GFC and sovereign risk: Mitigating measures and solutions from down under

Paper presented at the International Federation of Accountants Conference, March 19-20, 2012, Vienna, Austria: The sovereign debt crisis, a matter of urgency? From lessons to reform

CEDA, Chief Executive, Professor the Hon. Stephen Martin

INTRODUCTION

The Global Financial Crisis (GFC) was followed by the deepest recession in the world economy since World War II. However, it could be argued that this was largely a 'northern hemisphere' problem, with its severest effects felt in the United States and Europe.  Its consequential effects were not as severe in developing and emerging economies, or in some other developed economies such as Australia.

Governments in developed economies utilised enormous amounts of fiscal and monetary policy stimulus during the height of the GFC to strengthen demand and to restore financial stability in the banking system. Consequently even now interest rates are currently close to zero, while public debt burdens have swelled to the highest levels since the 1940s. Policy makers have had to resort to less orthodox measures to stimulate demand, including quantitative easing and manipulating the yield curve [1].

Northern hemisphere economies have recovered very slowly and continue to reflect deep malaise in the finance and banking, housing and industrial sectors. Importantly, the seeds of the current European sovereign debt crisis were sown prior to the GFC, were intensified during this time and continue to plague economic recovery in the Eurozone and potentially beyond. They have again focussed the world's attention on issues of globalisation, financial stability, regulatory regimes and political will to take hard decisions.

While various austerity measures and political accommodations devised by European leaders to delay the onset of an "event" have engendered bursts of optimism, financial and equity markets remain nervous and the risk of contagion from an indebted European country default remains elevated.

The Australian economy performed better during the GFC than other advanced economies on nearly all relevant indicators, and continues to do so in the face of current European upheavals. Financial conditions were stressed, but the financial system held up remarkably well; the economy slowed, but did not fall into recession; and while unemployment rose, it did so by far less than in many other advanced economies.

Although Australia was exposed the combined actions of the Government through discretionary fiscal expansion and aggressive monetary policy responses by the independent Reserve Bank of Australia (RBA) achieved remarkable outcomes. Whilst the delivery of several of the government's fiscal stimulus programs were open to criticism, there is no doubt the underlying strength of the Australian economy and its financial and regulatory system ensured Australia did not go the way of so many other western economies.

A range of factors have been advanced to explain the relatively strong performance of the Australian economy during and since the GFC. These include the strength and stability of the Australian financial system; a strong regulatory environment; prudent fiscal and monetary policies pursued by Governments of different political colours over a significant period that have avoided public debt issues while maintaining non-inflationary growth; the flexibility of the exchange rate; and the performance of Australia's major trading partners, particularly China. [2]

As a consequence of this underlying strength and the reasons behind it, lessons leant from the GFC and its limited exposure to European finances Australia is better positioned than most advanced economies to withstand the impact of the current European sovereign debt crisis. This paper examines Australia's response to both the GFC and current European sovereign debt crisis, and suggests why it was as resilient as it was and remains so. Lessons for policy makers are advocated.

GFC- A RE-CAP

The causes of the GFC have been well-documented [3]. The United States sub-prime crisis that began in mid-2007 caused financial institutions to lose confidence in lending to each other. A credit crisis throughout late 2007 and 2008 ensued, with the supply of liquidity and credit to financial institutions, businesses and households gradually drying up, and interbank lending spreads widening.

This situation took a dramatic turn for the worse in mid-September 2008 with the collapse of Lehman Brothers, the fourth-largest investment bank in the US. Confidence plunged - due to concerns over counterparty exposure to Lehman Brothers, further major institutional failures, and fear of a systemic crisis. Banks were considerably less willing to lend to each other and global credit markets effectively froze. Other institutions either sought to become commercial banks (Goldman Sachs, Morgan Stanley), or failed (Washington Mutual). The contagion spread to Europe, resulting in the collapse of several banks [4].

In response to worsening conditions in the US, Congress provided Treasury with US$700 billion to purchase the troubled assets of and take direct equity stakes in financial institutions. The Government subsequently announced a plan to purchase equity from financial institutions and guarantee all senior unsecured debt issued by eligible financial institutions, as well as guaranteeing non-interest bearing transaction deposit accounts.

