Constraints of persistent current account deficit on the Australian Economy

[green-jake]

handed in practice response to this question but my teacher wasn't happy with it. What are some major constraints of a persistent CAD?

[Essej]

Hey Jake!

I assume you're studying topic 2: Australia's Place in the Global Economy. Also,keep your head up, as long as you know your content any short answer/response question in this topic is a breeze!

A persistent CAD has numerous detrimental effects on the Australian economy, ranging from its impact on external stability (ability to repay foreign debt, leading to a debt sustainability crisis/cycle) to lower overall living standards (as the government must fund servicing on overseas loans rather than the welfare of its own citizens). A persistent CAD may also result in continued depreciation of the exchange rate (another syllabus point in this topic) due to a decline in exports and subsequent deficit on the BOGS. This is an example from one of my essays, including an example. These examples are essential if you want to access the higher bands in economics !

"In Australia for example, the manufacturing industry, once encompassing a large proportion of export income, now lacks efficiency in comparison to the emerging Asian economies of China and Japan. Owing to this, it often experiences a deficit in the net goods and net services balance on the current account, leading to a deficit. Because of this declining demand for exports in Australia’s secondary industries, the dollar in turn depreciates as economies worldwide demand less of these goods, leading to a drop in the value of the $AUD."

[Happy Physics Land]

Hey Jake!

I assume you're studying topic 2: Australia's Place in the Global Economy. Also,keep your head up, as long as you know your content any short answer/response question in this topic is a breeze!

A persistent CAD has numerous detrimental effects on the Australian economy, ranging from its impact on external stability (ability to repay foreign debt, leading to a debt sustainability crisis/cycle) to lower overall living standards (as the government must fund servicing on overseas loans rather than the welfare of its own citizens). A persistent CAD may also result in continued depreciation of the exchange rate (another syllabus point in this topic) due to a decline in exports and subsequent deficit on the BOGS. This is an example from one of my essays, including an example. These examples are essential if you want to access the higher bands in economics !

"In Australia for example, the manufacturing industry, once encompassing a large proportion of export income, now lacks efficiency in comparison to the emerging Asian economies of China and Japan. Owing to this, it often experiences a deficit in the net goods and net services balance on the current account, leading to a deficit. Because of this declining demand for exports in Australia’s secondary industries, the dollar in turn depreciates as economies worldwide demand less of these goods, leading to a drop in the value of the $AUD."

Wow do I see a potential Atarnotes Economics Lecturer right here??

[brontem]

Hey! I got a very similar question (in a short answer however) in my last exam so I may as well throw in my 2 cents worth

Effects of a high CAD on the Australian economy:
○ More reliance on overseas investment - becomes unsustainable to repay. Foreign debt may be solved by servicing it with overseas investment --> more outflows on the NPY account --> high/worsening CAD
○ The above can reduce the credit rating from AAA
○ May suddenly deter FDI, investor confidence & speculation as returns are no longer guaranteed --> worsen the CAD/induce economic crisis' (1997 Asian crisis, 2002 Argentina)
○ Higher CAD means the adoption of contractionary macroeconomic policies --> deter consumer spending and confidence --> low economic growth in the short run
○ More volatile exchange rates - high CAD can reduce investor confidence --> reducing the demand for the AUD --> resulting in a depreciation (a depreciation can also mean the value of foreign debt can increase)
○ The balance of payments constraint - a bit like a speed limit; the extent which the economy's ability to grow is constrained by the need to keep the CAD sustainable (as higher eco growth means more imports, bigger outflows, which worsens the CAD)

overall, Australia's persistently high CAD isn't a problem, as Australia invests in income returning assets, and the generated income does not facilitate the debt trap

They are a bit brief but I hope they make sense with all the arrow --> nonsense

[Empathy]

Hey Jake!

I assume you're studying topic 2: Australia's Place in the Global Economy. Also,keep your head up, as long as you know your content any short answer/response question in this topic is a breeze!

