Prepared By   : Chow Tai Wei, David

Student No. : 977438B

 

TABLE OF CONTENT

1. INTRODUCTION *

2. A FOREIGN DEBT CRISIS? *

3. PORTFOLIO BALANCE APPROACH TO EXTERNAL BALANCE *

Interests on Domestic and Foreign bond yields (I_d and I_f) *

Expected percentage change in the Value of Foreign Currency (xa) *

Home country's Real Income (Y_d) *

Home country Price Level (P_d) *

Home country Real Wealth (W_d) *

4. KEYNESIAN INCOME MODEL TO EXTERNAL BALANCE *

Government Budget Balance and CAD *

Did Private Debt Drove CAD? *

5. CONCLUSION *

LIST OF REFERENCES *

 

1.    INTRODUCTION

In recent years, there had been substantial debates on whether having a high level of foreign debt is a problem for Australia. These debates would usually centre on Australia's current account deficit (CAD) and low domestic savings rates (with respect to the GDP). This essay will first examine the relationship between the size of the current account balance and the amount of foreign debt, supported with data over recent years.

The second part of the essay will focus on the portfolio balance approach, and the Keynesian income model to identify factors that might affect the level of current account deficit in Australia. Data on these factors will be presented, and those deemed to have influenced the recent magnitude of Australia's current account balance would be examined in detail, including whether they indicate an aggravation of the current excessive foreign debt.

 

2.    A FOREIGN DEBT CRISIS?

 

Australia's foreign debt has increased sharply since the beginning of the 1980s and in net terms stands at $202 billion or around 45% of the GDP (as at Jun 1997). This worries many economists (and politicians like Paul Keating who made the 'banana republic' statement), notably Dr Fitzgerald, whose famous report in 1993 claimed that Australia faces economic disaster and the risk of plunging into a foreign debt crisis (Fitzgerald 1993). However, opinions vary on the extent to which this magnitude of foreign debt posses a problem to Australia. So, what contributed to the rise in foreign debt? The most important factor is the large and persistent deficits on its current account with the rest of the world (see Chart 2 overleaf). Since 1980, the CAD has not been much lower than 4% of GDP. This compares with an average deficit of 2¼% of GDP in the 1960s and 1970s (Fraser 1990a). So, does the CAD then pose a problem? Formal Governor of RBA, B.W. Fraser (1990b, pg. 9), argued that a young nation like Australia with limited savings but many investment opportunities, should "draw on overseas savings to exploit those opportunities". According to him, a current account deficit was seen as the normal state of affairs.

Before we examine the relationship between the size of the CAD and the magnitude of the foreign debt, let us look at its definition. According to Professor Pitchford (1989), the current account balance measures the excess of exports over imports of goods and services, plus net income from international transactions, which mainly consists of net receipts of interest and dividends from aboard. When the current account is in deficit, the agents in an economy are spending more than they earn, including net interest payments. Excess spending must then be financed either by borrowing or by running down assets (the change in foreign net assets is measured by the capital account). A CAD thus means an increase in the net level of foreign indebtedness by the private or public sector.

 



 

Chart 3 overleaf shows the slight correlation between CAD and the amount of foreign debt. This reaffirms the theory that the CAD being financed by external savings (also reflected as a capital surplus due to inflow of foreign funds into Australia) is the main cause for the escalating foreign debt.

 



 

Note also in Chart 3, that the CAD (as % of GDP) is usually higher when the economy grows strongly and falls when the economy slows.

From the point of view of the foreign debt, Clark (1997) identified four main factors that attributed to its dramatic rise:

1. The growth in demand for funds far outpaced growth in Australian savings, and overseas interest rates were lower than Australia's (see table 2);
2. Heavy borrowing by the Commonwealth and state governments (notably Queensland and WA) in the early 1980s, in response to an expected mineral boom;
3. Depreciation of the Australian dollar, which made debt servicing more expensive;
4. A dramatic upsurge in private sector borrowing.

These factors have also influenced the current size of the CAD.

