TRENDS IN AUSTRALIA S TRADE AND THE BALANCE OF PAYMENTS

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1 TRENDS IN AUSTRALIA S TRADE AND THE BALANCE OF PAYMENTS TIM RILEY Director Economic Literacy Centre and Tim Riley Publications Pty Ltd HSC Economics Day Thursday June 21st 2012 THE UNIVERSITY OF WOLLONGONG 1

2 Consecutive mining booms have had a major effect on Australia s balance of payments position. The first mining boom from 2003 to 2007 led to a record rise in resource exports, commodity prices and the terms of trade. This had the effect of increasing export income because of rising prices and volumes of resource exports. The first mining boom or mining boom Mark 1 ended with the Global Financial Crisis in and a period of world recession. The second mining boom or mining boom Mark II commenced with global recovery and the resumption of China s strong economic expansion in It is still underway although at a slower pace due to the impact of the European sovereign debt crisis and slow US recovery on the rate of world economic growth. The Impact of the Mining Boom on the Balance of Payments There are a number of effects of the current mining boom on Australia s external accounts or the balance of payments: A rise in export income associated with a sharp rise in commodity prices and increased volumes of resource exports. For example, mining exports rose from $120.1b to $159.4b between and as shown in Table 1. Strong growth in mining investment has led to rising volumes of capital imports needed to increase productive capacity in the mining and resources sector. The appreciation of the exchange rate has increased the demand for imports in the economy as imports have become more competitive relative to domestically produced goods. The appreciation of the exchange rate has reduced the competitiveness of manufactured and service exports such as education and tourism and this has had a negative impact on non resource exports. The rise in profits in the mining industry has increased the income of overseas residents in the form of profits, dividends and reinvested earnings flowing to foreign owners of equity in the Australian mining industry. This has led to a persistently high net primary income deficit in the current account. Inflows of both debt and equity capital into Australia's mining resources sector remain high and help to keep the financial account in surplus and offset the deficit in the current account. Table 1: The Value of Australia s Exports of Goods to Rural Exports $29,383m $25,589m $30,471m Mining Exports $140,073m $120,145m $159,455m Manufactured Exports $62,108m $56,075m $56,787m Total Exports of Goods $231,564m $201,809m $246,713m Source: ABS (2011), Balance of Payments and International Investment Position, Catalogue , September. 2

3 $m Figure 1: Australia's Exports ($m) Rural Mining Manufactured Exports and the Trade Balance Australia s mining export earnings have increased by almost 90% over the past five years with a 33% rise between and as shown in Figure 1. This has been largely due to a 60% rise in commodity prices in Australian dollar terms over this five year period driven largely by rising prices for iron ore and coal. At the same time Australia s rural exports have been affected by consecutive droughts and floods and have not grown substantially although there was some recovery in rural exports in , rising from $25.5b to $30.4b (refer to Table 1). Manufactured exports have remained relatively stable in value terms and increased slightly from $56.1b in to $56.7b in The relative shares of goods exports in were the following: Rural exports were 12.4% of the total. Mining exports were 64.6% of the total. Manufactured exports were 23% of the total. In terms of service exports the appreciating value of the Australian dollar has reduced the competitiveness of education and tourism exports. This has led to a decline in the value of service exports and a rise in the value of service imports such as outbound tourism. The goods balance (exports minus imports) and services balance (exports minus imports) between and for Australia are shown in Table 2. Australia recorded a surplus in the goods balance in and but deficits in the services balance over

