ISSUE 5!

JULY 2012

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SPECIAL EDITION !
AUSTRALIA'S EXTERNAL POSITION 2012! This edition includes two articles outlining the recent Terms of Trade situation and capital investment ows providing direct links to the WACE Stage 3 Economics Course.! ETAWA PUBLICATIONS! Examination papers for Stage 2 and Stage 3 for purchase - $80 for members, $100 for nonmembers - see yer in this publication for more information! UPCOMING EVENTS! Student revision seminar: 1st September - at the PLC Drama Centre. Only $20 entry.! RBA Monetary policy workshop: 15 August - Murdoch University - see yer in this publication for more information!

The Terms of Trade in 2012!

Contribution by ETAWA Member: Peter Evans

The Terms of Trade (ToT) is an index number representing the ratio of export prices to import prices. It can be calculated using the following formula!

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purchase more imports for a given level of exports, or can purchase the same amount of imports with a lower level of exports. Thus the purchasing power of Australias national income increases.!

ToT index number = Export Price Index (XPI) x 100! ! ! Import Price Index(MPI) 1! The XPI is calculated using a basket of export prices weighted according to their relative importance to total exports. Similarly, the MPI is calculated using a basket of import prices weighted according to their relative importance to total imports.!

There are three main ways that the ToT can increase. They are (i) XPI increases whilst MPI decreases, (ii) XPI increases greater than an MPI increase, (iii) XPI decreases less than an MPI decrease. !

The ToT is said to be favourable when the index number is more than 100. However, the actual value of the index is considered to be unimportant. The key focus is whether there has been a favourable movement or not i.e. has the ToT improved or deteriorated.!

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Year

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The ToT indicates the number of imports a country can receive for a given level of its exports. A rise in Australias ToT means Australia can

In recent years Australias ToT has reached its highest ever levels (see table and graphs below).! This is mostly due to increases in the XPI. The industrialisation and urbanisation of China and India has led to increased demand for raw materials such as coal and iron ore resulting in large increases in their prices, thus an increase in the XPI. During this time period the MPI has also fallen. Reasons for this fall include lower prices for imported manufactured goods coming from the worlds largest manufacturer, China, and lower prices for all imported goods due to the high value of the AUD. !

Figure 1: Terms of Trade

Terms of Trade 2.00 4.90 3.60 3.80 Movement -Unfavorable Favourable Favourable Source: ABS (5302.0: Table 6 seasonal)
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2008-09 2009-10 2010-11 Dec 2011

ETAWA UPDATE ISSUE 5 2012!

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The Terms of Trade in 2012 cont'!

Contribution by ETAWA Member: Peter Evans Australias XPI tends to fluctuate more than its MPI. This is due to Australias export reliance on resources, the demand for which varies greatly with changes in world economic growth ie agricultural and commodity prices fluctuate more than prices of manufactured goods. However, the increased importance of services in the XPI in recent and future years should reduce the severity of the fluctuations.! generates Vx. The value of imported goods and services is determined the same way. Thus any change in the XPI or MPI will lead to changes in the Goods and services outcome.!

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Relationship between changes in Terms of Trade and Goods and services outcome.! Changes in the terms of trade will impact on Australias balance of payments. Any change in the price of exports or imports will create a change in the Goods and services outcome. The Goods and services outcome is the difference between the value, in AUD, of exports and imports ie Goods and services outcome = Vx Vm. The value of an exported good or service, recorded in the current account, is determined by multiplying the price of the good or service by the quantity sold. The accumulation of all export values

The final effect of changes in the Terms of Trade on the Goods and services outcome depends on the elasticity of demand for exports and imports. ! In the case of Australia the basic rule of thumb is that an improvement in the Terms of Trade tends to lessen the deficit or increase the surplus on Goods and services, while a deterioration tends to increase the deficit or lessen the surplus on Goods and services. This is due to the fact that the world demand for Australias main exports (resources and agricultural goods) tends to be price inelastic. Similarly, Australias demand for imported capital and consumer (manufactures) goods tends to be price inelastic.! (A change in price of an inelastic good results in a smaller, if any, change in quantity.Thus an increase in export prices will lead to an increase in export revenue ie Vx rises.)!

Figure 2

Figure 3

Source: Reserve Bank of Australia

Questions!

1.! 2.! 3.! 4.! 5.! 6.! 7.!

