## _cr04353

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### Economic background and recent developments
- Expansion entering its 13th year; unemployment fell to levels not seen since the early 1980s.
- Real GDP: 3 percent for the year as a whole (2003), compared with 3.8 percent in 2002.
- Agricultural output: dropped by 33 percent in the year to March 2003.
- Housing prices for established houses grew in real terms by about 16 percent a year in 2002 and 2003; real house price index (weighted average for 8 capital cities) increased by 16¼ percent in 2003.
- Unemployment rate: 5.6 percent in 2003; historically low unemployment of about 5½ percent may remain broadly unchanged.
- Current account deficit: worsened from 4.4 percent of GDP in 2002 to 6 percent in 2003; projected to decline to 4 percent of GDP as drought effects dissipate and favorable terms of trade continue.
- Q1 2004: quarterly GDP growth slowed from 1.3 percent (Q4 2003) to 0.2 percent; domestic demand seasonally adjusted annual rate was 5 percent; net exports subtracted 3¾ percentage points from GDP growth.
- Inflation:
  - Overall CPI: temporary spike in March 2003, declined to lower bound of RBA’s 2–3 percent target in Q1 2004, edged up to 2½ percent in Q2 2004.
  - Nontradable CPI inflation: remained above 4 percent since March 2003.
  - Tradable goods inflation: declined sharply since March 2003, more recently picking up.
- Exchange rate and reserves:
  - Australian dollar: strengthened by 65 percent against the U.S. dollar from April 2001 low to February 2004 peak; trade-weighted appreciation 41 percent.
  - February 2004 peak: 21 percent above its ten-year average against the U.S. dollar (20 percent above on a trade-weighted basis).
  - February to July 2004: eased but remained 6 percent above ten-year average against the U.S. dollar (9 percent on trade-weighted basis).
  - Official reserves net of swap commitments: US$17.1 billion in June 2004, equivalent to 1½ months of imports of goods and services.
- Monetary policy:
  - Official Cash Rate (OCR): increased by 25 basis points in November and December 2003; kept unchanged at policy meetings in first half of 2004; target cash rate at early October meeting: 5.25 percent.
- Fiscal developments:
  - December 2003 MYEFO revised Commonwealth cash surplus for 2003/04 to $A 4.6 billion (0.6 percent of GDP), up from $A 2.2 billion (0.3 percent of GDP) in the 2003 Budget.
  - 2004 Budget package: $A 37 billion of additional tax cuts and new expenditure initiatives over five years (an average of about 0.9 percent of GDP each year).
  - 2004 Budget estimated underlying cash surplus of $A 2.4 billion (0.3 percent of GDP) for 2004/05.
  - Pre-election revision: fiscal surplus for 2004/05 projected at $A 3.6 billion (0.4 percent of GDP).

### Economic outlook and risks
- Growth projections:
  - Growth expected to increase to about 3¾ percent in 2004; medium-term growth expected around potential of 3¾ percent.
  - GDP growth projected to moderate from 3¾ percent in 2003/04 to 3½ percent in 2004/05.
- Rebalancing expected during second half of 2004:
  - Domestic demand growth gradually returning to trend; net exports becoming an alternative engine of growth.
- Domestic demand dynamics:
  - Two interest rate increases in late 2003 dampened dwelling investment and household consumption.
  - Retail trade acceleration partly due to Maternity Payment disbursed on July 1, 2004.
  - Business investment remains strong; investment intentions for 2004−05 suggest the investment cycle has reached its peak.
- Key near-term risks:
  - Overheating in the housing market and associated build-up of household indebtedness (investment loans now account for over 40 percent of new housing loans and about one-third of banks’ outstanding loans).
  - Re-emergence of drought.
  - Sustained high oil prices.
  - Weakening of external demand (including potential slowdown in China).
  - Combination of external and domestic shocks could trigger a sharp increase in household saving rates and severely weaken domestic demand; if net exports recovery fails, GDP impact could be marked.
- Upside potential:
  - Robust domestic demand combined with strengthening net exports and fiscal stimulus.

### Policy discussions — macroeconomic policy and fiscal stance
- Monetary policy:
  - Mission broadly endorsed current macroeconomic policy settings and RBA’s decision to keep monetary policy on hold since the two 25 basis point increases late last year.
  - RBA signaled interest rates would likely have to increase at some stage; possible triggers: increased wage growth, sustained high oil prices, further depreciation of the Australian dollar.
  - Authorities view exchange rate flexibility as cushioning external shocks; intervention may be warranted to reverse apparent overshoots or calm disorderly markets.
- Fiscal policy:
  - Fiscal policy fundamentally sound; 2004 Budget package could pose medium-term risks if underlying revenue growth is weaker than projected.
  - Package contingent on stronger revenue than projected in December 2003 by a cumulative $A 29 billion over five years.
  - Staff estimates the fiscal impulse for 2004/05 at about 1 percent of GDP; authorities estimate impact perhaps ½ percent of GDP.
  - Authorities would take measures if revenue turns out weaker than projected.
- Interaction risks:
  - The stimulatory fiscal package could complicate monetary policy if it coincides with domestic demand growth significantly above trend.
  - If significant downside risks materialize, fiscal policy has room to allow automatic stabilizers or provide additional discretionary stimulus.

### Structural challenges and reform priorities
- Long-term fiscal pressures:
  - Intergenerational Report (2002 Budget) estimated a financing gap of about 5 percent of GDP in the Commonwealth budget by 2042, assuming no policy or behavioral changes.
- Government’s five complementary policy areas to lift labor force participation and productivity:
  - Better incentives for work:
    - Redesign tax and income support systems; DSP program: 6¾ percent of the labor force in the program in 2003 vs unemployment rate of 5½ percent.
    - DSP criterion: continuing inability to work 30 or more hours a week, compared with 16 hours a week average for part-time workers.
    - Proposal to amend superannuation laws to relax requirement that workers between 55 and 65 must leave work before accessing superannuation benefits.
    - 2004 Budget measures include tax cuts via increases in thresholds for marginal tax rates and reductions in taper rates on family tax benefits.
    - Top marginal tax rate of 47 percent applies at $A 80,001.
  - Enhancing flexibility in the workplace:
    - Proposed amendments to the Workplace Relations Act to simplify procedures, increase flexibility, and link wages to productivity; some proposals blocked in the Senate.
  - Improving capacity for work:
    - Education, training, and closer links between education and business.
  - Investment in science, innovation, and infrastructure:
    - 2004 Budget extends Backing Australia’s Ability by $A 5.3 billion (following $A 3 billion in 2001).
    - New AusLink program: additional $A 1.9 billion over next 5 years for road and rail upgrades.
  - Enhancing product market competitiveness:
    - National Competition Policy reforms since 1995 produced benefits; Productivity Commission asked to inquire into impact and priorities.
- Healthcare cost control:
  - Amendment to the Pharmaceutical Benefit Scheme increases patient co-payment and safety net thresholds by 21 percent starting January 1, 2005.
  - 2004 Budget includes more resources for preventive health; additional measures still needed for long-run viability.
- Staff recommendation emphasis:
  - Continued structural reforms to raise productivity and labor force participation are critical to meet ageing-related fiscal challenges and sustain long-term growth.
  - Recommended policy priorities: improve labor market flexibility; reform welfare to improve work incentives; enhance product market competitiveness; invest in education, training, research and development, and infrastructure.

