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To outsiders looking in, Australia appears to be a prosperous country riding out the world recession on the crest of a booming mining industry.

Given this, it might be fair to assume that the country's higher education system is also in rude financial health. But those who scratch beneath the surface will discover cracks that could quickly create a funding crisis, especially if government ministers, like those in the UK, one day wake up to find that the money has run out.

A key moment for Australia's universities will be the transition next year to a "demand-led" system, under which restrictions on state-supported student places at individual institutions will be removed. While it is not clear what impact the policy will have, its success will be crucial, especially in light of a recent - and significant - drop in demand from overseas students.

So at what funding crossroads does Australia now find itself and how has it reached this juncture? What lessons can be learned by university systems elsewhere, particularly in the UK? And what risks does the country's higher education system face in the future?

Examining how higher education funding in Australia has evolved over the past 25 years, one trend is apparent above all others: a general drift downwards in the government's direct investment per student.

Since the introduction of Australia's Higher Education Contribution Scheme (Hecs) in 1989, the amount of university teaching funding that comes from students - who can take out government-backed loans that do not have to be paid back until graduation - has almost tripled. Meanwhile, government funding fell from 1994 to 2001 and has only recently regained ground.

Overall, the amount invested per student, taking into consideration both private and public contributions, is barely above what it was in 1989.

"There was a view that the federal government was insufficiently investing in higher education for a long period of time," says Peter Coaldrake, vice-chancellor of the Queensland University of Technology, who recently completed a term as chairman of Universities Australia.

The Liberal-National coalition government led by prime minister John Howard from 1996 to 2007 presided over much of this drift, Coaldrake explains. However, he acknowledges, it also boosted funding during its final years in office.

In an attempt to bridge the increasing gap between domestic funding and the cost of provision, universities went for the international student market in a big way. As a consequence, in recent years Australia has been far ahead of any other industrialised nation when it comes to the proportion of university students from overseas.

The problem is that this strategy - which many would argue has failed to stop an erosion in teaching standards - is now facing an imminent day of reckoning as demand falters because of a potent mixture of government visa policies, a strong Australian dollar and the reputational damage from violent race attacks on Indian students in Melbourne and Sydney in 2009.

"Restrictions on the supply side have now been followed by a sharp drop in demand, and this has spread from India - where demand for Australian education was always soft - to China, where it has long been robust," says Simon Marginson, professor of higher education at the University of Melbourne.

The Labor government has been rattled enough to review its student visa rules, first by making some immediate concessions and second through a wider review of the policy by Michael Knight, a former minister for the Sydney Olympics in the New South Wales state government.

But Marginson believes that there is a limit to how far politicians can now go on immigration, given that polling suggests that the country's electorate has turned against previous governments' commitment to a pro-immigration "Big Australia".

One of the Australian institutions hit hardest by the dent to the international market is Monash University, where around 30 per cent of students are from overseas. More than 300 members of staff recently took redundancy as the university sought to offset a predicted drop in enrolment.

Its vice-chancellor, Ed Byrne, says that the institution is in "robust financial shape" after allowing "for a small, modest but real contraction" in the international student market.

However, he is clearly not banking on a long-term recovery in overseas recruitment, forecasting that it will "stabilise at a lower level than it has been at its peak".

Paul Johnson, the vice-chancellor of La Trobe University who is soon to take the helm at the University of Western Australia, thinks that while Australia will never regain its share of the international student market, it will regain the numbers.

"The international student market is going to grow," he says. While many countries are expanding their own higher education systems, "the growth of middle-class spending power in India, Thailand, Indonesia, Malaysia and so on is growing faster", so demand for higher education will outstrip domestic supply.

There is no doubt that the current dip in overseas student numbers is putting the focus firmly back on to the domestic system, and the move to demand-driven places gives an opportunity to counter the loss of income.

The proposal to lift caps on state-sponsored domestic student places has its origins in the landmark review of Australian higher education led by Denise Bradley, former vice-chancellor of the University of South Australia, in 2008.

The Bradley Review recommended that Australia should introduce a demand-led system as a key driver in meeting another of the review's targets - that at least 40 per cent of 25- to 34-year-olds should possess a degree by 2020.

