Public Information Notice No. 01/27

Public Information Notice: IMF Concludes Article IV Consultation with Australia

March 21, 2001

On March 2, 2001, the Executive Board concluded the 2000 Article IV consultation with Australia.¹

Background

In 2000, Australia entered the tenth year of an impressive economic expansion characterized by strong productivity growth and low inflation. Since the current expansion began in the third quarter of 1991, growth has averaged 4¼ percent per annum. The comprehensive reforms undertaken since the mid-1980s have fostered a more competitive and outward-oriented economy, which, with sound and flexible macroeconomic policies, enabled Australia to make a remarkably smooth passage through the Asian financial crisis.

Growth was robust during most of 2000 but there are now signs of a moderation. Through September 2000, the economy grew at an annual rate of 4¼ percent supported by a strengthening of net exports. Although trends in domestic demand have been difficult to read owing primarily to the effects of the introduction of the New Tax System (TNTS) in July 2000 and the summer Olympic games in September 2000, there appears to have been a marked slowing in domestic demand the third quarter. Private dwelling investment, which surged in the first half of 2000 as spending was brought forward to avoid less favorable tax treatment under the GST, fell off sharply in the September quarter. As for business investment, machinery and equipment investment continued to exhibit strength, while spending on buildings and structures continued to be weak following the completion of several large mining projects and Olympics-related construction. Other signs of a softening in activity include the slowing of employment growth and the uptick in the unemployment rate from its low point of 6 1/3 percent in September 2000 to 6½ percent in December.

Underlying inflation (abstracting from the impact of the TNTS and rising fuel prices) has remained within the RBA's 2-3 percent target band, but there are some signs of upstream price pressures. Headline inflation shot up to 6 percent (y/y) in the September and December quarters, but abstracting from the impact of TNTS (estimated to be about 3 percent) and excluding volatile items such as oil, underlying inflation is now close to the lower end of the RBA's target band. However, producer prices, manufacturing output prices and import prices have all been rising markedly across a range of components. As for wages, the wage cost index was up only about 3½ percent (y/y) in the fourth quarter, and other measures of wage growth have also remained moderate.

A major event in 2000 was the sharp weakening in the value of the $A over the course of the year, at the same time that other indicators of market perception remained generally favorable. Belying the strength of economic fundamentals, the $A fell by about 20 percent against the U.S. dollar between January and November 2000, notwithstanding some foreign exchange market intervention in the last 4 months of the year. Following a modest rebound in December and January, the exchange rate has fallen again. However, other indicators of market sentiment toward Australia have remained favorable. The Australian equity market performed better than most countries in the region in local currency terms, and spreads on long-term government bonds and on private sector debt remained steady. Moreover, S&P recently confirmed Australia's AA+ rating, citing the high level of net external liabilities as the primary reason for Australia remaining shy of the AAA rating.

As a result of the exchange rate depreciation and favorable terms of trade movements, the current account improved markedly from a peak of over 6 percent of GDP in the second quarter of 1999 to 3 1/3 percent of GDP in the third quarter of 2000. Even abstracting from the effect of the Olympics, which boosted the third quarter outcome, the trend current account continues to improve strongly. Capital flows in the first three quarters of 2000 were characterized by a fall in equity flows and a rise in debt financed flows. Overall, net foreign liabilities increased to 63½ percent of GDP in September 2000 from about 60 percent of GDP at end-1999.

The interest rate tightening cycle launched in November 1999 in response to signs of rising price pressures ended in mid-2000, and monetary policy began to be eased in early 2001, with the 50 basis point cut in rates. Recent data suggest that the increases in official interest rates—by 150 basis points between November 1999 and August 2000—have started to bite into private sector credit growth, which has begun to ease from the peak of 13½ percent in August to 12 percent in January 2001, with growth in both housing and other personal credit recording a slowdown.

The degree of easing of fiscal policy in 2000/01 is likely to be smaller than originally anticipated. The 2000/01 Budget released in May 2000 contained only modest new initiatives in health and families and communities assistance, and a scrapping of the previously planned Timor tax. However, the major overhaul of the tax system that came into effect July 1, 2000, implied a significant net revenue loss. As a result, the accrual surplus was envisaged to decline from 1.5 percent of GDP in 1999/00 to 0.8 percent of GDP in 2000/01. (In the event, the surplus in 1999/00 turned out to be 2.1 percent of GDP reflecting stronger than expected growth and profits). However, the mid-year review of the 2000/01 budget and economic outlook announced in November raised the projected surplus for 2000/01 to 1.2 percent of GDP. This stronger fiscal outlook reflects both one-off factors that will boost GST revenues in 2000/01 (which indirectly strengthens the Commonwealth's fiscal position) and higher revenues resulting from stronger income and profit growth, which will be only partially offset by higher expenditures.

