External Stability PDF

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Exam notes for external stability section of economic issues...

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EXTERNAL STABILITY DEFINTION: the situation in which Australia is able to meet its international commitments. This means being able to afford M we want and also being able to service any external debt we have accrued.

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an aim of government policy that seeks to promote sustainability on the external accounts so that Australia can service its foreign liabilities in the medium to long run and avoid currency volatility. External stability ensures the economy is able to meet its international financial commitments without compromising current and future standards of living. Instability in the external accounts leads to continued leakages of domestic income into the global economy and constrains economic growth and prosperity.

The main external stability issues for the Australian economy have been: -

A persistent CAD Rising terms of trade (62 – 130 from 1980 – 2011) Australia’s lack of international competitiveness – high exchange rate Growth of foreign debt

The Pitchford Thesis states that as long as a CAD is the result of a savings and investment decisions by the private sector which are not the result of distortions to normal market mechanisms, then CAD is not bad – i.e. Australia

MEASUREMENT There are three aspects to the measurement of external stability 1. Size of the current account deficit (CAD) a. [ X =deficit o e.g. GFC - decrease in M, improving BOGS International demand for Aust. X: Level of economic activity overseas (the faster they grow, the more of our X they buy, the better the balance on G+S) ∴ X> M =surplus o e.g. growth of China has increased demand for Australian X, improving BOGS

Terms of trade: 

terms of trade=

price of X price of M

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as the price of our X increases relative to our M, improving BOGS and CAD

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Resources boom/Rise of China = increase ToT 40 (1950) – 100 (2011) – 95 (2012)

Australia's Internal Competitiveness: 

Exchange rate - high $A makes X less competitive (more expensive) and M more competitive (cheaper) ∴ worsening BOGS – lead to Dutch Disease

CAD – STRUCUTRAL COMPONENT (NPI) Trends: 

During mid 2000s, NPI deficit increased significantly - -4% of GDP 2006-07 o Since 2007-08, NPI has narrowed due to lower servicing costs on foreign debt and increase in savings - deficit of 3.1% of GDP 2011-12

What drives balance on NPI account (structural component)? Large stock of net foreign liabilities (due to worsening CAD) -

80% of liabilities is debt - riskier than equity financing as interest must be paid every year o Increases possibility of debt trap, where increased net foreign debt leads to increased interest costs which leads to worsening NPI and therefore CAD and ultimately more debt

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Increased foreign liabilities to fund domestic investment due to low domestic savings - increased servicing obligations, increased NPI deficit

Changes in global interest rates -

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As global interest rates ↑ , interest paid on foreign liabilities will increase o Increasing D in primary Y account ∴ increasing primary Y deficit Since GFC, global interest rates have decreased, thus interest paid on foreign liabilities has decreased

Changes in perceived risk of lending to Australia -

As risk of lending increases, interest rates increase Due to Australia's AAA rating, interest rates are low  lower debit flows ∴ improving deficit on Primary Y account

EXCHANGE RATE 

If global markets conclude that Australia's CAD is a problem, they will become less willing to hold $A which will cause a depreciation

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Given the extended appreciation of the $A we have seen over the last decade, markets don’t appear too concerned with the size of Australia's CAD or NFLs but sentiment can change quickly

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If the $A depreciated suddenly:

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In the long term - boost to X and reduction in M but this can take time (J-Curve effect)

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Some increase in debt servicing costs but will be muted due to: 

Much of Australia's foreign debt is denominated in $A

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Most of the rest of the non $A foreign debt has been hedged but over time these hedges will need to be rolled over as short term debt matures

TERMS OF TRADE

INTERNATIONAL COMPETITIVENESS International competitiveness is the ability for Aus firms to sell in domestic and overseas markets in competition with foreign firms, able to match other world producers with the price and quality of its exports Major reason that AUS is limited in its export base relates to our lack of IC, in the fast-growing areas of world trade -

Aus capacity constraint (things we can’t make) forces imports that cannot be produced but is highly demanded in AUS

NET FOREIGN DEBT Net Foreign Liabilities = aus financial obligations (net foreign debt + net foreign equity) to the rest of the world - the rest of the world’s financial obligations to Aus When businesses seek to attract investment funds  1. Undertake commercial borrowing – debt financing a. Total principle borrowing has to be repaid plus the interest on that borrowing b. Much larger

2. Equity financing – taking ownership a. More equity partners in the business that profit must be distributed among b. Doesn’t contribute directly to the foreign debt If NFD is too high – it limits our growth  the size and changes in NFD are a good indicator of our performance -

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But because we have high levels of debt, it threatens our currency A continued depreciation will impact consumer/investor confidence o If this happens we won’t be able to attract the investment, we need It’s not always true that if NFD increases and causes a depreciation that we are instable

