IMF – Page 9 – Digital Finance Analytics (DFA) Blog

Bank Risk-taking Behaviour Rises As Monetary Policy Eases

A newly released IMF working paper ” Does Prolonged Monetary Policy Easing Increase Financial Vulnerability?” looks at how banks behave in an easing monetary policy environment. They found that the leverage ratio, as well as other measures of firm-level vulnerability, increases for banks and nonbanks as domestic monetary policy easing persists. Cross-border effects are also notable. Results are non-linear, with risk-taking behavior rising most quickly at the onset of monetary policy easing.

We think think this means that in a low interest rate environment, counter-cyclical buffers should be increased. In Australia, in the current low rate environment, policy settings are still too generous.

While decisive and persistent monetary policy accommodation was necessary to support aggregate demand in advanced economies during and after the financial crisis, there is lingering concern about the side effects of low interest rates and central bank balance sheet expansion on risk-taking behavior in the financial sector. In this paper, we investigate the extent to which financial vulnerabilities build up at the firm level during extended periods of monetary policy easing at home and in the U.S.

Based on a data for roughly 1,000 bank and nonbank financial institutions—including insurance companies, investment banks and asset managers—in 22 countries over the past 15 years, we find significant evidence of increased risk-taking behavior. Domestic banks and nonbanks alike increase their leverage ratios in response to persistent monetary policy accommodation at home. In addition, prolonged Federal Reserve policy easing leads banks and nonbanks outside the U.S. to take on more risks, with an effect similar to equivalent domestic monetary policies.
These results are robust to alternative measures of financial vulnerability, controls, and specifications. Importantly, the relationship between persistent monetary policy easing and financial firm vulnerability appears to be non-linear, with risk-taking behavior rising most quickly at the onset of policy easing.

Our findings ideally will spur research in two directions. First, further work is needed to develop benchmarks for risk-taking behavior. While we document an increase in risks taken by financial institutions, we are unable to take a position on whether such increases in risk are worrisome or excessive. Some degree of change in risk-taking is an inherent part of the monetary policy transmission mechanisms. To some extent, if prudential policies and regulations inhibit financial institutions from taking more risk in response to monetary policy easing, the expansionary effect of monetary policy on the real economy may be diminished.

Second, our results should inform the ongoing debate on using monetary policy tightening for financial stability purposes (see IMF, 2015, for instance). Costs of doing so would arise from lower employment and output in the short to medium run, feeding back to higher defaults and funding costs, thus reducing financial stability. But benefits need further exploration. The emphasis so far has been on the link between policy rates and credit growth, and in turn between credit growth and financial stability (Svensson, 2015). However, this paper suggests that the link could also go through the leverage of financial sector firms.

But even without further work, our results have several policy implications. Countries should closely monitor financial sector risks during periods of monetary policy accommodation at home, and in the U.S. They should develop solid prudential and regulatory frameworks, so as to preserve room for monetary policy to manoeuver to achieve its inflation and output objectives. Such frameworks should apply to both banks and nonbanks.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Why International Financial Cooperation Remains Essential

From iMFdirect.

Economic growth appears to be strengthening across the large economies, but that does not mean financial-sector regulation can now be relaxed. On the contrary, it remains more necessary than ever, as does international cooperation to ensure the safety and resilience of global capital markets. That is why the Group of Twenty (G20) finance ministers and central bank governors reiterated their support for continuing financial-sector reform at their meeting in Baden-Baden last week.

The 2008 global financial crisis was exceptionally severe in the magnitude, breadth, and persistence of its effects, but it is one in a long series of financial crises stretching back centuries. Not only do crises cause financial losses for professional investors; more importantly, they impose high human costs for those who lose their jobs, homes, and savings. To protect their citizens, governments generally adopt an array of financial regulations designed to reduce the risk of a failure that could reverberate across the economy. These include balance-sheet standards, insider trading rules, broader conflict-of-interest laws, and consumer protections.

Too far?

Some argue that such existing regulations go too far and mostly hurt the economy by reducing financial institutions’ profits and thereby their ability to provide essential services. They claim that banks and other financial institutions—acting in their shareholders’ interest—would not knowingly risk failure; even if they avoid insolvency, the damage to their reputations would put them out of business. Yet history abounds with examples of reckless behavior, ranging from the Dutch Tulip Mania of the seventeenth century to the subprime lending boom of the 2000s. And even when a financial firm’s managers soberly assess their own personal risks, they still may not be prudent enough from society’s perspective, because some costs of failure fall on others, such as their shareholders and the taxpayers who must ultimately pay if there is a government bailout.

