HSC Topic 2 - Australia's Place in the Global Economy PDF

Balance of Payments: Structure of the Current Account Balance of payments The balance of payments is a record of monetary transactions between Australia and the rest of the world. -Shows the trade and financial flows in and out of the Australian economy. Current account (CA) Capital and financial ac...

Balance of Payments: Structure of the Current Account Balance of payments The balance of payments is a record of monetary transactions between Australia and the rest of the world. -Shows the trade and financial flows in and out of the Australian economy. Current account (CA) Capital and financial account (KAFA) E.g. Selling a pen and receiving credit in the account. -This is a CREDIT (inflow) to the account. It increases the account balance. -The buyer is the DEBIT (outflow) from the buyer's account. It decreases the account balance. Current Account Capital and financial account Is a record measured in dollar terms of the Records the borrowing, lending, sales and flow of goods, services, Primary Incomes and purchases of assets between Australia and Secondary Incomes into and out of Australia the rest of the world over a period of time -(What appears on this account is reversible) -Record of SPECIFIC transactions -The part of the balance of payments that shows the receipts and payments for trade in goods and services, transfer payments and income flows between Australia and the rest of the world in a given time period. -(What appears on this account is irreversible) The Current Account 4 sections: 1. The Goods Account 2. The Services Account 3. The Primary Incomes Account (Formerly Incomes account) 4. The Secondary Incomes account (Formerly Transfers account) The money flows from all exports and imports of goods and services, income flows(Primary Incomes) and non-market transfers(Secondary Incomes) for a period of one year. All money that flows in appears as a CREDIT, and all money that flows out appears as a DEBIT. Components Goods (tangible)- difference between what Australia receives for export (X) and pays for imports (M). Services (intangible) - Services bought/ sold without people receiving a physical good. E.g. Education, tourism. Balance on goods and services (BoGS) = net goods + net services Primary income - Earnings on investments (dividends, rent , interest, profit) (DRIP) Secondary income - Small / technical component -Non-market transfers (Pensions, unconditional foreign aid, remittances - foreign workers sending money home) Balance on current account (CA) = BoGS + NPY (net primary income) + NSY (net secondary income) Services -Has income for services minus payments for overseas services. -Australia used to have a large deficit on services but has moved towards a balance due to the lower Australian dollar, increase in tourism and income from international students and computer information services. The Capital and Financial Account (KAFA) Records the borrowing, lending, sales and purchases of assets between Australia and the rest of the world. 2 sections: 1. The Capital Account 2. The Financial Account Capital account -Consist with financial assets and liabilities that flow into and out of Australia. -The KAFA includes money flows relating to international borrowing, lending and the purchase of assets. -These transactions are reversible (unlike current accounts). So an investor can withdraw their money from an investment project. Capital account includes: -Capital transfers (Conditional foreign aid, debt forgiveness) -Non-produced, non-financial assets (Intelligible properties, patents, copyrights, franchises, trade markets) Financial accounts -Shows Australian transactions in foreign assets and liabilities. Includes: -Direct investment → FDI or new businesses Ownership > 10% -Portfolio investment → small stakes in existing businesses -Financial derivatives: Complex financial assets -assets based on performance of other assets -Other investment: loans, trade credits -Reserve assets: net transactions of RBA Net errors and omissions -Balancing item -Deals with statistical variations due to exchange rates Equation of balance of payment BOP = CAD + Capital and financial account surplus = 0 Australia’s current account is generally in a deficit and the Capital and financial account which has to be a surplus to finance and balance the current account. External stability External stability is an aim of government policy that seeks to promote sustainability on the external accounts so that Australia can service foreign liabilities in the medium to long run and avoid currency volatility. -Ensuring Australia can meet its financial obligations to the rest of the world. (foreign debt, foreign equity) -Repay interest on foreign debt/ reward investors for foreign equity -If Australia achieves external stability, people stay confident in the Australian economy and would not sell the Australian currency. Different measures of external stability -Current Account Deficit (CAD) as a percentage of GDP -Net Foreign Debt as a percentage of GDP -Net Foreign Liabilities as a percentage of GDP -Terms of Trade (ToT) -Exchange Rate -International Competitiveness 3 components -Current account deficit (CAD) as a percentage of GDP -Net foreign liabilities (foreign debt/ foreign equity) (FD/FE) -Volatility of the currency The value of the currency effects exports and imports - Balance of goods and services (BoGS) and net primary income (NPY) How does Current account deficit (CAD) link to external stability? -Australia has a persistent CAD -This means Australia experiences OUTFLOWS (Debit) that exceed INFLOWS (credit) on the balance of payments. Can this be negative for external stability? (Is the CAD sustainable? Can all those funds -debt- be repaid? Will this create economic problems? (reduced government spending in other areas to repay the debt) -Can this also be positive? Perspective one: Australia’s CAD can worsen Australia’s external stability -Australia’s CAD can lock Australia into a debt cycle/debt trap CAD can worsen external stability in two ways: 1.Trade deficit -Exports are lower relative to imports -BoGS deficit/worsen BOGS deficit -These cause an increase in CAD and create/worsen the debt cycle 2.Savings investment gap -Australia has a saving investment gap -Saving rate decline → increase need in capital inflows -increase in capital inflow → increase in NPY of outflows → increase in CAD Perspective two: Australia’s CAD is a positive development Pitchford’s thesis/consenting adults thesis (Lawson Doctrine in the UK) -Private sector= adults *Adults know they are doing The idea: -CAD/foreign liabilities come mainly from the private sector (Not the govt) -The private sector is using foreign debt/equity to fund productive investment in the economy. -The private sector calculates cost and benefits, evaluate risks, before investing -THEY KNOW WHAT THEY ARE DOING -It is widely argued that the current account balance need not, and cannot, be an objective for macroeconomic policies. Nor is it seen by itself as a reliable indicator of vulnerabilities. Australia’s experience is particularly relevant in this as the size of the CAD alone is NOT a good measurement of external stability. (RBA) However, does the private sector ALWAYS KNOW what it’s doing? How does external stability link with the Australian dollar (exchange rate)? External stability is achieved when export income is sufficient to finance import expenditure (Australia earns enough from exports it can pay for its exports), the servicing cost of Australia's foreign liabilities are met and the rate is relatively stable over time. -The Australian dollar is the Australian economy’s link to the rest of the world. -Changes in the value of $A can significantly affect Australia’s external stability (and international competitiveness) -These include: exports, primary income outflow, foreign debt, capital inflows -The value of $A fluctuates A LOT The floating $A helps Australia adjust to changes in the global economy Slow global growth: -Decline in global EG → decline in AUS export demand, decline in aggregate demand and economic growth in Australia. → decline in demand for the $A THEN: Increase competitiveness of Aus exports ($A is cheaper) → increase in export → increase in aggregate demand → increase in economic growth -Aus economy gets a boost from cheaper exports due to lower price of the $A. Rapid global growth: -Increase in global EG → increase in demand for Aus export (Aus export are “fuel for growth) → increase in demand for $A (for purchase of export) → appreciation THEN: Aus export becomes less competitive → export volume decrease → decline in AD/EG Increase of $A → reduces international competitiveness → reduces exports → worsens BoGS → worsen CAD Decrease of $A → increases international competitiveness → increase exports → improves BoGS → improves CAD The floating $A can have a positive and negative effect on external stability. -Large swings in the $A will affect key factors that influence external stability such as Australia’s international competitiveness, the size of foreign debt (in foreign currency) and the balance of payments. -Change in the $A → change value of Australia’s foreign debt, value of Australia’s NPY outflows A change in the exchange rate affects the balance of payments by affecting Australia’s international competitiveness and the size and servicing cost of our foreign debt. Therefore, if the value of the dollar is continually subject to change, two of the major indicators of Australia's external stability will also be volatile. How does the BoP balance under the floating exchange rate? What determines the supply and demand for the Australian dollar? Supply of $A (Outflows from BoP) Demand of $A (Inflows to BoP) -Determined by demand from import -Determined by demand from exports -Income debits -Income credits -Capital outflows (From AU→ overseas) -Capital inflows (from overseas → AU) Where does equilibrium occur under a