Currently the federal government will directly fund student places up to 10 per cent above a set limit for each university. Unlike the situation faced by their English counterparts in recent years, Australian universities can recruit more students above the cap without being fined. However, they do not receive any public funding for these extra students.

But under the demand-driven system proposed by the Bradley Review, and set to be implemented from 2012, most limits will be removed and the government will fully fund students wherever they choose to study.

If this had happened a few years ago, says Johnson, research-intensive universities might have questioned whether they wanted to take on more domestic undergraduates. But the game has changed; the loss of overseas students will create the room and incentive for domestic growth.

Many universities across Australia have recruited more undergraduates, in some cases above the cap, in anticipation of the demand-driven system coming on stream.

However, by turning to domestic growth to fill the gap left by the international market, vice-chancellors return to the same problem that led them to recruit from overseas in the first place: they argue that funding per student does not cover the real cost of a degree.

The Bradley Review sought to address this problem by calling for a 10 per cent increase in "base funding" for teaching and learning in higher education, with an improved formula for determining future increases.

But although the Labor government has allocated funding for the introduction of a demand-led system, the crucial issue of base funding will be considered in a review being led by Jane Lomax-Smith, another former Labor politician from a state legislature.

The Lomax-Smith Review, expected to report later this year, is taking a fresh look at the "enduring principles" that underlie public investment in higher education, and it is paying particular attention to the relative contributions from students and government and how they are determined (table, below).

It is therefore traversing the same politically treacherous territory encountered by the Browne Review in England, grappling with the question of who pays for higher education in a world of wider participation and limited resources.

At the moment, the amount of government grant that Australian universities receive for each student varies according to the subject studied.

Different subjects fall into different groups, with each group funded differently. Funding levels have evolved over time and have taken into account many factors, including the cost of providing particular courses, the economic importance of certain subjects to the country, and likely graduate salaries.

As a result, according to Johnson, "there is no logic to the existing subsidy structure".

The Lomax-Smith Review will attempt to untangle this web, according to the terms of reference, by "examining the relative costs of delivering courses by discipline and course level". The aim is to recommend a level of funding that can sustain the system as a whole in future.

However, for many vice-chancellors, assessing the relative costs of teaching will be a nearly impossible task. While he was deputy director of the London School of Economics, Johnson carried out an analysis of teaching that he says showed how difficult it is to link costs and subjects.

"I think the attempt to get at a technocratic view of the real cost of teaching will fail because the cost of teaching is inevitably contextual," he says.

According to Coaldrake, the area is "complex territory and almost politically impenetrable". Therefore, he argues, Lomax-Smith should instead "stand back a bit and look at some principles for the use of the public dollar from the perspective of the students".

Others think the review will take a keen interest in whether universities are using resources efficiently - a focus that is familiar in the UK.

"No government can really afford to continue along the track that we've been following for the past 20 or 30 years," says Steven Schwartz, vice-chancellor of Macquarie University in Sydney.

"What I mean by that is the traditional universities with long, languid holidays and buildings that are used for only half the year.

"If we are going to have quite a few more people, are we going to build a whole lot of other buildings that are going to be empty for half the year because universities only teach in the old-fashioned way?"

There is also the fundamental question of whether the review changes the current caps on student fees, which are again determined by subject area (see below).

Andrew Norton, research Fellow at the Centre for Independent Studies, an Australian public policy thinktank, believes that without more flexibility on the fees universities charge, the Lomax-Smith Review may struggle to find a solution.

He argues that, in the past, it did not matter that government subsidies per subject were "off target" compared with costs, as universities could redistribute their overall grants internally.

However, the move to the demand-led system means that discipline-level funding is potentially "very important".

"I really don't see how this can work effectively without more flexibility on student fees than we have," Norton says. "But the government, for a mix of ideological and political reasons, is unlikely to grant more fee flexibility. The outcomes could be very messy."

Johnson, however, thinks some degree of fee deregulation is possible, especially given that Labor is trailing in the polls and could be replaced by a right-leaning Liberal-National government by the time the Lomax-Smith Review is actually implemented.

He says that some of the current expansion by research-intensive institutions - which are calling for the fee cap to be lifted - anticipates a change.

"A number of universities are thinking, 'Let's take some extra students now so they're in the pipeline for that moment when the price flexibility comes in'," he says.

