Professional Documents
Culture Documents
Chapter 10
External Stability
MEASUREMENT OF THE CURRENT ACCOUNT DEFICIT
A key goal of the Australian government’s macroeconomic policy is to achieve the objective of external
stability or external balance. External stability is achieved when export income is sufficient to finance
import expenditure. Exports represent expenditure by foreigners on domestically produced goods and
services and are independent (or autonomous) of changes in domestic national income. In the five
sector model of the circular flow of income in the economy, equation (1) is used to determine exports:
(1) X = X0
where X = total export expenditure
X0 = autonomous export expenditure
Exports are an injection of funds into the circular flow of income. Export demand is determined by
decisions made in the rest of the world and is influenced by four main factors:
• Real GDP growth in the rest of the world: The higher (lower) the level of real GDP growth in the
rest of the world, the greater (lower) will be the foreign demand for Australian goods and services.
• The extent of international specialisation and factor endowments: Since Australia has a comparative
advantage in the production of agricultural and mineral commodities, some manufactured goods,
and services (such as travel and tourism), this creates a foreign demand for these goods and services.
• The prices of Australian made goods and services relative to the prices of similar goods and services
made in other countries: The cheaper (dearer) Australian goods and services are relative to competing
foreign goods and services, the greater (lower) the demand for Australian exports.
• The lower (higher) the value of the Australian dollar, the greater (lower) will be the demand for
Australian exports, since they are cheaper (dearer) relative to competing domestic goods in foreign
countries or markets.
Imports are a leakage of funds from the circular flow of income as they represent domestic demand for
foreign produced goods and services. Import expenditure consists of both autonomous (i.e. independent
of changes in income) and induced (i.e. dependent on changes in income) components. In the five sector
model of the circular flow of income in the economy, equation (2) is used to determine imports:
(2) M = M0 + mY
where M = total import expenditure
M0 = autonomous import expenditure
m = the marginal propensity to import = ∆M
∆Y
Import demand is determined by decisions made in Australia and is influenced by four main factors:
• Real GDP growth in Australia: The higher (lower) the level of real GDP growth in Australia, the
greater (lower) the demand for foreign produced goods and services or imports.
• The extent of international specialisation and factor endowments: Since other countries have a
comparative advantage in the production of consumer, capital and intermediate goods, and services
(such as travel and tourism) this creates an Australian demand for these goods and services.
• The prices of foreign made goods and services relative to the prices of domestic goods and services
in Australia: the cheaper (dearer) foreign goods and services are relative to Australian goods and
services, the greater (lower) the demand for foreign imports.
Figure 10.1: Exports and Imports in the Five Sector Circular Flow of Income Model
equilibrium (X = M)
• The higher (lower) the value of the Australian dollar, the greater (lower) the demand for foreign
imports, since they are cheaper (dearer) relative to domestically produced goods and services.
In Figure 10.1 autonomous exports are equal to 250, and import spending is equal to 50 + 0.2Y. Net
exports (X - M) will be zero when X = M. In Figure 10.1 this occurs when income (Y) is 1000 (i.e.
250 = 50 + 0.2Y, therefore Y = 1000). If we assume that other things remain equal (ceteris paribus),
an increase in national income above 1000 will lead to a trade deficit (where X < M), whereas at
income levels below 1000, trade surpluses are recorded since X > M. When net services, net primary
and secondary income (net income) are taken into account, the equilibrium condition for the current
account in the balance payments is denoted in equation (3):
Table 10.1: Australia’s Current Account Deficit, Net Foreign Liabilities and Net Foreign
Debt ($m) and as a Percentage of GDP 2002-03 to 2011-12
Table 10.1 shows the nominal dollar value of Australia’s current account deficit, net foreign liabilities
and net foreign debt between 2002-03 and 2011-12. In addition it shows each indicator as a percentage
of Australia’s GDP for the same period:
• The current account deficit varied from a low of -2.3% of GDP in 2010-11 and -2.8% in 2011-12
to a high of -6.2% in 2004-05 and -6.3% in 2007-08. Overall the current account deficit averaged
around -4.7% of GDP between 2002-03 and 2011-12.
