Australia: 2011 Article IV Consultation Concluding Statement
August 1, 2011
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
This statement contains our preliminary policy recommendations following discussions with the Australian authorities and private sector representatives. The discussions focused on the economic policy options to manage risks and make the most of the mining boom.
1. The recovery is being driven by a mining boom. The terms of trade are at historic highs reflecting strong demand for commodities from China and other Asian economies. As a result, investment and job creation in mining and related sectors are strong. The real effective exchange rate has appreciated by 13½ percent over the past year, which has helped contain inflation pressures but presents a challenge for tradable sectors that are not benefitting from high commodity prices. Household spending growth has slowed but higher saving should help strengthen household balance sheets.
2. Strong commodity demand is expected to be long lasting because of favorable prospects for sustained growth in emerging Asia, but there could be bumps along the road. To make the most of the boom, reforms should enhance the flexibility of the economy so that it can adjust to the structural changes taking place. At the same time, macroeconomic policy should continue to make room for a strengthening economy and not compound the emergence of capacity and price pressures. An additional policy challenge is that the growing importance of mining raises the economy’s exposure to swings in commodity income.
Outlook and Risks
3. The economic outlook is favorable. After a temporary setback in the first quarter due to natural disasters, activity is expected to bounce back in the second quarter. We project real GDP growth of 2 percent for calendar year 2011 and 3½ percent in 2012 on the back of strong demand for commodities and private investment in mining and liquefied natural gas. We expect employment to grow at a slower pace than in recent years but the unemployment rate should remain below 5 percent in 2011 and 2012. With the labor market approaching capacity, underlying inflation is likely to rise gradually. The external current account deficit is expected to narrow to 1 percent of GDP in 2011—due to the jump in the terms of trade—before progressively widening to about 6½ percent of GDP in the medium term, assuming the real effective exchange rate remains at its current level.
4. The risks to the outlook are broadly balanced. An upside risk is that investment in the resource sector could be larger than expected, boosting growth and adding to inflation pressures. A further upside risk is that households may become more confident as the boom progresses, and reduce their current high level of saving. On the downside, a key risk is that the global recovery stalls or Asian growth falters, impacting demand for commodities. Contagion from the euro area periphery and uncertainty about progress toward fiscal consolidation in the United States could destabilize global markets. On the domestic front, further softness in house prices (that appear to be overvalued) could depress consumption growth.
Near-Term Macroeconomic Policy Mix
5. The Reserve Bank of Australia (RBA) started earlier than many other central banks to remove monetary stimulus and gradually raised the policy rate to 4¾ percent. The policy rate has been on hold since November 2010, although monetary conditions have tightened further with the appreciation of the exchange rate. We agree with the policy stance taken over the past year, which has helped anchor medium-term inflation expectations.
6. If the recovery remains on track, a further increase in the policy rate is likely to be required to contain inflation pressures from the impact of the mining boom on the wider economy. In the absence of further tightening, we project underlying inflation (currently 2.7 percent year-on-year) to rise above the RBA’s 2-3 percent inflation target band in 2012. Importantly, the RBA should guard against inflation expectations becoming anchored at too high a level.
7. On fiscal policy, we commend the authorities for remaining committed to returning the Commonwealth budget to surplus by 2012/13, despite the worsening of the budget balance in 2010/11 as a result of natural disasters. Fiscal consolidation will strengthen fiscal buffers and take some pressure off monetary policy and the exchange rate. This consolidation is faster than in many other advanced economies and is more ambitious than earlier envisaged, with an adjustment of almost 4 percent of GDP over the next two years on a cash basis. We support the emphasis on expenditure control. If the growth outlook improves, higher-than-expected tax revenue should be saved to help monetary policy contain inflation.
