Australia's Trade Patterns

Australia's Trade Patterns - Introduction

• Geographic isolation means trade represents a high proportion of the country's economic activity.
• Australia trades to access overseas markets for primary commodities, to export services due to high development, and to import technology and goods not locally produced.
• Australia is a small open economy, producing less than 2% of the Gross World Product.
• Exports and imports each account for over a quarter of Australia's GDP.
• Global developments significantly impact Australia due to its economic structure.

The Changing Direction of Trade

• China has become Australia's dominant trading partner in the last decade.
• Past markets like Japan, the UK, and Europe are now less important.
• In 1973, the UK's entry into the European Union imposed trade barriers on Australia.
• Before 1973, the UK was Australia’s prominent trading partner due to colonisation, accounting for 70% of imports and 80% of exports in the 1880s.
• Australia subsequently shifted its trade focus to North-East Asia and ASEAN.
• Since 2023 Brexit has allowed tariff-free trade with the UK (though it is now a less significant market).
• Japan's economy in the 1960s increased demand for Australian minerals and energy, making Japan Australia’s largest export market for decades.
• China's growth from the early 2000s led to rapid export growth, making it Australia’s largest trading partner by 2007.
• In 2023, China accounts for 33% of Australia's export earnings.
• Trade with South Korea, India, Taiwan, Indonesia, Vietnam, and the Philippines is growing at over 10% annually in the 2020s.
• Australia's exports are mostly directed to emerging markets (China, ASEAN), while imports are largely from advanced economies like the US and Europe.
• This reflects Australia’s demand for capital equipment and consumer items from these regions.
• China has been Australia’s largest import source since 2016.
• High levels of imports from China and ASEAN economies align with the demand for manufactured goods.
• In 2022, the Albanese Government launched a long-term strategy to boost trade with South-East Asia through 2040.

The Changing Composition of Trade

• Agricultural and mineral exports dominate Australia’s trade due to a comparative advantage in commodities thanks to vast supplies of natural resources.
• Exports of agricultural products (wheat, wool, beef) and minerals (coal, iron ore, gold, lithium) account for over two-thirds of export earnings.
• Australia has been less competitive in manufacturing compared to other advanced economies.
• Reliance on primary exports has resulted in large imports of capital and manufactured consumer goods.
• Total exports in 2023-24 decreased to $657 billion, with a drop in commodity exports due to declining worldwide commodity prices and weaker global demand.
• Agricultural exports have decreased over recent decades as a proportion of Australia’s trade due to fluctuating world prices, trade protection policies, limited value-added in processing, and natural disasters.
• Manufactured goods make up a very small share of Australia’s exports due to the difficulty in competing in high-volume, low-cost goods.
• There has been, however, some success in niche, sophisticated goods since the 1990s.
• The mining boom made conditions tougher for manufacturing, with increased competition from low-cost economies like China.
• Reliance on commodity exports has raised concerns, countered by optimism for China, India, and other developing economies' growth and therefore demand for energy and natural resources.
• There are concerns over over-reliance on China as a market, given their trade barriers imposed on Australian goods in recent years.
• Over-reliance on coal and gas exports could be problematic as global demand may fall as economies transition to low-carbon energy sources, and carbon tariffs could be imposed.
• Australia aims to diversify exports toward new minerals, energy sources, and services (demanded by the growing middle class in Asia).
• The Albanese Government launched the Future Made in Australia package, investing in critical minerals like lithium, hydrogen, and green metals needed for renewable energy technologies.
• Australia has a skilled workforce, with a strong export market in education, finance, insurance, and tourism.
• The composition of imports has shifted toward increased consumer goods and steady capital goods imports, shifting away from large-scale manufacturing in Australia, partly due to tariff reductions and local content changes.
• Total imports in 2023-24 were valued at $526 billion, with intermediate goods making up the largest portion.