European nations also agreed to a package of measures to support the European financial system, including the guarantee of interbank loans and the purchase of equity in banks.

Notwithstanding these responses, a sharp deterioration in global financial conditions, with global financial markets highly stressed and financial institutions coming under extreme pressure, ensued. Equity prices fell under the weight of heightened uncertainty and risk aversion, solvency and liquidity was affected, causing share prices of banks to fall sharply.

A sharp deterioration in economic conditions- growth fell from 3.8% in June quarter 2008 to -2.8% in March quarter 2009- was accompanied by a collapse of global capital inflows, particularly in advanced economies. The volume of world trade fell sharply, and the pace of global industrial production growth slowed.

GFC AND AUSTRALIA

Australia was not immune from the global financial crisis but its impact could have been far worse. Businesses faced tighter credit conditions and higher funding costs, and falling asset prices raised the cost of capital funding from the share market. Business conditions generally, and investment intentions specifically, became subdued and confidence slumped. Sharp falls occurred on Australian share markets.

Demand for Australia's exports slowed with resulting falls in volumes and prices leading to subsequent falls in terms of trade and the exchange rate. Household financial wealth fell by around 16 per cent through the year to the June quarter 2008. The significant fall in consumer confidence resulted in weaker growth in household consumption and dwelling investment.

These combined to affect the Government's budget position and were reflected in revised GDP growth, unemployment rate and revenues [5]. Yet whilst the Australian economy slowed under the weight of global forces, the slowdown was much more moderate and the economy recovered more quickly than in most other advanced countries.

Business confidence recovered following the announcement of the Nation Building and Jobs Plan in February 2009 and a further cut in the official cash rate [6]. Consumer confidence rebounded sharply following the announcement of the March quarter 2009 GDP outcome, where the economy recorded solid positive growth, avoiding two consecutive quarters of falling real GDP.

Australia's unemployment rate peaked at 5.8 per cent compared with the OECD average of 8.8 per cent and economic activity rebounded in the March quarter 2009.

Australian Government's Response to the GFC

The Government was well prepared to deal with the contingencies flowing from a worsening international economic outlook.  Its 2008-09 Budget had been based on striking a balance between tackling inflation and responding to the risks posed by global economic conditions [7]. It had strengthened its financial position by building a $21.7 billion surplus to provide future policy flexibility and supported households by delivering tax cuts and increasing social welfare payments to pensioners and carers.

Additionally the RBA moved to protect growth and financial stability by providing liquidity to financial institutions as international money markets became dysfunctional and reducing the official cash rate rapidly as conditions dictated- an option not available to other economies where interest rates were already low.

However the dramatic shift in the macroeconomic outlook required the Government to implement a raft of proactive policy responses that included:

• Increasing the issue of Commonwealth Government Securities by up to $25 billion to ensure the smooth operation of Australia's financial markets, including enabling the Australian Office of Financial Management (AOFM) to purchase of $8 billion in prime, AAA-rated residential mortgage-backed securities (RMBS) that met strict criteria in relation to the quality of the underlying mortgages. The investment was of particular assistance to non-authorised deposit-taking institutions (ADIs) to restore competition in Australia's mortgage market.
• Guaranteeing the deposits of authorised deposit-taking institutions for a period of three years, with a $1m threshold below which no fees were charged
• Guaranteeing the wholesale funding of authorised Australian deposit-taking institutions to enable them to raise funds overseas with the same level of support as foreign institutions that received government guarantees, restore confidence in credit markets and ensure that Australia's financial sector continued to lend to Australian corporations, businesses and households [8].
• Establishing a Financial Claims Scheme [9] to provide depositors and general insurance policyholders with access to their funds in the event of a financial institution failure, and changes to the regulatory framework to allow better management of failing financial institutions [10]
• Strengthening the protection of consumers of financial services across Australia with the Commonwealth taking over responsibility for the regulation of mortgages, mortgage brokers, margin lending and non-bank lending and endorsed an implementation plan for the regulation of remaining areas of consumer credit
• Prohibiting short selling through the combined actions of the Australian Stock Exchange and Australian Securities and Investments Commission (ASIC).