4 Table 2: Australia s Goods and Services Balance in the Current Account to Exports of Goods (credits) $231,564m $201,809m $246,713m Imports of Goods (debits) -$220,649m -$204,676m -$218,968m Goods Balance $10,915m -$2,867m $27,745m Exports of Services (credits) $52,877m $52,323m $51,456m Imports of Services (debits) -$56,170m -$53,433m -$58,360m Services Balance -$3,293m -$1,110m -$6,904m Goods and Services Balance $7,622m -$3,977m $20,841m Source: ABS (2011), Balance of Payments and International Investment Position, Catalogue , September. If the goods balance is added to the services balance we get the overall balance on goods and services. In the goods balance showed a surplus of $27.7b largely due to the huge increase in mining exports. The services balance was in deficit by -$6.9b largely due to falling service exports and a rise in service imports. Taken together the balance on goods and services in was a surplus of $20.8b. Recent trends in the goods balance, services balance and the goods and services balance are shown in Figure 2. In there was a surplus in the goods balance of $10.9b which more than offset the services deficit of -$3.2b. This led to an overall surplus in the goods and services balance of $7.6b. In the impact of the Global Financial Crisis on the balance of payments significantly reduced export earnings which led to a small goods deficit of -$2.8b. The services deficit fell to -$1.1b as spending on imported services (such as outbound tourism) fell. The combined effect led to a deficit in goods and services of -$3.9b. $m Figure 2: Australia's Trade Balance Goods Balance Services Balance Goods and Services Balance

5 In impact of the mining boom on resource exports increased the trade surplus significantly to $27.7b but the impact of the higher exchange rate led to a larger services deficit of -$6.9b. However overall the surplus in the goods and services balance was $20.8b, a turnaround of $24,818b from Trends in Import Spending Australia imported consumption, capital, and intermediate goods and services valued at $277,328m in as illustrated in Table 3: Imports of consumption goods (such as food, beverages, electrical items, transport equipment, textiles, clothing and footwear, toys and leisure goods) were valued at $63,567m and accounted for 23% of imports in Capital goods (such as a machinery and industrial equipment, aircraft, computing, telecommunications and industrial transport equipment) were valued at $51,366m in and accounted for 18.5% of total import spending. Intermediate goods (such as fuels and lubricants, transport parts, chemicals, plastics and paper) used as inputs in domestic production were valued at $104,035m in and accounted for 37.5% of imports. Imported services (such as freight, travel, transportation, insurance, finance and business) were valued at $58,360m in and accounted for 21% of imports. The main trends in import spending between and were a general decline in import spending in as economic growth slowed after the GFC which reduced the demand for imports. However in there was a recovery in spending on imported capital and intermediate goods. The surge in mining investment to date has been accompanied by a sharp increase in the volume of capital imports (such as bulldozers and excavators) and intermediate goods (such as fuel and machinery parts) over the last five years. Table 3: Australia s Imports of Goods and Services to Consumption Goods -$61,419m -$62,333m -$63,567m Capital Goods -$49,843m -$47,027m -$51,366m Intermediate Goods -$109,387m -$95,316m -$104,035m Services -$56,170m -$53,433m -$58,360m Total Imports -$276,819m -$258,109m -$277,328m Source: ABS (2011), Balance of Payments and International Investment Position, Catalogue , September. 5

6 Table 4: Australia s Net Income Deficit to Trends in Net Primary and Secondary Income Australia s net primary income balance is the net sum of income flows associated with the stock of Australia s debt and equity assets and liabilities. Australia has a persistent net income deficit due to the large stock of net foreign liabilities and because foreigners are estimated to consistently earn higher returns on their investments in Australia than Australian residents receive on their investments abroad. The mining sector mainly affects the net primary income deficit through the share of mining profits that accrue to foreign investors through dividend payments and reinvested earnings or profits remitted on direct investment. It is estimated that the mining industry is up to 80% foreign owned. Other income measured in the net primary income deficit includes interest paid on the stock of foreign debt. The net primary income deficit was -$52,397m in up from -$47,782m in (see Table 4). Secondary income includes current transfers that are consumed within a short period (i.e. less than twelve months) and include food aid, remittances from residents temporarily abroad, and remuneration received by international students undertaking university studies. Secondary income credits in totalled $6,372m and consisted mainly of government transfers and personal transfers. Secondary income debits in totalled -$8,383m and consisted of government transfers, personal transfers and workers remittances. This resulted in a small deficit of -$2,011m in net secondary transfers in Australia s Current Account Deficit Primary Income -$45,407m -$47,782m -$52,397m - Credits $42,823m $36,825m $41,927m - Debits -$88,230m -$84,607m -$94,324m Secondary Income -$995m -$1,532m -$2,011m - Credits $6,657m $6,787m $6,372m - Debits -$7,652m -$8,319m -$8,383m Source: ABS (2011), Balance of Payments and International Investment Position, Catalogue , September. With the goods and services surplus of $20.8b in the current account deficit has slowed in growth and fallen as a percentage of GDP. This is because the increase in the goods and services surplus far outweighed the increase in the net primary income deficit. From a saving-investment perspective this reflects a rise in saving relative to investment in Australia, since the current account deficit is the difference between national saving and investment. 6