A persistent CAD has numerous detrimental effects on the Australian economy, ranging from its impact on external stability (ability to repay foreign debt, leading to a debt sustainability crisis/cycle) to lower overall living standards (as the government must fund servicing on overseas loans rather than the welfare of its own citizens). A persistent CAD may also result in continued depreciation of the exchange rate (another syllabus point in this topic) due to a decline in exports and subsequent deficit on the BOGS. This is an example from one of my essays, including an example. These examples are essential if you want to access the higher bands in economics !

"In Australia for example, the manufacturing industry, once encompassing a large proportion of export income, now lacks efficiency in comparison to the emerging Asian economies of China and Japan. Owing to this, it often experiences a deficit in the net goods and net services balance on the current account, leading to a deficit. Because of this declining demand for exports in Australia’s secondary industries, the dollar in turn depreciates as economies worldwide demand less of these goods, leading to a drop in the value of the $AUD."

I feel like the decline in exports point is a bit iffy, because that's not (theoretically) something that may always happen. Then again if it's in reference to a particular example that proves that this has happened it would work.

Another negative effect of a high/persistent CAD:
-As the Current Account represents all of the non-reversible transactions of the Australian Economy with the rest of the world, a persistent CAD is essentially a constant non-reversible leakage of funds out of the Australian Economy, which can constrain/reduce future economic growth.
-

[Essej]

I feel like the decline in exports point is a bit iffy, because that's not (theoretically) something that may always happen. Then again if it's in reference to a particular example that proves that this has happened it would work.

Another negative effect of a high/persistent CAD:
-As the Current Account represents all of the non-reversible transactions of the Australian Economy with the rest of the world, a persistent CAD is essentially a constant non-reversible leakage of funds out of the Australian Economy, which can constrain/reduce future economic growth.
-

My apologies Empathy!

I can see how what i mentioned is unclear. A decline in exports results in a decline of the CAD, but not vice-versa. However it can reduce Australia's terms of trade and favourability as a trading partner due to a lower credit rating (because it has to pay off its debt to foreign entities!)

The decline in exports example (BOGS->CAD) is an easy one to show cause/effect in an exam situation, as is the ensuing depreciation of the $A from a reduction in demand - once more due to a reluctance to trade with/invest in Australian industries.

[Spencerr]

could you please clarify the link between the decline in exports and terms of trade? from my own knowledge, the value of exports is equal to the quantity of the exports multiplied by the price of the exports and only the price of exports is linked to ToT

[Essej]

could you please clarify the link between the decline in exports and terms of trade? from my own knowledge, the value of exports is equal to the quantity of the exports multiplied by the price of the exports and only the price of exports is linked to ToT

Hi di! You are very right in that ToT takes the average price of exports as compared to imports.

Although not directly applicable to terms of trade, a decline in exports would result in lower international competitiveness and thus Australia's export markets would generally lower their prices in order to compete with more efficient overseas markets. We know from year 11 and the law of demand that as demand decreases (quantity) price also decreases (the numerator on ToT). Therefore there is a link, however it would be easier to use say inflation or exchange rate fluctuations as they have a more direct impact on the ToT.
If you're looking for an example, iron ore's price has almost halved in the past year or so as China's growth rates have levelled out. They demand less, therefore our export prices drop as we are no longer exporting the high level of commodities we were during the resources boom in the 2000's.

Sorry if anything was unclear!

[brontem]

Therefore there is a link, however it would be easier to use say inflation or exchange rate fluctuations as they have a more direct impact on the ToT.

Even easier to say "changes in global demand" - it works to say the price change to increase competitiveness but to avoid confusion I'd stay away from mentioning X volumes as the TOT is explicitly about prices, not quantities 

[Spencerr]

Hey Essej, thanks for clearing it up a bit but now I'm struggling to see the link between "a decline in exports and lower international competitiveness".  I thought the causation was the other way around.

