Australia's Balance of Payments (BOP) consists of both the Current Account and the Capital and Financial Account. The Current Account consists of all exports and imports of goods and services, net income and current transfers. Australia generally has an ongoing Current Account Deficit (CAD) meaning there is more money flowing out of the country in the form of exports, income and current transfers, than there is coming into the country.The Capital and Financial account records all financial assets and liabilities, including foreign investment, whose purpose is to borrow money in the form of investments, in order to fund the Current Account Deficit.
The measurement of the CAD as a % of GDP gives an accurate indication of its relative size to national output over time. If the CAD reaches over -5% of GDP it is considered to be unsustainable since it represents a constraint to domestic economic growth. If the economy is growing at say 4% and the CAD reaches -5%, then the economy cannot grow faster without spending more on imports which in turn will increase the goods deficit and the CAD. Here the RBA will increase interest rates in order to slow economic growth and decrease the size of the CAD as a percentage of GDP.
One reason of Australia's ongoing CAD and trends are both cyclical and structural. In cyclical terms when domestic growth is faster than world growth, this means that the domestic economy is undergoing increased levels of economic activity, and thus demanding more imports. However because world growth is below the level of domestic economic activity, the level of imports will exceed the level of exports.
A disadvantage of this situation and this cyclical component of the CAD, is that imports represent a leakage in the circular flow and is controlled through market forces of supply and demand. Similarly since the CAD must then be funded through the Capital and Financial Account, the CAD in turn increases Australia's foreign debt and liabilities.This then will increase the servicing cost of Australia's debt, which then increases the net income debits in the Current Account in the future, increasing the deficit further. The disadvantage is that if this debt is seen as unsustainable by other countries, it can lead to a large withdrawal of capital, and a shortage of savings within Australia. This is because if speculators fear Australia's inability to pay back its debt, they will lose confidence in Australia's investment and financial markets.
An example of this is the strong domestic growth in 1994-95 increasing the demand for imports, reflected in the CAD peaking at 6% of GDP.
In order to combat this, the RBA tightened Interest rates in 1994. The rise in interest rates, encouraged both foreign and domestic savings, decreasing economic activity and demand for imports. Thus combating the CAD. However this will have many implications for the whole economy. With lowered demand for imports, supply of the AUD would have decreased, leading to an appreciating and lowering imported inflation. This is advantageous for importers as they find imported goods and services cheaper, and may result in increased living standards and more need and wants are satisfied. However for exporters, the appreciation will cause them to lose competitiveness with overseas firms. Not only does this decrease sales and income, but it decreases the amount of their profits when converted back into domestic currency from overseas subsidiaries.
An advantage of this cyclical component is that, the CAD represents Australia's trade with other countries. This increased access to foreign technology, production methods, managerial skills and goods and services manufactured in an environment where comparative and absolute advantage is established can lead to technological innovation, increased competition, an increase in skilled labor, and increased living standards respectively. Thus the increase in foreign investment in Australia, as reflected in the Capital and Financial Account's surplus is beneficial as it represents an increase in foreign direct investment and Portfolio investment. This is an advantage as it increases Australia's Greenfield investment to build new capacity such as the building of new factories and infrastructure. Similarly firms gain access to foreign savings, allowing for the allocation of private capital to be directed into new businesses, via the purchase of shares. This represents an efficient means, of which firms can gain access to funds.
Similarly if world growth is slow, then the amount of exports demanded will fall. This decreases the balance of goods and services credits in the Current account. If demand for imports stays the same, then this could lead to an increase to the CAD. Similarly if demand increases, so will the CAD. This is a disadvantage as it reflects Australia's vulnerability to other countries and their business cycles. This greater trade dependency, limits Australia's independence as downturns in the international business cycle can lead to large CADs in Australia. The disadvantage of this influence, is that Australia's debt will then be increased to fund the CAD, and must then be serviced and paid back in the future as a debit, which is seen as a leakage in the circular flow.
