## _cr15274

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---

### Context and recent performance
- Long boom winding down: GDP has grown twice as fast as peers (averaging 3¼ percent since 1998); per capita income U.S. $61,000 in 2014; net debt 15 percent of GDP vs 79 percent for G20 advanced economy average.
- Growth drivers: resources sector ~10 percent of GDP and accounted for close to half of GDP growth in the past three years; net migration ~1½ percent population growth; flexible exchange rate, flexible labor market, credible monetary policy, strong institutions, prudent fiscal frameworks.
- Recent outcomes:
  - GDP grew by 2½ percent in the year to 2015 Q1.
  - Unemployment settled at a decade high of 6 percent.
  - Real net national disposable income per capita flat or falling in the past four quarters.
  - Reserve Bank of Australia policy rate cut by a further 50bps since February (2015); policy rate at historic low of 2 percent (later noted as average series values).

### Macroeconomic outlook and key projections
- Near-term drivers:
  - Net export volumes rise as iron ore and LNG export volumes ramp up; services exports improve with lower exchange rate.
  - Residential investment continues to grow; business investment gradually turns around.
  - Consumption moderate; household saving rate has begun to fall from a high level.
  - Inflation expected to stay in RBA target range of 2-3 percent; tradables inflation rises with exchange rate pass-through and oil price stabilization; non-tradables inflation contained by weak wages growth.
- Medium-term prospects:
  - Potential growth likely around 2½ percent rather than past 3¼ percent; per capita GDP growth back to advanced economy average ~1 percent.
  - To restore historical gross domestic income growth would require raising TFP to about 1½ percent per year (nearly double staff’s baseline).
- Key medium-term forecasts (calendar year)
  - GDP growth:
    - RBA: 2.25 2.5-3.5
    - Treasury 2/: 2.5 2.75 3.25
    - Consensus: 2.5 2.9 3.2
    - IMF: 2.5 3.0 3.1
  - CPI inflation 3/:
    - RBA: 2.5 2.0-3.0
    - Treasury 2/: 2/ 1.75 2.5 2.5
    - Consensus: 1.8 2.7 2.7
    - IMF: 1.8 2.6 2.4
  - Unemployment:
    - Treasury 2/: 2/6.25 6.5 6.25
    - IMF: 6.2 6.1 6.0
  - Notes:
    - 2/ Fiscal year; e.g. 2015 represents FY 2014-15.
    - 1/ Data sources: Staff projections, RBA Monetary Policy Statement (May 2015), Treasury Budget 2015 (May 2015), and Consensus forecasts from Consensus Economics Inc. (June 2015).
    - 3/ Annual average for IMF, Treasury, and Consensus; end of period for RBA.

### External sector assessment and REER
- Historical/current position:
  - Australia has run a current account deficit for much of its history and has a negative IIP position; NIIP around -54 percent of GDP (staff notes range -45 to -60 percent since 1992).
  - Official reserves relatively small at 4½ percent of GDP.
- Factors since summer 2014:
  - (1) Sharply falling commodity export prices and terms of trade.
  - (2) A decline in oil prices.
  - (3) Large bilateral exchange rate movements for the U.S. dollar, euro and Yen.
- Specific effects and staff outlook:
  - Continued ramp up in export volumes partly offsets lower commodity prices; net income deficit stays at around 2 percent of GDP.
  - Lower oil prices mildly improve the trade balance; LNG prices decline with a lag.
  - Australian dollar depreciated sharply vs U.S. dollar but only down 9 percent from a recent peak in nominal/real effective terms in earlier notes; REER assessed 0-15 percent overvalued.
  - Current account deficit expected in 2015 to widen to 3½ percent of GDP; medium-term current account around 3½ percent of GDP.
  - Staff assess external sector moderately weaker and REER moderately stronger than warranted; model-based approaches suggest REER overvalued by 0-15 percent and current account around 0-1½ percent weaker than implied by fundamentals.

### Fiscal position, projections, and public investment recommendations
- Current stance and outlook:
  - National deficit estimated at around 3 percent in 2014/15; May 2015/16 Budget projects return to surplus in 2019-20.
  - Public debt rising since the global financial crisis but substantially lower than most advanced economies.
  - Fiscal consolidation has become more difficult due to lower export prices, weak wage growth, higher unemployment, and limited political support for measures (some measures amounting to 0.4 percent of GDP by 2017/18).
- IMF staff fiscal projections (fiscal balance % GDP, Act./Proj.)
  - 2014/15: -2.9
  - 2015/16: -2.3
  - 2016/17: -1.6
  - 2017/18: -0.6
  - 2018/19: -0.2
  - 2019/20: 0.0
- Cyclically adjusted balance (% GDP)
  - 2014/15: -2.2
  - 2015/16: -1.7
  - 2016/17: -1.1
  - 2017/18: -0.2
  - 2018/19: 0.0
  - 2019/20: 0.1
- Recommendation: Slow the pace of fiscal consolidation (avoid overly frontloaded consolidation). Maintain a small surplus as a long-term anchor while using temporary borrowing to raise net public investment to support aggregate demand, catalyze private investment, relieve housing supply bottlenecks, and take advantage of record low interest rates.
- Public investment strategy elements:
  - Coordinate Commonwealth and states; support both small and large projects including repairs and maintenance.
  - Establish a pipeline of quality larger projects with transparent cost-benefit analysis.
  - Consider Commonwealth guarantees of states’ borrowing for additional investment to preserve accountability while addressing rating concerns.

### Housing, credit dynamics, and financial stability
- Housing and credit indicators (June 2015 unless noted):
  - Overall credit growth: 5.9 percent (y/y) in June (2015).
  - Housing credit growth: 7.3 percent in June (2015); investor credit growth 10.9 percent with investor lending accounting for almost half of housing credit growth.
  - House price inflation overall ~10 percent; around 16 percent in Sydney.
  - No signs of generalized credit boom; lending standards generally high and being tightened.
- House price valuation (Box 3 model estimates):
  - HP statistical filter: overvaluation ~5 percent.
  - Fundamentals model: overvaluation ~15 percent; equilibrium growth rates ~3-4 percent.
  - Fundamentals + supply factors: overvaluation ~8-10 percent.
  - User costs approach (Fox and Tulip, 2014): overvaluation 10-19 percent under lower expected appreciation assumptions.
  - Bottom line: House prices moderately overvalued, probably around 10 percent; concentrated in Sydney and fuelled by investor credit and interest-only loans.
- Prudential and regulatory actions:
  - APRA (Dec 2014) directed focus on higher risk mortgage lending; rein in investor lending growth above 10 percent a year; strengthen loan serviceability tests.
  - ASIC reviewing interest-only lending against responsible lending obligations.
  - Banks’ responses since mid-2015: reduced discounts on investor lending; curtailed high LVR loans; tightened interest-only lending.
  - APRA announced raising average mortgage risk weights for IRB banks from around 16 to at least 25 percent by July 2016 (equivalent to an 80 basis point change in CET1).
- Stress test scenarios (APRA, Nov 2014):
  - Scenario A (House price bust): Australian GDP growth declines to -4 percent, unemployment >13 percent, house prices fall cumulatively 40 percent.
  - Scenario B (Higher interest rates): RBA raises cash rate amid strong growth; global growth weakens; leads to higher unemployment and significant house price fall.
  - Results: Aggregate CET1 falls by ~3 percentage points from 8.9 percent though banks remain above minimum 4.5 percent; losses on residential mortgages ~one-third of total credit losses; banks likely use capital conservation buffers and face payout constraints.

### Macro-financial projections and bank resilience
- Macro-financial baseline (Box 4):
  - House prices baseline: soft landing with inflation slowing to 3-4 percent; no change in estimated overvaluation.
  - Household debt: nominal debt rises with projected house price increases; debt ratio initially rises then falls as income growth gathers.
  - Credit to private sector: slightly slowing growth; no further reduction in banks’ use of wholesale funding assumed.
  - Bank balance sheets: slower growth in risk-weighted assets reduces profitability; CET1 dips to 9 percent following 2016 mortgage risk-weight increases then rises to ~10 percent through profit retention; further increases could be achieved by reducing dividend payout ratios.
- Staff view on capital and buffers:
  - Building “unquestionably strong” bank buffers is appropriate given housing concentration, funding and systemic bank concentration.
  - Options: raise mortgage risk weights (including floors), Pillar 2 adjustments, countercyclical capital buffer 0-2.5 percent from 2016, higher D-SIB surcharge, and higher leverage ratio (upper end of 3-5 percent recommended by FSI).

### Risks, scenarios, and spillovers
- Overall risk skew: Downside.
- Key downside scenarios:
  - Persistently weak domestic demand: medium likelihood; high impact. Sensitivity: US$ 10/ton reduction in iron ore spot price → 3 percent fall in terms of trade and 0.8 percent reduction in nominal GDP; could reduce tax receipts by up to AU$ 4.4 billion (~0.3 percent of GDP) in a full year.
  - Housing market hard landing: medium likelihood; impact ranges Low–High depending on scenario. APRA stress tests illustrate severe impacts though banks could absorb shocks at the cost of higher funding costs and potential rating downgrades.
  - Structurally weak growth in China / sharp slowdown in 2015/16: likelihood High/Medium; impact Medium. Previous IMF work: a one percent slowdown in China’s investment growth can lower Australia growth by 0.2 percent.
  - Tighter/volatile global financial conditions: likelihood High/Medium; impact Medium. A simultaneous reassessment raising bond yields by 200bps could reduce world growth by 1.2 percent and cut Australia growth by 0.5–1 percentage point.
- Spillovers:
  - New Zealand: Australian bank subsidiaries constitute 90 percent of NZ banking system; subsidiaries ring-fenced and well capitalized; indirect reputational effects could affect NZ offshore funding access.
  - Pacific Island Countries: Australia accounts for ~20 percent of PICs’ trade on average; tourist arrivals from Australia ~50 percent in Fiji and Vanuatu; remittances from Australia ~35 percent of total in Fiji, Samoa, Vanuatu; Australian banks dominate PICs’ banking sectors.

