2. Australia's Place In The Global Economy

Question 1

Outline the direction of Australia’s trade timeline.

Answer 1

• 1950’s: Due to strong heritage ties with the British colony, the UK was Australia’s biggest trading partner.
• 1973: After the UK entered the European Union it became very difficult to trade with them due to protectionist policies (such as tariffs) associated with countries outside of the EU. Thus, Australia had to turn to regional trading partners. Around this time period, Japan was experiencing rapid growth, therefore Australia increasingly engaged with them as a major trading partner.
• 1990s-2000s: In the 1990s the Japanese economy began to experience downturns in activity till they hit a recession in 1991. After this, Australia found a new major trading partner in China (2007), who was rapidly becoming a large economic power in the world.
• Today: Today Australia’s major trading partner remains China however trade with North Asian counties is rising.

Question 2

Outline the composition of Australia’s trade timeline.

Answer 2

• 1950’s: Australia’s export performance between the 1900’s to the 1950s was concentrated on a much narrower base of goods and services than it is today. Australia exported a small range of agricultural commodities dispatched by sea to the UK.
• 1960’s: After WW2, Australia’s exports diversified with resources, manufactured goods and service-based exports growing in importance. Agricultural products dominated exports mainly through wheat, wool and beef.
• 1970’s: The composition of Australia’s major exports started shifting towards resources such as gold, iron ore and coal becoming more important.
• 1980’s: From the late 80’s the export of services grew rapidly, specifically including education, personal travel and business services.
• Today: Primary industries have always been the main focus of exports as Australia has a comparative advantage in commodities due to its vast natural resources. Together agricultural and mineral exports account for two-thirds of Australia’s export earnings in addition to service-based exports such as tourism.

Question 3

What are the trends in Australia’s financial flows?

Answer 3

• After the deregulation period in the 1970’s/80’s, there was an increase in financial flows through higher portfolio investment. This is because of the decrease in restrictions on purchasing financial assets, making it easier for consumers and investors to inject financial flows into the economy.
• The imbalance between investment in vs out - Australia is a net capital importer attracting higher foreign investment in order to compensate for low domestic investment (as a result of low domestic savings due to easily assessable funds).
• Prior to the deregulation of the financial sector, most financial flows came into Australia in the form of direct investment. Governments preferred direct investment because it brought the benefits of job creation and technology transfer.

Question 4

Fill in the correct structure for the Balance of Payments.

Answer 4

• 1 - Current Account
• 2 - Capital & Financial Account
• 3 - Capital Account
• 4 - Financial Account
• 5 - Portfolio Investment
• 6 - Financial derivatives
• 7 - Net secondary Income
• 8 - Net Services
• 9 - Net Goods

Question 5

What is the Balance of Payments?

Answer 5

In simple terms, the balance of payments records the transactions between Australia and the rest of the world. It consists of the current account (usually in deficit) and the capital & financial account (usually in surplus).

Question 6

What is the Current Account?

Answer 6

The current account shows the money flow from all exports and imports of goods services, income flows and non-market transfers for a period of a year. Transactions are non-reversible.

Question 7

What is the formula used to calculate the current account balance?

Answer 7

CAB = BOGS + net primary income + net secondary income

Question 8

What are net goods on the current account?

Answer 8

This refers to the difference between what Australia receives for its export of goods and pays out for its import of goods.

Question 9

What are net services on the current account?

Answer 9

It is the difference between what Australia receives for its export of services and pays out for its import of services.

Question 10

What is BOGS on the current account?

Answer 10

BOGS is the amount that is derived by adding net goods and net services together.

Question 11

What is net primary income on the current account?

Answer 11

This refers to earnings on investments, that is, income generated as a return. It takes into account the inflow (credits) and outflow (debits) of money associated with returning profits to the investor.

Question 12

What is net secondary income on the current account?

