RDP 2007-02: Current Account Deficits: The Australian Debate 1. Introduction

Large and persistent current account deficits are frequently raised as a cause for concern for a number of reasons. Perhaps the key concern is that countries in this situation could be on a path to insolvency, building up excessive net foreign debt, raising the prospects of default and/or a sharp reversal in capital flows, which might force an abrupt and costly adjustment.^[1] Also, large deficits and rising indebtedness could leave countries more vulnerable to adverse external shocks (including a change in sentiment of foreign creditors). Some argue that policy-makers should take steps to ensure that countries move towards a sustainable position in which the current account deficit is not so large that it will lead to an excessive build-up in foreign indebtedness.

At the other extreme is the argument that, so long as markets are efficient, current account deficits reflect the optimal decisions of borrowers and lenders. Therefore, policy intervention to reduce deficits is not only unwarranted but could reduce welfare. Moreover, policies that attempt to rein in deficits may be ineffective, while policies to improve market efficiency and enhance welfare could lead to higher current account deficits.

Because Australia has a long history of sizeable current account deficits, it makes for an interesting case study of these issues. This paper documents the clear change in the general view in Australia over the past three decades concerning the current account balance as a policy objective, highlighting issues related to solvency, sustainability, optimality and vulnerability. This period is also interesting because it spans the transition from a fixed exchange rate regime with stringent capital controls and a heavily regulated financial system, to a flexible exchange rate regime with an open capital account and liberalised financial markets.

Figure 1 shows Australia's current account balance and some related macroeconomic developments since the 1960s. A shift to larger sustained current account deficits was noticeable around the early 1980s, with the average increasing from about 2½ per cent to 4½ per cent of GDP. Most of this rise can be accounted for by a drop in the saving rate rather than a rise in investment. This change was sustained in the face of a sizeable turnaround in the fiscal position (as a share of GDP, public sector debt reached a little over 30 per cent in the early 1990s and has declined to around zero currently) and a large depreciation of the real exchange rate (of around 30 per cent between the mid 1970s and mid 1980s). Net foreign debt rose rapidly from around 6 per cent of GDP at the beginning of the 1980s to over 30 per cent by the mid 1980s (partly reflecting the effect of the depreciation on foreign-currency-denominated debt); since then it has risen to about 52 per cent. The profile of total net foreign liabilities is not quite as steep, with net foreign equity liabilities flat for much of the period and lower since the late 1990s.^[2]

From the early 1970s to December 1983, with the fixed (and later managed) exchange rate regime, current account deficits in Australia were a cause of policy concern to the extent that they were not matched by capital inflows and hence needed to be funded out of foreign exchange reserves. But the more general and growing concern was the problem of managing a partially fixed exchange rate while pursuing monetary policy goals with an increasingly open capital account. By late 1983 these pressures contributed to the complete opening of the capital account and floating of the exchange rate (Debelle and Plumb 2006).

The view that policy should and could do something to address large current account deficits and the build-up of external liabilities persisted after the move to the flexible exchange rate. Indeed, with the rapid build-up of external liabilities in the mid 1980s, concerns about excessive and persistent deficits became prominent, in part reflecting the fact that policy-makers could no longer rely on capital controls to rein in the current account. The key strategy to address this was through fiscal consolidation, as well as a number of other structural policies aimed at improving international competitiveness. While such policies had the stated objective of lowering the current account deficit, it is worth recognising that such pronouncements may have also played a useful rhetorical role in support of fiscal and market reforms. Of course, the usefulness of these warnings would have waned with the realisation that, despite determined attempts, there was no reduction in the trend current account deficit.

Monetary policy, it was hoped, could also play a role through its influence as a short-term demand management device. Under the ‘checklist’ approach to monetary policy in place from the mid 1980s, the balance of payments was listed explicitly as an important factor to guide policy decisions, and there were frequent references to the need to rein in sizeable current account deficits.

By the end of the 1980s, several Australian academics were arguing that policy should not attempt to influence what they perceived to be the outcome of optimal decisions by private agents. Within the RBA, there was a debate regarding the value of having the current account deficit as an explicit objective, as evidenced in various published statements. Even so, large current account deficits in the late 1980s were seen to be a symptom of excess domestic demand pressures and, at least in that sense, they were something to which monetary policy could usefully respond. The ‘consenting adults’ view was gradually taken up by policy-makers in public statements from the late 1980s onwards.^[3]

It is now widely argued that the current account balance need not, and cannot, be an objective for macroeconomic policies. Nor is it seen by itself as a reliable indicator of vulnerabilities. Australia's experience is particularly relevant in this regard, given its experience with large fluctuations in the exchange rate and sizeable foreign debt, much of it intermediated through the banking system. The floating exchange rate has been an important means of adjusting to external shocks, and provides a mechanism by which Australia's external position is subject to continual reassessment by the markets. The fact that Australia has managed to sustain investors' confidence is evident in the maintenance of the current account deficit at an average of around 4½ per cent of GDP over two decades combined with a real exchange rate showing no discernable trend over the same period.

The remainder of the paper is structured as follows. Section 2 provides a brief history of Australia's current account and incidence of capital reversals going back as far as the 1850s. Section 3 steps through the various stages of the debate about the role for policy in stemming large current account deficits in Australia. Section 4 briefly discusses some empirical evidence relevant to the optimality and sustainability of the current account in Australia. In Section 5, the issue of external vulnerabilities is discussed in the context of a range of structural features of the Australian economy. Section 6 concludes.

Footnotes

Milesi-Ferretti and Razin (1996) provide a thorough discussion of solvency – when the intertemporal budget constraint is satisfied – and sustainability – whereby the current account deficit is small enough so that net foreign liabilities do not rise as a share of GDP. Optimality by definition will satisfy solvency, but it will not necessarily satisfy sustainability. [1]

Gruen (2005) provides a detailed discussion of the evolution of the current account deficit in Australia and a comparison with other selected economies. Data compiled by Lane and Milesi-Ferretti (2006) show that since the late 1980s, Australia is one of five long-standing OECD countries with an annual average current account deficit of greater than 4 per cent (relative to GDP), along with Greece, Iceland, New Zealand and Portugal. These and other OECD countries experienced peak deficits on an annual basis of around 9 per cent or higher, compared with a peak of 6.2 per cent for Australia in 2004. These countries also have higher net foreign liabilities (relative to GDP) than Australia. [2]

This view, also known as the ‘Pitchford thesis’ in Australia, is known as the ‘Lawson doctrine’ in the UK, where these views had an earlier origin with Congdon (1982), while in Australia they can be traced back to Corden (1977). [3]