As the outlook for financial markets and the global economy deteriorated further the Government announced it would guarantee deposits and wholesale funding of authorised deposit-taking institutions; invest a further $4 billion in RMBS, bringing the total investment to $8 billion; and enact a $10.4 billion Economic Security Strategy [11].

As a consequence of these and other measures, Australia's major banks retained their AA credit ratings. No Australian bank or other authorised deposit taking institution failed, while in the United States, over 100 banks failed between January 2007 and August 2009 [12]. Australian banks also remained profitable and were able to access capital markets, enabling them to continue to lend [13].

Economic Security Strategy

A second critical element of the Government's response was a $10.4 billion discretionary fiscal stimulus package of around 1 per cent of GDP, overwhelmingly focused on the first half of 2009 and tightly targeted at those sectors of the economy showing the greatest weakness - household consumption and dwelling investment [14].

The package consisted of:

• $4.9 billion for an immediate down payment on long-term pension reform - a one-off payment of $1,400 to eligible single pensioners and $2,100 to eligible pensioner couples, including Commonwealth Seniors Health Card holders, as well as a one-off payment of $1,000 to Carer Allowance recipients for each person in their care;
• $3.9 billion in support payments for low and middle income families - a payment of $1,000 for each child in families eligible for Family Tax Benefit (A);
• $1.5 billion investment to help first home buyers purchase a home - from the date of the announcement to 30 June 2009, the Government  introduced the First Home Owners Boost for established homes of $7,000 (to take the total grant to $14,000), and for newly-constructed houses of $14,000 (to take the total grant to $21,000);  and
• $187 million to create 56,000 new training places under the 2008-09 Productivity Places Program.

This initiative was complemented with a $42 billion NationBuilding and Jobs Plan that included payments to low and middle income earners and investment in schools (although the Building the Education Revolution (BER) program was heavily criticised), housing, energy efficiency (the 'pink batts' fiasco was a major negative), community infrastructure, roads and support for small businesses.

Whilst nearly all the stimulus was delivered in 2008-09 the package was seen to fit squarely with principles underlying effective discretionary fiscal stimulus- early, temporary and targeted- and complemented the boost to economic activity from interest rate cuts particularly in the first half of 2009.

International financial institutions strongly endorsed Australia's response to the GFC. IMF commended the 'quick implementation of targeted and temporary fiscal stimulus' considering that it provided a sizeable boost to domestic demand in 2009 and 2010 [15]. OECD concluded that Australia's fiscal stimulus package 'was among the most effective in the OECD' and not only 'helped to avoid a recession as usually defined' but also that it 'had a pivotal role in boosting overall confidence' [16]. It attributed the effectiveness of the stimulus to both the size of the measures and the speed with which it was introduced [17].

The immediate effects of this stimulus dissipated from late 2010 and the transition from public to private demand accelerated accordingly.

EUROPEAN SOVEREIGN DEBT CRISIS

The current European sovereign debt crisis has been created by a combination of complex factors that include the globalization of finance; easy credit conditions during the 2002-2008 period that encouraged high-risk lending and borrowing practices; international trade imbalances; real-estate bubbles that have since burst; slow growth economic conditions 2008 and after; fiscal policy choices related to government revenues and expenses; and policy responses used by nations to bail-out troubled banking industries and private bondholders, assuming private debt burdens or socializing losses.

Its beginnings were manifest when several European countries faced the collapse of financial institutions, high government debt and rapidly rising bond yield spreads in government securities. With the collapse of Iceland's banking system in 2008, the crisis spread primarily to Greece, Ireland and Portugal during 2009. In 2010-11, the crisis touched other significant economies such as Spain and Italy, and even threatened the powerhouses of UK, Germany and France in different ways [18].

Before the GFC, several governments, most notably those of Portugal, Italy, Ireland, Greece, and Spain had been able to finance their deficits at artificially low interest rates. Some had accumulated unsustainable levels of public debts. Markets assumed that if the national situations got worse, these governments would be bailed out by other Eurozone countries in order to forestall a breakup of the euro.

Equipped with this implicit guarantee, many governments did not address structural problems such as uncompetitive labour markets or unsustainable welfare systems but papered over these problems with government deficits. As the financial crisis hit government deficits soared due to increasing public spending and falling revenues. Since Eurozone countries are not able to conduct their own monetary policy, they have a higher default risk than countries that can.

