Analyse the causes of Australias on-going current account deficit.

Discuss the consequences for

external stability and the domestic economy.

Current Account is the part of the Balance of Payments that shows the money flow from all exports
and imports of goods and services, income and current transfers between Australia and the rest of
the world for a period of one year. It covers external transactions that are non-reversible.

Australias current account has persistently been in large deficits since the mid 1980s. According to
the table, the deficit in 2005/06 is $ -52.8 billion dollars, and the deficit in 2006/07 is $ -58.4 billion
dollars. This shows an increasing trend of the CAD.

Australia has continued to pay out considerably large amounts of money for goods, services and
other income and transfer payments. Based on the table give, in year 2007/08, Australias balance on
goods and services, is a negative figure, $ -17.9 billion. This is mainly due to the increasing demand
for imports rather than exports, thus payment exceeds receipts. The table also shows a deficit in the
net income, $ - 50.1 billion. The net income deficit is a major contributor to the CAD figure as interest
payments on borrowings need to be paid overseas, and foreign investors need to return the profit or
dividends earned back overseas. Australias net current transfers is also recorded as a negative figure,
with a $ -0.1 billion deficit. The current transfer has little importance in scope of overall balance of
payments. Overall, the balance on current account in year 2007/08 is recorded a deficit of $ -68.2
billion dollars.

Australias CAD is measured as a proportion of GDP to allow a more accurate comparison across time
and between countries. Since mid 1980s, CAD has been higher on average as a percentage of GDP,
ranging between 3-6%. The deterioration in deficit was associated with a collapse in the terms of
trade and dramatic increase in Australias foreign liabilities during that decade.

The Australian Current account deficit moves in cycles and its movements are influenced by cyclical
factors, such as changes in global demand for commodities, Australias terms of trade and the
demand for imports from Australian consumers and businesses. In the domestic economy, high
economic activity will contribute to a high CAD, as it did in the mid 1980s, the late 1980s, and the
mid 1990s. Due to high economic activity, imports will increase. Since imports represent a leakage in
the circular flow of income, thus more payments are required to be made, and will therefore lead to
a deficit in the current account. An economic downturn will lead to the opposite effect, contributing
to a major improvement in the balance of goods and services.

Australias on-going high CAD is also caused by its structural component, the net income deficit that
remains high regardless of the cyclical swings in the CAD. The income account has consistently
recorded a deficit of around 3% of GDP, and has risen to more than 4% of GDP recently. This is due to
Australias foreign liabilities, both net foreign debt and net foreign equity. Overseas investment in
Australia wants returns on equity investments, such as profits on companies, rent on land and
dividends on shares. On the other hand, borrowing adds to Australias foreign debt. This reflects on a
higher interest servicing costs on Australias foreign debt and an increased net income deficit on the
current account, thus, contributing to a higher CAD.

In recent years, debt servicing ratio, which indicates the proportion of export revenue that must be
spent on interest payments on foreign debt, has been rising in Australia. In 2008, it remains about
11.5%. This high CAD will then create a vicious cycle known as the debt trap scenario, and Australias
interest payments will keep increasing as the foreign debt becomes greater. Todays foreign debt will
then add to future CADs because the high CAD needs to be financed by borrowing from overseas,
which in turn increases the CAD. The effect of debt servicing on the CAD is significant and is the
largest single cause of Australias high CAD.

The structure of Australias narrow export base, which is heavily weighted towards primary industry
commodities, also contributes to the volatility in the CAD. This is because Australia is exposed to
large fluctuations in commodity prices from year to year. Moreover, agricultural commodities are
subjected to high levels of protection throughout the world, which can make it difficult for Australian
to sell these exports. Australias narrow export base is strongly susceptible to global downturn, which
means global demand for commodities declines, prices will fall, export earnings will decrease and the
current account will deteriorate.

Changes in Australias terms of trade can have a large influence on Australias balance of payments. If
the terms of trade deteriorate, as they did between 1989 and 1994, it means that the same volume
of exports can buy fewer imports. This would ultimately lead to a larger deficit of the Balance of
Payments and thus increase in the CAD and in Australias foreign liabilities. The terms of trade index
has shown a flattening out in year 2007-08, and a probable deteriorate in year 2008-09 as demands
for Australias energy resources has decreased.

