RDP 9003: The Balance of Payments in the 1980s VII. Some Unresolved Issues: Foreign Debt and the Equilibrating Role of the Exchange Rate

The large rise in the stock of foreign debt attracted considerable attention during the decade.^[52] There was a wide range of views on the subject. While some suggested that the build-up of foreign debt may not be a matter of concern for macro-policy purposes, there were others who suggested that foreign debt is Australia's major economic problem.

Net foreign debt increased from 5 per cent of GDP in 1980/81 to 33 per cent of GDP in 1988/89. This rapid increase in the stock of foreign debt was due to the persistently high current account deficits experienced during the decade, the rise in Australian equity investment abroad (and the commensurate funding requirements) and the switch to portfolio borrowing as the predominant source of capital inflow. Debt is only one component of Australia's net liabilities to the rest of the world, therefore our net equity position must also be taken into account. Figure 24 plots the behaviour of net foreign debt and Australia's net international investment position which is defined as the difference between the stock of gross foreign investment in Australia and the stock of gross Australian investment abroad, both debt and equity.

The growth in the net international investment postition has been slower than that of net foreign debt. The net international investment position was much higher than net foreign debt at the beginning of the 1980s. This reflected the predominance of net equity inflow up to this time. (See Section IV(iii)). The rapid rise of both debt inflows and Australian equity investment abroad has seen this gap narrow in the 1980s. As noted in Robertson(1990), the growth in net foreign debt lends to overstate the pace of increase in Australia's reliance on overseas financing. Nevertheless, on either measure Australia must now devote a greater proportion of domestic production to service foreign liabilities. Figure 25 plots a number of measures of debt servicing.

Some commentators have seen Australia inexorably sliding towards a debt trap. Simple extrapolation of the recent current account position implies an unsustainable debt increase (i.e. where debt/GDP rises continuously). Others have pointed to possible adjustment paths – involving smaller current account deficits – towards a stable debt/GDP ratio: see Office of EPAC (1986, 1989a). While these exercises are useful for giving a feeling for the orders of magnitude involved, they ignore the fact that growing foreign debt will cause responses that will eventually bring us to some equilibrium position. Concerns about debt/GDP expanding for ever are therefore unfounded. Fahrer (1990) has shown that the conditions for a stable debt/GDP outcome to be reached are easily met Also, the results of the earlier tests show there is evidence that, in the long run, imports are constrained by export income (see Section VI). An important question is whether this adjustment process is costless.

Some argue that when the government's accounts are in balance, the current account deficit or surplus reflects the outcome of rational savings and investment decisions taken by households and firms.^[53] If the deficit is due to higher consumption, this simply reflects the household sector's preference for current rather than future consumption. If it is due to investment then firms expect that the returns to the investment will be sufficient to meet the future interest costs.^[54] Therefore, unless there are costs of external adjustment which are independent of, and larger than, the costs of policies aimed at bringing that adjustment about, there is no role for policy.^[55]

They acknowledge that some current account deficits may be undesirable to the extent that they reflect excessive government spending, excess demand or distortionary taxes or regulations. In these cases, however, it is not the current account that is the problem; it is merely the symptom. Reducing government spending or excess demand and removing distortions are desirable in their own right irrespective of the implications for the current account. It is possible therefore that certain deficits are “bad” while others are “good”. OECD(1989).

In some models that underly this “equilibrium view” there is no role for policy; prices are flexible and the adjustment path after a shock is the welfare maximizing one. Fahrer(1990) develops a model that introduces inertia to current account adjustment which is assumed to derive from a sticky real exchange rate. The adjustment path of this model in response to a number of shocks is then compared to that of a model in which there is no inertia. Two results emerge. The first is, that even with a sticky real exchange rate, external debt is not a problem in that it will eventually stabilise. However, the adjustment path to that point deviates from the welfare maximizing path. This implies that there is scope for pursuing welfare improving fiscal policies to replicate the welfare maximizing outcome. While the fiscal rules derived from this model are not useful for practical purposes the analysis demonstrates that there is at least theoretically a role for activist fiscal policy in response to shocks to the current account.

All this relies on the exchange rate playing a key equilibrating role. How effective is it, in practice, in this role? Dornbusch(1989) argues that a number of issues must be considered when assessing whether the exchange rate “works” as a costless adjustment tool. These include:

– does the exchange rate affect relative prices and, in turn, trade volumes?;

– does exchange rate adjustment minimize excess volatility and the misallocation of resources?; and

– will the financing of a given external debt proceed smoothly over time?

Most Australian studies show that nominal exchange rate changes do alter relative prices. There appears to be significant pass-through of exchange rate changes into import prices. See Coppel, Simes and Horn(1987) and Phillips(1988, 1989). Pass-through on a dissaggregated basis was examined by BIE(1986, 1987, 1988) and Lattimore(1989). These studies tended to find that the extent of pass-through varied between industries but in general was high. There is also considerable evidence that relative prices have a significant effect on import volumes. See Horton and Wilkinson(1989) and Phillips(1989). In general it has been more difficult to identify a significant relationship between exports and relative prices. See Macfarlane(1979). However, Gordon(1986) examined Australian empirical evidence and concluded that import and export price elasticities were such that a depreciation would reduce a trade account deficit.

