Jeremy Green

HSC Economics

LKB

Explain the causes of Australias current account deficit and

analyse the impact of a persistent current account deficit on the
Australian economy
The current account is a record of all non-reversible transactions of
imports and exports of goods and services, income flows and non-market
transfers for a period of one year. It is comprised of net primary income
(NPY), the balance on goods and services (BOGS) and the net secondary
income (NSY) accounts. Australia has had a persistent current account
deficit (CAD) recording a deficit of -10139 AUD Million in the fourth quarter
of 2013. Due to a myriad of cyclical factors in the BOGS such as
Australias exchange rate and terms of trade, as well as structural factors
comprising Australias narrow export base, capacity constraints and
international competitiveness; the causes of a persistent CAD on the
Australian economy are exemplified. On the net primary income account,
cyclical factors such as interest payments, global interest rates and the
domestic business cycle, as well as Australias overarching structural
factor, its savings and investment gap, are also critical when analysing the
causes and impacts of a persistent CAD on the Australian economy.
The BOGS is the amount that is derived by adding net goods and net
services together. In trend terms, the BOGS were a surplus of $1,229m in
February 2014, an increase of $308m (33%) on the surplus in January
2014. Australias exchange rate is a major cyclical factor that has
inherently impacted upon the economy and has been one of the causes of
Australias CAD. The Exchange rate is the bilateral value of one currency
in terms of another. The AUD reached parity with the US dollar in
November 2010, and was as high as $US1.11 in July 2011 its highest
level since floating the dollar in 1983. This markedly worsened the
international competitiveness of Australias non-mining exports whilst
encouraged consumers to increase their purchase of imports. The
phenomenon known as the Dutch disease driven by the mining boom
has been a major factor in the over-valued exchange rate of the Australian
dollar. A depreciation decreases the foreign currency price of AUS exports
(decreased to 93.80 Index Points in the fourth quarter of 2013 from 94.30
Index Points in the third quarter of 2013), increasing the international
competitiveness of Australian exports on world markets. A depreciation
also increases the $A price of imports and discourages consumers from
purchasing imports, also improving the BOGS account. In contrast, an
appreciation normally worsens Australia's international competitiveness,
decreasing demand for Australia's exports and increasing import
expenditure as consumers switch to imported substitutes.

Jeremy Green

HSC Economics

LKB

Australia's terms of trade, illustrating the relationship between the prices

Australia receives for its exports and the prices it pays for its imports, are
inextricably linked to Australias current account deficit. If export prices
are increasing relative to import prices, then Australia's terms of trade will
improve. If import prices are rising relative to export prices then
Australia's terms of trade will deteriorate. Since the beginning of the
global commodity boom in 2003, Australia experienced a doubling in its
terms of trade (increased to 88.10 Index Points in the fourth quarter of
2013 from 87.50 Index Points in the third quarter of 2013). However by
early 2013 the terms of trade had fallen by 17% from those peaks, with
the Treasury forecasting a further 5.75% slowdown in 2013-14 and 3.75%
slowdown in 2014-2015, reflecting the slowdown in the mining boom.
Normally, a higher term of trade means that exports receive higher prices
for the same output, increasing export revenue and improving BOGS.
However, because a higher terms of trade reflects an increase for
Australian exports, the demand for the $A rises, causing an appreciation
of the exchange rate.
Australias narrow export base and capacity constraints are overarching
structural factors that have significantly contributed to Australias CAD.
Australia has a narrow export base, in the sense that its exports are
heavily weighted towards primary commodities. Australias comparative
advantage lies in low value-added products such as minerals and
agriculture, which together account for two thirds (8/10 of our principle
exports are primary goods) of Australia's export earnings. Australia does
export some ETMs and while there has been an encouraging 10.2%
growth in these types of exports in the last decade, they are a relatively
small percentage of total exports compared to other developed countries.
The global commodities boom has led to significant improvements in
Australia's terms of trade and major growth in export revenues. Despite
the positive aspects of the global commodities boom, Australias capacity
constraints due to inefficient road and rail networks (transport
bottlenecks) and skills shortages on Australia's mineral exports. During
the 2000s, despite high levels of global commodity prices, Australia
managed to increase export volumes by only 3% per year on average. By
contrast, import volumes consistently grew at 8% per year. Shortages of
skilled labour have also pushed up wages, adding to business costs and
impeding growth in exports.
The net primary income account is a reflection of Australias net servicing
costs owed to overseas. The NPY account tends to record a deficit of 3-4%
of GDP. In 2012-13 it was equal to a deficit of 2.4% of GDP, down from
2.9% in 2011-12. The largest factor affecting the primary income deficit is
the overall performance of the domestic business cycle through its

