Directors agreed that the macroeconomic stimulus is being appropriately removed. They commended the Reserve Bank of Australia (RBA) for its well-paced monetary policy tightening, which has helped anchor medium-term inflation expectations. However, Directors observed that a further tightening of monetary policy could be warranted if the recovery remains on track, to counter the inflationary pressures from the unprecedented increase in mining investment. Directors welcomed the government’s commitment to return the Commonwealth budget to surplus in 2012/13, as it would strengthen fiscal buffers and take some pressure off monetary policy and the exchange rate.

Directors agreed that in the event of severe adverse developments in global financial markets or world growth, macroeconomic policy is well positioned to respond. They noted that the free-floating exchange rate regime has cushioned external shocks, the RBA has ample scope to cut policy interest rates, and there is ample space for countercyclical fiscal support, given the low level of government net debt.

Directors stressed that, over the medium term, the government should grasp the opportunity provided by the mining boom to strengthen fiscal buffers further, recommending that a budget surplus of at least 1 percent of GDP be targeted for the period beyond 2013/14. In this regard, they emphasized the importance of tax and structural reforms. Directors underscored that inefficient taxes such as state stamp duties on house sales, that discourage worker mobility, be eliminated and that the effective marginal income tax rates be further reduced. Business tax reform would also encourage private investment. Options to raise revenue to fund these reforms include greater reliance on consumption and land taxes, and a broadening of the proposed minerals resource rent tax. More broadly, Directors considered that reforms in the areas of education, infrastructure, and business regulation would enhance the economy’s capacity to adjust to structural changes.

Directors concurred that, while banks remain sound, continued intensive supervision remains critical. They welcomed the Australian Prudential Regulation Authority’s plans to undertake stress tests incorporating disruptions to funding markets. Directors generally noted that higher capital requirements and a further reduction of banks’ short-term external debt would reinforce financial stability, although a few Directors thought that any steps in this direction should await an international consensus on the appropriate norms.

Directors observed that the projected deterioration of the current account balance presents some risks, although future deficits should remain manageable as they reflect, in large part, an increase in private investment in the export sector. They pointed out that a projected decline in national saving also contributes to the widening of the deficit, which underlines the need for fiscal consolidation.

Directors took note of the staff’s assessment that the Australian dollar may be somewhat stronger than the level implied by medium-term fundamentals. They noted, however, that the overvaluation is partly cyclical and may dissipate with the eventual tightening of policy rates by major central banks.

Background

Australia’s performance since the onset of the global financial crisis has been enviable. It was one of the few advanced economies to avoid a recession in recent years, reflecting its strong position at the onset of the crisis and a supportive macro policy response. The good performance can also be attributed to a healthy banking system, a flexible exchange rate, and robust demand for commodities from Asia, especially China.

A recovery is now being driven by a mining boom. Real GDP growth picked up to 2¾ percent in 2010 with private demand and commodity exports beginning to take over from public demand as the main drivers. In the first quarter of 2011, however, activity was disrupted by cyclones and floods in Queensland and Western Australia that reduced output, especially exports of coal and iron ore (which comprise about ⅓ of Australia’s exports). Real GDP growth rebounded in the second quarter but coal export volumes have not fully recovered.

The exceptionally large rise in the terms of trade since 2002 has increased national income and improved the current account balance to about 2½ percent of GDP in the first half of 2011. The improvement has contributed to an appreciation of the real effective exchange rate to near the highest level since the dollar was floated in 1983. The appreciation has put pressure on sectors not benefiting directly from higher commodity prices.

Macroeconomic stimulus is being withdrawn. The Reserve Bank of Australia began to raise its policy rate in late 2009, but the rate has been held at 4¾ percent since November 2010, because of uncertainty regarding the global outlook and the impact of natural disasters on activity. The exit from fiscal stimulus began in 2010, as the recovery gained traction. However, fiscal consolidation has been complicated by natural disasters that contributed to a wider-than-expected budget deficit of 3½ percent of GDP in 2010/11.

The economic outlook remains favorable, but the risks to growth are tilted to the downside. Real GDP growth is projected at almost 2 percent for the calendar year 2011 and 3⅓ percent for 2012, on the back of strong demand for commodities and a sharp rise in private investment in mining. Key downside risks are that the global recovery stalls or Asian growth falters, impacting demand for commodities. Funding markets could also be disrupted by concerns about sovereign debt in advanced economies. On the upside, investment in the resource sector could be larger than expected and households may become more confident as the boom progresses.