Australia -- 2009 Article IV Consultation Concluding Statement
June 24, 2009
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
This statement contains our preliminary policy recommendations following discussions with the Australian authorities and a range of private sector institutions. The discussions focused on the economic outlook and policies needed to cushion the domestic impact of the global recession, preserve macroeconomic and financial stability, and reduce external vulnerabilities.
1. Following a prolonged expansion, reflecting sound macroeconomic policies and favorable terms of trade, global events have slowed Australia’s economic growth well below trend. Declining commodity prices, tightening credit conditions in global capital markets, and slowing world growth have reduced activity as well as household and business confidence. However, the downturn has been milder than in most other advanced countries. This is because of strong commodity exports, a flexible exchange rate, a healthy banking sector, and a timely and significant macro policy response.
2. With growing evidence that the global slowdown would have a significant domestic impact, the RBA’s early and substantive reduction in the cash rate helped support domestic demand as the external environment deteriorated. Further, the RBA’s measures to provide liquidity and the government’s introduction of guarantees on deposits and wholesale funding enabled the financial system to continue to provide credit. In addition, the enviable fiscal position, resulting from a string of surpluses that had eliminated Commonwealth net debt, created fiscal space that allowed a sizable stimulus to be delivered.
The Outlook and Risks
3. The near-term growth outlook remains weak and highly uncertain. Real GDP is projected to decline by ½ percent in 2009, as lower commodity income, rising unemployment, and weak confidence reduce domestic demand. The recovery will likely be slow. Growth is projected to rebound to about 1½ percent in 2010, led by government spending, as households and businesses deleverage. Output will likely remain below potential for a number of years, reducing core inflation. The current account is projected to remain in deficit, with net foreign liabilities relative to GDP rising, as Australia will remain an attractive destination for foreign investment, especially in the resource sector.
4. In our view, risks to the outlook are balanced. On the downside, the world economy could take longer to recover, with significant spillovers to Australia through commodity sector incomes, external demand, and international capital markets. Domestically, a sharper than expected deterioration in banks’ asset quality, possibly stemming from lower house prices, could constrain credit and deepen the downturn. A high impact tail risk would be a decline of investor confidence in the banks or the sovereign. However, this is highly unlikely given the low level of public debt and track record of sound macroeconomic policies. On the upside, a key risk is stronger-than-expected demand from China. A further upside risk is that domestic and foreign economies could be more responsive than expected to the considerable policy stimulus currently in place.
5. The earlier reductions in the cash rate were appropriate, as is the current stance of monetary policy. The substantial fiscal and monetary stimulus in train, and some signs of recovery in consumer and business confidence, should help support domestic demand. However, if the outlook for growth and inflation weakens, the RBA has scope to reduce the cash rate further. In view of the still fragile state of the global economy, the RBA should be more cautious than normal in tightening. The return of the cash rate to neutral can wait until there are clear signs that a sustainable recovery is underway.
6. The monetary transmission mechanism has not been impaired in Australia, unlike experience in some other countries. The bulk of the reductions in the cash rate have been passed through to lending rates. Consequently, unconventional monetary policy easing measures are unlikely to be needed. But it would be prudent to consider how such measures could be implemented if required.
7. The inflation-targeting framework has proven to be a highly effective nominal anchor. Over the last several years, which witnessed the largest boom in Australia’s commodity prices in half a century, wage growth remained relatively stable, suggesting well-anchored medium-term inflation expectations. Moreover, the flexibility embodied in the target of 2-3 percent average inflation over the cycle has allowed the RBA to take a wide range of factors into account, and thereby contain the buildup of potentially destabilizing imbalances.
Exchange Rate and External Stability
8. The flexible exchange rate has proved a helpful buffer for the Australian economy. The depreciation since its peak in July 2008, driven by the decline in commodity prices and the loosening of monetary policy, has helped sustain export incomes. In addition, this has had little negative impact on the balance sheets of banks or corporates, owing to extensive hedging of currency risk. Currently, our assessment is that the exchange rate is broadly in line with fundamentals, based on a range of indicators.
9. Although the projected build up in net external debt increases vulnerability, risks are mitigated by a number of factors. These include the limited currency risk associated with foreign debt, the sound banking system, and the robust macroeconomic policy framework. Moreover, while Australia’s net foreign liabilities are sizable, gross external debt relative to GDP is lower than in many advanced countries. With relatively attractive returns to investment in Australia, owing to high commodity prices and expected strong demand from China and other Asian economies, financing of projected current account deficits should be feasible. However, more limited access to foreign capital markets than assumed would require a lower current account deficit and associated domestic adjustment. Australia’s current account deficits largely reflect higher investment rather than low saving, and should be sustainable as long as investment leads to growth in export capacity.
