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HSC Economics, Topic 3: Economic Issues, Part Four External stability Measurement Definition of external stability  External stability refers to the situation in which an economy is able to meet its international financial commitments. It is denoted by the degree to which an economy’s external accounts may be regarded as sustainable and is characterised by sustainability in the CAD, NFL and stability in the ER  Examples of external instability
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  HSC Economics, Topic 3: Economic Issues, Part Four External stability Measurement Definition of external stability    External stability refers to the situation in which an economy is able to meet its international financial commitments. It is denoted by the degree to which an economy’s external accounts may be regarded as sustainable and is characterised by sustainability in the CAD, NFL and stability in the ER    Examples of external instability o   $A lost 40% of its value against most currencies after it was floated in 1983    Decline in investor confidence in Aus assets o   CAD inflated to over -6% of GDP two times in the past decade (2004-05, 2007-08) o   Rapid increase in the size of net foreign debt    From 6% of GDP in early 1980’s to over 55% in recent yrs      Major aim of government economic policy o   Relatively high concern in 1980’s      Due to decline in investor confidence in the Australian economy o   Relatively low concern in 1990’s, 2000’s      No major impact on economic performance; sustainable economic growth, low inflation, falling UE, no major negative shift in investor confidence    CAD as a percentage of Gross Domestic Product The nature of the CAD    Aus has a deficit in the CA of the BoP o   This varies bw -4% and -6.2% of GDP o   This is largely influenced by the size of the net income deficit and the size of the net goods deficit    The goods balance is usually in deficit o   This declined bw 2000-02, 2004-05, 2006-07 due to mining boom o   This increase bw 2002-04 due to declining rural exports from drought    Net services is usually in surplus o   This occurred bw 2000-01 and 2007-08 due to rising value, size of travel, education exports    Aus always has a net income deficit o   This has accounted for the majority of the CAD since 1999    Net current transfers record small deficits, surpluses o   Little expenditure on aid, migrant funds, overseas pensions CAD as a percentage of GDP    The CAD may be measured as a percentage of GDP o   A measure of how sustainable the CAD is over time    The CAD is considered sustainable when: o   CAD as a % of GDP ≤ economic growth  as a % of GDP    Eg growth in servicing cost s of external liabilities ≤  growth in output    Australia’s CAD is unsustainable   o   CAD at a value of -6.2% of real GDP in 2007-08 o   EG at a value of 3.7% of real GDP in 2007-08    Calculation of CAD as a percentage of GDP o   CAD as a percentage of GDP = CAD/GDP x 100    Net foreign liabilities as a percentage of Gross Domestic Product The nature of net foreign liabilities    Net foreign liabilities refer to the difference bw Australia’s foreign assets and Australia’s foreign lia bilities o   Where:    Foreign assets = debt + equity lending overseas    Foreign liabilities = debt + equity borrowing from overseas o   Includes two components:    Net foreign debt (external debt)    Total stocks of loans owed by Australians to foreigners less total stock of loans owed by foreigners to Australians    NFD = debt (liabilities) - debt (assets)    Net foreign equity     Total value of assets in Australia in foreign ownership less total value of assets overseas that are owned by Australians    NFE = equity (liabilities) - equity (assets) Net foreign liabilities as a percentage of GDP    NFL may be measured as a percentage of GDP o   An indication of Australia’s total debt, equity servicing costs due to accumulated CADs      Calculation of NFL as a percentage of GDP o   NFL as a percentage of GDP = NFL (debt + equity)/GDP x 100    Net foreign debt as a percentage of Gross Domestic Product The nature of net foreign debt    Net foreign debt refers to the difference bw foreign debt assets and foreign debt liabilities o   Where:    Foreign debt assets = Australian debt lending overseas    Foreign debt liabilities = overseas debt lending to Australia Net foreign debt as a percentage of GDP    NFD may be measured as a percentage of GDP o   A measure of total debt to total output    Indicates degree of sustainability of debt    Calculation of NFD as a percentage of GDP o   NFD as a percentage of GDP = NFD/GDP x 100 Trends Overview of trends    Significant growth in magnitude of CAD o   -$5.5b or -4% GDP (1980-81) o   -$22.3b or -6% GDP (1989-90) o   -$68.2b or -6.2% GDP (2007-08)    Significant growth in magnitude of net foreign liabilities o   $18.2b or 13% GDP (1980-81) o   $170b or 46% GDP (1989-90) o   $692.1b or 62.5% GDP (2007-08)    Growth in Australia’s foreign assets (debt + equity lending overseas by Aus)      $229b (2000-01) to $1025b (2007-08) o   Growth in debt lending    $94b (2000-01) to $472b (2007-08) o   Growth in equity lending    $180b (2000-01) to $553b (2007-08)    Growth in Australia’s foreign liabilities (debt + equity borrowing from overseas)       $596b (2000-01) to $1718b (2007-08) o   Growth in debt borrowing    $303b (2000-01) to $1072b (2007-08) o   Growth in equity borrowing    $249b (2000-01) to $649b (2007-08)    Significant growth in magnitude of net foreign debt o   $6.8b or 6% GDP (1980-81) o   $117b or 33% GDP (1989-90) o   $599b or 54.2% GDP (2007-08)    Recent fall in value of $A o   Fall in value of $A relative to $US    $1.00US/$0.9786AUD (July 16 2008)    $1.00AUD/$0.6326USD (March 3 2008) o   Fall in value of TWI    74.0 (July 2008)    54.1 (March 2009) Causes of trends    Significant growth in magnitude of CAD o   Growth in net foreign debt    Increase in cost of interest payments    2.5% of export earnings in 1970’s to 20% of export earnings in 1989 -90 (peak)    Denoted as an Y debit in the net Y component of the CA    Increase in debt, increase in interest payments, increase in CAD, increase in debt, etc.    