External Stability

External stability
● measurement
○ Current Account Deficit (CAD) as a percentage of Gross Domestic Product
○ net foreign debt as a percentage of Gross Domestic Product
○ net foreign liabilities as a percentage of Gross Domestic Product
○ terms of trade
○ exchange rate
○ international competitiveness
● trends
● positive and negative causes and effects

Policy responses and their effects in dealing with the economic objectives
● external stability

Past HSC questions

● External Stability is achieved when export income is sufficient to finance import
expenditure, service foreign liabilities and maintain the stability of the exchange rate

Measurement of External Stability

● The external stability of an economy can be measured through:

Indicator Notes Trend

This indicates how sustainable the Since the 1980’s the CAD has
size of debt repayments to the rest of grown at a faster rate than that
the world are. If the CAD increases of GDP. In 2019 Australia had
Current Account faster than GDP, the relative size of a CAS for the first time in 44
Deficit as a our repayments to the world will years indicating improving
percentage of GDP increase. external stability.

CAD 100
GDP Ratio = x
GDP 1

Net Foreign Debt This shows foreign debt assets
as a percentage of (Australian debt lending to overseas)
GDP minus foreign debt liabilities
(Australian debt borrowing from
overseas). This shows how
sustainable Australia’s debt
repayments to the rest of the world
are.
Over the past two years the
NFD as a percentage of GDP
has increased from 57.1% to
59.6% indicating worsening
external stability. This is still
lower than Australia’s peak of
63.8%
 Net Foreign Debt 100
Net Foreign Debt/GDP ratio = X
GDP 1

This shows the difference between Over the past two years the
Australia’s foreign assets (i.e. debt NFL as a percentage of GDP
and equity lending to overseas) and has decreased from 63.3% to
52.2% indicating improving
foreign liabilities (i.e. debt and
external stability.
equity borrowing from overseas.
Net Foreign This shows how sustainable
Liabilities as a Australia’s debt repayments to the
percentage of GDP rest of the world are.

Net Foreign Liabilities/GDP ratio =

Net Foreign Liabilities(debt+ equity) 100

X
GDP 1

This shows the growth of Australia’s Australia’s terms of trade

export prices relative to the growth
of import prices. An improvement in
the terms of trade would improve net
exports improving BOGS and the
Terms of Trade CAD. This shows how sustainable
Australia’s imports are.
have been improving since
2016. This indicates
improving external stability
and is the main reason behind
Australia’s Current Account
Surplus

Export Price Index 100

Terms of Trade = X
Import Price Index 1

This shows the value of the Australia’s dollar has been

Australian dollar. An appreciation
would improve Australia’s ability to
The Exchange repay debt through the valuation
Rate effect. Whilst an appreciation will in
the short run improve exports but
long run decrease exports through
the J Curve.
depreciating since 2018. In
the short run the depreciation
will worsen external stability
due to the valuation effect and
the J curve but in the long run
will improve external stability
due to the J curve.

This shows the competitiveness of The depreciating dollar has

Australian exports and imports from
overseas. International
competitiveness is impacted by the
International
exchange rate, inflation rate and
Competitiveness
microeconomic policies
seen an improvement in
competitiveness and increased
exports. Australia’s low
inflation has also improved
competitiveness. It has also
made foreign goods less
competitive improving
external stability.
 Trends

Table 10.2 shows the growth in the CAD, net foreign liabilities and net foreign debt between
1989-90 and 2018-19.

● Most indicators of external stability suggests an improvement in Australia’s external

stability.
o Australia has a Current Account Surplus- the first in 44 years. The
significance of this is argued by the Pitchford Thesis below.
o Net Foreign Liabilities as a percentage of GDP has declined over the previous
2 years
o Australia’s Terms of Trade has improved over the past 2 years
o The Australian Dollar has depreciated improving the international
competitiveness of domestic businesses and improving the value of exports in
the long term.

