Chapter 8 - External

Question 1

Define balance of payments

Answer 1

A record of financial transactions between residents of Australia and residents of the rest of the world, includes the current account and the capital and financial account

Question 2

Explain the set up of the bop

Answer 2

The BOP comprises of 2 major accounts: the current account (CA) and the capital and financial account (CAFA)
At the end of any period – any CA deficit must be exactly offset by a CAFA surplus – such the BOP (balance) must equal 0
Similarly the CA surplus needs to be offset by CAFA deficit

Question 3

Define the current account

Answer 3

In the BOP and includes the receipts and payments of a ‘current’ nature as opposed to transactions of ‘capital nature – the account has 4 sub accounts; balance of merchandise trade, net services, net income and current transfers

Question 4

Define balance of goods / merchandise

Answer 4

part of the current account of the BOP that is made up of merchandise export receipts (credits) minus merchandise import payments (debits) such as the sale of manufactured goods

Question 5

Define net primary income

Answer 5

part of the current account of the BOP that is made up of receipts (credits) of income from holdings foreign assets, such as dividends from shareholdings in foreign companies or interest repayments from foreigners minus payments (debits) of income to service foreign liabilities, such as dividend payments for foreign equity (e.g. profits sent to overseas owners) and interest repayments for foreign debt. In addition it includes receipts or payments of income earned from international labour

Question 6

Define net secondary income

Answer 6

part of the current account of the BOP that is made up of receipts in the form of foreign pensions, gifts or other gratuitous payments minus payments such as foreign aid, gifts, pensions and other gratuitous payments – formally referred to as ‘net transfers’

Question 7

Define net services

Answer 7

Part of the current account of the BOP is made up of services export receipts such as money received for the provision of education to foreigners, minus service import payments such as money spent overseas

Question 8

Define current transfers

Answer 8

formally apart of the current account of the BOP that is made up of receipts in the form foreign pensions, gifts or other gratuitous payments minus payments such as foreign aid now referred to as ‘secondary income

Question 9

Define capital and financial account

Answer 9

The second of the two account in the bop and made of of 2 sub accounts the capital account and the financial account

Question 10

Define the capital account

Answer 10

A sub account in the CAFA of the BOP a relatively insignificant account covering capital transfers, the acquisition/disposable or non produced, non financial assets between residents and non residents – is rarely referred to when discussing the goal of external stability
E.g. migrant transfers and debt forgiveness, the acquisition of non-produced, non-financial assets such as sales of embassy land or copyrights

Question 11

The financial account is made up of?

Answer 11

Official capital inflow – (e.g. Aus’t gov’t selling bonds to foreign residents which means foreign residents are lending to the Australian gov’t) and official capital outflow (e.g the Aus’t gov’t purchasing foreign bonds meaning the Aus’t gov’t is lending money to foreign residents)

Non official capital inflow and outflow which is made up of:
Borrowing an lending between Aus’t and overseas economic agents
Net direct investment (e.g setting up a production facility or purchasing more than 10% of a company’s shares)
Net portfolio investment (e.g. less than 10% investment in shares and/or net debt flows

Question 12

Define portfolio investment

Answer 12

less than 10% investment in share and/or net debt flows between countries

Question 13

Define direct investment

Answer 13

setting up a production facility or purchasing more than 10% of a company’s shares in a foreign country, typically a surplus for Australia meaning that foreign entities directly invest more in Aus’t than Australian entities invest aboard

Question 14

Explain net financial position

Answer 14

When the ABS releases statistical information related to Australia’s BOP it will also include statistics on the changes that have taken place in the value of Australia’s net international investment position – which is essentially the value of Australia’s net international obligations to the rest of the world. This is made up by Australia’s stock of net foreign liabilities (NFL’s) which is comprised of both net foreign debt and net foreign equity

Changes in Australia’s net international investment position will help policy makers to determine the sustainability of Australia’s relatively large CAD’s and the accompanying growth in Australia’s stock of net foreign liabilities

Question 15

Define net international investment position

Answer 15

the value of Australia’s international financial obligations to the rest of the world this is made up of Australia’s stock of net foreign liabilities which is made up of both net foreign debt and net foreign equity