The near-term outlook is for the pace of growth to continue to moderate over the year ahead. Recent indicators suggest continued slowing in consumption growth; dwelling investment is likely to remain weak, although activity in this sector is showing signs of bottoming out. Serving as a limit to the deceleration, business investment is likely to continue to grow. Overall, the staff forecasts that growth will slow from 4¼ percent in 2000 to 3¼ percent in 2001; the unemployment rate is expected to decline gradually to below 6¼ percent by end-2001 and the current account deficit is expected to remain at around 4¼ percent of GDP. Underlying inflation is expected to rise to the top of the 2-3 percent target range by mid-2001 and decline modestly thereafter. The main downside risk is of a hard landing in the U.S. and a sharp slowdown in Australia's main export markets, the likelihood of which has increased in recent weeks. However, even as the economy slows, a stronger rise in inflation from pressures still in the pipeline cannot be ruled out. Medium-term prospects remain generally favorable with growth projected to range from 3½-3¼ percent, the current account deficit to narrow to around 2½ percent of GDP, and net external liabilities to fall to around 60 percent of GDP.

Recent structural reforms efforts have focused on a continuation of labor market reforms aimed at further enhancing labor market flexibility; the launch of a gradual reform of the welfare system; measures to encourage innovation and entrepreneurship; and a comprehensive review of laws that restrict competition.

Executive Board Assessment

Executive Directors commended the authorities on the continued solid economic performance—characterized by robust economic growth during the past 10 years, broad-based productivity increases, and low inflation—which they attributed to prudent macroeconomic management and the sustained implementation of wide-ranging structural reforms since the mid-1980s.

Citing the moderation in economic growth since the latter part of 2000, the slowdown in world economic growth, and the absence of inflationary pressures, most Directors endorsed the recent cut in official interest rates. Nevertheless, Directors pointed out that, with tax cuts and increases in welfare benefits delivering some fiscal stimulus to the economy, and with the competitive exchange rate boosting net exports, economic growth prospects remained favorable. This assessment, and lingering concerns that inflationary pressures could emerge, led most Directors to recommend a cautious approach to further interest rate reductions.

Directors provided several comments on the methods used by the Reserve Bank of Australia to conduct the targeting of inflation, and broadly commended its pragmatic approach. Directors considered that the shift from semi-annual to quarterly policy statements will reinforce the already high degree of credibility and transparency of monetary policy, and some suggested that the issuance of brief statements after board policy meetings would further strengthen transparency.

Directors noted that the downward pressure on the Australian dollar during much of 2000, which occurred despite strong economic fundamentals, had made possible a marked reduction in the current account deficit. They supported the authorities' pragmatic approach to coping with the depreciation, which was concerned with addressing the inflationary consequences rather than with defending a specific exchange rate. Directors agreed that, while limited intervention can be helpful to stabilize the foreign exchange market, intervention would be futile in the face of sustained market pressure.

Although the mid-year budget review showed a strong fiscal position, Directors advised the authorities to keep public spending under close scrutiny to maintain investor confidence. They therefore welcomed the authorities' assurances that the fiscal initiatives being planned to meet the government's policy priorities in the pre-election period will contain only limited, well-targeted increases in spending, consistent with the policy of maintaining fiscal surpluses in periods of healthy growth.

Directors observed that the means-tested publicly provided age pension, the mandatory private superannuation scheme, and the tax incentives for additional voluntary saving provide a suitable framework for retirement income support over the longer term, while limiting the fiscal burden. They were more concerned about rising health care costs. Given the commitment to a strong public health care system, Directors considered that it would be prudent to run modest cyclical fiscal surpluses or develop other mechanisms to mobilize resources for future increases in health spending.

Directors noted that prudent economic management had created a dynamic, flexible economy that was well-positioned to withstand external shocks. They pointed to the narrowing of the current account deficit, the apparently limited impact of the sharp currency depreciation on balance sheets, and the generally strong financial sector indicators as evidence of this. In their view, these favorable external vulnerability indicators and the recent experience of adjustment to shocks indicated that external risks are manageable. Directors emphasized, however, that the high degree of external exposure underlines the importance of continued prudent fiscal policy and firm regulatory oversight of the financial system.

Directors cautioned that the structural reform effort must be sustained if Australia is to retain its place among the leaders in productivity growth. They felt that, in fostering the "new economy," Australia is most likely to maximize its growth potential by focusing on policies that promote innovation and technology absorption in industries and sectors in which it has a comparative advantage. They therefore welcomed recent initiatives to implement the recommendations of the Innovation Summit Implementation Group, including support for research and development and strengthened higher education, and encouraged the authorities to lower the top marginal tax rate to bolster Australia's capacity to develop and retain technical and entrepreneurial skills.

Directors acknowledged the inherent political difficulties with industrial relations reforms, but noted that the potential payoff in terms of growth and employment is likely to be significant, and welcomed the authorities' commitment to pursuing further actions in this area. They supported the introduction of legislation to streamline the awards system, turning it more into a safety net than a device for setting wages and working conditions, and to increase labor market flexibility.

Directors welcomed the steps being taken to reduce disincentives to workforce participation and endorsed the view that the welfare system should provide greater incentives for people to move from welfare to work. They emphasized that the biggest challenge will be to achieve these objectives in a manner consistent with fiscal prudence and with the government's commitment to leave no group materially worse off.

Directors also welcomed the continuing review of legislation that restricts competition. They also encouraged the authorities to eliminate the remaining low tariffs, and to make more concrete the timetable for eliminating tariffs in the other items by 2010. Finally, several Directors encouraged the authorities to increase their official development assistance from its current level to the United Nations target and to increase its market access to developing countries.

Directors acknowledged that, in many respects, Australia is at the forefront of the production and dissemination of high quality economic and financial statistics, and welcomed the ongoing efforts to improve these statistics.