Economic Implcations for the Australian Economy Essay

Custom Student Mr. Teacher ENG 1001-04 16 May 2017

Economic Implcations for the Australian Economy

Discuss the economic implications for the Australian economy of Australia’s continuing current account deficits Australia has a long history of large and persistent current account deficits. During the 1960s the current account deficit averaged the equivalent of 2 per cent of gross domestic product. The CAD rose considerably, due to the floating of the Australian dollar and the opening of the capital account in 1980s, and by 1990s CAD has sustained around an average of about 4.5 per cent of GDP. However, in recent years the deficit has been falling and in 2011 it was just 2.25 per cent. The decline in the CAD has been affected by what is happening to the nation’s levels of saving and investment. The level of Australia’s national investment has fallen as a share of GDP in the past year or two, dropping to 27 per cent in 2011.

This is due to the falling of business investment despite the strong mining investment. Although public investment spending has recovered from its decline in earlier decades but it has dropped a bit recently. Households’ spending has also fallen back in recent years. On the other hand, the level of nation’s saving is just a bit under 25 per cent of national income (GDP), its highest since the 1980s.

This is because saving by companies has been slowly trending up over the decades and at present it is at a record level of about 14 per cent of GDP. Government saving was very weak in the 1970s and 1980s but, following the deep recession of the early 1990s, strengthened to about 5 per cent of GDP. It is now back to zero as a consequence of the global financial crisis. The rate of household saving fell steadily through the 1970s to the 1990s, but began increasing sharply in the 2000s and is now back up to about 10 per cent of GDP. The decline in the CAD is therefore resulting from the decrease in the national investment and the increase in the national saving. ….

The balance of payments is the sum of all transactions that Australia has with the rest of the world. It shows the trade and financial flows in and out of the Australia economy. It is split up into two parts, the current account and the capital and financial account.

The current account is made up of 4 parts; Net goods and Net services. The total of net goods is calculated by the difference between what Australia pays for its exports and what it receives from its imports. The total of net services is calculated between the services that Australia sells (e.g transport, travel, communications and the services that we buy. Net primary income includes investments, rent profits and dividends. Net secondary income, which is when products or financial resources are provided without any product provided in return.

The capital and financial account involves money that flows from international borrowing; financial assets and liabilities. The main feature about capital and financial accounts is that these transactions are reversible. The two main parts of Capital Accounts are foreign aid and non-financial assets. Financial accounts are categorized by 4 main types; Direct investment, portfolio investment, derivatives, reserve assets. Cyclical factors such as exchange rates make the BOGS unstable.

The Australian dollar, which currently equates to approximately 1.03 US dollars, is currently one of the highest currencies in the world. Having a high dollar can make imports cheaper to buy, but it also makes exports harder to sell, therefore reducing the amount of net profit. For example, China has one of the biggest export bases. Their successful export base is due to their low dollar (1 Yuan = 0.16 US Dollar), low cost of labour and a large amount of factories. Their low dollar allows more exports to be sold due to the cheaper cost of manufacturing.

The Terms of Trade (TOT) is another cyclical factor that makes the BOGS inconsistent. The Terms of Trade shows the ratio of the export price index to the import price index. It is calculated by 100% x average export price index / average import price index. Australia’s Terms of Trade, the price we pay for our imports versus the price we get for our exports are falling, which affects the overall economic performance. September 2011, when the terms of trade had peaked, due to the foreign buyers for coal, iron ore and gas. However in the March quarter there was a 9.8% decline. Afterwards, the terms of trade dropped into another 7%, resulting in a massive decline. The fall in the terms of trade affects the Australian economy greatly. It affects the Australian economy by lowering the living standards.

Domestic economic growth affects the BOGS greatly. The higher the growth, the more demand for imports. The BOGS worsens due to an upturn in the domestic business cycle, which leads to higher consumption and higher disposable income. During the GFC, the slowdown in growth led to a decrease in spending on imports, which resulted in the BOGS having a surplus of 0.5% in 2008-2009.

International competitiveness also affects the BOGS. This is also called the ‘Dutch Disease’, where the growth in one export results in a higher exchange rate, This allows them to shake off the international competitors. Economies can be competitive due to selling products with higher quality or lower price than their competitors.

The International business cycle has phases of upswings and recessions. Upswings are when GDP, consumption levels, investment expenditure rise, and there is a decrease of unemployment. Higher growth overseas means more demand for our exports because the exchange rate is cheaper when there is less growth. A recession is a downturn in economic activity and is when GDP, consumption, investment expenditure get decreased. Whether a recession or upswing occurs, the BOGS will adjust to the economic activity.

Australia’s narrow export base is one structural factor affecting BOGS. Australia’s main exports are mainly coal, beef, iron ores and wool. Despite Australia having a strong manufacturing sector, many countries such as China are able to produce goods more cheaply. If many countries can produce the same goods at a cheaper price, it affects the rate of Australia’s exports. ….