Regional universities are also likely to pose fundamental questions for the potential success of a demand-driven market.

As the institutions at the top of the rankings pull in more domestic students, the "likelihood is that the universities that are least prestigious, and viewed in the market - rightly or wrongly - as less attractive, will lose out," Johnson explains.

But as such universities often play a key role in supporting the local economy in very remote areas, the government will find it "politically untenable" to let them fail.

The likely result will be that "despite this move towards a market, the political pressures will be to return to a system of significant cross-subsidisation from stronger to weaker institutions in order to support a commitment to localised and regionalised public benefit", says Johnson.

Whatever Lomax-Smith recommends, the government has two clear choices - either continue with the present situation of funding degrees below their real cost, or fully fund them and limit expansion of the system.

"The former approach carries fewer political penalties, although it leaves the system worse off. Letting quality slowly deteriorate has not cost any Australian government in the past two decades," says Marginson. The flaw in this approach, however, is that international fees may no longer be there to save the day.

Marginson notes that the federal government has given itself room to manoeuvre by putting a "safety valve" in legislation for the demand-driven system that retains powers to cap numbers and, if necessary, to limit funding.

This calls into question whether it will be a proper demand-driven system at all. Schwartz says the system "is not the full competitive voucher system that a lot of people described it as".

"It is obvious that they (the government) want to be able to control it if everything gets out of hand or if the budget requires it."

Quality is a key consideration for countries trying to corner the global student market, and on this - especially the often-quoted measure of staff-student ratios - Australia must be very careful, according to Don Nutbeam, vice-chancellor at the University of Southampton and former academic provost at the University of Sydney.

"Staff-student ratios ... have blown out in Australia over the last decade or so," he says. "If we are competing on the basis of quality, which we are, in an international global marketplace, students start to notice those sorts of things."

Australia has a new regulator, the Tertiary Education Quality and Standards Agency, and the approach it takes will be crucial, observes Paul Wellings, another UK vice-chancellor who is about to take over at an Australian institution.

"That whole debate about who's in charge of quality and standards, I suspect, is going to be, in the UK, Australia and the US, about the 'Kitemark' that students all over the world will go looking for," says Wellings, who is currently the vice-chancellor of Lancaster University and the future head of the University of Wollongong.

"In a world where you're spending more money and more of your own money, you do need some reassurance that whatever you're going to get at the end of it in terms of a degree has met whatever standard students and employers expect."

If government investment in higher education fails to match demand-led expansion and quality suffers, Wellings warns, "every silverback gorilla vice-chancellor will come out of the trees and make noises about funding instantly".

Some in the sector have asked whether the demand-led system will spark a "race to the bottom" among some universities desperate to maintain their numbers.

Monash's vice-chancellor, Ed Byrne, says: "We have no intention of doing this, but if a hypothetical university in huge demand decided to drop its entry criteria significantly, clearly you could draw a lot of students away from other institutions in the sector and cause them damage."

He suggests that this is a key reason why the Group of Eight universities - of which Monash is a member - has supported more flexible fees, although he adds that "any university would be very foolish to drop its admission standards to take more students, because they will affect their image, their stature and their brand. It would be very negative in the long term."

However, even if there is little change on fees, Byrne, who served as vice-provost for health at University College London until 2009, is still hopeful about the Australian government's commitment to higher education, which he contrasts sharply with the current turmoil in England.

"The mood in universities in Australia is a very optimistic one," he says. "The government has, by and large, committed to meet the financial demands of the Bradley Review."

In the UK, he adds, "the government clearly values higher education but it has been a lot more draconian in its approach".

On the government's decision to stop public teaching grants entirely for some subjects in England, he says: "I don't believe that would be acceptable in this country."

What is fascinating for Byrne is that recent developments in both countries have seen the shape of their higher education systems start to converge, but from two very different starting points.

"In Australia, public funding has started to rise a bit while the international student market becomes constrained. In the UK, public funding is falling...while UK universities are very keen to increase their share of the international student market.

"So, in terms of funding base, the two countries are moving a little closer to each other," he explains.

The regulatory regimes still display very important differences, however. Chief among them is that Australia does not have a "buffer" funding body separating vice-chancellors and politicians. Some argue that this makes Australian universities more politicised, but that this is not necessarily a disadvantage.