Question 16

2 types of debt

Answer 16

Public sector

Private sector

Question 17

Explain NFD

Answer 17

NFD is calculated by looking at the net debt obligations that flows from our ‘total borrowing’ from overseas and subtracting our ‘total lending’ to overseas. It is by far the largest component of Australia’s net foreign liabilities (making up more than 85% of the total net foreign liabilities) and is the most common statistic used when determining the ability of Australia to meet it’s international financial obligations

Question 18

Define net foreign debt

Answer 18

Financial obligations that flow from our ‘total borrowing’ from overseas exceeding and our ‘total Lending’ to overseas

Question 19

Explain net foreign equity

Answer 19

Is equal to the net equity obligations that stem from foreign ownership of Aus’t assets, such as property + shares minus the Australian ownership of foreign assets
It is typically the smallest of the two components of Australia’s net foreign liabilities and will sometimes be records as a net asset rather than liability which means Australia’s ownership of foreign assets exceeds foreign ownership of Australian assets

Question 20

Define net foreign equity

Answer 20

financial obligations that stem from foreign ownership of Australian assets, such as property and shares less (minus) Australian ownership of foreign assets

Question 21

Define net foreign liabilities

Answer 21

The net value of financial obligations that Australia has to the rest of the world. It includes the net foreign debt (NFD) and net foreign equity (NFE)

Question 22

Explain the exchange rate

Answer 22

The exchange rate is usually measured by the value of the AUD compared to the USD or the TWI
Since the floating of the currency in 1983 the value of the exchange rate is primarily determined by the forces of demand and supply
The demand ultimately comes from overseas residents seeking to pay Australians with AUD – this could be fore the purchase of Australian exports or other assets (e.g. property)
The supply comes from Australians wishing to sell AUD on the foreign exchange market for the purchase of imports or other foreign assets
Importantly the demand + supply of the AUD (and other currencies) also comes from foreign currency speculators who profit from buying currencies at one price and selling at a higher price – much of the volatility of the AUD is due to these speculators.
The relative strength of the dollar also comes as many foreign investors view Australia as a ‘safe haven’ in a world filled with financial uncertainty

Question 23

What is the gov’ts goal of external stability

Answer 23

Australia is able to meets it’s international financial obligations that result from transactions with the rest of the world, without jeopardizing economic growth or other economic goals – this requires a sustainable CAD and serviceable NFD (or NFL’s)’

Question 24

What represent the majority of Australia’s net foreign liabilities

Answer 24

Net foreign debt
In addition net foreign debt involves greater ‘risk’ to Australians in the event that we experience difficulty in servicing (repaying) the debt
This is because foreign investors (lenders) will often to continue to demand debt and interest repayments even when Australian borrowers experience financial hardship.
Net foreign equity on the other hand involves less risk for Australians because the foreign equity holders (e.g. shareholders) will be relatively more patient. This is because as owners of Australian assets, they are exposed to greater risk of loss if the Australian company does not end up being declared bankrupt

Question 25

The gov focus on 2 key variables to provide an indication of whether Australia is externally stable

Answer 25

The size of the Australia’s CAD in the BOP
The level of Australia’s NFD
The stability of Australia’s exchange rate

Question 26

Why does gov try to ensure sustainable cad

Answer 26

The gov’t tries to ensure the CAD is sustainable – so it does not cause problems for the wider economy. A CAD is not sustainable may result in failing credit ratings, withdrawal of foreign capital (money) higher interest rates and a rapidly depreciating value of the exchange rate – while there is no specific target documented by the gov’t it is generally recognized to be below approx. 5-6% of GDP – A CAD much higher than this may trigger some contractionary government policies in order to reduce it’s size

Again the gov’t does not have a specific target for the NFD – the gov’t tries to ensure that Australia’s level of NFD (like the CAD) is at a level where it can be adequately repaid (serviced) without causing problems for the economy, such as rapidly depreciating currency or much higher interest rates when it becomes clear that Aus’t is struggling to meet it’s financial obligations to foreigners – it is fair to say a sustainable level of NFD is one that is below 50-60% of GDP

