Public Information Notice No. 02/103

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Australia

September 18, 2002

On September 16, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Australia.¹

Background

Despite the synchronized slowdown in the rest of the world in 2001, the Australian economy has continued to grow strongly. This performance reflected the absence of major imbalances in the economy, an aggressive easing of monetary policy, fiscal policy stimulus, and a competitive exchange rate. Real GDP has risen at an average annual rate of 3¾ percent since end-2000. Buoyant private consumption and the housing sector led growth over the period, supported by lower interest rates, a rise in disposable income as income taxes declined, and significant gains in household net wealth, the latter partly reflecting the sharp rise in housing prices in recent years. In addition, the fiscal stimulus provided by the introduction of the First Home Owners Scheme (FHOS) contributed to a major boost in housing investment. Conditions in the labor market were relatively weak during 2001, before employment growth picked up in early 2002. The unemployment rate at around 6¼ percent in July and August 2002 generally drifted down from its higher level in late 2001. Inflation rose in 2001 primarily owing to the impact of several largely transitory factors, and it has come back down in line with the official 2-3 percent target during 2002.

With underlying inflationary pressures muted and the uncertainty about the depth and duration of the global slowdown, monetary policy was highly supportive of growth. Consistent with its inflation targeting framework, the Reserve Bank of Australia (RBA) cut the official cash rate by 150 basis points in four steps between February and early September 2001. With a marked rise in global uncertainty following the September 11 terrorist attacks, the RBA eased policy further by reducing the cash rate by 50 basis points in two steps between October and December 2001. In the event, the Australian economy did not slow as expected and with generally favorable prospects in early 2002, the RBA adopted a less accommodative policy stance and raised the cash rate by 25 basis points at both of its scheduled meetings in May and June. Subsequently, at its July, August, and September meetings, the RBA left the rate unchanged.

Fiscal policy was also eased significantly during 2001, providing additional stimulus to the economy. In the May 2001/02 Budget (fiscal year July-June) and in the October 2001 Mid-Year Economic and Fiscal Outlook (MYEFO), the government implemented several tax and spending initiatives which were expected to shift the fiscal balance (on an accrual basis) from a surplus of about 1 percent of GDP in 2000/01 to a deficit of about ½ percent of GDP in 2001/02. The underlying cash balance is expected to shift to a deficit of ¼ percent of GDP, the first cash deficit since 1996/97. Cumulative budget surpluses and significant privatization proceeds, have reduced the Commonwealth net debt from 18¼ percent of GDP in 1996/97 to an estimated 5½ percent of GDP in 2001/02.

A sharp real exchange rate depreciation in 2000 and 2001 and a recovery in Australia's terms of trade from its Asia-crisis lows helped to narrow the current account deficit from almost 6 percent of GDP in 1999 to 2½ percent in 2001. Most of the improvement was due to a sharp turnaround in the trade balance, which shifted from a deficit of 2½ percent of GDP to a surplus of roughly ½ percent of GDP. While the weak exchange rate and the favorable terms of trade helped to cushion the impact of the world slowdown, export volume growth decelerated markedly in late 2001. In the March 2002 quarter, the current account deficit was about 3 percent of GDP; however, as net exports registered a large decline in the June quarter, the current account deficit rose to 4 percent of GDP.

Executive Board Assessment

Executive Directors welcomed the continued impressive performance of the economy, despite the major external shocks that Australia has faced, and attributed this success to the authorities' skillful economic management. In particular, Directors commended the foundation established by the sound economic policies sustained over the past several years—including fiscal consolidation, adoption of an inflation targeting framework, structural reforms in the product and labor markets, and trade liberalization, aided by appropriate discretionary monetary and fiscal policy actions.

Looking ahead, Directors considered that the sound policy framework and the absence of imbalances suggest that the conditions for sustained high growth are in place, and that the Australian economy will continue to perform well. While favorable growth would suggest a need for further monetary tightening, Directors considered that near-term prospects now appear less certain, this mainly reflects changes in the outlook for the global economy and associated risks—although they also noted other uncertainties, relating to drought and the housing market in Australia. In these circumstances, Directors thought that the timing and pace of further monetary tightening was uncertain and would depend on how economic prospects evolve in the period immediately ahead. They agreed that the rapid rise in housing prices needed to be carefully assessed. Although monetary policy should not attempt to directly target asset prices, consideration would have to be given to the impact that a possibly unsustainable run-up in asset prices could have on growth and inflation. The supervisory authorities also would have to carefully consider the potential impact on the soundness of financial institutions.

Executive Directors viewed the stance of fiscal policy as fundamentally strong, supported by a sound framework and objectives for the public finances. They endorsed the authorities' policy approach, which has enabled them to act flexibly when needed.

