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Standing Committee on Economics
Reserve Bank of Australia annual report 2015

KENT, Dr Christopher, Assistant Governor, Economic, Reserve Bank of Australia

LOWE, Dr Phillip, Deputy Governor, Reserve Bank of Australia

STEVENS, Mr Glenn, Governor, Reserve Bank of Australia

Committee met at 9:31

CHAIR ( Mr Laundy ): I declare open this hearing of the House of Representatives Standing Committee on Economics and welcome representatives of the Reserve Bank, members of the public and the media, and school students. Since the previous hearing with the RBA in September 2015, monetary policy remains accommodative, with a cash rate of two per cent. Inflation is low with the CPI at 1.7 per cent and underlying inflation at about two per cent. In particular, the Governor noted in his monetary policy statement on 2 February that:

With … labour costs continuing to be quite subdued …, and inflation restrained elsewhere in the world, consumer price inflation is likely to remain low over the next year or two.

At the same time, the Governor noted that:

Surveys of business conditions moved to above average levels, employment growth picked up and the unemployment rate declined in the second half of the year …

The Australian economy continues to demonstrate resilience, even though the global economy is growing at a slightly lower pace than earlier expected. The Governor noted that:

… the available information suggests that the expansion in the non-mining parts of the economy strengthened during 2015 even as the contraction in spending in mining investment continued.

In relation to China, the February statement on monetary policy noted that:

The outlook for China's growth is a significant uncertainty for the outlook for the Australian economy.

The committee will examine these issues in more detail and examine the RBA about whether it is confident that the current monetary policy settings will effectively encourage growth and inflation, consistent with the target for coming years.

I remind you that, although the committee does not require you to give evidence under oath, the hearings are legal proceedings of the parliament and warrant the same respect as proceedings of the House. The giving of false or misleading evidence is a serious matter and may be regarded as a contempt of parliament.

Mr Stevens, would you now make your opening statement before we proceed to questions.

Mr Stevens : Thank you for the opportunity to meet with you again today. Since the committee's previous meeting in September, we have continued to see evidence that economic activity outside the resources sector has been gradually improving. The pattern observed six months ago, whereby businesses surveys were suggesting improving conditions, by and large continued through to the end of the year. Inevitably, this expansion is not uniform across the country or across industries. Areas that led the growth dynamic a few years ago are on the trailing edge now; conversely, some that were subdued for a few years are among those leading growth today.

But few, if any, expansions are completely even, either geographically or by industry. Given the nature of the economic events through which we have been living, moreover, it is not surprising that there are differences. The good thing is that there are strong areas to counteract the weak ones. The available information suggests that real GDP is expanding at a pace a bit lower than what we used to think of as normal. Our estimate is that growth over the four quarters of 2015 was about 2½ per cent. This continued expansion has occurred in the face of a very large contraction in capital spending in the mining sector, restrained public final spending and a reduction in national income coming from declining terms of trade. It has been helped by easing monetary policy and by the lower exchange rate. Notwithstanding below-average GDP growth, the demand for labour has increased at an above-average pace in 2015. The number of people employed, as measured, increased by well over two per cent, participation in the labour force picked up and the rate of unemployment declined to be below six per cent. That is a noticeably better outcome than we expected a year ago.

This, of course, poses the obvious question of: How, with apparently still somewhat below trend GDP growth, the rate of unemployment has fallen, and whether that pattern will continue? Of course, it may be that the labour force data overstate the strength. Alternatively, they may be telling us something not yet apparent in the GDP data. More data over time will presumably shed light that set of questions.

Part of the reconciliation appears to be that growth has been concentrated, somewhat, in labour intensive areas like certain households and business services. Another part of the reconciliation probably lies in the very modest pace of growth of labour costs. At any given rate of unemployment, wages growth appears to have been lower than would have been expected based on historical relationships. In fact, at an economy-wide level, unit labour costs—that is wages per unit of aggregate output—have not risen for four years. That surely helped employment.

This same phenomenon is also important in understanding the behaviour of inflation, which has been quite low. As measured by the consumer price index, inflation was 1.7 per cent across the four quarters of 2015. That result was affected by falling prices for petrol and utilities, the latter, in part, due to government policy decisions. But even the underlying measures, which remove or downweight those affects—and they are running at about two per cent—are low. Price rises from non-tradeable items are at their lowest for many years, and that reflects, amongst other things, the modest growth of labour costs.

In summary then, the economy is continuing to grow at a modest pace in the face of considerable adjustment challenges. It has apparently been generating more employment growth and lower unemployment than we expected, while inflation has remained quite low.

Let me turn then to the rest of the world, where there have been some fairly important developments since we last met with the committee. In December, the United States Federal Reserve raised its policy interest rate the first time in 9½ years. The last time the Fed actually commenced an upward phase of interest rates was as far back as 2004. The Fed's rationale for this change was that the US economy had sufficient strength that a zero interest rate was no longer needed, and, as such, it is a welcome development. The change had been very well telegraphed and was absorbed by financial markets without immediate disruption. That having been said, US dollar funding rates are important to many financial strategies around the world and when they start to increase, however gradually, investors adjust their positions. This had already been happening in anticipation of the Fed's decision, with funds seeking to lessen their exposures to emerging markets, high-yield instruments and so on. Those adjustments continued subsequent to the Fed announcement.

For some emerging market economies who also now face the lower commodity prices, things have become more challenging over the past year or so. At the same time, some other major jurisdictions have sought to ease their monetary policies further. Both the European Central Bank and the Bank of Japan have pushed rates on some deposits at the central bank below zero. So, in other words, policy trajectories among the major three jurisdictions are diverging, which creates the potential for market movements, not least in exchange rates.

Meanwhile, the Chinese economy has become more of a concern for many observers. It is not that actual data on the Chinese economy are that different from what we had been seeing. They are showing softness in growth, but they were already saying that some time ago. The more recent anxiety is probably best described as greater uncertainty over the intentions of Chinese policymakers and over whether they will be able to carry off the economic transition that China needs. This anxiety has been reflected in capital flows. In particular, there is considerable private capital seeking to leave China.

Commodity prices have generally fallen further over recent months. Most prominent was the further fall in crude oil prices to about US$30 per barrel. While this level of oil prices is not especially low in the longer-term context, it is a large decline from prices prevailing in recent years and it is bringing considerable adjustment. Oil-producing companies and nations are seeing a decline in their incomes, and yields on debt issued by corporates in the energy sector have increased sharply. Exploration expenditure and investment in new capacity is rapidly being curtailed. Sovereign asset managers from some key oil producers are liquidating some assets to help manage the effects on fiscal positions.

Of course, as with most price changes, there are gainers as well as losers. The fall in energy costs is a windfall to energy users and represents a terms of trade gain for countries that are net importers. Importantly, it does not appear to be the case that the fall in oil prices has been predominantly caused by weak demand for oil. Indications are that oil demand is still increasing, albeit not as quickly as it had been. Supply increases appear to have been more important than demand factors in explaining the large fall in oil prices—at least so far. Hence, we should not interpret the decline in oil prices as uniformly negative. On the contrary, a fall in oil prices resulting from additional supply has usually been seen clearly as a bonus for consumers and many businesses in advanced economies, including our own.

With all this happening, in financial markets investors and traders have sought to make sense of all these conflicting currents, and we have seen a period of volatility of late. That has been apparent in equity and bond markets as well as foreign exchange markets. Equity markets are lower; yields for core sovereign obligations are lower; and spreads for lower rated corporates and emerging market sovereigns are wider. Exchange rates have been more variable and currencies for many emerging market countries have declined. The Australian dollar is about where it was when we last met with the committee, though it is noteworthy that commodity prices are lower than they were then.

Looking ahead, forecasters expect a bit less growth in the global economy this year than they did a few months ago. Expectations for Australia's trading partner group itself are for growth to be a bit below average, though that expectation is not all that different to six months ago. Inflation globally looks quite subdued. Global interest rates will still be very low even if short rates move up a bit further in the United States.

For Australia, the adjustment we have been experiencing for a couple of years now will most likely continue. The terms of trade are still falling. The fall in mining investment spending will continue for at least another year, though its maximum contractionary effect on the rate of growth is probably happening about now. Other areas of demand are expected to add to growth. The net effect of all this—in our forecast at least—is likely to be continuing expansion at a moderate pace.

One key question will be whether the recent financial turbulence globally will itself have a material negative effect on demand either in Australia or abroad—or both. I do not think we know the answer to that question at the moment, and we may not know for a little while yet.

Another question is what the recent unexpected strength in the labour market means for the outlook. If it turns out that the strength is just temporary, then the outlook is still for moderate growth but no near-term acceleration. If, on the other hand, recent trends were to continue, the income gains coming from higher employment may start to feed into stronger demand growth, which would probably lead in due course to higher levels of investment. Alternatively, if demand growth were to be in areas that require relatively little capital to support the labour employed, then the apparent weakness in capital spending outside mining might be of less concern anyway.

As usual, there are these and many other questions regarding both our current circumstances and the outlook. At its recent meetings the Reserve Bank board has kept the stance of policy unchanged, with the cash rate at two per cent. We will be examining new information over the months ahead as we try to discern the answers to these and other questions. With inflation unlikely to cause a problem by being too high over the next year or two, the statement after the recent meeting indicated that the board retains the flexibility to ease further, should that be helpful.

With that, we await your questions.

CHAIR: Thank you very much. I might kick off. We have seen overnight US Chair of the Federal Reserve Janet Yellen brief their congress's relevant committee and in much the same way in her opening statement to them quote the rising interest rates—first in a decade—and in the consequent question and answer that came afterward discuss potentially negative interest rates. I see in your statement here that 'One key question will be whether the recent financial turbulence globally will itself have a material negative effect'. Is what we are seeing play out at the moment on the world stage leading us to a situation where our regulators are that uncertain of what lies ahead?

Mr Stevens : I think what we are seeing in global markets at present is markets are dropping their bundle. There are some latent issues that have been there all along, actually, on which people have now chosen to focus more strongly than they were a couple of months back. It is inevitably uncertain how that pans out. That is just the way it is in these financial market episodes, and I think policymakers are being honest enough to say that. That is just the reality of the world we live in, and we I do not think we can really pretend that it is otherwise. So what Chair Yellen is grappling with, and what we are all grappling with, is that you cannot know the future and you cannot be quite sure how these dynamics will work out.

