Current account deficits in Australia

Current account deficits in Australia

Sam Choon Yin (2003)

 

Introduction

            Current account represents one of the components in the balance of payments (BOP). The latter account records all international transactions that a country undertakes with other countries. The current account on the other hand records all sales and purchases of currently produced goods and services plus investment income plus unilateral transfers. Transactions like buying and selling of goods and services across nations, interest repayments of loans, and remittance of profits by overseas owned companies (and any other unilateral transfers) all play a part in affecting current account balances. The other important component in the BOP is the capital account. The capital account measures changes in the stocks of all non-reserve financial assets deriving from portfolio and foreign direct investments.

Generally, a transaction is recorded as a credit item if the transaction results in receipts of payments from foreigners. Conversely, the transaction is recorded as a debit item if it results in payments made to foreigners. If the total credits are larger (smaller) than the total debits, the nation is said to enjoy BOP surpluses (deficits).

            This essay discusses the current account deficit issue in Australia. The next section discusses what it means when we say that the current account is in deficit. I then seek to explain the causes of current account deficit in Australia; explore the implications of the deficits and discuss solutions to address the issue.

 

What is the meaning of current account deficit?

The current account is in deficit when the aggregate decisions of households, firms and governments spend more than what is produced in the nation domestically. It can be shown that the current account deficit is equivalent to public sector balance plus private sector saving-investment gap. Let Y be domestic production (national output), C is household consumption expenditure, I is private investment, G is government expenditure on goods and services, X is exports and M is imports. The expenditure approach to compute national income tells us that Y = C + I + G + X – M. It is also true that Y = C + S + T + F where S is private savings, T is net taxes (taxes less transfers) and S is servicing of foreign-owned capital. Thus it can be shown that:

 

(I – S) + (G – T) = (M + F) – X

 

The right hand side of the equation essentially represents the magnitude of current account deficit with the assumption that unilateral transfers are negligible. The above equation simply says that the current account balance is equal to private sector saving-investment gap (I – S) and public sector balance (G – T). If (M + F) – X > 0, the current account is in deficit, which could be attributed to widen investment-saving gap in the private sector or larger government’s budget deficit or both.

It can also be shown in national accounting terms that the current account balance is equivalent to the difference between domestic expenditure and domestic production. We can re-write Y = C + I + G + X – M as follows: (M + F) – X = C + I + G – Y. A current account deficit effectively indicates that the country’s domestic expenditure is greater than its domestic production.

            Australia has current account deficit for many years. Back in the 1960s and 1970s, the deficit accounted for around 2.4 percent of the GDP. In the 1980s, the deficit grew, accounting for an average of 4.4 percent of the GDP. For some years in the 1990s (like in the mid and late 1990s), the deficit represented about 5-6 percent of the GDP.

            Table 1 shows the recent current account balances. The second quarter of 2003 showed a record high current account deficit for Australia (the previous high was recorded in December 2002) attributed mainly to drought, weak world economy and outbreak of SARS which depressed exports of goods and services. Strong domestic demand worsened the problem (due to higher imports). Some of these events were generally unusual which may soon be ‘passed over’. It has also been reported that in June 2003, civil aircraft amounted to AUD1 billion was imported as part of the overall strategy in the airline industry to upgrade its fleets. This partly explained the unusual high current account deficit as claimed by John Howard’s government. Nevertheless, it is interesting to examine why Australia has been experiencing current account deficits for so many years.

 

Table 1

Current account deficit in Australia

 Seasonally adjusted (in millions of AUD)

Quarters

Current account

September 2002

December 2002

March 2003

June 2003

-8,180

-11,235

-10,230

-12,690

Source: http://www.abs.gov.au

 

Causes of current account deficit

            What are the reasons for Australia to experience current account deficits? Several reasons have been put forward. This section briefly discusses the causes.

            One of the causes is the worsening terms of trade. The TOT measures the relationship between the price of a country’s exports and the price of its imports. Over the years, Australia has been relying on exports of agricultural commodities and minerals. Prices of such commodities were more unstable and unpredictable. World economic performance and climatic factors can influence their prices. This was illustrated in the 1980s when the price of wool changed dramatically. More recently, world economic slowdown and droughts reduced the export prices. On the contrary, the price of imports is more stable. They are either remaining stable or increasing at a faster rate than the price of exports thus contributing to worsening of the TOT.

