External Stability

Demand Factors and External Stability (2)

Demand Factor	Theoretical Impact	Evidence
Consumer Confidence	When consumers are more confident they are more likely to spend their income, and this spending will be divided between locally produced goods and services and imported goods and services. If local production can not meet their demand, spending on imports will increase. This could lead to an increasing CAD and a depreciating AUD.	In 1998/9 consumer confidence increased, reaching 108 on the Westpac Index. This result correspond closely with an increase in the CAD/GDP ratio, which increased to -5.7% at that time. More recently, consumer confidence increased dramatically after 2001/2, finally peaking at around 120 on the index in 2003/04. At this time, the CAD/GDP ratio increased to -5.8 of GDP, and then -6.5% in the following year.
Business Confidence	Business confidence will affect external stability in a similar manner to consumer confidence. As business confidence increases they are more likely to spend on imported products to use in the production process. As a result, debits in the CAD may increase at a faster rate than the credits.	Business confidence climbed after the introduction of the GST, finally reaching a peak of 18.0 on the National Australia Bank Index in 2002/03. At the same time we recorded a balance on current account of -5.5% of GDP. Despite a fall in confidence in the following years, the CAD/GDP ratio remained high. This was due, in part, to the high value of the dollar, and the severe capacity constraints experienced by the Australian economy during this period. (In other words, producers were forced into a situation where they had to source their inputs from overseas.)
Interest Rates	Interest rates can have a very important effect on our external stability. As has been discussed previously, a change in interest rates will affect the spending patterns of consumers and businesses. However, the relative difference between interest rates in different countries can also have a strong impact on the exchange rate. If our cash rate is higher than that in the USA (for example), investors will want to put their money into the Australian overnight money market to get the higher return. This involves buying AUD on the Forex market, and so ultimately leads to an appreciating currency.	The recent appreciation of the AUD against the USD can partly be attributed to the interest rate differential. During 2003 Australian maintained a cash rate of 4.75% (until November) while the cash rate in the USA was 1.75%. As a result, the AUD increased from around 0.55USD to around 0.75USD (peaking at close to 0.80USD). Although the USA has now experienced an extended period of increases in the funds rate (their equivalent of the cash rate), the Australian cash rate remains higher. As a result, the Australian money market is still a more attractive investment, and therefore the Australian dollar has remained strong.
Overseas Economic Conditions	If our trading partners experience strong growth, they will normally increase their demand for our exports. As a result, this can lead to both an appreciating AUD and an improvement in the CAD. While the net income section is unlikely to be affected, the balance on goods and services is far more likely to be a surplus during these periods.	In 2004/05, Japan experienced 2.4% growth, and in the following year economic growth was still positive at 1.9%. This represented a change for the Japanese economy; four consecutive years of growth after almost a decade of recession and deflation. At the same time spending on Australian exports increased. Despite this, the CAD/GDP ratio fell to -6.5% from -5.8% the previous year. This apparent abberation can be explained, in part, by the high value of the Australian dollar during this period. It is also worth noting that growth in the Japanese economy was largely due to the consumption of surplus stocks which had been building up over the previous decade. As such, there was no need for imports into that country to increase.
Exchange Rate	Although it is a measure of our external stability, it is important to understand that changes in the value of the AUD can act as a strong demand factor affecting our external stability. When our dollar depreciates our exports become more internationally competitive, and as a result we will sell more of them. At the same time imports become more expensive, and so we will not buy as many of them. This has obvious implications for the CAD. However, a depreciating AUD can mean that it is more expensive to repay the interest on our NFD. As this is such a large percentage of the CAD, this may have a greater impact than that experienced in the balance on goods and services, and so the CAD may increase.	In 2000/01 the TWI fell to 49.7. As a result demand for our exports increased by 7.3%, which is above average for the period. Our CAD fell to only 2.7% of GDP – this was the lowest recorded in the last 10 years. However, the impact on the net income section can be seen in more recent times. During the years 2004-2006, the value of the dollar increased. As a result, Australians felt more confident borrowing money from overseas, and therefore our net foreign debt increased quickly. This caused an increase in the net income deficit, and therefore the CAD expanded. Despite the commodities boom, Australia was unable to record any improvement in the CAD at this time.
Disposable Income	As our income increases we will seek to satisfy more of our needs and wants. As this happens, we will purchase more imported products, especially if domestic production is unable to keep up with the increase in demand. This may make our CAD worse, and place downward pressure on the AUD.	Disposable income increased by 5.1% during 2004/5. This increase was one of several consecutive increases that was higher than the rate of inflation. Accordingly, our desire to purchase imported goods and services increased, and the CAD/GDP ratio increased to -6.5%. It is important to note here that confidence can “cancel out” the impact of an increase in disposable income. In 2000/01 gross disposable income increased by 9.9% due to a fall in income tax rates, but at the same time the CAD/GDP ratio fell to 2.7% (the lowest for the period). This is because at the same time consumer confidence fell to 101 on the Westpac Index, and so consumers did not spend the money that they received (spending on imports in that year fell by 1.3% - the only year in the last 10 in which spending on imports fell.

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