## _cr06374

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### Executive Summary — Booming commodity prices and cyclical developments
- Australia is experiencing "the most favorable terms of trade in three decades" after a house price boom; house prices rose by over 60 percent in 2001-03 and then cooled in the past 2½ years.
- Terms of trade have risen by over 30 percent during the past three years, driven by strong global growth (especially China) and higher prices for iron ore and coal.
- Business capital spending grew by 16 percent in 2005, particularly strong in the resources sector, helping to cushion real GDP growth which slowed to 2½ percent in 2005.
- Consumption showed signs of strengthening in 2006; household credit growth picked up modestly.
- External current account deficit was around 6 percent of GDP in 2005; net foreign liabilities reached 60 percent of GDP, while the ratio of net interest payments to exports remained low at 9 percent.
- Trade deficit narrowed owing to higher export prices but export volumes were held back by unfavorable weather, an appreciated exchange rate, and temporary transport disruptions.
- About half of the booming resource sector is foreign owned; external financing continued to rely on portfolio inflows, principally through offshore bond issues by major banks with a weighted average maturity of around four years.

### Labor market, inflation, and monetary policy
- Unemployment rate fell to 4.9 percent in June; average private sector wage growth rose to 4 percent (y/y) in March 2006 from 3½ percent in recent years.
- Unit labor cost growth rose in 2005 because labor productivity growth was unusually low in 2005; productivity growth recovered in the first half of 2006.
- Headline CPI inflation was 4 percent (y/y) in June 2006; excluding volatile items CPI inflation remained below 2½ percent. RBA statistical measures of core inflation rose to just under 3 percent.
- The Reserve Bank of Australia raised the cash rate by 25 basis points in May 2006 (first increase since March 2005) and by a second hike in August 2006, taking the cash rate to 6 percent.
- In July 2006 the Australian dollar was 11 percent above its 20-year average in real effective terms.

### Fiscal position and public finances
- Net debt of the Commonwealth government was eliminated in April 2006, aided by fiscal surpluses in 8 of the past 9 years.
- The underlying cash balance for the 2005/06 fiscal year (ending June) is estimated at 1½ percent of GDP, ½ percentage point higher than budgeted.
- Revenue was stronger than projected owing to unexpectedly strong employment growth, significant capital gains for investors, and rapid growth in corporate profits partly owing to high commodity prices.
- Authorities budget on the prudent assumption that coal and iron ore prices revert to historical average levels by 2008/09—implying a fall of about 25 percent in Australia’s export commodity prices—and allow for a significant decline in commodity prices in medium-term fiscal projections.
- The Future Fund was established in April 2006 to cover unfunded public service pensions with a goal to cover the outstanding liability by 2020, requiring the accumulation of an estimated A$140 billion in assets; seed capital of A$18 billion was provided in May, and around A$12 billion should be added in September after the 2005/06 budget outcome is confirmed.

### Outlook and scenarios
- Short- and near-term growth projections:
  - Growth is projected to pick up to about 3 percent in 2006 and 3½ percent in 2007.
  - Domestic demand growth is expected to slow gradually, with consumption likely to settle at around 3 percent.
- Medium-term outlook:
  - Real GDP growth is expected to average about 3¼ percent in the medium term.
  - With investment declining only gradually from current highs, net foreign liabilities could rise to about 70 percent of GDP by 2011.
  - Export commodity prices are assumed to start declining after a few years; past experience suggests about half of past terms of trade gains have been reversed within a few years.
- Risks to the outlook:
  - Downside: Commodity prices could fall more rapidly if global and/or Chinese growth slows; a disorderly global adjustment could amplify a fall in the Australian dollar.
  - Upside/persistence risk: Commodity prices could remain high for longer than expected, prolonging upward pressure on interest rates and the exchange rate and producing more divergent growth outcomes across the States.

### Monetary policy stance and exchange rate (additional detail)
- Core inflation expected to remain within "2½ to 3 percent in 2006-07" at the time of the mission.
- The RBA saw no need to change the monetary stance in the near term, though recent firming in indicators suggested the next change would be a tightening.
- Staff recommended a pre-emptive approach to reduce the risk that a larger, potentially more disruptive, tightening might be needed later.
- IMF staff estimated the Australian dollar was "5 percent above its multilateral equilibrium in February-March 2006."
- The exchange rate on a trade-weighted basis remains close to that level.
- The RBA accumulated a modest amount of reserves using the relatively high Australian dollar, with negligible effect on the foreign exchange market.
- RBA raised the target cash rate to 6 percent in two 25 basis point steps in May and August 2006; interest rate (90-day bill) was 6.2 percent (end of period, 2006, latest available month).