CHAIR: Moving to China, our tie to that economy, if you like, has been the source of such growth and profitability over recent times, and their policy settings. In your statement, you mentioned concern about how they handle different policy settings. Chair Yellen, again, said overnight that the biggest concern she had was with relevance to setting their currency, the way they determine currency valuations moving forward. Do you share those concerns and, if that is the case, what impact do you see that having for our economy?

Mr Stevens : The Chinese authorities have made some changes to the exchange rate mechanism over the past six months or so. The initial one of those was back in August or September. To my mind, I was surprised at the extent of reaction to that around the world. The size of the adjustment they made in the rate itself was actually quite small in the rate itself. The focus that they have indicated in recent times towards thinking about their exchange rate, as it travels against a basket of other currencies, is actually eminently sensible.

After such a long time of more of a focus on the US dollar rate and the stability that was seen in that rate, it is not surprising perhaps that other observers are slightly discomforted by these changes. But from the Chinese point of view, I think, the things they have done make eminent sense. Really, the rest of the world and international bodies and so on have been telling the Chinese for years, 'You guys should get a more flexible exchange rate,' well, that is what they are doing.

In the longer-run sweep of things, if they are heading towards a world where there is more market flexibility in those key prices in the longer run, that is to be welcomed, even though the road to get long run may have some bumps and potholes in it. So I think we should not overreact to these changes. That said, the other area where the Chinese authorities have been seeking to calm things down was in the stock market. I think that has proven much harder to do than they expected, and not altogether successful.

If people around the world were operating on the assumption that Chinese policymakers have this kind of aura of invincibility and could fix all the problems, as it turns out, like the rest of us, they cannot fix every problem and sometimes they struggle to get the response exactly right, and it proves to be more difficult to engender confidence than they had hoped, and they are in the same boat as everybody else in that respect.

For Australia, as you say, the exposure we have through exports with China and, to some extent, through capital flows coming out of China towards us are important things. My sense is that, as I said in the opening remarks, what we know about the Chinese real economy today is not that different to what we knew a few months ago. It is soft. It is weaker than they would really like, which is why they have been in the process of doing things that amount to stimulatory measures in a macro sense. I do not think it is disastrous, but it is softer.

The key issue has more become this uncertainty around what the policymakers actually want and whether they will be able to achieve it. When you think about the size of the economic transition that they are attempting here, this is a big thing. To transition away from the Asian model of export-led growth with a low currency to get to more domestic growth, less investment and more consumption, and for an economy of that size and the speed with which they are seeking to do this, it is probably without precedent in history. Inevitably, we do not know if they can land this.

CHAIR: 'Potentially some bumps and potholes', I think was the way you put it, but long term you are happy with the approach they are taking?

Mr Stevens : It is not for me to opine on whether they are doing the right thing, but—

CHAIR: Well, the right thing in terms of the Australian economy.

Mr Stevens : I think what they are trying to do is that they understand the need for a different growth model, and they are trying to bring that in. People will have their own opinions as to whether that is being done too quickly, too slowly, in the right way and so on, but I think they get the need for a different model. The people who are pro reform in China certainly get the need for more flexibility, more allowance for prices to do their job in capital markets and so on, and so they are trying to move that way. I think in the broader scheme of things that is all welcome. That does not mean that there will not be upsets along the way though. There are in any country.

CHAIR: Can I move to oil prices. You mentioned in your statement the impact they are having globally. In terms of Australia, obviously, when we talk oil prices, by default that has an impact on gas prices. You mentioned in your statement 'as the economy transitions from the mining investment phase to the production phase' and the capital investment that has fallen away there. One of the—I guess—still to be or continuing to be developed projects or parts of our mining sector is our gas reserves. With oil prices falling to where they currently are, what impact in investment still to come in that field do you feel there could be, and what risks do you think that could potentially play for the economy moving forward?

Mr Stevens : I might get Chris to talk about the sorts of intelligence we have and the assumptions that are embodied in our outlook. I think it is the case that there are investment projects being completed, and they will have to be completed because they are so far in train that it is still sensible to complete. So the issue would be whether there is another wave of these things later and presumably lower prices if that persists. Some people do not think it will persist. I do not know, but, if it does persist, presumably that must have an effect on the likelihood of future gas projects. For the projects which are in train, my understanding is that there are contractual arrangements for their prices, but presumably, if oil prices remain low for an extended period, that will find its way into the contracts eventually. Would that be right?

Dr Kent : Yes. The movement from oil prices through to LNG is fairly rapid, and you can see that LNG prices on spot markets have fallen a long way, albeit with a little bit of a lag. The nature of the contracts for LNG is really to supply certain quantities of gas, and there is also a formula in there that links the price that the gas producers get for selling their gas to the oil prices, so they will definitely decline.

I think that, as best we understand through our liaison efforts, the lower oil price and hence the lower gas price are not likely to have a substantial effect, if any, on the sorts of plans that are afoot already for plants that are well advanced and are nearing completion. They have already sunk big costs. The real issue is that even though it will affect their profits—they will not be making as much money as they otherwise would have liked—the cost of operating these things is so low compared to the cost of putting them in place that even with a low oil price and a low LNG price they will still be producing. So our forecasts still have a pretty substantial increase in LNG exports.

CHAIR: Thank you, Dr Kent. Obviously, when you sign a free trade agreement, there is a lag period that follows while business prepares and tools up and interaction happens with whatever that country may be. In your looking-forward capacity, have you factored in any impact with the signing and now start of the Chinese free trade agreement?

Mr Stevens : I think I will defer to the forecaster. My guess is not much effect over the horizon that we work on, which is 2½ years.

Dr Kent : That sounds about right.

Mr Stevens : Those effects start small and grow over time, but over that horizon I think we would be hard pressed to say that we could identify material impacts to build in.

Mr HUSIC: I just want to ask a series of questions more related to the world stage and picking up on the chair's questioning in relation to China. In January alone, $110 billion left China. That capital flight can be looked at in one way as positive, potentially fuelling a way for foreign investment, but it is being interpreted as a lack of confidence within China and in what is happening within their economy. On that shift that you mentioned, Governor, of potentially challenging the model that has been embraced by a lot of Asian countries to have an export led transition to a more domestic focused one, how will that capital flight aid in efforts to build a stronger domestic economy? Is this something that we should be having greater concern with? Did I misinterpret your view that you are not so concerned about that capital flight? And, if we should not be concerned about that capital flight, why should we have greater confidence that that is a good rather than a negative thing?

Mr Stevens : Well, I think that it is a fact, as you say, that capital is leaving China right now. That is, as best we can tell, mainly capital of Chinese people more than a flight of foreign capital. There are probably a few different components. Some of this would be a perfectly healthy desire on the part of Chinese people to diversify portfolios and invest elsewhere, but some of it, I am sure, is an acceleration of flow as a result of uncertainty about the outlook for China, policy uncertainty and so on. I think that is true. I think the Chinese authorities are sufficiently concerned by that that they have taken some steps to try to tighten up some of their rules on capital flow. I would assume that that means that they are concerned by it.

Can they manage it? Well, at the moment they are managing it by allowing some exchange rate flexibility but largely by having the central bank run down foreign exchange reserves. Now, their reserves have come down, but, boy, they are still pretty big. So I would say that for some time yet, at this pace, if they choose to manage it that way, they will still be able to do so. It does not go forever, but they have ample reserves still. There are a whole set of questions, actually, about: where does that capital land? What instruments is it in? Where does it go? What effect does that have? And so on.

I think that, to the extent that people want to move capital because they are uncertain about policy and uncertain about economic outlook, to the extent you can, it is better to lessen that uncertainty because uncertainty is not good. If we can make it less, we should. So to that extent it is a concern for policymakers up there, I think. The more they are able to do to articulate what they are seeking to achieve and how they want to get there and can grow confidence in the future for the Chinese economy, I think that is good. So there are different parts of the flow, as I say, and some of it is probably par for the course and run of the mill. Some of it is probably a sign of anxiety and uncertainty and, to the extent that that can be lessened, that is probably a good thing.

Mr HUSIC: In relation to Europe, there has been a lot of focus on Deutsche Bank and some of the troubles it has been exploring. Some would characterise it as being focused more on Deutsche Bank and the need for them to restructure and possibly refresh their board, but others are looking at it as a sign of something that is happening within the German economy. Given Germany's critical role within the EU and within their economy, is this something that we should be concerned about? Are there broader things to take note of there, or should we just be thinking that this is something that is focused on a particular bank?

Mr Stevens : I think the German economy, overall, has been travelling pretty well thus far. Things can change, but on most of the data that we have on Germany through last year they were travelling pretty well. Regarding the banking system in Europe, I think the issue here is that there remains some residual uncertainty—quite a bit of residual uncertainty—over the asset quality and the capital adequacy of the banks. I think the evidence for that proposition is: if you look at the valuation the share market puts on not just Deutsche Bank but many European banks, what does the share market value the net assets at compared with what the accounts say the net assets are? What is the price-to-book ratio, in other words? That is a long way below one. In other words, the markets, rightly or wrongly—and they have been saying this for some time—doubt that the underlying value of those banks is what their accounts say. Contrast that to our own case where our banks trade well above the book value in the share market, which is also true in countries like Canada. So while the Europeans have been making progress in assessing asset quality and getting capital adequacy up and so on, I think it is undeniable that they started that process much later than would have been ideal. You can contrast how quickly the Americans did this with how long it took the Europeans, and there are reasons for that to do with the way Europe functions. So I think part of the story here is that residual hangover from the crisis and doubt about the underlying strength of the banks. Why have the markets chosen the last month to put so much more focus on that than they did three months ago—because I do not think the underlying reality has really changed material in that time—why now? I do not have an answer for that.

Mr HUSIC: Well, it is not neatly the same—

Mr Stevens : Just to complete, the third thing I wanted to say is: there is this residual uncertainty about European banks that has bubbled up. It was there but it has now increased. The question might be: is that a doubt about banks globally, and will we see a material tightening up of funding conditions for banks around the world or not? I do not know the answer to that. That is an important question. At least in our banks to date we see no evidence that funding markets are impaired. There is a little bit of pressure on the cost—not all that much, actually—so I think we are travelling fine. But that is the relevant question. Does this generalise to banks around the globe will not? I am not sure there is a logical reason that it should. I do not think there is, but then everything is not always logical.