floating exchange rate? In the balance of payments When Supply of $A = Demand of $A M + Y debits + K outflows = X + Y credit + K inflows (M-X) (BoGS deficit) + (Y debit - Y credit) (NPY and NSY deficit) = K inflows - K outflows (KAFA surplus) CAD=KAFA surplus → How BoP balances under a floating exchange rate. Trends in the size and composition of Australia’s Balance of Payments -International competitiveness -Terms of trade -International burrowing -Foreign investment International competitiveness Competitiveness is a measure of a country’s advantage or disadvantage in selling its products in international markets. Two influences of Australia’s international competitiveness are: -Changes in relative inflation rates -Value of the Australian dollar exchange rate Australia will become more internationally competitive when: -Domestic prices rise slower than its international competitors -Value of the Australian dollar falls relative to the currencies of its competitors. Terms of Trade The Terms of Trade is a ratio of export prices to import prices. If this index increases it implies that Australia is receiving relatively more for its exports. An increase in export prices relative to import implies that Australia is better off. International borrowing Concerns with foreign debt: -Interest payments are part of the Net Primary Income (Debit). ↑ CAD -May impact credit rating (↑ interest) -Interest on these loans may increase -Increase volatility to the international market Since 2013, the level of Australian investment in foreign equity has exceeded the level of foreign investment in Australia equity. This reflects the sizeable offshore equity investment of the Australian superannuation sector as well as foreign exchange valuations effects, with the depreciation of the Australian dollar since 2013. Foreign investment Foreign investment fills the gap between what Australia saves and invests every year. 2016 Foreign investment in Australia is $3,192 billion (52% portfolio, 25% direct, 16% other investment, and 7% financial derivatives) Australia’s Current Account Australia have been mostly been in a deficit (CAD) Cyclical and structural factors Cyclical factor (business cycle) Structural factor (i.e. permanent reasons) Trade business Net income Balance Commodity prices Level of low domestic saving Terms of Trade Interest repayments (Net income balance) on foreign investment Interest rates Exchange rate volatility How does the net primary income (NPY) account affect the CAD? One Key factor that affects the CAD is the balance on the net primary income (NPY) NPY changes based on cyclical and structural factors. Cyclical factors - changes due to economic cycles (varies on the level of EG) Structural factors - consistent due to structure / nature of an economy (Does not vary on EG) Cyclical factor that affect NPY 1.Value of the $A Value of $A affects $A value of foreign debt (valuation effect) Foreign debt is typically denominated in foreign currency. ↑ $A → reduce foreign denominated value of Au debt → reduce the size of $A outflows (interest repayments) Therefore, ↓ value of NPY outflows (value of FD in $A terms ↓) → ↓ NPY deficit → ↓ CAD 2. Changes in domestic and global interest rates Borrowing funds at the value of the global interest rate. ↑ Global IR → ↑ Value of interest repayments on that FD Therefore, ↑ Interest payment (increase in outflow)→ ↑ NPY outflows → ↑ NPY deficit → ↑ CAD This goes the opposite way for a decrease in interest rate. 3. Changes in the domestic business cycle (reflecting domestic economic growth) Most shares on ASX are foreign owned. If company profits ↑ → dividends ↑ → these will go to foreign shareholders (NPY debit) Therefore, ↑ Au EG → ↑ company profit → ↑ dividends to shareholders → ↑ value of dividend payment overseas → ↑ NPY debit →↑ NPY deficit → ↑ CAD Structural factors that affect NPY Saving investment gap Australia has low levels of savings and therefore does not have enough to fund its domestic investments. In order to fund its domestic investments, Australia must borrow from overseas or seek foreign equity. KAFA inflows → CA outflows Inflows of I → NPY outflows (dividend, rent, interest, profits) S-I gap → KAFA inflows →NPY outflows → ↑ NPY deficit → ↑ CAD How does the balance on goods and services (BoGS) affect the CAD? When the BOGS changes, then the value of the current account will change. The BOGS changes based on structural and cyclical factors. Cyclical factors (Changes based on EG) Movements in the exchange rate $A changes → affect X/M → BOGS → CAD E.g. ↑ $A (appreciation) X becomes more expensive (less internationally competitive) → ↓ D for X → M becomes cheaper → ↑ D for M XM improves BOGS → ↓ CAD (improves) Terms of trade Ratio of export prices to import prices (Prices NOT volumes) X price rising faster than M price → Shows relative rising D for Aus X → Likely improve BOGS → likely improve CAD Domestic economic growth ↑ Aus EG → ↑ Y for consumers → ↑ disposable Y → ↑ demand for M → X