### Financial sector soundness and supervision
- FSAP findings: the financial sector is healthy and financial supervision is sound.
- Authorities plan further stress tests and are reviewing regulation of banks’ liquidity to promote robust risk management.
- Authorities are working to ensure legal foundations for the resolution of failed institutions to underpin resilience during a crisis; a proposed Financial Claims Compensation Scheme is considered a useful element.
- Household indebtedness reached 152 percent of disposable income in the first quarter, but debt equals only one-fifth of household assets; the RBA’s March 2006 Financial Stability Review found few signs of household financial distress.
- APRA actions and supervisory priorities:
  - Close monitoring of household debt service capacity and collection of detailed data on banks’ mortgage lending.
  - APRA tightened mortgage insurance requirements for "low doc" loans to qualify for a 50 percent risk weight.
  - APRA adopted a scenario approach to liquidity regulation; ADIs are diversifying funding sources and lengthening maturities.
  - APRA increased resources by almost 50 percent since the failure of the HIH Group in 2001; turnover among junior staff remains a concern.

### Structural reforms, productivity, and labor market
- Productivity growth slowed in the first half of the decade, leaving Australian per capita incomes "just over 20 percent below the level in the United States."
- The National Reform Agenda (COAG, February 2006) sets out an ambitious reform program including human capital and regulation issues.
- Competition-related reforms highlighted:
  - Export infrastructure: simpler and nationally consistent system of regulation for ports, railways, and other export-related infrastructure; mission urged timely implementation.
  - Land transportation and electricity: Productivity Commission inquiry on road and rail freight infrastructure pricing; Energy Reform Implementation Group to propose steps toward a fully national electricity market.
  - Water: National Water Initiative (2004) aims for full trading in water rights by 2014; water trade currently mostly within catchments and interstate water trading steps are falling behind.
- The mission urged steadfast implementation of action plans and recommended using some surge in revenues to spur reform implementation.
- WorkChoices reforms of industrial relations came into effect in March 2006.
- Employment gains will be reinforced by tightening eligibility for Disability Support Pensions and Parenting Payments (2005/06 budget) and measures in the 2006/07 budget that reduce effective marginal tax rates—which can be "as high as 74 percent for some levels of personal income."
- Australia plans to double its official development assistance: the 2006/07 Budget sets aside an estimated "0.3 percent of national income for ODA, up from 0.25 percent in 2005." By 2010 Australia plans to double its ODA from 2004 levels.

### Box summaries and recommendations
- Box 1 — The Future Fund:
  - Long-term fiscal challenge: By 2045 the annual fiscal balance of the general government is estimated to deteriorate by 6½ percent of GDP, with increases in health spending accounting for about 70 percent of this fall.
  - Purpose: cover unfunded public service pensions (about one-tenth of the estimated long-term fiscal gap); outflows will not begin until 2020 or when the liability is fully covered; projected payments average about 0.6 percent of GDP.
  - Investment mandate: long-term benchmark average annual real return of at least 4½ to 5½ percent; two restrictions include a 20 percent ceiling on holdings of any listed company and limits to minimize abnormal market volatility.
- Box 2 — Key FSSA recommendations:
  - Banking: continue strong risk management, regular stress testing, monitor ADIs shifting into new businesses, set appropriately strong capital requirements.
  - Failure resolution: develop a comprehensive framework and ensure necessary legal powers; proposed Financial Claims Compensation Scheme can be a useful element.
  - Supervisory capacity: ensure APRA and ASIC have adequate resources and flexibility; address junior staff turnover; prepare for Basel II and principle-based supervision.
- Box 3 — Achieving Structural Reform in a Federal System:
  - Conditional payments to States and analytical support from the Productivity Commission were key to past National Competition Policy success (estimated NCP-related reforms raised GDP by 2½ percent in the 1990s).
  - COAG to establish COAG Reform Council (CRC) to report annually on progress; Commonwealth to provide funding on a case-by-case basis when needed.

### Staff appraisal: outlook and risks (summary)
- Australia’s economic performance has been robust after "14 years of expansion," with growth strengthening following a modest 2005 slowdown.
- Macroeconomic policies are well positioned: monetary policy tightened appropriately; the Australian dollar is relatively high but not clearly significantly misaligned; exchange rate flexibility and medium-term monetary focus provide cushions.
- Fiscal position is enviable: net public debt eliminated while providing significant tax cuts; even with prudent allowance for a decline in commodity prices the medium-term fiscal outlook is robust.
- Recommendation: allow the fiscal surplus to exceed budget targets if growth and revenues are strong.
- Directors and staff emphasized continued vigilance in financial supervision and close monitoring of private external debt.

