## _cr08312 - Executive Summary

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---

### Executive overview
- Sound macroeconomic policies and structural reforms delivered more than 16 years of economic expansion, but productive capacity became increasingly stretched.
- Commodity-driven boom pushed up against capacity constraints, contributed to higher inflation and an appreciation of the currency.
- Staff view: balance of risk to growth lies on the upside (from an extraordinary jump in commodity export prices); risks to inflation are clearly on the upside, reflecting capacity constraints especially in the mining and housing sectors.
- As of June 2008, staff estimated the real effective exchange rate (REER) to be about 10 percent above its long-run equilibrium level.

### Inflation and monetary policy
- Underlying inflation rose to almost 4½ percent year on year in June 2008, the highest level in 16 years.
- RBA target: “2–3 percent, on average, over the economic cycle.”
- Monetary response:
  - Between August 2007 and March 2008, the policy rate was increased by 100 basis points to 7¼ percent.
  - Higher funding costs from global financial turmoil pushed up lending rates by a weighted average of around 60 basis points more than the rise in the policy rate over the period August 2007–July 2008.
  - Real interest rates are around the average for the past five years; credit growth has slowed sharply recently.
- Policy guidance:
  - Maintain a firm monetary policy stance to keep medium-term inflation expectations well anchored.
  - Tighten quickly if leading indicators suggest domestic demand will not slow as expected or the outlook for inflation deteriorates.

### Fiscal position and public finances
- Commonwealth fiscal outcomes:
  - Surpluses of around 1½ percent of GDP in recent years have eliminated Commonwealth net debt.
  - Revenue outcomes consistently surprised on the upside due to stronger-than-expected economy and buoyant corporate tax revenue related to the commodity boom.
- State governments:
  - States increased capital spending; budget balance shifted to a deficit of about ½ percent of GDP in 2007/08.
- Government policy actions:
  - New Labor Government prioritized fighting inflation by constraining spending and increasing the surplus.
  - Saving some commodity-boom revenue in three new funds intended to take pressure off monetary policy in the near term and enable increased infrastructure investment over the medium term.
  - Authorities and staff agreed that if inflation persists at an elevated level, further fiscal restraint may be needed.

### External sector, exchange rate, and capital flows
- Trade and current account:
  - Current account deficit widened in 2007 to more than 6 percent of GDP despite the commodity boom.
  - Widening reflected deterioration of the trade balance (export volume growth constrained by drought and export bottlenecks), strong import growth from buoyant domestic demand and REER appreciation, and a larger investment income deficit.
- Net foreign liabilities and capital inflows:
  - Net foreign liabilities rose to 67 percent of GDP at end-March 2008, mainly due to an increase in foreign debt channeled primarily through financial institutions.
  - Capital inflows remain strong and comprise mainly debt rather than equity.
- Exchange rate:
  - Higher commodity export prices and capital inflows contributed to REER appreciation.
  - Staff and authorities agreed the overvaluation is temporary; currency likely to fall back toward equilibrium over time as the RBA reduces the cash rate once inflation moderates, though with some permanent improvement in the terms of trade the currency expected to remain above its 10-year average.

### Banking sector and global financial turmoil
- Overall soundness:
  - Four large banks (about two-thirds of bank assets) reported strong profits through early 2008 and maintained adequate capital.
  - Impaired assets are very low at 0.2 percent of assets for large banks.
  - Smaller banks’ impaired assets ratio around ½ of a percent; aggregate capital ratio for smaller banks in excess of 10 percent.
- Mortgage and lending structure:
  - Mortgage loans account for 47 percent of total lending.
  - Low-doc mortgages comprise 7 percent of total mortgages; nonconforming (equivalent of sub-prime) an additional 1 percent.
- Impact of global turmoil:
  - Main effect was a sharp increase in funding costs; banks had a small exposure to sub-prime assets.
  - Turmoil highlighted vulnerability to rollover risks from short-term wholesale funding.
- Responses by banks and authorities:
  - Banks increasing liquidity, lengthening funding maturities, and diversifying funding sources.
  - Authorities introduced new liquidity guidelines to address rollover risk.
  - Several large banks increased provisioning for bad debts to reflect potential downturn and rising interest rates.

### Key quantitative indicators (selected)
- Real GDP growth picked up in 2007 to more than 4 percent.
- Underlying inflation: almost 4½ percent year on year in June 2008.
- Policy rate: increased by 100 basis points to 7¼ percent (Aug 2007–Mar 2008).
- Lending rates: weighted average about 60 basis points higher than policy rate rise over Aug 2007–July 2008.
- Current account deficit: widened to more than 6 percent of GDP in 2007.
- Net foreign liabilities: 67 percent of GDP at end-March 2008.
- Commonwealth surpluses: around 1½ percent of GDP in recent years.
- State budget balance: deficit of about ½ percent of GDP in 2007/08.
- Large banks’ impaired assets: 0.2 percent of assets.
- Low-doc mortgages: 7 percent of total mortgages; nonconforming: 1 percent.
- Mortgage loans share of total lending: 47 percent.
- Smaller banks’ aggregate capital ratio: in excess of 10 percent.
- REER: about 10 percent above long-run equilibrium as of June 2008.

### Policy implications and recommendations
- Monetary policy:
  - Maintain a firm stance to anchor medium-term inflation expectations.
  - Be prepared to tighten quickly if leading indicators show domestic demand will not slow or the inflation outlook worsens.
- Fiscal policy:
  - Constrain spending and build surplus to help fight inflationary pressures.
  - Save commodity-boom revenue in dedicated funds to reduce near-term pressure on monetary policy and finance medium-term infrastructure.
  - Consider further fiscal restraint if inflation remains elevated.
- Financial sector resilience:
  - Strengthen banks’ liquidity buffers and diversify funding sources to reduce rollover risk.
  - Implement and enforce liquidity guidelines to reduce systemic vulnerability to global financial market turmoil.
  - Monitor provisioning and credit quality, particularly for institutions with higher exposure to low-doc and nonconforming lending.

*Source: _cr08312 - Executive Summary (IMF staff report).*

### Turmoil, rollover risk, and banking liabilities

### Turmoil and rollover risk: key findings
- Wholesale funds account for about 60 percent of total funding of the banking system.
- More than 40 percent of wholesale funds come from offshore.
- About 30 percent of offshore funds and 75 percent of domestic wholesale funds of Australian banks have residual maturity of less than one year.
- Funding structure leaves banks vulnerable to increases in cost of funds and to protracted loss of access to international short-term debt markets.
- Spread between the 3-month bank bill rate and the overnight index swap (OIS) rate averaged around 50 basis points in March–July 2008, compared to average of 10 basis points in recent years.
- Credit default swap spreads for the major Australian banks widened sharply during the same period.
- Large banks maintained access to wholesale markets but at significantly higher spreads; they sought to improve liquidity by attracting more deposits and issuing short-term securities to one another.
- Banks attempted to lengthen funding maturities (domestic and offshore), including private placements of one-year extendible bonds in the United States and issuance of yen-denominated “samurai” bonds, but term funding premia remained high.
- Share of offshore wholesale funding fell by only 1¼ percentage point over June 2007–May 2008, to 25½ percent of total liabilities; debt structure remained predominantly short term.

### Australian Banks' Liabilities (Percent of total)
- Deposits (ex CDs): Jun 07 42.6; Dec 07 40.0; May 08 40.6
  - Household: Jun 07 17.2; Dec 07 16.3; May 08 16.6
  - Business: Jun 07 14.0; Dec 07 13.3; May 08 12.6
  - Intra-group: Jun 07 3.1; Dec 07 4.1; May 08 4.8
- Domestic wholesale: Jun 07 30.7; Dec 07 34.6; May 08 34.0
- Offshore: Jun 07 26.7; Dec 07 25.4; May 08 25.4
- Total liabilities: Jun 07 100.0; Dec 07 100.0; May 08 100.0

### Market segmentation and credit availability
- Turmoil led smaller institutions reliant on capital markets (particularly securitization) to face higher funding costs relative to deposit-rich institutions; availability of home mortgages from these institutions fell—especially for low-doc and sub-prime borrowers—while large banks increased market share for prime mortgage lending.
- Corporates issued fewer bonds and approached banks for funding, contributing initially to increased business credit growth in early 2008, but business credit growth declined in recent months with higher interest rates and some tightening of credit standards.