Jeremy Green

HSC Economics

LKB

influence on equity servicing costs. Equity (ownership of assets), enables

the owner a share of profits from that asset. When the domestic economy
experiences strong growth, domestic company profits rise, and these
profits are redistributed to shareholders and dividends. Australias primary
industries, the mining and service industries, with a combined weighting
of 74% of Australias total exports ($300 billion) in 2012 (accounting for
21% of GDP in 2012) are mostly foreign owned (83%). This is a major
cyclical factor affecting the size of the NPY deficit in recent years,
evidenced by Australias economic growth rate fluctuating between 0.6%
of GDP in 2012 and 0.8% of GDP in 2014.
Australias savings and investment gap is intrinsic to its ongoing NPY
deficit and is one of the overarching structural factors that have
perpetually affected the Australian economy. The savings and investment
gap revolves around the problem that Australia is a relatively small
economy with a historically low level of national savings reflected in the
household savings ratio, averaging 3.6% in the last decade. This means
that Australia tends to fund a large part of its investment through
international borrowing (which increases foreign debt) or selling ownership
in Australian assets (which increases foreign equity). This increases
Australias net foreign liabilities (increased $34.3b to a liability position of
$852.9b in the first quarter of 2014) and creates further servicing
obligations in the form of interest repayments (on debt) and dividends (on
equity). Investment also declined as a share of GDP from around 2008
following the global financial crisis. The increase in saving and decline in
investment saw the current account deficit narrow to around 2.25 per cent
of GDP in 2011 from an average of 4.25 per cent of GDP over the previous
two decades. Its clear that Australias savings and investment gap is
inherently linked to its NPY deficit and current account deficit (-$35.9 B)
that has remained constant over the past three decades.
A persistent current account deficit can have widespread effects on the
Australian economy, particularly seen through increased volatility of
exchange rates and investor confidence. A high CAD may undermine the
overseas investor confidence in the Australian economy and by reducing
demand for Australias currency, may result in a depreciation of the AUD.
With $US192 billion worth of foreign exchange transactions occurring in
the Australian market every day, it is clear that movements in the AUD
will invariably affect the Australian economy. In the short term, an
appreciation will decrease import prices without shifting the AUD price of
exports, resulting in an improvement in the BOGS and CAD. Conversely, in
the long term, a high AUD (currently sitting at $US0.92, 73 on the TWI) will
moderate export volumes due to reduced international competitiveness,
and experience an increase in import volumes as they are cheaper than

Jeremy Green

HSC Economics

LKB

domestic substitutes. This will in turn cause deterioration in the BOGS and
CAD in the long term. The inelasticity of demand for Australian resources
exports from China has systematically improved the BOGS and CAD, with
the BOGS in balance and a CAD of 10139 AUD Million in the fourth quarter
of 2013. The valuation effect also reduces Australias amount of foreign
debt, but to a lesser extent, as 90% of foreign liabilities are either evaded
or denominated in the AUD.
It is clear that there are several causes of Australias current account
deficit, all having varying influences. Australias persistent current account
deficit has had widespread impacts, both positive and negative, all
invariably affecting the performance of the Australian economy.