### Key statistics (selected, exact values)
- Net external liabilities: 57.2 percent of GDP in 2006.
- Net external debt: 52.2 percent of GDP in 2006.
- Net interest payments to exports: 9 percent.
- Current account deficit: -5.6 percent of GDP in 2006.
- Trade balance: -1.5 percent of GDP in 2006.
- Gross official reserves: 6.8 percent of GDP (2006, latest available month).
- Interest rate (90-day bill): 6.2 percent (end of period, 2006, latest available month).
- Treasury bond yield (10-year): 5.5 percent in 2006.
- CPI inflation: 3.5 percent in 2006.
- Net public debt: -0.6 percent of GDP in 2006.
- Underlying cash balance for 2005/06 fiscal year: 1.6 percent of GDP.
- 2006/07 budget targeted fiscal surplus: 1.1 percent of GDP; projects surplus to remain at "1 percent of GDP in the medium term."
- General government saving: 4.7 percent of GDP in 2006.
- Real GDP (percent change): 2001: 2.3; 2002: 4.1; 2003: 3.1; 2004: 3.6; 2005: 2.7; 2006: 3.1.
- Total domestic demand (2006): 4.0 percent change.
- Private consumption (2006): 3.2 percent change.
- Total investment (2006): 7.5 percent change; business investment: 11.9 percent change; dwelling investment: -3.7 percent change.
- Exports of goods and services (2006): 3.6 percent change; imports of goods and services (2006): 6.5 percent change.
- Unemployment rate (2006): 5.0 percent.
- Terms of trade changes: 2004: 1.2; 2005: 9.8; 2006: 6.5 (percent change).
- Real effective exchange rate (1990 = 100): 2001: 97.2; 2002: 101.5; 2003: 122.4; 2004: 121.8; 2005: 125.3; 2006: 124.5.
- US$/$A (period average, latest available month for 2006): 2006: 0.756.
- M3 (percent change): 2006: 11.8.
- Private domestic credit (percent change): 2006: 14.5.
- Current account (percent of GDP): 2006: -5.6.
- Net debt (percent of GDP): 2006: -0.6.

*Source: IMF staff report and Executive Board assessment (2006 Article IV consultation with Australia).*

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

### _cr06374 - Executive Summary ......................................................................................................

### Booming commodity prices and recent cyclical developments
- Australia is experiencing "the most favorable terms of trade in three decades" after a house price boom; house prices rose by over 60 percent in 2001-03 and then cooled in the past 2½ years.
- Terms of trade have risen by over 30 percent during the past three years, driven by strong global growth (especially China) and higher prices for iron ore and coal.
- Business capital spending grew by 16 percent in 2005, particularly strong in the resources sector, helping to cushion real GDP growth which slowed to 2½ percent in 2005.
- Consumption showed signs of strengthening in 2006; household credit growth picked up modestly.
- The external current account deficit was around 6 percent of GDP in 2005; net foreign liabilities reached 60 percent of GDP, while the ratio of net interest payments to exports remained low at 9 percent.
- The trade deficit narrowed owing to higher export prices but export volumes were held back by unfavorable weather, an appreciated exchange rate, and temporary transport disruptions.
- About half of the booming resource sector is foreign owned; external financing continued to rely on portfolio inflows, principally through offshore bond issues by major banks with a weighted average maturity of around four years.

### Labor market, inflation, and monetary policy
- The unemployment rate fell to 4.9 percent in June; average private sector wage growth rose to 4 percent (y/y) in March 2006 from 3½ percent in recent years.
- Unit labor cost growth rose in 2005 because labor productivity growth was unusually low in 2005; productivity growth recovered in the first half of 2006.
- Headline CPI inflation was 4 percent (y/y) in June 2006; excluding volatile items CPI inflation remained below 2½ percent. RBA statistical measures of core inflation rose to just under 3 percent.
- The Reserve Bank of Australia raised the cash rate by 25 basis points in May 2006 (first increase since March 2005) and by a second hike in August 2006, taking the cash rate to 6 percent.
- In July 2006 the Australian dollar was 11 percent above its 20-year average in real effective terms.

### Fiscal position and public finances
- Net debt of the Commonwealth government was eliminated in April 2006, aided by fiscal surpluses in 8 of the past 9 years.
- The underlying cash balance for the 2005/06 fiscal year (ending June) is estimated at 1½ percent of GDP, ½ percentage point higher than budgeted.
- Revenue was stronger than projected owing to unexpectedly strong employment growth, significant capital gains for investors, and rapid growth in corporate profits partly owing to high commodity prices.
- The authorities budget on the prudent assumption that coal and iron ore prices revert to historical average levels by 2008/09—implying a fall of about 25 percent in Australia’s export commodity prices—and allow for a significant decline in commodity prices in medium-term fiscal projections.

### Outlook and scenarios
- Short- and near-term growth projections:
  - Growth is projected to pick up to about 3 percent in 2006 and 3½ percent in 2007.
  - Domestic demand growth is expected to slow gradually, with consumption likely to settle at around 3 percent.
- Medium-term outlook:
  - Real GDP growth is expected to average about 3¼ percent in the medium term.
  - With investment declining only gradually from current highs, net foreign liabilities could rise to about 70 percent of GDP by 2011.
  - Export commodity prices are assumed to start declining after a few years; past experience suggests about half of past terms of trade gains have been reversed within a few years.
- Risks to the outlook:
  - Downside: Commodity prices could fall more rapidly if global and/or Chinese growth slows; a disorderly global adjustment could amplify a fall in the Australian dollar.
  - Upside/persistence risk: Commodity prices could remain high for longer than expected, prolonging upward pressure on interest rates and the exchange rate and producing more divergent growth outcomes across the States.

