RDP 8908: Capital Flows and Exchange Rate Determination II. Capital Movements
December 1989
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Pre-float
In nearly every year in the post-war period, Australia has run a deficit on its current account. Historically, this deficit has been viewed as part of the transfer of resources of the developed and older economies towards newer areas where rates of return are felt to be higher. Over the three decades from 1950 to 1980, the current account deficit averaged 2½ per cent of GDP.
During this time, over 60 per cent of the external deficit was financed by inflows of equity capital. There were exchange controls operating over this period, which limited the extent to which Australian firms could rely on external debt raisings, and lending abroad by Australian institutions was prohibited for most of this period. With generally strong domestic growth and with international interest rates not high in real terms, Australia's external debt to GDP ratio remained low. To the extent that there was any public sensitivity to international capital flows, it was directed against highly visible foreign equity in domestic Australian businesses.
Over this period, the exchange rate regime changed a number of times, but all the variants could be classified as fixed or quasi-fixed. The Australian dollar was fixed against the pound sterling until 1967, against the U.S. dollar until 1974, and against a trade-weighted index until 1976. From 1976 to 1983, the Australian dollar was moved in an adjustable peg arrangement against a trade-weighted index.
Post-float
When the Australian dollar was floated in December 1983, the remaining exchange controls on capital movements were lifted. Apart from a minor restriction on movements in currency, Australia ended all controls on movements of capital. The Exchange Control Department of the Reserve Bank was abolished. Australia can now be classified, with only minor qualification, as a country with a freely floating exchange rate and perfect capital mobility.
The financing of the current account deficit has responded to changes in the institutional environment, particularly with the acceleration in financial deregulation. Paralleling the development of deeper and more sophisticated debt markets, there has been a marked shift in the source of financing towards debt. As is shown by Table 1, this was not a recent development. Even in the pre-float period, there was a tendency for debt flows to grow at the expense of equity flows, or at the expense of long-term borrowings between related institutions. In other words, the interest-sensitive component of international capital flows tended to grow towards the end of the fixed exchange rate era, to become the predominant form of capital inflow. It now accounts for over 100 per cent of net capital inflow compared with around 10 per cent for most of the 1960s and 1970s. In the 1960s, debt finance largely took the form of investment by foreign parents in their Australian subsidiaries. Today, over 90 per cent of debt funding is in the form of portfolio investment.
| Direct Borrowing | Portfolio Borrowing | Equity & Other | |
|---|---|---|---|
| Sep 59–Jun 77 | 23.9 | 12.7 | 63.4 |
| Sep 78–Jun 83 | 8.7 | 80.4 | 10.9 |
| Sep 83–Mar 89 | 13.1 | 116.9 | −30.0 |
An important source of funds in recent years has been the Euro-Australian dollar bond market. The first Eurobond denominated in Australian dollars was issued in 1976, but raisings were negligible until 1983. Since that time, the raisings have increased rapidly (see Figure 1).[1] Issues rose strongly in 1985 and 1986 and peaked in 1987, before falling a little over the last two years. Outstandings in this market now amount to $37 billion (compared to $50 billion in the domestic government bond market and $66 billion in the bank bill market).
$A EUROBOND ISSUES
Initially, Australian residents, particularly semi-government authorities, were the main issuers, but more recently banks have been the predominant Australian issuers. Issues by non-residents grew quickly and have accounted for more than half the volume of new issues since 1985.
An important factor behind the growth of this market has been relatively high Australian interest rates which have encouraged a retail investor base in Europe. In addition, taxation and regulatory considerations have meant that Australian issuers have faced lower borrowing costs offshore. Funds raised offshore by Australian banks, for example, were not subject to the Statutory Reserve Deposit (SRD) requirement, which only applied to domestic deposits.[2] Also, Australian dollar Eurobonds issued by residents are usually structured so that they are exempt from interest withholding tax. The combined effect of these factors has been to encourage Australian companies to do their fixed interest borrowing offshore; the Euro-Australian dollar market is a replacement for a domestic corporate bond market.
The growth of non-resident issues has been encouraged by an active swap market in Australia. Non-Australian borrowers in the Euro-Australian dollar market typically swap the fixed rate Australian dollar proceeds to an Australian company, and in return receive, either directly or indirectly, a floating rate liability denominated in the currency of their preference.
Shorter term variations in the volume of issues can also be explained in terms of movements in Australian interest rates and in the Australian dollar. Apart from the initial fall in 1985, subsequent falls in the Australian dollar have tended to cause new issues to dry up. However, in periods when interest rates rose in response to the falling exchange rate (see Section III), new issues resumed. In particular, when Australian interest rates were high enough to steady the Australian dollar or cause it to rise, Euro-Australian dollar raisings picked up sharply. From Figure 2, it can be seen that this occurred in early 1986, in the first three quarters of 1987, and again through early 1988 and 1989.
$A EUROBOND ISSUES AND THE EXCHANGE RATE
