AOS 3: Eco - KK2

Unit 3 AOS3: Australia and the World Economy

• The Gains from International Trade

  • International trade provides several key benefits:

    • Lower prices for consumers.

    • Greater choice in the range of goods and services available.

    • Access to resources that may not be available domestically.

    • Economies of scale for producers.

    • Increased competition and efficiency within the domestic market.

• The Balance of Payments and its Components

  • Understanding the structure and recording of all financial transactions between Australia and the rest of the world.

• Cyclical and Structural Influences

  • Analysis of the factors affecting Australia’s current account balance over time.

• Net Foreign Debt and Net Foreign Equities

  • The composition and causes behind Australia's external liabilities.

• The Exchange Rate

  • Meaning, measurement, and factors affecting its value:

    • Relative interest rates.

    • Commodity prices.

    • The terms of trade.

    • Demand for exports and imports.

    • Foreign investment levels.

    • Relative rates of inflation.

    • Credit ratings and speculation.

• The Terms of Trade (TOT)

  • Meaning, measurement, and factors affecting it, such as commodity prices and production costs in trading partners.

• International Competitiveness

  • Factors include productivity, production costs, availability of natural resources, exchange rates, and relative rates of inflation.

• Domestic Macroeconomic Goals and Living Standards

  • The effect of movements in the terms of trade, exchange rate, and international competitiveness on Australia’s economic performance and quality of life.

The Balance of Payments (BOP): Definition and Fundamentals

• Formal Definition

  • The Balance of Payments (BOP) provides an annual statistical record of all the financial transactions between Australians and residents of the rest of the world.

• Accounting Principles

  • The records are categorized into two types of flows:

    • Credits: Any financial flow that leads to money entering the country (money coming into Australia from overseas).

    • Debits: Any financial flow that leads to money leaving the country (where Australia makes payments to overseas).

  • Zero Balance Rule: The balance of payments always balances; the theoretical total must always equal $0$.

• Current Account Balance States

  • The balance of these transactions is known as the current account surplus or current account deficit as total debits greatly exceed credits.

  • Current Account Deficit (CAD): Occurs when Payments (debits) > Receipts (credits).

  • Current Account Surplus: Occurs when Receipts (credits) > Payments (debits).

• Recent Trends (AUD Million)

  • Based on TradingEconomics and ABS data, the Australia Current Account has shown the following projected trend:

    • 2023 Q3: Approximately $-4.5 \times 10^3$ ($-4,500$ million).

    • 2024 Q3: Approximately $-13.5 \times 10^3$ ($-13,500$ million).

    • 2025 Q3: Approximately $-22.5 \times 10^3$ ($-22,500$ million).

Structural Components of the Balance of Payments

• Current Account (CA)

  • The figures in these four sub-categories added together equal the overall balance on the current account:

  • Balance on Merchandise Trade (BOMT): Also known as net goods. It is calculated as Export credits for goods sold overseas (e.g., wool, commodities, iron ore) minus import debits for goods purchased abroad (e.g., cars, oil, machinery).

  • Net Services: Service credits received in Australia (e.g., tourism, education) minus service debits paid abroad (e.g., tourism, education, royalties, license fees).

  • Net Primary Income: The income that Australian residents earn from, less that they pay to, the rest of the world from working (e.g., wages) and from financial investments (e.g., dividends).

  • Net Secondary Income: Consists of one-way transfers and has two parts:

    • Income earned by residents less what is paid to the rest of the world from the government (e.g., tax payments and refunds). Example credit: A European pension paid to Australian immigrants.

    • Current Transfers: Transactions where one party provides something to be consumed by another party without receiving anything in return (e.g., emergency food aid). Example debit: Foreign aid.

• Capital and Financial Account (CAFA)

The Balance on Capital and Financial Accounts

• The Capital Account

  • Capital Transfers: Transactions where one party has transferred ownership of something to another party without receiving anything specific in return. Examples include:

    • Forgiveness of debt (the borrower no longer has to pay back the loan).

    • Conditional grants for capital projects (e.g., foreign aid specifically to build roads, dams, and schools).

    • Transfer of assets between residents and non-residents.

  • Net Acquisition of Non-produced, Non-financial Assets: Covers the excess of credits over debits involving intangible assets and rights. Examples include:

    • Brand names, copyrights, and trademarks.

    • Rights to use land or water (e.g., for mining or fishing).