Mr HUSIC: My apologies for the earlier interruption. I was going to ask: while we are not being managed in exactly the same way or being driven by the same motivators, there are similarities in what has been happening here with the flag changes on capital requirements and the implementation of Basel. In the EU they are also going through the imposition of new banking rules. My earlier question was in relation to Deutsche and I am now broadening it out to the European banks and the reaction they have had to the bank recovery and resolution directive. Do you see that that will create further instability in the banking sector as it relates to Europe and then more broadly?

Mr Stevens : I don't know. The general thrust is towards more capital, and there are a bunch of things happening in the regulatory space there. There is also the question of the new thinking these days on potential resolution of banks that are in trouble with bail-in securities and all that sort of thing. So all of this is part of the mix. It is exceedingly complex. The backdrop, of course, is if you have had weak growth in the economy. Europe have been growing again for a couple of years now, but they actually had a double-dip recession. In 2008 they started a recovery and then went backwards again for a while. The compounded legacy of all that makes it very hard for banks to grow their profits and acquire the capital that way, which is the nice way to do it. That is how our banks can generally grow capital if needed—organically, by retaining profits. If profits are weak it is harder to do that. That is part of the European story. I think right now as well there is a little bit of tension over some of these so-called CoCo instruments, particularly in the Deutsche Bank space, but probably not only there. Just how they will behave in a moment when the bank is under a bit of stress: there is a lot of uncertainty there. So all of that is part of the European story.

I think the big picture is that since 2008 the European banks have not been able to help the process of economic recovery in anything like the same way that American banks were able to do. I cannot help feeling that is because the American banks confronted the capital shortfall issues in the typical American way—head on, very dramatic, very painful; but they fixed it in 2009 and then the banks were better placed to help the recovery when it came. The Europeans took much too long to get to that, and they are still really in the process of sorting things out. The fact that the economy has been weak makes it harder to do that, and then, vice versa, the fact that the banks are not sufficiently strong makes it harder to get the economy to go well as well. So you get a circular dynamic.

Mr HUSIC: Shifting the focus westward now to the huge investment that occurred in the energy sector, particularly the US with shale oil: prices for oil have dropped by roughly 70 per cent, I think, since the middle of 2014. There have been a number of factors at play there in terms of the OPEC response to the way that US oil production has surged. What exposure is there for our banks in terms of investment in production where the price has dropped and there is a concern about them being able to service those debts?

Mr Stevens : The evidence that we have is that the exposure of our local banks to the resources sector generally is just a few percentage points of the balance sheet, and then the oil would be a subset of that. There will be some exposure but I think it is quite small, and I am sure it will be adequately handled. That is the message that I think we are getting from the banks as well. Some of the foreign banks that are active in Australia are not as large in their footprint but some of them are a little more exposed. But amongst our own core institutions here I think the exposures, as best we can see at this point, are quite small. In Australia, a lot of the investment in the energy sector is by very large global corporations and a lot of it is their own funding—not from the local bank. I think we are okay there.

Mr HUSIC: If, based on what you have just indicated to us, ours are not so exposed, what concern would you have—putting aside our own banks—about other banks that have supported investment in the energy sector? If those loans go bad, do you see any ramifications either for the broader world economy or for us?

Mr Stevens : It depends on how much capital they are holding against them. This is why you have capital. If you calibrated the capital you had correctly, the bank in question obviously would sustain losses but it would have the resources to absorb that, without being in question in terms of its ability to repay its creditors. Time will tell, of course, whether the amount of capital held was correct or not; but, in principle, that is how it is supposed to work.

I do not think we see particularly evidence of the energy exposures per se being a thing driving pressure on banks. I think the stuff about the European banks is a broader set of capital adequacy and massive quality issues. So, at the moment, I do not think I see the oil price declines per se as likely to be a significant detriment to the global banking system. There are various other effects of the global oil prices: budgets in countries that rely heavily on it and so on. As I said earlier, in some of those cases the sovereign wealth funds are having to liquidate assets. So all of that is working through the markets and having effects. I do not think I would say that, through the global banking system, this is going to be the biggest issue.

Mr HUSIC: The reason why I mentioned those three areas is more to do with a broader concern about how fragile the global economy is. I suppose it is always about what side you are on: are you the optimist or the pessimist? If any of those things were to occur—if those bad loans impact on what is happening in the energy sector; we see the instability that is being experienced in Europe at the moment; and I know that you have talked through both sides but concerns exist about the Chinese economy—can we expect that things will get tougher through 2016-17?

Mr Stevens : It is hard to deny that the global growth outlook today looks not as good as it did, say, three or six months ago. Forecasts—for what they are worth—that people make are still in the process of being edged down. There is some commentary around that financial markets in the broad are on the point of almost pricing as though there will be a global recession. I think that might be a bit pessimistic. In saying that, I acknowledge that recessions are rarely very accurately forecast, but the nature of financial markets is that they typically do that. When you go back, you can find financial markets signalling recession prior to recessions happening but you also find plenty of occasions where they signalled it and it did not happen. So was it a false signal or a good one? I do not think we can know. My instinct at the moment is I think some of the gloom and doom is overdone. But it remains to be seen. But, for our country, what we know is the terms of trade are still falling. We know we have a large headwind from the fall in mining investment. We are a fair way through that, but we ain't finished and we have got a while to go, so that is still ahead. If there is a material tightening of financial conditions globally, then obviously that impairs our outlook and it makes it harder for us to grow—that cannot be denied.

Mr HUSIC: In terms of that investment that you talked about in the mining sector, I see a number of the big players are reassessing their dividend policy. Do you see this as them flicking the switch to greater investment? You have often reflected on the fact that, in terms of the investment that is required, there is not enough and there is a lot more that can be done and is not being done. What should be read into that?

Mr Stevens : The areas where I would have hoped we would see a bit more capital spending are outside of mining rather than in mining. The miners did a heck of a lot of investment. They were always going to have to scale that way back. That is happening. That dynamic was about as well predicted as any prediction we make, frankly. On the dividends, it is not for me to tell them what they should do, but the resources sector is a very cyclical business, and the notion that you never change the dividend and always grow it strikes me as not sitting easily with the cyclical nature of the business. My take is that their concern is to make sure that they continue to have a strong balance sheet in difficult times, and that is very much in the interests of the shareholders, even if it means the dividend is a bit lower for a while. I think that is probably what is going on.

Mr BUCHHOLZ: I have a couple of questions in and around the banks, then I have a question to lead on from our previous two speakers in and around fuel, and then, in conclusion, I will have one question for the Reserve Bank governor himself.

Mr Stevens : Uh, oh!

Mr BUCHHOLZ: Yes, I know, it is coming, mate; it is coming. Bill Evans, Westpac economist, recently noted that, in his opinion, the outlook for the cash rate will stay steady over the coming year. My question to you is: under what conditions would you suggest that the banks would move the variable rate independently in their standard variable rate to the cash rate?

Mr Stevens : I would not suggest to them that they move independently. Far be it from me to make such a suggestion.

Mr BUCHHOLZ: No. But what conditions would motivate them to do such an act?

Mr Stevens : I think that might be a question better directed to them, but—

Mr BUCHHOLZ: You are at the central bank governor.

Mr Stevens : I suspect that we will hear murmurings, if we have not already, about funding costs and so on. And it is true that, in wholesale markets, funding costs relative to the cash rate are up a little bit—it is only a little bit—and as best we can tell at present, to long-term debt, the new debt that is being sold to replace debt that is rolling over is still being sold into the market at a lower interest rate than the debt that it is replacing. So the marginal funding cost has gone up a bit, but it is still lower than the average funding cost in the stock that is outstanding. That is on the figures available to me. So I guess I have to say this: I do not see much of a case for independent increases in lending rates based on funding costs as they have evolved just lately. Of course, things may change as we go forward, but that is my take right now. As for Mr Evans's forecast of the cash rate, well he has made some pretty good forecasts in the past, but I have no comment on that particular one, obviously.

Mr BUCHHOLZ: Why do you suggest that the banks may have moved independently previously?

Mr Stevens : Which episodes are we referring to? There have been some.

Mr BUCHHOLZ: Last year I thought there were a number of cases.

Mr Stevens : There were some increases, particularly in mortgage rates for investors. They were being told by the supervisors and by us that we thought there was some risk that lending to investors might get a bit too strong. APRA had the benchmark where, if you are growing that part, if you book more than 10 per cent, well we are certainly going to be having a look. APRA has done a lot of very good work actually on investigating lending standards, and I think we have seen some improvement in lending standards as a result of that. Some of the banks are being told, 'Look, you might have to slow down a little bit, or at least not speed up.' I suspect they wondered how they might achieve that, and they thought they might achieve it by changing the price, which they then proceeded to do. I think that was a factor. There have been other episodes where funding costs were very genuinely moving differently to the cash rate, so decisions were taken at that time accordingly. There have been a few of these episodes over the last six or seven years, I guess. That is my story of I think what happened.

Mr BUCHHOLZ: You are comfortable in signalling to the banks that, if they did move independently, it would be unhelpful?

Mr Stevens : What I am saying is that I do not see a particularly strong case right now for material changes.

Mr BUCHHOLZ: With reference to exposure, Mr Husic spoke about the exposure of the banks in the oil sector. You mentioned that it was only a small percentage of exposure. Twelve months ago there were some articles in the Asian markets—the shopping centres, streets, suburbs, apartments being built—and there were one in five vacancies, a very high vacancy rate. With that Chinese growth softening, do you have a sense at all if our banks have any exposure in those Asian markets around real estate or property, and if so, to what extent?

Mr Stevens : To my knowledge any exposures there are quite small. I do not think we are going to have a material issue through our banks' exposures to China through Chinese property. I think the effects of the China slowdown, overwhelmingly, are much more importantly through the channels we have talked about—terms of trade, exports and so on. I am not aware of any evidence to give me concern over Australian major bank exposures into Chinese property.

Mr BUCHHOLZ: Are there any other sectors, before we leave that topic, in the areas of the globe that create a little bit more risk, maybe the European markets through the banking sector that was raised earlier on?