8. If global financial markets become severely disrupted or world growth falters, macroeconomic policy is well positioned to respond. The exchange rate would likely depreciate, limiting the fall in commodity prices in Australian dollars and providing stimulus to the non-commodity tradable sector. There is ample scope to cut the policy interest rate and provide liquidity support for banks, which proved effective in the global financial crisis. There is also fiscal space to delay the return to surplus and, if needed, to take temporary discretionary measures, given the low level of government net debt (6 percent of GDP).
Medium-Term Fiscal Policy
9. We recommend targeting a budget surplus of more than 1 percent of GDP, on average, for the period beyond 2013/14, while the mining boom continues to support growth. This growth will provide an opportunity to increase government saving and strengthen public finances further by cutting debt and building funds for a rainy day. Although Australia’s public debt is relatively low, larger fiscal buffers would give greater scope to spend during a downturn to support income and jobs. Moreover, a further strengthening of the Commonwealth government balance sheet should continue to contain economy-wide debt-servicing costs. This will be important given the likely upward pressure on global interest rates from sizable sovereign borrowing in coming years. We support the Government’s approach that while the economy is growing at or above trend, expenditure restraint will be maintained by the 2 percent annual cap on real spending growth, on average, until surpluses are at least 1 per cent of GDP.
10. The growing importance for the economy of mining exposes government revenue to swings in commodity income. In these circumstances, the automatic stabilizers should be allowed to work fully in both directions. This would imply running surpluses during upswings to avoid overheating, and these surpluses should be larger than in past upswings. Conversely in a downturn, sizable but temporary deficits would be appropriate. The impact of a large fall in commodity income on the budget could be presented to the public to build support for running sizable surpluses during good times.
11. The fiscal strategy recommended above would put the budget in a better position to deal with some of the long-term pressures from aging and rising health care costs. We welcome the reform agenda of the Council of Australian Governments to improve coordination and efficiency in the health care sector, including the development of nationally consistent performance indicators for patient care.
Tax and Structural Reforms
12. Tax and structural reforms will play a key role in allowing Australians to take full advantage of the mining boom. Labor force participation has risen in recent years in part reflecting Government initiatives, but the mining boom is increasing the demand for labor. Meeting this demand will require not only raising labor supply, but also moving labor across industries and regions. Productivity growth in Australia has slowed over the past decade, and the elevated level of the real exchange rate is generating pressure for efficiency improvements in the non-mining tradable sector.
13. The review of the tax system released last year provides a blueprint for tax reform. We welcome the progress already made in adopting many of its recommendations, which include reducing the company tax rate, taxing some mineral resource rents, and taking steps to reduce effective marginal tax rates for low-income earners. We support the proposed introduction of a carbon price as part of a transition to a permits trading system to mitigate greenhouse gas emissions. As part of this package, the increase in the tax-free threshold is welcome, as it should relieve an extra one million Australians from the need to lodge an income tax return and boost labor force participation.
14. Going forward, we recommend continued tax reform. A priority should be to remove inefficient taxes such as state stamp duties (that discourage regional mobility) and insurance taxes. Moreover, there is scope to improve work incentives by further reducing effective marginal tax rates and to encourage investment by reforms to business tax, together with simplification of the tax system. While we recognize the difficult political choices, options to replace the lost revenue from these reforms include more reliance on a consumption-based tax, reforming land taxes and broadening the coverage of the minerals resource rent tax.
15. On broader structural reforms, we welcome the steps taken to invest in skills training, which should help workers improve their mobility and income prospects. Looking ahead, it is important to use the window of opportunity provided by the current favorable economic outlook to push ahead with the Council of Australian Governments’ reform agenda, including in the areas of education, infrastructure and harmonization of business regulations. In addition, the government should resist pressures to prop up declining industries.
16. Banks were resilient to the global financial crisis, partly because of sound regulation and supervision. Prudential rules, often tighter than the minimum international standards, such as higher loss-given-default assumptions, together with a pro-active approach to supervision, helped maintain a healthy and stable financial sector. Moreover, the Council of Financial Regulators played a key role in coordinating the response to the global crisis.