### Financial sector soundness and vulnerabilities
- System strength:
  - Banks well capitalized, very profitable, and carry few bad debts; return on average assets: 1.1 (2003); return on average equity: 16.4 (2003).
  - Tier 1 capital: 7.6 (1998), 7.6 (2003) (percent of risk-weighted assets); total capital: 10.3 (1998), 10.1 (2003).
  - Impaired assets: 0.7 (1998), 0.4 (2003) (percent).
  - General and specific provisions (percent of impaired assets): 114.7 (1998), 138.3 (2003).
- Resilience to housing correction:
  - APRA stress tests: even with a 30 percent fall in house prices and dramatically higher mortgage default rates, more than 90 percent of deposit-taking institutions would continue to meet minimum regulatory capital requirements; breaches for a small number of institutions estimated to be small.
- Household sector indicators:
  - Household net worth (percent of gross disposable income): 465 (1998), 516 (2003).
  - Total liabilities: 101 (1998), 142 (2003).
  - Housing debt: 63 (1998), 100 (2003).
  - Interest payments on mortgages increased to 7¼ percent of disposable income (2003 figure stated as 7.3 in table).
  - Household net savings: 2.2 (1998), -2.3 (2003) (percent of gross disposable income).
- External liabilities and composition:
  - Net external liabilities: 55.0 percent of GDP (earlier) to 60.1 percent of GDP over the last five years.
  - Gross external debt: 62.8 (1998) to 76.4 (2003) (percent of GDP).
  - Private sector accounts for 88 percent of total external debt.
  - Net private debt: 33.4 (1998) to 46.9 (2003) (percent of GDP).
  - Net external equity liabilities: 14.3 (1998), 12.1 (2003) (percent of GDP).
  - Foreign equity investment in Australia: 46.6 (1998), 50.4 (2003) (percent of GDP).
  - Short-term gross external debt: 30.6 (1998), 37.3 (2003) (percent of GDP).
  - Short-term net external debt (residual maturity basis): 17.4 (1998), 18.4 (2003) (percent of GDP).
- Mitigating factors:
  - High degree of foreign currency hedging, deep derivatives market, strong bank capitalization and provisioning, improved household net worth, and substantial official reserves (gross official reserves: 25.0 (1998), 44.3 (2003) in $A billion).

### Trade policy, regional role, and aid
- Trade liberalization:
  - Aggressively pursued over past two decades; tariffs reduced to a maximum of 5 percent on passenger motor vehicles by 2010 and on textiles, clothing, and footwear by 2015.
  - Concluded free trade agreements with Singapore, Thailand, and the United States; exploring agreements with China, ASEAN, and other countries.
  - Provided tariff- and quota-free access for all goods from least developed countries.
  - Staff concern: bilateral agreements may dilute multilateral WTO efforts; urged authorities to extend commitments in bilateral agreements to all trading partners.
- Australia and the Pacific:
  - Australia is dominant regional power; increased involvement in Papua New Guinea and the Solomon Islands.
  - Australian aid allocations to the Pacific region increased by 60 percent to ($A 569 million) in the 2004 budget.
  - Papua New Guinea: 53 percent of total; Solomon Islands: 24 percent of total.
  - Australia provided 0.25 percent of GNP for ODA in 2003.

### Boxes and thematic findings
- House price surge (Box 1):
  - From end-2001 through Q1 2004, prices of established houses surged at average annual rate of 17¾ percent in nominal terms (14½ percent in real terms).
  - Since March 1996 trough, prices up almost 125 percent (85 percent in real terms).
  - Investment loans now over 40 percent of new housing loans and about one-third of banks’ outstanding loans versus about 15 percent in early 1990s.
- 2004 Budget (Box 2):
  - GDP growth projection: moderate from 3¾ percent in 2003/04 to 3½ percent in 2004/05.
  - Forecast underlying cash surplus of $A 2.4 billion in 2004/05 and a small surplus for following three years.
  - More Help for Families package: $A 36.7 billion over five years (an average of about 0.9 percent of GDP each year); Family Package costs $A 19.2 billion over five years.
  - Maternity Payment: $A 3,000 on July 1, 2004; $A 4,000 on July 1, 2006; $A 5,000 on July 1, 2008.
  - Two-step personal tax reductions worth $A 14.7 billion over next four years; over 80 percent of taxpayers face top marginal tax bracket of no more than 30 percent after changes.
  - Incentives for retirement saving: improvements costing $A 2.7 billion; superannuation co-contribution maximum benefit increased to $A 1,500.
- Terms of trade turnaround (Box 3):
  - Since 1987, terms of trade improved by 40 percent.
  - Primary drivers: decline in prices of imports where China is major exporter; rise in world market prices for commodities Australia exports.

### Financial regulation, oversight, and international engagement
- Regulatory developments:
  - Key Royal Commission recommendations on HIH implemented; amendments to Australian Prudential Regulation Authority Act 1998.
  - Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 became law on July 1, 2004.
  - Preparations for Basel II underway: APRA issued preliminary guidelines in 2003; proposals scheduled for implementation by 2007.
  - Australia in full compliance with FATF recommendations on money laundering following Suppression of the Financing of Terrorism Act 2002.
  - Ratified and implemented OECD Convention on Combating the Bribery of Foreign Public Officials in International Business Transactions.
- FSAP interest:
  - Authorities interested in participating in a Financial Sector Assessment Program (FSAP); likely participation in 2005–06 pending Treasurer’s clearance.

### IMF staff and Executive Board appraisal — principal conclusions
- Praise for outcomes: sustained reform and macro framework produced prolonged expansion, low inflation within target, falling unemployment, and sound public finances.
- Short-term risks manageable but include housing market overheating, external shocks, and drought; combination of shocks could materially lower GDP.
- Policy endorsements and recommendations:
  - Support for RBA’s measured monetary stance and flexible exchange rate policy with limited intervention.
  - Endorsement of fiscal strategy aiming for a balanced budget over the business cycle; caution on execution of $A 37 billion package if revenues fall short.
  - Support for structural reforms to boost labor force participation and productivity to address ageing-related fiscal pressures.
  - Commendation of financial system soundness and preparation for Basel II; recommendation for close monitoring of private external debt buildup and corporate/bank balance sheets.
- Procedural note:
  - Proposed next Article IV consultation on standard 12-month cycle.

*Source: IMF staff report Executive Summary and selected extracts from content unit _cr04353.*

### Executive Summary ......................................................................................................

### EXECUTIVE SUMMARY

### Economic Background
- The expansion is now entering its 13th year, with unemployment falling to a level not seen since the early 1980s.
- For the year as a whole, economic growth was 3 percent, inflation stayed within the Reserve Bank of Australia’s (RBA) target range of 2−3 percent, and the fiscal position remained strong.
- The current account worsened due to Australia’s relatively strong cyclical position, a substantial appreciation of the Australian dollar, and the drought.
- Growth is expected to increase to about 3¾ percent this year, with inflation remaining within the official target range.
- Main risks to the outlook:
  - Overheating in the housing market (recent indicators suggest a soft landing is likely).
  - Re-emergence of drought.
  - Sustained high oil prices.
  - Weakening of external demand.
  - Combination of external and domestic shocks could trigger a sharp increase in household saving rates and severely weaken GDP growth.
- Upside potential:
  - Robust domestic demand combined with strengthening net exports and fiscal stimulus.