But the task of financial-sector oversight, never easy, has become more complex over the past 50 years as financial activity increasingly crosses national boundaries. That is why national governments have stepped up collaboration to promote stability and create a level playing field in international financial markets.

The global scope of modern finance creates at least four major complications for national regulators and supervisors. First, it is hard to assess the operations of financial institutions that extend beyond their home countries. Second, financial firms may take advantage of regulatory differences among countries to place their riskiest activities in lightly-regulated locations. Third, complex institutions with operations spanning several national jurisdictions are harder to wind down if they fail. And fourth, countries might actively compete for international financial business while also supporting their national “champions” through lax regulatory standards. All of these factors undermine the stability of the global financial system, especially as financial instruments and networks become more complex.

Forums for international cooperation

To address these challenges, national regulators launched in 1974 a process of consultation and coordination under the aegis of the Basel Committee on Banking Supervision. The Basel Committee focuses on banking regulation, whereas the Financial Stability Board, set up by the G20 after the financial crisis of 2008, coordinates the development of regulatory policies across the broader international financial markets, bringing together national authorities, international financial institutions, and sectoral standards setters.

Governments cooperate through the Basel Committee and the Financial Stability Board because no single national authority, acting by itself, can guarantee the stability of its own financial system when banks and other financial institutions operate globally. International agreements on regulatory and supervisory standards discourage a race to the bottom by establishing a level global playing field for financial industry competition. More generally, when countries compete for business through excessive deregulation, all end up worse off because financial accidents become more likely, and, when they happen, are more severe and more likely to propagate across borders.

In the aftermath of the 2008 crisis, the Basel Committee undertook a major initiative, known as the Basel III accord, which includes higher minimum standards for both the quality and quantity of bank capital (the equity cushion that allows banks to absorb losses without going bankrupt and needing government support). While sufficient bank capital is vital, even higher capital levels could be threatened in a severe panic, so the accord includes additional measures to reduce banking risk. As a result, even though Basel III is still being phased in globally, banks are already much better capitalized and less vulnerable to market jitters than they were a decade ago.

The United States, which made banks recapitalize and restructure more aggressively after the crisis, recovered more quickly than countries that did not. But a safe global financial system needs more than balance-sheet constraints for banks. In parallel with the development of the Basel III standards, the Financial Stability Board created a common approach to handling the failure of the largest and most systemic financial institutions. It is critical that insolvent institutions can be wound down safely, even when they are big, international, complex, or otherwise would pose a threat to the broader financial system in case of failure. If they cannot, government bailouts are more likely, risk-taking is excessive, and market discipline is subverted.

Of course, financial regulation involves tradeoffs. In principle, requiring more capital and liquidity can raise the cost of credit for households and businesses or reduce market liquidity. So far, research studies indicate that any unintended consequences are relatively small. Yet the benefits of a safer financial system are unquestionably large.

Although the financial system is safer today, it is also true that financial regulations have become much more complex. In the United States, for example, the Dodd-Frank Act is more than a thousand pages long and has generated tens of thousands of pages of follow-up implementation rules. There is certainly room for simplification. For example, the threshold for designating banks as systemic and hence subject to enhanced regulatory standards, currently set at a balance-sheet size of $50 billion, might be made more flexible. Regulation of community banks could also be simplified without making the system riskier, as could the implementation of stress tests, which aim to assess banks’ resilience to potential economic and financial shocks.

At the same time, the core tenets of the new global regulatory regime must be preserved. Paradoxically, the relative resilience of financial markets in recent years, which is partly the result of more stringent internationally agreed standards, has itself been cited to argue that financial regulation is an excessive drag on growth. This view is shortsighted. As Hyman Minsky, a well-known writer on financial crises, put it, “success breeds a disregard of the possibility of failure…” In other words, policymakers should not be lulled into forgetting the hard lessons of the not-so-distant past. Continuing international financial cooperation remains essential—it is the solid foundation of a strong and stable world economy.

Fintech—A Brave New World for the Financial Sector?

From iMFdirect.

From smartphones to cloud computing, technology is rapidly changing virtually every facet of society, including communications, business and government. The financial world is no exception.