### Outlook, risks, and scenarios

### Baseline and key projections
- Activity is slowing; outlook more uncertain due to large countervailing forces.
- Growth in real domestic demand has begun to ease with tighter financial conditions, higher energy and food prices, and a sharp decline in confidence.
- An 80–240 percent jump in annual contract prices for the key exports of iron ore and coal will increase the terms of trade by 20 percent in 2008/09.
- Cuts in personal income taxes introduced on July 1, 2008 will reduce revenue by about 2 percent of GDP over the next four years.
- Further cuts in personal income taxes phased in from 2009/10 to 2011/12 will reduce revenue by about 1 percent of GDP over that period.
- Staff’s baseline forecast: real GDP will grow below trend for the next two years, easing domestic capacity constraints and returning CPI inflation back within the target band over the period.
- Current account deficit should narrow to 4¼ percent of GDP in 2009 due to slower domestic demand growth, the jump in export prices, a rebound in rural exports, and mining sector capacity coming on line.

### Risks to growth and inflation
- Balance of risk to growth tilted toward the upside; risks on inflation clearly on the upside.
  - Upside risks:
    - Growth could exceed expectations owing to the jump in commodity prices, sizable immigration flows, and increased state infrastructure spending.
    - Capacity constraints, especially in the mining and housing sectors, could push wage and CPI inflation higher than envisaged.
  - Downside risks:
    - Activity could slow significantly if tightening in credit conditions has a greater-than-expected impact on domestic demand.
    - Farm output may not rebound from the drought as projected.
    - A global slump could weaken export demand and reduce commodity prices.
    - Further international financial turmoil could tighten credit conditions, leading to a sharper-than-expected global slowdown.
- Authorities viewed risks to growth as more balanced than staff; they noted household spending may fall more than expected as consumer sentiment declined.

### U.S. slowdown scenarios (three-step modelling)
- Scenario 1 (trade effect only): In 2008, GDP and inflation in Australia fall by 0.2 percent, allowing a 50 basis point easing in the policy interest rate; impact dissipates quickly with economy back to baseline by 2010.
- Scenario 2 (total potential impact based on the small model): larger impact reflecting historical correlation.
- Scenario 3 (total with policy rate held unchanged first year): If policy rate is not changed in first year, inflation falls by roughly 1.5 percentage points by the second year, which would return inflation to the top end of the RBA’s 2–3 percent target given current CPI inflation.
- Caveat: correlation between Australian and U.S. GDP may be overstated because Australia has become more integrated with emerging Asian countries; simulated total effect should be thought of as an upper bound.

### Exchange rate assessment and external stability

### Drivers and effects
- Appreciation of the Australian dollar driven by higher terms of trade and positive interest rate differentials.
- Stronger exchange rate eased inflation pressures directly (lower import prices) and indirectly (switching expenditure to imports) as domestic capacity became stretched.
- Staff estimate currency about 10 percent above its long-run equilibrium level as of June 2008.
- Widening current account deficit and buildup in foreign debt increased external vulnerability; global turmoil highlighted rollover risks associated with sizable short-term foreign debt.
- Current account projection: projected to narrow in 2009 to about the estimated norm of 4–4½ percent of GDP and then widen somewhat over the medium term as commodity prices ease from the peak in 2008/09; projections assume constant REER at June 2008 levels.

### Equilibrium REER and overvaluation estimates (Box 3)
- Staff estimates suggest the Australian dollar was overvalued by about 10 percent as of June 2008.
- MB (macroeconomic balance) approach:
  - Baseline MB estimates suggest an overvaluation of 7–9 percent over the medium term, while the overvaluation in 2008 is about 6½ percent.
  - Sensitivity analysis suggests overvaluation is about 2–22 percent.
- ERER approach:
  - Baseline ERER estimates suggest an overvaluation of 7–12 percent.
  - The 42 percent improvement in terms of trade over the past five years contributed to an increase in equilibrium REER of about 15 percent.
  - Overvaluation in 2008 estimated at 10 percent, narrowing slightly to 7 percent by 2013 as terms of trade are expected to rise.
- ES (external sustainability) approach:
  - Implies an overvaluation of 11 percent if net foreign liabilities stabilize at their March 2008 level of 67 percent of GDP.
  - A larger overvaluation would result if net foreign liabilities stabilize at their 10-year average level of 55 percent of GDP.
- Desk corresponding equilibrium value of the RBA’s real trade weighted index (TWI) is 128–135, assessed relative to an estimate for June 2008 of 145; nominal TWI index was at 73.4 as of end-June.

### External vulnerability, fiscal framework, and policy settings

### External vulnerability mitigants
- Limited currency risk in foreign debt: About 40 percent of gross foreign debt is in Australian dollars, with half of the remainder in U.S. dollars.
- Hedging: Survey data suggests the bulk of foreign-currency-denominated debt is hedged against currency risk.
- Debt composition: Less than 10 percent of gross debt is with the public sector.
- Current account deficits largely reflect high investment rather than low saving, and should be sustainable as long as investment leads to growth in export capacity.

### Fiscal policy objectives and stance
- Medium-term objectives of the new Labor government:
  - Achieve budget surpluses, on average, over the medium term.
  - Keep tax as a share of GDP, on average, below the 2007/08 level (currently estimated at 24.7 percent).
  - Improve the government’s net financial worth over the medium term.
- 2008/09 budget near-term priorities: helping to fight inflation and reprioritizing spending to build capacity.
- 2008/09 projections:
  - Forecasts an increase in the underlying cash surplus to 1.8 percent of GDP.
  - Stance slightly contractionary, with staff’s estimate of the structural balance increasing by ¼ percent of GDP.
- Use of revenue surprises:
  - Budget saves about half of the revenue surprise from jump in terms of trade and higher nominal GDP; remainder funds personal income tax cuts and new initiatives.
  - For outer years, about 1/3 of the revenue surprise is saved.
- New funds:
  - Surpluses for 2007/08 and 2008/09 will be saved in three new funds for infrastructure, health, and education to finance capital spending; about 3 percent of GDP will be contributed to the funds, depending on final budget outcomes.

### Fiscal recommendations and structural implications
- Staff advice:
  - Further fiscal restraint may be needed.
  - Identify areas for additional spending cuts and save any positive revenue surprises to assist monetary policy until inflation declines.
  - Saving additional revenue in near term may avoid sharp future changes in taxes and spending given uncertainty about permanence of commodity price increases.
- Authorities’ stance:
  - Committed to saving any further positive revenue surprises in 2008/09; if there is a positive revenue surprise in the 2009/2010 Budget and inflation remains high, they would maintain tight controls on spending.
- Structural improvement options:
  - If budget balance improvement is structural (permanently higher commodity prices), scope to reduce taxes or increase spending over the medium term.
  - Staff analysis suggests combination of lower labor and capital income taxes, along with increased public investment, will generate largest economic gains; gains from lower consumption taxes or higher public consumption are not as large.
- Long-term challenges: Significant long-term fiscal challenges remain, particularly in healthcare spending; early adjustments will be key to preserving fiscal sustainability.

### Dealing with global financial market turmoil and banking resilience

### Authorities’ actions and supervisory measures
- RBA actions:
  - Provided liquidity support through exchange settlement accounts.
  - Increased range of securities accepted for repo lending in late 2007, including residential-mortgage-backed securities.
- APRA actions:
  - Intensified monitoring of asset quality, capital adequacy, and liability structure of banks.
  - Working with large banks on stress tests including extreme scenarios such as loss of access to offshore credit markets for an extended period.
- Bank funding adjustments:
  - Banks increasing liquidity, lengthening funding maturities, and diversifying sources; extending maturities has been costly due to higher term funding interest rates.
- Stress test findings:
  - Staff analysis suggests large banks could suffer a significant fall in profits from an increase in funding costs associated with loss of access to offshore markets for 90 days, but their capital would remain adequate.
- Liquidity guidelines and disclosure:
  - APRA plans to introduce liquidity guidelines focused on improved disclosure and stress testing to encourage reduced rollover risk, diversification, longer maturities, and sufficient liquidity.
  - Staff advised requiring banks to publish more detail on maturity structure of funding, especially from offshore markets.