Mr Stevens : There are some exposures that our banks have to various other parts of the world, though, compared with banks of that size that you might encounter in other countries, they are very much home focused. In truth, probably the largest foreign exposure that our banking system has is New Zealand because New Zealand's four largest banks are our banks. I am not saying there is any particular concern here, but that is easily the biggest exposure that they have to another single jurisdiction.

Mr BUCHHOLZ: That is comforting.

Mr Stevens : I hope so.

Mr BUCHHOLZ: To either Dr Lowe or Dr Kent—just on oil prices. Whilst the committee completely understands the masking effect of the Australian dollar and the effect that it has on fuel prices, the current $30 barrel price that you mentioned earlier on—do you have any concerns that we are not seeing lower prices at the bowser as a result of the downward trending prices?

Dr Kent : I think what you are referring to is the fact that, yes, the Aussie dollar depreciation that we have seen over the past six months, year or so, has meant that we do not get the full extent of the drop in oil prices through the pump—and that is definitely the case. But at the same time, in addition to that, it does seem that refining and retail margins are a bit wider now than they were a year ago when oil prices began to decline. So that is happening offshore where a lot of refining is happening, as well as retail margins domestically.

Mr BUCHHOLZ: Why do you suggest that the margins are widening at the detriment to the consumer? Is it a lack of competition?

Dr Kent : Well, ultimately competition is what bears down on business's margins and their ability to move margins around. So it has to be. I do not see any other reason.

Mr BUCHHOLZ: Sure. And I know it is a specific industry, and I do not suspect that you are across all of the details, but do you have a sense of how much wider the margins are today than historical long-term averages on margin in that sector?

Dr Kent : No. Look, I would hesitate to be too specific. Over 2015, the relevant oil price for us in Aussie dollars has come down about 20c a litre. And over a similar period, fuel prices declined by about 12c. So that gives you a sense. But that is not all retail margins—as I said, some, including offshore refining margins, possibly picked up.

Mr BUCHHOLZ: Sure. Thank you. And my final question to the Reserve Bank governor. Governor, you have served honourably for the last—your first seven-year term and then more recently a three-year term. This is potentially your second last appearance here with this committee. Can I, firstly, just acknowledge the work that you have done, and thank you for that contribution. And ask you, what are the qualities that you would look for in a replacement Reserve Bank governor?

Mr HUSIC: Start taking notes, Dr Lowe.

Mr Stevens : Well, thank you very much, Mr Buchholz, for your very kind words. We will be here in, I think, it is July, God willing. So that will be the last one.

Mr BUCHHOLZ: I may be on the front bench by then, mate—that is why I had to do it today.

Mr HUSIC: This hearing is making news all over the place today.

Mr BUCHHOLZ: I am being tongue-in-cheek.

CHAIR: Governor, self-praise is worth what you pay for it.

Mr HUSIC: If Dr Kent announces next week's Powerball, I am leaving!

Mr Stevens : I am sure the committee will welcome you back as a guest appearance.

Mr BUCHHOLZ: Thank you, brother.

Mr Stevens : I think the deputy governor has all the admirable qualities needed and more, more than me. A thick skin is probably the primary one, actually.

Mr BUCHHOLZ: Thank you.

Mr Stevens : Thank you for your kind words.

CHAIR: Thank you, Mr Buchholz. We will pass over to Mr Conroy.

Mr CONROY: Thank you, Chair. Thank you for appearing today. Can I go to the next issue of capital expenditure in the country again? I know I tend to ask at each appearance, and we have had animal spirits—

Mr Stevens : Unfortunately, I cannot give different answers either.

Mr CONROY: No, I know—but I want to explore more. We had animal spirits a couple of years ago, and at your last appearance you were making a point—and it is alluded to in your statement—that you think there might be a case that the growth in the economy is coming in areas that are not traditionally capital intensive. Hence, they are not being picked up in the CAPEX figures. I have had a look at 'other selected industries'—which covers most of the rest of the economy, other than key growth areas like education and health care. But even in 'other selected industries' we have seen a decline in capital expenditure. For example, it fell three per cent in the last quarter. 'Other selected industries' seems to cover an enormous amount of the economy, so where do we think the growth is?

Mr Stevens : The broad fact is that capital spending, outside of mining, is considerably weaker now than I would have expected if I had made a forecast two or three years ago. I do think animal spirits have improved a bit in the past year, and I think that is evident in the various business surveys. Nonetheless, as judged in the capital expenditure survey, there is very little sign at this point of intentions to invest more and the level of investment remains quite low.

On the composition of growth, if we add up the expenditure components—consumption, investment, government spending et cetera—the bit that seems to be missing is non-mining business expenditure. So we come up with a forecast for total expenditure, and therefore for GDP at the end, that we find is not too bad. But it is still a bit disappointing and it would be good if it was a bit more. And can't we get that non-mining capex to go up? And then when I look at what the economy has actually done, it seems as though we have been generating more jobs growth then we would have thought.

Yes, there are some reservations about data quality in the labour market, but I think it is hard to ignore the conclusion that we have had more jobs growth and lower unemployment than we thought. So in some expenditure components somewhere—I am not quite sure where—there is economic activity happening and demand occurring and, so far anyway, it did not require the pick-up in non-mining investment. I admit I am a bit surprised that that is the outcome, but I think it is pleasing that we have had that outcome.

That raises the question analytically: is it possible that you can get more growth in output and jobs, particularly with not so much non-mining capex? That is the question we have been asking ourselves. Chris can give more facts and figures on that than I can. There is some evidence for the proposition that some of the growth has been in areas where the amount of capital per head, per person working, that is needed to produce the output is a lot lower than it is in, say, manufacturing or the other industries. That seems to be a phenomenon that we are observing to some extent. Chris, do you want to elaborate?

Dr Kent : I would emphasise that point. We have seen a lot of growth in employment over the last year, more than we would have forecasted. Much of that would have been in the broad household services industries. Very roughly speaking, every person on average in the household services sector is accompanied by about $100,000 worth of capital. That is quite a bit less than in the goods related sectors and even some of the business services, where you are talking north of $350,000. That might go a little way to explaining the outcomes we have seen. I would not overstate that though.

One of the reasons is the assumption that we have measured very well what we are calling 'non-mining business investment', with which we have all been quite familiar. It may be that quite a bit of investment has occurred in that sector in the past that has actually been quite closely related to mining investment. A classic example would be where a law firm decides they need more bodies in Perth. They need a building to put them in so they build a building in Perth. That might appear in the non-mining business industries but it is in fact quite closely related to mining activity. So maybe the weakness we are seeing in resource investment is spilling over in those sorts of ways to the non-mining sector as well.

But the weakness in the manufacturing sector broadly, and the fact that it is declining as a share of the economy in terms of employment and output, is a global industrialised world phenomenon. That is weighing on investment. We have done a lot of investment in utilities in the past; we have gold-plated everything we could see. There is not as much of that happening now. So there are many possible reasons. Maybe we are just using the existing capital stock quite a lot better; we are using our buildings more efficiently these days and we did in the past. Maybe that is part of the explanation.

Mr CONROY: I want to move on to the labour force figures, which have obviously been the subject of a lot of debate—and that is mentioned in your statement as well. Does the RBA have a comment on the fact that John Fraser, the Secretary of the Treasury, at estimates on Wednesday acknowledged that the labour data looked a little better than it would otherwise have been and acknowledged that there are technical issues that might be impacting on employment figures? Are you similarly concerned about the fidelity of the data?

Mr Stevens : There have been concerns raised on a few occasions over the last year about month-to-month movements, which months the supplementary surveys were in and whether they affected the seasonally adjusted estimates and so on. It is all rather technical. So all that is fair enough. But let's suppose we discount some of the strength in employment for things like that. You could shave half a percentage point off the growth of employment and you would still have two per cent, which is strong actually. My understanding is that many of the technical difficulties that have been encountered should not significantly affect the ratios—the rate of unemployment as a share of the labour force or the participation rate. So I think it is fair to look to those ratios as providing some signal, allowing for monthly ups and downs and so on.

Job vacancies have been growing pretty much across all the series—and we have three or four of those. The ratio of employment to population has gone up a bit. There is still a fair way it could go yet before you would in any way say the labour market was tight, but it has gone up. Participation has gone up and unemployment has gone down. Employment growth, even discounting, is still pretty solid and the other labour indicators are consistent with that. So yes, there have been some issues with the published unemployment estimates and the bureau has done some work on resolving that. But, even discounting for that, I think it is hard to avoid the conclusion that the labour market is a bit better than we thought it would be, which is of course good news.

Mr CONROY: Yes, it is good news. But in layman's terms there seems to be a slight disconnect in the broader labour force figures. As I understand it, if the economy is picking up, logic would presume that they would use under-utilised resources first, they would sweat their existing labour more, before hiring new people. We have a healthy unemployment figure, though it can always be lower. It is under six per cent at the moment. At the same time, hours worked in the economy has actually gone backwards in the last six months. We have got an under-utilisation rate and an unemployment rate that are very high compared to the last five years. Surely we would expect average hours to pick up—and people looking for more hours in their existing jobs—before the headline rate, which has traditionally been seen as a lagging indicator.

Mr Stevens : You might. It depends where the expansion is coming from. If a lot of the new growth was in new firms then there are no under-utilised people in those firms to start with. I do not know the extent to which that is the case. But average hours is basically flat. Total hours worked has actually gone up quite a bit in the last year. Average hours worked is very volatile from month to month. But, on my chart, there has not been much change for a couple of years actually. Full-time jobs have grown quite quickly. Underutilisation rates have actually started to edge down, which they usually do in parallel with the headline unemployment rate. So I think all that adds up. I take the point that, in logic, where a firm is so-called underutilising the existing workforce, you would expect them to step that up before they went and got new people. I think that is right. I do not think we can tell, I cannot anyway, and I am not sure whether there is data that allows us to tell the extent to which that has happened or not at a detailed level, but at the aggregate level, as I read it, the various underutilisation rates have actually started to inch down. They are not crashing down, but they are moving approximately speaking in parallel with the headline rate.

Mr CONROY: Just to change the subject. There will be positives and negatives, but do you have any concerns about the slowing property market in Melbourne and Sydney, and is there a danger that we could actually see prices falling in some parts of these markets?