### Policy priorities and recommendations
- Three broad policy aims:
  - Sustain aggregate demand in the shorter term through the resource cycle transition.
  - Lift productivity in the longer term to sustain strong income growth.
  - Build resilience and reduce macroeconomic and financial vulnerabilities.
- Monetary policy:
  - Remain accommodative and could loosen further if recovery falls short, provided financial stability risks remain contained.
  - Avoid using blunt monetary policy to address housing market risks; instead use targeted prudential measures (APRA measures noted).
  - Monetary easing risks: could stoke house price inflation and interact with high household debt.
- Fiscal policy:
  - Slow the pace of consolidation near term; keep small surplus as a fiscal anchor in the longer term.
  - Use borrowing to finance higher public investment to support demand and productivity; coordinate Commonwealth and states; strengthen operating balance focus and raise public capital stock.
- Structural reforms to lift TFP and incomes:
  - Implement Competition Policy Review recommendations; improve infrastructure and housing supply (planning and zoning responsiveness).
  - Tax and fiscal reform package: shift to more efficient/simple taxes; reduce corporate tax rate; eliminate stamp duties and minor taxes; broaden GST (with compensation to low-income households); increase reliance on broad-based real-estate tax and excises.
  - Reduce incentives for excessive housing investment: limit concessional treatment of capital gains on real estate and deductibility of housing investment losses (negative gearing); cap Age Pension owner-occupied exemption.
  - Superannuation: align tax on contributions closer to personal income tax rates, phased adjustments to maintain fairness.
- Financial sector reforms and FSAP high-priority actions (selected):
  - Develop top-down stress testing (RBA); increase APRA stress testing resources; introduce higher loss absorbency (HLA) for systemic banks (APRA).
  - Intensify on-site liquidity supervision; upgrade daily liquidity reporting (implemented).
  - Ensure ASIC funding sufficiency and extend risk-based capital rules where needed.
  - Re-evaluate ex-ante funding for FCS and operationalize recovery and resolution planning.

### Key numeric indicators and selected projections (excerpts)
- Real GDP (annual % change, Table 1 row 2010–2020 excerpt): 2.3; 2.7; 3.6; 2.1; 2.7; 2.5; 3.0; 3.1; 3.0; 2.9; 2.8
- Reserve Bank of Australia cash rate (percent, avg series shown): 4.4; 4.7; 3.7; 2.7; 2.5; 1.7; 1.8; 2.2; 2.6; 3.0; 3.4
- Household/credit ratios and bank capital (selected):
  - Credit growth: 5.9 percent (y/y) in June (2015).
  - Housing credit growth: 7.3 percent in June (2015); investor credit 10.9 percent.
  - Regulatory capital ratio (% RWA, 2013–2020 excerpt): 11.8; 12.4; 12.9; 12.5; 12.9; 13.3; 13.7; 14.1
  - CET1 ratio (% RWA, 2013–2020 excerpt): 8.6; 9.0; 9.3; 9.0; 9.2; 9.4; 9.5; 9.7
- Fiscal time path (selected net lending/borrowing, percent of GDP 2010–2020): -5.1; -4.5; -3.5; -2.8; -2.9; -2.6; -2.0; -1.1; -0.4; -0.1; 0.1
- Current account (% GDP, Table 3 projections 2010–2020): -3.6; -2.9; -4.3; -3.3; -2.8; -3.4; -3.4; -3.6; -3.6; -3.5; -3.4
- Net international investment position (percent of GDP, projections): -55; -56; -56; -54; -54; -57; -58; -58; -59; -60; -60

*Source: IMF staff report excerpt (IMF Country Report _cr15274, August/September 2015).*

### 1. Australian Market Reaction to China and Greece Events  ________________________________________6

### 1. Australian Market Reaction to China and Greece Events

### Context: the long boom winds down
- Australia outperformed peers for the past two decades:
  - GDP has grown twice as fast as its peers (averaging 3¼ percent since 1998).
  - Per capita income stood at U.S. $61,000 in 2014.
  - Net debt only 15 percent of GDP compared to 79 percent on average for G20 advanced economies.
- Growth drivers and structural factors:
  - A resources sector that expanded to around 10 percent of GDP and accounted for close to half of GDP growth in the past three years.
  - Net migration contributing to population growth of 1½ percent a year.
  - Sound policy frameworks: flexible exchange rate, flexible labor market, credible monetary policy, strong institutions, and prudent fiscal frameworks.

### Recent macroeconomic developments and outlook
- Growth and demand:
  - GDP grew by 2½ percent in the year to 2015 Q1 with weak final domestic demand and declining public and private investment.
  - Capacity utilization and a soft labor market point to a sizeable output gap.
- Terms of trade and incomes:
  - The largest swing in the terms of trade for 150 years as resource commodity prices fell sharply.
  - Real net national disposable income per capita flat or falling in the past four quarters.
  - Unemployment settled at a decade high of 6 percent.
- Monetary policy and domestic demand:
  - The Reserve Bank of Australia cut its policy rate by a further 50bps since February (2015).
  - Housing investment has picked up strongly; consumption growth moderate; household saving rate has begun to fall from a high level.
- Exchange rate and external outlook:
  - Real effective exchange rate was only 6 percent lower in June (2015) despite commodity price falls of about 25 percent since mid-2014.
  - Current account deficit narrowed to 2.8 percent of GDP in 2014 but is expected to widen in 2015 as export prices fall.

### Box 1 — Market reaction to China and Greece events (findings)
- Market reaction described as relatively muted and supportive of activity:
  - The exchange rate depreciated further against the U.S. dollar and in nominal effective terms.
  - Long term bond spreads moved in a narrow range.
  - Wholesale markets were unaffected.
  - Ground lost on equities in early June (mainly resources and retail) was largely recouped by late July.
  - The iron ore spot price fell steeply to a low of $44 in early July (2015), influenced by Chinese equity market developments and seasonal demand factors.

### External sector assessment (Box 2 — findings and projections)
- Historical/current position:
  - Australia has run a current account deficit for much of its history and has a negative IIP position.
  - Official reserves are relatively small at 4½ percent of GDP.
- Factors affecting the current account since summer 2014:
  - (1) Sharply falling commodity export prices and terms of trade.
  - (2) A decline in oil prices.
  - (3) Large bilateral exchange rate movements for the U.S. dollar, euro and Yen.
- Specific effects:
  - Continued ramp up in export volumes partly offsets lower commodity prices; net income deficit stays at around 2 percent of GDP.
  - Lower oil prices have a mild positive effect on the trade balance (net oil imports of 2 percent of GDP); LNG prices decline with a lag.
  - The Australian dollar depreciated sharply against the U.S. dollar but by a smaller amount in nominal and real effective terms (down 9 percent from a recent peak).
  - Lower mining investment reduces capital goods imports.
- IMF staff outlook and assessment:
  - In 2015 the current account deficit is expected to widen to 3½ percent of GDP.
  - Over the medium term the current account deficit should remain contained at around 3½ percent of GDP.
  - Staff assess the external sector position remains moderately weaker and the real exchange rate moderately stronger than warranted.
  - Model-based approaches suggest the real exchange rate appears overvalued by 0-15 percent and the current account looks around 0-1½ percent weaker than implied by fundamentals.
  - The depreciation since June (2015) has narrowed the exchange rate gap a little.
  - Policy tightening in other advanced economies or monetary easing in Australia could result in a further depreciation, which would narrow the external imbalance and support rebalancing.

### Fiscal position
- Fiscal pressures and outlook:
  - National deficit estimated at around 3 percent in 2014/15, broadly unchanged from 2013/2014.
  - The May 2015/16 Budget projects a return to surplus in 2019-20.
  - Public debt has been rising since the global financial crisis but remains substantially lower than in most advanced economies.
  - Fiscal consolidation has become more difficult due to lower export prices, weak wage growth, higher unemployment, and limited political support for measures (some measures amounting to 0.4 percent of GDP by 2017/18).

### Financial cycle, housing, and credit
- Divergence across cycles:
  - Output gap widening while financial cycle shows high asset prices in some sectors.
  - Long-term bond yields fell over the past eighteen months (prior to some reversal since April 2015).
  - Equity prices continued to rise driven by financials despite fall in resources sector.
  - House prices: overall house price inflation close to 10 percent, around 16 percent in Sydney (Box 3).
  - Commercial and property development sectors turning down.
- Credit dynamics:
  - Overall credit growth picked up to 5.9 percent (y/y) in June (2015).
  - Housing credit rising at 7.3 percent in June (2015), led by investor credit at 10.9 percent, with investor lending accounting for almost half of all housing credit growth.
  - No signs of a generalized credit boom; lending standards generally high and being tightened.

### Box 3 — Are Australian house prices overvalued? (findings and model estimates)
- Stylized international comparisons:
  - Level of real house prices and house price to income ratio high relative to OECD average.
  - Sydney house price to income ratios around 7—similar to Auckland, London, Stockholm and Vancouver.
- Drivers of high prices:
  - Shift to low inflation, low nominal interest rates, financial liberalization, higher household indebtedness.
  - Supply side constraints: population concentrated in a few cities, planning and transport restrictions, remoteness of much of the country.
- Risks and assessment:
  - No generalized credit boom; run-up not accompanied by a construction boom.
  - Rapid house price inflation raises the risk of a sharp reversal given already high debt and house prices.
- Model-based overvaluation estimates (four approaches):
  - Statistical filter (HP): overvaluation of about 5 percent.
  - Fundamentals model: overvaluation of around 15 percent; equilibrium growth rates around 3-4 percent.
  - Fundamentals plus supply factors: overvaluation of around 8-10 percent.
  - User costs approach (Fox and Tulip, 2014): renting about as costly as buying based on average real appreciation since 1955; using a lower expected appreciation term results in overvaluation of 10-19 percent.
- Bottom line: House prices are moderately overvalued, probably around 10 percent; problem concentrated in Sydney and fuelled by investor credit and interest-only loans. Current rates of house price inflation imply rising overvaluation.

*Source: IMF staff report excerpt (2015).*

### 12.      Buoyant housing investor lending has prompted regulatory action. The Australian

### 12.      Buoyant housing investor lending has prompted regulatory action. The Australian

### Regulatory actions on housing investor lending
- APRA adopted a gradual and targeted approach and advised banks in December 2014 it would:
  - focus on higher risk mortgage lending (interest only and high loan to income or value ratios);
  - rein in growth of investor lending above 10 percent a year;
  - strengthen loan serviceability tests (by increasing interest rate buffers and floors).
- Failure by banks to act would trigger more intense supervisory action, potentially including additional capital requirements.
- ASIC is reviewing whether mortgage lenders’ interest-only lending complies with responsible lending obligations.
- Banks’ response since mid-2015:
  - reduced discounts on investor lending;
  - curtailed high loan to value ratio loans;
  - tightened interest only lending.
- Note: these measures were yet to be reflected in lending data given preapproval lags of 2-3 months.
- Separately, APRA announced that capital adequacy requirements for large banks using the internal risk based ratings approach would be increased (see Box 7 in source).

