EC-Ch 10 External Stability PDF

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Chapter 10: EXTERNAL STABILITY 1. Introduction a. External Stability = aim of government policy that seeks to promote sustainability on the external accounts so that Australia can service its foreign liabilities in the mid to long-term and avoid currency volatility b. 3 components of external stability i. Current account deficit ii. Net foreign liabilities iii. Exchange Rates c. Potential External Stability Issues for Australia i. Persistent CAD 1. Relatively high CAD deficits since 1980s driven by high NPY deficits 2. 2000s: ave 5.1% of GDP in deficit 3. 2010s: Improve to ave 3.1% of GDP in deficit 4. 2019: CAD surplus ii. Volatile Terms of Trade 1. Fluctuating heavily due to largest commodity price boom in Aus history from 2003-2011 due to rapid industrialisation of emerging economies eg China and India 2. Peaked in 2011 at highest level in 140yrs, 85% above 20th century ave 3. Fell 36% from 2011-2016 4. Increased by mid-2019 to only 16% below 2011 peak iii. Australian lack of international competitiveness 1. Remoteness and small population make it difficult to compete in secondary industries 2. Cost of transporting to o/s, high wages, lack of fin I for start-ups iv. Growth of foreign debt 1. Rapid growth in 1980s from 6 to 35% of GDP 2. Now up to 55%, lower than 1990s due to decreased foreign debt servicing costs v. Rising foreign ownership in Australia 1. High levels of foreign ownership mean more profits going o/s 2. Mineral and resources sectors have high levels of foreign ownership, with $366 million in 2018 a. In 2011, foreigners owned 80% of resources sector vi. Volatility of the Australian dollar 1. Very dependent on resources/commodities 2. Strong rise from 2001-2011(more than 60% on TWI) 3. By 2019, down by a quarter on TWI

2. CAD a. Positive and Negative Impacts of a large CAD i. “Houston, we have a problem” “Nah mate – she’ll be right” ● Problems of CAD = debt trap, constraint ● Debt means firms are investing, on growth expecting growth (Pitchford) ● Servicing costs ● NFE means foreign confidence ฀ ● Vulnerable to foreign decisions (pulling ‘thumbs up’ for the economy money, risk premiums) ● Reduced debt servicing ratio (20% down to 6%) ● CAD above long term sustainable ● Global IR relatively low average of 3% (IMF) ● Decreased investor confidence (but ● AAA credit rating AAA credit rating?) ● $A = shock absorber ● Volatile AUD (but shock absorber) ● NFE is negative! (4% of GDP) ● NFL high (52%) ● Positive BoGS, low CAD ● Narrow export base – low IC ● Compulsory super = decreased reliance on foreign S (9.75% to 12% in 2025) ● BoP constraint ฀ CAD = speed limit on growth ii.

Positive 1. Useful in the short-run 2. High levels of foreign capital drive economic growth far stronger than what a country could manage by itself iii. Negative 1. Higher NFL a. As servicing costs increase, NPY deficit increases, causing a further increased CAD (DEBT TRAP) 2. Loss of Investor Confidence a. Potentially increased interest rates as ‘risk premium’ for lenders i. Discourages local consumers b. Loss of AAA Credit Rating 3. Increased volatility of $A a. May further undermine consumer confidence 4. Non-development of local businesses a. Due to the domination of foreign competition b. Examine the arguments about whether the CAD is trade-related or a savings-investment issue i. CAD as a trade deficit 1. Lacks international competitiveness in value-added industries eg ETMs a. Manufacturing industries can’t compete with specialising large-scale, low-cost manufacturers eg China b. “Dutch disease” harmed non-resources industries during boom due to appreciation of $A

