Australia -- 2010 Article IV Consultation, Concluding Statement
September 28, 2010
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 pace of exit from macro stimulus, managing the mining boom, and addressing vulnerabilities related to high household and external debt.
1. Despite growth slowing due to the global financial crisis, Australia was one of the few advanced economies to escape recession in 2009. This reflected strong demand for commodities from China, a prompt and significant macro policy response, a healthy banking sector, and a flexible exchange rate. With a mining boom now driving the recovery and dissipating spare capacity, policy stimulus is appropriately being withdrawn.
2. Australia’s growing integration with emerging Asia also underpins its favorable medium-term growth prospects. However, it brings with it vulnerabilities to which policy will need to respond. The impact on Australia’s terms of trade from industrialization and urbanization in China and the rest of emerging Asia is expected to be long lived. Careful macroeconomic management of the mining boom could permanently raise household incomes in Australia. However, shifting resources to the mining sector without giving rise to inflationary pressures will be challenging. Moreover, the growing dependence on mining may amplify the business cycle, as the economy will be more vulnerable to swings in the terms of trade.
The Outlook and Risks
3. Real GDPis projected to grow by 3 to 3½ percent in 2010 and 2011, with private investment in mining and commodity exports leading the way, as the terms of trade is expected to recover to historical highs. Public investment also made a strong contribution to growth in early 2010. With the output gap forecast to close by mid 2011, inflation is projected at about 3 percent over the next three years, the top of the target range. The current account deficit is expected to narrow to less than 2½ percent of GDP in 2010 and 2011 as improved terms of trade help generate a trade surplus. However, the current account deficit is forecast to widen to about 6 percent of GDP over the medium term, as higher investment in mining results in a return to trade deficits.
4. The main risks relate to the global outlook and, in the near term, are tilted to the downside. If the global recovery stalls and Chinese demand for commodities declines, Australia’s terms of trade could fall sharply. In addition, concerns about fiscal sustainability in Europe could disrupt global financial markets and push up the cost of capital for Australian borrowers. On the domestic front, a fall in house prices could hit consumer confidence and slow the recovery, or the mining boom may have a larger-than-expected impact on output and inflation.
5. With the downturn milder than expected and growth rebounding, it was appropriate for the RBA to start withdrawing stimulus in late 2009. However, capital market turbulence generated by European sovereign debt concerns has increased uncertainty about prospects for world recovery, and the RBA paused in its policy tightening. With lending rates in Australia close to their recent historical averages and economic activity responding quickly to cash rate adjustments, the RBA has scope to wait for the outlook to become clearer.
6. Should the recovery unfold as expected, monetary policy will need to tighten further to contain inflation pressures generated by the mining boom. In determining the magnitude of the additional tightening, the RBA will need to consider two key factors. First, given the high level of household indebtedness, domestic demand is likely to be more responsive to interest rates than it has been in the past. Second, with core inflation having been above 3 percent for a number of years until recently, and inflation projected to remain close to the top of the band, the RBA needs to guard against inflation expectations becoming anchored at too high a level.
7. If global markets come under severe stress because of concerns over European sovereign debt or world growth falters, the RBA is well positioned to respond. There is ample scope to cut the policy rate and provide liquidity support for banks, which proved effective in the recent crisis.
Exchange Rate and External Stability
8. The flexible exchange rate is a helpful buffer for the Australian economy. The responsiveness of the exchange rate to commodity price fluctuations helped stabilize export incomes, while hedging of currency risk has minimized any negative impact on corporate or bank balance sheets. From a medium-term perspective, our assessment is that the exchange rate is mildly overvalued. This overvaluation is likely to be temporary and may dissipate with the eventual normalization of interest rates in the United States and other advanced economies.
9. With the current account deficit projected to widen to 6 percent of GDP over the medium term, growing external liabilities are a vulnerability. However, deficits of this magnitude should be sustainable as they are driven by investment in export capacity. While Australia’s net external liabilities are relatively high, at about 60 percent of GDP, gross external debt is lower than in many advanced countries, at just under 100 percent of GDP. Factors mitigating vulnerability include the limited currency risk, the strength of the financial system, and the robust macro policy framework. Short-term external debt remains sizable at 46 percent of GDP, but is lower than in many advanced countries.
10. The quick implementation of targeted and temporary fiscal stimulus provided important support for domestic demand, cushioning the impact of the global downturn. Additionally, the increase in public investment will continue to support activity in 2010, while addressing infrastructure shortfalls. The exit from the stimulus, which began this year, sees the budget back in surplus by 2012/13. If the recovery in Australia proceeds as expected, this pace of withdrawal is appropriate. This is faster than past consolidations in Australia and plans in most other advanced economies.
11. The automatic fiscal stabilizers should be allowed to operate fully. As the recovery proceeds, we recommend saving stronger-than-anticipated revenue to help avoid potential overheating from the mining boom. The emphasis on expenditures control in the consolidation plan places the government in a position to do so. Should downside risks associated with concerns over fiscal sustainability in Europe materialize, Australia’s fiscal position provides ample scope to allow the automatic stabilizers to operate and, if needed, temporary discretionary measures to be introduced.
