RDP 2007-02: Current Account Deficits: The Australian Debate 6. Conclusion

Australia has a long history of large and persistent current account deficits. In the mid 1980s, however, following the floating of the Australian dollar and the opening of the capital account, the deficit rose considerably and has been sustained around an average of about 4½ per cent of GDP since, with no discernable trend in the real exchange rate. This shift in the 1980s contributed to a rapid rise in net foreign debt, and the current account deficit became a key object of policy-makers in its own right. The chief concern was that such deficits raised the prospects of default and/or a sharp reversal in capital flows. That is, it was feared that the deficits were not sustainable – implying potentially disruptive adjustments in the future – and that they left the country more vulnerable to adverse external shocks (including a change in sentiment of foreign creditors). Hence, it was argued that all arms of policy, in both macroeconomic and microeconomic spheres, should and could attempt to reduce the current account deficit.

This view was challenged by those that argued that the current account merely reflected the optimal decisions of private agents and, as a result, concerns about sustainability were misplaced and there was certainly no role for macroeconomic policy to intervene. This did not mean that efforts at fiscal and other reforms were unwarranted, but that they should not be directed at influencing the current account balance, and indeed may not have had the desired effect in any case. Many elements of this view came to be accepted by policy-makers. In part, this may have been influenced by the realisation that despite widespread reforms (including a substantial fiscal consolidation leading ultimately to no net public debt), the current account deficit remained stable in trend terms.

This ‘consenting adults’ view of current account deficits has become widely accepted in Australia among academics and policy-makers. This paper presented empirical evidence providing some support to the idea that, following capital market opening in 1983, cycles in the current account deficit in Australia have been consistent with optimal consumption-smoothing behaviour. Sustainability calculations imply that, if the recent trend level of the current account deficit continues, foreign liabilities will eventually stabilise at around 86 per cent of GDP, compared with around 60 per cent in 2006. This says nothing about the more important question of solvency; however, in a flexible exchange rate regime, this is subject to the ongoing assessment provided by open and transparent capital markets.

It is generally acknowledged that large deficits and foreign indebtedness can imply some degree of vulnerability for a small open economy subject to large external shocks (including swings in investor sentiment). Australia is an interesting case study in this regard, as it is recognised as having a number of institutional features that help to lessen its vulnerability to external shocks. Stable government, credible and sustainable monetary and fiscal policies, a sound financial system based on efficient regulation and supervision, effective legal and accounting frameworks, and transparent and open markets both for factors of production and outputs are critical features to maintain the confidence of (both foreign and domestic) investors. Of particular note is the fact that foreigners are willing to participate in markets that allow Australian residents to hedge their foreign exchange exposures at reasonable cost. This allows balance sheets and trading activities of domestic corporations and households (which are net foreign debtors) to be resilient in the face of large nominal exchange rate fluctuations. Since floating, Australia has certainly demonstrated considerable resilience in the face of a number of large adverse external shocks.

Indeed, the features that underpin this resilience may have encouraged sizeable capital inflows in the first place. In other words, in Australia's case, a high debt level may be less of a signal of vulnerability and more a reflection of resilience which attracts foreign capital and keeps it in place.