### Outlook — cyclical pick up, but weaker medium-term prospects
- Near-term growth drivers:
  - Net export volumes rise despite lower commodity prices as iron ore producers ratchet up export volumes and LNG exports come on stream (Australia set to become the world’s largest exporter).
  - Services exports improve with the lower exchange rate.
  - Investment contributes to growth in the short run: residential investment continues to grow and business investment gradually turns around.
  - Recovery supported by strong corporate balance sheets, the weaker exchange rate, historically low interest rates and contained wages pressure.
- Consumption:
  - Remains restrained near term due to low wage growth and more muted income expectations, but improves further ahead with rising confidence, a drawdown of the savings ratio from high levels, and a pickup in income growth following stabilization of the terms of trade.
- Inflation:
  - Inflation stays in line with the RBA’s target of 2-3 percent; tradables inflation rises as exchange rate pass-through occurs and oil prices stabilize; non-tradables inflation remains relatively contained due to weak wages growth.
- Medium-term prospects:
  - Medium-term potential growth likely around 2½ percent rather than the 3¼ percent of the past, bringing per capita GDP growth back to the advanced economy average of around 1 percent.
- Financial cycle:
  - Policy rate expected by markets to eventually begin rising while inflation remains well anchored at 2-3 percent.
  - Banks likely to raise capital ratios (Box 4).
  - Growth of lending for housing likely to slow as house price inflation moderates partly in response to higher interest rates.
  - High household debt and fiscal consolidation may slow closing of the output gap.

### Key medium-term forecasts (calendar year)
- GDP growth:
  - RBA: 2.25 2.5-3.5
  - Treasury 2/: 2.5 2.75 3.25
  - Consensus: 2.5 2.9 3.2
  - IMF: 2.5 3.0 3.1
- CPI inflation 3/:
  - RBA: 2.5 2.0-3.0
  - Treasury 2/: 2/ 1.75 2.5 2.5
  - Consensus: 1.8 2.7 2.7
  - IMF: 1.8 2.6 2.4
- Unemployment:
  - Treasury 2/: 2/6.25 6.5 6.25
  - IMF: 6.2 6.1 6.0
- Notes:
  - 2/ Fiscal year; e.g. 2015 represents FY 2014-15.
  - 1/ Data sources: Staff projections, RBA Monetary Policy Statement (May 2015), Treasury Budget 2015 (May 2015), and Consensus forecasts from Consensus Economics Inc. (June 2015).
  - 3/ Annual average for IMF, Treasury, and Consensus; end of period for RBA.

### Macro-financial outlook (Box 4) — projections and relationships
- House prices:
  - Baseline projection: soft landing, with house price inflation slowing to a sustainable 3-4 percent, implying no change in estimated overvaluation and housing market risks remain heightened.
- Household debt:
  - Projected increases in house prices raise nominal household debt, but income growth should gather pace, resulting in the debt ratio initially rising before falling gradually.
- Credit to private sector:
  - Assumed to grow as a weighted average of house price increases and business investment, resulting in slightly slowing growth.
  - Combined with deposits staying broadly constant as a share of GDP, this results in no further reduction in banks’ use of wholesale funding.
- Bank balance sheets:
  - Slower growth in risk-weighted assets expected to reduce profitability somewhat.
  - Following the increase in mortgage risk weights in 2016, the CET1 capital dips to 9 percent but then rises to around 10 percent through profit retention.
  - Further increases could be achieved by reducing dividend payout ratios.
- Historical relationship checks:
  - Credit and activity: historically strong positive relationship that has flattened recently; projections are based on this flatter relationship.
  - House prices and activity: projected dwelling investment and house prices are somewhat higher than recent past but reflect strong momentum in housing construction and record high housing approvals.
  - House prices and credit: projected growth of housing credit (owner occupied) is in line with recent house price inflation and housing credit growth.

### Risks — skewed downwards; payoffs from active policies
- Key downside scenarios and transmission:
  - Persistently weak domestic demand:
    - Non-resource demand slower to pick up; further terms of trade falls could entrench slower growth, higher unemployment and fiscal deficits, especially with reform inertia or global deflationary forces and/or falling house prices.
  - Housing market hard landing:
    - Current efforts to rein in riskier property lending might not be sufficiently effective.
    - Against high house prices and household debt, price overshooting and excessive risk taking could occur.
    - A sharp correction (possibly driven by Sydney) could be triggered by external conditions (e.g., sharper slowdown in China or a rise in global risk premia) or a domestic employment shock.
    - Amplifying factors: leveraged investors exiting, turning commercial property cycle, investors in self managed superannuation funds with geared property exposure.
    - In a tail scenario, APRA’s stress tests suggest banks would probably face ratings downgrades/higher offshore funding costs and would likely resist capital ratios falling into capital conservation territory by sharply tightening credit conditions.
  - External shocks:
    - China slowing more than expected (property market slows) — reduces demand for commodity exports and could lower iron ore prices below production costs.
    - Bumpy QE exit — sharply raises risk premia, raises Australian risk premia and wholesale funding costs, dents profits and confidence, and leads to higher unemployment and lower growth.
- Box 5 — balance sheet risks and transmission channels:
  - Net liability position with the rest of the world:
    - Net liability position ranged from 50 to around 60 percent of GDP since 1994.
    - Vulnerabilities mitigated as most liabilities are Australian dollar denominated while majority of foreign assets are in foreign currency, leaving Australia with a net foreign currency asset position.
    - Banking sector has a net foreign currency liability position but is fully hedged; balance sheet would improve rather than worsen with a sudden Australian dollar depreciation.
  - Main transmission channels:
    - Banks’ use of external funding: higher funding costs would likely be passed on to households; currently households have mortgage buffers (two years debt service).
    - Other financial institutions: growth of superannuation funds increases households’ exposure to equity wealth changes and away from more stable forms of saving.
    - Non-financial corporate sector: net liability position with other sectors and external sector but has a small net foreign currency asset position; large private non-financial corporations typically finance abroad and profits are globally distributed.
    - Public balance sheet: strong, with a small negative net financial worth; government is a AAA borrower and borrows in domestic currency; public sector, RBA and Future Fund have net foreign currency asset positions.

### Risk assessment (summary table in source)
- Significant Risks, skewed somewhat to the downside:
  - Upside:
    1. Domestic demand recovers more strongly, supported by policy actions — Likelihood: Medium; Impact: High
    2. Iron ore prices recover strongly from current lows and raise the terms of trade — Likelihood: Low; Impact: High
    3. Middle-income Asia boosts demand for services exports — Likelihood: Low; Impact: Medium
  - Downside:
    1. Persistently weak domestic demand — Likelihood: Medium; Impact: High
    2. Housing market hard landing — Likelihood: Medium; Impact: High
    3. Structurally weak growth in China — Likelihood: Medium; Impact: High (short-term: A sharp slowdown in growth in China in 2015/16)
    4. Tighter or more volatile global financial conditions — Likelihood: High/Medium; Impact: Medium

### Spillovers
- New Zealand:
  - Australian bank subsidiaries make up 90 percent of New Zealand’s banking system.
  - As subsidiaries (not branches), New Zealand banks are ring fenced, do not rely on parents for funding, and are well capitalized with substantial liquidity buffers, though indirect reputational effects could affect access to offshore wholesale funding.
  - Net migration between the two countries matters; as Australia has slowed, net migration to New Zealand has turned positive.
- Pacific Island Countries (PICs):
  - Australia accounts, on average, for 20 percent of PICs’ trade.
  - Tourist arrivals from Australia account for about 50 percent of total arrivals in Fiji and Vanuatu.
  - Remittances from Australia represent around 35 percent of the total in Fiji, Samoa, and Vanuatu.
  - Financial linkages important with PICs’ banking sectors dominated by Australian banks.
  - Australia is the largest aid donor (aid budget reduced) and the largest foreign investor for PICs.

### Authorities’ views (summary)
- Conditions seen as supportive of a gradual strengthening of growth with highly accommodative monetary policy.
- Economy performed solidly given fall in the terms of trade and waning resources boom.
- Exchange rate decline supports transition to stronger and more balanced growth; further depreciation would assist.
- Weak income growth weighing on domestic demand, but moderate wages growth supporting employment and the transition.
- Main external risk: possibility of a sharper than expected slowdown in China; floating exchange rate plays key role in cushioning such shocks.
- Housing prices rising but risks not overstated: rapid house price growth concentrated in Sydney and limited segments of Melbourne; no evidence of widespread oversupply and most mortgage holders have sizeable repayment buffers.
- Coordinated APRA policy actions announced in December 2014 were taking effect; authorities noted policy space to respond to materialized risks and would use it actively if needed.

### Policy priorities to re-energize growth
- Three broad policy aims:
  - Sustain aggregate demand in the shorter term through the resource cycle transition.
  - Lift productivity in the longer term to sustain strong income growth.
  - Build resilience and reduce macroeconomic and financial vulnerabilities that could derail the transition to broader-based growth.
- Specific short-term point:
  - Monetary policy alone cannot deliver everything; expecting too much from it can lead to bigger problems (RBA Governor Stevens, June 2015).

*Source: IMF staff report excerpt (chapter/section provided).*

### 25.       The sizeable output gap and the large structural transition of the economy call for

### _cr15274 - 25.       The sizeable output gap and the large structural transition of the economy call for

### Aggregate demand, output gap, and inflation outlook
- The sizeable output gap and the large structural transition of the economy call for supportive aggregate demand policies.
- Inflation pressures are weak and the demand outlook is subdued against a backdrop of higher unemployment and lower income growth.
- The exchange rate appears still on the strong side when compared with the steep fall in the terms of trade.