c. Result of both cost factors(labour costs, exchange rates, productivity levels and non-cost factors (quality of production, reliability of supply, marketing, etc) 2. Terms of Trade a. Heavily influenced by commodity prices b. High TOT caused short-m d term increase in CAD, peaking at 6.7% of GDP in 2007 while investment exceeded output c. $470 billion exports in 2018-19 for largest ever trade surplus due to 23% increase in TOT ii. CAD as a savings-investment gap (more accepted) 1. CAD caused by excess of domestic investment over domestic savings 2. If domestic spending exceeds domestic output, we are forced to make up for this via financial inflow from o/s 3. K inflow can be explained as a consequence of country with small population, large land mass, and extensive natural resources 4. Foreign I and borrowing have made it possible for Aus to develop more rapidly than solely relying on domestic K 5. Therefore, CAD is sustainable in the long-term c. Describe Pitchford’s view that CAD is not an issue i. As long as CAD is a result of savings/investment decisions by the private sector, there is no cause for concern ii. Should only be worried if the CAD is caused by distortions to normal market mechanisms iii. Essentially, the “consenting adults” thesis argues that so long as NFL are accumulated by the private sector, the Australian Government does not need to intervene d. Outline recent CAD performance i. 2007/08- CAD at -6.6% of GDP ii. 2018/19- CAD at -0.6% of GDPt iii. June 2019- Surplus at +0.2% of GDP 1. Due to large trade surplus of $67Billion iv. CAD largely caused by high NPY deficit, especially interest payments on foreign debt 3. Net Foreign Liabilities/Debt/Equity a. Net Foreign Liabilities(NFL) = Australia’s financial obligations(equity + debt) to the rest of the world minus the world’s financial obligations to Australia b. Net Foreign Debt(NFD) = total stock of loans owed by Australians to foreigners minus total stock of loans owed by foreigners to Australians c. Net Foreign Equity(NFE) = total value of assets in Australia(ie land, shares and companies) in foreign ownership, minus the total value of of assets overseas owned by Australians

d. Debt Servicing Ratio = proportion of export revenue that must be spent on interest payments on foreign debt e. Explain why NFE is currently negative while NFL and NFD are positive i. NFE is negative because we currently have more equity investments overseas(overseas shareholdings owned by Australians) than shares of Australian companies owned by foreigners 1. Net negative foreign liability of $150 billion (-7% GDP) ii. NFD is negative because Australia borrows more money from overseas(due to saving-investment gap) than overseas borrow from us 1. Net positive at $1.15Trillion(59% GDP) iii. NFL=NFD+NFE 1. Therefore, NFL is positive at $1 Trillions (51.5% GDP) f. Outline what has happened to these identities over the last few years, giving reasons where possible i. 1980: NFD at 6.3% GDP, NFE at 16% of GDP, NFL at 22% of GDP ii. 2000: NFD at 42%, NFE at 11%, NFL at 53% 1. Sustained period of low global interest rates iii. 2010: NFD at 48%, NFE at 7.1%, NFL at 55% 1. Period of rising export revenue iv. 2019: NFD at 59%, NFE at -7%, NFL at 51.5% 1. Increased private sector debt as Australia invests in more equity shareholdings g. What problems might a rising NFL cause? i. Makes Australia vulnerable when economic conditions become more unstable ii. Reliance on ongoing inflow of foreign capital 1. Thus the government had to provide a temporary guarantee for all overseas loans of banks and financial institutions post-GFC 2. Otherwise significant crisis could have been created 4. Exchange Rates a. Examine the volatility of $A i. Almost totally reliant on commodities ii. $1.10 US high in 2012 at peak of mining boom 1. Foreign Investment, Aus Growth iii. Slumped to $0.70 in Jan 2016 1. Decreased China growth down to 6.1% 2. Decreased Aus growth at 2% iv. $0.66 in 2019 1. Cash rate at 0.75% v. $0.58 now due to coronavirus from $0.67 2 weeks earlier 1. Speculative! b. What are the possible positive and negative outcomes of this? i. Appreciation Negative Positive

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Increase value of AUD, so Australian EXPORTS become more EXPENSIVE ฀ more difficult to sell ฀   medium term deterioration in CAD IMPORTS become LESS EXPENSIVE – worsens CAD Bad for domestic producers of import substitutes Resulting outflows reduce growth Foreign investors find it more expensive to invest, but financial inflows may continue if currency expected to continue rising Reduces the AUD value of foreign income earned by Australians, deterioration in net primary income component of the CAD Reduces the value of foreign assets in Australia dollar terms, known as the valuation effect ii.

