Australia has just completed its 27th consecutive year of economic growth, with the adjustment to the largest terms of trade shock in our history and the associated huge mining investment boom running its course. The successful economic transition has occurred in the context of an open, diversified economy with a flexible exchange rate regime, liberalized capital account, flexible labor and product markets, supportive macroeconomic policies, strong institutional arrangements and robust regulatory frameworks. Economic growth is expected to be around potential in the near term. Authorities continue to pursue policies to boost potential growth, and remain firmly committed to open trade, investment and immigration. The 2018 Financial Sector Assessment Program (FSAP) underscores the strength and resilience of the Australian financial system. Stress tests highlight that Australian banks could withstand significant shocks, including the combination of a large slowdown in China with a severe correction in house prices.
Since the time of the 2018 IMF Article IV consultation in November 2018, the Australian economy has continued to perform strongly. The September quarter national accounts, despite showing softer growth than in previous quarters, reflected continued broad-based growth with household consumption, dwelling investment, net exports and new public final demand contributing to through-the-year real GDP growth of 2.8 percent. Notably, strong employment outcomes in the labor market continued in December 2018 with employment increasing by more than 21,000 and the unemployment rate falling to 5.0 percent, its equal lowest level since June 2011. Both underlying and headline inflation remain subdued, reflecting modest wage growth and continued strong retail competition and the impact of government child care policy initiatives. The Government released its Mid¬Year Economic and Fiscal Outlook (MYEFO) update in December 2018, which forecast a smaller fiscal deficit in 2018–19 than in the Budget and a return to surplus in 2019–20. Most recently, after ratifying the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (TPP-11) Australia joined Canada, Japan, Mexico, New Zealand and Singapore as part of the first group of countries where the TPP-11 entered into force on December 30, 2018.
Staff and authorities broadly agree on the outlook and risks for the Australian economy. Risks associated with Australia’s exposure to China as a result of the significant trade linkages were examined by staff1 in 2017. Results showed that spillovers to Australia in the event of a disorderly adjustment in China should be placed in the context of Australia’s relatively diversified economy and its willingness to accept the moderating influence of its flexible exchange rate and open economy. Staff also showed that Australia’s diversified economy is reliant on strongly established trading relations with the rest of Asia, both advanced and emerging countries, not just China alone, which mitigates the effects from a possible shock in China.
Labor market conditions are strong with robust employment growth, a historically high participation rate and the unemployment rate at its equal lowest level since June 2011, around the estimated level of the NAIRU. Continued strength in labor market outcomes is expected to support a gradual pick-up in wage and price growth. In Australia, as elsewhere in advanced economies, slower wages growth, inflation and inflation expectations have been a feature of the post-crisis era. In Australia’s case, the slow recovery in wages growth also reflects adjustments associated with the unwinding of high commodity prices following the terms of trade boom.
The authorities agree with staff that monetary and fiscal policy settings remain appropriate for the current economic conditions. Should an adverse external shock materialize, authorities have both conventional and unconventional monetary policy levers and significant fiscal space available to respond. The fully flexible exchange rate would also act as a buffer to certain adverse external shocks.
The accommodative stance of monetary policy is appropriately supporting stability and confidence in the Australian economy. It is also consistent with further progress towards full employment, including through reducing underemployment, and for inflation to return gradually toward the mid-point of the target. The current stance of monetary policy balances the need to support the economy in the final days of the transition to lower levels of mining investment against the risks stemming from current levels of household debt. Authorities note staff’s recommendation to provide clear guidance on the expected path of policy normalization. The Reserve Bank of Australia (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. Australia’s flexible inflation-targeting framework ensures that the RBA remains well-placed to respond to future developments.
Australia’s current account deficit continues to reflect that Australia’s strong investment outcomes are not able to be fully met by domestic savings, as is typical for resource endowed and sparsely populated countries. While Australia has a net foreign liability position, it has a net foreign currency asset position, because the bulk of Australia’s foreign liabilities are issued in, or hedged back into, Australian dollars. 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. Additionally, over the past decade Australia has tended to issue debt with longer term maturities reducing risks associated with rollover or refinancing. For these reasons, Australia’s net external liabilities have a relatively robust structure, minimizing exposure to exchange rate and other macro-financial risks, including risks associated with wholesale funding as identified in the FSAP. The current account deficit is expected to remain toward 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.
The Australian Government continues to maintain a responsible fiscal stance, while implementing its plan to lift potential growth by boosting productivity through lower taxes, targeted spending and investment in infrastructure. Consistent with the Government’s commitment to responsible budget repair, the fiscal position is projected to return to surplus in 2019–20 and continued strong fiscal discipline will ensure that these surpluses exceed 1 percent of GDP in the medium term. The Government is focused on containing recurrent spending, with average real payments growth now the lowest in fifty years. Authorities take note of staff’s suggestion of incorporating a medium-term debt anchor as a part of the fiscal strategy and will carefully weigh up this suggestion in the context of maintaining sufficient flexibility to respond to changes in economic conditions, alongside continued strengthening of the framework.
Australian authorities note staff’s advice that further increases in infrastructure spending could be considered given the IMF’s assessment of Australia’s fiscal space. The quality of investment in infrastructure is also important to deliver a boost to potential growth. The Australian Government has processes in place to facilitate high quality investment in infrastructure. Infrastructure Australia works to prioritize and progress nationally significant infrastructure projects that are underpinned by robust business cases. At the current levels of investment in infrastructure by the Commonwealth, State and Territory governments, some capacity constraints and skills shortages are emerging, which would potentially be amplified by a further lift in infrastructure spending. More broadly, Australian authorities consider that, given the current point in the cycle and as a small open economy, it is important to preserve fiscal space as a buffer to deal with significant adverse shocks should they materialize.