Mr Stevens : I think we have seen prices fall in, probably, some parts of Sydney. On the best I can tell, I do not think that is going to be developing into some kind of rout in property. For the property market, in the two most ebullient cities, to take a bit of a breather for a while is probably welcome, to be honest with you. Obviously, we do not want a crash but, with the pace of growth that we did have, you would have to really worry if that continued on and on, for a range of reasons.

Mr CONROY: You think that is a bigger issue rather than the fact that a lot of the growth in the economy in the last year has been driven by consumption and that the wealth effect of rising property prices will obviously be dissipated if we see stagnant or, in fact, property prices going backwards?

Mr Stevens : It could be. The wealth gain has slowed down. Probably the bigger threat right now on the wealth side is share prices, which are only a third of wealth as opposed to two-thirds in housing, but they have come down. I would be thinking if there are households who are feeling a bit anxious about the wealth that that would be the reason more than the house at this stage.

Mr CONROY: Thank you, Governor.

CHAIR: Governor, sitting behind you do have a fair few budding economists of the future as well as, I would argue, leaders of the future. At this morning's session, before we break for a coffee, we thought we would ask a couple of them to come up and ask you and your colleagues a couple of questions. Our first question today will be asked by Gracie, who is a student at Strathfield Girls High School.

Gracie Amilbangsa, Strathfield Girls High School, Strathfield : First of all, good morning. I hope you have had a nice morning so far. I am speaking on behalf of Strathfield Girls High School. Our question today is: Australia's economy has been approaching a decline, as seen by the depreciation of the Australian dollar, while China's economy has experienced a steady and high growth rate in recent years. Will this disparity in direction of economic growth between the two countries in any way affect the benefits of the recently established free trade agreement for both parties?

Mr Stevens : Thank you, Gracie, for the question. It is normal for China to grow faster than countries like our own because they have so much potential to grow and make their people richer, and they can catch up over time to the living standards that we have enjoyed for much longer. So it is normal for them to grow faster than us, and it is good for us because that is an opportunity and it has been a wonderful opportunity for many of our exporters to benefit from the growth in the Chinese market. And equally for China, I think their general opening to the rest of the world has been of great benefit to them and everywhere, not just to Australia. Trade is usually mutually beneficial because if you and I trade it allows you to do more of what you are good at me to do more of what I am good at and shelter each other. And usually we think we are both richer for having done that, so I think there are plenty of prospects for prosperity there in future.

CHAIR: The second question this morning, Governor, is from Nina, from Burwood Girls High School.

Nina Frost, Burwood Girls High School, Burwood : Good morning. Does the movement of interest rates by commercial banks independently of the RBA affect monetary policy, and specifically does this decrease the effectiveness of monetary policy? Thus, is the power of the RBA over the Australian economy decreased?

Mr Stevens : Thank you, Nina. This is a question we have confronted before, and I think the answer is that it makes it a bit more complicated for us. It does not mean that we cannot have the influence, but it means we have to configure the rate that we set, making some allowance for the behaviour of the banks that felt they needed to undertake it. I do not think that means monetary policy has been ineffective, it just is a bit more complicated to do it, that's all—so far, anyway.

CHAIR: Nina, that is called a politically correct answer.

Mr Stevens : As opposed to all my other answers?

CHAIR: Yes, and ours! Thank you, Governor, very much. We might at this stage adjourn for 15 minutes and have a coffee and come back and kick off the second part.

Proceedings suspended from 10:51 to 11:12

Mr ALEXANDER: I would like to say that this time last year there was a question to the governor from one of the students regarding her fear, when she bought a home at such low interest rates, of being caught in a debt trap and, when interest rates went higher, not being able to afford the repayments. That question led to an inquiry last year by parliament into home ownership. That paper will be coming out soon. So that is just to say that your questions are taken most seriously and listened to intently. Congratulations to both of those students who asked such good quality questions today.

CHAIR: Hear, hear!

Mr ALEXANDER: I did become like a dog with a bone on this issue and the concerns that were shared by many regarding the overheating of the real estate market, which moved some responsible people to say that there was a bubble in certain markets. As the year progressed and we took evidence, there were varying opinions. As the market went up, which often stole the headlines, with record prices in Sydney and Melbourne, there was concern expressed by APRA at the level of lending and, as we heard this morning, also that banks 'weighted' investors to cool the market down. Governor, you did say that uncertainty is not good and that we should do everything we can to avoid it. Do you think what has been done has been sufficient?

Mr Stevens : In housing?


Mr Stevens : Let's be clear on what was done: this was a focus on the pace of growth in lending to investors, which was the fast-growing part, and on the standard of lending decisions that were being taken. I think that was appropriate and it has had an effect in the direction that you would expect. By and large, I think those effects are welcome. We have seen a step up in the level of prudence surrounding the decisions to lend, where that needed to occur. We have seen some moderation in the pace of growth of lending to investors—the banks have probably overachieved a little bit there, actually. But, I suspect, at the moment what we are starting to see is a bit of a step up again in competition to lend in that space, just at the margin. One other thing we have seen is quite a lot of data revision, because when, as often is the case, the split between investors and owner occupiers became something of importance from a regulatory point of view, the people who were supplying the data out of the financial institutions took more interest in that split than they had done before and we had some pretty substantial revisions to the history of the data, as they tried to make it more accurate. We are probably still seeing some revisions flowing through, though, hopefully, the bulk of them are done.

As these sorts of measures go, this is really a regulatory intervention, so to speak, and it mainly took the form of the friendly bank supervisor having a good look at practices in this area. They have the ability to levy additional capital if needed, of course, but mainly this has been achieved by detailed interaction. It has had a positive effect and it has worked as well as these things ever could be expected to. It has been positive and I think it is enough for the time being, yes.

Mr ALEXANDER: Do you think it was timely or, with the benefit of hindsight, could it have been, in our language now, more 'agile' or more 'responsive'?

Mr Stevens : I do not think it was late. I do not think there has been a very large build up of very serious risks in bank balance sheets. There might have been had practices not improved, but that would have taken some time. I am not at all worried about the timing. I thought it was appropriate. As things evolved, the attention given, the language used and the degree of intrusiveness got stepped up appropriately as things went along. I think it was good.

Mr ALEXANDER: You mentioned the difference between investor-owned properties and home-owner occupied properties, it appears that during this time of low interest rates that investors are freed of the level of negative gearing—one of the interesting comments that came from one of our members the other day was: the only thing better than negative gearing is positive gearing—and that this has driven prices. It has put more properties in investor's hands and sometimes in fewer people's hands, which most people would agree is a less stable situation. But there is a level now that has moved from the traditional level of four times average earnings—averaged by so many in Australia—to something above 10 times. Is that a concern?

Mr Stevens : I do not want to particularly endorse the numbers you just quoted, because I think, in regard to ratios of price to income, it depends on what city you are talking about. It would not be 10 times earnings across the whole country. It might be in parts of Sydney. But as a general observation it is correct that the ratio of price to income has gone up, and a lot of that happened quite some years ago. We have talked in the past about the factors that helped to drive that, not least the big decline in inflation, the big decline in nominal interest rates, financial liberalisation and so on. The ratio of price to income now is also probably edging up to higher levels than it has been in the past. That is certainly true, and to my mind that actually brings quite a number of issues, many of them in the social space rather than the purely economic policy space.

Mr ALEXANDER: While we have been having this boom—and it seems that we are a boom or bust country—you mentioned there has been some price drops. There have been reports very recently of oversupply of apartments in Melbourne and Sydney and moves to restrict the flow of capital from China, which has been another driver. Given the recent volatility and the potential for volatility of a negative kind sometime in the future, do you think there should be further consideration given to the concept of having some counterbalancing mechanism that more responsively counters such volatility or uncertainty in the real estate market?

Mr Stevens : As for oversupply, I think our sense would be that there may be a bit of oversupply in some pockets. I do not think we would believe that we are heading into oversupply in aggregate, and certainly not in this city. As for other instruments, I know this is something that you have proposed before, and I, as a matter of principle, am open to the use of various new instruments. We might need to keep in mind that you have to think about who is going to wield them, how and to what end, and we, of course, do not have any experience in how these things would work. All those would be important considerations in getting too optimistic that we can tweak the property market as we would like with various new instruments. I would counsel caution—not undue negativity. But I would be cautious in that space, as I think I have said before.

Mr ALEXANDER: If it were possible, would it be desirable to contain real estate inflation within a prescribed range?

Mr Stevens : I am not sure it is possible. I am not confident that I could judge what the appropriate range might be. I think it would be a rather wide range—a lot wider than the two to three per cent we think of for CPI inflation. When we are thinking about general goods and services inflation, we have got enough knowledge to know that 10 per cent is way too high, that you should not aim at absolute zero and that a small positive number with a bit of allowance for variation across the cycle makes sense. I think we know enough about how economies work and the history of inflation and so on to be able to calibrate that. Is the right number two or 2½ or 1½ or three? Frankly, it is not possible to be doctrinaire about that, but we know it is not 10 or 50.

I am not sure I know quite what the right rate of average inflation for an asset price is. I think they are more complicated things. So far as I am aware, in the economics profession I do not think there would be many people who would be strongly supportive of a rate-of-price increase target for housing prices. I do not know—Phil, do you want to add anything?

Dr Lowe : Yes, there is generally little support for making that an explicit target of policy. Going back to the more general issue that you were touching on, I think that ever-rising house prices relative to people's incomes are not good for the society, partly for the social reasons that Glenn alluded to. So, if house prices are rising a lot relative to incomes, I think that how to deal with that is a legitimate issue of public policy. My own view is that that is largely dealt with on the supply side, that increasing the supply of housing is the main thing that you can do to reduce housing prices relative to people's income. And we are doing a reasonable job there now. I think the big increase in supply that we have seen is not unrelated to the changing price dynamics that we are seeing in some markets, and ultimately that is the best solution here—to make sure that the supply side is sufficiently flexible and that the infrastructure is there to make the new housing accessible to people. Ultimately that is the most sustainable solution. Trying to make house prices an explicit target for policy—I see just so many problems with that.

Mr ALEXANDER: The concern that you probably had was that, because of the very low interest rates, the deductibility and the favourable capital gains tax rates on real estate, you may increase supply, but the same game will play out time and again, where the investor always beats the new home buyer. So supply might not be the entire answer. It should be balanced with a cooling of the investor's ability to beat the home buyer-occupier.

