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Economics HSC Topic 2 –Australia’s Place in the Global Economy

Australia’s trade and financial flows

Value, composition and direction of Australasia’s trade and financial flows

        Trends in Australia’s trade pattern:
                 -Direction of trade: The direction of Australia’s trade has changed considerably over
                 recent decades. In the 1950s, Australia mainly traded with the United Kingdom and
                 other European countries. In subsequent decades, the direction has shifted and
                 Japan has become the major buyer of exports. More recently China, South Korea
                 and ASEAN countries have become increasingly important. This movement away
                 from United Kingdom was due to their decision to join the EU. Australia then
                 followed the economies in Asia with highest economic growth rates.
                 -Composition of Australia’s Trade: Primary industries always been focus of
                 Australia’s exports as we have a comparative advantage in commodity goods.
                 (Wheat, wool, beef, coal, iron ore and gold). Less competitive in manufacturing,
                 importing large quantities of capital goods, and manufactured consumer goods.
                 Agriculture decreased and minerals increased in importance.
        Trends in Financial flows: Although trade flows have increased substantially over recent
        years, the rate of growth in financial flows has been much greater as international
        businesses have bought Australian assets and invested in Australian businesses, and as
        Australian companies have increased their overseas investments. When the exchange
        system of fixed exchange rates came to an end in the 1970s, exchange rates around the
        world were floated allowing financial flows to grow rapidly. Prior to the deregulation of the
        finical sector, most financial flows into Australia were direct investment. Following however
        the benefits of Portfolio investment were seen. Foreign equity and debt has increased
        dramatically with equity much larger proportion.

Australia’s Balance of Payments

A record of transactions between Australia and the rest of the world, over a period of time.
Money flow IN referred to as a CREDIT (+)
Money flow OUT referred to as a DEBIT(-)
        Structure:
                -Current Account, debits and credits:
                       Net goods (export goods – import goods)
                       Net service (export service – import service)
                       Net income (credit – debit)
                       Secondary Income

                -Capital and Financial Account:

                        Capital Account: Transfers in the form of tied aid(for specific purpose),
                        purchase and sale of non-financial assets.
                        Financial Account: Direct Investment, Portfolio Investment, Financial
                        Derivatives, Reserve Assets.
Links between key Balance of Payments categories
    Current Account Balance + Capital and Financial Account Balance + Net Errors and omissions = 0
     The deficit on the current account = Surplus on the capital and financial account. The strongest
    link between the accounts on the balance of payments can be seen on the net primary income
    part of the current account. In the long term, a capital and financial account surplus will lead to a
    larger deficit on the net primary income account. This is because any foreign capital inflow to
    Australia will have to earn a return for its owner and these earning are a debit on the net
    primary income account
        Trends in the size and composition of Australia’s Balance of Payments

Main focus on the current account deficit, the balance of goods and services and net primary
income.Australia’s current account deficit moves in cycles due to both domestic and international
factors. Influenced by both cyclical and structural factors. Cyclical - those which vary with the level of
economic activity. Structural - factors those which have a persistent or underlying influence on the
BoP(e.g. export base, international competitiveness ,savings).

The balance on goods and services varies from small surpluses to large deficits. Cylical factors that
influence BOGs are the exchange rate, terms of trade (export price index/import price index x 100),
levels of domestic economic growth, international business cycle. Structural influences include
narrow export bade, lacking international competitiveness in manufacturing and capacity
constraints.

The Net Primary Income is the ongoing cause of Australia’s high CAD. Cyclical factors affecting NPI
are exchange rates (size of interest payments), changes in domestic and global interest rates(size of
interest payments made to OS investors), 40% of Australian public share market is foreign
owned(when domestic conditions are good, larger proportion of dividends paid to international
investors). Structural factors include very low levels of national savings and high investment
economy (major export industries in Aus require enormous amounts of capital investment form OS.