As a result, the financial world stands at a critical juncture. Yes, the widespread adoption of new technologies, such as blockchain-based systems, offers many potential benefits. But it also gives rise to new risks, including risks to financial stability. That causes challenges for financial regulators, a subject I addressed at the 2017 World Government Summit in Dubai.

For example, we need to define the legal status of a virtual currency, or digital token. We need to combat money laundering and terrorist financing by figuring out how best to perform customer due diligence on virtual currency transfers. Fintech also has macroeconomic implications that need to be better understood as we develop policies to help the Fund’s member countries navigate this rapidly changing environment.

Soaring investment

Financial technology, or fintech—a term that encompasses products, developers and operators of alternative financial systems—is challenging traditional business models. And it is growing rapidly. According to one recent estimate, fintech investment quadrupled from 2010 to 2015, to $19 billion annually.

Fintech innovation has come in many shapes and forms—from peer-to-peer lending, to high-frequency trading, to big data and robotics. There are many success stories. Think of cell phone-based banking in Kenya and China, which is bringing millions of people—previously “unbanked”—into the mainstream financial system. Think of the virtual currency exchanges that allow people in developing countries to transfer money across borders quickly and cheaply.

All this calls for more creative thinking. How exactly will these technologies change the financial world? Will they completely transform it? Will banks be replaced by blockchain-based systems that facilitate peer-to-peer transactions? Will artificial intelligence reduce the need for trained professionals? And if so, can smart machines provide better financial advice to investors?

The truth is: we do not know yet. Significant investment is going into fintech, but most of its real-world applications are still being tested.

Regulatory challenges

And the regulatory challenges are just emerging. For instance, cryptocurrencies like Bitcoin can be used to make anonymous cross-border transfers—which increases the risk of money laundering and terrorist financing.

Another risk—over the medium term—is the potential impact on financial stability brought about by the entry of new types of financial services providers into the market.

Questions abound. Should we regulate in some way the algorithms that underlie the new technologies? Or should we—at least for now—hit the regulatory pause button, giving new technologies more time to develop and allowing the forces of innovation to help reduce the risks and maximize the benefits?

Some jurisdictions are taking a creative and far-sighted approach to regulation—by establishing “fintech sandboxes,” such as the “Regulatory Laboratory” in Abu Dhabi and the “Fintech Supervisory Sandbox” in Hong Kong.

These initiatives are designed to promote innovation by allowing new technologies to be developed and tested in a closely supervised environment.

Here at the IMF, we are closely monitoring fintech developments. Last year, we published a paper on virtual currencies, focusing on the regulatory, financial, and monetary implications. We have since broadened our focus to cover blockchain applications more generally. And we have recently established a High-level Advisory Panel of Leaders in Fintech to help us understand developments in the field. We expect to publish a new study on fintech in May.

As I see it, all this amounts to a “brave new world” for the financial sector. For some, a brave new world means a frightening vision of the future—much like the world described in Aldous Huxley’s famous novel.

But one could also think of Shakespeare’s evocation of this brave new world in The Tempest: “O wonder! How many goodly creatures are there here! How beauteous mankind is! O brave new world.”

By Christine Lagarde

Inequality and the Decline in Labor Share of Income

From iMFdirect.

As discussed in the IMF’s G20 Note, and a blog last week by IMF Managing Director Christine Lagarde, a forthcoming chapter of the World Economic Outlook seeks to understand the decline in the labor share of income (that is, the share of national income paid in wages, including benefits, to workers) in many countries around the world. These downward trends can have potentially large and complex social implications, including a rise in income inequality.

This chart shows that advanced economies that experienced a larger decline in their price of investment goods (such as computers, and other information and communications technologies), relative to consumption goods, saw a larger decline in their labor share of income. Declines in the relative price of investment goods across countries were, to a large extent, driven by rapid advances in technology. But these declines varied across countries depending on their investment and consumption patterns, including their reliance on commodity trade.

For example, the decline was larger in countries with a higher share of machinery and equipment in their overall investment (e.g., US and Germany), while it was smaller in countries reliant on service industries, particularly tourism and finance, such as Cyprus, Belgium, and Sweden, or on commodity exports, such as Canada and Norway. A larger decline in the relative price of investment goods in turn, presented firms with stronger incentives to replace jobs with machines, more so in countries and sectors with a higher share of so-called “routine” occupations, particularly in the manufacturing sector.

