Funding Australia’s current account deficit
21 Sep 2017
- Australian Economy
- International Investment
- International Trade
Back in June I wrote a post looking at the Q1:2017 current account outcome, pointing out that the quarterly deficit had fallen to its lowest share of GDP since the floating of the Australian dollar. Earlier this month, the ABS released Q2 balance of payments data, which also provided a picture of the overall position for the latest financial year, FY2017. This annual data showed an outcome consistent with that earlier story of a declining external deficit. The current account deficit for 2016-17 dropped to just $29.5 billion, down from more than $74 billion in FY 2016. And as a share of GDP, the deficit shrank to less than two per cent, representing the lowest annual deficit since floating of the dollar, (and in fact, since the mid-1970s).
That turnaround in the external position has been driven by a combination of factors that I discussed in some detail in my June post. But to summarise, the key drivers included:
- First, a substantial shift in the balance on goods (or merchandise) trade. After running merchandise trade deficits equivalent to 0.8 per cent of GDP in FY2015 and 1.7 per cent of GDP in FY2016, the trade balance swung into a 0.8 per cent of GDP surplus in FY2017. The main contribution to that shift came from a rise in commodity prices that boosted the dollar value of resource exports, which in turn contributed to an increase of almost 20 per cent in the total value of goods exports in 2016-17.
- Second, a significant narrowing in the deficit on services trade, which fell from 0.6 per cent of GDP in FY2015 and FY 2016 to just 0.1 per cent of GDP in FY2017. An increase of eight per cent in the value of exports of Australian services (including tourism and international education) played a key role here, along with a three per cent decline in the value of services imports.
- Third, developments relating to the size of the deficit on the primary income balance. In fact, the FY2017 numbers show this deficit actually increasedmarginally, rising to 2.3 per cent of GDP from a 2.2 per cent of GDP deficit in FY2016 and a two per cent of GDP deficit in FY2015. When viewed over a slightly longer time period, however, the primary income deficit has declined from an annual average of more than 3.5 per cent of GDP over the ten years to FY2014. That longer-term trend reflects a combination of a relative decline in the yields Australians have paid to foreign creditors on our external liabilities, plus an increase in the income Australia has received on our holdings of foreign equity, the latter mainly a product of the growing portfolio of international shares held by Australian superannuation funds.
Remember that another way of thinking about the current account is as the difference between national savings and investment rates: when national investment exceeds national savings, the result is a current account deficit and a consequent need to tap foreign savings to meet the gap. Or put slightly differently, current account deficits require capital and financial inflows to fund them.
Therefore it follows that the recent decline in the current account deficit (or equivalently, the narrowing of the gap between our national savings and investment) has also produced a parallel decline in the quantum of inflows needed to finance it. This relationship is set out in the table below, which reports the balance of payments for FY2017 and shows how the current account deficit last year was funded by a net inflow on the capital and financial accounts.
In FY2017, a smaller current account deficit saw the balance on the financial account fall to a net inflow of just $25.4 billion (about 1.4 per cent of GDP), down from an inflow of $77.8 billion (about 4.7 per cent of GDP) in FY2016. Moreover, not only has the size of financial inflows declined, but there have also been some interesting shifts in the composition of those flows.
As the chart above shows, net inflows of foreign direct investment (FDI) and portfolio investment have together played a large role in funding much of Australia’s current account shortfall over the past decade or so. In particular, inflows of FDI have averaged almost three per cent of GDP each year for the past ten years, and in recent years have risen even higher, climbing to four per cent of GDP in FY2017. The driving force here has been substantial flows of inward FDI as a share of GDP. In contrast, outward FDI has been rather more volatile, with the past two years actually seeing a net repatriation of funds back into Australia that further supported total net inflows.
Over the same period, the contribution from net portfolio investment flows has tended to be more variable than that of net FDI, with sizeable net inflows of portfolio investment for much of the past decade but also two years of net outflows in FY2016 (equivalent to one per cent of GDP) and FY2017 (0.1 per cent of GDP). The chart below shows that this shift reflects quite marked falls in portfolio inflows as a share of GDP over the past two years. There has also been a decline in portfolio outflows but this has been much smaller than the drop in inflows (presumably in part reflecting ongoing purchases of foreign equities by Australian superannuation funds).
Two interesting speeches from Guy Debelle at the RBA (one from earlier this year, and one from 2014) dig into the composition of these capital flows in a bit more detail. Debelle emphasises three main developments in Australia’s financing story. First, the important role played by FDI into the mining sector, initially in the form of re-invested earnings that were used to fund new mining projects and subsequently in the form of the direct overseas funding of major LNG construction programs. Second, a shift from a period of substantial net financial inflows into the Australian banking system before the onset of the global financial crisis to a position of close to zero net inflows in the years following the crisis. And third, a significant rise in the purchase of Australian government debt by foreign investors.
It’s worth emphasising here that, just as the resources boom has helped reshape Australia’s current account in the form of a boost to merchandise exports, so has it also reshaped the financial account through promoting a sharp rise in inward FDI.