### Household exposure and failure resolution
- Household debt reached almost 160 percent of disposable income; debt-servicing costs about 14 percent of disposable income.
- More than half of banks’ loans are mortgages; asset quality would deteriorate with large increases in interest rates, unemployment, or a fall in house prices.
- Staff analysis: a very large increase in default rates (to 10 percent of all housing loans) would be required to reduce capital ratios of the four major banks below 8 percent.
- Staff estimates suggest house prices are moderately overvalued (5-15 percent); continued strong immigration and household income growth could increase equilibrium house prices.
- Failure resolution and crisis management:
  - Proposed Financial Claims Scheme would provide depositors of a failed authorized deposit-taking institution with early access to the first A$20,000 of their funds and policyholders of a failed general insurer with a right to have claims met.
  - Interdependence with New Zealand banking underscores importance of coordination of crisis management.

### Supervisory and regulatory follow-up
- Government intends a comprehensive national approach to regulating credit-related financial services (mortgage brokers, trustee corporations, property investment advisors).
- APRA will strengthen capital treatment of structured credit and securitization and update Basel II risk parameters and provisions.
- Authorities encouraging banks to strengthen risk disclosure.

### Structural reform agenda and staff appraisal

### Reform priorities and amounts (selected)
- Tax Reform: broad-ranging review covering all taxes, social security and transfer payments by the Commonwealth and states, excluding the GST.
- Commonwealth-State Financial Relations: new model to streamline payments and create incentive payments to states.
- Emissions Trading: plan for a ‘cap and trade’ emissions trading scheme.
- Healthcare: establish a Health and Hospital Fund ($A10 billion) for investment in health facilities.
- Education: establish an Education Investment Fund ($A11 billion) to help build education facilities.
- Infrastructure: establish a Building Australia Fund ($A20 billion) to help finance key projects.
- Water management: new ten-year $A12.9 billion national water policy framework.
- Labor relations: modernize and simplify awards; Australian Workplace Agreements (covering less than 3 percent of private sector workforce) to be phased out while preserving ability to negotiate individual contracts.

### Expected benefits and coordination
- Successful implementation expected to enhance flexibility, lift productivity, and foster labor force participation; essential to take full advantage of mining boom centered on Queensland and Western Australia which requires movement of capital and labor across states.
- Commonwealth working with states through an invigorated Council of Australian Governments meeting quarterly; state-level reform important for health, education, infrastructure, and business regulation.

### Staff appraisal: outlook and prescriptions
- Growth and inflation outlook:
  - Real GDP growth expected to slow over next two years to reduce inflation.
  - Upside risks to growth and inflation from a 20 percent boost to the terms of trade in 2008/09 due to extraordinary jump in commodity export prices.
- Monetary policy:
  - Firm monetary policy stance essential to reduce inflation.
  - RBA raised the cash rate appropriately as inflation increased; authorities should act quickly to tighten further if leading indicators suggest domestic demand will not slow or inflation outlook deteriorates.
  - Inflation-targeting framework remains suitable to anchor medium-term inflation expectations.
- Exchange rate:
  - Flexible exchange rate policy appropriate; recent appreciation has eased inflation pressures.
  - Australian dollar temporarily above long-run equilibrium but likely to fall back toward equilibrium over time as RBA reduces cash rate once inflation moderates.
- Fiscal policy role:
  - Fiscal policy providing support for monetary policy, but further restraint may be needed.
  - Reduction in public spending growth in latest budget will help reduce inflation; saving any further positive revenue surprises in 2008/09 will allow automatic stabilizers to work.
  - Additional fiscal restraint may be needed given upside inflation risks; if budget balance improvement is structural, scope to reduce taxes or increase spending over medium term.

*Source: IMF staff and Australian authorities, as presented in the provided content unit.*

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

### _cr08312 - Executive Summary

### Executive overview
- Sound macroeconomic policies and structural reforms have delivered more than 16 years of economic expansion, but the economy’s productive capacity has become increasingly stretched.
- A commodity driven boom pushed up against capacity constraints and contributed to higher inflation and an appreciation of the currency.
- Staff view: the balance of risk to growth lies on the upside (from an extraordinary jump in commodity export prices); risks to inflation are clearly on the upside, reflecting capacity constraints especially in the mining and housing sectors.
- As of June 2008, the staff estimated the real effective exchange rate (REER) to be about 10 percent above its long-run equilibrium level.

### Inflation and monetary policy
- Underlying inflation rose to almost 4½ percent year on year in June 2008, the highest level in 16 years.
- RBA target: “2–3 percent, on average, over the economic cycle.”
- Monetary response:
  - Between August 2007 and March 2008, the policy rate was increased by 100 basis points to 7¼ percent.
  - Higher funding costs from the global financial turmoil pushed up lending rates by a weighted average of around 60 basis points more than the rise in the policy rate over the period August 2007–July 2008.
  - Real interest rates are around the average for the past five years; credit growth has slowed sharply recently.
- Policy guidance:
  - A firm monetary policy stance is essential to keep medium-term inflation expectations well anchored.
  - Monetary policy should be tightened quickly if leading indicators suggest domestic demand will not slow as expected or the outlook for inflation deteriorates.

### Fiscal position
- Commonwealth fiscal outcomes:
  - Surpluses of around 1½ percent of GDP in recent years have eliminated Commonwealth net debt.
  - Revenue outcomes have consistently surprised on the upside because of a stronger-than-expected economy and buoyant corporate tax revenue related to the commodity boom.
- State governments:
  - States increased capital spending and their budget balance shifted to a deficit of about ½ percent of GDP in 2007/08.
- Government policy actions:
  - The new Labor Government prioritized helping fight inflation by constraining spending and increasing the surplus.
  - Saving some commodity-boom revenue in three new funds is intended to take pressure off monetary policy in the near term and enable increased infrastructure investment over the medium term.
  - Authorities and staff agreed that if inflation persists at an elevated level, further fiscal restraint may be needed.

### External sector, exchange rate, and capital flows
- Trade and current account:
  - The current account deficit widened in 2007 to more than 6 percent of GDP despite the commodity boom.
  - Widening reflected: deterioration of the trade balance (export volume growth constrained by drought and export bottlenecks), strong import growth from buoyant domestic demand and REER appreciation, and a larger investment income deficit (higher interest payments on foreign debt and large dividend payments, particularly from the resource sector).
- Net foreign liabilities and capital inflows:
  - Net foreign liabilities rose to 67 percent of GDP at end-March 2008, mainly due to an increase in foreign debt channeled primarily through financial institutions.
  - Capital inflows remain strong and comprise mainly debt rather than equity.
- Exchange rate:
  - Higher commodity export prices and capital inflows contributed to REER appreciation.
  - Staff and authorities agreed the overvaluation is temporary and the currency is likely to fall back toward equilibrium over time as the RBA reduces the cash rate once inflation moderates; however, with some permanent improvement in the terms of trade, the currency is expected to remain above its 10-year average.

### Banking sector and global financial turmoil
- Overall soundness:
  - The four large banks (about two-thirds of bank assets) reported strong profits through early 2008 and maintained adequate capital.
  - Impaired assets are very low at 0.2 percent of assets for large banks.
  - The smaller banks’ impaired assets ratio is around ½ of a percent, still low by international standards.
  - Aggregate capital ratio for smaller banks is in excess of 10 percent.
- Mortgage and lending structure:
  - Mortgage loans account for 47 percent of total lending.
  - Low-doc mortgages comprise 7 percent of total mortgages; nonconforming (the equivalent of sub-prime) an additional 1 percent.
- Impact of global turmoil:
  - Main effect was a sharp increase in funding costs; banks had a small exposure to sub-prime assets.
  - Turmoil highlighted vulnerability to rollover risks from short-term wholesale funding.
- Responses by banks and authorities:
  - Banks are increasing liquidity, lengthening funding maturities, and diversifying funding sources.
  - Authorities introduced new liquidity guidelines to address rollover risk.
  - Several large banks have increased provisioning for bad debts to reflect potential downturn and rising interest rates.

### Key quantitative indicators (selected)
- Real GDP growth picked up in 2007 to more than 4 percent.
- Underlying inflation: almost 4½ percent year on year in June 2008.
- Policy rate: increased by 100 basis points to 7¼ percent (Aug 2007–Mar 2008).
- Lending rates: weighted average about 60 basis points higher than policy rate rise over Aug 2007–July 2008.
- Current account deficit: widened to more than 6 percent of GDP in 2007.
- Net foreign liabilities: 67 percent of GDP at end-March 2008.
- Commonwealth surpluses: around 1½ percent of GDP in recent years.
- State budget balance: deficit of about ½ percent of GDP in 2007/08.
- Large banks’ impaired assets: 0.2 percent of assets.
- Low-doc mortgages: 7 percent of total mortgages; nonconforming: 1 percent.
- Mortgage loans share of total lending: 47 percent.
- Smaller banks’ aggregate capital ratio: in excess of 10 percent.
- REER: about 10 percent above long-run equilibrium as of June 2008.

