Australia-2013 Article IV Consultation Preliminary Concluding Statement
November 20, 2013
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.
Australia’s economy has performed favorably in recent years compared with other advanced economies with a track record of sustained growth, inflation close to target, a resilient financial sector, and public debt still low relative to other advanced countries. This performance has been aided by Australia’s strong institutional and policy frameworks, including a combination of a floating exchange rate and inflation targeting, relatively flexible labor and product markets, an intensive financial regulatory and supervisory framework, and strong and transparent fiscal institutions. This has allowed the economy to respond flexibly and has preserved macroeconomic and financial stability through the global financial crisis and in the face of an unprecedented rise in the terms of trade over the past decade.
With growth currently on the soft side, the real exchange rate still overvalued and weighing on the non-mining sector, and inflation within the target range, monetary policy should remain accommodative and act as the primary macroeconomic tool for managing the economy as mining investment begins to drop off over the next several years, although there is fiscal policy space to respond in the event of a sharp deterioration in the outlook While the details of the government’s fiscal strategy are yet to be set out, the broad aim of reaching a fiscal surplus over the medium term would help rebuild fiscal buffers and increase the policy scope to deal with adverse shocks.
Near Term Outlook and Risks
Growth will remain somewhat below trend in the near term as mining investment is expected to pass its peak this year and then fall sharply—we project growth at 2½ percent this year rising to its trend rate of about 3 percent by 2016. While resource exports will expand rapidly and contribute to growth going forward, the outlook for the non-resource sector is more uncertain. Cuts to interest rates since the end of 2011 have shown signs of generating some revival in interest-sensitive spending and could support housing investment going forward, but the soft labor market, excess capacity in the non-mining sector holding back investment plans, and the strong Australian dollar (which despite the depreciation since April still looks overvalued by around 10 percent), will continue to act as headwinds to overall growth.
Given these conditions there is a real possibility that the transition to broader based growth may prove to be bumpier than expected and the near-term growth outlook could worsen, especially if external developments keep the dollar from falling to levels consistent with fundamentals. If so demand for labor could fall, wage and employment growth slow further, consumption growth decline, and government finances weaken. The RBA has some room to respond, and the rapid and effective monetary transmission mechanism in Australia would allow for a nimble policy response should these risks emerge.
One of the channels through which a more accommodative monetary policy would be expected to support demand is increases in house prices. In this regard after a prolonged period where house prices have lagged income growth and construction has been weak, the recent revival in housing market activity is encouraging and has begun to lead to signs of a pickup in supply. This is welcome both from the perspective of contributing to near-term growth and to address persistent supply shortages. But housing construction by itself is unlikely to be sufficient and a broader pickup in activity in the non-mining services and tradable sectors is needed to underpin and sustain growth going forward.
To date house price increases have been regionally concentrated and overall household credit growth has remained moderate. Looking forward, attention should be paid to the risk—as in any situation where asset price inflation accelerates—that a prolonged period of rapid price growth could give rise to expectations-driven, self-reinforcing demand dynamics and price overshooting. A sudden house price decline, were it to occur—possibly triggered by a shock to household incomes and borrowing costs—could reduce consumer confidence and impact overall economic activity. The authorities would need to be prepared to take preventative actions if household credit growth, transactions volume, and prices accelerate. They have both the tools and experience to respond should these risks begin to emerge—following the large run up in house prices in the early 2000s, action by the RBA, Treasury, and APRA, through a combination of public communication, intensive supervision, and other actions led banks to take a more conservative approach to mortgage lending and helped cool the housing market without a sharp decline in prices.
In addition there are features of the Australian regulatory and supervisory approach to property lending that differ from other advanced economies which would help to limit the impact of a sharp decline in house prices on the financial system. Households have built up large mortgage buffers over the last several years, the full recourse nature of lending provides an incentive for continued repayment, banks’ capital positions are strong, and lending standards are tightly enforced with a strong regulatory focus on the borrowers’ ability to service their loans. These features have contributed to the low level of non-performing mortgage loans sustained over the past decade.
The main external risk to the Australian economy remains a slowdown in growth in China and other emerging Asia and a related fall in commodity prices. With over half of Australia’s exports going to emerging Asia and nearly two thirds coming from non-rural commodity exports (mainly iron ore, coal, and LNG) where the volume of these exports is increasing sharply in future years, the economy is vulnerable to changes in the external economic outlook. The floating exchange rate provides a key cushion against such shocks, and Australia’s modest public debt level gives the government scope to allow automatic stabilizers to operate in full and to temper the pace of budget deficit reduction in the event of a sharp deterioration in the outlook.
Separately, while monetary tightening in other advanced economies would likely weaken the exchange rate and support the adjustment of the Australian economy, a bumpy exit from unconventional monetary policy and renewed international financial market volatility could increase the cost of banks’ wholesale borrowing and lead to capital outflows, although Australia was largely unaffected by the market turmoil that hit emerging economies over the summer. Importantly, Australia has experienced and weathered well episodes of sharp declines in its exchange rate since the inflation targeting regime was introduced in 1993.
