Question

Dr. Edey wrote: “I am often asked why Australia was able to come through the GFC relatively unscathed. Unlike the US, the UK and the euro area, Australia didn't have a recession and we didn't have any bank failures. My usual response is that it was a mixture of good luck and good management.”

Explain what he means by “a mixture of good luck and good management,” making specific reference to both ad-hoc measures during the GFC and the general approach to financial stability. (max 400 words)

Answer 1

Australian Economy During Global Financial Crisis

Mixture of good luck and good management

Edey describes Australian economic stability under financial stress as mixture of good luck and management. We see below the factors which evolved and considered as good luck and also the better management of fiscal and monetary framework during the stress across the economy.

Australia is geographically well connected to the fastest growing part of the world economy Its demand for mineral resources has undergone a major expansion during the financial crisis Mining economy has played a major role in standing up against the economic stress during 2008-2009.

Australia's monetary and fiscal framework was sound, and it gave us plenty of scope to respond when the crisis hit. Interest rates were at relatively normal levels (actually on the high side of neutral) in the lead up to the GFC. This helped to limit some of the aggressive risk-taking seen elsewhere, and it allowed plenty of room to shift to a more expansionary stance when that was needed. On the fiscal policy front, successive governments had maintained high standards of discipline, and again this allowed plenty of room for expansionary action when needed.

At least as important as all this is that Australia was well served by its prudential regulatory framework. The post-Wallis framework that was put in place in 1998 established APRA as the integrated prudential regulator, affirmed the financial stability role of the RBA and set up the Council of Financial Regulators to ensure appropriate coordination among the regulatory agencies. Under APRA's leadership, Australian banks were held to much higher standards of resilience than many of their international counterparts. The banks remained profitable and well capitalised. Loan performance did deteriorate during the crisis period, but nowhere near as much as it did in the North Atlantic economies.

Financial system stability

A key factor underpinning the resilience of the Australian economy during this episode was the resilience of the Australian financial system. Australia’s financial system was appropriately regulated and well supervised in the lead-up to the crisis, and the underlying strength of the system was buttressed at a key time by both the Reserve Bank of Australia and the Government.

In sharp contrast with many other advanced economies, no major Australian bank failed during the financial crisis. Australian banks remained profitable, and were able to access capital markets, enabling them to continue to lend. Australia and Canada were the only advanced G20 countries not to provide a Government injection of funds to the banking system.

A key factor behind the stability of the Australian financial system during the crisis was its strong state before the crisis. Unlike many banks in advanced economies, Australian banks had not built up large exposures to exotic tradeable securities that were responsible for the bulk of losses at banks in other advanced economies. In particular, ‘Australian financial institutions had little exposure to complex structured instruments collateralised by US sub-prime mortgages.

Australian banks were also much more circumspect in their use of special investment vehicles and other devices that sought to transfer assets and liabilities off balance sheet through ‘shadow banking’ type activity. Household credit growth in Australia was underpinned by rising incomes and employment rather than declining credit standards, with relatively few low-doc or no-deposit mortgages compared with the United States.

A key reason for the strong position of the Australian financial system entering the crisis was the effectiveness of financial regulations and regulators in the lead up to the crisis.

It is also striking that ‘while all significant countries were operating on more or less the same minimum standards for bank supervision, some countries had serious financial crises, but many — in fact most — did not.

OECD analysis has found that banks in countries with stricter prudential regulation seemed to experience less of a run-up in share prices before the financial crisis but also less of a collapse afterwards with the net effect being positive overall.

However, indicators of the level of financial regulation are an imperfect measure of the effectiveness of regulators and regulations. In particular, Australia and Canada had less ‘strict’ regulation than most other OECD countries and, as noted above, were among the few advanced economies whose banking systems did not require capital injection from the public sector. This highlights the importance of implementation.

Another explanation for the strong performance of the Australian and Canadian financial systems during the GFC is the restrictions on competition for corporate control in the banking sector in both countries. Under this view, the effective protection from takeover or merger reduced the pressure on bank management to take bigger — and ultimately unsustainable — risks.

Nevertheless, it is clear that institutional and regulatory arrangements for the financial sector — following from both the implementation of the recommendations of the Wallis Inquiry and reforms following the collapse of HIH — were a key reason why the Australian financial system was better placed than those in many other advanced economies to cope with the global downturn.

