The Australian economy continues to perform well in the face of one of the largest terms of trade adjustments in its history. Despite global economic headwinds and the transition underway to broader sources of growth following the mining investment boom, the economy is expected to grow at around trend supported by a flexible exchange rate, adaptive macroeconomic policies and strong institutional arrangements. But challenges remain as Australia experiences some of the symptoms of the ‘new mediocre’, in particular low business investment. The authorities have introduced policies to support business investment and they remain committed to trade, foreign investment and immigration for future economic growth.

Recent developments and outlook

After 25 years of continuous growth, the economy is forecast to grow in line with potential, at about 2¾ per cent. This is a significant achievement given the challenges associated with adjusting to the size of both the terms of trade boom and subsequent decline and amid weak global growth. The unemployment rate has trended down over recent years to stand at 5.8 per cent, around only half a percentage point or so above the non-accelerating inflation rate of unemployment, while the authorities estimate the output gap to be of a similar magnitude. While GDP contracted by 0.5 per cent in the September quarter 2016, this was heavily influenced by a confluence of one-off factors and the economy is forecast by both the authorities and the IMF to continue to grow in 2017. Over the longer term, the authorities appreciate that productivity growth will be vital for improving living standards in the face of any decline in the terms of trade and modest wages growth.

The baseline outlook is for a continued gradual recovery as the economy transitions from a mining investment boom to broader sources of growth. The majority of the decline in mining investment has already occurred, and non-mining investment has begun to grow, albeit slowly. Resource exports are expected to contribute strongly to growth as mining production ramps up following a decade of strong mining investment. Tourism and education service exports are increasing in response to the depreciation in the exchange rate since the peak in the terms of trade in late 2011. Economic activity is also expected to be supported by an increase in public infrastructure investment at both federal and state levels of government. Strong growth in dwelling construction in response to lower interest rates and firm population growth is expected to taper off.

Underlying inflation has been running at about 1½ per cent and is forecast to gradually rise over the next 1-2 years. Longer-term inflation expectations appear well anchored. Growth in wages appears to have stabilised, although at low rates, and is expected to pick up gradually over the next couple of years, in line with further improvements in the labour market.

The authorities largely agree with staff that while the balance of risks has improved, it is still tilted to the downside. A deterioration in the external sector resulting from adverse economic or political developments in larger economies is seen as a particular risk, but not one that the authorities can respond to in a more proactive manner than the policy settings already in place. Domestically, there remains uncertainty about the pace of the pick-up in non-mining business investment. Apparent risks in the housing market are currently manageable. While some segments of the overall market are experiencing rapid price gains, credit growth is not unusually strong, and the Australian household sector as a whole has built significant mortgage buffers. The authorities also agree that there is the potential for a large external shock to interact with, or even trigger, domestic risks.

Fiscal Policy

The authorities welcome the IMF’s confirmation of the current timetable to return the budget to surplus and note only small differences in path profiles. The average annual pace of fiscal consolidation across the forward estimates is 0.5 per cent of GDP. To the extent that there have been weaker-than-planned budget outcomes over recent years, both staff and the authorities agree that these have reflected weaker-than-expected nominal growth leading to weaker-than-expected revenue, rather than a policy easing. Expenditure growth has slowed, consistent with the commitment to repair the budget by controlling expenditure.

Restraining recurrent spending creates room for productive spending. The authorities have a strong commitment to supporting jobs and growth through boosting infrastructure, innovation and investment while also rebuilding fiscal buffers. The Federal Government is, for example, investing a record $50 billion in national infrastructure, including in the National Broadband Network, the biggest infrastructure project in Australia’s history. State Governments, which have predominant responsibility for infrastructure in Australia, have also increased infrastructure investment. Private investment will be encouraged through a lowering of the corporate tax rate – starting with tax reductions for small businesses – while average wage earners will remain in lower tax brackets longer through adjustments to the personal income tax thresholds.

If large downside risks materialize, the authorities will continue to take a flexible approach, prudently supporting the economy while also adhering to a longstanding medium-term fiscal framework of achieving budget surpluses, on average, over the cycle. The flexibility of the economy means that there is less benefit, and more room for error, in trying to ‘fine tune’ the economy through minor adjustments to fiscal settings. The authorities question the Staff’s suggestion that infrastructure investment be used for short-term aggregate demand management, given the lags involved. Instead, the focus is on public and private investment in infrastructure to contribute to higher potential growth.

The authorities welcome the Staff’s discussion of options for reform of Australia’s fiscal framework and the suggestion that a long-term debt anchor could strengthen the current fiscal framework. Australia has benefited considerably from its longstanding commitment to maintain a budget surplus, on average, over the course of the economic cycle. Australia has also benefited from its regular Intergenerational Reports that assess long-term fiscal sustainability. The Commonwealth Government aims to stabilize and then reduce net debt over time – currently it is expected to peak at about 19 per cent of GDP in 2018-19 before declining to around 10 per cent in 2026-27 – although the uncertainties involved in policymaking mean that care is necessary to avoid policy becoming too constrained by using a rigid debt anchor. Together, the existing tools support a long-term disciplined approach towards fiscal policy that is necessary for a capital importing country which generally runs current account deficits.