• Net foreign liabilities reached a high of 60.8% of GDP in 2011-12, but averaged 57% of GDP
between 2002-03 and 2011-12.
• The net foreign debt reached a high of 53.3% of GDP in 2009-10 but averaged 50% of GDP
between 2002-03 and 2011-12.
Other international ratios compiled by the ABS include net investment income which is the ratio of net
income paid on foreign equity and foreign debt borrowings, to goods and services credits or income in
the current account of the balance of payments. These are measures of the cost of servicing net foreign
equity and net foreign debt borrowings from export income:
• In 2011-12 the net income to foreign equity ratio was -6.3%;
• In 2011-12 the net income to foreign debt ratio was -7.2%; and
• The net investment income ratio for foreign equity and foreign debt in 2011-12 was -13.5%.
Source: Commonwealth of Australia (2012), Budget Strategy and Outlook 2012-13, Canberra.
Figure 10.3: The Real Exchange Rate and the Terms of Trade
The Real Exchange Rate The Terms of Trade
International Competitiveness
Movements in the exchange rate for the Australian dollar against currencies of Australia’s trading
partners influence international competitiveness. Australia became less internationally competitive
between 2003 and 2007 and in 2010-11 because of the appreciation of the real exchange rate as shown
in Figure 10.3. Manufactured export volumes fell as did service exports such as travel, tourism and
education. These export categories showed little growth due to a lack of price competitiveness in export
markets. However the appreciation of the exchange rate did not impact adversely on resource exports
of minerals, metals and energy products. Strong demand from China and other fast growing emerging
economies underpinned higher resource export prices as well as export volumes. This was particularly
the case for coal, iron ore, gold and LNG exports and led to a continuation of high levels of investment
in resource projects to boost production capacity in the mining and energy sector of the economy.
The impact of the Global Financial Crisis in 2007-08 led to a depreciation in the real exchange rate,
helping to lift competitiveness through a lower exchange rate. Another depreciation occurred between
May 2010 and July 2010 because of the impact of the European Sovereign Debt Crisis (on foreign
exchange and financial markets), and the proposed Resource Super Profits Tax (RSPT) on mining
companies’ profits which weakened investor sentiment. However the Australian dollar recovered value
in late 2010 and during 2011, trading at around US$1.05, well above its post 1983 average of US$0.75.
But in late 2011 the Australian dollar lost value due to the impact of Euro Area and US debt crises.
Table 10.2: Recent Trends in the Current Account Deficit, Net Foreign Debt and Net
Foreign Liabilities 1980-81 to 2010-11
Current Account Deficit -$5.5b (-4% of GDP) -$22.3b (-6% of GDP) -$40.4b (-2.8% of GDP)
Net Foreign Liabilities $18.2b (13% of GDP) $170b (46% of GDP) $879.5b (60.8% of GDP)
Net Foreign Debt $6.8b (6% of GDP) $117b (32.9% of GDP) $756.1b (52.2% of GDP)
The servicing cost of net foreign debt requires interest payments abroad which are recorded as net
primary income debits in the current account. Since the 1980s, Australia’s private foreign debt has risen
substantially, with the accumulation of debt accentuated by the ‘debt for equity swap’ that prevailed in
the 1980s, when private sector businesses preferred to borrow overseas (because of lower interest rates
and tax deductions for interest payments) rather than using equity borrowings. The escalation in net
primary income payments overseas was a reflection of this rising debt servicing burden on Australia.
