HSC Economics, Topic 3: Economic Issues, Part Four

External stability

Measurement

Definition of external stability

 External stability refers to the situation in which an economy is able to meet its international financial commitments. It is
denoted by the degree to which an economy’s external accounts may be regarded as sustainable and is characterised by
sustainability in the CAD, NFL and stability in the ER
 Examples of external instability
o $A lost 40% of its value against most currencies after it was floated in 1983
 Decline in investor confidence in Aus assets
o CAD inflated to over -6% of GDP two times in the past decade (2004-05, 2007-08)
o Rapid increase in the size of net foreign debt
 From 6% of GDP in early 1980’s to over 55% in recent yrs
 Major aim of government economic policy
o Relatively high concern in 1980’s
 Due to decline in investor confidence in the Australian economy
o Relatively low concern in 1990’s, 2000’s
 No major impact on economic performance; sustainable economic growth, low inflation, falling UE, no major
negative shift in investor confidence

 CAD as a percentage of Gross Domestic Product

The nature of the CAD

 Aus has a deficit in the CA of the BoP

o This varies bw -4% and -6.2% of GDP
o This is largely influenced by the size of the net income deficit and the size of the net goods deficit
 The goods balance is usually in deficit
o This declined bw 2000-02, 2004-05, 2006-07 due to mining boom
o This increase bw 2002-04 due to declining rural exports from drought
 Net services is usually in surplus
o This occurred bw 2000-01 and 2007-08 due to rising value, size of travel, education exports
 Aus always has a net income deficit
o This has accounted for the majority of the CAD since 1999
 Net current transfers record small deficits, surpluses
o Little expenditure on aid, migrant funds, overseas pensions

CAD as a percentage of GDP

 The CAD may be measured as a percentage of GDP

o A measure of how sustainable the CAD is over time
 The CAD is considered sustainable when:
o CAD as a % of GDP ≤ economic growth as a % of GDP
 Eg growth in servicing costs of external liabilities ≤ growth in output
 Australia’s CAD is unsustainable
o CAD at a value of -6.2% of real GDP in 2007-08
o EG at a value of 3.7% of real GDP in 2007-08
 Calculation of CAD as a percentage of GDP
o CAD as a percentage of GDP = CAD/GDP x 100

 Net foreign liabilities as a percentage of Gross Domestic Product

The nature of net foreign liabilities

 Net foreign liabilities refer to the difference bw Australia’s foreign assets and Australia’s foreign liabilities
o Where:
 Foreign assets = debt + equity lending overseas
 Foreign liabilities = debt + equity borrowing from overseas
o Includes two components:
 Net foreign debt (external debt)
 Total stocks of loans owed by Australians to foreigners less total stock of loans owed by foreigners
to Australians
 NFD = debt (liabilities) - debt (assets)
 Net foreign equity
  Total value of assets in Australia in foreign ownership less total value of assets overseas that are
owned by Australians
 NFE = equity (liabilities) - equity (assets)

Net foreign liabilities as a percentage of GDP

 NFL may be measured as a percentage of GDP

o An indication of Australia’s total debt, equity servicing costs due to accumulated CADs
 Calculation of NFL as a percentage of GDP
o NFL as a percentage of GDP = NFL (debt + equity)/GDP x 100

 Net foreign debt as a percentage of Gross Domestic Product

The nature of net foreign debt

 Net foreign debt refers to the difference bw foreign debt assets and foreign debt liabilities
o Where:
 Foreign debt assets = Australian debt lending overseas
 Foreign debt liabilities = overseas debt lending to Australia

Net foreign debt as a percentage of GDP

 NFD may be measured as a percentage of GDP

o A measure of total debt to total output
 Indicates degree of sustainability of debt
 Calculation of NFD as a percentage of GDP
o NFD as a percentage of GDP = NFD/GDP x 100