Consequences of a high CAD:

           -    Large build up in foreign liabilities
           -    Increasing debt servicing cost
           -    Volatility in exchange rates
           -    Investors reluctant to invest
Exchange rates

An exchange rate is simply the price of one country’s currency in terms of another country’s
currency. Australia has a floating exchange rate determined bu the marker forces of supply and
demand.
Appreciate: increase in value
Depreciate: Decrease in value
         Measurement of relative exchange rates
Comparing Australian currency to other currencies is done by stating what the value of one unit of
Australian currency ($1) is relative to another currency. E.g. $A1 will buy US90c. The Trade Weighted
Index (TWI) is a measure of the Australian dollar against a basket of foreign currencies of major
trading partners. These currencies are weighted according to their significance to Australia’s trade
flow. In September each year the RBA amends the TWI based on the volumes of trade for the
previous finical year.
         Factors affecting the demand for and supply of Australian dollars
DEMAND                                            SUPPLY
    1. Level of Aus to OS interest rates             1. Level of Aus to OS interest rates
    2. Investment opportunities                      2. Investment opportunities
    3. Expectations                                  3. Speculators
    4. Export levels                                 4. Import levels
    5. Commodity prices                              5. Domestic income
    6. Terms of Trade                                6. Domestic competitiveness
    7. International competitiveness

        Changes in exchange rates – apprectiaton/depreciation
    APPRECIATION                                   DEPRECIATON
    1. ↑ Aust IR, ↓ o/s IR                         1. ↓ Aust IR, ↑ o/s IR
    2. ↑ inv opportunities in Aust                 2. ↓ inv opportunities in Aust
    3. ↑ $commodities                              3. ↓ $commods
    4. ↑ AustToT                                   4. ↓ AustToT
    5. ↑ int comp levels                           5. ↓ int comp levels
    6. ↓ inflation                                 6. ↑ inflation
    7. ↑ demand for Aust X                         7. ↑ demand for M in Aust

    expect of $ ↑ based on forecasts of           expect of $ to ↓ based on forecasts of
    factors                                        factors

        Determination of exchange rates including fixed, flexible peg and floating
               -Fixed: keeping the exchange rate at the same level always
               -Flexible peg: adjusting the exchange rate value each day and fixing it for 24 hours
               -Floating: allowing the forces of supply and demand to determine the exchange rate
The influence of the Reserve Bank of Australia on exchange rates
    Even though Australia’s exchange rate is primarily determined though the forces of demand
    and supply in the FOREX market, it is sometimes necessary for the RBA to intervene in the
    marker to prevent large fluctuations in the value of the $AUS which might impact on
    investor confidence. Can do this by:
            -Dirtying the Float: e.g. to avoid a rapid depreciation of the currency the RBA can
            buy $A, putting pressure upward pressure on the exchange rate.
            -Monetary Policy: rarely used, indirect e.g. to avoid a rapid deprecation, it may
            increase the demand for $A by raising interest rates, increasing intrust rates will
            attract more foreign savings which must be converted to $A

    The effects of fluctuations in exchange rates on the Australian economy
Changes in the BoP can influence the exchange rate e.g. If the value of imports incressead, while
exports remained unchanged, this would result in a deterioration in the current account deficit.
It would also cause an increase in the supply of $A, resulting in a deprecation of the currency.
Also, because of the deprecation, a given level of financial inflows would be able to buy more
$A. Therefore, the positive balance on the capital and financial account would increase in $A
terms to match the bigger deficit on the Current Account.

    POSITIVE APPRECIATION                          NEG APPRECIATION
        More purchasing power                          ↓ of X profits (cost more less buy)
        ↓ interest on servicing                        Deteriorating CAD as ↑ M
        ↓ $A value on o/s debt                         ↑M sees ↓ eco growth
        ↓ inflation pressure as imports are            Expensive to invest in Aust
        cheaper                                        ↓ value of foreign income
                                                       ↓ value of foreign assets to Aust