### Financial sector soundness and supervision
- The Financial Sector Assessment Program (FSAP) finds the financial sector healthy and financial supervision sound.
- Authorities plan to conduct further stress tests and are reviewing regulation of banks’ liquidity to promote robust risk management.
- The authorities are working to ensure legal foundations for the resolution of failed institutions to underpin resilience during a crisis.
- Household indebtedness reached 152 percent of disposable income in the first quarter, but debt equals only one-fifth of household assets; the RBA’s March 2006 Financial Stability Review found few signs of household financial distress.

### Policy implications and recommendations highlighted by staff
- Macroeconomic policy stance:
  - Monetary policy has been tightened appropriately; a further tightening may eventually be needed.
  - A flexible monetary policy response to potential external shocks, including commodity price swings, will help cushion growth while preserving low inflation.
- Fiscal policy and use of revenue windfalls:
  - The fiscal position is projected to remain in surplus in the medium term, providing a substantial buffer against shocks; the surplus should be allowed to exceed budget targets if growth and revenues are stronger than expected.
  - The recent surge in revenues provides resources that should be used to spur implementation of structural reforms to lift productivity and participation over the next decade.
- Structural and supervisory priorities:
  - Press ahead with implementing reforms to lift productivity and participation in order to sustain strong growth and better address challenges of an ageing population and rising healthcare costs.
  - Maintain vigilance in financial supervision and strengthen resolution frameworks and liquidity regulation.

*Source: _cr06374 - Executive Summary ......................................................................................................*

### 0.3 percent of outstanding loans they are very low by international standards, and bank credit

### _cr06374 - 0.3 percent of outstanding loans they are very low by international standards, and bank credit

### Monetary policy stance and exchange rate
- Core inflation expected to remain within "2½ to 3 percent in 2006-07" at the time of the mission.
- The RBA saw no need to change the monetary stance in the near term, though recent firming in indicators suggested the next change would be a tightening.
- Staff recommended a pre-emptive approach to reduce the risk that a larger, potentially more disruptive, tightening might be needed later.
- In the event, "the RBA lifted rates in August," reflecting an assessment that economic activity remained strong and underlying inflation was likely to exceed previous forecasts.
- If export commodity prices stayed high, strong domestic demand may be prolonged, requiring interest rates to be higher than otherwise.
- If global activity slowed and commodity prices fell, the Australian dollar could depreciate significantly; however, the RBA would still have room to cut interest rates because exchange rate pass-through has diminished and the inflation targeting framework is focused on the medium term.
- IMF staff estimated the Australian dollar was "5 percent above its multilateral equilibrium in February-March 2006."
- The exchange rate on a trade-weighted basis remains close to that level.
- The RBA accumulated a modest amount of reserves using the relatively high Australian dollar, with negligible effect on the foreign exchange market.

### Fiscal position and budget projections
- High terms of trade are supporting economic growth and tax revenue; the government targeted larger-than-usual budget surpluses.
- The 2006/07 Budget projects the underlying cash surplus to remain at "1 percent of GDP in the medium term," well above the objective of balancing the budget over the cycle.
- Compared with the previous budget, and before new policy measures, revenue is projected to be "1½ percent of GDP higher in 2006/07 and in later years."
- The 2006/07 budget implies a mild fiscal stimulus: the fiscal surplus is projected to decline by "½ percent of GDP in 2006/07," but most of this decline reflects tax cuts which, based on past experience, are generally expected to largely be saved.
- The mission recommended that the authorities limit changes in fiscal policies if revenue again runs ahead of budget estimates in 2006/07, allowing the fiscal surplus to exceed the budget target as was expected to occur in 2005/06.
- If Australia faced a global slow-down with a large fall in commodity prices, the strong fiscal position would allow a temporary move into deficit if needed.
- The Future Fund (announced in the 2005/06 budget) has been established to invest future budget surpluses.
- The 2006/07 budget proposes that benefits from most superannuation funds would become tax free for persons "aged over 60"; the mission encouraged the authorities to provide an assessment of the net long-run fiscal impact of the proposal.