Australia remains firmly committed to open trade, investment and immigration. The authorities underscore their steadfast commitment to a cooperative multilateral trading framework that promotes openness over protectionism. The commencement of the TPP-11 from December 30, 2018 is Australia’s first trade agreement with Canada and Mexico and offers important opportunities to both Australia and its trading partners. 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. Australia’s free trade agreements cover 70 percent of its total two-way trade and will rise to 88 percent when current negotiations are completed.
The recent cooling of the housing market is welcome amid significant and sustained price increases in recent years and is helping to improve housing affordability. Recent falls in house prices in Australia’s two largest cities have only partly unwound the strong growth recorded in those cities: capital city housing prices remain around 40 percent higher than in 2012. In this context, authorities expect the impact of the housing correction on consumption through the wealth effect to be relatively small. In addition, the correction to housing prices is occurring in the context of strong employment growth and labor market outcomes. Underlying demand is expected to remain strong, underpinned by population growth. On the supply side, the authorities agree that further reforms are needed to planning and zoning restrictions that impede supply with long lags.
Household debt is elevated relative to incomes and has been rising as moderate growth in debt has outpaced the low growth in household incomes in recent years. Downside risks from the housing market correction are a concern and vulnerabilities associated with household debt dynamics will be monitored closely. But, household balance sheets are generally strong, housing credit growth has not been unusually strong and many households have built significant mortgage buffers including through additional repayments and the use of offset accounts (mortgage buffers have doubled since 2008). Further, the distribution of debt is skewed towards high income households, with households in the top two income quintiles holding over 60 percent of Australian household debt. To the extent that higher income households are comprised of high skill workers that may be less vulnerable to unemployment shocks, this distribution enhances debt sustainability.
The authorities consider that staff’s assessment that changes to tax policy would reduce structural incentives for leveraged investment by households represents a misunderstanding of how Australia’s comprehensive income tax system works. The ability to offset costs incurred in earning income against all sources of income (negative gearing) is a fundamental element of such a system. In no way is it concessional. The authorities note that limiting such deductions would represent a move away from a comprehensive income tax system and would run the risk of introducing higher costs and distortions into the tax system.
Australian authorities welcome the FSAP recommendations and remain committed to continued improvement to regulatory frameworks and supervision practices. Australia’s financial system remains fundamentally sound. Australian banks’ capital ratios are around 50 percent higher than a decade earlier; banks have switched to more stable funding sources and increased their holdings of liquid assets and charges for bad debts are at historic lows. Stress testing shows that banks are resilient to significant shocks.
The Australian 2018 FSAP has taken place in the midst of a significant reform agenda for the financial sector, and against the backdrop of a Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. The FSAP recommendations will be considered in the context of the broader reforms to the financial system proposed by the 2014 Financial System Inquiry (FSI) and the Productivity Commission’s review into ‘Competition in the Australian Financial System.’ A number of recommendations from the FSI have already been implemented including ensuring that banks have ‘unquestionably strong’ capital ratios, strengthening and testing the crisis management framework and moving to industry funding for Australia’s corporate regulator, the Australian Securities and Investments Commission.
In a few places, the Australian authorities believe that the assessment and recommendations could have been better grounded within the context of Australia’s governance structure and the nature of the systemic risks being faced. This would be consistent with the recent IEO evaluation that emphasized advice should be fully anchored in the local circumstances and not overly reliant on off-the-shelf “international best practice” more suited in other contexts.
In particular, Australian authorities are disappointed by the IMF’s assessment of regulatory independence where staff’s assessment does not appropriately take into account the operational context associated with Australia’s system of government. Fundamental ‘checks and balances’ in Australia’s system are designed to hold government agencies accountable to the Executive and Parliament, and ultimately to the public. These checks and balances should not be considered as compromising the operational independence of Australian regulators. The Australian authorities agree that financial sector supervisors should be equipped with the resources and powers that they need to perform their roles effectively. The Government announced additional funding for the Australian Securities and Investments Commission and Australian Prudential Regulation Authority in the 2nd half of 2018.
Australia’s approach to managing financial risks involves a high degree of collaboration across key agencies that is coordinated through the non-statutory Council of Financial Regulators2 (CFR). Individual agencies remain accountable for the policies they adopt and their operations. The transparency of CFR activities has recently been enhanced through the publication of a quarterly statement on its activities, modernization of the CFR website and expanded coverage of CFR activities in the RBA’s Financial Stability Review.
On prudential policy, caps limiting investor and interest-only housing lending have been removed because they have met the objective of strengthening resilience across the financial system. This should not be seen as a loosening of prudential policy, but rather the removal of temporary speed limits as improved lending practices have become embedded. CFR agencies have worked together in recent years to reinforce sound residential mortgage lending practices in an environment of rising household indebtedness. A broad range of tools (including many used in other countries) were considered before arriving at the set of measures that CFR agencies agreed would best achieve policy objectives. The subsequent evidence suggests that the Australian approach has been successful in managing the financial stability risks faced.
The Australian authorities appreciated the opportunity to engage in an open and constructive dialogue with the AIV and FSAP mission teams on the Australian economy and financial system.
The significant role of trade linkages between Australia and China were examined in Karam and Muir, 2018, “Australia’s Linkages with China: Prospects and Ramifications of China’s Economic Transition,” in Australia: Selected Issues, IMF Country Report No. 18/45 (also available as IMF Working Paper 18/119).
The Council of Financial Regulators is the coordinating body for Australia’s main financial regulatory agencies. It comprises the Reserve Bank of Australia, the Australian Prudential Regulation Authority, the Australian Securities and Investments Commission and The Treasury.