### Policy implications and recommendations
- Monetary policy:
  - Maintain a firm stance to anchor medium-term inflation expectations.
  - Be prepared to tighten quickly if leading indicators show domestic demand will not slow or inflation outlook worsens.
- Fiscal policy:
  - Constrain spending and build surplus to help fight inflationary pressures.
  - Save commodity-boom revenue in dedicated funds to reduce near-term pressure on monetary policy and finance medium-term infrastructure.
  - Consider further fiscal restraint if inflation remains elevated.
- Financial sector resilience:
  - Strengthen banks’ liquidity buffers and diversify funding sources to reduce rollover risk.
  - Implement and enforce liquidity guidelines to reduce systemic vulnerability to global financial market turmoil.
  - Monitor provisioning and credit quality, particularly for institutions with higher exposure to low-doc and nonconforming lending.

*Source: _cr08312 - Executive Summary (IMF staff report).*

### 7.      The turmoil, however, highlighted the vulnerability of Australia’s financial

### _cr08312 - 7.      The turmoil, however, highlighted the vulnerability of Australia’s financial

### Turmoil and rollover risk: key findings (Box 1 and main text)
- Wholesale funds account for about 60 percent of total funding of the banking system.
- More than 40 percent of wholesale funds come from offshore.
- About 30 percent of offshore funds and 75 percent of domestic wholesale funds of Australian banks have residual maturity of less than one year.
- The funding structure leaves banks vulnerable to increases in the cost of funds and to the protracted loss of access to international short-term debt markets.
- The spread between the 3-month bank bill rate and the overnight index swap (OIS) rate averaged around 50 basis points in March–July 2008, compared to the average of 10 basis points in recent years.
- Credit default swap spreads for the major Australian banks widened sharply during the same period, indicating a higher cost of funding.
- Large Australian banks maintained access to wholesale markets but at significantly higher spreads; they sought to improve liquidity by attracting more deposits and issuing short-term securities to one another.
- Banks attempted to lengthen funding maturities (domestic and offshore), including private placements of one-year extendible bonds in the United States and issuance of yen-denominated “samurai” bonds, but term funding premia remained high.
- The share of offshore wholesale funding fell by only 1¼ percentage point over the period June 2007–May 2008, to 25½ percent of total liabilities; the debt structure remained predominantly short term.

Australian Banks' Liabilities (Percent of total)
- Deposits (ex CDs): Jun 07 42.6; Dec 07 40.0; May 08 40.6
  - Of which: Household: Jun 07 17.2; Dec 07 16.3; May 08 16.6
  - Business: Jun 07 14.0; Dec 07 13.3; May 08 12.6
  - Intra-group: Jun 07 3.1; Dec 07 4.1; May 08 4.8
- Domestic wholesale: Jun 07 30.7; Dec 07 34.6; May 08 34.0
- Offshore: Jun 07 26.7; Dec 07 25.4; May 08 25.4
- Total liabilities: Jun 07 100.0; Dec 07 100.0; May 08 100.0

- The turmoil led smaller institutions reliant on capital markets (particularly securitization) to face higher funding costs relative to deposit-rich institutions; availability of home mortgages from these institutions has fallen—especially for low-doc and sub-prime borrowers—while large banks increased market share for prime mortgage lending.
- Corporates issued fewer bonds and approached banks for funding, contributing initially to increased business credit growth in early 2008, but business credit growth declined in recent months with higher interest rates and some tightening of credit standards.

### Outlook and risks (baseline and risks to growth/inflation)
Baseline and key projections
- The staff and authorities agreed activity is slowing and outlook is more uncertain due to large countervailing forces.
- Growth in real domestic demand has begun to ease with tighter financial conditions, higher energy and food prices, and a sharp decline in confidence.
- An 80–240 percent jump in annual contract prices for the key exports of iron ore and coal will increase the terms of trade by 20 percent in 2008/09.
- Cuts in personal income taxes introduced on July 1, 2008 will reduce revenue by about 2 percent of GDP over the next four years.
- Further cuts in personal income taxes to be phased in from 2009/10 to 2011/12 will reduce revenue by about 1 percent of GDP over that period.
- Staff’s baseline forecast: real GDP will grow below trend for the next two years, easing domestic capacity constraints and returning CPI inflation back within the target band over the period (Table 5).
- The current account deficit should narrow to 4¼ percent of GDP in 2009 due to slower domestic demand growth, the jump in export prices, a rebound in rural exports, and mining sector capacity coming on line.

Risks
- Balance of risk to growth is tilted toward the upside; risks on inflation are clearly on the upside.
  - Upside risks:
    - Growth could exceed expectations owing to the jump in commodity prices, sizable immigration flows, and increased state infrastructure spending.
    - Capacity constraints, especially in the mining and housing sectors, could push wage and CPI inflation higher than envisaged.
  - Downside risks:
    - Activity could slow significantly if tightening in credit conditions (sharp fall in credit growth) has a greater-than-expected impact on domestic demand.
    - Farm output may not rebound from the drought as projected.
    - A global slump could weaken export demand and reduce commodity prices (one-year contracts for iron ore and coal would delay the impact).
    - Further international financial turmoil could tighten credit conditions, leading to sharper-than-expected global slowdown.

- The authorities viewed risks to growth as more balanced than staff; they noted household spending may fall more than expected as consumer sentiment declined with higher fuel prices and mortgage rates. The authorities agreed there is an upside risk to inflation stemming from the extraordinary jump in the terms of trade.

### Monetary policy guidance and authorities’ stance
- Staff advice: a firm monetary policy stance is vital to keep medium-term inflation expectations well anchored. With underlying inflation the highest in more than a decade, containing inflation is a challenge.
- The risk that wage inflation will rise further if CPI inflation persists at current levels calls for the RBA to maintain a tight policy stance until it is clear inflation will abate.
- Reducing inflation back within the target range will require a significant easing in domestic demand growth; further tightening may be necessary if global financial turmoil eases and confidence rebounds.
- The RBA should be prepared to tighten quickly if leading indicators suggest domestic demand will not slow as expected or the outlook for inflation deteriorates.
- Authorities’ view: the sequence of changes to the cash rate since August 2007, lender adjustments to rising funding costs, and tighter credit standards have produced tight financial conditions. The authorities considered this tightening sufficient to reduce growth to below trend for the next two years, easing capacity pressures and reducing inflation to less than 3 percent by end-2010. They indicated they would not hesitate to tighten policy further if needed.
- The authorities remain fully committed to the inflation-targeting framework; despite public criticism, they argued the framework can handle shocks such as global increases in energy and food prices and has helped anchor medium-term inflation expectations (absence to date of notable acceleration in wage inflation).
- Since December 2007, the RBA has published a statement explaining the board’s interest rate decision at the conclusion of every policy meeting, followed two weeks later by detailed meeting minutes (transparency measures).

### Scenarios: impact of a U.S. slowdown (Box 2)
- Two models used: IMF’s Global Economy Model (GEM) calibrated to include Australia, and an estimated small model of Australia and the United States.
- Analysis steps: trade impact alone; add potential impacts through financial market linkages and expectations calibrated via historical correlation; a third step holds Australia’s monetary policy rate unchanged for the first year.

Scenario results
- Scenario 1 (trade effect only): In 2008, GDP and inflation in Australia fall by 0.2 percent, allowing a 50 basis point easing in the policy interest rate. The impact dissipates quickly with the economy back to baseline by 2010.
- Scenario 2 (total potential impact based on the small model): larger impact reflecting historical correlation.
- Scenario 3 (total with policy rate held unchanged first year): If the policy rate in Australia is not changed in the first year in response to the slowdown, inflation falls by roughly 1.5 percentage points by the second year. Given current CPI inflation in Australia, such a decline would return inflation to the top end of the RBA’s 2–3 percent target.
- Caveat: correlation between Australian and U.S. GDP may be overstated because Australia has become more integrated with emerging Asian countries; the total simulated effect should be thought of as an upper bound.