Various rescue funds were devised, but with expectations from contributor nations that appropriate austerity measures would be implemented to reign in sovereign debt. From mid-2010, emergency and longer-term measures have been pursued by Eurozone members and individual states that have included various bank-sponsored rescue packages including those offered through European Financial Stability Facility [19], European Central Bank interventions, European Financial Stabilisation Mechanism and the European Stability Mechanism.

Europe's sovereign debt problems, together with a reassessment of European and US growth prospects [20], have raised risk aversion, and helped trigger a period of heightened turbulence in global financial markets [21]. Downgrades of Europe credit risk in January and February 2012 has heightened tensions, with economists and politicians divided on whether austerity measures being required as a condition of bailouts by the larger economies are in fact counter-productive, with the potential to exacerbate weak economic conditions in several countries [22]. The continuing turbulence in Greece and uncertainty about rescue packages for ailing economies highlights the more general difficulties faced by Eurozone countries [23].

AUSTRALIA'S ECONOMY- PREPARED FOR GFC AND EUROPEAN SOVEREIGN DEBT CRISIS

When the Commonwealth of Australia was created in 1901 it brought together the various colonies that had operated almost as independent countries within a political union. Importantly, the various Sates shared a common language and similar cultures and the new Federal Constitution provided for free trade in goods and services. The political union was accompanied by economic and currency union, thus ensuring all the necessary prerequisites for a strong single entity were created. The Constitution that was adopted clearly allocated responsibilities for trade, defence, education and the like between the federal and state jurisdictions.

In the case of the Eurozone, currency union may have been achieved but vastly different regulatory systems, cultures and languages have hindered the development of economic union and the third critical element is missing.

In understanding why Australia fared so well during and after the GFC, why the potential impact of the current European Sovereign Debt Crisis on its economy is relatively modest, and what lessons may be there for others to emulate, past and recent economic history must be appreciated.

Critical to this is recognising the near two decades of substantial economic reform that occurred in Australia in the 1980's and 1990's, and the consolidation of those reforms that subsequently occurred. These reforms, along with the underlying strength of the economy, the soundness of the financial sector, and the significance of trade with the Asian region are the most important factors in explaining these outcomes [24].

Australian Economic Reforms

Reforming Australia's economy began with the Hawke-Keating Labor Governments of the 1980's and early 1990's and consolidated under the Howard Coalition Government from mid-1990's to 2007. The Rudd-Gillard Labor Governments subsequently inherited a fundamentally strong economy that would assist in meeting the challenges of the GFC and those associated with the current European difficulties [25], but must be credited with taking some immediate and effective policy decisions as outlined earlier.

The most substantial economic and social reforms of the 1980's and 1990's included [26]:

• Trade liberalisation - reductions in tariff assistance and the abolition of quantitative import controls saw the effective rate of assistance to manufacturing fall from around 35 per cent in the early 1970s to 5 per cent by 2000.
• Capital markets - the Australian dollar was floated in March 1983, foreign exchange controls and capital rationing (through interest rate controls) were removed progressively and foreign-owned banks were allowed to compete.
• Infrastructure - deregulation and restructuring of airlines, coastal shipping, telecommunications and the waterfront occurred from the late-1980s. Commercialisation, corporatisation and privatisation initiatives for government business enterprises were progressively implemented from around the same time.
• Labour markets - progressively were freed, commencing with the Prices and Incomes Accord, award restructuring and simplification, and the shift from centralised wage fixing to enterprise bargaining. Politics and reform accelerated and collided from the mid-1990s with the introduction of the Workplace Relations Act 1996, further award simplification and the introduction of individual employment contracts. Subsequent significant changes were introduced by the Rudd/Gillard Governments through the Fair Work Act, 2008.
• Human services - competitive tendering and contracting out, performance-based funding and user charges were introduced in the late-1980s and extended in scope during the 1990s; administrative reforms (for example, financial management and program budgeting) were introduced in health, education and community services in the early 1990s.
• 'National Competition Policy' reforms - in 1995, further broad-ranging reforms to essential service industries (including energy and road transport), government businesses and anticompetitive regulation were commenced by all Australian governments through a coordinated national program.
• Macroeconomic policy - inflation targeting was introduced in 1993. From the mid-1980s, fiscal policy targeted higher national saving (and a lower current account deficit) and, from the mid-1990s, concentrated on reducing government debt, primarily financed through privatisation.
• Taxation reform - variously embracing capital gains tax; dividend imputation system; company tax; broad-based consumption tax (GST); and income-tax rates
• Superannuation reform- imposition of compulsory superannuation through employer contributions of 9% for every worker.

