be equivalent to aiming for bank capital ratios that are in the top quartile internationally. While acknowledging that comparisons are difficult, given differences in both capital measurement and risk weighted assets, the Inquiry used a schematic to demonstrate a range which estimates where Australian banks current CET1 ratios lie on an internationally comparable basis (10-11.6 percent) and where they would need to be to be in the top quartile internationally (12.2 percent and upwards).

  • Raise average mortgage risk weights for banks using internal ratings based models. In July, APRA announced an increase in average mortgage risk weights for these banks from around 16 to at least 25 percent by July 2016. This is equivalent to an 80 basis point change in the CET1 ratio. The increase is an interim step pending the finalization of the Basel Committee’s review. The change narrows the difference in capital adequacy requirements between banks using IRB and standardized approaches.

  • Report transparently on capital ratios against Basel minimum capital framework.

  • Introduce a leverage ratio that acts as a backstop to banks’ risk-weighted capital positions.

A01ufig29

Australian banks’ CET1 capital ratios below global 75th percentile

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: Financial System Inquiry, APRA, Australian Bankers’ Association (ABA) and Basel Committee on Banking Supervision Based on December 2013 global data

APRA’s subsequent study confirmed that, on an internationally comparable basis, Australian banks’ CET1 ratios would be around 300 basis points higher on average—this would place them above the median of international peers, but not in the top quartile as proposed by the Inquiry. Furthermore, to achieve a position in the top quartile for a range of capital adequacy measures, Australian banks would require significantly higher capital ratios. To be comfortably positioned in the top quartile, APRA noted that the major banks would need to increase their capital ratios by at least 200 bps relative to the June 2014 position.

Staff Views

45. To strengthen financial system resilience, building “unquestionably strong” bank buffers is a welcome goal. The particular vulnerabilities—housing, concentration and offshore funding—can transmit shocks from the financial system to the wider economy with spillback effects on the financial system. The housing and commercial property markets are prone to cycles and a large house price decline would hit the real economy hard. APRA’s stress tests (Box 8) note that while bank capital remains above the 4½ percent solvency ratio in an adverse scenario “it is unlikely that Australia would have the fully functioning banking system it would like in such an environment.” Avoiding this scenario with a high degree of certainty would likely require capital ratios substantially higher than 9 percent currently.

APRA Stress Tests

In November 2014, APRA conducted a stress test of the Australian banking system, focused on housing. APRA considered two severe tail macroeconomic stress scenarios, developed in collaboration with the Reserve Bank of Australia (RBA) and the Reserve Bank of New Zealand (RBNZ).

  • Scenario A: House price bust. A housing market decline, prompted by a sharp slowdown in China. In this scenario, Australian GDP growth declines to -4 percent, unemployment increases to over 13 percent and house prices fall by a cumulative 40 percent.

  • Scenario B: Higher interest rates. In the face of strong growth and emerging inflation, the RBA raises the cash rate significantly. Global growth weakens and a sharp drop in commodity prices leads to increased uncertainty and volatility in financial markets. This leads to higher unemployment and higher borrowing in Australia and a significant fall in house prices.

A01ufig30

APRA Stress Tests: CET1 ratios fall sharply

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

1/ Capital conservation buffer reflects D-SIB surcharge effective January 1, 2016.

Results. In each scenario banks face higher funding costs and credit losses, with a significant adverse impact on profitability and capital ratios. Losses on residential mortgages account for around one-third of total credit losses. The aggregate Common Equity Tier 1 (CET1) ratio falls by around 3 percentage points from 8.9 percent (though all banks remain above the minimum CET1 capital requirement of 4.5 per cent). Losses are greater than the capital held for housing for the internal ratings based risk weight (IRB) banks and almost all banks would use capital conservation buffers and face constraints on dividend and bonus payouts. Even though CET1 requirements are not breached, the head of APRA concluded that “it is unlikely that Australia would have the fully-functioning banking system it would like in such an environment. Banks with substantially reduced capital ratios would be severely constrained in their ability to raise funding (both in availability and pricing), and hence in their ability to advance credit. In short, we would have survived the stress, but the aftermath might not be entirely comfortable”

46. Gradually building higher capital and loss-absorbing capacity would reduce the risks from a highly concentrated banking system. Even after taking into account the strengths of Australia’s prudential system (and conservative measurement of capital), banks appear to have capital above the median internationally but not in the top quartile of banks. Other economies facing similar risks are taking a variety of different measures to boost capital and tighten risk weights (Hong Kong, Sweden and Switzerland)—the global trend is towards higher capital. Options to increase capital include:

  • Higher risk weights. Risk weights on mortgages are at historically low levels. Other jurisdictions (such as Sweden) have introduced risk weight floors for residential mortgages. APRA’s move to raise average risk weights for IRB banks is therefore welcome. Australia’s relatively conservative loss given default of 20 percent should be retained.

