2012 Article IV Consultation with Australia -- Preliminary Concluding Statement
September 20, 2012
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.
Overview. The authorities’ current macroeconomic policy stance is appropriate. With expected inflation within the target range, the strong Australian dollar, and given efforts to return the budget to surplus this year, monetary policy should remain accommodative, and should act as the first line of defense against near-term adverse shocks. The authorities’ fiscal consolidation path strikes a balance between the need to limit both public and external debt increases while containing any adverse impact on economic growth. The financial sector is sound, and the authorities should continue to ensure that banks’ liquidity and capital buffers are adequate given banks’ usage of offshore wholesale funding, their exposure to highly indebted households, and the systemic importance of the large banks.
Outlook and Risks
Developments. The Australian economy has been growing faster than most advanced countries. GDP growth accelerated from 2½ percent in the second half of 2011 to 4 percent in the first half of 2012, driven by growth in private domestic demand and exports. Investment, in particular mining-related construction, expanded strongly. Consumer spending grew in line with solid household income growth. However, growth has been uneven, with rapidly expanding resources and related sectors contrasting with slow growth in many other sectors, held back by the high Australian dollar, household and corporate deleveraging, low consumer and investor confidence, changed consumer patterns and subdued expectations for future asset price increases. The labor market has performed well in international comparison, but employment growth has recently slowed CPI inflation has eased with underlying measures of inflation remaining near the bottom end of the 2-3 percent target band.
Outlook. The outlook for the aggregate economy remains favorable, primarily driven by domestic private demand. We project growth of around 3¼ percent this year, broadly in line with potential. New natural resources-related investment is expected to reach a record level with large projects already committed or under construction. On the other hand, with an appreciated Australian dollar, uncertain global environment, and sluggish housing construction, investment outside of the resources sector is likely to remain weak in the near term.
Risks. Fundamentals have improved since the global financial crisis; household and business balance sheets have strengthened and banks have reduced their use of foreign funding. Nevertheless, vulnerabilities remain. Risks are tilted to the downside and are primarily external: the risk of financial and economic fallout from an intensification of the European debt crisis and a hard landing in emerging Asia, especially China, possibly compounded by a sharp decline in commodity prices. Turmoil in the international financial markets remains a concern as Australia’s banks will continue to use overseas wholesale funding. Domestically, despite a recovery in the household savings rate and a recent softening of house prices, high household debt coupled with elevated house prices remains a vulnerability. A potential fall in commercial real estate prices is also a risk.
Tail risks and downside scenarios. Many of the above risks are closely linked, and the importance of the resources sector to Australia’s near-term outlook makes it vulnerable if a downside global scenario materializes. For example, a hard landing in China would reduce demand for Australian mineral exports, worsen terms of trade, reduce household income, and could trigger a fall in house prices. This could in turn weaken consumer demand and growth, and negatively affect banks’ balance sheets. However, we consider this type of risk escalation to be a relatively low probability event.
Managing risks. The authorities have the monetary and fiscal policy space to respond to near-term shocks, with monetary policy serving as the first line of defense. The Reserve Bank of Australia (RBA) has the scope to lower interest rates and loosen monetary conditions to help buffer against a downside scenario. As evident during the global financial crisis, the free-floating Australian dollar provides an additional cushion against external shocks, including disruptions to offshore funding and a negative terms of trade shock. The authorities would also be able to provide emergency liquidity support to banks, a measure which proved effective when wholesale markets shut down in the wake of the 2008 crisis. Moreover, Australia’s modest public debt gives the authorities scope to delay their planned return to surplus and let the automatic stabilizers operate in the event of a sharp deterioration in the economic outlook.
Near-term Challenge: Keeping the Economy on an Even Keel
Monetary policy. We see the RBA’s monetary policy stance as broadly appropriate, given the sizeable fiscal adjustment and the absence of inflation pressure, and factoring in higher bank funding costs, the appreciated exchange rate, and modest overall lending growth. Our analysis suggests that the cash rate is compatible with underlying inflation (excluding the carbon price effect) gradually rising to the mid-point of the RBA’s 2–3 percent inflation target in 2013.
Fiscal policy. The government has made returning to surplus by 2012/13 a major policy priority. To reach this target, the government expects a rebound in receipts by 1½ percent of GDP and cuts in spending by about the same amount. Much of the adjustment will occur as receipts catch up with output growth which should help mitigate the impact of the planned fiscal consolidation on aggregate demand. In addition, unlike many other advanced economies, Australia’s monetary policy space is still sizable and output is close to potential. These conditions suggest that the fiscal multiplier could be lower than in other countries undergoing fiscal consolidation, mitigating its negative impact on output. Given these factors, we estimate that the contractionary impact of this budget will be less than would be suggested by the headline deficit reduction of 3 percent.
Further on macro policies. We support the authorities’ move toward a policy-mix that combines a tighter fiscal policy with an accommodative monetary policy stance, which will help ease pressure on the exchange rate. The fiscal consolidation is consistent with a policy setting where monetary policy plays the primary role in managing demand. The RBA’s high degree of credibility and the rapid monetary policy transmission in Australia allow for a more nimble response should growth circumstances change. We support the authorities’ strong commitment to a freely-floating exchange rate—a flexible rate has historically provided the economy with an important buffer, particularly to fluctuations in global commodity demand. The government’s planned fiscal consolidation will produce a desirable reduction in net government debt. Given that there are advantages to maintaining a stock of gross debt, the authorities should begin considering a framework for the management of public sector assets.