Of particular significance in shaping Australia's economy because of its impact and policy responses was the debt crisis that Australia confronted in the mid- to late 1980's. The Treasurer famously suggested that if substantial economic reforms were not undertaken Australia would become a 'banana republic' [27], and ratings agencies reflected these sentiments by downgrading the country's risk ratings. Subsequently this led to a focus on reducing the budget deficit, the current account deficit and public and private debt levels and drove fiscal consolidation and other major reform proposals. The Howard Government extended this further with the introduction of the Charter of Budget Honesty legislation in 1998 [28].

Australia's underlying economic strength

The Australian economy was particularly strong going into the GFC, enabling it to weather the storm better than other advanced economies [29]. Strong demand for raw materials produced a sustained rise in global commodity prices, a once-in-a-generation upswing in Australia's terms of trade, and helped unemployment fall to a low of 3.9 per cent in early 2008.

Contrary to international experience where interest rates were already low, monetary policy in Australia was tight as the RBA battled rising inflation, leaving scope to cut interest rates when the GFC broke [30].  Australia's official cash rate reached 7.25 per cent in September 2008, and within seven months had been lowered to 3 per cent.

During the GFC Australia's financial institutions became more cautious in extending credit and business, consumers became more cautious in their borrowing and spending behaviour and business and consumer confidence plunged. These recovered earlier and much more strongly than in other countries due to the sharp cuts in interest rates, and the early and substantial fiscal policy response [31].

The impact of the global shock was ameliorated somewhat by the sharp fall in the Australian dollar. This buttressed the Australian economy, moderating the impact of sharply lower global prices for Australia's commodity exports, and improving the competitiveness of Australia's manufacturers and services exports, and import-competing industries.

Additionally, the Australian Government's fiscal position was strong, allowing ample scope for a large stimulus to support growth [32]. An extended period of domestic economic growth and windfall gains from the commodities boom had reduced net public debt to zero.

Unlike most other OECD economies, Australian house prices did not collapse during the GFC. While house prices rose, they were supported by strong demand for housing and there were no significant pockets of excess supply. Importantly, non-conforming housing loans made up around one per cent of outstanding housing loans. The soundness of Australia's financial system reflected the fact that Australian banks, building societies and credit unions had almost no presence in the Australian non-conforming housing loan market.

A possible contributor to the resilience of the Australian economy during the crisis is that it has a relatively small manufacturing sector - and a relatively large commodity sector - compared with the OECD average. The global shock appeared to fall heavily on the manufacturing and related sectors, so having a relatively smaller proportion of activity concentrated in those sectors could help explain Australia's relatively strong performance during the global downturn [33].

Strong financial institutions

The Australian banking system was well capitalised and profitable going into the crisis. Indeed, Australia's banks maintained their AA rating and profitability throughout the GFC- reflecting a combination of prudent regulation, less aggressive lending and securitisation practices, and having learned lessons from the heavy loan losses incurred in the recession of the early 1990s. Australia's 'four pillars' policy shielded the major banks from competition that might otherwise have induced them to adopt more aggressive (i.e. riskier) lending practices.

Corporate financial distress was limited and isolated by comparison with experience overseas. Household financial stress increased but was limited in light of significantly lower interest rates (following the substantial easing of monetary policy), higher levels of household saving, and stimulatory expenditure packages funded by the Australian Government.

The Australian banking system remains relatively strong [34]. It is considerably better placed to cope with periods of market strain, having substantially strengthened its liquidity, funding and capital positions over several years. Growth in bank deposits continues to outpace growth in credit, and the major banks are ahead of schedule on their term wholesale funding plans. Profitability for the major banks has been quite spectacular, mainly due to further declines in charges for bad and doubtful debts [35].

