Analyse the causes and effects of fluctuations in external stability in Australia

Intro:
● External stability refers to an economy’s ability to service its foreign liabilities over the
medium-long term, ensuring that imbalances on its external accounts does not hinder
domestic economic goals such as growth, unemployment or inflation
● Measures of external stability include current account deficit (CAD), net foreign debt
(NFD), and net foreign liabilities (NFL) as a percentage of GDP
● Fluctuations in Australia’s external stability are caused by cyclical and structural changes
that affect the CAD, the level of NFL and exchange rate. Other factors also include the
TOT, exchange rate volatility and international competitiveness.
● These causes are best demonstrated through events such as the MIB, COVID and post-
COVID recovery
● Although external instability could result in negative effects such as a debt cycle,
threatened credit rating and lower investor confidence, the Pitchford thesis suggests that
the persistent CAD is not a major economic problem, thereby raising the potential for
growth.

Theory Paragraph:
● The prime indicator of external stability includes the CAD as a % of GDP
● A CAD is said to be unsustainable if its % of GDP is higher than the rate of economic
growth due to the cost of servicing the CAD rising faster than the ability to service it
● It occurs when the value of debits outnumbers the value of credits on the CA (BOGS,
NPY, NSY)
● It is a key indicator of external stability as it allows for year on year comparison and
comparison against other countries, as a percentage of GDP

Savings-Investment Gap (MIB and NFL):

● The largest structural factor impacting the NPY account and also the CAD is the
savings-investment gap, which has implications on external stability.
● This gap is a result of Australia’s historical low household savings ratio (1.5%), causing
us to rely on foreign investment to fund capital intensive industries such as mining
● In addition, Australia’s attractive AAA credit rating makes it a profitable and low risk
investment destination
● This was evident through a spike in NFL’s during the MIB, with 70% of LNG and 50% of
coal industry becoming foreign owned, and NFDs increasing from 6% to 60% worsening
external stability
● Additionally, this increased financial inflow on the KAFA, thereby increasing NPY
servicing costs with an NPY deficit of $59.6 bn, subsequently worsening the CAD as
foreign debt increased from 6% to 60% during the MIB II.
● Although this had a negative impact on Australia’s external stability, the increase in
investor confidence caused by the mining boom contributed to the appreciation of the
AUD to peak at $1.10 USD in 2011
 ● Whilst this increased the price of inelastic commodities, creating a BOGS surplus of
$22.4 bn, it rendered non-commodities such as manufacturing and services less
internationally competitive, creating a 2-speed economy
● However, the debits on the NPY outweighed credits on the BOGS, increasing the CAD
44% to 8.3m in Dec 2011 (4% of GDP), thereby overall worsening external stability
● In addition, in 2013 value of overseas assets owned by Australians exceeded value of
Australian assets owned by overseas residents due to increased equity accumulations
by superannuation industry, thereby reducing Australia’s NFL
● Despite this, the CAD still persisted as Australia's overseas loans increased by 6 times
in the same period, resulting in an overall larger NFL
● CAD sustainable in LT due to Pitchford thesis as it is driven by the private sector who
have a profit motive to build up Australia’s productive capacity, thereby having minimal
effect on external stability

COVID-19 and narrowing of S-I Gap:

● This Savings-Investment Gap has been narrowed due to structural changes imposed on
the economy such as Australia’s superannuation policy as well as the increased
precautionary motive to save due to low consumer confidence caused by COVID
pandemic.
● This has caused Australia’s h/h savings rate to soar to 18%, subsequently lowering the
amount of overseas borrowing to fund K intensive industries such as Australia’s primary
export of commodities.
● This is demonstrated through the consumer confidence index being at an all time low of
79.6 in 2020
● The value of super is 9.5% of employees’ wages and has also increased the level of
national savings, increasing levels of investment overseas, thus achieving a negative
NFE stance valued at $252.1bn.
● Therefore, Aus now receives more dividends from overseas equity, allowing credits on
the NPY to offset some of the debits, slightly reducing the NPY deficit and among other
factors leading Australia's CAS widening to AUD 14.52 billion in Dec 2020, from 10.71
billion in the previous quarter, improving external stability.