Trends in Financial Flows - Debt and Equity

• Financial flows have increased much faster than trade flows as international businesses have bought Australian assets, and Australian companies have increased their overseas investments.
• Financial flows were less important during the 1950s-1970s economic boom due to fixed exchange rates and closed international capital markets.
• The end of the Bretton Woods system in the early 1970s caused exchange rates to float, and capital movement restrictions were removed which grew financial flows as international capital markets opened.
• Technological changes made moving finance easier.
• The level of foreign investment in Australia and Australian overseas investment has more than doubled since 2010 due to globalisation and deregulation.
• There are two kinds of investment: Direct investment (long-term and managerial), and portfolio investment (short-term, speculative)
• Before deregulation, most financial flows entered Australia in the form of direct investment because the government preferred it as it created jobs and increased technology.
• The proportion of Australia’s financial outflows that are portfolio has increased from 20% in 1991 to 42% in 2023.
• Portfolio investment into Australia grew faster than direct investment post-1980s deregulation due to floating of the Australian dollar and increased foreign investment.
• Investment has increased from the EU, steadied from the US, and decreased from the UK.
• Australian investment abroad grew at 8.2% annually over five years to 2023, with major Asian economy investments doubling in the last decade.
• Australia remains a net capital importer, with foreign investment consistently higher than Australian overseas investment due to historically low domestic savings.
• In 2023, $4.7 trillion of foreign investment was in Australia, while Australia invested $3.9 trillion abroad.

Australia's Balance of Payments

• The Balance of Payments records all transactions flowing in and out of an economy
• Inflows = Credits and Outflows = Debits
• The Current Account records transactions that are earnings and non-reversible, while the Capital and Financial Accounts record the net change in ownership of assets and liabilities, which are reversible.
• Australia maintained a current account surplus (CAS) from Q1 2020 - Q2 2022, historically a deficit (CAD)
• The Current Account includes the Balance on Goods & Services account (BOGS), the Net Primary Income Account (NPY), and the Net Secondary Income Account (NSY).
• The Capital Account includes Capital Transfers and the Acquisition/ Disposal of non-produced, non-financial assets.
• The Financial Account includes Portfolio Investment, Financial Derivatives, Reserve Assets, and Other Investments.
• Net Errors and Omissions account for measurement errors and unmeasured transactions, ensuring the total balance of payments always balances.

Links Between Key Balance of Payments Categories

• The Financial Account records initial investments, and the NPY records the returns on these investments.
• In the long term, a KFA surplus leads to a larger deficit on the NPY account as any foreign financial flow must have a return (debit).
  • International borrowing requires regular interest payments/servicing costs, recorded as debits on the NPY, and only the repayment of the principle is recorded in the FA.
  • Foreign investment requires returns on the equity investment, such as rent, dividends, or profits, which are debits on the NPY.
• Over time, a high level of KFA surpluses leads to a larger CAD because of servicing costs associated with increased foreign liabilities.
• In extreme cases, this may lead to a “debt trap” scenario where an economy borrows from overseas to pay the interest on its existing foreign debt.

Australia's Savings + Investment

• Australia has a low savings rate, leading to reliance on foreign capital inflows.
• Current Account deficits (CAD) result, and reforms are needed to boost domestic savings.

Factors Influencing BOGS

• Cyclical factors vary with the level of economic activity, while structural factors are underlying influences on the BOP.
• The domestic business cycle impacts the amount spent on imports, contributing to BOGS debit, while overseas economic growth improves BOGS due to increased export revenue.
• Movements in the exchange rate affect the international competitiveness of Australia’s exports and imports.
• The J-curve shows short and long term impacts on the value of the $AUD, and these long term effects only happen if demand for exports is more price elastic compared to demand for imports.
• The Terms of Trade (ToT) measures the price movements in an economy’s exports and imports.
• An improvement in the terms of trade means that the same volume of exports can buy more imports, while a decline means import prices are rising faster than export prices, worsening the BOGS.

Structural Factors

• Key issues include the narrow export base, lack of international competitiveness, capacity constraints, Australia’s high labour costs, and small population.
• Australia's limited competitiveness outside of natural resources, mining, and agriculture makes it vulnerable to commodity price changes.
• Low domestic manufacturing and a reliance on importing high-value goods contribute to the BOGS deficit.
• Australia's shift from comparative advantage, finite industry issues, and Dutch disease effects influence.
• Diversifying exports towards high-growth, high value-added sectors and increasing service exports can strengthen international competitiveness.
• Infrastructure for transport and information also impacts competitiveness.
• Poor infrastructure, skills shortages, and a savings-investment gap impact international competitiveness.

Factors Influencing NPY (Net Primary Income)

Cyclical Factors

• Increasing domestic economic growth encourages foreign investment, leading to more NPY debits, but the NPY is mainly driven by structural factors.
• The exchange rate influences the NPY account is through the “Valuation Effect”, where changes in the $AUD affect the $AUD value of debt denominated in foreign currencies.
• If the $AUD appreciates, the $AUD value of debt decreases, improving the NPY and CAD.
• Changes in interest rates also impact the NPY, for example higher foreign rates increase repayments, worsening NPY.