Our economy is growing faster than our CAD which is positive Measurement 1. Net Foreign Debt – 99% of foreign liabilities a. Total stock of loans owed by Australians to foreigners, minus the total stock of loans owed by foreigners to Australians i. Aus historically low level of savings (household) creates a significant savings-investment gap where investment been financed from overseas ii. = high levels of foreign debt iii. Ability to pay back debt measured by debt servicing ratio Ratio of foreign debt (aus) to X income b. Aus savings investment gap = high foreign debt c. Borrowing adds to debt - debt servicing is largest cause of Aus high deficits 2. Net Foreign Equity a. Total value of assets in Aus (land, shares, companies) in foreign ownership – the total value of assets overseas owned by Australian’s b. Selling assets doesn’t add to foreign debt, however we have to send overseas returns on equity investments

IMPACTS ARGUMENTS FOR AUSTRALIA’S CAD

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Saving-Investment Gap - Mining Boom is capital investment: Australia has run a CAD in all but 2 of the last 50 years, because we are a young country and cannot fund all our valuable investment projects from domestic savings (savings-investment gap) o Without a CAD Australia wouldn’t be able to grow as we wouldn’t be able to fund investment opportunities o Mining boom will provide strong X income to service NFL The CAD is cyclical Private debt not Public: The CAD is driven by the private sector borrowing overseas, not government borrowing therefore not public debt - the Pitchford thesis o Public debt in Australia – 22% vs. 144% in Greece

Market Economy: Australia has low inflation and has undertaken years of microeconomic reform such that private decisions to borrow overseas are unlikely to be distorted by government intervention Many economic indicators (e.g. strong 20 yrs. of economic growth, ratio of the NPI deficit to X earnings or the different between interest rates in the US and Australia) suggest that the CAD is sustainable ARGUMENTS AGAINST AUSTRALIA’S CAD -

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Constraints on economic growth o If necessary to reduce CAD in short term – may implement contractionary macroeconomic policy = lower CAD and economic growth o Long term: due to CAD economy forced to limit growth to a level at which CAD is sustainable Australia has a debt to GDP ratio of 60% and around 3% of GDP must be used each year to pay off NFL o Over time high CAD will lead to an increased level of NFL Australia is highly dependent on foreign lenders and if there is a change in investor sentiment they may be reluctant to lend to Australia o Especially if there is a downgrade in Australia's credit rating which will increase the cost of any future debt Increase Australia's exposure to external shocks, such as a collapse in ToT and more susceptible to the risk of exchange rate fluctuations Much of our borrowing is by banks, which are implicitly guaranteed by government, and this has distorted the risk perceptions of market participants

EXCHANGE RATE -

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Affects price of G and S produced in Aus relative to price of G and S produced overseas (direct effect) o Which effects our decisions for production and consumption (indirect effect) Depreciation = M expensive, X cheap Aus has benefitted from AUD flexibility since floating in 83 o Movements in AUD has helped Aus adjust to changing conditions in the global economy High variability in AUD in response to external shocks is crucial in maintaining competitiveness o During GFC, low AUD insulated Aus from deterioration in international competitiveness, and created a BOGS surplus Volatility of AUD impacts on BOP by affecting inter. competitiveness and servicing costs of foreign debt o Valuation effect  high value AUD reduces real value of net foreign liabilities o However, volatility may undermine investor confidence (= speculation) Best measure = TWI

POLICY RESPONSES MICRO is more effective for external stability but macro may still be needed to decrease the short term fluctuations for long term success Monetary = not a good option (ineffective) Gov reducing budget deficits = reduce money taken out of domestic savings  enhanced external stability -

If gov borrows internationally = increase debt Borrow domestically = pushes out other investors

Compulsory superannuation  compulsory saving for retirement (9%) -

Creates a huge pool of saved funds that can be invested o Much of it is invested offshore o It earns an income – credit coming in acts to limit our level of foreign liabilities o $2.6 TRILLION

Microeconomic policy is based at bringing structural change that will make us more internationally competitive -

Aims to increase the efficiency and productivity in the Aus industry will improve our international competitiveness in the long run Migration policy to match skill shortages Lowering protection to improve int’l comp Labour market reforms o Wage rises = productivity Gov initiatives that can increase the participation rate

Best policies maintain international confidence in the Aus economy – continuing medium term targets such as inflation and CPI per year --> reducing the size of budget deficits or increasing services, and demonstrating a commitment to microeconomic reform Pursued through long term policy setting of microeconomics we can make our economy less vulnerable to external shocks – which affect our access to foreign investment funds -

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Being able to meet our financial obligations to the rest of the world  is how we measure external stability We don’t consider our level of ES a problem at the moment o Gov is targeting internal stability o If we achieve this, it will flow onto affect external stability WE are still vulnerable to external shocks o During GFC for example gov had to build up confidence  To prevent people running to the bank to get their money out  We want it private sector driven and financed

There are six main external stability issues facing Australia. These are 

A persistent current account deficit o Caused mainly by deficit on the net primary income account (savings gap)

o Structural increase in the CAD since 1980s. The CAD has averaged...