Answer 12

This refers to non-market transfers, meaning income not earned through a factor of production. These occur when products or financial resources are provided without a return. An example includes funds taken out of Australia in the form of unconditional aid to developing nations.

Question 13

What is the capital and financial account?

Answer 13

Records the borrowing, lending, sales and purchases of assets between Australia and the world. They are reversible transactions.

Question 14

What is the capital account?

Answer 14

A country’s capital account refers to any and all international capital transfers. This account captures the inflow or outflow of money once the initial investment has taken place. The capital account has two components, they are:

• Capital transfers - conditional foreign aid grants, debt forgiveness and debt cancellation.
• Purchase and sale of non-produced, non-financial assets - intellectual property rights such as patents, copyrights, trademarks and franchises.

Question 15

What is the financial account?

Answer 15

The financial account records Australia’s transactions in foreign financial assets and liabilities with 5 main categories.

• Direct investment -Covers foreign financial transactions to fund new investment in Australia or overseas, or to buy more than 10% of shares in an existing company.
• Portfolio investment - Refers to the buying of land, shares (less than 10% of the business) and other marketable securities - that is, securities that can be easily sold - in existing companies.
• Financial derivatives - Financial derivatives are a category of complex financial assets that have become increasingly significant in recent years. The value of these investments is normally derived from the performance of specific assets, interest rates or exchange rates.
• Reserve assets - Refer to those foreign financial assets that are available to and controlled by the central authorities for financing or regulating payment imbalances. Reserve assets include monetary gold (gold held by the Reserve Bank).
• Other investment - A category that captures transactions not classified as any of the above. They cover trade credits, loans etc.

Question 16

What are some links between key BOP categories?

Answer 16

• The deficit on the current account is equal to the surplus on the capital and financial account.
• An increase in the current account deficit (CAD) will result in a rise in the capital and financial account surplus.
• In the longer term, a capital and financial account surplus will result in a larger deficit on the net primary income account. This is because any foreign financial flow that comes into Australia must earn some kind of return for its owner, and these earnings are a debit recorded on the net primary income account.
• The sum of all transactions recorded in the balance of payments must be zero. The reason is, every credit appearing in the current account has a corresponding debit in the capital account, and vice-versa.

Question 17

What are some trends in the size and composition of Australia’s Balance of Payments?

Answer 17

• Throughout the 1970s Australia’s CAD averaged around 2.5% of GDP. Since the 1980s, this average has worsened to 4.75% of GDP, making it one of the worst performances of advanced, industrialised economies.
• The CAD as a % of GDP tends to hit dangerous levels of around 6% every 5 years.

Question 18

What are the cyclical factors that affect the trends in the balance on goods and services?

Answer 18

• Exchange rate - Movements in the exchange rate affect the international competitiveness of Australia’s exports and the relative price of the goods and services that Australia imports. Depreciation decreases the foreign currency price of Australia’s exports, increasing the international competitiveness of Australian exports in the world market.
• Terms of trade - The terms of trade shows the relationship between the prices Australia receives for its exports and the prices it pays for its imports. An improvement in the terms of trade means that the same volume of exports can buy more imports.
• Domestic economic growth - The level of domestic economic growth also influences the BOGS balance by affecting demand for imports. An upturn in the domestic business cycle results in increased business investment and higher disposable income, leading to higher consumption.
• The international business cycle - Changes in the international business cycle impact on the BOGS by affecting the demand for Australia’s exports. A slow down in global economic growth and weaker growth in Australia’s key regional trading partners both reduce growth in demand for Australia’s exports, worsening the BOGS.

Question 19

What are the structural factors that affect the trends in the balance on goods and services?

Answer 19

• Narrow export base - Australia has a narrow export base, exports are heavily weighted towards primary commodities - their comparative advantage lies within low value-added products. BOGS has tended to be in a deficit rather than surplus as import payments very often outweigh export revenues.
• Capacity constraints - Australia’s relatively poor level of infrastructure creates inefficiencies in their productive capacity. Therefore these limitations on production lesson Australia’s ability to export and as a result increases imports - Australia must import what they cannot manufacture themselves.