Dr Lowe : I think that, as Glenn said, the issues there would be: who is going to exercise this instrument? What criteria would they use to exercise it, and what other distortions would you create in the system? We should not aim for perfection here. I think we should be just focusing on a general increase in the aggregate supply of housing. That may not get you the perfect stability in the housing market that you are seeking, but I think it is going to go a fair way to addressing what is ultimately the fundamental problem here, which is ever-rising house prices relative to people's income, which is not good.

Someone asked earlier on about the wealth effects of the higher house prices. I look at what has happened in recent years. I would say the wealth effects are relatively muted compared to what we saw in the early 2000s when house prices were rising. I think it is because many people realise that, as their house price goes up, it is actually not creating genuine net wealth, because there are many people like me who would worry about the cost of housing for their children. They see: 'Well, I might get a capital gain on a house that I own, but my children are ultimately going to have to pay higher prices for their housing.' I think that increasingly in our society people appreciate or understand that intertemporal dynamic and that the wealth effects are not as strong as they previously were. It is really the social effects of reinforcing or even making worse the distribution of wealth across the society and the flexibility of people to move from one area to another or one part of the city to another—ultimately that is, I think, the bigger problem here, and supply, supply, supply is the way to address that.

Mr ALEXANDER: I would venture that the range that you might aim for is to put a limit on upward movement that we could not tolerate when it turns and falls—that there is an unacceptable level of damage, as a philosophical thing.

Dr Lowe : I think it is worth exploring. I think that the main issue is really the level of prices relative to the level of people's income, not the annual change in asset prices, because they can move around quickly for various reasons, and we should not be trying to stop that adjustment. It is really the level of house prices relative to people's income, and I think that is something that is a legitimate issue for public policy. If you see that ratio moving clearly in a direction that you are uncomfortable with, I think it is something that policy should focus on. But—to repeat myself—I think it is ultimately the supply policy that is the right one there.

Mr ALEXANDER: I too would like to add my compliments to the Governor, with Mr Buchholz. Looking at your likely career path, I hope this conversation continues.

Mr COLEMAN: Good morning, Governor and gentlemen. I just want to pick up on some of Mr Conroy's points before about the relative increase in employment in services, business services and household services and so on. Is that something that you have seen in other industrialised nations that are going through perhaps similar transitions, perhaps somewhat away from manufacturing and so on and more towards services?

Mr Stevens : The general trend towards economies having a higher weight of services in their output is one that is quite common to advanced countries and even countries that are emerging, so-called. China, in particular, is seeing the same thing. So that is common, and I think probably it would be true to say right now in the United States that they have had a fair bit of employment growth compared with the GDP growth they have seen. A little bit like us, perhaps, there are different things at work there. So these experiences have some echo in other places, for sure, yes.

Mr COLEMAN: Does that suggest that in the long run you would see capital investment forming a smaller proportion of GDP?

Mr Stevens : If we continue to move to a world increasingly where the services demanded by society could be supplied by an individual with an iPhone, if that is the world we are moving to, then, yes, you need certainly less capital associated with that particular worker. You may need other sorts of infrastructure capital, of course, to make all the technology work. I am not sure how far that trend can actually extend. I do not know. It seems to be to some extent a feature of the world we have been living in lately. Do you want to add anything?

Dr Kent : I was just going to mention briefly that the sort of fundamental driver of this, amongst other things, is that typically through human history we get pretty good productivity growth in the goods sector. We get better at making those things with less inputs, particularly less labour, which frees up labour to work in the services sector, and services are the things that, as we get wealthier, we tend to demand more of—education and health, just to name a couple. So recognising that is important. That is a global phenomenon, and hence this is happening not just in the advanced economies but in the developed world as well.

The other thing to recognise is that we have had a really big increase in capacity in manufacturing globally for a period of time. China are a very obvious source of that. They have done a lot of investment in producing goods, and the world is finding that it has a bit of an excess capacity, so industrial production is weak globally and in China. So maybe it is partly that the world does not need a lot of investment of physical capital to produce the goods and services, as the Governor suggested—it does not need as much capital; it needs a lot of labour. So it is not necessarily an enduring thing that we will see weak investment, but after a period of a big run-up in the global capacity to produce manufactured things maybe the world needs to pause there for a while. And that seems to be what is happening.

Mr COLEMAN: Does that suggest over time more people being employed in the services sector and that heir productivity becomes particularly important in GDP growth in the long run?

Dr Kent : I guess so. There is a sense, I think, globally, that part of the reason for the slowdown in productivity is we just keep moving into more production of services that just naturally tend to experience a bit less productivity growth. The nature of some of the services that people are wanting, whether it is education or, for example, the experience of going out, staying in a hotel, eating out, as part of your travel experience—the way those services are produced do not look too different from how they were produced a long time ago. So it is just the nature of the production process. It is not to say there is no productivity growth in services; there absolutely is.

Mr Stevens : It is the old story someone told: if the service we are consuming is listening to a symphony, we do not actually want the orchestra to play it twice as fast and be twice as productive per hour.


Mr Stevens : We probably want to record it better and have a better listening experience later. That is productivity.

CHAIR: I enjoyed the hotel example. You can use as many of those examples as you like. That is a very good analogy.

Mr HUSIC: He is very slow at pulling beers though!

Mr COLEMAN: In what you might describe as the more 'elaborate' services, for want of a better term, in technology and things like that, there are obviously significant opportunities for productivity growth in those areas.

Dr Kent : No doubt, and I think we will see that. That is going to help us drive incomes. That will produce employment that generates good wages and generates profits that are very sustainable—so absolutely.

Mr COLEMAN: Just another point on China, and this is just a general observation. Obviously, there are ups and downs in the commentary and what happens month to month, but with a GDP per capita of about a quarter of the Western world, it suggests that there is so much headroom for China to grow that, whatever the short-term variations in things, the long-term story is so very positive that there is reason for us to be optimistic about it.

Mr Stevens : There is no doubt that the potential for Chinese income per head to catch up to the Western world is massive. It is not guaranteed that catch-up happens. You have to do things right to realise the potential. You probably have to screw up pretty badly for an extended period not to have a fair bit of that potential realised, I think. I agree with you.

Mr COLEMAN: Just on Japan, in recent years it has been bumping along the bottom, up and down, but generally not a fantastic performance. When you are forecasting the impact on Australia, it is still our second biggest trading partner and so on. Do you see anything that is likely to change in Japan or is it a reasonably flat sort of outlook?

Mr Stevens : Do you want to talk about what assumption we are making?

Dr Kent : Our assumption, more or less, over the next couple of years is more of the same, which is not terrible growth by historical standards for Japan but low by many other standards. Part of that is just the ageing of the population. Their population is actually shrinking and getting older and retiring. Having said that, Japan has been in this situation for quite a long time, yet they still are demanding an increasing amount of our commodities, including things like LNG. So it has not been too harmful to us. I do not know if that answers your question.

Mr COLEMAN: Yes, broadly. You said fairly similar in the next few years to what it has been in the recent past?

Dr Kent : Right.

Mr COLEMAN: In your statement today I think your last comment was something along the lines of, 'There is capacity for further easing of rates.' Is it fair to interpret that as saying that your bias might be at the moment towards a reduction in rates rather than an increase in the next change?

Mr Stevens : It is, I think, pretty unlikely we are going to be raising rates any time soon. The question will be should we sit or go down some more, and that has been the question for some years now. So, yes, if that is what we mean by biased to ease, then, yes, that is a correct understanding.

Mr COLEMAN: Thank you.

Mr CRAIG KELLY: Governor, earlier today you said that animal spirits were on the improve this year as compared to last year. Could I ask if you could better suggest why that might be?

Mr Stevens : The evidence for my proposition is, I think, borne out in most of the surveys of business that we look at. You would not say that animal spirits are absolutely ebullient, by any means, but I think they have improved. I suspect various people will want to try to frame that in a political context, and I will avoid drawing any conclusions there, I think. I think it is appropriate for me to remain out of that. At least up until now—it could be that the turbulence that we are presently seeing could change this; I do not know—I think the mood in the business community has tended to improve over the past year. I think that will be pretty accepted around the place.

Mr CRAIG KELLY: Would you then rule out that that has been actually been caused by factors other than monetary policy?

Mr Stevens : I think monetary policy plays a role, but I think there are many factors that can play into how businesses feel about the future of their own business and the country. The main thing monetary policy does is, if we can do our job, present ourselves as competent and abreast of what is going on, making the needed response but not claiming more than we can deliver—that is the best thing we can do for confidence. There are plenty of other things that affect it, not just us, that is absolutely right.

Mr CRAIG KELLY: In your opening statement you also said:

The number of people employed, as measured, increased by well over two per cent, participation in the labour force picked up and the rate of unemployment declined to be below six per cent. That is a noticeably better outcome than we expected a year ago.

How much of those good results do you put down to animal spirits?

Mr Stevens : Some of them. If we accept the labour force data—let us discount them to some extent, perhaps, for the quality issues, but, as I said earlier, I do not think you can completely discount them—I am being arbitrary: let us say that we thought the true growth in employment was two per cent. That is actually a pretty good result. What that tells you is—and this is borne out by vacancies as well—people in businesses have started businesses and employed themselves or they have employed other people. So they had enough animal spirits to do that. Something has happened there in the past 12 months more than had been happening earlier. So something has been going on, and enough businesses around the country have had the confidence, the animal spirits, the need, whatever you want to call it, to employ some more bodies.

Mr CRAIG KELLY: Would you agree that that has not been created by any reduction in interest rates?

Mr Stevens : Interest rates have played their role. What we see is that employment in housing construction has grown very strongly. I think interest rates have had a fair bit to do with that. They are not the only factor but a pretty important one. But across other parts of the economy the effect of interest rates is much less direct. So I would say that monetary policy has played its role—the exchange rate coming down to levels which I think have helped competitiveness considerably. That is not to say it might not go down some more, but I think what has occurred thus far has had an effect in areas like tourism, education and so on, and we get this quite strongly in our liaison. Even parts of manufacturing now—some parts—have noted to us in liaison that the exchange rate has made a difference. So that is working. All these things are contributing.

Mr CRAIG KELLY: There was an article published earlier this week in The American Spectator. If I just quote a few passages from it, you might like to comment. It said:

America is languishing from historically low growth rates for the past ten years … In the fourth quarter of 2015, our growth rate was less than 1% at .70%.