The financing of successive current account deficits by borrowing overseas sets up a requirement for
continued interest payments to overseas creditors. At the end of the 1970s interest payments abroad
stood at 2.5% of export earnings, but peaked in 1989-90 at around 20% of export earnings. This debt
servicing cost in turn leads to a further deterioration in the current account balance. As the current
account deficit continues to grow, more overseas borrowing is required, and a current account deficit-
foreign debt cycle may become self perpetuating as illustrated in Figure 10.4.
Only successive reductions in/or stabilisation of the current account deficit and the retirement (repayment)
of foreign debt obligations can correct this cycle. This is why Australia cannot sustain a rate of economic
growth in excess of 5% if the current account deficit rises to over -5% of GDP, since the debt servicing
obligation becomes greater than the capacity of the economy to increase its income, without leading to
a rise in import spending, and a further deterioration in the current account deficit.
Figure 10.4: The Current Account Deficit – Net Foreign Debt Cycle
Increased Net Primary Income Deficit Increased Stock of Net Foreign Debt
The Pitchford Thesis: The Financial Account ‘Drives’ the Current Account
In the 1990s an alternative analysis of the current account deficit by Professor John Pitchford from
ANU was that the current account deficit was a result of the capital and financial account surplus. This
surplus sets up a high servicing cost in terms of interest, profit and dividend payments remitted overseas
and increases the size of the net primary income deficit and the current account deficit. Rising current
account deficits increase the need for foreign borrowings which increases the size of the net foreign debt.
Pitchford argued that this was not necessarily a problem if the funds borrowed were invested in export
industries, which would increase export income in the future. The Australian government has largely
accepted the ‘Pitchford thesis’ that the current account deficit reflects private saving and investment
decisions and that the current account deficit is sustainable if borrowings are invested in exports.
REVIEW QUESTIONS
MEASUREMENT AND TRENDS IN THE CURRENT ACCOUNT
DEFICIT, NET FOREIGN LIABILITIES AND NET FOREIGN DEBT
1. Explain the main components of exports and imports in the five sector circular flow model.
3. Refer to Figure 10.1 and explain how external stability is achieved in the five sector circular flow
of income model.
4. How are the relative size of the current account deficit, net foreign liabilities and net foreign debt
measured in terms of national output or GDP?
5. Discuss the trends in the size of the current account deficit, net foreign liabilities and net foreign
debt (in nominal dollar terms and as a percentage of GDP) between 2002-03 and 2011-12 by
referring to the data in Table 10.1.
6. Discuss the impact of Australia’s rising terms of trade on the current account deficit during the
resources booms between 2003 and 2008 and over 2010-11.
7. Discuss the impact of the rising terms of trade during the resources boom on the exchange rate.
8. Discuss the impact of the appreciation in the Australian dollar during the resources boom on
Australia’s international competitiveness.
9. Refer to Table 10.2 and Figure 10.4 and explain the relationship between the growth in the
current account deficit, net foreign liabilities and net foreign debt between 1989-90 and
2011-12.
10. Discuss the causes of the growth in the current account deficit in the 1980s, 1990s and 2000s.
11. Discuss the causes of the growth in the net foreign debt in the 1980s, 1990s and 2000s.
The FitzGerald Report on National Saving (1993) recommended that the government eliminate its
budget deficit, and reform the tax system as a means of boosting national savings, through greater
incentives for private saving. The Hawke government introduced the Superannuation Guarantee Levy
(SGL) in 1991 to encourage the spread of compulsory superannuation to help raise private saving. The
compulsory levy of 9% of gross earnings of employees paid into superannuation accounts had led to
the accumulation of around $1,400b in superannuation funds for retirement in 2012. The Howard
government, elected in 1996, implemented a number of the FitzGerald Report’s other recommendations,
designed to raise national saving and such as the following:
• Eliminating the Commonwealth budget deficit and returning the budget to surplus.
Budget surpluses lifted public savings and reduced the public sector’s call on private savings.
• Reducing the Commonwealth’s general government net debt to GDP ratio from 20% in 1995-96
to 1.3% by 2004-05 through the proceeds from the privatisation of a number of Public Trading
Enterprises (PTEs) as well as accumulated budget surpluses.