### Monetary policy: stance, risks, and guidance
- Current stance:
  - Policy rate is at an historic low at 2 percent.
  - Monetary policy is accommodative, and could become more so.
  - The policy rate remains high in real terms compared to peer countries with similar output gaps and the neutral rate may well have fallen.
- Risks of further easing:
  - Further rate cuts would stoke house price inflation.
  - Already high household debt levels may restrain the impact on consumption while heightening financial stability concerns.
- Staff recommendations:
  - Monetary policy should remain accommodative and could loosen further if the recovery falls short of expectations, provided financial stability risks remain contained.
  - Asymmetric risks for monetary policy—inflation expectations are well anchored and core inflation and growth appear more likely to under- rather than over-shoot. A weaker exchange rate would also help the recovery and the external position.
  - Housing market risks should be firmly addressed by prudential policy; target specific concerns (Sydney housing market, investor and interest-only lending) rather than using a blunt monetary policy response. APRA is already taking targeted measures which could be built upon if needed.
  - Policy tradeoffs:
    - Cutting rates if the recovery disappoints would provide insurance against a sharper slowdown, though it may require a steeper tightening once the economy gathers steam.
    - Keeping rates higher than warranted by output and inflation should only be considered if financial stability risks become broad based—with overheating of both credit and housing indicators—and if prudential policy is insufficient to contain risks. Then “leaning against the wind” might be appropriate as part of a broader prudential strategy.
    - Prudential measures aimed at building resilience should be implemented in a gradual manner to minimize effects on growth.
  - Timely high frequency data are important: enhance labor market data quality and fill the lack of monthly consumer price inflation data (Australian Bureau of Statistics).

### Fiscal policy: current impulse and recommended pacing
- Current stance:
  - Fiscal policy is imparting a substantial negative impulse.
  - The combination of tightening by the States and the Commonwealth implies that the national cyclically-adjusted balance improves by some ¾ of a percent of GDP on average over the next three years.
  - The envisaged tightening by the Commonwealth budget relies on historically strong revenue (reflecting bracket creep) and low spending growth (including on account of some as yet unlegislated budget measures).
- Staff view:
  - Slowing the pace of fiscal consolidation: a small surplus should remain a longer-term anchor and a credible, though gradual medium-term consolidation path should be maintained.
  - Staff assesses the planned pace of consolidation nationally (Commonwealth and states combined) as somewhat more frontloaded than desirable given the weakness of the economy, the size and uncertainty around the transition from the mining investment boom and the possible limits to the effectiveness of monetary policy.

### Fiscal projections and key fiscal figures (IMF staff projections)
- Fiscal balance (% GDP) by year (2014/15–2019/20, Act./Proj.):
  - 2014/15: -2.9
  - 2015/16: -2.3
  - 2016/17: -1.6
  - 2017/18: -0.6
  - 2018/19: -0.2
  - 2019/20: 0.0
- Cyclically adjusted balance (% GDP) by year:
  - 2014/15: -2.2
  - 2015/16: -1.7
  - 2016/17: -1.1
  - 2017/18: -0.2
  - 2018/19: 0.0
  - 2019/20: 0.1
- Change (ppts) by year:
  - 2014/15: 0.1
  - 2015/16: 0.5
  - 2016/17: 0.6
  - 2017/18: 0.9
  - 2018/19: 0.3
  - 2019/20: 0.0

### Boosting public investment: rationale and recommendations
- Rationale:
  - Raising public investment (financed by borrowing, thus reducing the pace of deficit reduction) would support aggregate demand, take pressure off monetary policy, and insure against downside growth risks.
  - It would employ resources released by the mining sector, catalyze private investment, boost productivity, could ease housing supply bottlenecks and would take advantage of record low interest rates.
  - Net public investment in Australia is higher than in advanced OECD peers, but has subtracted from growth in recent years; the public capital stock is projected to fall as a percentage of GDP over the medium term.
  - Australia is well positioned to benefit from public infrastructure investment—with efficient processes, an output gap, accommodative monetary policy and fiscal space allowing debt financing.
- Recommendations and strategy elements:
  - Careful coordination is needed given lags to implementation; strong governance to avoid waste.
  - Coordinate Commonwealth and states given states carry most public investment but face borrowing constraints.
  - Greater focus in budgeting on the national fiscal stance, strengthening the operating balance (which excludes capital spending) rather than the overall balance, and increasing the public capital stock.
  - Strategy components:
    - Support both small and large projects, including repairs and maintenance.
    - Continue to establish a pipeline of quality larger projects with transparent cost-benefit analysis (e.g., Infrastructure Australia pipeline).
    - Consider Commonwealth guarantees of states’ borrowing for additional investment to keep accountability with states while reducing concerns about credit ratings and without affecting the Commonwealth’s deficit.

### Fiscal anchor and medium-term stance
- Restoring a small budget surplus in the longer term is appropriate and should remain a fiscal anchor.
- Australia’s low public debt is a critical buffer and helps sustain the country’s AAA rating and the strong ratings of its banks.
- Additional measures may be required to ensure envisaged consolidation of the recurrent budget stays on track.

### Lifting productivity and income growth — context and challenges
- Structural change:
  - Drivers of growth (1990s structural reforms and the mining investment boom) have waned.
  - Maintaining the same growth rate and rise in incomes will be challenging.
- Labor force and participation:
  - Population growth will continue to support output growth, but labor force participation is likely to decline.
  - The participation rate has fallen back from a peak in 2010 to 64.7 percent in 2014-Q4 and is expected to decline slightly over the medium term as aging pressures emerge.
- Productivity:
  - Growth in output per hour has slowed since the mid 2000s and a productivity gap has opened up against best-performing peers.
  - Slower productivity growth partly reflects long investment lags for mining; mining productivity is rising as exports come on stream but likely insufficient for per capita income growth—productivity growth in other sectors will need to rise.

### Box 6 and potential growth / income projections
- Potential growth projections and comparisons:
  - Potential growth is estimated to slow to 2.8 percent over 2016-17, further declining to 2.6 percent over 2018-2020, driven by moderate input and slowing TFP growth.
  - Historical average potential growth: around 3.2 percent over 1990-2014.
  - Gross domestic income growth (adjusting for terms of trade movements) is projected to slow from an average of 3.5 percent over 1990-2014 to 2.8 percent in the medium term.
  - Raising gross domestic income growth to its historical average would require TFP growth between 1½ - 1¾ percent on average, nearly 80 percent more than the baseline projection.
  - Bridging half the TFP gap between U.S. and Australian TFP levels across sectors over 10-15 years would imply potential growth in the 3-3¼ percent range.
  - Recent IMF research: improved cross-sector allocation of inputs in advanced economies could boost TFP levels on average by 7-9 percent assuming optimal adjustment over 10 years.
- Staff assessment:
  - To sustain growth at past rates, TFP growth needs to accelerate to about 1½ percent per year (almost double staff’s baseline projections), requiring an ambitious reform agenda.

### Policy recommendations to lift TFP and incomes
- Focus areas and reforms:
  - Distribution sector (transport and domestic trade) shows most scope for catching up to the global TFP frontier.
  - Implement Competition Policy Review recommendations to strengthen competition and improve efficiency, including in human services and the retail sector.
  - Improve infrastructure investment to relieve bottlenecks and reduce housing supply constraints by making planning and zoning more responsive.
  - Trade agreements should help (recent agreements noted).
- Fiscal and tax reform package (interconnected elements):
  - Shift toward more efficient and simple taxes:
    - Prevent unchecked bracket creep impacting lower and middle incomes.
    - Reduce the corporate tax rate to international levels.
    - Eliminate stamp duties and minor taxes.
    - Finance reforms by broadening the GST (receipts from which are low by international standards) and possibly raising the rate, while at least fully compensating those on lower incomes via lower income taxes and higher transfers, and increasing reliance on a broad-based real-estate tax and excises.
  - Reduce incentives for excessive financial investment in housing:
    - Reduce concessional treatment of capital gains tax in real estate and the deductibility of housing investment losses from other taxable income (negative gearing effects).
    - Cap the exemption of owner-occupied housing for the calculation of the Age Pension.
  - Ensure fairness in superannuation:
    - Align tax rates on contributions closer to personal income tax rates to reduce concessions for higher earners and enhance revenue; adjust pension policies carefully and phased.

### Federal-state fiscal relations and implementation
- Adjust federal-state fiscal relations to facilitate tax reform (options include higher GST revenue to states in return for greater spending responsibilities).
- Greater coordination of fiscal policy stance between Commonwealth and States could facilitate macroeconomic management.

### Authorities’ views (summarized)
- Authorities agreed growth likely to continue below trend near term but improve as the economy rebalances.
- RBA noted scope for further policy easing given output gap, subdued labor costs, and inflation expected on average to remain in the 2-3 percent target, but limits to monetary fine-tuning; a lower real effective exchange rate likely needed for balanced growth.
- Government emphasized return to budget surplus remains a priority; 2015/16 budget planned a slower withdrawal of fiscal stimulus than prior budget. Authorities highlighted existing planned investments (including the national broadband network) and initiatives such as the Asset Recycling Initiative and Northern Australia Infrastructure Facility to support priority infrastructure while meeting medium-term fiscal strategy.
- Authorities saw competition, tax, workplace relations and federal relations reforms as important for raising efficiency; recognized need to consider Australia’s highly-progressive tax and welfare arrangements when changing tax and superannuation settings.

*Source: _cr15274 - 25.       The sizeable output gap and the large structural transition of the economy call for (IMF staff).*

### 41.       Australia’s financial system weathered the global financial crisis well, aided by flexible

### 41.       Australia’s financial system weathered the global financial crisis well, aided by flexible

### Financial system performance and structural vulnerabilities
- Recent strengths:
  - Major banks are highly rated and profitable compared with peers.
  - Low level of non-performing loans.
  - Decline in funding costs and reliance on external borrowing.
  - Higher capital ratios.
- Structural vulnerabilities:
  - Four major banks are systemic with broadly similar business models.
  - As a capital importer, economy is exposed to terms of trade shocks and a still relatively high proportion of offshore wholesale funding (though significantly reduced since the GFC and at extended maturities).
  - Residential mortgages account for a large proportion of banks’ assets and household leverage is high.
- On capital ratios:
  - Since 2008, much of the improvement in capital ratios for large banks (with internal risk based ratings) has been driven by a shift in banks’ loan books toward housing and a lowering of mortgage risk weights.
  - This has led to a wide divergence between the risk weights attached to mortgages between the big and smaller banks and may encourage lending for housing rather than to business.

