Topic 2: Australias Place in the global economy Australias trade and financial flows Value, composition and direction

of Australias trade and financial flows Composition: refers to what we buy and sell (import and export) i.e. resources, agricultural commodities, manufactured goods and services Direction: refers to with whom we trade Trends in Australias trade pattern Trade: refers to the exchange of goods and services across national boundaries Trends in Composition Exports Strong representation of agriculture and commodities In 1954 minerals and fuels accounted for 7% of export income, now 43% shift in exports due to commodities boom Fluctuations in agricultural exports due to drought and changes in agricultural commodity process Elaborately Transformed Manufactured goods: small but growing (such as motor vehicles, telecommunications equipment and medical technology.: grew323% over the nine years to 1994 and now constitutes 25% of all our exports Services represent 20% of our exports. E.g. tourism and education Last 5 years increase in primary exports due to recovery from drought and additional mineral exports to China. Principally export coal to China worth 60,000 AUD Imports Largely ETMs, finished luxury and consumer goods, capital equipment Small market for intermediary goods in manufacturing Great demand fro professional services (finance, law insurance) Composition: Travel 18000 million, Crude petroleum 17900 million, Transportation 17500 million Reliance on imports111111111111111 trade deficit since X >M Trends in direction Exports - lesser focus on Europe from 62% in the 1950s to 20% in 2009. Increase in exports to Japan, China and ASEAN nations. APEC is 68% of two way trade Push factors Distance = increased cost and reduced comparative advantage Regionalisation of trade Low transport costs preserve comparative advantage High regional growth in China and Japan Cheap labour in Asia Strategic alliance with the US Creation of trade barriers by the EU with tariffs and subsidies Pull Factors Harness comparative advantage enjoyed by Asian countries e.g. cheap labour Creation of free trade agreements, CERTA and Thailand Rapid economic growth in other countries increasing export market opportunities Financial Flows High FDI into minerals Growing service sector investing in China and Asian countries

Net position of $US 629 billion. However this creates a service burden. Australias Balance of Payment Balance of Payments: records the transactions between Australia and the rest of the world e.g. exports, imports, interest on debt, dividends Comprised of: The current Account The Capital and Financial Account Current Account balance will be equal In size, but opposite, to the balance on capital and financial account Hence when the current account is in deficit the capital and financial account is in surplus The current account Records all transactions of a current nature such as exports and imports of goods, services, income and transfers If total debits exceed total credits the current account is in deficit The current account consists of Goods Exports are credits (rural and non-rural) Imports are debits (consumption, capital and intermediate goods) Services E.g. tourism, education, transport and insurance Net income Income received from Australian owned assets overseas (credits) minus the payment of income for foreign owned assets in Australia (debit) Interest, rent, dividends, profit, royalties Net current Transfers Involve giving something and not getting anything in return i.e. aid Foreign pensions Trends Always in deficit due to net income, which is the structural component and is always negative it accounts for 70 90 % of the GDP. The goods balance is usually in deficit though a surplus was recorded in 2008 Australia has a persistent deficit of about -5% 2005-2006 reduction in CAD due to the global resources boom 2008-2009 increase in CAD due to increased public sector debt. Reason for trends Balance on goods and services = cyclical component

Movements of GDP and income elasticity for domestic demand for imports. An increase in income increase in imports An increase in aggregate demand leads to an increase in national income via the multiplier effect, which leads to an increasing demand for imports Demand for X is income inelastic In overseas markets consumers tend to buy better quality food rather than more China demand for exports is income elastic Price of exports is price inelastic i.e. changes in price do not affect great changes in demand Rise of imports is price inelastic i.e. changes in price do not attract great changes in demand.

Comparative Economic Growth - When a domestic economy grows faster than the world economy, import demand is greater than export demand. This causes BOGS to deteriorate. International Competitiveness (Australias ability to compete) Exchange rates a higher $A reduces international competitiveness Relative inflation rates higher inflation leads to export prices rising faster than imports. Changes in productivity increased productivity decreases costs Reliability of supply affected by drought.

Structural component of net income

The level of consumption and investment is greater than the level of national savings. Since we have insufficient savings we rely on the savings of others. we live beyond our means. There is a savings and investment gap in the private sector as in 2007 national savings were 18% of GDP, while investment was 24%. To maintain our standard of living we need constant borrowing and investment from overseas public and private sector debt This leads to a continual demand for foreign investment and foreign debt borrowing from overseas Our low interest rates means that non-residants are encouraged to lend or invest in Australia. Multiplier effect, increased foreign debt investment and productive capacity increase O, Y and E good standard of living (also leads to increased imports, which increases CAD)

Relationship between net foreign liabilities and the CAD

Accumulate foreign debt is financed by continual borrowing which adds to the external debt.