            Part of the reason for the worsening TOT is the lack of investment in research and technology in Australia. Australia still relies heavily on imports of manufactured and capital goods. Particularly significant is the trade deficits in ICT which accounted for more than 50 percent of the total current account deficit in the second quarter of 2003. While the problem appears to be similarly faced by US and Japan, the seriousness of the problem differs. Richard Hogg, the National President of the Australian Computer Society (ACS), succinctly explains this. He noted that the deficits in countries like US and Japan were largely driven by the offshore manufacturing efforts of their own multinational companies. Eventually, the profits of these ventures would return back to the home countries. This is unlike Australia. Australia has no MNCs offshore and the profits made from the equipment imported would remain in their countries of origin. He called for stronger investments in R&D in Australia and rely lesser on imports of ICT equipment. This would allow the local companies to do things better and in a cheaper way thus allowing them to gain competitiveness. It may be even be possible for Australia to export some of its capital goods abroad to narrow the current deficit problem in Australia.[i]

            It is unfortunate that the external economic environment in the last few years had been weak. About six years ago, the East Asian countries were hit with a crisis. The demand for Australian goods fell to some extent. The 911 incident, war against Iraq, continuous terrorist threats and outbreak of SARS in the last two years or so led to slowdown in world economies which negatively affect the demand for Australian goods. The tourist industry in Australia suffered a decline. Japan, its largest trading partner, continues to suffer from economic recession.

The preceding section notes that the current account deficit could be attributed to imbalances in government’s budget or widening saving-investment gap in the private sector, or both. It is important to recognize that the former does not appear to be the culprit a least from the Australian perspective. The government has been enjoying positive fiscal balances in most of the years. In 2004-05 for example, the fiscal balance is projected to represent 0.6 percent of the GDP up to 0.9 percent in 2005-06. Australia also has one of the lowest government debts in the industrialized world. The problem thus appears to be attributed to large saving-investment gap in the private sector.

A major cause of the current account deficit in Australia was the collapse in private savings in Australia. It seems that Australia was addicted to incurring debts. Australia’s economic growth was mainly driven by consumption, which included imports from abroad. People were essentially buying more than what they were entitled to. It did not help that financial institutions in Australia were promoting excessive borrowings. This could be partly due to competition that they face with other financial institutions both domestically and abroad.

Because of low domestic savings, most of the current consumption incurred in Australia is financed from foreign borrowings. This is represented by the strong capital inflows of foreign funds into Australia. This capital inflow is useful to finance the importation of goods and services. In fact, the capital account surpluses are much higher than the current account deficit such that Australia actually enjoys a balance of payment surplus in most years. But the problem is that the capital inflow will contribute to rising capital account deficit in future. This occurs because increased borrowings will result in increased interests and dividends payments on outstanding loans. Such payments are recorded as debit items in the current account.

The reason for current account deficit may go beyond economics. Australia does not have very good international relations with certain countries like Malaysia. Malaysia contemplated a ‘buy Australian goods last’ policy in 1991 when Australia produce a television series ‘Embassy’, which ‘depicted, unflatteringly, a state which was imaginary but, from its location, could have been constructed as having been Malaysia’ (Milne and Mauzy, 1999, p. 140).[ii] Another incident occurred in November 1993. Prime Minister of Malaysia, Mahathir Mohamad, was not happy with Australia’s former Prime Minister Paul Keating when the latter rejected Mahathir’s idea in forming the East Asian Economic Caucus. Perhaps as a sign to show his unhappiness, Mahathir announced that he would be attending the APEC meeting in Seattle. Keating responded by ‘saying that APEC was bigger than Australia, the United States, Malaysia, Dr. Mahathir, and any other recalcitrant’’ (Milne and Mauzy, 1999, p. 141). Keating later apologized for his remarks but the harm had already been done.