  • Pillar 2. APRA can require adjustments to capital above the minimum level after reviewing an institution’s risk profile, management and mitigation strategies to address systemic and concentration risks. Such Pillar 2 adjustments could be used to raise capital ratios for the major banks (and could be reduced in an adverse scenario).

  • Counter-cyclical capital buffer. Use of the countercyclical buffer could help both slow excessive risk buildup in an upswing and cushion the impact on the real economy in the downswing. From 2016 APRA could set a countercyclical buffer at a rate of 0-2.5 percent (others such as Norway and Switzerland have already imposed a positive rate). Application of the buffer could be warranted in the current conditions of a mature financial cycle, though the decision to activate it would need to go beyond the strict credit-gap approach and should include scope for discretion and judgment.

  • Higher D-SIB surcharge. This would provide higher loss absorbency. The minimum D-SIB surcharge of 1 percent seems on the low side, especially as a number of other countries with similar banking sector characteristics (Norway, Sweden) have applied much higher surcharges. However, a drawback of using the D-SIB surcharge is that since the minimum requirement rises, the capital conservation buffers would be quickly reached in an adverse scenario and banks may restrain lending before they hit these buffers, as they may be concerned about the market reaction if they use them.

  • A higher leverage ratio should complement higher capital requirements. It would serve as backstop, consistent with the substantially higher capital ratio thresholds and it would be useful in containing both ratings drift and the potential for lending to shift to lower-risk weighted housing loans. A leverage ratio at the upper end of the 3-5 percent suggested by the FSI would seem be appropriate.

Other jurisdictions have higher capital and risk weights

(In percent)

article image
Note: Definition of variables differs across jurisdictions which makes comparison difficult.

Includes systemic buffer of 3 percent.

47. The benefits of raising capital gradually over time are likely to outweigh the costs which are low. The major Australian banks are exceptionally profitable, enjoy a funding cost advantage derived partly from implicit government support, earn larger net interest margins than smaller domestic banks and international peers, have high price-to-book ratios, pay out high dividends, and are not balance-sheet constrained in providing credit. Lowering dividend payout ratios to international norms would comfortably allow building substantially stronger buffers over time at little or no cost to the economy, especially if done at a gradual pace.

48. Addressing emerging housing market risks. While investor lending is still rising strongly some months after APRA flagged its program of enhanced attention, staff expects APRA’s measures to begin to take effect and be reflected in slower credit growth in the second half of 2015. However, should investor lending growth or house price inflation fail to slow appreciably, the authorities would likely need to intensify their targeted approach with options including:

  • Higher risk weights for investor/interest-only lending, perhaps targeted by geography (e.g., just Sydney, similar to those recently introduced in New Zealand), could also be considered.

  • Capital. While APRA elevated its intensity of supervision with the measures adopted in December 2014, additional Pillar 2 capital requirements should be considered for large players that are still expanding their investor lending portfolios rapidly.

  • Interest only loans. A maximum interest only period could be considered to reduce the repayment risk from these types of loans.

  • Tax system. In the context of a broader reform of the tax system, incentives that give rise to the high degree of household and bank exposure to housing should be reduced.

Authorities’ Views

49. The authorities agreed that higher capital would be beneficial to increase the resilience of the financial system. They supported the findings of the FSI to make banks “unquestionably strong” and APRA was taking this forward. Any changes would need to be line with evolving international standards and commensurate with the risks. Regulatory changes would need to be gradual and the stability of policy settings was also an important goal to minimize unnecessary costs. Capital raising actions needed to take into account that APRA already imposes more conservative requirements compared to most other countries and that they also adopt an intensive supervisory approach. Nonetheless, recent stress tests and the FSI suggested that more needed to be done to strengthen banks’ capital ratios to ensure they were unquestionably strong and so that they could withstand severe economic stress and maintain their supply of new credit to the economy. APRA is currently considering what action to take, they are monitoring the calibration of the D-SIB surcharge in the context of industry and international developments.

50. The key areas of risk from investor lending, particularly in Sydney, were being addressed and contained. The authorities’ emphasized that the acceleration in investor lending had led to a gradual and targeted response, and that the effects of this were beginning to show with banks reducing or eliminating discounts for some borrowers. Banks have also tightened mortgage serviceability tests in response to increased supervisory focus on this aspect of their lending practices. As a result, investor credit growth was expected to slow in the second half of 2015, but this also did not rule out Pillar 2 actions if individual banks failed to rein in investor lending. They also pointed to a wide range of legal powers that enable direct action where there are threats to financial stability. APRA generally prefers to adopt a suasion approach when it identifies weaknesses in lending standards, with communication with the management and boards central to the approach. Coordination is conducted through the Council of Financial Regulators which includes the Treasury and 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.

Staff Appraisal

51. Outlook. Australia has outperformed its peers for the past two decades driven by a boom in the global demand for resources and supported by sound policies and frameworks. But the waning resource investment boom and sharp fall in the terms of trade have brought this outperformance to an end. A cyclical recovery is likely in the near term as net exports improve and accommodative monetary policy supports investment. But potential growth is likely to fall over the medium term, reflecting weak productivity growth.