The chapter also looks at strategies policymakers can consider to support displaced labor. Some policies may be temporary in nature, for instance unemployment benefits, or active labor market policies, such as job training or subsidies. However, policymakers need to also consider policies of a longer-lasting duration, including retooling of income policies and tax systems. Further, redesign of education and training policies to prepare people for rapid technological changes will be key.

See recent blog on Maintaining the Positive Momentum of the Global Economy by the IMF Managing Director, Christine Lagarde and the IMF G-20 surveillance note.

Addressing Persistently Sluggish Growth

A new report from the IMF “Labor and Product Market Reforms in Advanced Economies : Fiscal Costs, Gains, and Support” looks at concerns about persistently sluggish growth amid high public debt and mounting long-term fiscal pressures in advanced economies.

High on the agenda are a range of reforms designed to strengthen the functioning of product and labor markets. Nevertheless, progress toward these reforms has remained slow because of political opposition and concerns about their distributive and short-term economic effects. Reform adoption may also have been hindered by strained government budgets.

This raises questions about the fiscal costs and gains from reforms. To what extent can reforms help strengthen fiscal positions over the medium term? Can policy packages combining reforms with temporary upfront fiscal support yield a net fiscal gain over the medium term as well as facilitate implementation?

Persistently sluggish growth has led to growing policy emphasis on the need for structural reforms that improve the functioning of labor and product markets in advanced economies. However, reforms have progressed slowly because of political opposition and concerns about their distributive and short-term economic effects. At the same time, the ability to cushion these effects is hindered by high public debt and mounting long-term fiscal pressures. This note provides new empirical analysis, numerical simulations, and case studies to assess the fiscal impact of labor and product market reforms in advanced economies and evaluate the case for complementing reforms with fiscal support. As such, it provides a major addition to recent IMF analysis that examined the output and
employment effects of reforms.

Main findings of the analysis:

Most labor and product market reforms can strengthen medium-term public finances indirectly by raising output. In some cases, such as lower entry barriers for firms, this indirect fiscal gain can be sizable. In other instances, the gains can be amplified or offset by the direct fiscal impact of the reform. For instance, unemployment benefit reforms improve fiscal outcomes both indirectly and directly through lower spending, but the up-front costs of labor tax cuts and higher spending on active labor market policies are only partly recouped over time as output rises. A budget-neutral implementation of these reforms can yield unambiguous fiscal gains.
The effects of reforms on fiscal outcomes depend on business cycle conditions. Employment protection reforms strengthen fiscal positions in an expansion, but weaken them in periods of slack due to their short-term output cost. Similarly, the fiscal gains from unemployment benefit reforms are larger under strong cyclical conditions. In contrast, debt-financed labor tax cuts and active labor market policy spending have stronger indirect positive effects on public finances in times of economic slack because of larger fiscal multipliers, which must be weighed against their direct costs.
Under weak cyclical conditions, a package combining certain labor market reforms—such as easing job protection or reducing the level or duration of unemployment benefits where particularly high—and credible, temporary, and well-designed up-front fiscal stimulus on average can yield a net fiscal gain over the medium term. This is because the stimulus enhances the effect of these reforms on output and thereby on tax revenues. The package is self-financed over the medium term insofar as the increase in tax revenues from the reform exceeds the financing cost of the initial stimulus. The cost of temporary up-front fiscal stimulus may also be fully offset by subsequent gains if it helps reduce political obstacles to major reforms that yield medium-term fiscal gains, for instance by improving their distributive impact. However, country-specific circumstances—such as government funding costs and their response to stimulus, the magnitude and quality of that stimulus, and the strength of reform implementation—affect the extent to which such gains can be reaped.
Case studies suggest that fiscal incentives have indeed facilitated reforms by alleviating transition and social costs. These incentives comprised permanent reductions in distortive taxes and one-time measures, accompanied by a strong consensus and political commitment to reform. Even so, reforms have occasionally been reversed. Incentives have been provided in the context of either a supportive overall fiscal stance or fiscal consolidation—in which case they were financed by other reforms or harmful cuts in public investment. Policy implications—The case for temporary fiscal stimulus and incentives for labor and product market reforms depends on the type of reform, the initial cyclical position, the credibility of the political commitment to and consensus for comprehensive reforms—including strong ownership—and available fiscal space.
Countries with fiscal space can use it to provide temporary up-front reform support, especially if there is economic slack. Such support can take the form of targeted budgetary incentives to mitigate adjustment costs, especially for the most vulnerable; recalibration of distortive fiscal
measures; or other spending that raises long-term output—for example, infrastructure spending on high-return projects. A strong commitment to reforms is an essential prerequisite.
In countries that lack fiscal space, the decision to provide up-front fiscal support depends on the credibility of the government’s commitment to strong implementation of comprehensive reforms and sustainable fiscal policies. If these are forthcoming, temporary up-front fiscal support could in theory help mitigate the short-term economic or social costs of some reforms while delivering a medium-term fiscal gain. However, if a country’s commitment to fiscal prudence and reforms lacks credibility because of weak ownership or a track record of reform reversals or weak implementation, fiscal support is not warranted even when cyclical conditions are weak. In such cases, careful prioritization and sequencing of reforms are crucial to maximize output and fiscal gains and ensure that they are widely shared. Lower-cost measures with a beneficial impact on output and public finances, such as product market reforms, should be
implemented first. Labor market reforms should be designed in ways that mitigate possible short-term costs—for example, passing employment protection reform that takes effect over time can immediately boost hiring. Unemployment benefit reforms, labor tax cuts, and active
labor market policies should be implemented in a budget-neutral manner. Fiscal incentives could be considered, but as part of broader growth-friendly fiscal rebalancing. However, offsetting their cost by cutting public investment would be highly counterproductive.
The design and implementation of fiscal rules should encompass the flexibility to incentivize reforms and acknowledge their medium-term fiscal benefits. Such flexibility reduces the risk that support for reforms will be offset by harmful cuts in public investment. To preserve the credibility of the fiscal framework and confidence in efforts to ensure fiscal sustainability, such flexibility should be conditional on a credible political commitment to strong reforms (possibly only after the reforms), as well as on a strong medium-term fiscal plan. Institutions such as politically independent fiscal councils and productivity commissions can be helpful on this front.