Question 20

What are the cyclical factors that affect the trends in the net primary income account?

Answer 20

The net primary income deficit is a reflection of Australians net servicing costs owed overseas. These can take the form of interest repayments on foreign debt or in dividend payments and profits on foreign equity.

Foreign Debt The relative size of Australia’s interest repayments to overseas are affected by two main cyclical factors.

• Exchange rates: Movements in the exchange rate will alter the Australian dollar value of debt denominated in foreign currencies. This is known as the “valuation effect”. A depreciation will increase the Australian dollar value of debt denominated in foreign currencies, increasing the value of Australia’s interest repayments and worsening the net primary income deficit.
• Domestic & global interest rates: The servicing costs on foreign debt are set by interest rates. Hence, fluctuations in global and domestic interest rates will influence the value of debt repayments. The decline in Australian and global interest rates to record lows in recent years has reduced the cost of debt servicing. As a result, decreasing debits (money outflows) and improving the net primary income deficit

Foreign Equity

• Domestic business cycle: Equity - the ownership of assets - entitles the owner to a share of profits from that asset. When the domestic economy experiences strong growth, domestic company profits rise, and these profits are redistributed to shareholders as dividends. In turn, higher domestic profits will tend to results in higher equity servicing cost in the form of the dividend outflows, worsening the net primary income deficit.

Question 21

What are the structural factors that affect the trends in the net primary income account?

Answer 21

• Savings and investment gap: Australia is a relatively small economy with a historically low level of national savings. It requires high levels of capital investment to stimulate economic growth. Australia tends to fund a large part of its investment through international borrowing - increasing foreign debt - or selling ownership in Australian assets - increasing foreign equity. This increases Australia’s foreign liabilities and creates future servicing obligations in the form of interest repayments (on debt) and dividends (on equity). Servicing costs are recorded as outflows on the net primary income account and are the major causes of Australia’s persistent CAD.

Question 22

What are the consequences of a high CAD?

Answer 22

• The growth of foreign liabilities - A CAD implies financial inflow on the cap/fin account, either in the form of foreign debt or equity. This will mean lenders become reluctant to lend to or invest in Australia.
• Increased servicing costs - Increased servicing costs associated with high levels of foreign liabilities lead to larger outflows on the net primary income account, worsening the CAD. Foreign debt must be serviced through interest repayments that vary according to the level of domestic/overseas interest rates, and profits must be returned on foreign equity investment.
• Increased volatility for exchange rates - High CAD may undermine the confidence of overseas investors in the Australian economy and in turn, reducing demand for Australia’s currency may result in a depreciation of $AU.

Question 23

What happened to Australia’s exchange rate system in 1983?

Answer 23

In Dec 1983 Australia switched from a managed flexible peg to a floating exchange rate system. This structural changed is one of the most important in Australia’s economic history as it opened the economy to global financial flows.

Question 24

What is the Trade Weighted Index?

Answer 24

The Trade Weighted Index (TWI) gives an indication of how the value of A$ is moving against all currencies in general. The TWI is a measure of the value of the Aus dollar against a basket of foreign currencies of major trading partners. These currencies are weighted according to their significance to Aus trade flows.

Question 25

What are some factors affecting the demand for Aus $?

Answer 25

• Level of Aus interest rates relative to those overseas; higher domestic interest rates makes Aus a more attractive location for foreign investment, increasing demand for A$.
• The availability of investment opportunities in Aus; if there are more opportunities for foreign investors to start a new business or buy into existing ones via the share market, demand for A$ increases.
• Future expectations of an appreciation of AUD will increase current demand for A$ by speculators, thus contributing to the expected appreciation.
• The demand for Aus exports, determined by international competitiveness, global economic conditions as well as tastes and preferences of overseas consumers. E.g if China experiences strong economic growth their demand for Aus exports increase. They must convert their currency to AUD in order to pay Aus exporters, increasing demand for A$.