12. While public debt is projected to remain very low by advanced economy standards, returning quickly to budget surpluses as the authorities intend will put Australia on firmer footing to deal with future shocks. The increased supply of sovereign debt worldwide could eventually put significant upward pressure on funding costs. Maintaining low net Commonwealth debt levels will help contain debt-servicing costs associated with the private sector’s relatively high external debt. Further, increased public saving could help contain the current account deficit.
13. Looking further out, fiscal policy needs to help manage vulnerabilities from greater integration with emerging Asia. Faster-than-expected Asian growth can quickly place significant capacity pressures on the Australian economy. Although the exchange rate would adjust and monetary policy react, allowing larger cyclical increases in the fiscal balance than have occurred historically could help moderate inflation pressures.
14. Because of the growing importance of commodity prices for the budget, it would be advisable to prepare downside scenarios where the terms of trade return quickly to the long-run average. A sharper fall in commodity prices than currently analyzed in the budget would illustrate the importance of running larger surpluses during the good times to strengthen the fiscal position. A stronger sovereign balance sheet would provide more fiscal space to cushion the impact should the terms of trade deteriorate sharply.
15. Tax reform can also play a key role in allowing Australia to take full advantage of the mining boom. On that front, we welcome the recent review of the tax system as it provides a comprehensive blue print for tax reform issues. The planned introduction of the mineral resource rent tax is a step in the right direction and enables a reduction in the company tax rate. The resource rent tax also strengthens the automatic stabilizers in the budget, but we note that it is less effective in that regard than the original proposal. Consideration should be given to broadening the coverage to other mineral resources. Another objective of tax reform should be to facilitate the reallocation of resources so that Australia can fully benefit from improved terms of trade. We would therefore welcome more reliance on consumption-based taxes. This would allow for the elimination of inefficient taxes at the state level that impede labor mobility and allow for reductions in federal personal income taxes that would encourage increases in labor supply and saving.
16. In the long term, the budget faces considerable pressure from aging and rising health care costs. Although some pension and health care reform has been undertaken, further policy action will be needed to contain the public share of costs in these areas. In addition, measures to raise labor force participation and productivity, such as those discussed in the tax review, would help address pressures on the budget.
17. Banks entered the global financial crisis in a healthy position. Prudential rules, often tighter than the minimum international standards, together with a rigorous and proactive approach to supervision helped maintain healthy and stable conditions. Banks had adequate capital buffers and followed prudent business practices based on classical on-balance sheet lending.
18. Banks remained profitable in the face of the global crisis with adequate provisioning and sound asset quality—nonperforming loans rose to less than 2 percent of assets. Capital adequacy has also improved to about 12 percent, after banks raised private capital. While sound regulation and supervision helped maintain stability, the government guarantee on wholesale funding introduced in late 2008 was also instrumental. Moreover, the Council of Financial Regulators played an important role in coordinating the response to the global crisis.
19. Challenges, however, remain as banks could become complacent while still facing vulnerabilities from high household and external debt. Having weathered the global financial crisis quite well, banks could be emboldened to pursue riskier strategies in the future.
20. The potential risks, however, are mitigated by the Australian Prudential Regulation Authority’s (APRA) intensive prudential supervision. In particular, we commend APRA’s approach to stress testing as it carefully assesses the vulnerabilities that banks face. The severity of the scenarios provides reassurance about the resilience of the banks to large but plausible shocks. Because of banks’ sizable short-term external debt, explicitly including funding risk in future stress scenarios is advisable. We welcome efforts to improve banks’ own stress testing capabilities. We would encourage APRA to review assumptions regarding probability of default and loss given default in light of recent experience in Australia and elsewhere. Further, potential risks in the mortgage sector should also be examined carefully, especially given high household debt, possible house price overvaluation, and potential volatility from the mining boom. We support APRA’s intention to extend stress testing beyond the banking system to other financial institutions such as insurance companies.
21. We welcome progress in contingency planning for liquidity and solvency problems. In particular, we commend APRA’s approach that includes closely monitoring banks’ liquidity and funding plans. Initiatives to improve crises management are welcome. The planned Trans-Tasman crisis management exercise with New Zealand is an important step to identify possible challenges in a banking crisis.
22. Short-term external liabilities of banks remain a potential source of vulnerability despite some improvement in the composition of funding. Disruptions in global capital markets could put significant pressure on Australian banks. Therefore, APRA should encourage banks to rely more on medium- and long-term debt. Moving to longer-term funding would also put banks in a better position to meet the Net Stable Funding Ratio proposed by the Basel Committee. Given banks’ sizable short-term funding, complying with this ratio could present a challenge, even if revisions provide more favorable treatment of mortgage lending.
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The IMF team has enjoyed the candid and interesting discussions and we appreciate the authorities’ hospitality and thorough preparations for this mission.