etawa Conference 2011 Steven Kemp

1. etawa Conference2011Steven Kemp The CAD & Foreign Liabilities

2. The CAD & Foreign Liabilities • The balance of payments is one of the key sections of Unit 3A – Australia & the Global Economy • It is also one of the more difficult sections of the syllabus that students find confusing, esp the link between the CAD and foreign liabilities (incl. foreign debt) • External stability is specifically listed in Unit 3B (& 2B) dealing with economic policy objectives – despite not being officially recognised as a legitimate government policy objective

3. The balance of payments • Questions to ask your students • Are exports more important than imports? • Is it better to have a current account deficit or a current account surplus? • Is it better to have a financial account deficit or a financial account surplus? • Is it better to have a high $A or a low $A? • Are boys better than girls? • Are cats better than dogs?

4. The CAD & Foreign Liabilities • Many media commentators & texts still allude to misleading information concerning the balance of payments & foreign debt • Examples Foreign debt – Australia’s black hole! AUSTRALIA'S current account deficit improved slightly in the first quarter following a blowout at the end of last year, but the picture is marred by ballooning foreign debt. “The fact that we are still running a howler of a current account deficit looks pretty bad,” JPMorgan's chief economist, said. [smh, June 2007]

5. The CAD & Foreign Liabilities • Examples • AUSTRALIA'S foreign debt topped $1 trillion for the first time . . . as the nation borrowed at record levels to finance its spending habits. . . The nation's trade performance also deteriorated significantly” [Brisbane Times June, 2008] • “Increasing foreign ownership is creating a significant drag on Australia's current account balance; Over the last few years, Australia's net income balance has broken below its long-term floor of -3% and is forecast to deteriorate to -6% by 2013, worsening Australia's current account deficit in years ahead” [Senator Bob Brown June 29, 2011]

6. The CAD & Foreign Liabilities Even the WACE exam last year 7. A worsening current account deficit is most likely to be a result of (a) a decrease in economic growth. (b) capital expansion in domestic manufacturing plants. (c) a positive gap between domestic savings and domestic investment. (d) an increase in exports.

7. Balance on goods and services Very misleading Source: Hubbard 2009

8. Net income, Australia Very misleading Source: Hubbard 2009

9. The CAD & Foreign Liabilities • Both the RBA and Treasury now use the correct terminology • “The current account deficit is expected to narrow to 2 per cent of GDP in 2010-11, the smallest deficit as a share of GDP since 1979-80. The trade balance is expected to move from a deficit of 0.3 per cent of GDP in 2009-10 to a surplus of 2 ½ per cent of GDP in 2010-11. . . . With a large share of mining profits repatriated to overseas investors, a wider net income deficit is expected to more than offset the trade surplus, leaving the current account in deficit”. Australian Treasury Budget Papers

10. A little bit of history • Australia’s current account deficit (CAD) has attracted considerable debate over the past three decades. • The rise in the CAD from the early 1980s became a central focus for policymakers - high CADs were seen as a source of macroeconomic vulnerability and a constraint on economic growth. • It was generally agreed that policy should & could do something at reducing the CAD & foreign debt • Why? A legacy of the previous fixed exchange rate world

11. Long term view of the B of P Sizeable current account deficits have been recorded in Australia in almost every decade for at least 150 years Source: RBA

12. Cumulative Current Account Deficits Source: RBA

13. A little bit of history • The abrupt rise in the CAD after the float of the dollar combined with the rise in foreign debt led the treasurer, Paul Keating to warn of the risk that Australia could become a ‘banana republic’. • In the 1988-89 Budget Speech, Paul Keating reiterated that: • “The balance of payments deficit is Australia’s No.1 economic problem . . .” • Policy was directed at reducing the CAD but despite micro reform & fiscal consolidation, the CAD remained high

14. A little bit of history • By the late 1980s and early 1990s academics began to debate whether the CAD should be a policy target • The debate was led by John Pitchford & became known as the ‘consenting adults’ view • The ‘consenting adults’ view does not see the CAD as a problem if it is based on private saving & investment decisions • The Pitchford view countered the more traditional view that large CADs were unsustainable & imposed a constraint on growth – on the contrary, a current account deficit could promote economic growth through higher foreign investment

15. A little bit of history • By the early 1990s, both the Reserve Bank & the Government changed their policy stance on the CAD - monetary policy should not be used to target the current account • By 2004, Glenn Stevens firmly restated the RBA’s view towards the CAD • “Whether the current account position should be an objective of any policy is not obvious . . . let me be clear that the current account is not, and should not be, an objective for monetary policy. We have had that debate in Australia. It was settled more than a decade ago, and I do not wish to re-open it”.

16. Balance of Payments - Definitions 1. Current account balance = trade balance + net income balance CAD occurs when imports + income paid to foreign residents > exports + income received from abroad Expressed this way, a current account deficit often upsets the protectionists, who – apparently forgetting that a main reason to export is to be able to import – think that exports are "good" and imports are "bad."

17. Balance of Payments - Definitions 2. Current account balance = Savings - Investment The current account can be expressed as the difference between national (both public and private) savings and investment. A current account deficit may therefore reflect a low level of national savings relative to investment or a high rate of investment – or both CAD occurs when I > S

18. Balance of Payments - Definitions The saving-investment perspective is more useful since it provides a greater insight into the factors that cause the CAD to change over time e.g. A rise in the terms of trade may be expected to increase exports & reduce the CAD, but it often does the reverse! Why? A rise in the terms of trade may lead to a surge in investment which will increase the CAD Australia’s CAD has been higher this decade as a result of the mining boom In June 2010 the CAD fell to 1% of GDP Why??

20. Balance of Payments - Definitions • The saving-investment perspective also emphasises the role of the financial account – often forgotten in the trade view of the CAD • It is important to remember that with a floating exchange rate, the current account & the financial account balances must be equal & offsetting – both being determined simultaneously CAD = Financial Account Surplus I - S = Financial Account Surplus I = S + Net foreign investment

21. The Financial Account • The financial account records a country’s net foreign investment – the difference between capital outflows from a country and capital inflows • Net foreign investment is the twin-side of the CAD • After the floating of the dollar in 1983, both foreign investment in Australia and Australian investment abroad increased sharply

22. How often is a graph like this published?

23. Net Foreign Liabilities The increase in net capital inflow meant that the ratio of net foreign liabilities to GDP increased from around 20% in 1980 to close to 60% today. Is this cause for concern?

24. Net Foreign Liabilities But foreign liabilities can also be measured relative to i total financing & ii total capital stock Both of these ratios have remained relatively stable

25. The Financial Account • Is there a risk that rising foreign liabilities could undermine financial stability? • In Australia’s case, virtually all foreign liabilities are in Australian dollars • Foreign capital inflow into Australia has been used to fund high levels of investment & not consumption Note: Australia relies on foreign investment not because its savings ratio is low but because its investment ratio is high!

26. National Savings & Investment Is Australia a low saving nation? No! Australia’s saving ratio is equal to OECD average Australia’s investment ratio is well above average

27. Comparing Australia & the US Source: Australian Treasury

28. Net Foreign Liabilities & Government Net Debt 2008 Source: Australian Treasury

29. Some Summary Points • Australia’s high CADs/foreign liabilities are not a cause for concern • The CAD should be explained from the savings-investment perspective • Higher CADS in Australia have been due to high & rising investment rather than low or falling saving • The stock of foreign liabilities has increased over time, but so has the stock of capital assets and Australia’s wealth

30. Questions