Trends

Overview of trends

 Significant growth in magnitude of CAD

o -$5.5b or -4% GDP (1980-81)
o -$22.3b or -6% GDP (1989-90)
o -$68.2b or -6.2% GDP (2007-08)
 Significant growth in magnitude of net foreign liabilities
o $18.2b or 13% GDP (1980-81)
o $170b or 46% GDP (1989-90)
o $692.1b or 62.5% GDP (2007-08)
 Growth in Australia’s foreign assets (debt + equity lending overseas by Aus)
 $229b (2000-01) to $1025b (2007-08)
o Growth in debt lending
 $94b (2000-01) to $472b (2007-08)
o Growth in equity lending
 $180b (2000-01) to $553b (2007-08)
 Growth in Australia’s foreign liabilities (debt + equity borrowing from overseas)
  $596b (2000-01) to $1718b (2007-08)
o Growth in debt borrowing
 $303b (2000-01) to $1072b (2007-08)
o Growth in equity borrowing
 $249b (2000-01) to $649b (2007-08)
 Significant growth in magnitude of net foreign debt
o $6.8b or 6% GDP (1980-81)
o $117b or 33% GDP (1989-90)
o $599b or 54.2% GDP (2007-08)
 Recent fall in value of $A
o Fall in value of $A relative to $US
 $1.00US/$0.9786AUD (July 16 2008)
 $1.00AUD/$0.6326USD (March 3 2008)
o Fall in value of TWI
 74.0 (July 2008)
 54.1 (March 2009)

Causes of trends

 Significant growth in magnitude of CAD

o Growth in net foreign debt
 Increase in cost of interest payments
 2.5% of export earnings in 1970’s to 20% of export earnings in 1989-90 (peak)
 Denoted as an Y debit in the net Y component of the CA
 Increase in debt, increase in interest payments, increase in CAD, increase in debt, etc.
 Significant growth in magnitude of net foreign liabilities
o Growth in net foreign debt
 ‘Debt for equity swap’ of 1980’s
 Period in which private firms preferred to borrow overseas rather than use equity borrowings
o Due to: low IRs, tax deductibility of interest payments
 Growth in CAD
 Increase in CAD, increase in debt, increase in interest payments, increase in CAD, etc.

The Pitchford Thesis

 States that the CAD is a result of the CFA surplus

o Surplus in CFA causes high servicing costs of interest, dividend payments overseas
 Increase in magnitude of net Y deficit
 Increase in magnitude of CAD
o Deficit in CA causes high level of foreign borrowing
 Increase in magnitude of NFD
 Increase in magnitude of CAD
 CAD is not problematic
o Reflects strong D for Aus assets from overseas sources
 Increase in GDP, Y, standard of living
o Foreign debt funds private investment projects
 99% of NFD in 2008 was owed by the private sector