### Financial System Inquiry (FSI) findings and recommendations (Box 7)
- Core message:
  - Australia needed to be better placed than other economies given its structural vulnerabilities, with a strong public balance sheet as a critical backstop, and banks should have unquestionably strong capital levels and sufficient loss absorbing capacity.
- Key recommendations:
  - Set capital ratios such that Australian banks are “unquestionably strong”; FSI used a schematic estimating current CET1 ratios on an internationally comparable basis at 10-11.6 percent and top quartile internationally at 12.2 percent and upwards.
  - Raise average mortgage risk weights for banks using internal ratings based models; APRA announced an increase in average mortgage risk weights for these banks from around 16 to at least 25 percent by July 2016 (equivalent to an 80 basis point change in the CET1 ratio).
  - Report transparently on capital ratios against Basel minimum capital framework.
  - Introduce a leverage ratio that acts as a backstop to banks’ risk-weighted capital positions.
- APRA assessment:
  - On an internationally comparable basis, Australian banks’ CET1 ratios would be around 300 basis points higher on average—placing them above the median of international peers, but not in the top quartile as proposed by the Inquiry.
  - To be comfortably positioned in the top quartile, APRA noted major banks would need to increase their capital ratios by at least 200 bps relative to the June 2014 position.

### Staff views on resilience and options to strengthen buffers
- Rationale:
  - Building “unquestionably strong” bank buffers is a welcome goal given vulnerabilities—housing, concentration and offshore funding—that can transmit shocks to the wider economy.
  - While bank capital remains above the 4½ percent solvency ratio in an adverse scenario, “it is unlikely that Australia would have the fully functioning banking system it would like in such an environment.” Avoiding this would likely require capital ratios substantially higher than 9 percent currently.
- Options to increase capital and resilience:
  - Higher risk weights: risk weights on mortgages are at historically low levels; raising them (including risk weight floors) is appropriate. APRA’s move to raise average risk weights for IRB banks is welcome.
  - Pillar 2 adjustments: APRA can require capital above minimums after reviewing institution-specific risks; Pillar 2 could be used to raise capital ratios for major banks.
  - Counter-cyclical capital buffer: APRA could set a countercyclical buffer at a rate of 0-2.5 percent from 2016; application could be warranted given a mature financial cycle but should include discretion beyond strict credit-gap rules.
  - Higher D-SIB surcharge: the minimum D-SIB surcharge of 1 percent seems low; other countries have applied higher surcharges, though a higher surcharge raises the minimum and could cause earlier activation of conservation buffers.
  - Higher leverage ratio: as a backstop, a leverage ratio at the upper end of the 3-5 percent suggested by the FSI would be appropriate to contain ratings drift and prevent lending shifting into lower risk-weighted housing loans.

### APRA stress tests (Box 8) — scenarios and results
- Scenarios (November 2014, developed with RBA and RBNZ):
  - Scenario A: House price bust. Australian GDP growth declines to -4 percent, unemployment increases to over 13 percent and house prices fall by a cumulative 40 percent.
  - Scenario B: Higher interest rates. RBA raises the cash rate significantly amid strong growth and emerging inflation; global growth weakens and commodity prices drop, leading to higher unemployment and a significant fall in house prices.
- Results:
  - In each scenario banks face higher funding costs and credit losses; losses on residential mortgages account for around one-third of total credit losses.
  - Aggregate CET1 ratio falls by around 3 percentage points from 8.9 percent (though all banks remain above the minimum CET1 capital requirement of 4.5 per cent).
  - Losses are greater than the capital held for housing for IRB banks; almost all banks would use capital conservation buffers and face constraints on dividend and bonus payouts.
  - APRA’s assessment: “it is unlikely that Australia would have the fully-functioning banking system it would like in such an environment.”

### Addressing housing market risks and macroprudential tools
- Immediate measures and potential intensifications:
  - APRA’s December 2014 measures to raise average mortgage risk weights and enhanced supervisory attention are welcome.
  - If investor lending growth or house price inflation fail to slow, further targeted options include:
    - Higher risk weights for investor/interest-only lending, possibly targeted by geography (e.g., just Sydney).
    - Additional Pillar 2 capital requirements for large players rapidly expanding investor lending portfolios.
    - Maximum interest only loan periods to reduce repayment risk.
    - Tax system reforms to reduce incentives that drive high household and bank exposure to housing, as part of broader tax reform.
- Authorities’ approach:
  - Authorities agreed higher capital would be beneficial; changes should align with evolving international standards and be gradual to minimize costs.
  - APRA is monitoring calibration of the D-SIB surcharge and prefers suasion—communication with management and boards—while retaining legal powers for direct action.
  - Coordination occurs through the Council of Financial Regulators.

### Staff appraisal: outlook, risks, and policy priorities
- Outlook:
  - Australia outperformed peers for two decades but waning resource investment and a sharp fall in the terms of trade have ended that outperformance.
  - A cyclical recovery is likely in the near term as net exports improve and accommodative monetary policy supports investment; potential growth likely to fall over the medium term due to weak productivity growth.
- Risks:
  - Risks are skewed downwards: domestic demand could pick up more slowly, a house price correction could depress confidence, and external shocks (sharper China slowdown or volatile global financial conditions) could amplify risks.
  - Upside: domestic demand may respond to monetary stimulus and the exchange rate could depreciate further.
- Policy agenda:
  - Sustain demand through the resource boom transition:
    - Monetary policy: remain accommodative and stand ready to ease further if recovery falls short and financial stability risks are contained.
    - Fiscal policy: retain a small surplus as a long-term anchor, avoid overly frontloaded consolidation; boost public investment to support demand and coordinate across government.
  - Lift productivity:
    - Implement reforms from Competition Policy Review and address infrastructure and housing supply constraints; pursue fiscal reforms (tax shift, reduce corporate tax rate, prevent personal income tax bracket creep) funded by higher GST revenue.
  - Build resilience:
    - Implement FSI recommendations and prudential policies addressing housing market risks.
    - Raise bank capital substantially over time; mortgage risk weight increases help but capital ratios need further increases to be “unquestionably” strong.
    - Intensify housing market measures if investor lending and house price inflation do not slow in the second half of the year.

*Source: IMF staff report excerpt, Australia financial system assessment.*

### 57.      It is recommended that the next article IV consultation be held on the standard 12-month

### _cr15274 - 57.      It is recommended that the next article IV consultation be held on the standard 12-month cycle.

### Growth Performance and Macroeconomic Position
- Growth has weakened and disposable income per capita is stalling.
- Real GDP (y/y % change) shown historically; average GDP growth lines indicate pre crisis and post crisis periods (figures provided in source).
- Contribution to Growth (3Y moving avg.): domestic demand and net exports shown with recent weakening in domestic demand.
- Output gap: sizeable slack with unemployment at its highest for a decade; capacity utilization and inverted unemployment rate illustrated.
- Real net national disposable income per capita (A$, RHS) depicted with trend declines around the mining export phase transition.

### Terms of Trade, Mining Investment, and Current Account
- Mining investment (% GDP) has fallen back from the boom; mining investment boom ending noted (figures show mining investment falling to around 1.7 percent in projection years).
- Terms of trade (2000=100) have declined sharply; iron ore prices have fallen by over a third in the past year (figure caption).
- Export volumes continue to ramp up (Iron Ore and Liquified natural gas: Export Volume (2005=100) series).
- Trade and current account deficits are reduced as imports tail off; Current account balance (% GDP) displayed with improvement after end of mining investment boom.
- Australia’s net investment liability position remains high compared to peers (International Investment Position, 2014, % GDP chart).

### Financial Cycle and Housing Sector
- Housing near the peak of a cycle; real house price index and credit to business sector series plotted (cycle is difference from HP filter trend).
- Real House Prices vs OECD (1995=100) show Australia high relative to OECD average.
- Household Debt (% of GDP) series high compared to peers.
- House price inflation varies across cities—boom concentrated in Sydney (Residential Property Price Annual % change, 2015 Q2 shows Sydney highest).
- No general credit boom—credit growth concentrated in investor housing (Investor vs Owner-occupier housing series).
- Housing investment is relatively low given population growth (Real Housing Investment, 2000-14 (% of GDP) compared to OECD average).

### Monetary Policy and Financial Conditions
- Monetary policy has been easing for some time; Reserve Bank of Australia cash rate (percent, avg) series: 4.4, 4.7, 3.7, 2.7, 2.5, 1.7, 1.8, 2.2, 2.6, 3.0, 3.4 (2010–2020 as shown).
- Real interest rates are around zero (Real policy rate and Real 1-year OIS rate based on trimmed-mean CPI inflation).
- Yield curve lower which should support investment (Australia Commonwealth Yield Curves for Dec-13, Aug-14, Jun-15).
- Interest sensitive asset prices, especially housing, have responded, yet activity remains weak.
- Labor market conditions are soft: wages (annual % change) and unemployment series indicate subdued wage growth despite unemployment at decade highs.
- Terms of trade downturn not fully reflected in exchange rate level (Real Effective Exchange Rate and Terms of Trade (2000=100) series).

### Public Finances and Fiscal Outlook
- Australia has a relatively small government and a low level of public debt, but the deficit has widened partly driven by worsening terms of trade.
- Government aims at consolidation requiring substantially lower real expenditure growth; consolidated general government revenue and expenditure (% GDP) and real revenue/real primary expenditure annual % change series shown.
- Key fiscal numbers (Table 1, selected years/projections):
  - Net lending/borrowing: -5.1, -4.5, -3.5, -2.8, -2.9, -2.6, -2.0, -1.1, -0.4, -0.1, 0.1 (2010–2020).
  - Operating balance: -2.8, -2.5, -2.0, -1.6, -1.6, -1.3, -0.6, 0.2, 0.8, 1.1, 1.2 (2010–2020).
  - Gross debt: 20.5, 24.2, 27.9, 30.9, 34.0, 36.4, 37.8, 38.2, 37.5, 36.4, 35.1 (percent of GDP, 2010–2020).
  - Net debt: 3.9, 8.1, 11.2, 13.2, 15.7, 17.8, 18.7, 18.7, 18.0, 17.0, 15.9 (percent of GDP, 2010–2020).
- States are also consolidating; public investment stays low (charts and projections shown).