7 Table 5: Components of Australia s Current Account to If the current account is in deficit, this reflects investment being greater than saving. Table 5 shows the main components of the current account which is equal to the sum of balances of goods and services, net primary income and net secondary income. In the current account deficit was equal to -$38.7b but rose to -$53.2b in because of the fall in export earnings associated with the slump in export demand caused by the GFC. However the return to a large surplus of $20.8b in in the goods and services balance helped to reduce the current account deficit to -$33.5b or -2.5% of GDP. Capital Account In the balance of payments the capital account comprises both acquisitions and disposals of non produced, non financial assets such as patents and copyright as well as capital transfers. Capital transfers include Australian grants or gifts to developing countries for capital works projects such as the building of schools, roads and bridges. The balance on capital account is the net sum of credit and debit entries for the acquisition and disposal of non produced, non financial assets and capital transfers. In the balance on capital account was a small deficit of -$304m. Financial Account Current Account -$38,780m -$53,291m -$33,567m Goods and Services $7,622m -$3,977m $20,841m Net Primary Income -$45,407m -$47,782m -$52,397m Net Secondary Income -$995m -$1,532m -$2,011m Source: ABS (2011), Balance of Payments and International Investment Position, Catalogue , September. The financial account records all transactions between residents and non residents associated with a change in ownership of foreign financial assets and liabilities such as equities, bonds and notes. These transactions are recorded as assets if they are claims by residents on foreign financial assets, or as liabilities if they are claims by non residents on domestic assets. Transactions are divided into the following categories: Direct investment is long term investment in an enterprise in another economy and net direct investment was valued at $23,750m in as shown in Table 6. The main vehicles for direct investment include shares, reinvestment of earnings and debt instruments. Portfolio investment tends to be short term in nature and is channelled through financial markets and includes shares, and debt securities. Portfolio investment was valued at $32,512m in

8 Table 6: The Capital and Financial Account to Financial derivatives include swaps and options used to manage risk and mainly involve deposit taking institutions such as banks as well as central banks. There was a net deficit in derivatives of -$11,697m in Other investment includes currency and deposits, loans, trade credit and advances for both short and long terms with deposit taking corporations such as banks and pension funds. Reserve assets refer to the net holdings of the central bank (the Reserve Bank) of monetary gold, Special Drawing Rights with the IMF and foreign currencies and deposits. International Accounts Ratios Capital and Financial Account $53,959m $33,204m Capital Account -$291m -$304m Financial Account $54,250m $33,508m Direct Investment $20,810m $23,750m Portfolio Investment $70,100m $32,512m Financial Derivatives -$9,768m -$11,697m Other Investment -$32,821m -$7,859m Reserve Assets $5,929m -$3,198m Source: ABS (2011), Balance of Payments and International Investment Position, Catalogue , June Quarter. Table 7 shows international accounts ratios for the current account and its components between and The current account deficit has been sustainable at below -5% of GDP, reaching a low point of -2.5% in The goods and services balance reached an historic high of 1.5% of GDP in due to the large surplus in goods. The net primary income to GDP ratio was stable at around -3.7% of GDP between and Table 7: International Account Ratios to Current Account to GDP -3.1% -4.1% -2.5% Goods and Services to GDP 0.6% -0.3% 1.5% Goods Credits to GDP 22.7% 19.8% 21.8% Goods Debits to GDP -22.1% -20.1% -20.3% Primary Income to GDP -3.6% -3.7% -3.8% Source: ABS (2011), Balance of Payments and International Investment Position, Catalogue , September. 8

