Activity 7(i)

Activity 7i: Is a CAD a problem?

  1. This is because the CAD reflects the fact that more money is leaving the country (i.e. debits) than is entering the country (i.e. credits) before taking into account the debt or equity flows that are required to make up for the shortfall (i.e. the deficit). This is similar to a household that spends more than it earns over any given period. In both cases, the entity (i.e. Australia as a country or households in general) does not have sufficient income to support current spending levels (i.e. spending beyond its means), which therefore requires debt (e.g. borrowing) from overseas or the sale of assets (i.e. equity) to overseas interests in order to finance the shortfall in spending (i.e. finance the deficit).
  2. A CAD necessarily means that there is a savings/investment imbalance – with investment exceeding savings. In other words, the country as a whole is spending too much and therefore saving too little. As shown in the response to question 1, this imbalance requires foreign sources of funds in the form of either debt or equity. Given that net foreign debt plus net foreign equity equals net foreign liabilities, it must be true that any savings investment imbalance (which explains a CAD) must result in more net foreign liabilities.
  3. This is because a higher CAD/GDP percentage indicates or reflects the extent to which we are spending beyond our means. Another way of looking at this is to say that a bigger CAD/GDP percentage means that we are increasingly relying on foreign funds as a means of bringing forward future consumption. These liabilities need to be serviced into the future with future income.  As the liabilities increase in size relative to income, it means that it becomes increasingly difficult to service the liabilities (e.g. repaying interest on foreign debt) and therefore exposes the country to the possibility of future economic downturns in the event of an economic shock (e.g. a financial crisis and a large increase in interest rates).  This is why economists like to refer to the CAD in terms of its relationship to GDP (i.e. deficit relative to total income).  A CAD/GDP ratio greater than 5% is arguably one that exposes Australia to excessive risk of a major economic correction or downturn.  This is why the RBA suggests that a ratio in the order of 5% of GDP might be unsustainable.
  4. Given that Australia is a young country, in need of large scale investment in both infrastructure and industries more generally, it is to be expected that there will be a reliance on foreign funds to finance development. In this respect, provided that the CAD reflects ‘excessive’ spending on investment items (as opposed to consumption), then it is unproblematic and simply represents a structural feature of a growing economy.  Accordingly, it is very different to ‘excessive’ spending on consumption items that will not have the ability to generate future income.  This is the consenting adults view of the CAD where the borrowing (or sale of equity) that results from a CAD is an ‘adult decision’ (i.e. wise decision) that has been made with careful consideration, unlike the borrowing by minors, which is more likely to be made in haste or without taking into account the full financial implications that stem from the borrowing.
  5. This is because in the past, national spending was relatively excessive compared to national income, contributing to the imbalance between national spending and income. It is also true that during the last 30 years (prior to 2019) Australia’s growth in spending was typically strong, with spending tending to spill over into imports, which negatively impacted on the Balance on Goods and Services and the CAD. In contrast, over recent years, national spending has been relatively sluggish, with the reverse occurring. 
  6. This is the because the recession resulted in a large scale decreasing national spending (e.g. reducing demand for imports) which reduced the gap between national spending and income, resulted in a higher value of net exports, boosting the BOMT, BOGS and pushing the CA into surplus.
  7. With respect to interest rates, lower rates effectively reduce the servicing costs related to foreign debt which in turn led to relatively fewer interest debits flowing through the net primary income section of the current account (therefore contributing to a surplus). With respect to the retention of company profits, this meant that fewer dividends flowed through the net primary income section of the current account as debits which therefore further contributed to a surplus on the current account.