More recently still, there have been further adjustments to the pattern of inflows. In particular, in FY2017 the mining sector saw a net capital outflow for the first time this century, as the mining investment boom (and hence the need for external financing) wound down. In addition, the repayment of foreign-held debt by Australian banks has contributed to net outflows from the financial sector.
To wrap things up, we can take a look at how these trends in capital and financial flows have been reflected in changes to Australia’s international balance sheet. The International Investment Position (IIP) reports the stock of foreign financial assets and liabilities, and changes in the IIP are driven by trends in the financial account transactions described above, as well as by non-transactional changes (movements in asset prices such as shifts in equity and bond prices as well as exchange rate valuation effects). The data for FY2017 show that Australia’s net IIP as at 30 June 2017 was a net foreign liability of $1,000.3b, equivalent to about 57 per cent of GDP. This represented a decline of $46.4b relative to the position at the end of FY2016, when the net IIP represented a liability of $1,046.7 billion or a bit more than 63 per cent of GDP.
How did the net liability position decline when FY2017’s current account still required external financing (albeit at a much lower level of net inflows than in previous years)? Because the impact of net financial inflows of $25.4 billion was more than offset by the impact of price changes:
In fact, despite the sequence of current account deficits run over the course of the century to date, Australia’s net IIP relative to GDP has actually been relatively stable over the past decade or so (with the exception of an uptick in FY2016), with the FY2017 result roughly the same as FY2007’s outcome.
This rough stability has been delivered by favourable movements in relative asset prices over much of the period, which on balance have tended to see greater price rises for Australia’s foreign assets than for its foreign liabilities.
Although note that, along with an upward revision to the Q1 deficit, the Q2:2017 data showed the quarterly
current account deficit increasing
to more than two per cent of GDP, largely reflecting the impact of lower resource prices on the value of commodity exports.
The primary income balance reports the net balance of primary income flows between residents and non-residents. Primary income credits measure the return from giving non-residents the use of Australian labour or (financial) capital, while primary income debits refer to the return to non-residents from use by residents of foreign labour and capital. Primary income comprises three broad categories: (1) compensation of employees, (2) investment income (dividends, reinvested earnings, interest payments and receipts, and investment income attributable to policy holders in insurance, standardised guarantees and pension funds) and (3) other primary income (such as rents and taxes and subsidies). Secondary income measures the redistribution of income through current transfers. Current transfers comprise those offset items needed to balance transactions where real resources or financial items are provided in one direction without anything being provided in return by the recipient. This includes insurance claims, pensions and foreign aid to developing countries in the form of money for food or famine relief (although if these funds are being used for capital investment they will be included in the capital and financial account), along with workers remittances from residents temporarily abroad. Changes in the secondary income balance (as a share of GDP) have played a negligible role in driving the overall trend in the current account in recent years and are not discussed in the main text.
Previous falls in the value of the Australian dollar have also increased the Australian dollar value of overseas dividend receipts.
The balance of payments set out the economic transactions between Australia and the rest of the world, in this case for 2016-17. In theory
, the balance of payments must ‘balance’, which means that the current account balance should be exactly offset by the sum of the capital and financial accounts. In practice
, this is often not the case, mostly due to measurement problems, and the resulting difference between the current account on the one hand and the capital and financial accounts on the other is reported as net errors and omissions.
As noted above, the current account is financed by a combination of the capital and financial accounts. The capital account reports acquisitions and disposals of non-produced assets, such as the rights to natural resources, and of intangible assets, such as patents, copyrights, trademarks, franchises and leases. It also reports capital transfers (such as government debt forgiveness or the transfer of assets belonging to migrants). The financial account records transactions in financial assets and liabilities between residents and non-residents. In this post I largely ignore the capital account and focus on the financial account.
FDI captures investments where an investor secures an equity interest in an enterprise resident in another economy equivalent to ten per cent or more of the voting power (such as ordinary shares or voting stock). The idea here is that direct investment confers a degree of control on the investor. In contrast, portfolio investment refers to transactions and positions in equity and debt securities where the investor is not assumed to have any influence or control over the operation of the investment enterprise.
Other types of net capital flows shown in the chart include financial derivatives, other investment (which covers trade credits, loans (including financial leases), currency and deposits, and a residual category for any other assets and liabilities) and changes in reserve assets which refers to those foreign financial assets that are controlled by the monetary authorities (in the case of Australia, the Reserve Bank of Australia) for financing or regulating payments imbalances. Reserve assets include monetary gold, SDRs, reserve position in the International Monetary Fund and foreign exchange held by the RBA.
See also the article
on Australian capital flows in the June 2017 RBA bulletin which expands on the second of these speeches.
Most of Australia’s foreign liabilities are denominated in Australian dollars while most of our foreign assets are denominated in foreign currencies. As a result, a fall in the value of the Australian dollar tends to boost the value of our assets and lower the value of our liabilities, leading to an improvement in the net IIP measured in Australian dollar terms.