Safeguarding Financial Sector Stability
Background. A Financial Sector Assessment Program (FSAP) Update was conducted in conjunction with the 2012 Article IV consultation. Countries with financial sectors that are considered systemically important, such as Australia, must undertake a mandatory stability assessment every five years. The FSAP finds Australia’s financial system to be sound, resilient, and well-managed. Capital ratios are increasing and the banks are well-placed to meet Basel III capital requirements in line with the authorities’ accelerated timetable for implementation. On the asset side, banks have shifted the composition of their portfolios towards assets with lower risk weights, such as mortgages, and holdings of liquid assets have increased. Banks have also shifted toward more stable funding sources since the financial crisis—strong deposit growth has contributed to a decline in their use of wholesale funding, and the share of funding needs met by short-term debt has fallen.
Risks. At the same time, the banking system remains highly concentrated and interconnected. The four major banks are systemic, with broadly similar business models, and their use of wholesale and off-shore funding, even at reduced levels, remains a risk. Residential mortgages are the banks’ single largest asset but household debt is high and house prices are elevated. However, these are long-standing structural issues that will remain sources of risk over the medium-term, and several factors, including relatively low household leverage, mitigate this risk. Stress testing indicates that the major banks are adequately capitalized and are likely to withstand large macroeconomic shocks, but would require RBA liquidity support to withstand an extreme funding shock. The sector faces the prospect of slower credit growth as businesses and households continue to deleverage, and could take on riskier strategies in an effort to return to pre-crisis credit growth rates and maintain profitability. To further bolster financial system stability against these risks, we recommend that the authorities continue to emphasize intensive bank supervision and introduce higher loss absorbency for systemically important banks. We support ongoing efforts to implement recovery planning requirements for large and medium-sized banks, and would recommend that the authorities also introduce resolution planning.
Maintaining External Stability
Background. Australia’s terms of trade peaked in 2011, pushing up the real effective exchange rate further and narrowing the current account deficit to 2¼ percent of GDP. Since then the terms of trade have fallen by 10 percent as of June 2012, driven by sharp declines in export prices for iron ore and coal. However, in recent months the Australian dollar has remained high despite lower commodity prices and the weaker global outlook, in part related to portfolio reallocations of large reserve holders toward Australian government debt. We expect the current account deficit to widen this year to 4 percent of GDP as import volumes pick up, especially for capital goods, possibly reaching 6 percent by 2014.
External sector assessment. Much of the widening of the current account deficit is a natural counterpart to mining-related investment which will expand export capacity in the future, and is mostly financed by foreign investment rather than through borrowing from domestic banks. In these circumstances, a strong Australian dollar plays a necessary role in reallocating domestic resources towards mining away from other tradable sectors, accelerating structural change. Nevertheless, we estimate that the exchange rate is currently stronger than would be consistent with this adjustment alone, and at its current level, if continued, would result in a further increase in non-mining related net foreign liabilities going forward. There are however a number of factors contributing to the current high level of the Australian dollar, including the relative strength of the Australian economy, the gap between domestic and foreign interest rates and to some extent increased portfolio investments into Australia. If these factors were to ease, the exchange rate would likely depreciate, reducing the current account deficit over the medium term and limiting the reliance of banks on borrowing abroad. The government’s fiscal consolidation should also ease pressure on the exchange rate by boosting national saving, and additional steps to limit the projected decline in private saving, such as the planned increase in superannuation contributions, are appropriate.
The Challenge of Economic Structural Adjustment
New phase of the mining boom. While Australia is an advanced services-oriented economy, the resources sector will remain a key driver of economic growth in the near term. Commodity prices may have peaked but are expected to remain at high levels, given strong demand from ongoing urbanization and industrialization in emerging Asia. As a result, private resources sector investment is projected to reach historic highs as a percent of GDP over the next two years, driven by construction of several large iron ore and liquefied natural gas projects. This investment will boost Australia’s resources export capacity as projects come online. A key structural policy challenge is to facilitate the movement of resources across the economy.
Cyclical adjustments. The increasing share of the mining sector in the economy implies that Australia will be exposed more to volatile commodity prices, not only upward but also downward as in recent months. The floating exchange rate may offset some of the effects of this volatility, along with the counter-cyclical operation of fiscal policy allowed in the current medium-term fiscal strategy, but it offers little help in terms of mitigating asymmetric effects on different industries and regions within the country. This points to the importance of enhancing labor market mobility and flexibility, so that workers can smoothly move across industries/regions, complemented by temporary and permanent skilled migration. Their ability to do so will again be tested when investment in the resources sector comes off its peak and some labor currently employed there is to be absorbed by the rest of the economy. Another potentially useful tool for shock absorption is the redistribution of income across regions achieved by the federal tax-transfer and horizontal fiscal equalization system. Our tentative estimates suggest that Australia’s existing fiscal policy framework provide a fair amount of income insurance of this kind.
Medium-term adjustments. We applaud the government’s efforts to formulate a policy strategy for dealing with the economy’s longer-term structural transition, in particular making the most of the opportunities offered by the growth of Asian economies and addressing related challenges, and look forward to the recommendations in the forthcoming White Paper on Australia in the Asian Century. To benefit from the Asian Century, Australia needs more than a mining sector success, not least to ensure that the economy has diversified enough growth drivers. Asia’s globalization and integration already have several decades of history, and thus, finding low-hanging fruits in terms of market penetration might not be easy for Australia. Strong efforts, especially on the part of business leaders, to become Asia-conscious would be required to discover opportunities in the region. The government has a role to play in creating an environment conducive for Australian firms to cultivate their Asian markets.
We thank the authorities for their kind hospitality and fruitful discussions we have had during our mission.