An inevitable consequence of rising funding costs and need to maintain profit levels been has seen the four majors announce jobs cuts and bucking the RBA interest rate settings process [42]. ANZ Bank and Westpac both have indicated they will cut about 1600 jobs as they adjust to weak demand for financial services. Despite earning about $24.3 billion in profit last year, the big four banks are looking at cost-cuts as a means to maintain those profit levels [43]. The major banks suffered a downgrade in their credit ratings to AA- in late February ^[44]. The political argy-bargy over interest rate movements will continue [45].

There has also been progress over the past several months on a number of other international regulatory initiatives, including developing a policy framework to address the risks posed by systemically important financial institutions (SIFIs), the move towards central clearing of over-the-counter derivatives and developing policy frameworks to address the risks posed by shadow banks.

The Government has introduced legislation into Parliament that would permit deposit-taking institutions to issue covered bonds. It has also announced the permanent arrangements to be put in place for the Financial Claims Scheme, following a review by the Council of Financial Regulators (CFR) of how the Scheme should be configured in a post-crisis environment. More recently, the CFR has been examining a number of issues related to the regulation and crisis management arrangements for financial market infrastructures in Australia.

However, a recent IMF working paper has warned that Australian banks should hold greater capital levels to survive the shocks of a new global financial crisis and in case of a collapse in the country's property market [36]. The banks' main vulnerability is their exposure to highly indebted households through residential mortgage lending with the four largest banks holding more than 80 per cent of Australia's mortgages.  While a series of new rules (Basel III) will be easily met, more may be needed, although Australia's banks disagree [37].  IMF indicated it was working on a stress test of the Australian banking system [38].

Whilst there is no disputing that the cost of raising money from offshore markets has risen as the European debt crisis has deepened [39] Australian banks do not rely on offshore markets to anywhere near the extent they did back in 2007. They are more geared to domestic markets and to longer-term debt, making them less susceptible to sudden movements on wholesale funding markets [40]. However, the scope for banks' domestic balance sheets to expand is more limited than in the years preceding the GFC, given the more cautious approach of the household and business sectors towards leverage [41].

Sound financial regulation

Australia has a coordinated and centralised framework for the regulation of most financial enterprises and it has benefited from years of rigid supervision by them [46]. Australia's "more coherent regulatory structure", with the Australian Prudential Regulation Authority (APRA) acting as the single prudential regulator for the financial services industry, has helped avoid some of the issues experienced elsewhere [47].

The evolution of Australia's system of financial regulation has been guided by a number of major reviews (Campbell (1981), Martin [48] (1991) and Wallis [49] (1997)), the lessons of the East Asian financial crisis in 1997 [50] and the collapse of HIH Insurance in 2001. In addition, the capacity of financial institutions to withstand economic shocks was stress-tested by APRA and IMF (2006).

The strongest indication that Australia's financial regulators made a positive contribution to the country's benign experience of the GFC is the recommendations for improvements to financial regulations that emerged from post-GFC investigations overseas. Most of the recommendations for strengthening global financial regulations already applied in Australia, or were in the process of being applied, by its regulatory authorities [51]. These included a strong regulatory regime and licensing system for financial sales, advice and dealings in relation to financial products; APRA's Product Disclosure Statement (PDS) regime designed to shield the Australian market from riskier products offered by overseas investment banks; regulatory framework around managed investment schemes; and regulatory oversight of auditors, financial advisers and other intermediaries.

Importance of the Performance of Major Trading Partners

While Australia's major trading partners were affected by the global downturn, they recovered more quickly than the world economy as a whole (and advanced economies in particular) in the first half of 2009. This was particularly evident in China.

The large emerging and developing economies in Asia have become an increasingly important destination for Australia's merchandise exports and was an important factor underpinning its strong performance during the GFC and beyond [52].

RBA has noted Australia's trade surplus reached a 40-year high as a ratio to GDP in the September quarter 2011, reflecting large increases in bulk commodity contract prices. More recently, a decline in iron ore and coal prices has resulted in a smaller trade surplus as well as a fall in the terms of trade from their record level.  Solid growth in export volumes has been outstripped by more rapid growth in import volumes, reflecting the appreciation of the Australian dollar and the sharp upswing in mining investment.

