Cad Essay

CAD ESSAY
Balance of Payments Essay

Question 1: Analyse the impact of changes in the global and domestic
economy on Australia’s Balance of Payments. (20 marks)
Question 2: Analyse the impact of structural and cyclical factors on Australia’s

balance of payments.
Introduction
Both cyclical and structural factors in the domestic and global economy can
significantly affect Australia’s trade, investment and income flows hence influencing
the Balance of Payments (BOP). The balance of payments is a record of
transactions between Australia and the rest of the world during a given period of time
and consists of the Current Account (CA) and the Capital and Financial Account
(KAFA). Structural factors such as Australia’s historically low savings rate and poor
international competitiveness as well as cyclical factors such as the terms of trade
(TOT), exchange rates and the level of global economic growth will influence the
outcomes of the CA and KAFA. An unmanaged BOP poses a significant area of
concern for the government’s management of external stability.
Savings Investment Gap
A major structural factor impacting Australia’s balance of payments is its historically

poor domestic savings rate leading to a savings investment gap. Savings in Australia
are insufficient to fund the high investment needs of domestic industries such as
mining causing a savings-investment gap to arise. This forces Australia to act as a
net capital importer becoming reliant on foreign funds leading to high KAFA inflows
and an increase in Net Foreign Debt. These foreign funds will generate servicing
costs and are recorded as outflows on the net primary income account (NPY) hence
worsening the CA. In Australia since 1975 the household savings ratio declined from
a peak of 18% in 1975 to a low point of -4% in 2002 and currently remains at 3% in
2019. This low level of savings has given rise to a savings investment gap within
Australia which has averaged 5% of GDP since the 1980s. This caused increased
capital inflows and contributed to the lasting KAFA surplus averaging 4% of GDP
since the 2000s as “banks funded a large share of their lending by borrowing
overseas”- Australian Treasury. High foreign borrowing led to an accumulation of
foreign debt with NFD increasing from $120b in 1989 to $1.4T by 2019 leading to
large serving costs associated with paying interest. These servicing costs represent
outflows on the NPY leading to a persistent NPY deficit of -3% to -5% of GDP
contributing to the sustained Current Account Deficit averaging -4% of GDP in the
2000s. Furthermore, Australia’s high NFD poses an external stability issue as it
could lead to a debt trap scenario similar to what happened to Greece in 2011, with
poor investor sentiment and high debt repayments causing large capital flight and a
collapse of the economy. Hence Australia’s structurally poor savings rates
significantly impacts the outcomes of the balance of payments.
International Competitiveness and Narrow Export Base
Another significant structural factor contributing to Australia’s poor trade balances