Latest Global House Price Watch Warns On Australian Housing

The IMF has released their latest quarterly Global Housing Watch report. They classify Australia as in a “Boom” phase.

By some metrics, housing market conditions have cooled and credit growth to households has slowed, but risks related to house price and debt levels have not yet decreased.

Their specific assessment on Australia points out that house price gains have moderated [but this does not reflect more recent events]. However, the extent of cooling has varied considerably across cities. The strongest price increases continue to be recorded in Sydney and Melbourne, where underlying demand for housing remains strong. With house prices still rising ahead of income, standard valuation metrics suggest somewhat higher house price overvaluation relative to the previous IMF assessment.

The latest IMF assessment says that signs of commercial real estate overvaluation have emerged. Commercial real estate prices in Australia have increased rapidly since mid-2014. Rents have not followed at the same pace, and the price-to-rent ratio is now above average. Whether the latter is a good metric of fair value is difficult to assess. Risks to financial stability from any potential CRE overvaluation appear manageable. The share of commercial real estate lending in commercial banks’ total assets decreased in the past few years and has now stabilized at around 5 percent.

Overall the IMF’s Global House Price Index—an average of real house prices across 57 countries — continued to climb up in the third quarter of 2016. This is the sixteenth consecutive quarter of positive year-on-year growth in the index.

They classify countries by “Gloom”, “Bust and Boom” and “Boom”.

Gloom

Brazil: Rio de Janeiro, China: Shanghai, Croatia: Zagreb, Cyprus: Nicosia, Finland: Helsinki, France: Paris, Greece: Athens, Macedonia: Skopje, Netherlands: Amsterdam, Russia: Moscow, Singapore: Singapore, Slovenia: Ljubljana, and Spain: Madrid.

Bust and Boom

Denmark: Copenhagen, Estonia: Tallinn, Hungary: Budapest, Iceland: Reykjavik, Indonesia: Jakarta, Ireland: Dublin, Japan: Tokyo, Latvia: Riga, New Zealand: Auckland, Portugal: Lisbon, South Africa: Johannesburg, United Kingdom: London, and United States: San Francisco.

Boom

Australia: Melbourne, Austria: Vienna, Belgium: Brussels, Canada: Toronto, Chile: Santiago, Colombia: Bogota, Hong Kong: Hong Kong, India: Delhi, Israel: Tel Aviv, Korea: Seoul, Malaysia: Kuala Lumpur, Mexico: Mexico City, Norway: Oslo, Slovakia: Bratislava, Sweden: Stockholm, Switzerland: Zurich, and Taiwan: Taipei City.

