Download EXTERNAL STABILITY External stability or external balance

EXTERNAL STABILITY
External stability or external balance is a general term which describes a situ
ation where external indicators such as the balance of payment, foreign liabilities and the exchange
rate are at a sustainable level, that is, a level where they can remain in the longer term without
negative economic consequences. The past two decades saw the sweep in of globalisation, what was als
o seen as was the significant levels of external imbalance in Australia, which resulted in challenge
s on all three key indicators of external stability.
Balance of payment is influenced by a wide ran
ge of domestic as well as international factors. The problem associated with the balance of payments
is the growing current account deficit (CAD). Over a period of time a high CAD will contribute to a
n increased level of foreign liabilities. It is a general rule of thumb that if the CAD is above 6%
of GDP there is a problem. It is a problem because any outflow in the current account must be matche
d by an equivalent inflow in the capital and financial account. Thereby, a deficit in the capital ac
count will result in a surplus on the capital and financial account.
There are two components of fo
reign, net foreign debt and net foreign equity. A current account deficit results in financial inflo
w, either in form of borrowings from overseas (foreign debt) or through selling equity in items such
as property and companies (foreign equity). Therefore CAD, especially high levels of CAD, means tha
t lenders may become more reluctant to lend to Australia or to invest in Australia, and decisions af
fecting the Australian economy will increasingly be made by international businesses and not by Aust
ralians. The money borrowed must be eventually repaid and the debt must be serviced. Increased serv
icing costs associated with high levels of foreign liabilities impose a substantial servicing cost,
reflected by the large net income deficits on the CAD. Foreign debt must be serviced through interes
t payments that vary according to the level of interest rates in Australia and overseas, and profits
must be returned on foreign equity investments. Thus, a high foreign debt can create a vicious cycl
e, contributing to the problem of a debt trap, where Australia is borrowing money to service its exi
sting foreign liabilities. In the long-term, rising foreign debt in Australia can lead to a debt su
stainability problem. This means that over time Australia will find it harder to service its debt. I
f the size of the debt is rising faster than the increase in GDP, the interest repayments take up a
greater proportion of or GDP. As a result, this reduces both Australia's overall living standards an
d the economic growth potential of the economy.
As mentioned, high current account deficits represe
nts a constraint on future economic growth, in the long-term. The current account deficit acts as a
speed limit on economic growth. Higher levels of economic growth generally involve an increased impo
rts and deterioration in the CAD. Therefore an economy is forced to lower economic growth to a level
where the CAD is sustainable, this is known as the balance of payments constraint.
Another problem
associated with CAD is the increased volatility or exchange rates. Movements in the exchange rates
can also have a short-term influence on the level of foreign liabilities. High CAD may cause a loss
of confidence of overseas investors in the Australian economy and, by reducing demand for Australia'
s currency, may result in depreciation in the Australian dollar. If the Australian dollar is depreci
ating or appreciating rapidly, this generally indicates an external imbalance. Depreciation in the A
ustralian dollar will generally worsen Australia's CAD problem in the short-term, as the prices of i
mports and costs of servicing foreign debt increase.
Economists differ over the extent to which we
should be concerned about Australia's current account deficit and foreign liabilities, with some arg
uing that since the government is not contributing to the current account deficit and foreign liabil
ities problem, any external imbalances are simply the result of normal market transactions in a glob
al economy, therefore not considered a problem. Again some economist argue that Australia indeed hav
e a external imbalance problem, where other economists views differ immensely.
There is no major po
licy tool which has external balance as its major priority. As external balance has not been a major
focus of the economic policy mix in recent years. Though government policies are able contribute in
improving external balance in an indirect way. In particular, while microeconomic reform is not int
ended to improve external imbalance, it can contribute to the economy's competitiveness and therefor
e can improve export performance.
Also fiscal policies can contribute indirectly in balancing the e
xternal problem. The Howard government believed that ongoing budget deficits caused declining levels
of savings in Australia over the longer term, balanced budgets will help insure that the government
is not drawing on private savings and therefore indirectly contributing external imbalance. Monetar
y policy may be used as a short-term instrument to address an external imbalance crisis. While raisi
ng interest rates may reduce import spending in the short-term, it also attracts financial inflows o
n the capital and financial account, which in the longer term may raise net foreign liabilities, the
net income deficit and also the CAD. Also financial inflow may cause an appreciation of the Austral
ian dollar, which will result in a decline in the competitiveness of exports and may put further pre
ssure on the CAD.
Microeconomic reforms in the last two decades have been the most effective instru
ment to influence Australia's external performance. Microeconomic reforms include trade liberalisati
on, changes to wage determination and labour market regulations, the implementations of National Com
petition Policy, the deregulations of key sectors of the economy, privatisation of many government o
wned businesses and, most recently, taxation reforms. These changes have been designed to raise effi
ciency of production in Australia so that firms can better compete on global markets, which in the l
ong-term will improve Australia's Balance of Payment problems.
It is difficult to assess the effect
iveness of the government's approach to external stability in Australia. Improvements to long-term e
xternal problems take time, and it is important to view the longer term trends rather than focusing
on the short-term peaks and troughs in the current account deficit.
external stability external st
ability external balance general term which describes situation where indicators such balance paymen
t foreign liabilities exchange rate sustainable level that level where they remain longer term witho
ut negative economic consequences past decades sweep globalisation what also seen significant levels
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