This Selected Issues paper and Statistical Appendix focuses on two analytical approaches for judging whether the current account for Australia is sustainable. The paper implements the first approach, by asking how Australia’s net external liability position is likely to evolve over time, based on assumptions of future growth and interest rates. The paper implements the second approach by exploring the implications of a model of optimal external borrowing and lending. The main conclusions are also discussed in the paper.

Abstract

This Selected Issues paper and Statistical Appendix focuses on two analytical approaches for judging whether the current account for Australia is sustainable. The paper implements the first approach, by asking how Australia’s net external liability position is likely to evolve over time, based on assumptions of future growth and interest rates. The paper implements the second approach by exploring the implications of a model of optimal external borrowing and lending. The main conclusions are also discussed in the paper.

IV. Impact of the Asian Crisis and the Japanese Downturn on Australia: A Simulation Approach Based on MULTIMOD Mark III1

A. Introduction and Summary

1. The Asian crisis and the downturn of the Japanese economy have had widespread effects in the Asia-Pacific region. The possible channels for the effects on Australia and other noncrisis countries include lower exports (as a result of both diminished domestic demand and a depreciated exchange rate in the crisis countries) and increased competition in third-country markets (as a result of the depreciated exchange rate). On the other hand, a positive impact on the noncrisis countries may arise from the redirection of capital inflows from the crisis countries to the noncrisis countries which may act to boost asset prices and lower interest rates in the noncrisis countries. Another potential effect, which is outside the scope of the model used in this study, may come through changes in commodity prices as a result of lower world demand.

2. The seven countries most affected by the crisis (Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, and Thailand) account for about 40 percent of Australia’s merchandise exports (with Japan accounting for just under 20 percent) and about 25 percent of merchandise imports (with Japan accounting for 13 percent). These countries also account for a significant share of Australia’s trade in services, especially tourism receipts. Some of these countries (especially Japan and Korea) are also important competitors of Australia in third-country markets.

3. This chapter uses an extension of the Mark III version of MULTIMOD to quantify the main effects of the Asian crisis and Japanese slowdown on Australia. The remainder of the chapter is organized as follows. Section B discusses the model and the methodology that is used to measure the major external shocks that have affected the Australian economy. Section C presents the key results, which are obtained by using the change between the projections presented in the (precrisis) May 1997 World Economic Outlook and the latest IMF staff projections (as of mid-July 1998) as a measure of the underlying shock.

B. The MULTIMOD Framework and the Simulation Methodology

4. MULTIMOD is a dynamic multicountry macroeconomic model of the world economy that has been designed to study the transmission of shocks across countries as well as the short-run and medium-run consequences of alternative monetary and fiscal policies. It has several variants, the current versions of which are referred to as the Mark III generation. The core Mark III model includes explicit country submodels for each of the seven largest industrial countries and an aggregate grouping of smaller industrial countries, developing countries, and transition economies. In order to simulate the effects of the Asian crisis, this framework has been expanded to include additional individual blocks for Australia, Indonesia, and Korea, and one additional block aggregating Malaysia, Philippines, and Thailand.

5. The basic structure and properties of MULTIMOD are meant to represent well-established views about how modern industrial economies function and interact with each other.2 A consistent theoretical structure is employed for all industrial economies, and cross-country differences in the behavior of agents (or the functioning of markets) are reflected in different estimated parameter values. The model converges to a balanced-growth path that is characterized by a full stock-flow equilibrium in which debtor countries service the interest payments on their net external liabilities with positive trade balances. Despite the focus on medium- and long-run properties, MULTIMOD also exhibits important short-run Keynesian dynamics that result from significant inertia in the inflation process. MULTIMOD assumes that behavior is completely forward-looking in asset markets and partially forward-looking in goods markets. The model is solved with state-of-the-art simulation algorithms that have been designed specifically for solving large systems of equations.

6. Consumption-saving behavior is based on the assumption that agents have finite planning horizons, and a significant proportion of consumption may be constrained by disposable income insofar as households are unable to borrow against future labor income streams. Investment behavior is based on Tobin’s q theory, according to which the desired rate of investment exceeds the steady-state rate as long as the expected marginal product of capital is greater than its replacement cost. The model allows for significant adjustment costs.

7. MULTIMOD has a standard specification of import and export behavior that embodies the notion that countries trade in diversified products. Import volumes are a function of the main components of aggregate demand, with import contents of the different components calibrated on the basis of information from input-output tables. Exchange rates and interest rates are related by an adjusted interest parity condition that can allow for persistent risk premia.

8. A key assumption in the simulations described below relates to the choice of baseline, which is taken to be the May 1997 (precrisis) World Economic Outlook projections. Using MULTIMOD, the magnitude of the shocks in Asia and Japan are gauged using the change between the projections presented in the May 1997 World Economic Outlook and the latest IMF staff projections (as of mid-July 1998). These latest projections contain significant changes from those made more than a year earlier. Another assumption used in the simulations was that consumption decisions adjusted only gradually to the full impact of the Asian crisis, given the evolving nature of the crisis during 1997–98.

C. Assessment of Spillover Effects to Australia

9. The key results are as follows:

  • The combined shocks significantly decrease Australia’s exports (compared with the May 1997 baseline). This, combined with a reduction in Australia’s domestic demand, results in a reduction in output in Australia of ¾ percent in 1998–99. However, beginning in 2001, the effect on output turns positive in response to an easing in real monetary conditions associated with both lower interest rates and the weaker Australian dollar. Starting in 1999, there is also a modest decline in inflationary pressures relative to the baseline, with the effect of lower domestic demand pressures offsetting that of higher import prices.

  • The effect on the current account balance is strongly negative. The current account balance deteriorates by about 2 percent of GDP in 1998–99. However, a simulated depreciation of the real effective exchange rate helps to reduce the current account deficit over the medium term.3

  • In qualitative terms, the effects on Australia of the Asian crisis and the Japanese recession are similar. However, the Asian crisis’ effects are much larger than those of the Japanese downturn (about four times as large) because the magnitude of the shocks in Asia is significantly higher.

  • The short-term effects on Australia are much stronger than the effects on any of the major advanced countries. This reflects Australia’s stronger trade links with Asia.

10. The simulation is only illustrative, however, and the response of the main variables will be sensitive to a number of key assumptions. In addition, because factors other than the deterioration in the external outlook associated with the Asian shock will continue to affect Australia’s economic performance, the simulation does not provide the basis for a complete economic forecast.

1

This chapter was prepared by Douglas Laxton and Michael Sarel.

2

For documentation of the Mark III version of MULTIMOD, see “MULTIMOD Mark III: The Core Dynamic and Steady State Models, “ IMF Occasion… Paper No. 164.

3

This depreciation from the model simulation is consistent with the depreciation implied by actual exchange rate movements that occurred through July 1998.