The position of Australia on the price growth is probably understated (based on more recent data).

Credit growth in Australia is towards the upper end of the countries listed.

The price to income ratio is Australia is relatively high.

The house price to rent ratio shows Australia above the average.

This suggests the housing issues are global in nature, and not exclusively the result of local policy settings! Many countries are are feeling the draft from low interest, and rising home prices.

Islamic Banking Proposals Get IMF Approval

From IMF Direct.

Islamic banking, a small but fast-growing corner of the financial world, is receiving greater attention from regulators and policy makers. The IMF recently adopted a set of proposals on Islamic banking and called for a more comprehensive set of policies to ensure financial stability in countries with Islamic banking and support the sound development of the industry. The IMF is now calling for additional work and cooperation by its staff with other international agencies to improve the adoption of relevant standards for Islamic banking and to address remaining regulatory gaps.

The industry mushroomed to more than $1.5 trillion in assets last year from about $100 billion in the late 1990s and now has a presence in 60 countries, mostly in the Middle East and South and Southeast Asia, but increasingly in Africa, Central Asia, and Europe. While it represents less than 2 percent of global banking assets, its share is much bigger in many countries and has become systemically important (meaning its assets account for more than 15% of the total) in 14 of them, including Malaysia, Kuwait, and Saudi Arabia.

Islamic banking in numbers

Islamic banking refers to financial services that conform with Islamic finance principles, which bans interest, excessive speculation, gambling and short-sales; requires fair treatment; and institutes sanctity of contracts.Islamic banking has the potential to make financial services more widely available to people who are currently underserved and to support economic development. What’s more, its guiding principles can promote financial-sector resilience. Yet the industry’s rapid growth and characteristics that distinguish it from conventional banking pose challenges for supervisors and central bankers. As a result, there is broad international recognition of the need for a policy framework and an environment that promotes the financial stability and development of the industry.

International norms

For more than a decade, the Kuala Lumpur-based Islamic Financial Services Board has led efforts to develop regulatory and supervisory standards that complement existing international norms in areas relevant to Islamic banking. This process culminated in 2015 with the development of the “Core Principles for Islamic Finance Regulation” for banking. Now the challenge will be to ensure that these standards are applied broadly and consistently.

A number of other important areas still need to be addressed. These include developing robust resolution regimes (to deal with failing banks) and other financial safety nets and expediting the issuance of high-quality liquid assets such as sovereign Sukuk, a type of government-issued security. Finally, the recent emergence of hybrid financial products that replicate aspects of conventional finance in an Islamic banking context have raised new and complex risks that remain to be addressed by regulators.

Navigating The New Moderate

The IMF, alongshore its release today published a report on aspects of the Australian economy, looking mainly at the labour market, monetary policy and Government debt. It makes salutary reading. Its a big report, but the main take-outs on our reading are:

Labour Market

Though we seem to have managed to keep unemployment under control though the mining downturn, under-employment and static income growth are the consequences. This will continue for some time.

However, long term unemployment has risen and unemployment is higher than consistent with labor market equilibrium.

Monetary Policy

Growth will remain sluggish, and the RBA may need to cut rates further, but the net effect will be to smooth the outcomes, but not enough to reverse the growth trend. The IMF suggest the equilibrium interest rate has declined from around 2% to 1% now.

The policy rate has been below the equilibrium throughout most of the post-GFC recovery, indicating that monetary policy has been in a ‘loose’ stance.

The IMF also says there is room for greater policy transparency from the RBA.

Fiscal Policy

In recent years, the repeated ambitious fiscal consolidation to reach medium-term fiscal targets under a slowly recovering economy highlights the traditional focus on medium term fiscal objectives. Ambitious budget repair strategy risks being destabilizing in the short term.

Whilst, budget repair is required to return to the Government’s medium-term balance anchor, its pace is in question. The Government will find it difficult to reduce debt in the short to medium term. The IMF says a flexible long-term debt anchor can reinforce the commitment to debt sustainability under both temporary and persistent shocks and still allow for fiscal policy to a play a role in short-term macroeconomic stabilization. The medium-term budget balance anchor is less robust in
maintaining long-term sustainability in the face of persistent negative shocks.