Foreign Debt Repayment of interest Increase in CAD Increased net income deficit

Foreign Equity Increased net income deficit Increase in CAD Repayment of Dividends

Foreign debt/ equity interest/ derivatives are payed back and increase in net income deficit increase in CAD Net Foreign liabilities = net foreign debt + net foreign equity. Direct relationship (increase in net foreign liabilities increase in CAD Issues Associated With a current Account Deficit Not a problem Large problem Australia is structurally a poor saver and is Our CAD is 7th highest in the world a commodity exporter and high value We are to reliant on commodity exports added importer. Thus a CAD is a fact of and are hurt by protection life. Has a low level of savings Australia has strong economic growth Commodity exports means that we are even with a CAD tied to world frowth Pitchford Thesis Dependency - Were relying on the The CAD doesnt matter if it is driven by continual growth from China and on overseas funds for growth the private sector as it is between two We require funds from overseas to repay consenting adults As long as they are debt. Therefore, need to keep our interest using the borrowed funds in income generating areas e.g. aggregate supply then rates high the private sector borrows in order to make a profit Budget surpluses have repaid our foreign debt Credit ratings overseas lend to us as they know we can pay it bac.

The capital and financial account Records capital transactions which tend to be long term in nature such as foreign aid, portfolio and direct investment Consists of Capital Transfers Official government capital, gold, government assets in foreign currency, net capital transfers of foreign aid and net capital brought into Australia by migrants Financial account: Direct investment Seek 10% ownership of a firm, purchase shares, merges, takeovers Financial Account: portfolio investment Foreign debt (where our foreign savings come from - borrowings) Speculative investment in shares Derivatives and other Trends Is always in surplus to finance the persistence current account deficit. Mainly represents debt and equity borrowings by the private and public sectors In Australia to finance investment Summary Current Account Balance =

Goods Balance + Net Services + Net Income + Current Transfers Capital and Financial Account Balance = Capital Account Balance + Financial Account Balance Balance of Payments = Current Account Balance + Capital and Financial Account Balance

Issues Associated with trends in the balance of payments Terms of Trade Refers to the relative prices a country receives for its exports and pays for its imports It is the ratio of export prices to import prices Terms of trade index = Export Price Index x 100 Import Price index 1 A favourable movement in the terms of trade occurs when export prices rise faster than import prices, meaning that a country can finance a greater volume of imports with an existing volume of exports. Australias vulnerability: due to reliance on agricultural and mineral exports for earning export income. Demand for commodities is inelastic. Therefore, a fall in price = a fall in revenue Trends experienced improvements in its terms of trade between 2004 and 2008 due to rising commodity export prices.

Size of the current account balance as a percentage of Gross Domestic Product Measurement of the Cad as a % of GDP gives an accurate indication of its relative size to national output over time A CAD of 5% of GDP is desirable, anything over is considered to be unsustainable sine it constrains domestic economic growth. Since the economy cant grow faster without increasing imports, which increases the CAD. A concern is the increase in the accumulation of external liabilities to find the increase in the CAD. This increases servicing costs in terms of interest payments. Foreign Debt and Foreign liabilities CAD is financed by a surplus in the capital and financial account through debt and equity borrowings Net foreign liabilities = Net equity + Net Debt The growth in net foreign debt increases the amount of debt to be repaid in the future, plus the cost of servicing the debt in the form of interest payments.

International competitiveness Changes in international competiveness will affect the goods balance and the current account Measure of Australias international competiveness Real exchange rate Real unit labour costs

Structural Changes in the Australian economy

Structural changes refer to changes in the economys structure of production and technological progress. Linked to the allocation of resources between primary, secondary and tertiary industries. Implications for the Balance of Payments as a more efficient allocation of domestic resources and technology diversifies Australias export base and increases the competitiveness of exports. Sustainability of Australias external imbalance Interest, rent and dividend payments on net foreign liabilities as a percentage of exports needs to remain at about 9% to be sustainable Exchange Rates Exchange rates: the value of one currency in terms of another. Measurement of relative exchange rates: Bilateral: measure the value of a unit of domestic currency relative to another currency Trade Weighted Index: measures movements in the Australian dollar against a basket of currencies of Australian trading partners weighted according to their importance and proportion in Australian Trade. Gives a more accurate measure of Currency movements and there effects on Australias trade performance e.g. BOGS and CAD Chinese Remninibi is the currency with the highest weight Trends sharp depreciation in 2008 due to GFC and market volatility, fell from 63.4 to 54.6 between September and October. Resource boom between 2000-2008 it appreciated.

