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Summary about external stability notes for topic 3 of HSC economics...

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External Stability External stability - The aim of a government policy that seeks to promote sustainability on the external accounts so that Australia can service foreign liabilities in the medium to the long run and avoid financial instability. CAD is short term(released every quarter), whatever CAD is not paid is put onto the foreign debt bill. Whatever happens in the CA every quarter. Foreign debt is long term because it is money that needs to be paid across time(net foreign equity is a long-term Y. Main external stability issues for Australia has been: ● A persistent CAD: Australia has had relatively high deficits on its current account since the early 1980s due to the deficit on the net primary Y. ● Volatile terms of trade: The commodity prices have fluctuated wildly as a result of the commodity price boom during the mining boom from 2003 to 11. This commodity boom was supported by industrialising economies such as China and India. This boosted the Australian X Y however, had damaged other sectors because of the high AUD. ● Australia’s lack of international competitiveness: Australia has largely been uncompetitive because of its small population and, less competitive in areas such as technology and manufactured goods. Some possible factors that contribute to it include the cost of transporting these goods overseas, lack of economies of scale in domestic production, high cost of labour and a lack of financial backing for start-up businesses. ● The growth of foreign debt: Australia’s foreign debt grew significantly during the 1980s to around 35% of GDP. However, this growth has slowed down and combined with the low global interest rates has meant that foreign debt servicing costs are still lower compared to the 1990s ● Rising foreign ownership in Australia: The high level of foreign ownership means a large share of profits goes overseas. The outflows on the NPY are largely offset by the inflow of foreign investment by Australians. The high level of ownership is prominent in industries such as minerals with an estimated 80% of the sector being owned by overseas investors during the mining boom. ● The volatility of the AUD: The AUD fluctuates constantly because commodities reflect a large part of the exchange rate. However, overall Australia has been relatively stable with slowly decreasing CAD’s, low inflation, moderate eco growth and low unemployment. These factors have all helped keep foreign investor’s confidence, especially with the increasing commodities export revenue. During the mining boom, there was a high CAD which reflected the large inflow of investment into Australia.

Causes of the CAD CAD as a trade deficit When the CAD was a large problem during the 1980s, it was because of the BOGS deficit, slow export growth and growing demand for imports. Lack of international competitiveness: Australia has always been uncompetitive in ETM(Elaborately Transformed Manufactures.) This has largely been because of domestic firms

struggling to compete with overseas economies such as China where there is a low cost, largescale manufacturing. Australia’s manufactured sector has declined as a share of total output, reducing Australia’s exports of finished goods whilst increasing our demand for imports. Since the 2000s, Australia’s commodity prices have significantly increased, making our resources less competitive, reflecting the concept of “Dutch disease.” Whereby, a large increase in demand for one export may drive up the value of the e/r and make other exports less competitive. Australia’s impact from the TOT: During the final quarter of the twentieth century, following a sustained fall in commodity prices, Australia’s CAD increased as well as slower growth in Australia’s X revenue. The trend changed from 2003, after which the TOT increased significantly and instead of reducing the deficit, the higher terms of trade contributed to short-mid term increases in CAD. Example: A 23% increase in the TOT, during the 3 years from 2018-19 helped exports increase from $320 to $470 billion. This was Australia’s largest trade surplus however, Australia’s heavy reliance on the minerals and energy exports can also mean that a significant fall in P can cause a large increase in CAD. This reliance is emphasised by the reliance on coal and iron ore which comprise one-third of Australian export revenues. This reliance on coal is set to come to an end with the increase in demand for renewable sources such as solar panels.

CAD as the S-I gap Another possible cause of the CAD could be the large gap between domestic savings and domestic investment. When spending is greater than output, it causes a current account deficit and money must be brought in from overseas or by selling domestic assets to overseas investors. Foreign investment and borrowing have allowed Australia’s to develop more rapidly than if we had relied on domestic capital. So long as foreign investors and loans are increasing Australia’s productive capacity, it increases Australia’s capacity to service foreign liabilities making the CAD sustainable in the long-term. Note extra: The Pitchford thesis John Pitchford argued in the 1990s that the CAD and foreign liabilities are not a major concern, also referred to as the ‘consenting adults thesis.’ The thesis is based on the theory that the CAD and foreign liabilities is generated by the private sector. The theory is also based on the notion that the money is spent on increasing the economic capacity of Australia, making it possible to pay back the money and interest costs. Provided that Australia’s foreign liabilities are largely generated by the private sector and this capital is used to in private-sector decision making. As well as not being distorted or influenced by government policies, individuals and firms make proper calculations of risk, the borrowers and lenders are responsible for their own decision. I.e. They are ‘consenting adults’ However, there is some criticism where critics highlight the example of the GFC, with the collapse of the subprime housing market in the USA. Where financial institutions were unable to calculate the risks involved with borrowing and lending. The thesis also assumes that private