IMF Says Australia’s Housing and Debt Risks Remain

On February 3, the Executive Board of the International Monetary Fund (IMF) concluded the 2016 Article IV consultation with Australia.

Australia has enjoyed robust growth despite the commodity price and mining investment bust. The moderate impact of the large shocks since 2011 highlights the resilience of the economy and strong policy frameworks. From mid-2015, the recovery advanced with a marked pickup in activity, although underlying demand growth remained close to trend. Nevertheless, Australia has not been immune to some elements of the “new mediocre.” Wage and price pressures have been weak, underemployment has risen, and private business investment outside mining has been lackluster.

By some metrics, housing market conditions have cooled, in tandem with intensified prudential and regulatory steps, but risks related to house price and debt levels remain. In the continued low interest rate environment, house prices and household debt have risen further but house price growth has moderated. Intrinsic housing market risks are localized. Bank lending to household has slowed, especially in riskier loans, and banks have strengthened their balance sheets.

With inflation below the target range of 2-3 percent and a downshift in the path of inflation expectation in 2016, the Reserve Bank of Australia (RBA) lowered its policy rate by another 50 basis points to 1.5 percent. Core inflation has since stabilized at around 1.6 percent. Wage growth has remained weak, with nominal unit labor costs running at less than 0.5 percent on average, and cost pressures have been virtually absent suggesting that some economic slack is still present.

The federal government has recently aimed for substantial near-term fiscal consolidation but budget targets have not been met because of weaker nominal income. In the FY2016/17 budget, the government has projected a return to fiscal balance by FY2020/21. It has renewed its commitment to a federal government surplus of 1 percent of GDP over the business cycle as a medium-term fiscal anchor, which would imply a cumulative adjustment of up to 3.4 percent of GDP. The Mid-Year Economic and Fiscal Outlook 2016-17 (MYEFO) foresees a cumulative adjustment of the fiscal balance of 2.1 percent of GDP by end of FY2019/20, primarily related to stronger personal income tax collection due to bracket creep.

Recent structural reforms have focused on fostering innovation. The National Innovation and Science Agenda (NISA) includes measures to boost innovation and entrepreneurship in the high-tech sector, including through tax breaks. Legislation is being prepared for key components of the Harper Review, which has identified a number of reforms to boost competition and productivity in the services sectors, and to strengthen competition policy broadly.

Executive Board Assessment

Executive Directors noted that Australia’s robust economic growth and low unemployment during the current terms-of-trade adjustment reflect the resilience of the economy and strong policy frameworks. While the balance of risks to the growth outlook has improved, there remain significant risks and uncertainties, notably weaker-than-expected domestic consumption, housing-related vulnerabilities, the rise in protectionist policies in the global economy, and a significant slowdown in Australia’s main trading partners. Against this background, Directors stressed the importance of maintaining supportive macroeconomic policies, addressing macro-financial vulnerabilities, and boosting long-term potential growth.

Directors noted that continued demand support is needed to ensure a smooth transition to non-mining growth. They agreed that, with inflation below target, still elevated underemployment, and remaining economic slack, the monetary policy stance should remain accommodative. Directors welcomed the authorities’ readiness to ease monetary policy further if warranted, and encouraged steps to improve policy communication.

Directors supported the government’s plans to balance its budget over four years and make its expenditure composition more growth-friendly. Many Directors saw scope for using the available fiscal space to support aggregate demand and structural fiscal reforms, as well as increase infrastructure investment. Many other Directors viewed the authorities’ front-loaded consolidation path as appropriately prudent under the current circumstances. Directors welcomed the intention to take a flexible approach if large downside risks materialize, noting that contingency plans would also be helpful. While the current medium-term fiscal framework has served the economy well, Directors recommended that the authorities continue to consider options to strengthen it further.

Directors commended the progress in enhancing prudential and regulatory measures to mitigate risks associated with the housing market, and in improving AML/CFT safeguards in the real estate sector. They encouraged the authorities to remain vigilant and continue to enhance the resilience of the banking system to shocks with macro-financial implications, including by encouraging banks to strengthen their capital position. Financial regulatory authorities would need to stand ready to intensify targeted prudential measures, if lending or house price growth were to re-accelerate, while advancing the implementation of the regulatory reform agenda.

Directors welcomed the government’s structural reform agenda to boost productivity through fostering innovation and strengthening competition, especially in the services sector. They commended the authorities for their commitment to an open economy in trade, foreign investment, and immigration.