Australia has recorded current account deficits for most of the postwar period. From the 1950s through the 1970s, these deficits were relatively small and reflected a high level of investment associated with the development of the country’s natural resources, a high rate of population growth, and a large need for physical infrastructure. Since the beginning of the 1980s, however, Australia has suffered a significant structural deterioration in its external position. The current account deficit has widened to double its earlier levels, generating a large increase in the stock of net external liabilities, which is now quite high by industrial country standards. The deterioration of the current account can be attributed to a trend decline in national saving, which has fallen markedly since the mid-1970s, to one of the lowest levels in the OECD, rather than to a rise in investment, which has actually declined as a share of GDP in the 1990s, after remaining broadly unchanged throughout the 1970s and 1980s.
There has been wide, although not universal, recognition in Australia that the low level of saving and large current account deficit place a constraint on investment and the rate of sustainable growth. As noted in the previous chapter, the buildup in external debt caused financial markets to increase the risk premium on foreign lending to Australia, thereby dampening investment and growth.
This chapter discusses recent developments in the current account deficit and external liabilities. It then discusses whether the current account deficit matters, and whether it should be a concern of public policy.
Recent Developments in the Current Account
The deterioration in the current account position since the early 1980s has been both significant and structural (Figure 3.1). During the 1960s and 1970s, the current account deficit averaged about 2¼ percent of GDP. In contrast, during the 1980s and 1990s, the deficit widened to an average of 4¾ percent of GDP, exceeded 6 percent of GDP on three occasions (1985/86, 1989/90, and 1994/95), and never fell below 3 percent of GDP.
Developments in the Current Account
(In percent of GDP, year ending June)
Source: Australian Bureau of Statistics.Developments in the Current Account
(In percent of GDP, year ending June)
Source: Australian Bureau of Statistics.Developments in the Current Account
(In percent of GDP, year ending June)
Source: Australian Bureau of Statistics.This deterioration has had two proximate causes. The first was a fall in the trade balance, which swung from a surplus of 1¾ percent of GDP in the 1970s to a deficit of ½ percent of GDP in the 1980s. Import volumes rose sharply in the early and latter part of the decade, reflecting strong capital goods imports, while export volumes grew quite slowly. The trade deficit has subsequently improved to be near balance in the 1990s as export performance has improved significantly, benefiting from the economic reforms and the large depreciation of the real exchange rate in the mid-1980s (Box 3.1). Since the early 1980s, the terms of trade have fluctuated quite substantially, but around a broadly flat trend. While these fluctuations have played an important role in the activity cycles, and their impact shows clearly in the current account, the terms of trade have not been a significant factor in the structural deterioration in the current account deficit. Second, the factor income deficit doubled during the 1980s and 1990s, as net interest and other payments increased in line with the stock of net external debt and other liabilities (discussed below).
Underlying these developments has been a trend decline in national saving, which has outpaced the decline in investment (Table 3.1). In terms of decade averages, national saving declined modestly in the 1970s, by 3¾ percent of GDP in the 1980s, and by a further 3 percent of GDP in the 1990s. Investment remained broadly unchanged between the 1970s and 1980s, but has fallen in the 1990s, allowing some narrowing of the current account gap. As a result of this fall, however, Australia no longer has a particularly high investment rate, compared with the OECD average. Rather, the country’s low saving rate of 17 percent of GDP, virtually the lowest in the OECD, stands out as the explanation for the unusually high current account deficit. Most of the deterioration in the national saving/investment balance is attributable to the Commonwealth general government and the household sectors (see Chapter 4).
Current Account, Saving, and Investment
(Averages, in percent of GDP)
Up to 1996/97.
Current Account, Saving, and Investment
(Averages, in percent of GDP)
| 1960s | 1970s | 1980s | 1990s1 | |
|---|---|---|---|---|
| Current account deficit | 3.1 | 1.8 | 5.0 | 4.3 |
| Gross investment | 26.9 | 25.0 | 24.7 | 20.6 |
| Gross national saving | 24.4 | 23.7 | 20.0 | 16.9 |
| Discrepancy | –0.7 | –0.5 | –0.3 | –0.6 |
Up to 1996/97.
Current Account, Saving, and Investment
(Averages, in percent of GDP)
| 1960s | 1970s | 1980s | 1990s1 | |
|---|---|---|---|---|
| Current account deficit | 3.1 | 1.8 | 5.0 | 4.3 |
| Gross investment | 26.9 | 25.0 | 24.7 | 20.6 |
| Gross national saving | 24.4 | 23.7 | 20.0 | 16.9 |
| Discrepancy | –0.7 | –0.5 | –0.3 | –0.6 |
Up to 1996/97.
