CAD and External Stability

Australia has persistently recorded current account deficits during its history, although the
CAD has been substantially higher since the mid-1980 and is now one our major
structural problems. At present, Australia is experiencing a CAD at close to record highs
in economic conditions that should have seen it fall. The danger of the high CAD is the
limit It places on the growth of the economy, otherwise known as the Balance of
Payments constraint, and the burden it places on the economy for future years by raising
foreign liabilities.

Definition

The current account shows the flow of money from all exports and imports of goods and
services, income and current transfers for a period of one year. It reflects the non-
reversible flows on the balance of payments. The CAD is usually discussed in terms of a
percentage of GDP, rather than dollar value, to allow for comparisons between the sizes
of the CAD in different years and between different countries. According to treasury
estimates, in 05-06 the CAD is forecasted to reach $56.25bn or 6.0%, twice its 2001-02
level, this is teetering on the border of what the Washington-Consensus model deems
sustainable in the short term. Since December 2004, the CAD has been unusually large
and unusually persistent, stuck about 6% of GDP, and is likely to remain above this figure
over coming years. The continued poor CAD performance of 2006 is especially
concerning since recent global economic conditions have improved and Australias terms
of trade are at record highs of 121.7 compared to last years TOT of 109.9.

Components

There are two major components within Australias CAD; the persistent deficit on the net
income account which is often seen as the long-term structural component of the CAD;
and the balance on goods and services, which tends to fluctuate according to changes in
the domestic and global business cycle.

Recent record

The high cost of servicing our past and present foreign liabilities continues to be a drain
on Australias balance of payments, in the form of persistent deficits on the net income
account. One of the causes of Australias persistently large net incomes deficit is the low
level of household savings in Australia, which has deteriorated dramatically in recent
years, down to -2.6% in March 2006 which is a sharp decrease since 2000-01 in which it
was 4.2%. The basis of the view that we are spending beyond our means is the Keynesian
saving and investment identity in an open economy S + T + M = I + G + X.
Australias low savings means that we borrow heavily from overseas to fund investment,
adding to foreign debt and thus increasing the servicing costs on this debt. The net
income deficit has increased by 65% over the last 3 ears to 36.5% or 4.2% of GDP, in
March 2006. The increase is due to a surge in net foreign liabilities which passed half a
trillion dollars (65.1% of GDP) largely due to booming corporate profits and high levels
of business investment. The huge national income deficit is described by the record
profits of companies, many of these companies are part internationally owned. The record
profits these companies are making means that the payments of dividends to foreign
investors is accounting for part of the increasing net incomes deficit. Rising global
interest rate have increased the cost of interest repayments on these liabilities, further
widening the deficit. The net income deficit now accounts for roughly two-thirds of the
CAD.

BOGS/TOT

Another factor influencing the CAD is the Balance on goods and services. Australias
BOGS performance is closely linked with the international business cycle as well as
domestic factors. In March 2006, the BOGS deficit fell to $17.1bn (1.9% of GDP), down
from $25.9bn (3% GDP) in March 2005. This improvement comes as Australias TOT
increased by 10.7% to its highest level since the records began in 1959, meaning our
export performance is finally benefiting from strong overseas demand. Despite record
growth in Australias TOT, the BOGS remained in deficit of between 2-3% of GDP
throughout 2005. the rise in export prices was not enough to push the BOGS into surplus
and was offset by a surge in import volumes. It is concerning that Australia was unable to
improve its BOGS despite record high TOT. The record profits being made in the
commodities market is not from increasing number of exports but rather massive demand
has pushed up prices. Even though commodities are at record prices Australia is not
producing more goods due to capacity constrains, this is currently being targeted by
micro-economic reform couple with the federal budget to increase funding on
infrastructure.

Exchange rates

In 2005, the Australian dollar stabilized at around US75 cents after sustained appreciation
in 03-04, this is well above the record low of US48 cents in April 2001; meanwhile our
trade weighted index is stable at 63.2. The recent strength of commodity prices is one of
the main factors supporting the rise of the Australian dollar, as Australia relies heavily on
mining and agricultural exports. The relative strength of the dollar has contributed to the
deterioration in the trade account over the last two years and has reduced the
competitiveness of Australias exports. Treasury predicts that the dollar will remain at
around US74 cents in 06-07. The strong dollar couple with strong domestic demand has
fuelled growth in import volumes which are becoming ever cheaper, imports grew by
13% in the March 2006 quarter.

Capacity constraints
On the supply side, the emergence of capacity constraints in the export ports of several
commodity industries has limited the ability of firms to increase output in response to
strong global demand. However, treasury estimates capacity constraints to begin easing
as investment in infrastructure from previous years has expanded infrastructure capacity.

Narrow export base

Further adding to the CAD is Australias narrow export base and reliance on commodities
meaning that our goods account is overly influenced by global economic conditions
demand for commodities and global commodity prices. The current record TOT
illustrates the tendency for prices to fluctuate wildly. Australia also relies heavily on
imports of consumer and capital goods, with more that two-thirds of capital goods
purchased overseas. The strong domestic demand has meant that spending on consumer
imports has remained high, accentuating Australias weaker BOGS. Australias lack of
economies of scale and competitiveness has meant that exports of manufactured goods
are relatively low in comparison to global standards, comprising of only 16% of exports
in 04-5. Similarly, Australia suffers from high labour costs and a relatively low level of
apprenticeship displayed by the low level of tradesmen; these are all detrimental to the
services sector.