Appreciation The value of the Australian dollar increases its purchasing power relative to another currency Australian exports are more expensive and imports less expensive Reduces international competitiveness S D1 D Q1 Q 0.7 0.9569lolololololololol $US/$A

Demand Shifts outwards D-D1 creating a new equilibrium at an inflated price S1 S D Q Q1

$US/$A 0.95 0.7

Figure 2: Supply Contracts S-S1 creating new inflated equilibrium Depreciation The value of the Australian dollar falls in purchasing power relative to other countries Leads to exports being less expensive and imports being more expensive Increases international competitiveness Demand shifts inwards D-D1 creating a new equilibrium at deflated price Supply Shifts outwards S-S1 creating new deflated equilibrium Factors affecting the demand for $A Foreigners purchasing exports goods and services, imports in overseas countries Foreigners wishing to pay income (interest, rent, dividends) to Australian residents Foreigners transferring unrequited payments to Australia (e.g. English pensions) Foreigners investing in Australia Tourists to Australia Factors affecting the Supply of $A Australians buying imports of goods and services Australian paying income to non-residents Australians making transfer payments to non-residents 9e.g. foreign aid) Australians investing In other countries Australian tourists overseas. Reasons for recent movements in the $A Appreciation Trend 2007Depreciation Trend 2008 Appreciation End 2009 2008 mid 2009 Commodity based currency Global downturn Massive global public positive terms of trade T of Trade fell sector stimulus Heavily speculated upon More conservative China corrected its GDP Taxation reforms mentality growth rate Financial stability Flight from Asia to China and India = Australia increased demand for commodities Interest rate differential Current Account influences on the demand for Australian exports and imports include: Interest rate differentials

Affect the relative prices of competitiveness of exports and imports A rise in the relative inflation differential will reduce Australias export competitiveness and the demand for its exports This causes the exchange rate to depreciate

Terms of Trade Important for commodity currencies like Australias Falls in the terms of trade results in a decline in export earnings and decreased demand for the Australian dollar This causes the exchange rate to depreciate

Comparative economic growth Lower rates of world economic growth leads to decreased demand for Australia exports and $A Stronger Australian economic growth leads to an increase in demand for imports and an increase in the supply of $A This causes the exchange rte to depreciate Capital and financial account influences on the demand for Australian and foreign assets include: Interest rate differentials A fall in Australian interest rates relative to those overseas may decrease the interest rate differential causing decreased capital inflow This decreased demand for the Australian dollar may cause it to depreciate

Speculation Exchange rate expectations about the future value of the exchange rate can influence the demand and supply of Australian dollars If foreign speculators expect the Australian dollar to appreciate in the future, they may buy $A and sell foreign exchange. Increase demand for $A causes and appreciation Under a floated exchange the current account balance = capital and financial account. Types of Exchange rates Floated Exchange Rates The exchange rate is determined solely by demand and supply. There is no government intervention. Advantages Reflects Australian economy Discourages destabilising speculation Government can pursue effective monetary policy as balance of payment surpluses/ deficits would not impact monetary supply Disadvantages Volatility may cause uncertainty Subject to sudden shifts

Managed Exchange Rates Some RBA invention Keeps the exchange within a target band Fixed Exchange Rate

Central Bank buys/ sells currency to maintain a predetermined value against another currency or gold Advantages Certainty about immediate short term exchange value. Assists importers and exporters Disadvantages Speculation increases Requires large foreign exchange reserves Balance of payments influences domestic inflation rates. E.g. current account surplus raises money supply causing inflation

RBA influence on exchange rates Indirect effect monetary policy seeks to create a low inflationary economy with consistent economic growth rates Foreign investors see this as an attraction and move their money into $A appreciation Statements on monetary policy changes expectations of market participants by increasing the information available Direct effect Enter the Foreign exchange market to dirty the float. This involves the buying and selling of $A to send a signal to the market Buying $A Takes AUD out of financial system and sterilises by buying government securities. This means no change to money supply and interest rates. Selling $A Increases the supply of $A, sterilises this by selling government securities so as not to affect interest rates Symbolic gesture have insufficient finds and resource of currency to influence in the long term Effect of Exchange Rate fluctuations J-curve theory Short Term A country with existing Cad that has a currency depreciation will experience a worsening of its trade balance in the short term Due to low price elasticity of demand for imports and exports in the immediate aftermath of an exchange rate change Hence export revenue falls and import prices rise Long term The depreciation improves international competitiveness as demand for exports picks up and domestic consumers switch their spending away from imported goods and services This reduces the size of its trade deficit and its CAD

Effects of Depreciation Inflation Cost push inflation Price inelastic demand for intermediary and finished goods Aggregate supply reduces owing to raised input costs New equilibrium recorded at a higher price Potential wage-price spiral. Then the cost of production in Australia will accelerate, eroding any short term improvement of international competitiveness Inflation also increases the uncertainty about future returns, and hence may cause entrepreneurs to lost confidence and reduce investment Current Account Deficit BOGS Immediate depreciation with long term gains (J-curve) External Debt Depreciation increase external debt, as 62% of overseas borrowings are denominated in foreign currencies Increase in both the repayment of principal, and also the debt servicing ratio Higher interest payments are likely to lead to a higher net income deficit, and increase the size of the CAD