and a persistent CA deficit is Australia’s lack of international competitiveness and
narrow export base. Australia’s comparative advantage exists in mining with mineral
exports accounting for 58% of Australia’s exports but involves little to no value
addition as it is a primary resource. This narrow export base leaves Australia’s trade
balance very vulnerable to fluctuations in commodity prices. Furthermore,
Australia’s manufacturing industries lack international competitiveness due to high
domestic labour costs at 3 times the global average. As such Australian
manufacturers cannot compete with low cost Asian manufacturers with
manufacturing exports declining from 16% of exports in 2000 to 11% of exports in
2019. As such Australia’s imports of consumer goods have increased from 13% of
imports in 1980 to 20% of imports in 2018. Combined, Australia’s narrow export base
and dependence on imports for expensive consumer goods and ETMS has
contributed to a poor trade balance with Australia’s balance on goods and services
account (BOGS) being in deficit 70% of the time since the 1980s, with an average
deficit of -2%, only reaching surplus during TOT booms. This further contributes to
Australia’s almost perpetual CA deficit. Hence Australia’s structural lack of
international competitiveness in manufacturing and narrow export base has
contributed to sustained poor trade balances worsening the current account.
Terms of Trade
The Terms of Trade is an important cyclical factor that will significantly influence
export revenues especially due to Australia’s narrow export base as such impacting
BOGS and thus the BOP. The TOT is the relative prices received for exports in
relation to prices paid for imports and is calculated as . Australia’s TOT is
significantly impacted by commodity prices with mining accounting for 58% of all
exports in 2019. An improvement in the TOT means that the same volume of exports
can buy a greater amount of imports and thus should improve the balance on goods
and services (BOGS) components of the CA. From 2016 to 2019 commodity prices
rapidly increased due to strong global demand, stemming from strong global
economic growth averaging 3%, coupled with a contraction in Brazilian iron ore
supply by 67 million tonnes following the collapse of the “Vale Tailings Dam” in early
2019 . This rapidly increased iron ore prices causing Australia’s TOT to improve by
11%, which increased exports of metal ores and minerals from $90B in 2018 to
$109B in 2019. Consequently, Australia’s BOGS rose from a deficit of -3% of GDP in
2015 to a surplus of 4.5% of GDP in 2019 which improved the CA from a deficit of -
5% to a surplus of 1.5%. Hence the terms of trade is an important cyclical factor that
significantly influences the outcomes of the BOP.
Exchange Rates
Another cyclical factor that greatly impacts the BOP is the exchange rate, with
movements in the Australian dollar (AUD) impacting the short-term international
competitiveness of firms. A depreciation of the Australian dollar (AUD) will
significantly improve the international competitiveness of Australian exports in
foreign markets as the AUD purchases less foreign currency, reducing prices and
hence increasing export revenues. Concurrently, a depreciation also increases the
domestic prices of foreign imports, reducing import expenditure. Combined a
depreciation should increase export revenues relative to import expenditure thus
improving the BOGS and the CA. Research by the RBA suggests that “a 10%
depreciation can lead to a 4% increase in exports.” Following the global financial
crisis, the AUD acted as a “dampener” with the TWI falling from 70 in 2008 to 60 in
2009. As a result, the international competitiveness of exports increased causing the
BOGS to improve from a deficit of -3% of GDP in 2008 to a surplus of 2% by 2009
which reduced the CA deficit from -7% of GDP to -2% of GDP. Thus, the exchange
rate is an important cyclical factor that will substantially influence the outcome of the
BOP.
Global Economic Growth
Finally, cyclical fluctuations in the international business cycle will greatly influence
Australia’s export revenues and as a result influence the BOP. If global economic
growth is low, the disposable incomes of foreign consumers will decrease and
coupled with poor business expectations will reduce demand for Australian exports
thus worsening the BOGS and the CA. Following the global spread of the COVID-19
virus many nations locked down their economies causing global economic growth to
fall with the IMF predicting a global economic contraction of 3% in 2020 with
Australia’s largest trading partner, China, experiencing a rapid fall in growth from 6%
in 2019 to -7% in early 2020. This caused the BOGS to worsening from a surplus of
4.5% in 2019 to 2.75% in 2020 as export revenues contracted causing the CA to fall
from a surplus of 1.5% to 0.25%. Thus, the international business cycle is a major
cyclical factor that significantly influences the outcome of the BOGS and ultimately
the CA.
Domestic Economic Growth
Additionally, cyclical changes to the level of domestic economic growth will impact
foreign investor confidence and import expenditure thus impacting the BOP. A
contraction in Australian economic growth will reduce foreign investor confidence
resulting in a withdrawal of funds, decreasing capital inflows on the KAFA. This will
reduce servicing costs and hence should improve the NPY account and thus the CA.
Additionally, low economic growth reduces the disposable incomes of consumers
thus reducing import expenditure further benefiting the CA. Poor economic growth in
Australia falling from 3.92% in 2012 to 2.19% in 2015 following the end of the mining
boom resulted in capital flight as foreign investors abandoned Australia causing NFD
to contract from 1,044B in 2015 to 990B in 2016, hence reducing KAFA inflows.
Additionally, there was a decrease in consumer demand with the Westpac consumer
sentiment index falling from 101.3 to 97.3 in the same period. The reduced outflows
on the NPY combined with reduced import expenditure saw the CA deficit improve
by 29% driven by a $2B improvement in the NPY. Hence fluctuations in domestic
economic growth will impact the BOP.
Global Interest Rates – 147 Words
Finally, changes to global interest rates will influence NPY servicing costs and as a
result impact the BOP. Interest rates will determine the size of servicing costs on
foreign debt and as such influence the size of NPY outflows, with low global interest
rates reducing the value of NFD servicing costs thus improving the NPY and CA.
After the global financial crisis in 2008 interest rates around the world plummeted as
central banks attempted to stimulate economic recovery. Policy interest rates in the
US fell from 5% in 2007 to 0.2% in 2009 and UK policy rates dropped 5% in the
same period. This significantly reduced servicing costs on foreign debt causing the
NPY to improve from a deficit of -5% of GDP in 2008 to -3% of GDP in 2009. As can
be seen, global interest rates will influence NPY outflows and as such the outcome
of the BOP.
Conclusion
In conclusion, Australia’s balance of payments is influenced by many structural and

cyclical factors. Structural factors such as poor domestic savings and the narrow
export base as well as cyclical factors including changes to the terms of trade, the
exchange rate and global economic growth will substantially influence the outcome
of the CA and the KAFA.

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CAD ESSAY

Balance of Payments Essay

Question 2: Analyse the impact of structural and cyclical factors on Australia’s

Savings Investment Gap

A major structural factor impacting Australia’s balance of payments is its historically

Another significant structural factor contributing to Australia’s poor trade balances

Global Economic Growth

Domestic Economic Growth

Global Interest Rates – 147 Words

In conclusion, Australia’s balance of payments is influenced by many structural and

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