### Exchange rate, external stability, and equilibrium assessments (Figure 9, Figure 10, Box 3)
- The appreciation of the Australian dollar has been driven by the higher terms of trade and positive interest rate differentials.
- The stronger exchange rate has eased inflation pressures directly through lower import prices and indirectly by switching expenditure to imports as domestic capacity became stretched.
- Staff estimate the currency was about 10 percent above its long-run equilibrium level as of June 2008.
- The widening current account deficit in recent years and buildup in foreign debt increased external vulnerability; recent global turmoil highlighted rollover risks associated with sizable short-term foreign debt.
- Current account projection: projected to narrow in 2009 to about the estimated norm of 4–4½ percent of GDP and then widen somewhat over the medium term as commodity prices ease from the peak in 2008/09. Projections assume a constant REER at June 2008 levels; a depreciation of the REER to equilibrium would narrow the current account further and slow accumulation of external liabilities.

Box 3: Equilibrium REER and overvaluation estimates
- Staff estimates suggest the Australian dollar was overvalued by about 10 percent as of June 2008.
- MB (macroeconomic balance) approach:
  - Baseline MB estimates suggest an overvaluation of 7–9 percent over the medium term, while the overvaluation in 2008 is about 6½ percent.
  - Sensitivity analysis suggests overvaluation is about 2–22 percent.
- ERER approach:
  - Baseline ERER estimates suggest an overvaluation of 7–12 percent.
  - The 42 percent improvement in terms of trade over the past five years contributed to an increase in equilibrium REER of about 15 percent.
  - Overvaluation in 2008 is estimated at 10 percent, narrowing slightly to 7 percent by 2013 as terms of trade are expected to rise.
- ES (external sustainability) approach:
  - Implies an overvaluation of 11 percent if net foreign liabilities stabilize at their March 2008 level of 67 percent of GDP.
  - A larger overvaluation would result if net foreign liabilities stabilize at their 10-year average level of 55 percent of GDP.

- Desk corresponding equilibrium value of the RBA’s real trade weighted index (TWI) is 128–135, assessed relative to an estimate for June 2008 of 145; nominal TWI index was at 73.4 as of end-June.

*Source: IMF staff report content provided in the supplied PDF excerpt.*

### 18.      The staff and authorities agreed that there are a number of factors mitigating

### _cr08312 - 18.      The staff and authorities agreed that there are a number of factors mitigating

### External vulnerability
- Limited currency risk in foreign debt: About 40 percent of gross foreign debt is in Australian dollars, with half of the remainder in U.S. dollars.
- Hedging: Survey data suggests the bulk of the foreign-currency-denominated debt is hedged against currency risk.
- Debt composition: Less than 10 percent of the gross debt is with the public sector, leaving most of the debt with financial institutions.
- Current account: Australia’s current account deficits largely reflect high investment rather than low saving, and should be sustainable as long as investment leads to growth in export capacity.

### Fiscal policy: objectives and near-term stance
- Medium-term objectives of the new Labor government:
  - achieving budget surpluses, on average, over the medium term;
  - keeping tax as a share of GDP, on average, below the 2007/08 level (currently estimated at 24.7 percent);
  - improving the government’s net financial worth over the medium term.
- 2008/09 budget near-term priorities: helping to fight inflation and reprioritizing spending to build capacity.
- 2008/09 budget projections and effects:
  - forecasts an increase in the underlying cash surplus to 1.8 percent of GDP;
  - the stance is slightly contractionary, with the staff’s estimate of the structural balance increasing by ¼ percent of GDP, broadly in line with the change in the underlying cash surplus.
- Revenue surprises and use:
  - The budget saves about half of the revenue surprise from the jump in the terms of trade and higher nominal GDP; the remainder funds personal income tax cuts targeted at lower income earners and helps finance new initiatives for health, education, climate change, and housing.
  - For outer years, about 1/3 of the revenue surprise is saved (revenue surprise calculated using the May 2007 budget projections as the baseline).
- Medium-term projections: Beyond 2008/09, spending is projected to pick up and the underlying cash surplus is expected to fall slightly over the next four years.

### Fiscal policy: funds, recommendations, and structural implications
- New funds: Surpluses for 2007/08 and 2008/09 will be saved in three new funds for infrastructure, health, and education to finance capital spending; about 3 percent of GDP will be contributed to the funds, depending on final budget outcomes, and spending from the funds is included in the budget.
- Staff advice:
  - further fiscal restraint may be needed;
  - identify areas where additional spending cuts can be implemented and save any positive revenue surprises to assist monetary policy until it is clear inflation will decline;
  - saving additional revenue in the near term may avoid sharp future changes in taxes and spending given uncertainty about permanence of commodity price increases.
- Authorities’ stance:
  - committed to saving any further positive revenue surprises in 2008/09;
  - if there is a positive revenue surprise in the 2009/2010 Budget and inflation remains high, they would maintain tight controls on spending.
- Structural improvement and policy options:
  - To the extent the budget balance improvement is structural (permanently higher commodity prices), there should be scope to reduce taxes or increase spending over the medium term.
  - Staff analysis suggests that a combination of lower labor and capital income taxes, along with increased public investment, will generate the largest economic gains; gains from lower consumption taxes or higher public consumption are not as large.
- Long-term challenges: Significant long-term fiscal challenges remain, particularly in healthcare spending; early adjustments will be key to preserving fiscal sustainability.
- Authorities’ conditional reform scope: Scope to reform taxation and increase spending in priority areas if recent gains in commodity export prices prove permanent; budget projections assume some easing in commodity prices over the medium term from record levels forecast for 2008/09.

### Dealing with the global financial market turmoil
- RBA actions:
  - provided liquidity support to banks through exchange settlement accounts;
  - increased the range of securities accepted for repo lending in late 2007, including residential-mortgage-backed securities.
  - Many banks have securitized mortgages and are holding them on their books as contingency for obtaining RBA liquidity.
- APRA actions:
  - intensified monitoring of asset quality, capital adequacy, and liability structure of banks;
  - in the context of Basel II, working with large banks on stress tests including extreme scenarios such as loss of access to offshore credit markets for an extended period.
- Bank funding adjustments:
  - banks are increasing liquidity, lengthening funding maturities, and diversifying sources;
  - extending maturities has been costly due to higher term funding interest rates and limited progress in reducing rollover risk from short-term wholesale funding.
- Stress test findings:
  - Staff analysis using extreme stress test scenarios suggests large banks could suffer a significant fall in profits from an increase in funding costs associated with loss of access to offshore markets for 90 days, but their capital would remain adequate.
- Liquidity guidelines and disclosure:
  - APRA plans to introduce liquidity guidelines focused on improved disclosure and stress testing to encourage reduced rollover risk, diversification, longer maturities, and sufficient liquidity.
  - Staff advised requiring banks to publish more detail on the maturity structure of their funding, especially from offshore markets.
- Household exposure and resilience:
  - household debt reached almost 160 percent of disposable income;
  - debt-servicing costs at about 14 percent of disposable income;
  - more than half of banks’ loans are mortgages, so asset quality would deteriorate with a large increase in interest rates, unemployment, or a fall in house prices.
  - Staff analysis: a very large increase in default rates (to 10 percent of all housing loans) would be required to reduce capital ratios of the four major banks below 8 percent.
  - Staff estimates suggest house prices are only moderately overvalued (5-15 percent) and that continued strong immigration and household income growth could increase equilibrium house prices.
- Failure resolution and crisis management:
  - proposed Financial Claims Scheme would provide depositors of a failed authorized deposit-taking institution with early access to their funds (timely access to the first $A20,000 of their funds) and policyholders of a failed general insurer with a right to have claims met.
  - interdependence with New Zealand banking underscores importance of coordination of crisis management.
- Supervisory and regulatory follow-up:
  - government intends a comprehensive national approach to regulating credit-related financial services (mortgage brokers, trustee corporations, property investment advisors);
  - APRA will strengthen capital treatment of structured credit and securitization and update Basel II risk parameters and provisions;
  - authorities encouraging banks to strengthen risk disclosure.

