2024 AI LEADERSHIP SUMMIT HIGHLIGHTS
Australia's persistent current account deficits (CADs), trade performance and level of foreign debt remain central to ongoing economic policy debate, with most commentary still interpreting the economy's balance of payments situation as cause for concern.
Since 1980 Australia has experienced an average CAD of over 4 per cent of GDP (see Figure 1) with no prospect of change in the coming years.
Figure 1: Australia's external deficit
Source: Based on data from International Monetary Fund, International Financial Statistics.
Despite the relentless regularity of CADs, and economic arguments previously advanced to dispel anxiety about them, evidence of a pessimistic predisposition to the external accounts remains. This jaundiced view is also reflected in media commentary whenever the latest CAD figure is released by the Australian Bureau of Statistics. CADs are invariably interpreted as "worsening" if bigger than the previous release and "improving" if smaller.
Moreover, foreign debt levels are only ever reported in absolute dollar terms or relative to GDP without reference to corresponding asset items in the national balance sheet (such as the value of the capital stock) to put them in the proper macroeconomic accounting context. Current account imbalances are widely, yet mistakenly, also perceived as a trade competitiveness problem. Unfortunately, this has invited direct trade policy "solutions", such as export subsidies or higher tariffs on imports.
Foreign investment as a supplement to saving
What is most often neglected in discussion of Australia's economic relations with the rest of the world is the positive role that foreign capital inflow plays in Australia's economic development. International trade in saving has been a far more important influence on Australia's macroeconomic performance than it has been given credit for, perhaps even more than international trade in goods and services.
In the external accounts, the capital account surplus is recorded opposite the current account. Focusing on the capital account side of the balance of payments leads to quite a different story about Australia's external position. In financially liberalised open economies, aggregate borrowing for investment spending can exceed domestic saving to the extent of foreign borrowing, or domestic saving exceed investment to the extent of foreign lending.
This is because international macroeconomic accounting dictates that an economy's current account deficit, or its use of foreign saving through net capital inflow or foreign investment, equals its investment-saving gap (CAD=S*=1-S). Hence, increases in the domestic real capital stock are partly financed by domestic saving and partly by foreign saving (?K=I=S+S*).
In other words, net capital inflow that matches the CAD enables Australia to accumulate more real capital than if domestic saving alone funded domestic investment. Another way of thinking about the significance of the external imbalance is that it measures the volume of consumption spending we would have to forego as a nation in order to lift domestic saving to match the existing level of investment.
The extent to which a steadily increasing share of foreign investment is combined with domestic saving to fund domestic investment in Australia is illustrated in Figure 2.
Figure 2: Domestic investment, saving and foreign investment
Source: Based on data from International Monetary Fund, International Financial Statistics.
By investing excess saving through equity participation, loans to resident firms and purchases of real assets from residents, foreigners finance much more domestic investment. Moreover, the pool of funds available for investment is also supplemented when real domestic assets like property are bought by foreigners.
The dividend from foreign investment
When foreign funds finance expansion of the domestic capital stock, the rise in external liabilities must be matched by an increase in the level of productive plant, equipment and buildings. In turn, this additional investment augments the economy's capital stock, which allows for greater production of output, economy-wide. Extra real capital therefore leads to higher national output per worker.
The inference that the rise in external liabilities must be a macroeconomic problem implies that resident enterprises that have borrowed offshore to finance the acquisition of saleable real assets have been acting imprudently and have consequently put the economy at risk. Yet, in the case of foreign borrowing, borrowers, lenders and the institutions channelling the funds would normally have prudently assessed whether the income stream generated through the use of foreign capital would be sufficient to meet future repayments.
To the extent that, in aggregate, the productivity of the extra physical capital acquired through foreign capital inflow exceeds the servicing costs on that foreign investment, then national income can grow faster than it could otherwise. The total size of the nation's capital stock is now a large multiple of the value of its foreign liabilities, and the extra production made possible in Australia from using foreign funds has indeed on average significantly exceeded interest and other investment income paid abroad.
For instance, using a growth accounting framework, I estimated that between 1996 and 2005 additional real national income attributable to foreign investment has been, at a minimum, around $25 billion or around $2,500 extra income per worker per year, the equivalent of a $50 a week tax cut (Makin 2006).
Conclusion
Ultimately, whether net capital inflow and associated CADs are desirable essentially depends on whether the extra real output made possible by foreign saving exceeds the real servicing cost on that source of funds. This has easily been the case for Australia yielding a national dividend that manifests as higher national income.
It is essentially Australia's saving propensity combined with the productivity of capital that explains the persistent net capital inflow. Relatively high real rates of return on capital induce heavy capital inflow and its counterpart is the deficit on current transactions, including trade in goods and services. The most fundamental reason for the persistence of the external deficit is that domestic private saving falls short of investment opportunities, as perceived by foreigners and residents alike.
International capital inflow, measured in the balance of payments accounts as capital account surpluses, can indeed be beneficial in the long run, for foreign money helps nations expand their stocks of productive capital. Focusing only on the matching CADs and the cost of foreign capital in the external accounts is misleading. Rather than being alarmed by CADs, we should welcome foreign investment and the additional national income that accompanies it.
References
International Monetary Fund, International Financial Statistics, International Monetary Fund, Washington.
Makin, T. (2006), "Has foreign capital made us richer?", Agenda, vol. 13, no. 2, pp. 225-37.