The Consequences of a High CAD (HSC SSCE Economics): Revision Notes
The Consequences of a High CAD
Understanding the debate
There is ongoing debate among economists about how concerning Australia's historically high current account deficits should be. Some economists argue that if only private sector borrowing is involved, external imbalances simply reflect normal market transactions in a globalised economy. Others suggest that current account deficits and foreign debt can actually benefit the economy by enabling higher investment levels and faster growth.
However, international organisations like the International Monetary Fund (IMF) have established thresholds to identify when a CAD becomes problematic:
IMF Thresholds for CAD Concern
- Medium to long term: A CAD averaging over 4% of GDP is considered too high
- Short term: A CAD exceeding 6% of GDP raises concerns
These benchmarks help policymakers assess whether Australia's external position is sustainable.
Key risks of a sustained high CAD
A persistently high current account deficit can create several serious economic problems. Understanding these risks is essential for evaluating Australia's external position and policy responses.
Growth of foreign liabilities
When Australia runs a current account deficit, it must attract matching financial inflows on the capital and financial account. This happens through two main channels:
- Foreign debt: Borrowing from overseas lenders, which creates obligations to repay principal plus interest
- Foreign equity: Selling ownership stakes in Australian assets such as property, businesses, or shares to foreign investors
Over time, sustained deficits cause Australia's stock of foreign liabilities to grow. As these liabilities accumulate, international lenders and investors may become increasingly reluctant to provide further funding to Australia. They may perceive growing risk that Australia will struggle to service or repay its obligations.
This growing hesitancy can make it more difficult and expensive for Australian businesses and governments to access international capital markets. The accumulation of foreign liabilities is a key concern because it affects lender confidence and increases borrowing costs.
Increased servicing costs
Higher levels of foreign liabilities generate larger servicing obligations, which appear as outflows on the net primary income account. This creates a self-reinforcing cycle that worsens the current account deficit.
Interest payments on foreign debt: These vary according to both Australian and international interest rate levels. When Australia's foreign debt is high, creditors may demand a risk premium – an additional interest rate above normal market rates to compensate for perceived risk. This forces up borrowing costs across the economy.
Profit returns on foreign equity: Foreign shareholders expect dividends and profit distributions from their Australian investments. These returns flow out of Australia, increasing the deficit on the net primary income account.
The Servicing Cost Spiral
The problem compounds over time: as servicing costs rise, they worsen the CAD, which requires more foreign borrowing or equity sales, which increases servicing costs further. Breaking this cycle becomes progressively more difficult.
Exchange rate volatility
A sustained high CAD can undermine international investor confidence in the Australian economy. When confidence weakens, overseas investors become less willing to hold Australian dollars or Australian assets.
This reduced demand for Australian currency places downward pressure on the exchange rate, potentially causing depreciation of the Australian dollar. While some depreciation can help improve export competitiveness, excessive or unpredictable exchange rate movements create several problems:
- Imported inflation as the cost of imports rises
- Uncertainty for businesses engaged in international trade
- Increased cost of servicing foreign debt denominated in other currencies
- Reduced investor confidence, potentially triggering further depreciation
Exchange rate instability makes economic planning more difficult and can deter both domestic and foreign investment.
Constraint on economic growth
In the longer term, a high CAD can act as a balance of payments constraint – effectively placing a speed limit on how fast the economy can grow sustainably.
How the Balance of Payments Constraint Works
The relationship works as follows: when the economy grows faster, incomes rise and consumers and businesses increase their spending. Much of this additional spending goes on imports, causing the CAD to deteriorate. If the CAD is already problematically high, further deterioration becomes unsustainable.
Governments facing this constraint must limit economic growth to the rate at which the CAD remains manageable. This means forgoing some potential growth and accepting lower living standards than might otherwise be achievable. The economy cannot grow as quickly as productive capacity might allow because external balance considerations impose a binding constraint.
More contractionary economic policy
When governments judge that the CAD needs to be reduced in the short term, they may implement tighter macroeconomic policies:
Contractionary fiscal policy: Reducing government spending or increasing taxes to slow economic activity and reduce import demand
Contractionary monetary policy: Raising interest rates to slow consumption and investment spending
While these policies can help reduce the CAD in the short run by slowing import growth, they have significant costs. Tighter policy reduces economic growth, increases unemployment, and can push the economy toward recession. The government faces a difficult trade-off between external balance and domestic economic objectives.
Governments might also accelerate microeconomic reforms to improve international competitiveness, though these typically take longer to affect the CAD.
Sudden loss of international investor confidence
Perhaps the most serious risk is that a high CAD makes an economy vulnerable to sudden shifts in global market sentiment. International investor confidence can change rapidly, and when it does, countries with large external imbalances are particularly exposed.
Crisis triggers: Economic crises can be triggered when global markets suddenly judge a country's external position to be unsustainable. Recent examples include:
- Sri Lanka: Faced a severe economic crisis as investor confidence collapsed in response to unsustainable debt levels
- Argentina: Experienced recurring crises driven by loss of confidence in its ability to service foreign obligations
Rapid capital flight: When confidence evaporates, international investors rush to withdraw their capital, creating a self-fulfilling crisis. The country may be unable to access international credit markets, forcing painful economic adjustments.