    • Debit Example: Australia purchasing the license to play MasterChef on TV.

    • Credit Example: Vance Joy's music being played on Spotify in America.

• The Financial Account

  • Direct Investment: Financial transactions related to long-term capital investment in a business (e.g., purchase of machinery, buildings, and factories). The investor must have significant voting power, defined as $10 \, \%$ or above ownership of shares.

    • Credit Example: The purchase of Toll Group by a Japanese company; Uniqlo opening a store in Chadstone.

    • Debit Example: An oil field being opened in Papua New Guinea by an Australian company.

  • Portfolio Investment: The purchase of equity or debt (shares or bonds) in a business where the transaction involves less than $10 \, \%$ of shares.

    • Credit Example: The sale of Qantas shares to a foreign buyer.

    • Debit Example: The purchase of Apple shares by an Australian Superannuation Company.

  • Financial Derivatives: The purchase of financial contracts between two parties where the value is derived from another financial instrument (e.g., a bond, share, or market index). These involve the exchange of risk rather than funds.

  • Reserve Assets: The purchase or sale of assets held by the Reserve Bank of Australia (RBA) to meet policy objectives, such as intervening in the foreign exchange market or meeting commitments to the International Monetary Fund (IMF).

    • Credit Example: RBA purchases $AUD$ on the forex market to smooth a volatile exchange rate.

    • Debit Example: The government transfers money to the United Nations (UN) for research.

  • Other Investment: Transactions not fitting other categories, such as 'currency and deposits' (bank transfers, coins, and banknotes).

    • Credit Example: Borrowing by National Australia Bank (NAB) from a Japanese bank.

    • Debit Example: A deposit by ANZ into a Swiss bank.

• Net Errors and Omissions

  • This reflects inaccuracies in calculations and estimations.

  • While the BOP should be zero, measurement errors occur because it is difficult to record every transaction; some are omitted entirely.

Summary Table of Capital and Financial Account (Table 8.4)

• Capital Account

  • Recording: Movement of 'capital' between nations.

  • Credit Example: The receipt of intellectual property income (e.g., royalties) by an Australian artist; the purchase of the Vegemite brand by Philip Morris (American company).

  • Debit Example: Australian grants to developing countries for the building of roads and bridges.

• Financial Account: Direct Investment

  • Recording: Creation of new assets/liabilities in a foreign country (setting up production or >10 \, \% share purchase).

  • Credit Example: Opening of a new Gap store at Chadstone shopping centre.

  • Debit Example: New oil field opened in Papua New Guinea by Oilsearch (Australian company).

• Financial Account: Portfolio Investment

  • Recording: Transactions involving <10 \, \% investment in a company.

  • Credit Example: Sale of shares in Qantas to a foreign household.

  • Debit Example: Purchase of Apple shares by Australian Super.

• Financial Account: Financial Derivatives

  • Recording: Complex instruments creating assets or liabilities.

  • Credit Example: Sale of options by the Commonwealth Bank of Australia to an American merchant bank.

  • Debit Example: Purchase of iron-ore futures by Fortescue Metals Group.

• Financial Account: Other Investment

  • Recording: Lending and borrowing not otherwise classified.

  • Credit Example: Borrowing by NAB from Nomura Holdings (Japanese institution).

  • Debit Example: Deposits by ANZ in Swiss bank accounts.

• Financial Account: Reserve Assets

  • Recording: RBA/Government foreign currency transactions, IMF/UN contributions.

  • Credit Example: RBA purchases $AUD$ on the forex market to smooth volatility.

  • Debit Example: Australian Government sends money to the UN for research purposes.

The Relationship between Current Account and CAFA

• The Offset Mechanism

  • Australia generally runs large Current Account Deficits (CADs).

  • Australia's CADs are exactly offset by a surplus on the capital and financial accounts (CAFA).

  • This surplus mostly involves an increase in foreign liabilities (debt and equity).

• Mathematical Balance

  • The overall BOP account is designed to balance exactly to zero:

  • $BOP = 0$

  • To achieve this, the balance of the four items in the Current Account must be offset by the Capital and Financial Account surplus.

  • Numerical Example:

    • If the Current Account Balance is $-72,829$, it must be offset by a CAFA balance of $+72,829$.

    • Formula: $-72,829 + 72,829 = 0$

  • Implication: A deficit means Australia needs to borrow from overseas, which creates a liability equal to the deficit amount (e.g., $72,829$).