Moreover, the sharp differences in experiences of countries with similar regulatory arrangements highlights the critical nature of supervisory practice and implementation, which in turn emphasizes the importance of the quality of financial regulators. Australia’s experience during the global downturn strongly suggests that it has ‘benefited from years of rigid supervision by “better than world-class” financial regulators.

Financial policy response

Despite the strong state of the Australian financial system in the lead up to the GFC, the extent of disruption in global financial markets, combined with actions of other countries, meant that Australian financial institutions’ access to the wholesale funding needed to continue lending was sharply impaired.

Moreover, at the height of the GFC the sudden lack of liquidity in key financial markets — including short-term debt securities and foreign exchange markets — and the resultant greater volatility in markets, posed risks even for highly rated solvent institutions.

In this context, measures put in place to support the financial sector over this period were clearly important for maintaining financial system stability and growth (and employment) in the economy.

The Reserve Bank acted appropriately to ensure continued liquidity in the Australian banking system and foreign exchange markets. The range of securities accepted from authorised deposit-taking institutions (ADIs) as collateral for the RBA’s Exchange Settlement facility was expanded and the RBA entered into a swap agreement with the US Federal Reserve to address the elevated pressures in US dollar short-term funding markets in the Asian time zone.

The Government put in place a range of other measures to support the financial sector, including providing government guarantees for deposits and for wholesale debt securities issued by ADIs, and directing the purchase by the AOFM of a substantial package of mortgage-backed securities.

The option for banks to issue securities with a government guarantee (for a commercial fee) was important in maintaining the continued flow of funding to banks during the GFC.

This suggests that the relative strength of the Australian financial system during the GFC is likely to have been a significant factor in the relatively strong performance of the Australian economy during the global downturn. Moreover, it is likely that the monetary policy response would have been considerably less effective had Australia’s financial system succumbed to the crisis in the manner of many other advanced economies.

Monetary policy

The Reserve Bank of Australia eased monetary policy significantly in response to the global downturn, with the official cash rate falling from 7.25 per cent at the start of September 2008 to 3 per cent in April 2009, a reduction of 425 basis points over seven Board meetings, with the bulk of this easing (375 basis points) occurring in the four Board meetings from October 2008 to February 2009.

Importantly, the bulk of this easing in the official cash rate flowed through to lending rates. With most households and business loans in Australia being variable, monetary policy was rapidly translated to a change in household disposable income (muted somewhat by many households choosing to maintain their regular repayments).

In contrast, in most advanced economies interest rates were already low at the start of the global downturn, leaving much less scope for monetary policy to respond

The extent to which monetary policy was able to support the economy may have been muted somewhat because of the nature
of the shock. Financial institutions became more cautious in extending credit during, and to a lesser degree, after the downturn, and business and consumers became more cautious in their borrowing and spending behaviour.

One intangible, but nonetheless important transmission channel for monetary policy is through effects on confidence. Business and consumer confidence plunged in the early part of the crisis, but they recovered earlier and much more strongly than in other countries. It is reasonable to assume that the sharp cuts in interest rates, and the early and substantial fiscal policy response, contributed to this rebound, reinforcing the direct first-round effects.

Fiscal policy

The role of fiscal policy during and since the downturn has been the subject of considerable discussion and debate. Australia entered the crisis in a stronger fiscal position — with a budget surplus and negative net debt — than most advanced economies. The additional flexibility and credibility this gave Australia’s fiscal response to the crisis may have increased its effectiveness (Blanchard, 2010).

Australia’s fiscal space gave the Government room to allow the automatic stabilisers to act and to put in place a substantial discretionary stimulus, while still maintaining a strong fiscal position.

Conclusion

In particular, the Australian policy response appears to have been an important contributor to the outperformance of the Australian economy during the downturn.

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 in Australia. The strength of Government’s fiscal position meant that it was well placed to undertake an appropriate fiscal policy response to these developments. Fiscal stimulus estimates imply that growth would have been negative for three consecutive quarters 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).It is also clear that improved policy and institutional arrangements in Australia following a quarter century of reforms have made the Australian economy much more resilient to external shocks.

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.

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 relatively strong performance would have been assisted by its industrial structure, with a relatively low share of the sectors hardest hit by the downturn compared with most other advanced economies.