When the economy does experience signs of external instability – such as high CAD or NFD it may lead to instability in the value of the currency as foreign investors lose confidence in the Aus’t economy. Consequently foreign investors may seek to reduce their exposure to Aus’t, sparking large capital outflows, further de-stabilizing the currency and causing the market interest rates to rise (as supply or funds begin to shrink)

Question 27

Aud - explain impacts about suspected falling dollar

Answer 27

Any persistent volatility or speculation about the value of the Aud might indicate that there is international uncertainty about the financial (or external) stability of the Australian economy – whether these fears are well founded is irrelevant. The volatility can deter investment in Australian assets placing further downward pressure on the AUD – increasing our international debt obligations – this is because Australian borrowers must pay a higher risk premium for overseas borrowings (e.g. higher interest rate) and any debt denominated in foreign currency ( and not ‘hedged’ to the aud) will cost more to service. Global lenders may even be reluctant to lend (or roll over debt) altogether. This would have negative implications for Australia’s ability to continue to funding domestic investment with foreign savings, consequently the gov’t (via the RBA) will seek to smooth out any damaging fluctuations in the exchange rate in order to prevent the spread of contagious panic and ensure that the value of the dollar does not stray too far from it’s fundamental value

Question 28

Overall Australia can achieve its goal of external stability if

Answer 28

The level of CAD is sustainable
The level of NFD is sustainable
The value of the Aud is relatively stable

Question 29

Explain structural vs cyclical components of CAD

Answer 29

The CAD is a relatively structural feature of a young Australian economy – an economy that requires foreign funds to finance investment – given the ongoing imbalance between domestic savings and investment, Australia will continue to have a CAD into the future
The size of the CAD will continue to change in line with the economic cycle over time, resulting in a CAD that moves either below or above it’s relatively normal or ‘structural’ level

During peirods of stong eco growth, the CAD will tend to grow because the gap between investment and savings gets bugger and strong spending trends to spill over into greater import demand – meaning that not only is there more borrowing from overseas to fund investement, adding to the CAD because of increased net incomes debits required to service these liabilities, but also the trade balance is more likely to record a deficit – further increasing the CAD

When AD and economic growth are weak, economic agents save more and spend less – reducing the gap between investment and savings – additionally there is less spill over into import spending and overall the CAD will get smaller.

The movements in the CAD that is tied to the movements in the economic cycle is referred to as the ‘cyclical component of the CAD’ if we remove these cyclical components in the CAD then what remains is the ‘structural component of the CAD’ – structural component of the CAD is essentially the CAD that exists when the economy is running at it’s long run trend rate growth approx. 3% per annum

Question 30

Define free trade

Answer 30

Where nations can emerge in international trade without facing ‘protection’ or ‘trade barriers from other countries

Question 31

Define protection

Answer 31

efforts by the government to protect local import competing producers from the threat of imports. It is commonly implemented via tariffs, quotas and subsides

Protection can take many forms but most commonly implemented via; tariffs, quotas + subsides

Question 32

What is a tariff

Answer 32

A tariff is a tax imposed on imported units of a product and is the most common from of protection – it can be based on certain percentage of import volume (e.g. 10% of the value being imported)
Tariffs raise the local price of the product, resulting in some consumers substituting the imported product for a local alternative – this reduces the demand for imports and leads to an increase in Australian production levels

Question 33

Define tariff

Answer 33

A form of protection involving taxing on imports

Question 34

What is a quota

Answer 34

A quota controls the volume of imports entering the country such that local producers are guaranteed a bigger share of the market. While it works via restricting supply of imports it has a similar impact to tariffs because it artificially raises the price of the relevant imports

Question 35

Define a quota

Answer 35

Form of protection involving controls or limits on the volume of imports entering the country

Question 36

Explain subsidies

Answer 36

Subsidies involve the gov’t providing local producers with financial (grants) or other forms of assistance (loans at concession rates) it works to artificially lower the price of import competing products but adds to the cost structure of the economy by the effects of taxes

Question 37

Define subsidies

Answer 37

form of ‘protection’ involving the government providing local producers with financial and or other forms of assistance