### Banking System and Financial Stability
- Australian major banks are highly rated and profitable (Bank Ratings and Return on Equity/Return on Assets charts).
- Dividend payout ratios are high (Australian Banks and GSIBs: Dividend Payout Ratio, 2014).
- Lending is concentrated in housing (Banks' Lending Structure: housing share high).
- Offshore wholesale funding share remains large though less than at time of GFC (Banks' Funding domestic books; shares by instrument).
- Capital ratios have risen but driven by declining risk weights (Tier 1 capital and Risk-weighted assets/total assets (RHS) series).
- Monetary and financial sector table (Table 4) highlights:
  - Total assets (in billions of A$): 3,296; 3,650; 3,719; 3,902; 4,100; 4,307; 4,528; 4,764 (2013–2020).
  - Loans (in billions of A$): 2,349; 2,541; 2,685; 2,825; 2,978; 3,124; 3,273; 3,420 (2013–2020).
  - Regulatory capital ratio (% RWA): 11.8; 12.4; 12.9; 12.5; 12.9; 13.3; 13.7; 14.1 (2013–2020).
  - CET1 ratio (% RWA): 8.6; 9.0; 9.3; 9.0; 9.2; 9.4; 9.5; 9.7 (2013–2020).
  - Gross impaired assets (% total assets): 0.9; 0.6; 0.7; 0.7; 0.7; 0.7; 0.7; 0.6 (2013–2020).

### Financial Markets and Spillovers
- Equity prices boosted by low interest rates; resources sector has weakened while financials have supported indices (ASX 200, S&P/ASX indices charts).
- Bank CDS spreads are low; markets expect rates to remain on hold (CDS spreads and OIS/cash rate/market expectations charts).
- Bond yields and sovereign spreads have narrowed since 2013 (Australia Commonwealth Debt Yields and Australia Sovereign Spreads series).
- Trade links mainly with China (Exports by Destination (% total): China a large share in 2014 vs 2001).
- Financial links concentrated with New Zealand, United Kingdom, United States; foreign claims of Australian banks by region shown.
- Links to Pacific Islands via trade, remittances, and financial channels; market share of Australian banks in Pacific Islands and non-performing assets of overseas operations presented.

### Key Indicators and Projections (Selected from Tables)
- National Accounts (Table 1 projections, annual % change):
  - Real GDP: 2.3; 2.7; 3.6; 2.1; 2.7; 2.5; 3.0; 3.1; 3.0; 2.9; 2.8 (2010–2020 row in Table 1).
  - Investment (percent of GDP): 27.1; 27.6; 29.1; 27.6; 26.7; 26.3; 26.5; 26.7; 26.9; 27.0; 27.2.
- Prices and Commodities (Table 1):
  - Terms of trade index (goods, avg): 104; 118; 104; 100; 92; 82; 80; 79; 80; 80; 80.
  - Consumer prices (avg): 2.9; 3.4; 1.7; 2.4; 2.5; 1.8; 2.6; 2.4; 2.5; 2.5; 2.5.
- Labor Market (Table 1):
  - Unemployment (percent of labor force): 5.2; 5.1; 5.2; 5.7; 6.1; 6.2; 6.1; 6.0; 5.8; 5.7; 5.5.
  - Wages (nominal percent change): 3.2; 3.8; 3.7; 2.9; 2.5; 2.7; 3.3; 3.5; 3.7; 3.8; 3.8.
- Balance of Payments (Table 3 projections, % GDP):
  - Current account: -3.6; -2.9; -4.3; -3.3; -2.8; -3.4; -3.4; -3.6; -3.6; -3.5; -3.4 (2010–2020).
  - Net international investment position: -55; -56; -56; -54; -54; -57; -58; -58; -59; -60; -60.
- Monetary/Fiscal (selected from Tables 2 & 4):
  - Reserve Bank of Australia cash rate (percent, avg): 4.4; 4.7; 3.7; 2.7; 2.5; 1.7; 1.8; 2.2; 2.6; 3.0; 3.4 (Table 1).
  - Consolidated general government net lending/borrowing (Table 2): -5.5; -4.8; -4.3; -2.7; -2.9; -2.9; -2.3; -1.6; -0.6; -0.2; 0.0 (2009/10–2019/20).

*Source: IMF staff presentation and tables as provided in the content unit.*

### Annex I. Risk Assessment Matrix

### _cr15274 - Annex I. Risk Assessment Matrix

### Risk Assessment Matrix — Upside scenarios
- Context: These scenarios would reduce pressure for monetary policy to ease further and would enable the envisaged gradual fiscal consolidation to stay on track.
- Overall likelihood / impact header as shown: Medium . Hi g h
- 1. Domestic demand recovers more strongly than expected, supported by policy actions.
  - Description: With supportive monetary and fiscal policies business investment and domestic demand could pick up more quickly than in the baseline, the labor market could improve and household confidence and spending would rise.
  - Likelihood: Low
  - Impact: Medium
- 2. Iron ore prices recover from current lows and raise the terms of trade.
  - Description: A higher iron ore price would improve the terms of trade, boost nominal incomes and help improve the fiscal position. A rise in prices—if expected to be sustained could also re-energize further investments and could boost exports. (See below for sensitivity estimates).
  - Likelihood: Low
  - Impact: Medium
- 3. Middle-income Asia boosts demand for services exports.
  - Description: Australia’s service exports to China and India have increased threefold over the past decade. As Asia’s middle class expands, the demand for a range of services—higher education, healthcare, business services tourism and financial services—will likely increase. Some economies have large infrastructure needs which could also bolster demand for resource exports.
  - Likelihood / Impact as shown: (header context) Medium . Hi g h

### Risk Assessment Matrix — Downside scenarios and policy responses
- Downside policy cushion items (excerpted):
  - The floating exchange rate provides an important cushion against terms of trade shocks.
  - For housing market risks, pre-emptive early targeted prudential actions and strengthening banks’ capital positions over time could help engineer a soft landing in the housing market similar to 2002-2003.
  - If downside risks materialize there is room to ease monetary policy further.
  - The modest public debt level leaves scope for the automatic stabilizers to operate in full, for additional discretionary recurrent spending, and for a return to surplus to be delayed.
  - In the event of a severe shock the authorities could react as they did at the onset of the global financial crisis including considering a government guarantee if banks lose access to wholesale funding.
- Overall likelihood / impact header as shown: Medium  High
- 1. Persistently weak demand, perhaps resulting from a further decline in the terms of trade or a weaker monetary policy transmission.
  - Sensitivity / quantitative estimate: Australian Treasury estimates suggest a US$ 10 per ton reduction in iron ore spot prices results in a 3 percent fall in the terms of trade and a 0.8 percent reduction in nominal GDP which by rules of thumb could reduce tax receipts by up to AU$ 4.4 billion (about 0.3 percent of GDP) in a full year. The effects would be bigger if prices fall to levels below production costs.
  - Likelihood: Medium
  - Impact: Hi g h
- 2. Hard landing in the housing market.
  - Stress-test reference: APRA’s stress tests suggests that although banks could absorb as severe shock (house price fall of 40%, unemployment of 13% and an output fall of 4%), but they may face ratings downgrades, higher funding costs and could tighten credit conditions.
  - Assessment: RBA work shows household financial resilience is relatively high; but in a severe scenario the sector’s vulnerability to macroeconomic shocks may have increased a little since the early 2000s.
  - Likelihood: Medium
  - Impact: Low   High
- 3. Structurally weak growth in China over the medium term or sharp slowdown in 2015/16.
  - Sensitivity / quantitative estimates: Previous IMF work suggested that a one percent slowdown in China’s investment growth can lower growth in Australia by 0.2 percent. IMF work shows that, based on a variety of datasets, there is oversupply of real estate nationwide and growth could be negative in 2015. A sharp adjustment in the Chinese real estate market would likely result in falling iron ore prices, denting Australia’s terms of trade.
  - Likelihood as shown: High/Medium
  - Impact: Medium
- 4. Tighter or more volatile global financial conditions.
  - Sensitivity / quantitative estimates: Previous IMF work illustrates that a simultaneous reassessment of sovereign risk in the United States, Euro Area and Japan which raises bond yields by 200 basis points in the first year and leaves yields 100 basis points higher for a prolonged period could reduce world growth by 1.2 percent compared to the WEO baseline and by 0.5 to 1 percentage point for Australia.
  - Caveat: It is difficult to quantify shocks as they may not occur in isolation; together the effects could amplify and their severity could vary widely. Policy responses in Australia and abroad would have an important bearing on outcomes.
  - Likelihood / Impact: (discussed but not given a single figure)

- RAM definitions and timing:
  - “Low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent.
  - “Short term” and “medium term” indicate risks could materialize within 1 year and 3 years, respectively.
  - Non-mutually exclusive risks may interact and materialize jointly.

### External Sector Assessment — key findings
- Foreign asset/liability position and trajectory
  - Australia has a high negative net international investment position (NIIP) of 54-percent of GDP.
  - The NIIP ratio has varied between -45 and -60 percent of GDP since 1992.
  - Liabilities are largely denominated in Australian dollars but assets are in foreign currency.
  - Liabilities composition: around one quarter FDI, one half portfolio investment (principally banks borrowing abroad and foreign holdings of government bonds) and one quarter other investment and derivatives.
  - Current account deficit is expected to remain at 3-4 percent of GDP over the medium term, resulting in a gently rising NIIP to GDP ratio reaching around 60 percent of GDP in 2020.
- Assessment highlights
  - The structure of the balance sheet reduces vulnerability: NIIP liabilities mainly in Australian dollars and a net foreign currency asset position mean a nominal depreciation would strengthen the external balance sheet.
  - The banking sector has a net foreign currency liability position but it is fully hedged.
  - The NIIP level and trajectory are sustainable.
  - The maturity of banks’ external funding has improved since the global financial crisis.
  - The government’s strong balance sheet position allows it to offer credible support in a tail risk event.

- Overall Assessment for 2014–2015
  - In 2014 the external position was assessed to be moderately weaker than the level consistent with medium term fundamentals and desirable policies.
  - Since then a sharp decline in the terms of trade has been partly offset by a depreciation of the Australian dollar against the U.S. dollar.
  - If these trends are sustained through 2015 the assessment would be that the external position remains moderately weak, however there is uncertainty surrounding this assessment.
  - Drivers include strength of the exchange rate related to ample global liquidity and the relative attractiveness of highly-rated Australian assets.
- Potential policy responses noted:
  - If growth remains on the weak side, further monetary accommodation could be warranted.
  - A faster than expected exit from unconventional monetary policies by major advanced economies could result in a further exchange rate depreciation which would help support the transition of the economy towards more balanced growth.
  - The government’s planned gradual fiscal consolidation over the longer term should help improve the current account by boosting national savings.