What is the terms of trade?! What is Australias export price index?! Why did Australias ToT deteriorate in 2009-10?! Account for the favourable movement in Australias ToT in recent years.! How might the rise in the ToT benefit the Australian economy?! Why are Australias exports and imports usually price inelastic?! How will a change in Australias ToT affect the Goods and services outcome?!

ETAWA UPDATE ISSUE 5 2012!

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JULY 2012

Foreign Investment in Australia 2012!

Contribution by ETAWA Member: Peter Evans

Foreign investment into Australia has enabled the Australian economy to attain a standard of living, wealth and growth rates beyond that possible if financing of expansion was limited to only domestic savings. Foreign investment in Australia is simply foreign savings coming into the economy. !

! Australias foreign liabilities are much greater ! than its foreign assets and thus we can say that ! Australia owes more than it owns, in relation the ! foreign sector.! ! ! ! ! ! investment refers to the stock of Foreign Why is this so?!! Australia has a significant ! foreign assets and liabilities, and Savings/Investment gap (due to low population/ Australian ! savings and large mining investment/expansion) financial transactions, recorded in the Financial ! of the BoP, that change this stock.! that requires funding, either by borrowing from Account ! or selling shares to overseas investors. Foreign liabilities are the stock of Australian ! assets owned by non-residents, usually overseas This leads to capital inflow in the Financial financial ! Account ie foreign liabilities. Australia may also in the form of debt or equity, and capital inflow !the Financial Account of the BoP.! have to borrow funds from overseas to finance a into ! deficit in its balance of goods and services, thus Foreign assets are the stock of o/seas ! assets creating more foreign liabilities.! financial owned by Australian residents, ! Foreign liabilities, whilst important to enable usually the form of debt or equity, and capital ! ininto expansion of the Australian economy, create outflow the Financial Account of the BoP. ! ! Stock ! refers to the accumulation of borrowed debit payments (interest or dividend payments) ! and asset sales over many years, whereas in the primary income component of the funds ! inflow refers to money flows, as Current Account in subsequent years. These capital ! ! ! ! Figure 4 : Foreign Investment Flow Chart ! !
Foreign! Investment

! ! ! recorded in the ! !Financial Account, in a particular year.! ! !

Assets!

Liabilities!

Debit entries in Financial account

Credit entries in Financial account

Equity!

Debt!

Equity!

Debt!

Buying shares from Lending money to overseas overseas banks

Selling Australian shares to overseas

Borrowing money from overseas

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The focus of the 3A Eco course is Foreign Investment into Australia i.e. liabilities.!

Foreign investment stock is recorded in the International Investment Position, whilst foreign investment transactions (capital inflow) are recorded in the Financial Account of the Balance of Payments. Data for both can be found in the ABS Balance of Payments and International Investment Position.!

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Foreign investment transactions are categorised as being direct, portfolio, financial derivatives, reserve assets (RBA) or other (bank loans). The two most important are direct and portfolio investment.! Foreign direct investment (FDI) involves the foreign company/investor gaining significant ownership rights. Ownership of 10% or more of a business is considered significant. Direct investment is usually in the form of buying shares, property, establishing a new subsidiary or reinvestment of earnings. These are also known as equity securities. Many foreign companies reinvest their share of dividends to enable the Australian business to expand and

become more profitable. FDI is typically associated with a long term commitment to the Australian economy, and is recorded in the Financial Account as Direct Investment. Australias abundant mineral resources and high levels of infrastructure have attracted FDI. Our stable political environment and welcoming attitude to FDI are also reasons for foreign companies investing in Australia.! ! Foreign portfolio investment does not involve gaining significant ownership rights ie less than 10%. It is usually in the form of borrowing/loans ie debt. There is also some equity portfolio investment. The accumulation of debt securities is known as Foreign Debt. Most loans into Australia are recorded in the Financial Account as Portfolio Investment.!

As at December 2011 the total stock of Foreign Investment in Australia was $2 066.9bn, comprising FDI (Equity) of $701.7bn and Portfolio investment (Debt) of $1 365.1bn. The total inflow of Foreign Investment during 2010/11 was $159.1bn, comprising FDI of $39.3bn, Portfolio investment of $93.7bn and Other of $26.1bn.!

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Student Activities!

Distinguish between foreign assets and foreign liabilities.! Distinguish between capital stock and capital inflow.! Why does Australia have a large foreign liability?! Describe the relationship between foreign investment and the balance of payments.! Distinguish between direct and portfolio investment.! Distinguish between equity and debt securities.

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