This flexibility allowed policy to provide a fiscal stimulus to the economy during 2001, with one-off factors and modest policy initiatives reducing fiscal resources-contributing to a shift of the 2001-02 budget into a small deficit, along with reducing prospective surpluses over the medium term. Looking ahead, pressures on the budget, particularly from health care, are rising and are likely to intensify as the population ages. While agreeing that Australia is well placed as it turns to address the challenge of rising health care expenditure, Directors considered that certain features of the system appear to contribute to substantial moral hazard, pushing up costs. Short-term actions—like the changes to the Pharmaceutical Benefits Scheme proposed in the budget—are needed to contain costs, but a dialogue also has to begin on more comprehensive solutions. In this regard, Directors welcomed the InterGenerational Report released with the budget, which provides a very useful vehicle to begin a dialogue on the medium-term fiscal problems that Australia faces. Several Directors considered that Australia's example could offer useful lessons for other countries.

Directors also cautioned that, over the medium term, fiscal policy must generate sufficient resources to finance the further reforms needed to sustain high growth and to ensure that all Australians share in these gains. Directors agreed that changes in the tax, income support, and industrial relations systems should be considered as part of a comprehensive and coordinated package—with the aim of improving incentives, expanding opportunities for participation in the economy, and enhancing the flexibility and efficiency of the labor market. Substantial resources may be needed to finance these reforms, calling for continued discipline over spending and for a reallocation of budgetary resources to higher priority areas. Directors encouraged the authorities to garner the necessary broad support for these and other reforms, noting that successful implementation would require careful preparation of the ground.

Directors noted that reforming the personal income tax system should be a major priority to enhance incentives to work, save, and invest. In particular, the top marginal tax rate takes effect at a relatively low income level (one that is about twice the median income) and is high in relation to the corporate income tax rate. Directors generally encouraged the authorities to bring down the top marginal tax rate over time to a level more in line with the corporate income tax rate, and to apply it at a higher income threshold.

Directors welcomed the authorities' efforts to overhaul the income support system. They also agreed that further reforms would be needed to simplify the system and the benefits provided, to strengthen incentives to move to gainful employment, and to ensure that support is effectively used to help in the transition to work. As part of a comprehensive reform, Directors suggested that consideration be given to reducing the high effective marginal tax rates faced by income support recipients when they go back to full-time work; tightening eligibility requirements for some income support programs; and maintaining strong activity tests, and penalties for breach of obligations by recipients of unemployment benefits, and enforcing them consistently and uniformly across all recipients.

Directors recognized that considerable progress has been achieved in reforming the labor market. However, they considered that labor market flexibility and efficiency could be enhanced further. In particular, award and wage bargaining systems could be further simplified by establishing a single national industrial relations system-moving away from the complicated array of federal and state frameworks that may currently apply to different groups of employees in a single enterprise. In addition, the role of the award system in setting minimum wages should be diminished in order to reduce what may be a significant barrier to the entry of low-skilled individuals into employment. Historically, the minimum wage in Australia has been used as a vehicle to try to ensure a "living wage". Directors noted that this goal could be achieved more efficiently, with the creation of fewer economic distortions, by using the tax and/or income support systems.

The collapse of several large firms in the last year has focused attention on the potential fallout for the financial system and has raised concerns about the supervisory and regulatory framework. Directors agreed that exposures to the failed firms are unlikely to seriously affect the banking system, given high levels of profitability and capital adequacy. They also commented favorably on the steps being taken to strengthen the prudential frameworks for the non-life insurance sector and superannuation funds.

Directors pointed out that Australia has an impressive track record in adjusting to adverse shocks in recent years. Household, corporate, and bank balance sheets remain basically sound; and all sectors have coped well with the sharp real depreciation of the exchange rate, the wide swings in commodity prices, and the more recent episodes of corporate distress. Nevertheless, they noted that the potential implications of some recent trends—such as the rapid pace of growth in external indebtedness and a shortening in its maturity structure, and the sharp rise in house prices—should continue to be carefully assessed. Directors also noted that developments in the rest of the world in recent years have led to substantial fluctuations in the value of the Australian dollar, and generally considered that exchange market intervention had played a useful role in helping to maintain orderly market conditions.

Directors commended the authorities' commitment to trade liberalization. They welcomed the steps Australia has taken to provide duty- and quota-free access to most products from least developed countries, and encouraged the authorities to remove any remaining restrictions. In this spirit, Directors also encouraged the authorities to raise the level of ODA from its present level of 0.3 percent of GNP. Directors also commended the authorities on the significant progress made in dealing with anti-bribery and money laundering initiatives.