52. Risks. While Australia’s vulnerabilities are low, the risks are skewed downwards. Domestic demand could pick up more slowly than expected, a house price correction could knock confidence and demand, and external risks—a sharper China slowdown or more volatile global financial conditions—could trigger or amplify these risks. But on the upside, domestic demand could respond more quickly to recent monetary policy stimulus, and the exchange rate could depreciate further, stimulating the tradable sector. There is also policy space to cushion downside risks.

53. Policy agenda. The weaker outlook can be avoided. Australia has strong institutions, a flexible economy, and is well placed to seize opportunities created by Asia’s rapid growth. Reinvigorating the outlook requires policymakers being on the front foot to enable Australia to make the most of its considerable potential.

54. Sustaining demand through the resource boom transition. The output gap and large structural transition of the economy call for supportive aggregate demand policies.

  • Monetary policy. Given the sizeable output gap and subdued inflation, monetary policy should remain accommodative and stand ready to ease further should the recovery fall short of expectations and provided financial stability risks remain contained.

  • Fiscal policy. A small surplus should remain a longer-term anchor of fiscal policy. But staff assesses the planned consolidation as somewhat more frontloaded than desirable. Boosting public investment would support demand, take the pressure off monetary policy, and insure against downside growth risks. This would need careful coordination between different levels of government and broader federal support.

55. Lifting productivity to sustain strong income growth. Maintaining income growth at past rates requires higher productivity growth. This could be achieved with an ambitious reform agenda.

  • Many targets, no silver bullets. There are few low-hanging fruit, but a range of reforms have been identified. The Competition Policy Review recommended reforms to strengthen competition and improve efficiency in the human services and retail sector. Addressing infrastructure needs would relieve bottlenecks and housing supply constraints. The recent trade agreements should also help.

  • Though politically challenging, fiscal reforms can help. The tax system should shift towards more efficient taxes, while ensuring fairness, including by preventing personal income tax bracket creep and reducing the corporate tax rate, paid for by higher GST revenue.

56. Building resilience. Implementing the recommendations of the Financial System Inquiry should be a priority and prudential policies should continue to aim at addressing housing market risks.

  • Raising bank capital. While sound and profitable, Australian banks do not appear to have particularly high capital ratios, and they would require significantly higher capital in a severe adverse scenario to ensure a fully-functioning system. Raising mortgage risk weights will help, but capital ratios need to be increased substantially to ensure banks are “unquestionably” strong. The benefits of raising capital over time are likely to outweigh the costs, which are low.

  • Housing market risks. The regulator has taken appropriately targeted action to address areas of risk in the housing market. But if investor lending and house price inflation do not slow appreciably in the second half of the year, these policies may need to be intensified.

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

Figure 1.
Figure 1.

Following Two Decades of Strong Performance, Growth Has Slowed

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: Haver Analytics; Econdata; ABS; and IMF staff calculations.
Figure 2.
Figure 2.

Current Account Improving After End Of Mining Investment Boom

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: Haver Analytics; IMF, World Economic Outlook; ABS; RBA; and IMF staff calculations.
Figure 3.
Figure 3.

Financial Cycle Maybe Peaking

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: OECD; Reserve Bank of Australia; Australian Prudential Regulation Authority; Reserve Bank of New Zealand; BIS; Haver Analytics; and IMF staff calculations.
Figure 4.
Figure 4.

Monetary Policy Faces a Dilemma

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: RBA; Haver Analytics; and IMF staff estimates.
Figure 5.
Figure 5.

Strong but Deteriorating Public Finances

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: Commonwealth and State/Territory Treasuries; 2014-15 Budget; IMF, World Economic Outlook; and IMF staff estimates and projections.
Figure 6.
Figure 6.

Banking System Remains Strong

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: Bankscope; RBA; APRA; Financial Soundness Indicators; and IMF staff calculations.
Figure 7.
Figure 7.

Financial Market Indicators: Equity Market Propped up By Financial Sector

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

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

Interconnections and Spillovers

Citation: IMF Staff Country Reports 2015, 274; 10.5089/9781513543239.002.A001

Sources: ABS; APRA; RBA; IMF, Direction of Trade Statistics; BIS; and IMF staff calculations.
Table 1.

Australia: Main Economic Indicators, 2010-2020

Annual Percentage change (unless otherwise indicated)

article image
Sources: Authorities’ data and IMF staff estimates and projections.

Calendar year.

Table 2.

Australia: Fiscal Accounts, 2009/10-2019/20

(In percent of GDP, unless otherwise indicated)

article image
Sources: Authorities’ data and IMF staff estimates and projections.

Accrual basis; GFS. Comprises the Commonwealth, and state, territory, and local goverments.

Includes Future Fund assets.

Excludes general revenue assistance to states and territories from revenue and expenditure.

Excludes Commonwealth payments for specific purposes from revenue and expenditure.