Public Information Notice No. 03/129

Public Information Notice: IMF Concludes 2003 Article IV Consultation with Australia

October 29, 2003

On October 22, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Australia.¹

Background

Australia's economy has continued to perform remarkably well over the past year, despite encountering major adverse shocks, including persistent weakness in the global economic environment and a sustained, severe drought at home. Real GDP growth picked up from 2¾ percent in 2001 to just over 3½ percent in 2002, led by buoyant domestic demand. The strength of domestic demand reflected an easing of monetary policy in 2001 (which was only partially reversed in 2002), further moderate fiscal stimulus during 2001/02, an improvement in the terms of trade, and a competitive exchange rate. Continued strength in the housing sector-supported by a low interest rate environment, government incentives to first-time homeowners, and perceived high rates of return on property-and a robust rebound in business investment underpinned the growth momentum in 2002. In the first half of  2003, GDP growth slowed to 1.4 percent (seasonally adjusted annualized rate), as the drought, weak foreign demand, and appreciation of the Australian dollar placed a substantial drag on exports. Domestic demand also softened.

Employment growth picked up, bringing the unemployment rate down from 6.8 percent at end-2001 to 5.8 percent in August  2003. Inflation has remained in check. CPI inflation picked up in early March 2003 to an annual rate of 3.4 percent, reflecting a temporary rise in oil prices and drought-related food price increase; subsequently, it has come back down, easing to a 2.6 percent annual rate in September 2003. Measures of core CPI inflation have remained relatively stable and within the Reserve Bank of Australia's (RBA's) 2-3 percent official target range. Housing prices continued to post strong gains, with an index of real property prices in major cities rising by 18½ percent in 2002 and some 46 percent over the past three years. After significant weakness in 2000-01, the Australian dollar has strengthened markedly over the past year and a half, appreciating by June 2003 by almost 30 percent against the U.S. dollar and by about 12 percent on a real effective basis since its low in early 2002. The external current account deficit has widened, increasing from about 2.4 percent of GDP in 2001 to 6.7 percent in June 2003.

In response to slowing growth in 2001, the RBA cut the short-term cash rate six times to a post-war low of 4¼ percent. Monetary conditions also eased as a result of the depreciating Australian dollar. As domestic demand recovered strongly, the RBA raised the cash rate by a total of 50 basis points in May-June 2002 to 4¾ percent. Subsequently, the cash rate has remained unchanged.

With the domestic and international economic environment expected to strengthen, the May 2002 Budget was intended to withdraw some of the fiscal stimulus that had been injected in the previous two years. The Commonwealth budget and the state and local government sector were projected to be in approximate balance in 2002/03. In the event, Australia's participation in the war in Iraq resulted in some unanticipated defense and security expenditures, while growth was slightly weaker than had been expected. Nevertheless, revenues proved to be surprisingly robust, and the Commonwealth budget recorded an underlying cash surplus of 1 percent of GDP in 2002/03. The May 2003 Budget forecasts small underlying cash surpluses in 2003/04 and over the medium term after the introduction of new measures including tax cuts and modest expenditure increases in the areas of defense and domestic security, health care, and higher education.

Real GDP growth is expected to slow to 3 percent in 2003 reflecting continued sluggish external demand growth, ongoing effects of the drought, and the appreciation of the exchange rate. Risks to the short-term outlook have become more balanced, with upside risks becoming more prominent given continuing strength in domestic demand and recovery in agriculture from the drought. Downside risks stem from the possibility of further weakness in external demand and/or appreciation of the Australian dollar. A sharp correction in housing prices also could have significant adverse effects across the economy.

Executive Board Assessment

Executive Directors commended the continued strong performance of the Australian economy in the face of persistent weakness in external demand and a severe drought at home. They attributed Australia's ability to generate robust economic growth with low inflation to the enhanced resilience of the economy, brought about, in turn, by steadfast pursuit of prudent macroeconomic policies and structural reforms within transparent policy frameworks.

Directors acknowledged that a number of risks cloud the economic outlook, including those generated by the uncertain outlook for external demand, the drought, rapidly rising property prices, and a sharp appreciation of the currency. However, they noted that Australia's economic fundamentals are strong, and that the authorities remain committed to sound macroeconomic management and structural reform. Overall, they judged Australia's near- and medium-term economic growth prospects to be favorable, and expected inflationary pressures to be held in check.