Causes

Causes of the CAD

Theoretical causes of an increase in the magnitude of the CAD

 The CAD has a cyclical component
o Due to BOGS
 Experiences small surpluses, deficits of up to 2% GDP
 BOGS is affected by short term cyclical factors (eg changes in global D for X, Aus D for M, Aus’ terms of trade)
 When domestic ec grows faster than global ec, D for M grows faster than D for X
 M spending rises more quickly than X spending
o Increased BOGS deficit
 When domestic ec grows slower than global ec, D for M grows slower than D for X
 X spending rises more quickly than M spending
o Reduced BOGS deficit
 Background: consistent deficits on BOGS due to increase in ToT, domestic growth, commodities boom
 Current situation: first surplus (mid 2008) since 2001-02
 Due to improvements to ToT, reduction to D for M
 Causes of the CAD relevant to BOGS
 Aus has a narrow export base
 o 68% of Aus’ X are products of the primary sector
 The value of these products tend to rise slower than value added products
 Declining ToT
o Traditionally, value of Aus’ Ms tends to rise faster than value of Aus’ Xs
o Excluding last few yrs (due to com boom), Aus’ ToT have been in decline for 60 yrs
 Aus has to sell more X to pay for the same quantity of M
 World protection
o Reduction to Aus’ agricultural X due to Japanese, US, EU protectionist policies
 Aus’ lack of IC
o Inefficiency of manufacturing industries reduces quantity, value of potential X
 Due to high level of protection, use of tariffs
 Decline in global growth relative to domestic growth
o This reduces D for X, decline in ToT
 Eg Asian currency crisis (1997-2000), US/Europe (2001-05)
 Measures of overspending
o This increases M relative to X
 Eg as occurred in the 1980’s (global domestic expenditure exceeded GDP)
 The CAD has a structural component
o Due to net income deficit
 Consistent deficits of around 3% of GDP
 Recent rise to 4% of GDP
 Reflects increased servicing costs of Aus’ debt, equity borrowings (total external liabilities)
 Net income affected by structural factors (eg foreign liabilities, their servicing costs)
 Background: net income has remained fairly constant since 1990s
 Current situation: recent global increases to IRs will increase net income deficit
 Causes of the CAD relevant to net income
 Financial deregulation of the 1980’s
o This made it easier for Aus banks to borrow from overseas
 Budget deficits
o Increased amount of foreign borrowing due to budget deficits of the 1980’s-90’s
 Low savings ratio
o Aus does not save enough to provide for its own investment
o Aus level of savings has been in decline since 1970’s
 Depreciation of $Aus
o Falls in $Aus increase the level of foreign debt
 Eg as occurred following Keating’s Banana Republic Speech (20%)
 Eg as occurred in 2001 (25%)
 High level of inflation
o 40% of Aus’ foreign debt is denoted in $Aus
 Eg as occurred in 1980’s (8%)
Existing causes of an increase in the magnitude of the CAD
 Factors that contributed to recent growth in the magnitude of the CAD
o Growth in net foreign debt in 1980’s
 ‘Debt for equity swap’ of 1980’s
 Characterised by preference of debt borrowings over equity borrowings
 Increase in net Y deficit; increase in CAD
o Due to increase in debt, increase in servicing payments
o Growth of public sector borrowing requirement (PSBR) in early 1980’s, 1990’s
 Increase in foreign borrowing by public trading enterprises
 Increase in net Y deficit; increase in CAD
o Due to increase in debt, increase in servicing payments
o Decline in IC of exports in 1980’s
 Low levels of productivity/efficiency, high inflation
 Increase in BOGS deficit; increase in CAD
o Due to decrease in D for X, decrease in X Y
o Deterioration of Aus’ ToT in mid 1980’s, late 1990’s
 Falling commodity prices, Asian financial crisis
 Increase in BOGS deficit; increase in CAD
o Due to decrease in D for X, decrease in X Y
o Saving-investment and output-spending gap
 Insufficient domestic savings to finance domestic investment
 Reliance on foreign borrowing
o Increase in net Y deficit; increase in CAD
 Insufficient output (GDP) to finance expenditure
 Eg C + I + G > C + I + G + (X-M)
 Reliance on foreign borrowing
o Increase in net Y deficit; increase in CAD
 o Decrease in protection of domestic industry, growth of domestic D for M in 1980’s, 1990’s
 Increase in M penetration; increase in M volumes
 Increase in BOGS deficit; increase in CAD
o Due to increase in D for M, increase in M expenditure
o Decline in global EG relative to domestic EG in late 1990’s
 Falling D for commodities, services X, recession in Asia
 Increase in BOGS deficit; increase in CAD
o Due to decrease in D for X, decrease in X Y
o Due to increase in D for M, increase in M expenditure
o Depreciation in value of $A in 2000-02
 Increase in value of net foreign debt denoted in other currencies
 This accounts for approximately 40% of NFD
 Increase in net Y deficit; increase in CAD
o Due to increase in debt, increase in servicing payments
o Decline in agricultural exports due to drought and EU/US protectionist policies in 2002-03
 Falling D for agricultural X
 Increase in BOGS deficit; increase in CAD
o Due to decrease in D for X, decrease in X Y
The CAD as a result of low national saving
 The level of domestic savings is insufficient to service D for funds for domestic investment
o Nature
 National savings = public savings + private savings
 Overall trend of decline
o From 30% GDP (mid 1960’s) to 20% GDP (mid 2000’s)
 Public saving: <5% (mid 1990’s)
 Private saving: 20% GDP (1970’s) to 15% GDP (late 1990’s)
 National investment = public investment + private investment
 Overall trend of stability
o Fluctuation bw 25% GDP, 30% GDP (mid 1960’s to mid 2000’s)
o Outcome
 Supply of domestic funds < demand for domestic funds
 Excess D for funds is financed by foreign loans
o Increase in NFD, increase in CAD