[Essej]

Hey Essej, thanks for clearing it up a bit but now I'm struggling to see the link between "a decline in exports and lower international competitiveness".  I thought the causation was the other way around.

My gosh i'm really sorry - my original post was literally 5 minutes after i'd learnt the content myself - i've really dug myself into a hole here  but i'll do my best to help out!

International competitiveness is a pretty broad term - you can measure it through exchange rate, real labour costs etc.

So therefore they can be interchangeable e.g. an increase in $A due to increased demand for commodity prices (driving exchange rate up) may reduce demand for say agricultural goods - who would want to invest in $A to buy wheat when it's trading $1.20 to the $1USD when they can get it cheaply in the subsidised EU markets? You're totally right in that instance.

My line of thinking relates more so to domestic rather than international factors - namely a rise in real wage costs. If our real wages are rising faster than the rest of the world, then we have less allocative efficiency in that we are spending more on labour than on inputs (compared to the rest of the world). Therefore our exports would decline in comparison to say China's (who have a weak af industrial framework) as they are producing with lower cost inputs at a higher quantity of outputs and therefore Australia really doesn't have much to contribute in the hypothetical industry. We are now less internationally competitive than China! Yay!

Remember, as long as you can back your thinking up in economic theory, you should be fine 
Really sorry once again, I know it sounds confusing !

[Spencerr]

Yup that clears alot up.
Just another question to encourage further discussion you mentioned:
"If our real wages are rising faster than the rest of the world, then we have less allocative efficiency in that we are spending more on labour than on inputs (compared to the rest of the world)"
Would this only hurt allocative efficiency (which i define as the ability of the price mechanism to accurately reflect the marginal cost of a product) if productivity wasn't increasing as fast. What if perhaps real wages were rising faster than the rest of the world due to productivity increase (now that wage rises are linked with productivity due to decentralisation), will it still hurt allocative efficiency?

[Essej]

Yup that clears alot up.
Just another question to encourage further discussion you mentioned:
"If our real wages are rising faster than the rest of the world, then we have less allocative efficiency in that we are spending more on labour than on inputs (compared to the rest of the world)"
Would this only hurt allocative efficiency (which i define as the ability of the price mechanism to accurately reflect the marginal cost of a product) if productivity wasn't increasing as fast. What if perhaps real wages were rising faster than the rest of the world due to productivity increase (now that wage rises are linked with productivity due to decentralisation), will it still hurt allocative efficiency?

You make a really good point!

The real wage argument for international competitiveness does hinge on the premise that real wages are not matched with a sufficient increase in productivity. This is the case in many of Australia's export industries (manufacturing for one) due to the decentralisation of wages and general inefficiency of the industry - in our industrial climate (see Fair Work Act 2009) awards are actually not allowed to be renegotiated to leave the worker worse off than before! The harsh reality is that productivity will more than likely be matched by the (let's just call it an emerging country like japan) economy in question without the subsequent rise in real wage rates - Allocative efficiency in regards to inputs is simply better - and no amount of protection will change this structural flaw in our economy.

This is really good discussion!

[olivercutbill]

Hello-

-Downgrade of credit rating from AAA (budget not returning to deficit until 2020/21 (gittins warns of the credibility of these ratings post-2008/09)
-Debt sustainability issues, investor confidence reduced, possibly leading to capital flight - AFC 1997
-Resources have to be allocated to servicing increasing NFL - thus placing a BOP constraint on the economy
-A possible debt trap scenario

However, the CAD may not be an issue:

-Economists argue that CADs are just sine qua non of growing economies
-Australia has experienced 99 quarters of economic growth -- the last recession was 1991
-The Pitchford Consenting Adult thesis (the government does not always subscribe to this, such as during the GFC when it made a blanket guarantee on deposits in Australian banks, saving the exchange rate and avoiding capital flight)