### Implementing further structural reform
- Reform agenda (Commonwealth and state governments) includes: taxation, emissions trading, healthcare, education, infrastructure, business regulation, labor relations.
- Reform delivery and coordination:
  - Commonwealth working with states through an invigorated Council of Australian Governments meeting quarterly.
  - State-level reform important because states provide most health, education, and infrastructure services and administer some taxes and business regulations.
- Reform aims: raise productivity and labor force participation by reducing barriers to competition and movement of resources.
- Box 4: Selected elements and amounts in the reform agenda:
  - Tax Reform: broad-ranging review covering all taxes, social security and transfer payments by the Commonwealth and states, excluding the GST.
  - Commonwealth-State Financial Relations: new model to streamline payments and create incentive payments to states.
  - Emissions Trading: plan for a ‘cap and trade’ emissions trading scheme.
  - Healthcare: establish a Health and Hospital Fund ($A10 billion) for investment in health facilities.
  - Education: establish an Education Investment Fund ($A11 billion) to help build education facilities.
  - Infrastructure: establish a Building Australia Fund ($A20 billion) to help finance key projects.
  - Water management: new ten-year $A12.9 billion national water policy framework.
  - Labor relations: modernize and simplify awards; Australian Workplace Agreements (covering less than 3 percent of private sector workforce) to be phased out while preserving ability to negotiate individual contracts.
- Expected benefits: successful implementation would enhance flexibility, lift productivity, and foster labor force participation; essential to take full advantage of the mining boom centered on Queensland and Western Australia which requires movement of capital and labor across states.

### Staff appraisal: outlook and policy prescriptions
- Growth and inflation outlook:
  - outlook is for real GDP growth to slow over the next two years, as needed to reduce inflation;
  - upside risks to growth and inflation from a 20 percent boost to the terms of trade in 2008/09 due to extraordinary jump in commodity export prices.
- Monetary policy:
  - a firm monetary policy stance is essential to reduce inflation;
  - the RBA raised the cash rate appropriately in the past year as inflation increased to the highest level in more than a decade;
  - authorities should act quickly to tighten monetary policy further if leading indicators suggest domestic demand will not slow as expected or the inflation outlook deteriorates;
  - the inflation-targeting framework remains suitable to anchor medium-term inflation expectations.
- Exchange rate:
  - the flexible exchange rate policy is appropriate; recent appreciation has eased inflation pressures;
  - the Australian dollar is temporarily above its long-run equilibrium level but is likely to fall back toward equilibrium over time as the RBA reduces the cash rate once inflation moderates.
- Fiscal policy role:
  - fiscal policy is providing support for monetary policy, but further restraint may be needed;
  - reduction in public spending growth in the latest budget will help reduce inflation, and saving any further positive revenue surprises in 2008/09 will allow automatic stabilizers to work;
  - additional fiscal restraint may be needed to take pressure off monetary policy given upside inflation risks;
  - if the budget balance improvement is structural (permanently higher commodity prices), there should be scope to reduce taxes or increase spending over the medium term.

*Source: IMF staff and Australian authorities, as presented in the provided content unit.*

### 40.      Australia’s banking system is sound, but some vulnerabilities remain. The

### Australia’s banking system is sound, but some vulnerabilities remain.

### Banking system assessment and vulnerabilities
- Authorities’ response to the credit market turmoil has been timely: the RBA provided liquidity support and APRA intensified monitoring of banks.
- The four large banks remain profitable and well capitalized, but the turmoil highlighted vulnerability to rollover risks arising from short-term wholesale funding.
- Planned introduction of liquidity guidelines expected to reduce risk of disruptions from loss of access to offshore funding.
- Recommendation: Require publication of more detail on the maturity structure of banks’ funding, especially from offshore markets, to encourage reduction of exposure to rollover risk.
- Crisis-management reform: Government announced intention to introduce a Financial Claims Scheme (FCS) to provide depositors in a failed authorized deposit-taking institution (ADI) with timely access to the first A$20,000 of their funds, and to give policyholders of a failed general insurer a right to have claims met.

### Structural reform opportunity
- Authorities encouraged to seize window provided by robust economic performance and strong fiscal position to advance structural reforms.
- If implemented fully, the broad reform agenda should enhance flexibility of the economy and lift productivity and labor force participation.

### Key macroeconomic facts (selected)
- Nominal GDP (2007): $A 1,084 billion (US$911 billion)
- Quota (in millions): SDR 3,237
- GDP per capita (2007): US$43,341
- Population (December 2007): 21.1 million

- Real GDP (percent change): 2004: 3.9; 2005: 2.9; 2006: 2.7; 2007: 4.3; 2008 Proj.: 2.7; 2009 Proj.: 2.8
- CPI inflation (in percent): 2004: 2.3; 2005: 2.7; 2006: 3.5; 2007: 2.3; 2008 Proj.: 4.4; 2009 Proj.: 3.5
- Unemployment rate (in percent): 2004: 5.4; 2005: 5.1; 2006: 4.8; 2007: 4.4; 2008 Proj.: 4.2; 2009 Proj.: 4.7

### Fiscal indicators (selected)
- Commonwealth government receipts (cash basis, percent of GDP) 2004/05: 26.3; 2005/06: 26.5; 2006/07: 26.0; 2007/08: 26.2; 2008/09 Proj.: 25.4
- Commonwealth government payments (cash basis, percent of GDP) 2004/05: 24.8; 2005/06: 24.8; 2006/07: 24.2; 2007/08: 24.4; 2008/09 Proj.: 23.4
- Underlying cash balance (percent of GDP) 2004/05: 1.5; 2005/06: 1.6; 2006/07: 1.6; 2007/08: 1.5; 2008/09 Proj.: 1.8
- Fiscal balance (accrual basis, percent of GDP) 2004/05: 1.4; 2005/06: 1.7; 2006/07: 1.6; 2007/08: 1.8; 2008/09 Proj.: 1.9

### External sector and balance of payments (selected)
- Current account balance (percent of GDP): 2004: -6.0; 2005: -5.8; 2006: -5.5; 2007: -6.1; 2008 Proj.: -6.1; 2009 Proj.: -4.2
- Goods balance (percent of GDP): 2004: -2.8; 2005: -1.9; 2006: -1.3; 2007: -1.9; 2008 Proj.: -1.6; 2009 Proj.: 1.4
- Exports (percent of GDP): 2004: 13.6; 2005: 15.0; 2006: 16.5; 2007: 15.6; 2008 Proj.: 16.6; 2009 Proj.: 19.1
- Imports (percent of GDP): 2004: -16.4; 2005: -16.9; 2006: -17.8; 2007: -17.5; 2008 Proj.: -18.2; 2009 Proj.: -17.7
- Net income (percent of GDP): 2004: -3.3; 2005: -3.9; 2006: -4.3; 2007: -4.4; 2008 Proj.: -4.6; 2009 Proj.: -5.7
- Net interest payments (percent of GDP): 2004: -1.6; 2005: -1.7; 2006: -2.2; 2007: -2.3; 2008 Proj.: -2.9; 2009 Proj.: -3.8

### External vulnerability indicators (selected)
- Net external liabilities (percent of GDP): 2004: 55.5; 2005: 56.8; 2006: 60.2; 2007: 66.5; 2008 Proj.: 66.6; 2009 Proj.: 65.3
- Net external debt (percent of GDP): 2004: 47.5; 2005: 50.0; 2006: 52.0; 2007: 55.8; 2008 Proj.: 56.3; 2009 Proj.: 55.1
- Gross external debt (percent of GDP): 2004: 79.8; 2005: 82.3; 2006: 90.3; 2007: 91.1
- Short-term net external debt (residual maturity basis, percent of GDP): 2004: 17.8; 2005: 19.3; 2006: 19.2; 2007: 25.5
- Gross official reserves (in billions of Australian dollars): 2004: 47.4; 2005: 59.0; 2006: 69.6; 2007: 30.5
- Gross reserves in months of imports: 2004: 3.2; 2005: 3.6; 2006: 3.8; 2007: 1.5

### Financial sector indicators (selected)
- Regulatory capital to risk-weighted assets (percent): 2004: 10.5; 2005: 10.4; 2006: 10.4; 2007: 10.2; 2008: 10.5
- Tier I capital to risk-weighted assets (percent): Average 1997–2006: 7.6; 2007: 7.6; 2008: 7.4; 2009 Proj.: 7.2; 2010 Proj.: 7.3
- Impaired assets to total assets (percent): 2004: 0.3; 2005: 0.2; 2006: 0.2; 2007: 0.2; 2008: 0.3
- Specific provisions to impaired assets (percent): 2004: 41.4; 2005: 37.0; 2006: 39.5; 2007: 39.5; 2008: 36.8
- Loans composition (share of total): Housing loans 2004: 53.6; 2005: 53.8; 2006: 51.9; 2007: 46.7; 2008: 46.6

### FSAP key recommendations and implementation progress (selected)
- Risk management and stress testing: Basel II came into effect January 2008; three of the four large banks approved to adopt the internal ratings based approach with respect to credit risk; the fourth large bank expected to adopt by end-2008.
- Failure resolution and crisis management: FCS proposed to provide depositors access to first A$20,000 and to enhance regulators’ ability to deal with distressed ADIs and general insurers.
- Supervisory capacity: APRA received additional funding in the 2007/08 Budget over a four-year period; ministerial consent requirement for administrative actions removed; ASIC received substantial funding increases.
- Trans-Tasman cooperation: Legislative changes requiring regulators to be alert to each other’s interests came into force December 2006; work now focuses on practical coordination in crisis management.
- Insurance sector: Stage II reforms for nonlife insurance completed in 2006; from July 1, 2008, all Direct Offshore Foreign Insurers operating in Australia must be authorized by APRA.
- AML/CFT: AML/CFT Act adopted December 2006; implementation proceeding on a 24-month schedule; second tranche legislation under development.