    POSITIVE DEPRECIATION                          NEG DEPRECIATION
        Cheaper X CAD                                Less purchasing power
        Expensive M CAD (buy less)                   Increased servicing
        ↑ growth                                       More foreign debt
        ↑ foreign income earned                        Increased inflation pressure
        ↑ $AU value of foreign assets
        Cheaper to invest in Aust
Free Trade and protection
        Australia’s policies regarding free trade and protection
        History:
                 -Australia typically has relied heavily on trade
                 -Historically Aus was one of the most highly protected economies (manufacturing)
                 -In recent decades Aus had attempted to reduce protection levels, now one of the
                 most open economies.
        Government aims in reducing protection:
                 -Force domestic businesses to become internationally competitive
                 -Encourage allocation of resources away from inefficient industries
                 -Allow Aus to benefit from integration with the global economy, access to more G&S
        Government initiatives:
                 -Gradual decline in average tariff levels 1969-36% 2008-2.5%
                 -Phasing out of other barriers, such as quotas and subsidies
                 -Whitlam Gov reduced tariffs by 25% across board in 1973
                 -comprehensive program of trade liberalisation continued into 1990s
                 -Today 50% of all goods are tariff free
                 -Australia’s reduction in protection goes well beyond those recommended by
                 international trade agreements such as WTO
        Australia’s multilateral and bilateral free trade agreements
        Australia is very active seeking free trade agreements with other nations.
        Bilateral:
                 -Closer Economic Relations agreement with New Zealand (CERTA), has led to free
                 trade between the two countries and increased standardisation of laws, business
                 practices and commercial structures.
                 -Singapore-Australia Free Trade Agreement (SAFTA) was Australia’s first free trade
                 agreement with an Asian country. Covers the elimination of tariffs and improves
                 market access for services exporters such as telecommunications, financial and
                 professional services.
        Multilateral:
                 -ASEAN-Australian-New Zealand Free Trade Agreement (AANZFTA), covers 21% of
                 Australia’s trade in goods and services and effectively creates a free trade area for
                 the included members. Complementary economies.
                 -Asia Pacific Economic Cooperation forum (APEC), aims for free trade between its
                 members but has made little progress as there are no binding agreements.
The implications of Australia’s policies for individuals, firms and governments




         Implications for Australia of protectionist policies of other countries and trading blocs
Just as domestic policies to protect Australian industries have an impact on the Australian
economyso do the policies of other nations to protect their industries. When other countries put
tariffs on Australian goods and services, our exports become less competitive and struggle to
penetrate foreign markets. When other countries subsidise their exports, they raise the supply and
reduce the price of those goods on global markets. The result is that countries like Australia that
compete to sell similar products on global markets have their income reduced. Overall protectionism
reduces that output of the Australian economy.

