Public Information Notice No. 05/123

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Australia

September 12, 2005

On August 29, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Australia.¹

Background

Australia has implemented wide-ranging structural reforms and strengthened the frameworks for monetary and fiscal policies over the past two decades. As a result, Australia's economic expansion is now in its 14^th year, with growth averaging 3¾ percent owing to a combination of strong job creation and high productivity growth. Inflation has remained low and the consistent fiscal surpluses in recent years have contributed to the elimination of net public debt.

Real GDP rose by 3¼ percent (y/y) in 2004, but growth slowed in the second half of 2004. The slowdown mostly reflected a deceleration of domestic demand following a welcomed cooling of the housing market, with housing prices slowing from an annual average growth of 17½ percent in 2001-03 to being largely flat in the year to March 2005. As a result, consumption growth moderated and dwelling investment fell. Business investment remained buoyant, reflecting high levels of profitability and capacity utilization. Employment has grown strongly, at 3 to 4 percent in 2005, reducing unemployment to a 28-year low of 5 percent, with no sign of generalized wage pressures.

The external current account deficit widened to 6½ percent of GDP in 2004 as payments to foreign investors rose owing to high mining sector profits. The trade balance was stable, with increases in the terms of trade to historically high levels offsetting the strong growth in imports following the large exchange rate appreciation in 2002-03. In the first quarter of 2005, the real exchange rate stood 16 percent above its average level since 1990. Export volume growth was limited to 4 percent despite the strong global demand for commodities, partly as a result of constraints on mine capacity and on transportation infrastructure in some areas. The current account was financed mainly through external debt issues by financial institutions, with net external liabilities rising to 65 percent of GDP.

CPI inflation has been steady at about 2½ percent, with a waning of the effects of the exchange rate appreciation on tradable goods prices balanced by a modest easing in the inflation rate of nontradable goods. Having kept interest rates on hold since late 2003, the Reserve Bank of Australia (RBA) raised the target cash rate by 25 basis points to 5½ percent in March 2005, to lean against a projected rise in inflation to about 3 percent by the end of 2006.

The fiscal position continued to be strong. In the 2005 budget released in May, the government projected the underlying cash balance to reach 1.1 percent of GDP in 2004/05, compared with the surplus of 0.3 percent of GDP projected in the 2004 budget. Revenue is projected to be almost 1 percent of GDP higher than budgeted, with company taxes particularly buoyant, partly reflecting the boost in profits from rising export commodity prices.

Growth is expected to rise from 2¼ percent in 2005 to about 3½ percent in the medium term, although this will require continued strong growth in productivity. Domestic demand growth will likely remain moderate as stimulus from the housing market fades, while exports are expected to strengthen as substantial investment in the export sector boosts capacity. As a result, the external current account deficit is expected to decline back to its historical average of about 4½ percent of GDP in the medium term even as part of recent terms of trade gains unwind owing to increases in the global supply of commodities. While headline inflation may approach 3 percent in 2005 because of higher oil prices, the recent easing in domestic demand growth suggests that underlying inflation will edge up only modestly before declining back towards the middle of the target range in the medium term.

Executive Board Assessment

Executive Directors commended the authorities for the sustained strength of Australia's economic performance, which they attributed to an exemplary setting of economic policies and institutions, supported by broad consensus on many issues. This includes wide-ranging structural reforms implemented over the past two decades, along with a prudent and flexible management of monetary and fiscal policies within transparent medium-term policy frameworks that has helped enhance the resilience of the economy. Going forward, Directors encouraged the authorities to continue with their structural reform efforts, in order to further raise productivity and labor force participation and address the fiscal impact of an ageing population.

Directors concurred that the outlook for the economy is favorable. While growth had slowed somewhat in the second half of 2004 owing to a welcome cooling of the housing market and the earlier appreciation of the Australian dollar, the resumption of growth in early 2005 is expected to continue, with demand underpinned by strong job creation and business investment. Medium-term prospects for stronger growth in exports supported by high investment in the resource sector, together with moderate growth in domestic demand, will tend to narrow the large external current account deficit.