The Pitchford Thesis

● Economist John Pitchford, argued Australia’s CAD was the result of investment in the
Capital and Financial Account leading to an NPI deficit in the Current Account.
● He argued this was not an issue as long as the investment into the Capital and
Financial Account increased the productive capacity of the economy which increased
Australia’s net exports in the long term.
● As such the extent to which the Current Account Deficit should be used to determine
Australia’s external stability is questioned.
● Successive governments accepted this thesis which was known as the Pitchford
Thesis.
The causes of impacts on External Stability

● The persistent CAD can be attributed to a number of factors including:

○ Borrowing (both public and private) during the 1980s which worsened NPI.
 ○ Borrowing by the government to finance deficits in the 1980s and the 1990’s.
This is referred to as the Public Sector Borrowing Requirement which
worsened NPI.
○ High inflation and poor international competitiveness in the 1980’s lowered
the export income which worsened BOGS and the CAD.
○ An unfavourable movement in the Terms of Trade in the mid 1980’s and late
1990’s resulted in falling export incomes and rising import expenditure
increased the BOGS deficit and the CAD
○ The Savings/Investment gap (S-I gap) which meant that because investment
was higher than savings individuals, businesses and the government had to
borrow money worsening NPI and the CAD. This is referred to as the
structural reason for the CAD,
○ The spending/output gap which meant spending exceeded the level of
domestic production there is demand for imported goods worsening BOGS
and the CAD.
○ The lowering of protection led to increased import volumes worsening BOGS
and the CAD.
○ A slowdown in the global economy during the Asian Financial Crisis and GFC
led to exports decreasing BOGS and the CAD.
○ The depreciation of the AUD increased servicing costs through the valuation
effect worsening the NPI and the CAD.
● Australia has had the first current account surplus in 44 years largely to an
improvement in the terms of trade leading to an improvement in BOGS and the
Current Account.
● The growth in the net foreign debt can be attributed to factors including::
○ Persistent CAD’s required financing through borrowings from overseas. This
is referred to as the CAD-NFD Cycle.

○ The shift from equity to debt borrowing during the 1980s led to private sector
debt this accounts for 60% of Australia’s debt.
○ The outflow of equity investment from Australia to overseas was financed by
debt borrowing.
▪ The Savings-Investment gap led to reliance on foreign saving to
finance domestic investment.
 ○ Federal Budget deficits in the 1980’s and 1990’s led to an increase in public
sector debt

The Effects of the CAD and Net Foreign Debt

● The economic effects of the Australia’s CAD include:

○ Persistent CAD’s increase servicing costs on loans increasing NPI and CAD.
○ A persistent CAD increases Australia’s exposure to external shocks
○ Australia is more susceptible to exchange rate fluctuations, such as the
valuation effect on debt which increases debt servicing costs.
○ Depreciation caused by running a persistent CAD will increase the cost of
imports causing imported inflation.
○ Exposure to a high level of debt can lead to a downgrading of Australia’s
credit rating making future borrowing more expensive. This occurred in the
late 1980’s. The shift to equity borrowing has addressed this issue.
○ Tighter monetary policy may be needed to slow down the growth of imports to
improve BOGS and the CAD.
○ Tighter fiscal policy may be needed to raise the level of national savings to
decrease the level of public debt to improve NPI and the CAD.

Policies to reduce the CAD

● The Australian government has used a number of policies to reduce the CAD
including:
○ Monetary Policy which aims to keep inflation within the target band of 2%-
3%. This improves international competitiveness, BOGS and the CAD.
▪ Contractionary Monetary Policy can be used to reduce imports and
improve BOGS and the CAD.
○ Fiscal policy has been used to raise national savings and decrease the demand
for foreign lending allowing Australian businesses to borrow from domestic
sources like the government. This is referred to as the Twin Deficits
Argument. This would improve the NPI and CAD.
▪ The Hawke government introduced the Superannuation Guarantee
Levy in 1991 to increase national savings
▪ The Howard government returned the budget to surplus and privatised
PTE’s like Telstra. They also implement measures to increase savings
like tax incentives.
○ Microeconomic Policies raised productivity improving Australia’s
international competitiveness, BOGS and CAD. Examples include:
 ▪ Industrial Relations policy to link improvements in productivity to
higher wages. For example the Work Choices legislation.
▪ Reforms to reduce the costs of inputs in the electricity, transport,
water, gas and telecommunications industries improving international
competitiveness. This increased exports, BOGS and the CAD.
▪ Cuts to protection increasing international competitiveness, exports
which improves BOGS and the CAD.
▪ The National Competition Policy (NCP) improving productivity,
international competitiveness which improves BOGS and CAD.

Q16 2012 A

Q14 2011 D