### Stress tests and scenarios (selected)
- External debt DSA bound tests show baseline gross external debt around 101 (gross external debt in percent of GDP, box label) with scenarios including:
  - Interest rate shock (permanent one-half standard deviation shocks)
  - Non-interest current account shock
  - Growth shock (permanent 1/4 standard deviation)
  - Real depreciation shock: one-time real depreciation of 30 percent occurs in 2009 (scenario assumes foreign exchange hedging covers 79 percent of foreign currency debt)

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

### Appendix I. Exchange Rate Assessment Methodology and Confidence Intervals

### _cr08312 - Appendix I. Exchange Rate Assessment Methodology and Confidence Intervals

### Methodology
- Desk estimates of the equilibrium value of the REER under the macroeconomic balance (MB) and the equilibrium real exchange rate (ERER) approaches are based on panel regression models estimated by the generalized method of moments (GMM).
- To control for endogeneity, lagged explanatory variables are employed as instruments, where appropriate.
- The desk methodology allows confidence intervals to be calculated; wide confidence intervals suggest that results need to be interpreted with caution.
- Further details are available in a forthcoming working paper.

### MB Estimation Results for 55 Economies, 1973–07
- Dependent variable: CA/GDP Estimate t Ratio
- Coefficients and t-ratios (as reported):
  - Rel. old age dependency: −0.70 −5.02
  - Rel. population growth: −4.19 −2.82
  - Rel. income growth: −0.45 −2.08
  - Oil trade balance: 0.78 5.69
  - Initial net foreign assets: 0.001 2.45
- Observations: 838
- R Squared: 0.52
- MB Approach: Contributions to CA/GDP Norm (In percent) — graphical series summarized in source include:
  - Fixed effect
  - Rel. old age dependency
  - Rel. population growth
  - Rel. income growth
  - Oil trade balance
  - Initial net foreign assets
  - CA/GDP projection
  - CA/GDP norm
- Time axis shown from 2000 to 2012 in the figures.

### ERER Estimation Results for 55 Economies, 1973–07
- Dependent variable: REER Estimate t Ratio
- Coefficients and t-ratios (as reported):
  - Terms of trade: 0.36 3.78
  - Rel. productivity: 0.24 5.33
  - Rel. government consumption: 1.58 4.05
- Observations: 945
- R Squared: 0.51
- ERER Approach: Contributions to Equilibrium REER (Log scale) — graphical series summarized in source include:
  - Fixed effect
  - Terms of trade
  - Rel. productivity
  - Rel. govt. consumption
  - Projected REER
  - Equilibrium REER
- Time axis shown from 2000 to 2012 in the figures.

### Confidence Intervals (Ninety Percent Confidence Intervals for MB and ERER)
- Current Account Deficit (Percent of GDP) — MB: 2 to 6½
- Deviation of REER From Equilibrium (Percent) — MB: −6 to 22
- Deviation of REER From Equilibrium (Percent) — ERER: −6 to 20
- Source: Fund staff estimates.

---

### Australia — Fund Relations and Statistical Issues (Selected items from Annex I and Annex II)
- Membership Status: Joined: August 5, 1947; Article VIII
- Quota: 3,236.40 SDR Million (100.00 percent quota)
- Fund holdings of currency: 2,997.38 SDR Million (92.61 percent)
- Reserve position in Fund: 239.41 SDR Million (7.40 percent)
- SDR Department net cumulative allocation: 470.55 SDR Million (100.00 percent)
- SDR Department holdings: 117.07 SDR Million (24.88 percent)
- Outstanding Purchases and Loans: None
- Financial Arrangements: None
- Projected Obligations to Fund: None
- Exchange Rate Arrangement:
  - Australia has accepted the obligations of Article VIII, Sections 2, 3 and 4.
  - Exchange system is free from restrictions on current international transactions except notified security-related restrictions.
  - Exchange rate is independently floating; the Reserve Bank of Australia retains discretionary power to intervene.
  - No taxes or subsidies on purchases or sales of foreign exchange.
- Restrictions on Capital Transactions:
  - Regime virtually free of restrictions.
  - Two main restrictions on foreigners require authorization for significant ownership of Australian corporations and approval for acquisition of real estate.
- Article IV Consultation:
  - Australia is on the 12–month consultation cycle.
  - 2007 Article IV consultation discussions were held during June 18–27, 2007; Executive Board concluded consultation on August 31, 2007 (IMF Country Report No. 07/314).
- FSAP Participation:
  - FSAP missions: November 30–December 14, 2005, and March 26–April 12, 2006.
  - Related country reports published as Country Reports No. 06/372, No. 06/415, and No. 06/437.
- Fourth Amendment: Australia has accepted the Fourth Amendment to the Articles of Agreement.

### Australia — Statistical Coverage and Timeliness (Table of Common Indicators Required for Surveillance, as of July 31, 2008)
- Exchange Rates: Latest Observation 07/31/08; Date Received 07/31/08; Frequency of Data D; Frequency of Reporting D; Frequency of Publication D
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Latest Observation 06/08; Date Received 07/17/08; Frequency M M M
- Reserve/Base Money: Latest Observation 05/08; Date Received 07/08/08; Frequency M M M
- Broad Money: Latest Observation 05/08; Date Received 07/08/08; Frequency M M M
- Central Bank Balance Sheet: Latest Observation 06/08; Date Received 07/17/08; Frequency M M M
- Consolidated Balance Sheet of the Banking System: Latest Observation 05/08; Date Received 07/08/08; Frequency M M M
- Interest Rates: Latest Observation 07/31/08; Date Received 07/31/08; Frequency D D D
- Consumer Price Index: Latest Observation Q2 2008; Date Received 07/23/08; Frequency Q Q Q
- Revenue, Expenditure, Balance and Composition of Financing – General Government: Latest Observation 2006/07; Date Received 10/07; Frequency A A A
- Revenue, Expenditure, Balance and Composition of Financing – Central Government: Latest Observation 04/08; Date Received 07/17/08; Frequency M M M
- Stocks of Central Government and Central Government-Guaranteed Debt: Latest Observation 04/08; Date Received 07/17/08; Frequency M M M
- External Current Account Balance: Latest Observation Q1 2008; Date Received 06/03/08; Frequency Q Q Q
- Exports and Imports of Goods and Services: Latest Observation 05/08; Date Received 07/17/08; Frequency M M M
- GDP/GNP: Latest Observation Q1 2008; Date Received 06/04/08; Frequency Q Q Q
- Gross External Debt: Latest Observation Q1 2008; Date Received 06/03/08; Frequency Q Q Q
- International Investment Position: Latest Observation Q1 2008; Date Received 06/03/08; Frequency Q Q Q

Notes from table footnotes (as presented):
- Includes reserve assets pledged or otherwise encumbered as well as net derivative positions.
- Interest rates: Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes and bonds.
- Financing includes foreign, domestic bank, and domestic nonbank financing.
- Central government consists of the central government (including budgetary, extra budgetary, and social security funds) and state and local governments.
- Stocks include currency and maturity composition.
- Frequency codes: Daily (D), Weekly (W), Monthly (M), Quarterly (Q), Annually (A), Irregular (I); Not Available (NA).
- International Investment Position includes external gross financial asset and liability positions vis a vis nonresidents.