### Overview and Structural Challenges
- Australia benefits from sustained implementation of appropriate macroeconomic policies and structural reforms: strong growth, low inflation, substantial declines in unemployment and public indebtedness.
- Reforms, a transparent macro policy framework, and a floating exchange rate have enhanced flexibility and resilience.
- Despite strong recent performance, demographic transition to an older population poses long-term risks to growth.
- The staff supports authorities’ ambitious reform agenda to raise productivity and labor force participation to meet ageing-related fiscal pressures.
- Political context: Prime Minister John Howard is expected to call for federal elections before 2005.

### Recent Economic Developments
- After slowing in H1 2003, growth rebounded due to buoyant domestic demand, improved external environment, and gradual recovery from the drought.
- Real GDP growth: 3 percent in the year as a whole (2003), compared with 3.8 percent in 2002.
- Agricultural output dropped by 33 percent in the year to March 2003.
- Domestic demand drivers: consumption, housing investment, business investment—each growing at above-trend rates.
- Housing price surge: prices for established houses grew in real terms by about 16 percent a year in 2002 and 2003.
- Labor market: unemployment rate fell to 5.6 percent in 2003.
- Current account deficit: worsened from 4.4 percent of GDP in 2002 to 6 percent in 2003.
- Q1 2004: quarterly GDP growth slowed from 1.3 percent (Q4 2003) to 0.2 percent; domestic demand seasonally adjusted annual rate was 5 percent.
- Net exports in Q1 2004 subtracted 3¾ percentage points from GDP growth.
- Inflation dynamics:
  - Overall CPI: temporary spike in March 2003, then declined to the lower bound of RBA’s 2–3 percent target in Q1 2004, edged up to 2½ percent in Q2 2004.
  - Nontradable CPI inflation: remained above 4 percent since March 2003.
  - Tradable goods inflation: declined sharply since March 2003 due to large appreciation of the Australian dollar; more recently picking up with commodity price boom and easing of the Australian dollar.
- Exchange rate and reserves:
  - From April 2001 low to February 2004 peak, the Australian dollar strengthened by 65 percent against the U.S. dollar.
  - On a trade-weighted basis, appreciated by 41 percent.
  - At February 2004 peak, Australian dollar was 21 percent above its ten-year average against the U.S. dollar (20 percent above on a trade-weighted basis).
  - From February to July 2004, the Australian dollar eased but remained 6 percent above its ten-year average against the U.S. dollar (9 percent on a trade-weighted basis).
  - Official reserves net of swap commitments were US$17.1 billion in June 2004, equivalent to 1½ months of imports of goods and services.
- Monetary policy:
  - Official Cash Rate (OCR) unchanged during first three quarters of 2003.
  - OCR increased by 25 basis points in November and December 2003.
  - OCR kept unchanged at policy meetings in first half of 2004.
- Fiscal developments:
  - December 2003 MYEFO revised Commonwealth cash surplus for 2003/04 to $A 4.6 billion (0.6 percent of GDP), up from $A 2.2 billion (0.3 percent of GDP) in the 2003 Budget.
  - 2004 Budget: $A 37 billion package of additional tax cuts and new expenditure initiatives over five years (an average of about 0.9 percent of GDP each year), maintaining a modest cash surplus through the medium term.
  - 2004 Budget estimated underlying cash surplus of $A 2.4 billion (0.3 percent of GDP) for 2004/05.

### Policy Discussions
- Macroeconomic policy stance:
  - Mission broadly endorsed current macroeconomic policy settings.
  - Staff supports RBA’s decision to keep monetary policy on hold since the two 25 basis point increases late last year.
  - RBA’s wait-and-see stance appropriate given subdued inflation pressures and housing market uncertainties.
- Fiscal policy and risks:
  - Small surpluses projected in the 2004 Budget hinge on continued buoyancy of fiscal revenue growth.
  - In the short run, stimulatory fiscal package could complicate monetary policy implementation if it coincides with domestic demand growth significantly above trend.
  - Longer-run: government intends to address ageing-related fiscal problems via structural reforms to boost productivity and labor force participation.
- Financial sector:
  - No significant vulnerabilities identified in the financial system.
  - Banks have substantial exposure to the housing market, but stress tests indicate even a large decline in house prices would not have systemic implications for the banking system.
- Trade policy:
  - Australia strongly supports multilateral trade liberalization.
  - Authorities have pursued a number of free trade agreements given limited multilateral progress, while recognizing the risk that bilateral agreements may dilute efforts to conclude WTO negotiations.

### Staff Appraisal (summary points reflected in Executive Summary and Overview)
- Australia’s sustained reform and macroeconomic framework have produced strong outcomes: prolonged expansion, low inflation within target, falling unemployment, and sound public finances.
- Risks to the outlook are manageable in the short term but include housing market overheating, external shocks, and drought; combination of shocks could materially lower GDP.
- Continued structural reforms to raise productivity and labor force participation are critical to meet ageing-related fiscal challenges and to sustain/improve long-term growth performance.

*Source: IMF staff Executive Summary (content unit _cr04353).*

### 3.8 billion in the December 2003 MYEFO. Small underlying cash surpluses of between 0.2

### _cr04353 - 3.8 billion in the December 2003 MYEFO. Small underlying cash surpluses of between 0.2

### Economic Outlook
- Real GDP growth projected to boost to near potential of about 3¾ percent in 2004 due to:
  - Strong momentum in domestic demand.
  - Recovery from the drought.
  - Improving external environment.
- Rebalancing of growth sources expected during the second half of 2004:
  - Domestic demand growth gradually returning to trend.
  - Net exports becoming an alternative engine of growth.
- Domestic demand dynamics:
  - Two interest rate increases in late 2003 dampened dwelling investment and household consumption.
  - Recent data show an acceleration in retail trade due to the new Maternity Payment disbursed on July 1, 2004.
  - Business investment remains strong; investment intentions for 2004−05 suggest the investment cycle has reached its peak.
- External sector and currency:
  - Gradual cooling of domestic demand expected to be partially offset by a pick up in external demand for nonagricultural exports and a rebound in agricultural output.
  - Recent moderation of the Australian dollar expected to strengthen net exports' contribution to growth.
- Key near-term risks:
  - Main risk: housing market and associated build up of household indebtedness.
  - Other risks: re-emergence of drought; sustained high oil prices; weakening of external demand (perhaps associated with a slowdown in China); building inflation pressures from a tight labor market or further depreciation of the currency.
  - Combination of external and domestic shocks could trigger a sharp increase in household saving rates and severely weaken domestic demand; if net exports recovery fails to emerge the impact on GDP growth could be marked.
- Medium-term prospects:
  - Favorable outlook due to transparent monetary and fiscal frameworks, healthy public finances, and government commitment to pro-growth strategy.
  - Growth expected to be around Australia’s potential of 3¾ percent.
  - Historically low unemployment rate of about 5½ percent may remain broadly unchanged.
  - Current account deficit projected to decline to 4 percent of GDP as drought effects dissipate and favorable terms of trade continue.
  - Persistent current account deficit and relatively high household debt remain potential vulnerabilities.