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Economics hsc topic 2

  • 1. Economics HSC Topic 2 –Australia’s Place in the Global Economy Australia’s trade and financial flows Value, composition and direction of Australasia’s trade and financial flows Trends in Australia’s trade pattern: -Direction of trade: The direction of Australia’s trade has changed considerably over recent decades. In the 1950s, Australia mainly traded with the United Kingdom and other European countries. In subsequent decades, the direction has shifted and Japan has become the major buyer of exports. More recently China, South Korea and ASEAN countries have become increasingly important. This movement away from United Kingdom was due to their decision to join the EU. Australia then followed the economies in Asia with highest economic growth rates. -Composition of Australia’s Trade: Primary industries always been focus of Australia’s exports as we have a comparative advantage in commodity goods. (Wheat, wool, beef, coal, iron ore and gold). Less competitive in manufacturing, importing large quantities of capital goods, and manufactured consumer goods. Agriculture decreased and minerals increased in importance. Trends in Financial flows: Although trade flows have increased substantially over recent years, the rate of growth in financial flows has been much greater as international businesses have bought Australian assets and invested in Australian businesses, and as Australian companies have increased their overseas investments. When the exchange system of fixed exchange rates came to an end in the 1970s, exchange rates around the world were floated allowing financial flows to grow rapidly. Prior to the deregulation of the finical sector, most financial flows into Australia were direct investment. Following however the benefits of Portfolio investment were seen. Foreign equity and debt has increased dramatically with equity much larger proportion. Australia’s Balance of Payments A record of transactions between Australia and the rest of the world, over a period of time. Money flow IN referred to as a CREDIT (+) Money flow OUT referred to as a DEBIT(-) Structure: -Current Account, debits and credits:  Net goods (export goods – import goods)  Net service (export service – import service)  Net income (credit – debit)  Secondary Income -Capital and Financial Account: Capital Account: Transfers in the form of tied aid(for specific purpose), purchase and sale of non-financial assets. Financial Account: Direct Investment, Portfolio Investment, Financial Derivatives, Reserve Assets.
  • 2. Links between key Balance of Payments categories Current Account Balance + Capital and Financial Account Balance + Net Errors and omissions = 0 The deficit on the current account = Surplus on the capital and financial account. The strongest link between the accounts on the balance of payments can be seen on the net primary income part of the current account. In the long term, a capital and financial account surplus will lead to a larger deficit on the net primary income account. This is because any foreign capital inflow to Australia will have to earn a return for its owner and these earning are a debit on the net primary income account Trends in the size and composition of Australia’s Balance of Payments Main focus on the current account deficit, the balance of goods and services and net primary income.Australia’s current account deficit moves in cycles due to both domestic and international factors. Influenced by both cyclical and structural factors. Cyclical - those which vary with the level of economic activity. Structural - factors those which have a persistent or underlying influence on the BoP(e.g. export base, international competitiveness ,savings). The balance on goods and services varies from small surpluses to large deficits. Cylical factors that influence BOGs are the exchange rate, terms of trade (export price index/import price index x 100), levels of domestic economic growth, international business cycle. Structural influences include narrow export bade, lacking international competitiveness in manufacturing and capacity constraints. The Net Primary Income is the ongoing cause of Australia’s high CAD. Cyclical factors affecting NPI are exchange rates (size of interest payments), changes in domestic and global interest rates(size of interest payments made to OS investors), 40% of Australian public share market is foreign owned(when domestic conditions are good, larger proportion of dividends paid to international investors). Structural factors include very low levels of national savings and high investment economy (major export industries in Aus require enormous amounts of capital investment form OS. Consequences of a high CAD: - Large build up in foreign liabilities - Increasing debt servicing cost - Volatility in exchange rates - Investors reluctant to invest
  • 3. Exchange rates An exchange rate is simply the price of one country’s currency in terms of another country’s currency. Australia has a floating exchange rate determined bu the marker forces of supply and demand. Appreciate: increase in value Depreciate: Decrease in value Measurement of relative exchange rates Comparing Australian currency to other currencies is done by stating what the value of one unit of Australian currency ($1) is relative to another currency. E.g. $A1 will buy US90c. The Trade Weighted Index (TWI) is a measure of the Australian dollar against a basket of foreign currencies of major trading partners. These currencies are weighted according to their significance to Australia’s trade flow. In September each year the RBA amends the TWI based on the volumes of trade for the previous finical year. Factors affecting the demand for and supply of Australian dollars