Economics, Commerce and Industrial Relations Group
29 June 1998
Foreign Debt-where are we headed?
Appendix: Technical details
The current account deficit (CAD) measures the net result of
Australia's current transactions with the rest of the world. As a
first approximation the CAD can be thought of as giving Australia's
exports less imports. Exports of goods and services enter with a
positive value and imports of goods and services are deducted. In
addition to exports and imports, incomes received from abroad minus
incomes paid abroad are included as are other current transfers,
items such as pensions received by Australian residents. The
current account is financed by capital inflows, including borrowing
from overseas. Overseas borrowings increase the foreign debt. Hence
there is a fairly close link between the CAD and Australia's
The CAD is once again an issue in Australia. Recent figures
suggest a large widening in the CAD that is once again the subject
of public attention. At the time of the 1997 Budget the 1997-98 CAD
was forecast at $21 billion or 4 per cent of GDP. The mid-year
review increased that to $23 billion or 4.25 per cent of GDP. The
1998 Budget estimates the CAD at $25 billion or 4.5 per cent of GDP
for 1997-98, rising to $31 billion or 5.25 per cent of GDP in
1998-99. Some private forecasts are higher.
There has also been discussion from time to time about the
sustainability of our foreign debt. At one stage there was a concern that
Australia's foreign debt to GDP ratio would continue to increase
apparently without limit. This possibility is examined further
The latest figures for foreign debt show it now stands at $224.5
billion or 41.3 per cent of GDP (based on the seasonally adjusted
GDP (expenditure estimate) for March 1998 expressed as an annual
rate).(1) The former governor of the Reserve Bank of Australia
(RBA), Mr Bernie Fraser, pointed out in 1995 that the bulk of the
growth in Australia's foreign debt occurred in the first half of
the 1980s when the net debt rose from 6 per cent of GDP to around
35 per cent. The increase since then had been more gradual peaking
at 42 per cent in 1993 and then easing back to 40 per cent in mid
1995.(2) The rapid increase in foreign debt in the 1980s followed
the widening of the balance of payments current account deficit
(CAD) which began in the late 1970s. This was associated at the
time with the euphoria surrounding the so-called 'resources
Generally the 1990s have seen foreign debt hover at or just
above 40 per cent. We have perhaps even become complacent about the
foreign debt position. In November 1997 the current RBA Governor,
Mr Ian Macfarlane, giving evidence to the House of Representatives
Standing Committee on Financial Institutions and Public
Administration, talked about the foreign debt as being one of those
problems either eliminated or under reasonable control.(3) Since
then, in a speech given in March 1998, the Governor has again drawn
attention to Australia's weaknesses due to the widening of the CAD
in the short term and the large increase in external debt likely to
follow.(4) He also cited IMF estimates of the external debt of
other countries, these being reproduced in the table below.
Net External Debt-% GDP
New Zealand (1996)
United States (1996)
Source: IJ Macfarlane, 'Some thoughts on Australia's position in
the light of recent events in Asia,' Speech to the Bull and Bear
Luncheon, 26 March 1998.
While Australia's net foreign debt is not the highest on the
list, only New Zealand is significantly higher.
Some other interesting features of the table are worth
commenting upon. Every debt is held by someone else who treats it
as an asset. The same applies to external debts-a negative entry
indicates that residents of that country hold more debt incurred by
overseas borrowers than those residents have incurred overseas.
Japan is the largest creditor country by size, though the largest
as a proportion of GDP is Switzerland. Overall the total of
all countries' net external debt should sum to zero.
There has been a view that the foreign debt incurred by
governments is a problem for the nation while private debt incurred
overseas is only an issue for the individual borrower. The
unfolding Asian financial crisis illustrates the problems that can
be associated with foreign debt, even if it is mainly
private foreign debt. The Asian financial crisis has also
caused Australia's CAD on the balance of payments to begin to
widen. Now that Australia's foreign debt is once again an issue it
is timely that we have a close look at where Australia's foreign
debt is heading.
Returning to the actual figures, Australia's foreign debt is now
$224.5 billion. The CAD should be around $25 billion in 1997-98
rising to $31 billion in 1998-99 according to the 1998-99 Budget
Papers. The bulk of the CAD will be financed with debt. A small
share of the CAD has been financed by direct investment recently.
For the moment, for the purposes of this argument, equity
investment will be ignored to keep things simple and because direct
foreign investment cannot be relied upon. On that basis the foreign
debt would increase to around $260 billion, a little under a 16 per
cent increase by June 1999. By contrast GDP itself is likely to
grow at around 8.3 per cent per annum over the next five quarters
based on the Budget forecast of 3 per cent real GDP growth and 3.5
per cent through year increase in the GDP deflator. On those
figures the foreign debt to GDP ratio is likely to increase from 41
per cent to about 44 per cent over the next 12 months.
As it happens there is a formula, which allows us to simply
answer questions of the form 'what would happen to the debt to GDP
ratio if the CAD remains at present levels?' The formula derived in
the appendix says that, at any time, the economy is heading for a
foreign debt to GDP ratio (from now on just the 'foreign debt
ratio') equal to the ratio of the CAD, as a share of GDP, to the
growth in GDP, the standard measure of economic growth. The formula
can be expressed in the following words: we are heading
towards a foreign debt ratio equal to the CAD ratio divided by the
On the latest figures we have an official forecast CAD to GDP
ratio of 5.25 per cent and a GDP growth rate (nominal) of 6.6 per
cent. Using the formula, these figures suggest that we are heading
for a foreign debt to GDP equilibrium ratio of 5.25/6.6, or 80 per
Australia now has a foreign debt ratio of 41 per cent. That
means we are a bit over half the way to the foreign debt ratio
likely to be generated by Australia's economic fundamentals.
