Topic 3 - External Stability

Question 1

What are the measurements of External stability?

Answer 1

CAD as a % of GDP

Net foreign debt as a % of GDP

Net foreign liabilities as a % of GDP

Terms of Trade

Exchange Rate

International Competitiveness

Question 2

What is external stability?

Answer 2

It is an aim of government policy that seeks to promote sustainability on the external accounts so that Australia can service its foreign liabilities in the MT to LT to avoid currency volatility

Question 3

What are the main issues with Aus’s ext stability?

Answer 3

Persistent CAD

Volatile terms of trade

Lack of IC

Growth in foreign debt

Rising foreign ownership in Aus

Volatility of the AUD

Question 4

What is a current account deficit?

Answer 4

A deficit on the overall Current Account of an economy

Question 5

Has Aus been averaging a CAD or a CAS

Answer 5

Historically averaging a CAD, but recently has turned into a CAS

Question 6

What are the 3 reasons proposed for a CAD?

Answer 6

CAD as a trade deficit

CAD as a savings invesment gap

The consenting Adults (pitchford) thesis

Question 7

What is the CAD as a trade deficit theory?

Answer 7

Originally explained as a product of Australia’s trade problems where CAD was blamed on persistent deficits on the BOGS, caused by a combination of slow export growth and expanding demand for imports

It argues that this is caused by a lack of IC in many of the higher value added values of global trade such as ETMs. Also, Aus’s TOT has a major impact on trade deficit, with it being reliant on commodity prices, in the final quarter of the twentieth century, global commodity prices when into LT decline, contributing to slow growth in Aus exports, and worsening the trade deficit and thus the CAD

Question 8

What is the CAD as a savings investment gap?

Answer 8

The current view on the CAD is primarily a result of an excess of domestic investment required over domestic savings- the savings-investment gap

If domestic spending exceeds domestic output, resulting in a deficit on the CA, we are forced to make up for this by bringing in financial inflow from overseas –> savings investment gap –> increased investment from overseas to meet domestic D for investment which our savings alone cant satisfy –> increased investment into Aus –> worsening the NPY accounts through the increase repayments

Question 9

What are the main causes of Aus’s s-i gap?

Answer 9

Small population, large land mass and extensive natural resources, to develop the economy we have had to rely on overseas capital to fill the gap between domestic savings and investment

Historically low levels of household savings

Question 10

What is the consenting adults’ thesis (Pitchford Thesis)

Answer 10

The Pitchford thesis- states as long as a CAD is the result of S and I decisions by the private sector which are not the result of distortions to normal market mechanisms→ there is no cause for concern about an economy’s external stability

Question 11

What is net foreign liabilities made up of?

Answer 11

Two key components:

Net foreign debt (NFD)

Net Foreign Equity (NFE)

Question 12

What is net foreign debt?

Answer 12

The total stocks of loans owned by Australians to foreigners, minus the total stock of loans owned by foreigners to Australians

Question 13

What is net foreign equity?

Answer 13

Net foreign equity is the total value of assets in Australia such as land, shares and companies in foreign ownership, minus the total value of assets overseas that are owned by Australians

When foreign investors buy assets in Aus, this is recorded as an increase in foreign equity, THUS A NEGATIVE NFE IS A GOOD SIGN FOR AUS

Question 14

What is the influence on NFD?

Answer 14

Overseas borrowing - It adds directly to Australia’s foreign debt. The initial borrowed sum eventually has to be repaid and the debt must be serviced with regular interest payments. Servicing of Australia’s debt constitutes an outflow of funds on the current account, increasing our CAD

Question 15

What is the debt servicing ratio?

Answer 15

It is a measure of the country’s capacity to service its foreign debt and indicates the proportion of export revenue that must be spent on interest payments on foreign debt

Question 16

What credit rating does Aus have? What is it?

Answer 16

Aus holds a AAA credit rating, as it represents a low risk level for investment –> greater levels of investment within Aus

Question 17

Is NFE more volatile?

Answer 17

Yes, due to ER movements and shifts in market valuation of companies and assets, affected by investor sentiment

Question 18

What is the effect of NFE on ext stability?

Answer 18

Puts strain on Aus’s external accounts by worsening the NPY account (although it is offset by earnings from Aus’s overseas investments)

Equity servicing costs account for around half of total primary income outflows

However, the sustainability of servicing costs for foreign equity is less concerning as dividends are only sent overseas when the Aus business is profitable unlike Interest repayments on debt

Question 19

What is the effect of NFD on ext stability?

Answer 19

Needs to pay off the borrowed money –> worsening ext stability through worsening the NPY outcomes

Question 20

How does ER influence ext stability?

Answer 20

ER has a significant impact on Australian’s IC, which further influences the ext stability of Aus. During periods of high ER, Aus’s IC of X decrease, and there is an increase in spending on M –> worsening BOGS and ultimately worsening the CAD and ext stability

Meanwhile, a fall in ER will improve IC –> increased purchase of Aus X + decreased purchase of M due to higher prices –> Improving BOGs, improving the CAD and ext stability

Question 21

How has the floating ER been beneficial on the BOP?

Answer 21

ER acts as a stabilising mechanism.

During downturns, the depreciation increases IC of exporting industries increasing economic growth and bringing economic activity back up and directly combats Dutch disease as seen after the MIB. This is similar vice versa, and prevents the BOGS from fluctuating too much and also EG from fluctuating too much

Question 22

What is the influence of ER on foreign liabilities?

Answer 22

Theoretically, an depreciation will mean that Aus’s NFD increases, and repayments increase, however, due to 85% of NFD denominated in AUD or hedged against unfavourable er movements, it is unlikely for ER to negatively impact Aus NFD

Question 23

What is the impact of IC on ext stability?

Answer 23

Fluctuations in the IC will either increase or decrease the IC of aus X. During increases of the IC, there is an increased sale of Aus X –> improvement in the BOGS –> improved CAD and thus ext stability. Meanwhile, during decrease of the IC, there is a decreased sale of Aus X –> worsening the BOGS –> worsening CAD and thus worsening ext stability

Question 24

How does terms of trade impact ext stability?

Answer 24

A positive change in the TOT can result in increased X revenue, and will have to pay less for M –> improved BOGS –> improvements in the ext stability

Conversely, if TOT deteriorates (X prices decline relative to M prices), costs of M increases in terms of X earnings –> More outflows from M compared to X –> worsening the BOGS –> worsening ext stability

Aus is also heavily influenced by the TOT because of its direct link to commodity prices, and thus, fluctuations in the TOT will impact whether Aus is making high sales of minerals –> improvements in the ext stability

Question 25

What is the TOT?

Answer 25

It is the relative movements in the prices of Aus X and M over a period of time

Question 26

How is TOT calculated?

Answer 26

(X price index / M Price index ) x 100