9 Table 8: Foreign Assets and Foreign Liabilities by Industry in Foreign Assets Foreign Liabilities Total -$1,253,049m $2,034,170m Mining -$163,258m $241,230m Manufacturing -$64,652m $132,223m Electricity, gas, water and waste services -$7,805m $18,518m Wholesale trade -$5,507m $47,163m Retail trade -$3,248m $12,261m Transport, postal and warehousing -$3,835m $23,073m Financial and insurance services -$862,839m $1,064,621m Rental, hiring and real estate services -$9,309m $29,229m Other industries -$103,764m $233,765m Unallocated -$28,832m $232,087m Source: ABS (2011), Balance of Payments and International Investment Position, Catalogue , June Quarter. Foreign Investment Foreign investment has two dimensions in the balance of payments: The investment of debt and equity funds in Australia by foreigners in acquiring Australian assets. The inflows of these funds are recorded as foreign liabilities by the ABS because they must be serviced and eventually repaid. The investment of debt and equity funds by Australians and Australian companies overseas in acquiring foreign assets which are recorded as debits since they represent outflows of funds from Australia to the rest of the world. Table 8 shows the value of foreign assets and liabilities in by industry. The total stock of foreign assets owned by Australians and Australian companies was - $1,253,049 which represents the claims on foreign assets. Total foreign liabilities were valued at $2,034,170m in The major industries involved in international debt and equity lending and borrowing were financial and insurance services and mining. Since Australia has a growing economy with large investment opportunities in mining and other sectors, the inflow of foreign investment exceeds the outflow of Australian investment abroad. In this led to a financial account surplus of $33,508m (Table 5). 9

10 Table 9: Australia s Net International Investment Position in Foreign Assets Foreign Liabilities Total Equity Debt Total Equity Debt -$1,253,049m -$628,520m -$624,529m $2,034,170m $734,650m $1,299,520m Net Foreign Liabilities $781,121m (57.3% of GDP) Net Foreign Equity $106,130m (7.8% of GDP) Net Foreign Debt $674,991m (49.5% of GDP) Source: ABS (2011), Balance of Payments and International Investment Position, Catalogue , June Quarter. Table 9 shows that over time the stock of foreign liabilities had risen to $2,034,170m in , consisting of $734,650m in equity borrowings and $1,299,520m in debt borrowings. Total foreign assets were valued at -$1,253,049m in , consisting of -$628,520m in equity lending and -$624,529m in debt lending abroad. Australia s stock of net foreign liabilities (i.e. foreign liabilities less foreign assets) was $781,121m or 57.3% of GDP in , the majority of which was represented by net foreign debt of $674,991m (or 49.5% of GDP), with net foreign equity at $106,130m (or 7.8% of GDP). The servicing cost of net foreign liabilities in terms of interest and dividend payments abroad, leads to the net primary income deficit. The Structural Problem of Low National Saving The structural or underlying problem in the Australian economy causing the persistent current account deficit is the shortfall of national savings in relation to domestic investment. National saving is equivalent to private saving plus public saving. National saving declined from nearly 30% of GDP in the mid 1960s to around 20% of GDP by the late 1990s and mid 2000s, whilst national investment fluctuated between 30% and 25% of GDP in the same period. This led to increasing reliance on foreign saving to finance that part of national investment not financed by national saving. Public saving deteriorated in the recession of the early 1990s to less than 5% of GDP, whilst private saving fell from 20% of GDP in the 1970s to 15% by the late 1990s. The Australian government tried to achieve budget surpluses in the late 1980s because many economists argued that a rise in public sector saving could help to reduce the current account deficit and foreign debt. This was based on the twin deficits hypothesis as illustrated in equations (1), (2) and (3): (1) Y = C + I + G + X - M (i.e. the sources of national income or GDP) (2) Y = C + S + T (i.e. the uses of national income or GNE) Subtract equation (2) from equation (1) and rearrange terms, gives us equation (3): Y - Y = C - C + (I - S) + (G - T) + (X - M) 0 = (I - S) + (G - T) + (X - M) (3) S - I = (G - T) + (X - M) i.e. Saving - Investment = Budget Deficit + Current Account Deficit 10