The Australias CAD is also susceptible by interest rates and exchange rates movements. When
interest rates are low, servicing costs of foreign debt will be lower. If it rises, as it did in 2007,
servicing costs increases. Changes in exchange rates also affect Australias CAD as a fall in Australias
exchange rate will increase the size of foreign loans and the interest payments if loans were
denominated in foreign currency, such as US dollars.

Australias on-going high CAD is also caused by the persistently low level of national savings. Australia
has one of the lowest levels of household savings in the developed world, and also one of the highest
levels of household debt in the industrialised world. This combination will ultimately contribute to a
higher level of foreign liabilities, because Australia has to rely more on the savings of foreigners to
fund local investment. As Australia relies more on foreign savings, it is attracting large financial
inflows on the capital and financial account, contributing to the size of its foreign debt and CAD.

Over a period of time, sustaining a high CAD may impact on the Australian economy, and thus have
consequences on the external stability of the domestic economy.

External stability is the issue relating to a countries ability to meet its short and long-term goals with
the global economy, and to achieve external stability, Australia will need to monitor the size of its
CAD, the level of debt and equity and also its servicing costs on liabilities.

A high CAD will eventually lead to the growth of foreign liabilities. Australias net foreign debt has
grown dramatically from the beginning of the 1980s, to reach $600 billion in 2007-08. This growth of
foreign liabilities is mainly because CAD results in a larger inflow of funds, either in the form of
borrowing from overseas or selling equity items. This will affect Australias ability to borrow more
funds as lenders may be reluctant to lend to Australia or to invest in Australia.
Due to the growth of foreign liabilities, Australia will then have a debt sustainability problem, as it
finds itself difficult to service its debts. If the size of the debt is rising faster than the increase in GDP,
as it has done in recent years, the interest payments on the debt will progressively take up a greater
proportion of our GDP. This will ultimately reduce Australias standard of living and the growth
potential of the economy.

A high CAD will affect the volatility of the exchange rate. A change in the exchange rate affects the
balance of payments by affecting Australias international competitiveness and the size and servicing
costs of our foreign debt. Thus, if the value of the dollar is continually subject to change, this may
undermine the confidence of foreign investors, by suggesting that Australias economic fundamentals
are unstable. Because of this reason, the demand of Australias currency will drop, thus resulting in a
depreciation in the $A. A depreciation of the Australia dollar will heighten Australias CAD problem,
as the prices of imports increase.

High CADs can also lead to a constraint on future economic growth. In the longer term, higher levels
of economic growth means an increase in imports, and a natural deterioration in the CAD. Economies
with a CAD problem are therefore forced to limit growth to the level at which the CAD is sustainable.
This is known as the balance of payments constraint.

High CADs can cause investors to lose confidence in the Australian economy. A high foreign liability
can be a significant risk to an economys future performance. If markets suspect the level of debt
may become unsustainable for the debtor country, they may reduce the countrys international
credit rating, which reflects the confidence that world financial markets have in that country. A
downgrade in Australias credit rating would make it more difficult to borrow funds internationally as
overseas investors and lenders lose confidence in Australia. In recent years, a high CAD has caused
several countries to experience economic crises due to a sudden loss of international investor
confidence. For example, a major crisis occurred in Argentina in 2002 because of its external
imbalances.

As high CAD can have negative consequences to the domestic economy, it may also have positive
consequences.

A high CAD means that Australia is interacting greatly with other nations and countries through the
increased interaction of financial flows. This encourages globalisation, and increases Australias
trading partners, thus resulting in the process of freeing world markets.

A high CAD can also lead to an increased savings level in Australia. A high CAD means that Australia
has high foreign liabilities, which prompted measures to increase savings level in Australia, such as
the compulsory superannuation scheme. As people are putting their money in superannuation funds,
their money are being invested, thus earning returns or interests, which can help stimulate the
economy.

High level of foreign liabilities will lead to higher CAD, which can help raise the overall standard of
living in Australia. Without the help of foreign liabilities, the level of overall standard of living and the
level of sustainability cannot be made with limited sources of funds.

All in all, there are many factors that cause Australias on-going current account deficit, and these
causes will ultimately lead to consequences for the external stability, both positively and negatively.
However, negative consequences exceed positive ones, and thus, an on-going current account deficit
may be unsustainable in the longer-term.