### Current account — background and assessment
- Background statistics and trends:
  - Australia has run current account (CA) deficits for most of its history, with deficits averaging around 4 percent of GDP in the last three decades.
  - The deficit narrowed to 2.8 percent of GDP in 2014 but is likely to widen in 2015 following a sharp fall in the terms of trade (iron ore prices have fallen by over 35 percent in the past year).
  - The current account effect is cushioned by the depreciation of the Australian dollar.
  - Resource export volumes are increasing sharply as mining capacity comes on stream; mining related imports are falling back; lower oil prices will improve the oil balance—overall the current account widened by 0.6 percent of GDP.
  - Over the medium term, the deficit is expected to be below 4 percent of GDP with a smaller trade deficit partly offset by a larger income deficit as global interest rates normalize and mining income accruing to foreign investors rises.
  - With over half of Australia’s exports going to emerging Asia, a key risk is a sharper than expected slowdown in China which could result in a further sharp decline in commodities prices.
- Staff assessment:
  - Australia’s persistent CA deficits reflect a structural saving-investment imbalance with very high private investment relative to a saving rate which is already high by advanced country standards.
  - After accounting for Australia-specific factors driving investment, the staff assessment is that the cyclically-adjusted current account is about 0-1½ percent of GDP below the level implied by medium-term fundamentals and desirable policy settings, but this assessment is subject to uncertainty given how non-oil commodity prices evolve.

### Real exchange rate (REER) — background and assessment
- As of May 2015:
  - The REER has depreciated by 10 and 5 percent compared to its 2013 and 2014 averages respectively and is 9 percent down from a recent peak.
  - But it is 15 percent above its average over the last 30 years and looks relatively high when set against the fall in the terms of trade.
  - Contributing factors to an elevated Australian dollar include continued substantial capital inflows (possibly related to extraordinary monetary easing in major advanced countries), and domestic/foreign interest rate differentials.
- Staff assessment:
  - Taking into account factors including the attractiveness of highly-rated Australian assets, staff assesses the REER to be 0 to15 percent above the level implied by medium-term fundamentals and desirable policy settings with the depreciation since June closing the gap a little.

### Capital and financial accounts; FX intervention and reserves
- Capital and financial accounts:
  - The mining investment boom was funded predominantly offshore.
  - Net FDI inflows into mining partially offset the reduced need for the banking sector to borrow abroad.
  - As mining investment winds down, related import demand will decrease, buffering the impact on the overall balance of payments.
  - Australia also received large inflows in recent years into bond markets given its sound fiscal position relative to other advanced economies, owing to relatively high interest rate differentials.
  - Assessment: Credible commitment to a floating exchange rate and strong fiscal position limit the vulnerabilities.
- FX intervention and reserves:
  - Australia has been a free-floater since 1983.
  - The central bank did brief but large intervention in 2007–08 when the market for Australian dollars became illiquid.
  - The authorities are strongly committed to a floating regime which reduces the need for reserve holding.
  - Although domestic banks’ external liabilities are sizable, they are either in local currency or hedged with little or no counterparty risks, so reserve needs for prudential reasons are limited.

### Technical background notes (selected exact excerpts)
- RAM probability definitions: "low" = probability below 10 percent; "medium" = between 10 and 30 percent; "high" = between 30 and 50 percent.
- EBA CA regression approach for 2014 estimates a CA gap of -1.6 percent of GDP but widens to around 2 percent of GDP when based on 2015 projections; using estimated elasticities these would be consistent with an exchange rate overvaluation of around 6-12 percent in 2014 and around 9-15 percent currently; staff assessment: current account gap is in the range of 0-1½ percent of GDP.
- EBA REER regression approach and other approaches provide estimates of a gap encompassing a wide range from 7 to 17 percent in 2014. Taking into account that the current REER is now around 5 percent lower than the average for 2014 but part of this reflects a decline in the terms of trade, staff assess the extent of overvaluation to be in a range from 0 to 15 percent.

*Source: _cr15274 - Annex I. Risk Assessment Matrix (IMF staff text).*

### Annex IV. High-Priority FSAP Recommendations

### Annex IV. High-Priority FSAP Recommendations

### Financial Stability
- Recommendation 1: Develop a top down stress testing framework and publish top down stress test results in the Financial Stability Review (RBA)
  - Implementation status: On track.
  - Notes: The RBA is developing a top down stress testing framework for banks, to complement APRA’s stress tests. Practices at other central banks have been assessed and the RBA is consulting stakeholders. Research papers on Australian credit loss models have been published.
- Recommendation 2: Devote more resources to stress testing (APRA)
  - Implementation status: Implemented.
  - Notes: APRA has increased resources for stress testing and is implementing an internal stress testing strategy.
- Recommendation 3: Introduce higher loss absorbency (HLA) for systemic banks (APRA)
  - Implementation status: On track.
  - Notes: APRA released an information paper setting out its framework for identifying and imposing higher loss absorbency on domestic systemically important banks. The framework will come into effect from January 1, 2016.

### Financial Sector Oversight
- Recommendation 4: Intensify on-site supervision of bank liquidity and upgrade daily liquidity reporting requirements to ensure consistency (APRA)
  - Implementation status: Implemented.
  - Notes: The daily liquidity reporting requirement took effect on April 1, 2015. APRA is testing each ADI’s ability to produce the report. This process will continue until March 2016.
- Recommendation 5: Improve the effectiveness of conduct of business supervision for insurance companies (note recommendation 6) (Treasury)
  - Implementation status: Implementation in progress.
  - Notes: In October 2014, ASIC published a Review of retail life insurance advice, which considers the advice provided to consumers on life insurance. Further consideration of the financial services regime and remuneration for life insurance advisers will be undertaken in the context of the Government’s response to the Financial System Inquiry.
- Recommendation 6: Ensure sufficiency and stability of ASIC core funding (Treasury)
  - Implementation status: Further consideration required.
  - Notes: ASIC has received new funding of $20.1 million over four years as part of Budget 2015-16. ASIC’s funding will be further considered in the context of the Government’s response to the Financial System Inquiry.
- Recommendation 7: Extend risk based capital requirements, large exposure rules, and reporting requirements to ensure that AFSL holders are appropriately covered (Treasury/ASIC)
  - Implementation status: Further consideration required.
  - Notes: ASIC has introduced increased risk based capital adequacy requirements and periodic reporting for additional classes of licensees e.g., custodians. ASIC is undertaking preliminary work to gauge the extent to which there are significant potential risks from large exposures in Australia.

### Crisis Management
- Recommendation 8: Re-evaluate the merits of ex-ante funding for the FCS with a view to converting it to an ex-ante funded scheme (Treasury/CFR)
  - Implementation status: On track.
  - Notes: In August 2013 the previous Government committed to establishing a dedicated Financial Stability Fund, from January 2016. Implementation will be subject to the outcomes of the Financial System Inquiry.
- Recommendation 9: Introduce HLA for systemic banks (APRA)
  - Implementation status: See recommendation 3 above.
- Recommendation 10: Ensure ADI implementation of single customer view (SCV) on, or where possible, ahead of the agreed timetable (APRA)
  - Implementation status: On track.
  - Notes: Under the Prudential Standard, ADIs were required to have implemented the SCV by January 1, 2014. A number of ADIs received an extension to this deadline due to the complexity and size of the IT system changes. Only two ADIs are currently outstanding with their SCV implementation.
- Recommendation 11: Conduct frequent and focused crisis simulations and other forms of resolution testing (APRA/CFR)
  - Implementation status: Implemented.
  - Notes: APRA adopted a new internal framework for crisis simulations which includes more frequent simulations of various scopes. The CFR adopted a new framework for cross-agency simulations, including Trans-Tasman involvement.
- Recommendation 12: Continue recovery planning and introduce resolution planning (APRA)
  - Implementation status: On track.
  - Notes: APRA completed a recovery planning pilot exercise which included the six largest ADIs, and has since extended the requirement to a number of medium-sized ADIs. APRA is continuing to develop a formal framework and updated guidance for recovery planning. In regard to resolution planning, APRA continues to operationalize the FCS and to consider the development of entity-specific resolution plans, where appropriate working with the other CFR agencies.

### Fund Relations (As of June 30, 2015)
- Membership Status: Joined: August 5, 1947; Article VIII
- General Resources Account:
  - Quota: 3,236.40 SDR Million, 100.00 Percent Quota
  - Fund holdings of currency (exchange rate): 2,668.68 SDR Million, 82.46 Percent Quota
  - Reserve tranche position: 568.13 SDR Million, 17.55 Percent Quota
  - Lending to the Fund New Arrangements to Borrow: 419.55 SDR Million
- SDR Department:
  - Net cumulative allocation: 3,083.17 SDR Million, 100.00 Percent Allocation
  - Holdings: 3,234.93 SDR Million, 104.92 Percent Allocation
- Outstanding Purchases and Loans: None
- Financial Arrangements: None
- Type: Stand-By
  - Date of Arrangement: May 01, 1961
  - Expiration Date: Sep 05, 1961
  - Amount Approved (SDR Million): 100.00
  - Amount Drawn (SDR Million): 0.00
- Projected Obligations to Fund (SDR million; based on existing use of resources and present holdings of SDRs):
  - Forthcoming Principal Charges/interest (2015–2019): 0.05 0.05 0.05 0.05
  - Total (2015–2019): 0.05 0.05 0.05 0.05

### Exchange Rate Arrangement and Other External Relations
- Exchange Rate Arrangement: Australia has accepted the obligations of Article VIII, Sections 2, 3, and 4. The exchange rate is free floating, but the Reserve Bank of Australia retains discretionary power to intervene. There are no taxes or subsidies on purchases or sales of foreign exchange.
- Restrictions on Capital Transactions: Australia maintains a capital transactions regime that is 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. The 2015 Article IV consultation discussions were held during June 11-24, 2015; the Executive Board discussed the staff report and concluded the consultation on September 14, 2015.
- FSAP Participation: The last FSAP Update involved two missions: April 23-May 15 and July 9-24, 2012; the Executive Board discussed the assessment (IMF Country Report No. 12/308) on November 12, 2012.
- Fourth Amendment: Australia has accepted the Fourth Amendment to the Articles of Agreement.