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Increased PURCHASING POWER Decreases the INTEREST SERVICING COST on foreign debt – reduces outflow on net primary income component of current account Valuation effect* Inflationary pressures reduced, as M become cheaper Reduces pressure on RBA to raise interest rates to defend its inflation target

Essentially means that when Australia’s CAD increases, $A depreciates 1. This makes exports more attractive globally(valuation effect)

5. Policies to achieve External Stability a. Briefly outline the possible policies to assist our external stability i. Monetary policy 1. Contractionary monetary policy was previously used to reduce spending on imports but NOT ANYMORE because it just slows down the whole economy ii. Fiscal policy 1. Running balanced/surplus budgets for fiscal consolidation has attempted to increase private savings 2. Encourage Australia to fund more domestic investment with domestic savings rather than further foreign borrowing iii. Compulsory Superannuation 1. 9.5% of employee’s wages must go to superannuation 2. Increased Australia’s foreign investments, creating financial inflows on the NPY, reducing pressures on Aus external accounts iv. Microeconomic Reform 1. Used to address structural problems causing Australia’s external imbalances 2. Improve infrastructure, alleviate skills shortages, remove protectionist barriers shielding inefficient producers

Does Australia have an external stability issue? Considering Australia’s recent issues regarding all 3 metrics for external stability (High CAD, High NFL and volatile exchange rate), it is fair to suggest that Australia does indeed have a problem. Since the 1980s, Australia has had relatively high CAD deficits, particularly driven by high NPY, creating issues in the long-run. Although 2019 did see the first CA surplus, Australia’s general trend for the 2010s saw Australia with a CAD averaging 3.1% of our GDP, slightly above the recommended sustainable growth. It is only due to $67 Billion trade surplus in 2019 that a CAS occurred, and due to a high NPY deficit, caused primarily by interest payments on foreign debt, the CAS is unlikely to improve, leaving our external stability with problems. Although Pitchford and his ilk contend that CAD is a non-issue, and is simply a result of the ‘saving-investment gap’, in the long run, it ultimately damages confidence in Australia, both from domestic consumers, and foreign investors. Furthermore, despite decrease in NFE (to -7% in 2019), NFD has reached 59% in 2019 and creates significant issues for th Australian economy. While Australia may appear stable in good economic times, its consistently high level of NFL(above 50% of GDP) renders us vulnerable in more adverse conditions. Particularly, our reliance on the ongoing inflow of foraign capital means that in times such as post-GFC, the government is forced to provide a temporary guarantee for all overseas loans of banks and financial institutions, placing significant pressure on the government. Finally, the highly volatile Australian dollar, which is almost entirely reliant on commodities, renders Australia as externally unstable. In recent times, the Australian dollar has boomed and busted with commodities, peaking at US$1.10 in 2012 at the peak of the mining boom before dropping to $0.66 in 2019. Not only this, but the recent novel coronavirus has created an even more volatile market due to speculative investment(and lack thereof) that saw the dollar drop to US$0.58. While a low Australian dollar is not an inherently bad thing (for one, a weak dollar increases foreign demand for our exports), the volatility that plagues the Australian market most certainly is, as it makes consumers and investors alike very uncertain, and unwilling to engage with the Australian market, creating a significant issue regarding foreign stability. Thus, because trends in all 3 metrics for external stability provide ominous signs, Australian external stability is undoubtedly a major issue....