Question 38

Explain local content rules

Answer 38

require that certain goods and services produced in Australia must contain a specified level of Australian content – e.g. film + tv industry require locally produced programs to make up 55% of free to air content

Question 39

Define local content rules

Answer 39

A form of ‘protection’ involving the requirement for goods + services produced in Australia to contain a specified percentage of Australian content

Question 40

Explain parallel import restrictions

Answer 40

protect local producers (and ‘culture’) from imported products by preventing foreign businesses from producing and selling goods into Australia that are protected by Australian copy right laws e.g. books

Question 41

Define parallel import restrictions

Answer 41

A form of ‘protection’ involving the prevention of foreign businesses from producing and selling goods into Australia that are protected by Aus’t copy right laws

Question 42

Explain preferential (special) treatment

Answer 42

of local producers in gov’t procurement policies provide local producers with a better chance of winning government contract compared to foreign providers of goods + services. This form of protection has been reduced significantly across Aus’t since the GFC

Question 43

Define preferential treatment.

Answer 43

A form of ‘protection’ involving government procurement policies providing local producers with a better chance of winning a government contract compared to foreign providers of goods and services

Question 44

Types of protection

Answer 44

Tariff
Quota
Subsidy 
Local content rules
Parallel import restrictions 
Preferential treatment

Question 45

Why protect local

Answer 45

The underlying reason for protecting local producers relates to the perceived benefits for domestic production, employment and income. By making import products less competitive, local producers can more easily retain market share, which boosts production levels, maintains employment growth and prevents domestic incomes from failing

Economists and policy makers would point to more specific reasons for production including:

To protect infant industries – this is often referred to as the infant industry argument where tariffs are used to protect relative young industries from low priced competition. Once local industries develops (achieves requisite level of efficiency + profitability to compete without protection) then tariffs are removed
To counter the effect of countries ‘dumping goods’ onto local markets – dumping refers to the practice of selling a good in a foreign market at a price below the costs of production – it is often done to eliminate competition (after which priced will be increased) to offload stock that is in excess supply, or because the product is highly subsidized in the country of origin

Dumping - refers to the practice of selling a good in a foreign market at a price below the costs of production – it is often done to eliminate competition

To retaliate against the imposition of protective barriers set up in foreign markets (e.g. Aus’t may refuse to lower tariffs, until the USA, Japan or France remove subsides given to their agricultural producers)

To protect local culture and identity – e.g. Aus’t tv + book industries. It is argued that Aus’t needs to protect our local identity and talent from programs and books that flood our markets at cheap prices from overseas (US, china)

To provide for longer term security – by ensuring that Australia remains the capacity to provide for itself in the long term – in terms of essential goods + services. This includes defence capabilities, food + energy supplies

To support industries which heavily invest in research + development, whose innovations and advances in technology can be utilized across the economy, thereby providing a positive externality to the nation (increase national productivity)

To protect and maintain high product standards and prevent the importation of products that threaten local industries pose risks to human safety (such as imports of agricultural products that can spread viruses or disease

Question 46

Define dumping

Answer 46

refers to the practice of selling a good in a foreign market at a price below the costs of production – it is often done to eliminate competition

Question 47

Why protection can be self deprecating strategy *arguments against

Answer 47

Free trade encourages a reallocation of resources in the economy towards those sectors or industries where Australia has a comparative advantage

Common arguments are used to support the notion that protection should be removed as it misallocates resources to the production of goods + services that could be made more efficiently else where:

By shielding local producers from competition – protection reduces incentive (and need) to be efficient – essentially protection ‘props up’ relatively inefficient industries at the expense of more efficient industries

Assuming the protected industry is a producer goods industry (e.g. producing goods that are inputs in the production process) protection raises input costs, increases prices and reduces the competitiveness of other producers

The increased profitability of the protected industry in the short term gives it increased ‘purchasing power’ over resources relative to other industries (e.g. can pay more for certain raw materials which increases the cost for all firms. Protection can therefore act like a ‘tax on local producers’

