Fluctuations in External Stability

Topics: Macroeconomics, Currency, Investment Pages: 5 (1637 words) Published: June 21, 2012
Economics PAT

“Analyse the causes and effects of fluctuations in Australia’s external stability”.

Achieving external stability is an important objective of economic policy, achieving this stability ensures that imbalances in Australia’s economic relationships with other economies do not hinder achieving domestic economic policy goals such as lower rate of unemployment, higher rate of growth and lower inflation. There are three main factors that effect external stability the deficit on the current account (CAD), net foreign liabilities and the Australian dollar. Australia’s experienced times when overseas investors decided that the economy’s external position was unstable, and when investors like such decide to withdraw their investment from the Australian economy it creates a strain on the economy which can lead to a depreciation of the currency, higher interest rates and slower economic growth.

The best way of assessing a country’s external stability is to look at the sustainability of its external accounts, in particular the country’s foreign liabilities and the CAD. Since the 1980’s Australia has persistently had a large deficit on the current account, Australia has paid out more for goods, services, income and transfer payments than it has received from overseas. As a country it is irregular to have a CAD, usually countries aim for their economy’s to generate surpluses. The CAD as a percentage of GDP is the best measure of trends in the current account over time, rather then the size of the deficit in dollar terms. In the 1970’s GDP was calculated as a percentage and the CAD averaged at 1.1%, in the 1980’s its average was 4.3%, this increase was viewed as a trade problem, and believed it resulted because of an imbalance of goods and services. This large increase on the deficit lead to major structural reforms to restore the competitiveness of the economy. Instead of being seen as a trade gap it’s now perceived to be a savings and investment gap that is sustainable.

It’s still perceived that the CAD is a result of spending exceeding savings. For the savings investment gap to achieve its objective Australia must sell and borrow domestic assets overseas to fund capital to increase economic development. Australia is a low populated country with large land mass and many natural resources which overseas investors need to take advantage of. Although the problem with this is borrowings need to be serviced and interest must be paid, increasing to the current deficit in the primary income section of the current account. Investments funded by overseas should generate sufficient returns allowing this to pay for the interest and the servicing costs. This is backed by the Pitchford thesis or “consenting adults” thesis, which states that as long as the current account deficit is caused by the private sector and as a result of savings and investment decisions that are not distorted from the market mechanism, that there should not be concern for external stability. Parties lending money and parties borrowing money are both consenting adults and there for are responsible for their own actions.

A long-term impact of a high CAD is growth of net foreign liabilities, these liabilities are calculated up on Australia’s total financial obligations to foreigners, minus foreigner’s financial obligations they owe to Australia. Selling assets to foreigners does not add directly to Australia’s foreign debt because Australia does not have to repay the price of purchasing equity unless the asset is sold back to Australia, although on the other hand borrowing does add directly to the foreign debt because the initial borrowed some must be payed back at some point and the debt must be serviced. The servicing of Australia’s debt constitutes an outflow of funds on the current account and thus increases our CAD, the effects of debt servicing on the CAD is very significant and is the largest single cause of Australia’s consistent high...
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