 

3.    PORTFOLIO BALANCE APPROACH TO EXTERNAL BALANCE

According to Appleyard & Field (1998), the portfolio balance approach to the balance of payments (including current account balance) "extends the monetary approach" (which utilises the quantity theory of money where the demand for money is expressed as directly proportional to the nominal value of a country's national product) "to include other financial assets besides money" (pg. 505). The general framework of this approach is that there are:

1. two countries - a home country and a foreign country;
2. two currencies - domestic and foreign money;
3. two non-money securities - a home and a foreign bond.

Here we assume that home individual is able to hold any of the three assets: home money, home bond, and foreign bond, whose demands are designated as L, B_h and B_f respectively. Also, we assume imperfect substitution between domestic and foreign assets, where a risk premium (RP) is included, together with the expected appreciation of foreign currency (xa). Thus, the interest yield on domestic bond is given by:

I_d = I_f + xa - RP, where xa is calculated as

Using the general functional form presented in Branson & Henderson (1985), the demands for each form of asset are written as:

L = f( id, if, xa, Y_d, P_d, W_d )

Bd = h( id, if, xa, Y_d, P_d, W_d )

eBf = j( id, if, xa, Y_d, P_d, W_d )

The predicted sign of these 6 factors (the other 3 being home country real income, price level and real wealth, Y_d, P_d, and W_d respectively) are given below:

Table 1: Expected sign of the 6 factors related to the demand of each assets [Source: Appleyard & Field (1998)]

Using data compiled from various sources, we extract 5 factors (namely id, if, xa, Yd and Pd) proxied by the domestic 10 years' treasury bond yields, US 10 years' government security yields, the calculate xa, real gross domestic income, and CPI respectively, to analyse how the current trend influenced the size of Australia's current account balance.

Table 2: Proxied data on the 5 factors affecting the current account balance [Sources: RBA bulletin and ABS (Various issues)]

Interests on Domestic and Foreign bond yields (I_d and I_f)

First, we look at the first 2 factors - interest on domestic and foreign bond yields. We can see from Chart 4 that these 2 rates exhibit a downward trend over the years. According to the portfolio balance approach, a decrease in domestic bond rates will lead to an increase in the demand for foreign bonds (and a fall in demand for domestic bonds), and reverse consequences for falling foreign bond rates; while the demand for home currency increases in both cases. However, comparing the yields for both bonds, the domestic bonds seem to offer higher interest rates than their foreign counterparts. Thus, foreign investors will be attracted to buy domestic bonds and will lead to capital inflow (capital account surplus) and current account deficit for home country Australia.

Expected percentage change in the Value of Foreign Currency (xa)





 

xa is calculated using uncovered interest parity (a negative xa is an expected depreciation of the foreign currency and vice versa). Recently, the xa is falling, hitting -0.28% in 1997. This will, according to the portfolio balance approach, decreases the demand for foreign bonds in anticipation of the lower return when converted back to home currency at a later date (while the demand for domestic bonds soar). The demand for local currency also increases. This reduces the capital outflow while increases capital inflow (foreigners to buy domestic bonds). Thus, it has a negative effect on the current account balance.

 



 

Home country's Real Income (Y_d)

From Chart 4, we can see that the level of real income in Australia has risen over the years. Consequently, individuals' demand for money increases to facilitate the increased transactions. They may attempt to increase their money holdings by selling both domestic and foreign bonds which, because of capital inflow from the sales of foreign bonds, worsen the CAD.

Home country Price Level (P_d)

From Chart 6 again, we have a declining CPI in the recent years. This will cause opposite effects (on the level of demand for all three assets) to an increasing real income discussed above, which will see improvement done on the current account balance.

Home country Real Wealth (W_d)

As shown in Figure 1, the real wealth of the home country is positively related to all three classes of assets. This is because with increased wealth, home investors will want to hold more of all assets. However, without more information on the relative strength of the effects of increasing demand for these assets, we cannot determine the net effect of the capital account and current account.

We can thus summarising the trends of each individual factor with relation to the current account balance as below:

Table 3: Trends of the 6 factors related to effects on the Current Account balance

 

Thus, according to the portfolio balance approach, the falling foreign bonds yield rates, the expected depreciation of foreign currency (or an expected appreciation of home currency), and the increasing real income in Australia seems to have influence the recent size of Australia's CAD.