Protection can contribute to inflationary pressure both in the short term (via higher import prices) and in the long term (via a reduction in efficiency and an erosion of competitiveness)

The inflationary impact of higher tariffs or quotas will tend to cause a ‘depreciation of the AUD’ over time. This further penalizes some Australian producers as a result of higher cost of capital imports (imports as inputs)

Once protection has been introduced, it can become extremely difficult to first – ‘prevent the call for protection’ from other industries, and second – to dismantle them at some later stage

Question 48

Explain the move towards free trade

Answer 48

Protection generally tends to result in negative outcomes for the economy in the long term – this is primarily because higher levels of protection reduce competition for local import competing producers and results in less pressure to minimize costs and prices
Accordingly there is less incentive to improve efficiency and protection can also work as a tax on other Australian industries therefore consumers
Over time foreign producers tend to become relatively more efficient as they are exposed to greater competitive pressures. They are then able to seek the protection of government policies and ask for an increase in tariffs to ‘protect Australian jobs’ – this process becomes destructive as inefficiency of local imports competing producers become entrenched, raising the cost structure of the Aus’t economy and increasing the likelihood that foreign gov’ts will retaliate and protect their own local producers from those Australian exporters, that have a ‘comparative advantage’

Question 49

Define a comparative advantage

Answer 49

A theory, stating a country should produce those goods and services where it is most efficient at producing, relative to another country. That is, a country will trade where the opportunity cost of producing a good or service are lower than other countries

Question 50

Define trade liberalisation

Answer 50

The movement towards international trading relationships that are not subject to protectionist policies. Also defined as any government policy initiative that is designed to promote free trade, or reduce restrictions or barriers of free trade

Question 51

How does disposable income and savings influence cad

Answer 51

Disposable income is one measure of income earners’ spending power and has a significant effect on consumption demand and national spending (GNE). When disposable income increases we would expect this to cause an increase in demand for imports relative to exports, reducing export demand (X – M) decreasing the BOMT (or BOGS) and increasing the CAD
this can also be analyzed in terms of the impact a changing disposable income is likely to have on the gap between spending (GNE) and income (GDP). Higher rates of growth in disposable income are likely to widen the gap between spending and income, thereby increasing the CAD
Australia’s CAD is ultimately due to insufficient national savings – it stands to reason that higher levels of savings should help to reduce pressure on CAD precisely the opposite reason that an increase in disposable income should increase the CAD – accordingly an increase in household savings ration (disposable income less consumption expenditure) should help to reduce pressure on the CAD as less foreign savings is needed to fund the smaller gap between national spending and income

Question 52

How does a change in interest rates affect cad

Answer 52

changes in interest rate will have a major impact on international transactions but uncertain effects on Australia’s CAD. On the other hand, higher interest rates will tend to reduce aggregate demand or national spending (GNE) in the economy, which tends to reduce both imports and the gap between GNE and income GDP
Accordingly this will tend to improve the CAD and reduce pressure on NFD) On the other hand, the higher interest rates attract capital inflow (in the form of overseas lenders chasing higher domestic returns) and exerts upward pressure on the value of the AUD – this worsens Australia’s international competitiveness, reducing the net exports (x-m) and increasing the CAD – this conflict is the reason why the RBA will not increase interest rates to reduce the CAD

Question 53

Explain how taxation rates affect cad

Answer 53

As personal income tax rates in Australia have generally fallen over the past 4 years we would expect that on the demand side, it would have identical effects to international transactions and the CAD as that for disposable income. Indeed lower tax rates have helped to boost disposable incomes- however on the supply side lower tax rates may have helped to boost labour productivity reduce RULC and contain inflationary pressures. This will have helped to increase international competitiveness, boost net export demand, improve the BOMT and reduce the CAD. In reality the demand side impact od lower income tax rates is likely to outweigh the supply side impact. Accordingly, it is expected that lower tax rates over recent years has contributed to pressure on the CAD over the past 4 years

Question 54

How does gov’t assistance affect cad

Answer 54

subsides or tax concessions provided to businesses in order to stimulate the private sector investment tend to stimulate national spending and have negative impacts on net exports (x-m) and the CAD. This will be felt most in the short term as the growth in spending might spill over into import demand such as importation of capital and intermediate goods by businesses. However this assistance also has the potential to generate supply side benefits that result in lower costs, an increase in international competitiveness and a reduction in the CAD