The decline in Australia’s rate of saving has meant greater reliance on foreign saving to finance investment activities. Accordingly, the outstanding stock of net external liabilities has increased significantly (Figure 3.2). This increase was particularly pronounced in the 1980s, when large current account deficits and a significant real exchange rate depreciation caused Australia’s net external liabilities/GDP ratio to double from 23 ¼ percent in 1980/81 to 46 percent in 1989/90. Even more striking was the swift accumulation of net foreign debt within this total, which rose from 6 percent to 35¾ percent of GDP (see Box 3.2). Net external liabilities have risen further in recent years, reaching around 60 percent of GDP in 1996/97. After peaking at 43 percent of GDP in 1992/93, net external debt declined somewhat to about 41 percent of GDP by 1996/97, owing partly to the valuation effects of the Australian dollar’s real appreciation over this period.
External Liabilities
(In percent of GDP, year ending June)
Source: Australian Bureau of Statistics.External Liabilities
(In percent of GDP, year ending June)
Source: Australian Bureau of Statistics.External Liabilities
(In percent of GDP, year ending June)
Source: Australian Bureau of Statistics.Australia’s current account deficit and net external debt and liabilities are relatively high by industrial country standards, with only New Zealand having a higher deficit and outstanding stock of liabilities (Figure 3.3). The servicing burden of this debt, however, is moderate and declining: the debt-service ratio has fallen to 11 percent of exports in 1996/97 from 19¾ percent in 1990/91.
Current Account and Net International Investment Position of Selected OECD Countries
(In percent of GDP; 1991-96 averages)
Source: IMF, International Financial Statistics.Current Account and Net International Investment Position of Selected OECD Countries
(In percent of GDP; 1991-96 averages)
Source: IMF, International Financial Statistics.Current Account and Net International Investment Position of Selected OECD Countries
(In percent of GDP; 1991-96 averages)
Source: IMF, International Financial Statistics.Does the Current Account Deficit Matter?
The deterioration in the current account position since the early 1980s has sparked a vigorous debate as to the consequences of running large and persistent current account deficits, and to the remedies, if any, that may be required. The Australian authorities clearly recognize the potential constraints associated with a low national saving rate, large current account deficit, and high external debt. In the 1996/97 budget papers, the authorities stated (page 1-9):
Increasing dependence on foreign savings, as reflected in growing net foreign liabilities, exposes the economy to sudden shifts in market confidence, leads to higher borrowing costs for Australian business, and makes the economy more vulnerable to external shocks. Inevitably, the effect of these risks is to place an external “speed limit” on the pace at which economic growth can be sustained.
Some commentators have argued that the external position should not, in itself, be a cause for public policy concern or a target for economic policy as long as it is not the result of distortions or externalities (see Pitchford 1989a and 1989b, and Corden 1991). The basis for this view is that, provided the public sector is not borrowing, the current account deficit is simply the difference between private investment and private saving. The former depends on profit opportunities, the latter on how consumers wish to spread their consumption through time. As long as these private sector actions are not distorted by government policy (for example, by tax provisions that encourage borrowing or special benefits that promote consumption) they should not concern policymakers. If private actions are distorted, the distortions should be addressed directly rather than by trying to narrow the current account deficit per se (for example, by implementing restrictive demand management policies).
Australia’s Export Performance and International Competitiveness
In the early 1980s, exports of goods and services stood at only 13 percent of GDP, with rural and resource exports accounting for more than 70 percent of the total. Among OECD countries, Australia was almost alone in not increasing its international integration in the 1960s and 1970s, and its trade share was relatively low when compared with other industrial countries of a similar size.
Over the past decade, Australia has embraced the idea of an outward-looking, export-oriented economy and both its goods and financial markets have become increasingly integrated into the world market. Central to these trends have been: the removal of foreign exchange controls in 1983; a sharp reduction in the rate of industry assistance since the mid-1980s, which boosted export competitiveness by directly reducing imported input costs and by generating dynamic gains in other areas of the economy (see Chapter 7); and a decline in the real effective exchange rate of more than 20 percent compared to its level in the early 1980s, which made exporting more attractive (see figure). Together, these developments have sparked a surge in export growth. Since 1989/90, exports have risen by 8½ percent per annum (in volume terms), outstripping import growth by 2 percentage points over this period, and the ratio of exports-to-GDP has increased to more than 20 percent.
Exports of manufactured goods have grown particularly strongly, with volume growth averaging 16 percent per annum in the past decade, expanding their share of total merchandise exports to around one-quarter, from one-tenth a decade ago. Bullock, Grenville, and Heenan (1993) estimate that the increase in exports of manufactured goods over the period 1986–91 can be explained by the reduction in industry assistance (about 40 percent of the increase), improved competitiveness through the lower exchange rate (about 45 percent of the increase), and strong income growth in partner countries, particularly Asia.1 Further, a change in attitudes in industry engendered by the opening up of the economy seems to have resulted in a more pro-export culture. Exports of services have also expanded quite strongly, led by growth in the tourism sector. As a result of the increase in manufactured and service exports, the share of rural and resource exports in total exports has fallen to less than 60 percent.
