Statement by Nigel Ray, Executive Director for Australia and Laura Johnson, Senior Advisor to Executive Director, and Anna Park, Advisor to Executive Director February 21, 2020

2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Australia

Abstract

2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Australia

Australia has just completed its 28th consecutive year of economic growth. The adjustment to the largest terms of trade shock in Australia’s history and the associated huge mining investment boom has run 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.

Australia’s economic fundamentals remain sound. The economy continues to show resilience in the face of weak momentum in the global economy, as well as domestic challenges such as the devastating effects of drought and bushfires. While economic growth has slowed, a gradual recovery is expected.

Outlook and risks

Growth in the Australian economy is expected to lift from the growth rates recorded over the past two years. Activity will be affected in the near-term by the impact of the drought and bushfires, and the outbreak of COVID-19, although it is too early for the economic impact to be precisely known. The domestic outlook is supported by a modest lift in global growth as key global risks have eased following the ‘phase one deal’ between the US and China and the reduced uncertainty over Brexit. Domestically, accommodative monetary policy, recent tax cuts, solid employment growth and a turnaround in mining investment will support activity.

Labor market conditions in Australia remain strong, with employment growth outpacing population growth and, at 2.1 per cent through the year to December is running at more than twice the OECD average. Consistent with improved opportunities in the labor market, as well as continued increases in participation by women and older Australians, the headline participation rate has increased to record highs over the past year. Ongoing employment growth is expected to support a modest pick-up in wage and consumer price growth. As has been the case in other advanced economies, wage growth in Australia has been slow to respond to improving labor market conditions.

Staff and authorities broadly agree on the outlook and the risks for the Australian economy. The outbreak of COVID-19 represents a new source of uncertainty. It is too early to tell what the impact will be, but given China is a larger part of the global economy and more closely integrated, including with Australia, the international spillovers could be larger than experienced in 2003 with the outbreak of SARS. Domestically, consumption growth remains weaker than expected and continues to be a downside risk.

The bushfires and drought are also weighing on growth. Most of Australia has been affected by a severe drought. 2019 was the warmest and driest year on record for Australia. These conditions have contributed to one of the worst bushfire seasons on record. In addition to the tragic loss of life, the bushfires have caused widespread damage to public infrastructure and private property in affected regions. They have disrupted businesses, including tourism, where the full cost is not likely to be known for some time. The authorities have estimated that the bushfires will reduce Australian GDP growth by around 0.2 percentage points across the December and March quarters. The recovery effort following the bushfires is likely to reverse the negative near-term economic effects of the fires on aggregate activity. Drought conditions are likely to continue to weigh on rural production and exports and the Reserve Bank of Australia (RBA) has forecast this to reduce GDP growth by a quarter of a percentage point in 2020.

Macroeconomic policy settings

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 fiscal space available to respond. The fully flexible exchange rate would also act as a shock absorber to certain adverse external shocks.

Monetary policy was eased in 2019 and is likely to remain accommodative for some time. In recent meetings, the RBA Board has decided to keep the cash rate steady, noting that interest rates have already been reduced to a very low level and there are long and variable lags in the transmission of monetary policy. This decision also reflects a judgement about the balance between the benefits of low interest rates and the risks associated with having interest rates at very low levels. The nature of this balance can change over time and is dependent on the state of the economy. Accordingly, the RBA will continue to monitor developments carefully.

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 budget repair, the Commonwealth budget has returned to balance for the first time in 11 years, with the 2019–20 Mid-Year Economic and Fiscal Outlook (MYEFO) projecting a surplus in FY2019–20. The authorities’ strong fiscal position has enabled Australia to deal with domestic and international challenges including the devastating drought and bushfires as well as deliver personal income tax cuts. The authorities have provided significant funding to those affected by drought and are continuing to provide immediate relief to families and businesses affected by the bushfires to help communities get back on their feet including through the establishment of a A$2 billion National Bushfire Recovery Fund. The authorities have also established the National Bushfire Recovery Agency to coordinate the national response and recovery efforts and the Prime Minister has sought agreement from the states and territories for a Royal Commission into the season’s bushfires. Australia’s gross and net public debt levels remain low by OECD standards.