"It means vice-chancellors have more access to ministers than would be the case in the UK, but equally, ministers have more access to vice-chancellors," says Johnson.

In its submission to the base funding review, the University of Melbourne argues that a stable funding formula is possible only through an independent regulator to "ensure standards and funding are in alignment" and to "provide binding advice to government on base funding levels".

If this advice is taken on board, the Australian and English systems will end up looking remarkably similar, despite being thousands of miles apart.

Sidestepping controversy: an integrated funding system

One area of university funding where Australia has led the UK is in its system of student financing. In 2010, state-sponsored university students contributed A$3.1 billion (?2 billion) towards their education.

Introduced in 1989 by Bob Hawke's Labor government, the Higher Education Contribution Scheme (Hecs) followed a landmark review that concluded that "on historical and overseas precedents" it was "not unreasonable" to expect students to contribute about 20 per cent of the government's costs for higher education, which equated to an average of A$1,800 per student per year.

The key change brought in under the Hecs was that students could defer their payment until they graduated and were earning above a certain income threshold.

At first, students paid a flat rate of A$1,800. However, in 1997, the Hecs contribution was split into three subject "bands" - set at A$3,300, A$4,700 and A$5,500 - designed "to reflect the balance of public and private returns to higher education, the relative costs of courses and the earning potential of graduates in particular fields".

In 2005, the system was partially deregulated, renamed the Higher Education Loan Program (Help), and extended to a four-band structure, including one for "national priority" subjects.

Instead of a fixed amount, universities were allowed to set the contribution up to a maximum cap that, for most courses, was 125 per cent higher than previously.

In 2011, the highest band, covering subjects including law, medicine and economics, has a maximum contribution of just over A$9,000 (?6,032) a year, while the national priorities - mathematics, statistics and science - are capped at A$4,355.

Of the A$3.1 billion contribution charged to state-sponsored students, around A$2.4 billion is expected to be deferred.

It is significant that the Australian system has tried to avoid the emotionally charged language of fees and loans used in the UK. Libby Hackett, director of the UK's University Alliance group, which proposed a graduate contribution scheme in its submission to the recent Browne Review of higher education funding, says this decision was crucial.

"Something as simple as what you call the system was done very effectively over there," she says. "If you talk to Australians, the understanding and language of the Hecs is so embedded in their culture that it is regularly referenced in soaps. When you get to that level of referencing and cultural understanding it is quite an achievement."

Its integration means it does not attract the same political controversy as the English system, she adds, which has given the Australian federal government leeway to reduce its subsidisation of student loans.

Don Nutbeam, vice-chancellor of the University of Southampton and former academic provost at the University of Sydney, says the other impressive aspect of the Australian system is its flexibility and options for postgraduate students.

"What this reflects is a sophisticated understanding that university education isn't all about spending three years as an undergraduate," he says.

Full-fee places: a divisive issue Down Under

One of the most highly charged debates in Australian higher education in recent years has been about permitting universities to offer places to domestic students at full-fee rates.

From 1997 to 2009, Australian universities could admit domestic students who were willing to pay the full cost of a degree.

This allowed institutions to increase student numbers beyond the government cap on state-supported places.

This "off quota" option - which recently sparked a huge row in the UK when David Willetts, the universities and science minister, appeared to propose something similar - polarised opinion in Australia.

Advocates claimed that it provided much-needed income for universities when the government was slowly cutting investment per student and also created more places for poorer students.

Others contended that it gave richer students an unfair route to university study.

Don Nutbeam, vice-chancellor of the University of Southampton and former academic provost at the University of Sydney, says the issue "was probably one of the most divisive in Australian higher education for a decade".

"The reality was it was almost the only way in which we were going to see a significant expansion in domestic student numbers in higher education, certainly in the early stages of the (John Howard) government," he says.

Full-fee places are a sign that all is not right with the government's investment in higher education, according to Peter Coaldrake, vice-chancellor of the Queensland University of Technology.

"When people start talking about full-fee places, they are basically inviting the government of the day to withdraw public investment - that's where that discussion leads," he explains.

But the Australian government has now committed to increasing the number of places under a new demand-driven system and has pledged to fund any domestic student who wants a place.

Source: 2010 figures supplied by Department of Education, Employment and Workplace Relations