The net primary income account, in the balance of payments, plays an ongoing part in the cause of Australia’s current account deficit (CAD). This occurs mainly due to the fact that the net primary account is comprised of payments of interest and dividends on Australia’s net foreign debt and equity. In 2011-2012, it was equal to a deficit of 3.1% of GDP; however it is expected to increase in the future due to large returns to overseas investors in Australia’s mining industry. Cyclical and structural factors affect the net primary income account which has a great influence towards the CAD. The
relative size of Australia’s interest repayments overseas is the major cyclical factor affecting the CAD through the net primary account. The changing value of the exchange rate and lead to the valuation effect, where the Australian dollar value of debt denominated in foreign currencies will alter. Hence is there were to be a depreciation of the Australia dollar in global exchange rates, it will increase the value of Australia’s interest repayments and worsening the net primary income deficit.

Though, as this theory can work vice versa, economists argue that the recent appreciation of the Australian dollar has reduced the value of net primary income outflows, hence improving the net primary income deficit. Also, as a large amount of Australia’s foreign debt would be hedged, fluctuations in the exchange rate would not play a significant factor in the CAD through the net primary income. On the other hand, Australia’s ongoing primary income deficit is largely attributed to the structural factor in the savings and investment gap. Due to fact that Australia has a relatively small economy and low population, yet is a high investment economy, due to its large export industry of minerals, firms resort to funding their investment through international borrowing.

This increases foreign debt which in turn increases Australia’s foreign liabilities and creates future servicing obligations, for example interest repayments and dividends. Also Australia’s historic high levels of household spending coupled with governments fiscal policies usually running deficits resulting in government borrowing to fund government spending, places a strain on the net primary income. However, in recent years the household saving ratio has increased to equal 9.3% in 2011-2012. This reflects the fact that households are saving more. This reduces borrowings in response to global economic uncertainty, which has led to a reduction of pressure on the net primary income account. ….

There are concerns involving a high current account deficit. It is believed that the current account deficit reflects Australia’s increasing productivity capacity and the foreign debt can be beneficial because borrowing from overseas can increase investment and help economy grow faster. However, it is also mean that Australians are spending beyond their means which indicates the risks associated with a high current account deficit. Firstly, over a period of time a high current account deficit will contribute to an increased level of foreign liabilities. In the form of borrowings from overseas or through selling equity in items such as property and companies, a current account deficit presupposes financial inflow on the capital and financial account.

This means that lenders may hesitate to lend to Australia or to invest in Australia. For instances, Australia’s debt to the rest of the world has increased. Real net foreign debt grew on average by 6.1 per cent per year on a per capita basis between June 1999 and June 2009, increasing from $15 400 to $27 900 (in 2007-08 prices). Current account deficit may result in an increased in the volatility for exchange rates. High CAD may deteriorate the confidence of overseas investors in the Australian economy. This may reduce the demand for Australian currency and may result in a depreciation of the Australian dollar.

For example, in 2000 the Australian dollar has fallen to an all-time lowest of 54.93 cents as measured against the American dollar. This is the lowest point since the floating of the dollar commenced in 1983. The decline in the value of Australian dollar is beneficial for Australian exporters, but the cost of imports will increase. A high current account deficit may also become a speed limit on economic growth. A sudden loss of international investor confidence may contribute to an economic crisis which often results due to a high CAD. For example, the Asian Economic Crisis in 1997 had worsened the GDP of those affected such as Thailand. The GDP in Thailand fell from 5002.431 in 1996 to 4963.134 in 1997 which was when the crisis has taken place and the average CPI of that year has been restricted to only 5.626 per cent.

Despite this daunting downside to having a current account deficit when looked at objectively, for Australia in particular, this problem for others has proven to be inconsequential for Australia’s economy. The Pitchford Thesis (also known as “consenting adults”) states that as long as a current account deficit is the result of savings and investment decisions by the private sector which are not the result of distortions to normal mechanisms there is no cause for concern about an economy’s external stability. This means even if a country has a budget deficit, if it is the result of investment and savings decisions of the private sector, there should be no concern about whether a current account deficit is sustainable. Pitchford argued that Australia’s current deficit problem was different, as other countries such as Greece in the European Crisis, had debt due to government borrowings.

In Australia’s case, it was that liabilities helped to fund private investment projects, or were direct investments in firms and ventures by foreign residents. In accordance to this, the private sector accounted for 80 per cent of Australia’s net foreign debt in 2012 and around 5 per cent or primary income flows in the form of interest servicing costs. From this, Pitchford concluded that as long as the private sector decision making was not distorted by other factors (e.g. government policies), individuals and firms make proper calculations of the risks and costs of borrowing from overseas, borrowers and lenders are responsible for their own decisions. The government should not be concerned about the current account deficit.

This has shown to be proven true by Australia’s strong economic performance supported the view that Australia’s external imbalances are sustainable. However, despite this, there is one major flaw that economists have found in his thesis. The Pitchford thesis relies on the private sector decision making process to always involve proper calculations of risks. However as shown by the Global Financial Crisis, whereby the mortgage in the US did not calculate the risks of financial institutions borrowing and lending associated with mortgage-backed securities. In addition it is also assumed, by the Pitchford Thesis that private sector debt is entirely separate from the public sector debt. However, the Global Financial Crisis demonstrated that governments are forced to assume the liabilities of the private sector banks to avid a more serious financial collapse.

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