Question 26

What are some factors affecting the supply for Aus $?

Answer 26

• Level of Aus interest rates relative to those overseas; lower domestic interest rates discourage foreign investment and therefore contribute to a lack of demand for A$.
• The availability of investment opportunities overseas; greater opportunity to open businesses or purchase shares overseas, will increase financial outflows and increase the supply of A$.
• Future expectations of a depreciation of AUD; speculators in the FOREX market who expect the value of A$ to go down will sell it, increasing the supply and thus contributing to the anticipated depreciation.
• The level of domestic demand for imports, determined by the level of domestic income, the competitiveness of domestic firms as well as the tastes and preferences of domestic consumers. E.g tastes and preferences of domestic consumers change over time, and an increasing preference for specific goods and services from overseas will raise the supply of AUD on the FOREX market.

Question 27

What is occurring in the graphs below?

Answer 27

The figure shows the effects of an appreciation of Aus dollars on demand and supply. As the value of A$ increases so does the demand for the currency. As a result, supply of Aus dollars begin to decrease in the FOREX market - due to high demand.

Question 28

What is occurring in the graphs below?

Answer 28

The figure shows the effects of a depreciation of Aus dollars on demand and supply. As the value of A$ decreases so does the demand for the currency. As a result, supply of Aus dollars begins to increase in the FOREX market - due to low demand.

Question 29

What are the main factors that cause an appreciation in AUD?

Answer 29

• An increase in Aus interest rates or decrease in overseas interest rates
• Improved investment opportunities in Aus to deterioration in foreign investment opportunities
• An improvement in Aus international competitiveness
• Increased demand for Aus exported goods and services
• Future expectations of a currency appreciation

Question 30

What are the main factors that cause a depreciation in AUD?

Answer 30

• A decrease in Aus interest rate or increase in overseas interest rate
• Deterioration in investment opportunities in Aus or improvement in foreign investment opportunities
• A deterioration in Aus international competitiveness
• Increased demand for imported goods and services
• Future expectations of a currency depreciation

Question 31

What is a fixed exchange rate?

Answer 31

Under a fixed exchange rate system, the Gov or RBA officially set the exchange rate - that is, it would not be left up to the forces of supply and demand. The Gov/RBA can attempt to maintain a fixed exchange rate by either buying or sell foreign currency in exchange for A$. Thus, in order to intervene in the FOREX market under a fixed exchange rate system, the Gov would need foreign reserves of overseas currency and/or gold.

Question 32

What is a managed flexible peg exchange rate?

Answer 32

Under this system, the RBA would “peg” the value of the A$ at 9am each day and that price would operate throughout that day. A flexible peg system provides more flexibility than the fully fixed rate, but it can still allow the official rate to drift away from that which would exist under pure market forces.

Question 33

The RBA may influence the exchange rate by dirtying the float, what does this mean?

Answer 33

When the RBA feels a significant short-term change in the exchange rate - often due to excessive speculation - it may decide to step into the FOREX market, as either a buyer or seller in order to stabilise the AUD. The RBA’s ability to directly intervene through buying A$ is limited to the size of its foreign currency holdings - that is, its reserves of foreign currency and gold that can be used to fund such purchases. In scope, it is relatively small and not even equal to one day’s total transactions in the currency.

Question 35

The RBA may influence the exchange rate through monetary policy decisions, what does this mean?

Answer 35

Monetary policy initiatives are an indirect way of influencing the exchange rate and are rarely used for this purpose. If the RBA wants to curb a rapid depreciation, it may increase the demand for A$d by raising interest rates. Higher interest rates will attract more foreign savings, which must be converted into $A. This will increase the demand for A$ and put upward pressure on the exchange rate. However, this policy will generally only be effective for a limited time.

