RDP 2007-02: Current Account Deficits: The Australian Debate 5. Current Account Deficits and External Vulnerability

Instead of focusing on questions of sustainability, it may make more sense to consider the potential costs of large current account deficits and the associated build-By examining time-series data acrossup of foreign liabilities in terms of the vulnerability of an economy to external shocks. In essence, such an approach can be thought of as falling somewhere in between those that argue that markets are always efficient and, therefore, that all current account deficits are optimal, and those that caution that countries with large foreign debts should (gradually) reduce their dependence on foreign funds so as to avoid potentially costly adjustments in the future.

In the wake of the Mexican and Asian financial crises of the 1990s, a number of studies sought to develop models that might provide an early warning of external crises which, by definition, imply a costly adjustment (either in the form of a deep recession associated with higher borrowing costs and/or a cessation or reversal of capital flows).^[18] By examining time-series data across a wide range of countries, this literature attempts to find indicators that can reliably point to an increasing likelihood of an external crisis. These studies contributed to a perceived association between large net external debt positions and external risks. Australia is a clear outlier in this context, with relatively large net external debt and persistent current account deficits, but no crises.

One problem with such an approach is that it is generally restricted to a limited set of potential indicators, and tends to encourage a ‘one-size-fits-all’ approach to assessing vulnerability, encouraging analysts to treat large current account deficits and external debt as sufficient statistics for vulnerability. However, the value of recognising the role of institutional differences between countries is increasingly being acknowledged (see, for example, Daseking 2002). In this regard, Australia has a number of features that tend to make it relatively resilient in the face of considerable external shocks. Indeed, these features underpin the stability which encourages sizeable capital inflows in the first place. This suggests that a high debt level may not signal vulnerability but rather that it reflects resilience which permits high debt to be sustained.

One feature, in particular, assists Australia to be resilient in the face of large external shocks, in spite of relatively high foreign indebtedness. Namely, foreigners are willing to participate in markets that allow Australian residents to hedge their foreign exchange exposures at reasonable cost; one (but by no means the only) aspect of this is that foreigners are willing to hold Australian debt denominated in Australian dollars. 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, sharp nominal exchange rate fluctuations. Of course such markets can only be expected to evolve fully under a flexible exchange rate regime, in which frequent and often large fluctuations in the nominal exchange rate are the norm. The flexible exchange rate regime also has the advantage of providing a timely and automatic mechanism to adjust to external shocks. That is, it can act as a buffer, allowing shocks to dissipate rapidly across the domestic economy with a more modest impact on inflation than was the case under the fixed exchange rate regime.^[19]

The development of this resilience of the Australian economy to external shocks has been well documented in a number of studies (Caballero et al 2004, Becker and Fabbro 2006, Debelle and Plumb 2006, Macfarlane 2006b and McCauley 2006). These studies emphasise the value of maintaining investor confidence in the face of sizeable external shocks via: a robust financial system, with deep, liquid and stable financial markets and strong financial institutions; credible and stabilising macroeconomic policies; and low net foreign currency exposure.^[20] Arguably, an element of luck and perseverance has also helped in the early stages of floating, allowing these markets and policies to develop. This section of the paper summarises this literature by briefly tracing through these key features. In doing so, it becomes clear that while many of these features have come about through a conscious effort of policy-makers seeking to generate resilience, others have arisen more as a by-product of other pursuits or the result of learning-by-doing.

5.1 The Record on Inflation

A record of, and a commitment to, low and stable inflation is necessary to keep down the cost of issuing debt – it reassures holders of debt denominated in domestic currency that the value of this will not be eroded to the benefit of issuers. In Australia, the adoption of inflation targeting by the RBA in 1993 has achieved the goal of keeping year-ended inflation on average between 2 and 3 per cent over the cycle. Caballero et al (2004) argue that, notwithstanding higher inflation in the 1970s and 1980s, over the past 100 years policy in Australia has established a reputation of being willing and able to maintain modest and stable inflation.

5.2 The Government Debt Market

A key factor behind the confidence of foreigners in the market for Australian government debt is the fact that foreign holders have never suffered from any defaults on the debt (see discussion in Section 2.1).

A number of changes around the early 1980s have been identified as having strengthened the market for government debt in Australia, apparently contributing to the take-up by foreigners of Australian-dollar-denominated debt for the first time. McCray (2000) highlights the role of financial deregulation in reducing the extent to which domestic financial institutions acted as a ‘captive market’, thereby contributing to a rise in yields. He also points to a range of important operational changes that were made as the market moved from a highly regulated environment, with tap issuance (whereby authorities set the price) and a ‘buy and hold’ mentality, to one of open price discovery (through auctions) and an active secondary market (see also McCauley 2006).

As a result, more than one-half of Australian Government debt – almost all of which is issued domestically in Australian dollars – is held offshore.^[21] Foreign investors also hold debt issued by Australian state and local governments and corporations. Indeed, more than 70 per cent of corporate debt is held by offshore investors, with the corporate bond market around eight times larger than the Australian Government bond market. Foreign investor interest in Australian corporate bonds has been facilitated by a liquid cross-currency interest rate swaps market, which has allowed foreign investors to accept currency risk whilst insulating themselves from the credit risk associated with lending to Australian firms (McCauley 2006).