While Australia's aggregate trade balance remains close to record highs, this masks diverging trends in goods and services trade where a sizeable deficit in services trade has emerged. The latter trend has been driven largely by the increase in Australia's exchange rate, coupled with strong growth in Australian incomes [53].

Social/Economic Interconnectedness

Australia's current good fortune is not just about China's hunger for commodities, but also a rather admirable balancing act in targeting social welfare spending [54]. Australia's success has hinged on the ability to deliver a relatively high level of social safety (among the top half dozen or so OECD countries) while also being a relatively low-tax country (in the bottom third of the OECD).

AUSTRALIA'S ECONOMIC PERFORMANCE- NOW AND FUTURE PROSPECTS

Describing Australia's current economic circumstances is somewhat easy.  The IMF's Country Report on Australia in October 2011 indicated Australia's performance since the onset of the global financial crisis has been enviable and is being driven by a mining and investment boom expected to be long lasting, given the favourable prospects for sustained growth in emerging Asia ^[55].

In January 2012 intensifying risks to the international economy from the worsening European sovereign debt crisis prompted the IMF to slash its 2012 global growth forecasts [56]. Predicting the world economy will grow by only 3.3 per cent, down 0.7 percentage points from expectations of four months previously, it noted Europe would hit a mild recession that would create economic consequences for the world [57], echoing similar predictions by The World Bank [58]. However neither institution predicted the GFC. As a consequence it may be argued that the current figures and language being employed reflects a greater degree of caution than might otherwise be necessary.

In re-evaluating its previous report findings, IMF noted that Australia's underlying economic fundamentals were still very sound, with unemployment half the levels of Europe, a massive investment pipeline, contained inflation and very low government debt (24% of GDP, compared with United States 100%, Italy 120% and Greece 152%). Australia's major trading partners of China and India were forecasting solid growth, although these levels are more moderate than in past years [59]. Australia recently received the coveted AAA credit rating from all three global ratings agencies for the first time in its history [60].

This reassertion of Australia's economic health was in line with that made by the Government in its November 2011 Mid Year Economic and Fiscal Outlook [61] and the RBA's February 2012 Statement on Monetary Policy [62].  Both confirmed the factors currently influencing Australia's economy include the sovereign debt problems in Europe, changes in household spending patterns, softness in the housing market [63], the investment and terms of trade boom and very high exchange rate [64].

The once-in-a-century investment boom in the resources sector has witnessed business investment rising by around 20 per cent over the past year with more forecast. As a consequence, the RBA is expecting double digit increases in business investment in each of the next two years. It is occurring at a time when the terms of trade are also at a very high level, with the industrialisation and urbanisation of Asia supporting commodity prices and putting downward pressure on the prices of manufactured goods. The boom is having positive spill-over effects to a number of industries, with some of these effects being direct and others being indirect- hence the concerns about a multi-sector economy.

At the same time, the high exchange rate is having a contractionary effect on other parts of the economy, as it reduces the international competitiveness of some industries- notably manufacturing, tourism, education, agriculture and some business service sectors [65]. Over recent months, the Australian dollar has appreciated despite the uncertainty about the global economic outlook and some decline in commodity prices since mid 2011. After adjusting for differences in inflation rates across countries, the exchange rate is currently at around its highest level since the early 1970s.

RBA data has suggested that the pace of consumer spending has moderated, particularly in retail sales volumes and motor vehicle sales. While consumer confidence has recovered somewhat following the sharp decline in mid 2011, it remains below its long-run average with sentiment being affected by developments overseas, falls in asset prices and the softening in labour market conditions over 2011.

Household wealth was around 2½ per cent lower over the year, with a 3½ per cent fall in average dwelling prices more than offsetting a small rise in the value of financial asset holdings over the year.  In contrast to wealth, incomes have been growing strongly.  Households have continued to devote a significant portion of their income to rebuilding assets and paying down debt. Residential building activity was very soft in 2011 partly reflecting the earlier pull-forward of demand from the boost to grants to first home buyers in 2009, as well as lower expectations about capital gains from housing.

The government's fiscal strategy envisages three pillars:

1. achieving budget surpluses, on average, over the medium term;
2. keeping taxation as a share of GDP below the 2007-08 level on average (23½ per cent of GDP); and
3. improving the government's net financial worth over the medium term.