There is a need for Australia to develop better relations with ASEAN (in particular) and the rest of Asia to expand its exports to these countries. This is important particularly when the Asian countries (like Thailand, Taiwan, Indonesia, Malaysia and Korea) are beginning to attract more capitals from abroad. Demand for foreign goods is likely to rise. Australia should take advantage of this and capture a ‘big’ slice of the pie.

 

Is the current account deficit a serious problem?

            Some observers have noted that the current account deficit situation in Australia is not serious. There are several reasons.

            First, the situation has been with Australia for so many years. No serious negative consequences have been felt. Capital accounts were in the positive territory, and were sufficient to cover the current account deficits. While this is generally true, Australia should learn from the East Asian crisis. Capitals that came in could flow out of the country relatively easy. Investors did not seem to care much about the country’s economic fundamentals. Instead, they follow the crowd. Capital account surpluses therefore are volatile. Unless Australia can assure that a substantial proportion of the capitals are invested for long-term purposes, capital accounts surpluses may not be sustainable. Should there be rapid capital outflows (and coupled with the current account deficit), some severe balance of payment problems will be felt by Australia.

            Some observers claimed that the current account deficit problem in Australia was not serious because the deficit did get smaller sometimes. It seems that the seriousness of the current account deficit is cyclical in nature. Droughts for example occur in certain months in a year and not in others. Economic performances in major trading partners are also subject to their respective business cycles. Thus in some years, the deficit may widen while in others, the deficit narrows. Unfortunately, the argument here does not say anything about turning the current deficit from negative to positive. Negative current deficit still implies incurrence of external borrowings thus subjecting Australia to pay interests and dividends to foreign countries. The future generations are still required to pay debts that are incurred by earlier generations. These problems are not resolved.

            In Australia, the government does not appear to be at fault as far as current account deficit is concerned. The government enjoys budget surpluses in most years and its level of debt is one of the lowest in the OECD countries. The problem lies with the private sector. The imbalances were thought to be acceptable. They were basically resulted from market forces. Competitive pressures will ensure that all parties are better off in the future. Unfortunately, as Keynes said, in the long run, all of us are dead. There is a need to see that the deficit does not get too large before it is too late.

            Generally, the current account deficit does posses a problem to Australia. The deficits inform Australia that efforts need to be put in to encourage more research and development investments. This is to lessen Australia’s dependence on imports of capital goods from foreign countries. The effort may bring additional benefits like encouraging exports of capital goods from Australia to other countries. Also, efforts should be made to encourage private savings. Too much borrowing in the present generation would only put excess burden on future generations to repay the debts incurred. Presently, Australian households have high household debts and credit card debts. It has been estimated that the present debt level amounts to AUD18,000 per person. There should also be a concern with current account deficit for it translates to potentially lower GDP growth in the future. Some of the other concerns have been addressed in the preceding section. 

 

Conclusion

            While Australia should recognize the potential problems in which the current account deficit can bring, addressing the issue must be thought through carefully. Government interventions, as economic theories have illuminated, could generate negative welfare effects to the society. For instance, limiting imports through imposition of tariffs essentially create positive deadweight losses. Consumers are worse-off, which exceed the gains enjoyed by the government and producers. So is providing export subsidies to producers. The loss to government exceeds the gains enjoyed by consumers and producers. Deadweight losses are generated.

            Earlier on, it has been suggested that the Australian government should encourage more firms to invest in R&D to minimize dependence on imports of capital goods from abroad. The result of this effort is higher productivity. Australian companies generally should become more competitive. Exports are likely to grow creating a multiplier effect on the nation’s equilibrium national income. The current account deficit should correspondingly narrow. The question that arises is how will the increased in national income affect production and savings? The current account deficit may not improve (or narrow) if imports are substantial in response to higher national income. If the increased in national income translates to higher demand for foreign produced goods, the current account deficit may retain in its current position or even worsen. Carefully studying the impact is thus called for. A controversial solution is to increase tax rates in Australia to raise government savings and minimize private consumption. We know that such a move can create negative welfare effects on the society and perhaps face strong oppositions from certain sections of the population.

           

 



[ii] Milne, R.S. and Mauzy, Diane (1999) Malaysian Politics Under Mahathir. Routledge (Great Britain).