5.3 Financial Markets

Caballero et al (2004) emphasise the importance of deep and efficient financial markets in helping to ensure that domestic residents are able to hedge foreign exposures at a reasonable cost. International comparisons suggest that these markets are relatively deep for Australia. For example, Australia's share of world output is relatively small at around 1½ per cent (making it the 15^th largest economy), but (against the US dollar) turnover in the Australian dollar spot and derivatives markets is the 4^th largest in the world (BIS 2005). The average daily turnover of the Australian dollar swaps market is A$45 billion (US$34 billion). This market is deep enough that the net derivatives position of the banking sector could be turned over more than three times a month (Becker and Fabbro 2006).^[22]

Of course this was not the case during the era of capital controls and regulated financial institutions. Debelle and Plumb (2006) discuss the early stages of development of these markets as these controls were eased. One important facet of this was the lesson learnt by Australian borrowers early on in the post-float period about the dangers of unhedged foreign-currency borrowing (see also Becker and Fabbro 2006). In the mid 1980s, some borrowers took out (unhedged) Swiss franc loans to avoid paying much higher domestic interest rates. These borrowers made substantial losses when the Australian dollar depreciated by more than 50 per cent against the Swiss franc between January 1985 and August 1986. While the scale of the borrowing was relatively small – so that the losses did not disrupt the economy or the banking system overall – they generated enough publicity to provide a salutary lesson to both businesses and households.

Nowadays, the bulk of Australia's non-government foreign debt is raised by the banking sector. These institutions are not only able to raise funds at a relatively low cost (given that they tend to be highly rated), but they are also in a good position to hedge exchange rate risks arising from these borrowings. It is advantageous, therefore, for these financial institutions to act as intermediaries for business and household sectors given that they can provide Australian borrowers with relatively low cost and fully hedged access to foreign funds.

As in the United States, Australian residents have a net long position in foreign currency (before accounting for hedging activities); that is, gross foreign currency-denominated assets exceed gross foreign currency-denominated liabilities (Becker and Fabbro 2006). Of Australia's net external debt, around 40 per cent is denominated in Australian dollars. According to a recent survey by the ABS (2005), most of the remaining net exposure is hedged, with just over one-tenth of net external debt being in ‘unhedged’ foreign currency (Becker and Fabbro 2006), which is not to say that it may not be covered by some natural hedge. Much of the hedging activity appears to have non-residents as counterparties, thereby insulating domestic residents as a whole against unfavourable exchange rate fluctuations.

While currency risk does not appear to present much of an issue for Australia, attention has instead focused on refinancing risk, particularly of short-dated debt (see, for example, IMF 2006). Much of Australia's offshore debt is issued by financial institutions, with foreign liabilities accounting for about 27 per cent of Australian banks' total liabilities, compared to around 15 per cent a decade ago. While debt securities comprise the majority of banks' foreign liabilities, more than two-thirds of these have been issued with a term to maturity of greater than one year, with an average maturity of around four years; Australian corporations borrowing offshore tend to issue longer-dated debt. It is beyond the scope of this paper to make more than three brief remarks on refinancing risk. First, thus far, rolling over debt has not been an issue for Australia, even during periods of adverse shocks, such as the Asian crisis. Second, Australian banks have tended to issue offshore debt in a range of different markets and in a range of different currency denominations, providing some diversification against shocks that may adversely affect any one market (RBA 2006). Third, in response to an adverse shock it is likely that much of the adjustment would occur through a depreciation of the exchange rate.

5.4 Institutional Framework

Stable government with credible and sustainable monetary and fiscal policies is necessary for a country to maintain the confidence of both foreign and domestic investors. Other critical institutional features include 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. In the extreme, these reduce the likelihood of some type of expropriation of wealth and/or income (to the advantage of particular domestic residents), either by direct or indirect means. More generally, however, they also allow countries to better withstand adverse external shocks that might otherwise harm foreign investors' interests.^[23] Certainly, Australia appears to rank highly on a range of indicators in this regard. For example, in 2006 Australia ranked 9^th (out of 161 countries) in the Economic Freedom of the World Index, which attempts to systematically compare countries across the types of institutional features mentioned above.

One episode that points to the resilience of the Australian economy is the period of the Asian economic crisis of 1997 and 1998, in which there was a sizeable decline in demand from many of Australia's major trading partners in the region. The nominal exchange rate depreciated in effective terms by about 20 per cent from mid 1997 to early 2001, but again the inflationary impact of this was relatively modest. Indeed, unlike a number of countries with substantial commodity exports to the region, the RBA did not tighten policy in response to the depreciation. Instead, the depreciation was viewed as a necessary part of the adjustment to an adverse shock of this type. A widening in the current account deficit – of more than 4 percentage points of GDP over the two years to mid 1999 – was also an important mechanism dampening the impact of the shock on the domestic economy. Caballero et al (2004) note that the stimulatory impact of the depreciation (including by facilitating a diversion of exports to the US and Europe) was in contrast to less-developed economies for which the depreciation adversely affected balance sheets of corporations with sizeable exposures to unhedged foreign-currency-denominated debts.

Footnotes

For example, see Kaminsky and Reinhart (1999). [18]

The RBA believes occasional intervention in foreign exchange markets to be desirable. The Asian crisis is one such example where intervention was used to limit downward pressure on the exchange rate, but only after the exchange rate had moved a long way, consistent with the view that depreciation was a desirable and necessary part of adjustment (Stevens 2006). [19]

Caballero et al (2004) argue that this confidence reflects what they term ‘currency trust’ and ‘country trust’. Closely related to currency trust is what McCauley (2006) describes as the internationalisation of the Australian dollar. [20]

As at June 2006, the Australian Government had A$65 billion of bonds on issue of which A$33 billion, or 52 per cent, was held by offshore investors. [21]

The average daily turnover of Australian dollar swaps between domestic and overseas banks is around A$25 billion (US$19 billion), or 2.8 per cent of GDP over the year to March 2005. [22]

Kent, Smith and Holloway (2005) present evidence that structural reforms leading to stricter monetary policy regimes, greater labour market flexibility and increased product market competition have played a role in reducing the volatility of output across a range of developed economies. [23]