DEMAND SUPPLY 1. Level of Aus to OS interest rates 1. Level of Aus to OS interest rates 2. Investment opportunities 2. Investment opportunities 3. Expectations 3. Speculators 4. Export levels 4. Import levels 5. Commodity prices 5. Domestic income 6. Terms of Trade 6. Domestic competitiveness 7. International competitiveness Changes in exchange rates – apprectiaton/depreciation APPRECIATION DEPRECIATON 1. ↑ Aust IR, ↓ o/s IR 1. ↓ Aust IR, ↑ o/s IR 2. ↑ inv opportunities in Aust 2. ↓ inv opportunities in Aust 3. ↑ $commodities 3. ↓ $commods 4. ↑ AustToT 4. ↓ AustToT 5. ↑ int comp levels 5. ↓ int comp levels 6. ↓ inflation 6. ↑ inflation 7. ↑ demand for Aust X 7. ↑ demand for M in Aust expect of $ ↑ based on forecasts of expect of $ to ↓ based on forecasts of factors factors Determination of exchange rates including fixed, flexible peg and floating -Fixed: keeping the exchange rate at the same level always -Flexible peg: adjusting the exchange rate value each day and fixing it for 24 hours -Floating: allowing the forces of supply and demand to determine the exchange rate
  • 4. The influence of the Reserve Bank of Australia on exchange rates Even though Australia’s exchange rate is primarily determined though the forces of demand and supply in the FOREX market, it is sometimes necessary for the RBA to intervene in the marker to prevent large fluctuations in the value of the $AUS which might impact on investor confidence. Can do this by: -Dirtying the Float: e.g. to avoid a rapid depreciation of the currency the RBA can buy $A, putting pressure upward pressure on the exchange rate. -Monetary Policy: rarely used, indirect e.g. to avoid a rapid deprecation, it may increase the demand for $A by raising interest rates, increasing intrust rates will attract more foreign savings which must be converted to $A The effects of fluctuations in exchange rates on the Australian economy Changes in the BoP can influence the exchange rate e.g. If the value of imports incressead, while exports remained unchanged, this would result in a deterioration in the current account deficit. It would also cause an increase in the supply of $A, resulting in a deprecation of the currency. Also, because of the deprecation, a given level of financial inflows would be able to buy more $A. Therefore, the positive balance on the capital and financial account would increase in $A terms to match the bigger deficit on the Current Account. POSITIVE APPRECIATION NEG APPRECIATION More purchasing power ↓ of X profits (cost more less buy) ↓ interest on servicing Deteriorating CAD as ↑ M ↓ $A value on o/s debt ↑M sees ↓ eco growth ↓ inflation pressure as imports are Expensive to invest in Aust cheaper ↓ value of foreign income ↓ value of foreign assets to Aust POSITIVE DEPRECIATION NEG DEPRECIATION Cheaper X CAD Less purchasing power Expensive M CAD (buy less) Increased servicing ↑ growth More foreign debt ↑ foreign income earned Increased inflation pressure ↑ $AU value of foreign assets Cheaper to invest in Aust
  • 5. Free Trade and protection Australia’s policies regarding free trade and protection History: -Australia typically has relied heavily on trade -Historically Aus was one of the most highly protected economies (manufacturing) -In recent decades Aus had attempted to reduce protection levels, now one of the most open economies. Government aims in reducing protection: -Force domestic businesses to become internationally competitive -Encourage allocation of resources away from inefficient industries -Allow Aus to benefit from integration with the global economy, access to more G&S Government initiatives: -Gradual decline in average tariff levels 1969-36% 2008-2.5% -Phasing out of other barriers, such as quotas and subsidies -Whitlam Gov reduced tariffs by 25% across board in 1973 -comprehensive program of trade liberalisation continued into 1990s -Today 50% of all goods are tariff free -Australia’s reduction in protection goes well beyond those recommended by international trade agreements such as WTO Australia’s multilateral and bilateral free trade agreements Australia is very active seeking free trade agreements with other nations. Bilateral: -Closer Economic Relations agreement with New Zealand (CERTA), has led to free trade between the two countries and increased standardisation of laws, business practices and commercial structures. -Singapore-Australia Free Trade Agreement (SAFTA) was Australia’s first free trade agreement with an Asian country. Covers the elimination of tariffs and improves market access for services exporters such as telecommunications, financial and professional services. Multilateral: -ASEAN-Australian-New Zealand Free Trade Agreement (AANZFTA), covers 21% of Australia’s trade in goods and services and effectively creates a free trade area for the included members. Complementary economies. -Asia Pacific Economic Cooperation forum (APEC), aims for free trade between its members but has made little progress as there are no binding agreements.
  • 6. The implications of Australia’s policies for individuals, firms and governments Implications for Australia of protectionist policies of other countries and trading blocs Just as domestic policies to protect Australian industries have an impact on the Australian economyso do the policies of other nations to protect their industries. When other countries put tariffs on Australian goods and services, our exports become less competitive and struggle to penetrate foreign markets. When other countries subsidise their exports, they raise the supply and reduce the price of those goods on global markets. The result is that countries like Australia that compete to sell similar products on global markets have their income reduced. Overall protectionism reduces that output of the Australian economy.