Causes of net foreign liabilities

Theoretical causes of an increase in the magnitude of net foreign liabilities

 Increase in net foreign liabilities due to increase in net foreign equity
o Recorded as an outflow on net Y component of CAD, as return
 Y paid to foreign investor
 Increase in net foreign liabilities due to increase in net foreign debt
o Recorded as an outflow on net Y component of CAD
 As debt (total sum owed must be repaid)
 As ongoing interest payments (servicing cost of debt)
o Creates self-perpetuating ‘debt trap’ scenario
 High CAD -> inflow of foreign funds (debt) to service CAD -> increase in CAD -> increase in servicing costs ->
increased inflow of foreign funds (debt) to service CAD -> increase in CAD
o Represented by:
 Increase in NFD to GDP ratio over time (proportion of NFD to GDP)
 NFD at average of 35% in 1980’s
o Due to: equity sales rather than debt used to fund CAD
 NFD experienced significant growth in late 1990’s
o Due to: sharp depreciation to $Aus; increase in $Aus value of NFD
 Increase in debt servicing ratio over time (proportion of X revenue used to service debt)
 DSR peaked at 20% in late 1980’s
 DSR continues to fall
o Due to: lower IRs, domestic growth
 DSR currently sustained at 11.5%
o Due to: recent increases to ToT
Existing causes of an increase in the magnitude of net foreign liabilities
 Factors that contributed to recent growth in the magnitude of NFD
o Persistent, increasing CADs in 1980’s, 1990’s, 2000’s
 Financed thr increase in debt, equity borrowings
 Increase in net Y deficit, CAD; increase in servicing costs of NFD; increase in NFD
o Shift from equity to debt financing in 1980’s
 Financial deregulation led to increased accessibility of overseas funds for investment
 Increase in net Y deficit, CAD; increase in servicing costs of NFD; increase in NFD
o Long term depreciation in value of $A in 1980’s, 1990’s
  Increase in magnitude of NFD denoted in foreign currencies
 This accounts for approximately 40% of NFD
 Increase in net Y deficit, CAD; increase in servicing costs of NFD; increase in NFD
o Decrease in private, public domestic savings in 1980’s, 1990’s
 Increased reliance on foreign funds for investment
 Increase in net Y deficit, CAD; increase in servicing costs of NFD; increase in NFD
o Federal budget deficits in 1980’s, 1990’s
 Increase in total NFD
 Increase in net Y deficit, CAD; increase in servicing costs of NFD; increase in NFD

Causes of volatility in the exchange rate

Existing causes of a fall in the exchange rate

 Decrease in D for $A
o Decrease in D for X
 Decline in global growth
 Nature of Aus’ export base
o Eg commodities, agricultural goods, education, tourism
o Relatively price elastic
 Decrease in growth, more than proportional decrease in D
 Decrease in growth of Aus’ trading partners
o Eg China’s rate of EG is expected to half by 2010
o Decrease in foreign D for domestic assets
 Decline in global growth
 Decrease in investor confidence
o Decrease in speculative flows
 Decrease in cash rate
o Countered by:
 RBA intervention in FX market in October, November 2008
 Purchasing $A (increasing D)
 Aimed to ‘enhance the functioning of the market’
 Increase in S of $A
o Increase in D for M
 Stable domestic growth
 Nature of Aus’ import base
o Eg consumer goods, intermediate goods, capital goods
o Relatively price inelastic
 Decrease in growth, less than proportional decrease in D
o Increase in domestic D for foreign assets
 Stable domestic growth
 Decrease in foreign IRs relative to Aus’ IRs
o Countered by:
 RBA intervention in FX market in October, November 2008
 Selling $A (decreasing S)
 Aimed to ‘enhance the functioning of the market’