Question 36

What are the positive effects of an appreciation in A$?

Answer 36

• Australian consumers enjoy increase ‘purchasing power’ - they can buy more overseas produced goods with the same quantity of A$.
• An appreciation decreases the interest servicing costs on foreign debt. This would reduce outflow on the net prim income component of the CA in future years and help reduce the CAD.
• An appreciation will reduce the $A value of foreign debt that has been borrowed in foreign currency - valuation effect
• Inflationary pressures in Aus will be reduced as imports become cheaper. This is likely to reduce pressure on the RBA to raise the interest rate to defend its inflation target.

Question 37

What are the negative effects of an appreciation in A$?

Answer 37

• By increasing the value of $A in terms of other currencies, Aus exports become more expensive on world markets and therefore more difficult to sell, leading to a decrease in export income and deterioration in the CAD.
• Imports will be less expensive, encouraging import spending and worsening the CAD.
• Foreign investors will find it more expensive to invest in Aus, leading to lower financial inflows.
• An appreciation reduces the $A value of foreign income earned on Aus investments abroad and would cause a deterioration in the net prim income component of the CA.
• An appreciation will reduce the value of foreign assets in Aus dollar terms - valuation effect

Question 38

What are the positive effects of a depreciation in A$?

Answer 38

• by decreasing the value of A$ in terms of other currencies, Aus exports become cheaper on world markets and therefore easier to sell, leading to an increase in export income and an improvement in CAD.
• Imports will be more expensive, discouraging import spending and potentially improving CAD.
• Lower import spending and greater export revenue will increase Aus growth rate but this may not happen if Aus is unable to replace its imports with domestically produced goods.
• A depreciation will increase the value of foreign assets in Aus dollar terms - valuation effect
• Foreigners will find it less expensive to invest in Aus, generally leading to greater financial inflows.

Question 39

What are the negative effects of a depreciation in A$?

Answer 39

• Aus consumers suffer reduced ‘purchasing power’ - they can buy fewer overseas produced goods with the same quantity of A$.
• A depreciation increases the interest servicing costs on Aus foreign debt, as less overseas dollars can be bought with domestic currency. This increases income outflow on the net income component on the current account and thus increases the CAD - foreign equity
• A depreciation will also raise the A$ level of foreign debt that has been borrowed in foreign currency as expressed in Aus dollar terms - valuation effect
• Inflationary pressure in Aus will increase as imports would now be more expensive. This may increase pressure on the RBA to raise interest rates to defend its inflation target.

Question 40

What bilateral FTAs? Name two that include Aus.

Answer 40

Bilateral agreements involve just two nations. They are the easiest trade agreements to negotiate because they only need to factor the interests of the two participants.

ChAFT (China Australia Free Trade Agreement)

• signed in 2015
• Upon implementation 95% of Aus exports to China were tariff-free, improving competitiveness of agricultural industries
• Gives greater access to Chinese markets for Aus service providers
• Allows Aus export of services to increase as China increases demand

KAFTA (Korea Australia Free Trade Agreement)

• In operation since 2014
• Improves access for Aus exporters to the Korean economy
• Projected tariff-free exports rising from 84-99% over the next 20 years
• Facilitates more services trade (legal, accounting, education and engineering)

Question 41

What multilateral FTAs? Name two that include Aus.

Answer 41

Multilateral agreements involve more than two nations. Multilateral agreements may refer to those administered by the WTO (global agreements) or may refer to regional trade agreements such as the EU or NAFTA.