• Introducing measures to increase private saving such as tax rebates for private savings; an extensive
retirement incomes policy; taxation reform measures in budgets between 2000 and 2007, such
as introducing the GST and cutting marginal tax rates (MTRs) to boost private saving; and the
elimination of taxation on superannuation in the 2006 budget for retirees reaching 60.
Australia also has a relatively high level of investment as a share of GDP compared with other advanced
economies. Private business investment accounts for over half of national investment on average and
in recent years private business investment has reached historic highs of 15% of GDP, with public
investment in infrastructure accounting for an average of 5% of GDP. The growth in Australian private
and public investment has been driven by strong investment in the mining sector in terms of new
projects for LNG and an expansion of existing iron ore and coal projects. Mining investment was
forecast to account for 8% of GDP in 2012, more than double its share in previous mining booms.
Table 10.3 shows that Australia’s current account deficit was -6.2% of GDP in 2004-05 which was
the worst outcome since the impact of the Asian crisis in 1998-99 on exports. The deterioration in
the current account deficit began in 2003-04, due to the slowdown in world growth and the impact of
the drought, which reduced export volumes and export income. However the net income deficit still
accounted for 54.6% of Australia’s current account deficit in 2004-05, and the size of this deficit reached
over -$32b. This required more overseas borrowing in the form of both debt and equity finance, which
led to a further build up in Australia’s net foreign liabilities and net foreign debt. The current account
deficit stabilised in 2005-06 as the global resources boom increased mining exports.
Between 2005-06 and 2006-07 the current account deficit stabilised at around -5.6% of GDP due to an
improved trade performance through increased mineral and resource exports. However the net primary
income deficit continued to widen in 2007-08 because of increased remittances of profits, dividends
and interest, and the current account deficit rose to -6.1% of GDP in 2007-08. The current account
deficit fell to -4% of GDP in 2008-09 and stabilised at -4.2% of GDP in 2009-10 as exports increased
due to a resumption in commodity exports to China and other emerging economies.
In terms of microeconomic policies the Australian government has used various microeconomic reforms
in the longer term to improve the economy’s level of allocative efficiency and productivity. For example,
industrial relations policy is important in linking wage movements to improvements in productivity
at the workplace. This helps to contain wage expectations and encourages firms to adopt competitive
labour and management practices which are essential for firms exporting to the global market. Labour
market reforms such as the Workplace Relations Act 1996, the Workplace Relations Amendment Act 2006
and the Fair Work Act 2009 have all placed an emphasis on productivity based wage bargaining.
Microeconomic reforms in infrastructure industries such as electricity, transport, water, gas and
telecommunications have also been critical in reducing input costs for Australian industry and assisting
the improvement in international competitiveness and productive capacity over time.
Other important microeconomic reforms include the national competition policy and the cuts to
industry protection, which have increased the level of competition in the Australian economy. More
competitive domestic industries help to boost exports as a share of GDP, thereby reducing the trade
deficit and the size of the current account deficit. Industry policy also has a role to play in encouraging
innovation, risk taking and investment in research and development, which the Australian government
believes are essential for building world competitive firms.
REVIEW QUESTIONS
LOW NATIONAL SAVING AND THE EFFECTS OF THE CURRENT
ACCOUNT DEFICIT AND NET FOREIGN DEBT
1. What is meant by national saving? Refer to Figure 10.5 and discuss the trends in national
saving and investment between 1961 and 2011.
3. How does the Twin Deficits hypothesis suggest that the current account deficit can be reduced?
4. How did Australian governments use macroeconomic policy to reduce the current account deficit
in the 1990s when it became unsustainable?
5. What measures did the Australian government take to raise national saving as suggested by the
FitzGerald Report in 1993?
6. Discuss the economic effects of the current account deficit and the net foreign debt in terms of
debt servicing costs, the stability of the exchange rate and the conduct of government economic
policy.