 

4. KEYNESIAN INCOME MODEL TO EXTERNAL BALANCE

According to the Keynesian income model, the national income or production (Y) consists of consumption demand by households (C), planned investment by firms (I), government spending on goods and services (G), exports (X) and imports (M) of goods and services. This relationship can be expressed as:

(1) Y= C + I + G +(X-M)

As the current account deficit (in Australian context) equals to imports of goods and services plus net income transfer to foreign residents (F) less exports, we can write:

(2) CAD = M + F - X

We can define the gross national expenditure (E) as:

3. E = C + I + G + F

The difference between total spending and total production in the economy is equal to the current account deficit:

4. E - Y = M + F - X = CAD

Also, the national income consists consumption, savings, taxes and net income paid to overseas, we have:

5. Y = C + S + T + F

Equating both equation (1) and (2):

(6) C + I + G +(X-M) = C + S + T + F

Rearranging, we have:

6. (I - S) + (G - T) = M + F - X = CAD

This shows that the current account deficit is equal to government sector balance (denoted by G - T) plus the private sector saving-investment gap. The government balance can be viewed as public savings. Therefore, the CAD is equal to the difference between total investment and total saving. When total investment is more than total savings (which is the case in Australia, which is often criticised for its low saving rate), the current account is in deficit. This saving-investment gap is shown in Chart 7 and 8 below.

Chart 7: National Saving and Investment in Australia [Source: ABS]

 

 

 

 

 

 

 

 

 

Chart 8: Saving-investment gap and the Current Account Deficit

 

 

 

 

 

 

 

 

Thus, the main factors that play a part in explaining Australia's CAD in the Keynesian income model are government budget balance, and the level of total saving verses total investment. When either of the components ran into deficit, it will have to be financed by public and private debt respectively.

Table 4 below is a compilation of figures on the government budget balance, and the level of public and private debt:

Table 4: Factors affecting the current account balance in a Keynesian income model [Sources: RBA bulletin and ABS (Various issues)]

Government Budget Balance and CAD

From Chart 9 below, it seems that the government budget balance is negatively correlated to the current account balance. However in times of budget surplus, Australia still runs a current account deficit. This can be interpreted that private (instead of public) debt drove a very much higher potion of the CAD.

 



 

Did Private Debt Drove CAD?



To examine this issue, we first look at the composition of the foreign debt. Chart 10 shows that the amount of private debt far exceeds the public debt in dollar term.

 



 

Looking as a percentage of GDP, we can see that the foreign debt consists of a large portion of private debt (about 70% in the last few years) and together, they accounted for about 45% of the GDP (where private debt alone took up slightly more than 30%). With this continued trend of huge foreign borrowing by the private sector, Australia may be said to have a long-term tendency towards current account deficits.

 

5. CONCLUSION

From both the portfolio balance approach and the Keynesian income model, we have identified the factors that might influence the level of the CAD. Judging from the recent trend of these factors, it seems that Australia is going to endure a long-term current account deficit, with adverse effects to the present level of foreign debt.

 

 LIST OF REFERENCES

Appleyard, D.R. and Field, A.J., (1998) International Economics, 3^rd ed., Irwin/McGraw-Hill, Boston.

Branson, W.H. and Henderson, D.W., (1985) "The Specification and Influence of Asset Markets", Handbook of International Economics, Vol.II, Edited by Ronald W.Jones and Peter B. Kenen, Amsterdam, Ch.15.

Clark, D. (1997) Student Economics Briefs 1998, The AFR Books, Melbourne

Dombusch R., Fisher S., and Kearney C., (1995) Microeconomics, Australian ed., McGraw-Hill, Sydney.

Fitzgerald V., (1993) National Saving: A Report to the Treasurer, AGSP, Canberra.

Fraser, B.W., (1990a) "Some Aspects of Australia's Foreign Debt", Bulletin, Reserve Bank of Australia, Mar., Pg.25-32.

Fraser, B.W., (1990b) "Understanding Australia's Foreign Debt and the Solutions", Bulletin, Reserve Bank of Australia, Aug., Pg.9-15.

Pitchford, J.D., (1989) "Does Australia Really Have a Current Account Problem?", Economic Papers, Vol.8, No.4, Pg.25-32.