Problem with high CAD

One of the major problems of the huge CAD is that it acts as a limitation of level of
growth. If Australia grows at an unsustainably high level, the increased demand for
imports can lead to a blowout in the external accounts. If the CAD grows significantly, it
may be necessary for Australia to reduced economic growth in the short term, through
tighter macro policy (RBA increasing interest rates and the Federal government running a
larger surplus.). In the longer term, the CAD may become a major constraint on growth
and have a significant negative impact on domestic living standards. Economists
following the Washington-Consensus model believe that an economy should not sustain
CAD of over 4% in the long term to avoid this problem, and once CAD exceeds 6% in
the short term it may become a danger to the economy.

An obvious consequence of a high CAD is that it will require significant capital inflow to
balance out the deficit. In the longer term this will add to foreign liabilities, a problem
highlighted in Australia with the growth of net foreign liabilities to $571bn in March 06.
Capital inflows today are leading to a higher CAD in the long run, through servicing
costs on debt or interest and dividend repayments on equity. In the long run a debt trap
scenario can force a country to grow at much slower rates. A high CAD makes Australia
more vulnerable to overseas developments, and more reliant on an ongoing capital
inflow, making the $A more volatile. A widely fluctuating exchange rate can in turn
distort foreign trading and investment patterns due to weak levels of confidence on
FOREX markets.

Pitchford theory

In the 1990s an argument that the CAD and foreign liabilities are not a major concern
was popularized by Professor John Pitchford, and is known as the Pitchford theory. His
theory states that the current account problem is different from that of many Latin
American countries, which suffered from excessive indebtness in the 80s because most of
their foreign debt was accumulated by governments in order to cover day to day
spending. Australias CAD and foreign liabilities are almost entirely generated by the
private sector 98% of net foreign liabilities in 2004 was from private sector borrowing
this means that most of foreign borrowings are for the purposes of funding private
investment, so long as private sector decision making is not distorted by other factors and
firms make proper calculations of risks from foreign borrowing, Pitchford argues that
there is no need to be too concerned any more than it should be with the domestic
liabilities of private firms.

Policies.
In the time to come, the government must try to establish a way to control the ever
increasing CAD before it gets too out of hand. This can be achieved by increasing level
of savings or eliminating the expenditure gap by ensuring that the economy collapses into
a recession or slower growth (this method is obviously unacceptable). The use of an
effectual policy mix, comprised of fiscal, monetary and microeconomic reform, can help
to improve Australias problem with external stability. The main tool used by the
government to improve external stability is microeconomic reform to increase aggregate
supply. Fiscal consolidation is undertaken to reduce the pressure on the CAD by
increasing national savings. Fiscal consolidation removes the public sector burden on the
already small domestic savings pool and reduces the crowding out effect. This has
largely been achieved through the privatization of public assets such as Telstra.

Fiscal policy can have both positive and negative effects on the current account balance.
The twin deficit argument when fiscal policy takes a budget deficit. this argument states
that when savings are too low in relation to the desire to invest when a budget deficit to
occur, then a CAD will result. If we eliminate the budget deficit and run a budget surplus
then this would help reduce the CAD assuming that savings and investment do not
change. A budget surplus helps to increase public savings and reduces public foreign
liabilities. This may occur as the government may increase taxes, making investment less
attractive, or, the government could use the surplus to pay back some of the foreign debt,
reducing the interest cost of foreign borrowings as a drain on the BOP. This option
although has its disadvantages of higher rates of tax or the objection of Galbraith of
private affluence and public squalor if government expenditure cuts are relied on.

The government has also encouraged savings through compulsory superannuation, which
should help to reduce Australias reliance on overseas funds for investment. However, the
progress made by superannuation has been limited, with people simply substituting their
compulsory savings for what previously would have been voluntary savings. The
elimination of the superannuation exit tax outlined in the 06-07 budget aims to further
encourage high income earners to save.
The longer term government response to a rising foreign debt is likely to involve
implementing structural reforms to improve international competitiveness and help
reducing the CAD, all these actions are taken to remove capacity constraints. This action
involves the use of a range of micro reforms covering competition policy, labour market
reform, industry policy, public sector reforms, and infrastructure and tax reform.
Microeconomic reform actions through deregulation of individual industries will, in the
long term, remove the countrys supply side constraints by spending on infrastructure.
This will in turn increase our levels of exports and thus the deficit on the current account
will shrink and therefore improve the balance of payments.

The government has the ability to restrain the growth of debt by diverting financial
inflow into equity. Methods of making equity more attractive include investment
allowances, relaxing controls on foreign ownership and general improvements in
international competitiveness.

The second mechanism of the governments policy mix to fight external stability is
through running budgetary surpluses to slow growth. This will increase the amount of
national savings, thus reducing the reliance on foreign funds. Another fiscal strategy is to
tax consumption more heavily rather than having a strong reliance on income tax as a
base. Also stricter asset testing and income testing on pensions to encourage private
savings will all improve external stability.

The final and least employed policy to fight the CAD is monetary policy. The
government can attempt to improve the CAD by tightening monetary policy (involving
the selling of bonds by the RBA to reduce liquidity in the market, thus increasing interest
rates), this was thought to increase national savings and reducing borrowings. Although
higher interest rates have an impact of the CAD this is only temporary, the higher interest
rates dampens investor confidence and push the economy into recession, as shown by the
1990s recession.

Conclusion
If the CAD keeps increasing this will lead to an increased strain on future governments,
therefore the government must act now to improve Australias poor external stability or
severe problems may occur.