It goes on to talk about Japan. It says:

Japan has followed this same pattern of high tax rates, lower interest rates, and endless government spending for the past 25 years. The result is massive federal debt, a slow growth economy, and reduced international competitiveness.

Then it goes on to Europe:

Europe has followed the same prescription, with similar results …

Then it goes on:

Jean-Baptiste Say theorized that the growth of economies is not demand-driven, but growth is created by new and lower cost products and services.

Do you think that governments worldwide over the past six, seven or eight years have been too much focused on stimulating from the demand side rather than from the supply side?

Mr Stevens : Say's law, as it is known, is a long-run proposition that supply creates its own demand. I think my colleagues are more educated in economics than I, but my sense is that mainstream economics would admit that there are occasions when, for one reason or another, aggregate demand in the economy can fall short of its supply capacity, and we lived through one of those. It is actually pretty likely that will happen in a financial crisis, and that is what happened. So it was appropriate for the countries affected—which were many, including us—to adopt more expansionary demand management policies, both monetary and, where space allowed, fiscal.

But then the question is: it is one thing to manage demand around the cycle—most mainstream economics accepts that some of that should be done, especially in deep downturn episodes where it is virtually certain that it is a deficiency of demand that has caused it—but, in the longer run, where does the growth come from? This is a point where I am a broken record, but this is the point we have made many times. It cannot really be the case that we get long-run growth by just using monetary policy which, in the end, borrows from tomorrow's income to spend today. That cannot be a recipe for sustained, strong long-run growth. The sustained and strong long-run growth in living standards comes from innovation, risk taking, productivity et cetera et cetera. We have talked about all that, as you know, many times before, and I think the committee understands our view.

So I would say that in the past seven or eight years too much has been expected of monetary policy to keep delivering growth. Really—and I am speaking at a global level here—monetary policy globally has been asked to do something it cannot really do. It is not simple to put long-run growth on a better track, but this is why, when we hosted the G20, we talked about the growth plan structural initiatives. None of those initiatives were that the central bank should cut rates further to get the two per cent extra growth the G20 talked about, they were all structural things to help make economies work better—to help productivity, to assist innovation et cetera. That is where prosperity comes from. It does not come from manipulating the price of money. There is a place for doing that in a demand downturn but long-term growth does not come from that. We have been very clear about that.

Mr CRAIG KELLY: Would Dr Lowe or Dr Kent like to make a comment on those points?

Dr Lowe : I think the fundamental problem in the global economy at the moment is that there is this very elevated appetite for people to save because they borrowed too much previously—the private sector and governments—and the desire to invest is very low. Even though companies around the world can borrow at the lowest interest rates in a century, investment is very low. So there is all these savings and people do not want to use them. How do you get out of that problem? As Glenn was saying, at a global level, it is not just through ever lower interest rates. The level of borrowing costs is the lowest in the century. So that is not the solution. The solution is to get more people to invest. How can governments do that? Through creating in a whole range of areas a pro-investment climate that focuses on innovation, productivity and incentives for people to take risks. In some cases, there is also a possibility for the government itself to invest, particularly in national infrastructure assets which have a strong cost-benefit case. Borrowing costs for governments around the world—many of them—are also the lowest in a century. But governments themselves the do not want to invest in assets because—

Mr CRAIG KELLY: You are assuming that we governments can spend it wisely, however.

Dr Lowe : This is the issue: can you find investment projects that generate sufficient returns to the society? I think this is the problem that many people have—governance around project selection. The inability to solve those problems at the global level is making governments themselves reluctant to use the very low interest rates to build assets. Glenn spoke about the G20. One of the things we spoke a lot about is: is there some way that governments, either through their own balance sheet or through other mechanisms, can encourage infrastructure investment? The basic problem that the world faces is that no-one wants to use this pool of savings. We have got to somehow create a climate where the private sector, and in some cases possibly the government, use the pool of savings to expand aggregate demand.

Mr CRAIG KELLY: You talk about the climate that we need for investment and innovation in Australia. Is it a concern to you that our corporate tax rate is substantially higher than our nearest competitors—Hong Kong, New Zealand, Singapore?

Dr Lowe : I do not think that is the main issue here. It is across a whole range of policies. You could systematically go through and say: how do we create a pro-investment climate? Much of it is about the culture—links with business and university, the tax rates that people face on investments, their incentive to invest. There is no one magic bullet.

Mr CRAIG KELLY: But our tax rates being higher than those of our international competitors must have some slight negative effect on that innovation and investment.

Dr Lowe : You could argue that at the margin but I think it would be incorrect to focus on corporate taxation as the solution here. It is more holistic in terms of the general incentives that people face for education and collaboration with universities. There is a whole range of things. I would not like to single out corporate tax as the magic bullet here. There is not a single solution. It is about working across a whole range of areas to create a pro-investment climate for the economy. And it is not just Australia, of course. Investment in all the advanced economies is kind of low. Ultimately, as Glenn was saying, it is improvements in technology that will be the cause of future increases in our living standards. There is no other way. So we have got to have an environment that encourages technological advancement and the use of that technology for production.

Mr CRAIG KELLY: Just on another subject, you also talked about a decline in our terms of trade, and obviously that is different for different parts of the economy. The average consumer would benefit from lower petrol prices. Could you maybe expand a bit on how our terms of trade could affect some parts of the economy negatively and some parts of the economy, perhaps, positively, where we are seeing that decline in oil prices?

Mr Stevens : A fall in oil prices at the moment is a positive terms-of-trade event for Australia. In the future, it will not be, because we will be a net energy exporter because of the gas that we talked about earlier. But at present a fall in the price of oil is a terms-of-trade gain for this country. The terms-of-trade loss is happening because of lower coal, iron ore and other metals prices. Where does the average person see that? Well, I think the average person in Western Australia is seeing that through generally weaker conditions in that state. For the rest of us, in the east: if we are shareholders, we are seeing it—we talked earlier about dividends. I think the way that the terms of trade decline, also governments see it, and therefore government has fewer resources. As citizens, we are clearly affected there. One of the ways that we here in Sydney would experience the lower terms of trade is that the exchange rate goes down as the terms of trade fall, and therefore our purchasing power directly over foreign goods and services goes down. And that is actually what a terms-of-trade decline means; it means the purchasing power of our national output basket over foreign goods and services is reduced, and the most direct manifestation that most of us have of that is: the exchange rate goes down, and the price of petrol, although low, is higher than it would have been if the exchange rate had not fallen. If we want to go on holidays to Hawaii—which, I read, many of us do—it costs more, because the exchange rate is lower. That is one of the ways that we are experiencing the loss of national income that a lower terms of trade means.

Mr CRAIG KELLY: So if one of the bonuses is that lower petrol price, surely it must be a concern to the Reserve Bank, and also should be to governments, if we are not getting that reduction in petrol price at the bowser through, perhaps, competition issues. I think you mentioned 8c to 12c a litre earlier, Dr Kent?

Dr Kent : Yes.

Mr CRAIG KELLY: If we are not getting that through, surely that has a significant effect on the economy?

Mr Stevens : This is an issue of incremental increases, or not, in real consumer income, and some of these margins, of course, as Chris said, I think are refiner margins. They are not actually in this country, necessarily. We may not like that. I am not sure what we do. To the extent that we are talking about domestic retail margins, that is clearly a potential matter for the competition authorities, and I think actually they keep a close eye on that, is my understanding.

CHAIR: Governor, the buzzword at the moment, obviously, is that there is a conversation happening about taxation—at least, within the government there is.

Mr HUSIC: Oh yeah!

CHAIR: The Treasurer has repeatedly raised the issue of bracket creep, and I am interested in the Reserve Bank's thinking re future growth within the economy and the impact that fiscal drag may have if not addressed by government.

Mr Stevens : I am not across all the tax details. My understanding is that, under the current tax scales if they are not adjusted, clearly we will have progressively more people moving up into higher tax brackets. That is true. I am not sure I can quantify for you what the incentive effect of that is, which I think is the important thing. The important thing here is incentives to work or not and to take risk or not. They are the kind of longer run growth impacts that we should be concerned about. I cannot quantify those.

I would observe that the broader conversation that I am still not sure the country is having, really, is that, as I have said before, we have all voted as voters for the government to give us good things; we have not actually voted for the funding. There is a gap. It is not disastrous—we are not heading to hell any time soon here—but there is an issue here over the medium term that still, it seems to me, we are not quite having a conversation in the country about. That is relevant for thinking about how much relief you feel you will be able to give to median and average earners as they step up into these brackets, because sooner or later we do have to have the conversation about funding the very good things that we all want, and I do not think we have quite had it yet.

CHAIR: Presumably, though—digging into the middle of that answer—if bracket creep continues to occur moving forward, not just over the forward estimates of the budget but, say, in the medium term—the 10 years; we jump between the four- and 10-year analysis—the resultant decrease in income to any wage earner would have to have a detrimental impact on growth moving forward.

Mr Stevens : Compared with not having the bracket creep, that is right. So what is happening there is that this is basically automatic stabilisers in the budget working to act in a restraining way. As the economy grows and people's incomes rise, more tax proportionately gets extracted, the budget deficit would be smaller, government borrows less, and the government is in effect through that default mechanism, so far as I can see, appropriating through the tax system the resources that it is spending on the spending side. That is what will happen. Yes, you and I—well, we are bad examples—or the median earner, compared with a world where the tax scales were indexed, say, has less resources in their pocket, because the government now has them to do what it is doing. That is the scenario that you paint. That is right.

CHAIR: Finally, before I hand to the deputy chair to conclude, given those two answers—and I agree with you, by the way, that the expectation of what the community want and the way it is funded are fundamentally mismatched at the moment—there are two possible ways to fix that moving forward: decrease taxation and spending, or increase taxation and spending. Which one—to fix that fundamental mismatch—would be more beneficial to growth of the economy moving forward?

Mr Stevens : I think the answer to that depends on what weight you attach to the value and the importance of a particular level of government spending as a share of the economy, versus the disincentives of the taxation that is required to fund it. The way of closing the gap that you did not mention, which we may end up with by default, is a bit less spending and a bit more tax to close the gap.

