Public Information Notice No. 06/123

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with Australia

October 23, 2006

On October 11, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Australia.¹

Background

Australia's economic performance continues to be robust and prospects remain bright. The economy is entering its 16^th year of expansion, reflecting the benefits of wide-ranging structural reforms and sound macroeconomic policies. After a modest slowing in 2005 following a welcome cooling of the housing market, growth is expected to strengthen once more because strong global growth has lifted Australia's terms of trade to the highest level in three decades. As a result, business investment has risen sharply, laying the foundation for solid export-led growth in the medium term.

Real GDP growth eased to 2¾ percent in 2005 as consumption growth declined and dwelling investment fell modestly following the cooling of the housing market. The slow down was cushioned by rapid growth in business capital spending, with investment being particularly strong in the mining sector. The unemployment rate has fallen to 4.8 percent in recent months, its lowest level in 30 years, but there has been little generalized wage pressure. Nonetheless, resource utilization is relatively high in some sectors and regions, and the Reserve Bank of Australia's (RBA) preferred measure of the core CPI inflation edged up to almost 3 percent (y/y) in June, while headline CPI inflation was 4 percent y/y owing to rising oil and fruit prices.

The external current account deficit was 6 percent of GDP in 2005, exceeding its typical level of about 4½ percent owing to high business investment. The trade deficit narrowed with the rise in export prices, but export volume growth was slow, reflecting unfavorable weather, the appreciated exchange rate, and disruptions of transport infrastructure for commodity exports. More recently, the trade and current account deficits have both eased somewhat. The Australian dollar has been broadly stable, but remains relatively high by historical standards, at about 12 percent above its 20-year average in real effective terms in September 2006. Net foreign liabilities reached a new high, at 57 percent of GDP, but the ratio of net interest payments to exports remained low at 9 percent.

Monetary policy was tightened modestly, with the RBA raising the target cash rate to 6 percent in two 25 basis point steps in May and August 2006. The fiscal position continues to be robust, with fiscal surpluses recorded in eight of the past nine years. Indeed, the net debt of the Australian government was eliminated in April 2006. The underlying cash balance for the 2005/06 fiscal year was 1.6 percent of GDP, ½ percentage point higher than budgeted owing to strong revenues. The 2006/07 budget targets a fiscal surplus of 1.1 percent of GDP, and projects the surplus to remain at 1 percent of GDP in the medium term.

Growth is expected to pick up to about 3 percent in 2006 and 3½ percent in 2007. Domestic demand growth is expected to slow gradually as investment growth moderates. With mining sector projects scheduled to come on stream, higher exports will help reduce the trade deficit, but the external current account deficit will decline more modestly owing to rising equity income outflows. Unemployment is expected to remain stable or decline gradually, and core CPI inflation and wage growth are projected to remain broadly stable. In the medium term, export commodity prices are assumed to decline significantly owing to an expansion in the global capacity of the mining sector, but there are both upside and downside risks to this outlook.

Executive Board Assessment

Australia's current economic expansion is now in its sixteenth year and unemployment has fallen below 5 percent for the first time in three decades. Executive Directors commended the authorities on their sound macroeconomic management and continuing structural reform efforts that have underpinned the sustained strong economic performance. Looking ahead, macroeconomic policies are well positioned to face potential external shocks, and Directors were confident that the authorities will press ahead with necessary reforms to address medium-term growth and fiscal challenges.

Directors judged that monetary policy has been tightened appropriately as the medium-term prospects for inflation had risen owing to rising world commodity prices and the relatively high level of resource utilization in some sectors and regions. They noted that further monetary tightening may eventually be needed if domestic demand growth or other factors lead to an increase in underlying inflation pressure. Although the Australian dollar is relatively high by historical standards, Directors saw no clear signs of misalignment given the high level of commodity prices and the prospects for stronger growth in export volumes.

Directors commended Australia's continued strong fiscal position, observing that the elimination of net public debt by the Australian government was an impressive milestone that few countries have been able to achieve. With the budget expected to remain in surplus in the medium term, Directors endorsed the establishment of the Future Fund to invest these surpluses to help Australia manage its long-term fiscal challenges. Noting that the current fiscal policy stance is mildly stimulatory at a time of relatively high resource utilization in some sectors and regions, Directors recommended that the fiscal surplus be allowed to exceed budget targets if growth and revenues are higher than expected.

Directors noted that that much of the recent improvement in Australia's terms of trade may eventually be reversed, and that there are also broader downside risks to the global economic outlook in the medium term. Nonetheless, Directors considered that Australia's macroeconomic policies, flexible exchange rate regime, and the robust medium-term fiscal outlook and the medium-term focus of monetary policy provide substantial cushions to help the economy cope with a fall in commodity prices or other shocks. Although potential vulnerabilities are contained and private sector risk management practices are sufficient, Directors recommended that the authorities continue to monitor private external debt closely.

Australia's participation in the Financial Sector Assessment Program was welcomed by Directors, and they endorsed the finding that Australia's financial system is healthy and financial supervision is sound. Nevertheless, with financial institutions entering new businesses and facing growing competition, Directors encouraged the authorities to remain vigilant by promoting robust risk management practices. In this regard, Directors welcomed the close monitoring of household debt servicing capacity by the Australian Prudential Regulation Authority, along with the review of liquidity regulation that is currently underway, and they fully supported the authorities' request to the banks to conduct regular stress tests. They also welcomed the steps taken to enhance supervisory cooperation with New Zealand. Directors emphasized that the authorities' ongoing work to ensure the legal foundations for timely and minimally disruptive resolutions of failed institutions was important to underpin the resilience of the financial system and minimize fiscal cost.

Directors welcomed the agreement between the Australian and state governments on the ambitious National Reform Agenda to lift productivity and labor participation over the next decade. They supported the broadening of the reform agenda to include human capital issues such as education, training, and health care. However, Directors recognized that progress on this reform agenda would be challenging, as evidenced by the lagging reform implementation in crucial areas—such as trading in water. Accordingly, Directors urged the authorities to make appropriate use of the resources provided by the recent surge in fiscal revenues to help spur the implementation of reforms. They considered that such an investment in reforms would help sustain strong economic growth and better position Australia to address the challenges of an ageing population and rising healthcare costs.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.