### Statistical Issues
- Data provision is adequate for surveillance.
  - Australia has subscribed to the Special Data Dissemination Standard (SDDS) since April 1996, and its metadata are posted on the Fund’s Dissemination Standards Bulletin Board (DSBB).
  - Australia participates in the G-20 Data Gaps Initiative and has implemented all the recommendations of the first phase of the DGI, with the exception of semi-annual Coordinated Portfolio Investment Survey (CPIS) data.
  - Australia has no plans to adhere to the SDDS Plus.
  - The Australian Bureau of Statistics (ABS) has taken initiatives to improve data quality, such as issues relating to seasonal adjustment of unemployment and employment statistics.
  - Adding monthly inflation data to the suite of statistics would assist surveillance.
- Table of Common Indicators Required for Surveillance (As of July 31, 2015) — Selected entries with latest observation and frequency:
  - Exchange Rates: Latest Observation 07/31/15, Date Received 07/31/15, Frequency of Data D, Frequency of Reporting D, Frequency of Publication D
  - International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Latest Observation 06/15, Date Received 07/07/15, Frequency M M M
  - Reserve/Base Money: 06/15, 07/07/15, M M M
  - Broad Money: 05/15, 06/30/15, M M M
  - Central Bank Balance Sheet: 07/29/15, 07/31/15, W W W
  - Consolidated Balance Sheet of the Banking System: 05/15, 06/30/15, M M M
  - Consumer Price Index: Q2 2015, Date Received 07/21/15, Q Q Q
  - External Current Account Balance: Q1 2015, Date Received 06/01/15, Q Q Q
  - GDP/GNP: Latest Observation Q1 2015, Date Received 06/02/15, Q Q Q
  - Gross External Debt: Q1 2015, Date Received 06/01/15, Q Q Q
  - International Investment Position: Q1 2015, Date Received 06/01/15, Q Q Q

### Supplementary Information (since Staff Report circulated August 6, 2015)
- Global financial market developments (as of Supplement):
  - Volatility increased since July with commodity prices and stock markets weakening in response to developments in China.
  - The Australian dollar has depreciated further against the US dollar and on a trade weighted basis.
  - Iron ore prices have traded in a weak U.S.$45-50 range.
- Domestic activity and outlook:
  - GDP data for Q2 came in at the weak end of market expectations but broadly in line with staff projections.
  - Weather-related effects weighed on net exports and dampened growth in Q2 after a stronger outturn in Q1.
  - The continued decline in mining investment also exerted a drag on growth.
  - Annualized growth in H1 was 2.2 percent.
  - Staff has revised growth projections for 2015 and 2016 to 2.4 percent and 2.9 percent respectively (from 2.5 percent and 3.0 percent respectively).
- Other risks and labor market:
  - Population growth slowed to 1.4 percent in 2014 (compared to 1.6 percent in 2013), which could pose a modest downside risk to potential growth estimates if it persists.
  - Labor market conditions: unemployment rose to 6.3 percent in July, employment held up and the participation rate rose.

*Prepared by Asia and Pacific Department; August 3, 2015 (supplement dated September 8, 2015).*

### 6.      The Reserve Bank of Australia left interest rates on hold at the August and

### 6. The Reserve Bank of Australia left interest rates on hold at the August and September meetings

### RBA decision and forecasts
- The Reserve Bank of Australia left interest rates on hold at the August and September meetings.
- Latest RBA forecasts reduced projected growth to 2-3 percent in 2016 (down from 2½-3½ percent) and left 2015 unchanged at 2¼ percent.
- Inflation is expected to remain consistent with the 2-3 percent target.

### Authorities’ overall assessment
- The Australian economy is performing well despite one of the largest terms of trade adjustments in its history.
- Recent macro outcomes:
  - Growth has remained around 2½ per cent.
  - Unemployment around 6 per cent.
  - Inflation and inflation expectations appear well anchored.
  - Public debt remains low by international standards.
- Authorities emphasize policy approaches that supported 25 years of growth:
  - Medium term macroeconomic policy frameworks emphasizing prudence and flexibility.
  - A flexible exchange rate.
  - Flexible and competitive product and labor markets.
  - Measures to build productivity and participation.
  - Strong economic engagement with the region.
  - Sound financial regulatory arrangements.

### Outlook and risks
- Authorities agree with staff that activity is likely to gradually strengthen and the transition from mining-led to broader-based growth is underway.
- Key developments and buffers:
  - Fall in commodity prices from their peak in 2011 contributed to the largest fall in the terms of trade in more than 50 years.
  - Trade-weighted exchange rate depreciated by about 20 percent over the same period, providing a buffer for the real economy.
  - Mining export production is continuing to ramp up apart from recent temporary weather-related factors in the June quarter.
  - Service exports are growing strongly, partly due to the lower exchange rate.
  - Accommodative monetary policy is underpinning gradual growth improvement, including support for dwelling construction.
  - Private consumption remains firm; conditions support a pick-up in non-mining business investment.
  - Subdued wage growth is supporting employment and the growth transition.
- Inflation expected to remain in line with the RBA’s target of 2 to 3 per cent, on average, over the business cycle.
- Key uncertainties and risks:
  - Whether pick-up in non-mining investment will be sustained in 2015-16 and offset falls in mining investment (poses upside and downside risks).
  - Outlook for China: authorities note Budget based on relatively conservative forecasts of Chinese growth; commodity prices remain in line with Budget forecasts; Chinese authorities have numerous policy tools.
- Housing market assessment:
  - Staff analytical work on Australian house prices is appreciated; indicates risks should not be overstated.
  - Rapid price growth concentrated in particular markets.
  - Few generalized signs of oversupply or mortgage overextension.
  - Coordinated regulatory policy actions are starting to take effect.
- External and macro-financial positions:
  - Current account deficit reflects strong investment opportunities not fully met by domestic savings and is close to that estimated by the External Balance Assessment.
  - Australia has a net foreign liability position but a net foreign currency asset position, given bulk of foreign liabilities are denominated in, or hedged back into, Australian dollars.
  - Banking sector has a diversified funding mix; sizeable share of wholesale funding through instruments with maturities greater than a year.
  - Corporate sector generally well hedged against exchange rate movements.
  - Current account deficit expected to remain towards the low end of the range in which it has fluctuated over recent decades.
  - Net foreign liabilities have been stable as a share of GDP over the past decade.

### Monetary policy
- RBA largely agrees with staff on monetary policy:
  - Monetary policy is supporting economic growth; interest-sensitive parts of the economy are responding.
  - Finance remains readily available to creditworthy borrowers, supporting housing activity and dwelling construction and providing a platform for business investment.
  - Australian dollar is adjusting to significant declines in key commodity prices.
  - Authorities recognize monetary policy cannot be the driver of medium-term growth; cost of credit is not holding back investment.

### Fiscal policy
- Fiscal policy anchored by return to surplus over the medium term.
- Returning to a budget surplus remains a priority because of:
  - Long-term social spending commitments (including those associated with ageing).
  - Importance of retaining favorable standing with external creditors (Australia is one of only eight sovereigns with the highest credit rating with all agencies).
- Government has set out a clear and credible fiscal consolidation path; 2015/16 Budget prioritizes spending to build a stronger economy, including measures to boost infrastructure and business investment, including by SMEs.
- Authorities disagree with staff characterization of aggregate fiscal consolidation as “somewhat more frontloaded than desirable”; view current gradual consolidation as appropriately balanced.
- Revenue weakness, including that associated with commodity price write-downs, has been allowed to flow through to a more gradual fiscal consolidation.
- Recent state budgets imply less aggregate consolidation in 2015/16 than expected at the time of the May Federal Budget; combined state and local government deficit expected to increase this year.
- Infrastructure focus:
  - Funding infrastructure is a key focus; key spending added and brought forward.
  - Substantial investments planned in transport infrastructure and the national broadband network in the next few years.
  - Asset Recycling Initiative and Northern Australia Infrastructure Facility will provide scope for additional investment.
  - Largest infrastructure program in Australia’s history expected to permanently boost the size of the economy by one percent over the longer term.
  - Infrastructure Australia formulating a 15-year plan based on national and state priorities and providing independent advice to prioritize nationally significant infrastructure.

### Potential growth and structural reforms
- Authorities recognize need for continued action to secure future prosperity, focusing on productivity-enhancing reforms.
- Review processes underway on reform in labor markets, competition, taxation, and federal-state relations.
- Given Australia is near the productivity frontier in numerous sectors, a range of approaches is required rather than a single large-impact lever.
- Authorities aim to balance reform impacts on groups and explore complementary reforms to reinforce growth while ensuring fairness.
- Any changes to tax and superannuation must consider Australia’s highly progressive tax and welfare arrangements and investment decisions made by people in good faith, and complexities in a low-return environment.
- Authorities note costs associated with continued tax bracket creep on labor supply.
- Opportunities for potential output growth:
  - Increasing diversification of the economy and integration with Asia.
  - Growing middle class in Asian emerging economies likely to increase demand for goods and services produced in Australia.
  - Recently concluded free trade agreements with Japan, Korea and China will assist, including opening trade and investment in service sectors.
- Key to ensuring continued strong growth is policies to improve innovation, productivity, and participation.

### Financial stability
- Australian financial system continues to perform strongly; near-term risks to financial stability from households, businesses and the financial sector appear low.
- Regulatory and supervisory framework:
  - APRA’s intensive and risk-based approach to regulation and supervision supports system resilience.
  - Strong capital position and broadly prudent practices of Australia’s banking system have helped withstand shocks.
- Targeted responses to property sector developments:
  - Reinforcement of sound lending practices, focus on heightened investor activity in housing market.
  - ASIC review into interest-only lending practices.
  - RBA assessment and public noting of need for prudent risk taking by lenders and borrowers.
  - Evidence of effects: changes in banks’ loan pricing, loan serviceability standards and product offerings.
  - Growth in investor credit expected to slow in the second half of 2015.
  - Regulators will monitor effectiveness and consider additional steps, including Pillar 2 actions if individual banks fail to rein in investor lending.
  - Actions coordinated through the Council of Financial Regulators (RBA, Treasury, APRA and ASIC).
- Capital position enhancements:
  - Authorities increasing over time the capital position of banks and other ADIs.
  - APRA announced plans to increase amount of capital held by the largest banks against housing loans.
  - Major banks have recently issued, or are in the process of issuing, a significant amount of additional capital and appear well placed to accumulate capital ahead.
  - Authorities support Financial System Inquiry (FSI) finding that capital ratios of ADIs should be “unquestionably strong”.
  - APRA’s final response to the FSI will require further consideration; changes to be in line with evolving international standards, commensurate to risks, and gradual to minimize unnecessary costs.
  - APRA has indicated publicly that it is likely the major banks will need to increase their capital ratios further over the next couple of years.

*Statement by Barry Sterland, Executive Director for Australia and Christopher Stewart, Advisor to Executive Director — September 14, 2015*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr15274.pdf_