CHAIR: Of the three, then—insert a third model, granted—

Mr Stevens : I am reluctant to be drawn too far here because, at an extreme, people will say, and with justification, that tax is a restraint on private economic activity, so you are going to have less of it if you levy tax. Well, that has to be true, but that, pushed to extreme, means that you have no government, no defence, no police, no public infrastructure. Obviously that is not a very good economy either, so there is an optimum to be struck. I do not know quite where that is. Many countries have struck the balance at much higher levels of taxation and spending than we have. I am not sure they are very good models though. Some have struck it lower. But this is a conversation that has to be had, and it is the responsibility of the political leaders to engage the community in it.

There is the slightly separable question of raising whatever amount of revenue we have decided we need the most efficient way, which is really what tax reform is about. That is a slightly separate question.

CHAIR: Fair enough.

Mr HUSIC: There are two issues. First, given the drop in commodity prices, are you perplexed by the resilience of the dollar?

Mr Stevens : There was a period when we felt that the exchange rate was not quite doing the job we might have expected, and we said so. It then adjusted, and our language has of late been, 'It's adjusting.' I would still say that. I would also note that commodity prices are continuing to fall as we speak.

Mr HUSIC: On another, quite distinct matter: late last year, the person responsible for incinerating damaged banknotes pleaded guilty to pocketing close to a million dollars, following an investigation by the AFP. I know that the bank has viewed this as a very serious issue. The alleged proceeds of the crime were spent to fund a fairly lavish lifestyle, and this person handed themselves in in August last year. I note that the Reserve Bank, through a spokesperson, and Note Printing Australia, which I understand is a subsidiary wholly owned by the RBA, said:

Following this matter in 2012, processes and procedures at the bank's Craigieburn office were reviewed by an independent security specialist and some improvements implemented …

In the time I have been here as the deputy chair, I do not think—and I am happy to stand corrected, Governor—the RBA has ever updated us as part of our review process of the RBA as to where things are at on this matter, and we have had a development since our last meeting. Why has the RBA not updated us on this, and do you have anything that you can provide by way of an update on 'some improvements'?

Mr Stevens : The failures that allowed the person concerned to do what he did were serious failures of procedure and security. The security, had it been implemented properly, would have prevented it, but there were serious lapses in its implementation. They have all been addressed so far as I know. I could check—I do not have in my mind the detail now of what the external consultant recommended. I would be very surprised if we had not implemented every substantive thing that was there, so that has been done.

As for what we say to the committee, we certainly respond to your questions. If you have them, I am happy to do so, including offline if you have further detailed questions.

Mr HUSIC: Is it incumbent on us to ask you those questions, or does the RBA accept that it should be a bit more up front about the way that it is dealing with something that I think a lot of people would have genuine concerns about?

Mr Stevens : I do not think we are in any way seeking to conceal, from this committee or anything else, that matter. It has been in the papers. It was appropriately dealt with by the authorities—police, prosecutors and so on. We are not hiding anything about it. We are quite happy to respond to questions about it. Most of the interest of the committee is usually on the things we talked about today.

Mr HUSIC: Sure, but when you look at your website at around the time that this matter was ventilated, in late November, there is nothing in your media release section that says what you are doing and there is nothing in the speeches that are being given by RBA officials. You have said you will take on notice what we are saying. You say you are not hiding anything, but you are not exactly being up-front either, on your own websites or in statements you make to the public or to the committee, about this matter. I am asking: will there be a change to this, will you be providing an update on where things are at, and will you actually say what processes have changed to ensure this is not repeated? The other question I would ask is: what is the board doing to change the way it oversights this type of issue so that it is not repeated or the chances of it are minimised.

Mr Stevens : I think the board, through the audit process and other reporting, has had visibility of this matter and the bank's operations at Craigieburn generally. So I think their oversight is good. I think the way the matter was dealt with is that it came to our attention as a result, basically, of someone speaking up, the appropriate action was taken, the police were called, the relevant person concerned was charged and so on, and we have not sought to hide any of that. It is certainly true that we do not make public announcements that this has happened. That would be a new idea to me, frankly, that we should do that. I think the appropriate thing is to deal with it, fix the problem—which we have—and let the legal process do its job, which we did.

Mr HUSIC: The issue has been serious enough for Transparency International to actually point to this episode as an issue of concern about the way that public sector corruption is managed in this country. I am not, by the way—

Mr Stevens : I do not see why.

Mr HUSIC: Well, they have pointed to it and basically, in late January this year, have released an overview of the way in which governments manage these things worldwide, and they have seen fit to actually point to this matter as a serious one, and yet—

Mr Stevens : Well, they may have, but—

Mr HUSIC: If I can just finish the question, Governor, you have indicated that you do not see why you should release details of how you are managing it. We do not necessarily need to know the nuts and bolts of what actually occurred. What I am asking for is: what processes and systems have changed to avoid a situation with a million dollars that was supposed to be burned and destroyed, so that we do not see a repeat of that type of action where that money is taken away and not treated in the way it should be? What has changed?

Mr Stevens : All the security, in terms of multiple locks, triple control, the video camera in operation—all those things that were at fault at the time, which opened the loophole or the weakness for that individual to do what he did. Those things have been fixed. They have all been fixed.

Mr HUSIC: My final question is: have you detailed that? Other than in response to my questioning right now, have you detailed that in an open and transparent way elsewhere that I have overlooked?

Mr Stevens : I cannot point you to a website release or a public statement, no. I do not think I can.

Mr HUSIC: Are you happy and satisfied with that situation?

Mr Stevens : I think we have handled it properly. We fixed the problem.

Mr CONROY: I have two quick questions, Governor. We were talking about tax before, and I acknowledged we can always have debates about the mix of taxes and the current gap between tax and expenditure, but it is true that amongst developed nations—OECD nations—we are one of the lowest taxing nations. I just had a quick look online, and I think we ranked about sixth. Is that your understanding too? I am not trying to get into a political debate, but we are one of the lowest taxing developed nations in the world, aren't we?

Mr Stevens : My recollection is that in the OECD group we are down towards the lower end there—probably not at the lower end. Of course, a number of the quite low tax jurisdictions are not in the OECD.

Mr CONROY: I accept that. I just wanted to try and put that in context. Given the depreciation of the dollar, have we seen that flowing fully through into the CPI, or is it still the case that, for example, retailers are squeezing their margins to maintain market share? Are you expecting more of an inflation bump from where the dollar is and where it is expected to go?

Mr Stevens : There are still, I think, further effects of the depreciation to come through. Chris would be able to talk to the detail. I think we have seen a bit but, if the relationships of the past are repeated, there would be further to come.

Dr Kent : Yes, that is right. As the governor suggested, we do have further pass-through of the exchange rate effect to come through still, and that will take a couple of years, if history is any guide. What we have seen to date has been less than history might have suggested, but in any given episode there is always quite a lot of variability about how much is passed through.

What we have seen in a range of goods, particularly consumer durable goods, is that consumers benefited to an extent beyond what you might have thought, given that the costs of importing these things have definitely gone up. The ABS provides measures of the cost of those things landing at the docks. They have gone up, basically in line with the movements in the exchange rate.

There are a number of reasons why that takes time to pass through to final prices, but there are lots of pressures coming to bear that have probably reduced at least evidence of those price increases of goods across the docks in the final prices they pay, including pressure on margins at the retail and wholesale level, as well as retailers, wholesalers and the transport industry striving for efficiency gains. Part of that does seem to be that there is quite a lot of extra competition, including in the retail sector, from new entrants, whether that is in supermarkets and food, with some of the big new entrants there, or in clothing and retail generally.

Mr CONROY: To the extent that it has flowed through and will flow through, is it of such generalised impact that it is part of your measure of underlying inflation, or is it something that you see through? I am just asking from a technical point of view. Is it something that is just so broad that it has to be taken account of when you measure underlying inflation, or is it like other shocks that you tend to try and see through?

Dr Kent : It is there in underlying inflation, and the process can take a long time. The amount that you think you can measure coming through, say, trade or prices of goods and services is quite volatile from one quarter to the next. But yes, it should come through and our forecasts have it coming through in a gradual way over the course of the next couple of years.

CHAIR: Thank you, Governor. We might finish this session the same way we did the first one, and that is by asking Lyarna and Sophie to come up. Lyarna is the school captain of Inaburra School in Menai and she has a lot of her classmates sitting behind you. She would like to ask you a question.

Lyarna Woellner : My question today is that, given we live in a competitive global world where we can choose to work here or somewhere else like Singapore, is there a danger that our current Australian personal tax rates may discourage my generation from staying in Sydney to work?

Mr Stevens : Good question, Lyarna—thank you. I think there is a sense in which certain types of high-skilled labour probably do pay attention to tax rates across countries, and there is a phenomenon already where people are prepared to shift location in order to benefit from lower taxes. I think that is a relevant factor in the marginal tax rate for some people. I suspect that, for the bulk of people presently working, it is not the main factor. But for people with very high prospects in the future, like yourself, it may well be important. I guess the thing to remember also will be that the headline marginal tax rate is not the only factor to consider. Some countries have other sorts of taxes—state taxes, local taxes—and various other things that also need to be taken into account in making that comparison, including public amenity, lifestyle issues and so on. But I think it is a relevant consideration that you raise that. For the most skilled and the most mobile labour, that marginal tax rate is a thing that matters—not the only thing, but it certainly does matter.

CHAIR: Excellent question, Lyarna.

Lyarna Woellner: Thank you.

CHAIR: To conclude today, joining us from Domremy College in Five Dock we have Sophie Markakis from year 11, who would like to ask you a question.

Sophie Markakis: We were wondering: if the Australian dollar were to depreciate too far, would you use the monetary policy to prop up the dollar?

Mr Stevens : The level of the exchange rate and its effect on the economy is certainly something that we have to take into account when setting monetary policy. I am a bit cautious, though, about the idea that we would try to configure the interest rates specifically to just affect the currency. The history when countries have sought to do that is not always happy. In fact, it is, more often than not, an unhappy one. So the exchange rate matters—it is taken into account—but we do not try to directly target it with the interest rate.

Sophie Markakis: Thank you.

CHAIR: Thank you very much, Sophie. Governor Stevens, Dr Lowe and Dr Kent, on behalf of the committee I would like to thank you very much for answering not only our questions but those of our amazing students behind us.

Resolved that these proceedings be published.

Committee adjourned at 12:22