Directors noted that the inflation targeting framework has worked well. They considered the stance of monetary policy during the past year to have been generally appropriate, and recommended that the authorities continue to remain cautious and alert to signs of changing circumstances.

Directors considered that the rapid increase in housing prices poses a challenge for monetary policy in the near term, particularly in view of the appreciation of the Australian dollar. While agreeing that the increase in housing prices largely reflects economic fundamentals up to now, they cautioned that there may be speculative elements at work in some parts of the market, and that the authorities should continue to monitor housing market developments closely. Although monetary policy should not target asset prices, attention has to continue to be given to the impact that possibly unsustainable increases in housing prices could have on economic activity and inflation. Directors agreed that the appreciation of the Australian dollar is generally in line with its medium-term equilibrium value and is mostly due to the relative strength of the Australian economy.

Directors regarded Australia's fiscal position as fundamentally sound, reflecting the authorities' disciplined implementation of their policy framework. Directors endorsed the authorities' strategy of balancing the budget on average over the business cycle. They noted the authorities' preference to use discretionary fiscal policy in a manner that would make a lasting contribution to potential output rather than just temporarily boost demand. In this context, they noted that the very sound fiscal position provided scope for the full functioning of automatic stabilizers.

Directors noted the significant fiscal pressures that the authorities are likely to face over the longer term as a result of the aging in the population. They praised the authorities' strategy to cope with aging-related pressures. In particular, forward planning was considered preferable to delaying actions, which may lead to undesirable imbalances in the future. They also considered that the strategy outlined in the 2003/04 budget to tackle these challenges-which emphasizes raising labor force participation rates and sustaining strong productivity growth-is comprehensive and well conceived. Directors noted that the authorities are already implementing a range of measures in line with this strategy, as well as exploring other specific options for reforms. They agreed that the government may need to run somewhat larger budget surpluses than currently planned in order to build up a sufficient stock of resources to meet financing needs, particularly for comprehensive reforms in such areas as the personal income tax and the income support system.

Directors considered sound and stable macroeconomic policies and further reform of the personal income tax system to be essential elements of the authorities' strategy to strengthen growth. They concurred that, the fiscal position permitting, it would be desirable to raise further the income thresholds at which the different marginal tax rates apply, and to bring down over time the top marginal tax rate. Moreover, reductions in the personal income tax might be needed to maintain an internationally competitive tax system.

Directors agreed that a comprehensive reform of the complex system of income support would provide stronger incentives for labor force participation. They noted that the interplay between the current income support and the personal income tax system creates high effective marginal tax rates when individuals move from welfare to work. The transition to work would be facilitated by reducing these high effective marginal tax rates through further income tax reform, improved support services-including employment, job training, and child care services-and a more tapered reduction in assistance. Tightening eligibility for income support programs and instituting penalties for breach of obligations with regard to unemployment benefits would provide stronger incentives to return to employment. Directors noted that proposed changes to the industrial relations system and investment in education would also help raise labor market participation rates, enhance the flexibility of the labor market, and increase labor productivity. Directors also noted the authorities' efforts to reduce health care cost pressures, and urged the authorities to implement the announced changes to the Pharmaceutical Benefits Scheme.

Directors commended the authorities for their commitment to trade liberalization. With trade barriers to other countries not being raised, Australia's pursuit of bilateral free trade agreements was seen as supportive of the country's multilateral liberalization efforts. Directors commended the authorities for their recent unilateral decision to provide complete duty- and quota-free market access to the least developed countries. However, they encouraged Australia to further raise its level of official development assistance.

Directors noted the soundness of Australia's financial system, and they commended the authorities for the steps that have been taken to strengthen financial supervision. They welcomed the results of the recent stress tests of the housing loan portfolios of individual banks, which suggest that these institutions could safely manage a sharp decline in housing prices and avoid systemic disruptions. Directors agreed, however, that close supervision of the lending standards and information systems of financial institutions will need to be maintained. They also welcomed the steps that have been taken to strengthen supervision of the insurance industry, and they encouraged the authorities to proceed expeditiously with their planned reforms to strengthen the governance of superannuation funds. Directors commended the authorities for their efforts to combat money laundering and the financing of terrorism, noting that Australia is in full compliance with the recommendations of the Financial Action Task Force.