AANZFTA (ASEAN Australia New Zealand Free Trade Agreement)

• Came into effect in 2010
• Covers 20% of Aus trade in g&s
• Creates a free trade area of over 650 million people with combined GDP of US$4 trillion
• ASEAN economies and Aus are complimentary - meaning the goods Aus exports are heavily demanded by ASEAN economies.
• South-East Asia can export to Aus the goods we cannot produce competitively

APEC (Asia-Pacific Economic Co-operation)

• formed in 1989
• Main forum for countries to facilitate economic growth, policy cooperation, trade & investment in the Asia-Pacific region
• The agreement includes 21 member countries
• Since establishment, it has worked to reduce tariffs and other trade barriers to create more efficient economies and increase exports

Question 42

What are the implications of Australia’s policies on individuals?

Answer 42

• Increase structural employment as reduced protection has caused the restructuring of industries and cuts in local production - fewer workers required.
• Import competing industries & manufacturing sector most affected as they require low skilled, production line jobs are not easily transferred to other workplaces.
• Gov has funded many retraining programs helping workers made redundant gain new skills - e.g the gov established $155 million growth fund to support the automotive industry.

Question 43

What are the implications of Australia’s policies on firms?

Answer 43

• Individual firms operating in small, import-competing industries may shrink unless they can become more competitive. Some sectors may cease production altogether e.g car manufacturing in Aus 2017
• Removing protection forces local industries to innovate and develop the efficiency necessary to compete in the global economy.
• Promotes internationally competitive firms in the future.

Question 44

What are the implications of Australia’s policies on governments?

Answer 44

• Cutting tariffs reduces gov revenue since tariffs provide indirect tax revenue.
• Increase competition through reduced tariffs forces firms to increase productivity and efficiency leading to greater profits resulting in more revenue for the gov (through company tax).
• Provide financial support to certain industries to assist in adjustment process e.g job search.
• Gov can be impacted by political consequences in relation to a reduction of tariffs e.g structural unemployment and closure of factories and businesses may cause gov to lose votes.

Question 45

What is the overall effect of international protectionism?

Answer 45

When other countries put tariffs on Aus g&s, Aus exports become less competitive and struggle to penetrate foreign markets. When other countries subsidies their esports, they raise the supply and reduce the price on global markets. The result is that countries like Aus that compete to sell similar products on global markets experience a reduction in their income. Overall, international protectionism reduces the output of the Aus economy.

Question 46

What is the overall effect of international protectionism on the agricultural industry?

Answer 46

• There has been a lack of progress reducing agricultural protection as countries have found complex loopholes in WTO regulations.
• US, EU, Korea & Switzerland all protect their farmers and agricultural industries. Therefore a small economy, farmers competing in the global market have a significant disadvantage.
• The EU has for several decades has heavily subsidised agricultural production through the Common Agricultural Policy (CAP).

Question 47

What is the overall effect of international protectionism on the mining and resource industry?

Answer 47

• These industries face very few barriers to trade as the products from this sector are in very high demand worldwide.
• Mining companies are more likely to face export restrictions from Aus gov trying to secure energy supplies for the domestic economy than from a foreign gov trying to protect their industries.
• The countries importing Aus energy and mineral resources often do not have their own resources to produce domestic alternatives. If a foreign gov was to impose tariffs on Aus resource exports, it would simply raise costs for their own consumers and businesses.

Question 48

What is the overall effect of international protectionism on the manufacturing industry?

Answer 48

• Aus manufacturing industries face few barriers to trade because of the substantial reduction in industrial tariffs in recent decades, negotiated through FTAs.
• Some Aus exporters argue that non-tariff barriers to trade, such as technical restrictions and licensing, act as disguised trade barriers. E.g varying health regulations for processed foods in different countries make it difficult for Aus exporters to access foreign markets.

Question 49

What is the overall effect of international protectionism on the service industry?

Answer 49

• This industry faces the most prohibitive barriers to international trade
• In some situations, trade is simply not feasible due to natural barriers caused by geography, transport, language barriers and cultural differences, rather than the result of protectionist trade policies in other countries.
• Gov regulations often have the effect of restricting services trade. e.g financial services - banking sectors may be protected from foreign competition by restrictions on foreign ownership in banks.