RDP 2007-02: Current Account Deficits: The Australian Debate 2. The History of Australia's Current Account

2.1 A (Brief) Long History of Current Account Deficits

Sizeable current account deficits have been recorded in Australia in almost every decade for at least 150 years (Figure 2). One of the chief concerns associated with large and persistent current account deficits is that they might increase the prospects of a sharp reversal in capital flows requiring costly adjustments to domestic econ omic activity.^[4] This section briefly documents the fact that sharp reversals in capital flows have not been a regular, and certainly not a recent, feature of the Australian experience and, most importantly, there have been no instances of default on Australian public debt.

Nevertheless, there have been two episodes of rapid and unsustained rises in net foreign liabilities, the unwinding of which were both associated with depressions in the 1890s and 1930s.^[5] These episodes are illustrated quite starkly in Figure 3, which shows the cumulated current account deficit (as a share of GDP). This measure can provide a reasonable approximation to net foreign liabilities to the extent that valuation effects are small and real GDP growth tends to reduce any past discrepancies over time. Indeed, this appears to be the case given that after 120 years, the cumulative measure matches the first available direct estimate of net foreign liabilities very closely.

Large inflows of capital in the 1870s and 1880s pushed up net foreign liabilities to very high levels (over 150 per cent of GDP). These inflows helped to fuel substantial growth in lending by financial institutions, much of it finding its way into the property market (Fisher and Kent 1999). The collapse of property prices in the early 1890s coincided with more than half of the trading banks of note issue suspending payments (with around 60 per cent of these eventually closing their doors permanently) and a large number of non-bank financial institutions failing. Deposits in many of these trading banks were effectively frozen for years, with the government enforcing reconstruction of these institutions. Most deposits were repaid between 1893 and 1901, but in some cases deposits did not get repaid until as late as 1918. Not surprisingly, overseas investors took flight during the 1890s, and their full confidence was not restored until the 1910s. The aggregate data imply that large capital inflows were restored by the second half of the 1890s, but this appears to reflect large direct flows to fund mining ventures and related investments associated with the 1890s gold rush in Western Australia (Merrett 1997).

The availability of foreign capital in the 1890s was also affected by turmoil in global financial markets. The large London discount house, Barings, suffered a liquidity crisis in the 1890s, in part owing to its financial exposures in South America. This generated concern about all offshore exposures, and it became difficult for Australians to raise funds in London at this time. London remained the main source of offshore funds even into the 1920s. Australia was virtually cut off from long-term borrowings in London from the late 1920s onwards, as money flowed into the New York stock exchange instead (Royal Commission on Monetary and Banking Systems in Australia 1937, paragraph 114).

Fisher and Kent (1999) argue that for Australia the 1930s depression was somewhat different from the depression of the 1890s. In contrast to the 1890s, the banking sector was relatively healthy in the run-up to the 1930s depression, having taken a more conservative approach to lending in the boom years of the 1920s. Certainly, net foreign liabilities (relative to GDP) peaked at a much lower level than in the 1890s (according to the indirect estimate presented in Figure 3). Only three financial institutions had cause to stop payments in the 1930s depression and none of these were trading banks. After the 1929 stock market crash, foreign capital dried up, but there was not the same capital flight that was seen in the 1890s episode. Even so, despite initial resistance by the trading banks – which kept interest rates high in early 1930 – concerns about economic weakness, combined with a reduction in foreign exchange reserves underpinned a devaluation of the exchange rate in late 1930. Thereafter, the current account returned to rough balance, reflecting a combination of factors including the decline in activity, the exchange rate devaluation and an increase in trade protection.

A key development of the 1930s episode was the lengths to which the Australian Government went to avoid default, especially on debt held by foreigners (Caballero, Cowan and Kearns 2004). From April to June 1931, the government of the largest state, New South Wales, did not fully meet interest due on foreign debt. However, the Australian Government and the Commonwealth Bank made good on these payments to protect the ratings of Australian governments (with compensating reductions in revenue payments made to NSW by the Commonwealth). More generally, the Australian and state governments cut expenditure, raised taxes and cut bank interest rates and interest paid to domestic holders of debt in order to ensure adequate funds for the payment of foreign debts. In this way, Australia maintained an unblemished record with regards to foreign holders of debt.

Foreign capital inflows were largely curtailed during the period of World War II and were tightly controlled thereafter by a comprehensive system of controls introduced as emergency measures during the war.

Debelle and Plumb (2006) document a number of episodes of capital flight in the 1970s and early 1980s. These tended to be short-lived events based on speculation of devaluations in the context of the fixed and, later, crawling peg exchange rate regimes.^[6] However, the overarching pressure over this period was the tendency for sizeable capital inflows (with an increasingly open capital account), which made it difficult to achieve the goal of internal balance. Eventually this tension led to the floating of the Australian dollar in December 1983 and a complete liberalisation of the capital account.