### Policy Discussions — Macroeconomic Policies
- Authorities and staff broadly agree on macro policy settings for short-to-medium term and key elements for longer-term challenges (healthcare costs, ageing).
- Monetary Policy and the Exchange Rate:
  - RBA kept monetary policy on hold since two 25 basis point increases in the Official Cash Rate late last year.
  - Underlying inflationary pressures may build during the second half of 2004 as exchange rate appreciation effects fade.
  - RBA signaled in its August Monetary Policy Statement that interest rates would likely have to increase at some stage in the current expansion.
  - Possible triggers for tightening: increased wage growth, sustained high oil prices, further depreciation of the Australian dollar.
  - Authorities view exchange rate flexibility as cushioning external shocks; intervention may be warranted to reverse apparent overshoots or calm disorderly markets.
  - Foreign exchange reserves were unusually low in early 2002; RBA rebuilt reserves until mid-February 2004 and then stayed on the sidelines as the Australian dollar eased.
  - Conditions seen as favorable for gradual depreciation of the Australian dollar toward its long-term average with global pickup and expected increase in world interest rates.
- Fiscal Policy:
  - Fiscal policy fundamentally sound, but the 2004 Budget package could pose medium-term risks.
  - Underlying cash balance projected to remain positive despite tax cuts and new expenditure, contingent on significantly stronger revenue than projected in December 2003 by a cumulative $A 29 billion over five years.
  - The mission noted the short-term stimulatory effect of the $A 37 billion package, of which $A 14 billion is earmarked for 2004/05 and 2005/06 (an average of about 0.9 percent of GDP each year), could complicate monetary policy if domestic demand growth is still significantly above potential.
  - Authorities believe the stimulus from the package will be relatively small; staff estimates the fiscal impulse for 2004/05 at about 1 percent, while the authorities estimate the impact to be somewhat less, perhaps ½ percent of GDP.
  - Authorities would take measures if revenue turns out weaker than projected.

### Structural Policies
- Long-term spending pressures from increasing healthcare costs and population ageing:
  - Intergenerational Report (2002 Budget) estimated a financing gap of about 5 percent of GDP in the Commonwealth budget by 2042, assuming no policy or behavioral changes.
  - Australia’s strong fiscal position makes the pressures more manageable if a measured and timely response is adopted.
- Continued structural reform needed to close productivity gap and sustain growth:
  - Product and labor market liberalization improved competitiveness and potential growth—perhaps by as much as 1 percentage point.
  - Average real GDP growth increased from 2.7 percent (decade prior to reforms, 1975−84) to 3.9 percent in the past decade.
- Government’s five complementary policy areas to lift labor force participation and productivity:
  - Better incentives for work:
    - Redesign tax and income support systems to encourage workforce participation and tighten targeting.
    - Disability Support Pension (DSP) program: 6¾ percent of the labor force in the program in 2003, exceeding the unemployment rate of 5½ percent.
    - DSP criterion: continuing inability to work 30 or more hours a week, compared with 16 hours a week average for part-time workers.
    - Government proposal to tighten DSP eligibility blocked in the Senate.
    - Proposal to amend superannuation laws to relax requirement that workers between 55 and 65 must leave work before accessing superannuation benefits.
    - 2004 Budget measures include tax cuts via further increases in thresholds for marginal tax rates and reductions in taper rates on family tax benefits.
    - Note: top marginal tax rate of 47 percent applies at $A 80,001.
  - Enhancing flexibility in the workplace:
    - Proposed amendments to the Workplace Relations Act intended to simplify procedures, increase flexibility, and link wages to productivity.
    - Need for further simplification of wage bargaining system, reduction in overlap of federal and state award systems, and diminished role of award system in setting minimum wage.
    - Some government proposals blocked in the Senate.
    - New initiatives: enhancing Job Network Program, extending childcare program, removing age discrimination for federal government jobs.
  - Improving capacity for work:
    - Reduce skill mismatch via education improvements, training, closer links between education and business, and competitive tax system to attract talent.
  - Investment in science, innovation, and infrastructure:
    - 2004 Budget extends Backing Australia’s Ability by $A 5.3 billion (following $A 3 billion in 2001).
    - New infrastructure program AusLink: additional $A 1.9 billion over next 5 years for road and rail upgrades.
  - Enhancing product market competitiveness:
    - National Competition Policy (NCP) reforms since 1995 produced benefits in electricity, gas, road transport, water sectors.
    - Government asked Productivity Commission to inquire into impact and identify priority areas for further reform.
- Healthcare cost control:
  - Interaction of ageing, technological innovation, and “luxury goods” nature of healthcare will boost public expenditure.
  - Amendment to the Pharmaceutical Benefit Scheme (PBS) increases patient co-payment and safety net thresholds by 21 percent starting January 1, 2005.
  - 2004 Budget includes more resources for preventive health; additional measures still needed for long-run viability.

### Financial Sector Issues
- Financial system sound with strong risk management culture:
  - Banks well capitalized, very profitable, and carry few bad debts.
  - Insurance and superannuation industries have benefited from robust environment, equity market recovery, and global increase in insurance premia.
- Resilience to housing market correction:
  - Recent APRA stress tests indicate that even with a 30 percent fall in house prices and dramatically higher mortgage default rates, more than 90 percent of deposit-taking institutions would continue to meet minimum regulatory capital requirements.
  - For the small number of institutions that fell below minimum, the breach was estimated to be small.
- Risks from abrupt household balance-sheet consolidation:
  - A combination of shocks causing large increases in mortgage interest rates and high unemployment could harm banks’ balance sheets.
  - Few historical instances where household balance-sheet adjustment was a major factor in downturns; corporate and financial institution adjustments have been more common.
- External vulnerability:
  - External current account deficit has widened, mainly reflecting sharp appreciation of the Australian dollar and strong cyclical position.
  - Low and declining public debt, relatively stable external financing, and strong risk management in financial institutions limit external vulnerability.
  - Sustained current account deficits and build-up of external debt (mainly in private financial sector) could increase vulnerability to shifts in market sentiment; careful monitoring needed.
  - Corporate and banking balance sheets generally sound and resilient to large swings in exchange and interest rates.
  - Households could face more stress if both interest rates and unemployment rise substantially.
- Regulatory and institutional developments:
  - Key Royal Commission recommendations on HIH implemented: amendments to Australian Prudential Regulation Authority Act 1998 to strengthen governance, clarify role, enhance disclosure/conflict of interest framework, and promote cooperation with other regulators.
  - Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 became law on July 1, 2004 to enhance auditor independence and disclosure, and improve enforcement.
  - Preparations for Basel II underway:
    - In 2003 APRA issued preliminary guidelines for internal risk models to calculate regulatory capital per proposals scheduled for implementation by 2007.
    - APRA expects to conform to international consensus where possible, amending components for Australian circumstances.
  - Australia in full compliance with FATF recommendations on money laundering following Suppression of the Financing of Terrorism Act 2002.
  - Australia has ratified and implemented the OECD Convention on Combating the Bribery of Foreign Public Officials in International Business Transactions.
  - Authorities interested in participating in a Financial Sector Assessment Program (FSAP); likely participation in 2005–06 pending Treasurer’s clearance.