### Supplementary Information — Selected Economic Developments (September 5, 2008 supplement)
- Recent growth and outlook:
  - Real GDP grew by 1.2 percent in the June quarter in annualized seasonally adjusted terms, reducing growth to 2.7 percent in y/y terms.
  - Staff’s real GDP projections remain broadly unchanged; risks more balanced than in the staff report.
  - Household consumption contracted slightly while private investment remained strong.
- Credit and financial conditions:
  - Credit growth fell from 16 percent y/y in December 2007 to 6 percent in July 2008 (in seasonally adjusted, annualized terms).
  - Higher interest rates and tightened credit standards cited as drivers of the slowdown in credit growth.
  - Financial turmoil continued to put upward pressure on banks’ funding costs; variable and fixed mortgage rates rose further in July.
- Monetary policy actions:
  - Reserve Bank of Australia reduced its cash rate by 25 basis points to 7 percent on September 2, 2008.
  - RBA noted financial conditions had become quite tight; cut offsets recent tightening and RBA forecasts inflation to fall below 3 percent in 2010.
- Staff view on policy:
  - Monetary policy remains sufficiently firm to reduce inflation but a cautious approach is important given high core inflation, commodity price pressures, and large immigration inflows.
  - Even after the cash rate cut, bank lending rates are more than 150 basis points above mid-2007 levels and credit conditions have tightened considerably.
- Exchange rate:
  - The Australian dollar has fallen by about 10 percent since June 2008, in nominal effective terms.
  - Recent depreciation driven by market expectations of easing in monetary policy and a decline in base metal prices as global growth forecasts were revised downward.
  - The staff report estimated an overvaluation of the Australian dollar of about 10 percent; recent depreciation brings the currency into line with its medium-term equilibrium level.

*Source: Fund staff estimates and IMF staff report excerpts contained in the provided content.*

### 8. The current account deficit narrowed to 4½ percent of GDP in the June quarter.

### 8. The current account deficit narrowed to 4½ percent of GDP in the June quarter.

### Current account and external position
- The trade balance moved into surplus for the first time in six years, driven by a sharp increase in export prices for iron ore and coal and a broader pickup in export volumes.  
- The improvement in the trade balance was partly offset by a wider income deficit, as debt service costs and dividend payments increased.  
- Net foreign liabilities were revised down by 4–5 percent of GDP for the past year, and stood at about 60 percent of GDP for June 2008.  
- Australia’s current account deficit fell sharply to 4.4 per cent of GDP in the June quarter.  
- The net income deficit remained high, reflecting robust growth in corporate profits, particularly in the mining sector, and rising net interest payments from a higher stock of net foreign debt.  
- Outlook: the current account deficit is expected to remain around historical norms of 4 to 5 per cent of GDP as domestic demand moderates, rural exports rebound, and significant mining investment projects come on stream.  
- Sectoral note: the increase in net borrowing reflects exceptionally high rates of investment by the non-financial corporate sector; gross investment by that sector rose by nearly 4 percentage points of GDP over the last five years.

### Key macroeconomic indicators and inflation
- CPI inflation rose to 4½ percent (year to the June quarter 2008).  
- Measures of underlying inflation rose to around 4 per cent.  
- Wages growth: annual growth around 4 per cent for the past three years.  
- Real GDP growth slowed to 2.7 per cent over the year to the June quarter, with the quarterly growth rate of 0.3 per cent.  
- Household consumption fell slightly in the June quarter; consumer sentiment fell to 15-year lows.  
- Housing: national house prices were flat in the first half of the year; forward indicators point to declines in housing construction activity.  
- Employment outlook: unemployment rate expected to rise to 4¾ per cent by mid 2009.  
- RBA’s August forecasts: underlying inflation to remain around 4 to 4½ per cent over the year to the December quarter and then decline gradually to 2¾ per cent by the end of 2010.

### Monetary policy and interest rates
- The RBA tightened monetary policy in response to rising inflation, increasing the cash rate 100 basis points between August 2007 and March 2008 (part of a cumulative 300 basis points from mid-2002 to March 2008).  
- Global funding pressures pushed up lending rates further; banks passed on increased funding costs to borrowers (adding a further 50-80 basis points to average bank lending rates since August 2007).  
- Credit growth slowed from an average monthly rate of 1.3 per cent over the December quarter 2007 to an average monthly rate of 0.5 per cent over the June quarter.  
- In September, the RBA Board lowered the cash rate by 25 basis points to 7.0 per cent, judging that tight financial conditions had exerted needed restraint on demand and that there was scope for policy to become less restrictive.  
- Going forward, the RBA will continue to assess prospects for demand and inflation and set policy to bring inflation back to the 2-3 per cent target range over time.

### Fiscal policy
- The Commonwealth government has run surpluses in recent years and eliminated its net debt; revenue outcomes have surprised on the upside due in part to buoyant corporate tax revenue from the commodity boom.  
- The 2008-09 Budget (July-June) is contractionary with expenditure restraint and a higher projected underlying cash surplus; the Government projects an underlying 2008-09 cash surplus equivalent to 1.8 per cent of GDP.  
- Further budget surpluses in the order of 1½ per cent of GDP are projected over the following three fiscal years.  
- The Government will reduce tax as a share of GDP (from 24.7 per cent in 2007-08 to 23.8 per cent in 2008-09) while restraining expenditure growth (real spending growth reduced to 1.1 per cent).  
- Policy design: intention to save any further positive revenue outcomes in 2008/09; establishment of three new funds (initial contributions from 2007-08 and 2008-09 surpluses) amounting to around 4 per cent of GDP to raise productivity via investment in infrastructure, education, and health.

### Financial sector resilience and vulnerabilities
- The banking sector is sound: high profitability, high capitalization, and low levels of nonperforming loans; large Australian banks maintain high credit ratings.  
- Australian banks have minimal direct exposure to sub-prime problems and typically earn less revenue from trading in financial markets compared with many overseas banks.  
- Effects of global turmoil: bank share prices have fallen and funding costs have risen significantly; banks have raised lending rates by more than the increase in the cash rate over the past year.  
- Banks are increasing holdings of liquid assets, lengthening funding maturities, maintaining access to domestic and international capital markets (at higher cost), and have benefited from stronger deposit growth.  
- Authorities’ actions and regulatory reforms:
  - RBA provided liquidity support; APRA intensified monitoring of banks.  
  - Implementation of Basel II at the beginning of the year; APRA reviewing operation and liquidity prudential standards, focusing on disclosure and stress testing.  
  - Progress on FSAP recommendations, strengthening failure resolution and crisis management frameworks; planned introduction of liquidity guidelines to reduce offshore funding disruption risk.  
  - Establishment of a Financial Claims Scheme to provide timely payouts to depositors/policyholders of failed institutions; legislative changes to enhance regulators’ powers for managing troubled institutions.  
  - Ongoing engagement with New Zealand authorities on trans-Tasman crisis management.

### Policy recommendations and assessments by Executive Directors
- Commended authorities for fiscal, monetary, and structural management that supported long expansion.  
- Supported strong commitment to the inflation targeting framework; welcomed RBA’s actions to tighten and then cautiously ease policy given evolving financial conditions.  
- Recommended saving upside revenue outcomes in 2008/09 and allowing the surplus to exceed budget forecasts if growth and revenues are stronger than expected until inflation clearly declines.  
- Noted scope to reduce taxes or increase spending over the medium term if budget improvement is structural and associated with permanently higher commodity prices.  
- Urged careful monitoring of wage and price developments, given high core inflation and commodity-driven pressures.  
- Encouraged monitoring banking sector vulnerabilities to rollover risks from short-term wholesale funding and risks from large household indebtedness.  
- Supported further structural reforms to enhance flexibility, productivity, and labor force participation.

### Structural reform agenda
- Government committed to an ambitious reform agenda, including:
  - Introducing an emissions trading scheme from 2010.  
  - Conducting a comprehensive review of the tax and transfer system.  
  - Establishing three new funds to raise productivity through investment in infrastructure, education, and health (around 4 per cent of GDP in total).

*Source: IMF staff report and Public Information Notice summarizing the 2008 Article IV consultation with Australia (material dated and described in the supplied content).*

### Conclusion

### Conclusion

### Acknowledgment

- Finally, our Australian authorities would like to thank Ray Brooks and his team for the constructive policy discussions during the Article IV mission, reflected in their high quality staff report and selected issues paper.

*Source: _cr08312 - Conclusion*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08312.pdf_