Monetary Policy

Monetary policy remains accommodative and supportive of economic growth. The decline in inflation in Australia has been much more recent and much more modest than in other advanced economies and longer-term inflation expectations remain well anchored. As such, while the neutral cash rate has declined somewhat, monetary policy has ensured that finance remains readily available to creditworthy borrowers, supporting dwelling construction and providing a platform for business investment. The RBA’s flexible inflation- targeting framework ensures that it remains well placed to respond to future developments.

The RBA will consider staff’s suggestion of lengthening its forecast horizon in monetary policy statements to help clarify its projections for longer-term inflation. More generally, the RBA will continue to ensure that the public understands its reaction function, allowing them to form their own views on the potential path of interest rates.

Financial system

The Australian financial system remains in good shape in terms of both its resilience to shocks and its ability to support real economic activity. Resilience has increased over recent years. Banks have improved their capital buffers, with the weighted average CET-1 capital ratios of the four largest Australian banks moving into the upper quartile of international peers on a comparable basis (at about 13.5 per cent as at December 2015). Banks are expected to steadily accumulate further capital as the Australian Prudential Regulation Authority continues to finalise its assessment of what constitutes ‘unquestionably strong’ capital positions. The banks have also improved their liquidity profiles by increasing the share of stable funding, including by sourcing more funds from domestic deposits and longer-term debt. Indeed, of those authorized deposit-taking institutions that are subject to the net stable funding ratio (NSFR), most already appear to broadly meet the minimum requirements which come into effect in 2018. The banks are working to maintain their profitability through an increased focus on simplifying their businesses and cutting costs, with the major banks’ return on equity currently about 14 per cent.

Lending standards will remain under scrutiny given APRA’s intensive and risk-based approach towards supervision. There has been increased attention on reinforcing sound lending standards in response to developments in some segments of the property market. Furthermore, the riskiness of existing housing loans continues to be somewhat mitigated by the sizable mortgage buffers that borrowers have built by maintaining their debt repayments above required repayments as interest rates fell. More generally, the Council of Financial Regulators will continue to monitor potential risks and take additional steps if necessary.¹ In this regard, however, the motivation behind the authorities’ actions is to improve the resilience of the economy, not to influence housing prices. They will also continue to carefully monitor commercial property lending and are working to finalize legislation to further improve their crisis management and bank resolution toolkit, in line with the recommendations of the Financial System Inquiry accepted by the Government.

The structure of Australia’s net external liabilities largely mitigates any potential macro-financial vulnerability. Australia’s current account deficit continues to reflect that Australia’s strong investment outcomes are not able to be fully met by domestic savings. Furthermore, while Australia has a net foreign liability position, it has a net foreign currency asset position, given that the bulk of foreign liabilities are denominated in, or hedged back into, Australian dollars. Indeed, despite the cost, the banking sector not only hedges its foreign currency liabilities but does so in a way that matches the duration of its hedges with the underlying liabilities. Finally, the current account deficit is expected to remain towards the low end of the range in which it has fluctuated over recent decades, and net foreign liabilities have been stable as a share of GDP over the past decade.

Structural Reforms

The authorities appreciate the importance of further reforms to boost productivity growth. With the terms of trade unlikely to return to its previous highs, improvements in productivity are essential to invigorate growth in living standards. Further reform is also important to create the conditions for stronger private investment as the weakness in non-mining investment is an aspect of the “new mediocre” that is most evident in Australia.

The authorities welcome Staff’s message that the reform agenda is appropriately focused on fostering innovation and competition. The National Innovation and Science Agenda will play a key role in supporting investment, innovation and enterprise, with its effectiveness underpinned by annual assessments. The first tranche included changing funding arrangements for some government services; the second tranche may focus on improving critical science capabilities and business investment in innovation. With regards to taxation reform, this was the focus of comprehensive analysis and national debate in 2015 and 2016, the outcome of which was a focus on lowering the corporate tax rate and adjustments to personal income tax brackets to ensure average wage earners remain in lower tax brackets for longer.

Heightened competition will be supported by the implementation of recommendations from the Harper Review into competition policy, including introducing competition, contestability and consumer choice in the provision of (largely publicly provided) human services. The Government has also initiated specific inquiries into the efficiency of the superannuation industry as well as competition in the financial system. This is on top of the changes to the financial system coming out of the Government accepting all but one of the recommendations from the Financial System Inquiry. More broadly, the Productivity Commission has been tasked with undertaking regular reviews of the nation’s productivity performance.

Australia remains firmly committed to an open economy in trade, foreign investment and immigration. Australian policymakers understand that it is in Australia’s national interest to stay the course and continue liberalizing trade. Australia remains well placed to benefit from its diversification and integration into Asia, and continues to benefit from recent FTAs with China, Japan and South Korea. In addition, Australia is developing new