Significant growth in magnitude of net foreign liabilities o   Growth in net foreign debt    ‘Debt for equity swap’ of 1980’s      Period in which private firms preferred to borrow overseas rather than use equity borrowings o   Due to: low IRs, tax deductibility of interest payments    Growth in CAD    Increase in CAD, increase in debt, increase in interest payments, increase in CAD, etc. The Pitchford Thesis    States that the CAD is a result of the CFA surplus o   Surplus in CFA causes high servicing costs of interest, dividend payments overseas    Increase in magnitude of net Y deficit    Increase in magnitude of CAD o   Deficit in CA causes high level of foreign borrowing    Increase in magnitude of NFD    Increase in magnitude of CAD    CAD is not problematic o   Reflects strong D for Aus assets from overseas sources    Increase in GDP, Y, standard of living o   Foreign debt funds private investment projects    99% of NFD in 2008 was owed by the private sector Causes Causes of the CAD Theoretical causes of an increase in the magnitude of the CAD    The CAD has a cyclical component o   Due to BOGS    Experiences small surpluses, deficits of up to 2% GDP    BOGS is affected by short term cyclical factors (e g changes in global D for X, Aus D for M, Aus’ terms of trade )    When domestic ec grows faster than global ec, D for M grows faster than D for X    M spending rises more quickly than X spending o   Increased BOGS deficit    When domestic ec grows slower than global ec, D for M grows slower than D for X    X spending rises more quickly than M spending o   Reduced BOGS deficit    Background: consistent deficits on BOGS due to increase in ToT, domestic growth, commodities boom    Current situation: first surplus (mid 2008) since 2001-02    Due to improvements to ToT, reduction to D for M    Causes of the CAD relevant to BOGS    Aus has a narrow export base  o   68 % of Aus’ X are products of the primary sector      The value of these products tend to rise slower than value added products    Declining ToT o   Traditionally, value of Aus’ Ms tends to rise faster than value of Aus’ Xs   o   Excluding last few yrs (due to com boom), Aus’ ToT have been in decline for 60 yrs      Aus has to sell more X to pay for the same quantity of M    World protection o   Reduction to Aus’ agricultural X due to Japanese, US, EU protectionist policies      Aus’ lack of IC o   Inefficiency of manufacturing industries reduces quantity, value of potential X    Due to high level of protection, use of tariffs    Decline in global growth relative to domestic growth o   This reduces D for X, decline in ToT    Eg Asian currency crisis (1997-2000), US/Europe (2001-05)    Measures of overspending o   This increases M relative to X    Eg as occurred in the 1980’s (global domestic expenditure exceeded GDP)      The CAD has a structural component o   Due to net income deficit    Consistent deficits of around 3% of GDP    Recent rise to 4% of GDP    Reflects increased servicing costs of Aus’ debt, equity borrowings (total external liabilities)      Net income affected by structural factors (eg foreign liabilities, their servicing costs)    Background: net income has remained fairly constant since 1990s    Current situation: recent global increases to IRs will increase net income deficit    Causes of the CAD relevant to net income    Financial deregulation of the 1980’s   o   This made it easier for Aus banks to borrow from overseas    Budget deficits o   Increased amount of foreign borrowing due to budget deficits of the 1980’s - 90’s      Low savings ratio o   Aus does not save enough to provide for its own investment o   Aus level of savings has been in decline since 1970’s      Depreciation of $Aus o   Falls in $Aus increase the level of foreign debt    Eg as occurred following Keating’s Banana Republic Speech (20%)      Eg as occurred in 2001 (25%)    High level of inflation o   40% of Aus’ foreign debt is denoted in $Aus      Eg as occurred in 1980’s (8%)  Existing causes of an increase in the magnitude of the CAD    Factors that contributed to recent growth in the magnitude of the CAD o   Growth in net foreign debt in 1980’s      ‘ D ebt for equity swap’ of 1980’s      Characterised by preference of debt borrowings over equity borrowings    Increase in net Y deficit; increase in CAD o   Due to increase in debt, increase in servicing payments o   Growth of public sector borrowing requirement (PSBR) in early 1980’s, 1990’s      Increase in foreign borrowing by public trading enterprises    Increase in net Y deficit; increase in CAD o   Due to increase in debt, increase in servicing payments o   Decline in IC of exports in 1980’s      Low levels of productivity/efficiency, high inflation    Increase in BOGS deficit; increase in CAD o   Due to decrease in D for X, decrease in X Y o   Deterioration of Aus’ ToT in mid 1980’s, late 1990’s      Falling commodity prices, Asian financial crisis    Increase in BOGS deficit; increase in CAD o   Due to decrease in D for X, decrease in X Y o   Saving-investment and output-spending gap    Insufficient domestic savings to finance domestic investment    Reliance on foreign borrowing o   Increase in net Y deficit; increase in CAD    Insufficient output (GDP) to finance expenditure    Eg C + I + G > C + I + G + (X-M)    Reliance on foreign borrowing o   Increase in net Y deficit; increase in CAD
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