Narrow Export Base:

● Moreover, Australia’s narrow export base is another structural factor of fluctuations in
external stability.
● 60% of Australia’s export income comes from mineral and rural exports, low value added
and volatile, compared to Australia’s high value added IT and ETM imports
● Thus, changes in world prices for commodities disproportionately affect Australia’s
external stability as lower prices reduce credits in the BOGS, causing a trade deficit and
a higher CAD
 ● This was reflected post MIB when a fall in commodity prices due to weakening Chinese
growth deteriorated Australia's TOT from 130 (2011) to 83 (2015), from a BOGS surplus
of $2.5bn to a deficit of $3.9bn respectively
● Moreover, trade liberalisation has allowed for efficient resource allocation, thereby
enabling greater specialisation and contributing to Australia’s narrow X base, as infant
firms will not be able to compete with international firms and reap economies of scale.
● Exemplified through Australia’s persistent CAD for 44 consecutive years up until 2019
● Hence, this shows how Australia's narrow export base is vulnerable to global price
fluctuations, resulting in persistent external instability through the CAD as a % of GDP.

Lack of international competitiveness:

● Persistent external instability can be caused by Australia’s low productivity/lack of
international competitiveness
● Our inability to compete in global markets in industries such as STMs and ICT goods is
due to a lack of comparative advantage, combined with high wages and taxes and
overall lack of labour productivity, which only rose 0.4% in 2019
● This lower productivity results in greater costs of production for firms, which is passed
onto consumers (cost-push inflation), reducing the international competitiveness of
Australian exports and hence, sustaining the CAD
● This leads to a decrease in export revenue and worsens the BOGS and hence CAD,
further causing external instability

Exchange rate:
● A depreciation of the E/R can lead to a worsening of the CAD and increasing in NFLs.
● With the depreciating trend of the AUD, following the end of the MIB valued at a peak of
$1.10USD in 2011 to now $0.78USD in 2021, foreign inbound investment has become
cheaper and more attractive, increasing KAFA inflows. As a result, this increases NPY
servicing costs and hence NFD as a percentage of GDP has increased from 49.5% in
2010 to 57.1% in 2018.
● A depreciation also leads to increased servicing costs owed overseas due to lower
purchasing power of AUD relative to foreign currencies
● This leads to increased NPY costs and worsens the CAD and external stability.
● This process is referred to as the valuation effect, however in real world conditions, is
insignificant, as Australia hedges 90% of its debt in the AUD. The impact on external
stability is therefore minimal.

Strong Exports:
● Australia’s trade balance has been rising since early 2018 as a result of strong exports,
reaching an all time high of 3.5% of GDP in late 2018
● Since the collapse of a Brazilian mine in late 2019, coupled with the inelastic supply of
commodities, there has been a drastic rise in commodity prices, with iron ore increasing
from 37USD/tonne in 2016 to 193USD/tonne currently
 ● Furthermore, growth in demand for Aus’ LNG exports has also underpinned a strong
trade performance, with Australia being the world’s largest exporter of LNG since 2019
● This improvement in the BOGS contributed to the CAS in September 2019, worth 1.5%
GDP and contributing to Australia’s economic growth

Global Low I/rs (COVID and the recovery):

● Reductions in the level of global interest rates have led to decreasing NPY debits,
thereby improving the CAD.
● In response to COVID-19, central banks across the world have adopted record low cash
rates in order to stimulate consumer activity due to decreased consumer confidence and
market uncertainty.
● These global low i/rs have benefitted Australia’s CAD as the debt servicing repayments
on Australia’s net foreign debt will be lowered, resulting in lower outflows recorded on
the NPY
● These factors have facilitated Australia’s successful response to COVID, and the strong
rebounding of the economy as shown in the treasury forecasting Australia’s NFD as a %
of GDP to be 36.1% at the end of 2021, reduced from 57.1% in 2018 thus increasing
external stability.