Medium Term Issues
Australia's fiscal position, with low debt and deficits, compares well to its advanced economy peers, although debt has increased in the aftermath of the global financial crisis. While the government’s aim to return to budget surplus over the medium term in a manner that would not disrupt near-term growth prospects is welcome, achieving and sustaining such a surplus over the next decade will become more challenging in light of current social spending commitments. Our analysis shows that sustaining a surplus, were tax revenue as a share of GDP to be capped, would require sizeable cuts in projected spending. We would encourage early decisions on policy changes required to ensure the medium-term consistency of fiscal policy goals so as to preserve policy flexibility. In this regard the Commission of Audit’s Review of possible policy actions to reduce spending pressure over the medium term, expected to be finalized before the May budget, will play an important role.
The financial sector
Australia’s financial sector has strengthened further over the last several years. Asset quality is good, the ratio of nonperforming loans to total assets is low and continues to decline from its peak, and profitability is strong. Capital adequacy has improved and is well above the Basel III requirements. Banks have shifted toward more stable funding sources facilitated by a combination of strong overall deposit growth and slower credit growth. Reliance on offshore wholesale funding has been reduced and is of longer maturity, and deposits now meet more than half of banks’ funding requirements. Taking into account both their foreign currency asset holdings and their use of derivatives, bank liabilities are almost entirely hedged to exchange rate and maturity risk.
Nevertheless, vulnerabilities remain. The four major banks are systemic with broadly similar business models and their reliance on wholesale offshore funding, although falling, still represents a risk. Residential mortgages, which account for a large part of banks’ assets, are vulnerable to price fluctuations and household leverage is still high. These are longstanding structural issues that will remain sources of risk over the medium term.
The authorities’ regulatory framework seeks to address these vulnerabilities. Conservative risk weights give Australian banks higher quality capital than most of their advanced country peers. The authorities’ recent stress tests, consistent with the IMF’s 2012 comprehensive review of the financial sector, suggest that the major banks could withstand a number of sizable shocks, but the effects of these shocks would make major inroads into their capital buffers. Banks would also likely require RBA help to withstand an extreme funding shock. Banking sector vulnerabilities should be assessed on an ongoing basis to manage the risk that systemically important banks pose to the economy, taking into account the currently evolving international standards.
The external outlook
Australia’s current account deficit has averaged around 4 percent of GDP over the last three decades reflecting an elevated level of private investment relative to a savings rate already high by advanced country standards. Looking forward we expect the current account deficit to remain below 4 percent of GDP and the net foreign liability position to stabilize as imports related to mining investment decline and mining export capacity comes on stream. Although still high Australia’s net foreign liabilities have evolved to become more stable and resilient to shocks over the past several years—as highlighted above, banks have reduced their use of short term offshore funding, and together with increased foreign holdings of long term public debt, this has lengthened the maturity profile of the external debt position. A major portion of resources investment has taken the form of foreign direct investment which is typically more stable than other forms of external financing.
The role of the mining sector
The increased volume of resource exports over the medium term will make the economy more sensitive to terms of trade shocks. There are several factors which should mitigate the direct effects of a decline in the terms of trade. Export volumes for most mining sector projects are relatively inelastic to modest declines in prices. The floating exchange rate can help buffer shocks by depreciating when the terms of trade fall, making other tradable goods and services more competitive. Since the mining companies have globally distributed shareholdings, the effect on profits would be spread between Australia and abroad, moderating the direct effect on the domestic economy. The indirect effects however could be large. The impact of a faster-than-anticipated decline in the terms of trade on nominal output would affect revenue more broadly and harm the budget position. Income dependent on sectors servicing the mining sector would also be affected. Confidence effects, although difficult to predict, could be significant.
Robust income growth over the past decade has been supported in large part by the unprecedented increase in the terms of trade, which as it unwinds, is likely to detract from income growth going forward. That implies that a significant pickup in labor productivity will be needed to maintain growth in living standards over the coming decade. While productivity in the mining sector should improve as the investments begin yielding results, productivity growth in other sectors will also need to increase. Since Australia has already benefited from sizeable productivity improvements following substantial structural reforms in the 1990s, finding further scope for improvement will not be easy. In this regard the government’s focus on productivity, including the aim to address infrastructure bottlenecks, is welcome. A framework for the selection and prioritization of infrastructure projects based on rigorous cost-benefit analysis, and including more involvement by the private sector, would help allow for spending on infrastructure consistent with the government’s deficit reduction goals. More generally a shift to broader-based growth would be helped by making the most of the opportunities offered by a growing Asian middle class, which could support demand for Australia’s services exports—in particular health, education, tourism and professional services.