Directors viewed the current wait-and-see monetary policy stance of the Reserve Bank of Australia as appropriate. While headline inflation may approach 3 percent in 2005 owing to higher oil prices, underlying inflation is likely to remain consistent with the authorities' targets over the medium term, given the moderation in domestic demand growth. Directors welcomed the stabilization of the housing market in 2004 and 2005, together with the easing in household credit growth, which partly reflected astute and timely policy actions. Nevertheless, close monitoring of the housing market and household sector finances will need to continue.

Against this background, Directors welcomed the continued improvement in risk management techniques by banks, and supported the timely refinements of prudential regulations in response to the emergence of nonstandard household lending. To preserve the soundness of Australia's financial sector, they encouraged continued efforts to enhance financial regulation, and welcomed the authorities' commitment to using the forthcoming FSAP to help identify reform priorities.

Directors agreed that Australia's medium-term fiscal position is robust, with the underlying fiscal surplus projected at almost 1 percent of GDP on average over the next four years, partly reflecting large increases in export commodity prices. Since not all of these gains may be lasting, Directors considered the allowance for a substantial decline in export prices in the medium-term revenue projections of the 2005 budget to be appropriately prudent. They also welcomed the tax reductions in the past two budgets, which, by contributing to a mildly expansionary fiscal stance, may have helped cushion the recent slowing in growth.

Directors considered that exchange rate flexibility will continue to play a key role in tempering the impact of possible shocks on growth, including those that might arise from a rapid reversal in recent terms of trade gains. They also supported the free operation of the automatic fiscal stabilizers and the readiness of monetary policy to respond flexibly to external or domestic shocks. Directors noted the role that extensive foreign currency hedging is playing in contributing to the resilience of the economy to substantial exchange rate fluctuations. At the same time, Directors concurred that the high level of private external debt, in the context of sustained current account deficits, requires continued close monitoring.

Directors considered that Australia's strong track record of successful implementation of structural reforms bodes well for addressing the significant economic challenges that lie ahead from an ageing population and rising healthcare costs. They endorsed the authorities' strategy to address those challenges through further reforms to boost medium-term growth, and hence the revenue base, complemented by measures to enhance the sustainability of expenditure. Directors observed that Australia's sound economic outlook and robust fiscal position create an exceptional opportunity to implement these reforms.

Directors accordingly welcomed the measures announced in the 2005 budget to expand labor force participation by encouraging the transition from welfare to work. They supported the proposed reforms of the industrial relations system aimed at further improvements in labor market flexibility that would facilitate additional gains in productivity and employment. The authorities should also continue efforts to raise labor force participation among the population aged over 55 to moderate the impact of population ageing on the outlook for employment and growth.

To further raise productivity and incomes toward those in the leading economies, Directors recommended the adoption of an ambitious new reform agenda in key infrastructure sectors. In particular, steps to improve the price signals for water, land transportation, and electricity would enhance incentives for their efficient use and stimulate timely investments to expand infrastructure capacity. The importance of stronger competition in the communications sector and increased research and development was also highlighted.

Directors welcomed the recent reforms of pharmaceutical benefits and Medicare as important steps to address rising healthcare costs, which are the main source of long-term fiscal pressures. Further efforts to enhance the sustainability of healthcare spending will nevertheless be needed, and Directors encouraged the authorities to explore how incentives in the health system could be strengthened to improve healthcare productivity growth. Directors agreed that the proposed Future Fund, by covering unfunded public service pension liabilities, and operating in accordance with international best practices, is also set to play a valuable role in meeting long-term fiscal challenges.

Directors commended Australia's commitment to trade liberalization under the Doha Round, and the increase in official development assistance. They encouraged the authorities to continue to make progress toward the United Nations target.