External_Stability

External Stability External Stability is a goal of financing. It is achieved when export income is sufficient to finance import expenditure. External stability involves containing the current account deficit (CAD) to under -5% of GDP, ensuring that the servicing cost of net foreign liabilities is met, and that the exchange rate is relatively stable over time. There are three measures of external stability: CAD/GDP ratio; net foreign liabilities (debt + equity)/GDP ratio; net foreign debt/GDP ratio. Net foreign liabilities refer to the difference between Australia’s foreign assets (debt + equity lending from overseas) and Australia’s foreign liabilities (debt + equity borrowings from overseas). Its is an indication of Australia’s total debt and equity servicing costs of accumulated current account deficits. Net foreign debt refers to foreign debt assets (Australia debt lending overseas) minus foreign debt liabilities (overseas debt lending to Australia). Historically, Australia has recorded persistent current account deficits. The CAD grew in nominal dollar terms from -4% of GDP in 1980-81 to -3.2% of GDP by 2008-09. To finance the growth in the size of the CAD, net foreign liabilities grew from 13% of GDP in 1980-81 to 60.6% of GDP by 2008-09. Net foreign debt grew from 6% of GDP in 1980-81 to 52.9% of GDP by 2008-09. The servicing cost of net foreign debt required interest payments abroad which are recorded as income debits in the current account. Since the 1980s, Australia’s private foreign debt has risen at an unprecedented rate. This trend was accentuated by the ‘debt for equity swap’ (1980s) when the private sector firms preferred to borrow overseas rather than using equity borrowings. The escalation of net income payments overseas during this time was a reflection of the debt servicing burden on Australia. The financing of successive current account deficits by borrowing overseas set up a requirement for continued interest payments to overseas creditors. At the end of the 1970s interest payments overseas stood at 2.5% of export earnings this figure peaked to 20% in 1989-90. This debt servicing cost in turn leads to deterioration in the current account balance. As the CAD continues to grow, more overseas borrowing is required. This is the reason to why Australia’s economic growth can not exceed 5% if the CAD rises to over -5% of GDP, since the debt servicing obligation becomes greater than the capacity of the economy to increase its income, without leading to a rise in import spending, and a deterioration on the CAD. Alternatively economists like Professor Pitchford (ANU) argue that the CAD is a result of capital and financial account surplus. This surplus sets up a high servicing cost in terms of interest and dividend payments remitted overseas, this in turn increases the size of net income deficit and the CAD. Rising CAD increases the need for foreign borrowing which increases the size of net foreign debt. Pitchford argues that this is not necessarily a problem if the funds borrowed are invested in export industries, thereby increasing export income in the future. The growth in the size of the CAD can be attributed to a number of factors. The growth in foreign borrowings (both private and public) during the 1980s: foreign debt replaced equity investment as the main source of foreign capital, raising the size of net income deficit through higher interest payments overseas; high inflation and declining international competitiveness in the 1980s reduced Australia’s export earnings relative to import expenditure, worsening the goods balance in the current account; collapse in Australia’s terms of trade during the mid 1980s and late 1990s resulted in falling commodity prices, reducing Australia’s export earnings and raised the cost of imports; lowering of protection barriers to trade (tariffs, quotas) in 1980s-1990s, coupled with the growth of domestic demand, led to increased import volumes. This increased import spending relative to growth in export earnings; deteriorating state of the global economy in 1997-98 (Asian recession) led to large increase in the goods deficit increasing the size of CAD; depreciation of the $AUS in 2000-02 led to increase debt servicing costs, since 40% of Australia’s net foreign debt is in foreign currency loans. This increases the risk exposure of Australian borrowers and foreign lenders to depreciation in the exchange rate; impact of drought in 2002-03 reduced farm exports. Factors contributing to the growth in net foreign debt include: persistent and increasing CAD which required financing through higher levels of overseas debt and equity borrowings; shift from equity financing to debt financing (deregulation of financial system made it easier and cheaper to borrow overseas); decline in domestic savings led to increased reliance on foreign savings to finance domestic investment; federal budget deficits and other sources of public sector borrowing. The underlying or structural problem in the Australian economy causing persistent CAD is the shortfall of national (public + private) savings in relation to domestic investment. This therefore leads to Australia’s increasing reliance on foreign saving to finance that part of national investment not able to be financed by national saving. Australia has the second highest CAD as a percentage of GDP (after the US) compared to the OECD Major 7. There are several effects on the economy due Australia’s large CAD. Persistent CAD increase the servicing cost of net foreign liabilities in the future, leading to a larger net income deficit in the current account. This may therefore lead to an ongoing CAD problem, especially if borrowings are used for consumption as oppose to investment in exports. A further problem with persistent CAD and large foreign debt increase the exposure of the Australian economy to shocks such as terms of trade collapse (1997), this may therefore reduce export income and increase the servicing cost of foreign debt out of current export income. Exposure to a high level of net foreign debt liabilities can lead to a downgrading of Australia’s credit rating by international ratings agencies making future foreign borrowings more costly.