### Financial system soundness and supervisory vigilance
- Mortgage arrears rose; authorities attribute the rise mainly to a deliberate easing by financial institutions of their conservative credit standards. An increase in arrears in New South Wales was associated with a rise in bankruptcies.
- Australia’s financial system is described as healthy, profitable, and resilient to shocks.
- The recent FSAP found prudential supervision by APRA and market conduct supervision by ASIC are sound, with a high level of compliance with international standards.
- Stress tests did not reveal near-term stability concerns, including for a scenario combining a sharp recession, large falls in house prices and the exchange rate, and a significant rise in the cost of wholesale funding.
- Authorities endorsed key FSAP recommendations:
  - APRA increased resources in recent years; ASIC funding arrangements were revised in the 2006/07 budget to enhance flexibility.
  - APRA saw moderating turnover among junior staff as a priority to strengthen supervisory capacity.
  - APRA noted the need to ensure suitable risk management by authorized deposit-taking institutions (ADI) entering new businesses; supervisors are assessing ADI risk management capabilities and expect greater use of differentiated capital requirements.
- FSSA highlights bank vulnerabilities including heavy exposure to households with historically high debt levels, elevated house prices, easing credit standards, and reliance on wholesale funding.
- APRA tightened mortgage insurance requirements for "low doc" loans to qualify for a 50 percent risk weight.
- APRA is collecting detailed data on banks’ mortgage lending to better understand households' debt service capacity.
- APRA adopted a scenario approach to liquidity regulation; ADIs are diversifying funding sources, lengthening maturities, and avoiding concentrations of rollover dates.
- Authorities are formalizing a framework for failure resolution and crisis management, including development of legal foundations and policy approach to achieve timely and minimally disruptive resolution of failed institutions at least fiscal cost.
- The proposed Financial Claims Compensation Scheme is considered a useful element of the framework.
- Authorities are seeking legislation to provide APRA with legal powers to deal with a troubled general insurer.
- Steps to enhance supervisory cooperation with New Zealand were agreed to promote enhanced cooperation between APRA and the Reserve Bank of New Zealand.
- Legislation to address AML/CFT issues will be tabled in 2006 following a review since late 2003 and consideration of the October 2005 FATF mutual evaluation.

### Structural reforms, productivity, and labor market
- Productivity growth slowed in the first half of the decade, leaving Australian per capita incomes "just over 20 percent below the level in the United States."
- A recent study estimates that only about half of the difference in productivity levels that underpins this income gap can be accounted for by Australia’s remoteness from global markets.
- The National Reform Agenda (COAG, February 2006) sets out an ambitious reform program including human capital and regulation issues.
- Competition-related reforms highlighted:
  - Export infrastructure: COAG agreed a simpler and nationally consistent system of regulation for ports, railways, and other export-related infrastructure; the mission urged timely implementation.
  - Land transportation and electricity: Productivity Commission inquiry on road and rail freight infrastructure pricing; Energy Reform Implementation Group to propose steps toward a fully national electricity market.
  - Water: National Water Initiative (2004) aims for full trading in water rights by 2014; water trade currently mostly within catchments and interstate water trading steps are falling behind.
- The mission urged steadfast implementation of action plans and recommended using some surge in revenues to spur reform implementation.
- WorkChoices reforms of industrial relations came into effect in March 2006; resulting increases in labor demand may be most evident among small businesses.
- Employment gains will be reinforced by tightening eligibility for Disability Support Pensions and Parenting Payments (2005/06 budget) and measures in the 2006/07 budget that reduce effective marginal tax rates—which can be "as high as 74 percent for some levels of personal income."
- Maintaining labor market flexibility was emphasized to facilitate smooth adjustment to commodity price swings or other shocks.
- Australia plans to double its official development assistance: the 2006/07 Budget sets aside an estimated "0.3 percent of national income for ODA, up from 0.25 percent in 2005." By 2010 Australia plans to double its ODA from 2004 levels.

### Staff appraisal: outlook and risks
- Australia’s economic performance has been robust and prospects remain bright after "14 years of expansion," with growth strengthening again following a modest 2005 slowdown.
- Strong business investment, high capacity utilization, and the highest terms of trade in three decades are laying the foundation for solid export-led growth in the medium term.
- Staff noted that much of the terms of trade improvement will, sooner or later, be reversed.
- Macroeconomic policies are well positioned: monetary policy tightened appropriately; the Australian dollar is relatively high but not clearly significantly misaligned; exchange rate flexibility and medium-term monetary focus provide cushions against external shocks.
- Australia’s fiscal position is enviable: net public debt eliminated while providing significant tax cuts.
- Even after prudent allowance for a decline in commodity prices the medium-term fiscal outlook is robust; the fiscal surplus should be allowed to exceed budget targets if growth and revenues are strong.
- Potential vulnerabilities are contained by sound macroeconomic policies and sophisticated private sector risk management; close monitoring of private external debt should continue.

*IMF staff report content from the provided PDF excerpt.*

### 31.      Financial supervision must remain vigilant. Australia’s financial system is healthy

### 31.      Financial supervision must remain vigilant. Australia’s financial system is healthy

### Financial system assessment and supervisory priorities
- Australia’s financial system is healthy and financial supervision is sound.
- Continued efforts are needed to promote robust risk management practices by financial institutions as they enter new businesses and face growing competitive pressures.
- APRA’s ongoing and planned actions noted as welcome:
  - close monitoring of household debt service capacity;
  - plans to conduct further stress tests;
  - review of liquidity regulation;
  - efforts to moderate staff turnover.
- The authorities’ initiative to ensure the legal foundations for timely and minimally disruptive resolution of failed institutions, at the least fiscal cost, is important to underpin resilience during a crisis.