17. Bank profits have recovered and the return on equity for the major banks is now around pre-crisis levels. Capital adequacy has improved, driven both by increases in capital and declines in risk-weighted assets. Common equity as a share of tangible assets has also risen to nearly 5 percent for the four large banks. The ratio of nonperforming loans to total assets has decreased slightly from a peak of 1.7 percent in March 2010. Banks have made significant changes to the structure of their funding over the last two years by increasing retail deposits and long-term wholesale funding.
18. Challenges remain, however. Banks may be tempted to take on riskier strategies in an environment of structurally lower credit growth. Household debt remains high (150 percent of disposable income) and a rise in mortgage rates could lead to an increase in bad loans, although current arrears are modest. While we recognize improvements in the composition of banks’ funding structure, their sizable short-term external borrowing still remains a risk. In addition, concentration in the banking sector has increased in the wake of the crisis with the assets of the four large banks now comprising about 75 percent of total bank assets, although competition in lending has shown recent signs of recovery. We note the package introduced by the government which addresses funding diversity, stability and competition issues.
19. The risks outlined above underline the importance of continued rigorous prudential bank supervision by the Australian Prudential Regulation Authority (APRA). The government should ensure that APRA’s capacity keeps pace with emerging risks. We support APRA’s plan to undertake more comprehensive stress tests of banks than in 2009/10, including stress tests incorporating a disruption to funding markets. We welcome progress on contingency planning for liquidity and solvency problems at systemically important banks, including for the New Zealand subsidiaries. The Trans-Tasman crisis management exercise with New Zealand should help identify possible challenges in a banking crisis. We note the Government has confirmed the Financial Claims Scheme as a permanent feature of the financial system.
20. While continued strong bank supervision is the key to maintaining financial stability, we would also encourage the authorities to consider higher capital requirements on banks that are systemically important in the domestic market, taking into account the currently evolving international standards. Analysis of the appropriate capital requirements could be undertaken over the next year and discussed in the 2012 update of the Financial Sector Stability Assessment with the IMF.
21. While banks have reduced their reliance on short-term external borrowing, disruptions in global capital markets could still put pressure on their funding. Therefore, banks should be encouraged to further reduce their short-term borrowing. To this end, we recommend that the authorities consider the merits of introducing a Net Stable Funding Ratio requirement, ahead of the 2018 schedule proposed by the Basel Committee.
Exchange Rate and External Stability
22. The appreciation of the exchange rate over the past year is greater than suggested by the change in medium-term fundamentals, such as the terms of trade. Our assessment is that the Australian dollar is overvalued by 10–20 percent, although these estimates are subject to substantial uncertainty. Part of the overvaluation reflects higher policy interest rates in Australia than elsewhere and may dissipate over time with eventual tightening by major central banks. The appreciation of the exchange rate has helped contain inflation pressures and has contributed to a structural shift of resources toward industries where Australia has a long-term comparative advantage.
23. We project net external liabilities to increase to more than 65 percent of GDP by 2016, which is relatively high for advanced economies. This reflects a widening of the current account deficit, driven by higher investment during the construction phase of the mining boom. While the current account deficit is expected to rise to a relatively high level over time, it should be manageable as the investment increases export capacity and is expected to be financed through foreign direct investment, retained earnings and long-term debt.
24. Our projected increase in the current account deficit is also partly because of a forecast decline in the national saving rate. Demographics are likely to put downward pressure on household saving over time, as a growing share of the population draws down savings to fund retirement. We also expect corporate saving to decline as exceptionally high commodity prices gradually fall in response to increased global supply of Australia’s key non-rural commodity exports. The decline in private saving underlines the need for fiscal consolidation to raise national saving. We welcome the authorities’ decision to increase compulsory superannuation contributions to encourage saving. Tax reforms to remove distortions to private saving and investment decisions would be welcome, as outlined in the recent tax review.
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The IMF team has enjoyed the candid and interesting discussions and we appreciate the authorities’ hospitality and thorough preparations for this mission.