More problematical is whether the exchange rate automatically finds the ‘proper’ level to induce the required adjustment. The evidence that the exchange rate adjusts quickly to shifts in fundamentals and therefore minimises resource costs is not compelling. Australian and international evidence shows that the foreign exchange market is not efficient in a technical sense.^[56] Expected returns do not appear to be equalised across countries. Smith and Gruen(1989) argue that in the case of Australia this has little to do with the risk preferences of market participants. They find that, ex-post, investors are over-compensated for holding Australian dollar assets and that these excess returns are too large to be accounted for by conventional measures of risk. Over long periods, since the float, what they gained from high interest rates in Australia vis-a-vis the rest of the world, they do not lose in terms of a depreciation of the Australian dollar in terms of other currencies. A possible explanation is that the expectations of market participants are not formed “rationally”. It appears that the market does not incorporate all available information into its pricing decisions. Furthermore, Frankel and Froot(1987) and Nakao(1989) find that expectations appear to be formed extrapolatively. That is, if the market observes an appreciation in the present period then it will expect an appreciation next period. This means that the exchange rate can drift away from from a value implied by fundamentals.

It appears, therefore, that there is the potential for the exchange rate to result in a misallocation of resources. This is because, in the short-run, movements of the nominal exchange rate do not appear to be entirely explained by fundamentals.^[57] Over the longer run, the available evidence suggests that there is a tendency for the nominal and real exchange rate to move with fundamentals (particularly the terms of trade and relative inflation). (Blundell-Wignall and Thomas(1987), Blundell-Wignall and Gregory(1989) and Macfarlane and Tease(1989)). However, the evidence that the exchange rate responds in a way to reduce current account imbalances is limited. This is partly due to the fact that both the current account and the exchange rate are endogenous and therefore the behaviour of the exchange rate vis-a-vis the current account depends on the nature of the underlying disturbances.

Nevertheless, there appears to have been no long-run tendency for the real exchange rate to depreciate to offset the widening of the current account deficit.

The extent to which a given external balance will be financed smoothly over time is difficult to answer. A good deal depends on the perceptions of the financial markets. One argument for concern about high overseas debt is that, at some point, the financial markets will come to view the situation as unsustainable and therefore lead to an abrupt and disruptive change in the exchange rate. The experience of the past few years has shown that financial markets, both domestic and foreign, have been more forgiving than most commentators would have thought. In the main, growing external imbalances have been financed relatively smoothly. (Although this does not mean that they will continue to do so). However, there have been occasions when there have been sharp changes to the exchange rate. Smith and Gruen(1989) find that the Australian dollar is more skewed than other currencies (i.e. falls tend to be sharper than rises). They suggest that this is due to the perceived need for external adjustment, which makes holders of $A nervous whenever there is weakness in the foreign exchange market.

While a depreciation of the Australian dollar is part of the adjustment needed to reduce the current account deficit, the way in which these depreciations occur place strains on the economy and induce policy responses. For instance, the cumulative depreciation of around 40 per cent between early 1985 and May 1986 raised concerns about the capacity of the economy to absorb such a large relative price change. Consequently, monetary policy was tightened. See Macfarlane and Tease(1989). The OECD(1988, 1989) suggest that one of the consequences of having an unsustainable adjustment path is the need for abrupt changes in policy.

This evidence, taken together, suggests that while over the longer term the exchange rate responds to the terms of trade and relative inflation and induces responses in relative prices and trade volumes that one would expect, it can, for a period, be influenced by short-term market driven phenomena. As a result, there is the potential for a misallocation of resources. This may hinder the adjustment towards the optimal current account/external debt position. Furthermore, while the financing of the external imbalance has occured smoothly relative to some expectations, it appears that the external adjustment problem has resulted in some unusual behaviour in the foreign exchange market.

On the basis of the above discussion, the “middle ground” in this debate would involve:

• acknowledging that there are ‘good’ and ‘bad’ deficits, but that even when a ‘bad’ deficit is identified (i.e. one which reflects fiscal imbalance, distortions or externalities), the appropriate response is to address the problem directly; and
• recognising that if the world market has volatile and discontinuous changes of sentiment about a country's credit-worthiness, then adjustment (when it comes) may be traumatic. There may be a role for policy in bringing-forward or softening the adjustment process. Even where this is accepted, the exact policy prescription is not clear.

Footnotes

See the references to Office of EPAC in the Bibliography. They have done a great deal of work on debt projections. [52]

The principal proponent was Pitchford(1989a,c). This view was also expressed by others including Makin(1987, 1989), Harper and Lim(1989) and Sjaastad(1989). Earlier versions can be found in Corden(1977), Buiter(1981), Obstfeld(1981) and Frenkel and Razin(1987a). [53]

If, because of some miscalculation or altered circumstances, the projects are unprofitable, then the foreign debt is extinguished by the bankruptcy of the borrower. [54]

The following quote from Pitchford(1989c) p. 13 expresses the essence of the argument. “Until a case is made that privately generated current account deficits and foreign debt produce costs of some kind commensurate with those of recession and inflation, there would seem no reason to justify intervening with macro policy, given its readily calculated costs to affect their outcomes.” [55]

Tease(1988) and Smith and Gruen(1989). [56]

This discussion has ignored the possible effects of short-term exchange rate volatility on trade and investment. Day-by-day volatility should not be a great cause for disruption to markets or policy-concern, because traders can hedge cheaply. But just for completeness we note that volatility appears to have increased, as one would expect, since the float. Trevor and Donald(1986). [57]