11 Equation (3) suggests that the difference between saving and investment is equivalent to the sum of the difference between government spending and revenue (i.e. the budget deficit) plus the difference between exports and imports (i.e. the current account deficit). It was argued that a direct way to reduce the current account deficit (and the saving-investment or spending-output imbalance/gap) was to reduce the size of the budget deficit. Although the federal government achieved budget surpluses between 1987 and 1989, the current account deficit and the foreign debt continued to represent an ongoing constraint to domestic economic growth. For example, the asset price boom in led to an import binge, a further blow out in the current account deficit, and a burgeoning net foreign debt, as overseas borrowings escalated to finance the current account deficit. In the government used a high interest rate policy to reduce gross national expenditure or GNE to slow down import spending and the inflationary boom. In the early 1990s the current account deficit became more sustainable, remaining below -4% of GDP, whilst the equity for debt swap saw the net foreign debt fall to as low as 37.3% of GDP. However by domestic economic growth had again risen to an unsustainable level, causing the current account deficit and net foreign debt to both grow as percentages of GDP. This prompted three tightenings in monetary policy in late The Asian crisis (coupled with high domestic growth) in led to a large fall in Australia s export earnings relative to import spending, resulting in a current account deficit of over -5% of GDP, and the net foreign debt also increased to over 40% of GDP by The FitzGerald Report on National Saving (1993) recommended that the government eliminate its budget deficit, and reform the tax system as a means of boosting national savings, through greater incentives for private saving. The Hawke government introduced the Superannuation Guarantee Levy (SGL) in 1991 to encourage the spread of compulsory superannuation to help raise private saving. The Howard government, elected in 1996, implemented a number of the FitzGerald Report s recommendations, designed to raise national saving: Eliminating the Commonwealth budget deficit and returning the budget to surplus. Budget surpluses have lifted public savings and reduced the public sector s call on private savings. Reducing the Commonwealth s general government net debt to GDP ratio from 20% in to 1.3% by through the proceeds from the privatisation of a number of Public Trading Enterprises (PTEs) and accumulated budget surpluses. Introducing measures to increase private saving such as tax rebates for private savings; a retirement incomes policy; taxation reform measures in budgets between 2000 and 2007, such as introducing the GST and cutting marginal tax rates (MTRs) to boost private saving; and the elimination of taxation on superannuation in the 2006 budget for retirees reaching 60. NB: The Gillard government is planning to increase the superannuation guarantee levy (SGL) from 9% to 12% of gross earnings in

12 The Current Account Balance and National Saving and Investment Between and the current account deficit was affected positively by Australia s rising terms of trade. The trade balance improved because of the increased volume and value of mineral and resource exports, although the net primary income deficit continued to widen, reflecting robust growth in the remittance of mining profits and rising net interest payments because of a rising stock of net foreign debt. Overall the current account deficit was relatively stable at -5% of GDP, reflecting some improvement in the trade balance but continued growth in the net primary income deficit. In terms of Australia s net lending position (i.e. the difference between national gross saving and investment), changes have occurred in the net lending position of various sectors in the economy: Households have historically been net lenders, but between the 1980s and 2000s shifted to a net borrowing position, particularly in to fund spending on housing. However with higher domestic interest rates, households reduced their borrowing between 2003 and 2011 and increased their saving with the household savings rate rising to 11% in This was partly a response to the Global Financial Crisis in as households reduced their levels of debt and increased their precautionary saving as part of a strategy to repair household balance sheets. The government sector has increasingly become a net lender, with rising general government saving due to the accumulation of budget surpluses, more than offsetting government investment. However the return to budget deficits between and due to the impact of the Global Financial Crisis on taxation revenue and government expenditure reversed this trend, and the government sector became a net borrower of funds in financial markets in The business sector has remained a net borrower of funds reflecting high rates of investment, particularly in the mining and energy sectors as well as investment in ICT goods. Policies to Reduce the Current Account Deficit The Australian government has used a combination of macroeconomic (i.e. monetary and fiscal policies) and microeconomic policies to try to reduce the size of the current account deficit to under -5% of GDP. This is the condition for achieving sustainability in the growth of the current account deficit. Monetary policy is conducted by the Reserve Bank of Australia and is used to control CPI inflation and to provide an anchor for inflationary expectations. This is achieved through the use of an inflation target of 2% to 3% CPI inflation over the economic cycle. Keeping inflation within the target band is important for maintaining the competitiveness of Australia s export and import competing industries, which are vital for reducing the size of the current account deficit. Contractionary monetary policy can also be used to reduce the growth in import spending if the current account deficit becomes unsustainable. Higher interest rates would reduce import spending and stabilise the current account deficit but could be at the cost of lower economic growth and higher unemployment. 12

