Australia’s shrinking current account deficit

23 Jun 2017

Tags

  • Mark Thirlwell
  • Australian Economy
  • International Investment
  • International Trade

In the March 2017 quarter, Australia’s current account deficit shrank to A$3.1 billion, or just 0.7 per cent of GDP[1]. That’s not only the smallest deficit as a share of GDP recorded since the float of the Australian dollar, it’s actually the lowest ratio since December 1979. Following on from a 0.8 per cent of GDP deficit in the December 2016 quarter, the Q1 2017 result therefore marks a second consecutive quarter of deficits below one per cent of GDP.

Australia: Current account balance since AUD float, per cent of GDP, quarterly, s.a.

From a macro perspective, the current account balance represents the difference between national savings and investment rates. Historically, although Australia has tended to have relatively high savings rates by developed country standards, our investment rates have usually been higher still, and as a result we’ve typically run quite sizable current account deficits. Indeed, the last time we had a quarterly surplus was all the way back in June 1975. As a result, we’ve become used to life as a ‘structural’ current account deficit economy, with the associated reliance on foreign capital that this implies[2].

Australia: Gross national saving and investment rates, per cent of GDP, quarterly, s.a.

Viewed from this perspective, the ongoing narrowing in the current account deficit mainly reflects the impact of a multi-year decline in the national investment rate, along with a more recent increase in gross national savings.

Not surprisingly, recent developments in investment have been dominated by the changing phases of the mining investment boom. Thus the increase in mining capital expenditure during the initial phases of the commodity boom was reflected in a widening in our current account deficit over same period, and while investment rates did fall back in response to the global financial crisis, this proved to be a temporary retreat with investment then bouncing back and staying relatively high until the end of 2012. Since then, the completion of most of the construction phase of the resource boom and the subsequent transition to a production phase has contributed to a sustained fall in investment as a share of GDP, starting around the beginning of 2013.

Australia: Mining investment, and Non-financial corps, saving & investment

What about national savings? After having fallen during the 1980s and 1990s (a phenomenon that’s attributed in part to households responding to the deregulation of the Australian financial sector by increasing their borrowings), the national savings rate had started to rise from the mid-2000s as households increased their savings. The onset of the global financial crisis reinforced the precautionary savings behaviour of households and saw an increase in savings from the non-financial corporate sector, but at the same time it also triggered a sharp decline in public sector savings as the government budget swung into deficit. More recently, after falling between mid-2014 and end-2015, the national savings rate has risen again in the past two quarters, reflecting increases in corporate and government savings.

Australia: General government saving & investment, and Gross household sector savings

A different perspective on the drivers of the current account comes from breaking down the overall balance into its trade and income components. The trade balance comprises net exports and imports of goods and services, while the income balance consists of the primary income balance, which reports net investment and other income[3], and the secondary income balance, which includes transfer payments such as foreign aid[4]. Seen in this framework, the current narrowing in the overall deficit has been driven by a sharp move into trade surplus over the past two quarters combined with what had until the latest quarter been a steady narrowing of the net income deficit over a period of several years (the income deficit widened in March 2017).

Australia: Trade and Income balances since AUD float

As can be seen in the previous chart, the balance on goods and services trade is normally the more volatile of these two components and as such tends to be the main influence on short-term movements in the deficit. Here again the data capture two trends at work, with the balance on goods (or merchandise) trade moving rapidly into surplus during the second half of 2016 while the deficit on services has seen a more gradual decline, staring around early 2014.

Australia: Goods and services balances since AUD float

The turnaround in the merchandise trade balance has in large part been based on the familiar story of the pickup in commodity prices that started in the second half of last year and then carried on through into the first quarter of 2017. Higher prices boosted the value of resource exports and delivered a series of monthly merchandise trade surpluses starting from November 2016. As a result, merchandise exports as a share of GDP have increased from about 14 per cent as of the March 2016 quarter to almost 18 per cent in March 2017. Meanwhile, the decline in investment rates noted above has contributed to a fall in the value of imports of intermediate and capital goods. Softer economic growth has also helped cap import demand in recent quarters. These developments have seen the value of goods imports slide from more than 17 per cent of GDP in the September 2015 quarter to less than 16 per cent of GDP by the March 2017 quarter.

Australia: Merchandise exports and imports, and Merchandise imports by type

In the case of services trade, exports have demonstrated a sustained increase, rising from 3.4 per cent of GDP in the third quarter of 2012 to 4.2 per cent as of the first quarter of this year. The adjustment in service imports has been more recent, with a decline from 4.9 per cent of GDP in the final quarter of 2015 to 4.2 per cent by March 2017. Developments in Australia’s Visitor Economy have played a key role in the overall picture here, with a dramatic shift in net tourism flows.