### National Reform Agenda and fiscal context
- It is recommended to press ahead with the ambitious National Reform Agenda to lift productivity and participation over the next decade.
- The reform agenda has been broadened to include human capital issues, yet implementation is lagging in crucial areas such as trading in water.
- The recent surge in revenues provides resources that should be used to spur reform implementation.
- By sustaining strong economic growth, these reforms will help narrow the gap between living standards in Australia and those in the most advanced economies, and better position Australia to address the challenges of an ageing population and rising healthcare costs.

### Consultation timing
- It is proposed that the next Article IV consultation with Australia take place on the standard 12-month cycle.

### Box 1 — The Future Fund: objectives, financing, and governance
- Long-term fiscal challenge:
  - By 2045 it is estimated that the annual fiscal balance of the general government will deteriorate by 6½ percent of GDP, with increases in health spending accounting for about 70 percent of this fall.
- Role of structural reforms:
  - Government strategy emphasizes structural reforms to lift productivity and labor participation.
  - Approach facilitated by relatively gradual ageing and reliance on mandatory private pensions.
- Purpose of the Future Fund (FF):
  - Established in April 2006 to cover unfunded public service pensions, which will address about one-tenth of the estimated long-term fiscal gap.
  - Goal is to cover the outstanding liability by 2020, requiring the accumulation of an estimated A$140 billion in assets.
  - FF will receive inflows from future fiscal surpluses, privatization proceeds, and its own investment income.
  - Outflows will not begin until 2020, or when the liability is fully covered, and can only be used to meet the pension payments covered by the FF, which are projected to average about 0.6 percent of GDP.
- Near-term financing and potential growth:
  - Seed capital of A$18 billion was provided in May, and around A$12 billion should be added in September after the 2005/06 budget outcome is confirmed.
  - Completing the privatization of Telstra could lift the fund to over A$50 billion.
  - If fiscal surpluses projected in the next three or four years are realized, and assuming the FF earns reasonable returns, it will be well placed to reach its long-term goals.
- Investment mandate and restrictions:
  - Long-term benchmark average annual real return of at least 4½ to 5½ percent.
  - Two main restrictions:
    - FF is not to hold controlling stakes; 20 percent ceiling on holdings of any listed company.
    - FF must “act in a manner that minimizes the potential to cause any abnormal change in the volatility or efficient operation of the Australian financial markets,” implying limits on outright holdings of Commonwealth government bonds.
  - Otherwise free to set risk tolerance and asset allocation (domestic vs foreign assets).
  - Management envisaged to be contracted out to private managers for some time.
- Governance:
  - Governance of the FF is consistent with international best practice.
  - The Board of Guardians was appointed in late March, consisting of the Chairman and six members, all with significant expertise in investment management and corporate governance, and none are government employees.
  - Government retains the right to direct the Board by changing the investment mandate, but if the Board considers a new mandate inconsistent with basic objectives it may table a submission to Parliament opposing the change—providing transparency to minimize politically motivated investments.

### Box 2 — Key recommendations from the Financial Sector Assessment Program (FSSA)
- Banking:
  - APRA should continue to ensure strong risk management practices including through regular stress testing.
  - As authorized deposit-taking institutions (ADI) shift away from real estate lending and into businesses such as SME lending, wealth management, and expansion overseas, it is important to monitor and evaluate ADIs’ capacity to manage these new risks, and to set appropriately strong capital requirements.
  - Authorities should build on FSAP stress test experience by requesting that banks conduct stress tests on a regular basis to strengthen risk management capacity.
- Failure Resolution and Crisis Management:
  - Continue to develop a formal process to manage the failure of individual institutions and more widespread crises.
  - Historically, few failures of financial institutions occurred and past responses were ad hoc and relied on official support.
  - FSSA strongly supports development of a comprehensive framework for resolution and crisis management to minimize the likelihood of costly government bailouts.
  - Main requirement is ensuring necessary legal powers are in place for speedy and orderly resolution; the proposed Financial Claims Compensation Scheme could be a useful element.
- Supervisory Capacity:
  - Ensure supervisory agencies have adequate resources and flexibility.
  - APRA has increased staff resources by almost 50 percent since the failure of the HIH Group in 2001, and it has a cadre of experienced senior staff.
  - Turnover among more junior staff is relatively high, which could adversely affect supervisory capacity.
  - Financial institutions will need greater emphasis on risk management, especially under Basel II, increasing demand for these skills.
  - Important to ensure APRA and ASIC have the financial resources and flexibility to deploy them so sufficiently well-qualified staff are available to implement Basel II and principle-based supervision of large banks.