Unpredictability: The timing of confidence shifts is difficult to predict. An economy might sustain a high CAD for years before sentiment suddenly turns negative, making the risk particularly dangerous.
Australia's recent experience
Why concerns have decreased
Although Australia maintained high current account deficits for several decades, concerns about the external balance have substantially decreased in recent years. Several factors explain this shift in perspective.
The mining boom effect: As the scale and persistence of Australia's mining boom became clear over the past two decades, financial markets grew more confident about Australia's export prospects. The boom demonstrated that Australia's natural resource wealth could underpin strong export growth, providing the means to service foreign liabilities over the long term.
Globalisation and financial markets: During the era of globalisation, international financial markets became more willing to accept external imbalances. Increased global capital mobility meant that deficits that might previously have caused concern were viewed as normal features of integrated global markets.
IMF Assessment (2018)
The International Monetary Fund's 2018 report on Australia provided reassurance about the sustainability of Australia's external position. The IMF concluded that:
- Australia's CAD would likely remain below pre-2008 levels for the foreseeable future
- If Australia maintains a CAD in the range of 2.5% to 3% of GDP on average, net foreign liabilities can be sustained at around 55% of GDP
- This external position is "broadly consistent with medium-term fundamentals and desirable policies"
Recent surpluses: A series of current account surpluses in recent years has helped reduce Australia's net foreign liabilities, further improving the external position and demonstrating the economy's resilience.
Remaining long-term risks
Despite these improvements, some economists warn that the current account could still re-emerge as a significant long-term risk for Australia. Several factors support this more cautious view.
Changing external conditions: Australia's improved position depends heavily on favourable external circumstances that could change:
- Loss of Chinese export markets due to geopolitical tensions or China's economic slowdown
- Rising global interest rates increasing the cost of servicing Australia's foreign debt
- Commodity price declines reducing export earnings
Treasury forecasts indicate that current account deficits could return under less favourable conditions. Australia's current position reflects favourable circumstances rather than fundamental structural improvements.
Dependency on financial inflows: Sustained current account deficits, even at moderate levels, make Australia dependent on continuing financial inflows to fund servicing costs on existing foreign liabilities. This creates ongoing vulnerability to shifts in international investor sentiment.
Historical precedents: Until the sudden onset of the Global Financial Crisis in 2008, investors were willing to lend freely to many economies that subsequently experienced severe economic crises. This demonstrates that sustained periods of stability can give way rapidly to crisis conditions.
Need for structural improvements: Some economists argue that Australia would be more resilient with:
- A more diversified export base, reducing dependence on commodity exports to China
- Lower net foreign liabilities, reducing vulnerability to confidence shifts
- Stronger domestic savings, reducing reliance on foreign capital
While Australia's current account has not caused significant problems recently, this reflects favourable circumstances rather than fundamental elimination of risk.
Exam guidance
When analysing CAD consequences, examiners look for:
Exam Strategy for CAD Questions
Explain questions: Clearly describe the mechanism linking CAD to the consequence, using appropriate economic terminology (e.g., net primary income account, risk premium, balance of payments constraint)
Analyse questions: Break down cause-and-effect relationships, showing how a high CAD leads to specific outcomes through logical chains of reasoning
Evaluate/Assess questions:
- Consider both short-term and long-term effects
- Balance discussion of risks against potential benefits
- Reference Australia's specific circumstances and recent experience
- Acknowledge uncertainty and differing economic perspectives
- Consider whether consequences depend on the source of the CAD (public vs private sector)
- Use evidence such as IMF thresholds and recent Australian data
Diagrams: Consider including exchange rate diagrams showing depreciation effects or circular flow diagrams showing servicing cost cycles
Remember!
Key Thresholds
- IMF considers CAD problematic if averaging over 4% of GDP (medium-long term) or above 6% (short term)
- IMF suggests 2.5-3% of GDP CAD sustainable for Australia with net foreign liabilities around 55% of GDP
Six Main Risks of High CAD
- Growth of foreign liabilities – reduced willingness to lend/invest in Australia
- Increased servicing costs – higher interest and profit outflows worsening CAD further
- Exchange rate volatility – loss of confidence causing currency depreciation
- Growth constraint – CAD acts as speed limit on economic expansion
- Contractionary policy – governments forced to slow economy to reduce CAD
- Confidence crisis – sudden capital flight triggering economic crisis
Australia's Recent Position
- Concerns have decreased due to mining boom, globalisation, and recent surpluses
- But long-term risks remain from potential changes in external conditions
- Dependence on favourable circumstances rather than structural improvements
Key Terms
- Risk premium: Additional interest rate demanded by lenders due to perceived risk
- Balance of payments constraint: CAD limiting how fast economy can sustainably grow
- Net primary income account: Records interest, dividends, and profit flows
- Foreign liabilities: Combination of foreign debt (borrowed funds) and foreign equity (foreign ownership)