Extended Response Practice Question

Describe recent trends in the size and composition of Australias balance

of payments. Explain the issues associated with Australias balance of
payments problem.
In the recent decade (the 1990s), Australia has recorded a persistent deficit in
the Current Account and thus a surplus in the Capital and Financial Account to
service this deficit. Since internationalisation of the Australian economy in the
1980s, Australia has become more integrated with world markets. The
introduction of the floating exchange rate has allowed Australian firms to export
more goods and services. However, G and S imported from overseas have grown
quicker than exports and today this difference represents a large portion of the
deficit in the Current Account.
Another, and more significant component, is the net income. This is the sum of
capital entering and leaving Australia through interest repayments, dividends and
royalties. In 1998-99, net income represented 60% of Australias Cad, putting a
heavy burden on the economy in terms of economic growth, exchange rates and
foreign investment.
Australias balance of payments is affected by cyclical factors. In the recent
decade, it has improved (ie. recording a smaller deficit in the Current Account)
and deteriorated (ie. a greater CAD) due to changing economic factors in the
global and domestic economy.
In 1991-92, the world was in recession. Australias economic growth slowed
down, and this reduced the demand for imported G and S. It helped reduce the
CAD recorded in the previous decade (the 1980s) to -$13,377. As such, the
surplus in the Capital and Financial Account also dropped to offset the amount.
During 1992-94, the world economy recovered. This improved the growth rate of
Australias economy and thus the demand for imports. As a result, the CAD rose.
In 1994-95, strong domestic growth created a peak in the goods deficit of $8216m. The net income component had also reached high levels. The CAD
represented 6% of Australias GDP, which was considered to be unsustainable. In
response, the RBA raised interest rates during 1995-97 to slow domestic growth
and demand, and attract the entry of foreign capital to finance the foreign debt.
The CAD became more sustainable during this period.
The Asian Financial Crisis of 1997-99 had a great impact on Australias trade, and
it was reflected in the Balance of Payments. Strong domestic growth increased
imports while recession in the Asian economies decreased exports. The goods
deficit grew, and as a result, the CAD deteriorated to -$32,966m. After the crisis,
Australias CAD improved and good economic policies have kept it so, until the
drought of 2002 weakened commodity exports and worsened the deficit.
The reasons for Australias consistent deficit in the Current Account can be
contributed to cyclical and structural factors. Because Australia is integrated with
the world economy, it is subject to fluctuations caused by the international
business cycle and growth rates of other economies. If domestic growth outstrips
world growth, imports will rise and this will usually cause a greater goods and
services deficit in the Current Account. Conversely, if world growth exceeds
Australian growth, there will be more demand for domestic exports and thus
reduce the G and S deficit and the CAD. An example of this effect was the Asian

Financial Crisis, in which Australias high growth coupled with recession in the
Asian economies saw a decrease in exports and rise in imports, resulting in a high
CAD. These cyclical effects are often unavoidable, but the government can help
smooth out dramatic changes by conducting certain economic policies such as
interest rate adjustments.
The more important aspect of the continual CAD is the net income component.
This records the capital flowing out of the country due to our need to finance our
foreign debt. In the 1980s, Australia had built up a significant amount of debt
due to borrowing by the private sector. Because of the low amounts of saving by
Australians, firms had to look overseas for capital. As a result, the large amount
of debt (considered one of the largest in OECD countries) has to be serviced and
is recorded as a deficit in the Current Account. To finance this deficit, Australia
must borrow to create an equal surplus in the Capital and Financial Account. This
continuous cycle is the main reason why Australia maintains a high CAD.
A high CAD has several negative impacts on the economy. When foreign investors
look to invest in countries, one of the major factors affecting them is nations
CAD. A high CAD puts more risks on the investor, and thus higher interest rates
are demanded. This will reduce the amount of foreign capital entering Australia,
and worsen the CAD as well as slowing projects by Australian firms. Australia
usually runs a deficit of 3%, which is considered by many to be unsustainable in
the long run.
When the CAD reaches 6%, as it does about every five years, there is a serious
threat of a financial crisis. As investors withdraw money from Australia. This may
lead to depreciation of the AUD, rise in interest levels by the RBA, lower demand
by consumers, slower economic growth, firms going bankrupt and rise in
imported inflation. Thus far, Australia hasnt had a serious financial crisis, due to
well-conducted economic policies. But nevertheless, the structural component of
the CAD remains a significant problem in Australias trade flows.