In addition to the change in the commodity composition, the destination of Australia’s exports has shifted, with Asia (excluding Japan) having become an increasingly important destination for Australian exports. Countries belonging to the Association of South East Asian Nations (ASEAN) accounted for 15½ percent of all merchandise exports in 1996/97, compared with only 8¾ percent as recently as 1988/89.
This thesis is unlikely to apply to Australia, however. Australia’s net external debt is not solely attributable to private sector decisions, since public sector debt accounts for about one-third of total outstanding debt. Furthermore, numerous government policies affect private investment and saving decisions. As discussed in Chapter 2, the interaction of high inflation with taxation arrangements designed for a regime of more stable prices provided a strong incentive for individuals and firms to borrow and invest in the housing and commercial property markets during the 1980s. In addition, the availability of government transfers is likely to reduce the incentives for an individual to save (see Chapter 4). While it is important to minimize these distortions as far as possible, and some existing distortions can be eliminated, others, such as unemployment benefit payments, have a strong social justification.
Indeed, empirical research suggests that the current account deficit has not been the result of optimal behavior. Cashin and McDermott (forthcoming) compare the actual current account deficit with an optimal current account derived from an intertemporal model based on the permanent income theory of consumption and saving. This approach views the current account as the outcome of forward-looking dynamic saving and investment decisions. Their findings indicate that while it is optimal for Australia to run a current account deficit, the actual deficit has been larger than optimal since the early 1980s, and, consequently, the outstanding stock of net external liabilities has increased more rapidly than would be warranted. They find that national saving should have been about 1 percent of GDP higher, on average, to ensure there was no unwaranted current account deficit. However, given that the actual deficits have resulted in a higher-than-optimal outstanding stock of external liabilities, the increase in national saving required to return the economy to its optimal path is now somewhat higher (possibly 2 percent of GDP).
Moreover, the current account deficit may be a cause for concern even if it is based on undistorted private sector decisions. Individual private sector borrowing decisions may not internalize the increased risks associated with a higher level of external debt in the economy as a whole, so that while each individual decision may be a reflection of optimal behavior, the outcome may not be optimal for the economy in aggregate. For example, additional external debt may raise the risk premium on a country’s assets, increasing the borrowing costs for all agents in the economy (of course, the size of any risk premium will also depend on the state of the economy, confidence in policy settings, and the economy’s future prospects, including how the borrowed funds are being used, and its ability to service the debt) (see Box 3.3). The risks associated with a large current account deficit are magnified by Australia’s already high level of net external liabilities, and by its greater reliance on commodity exports compared with most other industrial countries, making it more vulnerable to sudden swings in investor sentiment and the terms of trade.
Finally, the current account deficit matters because it may constrain economic growth, particularly if saving and investment decisions in the public and private sectors are not soundly based. As noted in the previous chapter, this was most apparent in 1985 and 1986, when financial markets responded to concerns about the sustainability of macroeconomic policy settings and a rapid widening in the current account deficit to more than 6 percent of GDP. The exchange rate fell sharply, and short-term interest rates rose substantially, which put downward pressure on investment. When the current account deficit widened on two other occasions (in 1989 and 1995), however, the exchange rate did not fall as sharply as in the 1985–86 episode, but the real yield differential between Australian and U.S. bonds widened considerably (particularly in 1989), adversely affecting investment. While such episodes have been manageable, a lower structural current account deficit would allow the natural cyclical swings in the deficit to occur without it reaching uncomfortably high levels. Fundamentally, however, any increase in the current account deficit is less likely to cause concern in financial markets if the saving and investment decisions underpinning the deficit are sound. To this end, one of the primary goals of government policy has been to address structural weaknesses in the economy, including moves to increase national saving (which is discussed in the next chapter).
Developments in the Capital Account
Traditionally, minimal fiscal deficits and restrictions on overseas borrowing meant that most of Australia’s capital inflows were in the form of equity investment. Private debt flows, to the extent they existed, mainly related to borrowing by domestic subsidiaries from parent companies abroad. Capital outflows were negligible. Starting in the late 1970s and early 1980s, financial deregulation resulted in a substantial increase in overall flows and a significant shift in financing patterns.1 Total gross flows increased to 10 percent of GDP in the 1980s from 3½ percent of GDP in the 1970s, owing mainly to a sharp increase in external borrowing inflows and equity outflows.