*Source: IMF staff report content from _cr04353 (excerpts as provided).*

### 33.      Trade liberalization has been aggressively, and often unilaterally, pursued over

### _cr04353 - 33.      Trade liberalization has been aggressively, and often unilaterally, pursued over

### Trade liberalization and external trade policy
- Trade liberalization has been aggressively, and often unilaterally, pursued over the past two decades as an integral aspect of Australia’s growth strategy.
- Further liberalization in the pipeline:
  - Tariffs reduced to a maximum of 5 percent on passenger motor vehicles by 2010.
  - Tariffs reduced to a maximum of 5 percent on textiles, clothing, and footwear by 2015.
- Australia’s multilateral and bilateral strategy:
  - Strong supporter of multilateral trade liberalization; seeks a constructive role in the Doha Round.
  - Concluded free trade agreements with Singapore, Thailand, and the United States; exploring agreements with China, ASEAN, and other countries.
  - Recently provided tariff- and quota-free access for all goods from least developed countries.
- Risks and staff recommendations:
  - Authorities aware that bilateral agreements may contribute to proliferation of regional trade blocs, reduce political will for further unilateral liberalization, and dilute multilateral efforts at the WTO.
  - Authorities determined to conclude only high quality bilateral agreements and may extend commitments in bilateral agreements to all trading partners.
  - IMF staff urge the authorities to extend commitments in bilateral agreements to all trading partners.

### Australia’s regional role and official assistance
- Australia is the dominant regional power with long political and economic relationships with Pacific island countries.
- Recent developments and aid allocations:
  - Increased involvement in Papua New Guinea and the Solomon Islands reflecting concerns about lack of sustainable economic progress.
  - Australian aid allocations to the Pacific region increased by 60 percent in the 2004–05 Budget.
  - About one-half of total assistance to the region is expected to go to Papua New Guinea.
  - About one-fourth of total assistance to the region is expected to go to the Solomon Islands.
  - Australia provided 0.25 percent of GNP for ODA in 2003, in line with the average for industrial countries but below the 0.7 percent United Nations target, which Australia remains committed to achieve.

### Short- to medium-term macroeconomic outlook and risks
- Macroeconomic performance and outlook:
  - Australia continues to reap benefits of sustained implementation of appropriate macroeconomic policies and structural reforms: strong economic growth, low inflation, substantial declines in unemployment and public indebtedness.
  - The short-to medium-term outlook remains favorable; the expansion is now entering its 13th year, with unemployment falling to levels not seen since the early 1980s.
  - Growth expectations: growth expected to become better balanced with a cooling in domestic demand (slowing dwelling investment and household consumption) and a pick up in net exports as the global economy strengthens and agricultural output rebounds from the drought.
  - Inflation is expected to remain comfortably within the official target range.
  - The current account deficit is expected to narrow as a percent of GDP.
- Main short-term risk:
  - Housing market and associated buildup of household indebtedness.
  - RBA has used jaw boning and a couple of taps on the monetary brakes; scattered evidence suggests a soft landing in the housing market is most likely.
  - Possible worst-case scenario: combination of external and domestic shocks could trigger a sharp increase in household saving rates and a severe weakening of domestic demand; if net exports fail to recover, GDP growth could decline sharply — not the most likely outcome but cannot be ruled out.
- Policy stance and flexibility:
  - Macroeconomic policy is well placed to respond to unexpected developments.
  - RBA’s wait-and-see stance judged appropriate given benign inflation and housing market uncertainties.
  - Risks from policy interactions:
    - Monetary policy mildly accommodative; dampening effect on inflation from earlier exchange rate appreciation weakening.
    - The stimulatory effect of the fiscal package may complicate monetary policy implementation if it comes into play when domestic demand growth is still robust and external demand is strengthening.
    - If significant downside risks materialize, fiscal policy has ample room to allow automatic stabilizers or provide additional discretionary stimulus.
    - Risk that fiscal revenue may be lower than projected; execution of the $A 37 billion package of tax cuts and new spending initiatives in the 2004 Budget should be reviewed in that case.

### Exchange rate, financial system resilience, and supervision
- Flexible exchange rate and risk management:
  - Flexible exchange rate and good risk management practices have increased economic resilience.
  - Flexible exchange rate helped weather severe external shocks: the Asian crisis, a global recession, and wide commodity price fluctuations.
  - Staff supports authorities’ policy to limit foreign exchange interventions to situations where the exchange rate is clearly misaligned or to calm disorderly market conditions.
- Financial system soundness:
  - Financial system is sound with a strong risk management culture; banks are generally very profitable and well capitalized.
  - Exposure to housing market:
    - Loans for investment properties now account for over 40 percent of new housing loans approved by financial institutions.
    - Investment loans account for about one-third of banks’ outstanding loans.
    - In the early 1990s, investment loans accounted for about 15 percent of new and outstanding loans.
  - APRA stress tests indicate even a substantial decline in housing prices would not have systemic implications for the banking system.
  - IMF staff commends APRA for preparing for Basel II and welcomes authorities’ interest in participating in a future Financial Sector Assessment Program.

### Long-term fiscal pressures and structural policy recommendations
- Long-term pressures:
  - Significant long-term spending pressures from increasing healthcare costs and population ageing.
- 2004 Budget and policy orientation:
  - The fiscal package in the 2004 Budget is consistent with the government’s long-term objective of lifting labor force participation and promoting productivity growth.
  - Recent changes to the Pharmaceutical Benefit Scheme will help contain healthcare cost.
- Recommended policy priorities for future budgets and legislation:
  - Target areas expected to deliver highest boost to long-term growth, including:
    - Measures to further improve labor market flexibility.
    - Reforms to the welfare system to improve work incentives.
    - Measures to enhance competitiveness of product markets, based in part on the forthcoming review of national competition policy by the Productivity Commission.
    - Investment in education, training, research and development, and infrastructure.
- Labor force participation and pension/income support reforms:
  - Authorities rightly place higher productivity and labor force participation at center of strategy to achieve higher growth and close long-term fiscal gap.
  - Recent measures:
    - Reduction in effective marginal tax rates for low income families returning to work.
    - Allowing older workers to start drawing down certain superannuation income streams without having to cease work.
  - Further steps urged:
    - Stronger incentives to remain in the labor force through tighter eligibility requirements for the Disability Support Pension and other income support programs.
    - Broader measures to increase labor market flexibility, including reducing overlap of federal and state award systems and diminishing the award system’s role in setting minimum wage, which has contributed to relatively high unemployment for low-skilled workers.

### House price surge (Box 1) — key statistics and features
- Price dynamics:
  - From end of 2001 through the first quarter of 2004, prices of established houses surged at an average annual rate of 17¾ percent in nominal terms (14½ percent in real terms).
  - Over the longer term, prices have increased by almost 125 percent (85 percent in real terms) since the last housing cycle trough in March 1996.
- Unusual features of current cycle:
  - Occurred during a period of low overall inflation and continued over a longer period than previous upswings.
  - Nationwide boom rather than region-specific.
  - Focused on residential properties (including apartments); commercial property prices have not yet recovered to late 1980s peaks.
  - Very strong demand by household investors for rental residential properties despite low rental yields and high vacancy rates.
  - Loans for investment properties now account for over 40 percent of new housing loans and about one-third of banks’ outstanding loans—both high by international standards—compared with about 15 percent in the early 1990s.
- Comparative notes:
  - Since 1996, house prices have increased sharply in several other advanced countries, led by Ireland and the United Kingdom.
  - Around 70 percent of Australians own their homes (compares with 40 percent in Germany and over 80 percent in Spain).
- Productivity Commission findings on drivers:
  - House prices have risen more than would be explained by longer-term fundamentals (population growth, smaller household size, land supply constraints, household income and wealth gains, structural reduction in inflation and interest rates, financial innovations).
  - Factors boosting demand: negative gearing, changes to capital gains and other income taxes since 1999, the First Home Owners Scheme, and expectations of further price appreciation by households (including investors).