sector debt is entirely separate from public-sector debt. However, the GFC demonstrated that the national governments are often forced to assume the liabilities of the country’s private sector to avert a more serious financial collapse(debt trap.) Overall. Australia’s strong performance throughout the GFC supports the view that in an environment of strong commodity prices, Australia’s large external imbalances are sustainable.

Australia’s foreign liabilities One of the long-term consequences of high CAD is the growth of net foreign liabilities. Net foreign liabilities reflect Australia’s total financial obligations to foreigners minus the financial obligations of foreigners to Australia. Net foreign liabilities are comprised of net foreign debt and net foreign equity. Net foreign debt: Total stock of loans owed by Australians to foreigners minus the total stock of loans owed by foreigners to Australians. Net foreign equity: The total value of Australian assets(land, shares and companies) in foreign ownership minus the total value of overseas assets owned by Australians.

Net foreign debt Overseas borrowing contributes directly to Australia’s debt because the initial principal has to be paid as well as the debt serving costs of interest. The servicing costs/ interest is recorded on the BOP in the NPY, constitutes an outflow of funds on the Current account and thus, decreases the CAD. In recent years, equity servicing costs on the NPY have exceeded interest repayments on debt. The returns on equity paid by Australians is partly offset by returns received by Australians from investments overseas. In the long term, if the net foreign debt is rising faster than the increase in GDP, the interest payment will progressively take up a greater proportion of our GDP. This reduces Australia’s overall eco standard of living and eco growth potential. High foreign debt may lead to a ‘debt trap scenario’ which begins with a high CAD, requiring an inflow of capital of foreign funds either from foreign debt or selling of Australian assets to foreigners. With a larger foreign debt, which is recorded as PY debits that flow our of the current account. This debt will be carried forward in the CAD and if international financial markets suspect that Australia’s debt is unsustainable. Australia’s financial credit rating(confidence of international financial markets have in Australia.) A downgrade in financial credit rating would make it more difficult to borrow money and hence, increase the i/r on borrowing. One of the most reliable measures of a country’s ability to service foreign debt is the debt servicing ratio. This figure indicates the proportion of export revenue that must be spent on interest payments from foreign debt. A country is better able to service its debt if it has a high volume of exports and therefore, earning a large amount of foreign currency. Historically, most foreign investment flows into Australia(debt and equity) has been into the

private sector. Part of this represents an inflow from the offshore funding of the banking sector i.e. banks have had to borrow from overseas to lend to domestic customers(households and individuals.) However, recently an increase in domestic savings has decreased, the bank’s reliance on foreign borrowing. Foreign investors held 55% of government bonds in 2019, because of the Aus government’s AAA credit rating as well as public sector debt only representing 20% of net foreign debt.

Net foreign equity Net foreign equity is smaller in size compared to net debt. When foreign investors buy assets in Australia, this is recorded as an increase in foreign equity, vice versa. Since 2013, the value of Australian’s foreign assets has been greater than the value of foreign ownership of Australian assets(i.e. Net foreign equity is negative.) Foreign equity servicing costs are recorded as profits or dividends that are returned to overseas investors. This can sometimes create a strain on Australia’s CAD by worsening the NPY, the costs account for around half of total primary income outflows. Although there are some disadvantages, equity is more sustainable because profits only have to be paid when a business or asset is generating a profitable return. There has been an increase in net foreign equity, although this hides the increasing overseas investment and growth of countries liabilities to Australia. Between 2000-2001 and 2018-19, Australian ownership of foreign equity rose from $306 billion and $1554 billion, while Australian loan overseas grew from $211 billion to $1271 billion, gross debt increased from $506 billion to $2414 billion. Gross foreign debt is around double the level of Australian lending overseas. Overall, Australia has become increasingly integrated with the global economy, foreigners lending and investing more than Australia has been lending/investing overseas.