10. We welcome the quick implementation of targeted and temporary fiscal stimulus. The stimulus provides a sizable boost to domestic demand in 2009 and 2010 that will cushion the impact of the global recession. The transfers to households had an immediate impact on activity that helped underpin confidence. The increase in public investment will continue to support activity in the near term, while addressing infrastructure shortfalls. In addition to the stimulus measures, the weaker outlook for growth and commodity prices is projected to shift the underlying budget balance into a large deficit in the near term, which is appropriate in current circumstances.
11. There is scope for further fiscal stimulus if the outlook for growth weakens, although we would advise using monetary policy as the first line of defense. In this situation, automatic fiscal stabilizers should be allowed to work fully. If additional fiscal stimulus is deemed necessary, our analysis suggests that the impact on growth is highest for public investment spending. However, transfers targeted to low-income households have a faster yet still large impact, and could be the most appropriate measure if a prompt demand impetus is required.
12. The government’s commitment to return to surpluses and achieve a positive budget balance on average over the medium term is commendable. Few other advanced countries have adopted such a clear commitment. This commitment will be implemented with conditions in the global environment implying considerable uncertainty about Australia’s medium-term prospects. If trend growth or the terms of trade are not as high as assumed, government revenue would be impacted. In such circumstances, further fiscal adjustment would be needed to return to surpluses at a horizon consistent with the government’s medium-term objective. In particular, the growth of real spending would need to be constrained below the 2 percent annual rate envisaged in the budget, once growth has recovered. Alternatively, if revenue is higher than currently expected, an earlier return to surpluses could be achieved.
13. Although Commonwealth government debt is projected to remain low compared with other advanced economies, several factors argue for continued prudence. While the probability is extremely low, the government may need to assume additional debt on behalf of the banks should they be unable to rollover their significant short-term external liabilities. Guarantees on banks’ deposits and wholesale funding as well as state-government debt, presents an additional, although again similarly low probability risk. Relatedly, servicing government debt could become more expensive as increased global supply drives up sovereign debt yields. Returning to lower debt levels once economic growth recovers would put Australia on a firmer footing to respond to future shocks. Looking further out, while some pension and health care reform has been included in the budget, remaining longer-term pressures from aging and rising health care costs argue for more policy action.
14. State governments are projecting higher cash deficits and increased debt levels. This highlights the importance of maintaining fiscal restraint at the Commonwealth level over the medium term, given the new guarantee of state debt.
15. The Australian banking sector entered the financial crisis in a healthy position. Profitability was high, capital buffers were well above regulatory requirements, and exposure to sub-prime mortgages was very low. APRA’s proactive approach and conservative capital adequacy rules helped avoid risky lending behavior. Consequently, the major Australian banks maintained their AA credit ratings and raised equity during the turmoil. However, some vulnerabilities remain. Australian banks must continue to manage their short-term offshore liabilities that represent a significant share of their funding. On the asset side, non-performing loans have started to rise (albeit from a low base), and could rise further as unemployment increases and growth remains weak.
16. Timely and appropriate policy intervention also helped the Australian financial sector. Wholesale funding guarantees allowed for continued access to international capital markets. Guarantees on all deposits under a million dollars bolstered confidence in the financial system and RBA actions helped ensure the financial system had sufficient liquidity.
17. We commend APRA for regularly stress testing the banking sector and we advise the use of more extreme scenarios than applied in the past and the inclusion of Australian banks’ overseas subsidiaries. Prudential judgment should be used to assess the adequacy of the banks’ capital buffers, and capital requirements raised if necessary. Our preliminary analysis suggests that banks will be able to withstand potential further losses from a sizable downside shock.
18. The planned introduction of new liquidity guidelines is welcome. Recognizing the increased importance of liquidity and the rollover risks associated with short-term liabilities, banks have started to increase medium-term funding. However, future liquidity positions should be based on prudentially enforced liquidity guidelines. The stability benefits of strengthening liquidity positions and reducing rollover risks justify the likely increases in funding costs.
19. Exit strategies from the policy measures introduced during the financial crisis are, appropriately, being considered. We recognize that the risk-pricing element of the wholesale funding guarantee provides a natural exit strategy once markets normalize.
20. The ongoing work on crisis preparedness will help strengthen financial stability. Importantly, a framework is being developed to deal with liquidity or solvency problems in major banks in Australia and New Zealand, in the unlikely event that they should emerge.
* * *The IMF team has enjoyed the candid and interesting discussions. We have particularly benefited from close cooperation with the Australian authorities during the past year of global financial turmoil. Finally, we appreciate the authorities’ hospitality and thorough preparations for this mission.