### 2004 Budget (Box 2) — projections and major measures
- Macroeconomic projections and fiscal outlook:
  - GDP growth projected to moderate from 3¾ percent in 2003/04 to 3½ percent in 2004/05.
  - Fiscal outlook: forecast underlying cash surplus of $A 2.4 billion in 2004/05 and a small surplus for the following three years.
- More Help for Families package:
  - Total package amounts to $A 36.7 billion over five years (an average of about 0.9 percent of GDP each year).
  - Family Package costs $A 19.2 billion over five years.
  - Maternity Payment introduced at $A 3,000 on July 1, 2004; increased to $A 4,000 on July 1, 2006; increased to $A 5,000 on July 1, 2008.
- Tax cuts and personal taxation:
  - Two-step reduction in personal taxes worth $A 14.7 billion over the next four years.
  - Tax cut increases thresholds above which incomes are taxed at 30 percent, 42 percent, and 47 percent.
  - This will ensure that over 80 percent of taxpayers face a top marginal tax bracket of no more than 30 percent.
  - New personal tax rate thresholds table reflected phased changes from July 1, 2004 and July 1, 2005.
- Incentives for retirement saving:
  - Improvements costing $A 2.7 billion.
  - Maximum benefit under the superannuation co-contribution scheme increased to $A 1,500 to match a $A 1,000 personal contribution.
  - Superannuation surcharge rate for high-income earners to be progressively reduced from 15 percent to 7½ percent in 2006–07.

### Terms of trade turnaround (Box 3) — key points
- Since 1987, Australia’s terms of trade (TOT) have improved by 40 percent.
- Primary drivers of the TOT improvement:
  - Rapid decline in prices of imports of goods for which China is a major world exporter is the single most important contributing factor.
  - Rise in world market prices for commodities that Australia exports is the second most important factor.
- Dampening factors:
  - Decline in export prices of elaborately transformed products.
  - Rise in import prices of products which China does not export on a large scale.
- Outlook:
  - Several factors suggest the improvement in Australia’s TOT may continue for some time, including sustained Chinese industrialization and potential similar dynamics from other currently poor economies such as India.

### Institutional and procedural note
- It is proposed that the next Article IV consultation with Australia take place on the standard 12-month cycle.

*Source: IMF staff report (selected extracts).*

### Box 4. Current Account Reversals in Industrial Countries

### Box 4. Current Account Reversals in Industrial Countries

### Context and framing
- Some economists and policy makers have argued that an increase in the current account deficit that results from decentralized (optimal) decisions on private saving and investment made by private agents should not matter or be a concern, including for public policy. This view is often called the “Lawson Doctrine.” 1
- The view has come into question owing to a number of currency crises and sharp current account reversals that have occurred in emerging market and industrial countries in recent years. 1
- The issue is of particular relevance to Australia in the current conjuncture with the current account deficit around 6 percent of GDP, a government fiscal surplus, and low and declining public sector debt.

### Average characteristics of industrial countries that experienced large current account reversals 2
- Typically, the reversal involves:
  - a cyclical slowdown with decreasing income and GDP growth (possibly, related to monetary tightening) and a real exchange rate depreciation.
  - There is no significant evidence that the current account deficit itself triggers the cyclical slowdown.
- Fiscal position:
  - Although countries that suffered a reversal had a fiscal deficit on average, a number of these countries maintained fiscal surpluses, and fiscal balances on average were not deteriorating prior to the reversal.
  - Subsequent to the reversal, fiscal balances deteriorated.
- Interest rates:
  - Interest rates increased before the reversal and subsequently fell back following the reversal.
- Saving and investment dynamics:
  - The increase in the current account deficit prior to the reversal reflected on average decreased national (and private) saving with a stable domestic investment rate.
  - The current account adjustment during the reversal was on average due to a sharp fall in investment with saving only rising slightly.
- Trade composition during reversal:
  - Net exports recovered substantially during the current account reversal, owing to increasing exports as a share of GDP.
  - Imports also increased, but to a lesser degree, as a share of GDP.

### Possible explanations for breakdown of the “Lawson Doctrine”
- Distorted private saving and investment decisions, including due to policy or market failures. Examples:
  - Excessively optimistic expectations about changes to permanent income that lead to over-consumption and over-borrowing after major policy regime changes (such as from financial sector deregulation).
  - Asset market bubbles (through the associated wealth effects).
  - The Harberger externality—private borrowers may not internalize the increasing marginal social cost of external borrowing that arises from the upward-sloping supply of foreign capital.
- Private sector liabilities as contingent public sector liabilities:
  - Creditors may force governments to absorb private sector debts in the aftermath of a crisis.
  - Fiscal policy may need to be used in the event of a current account adjustment for counter-cyclical purposes or to resolve financial sector crises.
- Ricardian equivalence (or forward-looking rational expectations) perspective:
  - Current account deficits are always the result of private sector decisions, independent of fiscal policy.
- Exchange rate valuation channel:
  - A worsening current account deficit may be a reflection of, or lead to, an unsustainable appreciation in the real exchange rate.
  - An overvalued exchange rate, in turn, could be distortionary.

*Source: Box 4, “Current Account Reversals in Industrial Countries.”*

### Box 5. Australia and the Pacific Island Countries

### Box 5. Australia and the Pacific Island Countries

### Overview
- Australia is the dominant regional power with long-standing close political and economic relationships with the Pacific island countries.
- Australia’s role was enhanced over the past year through its involvement in Papua New Guinea and the Solomon Islands.
- Short-term economic developments in Australia mainly affect the Pacific island countries through tourism.
- More important medium-term issues for the island countries are trade liberalization, external assistance, and a possible currency union.
- A prosperous Australian economy benefits the island countries.

### Foreign Trade
- Australia accounts for a major share of exports and imports of the island economies, based on well established trading relationships.
- Over the medium term, a major factor will be the impact of the Pacific Agreement on Closer Economic Relations, one aim of which is to develop trade among the island countries with Australia; this will be crucial for the Fiji garments sector.
- Indicators suggest that, in light of the Australian dollar appreciation over the past two years, a few traders have been seeking cheaper Asian sources for island imports.

### Tourism
- Tourism is the main channel through which Australian economic developments could impact the Pacific island economies.
- Australia is the main source of visitors to the region, especially for Fiji and Vanuatu, and as passengers on cruise ships.
- The perception of the region as a safe haven has helped the tourist industry since 9/11.

### External Aid
- Australian aid allocations to the Pacific region increased by 60 percent to ($A 569 million) in the 2004 budget.
- Papua New Guinea accounts for 53 percent and the Solomon Islands for 24 percent of the total.
- Given the importance of the recent Enhanced Cooperation Program with Papua New Guinea and the Regional Assistance Mission in the Solomon Islands, it is unlikely that the aid program will be reduced in the short run.