2.2 After the Float

A significant feature of the years following the floating of the exchange rate was a sustained widening in the current account deficit and the consequent rapid accumulation of foreign debt, which more than doubled between 1984 and 1989. As early as 1984, the then Secretary to the Treasury, John Stone, gave a speech expressing concern that a default elsewhere in the world would harm Australia as international financial markets took ‘flight to quality’ (Stone 1984, p 8). In 1984, Argentina had come close to default a number of times, and he suggested there were lessons to be drawn from the 1890s experience, when poor returns from offshore investments in South America, particularly Argentina, spilled over into foreign investor concern about investing in Australia.^[7]

The rise in the current account deficit from 1985 to 1986 partly reflected a fall in the terms of trade and the associated depreciation of the exchange rate (of around 50 per cent in nominal effective terms over this period).^[8] Combined with the rise in foreign debt this led the Treasurer at the time, Paul Keating, to warn of the risk of Australia becoming a ‘banana republic’ and underpinned further reform efforts. On the financial side, the banking sector underwent further deregulation, a process which had started in the late 1970s. This largely removed controls on lending to businesses and households, and freed up access to international capital markets. Also, industrial reforms were implemented as arguments mounted for Australian industry to become more internationally competitive. A key aspect of this was the Prices and Incomes Accord (an agreement between the government and trade unions), which had the dual aims of containing domestic inflation and improving international competitiveness (Chapman and Gruen 1990). A further reduction in tariffs on imports and other barriers to trade (following an across-the-board cut in tariffs of 25 per cent in 1973) was another important change.

The large depreciation that followed the float of the exchange rate went some way to improving the competitiveness of domestic firms and insulating them from the reduction in trade barriers. However, the depreciation did not generate inflation to the extent that might have been expected under the old fixed exchange rate regime (in part due to the impact of the Prices and Incomes Accord) and proved to be stimulatory in the face of the declining terms of trade (Debelle and Plumb 2006).

Australia also provides evidence of the potential for changes in the supply of capital to influence the current account. The removal of capital controls with the floating of the exchange rate allowed foreigners desiring to invest in Australia to bring in capital, and to some extent the economy and the current account adjusted to absorb this inflow of capital. An episode during the late 1990s also illustrates this general point. During the height of the global technology boom, it appears that Australia was viewed as being an ‘old economy’, contributing to a sizeable depreciation of the exchange rate (not matched by a change in the terms of trade) (Macfarlane 2000). The trade balance moved from a deficit of about 2½ per cent of GDP in 1999 to a surplus of ½ per cent by 2001, with a commensurate turnaround in the current account deficit.^[9]

The question of resiliency in the face of large external shocks and exchange rate volatility is taken up again in Section 5 of the paper. In the next section we focus on the evolution of the debate about the need for monetary and fiscal policies to respond to large current account deficits.

Footnotes

For evidence on this issue see Edwards (2004) and Bordo and Eichengreen (1999). [4]

The 1871 reversal appears to have reflected a decline in confidence by overseas investors associated with the collapse of prices of gold mining shares. However, confidence was restored fairly quickly, with these mining companies paying hefty dividends in the few years immediately following (Blainey 1963). During the few years either side of 1910, Australians had difficulty raising funds offshore. Foreign investors had lost confidence in Australia's economic prospects as Australia experienced a drought and a decline in its terms of trade at a time when the distress of the 1890s was still a fresh memory. The reversal in net capital inflows in 1951 was not due to a withdrawal of capital but reflected a sizeable temporary increase in export earnings associated with a spike in prices received for exports of wool (and to a lesser extent metals) at the onset of the Korean War. [5]

There were heavy outflows in the week leading up to the Federal election in March 1983. After the election, the exchange rate was devalued by 10 per cent, contributing to the perception that speculators could precipitate significant exchange rate adjustments. Speculative inflows also occurred in anticipation of revaluations, particularly towards the end of 1983. [6]

Other pieces written in the 1980s were less alarmist (Jonson and Stevens 1983; Johnston 1987). While similarities were acknowledged between the 1980s and the 1930s, differences were also noted. In terms of overseas borrowings, foreign debt as a per cent of GDP was higher in the 1930s than the 1980s, as was the burden of servicing this debt as a share of export receipts. While capital inflow dried up in the 1930s, in contrast, the 1980s was a period of significant capital inflow. [7]

Indeed, the depreciation, by raising the Australian-dollar values of debt denominated in foreign currency, also saw a widening of the net income deficit, which accounted for roughly three-quarters of the widening seen in the current account deficit at this time. [8]

Dvornak, Kohler and Menzies (2003) provide estimates regarding the relationship between the current account deficit and the exchange rate in Australia. [9]