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Relationship Between the Current Account Deficit and Foreign Debt
Tony Kryger
Statistics Group
While current account deficits put upward pressure on a nation's net
foreign debt, the deficit for a given period does not have to equal the
build up of net foreign debt that occurred over that period. For example,
in 1994-95 the current account deficit totalled $26.9m while net foreign
debt increased by $17.2m. The discrepancy between these figures can be
explained by looking at the way in which current account deficits are
financed.
Financing the Current Account Deficit
A current account deficit can be financed in two ways - by increased borrowing
from overseas and by increased equity investments by foreigners in Australia.
In theory, a current account deficit could be entirely financed by foreign
equity investments in which case there would be no need to borrow any overseas
funds at all. In practice however, deficits are financed by a combination
of borrowing and equity investments. While it may be thought that the increase
in overseas borrowing has to equal the increase in net foreign debt, this
need not be the case. Consider for example a situation in which Australia
has a current account deficit in a particular quarter and borrows funds
from overseas to cover the deficit. At the same time the Australian dollar
appreciates in value against other currencies which causes the Australian-dollar
value of our debt to fall (so-called valuation effect). If the
value of our foreign debt falls far enough, it may offset the additional
funds borrowed during the quarter so that net foreign debt is lower at the
end of the quarter than it was at the start.
A current account deficit in a given period is therefore equal to the
change in net foreign liabilities (debt plus equity) - minus valuation
effects - that occurred over that period. Valuation effects, which can
be substantial, are those changes in the value of net foreign liabilities
that are due to exchange rate movements and equity revaluations (mainly
revaluations of issued shares and securities purchased by overseas investors).
The table above illustrates the relationship between the current account
d eficit in the September quarter 1995 and the change in net foreign liabilities
that occurred during this quarter.
In the September quarter 1995 therefore, Australia had a current account
deficit of $6393m. While in theory the current account deficit should
equal the capital account surplus, in practice these items are rarely
in balance and equality has to be achieved by the balancing item. If we
make the current account deficit equal the capital account surplus by
subtracting the balancing item, the deficit for the September quarter
is $6184m. In order to finance a deficit of $6184m, Australia borrowed
$2805m in overseas funds and allowed foreigners to make $3379 worth of
equity and 'other' investments in Australia ($3484m less $105m). Note
that although Australia borrowed $2805m during the September quarter,
the overall level of net foreign debt did not rise by this amount but
rather fell by $505m. This was due to favourable valuation effects which
actually reduced the value of our debt by $3310m.
Changes in levels during September Quarter 1995
-----------------------------------------------
Total Valuation Capital
effects transactions
($m) ($m) ($m)
-----------------------------------------------------------------------------
Net equity liabilities 10371 6887 3484
plus
Net foreign debt -505 -3310 2805
plus
Net other investment 204 309 -105
equals
Net foreign liabilities 10070 3886 6184
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*
*
*
*
September Quarter 1995 ($m) *
-------------------------------------------------------------- *
*
Capital account surplus 6184 *************
plus
Balancing item 209
equals
Current account deficit 6393
--------------------------------------------------------------
It should also be noted that just as current account deficits can affect
the level of Australia's net foreign debt, so the cost of servicing this
debt can add directly to our current account deficit by increasing the income
deficit. In 1994-95 for example, 9 per cent of all Australia's current account
debits (and almost half its income debits) consisted of interest payments
on foreign debt.
Historical Perspective.
While Australia has nearly always had a deficit on its current account,
it wasn't until the 1980s that these deficits were associated with a build
up of foreign debt. Earlier deficits were not associated with a build up
of debt because the deficits were on average lower and the capital inflow
to finance these deficits was largely long-term equity. In the 1980s however,
Australia experienced persistently high current account deficits and almost
all the capital inflow needed to finance these deficits was in the form
of overseas borrowings.
In the 1990s, a high proportion of the capital inflow to Australia has
been coming in the form of foreign equity investment. In 1993-94 for example,
the inflow of net foreign equity investment was $25b, more than sufficient
to cover the $17b current account deficit in that year. This was a major
factor contributing to the $4.1b decrease in Australia's net foreign debt
between 1992-93 and 1993-94, despite an increase in the current account
deficit during the period. (The appreciation in the Australian dollar
over the period also contributed to the fall in our net foreign debt).
Reducing the CAD and Foreign Debt.
If Australia is to reduce both its current account deficit and its net foreign
debt then progress needs to be made simultaneously on two fronts. First,
exports have to grow faster than imports. Second, there needs to be a corresponding
increase in savings so that more of our investment is financed from domestic
savings rather than by borrowing from overseas. Without an increase in savings,
any income gain from a rise in exports will be lost to an increase in expenditure
on imports.
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