7. Refer to Table 10.3 and compare the size of Australia’s current account balance with other
major industrial countries between 2004 and 2010. Discuss the policies that can be used by the
Australian government to reduce the size of the current account deficit.
Refer to the table of data above for real GDP, the current account deficit, net foreign
liabilities and net foreign debt for Australia between 2005-06 and 2011-12 and
answer the questions below. Marks
2. Calculate the current account deficit as a percentage of real GDP in 2011-12. (1)
4. Explain the relationship between the current account deficit and net foreign liabilities. (1)
5. Explain TWO reasons for the growth in the net foreign debt between 2007 and 2012. (2)
6. Discuss THREE effects of the current account deficit on the Australian economy. (3)
Source: Commonwealth Government (2006), Budget Overview and Economic Outlook 2006-07.
“From a saving and investment perspective, the deterioration in the current account deficit reflects
strong growth in investment. Since 2000-01, nominal investment has been increasing as a
share of GDP, initially driven by strong dwelling investment, but more recently by strong business
investment. On the other hand, national saving has remained broadly stable as a share of GDP,
in part because of the support from the strong fiscal position of the government sector.”
Explain the relationship between the trends in national saving and investment and Australia’s
current account deficit.
CHAPTER SUMMARY
EXTERNAL STABILITY
1. External stability is a major objective of macroeconomic policy. External stability is achieved when
a country such as Australia is able to finance its import expenditure with its export income. Other
aspects of external stability are containing the current account deficit to under -5% of GDP, ensuring
the servicing cost of net foreign liabilities is met, and the exchange rate is relatively stable over time.
3. Historically Australia has recorded persistent current account deficits. Since the 1980s there has
also been an accompanying increase in net foreign liabilities and the level of net foreign debt.
4. The major causes of Australia’s persistent current account deficit are both cyclical and structural. In
cyclical terms Australia’s export income is not sufficient to finance import expenditure. The balance
on goods is usually in deficit and this deficit increases if world growth slows and/or drought
impacts on farm exports. The major structural factor influencing the current account deficit is the
large net primary income deficit, which is a reflection of the servicing cost of Australia’s large level
of net foreign liabilities which include debt and equity borrowings from overseas.
5. Trends in Australia’s terms of trade, exchange rate and international competitiveness can influence
the size of the current account deficit over time.
6. Australia’s large level of net foreign debt is a result of past and present borrowings to finance
persistent current account deficits. Since national savings are insufficient to finance all of national
investment, some funds must be borrowed overseas to meet this savings-investment gap.
7. The structural problem of low national savings in Australia is a reflection of both low private and
public savings. The FitzGerald Report in 1993 recommended that the government eliminate its
budget deficit and increase the incentives for private saving to boost national saving.
8. Under the Howard government from 1996 to 2007, the level of fiscal responsibility was increased
through the Charter of Budget Honesty Act which set an objective of balancing the federal budget
over the economic cycle. Consecutive budget surpluses were used to eliminate public debt and
boost public savings. The government also increased the incentives for private saving through
changes to superannuation and cuts to personal income tax in federal budgets over 2000-08.
9. The effects of the current account deficit and net foreign debt on the economy are numerous:
• The economy has a large net primary income deficit in the balance of payments, which reflects
the servicing cost of past borrowings and adds to the size of the current account deficit;
• The economy is more exposed to external shocks such as a slowdown in world growth, or a
collapse in the terms of trade, which can reduce export income and increase the size of the
current account deficit and level or stock of net foreign debt;
• The exchange rate is subject to depreciation if foreigners holding debt lose confidence in
Australia’s ability to service the debt and may withdraw their capital from Australia; and
• The government may need to tighten monetary policy by putting up interest rates to reduce
economic growth and import demand if the current account deficit becomes unsustainable.
This could cause the rate of economic growth to fall and the rate of unemployment to rise.