Impacts:

Debt-trap:
● A CAD as a result of increased foreign liabilities can lead to a negative effect of
constraining economic growth
● High CAD has potential to lead to a debt-trap scenario, where an economy borrows from
overseas to pay for its servicing costs on existing foreign debt
● This worsens the NPY and the CA as servicing costs increase, leading to a decrease of
investor confidence and possibly a decrease of Australia’s AAA credit rating as lenders
become more reluctant to lend to or invest in Australia
● This can lead to foreign lenders demanding a ‘risk premium’ on loans, and may lead to K
flight in which decreased financial inflows decrease economic growth in the LT and
increases unemployment

Depreciation:

● A large CAD and high levels of net foreign debt can make an economy more susceptible
to exchange rate fluctuations, as it can cause low investor confidence, thereby
depreciating the AUD.
● If a depreciation occurs because of a higher CAD, this leads to the valuation effect on
that part of the net foreign debt denominated in foreign currencies, with more AUD being
 paid back to foreign lenders. However, as Australia hedges 90% of its debt in the AUD,
this effect of a depreciation is insignificant.
● A depreciation also increases inflationary pressures on the economy. It makes imports
more expensive, thereby leading to imported inflation and it increases costs of
production for businesses that import goods, leading to cost-push inflation. This has a
negative impact as it decreases SOL

Pitchford Thesis:
● Australia has not experienced the negative effects of a high CAD, which can be
explained by the Pitchford thesis, which states that private firms engaging overseas
borrowing make calculated decisions, lowering the risk of not being able to repay debt.
● Furthermore, if foreign investment is used to expand productive capacity of an economy,
CAD will not pose a problem to external stability, as in the long run export capacity
increases so that the BOGS outweighs the NPY.
● This has been highlighted in the improvement of the CAD and achievement of economic
goals in the past 10 years, resulting in a CAS since 2019, valued at $14.5bn in the
December quarter 2020.

CAS effects: (Xerxes commented this is a weak argument)

● If the CAS is a result of increased exports, this can lead to increased domestic
employment, increasing economic growth
● However, the CAS can still exist with fragile external stability if it is as a result of
decreased consumer demand and decreased demand for imports
● This could shrink the economy in the LT, as seen in Japan where funds for investment
could exit overseas in the LT
● Furthermore, could deplete the domestic economy of domestic savings if domestic
savings are borrowed from other countries to finance their investment
● Mitigated by Australia’s recent high savings rate of 18% in 2020

Economic policies:
● In the long term, a high CAD may become a speed limit on economic growth as high
levels of economic growth generally involve an increase in imports and therefore a
deterioration in the CAD. Economies are therefore forced to limit growth to a level at
which the CAD is sustainable known as the BOP constraint.
● Governments can therefore use economic policy to reduce the CAD in the ST.

● In the past, contractionary monetary policy was used to reduce consumer spending on
imports in order to create ST improvements on BOGS. However, as its impact is only
temporary and results in slowdown in whole economy, it is considered ineffective. This
approach can also increase capital inflows, generating higher NPY outflows, thereby
worsening the CA.
 ● By adopting policy of fiscal consolidation, governments since late 1990’s have
addressed concerns of Australia’s historic low level of national savings. In addition,
compulsory superannuation set at 9.5% of employee’s wages have lifted the level of
national savings since the 1990s. This has led to increased outbound investment which
has created financial inflows on the NPY and hence improved the CA. It has been
successful and is set to increase to 12% of employee’s wages by 2025.
● More recently however, the government has announced a record increase in the budget
deficit to fund policy response to Covid-19 pandemic, with the treasurer committing to
reducing the budget deficit once the economy has recovered.
● Microeconomic reform has been used to improve Australia’s international
competitiveness by lifting the efficiency and productivity of Australian producers. These
policies have included measures to improve infrastructure and alleviate skills shortages,
remove protectionist barriers that shield inefficient producers from foreign competition,
and labour market reforms to increase productivity and workforce participation.

Conclusion:
● In conclusion, Australia’s CAD has fluctuated due to several factors such as its savings-
investment gap and narrow X base.
● However, recent favourable economic conditions including cyclical factors such as
depreciation of the AUD, low domestic interest rates along with a favourable government
response to the COVID pandemic have resulted in Australia’s CAS since 2019, thereby
improving external stability.