Public Information Notice No. 04/124

Public Information Notice: IMF Concludes 2004 Article IV Consultation with Australia

November 8, 2004

On October 27, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Australia.¹

Background

The expansion is now entering its 13^th year, with unemployment falling to levels not seen since the early 1980s. After slowing in the first half of 2003, economic activity rebounded, underpinned by continued buoyancy of domestic demand and a gradual recovery from the drought. For the year as a whole, real GDP growth was 3 percent, only moderately lower than the 3.8 percent in 2002, as strong domestic demand continued to offset weak net exports and a large decline in agricultural output. The strength in domestic demand was broadly based, with consumption, housing and business investment all growing at above-trend rates. Domestic spending was underpinned by supportive financial conditions, substantial increases in household wealth from a surge in dwelling prices, a strong labor market, and a rebound in farm incomes. The buoyant domestic economy and the substantial appreciation of the Australian dollar led to a deterioration of the current account deficit from 4.4 percent of GDP in 2002 to 6 percent in 2003. A boost in imports pushed net exports to a record low in the first quarter of 2004, before net exports recovered as imports retreated in the second quarter. As a result, GDP growth was weaker than expected, although the economy retained significant momentum.

Headline inflation, which has remained within the Reserve Bank of Australia's target range of 2-3 percent, masks very different trends in tradables and nontradables inflation. While CPI inflation for nontradable goods was around 4 percent, price increases for tradable goods declined sharply since March 2003 due to the large appreciation of the Australian dollar. Recent data show that the dampening effect on inflation from tradable goods may be eroding due, to a large extent, to the recent easing of the Australian dollar.

Monetary policy was kept on hold during the first three quarters of 2003, reflecting conflicting risks to the outlook at the time. The RBA had to contend with the potential for protracted weakness in the external environment, further appreciation of the Australian dollar, uncertainty about the recovery from the drought, on the one hand, and continued rapid growth in housing credit on the other. By the end of 2003, however, with external risks abating, domestic demand growing faster than expected, signs of recovery in the agricultural sector emerging, and the housing sector continuing to expand at an unsustainable rate, the RBA increased the Official Cash Rate (OCR) by 25 basis points in both November and December. The RBA kept the OCR unchanged at its policy meetings in the first three quarters of 2004, based on emerging signs of easing domestic spending, a cooling in the housing market, and subdued inflation pressures.

The centerpiece of the 2004 Budget is the government's More Help for Families package, which provided assistance to Australian families, continued the government's ongoing structural tax reform, and enhanced incentives to save for retirement. It contained additional tax cuts and new expenditure initiatives of $A 37 billion over five years (an average of about 0.9 percent of GDP each year), while maintaining a modest cash surplus of less than ½ percent of GDP each year through the medium term. The Commonwealth net debt was projected to turn negative by 2007/08.

Forward-looking indicators of economic activity point to continuing strength, albeit with some moderation, in domestic demand and there are some signs of slowing in the housing sector. Real GDP growth is projected near potential of about 3¾ percent in 2004. The gradual cooling of domestic demand is expected to be, at least partially, offset by a pick up in external demand and a rebound in the agricultural sector, bringing about the long awaited rebalancing of sources of growth. The main risk to the outlook centers on the housing market and the associated build-up in household indebtedness, but recent indicators suggest a soft landing is likely. Medium-term prospects remain favorable.

Executive Board Assessment

Executive Directors commended the authorities for Australia's strong performance, with six years of budget surpluses, falling public debt, low inflation, high and rising productivity, and a long period of uninterrupted growth that has underpinned a dynamic job market.They attributed this performance to the authorities' exemplary record of macroeconomic and financial management and implementation of structural reforms, carried out in a transparent economic policy formulation framework.

Directors concurred that the outlook for the economy remains favorable. A sharp correction in the housing market, further increases in oil prices, and a weakening of external demand are factors that could affect the positive outlook, but Directors felt that these downside risks were balanced by the upside potential of domestic demand remaining buoyant. Directors agreed that growth is likely to be rebalanced, with domestic demand growth gradually slowing and net exports picking up as the global economy strengthens and agricultural output recovers from the drought. They noted, in particular, recent data that are consistent with a soft landing in the housing market and cooling of domestic demand.

Directors commended the authorities' successful management of monetary policy—based on inflation targeting—in the face of diverging pressures from a strong housing market and robust domestic demand, on the one hand, and weakness of net exports and an appreciation of the Australian dollar, on the other. They pointed out that the main risk in the short term centers on the housing market and the associated buildup of household indebtedness, and considered that the measured actions of the Reserve Bank of Australia, including some tightening of the official cash rate target in late 2003, contributed to a welcomed cooling in the market. They viewed the RBA's current wait-and-see stance as appropriate in light of subdued inflation pressures and remaining uncertainties in the housing market.

Directors agreed that the flexible exchange rate combined with a strong risk management culture have helped increase the resilience of the Australian economy. The significant appreciation of the Australian dollar during the past two years mainly reflected a weak U.S. dollar, strong commodity prices, Australia's more favorable cyclical position compared with other industrial countries, and a bounce back from the Australian dollar's undervalued level in 2001. Directors supported the authorities' policy to limit foreign exchange interventions to situations where the exchange rate is clearly misaligned or to calm disorderly market conditions.

Directors regarded Australia's fiscal position as fundamentally sound, and noted that revenue had remained stronger than expected during the first half of 2004. They endorsed the authorities' medium-term strategy of aiming for a balanced budget over the business cycle to support sustainable economic growth. They called attention to the significant long-term spending pressures due to increasing healthcare costs and population ageing, and welcomed the recent amendment to the Pharmaceutical Benefit Scheme, which will help contain the growth of healthcare spending.

Directors supported the envisaged structural reforms in the 2004 Budget to promote labor force participation and productivity growth in order to achieve higher growth, close the potential long-term fiscal gap, and address the challenge of an ageing population. They welcomed the measures to reform the tax and income support system to provide better incentives to work, such as reducing effective marginal tax rates for low-income families returning to work, allowing older workers to access their superannuation benefits without having to stop working, and tightening the eligibility requirement for the Disability Support Pension. Directors also welcomed the government's plans to take additional measures to further increase labor market flexibility, reform the welfare system, enhance competitiveness, and invest in research and development and infrastructure, in order to further strengthen long-term growth prospects.

Directors commended the soundness of Australia's financial system and strong risk management culture. They welcomed the steps that had been taken to strengthen financial supervision, including the latest legislative changes on insurance industry supervision and audit reform. Directors concurred that developments in the housing market are unlikely to pose systemic risk to the financial system, as indicated by the Australian Prudential Regulation Authority's recent stress tests. While a combination of external and domestic shocks could result in a sharp increase of household savings and weaker GDP growth that would have a negative impact on banks' balance sheets, such a "worst case scenario" is unlikely. At the same time, Directors pointed to potential risks stemming from the sustained high current account deficit and the build-up of private external debt, and advocated close monitoring of corporate and banks' balance sheets. Directors commended the authorities for their preparation for the implementation of Basel II regulatory capital requirements, and welcomed their interest in participating in a Financial Sector Assessment Program in the near future.

Directors praised the authorities for their commitment to trade liberalization. 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, and were encouraged by the envisaged further liberalization of the more protected sectors.

Directors welcomed Australia's constructive involvement in neighboring Pacific Island countries, including a significant increase in aid allocation to the region in the 2004 budget. They noted that the authorities remain committed to achieving the UN official development assistance target.