*IMF staff assessment as presented in the source content.*

### Box 3. Achieving Structural Reform in a Federal System

### Box 3. Achieving Structural Reform in a Federal System

### Federal context and instruments
- Structural issues are often in the jurisdiction of the Australian States.  
- The Australian Government (or the Commonwealth) has few exclusive powers, and in a large number of areas it can only exercise powers concurrently with the six State Governments, who retain responsibility for all other areas.  
- The Commonwealth can influence State policies and programs by granting financial assistance on terms and conditions that it specifies.  
- To coordinate policies, the Commonwealth and State governments meet biannually in the Council of Australian Governments (COAG).

### National Competition Policy (NCP): objectives and impact
- NCP was agreed by COAG in 1994 with the goal of promoting efficiency gains through competitive national markets.  
- Implementation across levels of government was required to:
  - reduce legal barriers to competition,
  - ensure competitive neutrality for government businesses,
  - enhance third-party access to infrastructure, and
  - reform the transport, electricity, gas, and water sectors.  
- It is estimated that the NCP-related reforms raised GDP by 2½ percent in the 1990s.

### Key factors underpinning successful implementation
- Political leadership was important, and two institutional mechanisms supported implementation:
  - Conditional payments to the States:
    - Part of the benefits of reforms accrue to the Commonwealth through higher income taxes, so “competition payments” were established to recycle these gains back to the States.
    - Actual payments to the States were subject to penalties if reform commitments were not met, as assessed by the independent National Competition Council.
    - While these penalties were usually not large relative to State budgets, in practice they could have significant leverage.
  - Analytical and advisory support from the Productivity Commission:
    - The Productivity Commission provides advice to governments on structural reform, and its legislation ensures independence, openness, and an economy-wide focus.
    - Its advice is shaped by extensive public submissions in response to draft reports, which tends to expose weaknesses in the arguments of vested interests, increase awareness of the broader public, refine recommendations, and promote consensus on the need for reforms and on the best way forward.

### National Reform Agenda and institutional arrangements
- The National Reform Agenda will require a broadening of reform cooperation, with a continuing role for Commonwealth funding and for analytical support from the Productivity Commission.  
- COAG has agreed to establish an independent body, the COAG Reform Council (CRC), to report to COAG annually on progress in implementing the National Reform Agenda.  
- If funding is needed to ensure a fair sharing of the costs and benefits of reform, the Commonwealth will provide funding to the States and Territories on a case-by-case basis once specific implementation plans have been developed—plans for transport, energy, and infrastructure regulation are expect to be available in early 2007.  
- The amount of funding will take into account the relevant costs and benefits, and the CRC will draw on the resources of the Productivity Commission in making cost-benefit assessments of the various reform options.

*Source: _cr06374 - Box 3. Achieving Structural Reform in a Federal System*

### 2006. Net foreign liabilities reached a new high, at 57 percent of GDP, but the ratio of net

### _cr06374 - 2006. Net foreign liabilities reached a new high, at 57 percent of GDP, but the ratio of net

### External position and external finances
- Net external liabilities reached a new high of 57.2 percent of GDP in 2006.
- Net external debt was 52.2 percent of GDP in 2006.
- Net interest payments to exports remained low at 9 percent.
- Current account deficit was -5.6 percent of GDP in 2006; trade balance was -1.5 percent of GDP.
- Gross official reserves were 6.8 percent of GDP (2006, latest available month).
- Directors recommended continued close monitoring of private external debt.

### Monetary policy and inflation
- The RBA raised the target cash rate to 6 percent in two 25 basis point steps in May and August 2006.
- Interest rate (90-day bill) was 6.2 percent (end of period, 2006, latest available month).
- Treasury bond yield (10-year) was 5.5 percent in 2006.
- CPI inflation was 3.5 percent in 2006; core CPI inflation and wage growth projected to remain broadly stable.
- Directors judged monetary policy tightened appropriately and noted further tightening may eventually be needed if underlying inflation pressure increases.

### Fiscal position and public finances
- Net public debt was eliminated in April 2006; net debt was -0.6 percent of GDP in 2006.
- Underlying cash balance for 2005/06 fiscal year was 1.6 percent of GDP, ½ percentage point higher than budgeted.
- The 2006/07 budget targets a fiscal surplus of 1.1 percent of GDP and projects the surplus to remain at 1 percent of GDP in the medium term.
- General government saving was 4.7 percent of GDP in 2006.
- Directors commended the elimination of net public debt and endorsed establishment of the Future Fund to invest surpluses.
- Recommendation: allow the fiscal surplus to exceed budget targets if growth and revenues are higher than expected.