During the 1980s, the principal inflow was short-term borrowing, due to the financing of mining projects during the resources boom and large capital expenditure projects by public trading enterprises (PTEs) in the early part of the decade, and to borrowing by the corporate sector in the latter part. A significant proportion of these funds were raised offshore by the financial sector and then on-lent through the domestic market. In addition, the larger fiscal deficits run by the government, together with the granting of direct access to international capital markets for the state governments,2 at times resulted in general government net capital inflows accounting for a substantial proportion of total capital inflows. The removal of controls on capital flows fostered the development of significant offshore Australian dollar security markets. In the second half of the 1980s, the funds raised in offshore capital markets, particularly the Euro-$A market were, in principle, sufficient to fund the whole of the current account deficit (Tease, 1990).
Nonofficial capital outflows, which had previously been negligible, increased to an average of 2 percent of GDP during the 1980s as Australians sought to diversify their investment portfolios and improve commercial and manufacturing linkages with major trading partners. Direct equity investment abroad was particularly strong in the second half of the 1980s, as Australian companies acquired interests in foreign companies, mainly in the United Kingdom, the United States, and New Zealand (see Robertson, 1990).
Gross capital flows in the 1990s have declined compared to the 1980s, while the composition of flows has, on average, been more evenly balanced between debt and equity, although this split has been volatile year-to-year. The early 1990s were characterized by increasing net inflows of official borrowing due to the state governments, which have become major borrowers in the international capital markets. Despite relatively strong net equity flows, nonofficial net capital inflows declined sharply in the early 1990s, as net debt flows weakened considerably compared with the 1980s. This position has reversed over the two years to 1996/1997 as net official flows have turned negative due to state general government debt repayments, while increased borrowing has resulted in a strengthening of nonofficial inflows.
Capital Flows
(In percent of GDP, year ending June)
Source: Australian Bureau of Statistics.Capital Flows
(In percent of GDP, year ending June)
Source: Australian Bureau of Statistics.Capital Flows
(In percent of GDP, year ending June)
Source: Australian Bureau of Statistics.Australia’s External Debt, Credit Rating, and Cost of Borrowing
Results reported by Cantor and Packer (1996) support the view that a country’s external debt level is an important determinant of its credit rating, which in turn affects the cost of its foreign borrowing. Largely reflecting the increasing level of external debt, Australia’s credit rating was downgraded in the mid-1980s to Aa2/AA.
Cantor and Packer find that countries with lower credit ratings pay higher yields, and that the credit rating itself appears to provide additional information beyond that contained in the standard macroeconomic variables in explaining yield differentials. For Australia, Fitzgerald (1993) estimated that the credit downgrade in the mid-1980s added between one-fourth and one-half of a percentage point to the interest rate that the Commonwealth Government had to pay on U.S. dollar borrowing in mid-1993.
References
Bullock, M., S. Grenville, and G. Heenan, 1993, “The Exchange Rate and the Current Account,” in The Exchange Rate, International Trade, and the Balance of Payments, ed. by A. Blundell-Wignall (Sydney: Reserve Bank of Australia).
Cantor, R., and F. Packer, 1996, “Determinants and Impacts of Sovereign Credit Ratings,” Federal Reserve Bank of New York Research Paper No. 9608 (New York).
Cashin, P., and C. J. McDermott, forthcoming, “Are Australia’s Current Account Deficits Excessive?” Economic Record.
Commonwealth Government of Australia, Budget Papers, various volumes.
Corden, W., 1991, “Does the Current Account Matter? The Old View and the New,” Conference in Honor of Jacques Polak (Washington: International Monetary Fund, January).
Fitzgerald, V., 1993, National Saving—A Report to the Treasurer, 1993 (Canberra: Commonwealth Treasury).
Menzies, G., and G. Heenan, 1993, “Explaining the Recent Performance of Australia’s Manufactured Exports,” Reserve Bank of Australia Research Discussion Paper No. 9310 (Sydney).
Pitchford, J., 1989a, “Does Australia Really Have a Current Account Problem?” Economic Papers 8, pp. 25–32.
Pitchford, J., 1989b, “A Sceptical View of Australia’s Current Account and Debt Problem,” Australian Economic Review, Vol. 86, pp. 5–14.
Rider, M., 1994, “External Debt and Liabilities of Industrial Countries,” Reserve Bank of Australia Research Discussion Paper No. 9405 (Sydney).
Robertson, R., 1990, “Australian Equity Investment Abroad,” Bulletin, Reserve Bank of Australia (Sydney, March).
Tease, W., 1990, “The Balance of Payments in the 1980s,” in The Australian Macro-Economy in the 1980s, Reserve Bank of Australia (Sydney), pp. 158–221.