Australia: Exports and imports of services, and Tourism-related services balance

Alongside these developments in goods and services trade, Australia’s shrinking current account deficit has also reflected a decline in the net income deficit – the initial phase of which was explored in some detail in this RBA article.

The long-running deficit that had hitherto applied to Australia’s net income balance has been the product of two features of our external financial position. First, the fact that the stock of our foreign liabilities (that is, the debt and equity claims on Australia that are held by overseas creditors/investors) has been larger than the stock of our foreign assets (the debt and equity claims that we hold on foreigners[5]). And second, that the average return that those overseas investors/creditors have received on their Australian assets (that is, the combination of interest and dividend payments relative to the stock of their investments) has typically exceeded the return that we have received from our own cross-border investments[6].

Australia: Foreign assets and liabilities, and, Net foreign liabilities by type

As that RBA piece explains, however, between late 2010 and late 2013 a shift in the second of these two factors produced a contraction in the net income deficit: in other words, there was a relative decline in the yields Australians paid to their foreign creditors. In the case of our external debt, that fall in yield was the product of a rise in the share of Australian government debt in our overall foreign debt stock (since the government can borrow at a lower interest rate than the private sector this drove down the average interest rate paid) and in the case of equity it reflected a drop in the average profitability of the mining sector and hence a decline in dividend payouts made to overseas investors[7]. More recently, and as set out in a new RBA article, in the years since 2013 the decline in the net income deficit has been driven more by an increase in the income Australia has received on its holdings of foreign equity. That increase is the product of ongoing purchases by Australian superannuation funds of international shares. It also reflects the impact of past falls in the value of the Australian dollar (which worked to increase the Australian dollar value of overseas dividend receipts).

Australia: Implicit yields on foreign assets and liabilities

The marked decline in the current account deficit over the past couple of quarters has led to predictions that Australian might soon see a current account surplus. If so, that would be the first surplus since the second quarter of 1975, and if sustained, would mark a momentous shift (pdf) in our external financing position. Is that likely? We’re certainly getting close, although it’s important to keep in mind that some of the recent drivers of the current account shift look to be of uncertain duration (the run-up in commodity prices, which has already unwound to some extent, is an obvious risk here). Still, other factors would seem to be more durable: the expansion of capacity that occurred during the investment phase of the mining boom will have a lasting effect on resource export volumes, for example, while the growth of Australian superannuation funds offshore assets seems likely to be sustained under current conditions.

If we are headed for a new era of current account surpluses, that would have some important implications for the economy. By definition, there would be significant consequences for the volume (and probably composition) of foreign capital inflows, for example. It would follow that surpluses would also have implications for the real equilibrium level of the Australian dollar and for the level of our interest rates. And while the old debates about the potential vulnerability to Australia posed by current account deficits were firmly resolved in favour of the benefits of external borrowing (the so-called ‘consenting adults’ view of external deficits), it’s still the case that institutions such as the ratings agencies treat a reliance on external financing as a potential source of vulnerability. So in this context, a shift to surplus would provide support for our sovereign ratings, all else equal.

All of which means it’s worth keeping a close eye on how the various components of our external position track from here.

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[1]  On a seasonally adjusted basis.
[2]  A current account deficit is funded by net capital inflows in the form of foreign direct investment, portfolio investment and other capital flows.
[3]  This includes receipts and payments on Australia’s stock of foreign assets and liabilities, which is made up of interest (on debt) and dividends (on equity) as well as employee compensation.
[4]  Changes in the secondary income balance (relative to GDP) have been very small and hence the focus here is on the primary income balance. For example, in Q1:2017 the secondary income deficit was equivalent to about 0.1 per cent of GDP – a ratio that was unchanged from the previous 19 quarters.
[5]  In other words, we have a net foreign liability position. This reflects the fact that, as already noted, we have run current account deficits for most of our history because our national savings have been insufficient to meet our national investment demands. We’ve made up the difference by external borrowing, which over time has increased the stock of our overseas liabilities.
[6]  This negative yield gap has reflected a combination of Australia’s foreign debt tending to have a longer maturity than its foreign assets (and hence requires a higher return), and in the case of equities, the impact of our system of dividend imputation which tends to encourage higher dividend payout ratios by Australian companies relative to international standards. [7]  Remember, our mining sector is majority foreign-owned.