Effects

Effects of the CAD

Effects of net foreign liabilities

 Economic effects of an unsustainable CAD, net foreign debt

o Self-perpetuating CAD-NFD accumulation cycle
 Due to: persistent CAD is financed by an increase in foreign equity, debt
 Increase in net Y deficit; increase in CAD
o Through direct debt repayment
 Servicing costs on debt
o Through direct equity return payments
 Effects:
 Larger stock of NFD and persistent CADs
 Inability to contain growth of CAD, NFD
o Increase in susceptibility to external shocks
 Due to: increased integration in global economy
 Effects:
 Decrease in X Y w collapse of trade
o Increase in BOGS deficit, increase in CAD
 Increase in possibility of capital outflow
 o Due to decline in foreign investor confidence, inability of gov to manage CAD
 Increase in IRs on foreign loans
o Due to decline in investor confidence
 To minimise risk of lower returns
o Increase in susceptibility to exchange rate fluctuations
 Due to: increased integration in global economy
 Effects:
 Increase in the value of NFD denoted in foreign currencies (40%)
o Due to a depreciation in value of $A
o Increase in NFD, increase in CAD
 Increase in the value of NFD denoted in domestic currency (60%)
o Due to an appreciation in value of $A
o Increase in NFD, increase in CAD
 Higher domestic inflation
o Due to depreciation in value of $A, increase in cost of M (imported inflation)
o Decline in investor confidence in domestic assets
 Due to: downgrading of Australia’s credit rating by international rating agencies
 Magnitude of CAD, net foreign liabilities is considered unsustainable
 Effects:
 Decrease in S of funds to investors
o Due to decline in investor confidence
 Increase in IRs on foreign loans
o Due to decline in investor confidence
 To minimise risk of lower returns
o Increase in servicing payments on NFD, increase in CAD
 Potential shift to equity financing
o Decrease in rate of growth of NFD, rate of growth of CAD
o Tighter monetary policy by RBA
 Due to: increase in D for M, increase in rate of inflation
 EG becomes unsustainable
 Effects: rise in IRs
 Due to rise in rate of expenditure growth over rate of economic growth
 Causes decline in economic growth, investment, higher rate of UE

Effects of volatility in the exchange rate

 Economic effects of a volatile exchange rate

o Increase in volatility of CAD, NFD
 Due to component of NFD denoted in domestic currency, foreign currencies
 Effects a decline in investor confidence
 Increase in capital outflows, decline in EG, increase in UE, etc.
 Due to instability of economic fundamentals

Government policy to maintain external stability

 Historical overview of government attempts to maintain external stability

o 1980’s and 1990’s
 A significant objective of economic policy
 Examples include:
 Fiscal and monetary policy tightened in late 1980’s
o Aimed to reduce consumption and investment and thereby reduce the size of the CAD
 Downwards pressure on high inflation
 Improve IC of exports; BOGS
 Downwards pressure on overseas borrowing
 Improve net foreign debt; net income
 Microeconomic reform policies of late 1980’s
o Aimed to improve efficiency, IC of exports and thereby reduce the size of the CAD
 Downwards pressure on BOGS
 Fiscal balance of 1990’s
o Aimed to increase domestic capacity to service demand for funds
 Public sector not to draw on domestic funds
 Increase in supply of domestic funds for private investment
 Downwards pressure on overseas borrowing
o Improve net foreign debt; net income; CAD
 Due to crowding out theory
 Budget deficit causes gov to borrow from domestic public
 o This ‘crowds out’ domestic private investment; no domestic
funds available for domestic investment
 Upwards pressure on overseas borrowing
o Deterioration of net foreign debt; net income; CAD
 Recent overview of government attempts to maintain external stability
o 2000s
 Not a major objective of macroeconomic policy although gov continues to monitor net foreign debt, CAD, ER
 Due to:
 Increase in popularity of ‘consenting adults’ view of current account
o States that the CAD, net foreign debt is due to the decisions of the private sector, should
not be distorted by gov intervention
 Improvement in economic outcomes
o Despite increasing external instability
 Ineffectiveness of policy to maintain external stability in previous yrs
 High levels of investor confidence in Australian equity
o Eg loss of investor confidence, loss of capital inflow, collapse of BoP
o Determined by a range of factors;
 CAD and the trade balance
 Indicates effectiveness of past borrowings in improving X, Y inflow
 Foreign debt
 Indicates risk involved in lending
 Determines IR to be paid by borrower
 Interest rates
 Relatively higher IRs will attract foreign I; increase financial inflow
 Inflation
 Relatively higher inflation rate will distort prices, investment
decisions, reduce IC of exports; reduce financial, export inflow
 Fiscal deficit
 Indicator of gov management; reduces financial inflow
 Considered to be a long term objective of economic policy
 Addressed through general economic framework
o Examples
 Microeconomic reform to increase productivity, IC of exports
 Improvement in CAD
 Incentives to increase savings by households, firms
 Improvement in net foreign debt
 Maintenance of investor confidence in Aus equity
 Improvement in stability of ER
 Australia is vulnerable to changes in investor confidence
 Decline in investor confidence may occur due to increase in external instability
 Due to: increasing level of external instability, narrow nature of export base