Structural Factors

• The savings-investment gap in Australia leads to overseas borrowing (debt) and selling ownership stakes (equity), increasing foreign liabilities and future servicing obligations.
• Reduced savings or increased government borrowing eats into national savings.
• Policies like increasing compulsory superannuation and reducing budget deficits can promote higher savings.

Consequences of a High CAD

• High CAD can lead to a growth of foreign liabilities, requiring lenders to lend or invest more in Australia.
• Increased servicing costs associated with foreign debt can result in a debt trap where borrowing covers interest payments.
• Volatile exchange rates erode consumer confidence, while capital flight can lead to an economic crisis.
• A high CAD constrains future economic growth, demanding the government accept higher unemployment and use contractionary economic policies.
• While globalisation has lessened concerns about Australia's CAD due to natural resource wealth, maintaining a diversified export base and managing foreign liabilities remain important.

Trends in Australia’s Terms of Trade (ToT)

• The ToT has shown strong growth in past 2 decades, with commodity prices fluctuating due to events like COVID-19 and the Russia-Ukraine war.
• Despite mining profits decreasing the NPY deficit, the CAD overall improved, resulting in a surplus starting 2019-2020.
• Reduced demand for commodities due to slow Chinese economic growth will likely influence the ToT.

Exchange Rates - Introduction

• Exchange rates are the relative price of one currency expressed in terms of another currency.
• Exchange rate movements can impact international competitiveness, trade flows, investment decisions, inflation and other factors in an economy.
• The Australian dollar ($AUD) is the 6th most traded globally, accounting for 6.4% of daily forex trades.
• 92% of $AUD traded in Australia is exchanged for US dollars.
• Australia’s forex market turnover averaged US$150 billion per day in April 2022.
• A country’s system/methods for determining the exchange rate for their currency include: Floating exchange rate systems (clean or dirty float), fixed-rate systems, or the flexible/adjustable peg system.
• Monetary unions, like the eurozone (20 EU members + 4 others), use a common currency - (Euro)

Australia's Floating Exchange Rate System

• A floating exchange rate occurs when the value of an economy’s currency is determined by the forces of demand and supply in foreign exchange markets.
• Australia switched from a managed flexible peg to a floating exchange rate system in December 1983, marking a significant structural change in the economy.
• International competitiveness is a measure of the ability of Australian producers to compete with overseas producers in both domestic and world markets.

Measurement of Relative Exchange Rates

• Australia has multiple exchange rates, one for each foreign currency involved in trade.
• Comparing $AUD to a single currency, like the US dollar, can be misleading due to unique factors affecting each currency.
• The Trade Weighted Index (TWI) measures the value of the $AUD against a basket of currencies from major trading partners (17) weighted according to their significance to Australia’s trade flows.
• TWI gives an indication of how the value of the $AUD is moving against other currencies in general.
• Each year, the Reserve Bank amends the measurement of the TWI based on the volumes of trade for the previous financial year.

Limitation of the TWI

• The TWI exchange rate measurement is weighted only based on volumes of trade regardless of the currency in which exports and imports are invoiced.
• Almost 90% of Australia’s merchandise exports and more than half of imports are priced in US dollars.
• As a result, the $AUD/$USD exchange rate is far more important than the weight it receives in the TWI calculation.

Summary of $AUD Trends

• AUD appreciation occurred during the 2000s, followed by a trend depreciation since 2011.
• From 2003, the $AUD appreciated due to rising commodity prices.
• In 2009, the GFC saw the $AUD fell sharply (lost 1/3 of its value against $USD), but recovered quickly, peaking at USD$1.10 in 2011.
• Mid-2010s: $AUD depreciated to a range of 70-80c $USD.
• During the COVID-19 pandemic, the $AUD briefly hit 55c $USD in March 2020, before recovering to 80 cents in early 2021.
• Commodity prices significantly influence the $AUD volatility as Australia is a major commodity exporter.
• Resource booms have seen commodity prices surge, increasing demand for Australian exports and speculative investment in the $AUD.
• Carry trade: When Australia’s cash rate is higher than other advanced economies, foreign investors are drawn to Australia, supporting the $AUD in the last 20 years.
• Long-term factors like economic growth, commodity prices, and investment returns impact the $AUD’s value.
• In recent years, short-term factors and global financial markets (including speculators) have had more influence on the $AUD’s value than long-term economic trends.