13 The Australian government has tended to mainly use fiscal policy to reduce the size of the current account deficit. Fiscal policy had a medium term focus of raising public saving through the accumulation of underlying budget surpluses between 1998 and Budget surpluses helped to eliminate the public sector s call on national saving through the retirement of public debt. This helped to reduce that part of the net foreign debt owed by the Australian government. The fiscal consolidation strategy was based on the Twin Deficits Argument of a link between the budget deficit and the current account deficit. In terms of microeconomic policies the Australian government has used various microeconomic reforms in the longer term to improve the economy s level of allocative efficiency and productivity. For example, industrial relations policy is important in linking wage movements to improvements in productivity at the workplace. This helps to contain wage expectations and encourages firms to adopt competitive labour and management practices which are essential for firms exporting to the global market. Labour market reforms such as the Workplace Relations Act 1996, the Workplace Relations Amendment Act 2006 and the Fair Work Act 2009 have all placed an emphasis on productivity based wage bargaining. Microeconomic reforms in infrastructure industries such as electricity, transport, water, gas and telecommunications have also been critical in reducing input costs for Australian industry and assisting the improvement in international competitiveness and productive capacity over time. Other important microeconomic reforms include the national competition policy and the cuts to industry protection, which have increased the level of competition in the Australian economy. More competitive domestic industries help to boost exports as a share of GDP, thereby reducing the trade deficit and the size of the current account deficit. Industry policy also has a role to play in encouraging innovation, risk taking and investment in research and development, which the Australian government believes are essential for building world competitive firms. The Pitchford Thesis: The Financial Account Drives the Current Account In the 1990s an alternative analysis of the current account deficit by Professor John Pitchford from ANU was that the current account deficit was a result of the capital and financial account surplus. This surplus sets up a high servicing cost in terms of interest, profit and dividend payments remitted overseas and increases the size of the net income deficit and the current account deficit. Rising current account deficits increase the need for foreign borrowings which increases the size of the net foreign debt. Pitchford argued that this was not necessarily a problem if the funds borrowed were invested in export industries, which would increase export income in the future. The Australian government has largely accepted the Pitchford thesis that the current account deficit reflects private saving and investment decisions and that the current account deficit is sustainable if borrowings are invested in exports. Forecasts for The current account deficit is expected to widen to 4.75% of GDP in and 6% of GDP in as the trade balance moves into deficit, driven by declining non rural commodity prices and surging import volumes associated with the resources investment boom. 13

14 2011 HSC Economics Examination Question 22 (10 Marks) (a) The table shows current account data for an economy. Component Year 1 Year 2 ($bn) ($bn) Exports of goods and services Imports of goods and services Net Income Current Transfers -5-5 (i) Calculate the change in the current account balance from Year 1 2 to Year 2. (ii) Outline ONE factor that may have caused the change in the 2 Net Income component of the current account. (iii) Outline ONE factor that may have caused the change in the 2 Import component of the current account. 14

15 (b) Why does Australia have a persistently high current account deficit? 4 15

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