Banking and financial sector

Australia’s financial system remains fundamentally sound. Capital ratios for banks are high by both historical and international standards, and the implementation of the framework for loss-absorbing capacity announced by the Australian Prudential Regulation Authority (APRA) will further improve the resilience of the financial system. Insurers’ capital ratios continue to be well above their regulatory requirements. Profitability in the banking andgeneral insurance industries remains at healthy levels that are above international peers and the cost of capital.

Household debt remains high, but there are factors which reduce the potential losses for lenders. Housing debt is generally well collateralized. Three-quarters of debt is owed by households in the top 40 per cent of the income distribution, who generally have a high capacity to make repayments and are less likely to experience sustained unemployment. The tightening in lending standards for residential mortgages in recent years has appropriately improved the quality of new lending. The removal of thresholds limiting investment and interest-only housing lending should not be seen as a loosening of prudential policy, but rather the removal of temporary measures as improved lending practices became embedded.

There are potential risks from a renewed pick-up in house prices and household borrowing, which continue to be closely monitored by the Australian authorities. Through the Council of Financial Regulators, work is also ongoing to consider what tools might be available – if needed –to address systemic risks, the circumstances in which they might be suitable and any restrictions on their use. Efforts to facilitate housing supply reforms also have a role to play in containing housing price growth.

Australian banks’ funding has become more resilient over the past decade, with the share of deposit funding increasing. Wholesale debt still funds around one-third of lending activity and two-thirds of this (20 per cent of total funding) is from offshore wholesale debt markets. Australian banks use offshore wholesale funding to diversify their funding sources, access deeper and more liquid markets and borrow for longer terms than they often can domestically. While Australian banks’ relatively high use of offshore funding could in-principle create vulnerabilities, the risks are appropriately managed. Australian banks fully hedge against foreign exchange risk and mainly use the currency-hedged offshore funding to extend Australian dollar loans. Banks have lengthened the duration of their funding over the past few years, reducing risks associated with rollover or refinancing.1

Efforts to enhance the regulatory framework have continued with a renewed focus on improving non-financial risk management. Recommendations from the 2018 FSAP are being implemented as part of a significant reform agenda following the 2014 Financial System Inquiry, the Productivity Commission’s review into Competition in the Australian Financial System and the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. Actions taken by regulators have included a proposed new standard to strengthen remuneration requirements for prudentially regulated institutions and enhancing consumer protection in the financial services industry.

Australian financial regulators are also taking steps to address emerging climate risks. APRA is increasing its scrutiny of institutions’ climate risk management. The Australian Securities and Investments Commission (ASIC) has provided updated regulatory guidance on disclosure of climate-risk-related information to investors. The RBA monitors climate risks as part of its monetary policy and financial stability mandates, including by monitoring the evolving risks to financial institutions.

Structural reforms to foster strong, sustainable and inclusive growth

Australia is committed to the Paris Agreement and the need to take action to reduce global emissions, to mitigate the risk of climate change. The Australian authorities have made it clear that Australia intends to meet its 2030 commitments. Australia is a world leader in renewable energy. Australia is on track for around a third of its electricity needs being met by renewables in the early 2020s. More than 2.2 million Australian households have rooftop solar panels – the highest proportion of households in the world.

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. Public infrastructure spending is currently at very high levels and the Commonwealth Government announced a bring forward of infrastructure spending in MYEFO. 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. 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.

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. Australia remains well placed to benefit from its economic diversification and increasing integration into the Asia-Pacific region. Australia is continuing to expand its network of Free Trade Agreements (FTAs), which cover around 70 per cent of its total two-way trade, seeking to reach a target of around 90 per cent of two-way trade covered by FTAs by 2022. Australia has bilateral FTAs with key trading partners, such as China, Japan, South Korea, the US, and ASEAN nations. FTAs with Hong Kong SAR and Peru recently entered into force, the FTA with Indonesia is expected to enter into force in the first half of 2020, and the FTA with Pacific Island countries, PACER Plus, is also expected to enter into force in 2020. Australia is currently negotiating FTAs with the EU and the Pacific Alliance and has commenced bilateral discussions with the UK. The finalization of the Regional Comprehensive Economic Partnership will further integrate Australian businesses into the world’s fastest growing region which accounted for 58 per cent of Australia’s trade in 2018–19.

1

For more information, see Kellie Bellrose and David Norman (2019), ‘The Nature of Australian Banks’ Offshore Funding’, RBA Bulletin, December, pp 61–70.