To achieve this aim, the government is committed to limiting spending growth. While the economy is growing at or above trend, real spending growth will be capped at 2 per cent annually until surpluses are at least 1 per cent of GDP.

Australia's unemployment rate has remained around 5¼ per cent in recent months, although employment growth has been soft and the participation rate has appeared to fall. Growth in total employment remains patchy, with mixed employment outcomes across industries and little net employment growth over 2011. In part this reflects structural adjustment to the resources boom and the accompanying high exchange rate.

Looking forward the RBA's central forecasts are for around trend growth in the economy over the next two years, and for underlying inflation to remain in the 2-3 per cent range. The unemployment rate is also expected to remain low (at around 5-5.25 per cent), although some increase is possible over coming months. At the industry level the economy is clearly going through a period of heightened structural change, and this is set to continue.

CONCLUSIONS

Australia's economy was in a much stronger position to withstand the fallout of the Global Financial Crisis than most other countries. Economic growth remained solid and the economy did not go into recession. Australia was a major beneficiary of the economic growth resulting from the industrialisation of emerging economies such as China and India. Furthermore, the Australian housing market did not possess the excess of physical stock that is evident in some overseas markets, particularly the United States.

The regulation and supervision of Australia's financial institutions was strong, effective and coherent. Australia's largest four banks are among only 11 of the world's top banks with AA credit ratings or above. The regulatory framework for the financial system implemented by high quality regulatory institutions helped Australia avoid the excesses that resulted from lax or ineffective prudential regulation in many other advanced economies.

A number of mutually reinforcing factors helped Australia outperform other advanced economies during the downturn, albeit some more important than others. Australia's recent economic history and the substantial changes that occurred in the underlying economic and social composition of the country are important determinants as to why Australia was able to withstand the dire effects of both the GFC and more recently the European sovereign debt crisis.

The Australian policy response was an important contributor. Rapid and large monetary and fiscal policy stimulus played a critical role in increasing effective demand and the early recovery of consumer and business confidence. The strength of Government's fiscal position meant that it was well placed to undertake an appropriate policy response to these developments. Fiscal stimulus estimates imply that growth would have been negative for three consecutive quarters (and hence a technical recession) absent fiscal stimulus.

Measures to support the financial system were important in ensuring continued financial stability in Australia, allowing the flow of credit to households and businesses to continue (albeit at a slower pace). Improved policy and institutional arrangements in following a quarter century of reforms have made the Australian economy much more resilient to external shocks.

More competitive and flexible product and capital markets - along with the weakness in domestic demand - meant that the sharp depreciation in the exchange rate helped cushion the impact of the downturn on the real economy, rather than simply resulting in higher prices and wages.

The Australian economy also benefited from the relatively early, and strong, recovery in growth in most of our major trading partners throughout 2009, which in turn was driven by substantial macroeconomic policy stimulus in those countries.

Australia's massive resources boom, the consequential investment phase currently underway, the insatiable demand for its resources from the Asian region and its relatively low exposure to European financial markets are all contributing to the current healthy state of the economy.

In practice, these explanations complement one another, with the combination of factors - both institutional and policy - working together to support the economy.

Finally, what lessons are there from Australia's economic experience that might be useful to other developed economies wrestling with recession or low growth [66]?

Currency union without fiscal union is an accident waiting to happen.

The longer-term goal for monetary policy (low, single-digit inflation) remains much clearer than for fiscal policy. The achievement of this goal of has important benefits, but also one serious drawback. It means that some economic shocks are now too big for monetary policy and the automatic stabilisers to cope with on their own. A significant discretionary fiscal stimulus is also desirable in response to such shocks.

What about fiscal consolidation? Can it be expansionary for the economy?

The answer to this question is yes, but mainly in countries where doubts about solvency have raised borrowing costs, and the consolidation could reduce these costs sharply.

There are undoubtedly substantial benefits from announcing and legislating far-reaching fiscal consolidation that begins once the economies have emerged from liquidity traps, and resumed good economic growth. However, in countries with high levels of government debt, political economy considerations can lead to a chosen path for fiscal policy that appears far from optimal.