Question 55

How does the exchange rate affect cad

Answer 55

exporters in Australia that are ‘price takers’ (or simply rely on the world USD price on their goods when selling on world markets) will receive less income for any given volume of exports
Exporters that are not ‘price takers’ (such a the tourism and education industries) experience a decrease in international competitiveness as the price od the good or service will be relatively more expensive for foreign purchasers
Import values should increase as they are now relatively cheaper in Aud terms

These demand side impacts should result in low net export demand, a smaller balance of goods and services (BOGS) surplus (or possibly a deficit) and larger CAD. Conversely, a declining value of the Aud should help to improve the BOGS and reduce the CAD – while it is sure that a higher Aud will result in upward pressure on the CAD, it is important to note that a higher Aud might actually occur alongside a lower CAD e.g. this will occur when strong export demand is the driving force behind the change to the balance of payments and the value of the Aud – as export demand decreases this will cause the BOGS to improve the CAD to fall and the value of the Aud to rise

Question 56

How does consumer and bus confidence affect cad

Answer 56

both follow with a slight lag, the movements in the business cycle. It will then tend to be ‘pro-cyclial’ in it’s effect on national spending such that growth in confidence will increase pressure on AD and or GNE. As was the case for growth in disposable income, we would expect this to cause an increase in demand for imports relative to exports, reducing net export demand (x-m), decreasing the BOMT and increasing the CAD alternatively it widens the gap between GNE and GDP and increases the CAD

Question 57

Explain impact overseas rates of growth has on cad

Answer 57

Higher overseas eco growth is likely to improve net export growth in Aus’t for a number of reasons:
There is likely to be an increased demand for capital and raw materials that are needed to fuel growth in overseas economies – particularly the case in developing countries that require large quantities of resources (e.g. iron ore) that Australia has in abundance

There is likely to be an increase in the demand for Australian exports of consumer items (e.g. tourism + education) that will be related to the growth in national incomes aboard –e.g. strong Chinese eco growth increased foreign students living in Aus’t

The growth rates overseas trigger inflationary pressures in those economies, resulting in Australian demanding a smaller volume of imports and instead purchasing relatively cheaper domestic alternatives

As a consequence – it is expected that strong overseas eco growth to contribute to a higher BOMT and balance of goods + services (BOGS) and a lower CAD

Question 58

Explain how tot affects cad

Answer 58

higher TOT means we can purchase more goods + services from any given volume of exports. This is because the average prices received for exports are increasing at a faster rate than the average prices paid for imports – this should boost the
net export demand, increasing the BOGS and reduce the CAD – for 2 main reasons:

Assuming the TOT has risen as a result of a higher export price, exporters will benefit because any given volume of output can now be sold for a higher price, boosting export incomes and export credits in the BO{

As Australia’s exports are largely capital (or immediate) goods with low price elasticity of demand, any reduction in export prices will tend to have a relative small effect on volumes but a larger (beneficial) impact on imports values

Question 59

Explain how bus productivity affects cad

Answer 59

outputs/inputs) growth reduces average production costs and prices and therefore improves the international competiveness of Australia’s tradeables sector. This should boost net exports, improve the BOGS and reduce the CAD. The general improvement in Australia’s productivity performance over the past year would be expected to contribute to an improvements in the CAD

Question 60

How do labour costs affect cad

Answer 60

A reduction in labour costs for businesses should help to ease problems of the costs of production and reduce inflationary pressures. This should assist in boosting Aus’t international competiveness and like higher productivity boost net exports, improve the BOGS and reduce the CAD

Question 61

How do climate factors affect cad

Answer 61

can add to price pressure in the economy via their impact on commodities like agricultural produce or minerals such as oil. The natural disaster of 2011 resulted in supply disruptions in agricultural markets which lead to higher prices for Australian fruit and vegetables. This damaged Australia’s international competiveness, reduced net exports and negatively influenced the CAD