Australia’s external imbalance has the potential to cause serious trouble for Australia, although hasn’t been a concern in recent times. Among advanced economies, Australia has the highest CAD and foreign liabilities, our CAD has been seen as unsustainable in the long term. This has not stopped Australia from achieving a long period of moderate eco growth, it makes the economy vulnerable to unstable global economic conditions.

Australia’s exchange rate The exchange rate provides a direct link between Australia and the global economy since all trade and financial relationships are mediated through it. Therefore, e/r has a large impact on external stability and international competitiveness. Australia’s e/r is extremely volatile as can be seen at the turn of the century, with low commodity prices and the dawn of the “internet” age that ignored low-tech economies such as Australia. However, this changed in 2003 after a large increase in the terms of trade because of a large commodity price increase helped by China’s surging demand for natural resources. Other than a dip during the GFC, the trend increased until 2011, underpinned by rising exports, sustained eco growth and the interest rate differential. However, a sharp fall in the TOT brought a sharp fall in the early 2010s and reflected weakness in the Aus eco. Although the e/r itself is volatile, it has acted as a powerful stabilising mechanism to help the economy adapt to changing conditions in the global eco. During a period of weaker growth, the e/r can help make exports more competitive and stimulate eco growth. The depreciation of the AUD following the fall in terms of trade in 2019, made exporters and import-competing firms more competitive. However, a change in the e/r will cause a change in the BOP by affecting Australia’s competitiveness and size/servicing costs of our foreign debt. Therefore, if the dollar is volatile, then two of the major indicators of Australia’s external stability will also be volatile. This is especially evident in large falls/ depreciation in the AUD, which can cause significant falls in investor confidence, and becomes a target of speculators. Which will remain until investors believe that the AUD is undervalued and begin buying AUD again.

Policies to help external stability Achieving external stability has been an important objective of economic policy in Australia for a long time. However, in more recent years, external stability has not been a major objective of macroeconomic policy, the government and RBA have continued to monitor the CAD, foreign liabilities and the e/r. The aim of achieving external stability is not a major influence on FP and MP. It means achieving sustainable outcomes on the current account and financial liabilities are now a long-term objective of economic policy. ● Monetary policy - Contractionary monetary policy has been used to reduce consumer spending on imports in order to create short-term improvement in the BOGS. This is a temporary fix because it results in a slowdown in the whole economy. As well as an increase in i/r, it means that there are increased financial inflows and generates higher NPY outflows and worsens the CA. MP is unable to target the long-term structural causes of Australia’s external imbalance. ● Fiscal policy - Some role in addressing Australia’s historically low domestic savings. By adopting fiscal consolidation(balanced or surplus budgets over the course of the economic cycle.) Governments have tried to rely less on private savings over the

midterm, Australia is able to fund more of its domestic investment with domestic savings rather than additional foreign savings. Reducing the deficit can less upward pressure on interest rates or “the crowding out” of private borrowers ● Compulsory superannuation - The policy to ensure employers set aside 9.5% of Y into a superannuation fund has lifted national savings since the 1990s. The major contributor to Australia’s increased overseas I help to create financial inflows on the NPY. The government’s plan to increase superannuation to 12-13% will further increase S and potentially reduce long-term pressures on Australia’s external accounts. ● Microeconomic reform - Can be used to address structural problems causing Australia’s external imbalances. The international competitiveness of Australian goods and services should be improved by measures that lift the efficiency and productivity of Australian producers. These policies have included measures to reduce capacity constraints by improving infrastructure and alleviating skill shortages. As well as removing protectionist barriers to shield inefficient producers from foreign competition and labour markets to increase productivity and workforce participation. Governments aim to sustain international confidence in the Australian economy, through consistent and medium-term policies such as Australia’s inflation targeting regime, the goal of budget surpluses and a continued commitment to microeconomic reform. This approach has largely been effective in maintaining international confidence in the Aus eco, as well as economists have accepted the “consenting adults” view of Australia’s CAD and foreign debt. However, overall the GFC has been a stark reminder of the link between the public and private sector borrowing. Even if a high level of foreign debt is the result of private-sector borrowing, governments may be forced to take responsibility for the debt, in order to prevent a financial meltdown and a potential economic depression. Even in Australia, the gov felt it was necessary to guarantee all the private borrowings of Australian banks in 2008. The gov guaranteed the nation’s private sector foreign debt, highlighting how in times of financial instability, an external imbalance can make the eco more vulnerable to shocks....