Factors Influencing Demand for the $AUD

• The size of foreign financial flows into Australia.
• Interest rates (Us VS overseas)- Higher A interest rates attract more foreign savings, increasing demand for $AUD.
• Availability of Investment opportunities- More business opportunities here (buy new or existing businesses) ↑demand for $AUD.
• Expectations of future $AUD movements- Speculation on the future appreciation of $AUD increases demand.
• Demand for Australian exports: Foreign buyers need to convert their currency into $AUD to purchase Australian goods.
• Changes in Commodity prices.
• Changes in the ToT: If Australia's export prices rise relative to the prices it pays for imports, this improves the country's economic position, making Australia more attractive for investment → increasing demand for $AUD.
• Competitiveness of domestic exporters.
• Changes in Global economic conditions: Recession or growth in trading partner economies affects export demand and $AUD value.
• Consumer preferences: Overseas consumer tastes can affect demand for Australian exports.

Factors Influencing the Supply for $AUD

• Level of Financial flows out of Australia: Australian investors buying foreign assets need to sell $AUD to purchase foreign currency.
• Interest rates (A vs others): Lower Australian interest rates make overseas investment more attractive, increasing the supply of $AUD.
• Availability of Investment opportunities overseas: More opportunities abroad for Australians to invest or start businesses increase the supply of $AUD.
• Speculators: If speculators expect the $AUD to depreciate, they will sell $AUD, ↑ its supply.
• Domestic demand for imports: Australian importers need to sell $AUD to buy foreign currencies to make import payments.
• The government can also influence the AUD level- In 2020, the RBA purchased bonds to increase liquidity and lower interest rates, which increased the supply of $AUD.

Floating Exchange Rate System

• A floating exchange rate allows market forces to determine currency value and acts as an "automatic stabiliser" - helps protect the economy from external booms or busts.
• During Australia's mining boom (mid-2000s to early 2010s), increased demand for Australian resources pushed commodity prices up, causing the $AUD to appreciate.
• The appreciation of the $AUD led to higher costs and reduced demand for non-mining industries.
• The currency's appreciation helped the economy reallocate resources (labor and capital) to the mining sector, reducing inflation and maintaining stable employment.

Changes in Exchange Rates - Appreciation/Depreciation

• Appreciation can be caused by: An increase in Australian interest rates or decrease in overseas interest rates / Improved investment opportunities in Australia or deterioration in foreign investment opportunities / A rise in commodity prices and an improvement in Australia’s terms of trade / An improvement in Australia’s international competitiveness / Lower inflation in Australia (high value of $ currency) / Increased demand for Australia’s exports (G + S) / Expectations of a currency appreciation based on forecasts of one of the above factors.
• Depreciation can be caused by: A decrease in Australian interest rates or increase in overseas interest rates / Deterioration in investment opportunities in Australia or improvement in foreign investment opportunities / A fall in commodity prices and a deterioration in Australia’s terms of trade / A deterioration in Australia’s international competitiveness / Higher inflation in Australia / Increased demand for imported goods and services / Expectations of a currency depreciation based on forecasts of one of the above factors

Determination of Exchange Rates Including Fixed, Flexible and Managed Rates

• Pegged: Fixed to a set currency and maintained at that rate for extended periods, having only the occasional small revaluations and devaluations.
• Crawling peg: More flexible than a ‘hard’ peg, allowing regular adjustments to the level of the exchange rate (e.g on a daily basis).
• Before Nov 1976: Fixed (AUD was pegged against UK, then US, then TWI, at different times)
• Nov 1976 - Dec 1983: Managed flexible peg.
• December 1983 - Australia adopted a floating exchange rate system.
• China moved from fixed → managed flexible peg (keep Renminbi value deviating more than 2% per day since 2014).

Types of Exchange Rate Systems

• Fixed Exchange Rate System: the government of RBA officially sets the exchange rate by buying and selling foreign currencies in exchange for $AUD.
• Managed Exchange Rate System: Similar to fixed, but the currency is ‘pegged’ or adjusted daily to variations in major trading partner’s currency.
• Flexible/floating Exchange Rate System: The value of a currency is determined by market forces (supply and demand).