Economic Growth and Unemployment Economic growth The increased profitability of exports would tend to encourage production, raising the quantities of factors of production required, and stimulating a further increase in national income, savings, investment and aggregate demand Structural adjustment through pressures Depreciation in mid 1980s, assisted growth of manufacturing and service exports, raising dynamic and allocative efficiency, exports rose 25% (1987-1993) Unemployment Derived demand from growth with potential structural change

Environmental Sustainability Derived from growth and resource use

Australias free trade and protection policies Unilateral policy agreements The active decision to reduce protection on Australian industry Australia has a long history of protection in the manufacturing sector where tariffs and quotas have been used to shield firms from direct import competition Whitlam Government 1973: Whitlam introduced 25% across the board protection cuts

1980s: Raised protection as passenger motor vehicles, steel, textiles, clothing and footwear (65%) subject to intensified competition This led to low levels of efficiency, exports and innovation Hawke Government 1988 Industry Statement Dismantled industry protection on a large scale Protection of manufacturing reduced from 15% in 89 to 10% in 94 1991 Industry Statement Majority of tariffs to 5% by 1996 Abolition of quotas and a reduction in tariffs for PMV to 15% by 2000 TCF maximum tariffs of 25% by 2000 Howard Governments Most tariffs averaged 5% Bilateral Policy Australia has actively sought to reduce protection on Australian industry ANZCERTA USA and Thailand However not complete e.g. US and agriculture Multilateral policy WTO Cairns Group 19 agricultural countries Aim to abolish export subsidies and domestic, trade distorting support Enhanced free trade (Doha) but limited recent success Implications of Australian Protectionist policies Nominal Rate of protection The apparent tariff rate Effective Rate of protection The nominal rate of protection plus any other levels of protection that change the final effect of protection e.g. protection can occur on raw materials and parts Passenger motor vehicle industry Tariffs reduced from 40% to 10% from 1990-2005 Niche marketing in larger passenger vehicles Per employee increases 12-18 from 1990-2005 Exports increased from 10-30% of production from 1990-2005 Faults per vehicle reduced 50% $A 224 million - $A 372 million profit between 1990 and 2005

Long Run Benefits Competition Reduction in protection eposes previously protected industries and firms to more import competition. This reduces prices and dampens inflation. Lower input costs for efficient industry Productivity Forced productivity gains through competition Resource allocation Releases resources previously locked into inefficient an less competitive industries and firms become more efficient, productive and growing industries. This process of

structural change enhances economys productive capacity and increases employment in the tradable goods sector of the economy Income redistribution Redistribute income away from the government an d inefficient industries to consumers and export firms in the form of lower prices, taxes and costs Government social responsibilities as $50m education and retraining for Mitsubishi Adelaide Value of reduced protection The productivity commission estimate a permanent gain in Australias GDP o $4b Export volumes were estimated to rise by 8.6$ Employment growth was estimated to increase by 0.1% CPI to fall by 3.8% Short Term Costs Structural unemployment Uncompetitive industries contract and unviable firms go out of business Lower employment levels have occurred in TCF and PMV industries Structural adjustment also leads firms to substitute more capital for less labour to achieve higher productivity Specific job training programs such as Jobtrain, Skillshare, Jobskiss and Jobstart were developed by the federal government and targeted at the long term and structurally unemployed. Regional Adjustment Cities dependent upon manufacturing industries i.e. Geelong, Newcastle and Port Kembla have high levels of structural unemployment because of structural change Unemployed workers find it difficult occupationally and geographically to find jobs in growing sectors of the economy such as services, because they lack the skills demanded or the willingness to relocate Import Spending Will rise, worsening CAD and foreign debt This has happened in the past because of Australias lack of competitiveness and the reliance on primary export income

Implications of International Policy GATT saw tariff reforms from 40% to 5% between 1947 and 1985 The absence of GATT codes for trade in agricultural commodities left Australian in a vulnerable position because US wheat subsidies through the Export Enhancement Programme (EEP) and EU wheat subsidies through the common Agricultural policy (CAP) denied market access for Australian wheat and depressed world wheat prices, cutting export returns to Australian farmers Non-tariff reforms of protection such as voluntary export restraints impeded the growth of world trade and penalised efficient commodity producers like Australia in favour of less efficient producers in North America n Europe WTO Uruguay rounds International Outcomes 36% reduction in agricultural subsidies

Manufactured goods tariffs cut by 15% Outcomes for Australia Scaling down of Agricultural subsidies in the EU and USA Governments subsidising agriculture were forced to adhere to WTO rules on agriculture Increased market access for trade services was a boost for Australias service exports