### Foreign Direct Investment
- Pacific island investments in Australia are extremely small and limited primarily to equity holdings by superannuation funds and property purchases from Papua New Guinea sources.
- Australian investments in the region are mainly related to mineral projects in Papua New Guinea, including the prospective but uncertain Queensland gas pipeline.

### Currency Issues
- If the economic policies of the Pacific island countries converge and their overall resilience to external shocks is enhanced by appropriate fiscal and monetary policies, structural reforms, and trade diversification, there could be scope to strengthen financial links between Australia and the island region.
- For at least the next several years, radical moves toward regional financial integration seem improbable; island authorities do not hold a strong view that monetary union would promote growth of output, employment, and productivity.
- The possible adoption of the Australian dollar as the regional currency has been raised by some island Finance Ministers and Central Bank Governors, and by a 2003 Australian Senate Inquiry.

*Source: Box 5. Australia and the Pacific Island Countries (IMF staff report content).*

### 2.      Net external liabilities have increased from 55 percent of GDP to 60 percent of

### _cr04353 - 2.      Net external liabilities have increased from 55 percent of GDP to 60 percent of

### External liabilities and composition
- Net external liabilities increased from 55.0 percent of GDP to 60.1 percent of GDP over the last five years (Table 1).
- Gross external debt rose from 62.8 to 76.4 percent of GDP between 1998 and 2003.
- Private sector accounts for 88 percent of total external debt; financial corporations are the largest component of private external debt.
- Public sector gross external debt declined significantly; net public debt moved from 7.4 percent of GDP (1998) to 1.1 percent of GDP (2003).
- Net private debt rose from 33.4 percent of GDP to 46.9 percent of GDP over the period.
- Net external equity liabilities and related flows:
  - Net external equity liabilities: 14.3 (1998), 12.1 (2003) (percent of GDP).
  - Foreign equity investment in Australia: 46.6 (1998), 50.4 (2003) (percent of GDP).
  - Australian equity investment abroad: -32.3 (1998), -38.3 (2003) (percent of GDP).

### Currency and maturity profile
- Share of gross external debt denominated in foreign currency remained broadly flat at under 65 percent; foreign currency-denominated gross external debt values in Table: 39.4 (1998), 50.5 (2003) (percent of GDP).
- Australian dollar–denominated gross external debt: 23.4 (1998), 26.7 (2003) (percent of GDP).
- Short-term gross external debt increased then eased: 30.6 (1998), 37.3 (2003) (percent of GDP).
- Short-term net external debt (residual maturity basis): 17.4 (1998), 18.4 (2003) (percent of GDP).
- Medium-term trends through 2002 showed shortening of maturity and an increase in foreign currency component; these trends reversed somewhat in 2003.
- High degree of hedging mitigates foreign currency exposure; ABS 2001 survey indicated foreign currency assets exceeded foreign currency liabilities at end-June 2001.
- Banks made substantial use of derivatives to hedge foreign currency exposure; market for these instruments appears reasonably deep and resilient.

### Sectoral balance sheets — corporate, households, banks
- Nonfinancial corporate sector:
  - Debt-to-equity ratio (end-June): 70.6 (1998), 80.5 (2003) (percent).
  - Debt (percent of GDP): 73.3 (1998), 76.2 (2003).
  - Operating income/sales: 25.3 (1998), 26.4 (2003) (percent).
  - Return on permanent capital: 10.3 (1998), 9.4 (2003) (percent).
  - EBITDA interest cover (times): 5.1 (1998), 4.9 (2003).
  - Assessment: indicators suggest the nonfinancial corporate sector remains sound despite a gradual increase in debt-to-equity; debt as a share of GDP was reduced during 2002–03; operating margins improved and interest cover is adequate.
- Households:
  - Net worth (percent of gross disposable income): 465 (1998), 516 (2003).
  - Total assets: 567 (1998), 658 (2003).
  - Dwellings and land: 281 (1998), 358 (2003).
  - Financial assets: 245 (1998), 264 (2003).
  - Total liabilities: 101 (1998), 142 (2003).
  - Housing debt: 63 (1998), 100 (2003).
  - Interest payments on mortgages increased to 7¼ percent of disposable income (2003 figure stated as 7.3 in table).
  - Household net savings: 2.2 (1998), -2.3 (2003) (percent of gross disposable income).
  - House price developments: real house price index (weighted average for 8 capital cities) increased by 16¼ percent in 2003.
  - Risk noted: current surge in house prices driven in part by investment housing concentrated in CBDs may be more at risk of a price correction, with potential spillovers weakening household balance sheets.
- Banking sector:
  - Loans (share of total assets): 69.3 (1998), 67.0 (2003) (percent).
  - Loans to persons: 39.0 (1998), 42.0 (2003) (percent).
  - Housing loans: 32.6 (1998), 35.8 (2003) (percent).
  - Net interest margin: 2.9 (1998), 2.2 (2003) (percent).
  - Return on average assets: 1.0 (1998), 1.1 (2003) (percent).
  - Return on average equity: 15.0 (1998), 16.4 (2003) (percent).
  - Tier 1 capital: 7.6 (1998), 7.6 (2003) (percent of risk-weighted assets).
  - Total capital: 10.3 (1998), 10.1 (2003) (percent of risk-weighted assets).
  - Impaired assets: 0.7 (1998), 0.4 (2003) (percent).
  - General and specific provisions (percent of impaired assets): 114.7 (1998), 138.3 (2003).
  - Net foreign currency liabilities: 8.0 (1998), 9.5 (2003) (billion? table header indicates “In billions of Australian dollars, as of June 30, 2001” for some tables; in banks’ table these are percent of assets).
  - Assessment: banking sector performance remains very strong; four major banks’ return on assets over 1 percent and return on equity 16½ percent (text); total capital around 10 percent and tier-one around 7½ percent; impaired assets ratio about 0.4 percent; provisions almost 140 percent of impaired assets; four major banks have credit ratings of AA- or better. However, housing loans comprise about half of total bank loans and a major correction in housing prices could have spillover effects despite current low delinquency rates (<1 percent).

### Vulnerabilities and indicators of resilience
- Net interest payments to exports declined from 9.1 (1998) to 8.7 (2003) (percent), reflecting a relatively lower interest rate environment.
- Gross official reserves (in $A billion): 25.0 (1998), 44.3 (2003).
- RBA outstanding forward contracts (in $A billion): 10.1 (1998), 26.4 (2003).
- Net official reserves (in $A billion): 14.9 (1998), 17.9 (2003).
- Gross official reserves (in months of imports): 2.3 (1998), 3.3 (2003).
- Gross official reserves to short-term foreign currency denominated debt (percent): 19.5 (1998), 21.7 (2003).
- The medium-term rise in the share of the financial sector’s external debt has shortened the maturity profile of Australia’s external debt because the financial sector raises most of its funds at shorter maturities than the government and corporate sectors.
- Mitigating factors: high degree of foreign currency hedging, deep derivatives market, strong bank capitalization and provisioning, improved household net worth, and substantial official reserves.