Flexible/Floating Exchange Rate System

• Floating in 1983 under Paul Keating - important structural change for Australia - opened us up to global financial flows
• Australia switched to a flexible/floating exchange rate system to create a more efficient method for determining the value of the currency, create greater control over monetary policy, expose the economy to international competitive markets and cushion the economy from external shocks.
• This means there is no need to hold vast reserves of foreign currency, allows monetary policy to be used more for meeting domestic objectives and the economy can respond more effectively to world shocks

Managed Flexible Peg

• From 1976 to 1983, the RBA would ‘peg’ the value of the $AUD at 9am each day, and the currency would be traded at that price all day, allowing more flexibility than the fully fixed rate but still allowing the official rate to drift away from that which would exist under pure market forces.
• This was used by China since 2005 - the Crawling Peg system used to peg Renminbi to the movements of major trading partners where China was accused of keeping an artificially low exchange rate, upsetting other countries

Fixed Exchange Rate Systems

• Government or central bank officially sets the exchange rate for a period of time based on the value of another currency.
• This requires a large amount of foreign reserves of foreign currency or gold.
• An official and intended increase/decrease in the exchange rate is called revaluation/devaluation.
• Governments may want to keep the exchange rate artificially low to increase demand for exports.
• The other avenue open to the government would be to change the exchange rate “officially”, so that it was closer to the real market value. It would devalue the $AUD when it officially lowered the exchange rate and revalue the $AUD when it increased the exchange rate.
• Benefits of a Fixed Exchange Rate System: Certainty over value of currency/ Less volatility/ Certainty for foreign investors / Choosing a low exchange rate makes imports more internationally competitive / Helps control inflation

The Influence of the Reserve Bank of Australia on Exchange Rates

• While mainly market forces determine the exchange rate, the RBA may influence the value of the currency in the short term, though it cannot change the value of the Australian dollar in the long term.
• The RBA does this by using dirtying the floating + monetary policy intervention.

Dirtying the Float

• The RBA may decide to intervene in the foreign exchange market to step in to buy or sell the $AUD to stabilise the currency if the RBA feels that a large short-term change in the exchange rate will be harmful to the domestic economy.
• In order to curb a rapid depreciation of the currency, the RBA will buy A$, putting upward pressure on the exchange rate by increasing demand.
• The RBA last intervened significantly in the foreign exchange market in 2007–08 during the global financial crisis.
• The RBA’s ability to intervene through buying A$ is limited by the size of its foreign currency holdings.
• The RBA also uses monetary policy decisions to influence levels- if the RBA wants to curb a rapid depreciation, it may increase the demand for A$ by raising interest rates.

The Effects of Fluctuations in Exchange Rates on the Australian Economy

• Due to Australia’s open economy, the value of the exchange rate can change substantially in response to economic developments.
• BOP and under a floating exchange rate, the quantity of Australian dollars supplied must always equal the quantity of dollars demanded.
• If there is any disequilibrium on the balance of payments, it is only temporary and is automatically corrected by a movement in the exchange rate.
• Example of an exchange rate correction: If value of imports increased whilst exports remained unchanged → deterioration of the Current Account → Increase in supply of $AUD (importers sell more $AUD to buy foreign currency) → Depreciation of dollar → People can invest more with same amount of money → Positive balance of KFA
• If financial markets perceive a current account deficit as unsustainable they will be less willing to buy $AUD and the currency will devalue. However, if they maintain confidence in the economy they will be more willing to lend and the $AUD may appreciate even with a growing CAD.
• Central bank digital currency (CBDC): The RBA issues the Australian dollar as physical money and digital money (balances held by commercial banks), and explored a Central Bank Digital Currency (CBDC), but concluded its costs outweigh benefits. Globally, CBDCs are being explored to improve payment efficiency and digital access, with several countries already launching or testing them.

Effects of a Change in The Exchange Rate on Australia

• If financial markets perceive a current account deficit as unsustainable: They may be less willing to buy Australian assets leading to a decline in the value of the $AUD.
• What is the biggest influence on exchange rate movements? How financial markets unpredictably choose to react to changing economic indicators→ market sentiment changes → instability + volatility in forex market → herd mentality

Impacts of Appreciation and Depreciation on:

• Appreciation: Reduced export competitiveness leading to decreased export income and a deteriorating CAD. Imports become cheaper encouraging higher consumption.
• Depreciation:Increased export competitiveness leading to increased export income and improved CAD. Imports become more expensive encouraging less consumption and increased domestic production.