### Growth, demand, and labor market outlook
- Growth projections: about 3 percent in 2006 and 3½ percent in 2007.
- Real GDP growth by year: 2001: 2.3; 2002: 4.1; 2003: 3.1; 2004: 3.6; 2005: 2.7; 2006: 3.1 (percent change).
- Total domestic demand: 2006: 4.0 percent change.
- Private consumption: 2006: 3.2 percent change.
- Total investment: 2006: 7.5 percent change; business investment: 11.9 percent change; dwelling investment: -3.7 percent change.
- Exports of goods and services: 2006: 3.6 percent change; imports of goods and services: 2006: 6.5 percent change.
- Unemployment rate: 5.0 percent in 2006; Directors noted unemployment had fallen below 5 percent for the first time in three decades.
- Directors expected domestic demand growth to slow gradually as investment moderates, while higher exports from mining projects would help reduce the trade deficit.
- External current account deficit expected to decline more modestly owing to rising equity income outflows.

### Terms of trade and risks
- Terms of trade changes: 2004: 1.2; 2005: 9.8; 2006: 6.5 (percent change).
- Medium-term assumption: export commodity prices are assumed to decline significantly owing to an expansion in global mining sector capacity.
- Directors highlighted both upside and downside risks to this outlook and considered Australia well-positioned (flexible exchange rate, robust fiscal outlook, medium-term focus of monetary policy) to cope with a fall in commodity prices or other shocks.

### Financial sector assessment and supervision
- Australia’s participation in the Financial Sector Assessment Program was welcomed; finding: Australia’s financial system is healthy and financial supervision is sound.
- Directors encouraged vigilance as financial institutions enter new businesses and face growing competition, promoting robust risk management practices.
- Directors welcomed APRA’s close monitoring of household debt servicing capacity and the review of liquidity regulation; they fully supported the authorities’ request to banks to conduct regular stress tests.
- Recommendation: continue work to ensure legal foundations for timely and minimally disruptive resolutions of failed institutions to underpin financial system resilience and minimize fiscal cost.
- Directors welcomed enhanced supervisory cooperation with New Zealand.

### Structural reforms and medium-term challenges
- Directors welcomed the National Reform Agenda to lift productivity and labor participation over the next decade and supported broadening the agenda to include education, training, and health care.
- Noted implementation lags in crucial areas (example given: trading in water) and urged use of recent fiscal revenue surges to spur reform implementation.
- Directors considered investment in reforms important to sustain strong economic growth and to address challenges of an ageing population and rising healthcare costs.

### Key statistics (selected from Table 1, exact values)
- Real GDP (percent change): 2001: 2.3; 2002: 4.1; 2003: 3.1; 2004: 3.6; 2005: 2.7; 2006: 3.1.
- CPI inflation (percent): 2001: 4.4; 2002: 3.1; 2003: 2.8; 2004: 2.3; 2005: 2.7; 2006: 3.5.
- Unemployment rate (percent): 2001: 6.8; 2002: 6.4; 2003: 6.1; 2004: 5.5; 2005: 5.1; 2006: 5.0.
- Gross national saving (percent of GDP): 2004: 19.6; 2005: 20.2; 2006: 21.0.
- Gross capital formation (percent of GDP): 2004: 25.9; 2005: 26.5; 2006: 26.5.
- Receipts (percent of GDP, cash basis, excludes asset sales): 2001: 23.4; 2002: 22.1; 2003: 22.5; 2004: 22.3; 2005: 22.8; 2006: 23.1.
- Payments (percent of GDP): 2001: 22.5; 2002: 22.3; 2003: 21.6; 2004: 21.4; 2005: 21.3; 2006: 21.4.
- Underlying balance (percent of GDP): 2001: 0.9; 2002: -0.1; 2003: 1.0; 2004: 1.0; 2005: 1.5; 2006: 1.6.
- Net debt (percent of GDP): 2001: 6.2; 2002: 5.2; 2003: 3.8; 2004: 2.8; 2005: 1.3; 2006: -0.6.
- Interest rate (90-day bill, percent, latest available month for 2006): 2006: 6.2.
- M3 (percent change): 2001: 13.7; 2002: 7.0; 2003: 11.7; 2004: 9.0; 2005: 8.2; 2006: 11.8.
- Private domestic credit (percent change): 2001: 9.8; 2002: 12.5; 2003: 12.4; 2004: 14.1; 2005: 13.5; 2006: 14.5.
- Current account (percent of GDP): 2001: -2.1; 2002: -3.9; 2003: -5.6; 2004: -6.2; 2005: -6.0; 2006: -5.6.
- Terms of trade (percent change): 2003: 3.1; 2004: 9.8; 2005: 11.9; 2006: 6.5.
- Trade-weighted index (period average, latest available month for 2006): 2004: 63.0; 2005: 62.8; 2006: 63.7.
- US$/$A (period average, latest available month for 2006): 2001: 0.509; 2002: 0.566; 2003: 0.750; 2004: 0.769; 2005: 0.743; 2006: 0.756.
- Real effective exchange rate (1990 = 100): 2001: 97.2; 2002: 101.5; 2003: 122.4; 2004: 121.8; 2005: 125.3; 2006: 124.5.

*Source: IMF staff report and Executive Board assessment (2006 Article IV consultation with Australia).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06374.pdf_