*Source: IMF staff report content (Annexes I–III excerpts provided in source PDF).*

### 1.      This statement contains information that has become available since the Staff Report

### _cr04353 - 1.      This statement contains information that has become available since the Staff Report

### New information since the Staff Report
- This statement contains information that has become available since the Staff Report was circulated to the Executive Board on August 31, 2004. This information does not alter the thrust of the staff appraisal.

### Political developments and government objectives
- In the October 9 national election, Prime Minister John Howard’s Liberal-National coalition won a fourth three-year term with an increased majority in the lower house.
- The new government announced chief goals: maintaining strong economic growth, reforming the industrial relations system, protecting national security, and pursuing free-trade agreements.

### Fiscal outlook and budgetary developments
- The Departments of Treasury and Finance issued a Pre-Election Economic and Fiscal Outlook in early September.
- Fiscal outcomes and projections:
  - The fiscal surplus in 2003/2004 was 0.3 percent of GDP higher than previously expected.
  - The fiscal surplus for 2004/05 is now projected at $A 3.6 billion (0.4 percent of GDP), compared with the May budget forecast of $A 0.7 billion.
  - Fiscal surpluses during 2005–08 are expected to exceed the previous forecast by about 0.4–0.5 percent of GDP each year.
- The 2004 Budget “More Help for Families” package:
  - 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).
  - Maintains a modest cash surplus of less than ½ percent of GDP each year through the medium term.
  - Commonwealth net debt projected to turn negative by 2007/08.

### Recent economic activity and outlook
- GDP and demand:
  - Real GDP growth in the second quarter picked up slightly to 0.6 percent from 0.5 percent in the first quarter.
  - For the year as a whole, real GDP growth was 3 percent, compared with 3.8 percent in 2002.
  - Real GDP growth is projected near potential of about 3¾ percent in 2004.
- External sector:
  - The deficit on net exports narrowed to 2 percent of GDP in the second quarter from 3½ percent of GDP in the first quarter.
  - The current account deficit deteriorated from 4.4 percent of GDP in 2002 to 6 percent in 2003.
- Domestic demand and labor market:
  - Strong domestic demand continued to sustain forward momentum.
  - Retail trade growth slowed to 6 percent (y/y) during June-August, compared with 10 percent peaks earlier in the year.
  - Unemployment remains low.
- Risks and rebalancing:
  - Main risk: the housing market and associated build-up in household indebtedness.
  - Rebalancing expected: domestic demand growth gradually slowing and net exports picking up as the global economy strengthens and agricultural output recovers from the drought.
  - Recent indicators consistent with a soft landing in the housing market.

### Housing market developments
- Price and activity indicators:
  - The price index for established houses fell 1.2 percent in the second quarter after an increase of 2.5 percent in the first quarter (first fall since Q3 2000).
  - Regional variation: prices fell in Sydney and Canberra but continued to rise in other capital cities.
  - Building approvals and the value of new lending on housing have continued to decline in the past few months.
  - Overall decline in lending in August was driven by a drop in lending to investors; lending to owner occupiers was boosted by the return of first-time buyers.

### Monetary policy
- At its regularly scheduled meeting in early October, The Reserve Bank of Australia left the target for the cash rate unchanged at 5.25 percent for the tenth consecutive month.
- RBA policy background:
  - OCR was increased by 25 basis points in both November and December 2003.
  - RBA kept the OCR unchanged in the first three quarters of 2004 due to signs of easing domestic spending, cooling in the housing market, and subdued inflation pressures.
- Inflation dynamics:
  - Headline CPI inflation remained within the RBA’s target range of 2–3 percent.
  - Nontradables inflation around 4 percent; tradables inflation declined sharply since March 2003 due to appreciation of the Australian dollar.
  - Recent easing of the Australian dollar may be eroding the dampening effect on tradables inflation.

### IMF Executive Board assessment and recommendations
- Executive Directors’ appraisal:
  - Commended Australia’s strong performance: six years of budget surpluses, falling public debt, low inflation, high and rising productivity, and uninterrupted growth supporting a dynamic job market.
  - Attributed performance to exemplary macroeconomic and financial management and structural reforms.
- Views on outlook and risks:
  - Outlook remains favorable; downside risks include a sharp housing correction, further increases in oil prices, and weakening external demand.
  - Directors considered downside risks balanced by upside potential from buoyant domestic demand.
- Policy endorsements and recommendations:
  - Supported authorities’ monetary policy stance (inflation targeting) and the RBA’s measured actions.
  - Supported flexible exchange rate policy and limited foreign exchange intervention only when the exchange rate is clearly misaligned or markets are disorderly.
  - Endorsed fiscal strategy of aiming for a balanced budget over the business cycle.
  - Called attention to long-term spending pressures from increasing healthcare costs and population ageing; welcomed Pharmaceutical Benefit Scheme amendment.
  - Supported structural reforms to promote labor force participation and productivity, including tax and income support changes to improve work incentives and measures to increase labor market flexibility, reform welfare, enhance competitiveness, and invest in research and development and infrastructure.
  - Commended financial system soundness and risk management culture; welcomed steps to strengthen supervision, insurance industry supervision legislation, and audit reform.
  - Noted potential risks from sustained high current account deficit and private external debt buildup; advocated close monitoring of corporate and banks’ balance sheets.
  - Commended preparation for Basel II implementation and interest in participating in a Financial Sector Assessment Program.
  - Praised commitment to trade liberalization and unilateral duty- and quota-free market access to least developed countries.
  - Welcomed increased aid allocation to neighboring Pacific Island countries and commitment to achieving UN official development assistance target.

### Key statistics (selected, as reported)
- Fiscal and macro figures:
  - Fiscal surplus 2003/2004: 0.3 percent of GDP higher than previously expected.
  - Fiscal surplus 2004/05 projected: $A 3.6 billion (0.4 percent of GDP); May forecast was $A 0.7 billion.
  - 2004 Budget initiatives: $A 37 billion over five years (about 0.9 percent of GDP each year).
- Output and demand (period references as in the source):
  - Real GDP (annual entries shown): 5.2 4.3 3.2 2.5 3.8 3.0
  - Total domestic demand: 6.6 5.6 2.2 1.3 6.5 6.2
  - Private consumption: 4.6 4.9 3.1 2.8 4.2 4.3
  - Fixed investment: 8.2 7.0 1.5 -1.1 15.5 9.6
  - Exports of goods and services: 0.0 4.5 11.2 1.6 0.3 -2.3
  - Imports of goods and services: 6.0 9.1 7.8 -4.2 11.5 11.3
- Inflation and labor:
  - CPI inflation: 0.9 1.5 4.5 4.4 3.0 2.8
  - Unemployment rate: 7.7 6.9 6.3 6.8 6.4 6.1
- Balance of payments and external:
  - Current account (percent of GDP): -4.9 -5.7 -4.0 -2.4 -4.4 -6.0
  - Net external liabilities (percent of GDP): 55.1 55.1 53.8 53.5 56.7 59.5
  - US$/$A (end of period): 0.614 0.654 0.554 0.509 0.566 0.750
- Monetary/market rates:
  - Reserve Bank cash rate target (as of early October meeting): 5.25 percent.
  - Interest rate (90-day bill, in percent, selected years): 4.8 5.7 6.2 4.2 4.8 5.5

*Source: _cr04353 - 1.      This statement contains information that has become available since the Staff Report (IMF Public Information Notice No. 04/124, November 8, 2004).*

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