Our analysis suggests that if we had had a history of the CAD
ratio and GDP growth at current levels, then we would now have
foreign debt of around $435 billion, not the $224.5 billion we
actually had in March 1998.
Fortunately we have indeed had a different history with the CAD
ratio often lower than the present, and more importantly the
nominal GDP growth rate normally much higher than the present.
Nominal growth has fallen because inflation has fallen. It is worth
reflecting on the significance of the nominal GDP growth rate in
Every homeowner who bought a house before the 1990s is aware of
the effect of past high inflation rates in quickly eroding the real
value of their home loans. Over time as their incomes increase,
they also find their capacity to service the outstanding loan
improves with time.
In previous years much the same thing was happening to
Australia's foreign debt. For example, for much of the 1970s and
1980s we had inflation of around 10 per cent and real growth around
4 per cent. That gives us a nominal GDP growth of 14 per cent.
Using that figure with our current CAD ratio would have us head
towards a foreign debt to GDP ratio of 31 per cent of GDP. That is
more like the sort of figure we experienced in earlier years. For
example, at the end of 1988-89 the foreign debt to GDP ratio was 33
More recently inflation has been relatively low averaging
between 2 and 3 per cent while the CAD ratio has remained much the
same as it has always been. In 1988-89, to continue the example,
the CAD ratio was 5.6 per cent, though that was something of a high
point. From 1988-89 to the present the average CAD ratio has been
4.6 per cent, about the same as now. The important thing to realise
is that, with a CAD ratio of say 5 per cent, as nominal economic
growth (i.e. real growth plus inflation) falls from 14 to around 6
per cent, we head for a foreign debt ratio of 80 odd per cent
rather than the 32 per cent we were trending towards or hovering
about in the earlier decades.
There has also been discussion from time to time about the
sustainability of our foreign debt. The formula developed
here can throw some light on those types of questions. For example,
suppose we maintain inflation within the Reserve Bank's 2-3 per
cent target range and maintain real growth at 3.5 per cent. We can
now easily determine that under those conditions if we want to
stabilise the foreign debt ratio at the current 41 per cent we need
to reduce the CAD ratio to 2.5 per cent (0.41 times 6). If instead
the CAD is allowed to continue at 5 per cent of GDP, then foreign
debt will blow out to 83 per cent of GDP. At 4.6 per cent, the
average CAD ratio over the last 9 years, the foreign debt ratio
would blow out to 77 per cent. For the same CAD ratio, a lower rate
of growth produces a higher ultimate foreign debt ratio.
An important implication to note is that the foreign
debt ratio, whatever that ratio might be, is in fact
stable. The CAD could in principle be any magnitude but
the formula would show that Australia would nevertheless head
towards a stable debt ratio. That ratio may well be too high for
general acceptability, but at least it does not accelerate as was
feared in the 1980s.
With low inflation it would appear wise to keep the CAD to GDP
ratio as low as possible in order to avoid blowing out the foreign
debt to GDP ratio. Unfortunately the current settings suggest we
are headed for a level of foreign debt much higher than we have
experienced in modern times. As we approach those levels there is
bound to be heightened interest in issues to do with foreign debt
and, as related issues, levels of foreign investment and ownership.
The current settings suggest we are on the way to foreign debt at
80 odd per cent of GDP compared with 41 per cent in March 1998.
Strictly speaking the formula applied here refers to
all net liabilities to foreigners-not just foreign debt.
If Australia experienced higher direct investment it would mean
that less debt would be required to cover the CAD. Direct or equity
investment has been running at low levels lately. Also, for many
people foreign ownership is hardly less important as a policy issue
than foreign debt. Nevertheless, it is easy to adjust the formula
to exclude equity investment if that is desired. That is done in
This is not the place for a full policy discussion. However, a
few observations would appear to be in order.
Foreign direct investment in Australia has barely moved
recently. If Australia can attract more equity investment the need
for additional foreign debt will be reduced. However, that would
then raise another set of issues to do with foreign investment.
The Budget Papers suggest that the blow out in the CAD is likely
to be temporary. While it is far from clear how long it will take
to occur, once Asia recovers, exports can be expected to resume
their earlier path. If that turns out to be the case then some of
the problems identified here will no longer be relevant. There
would be a rise in the temporary foreign debt ratio, but we would
soon revert to a course towards a lower foreign debt ratio. Of
course, potential problems with China and Japan, both of which are
facing uncertain outlooks, may interfere with this scenario.
Higher inflation would increase nominal growth and so lower the
foreign debt ratio towards which Australia is heading. However, it
is hardly sensible to advocate that as a desirable course of
The only other approach to prevent a blow out of foreign debt to
80 per cent of GDP is to directly tackle the CAD itself. Just how
to do that raises a raft of policy options.
- Industry policy, including competition policy is designed to
make domestic industry more competitive in the world economy.
- Macroeconomic responses that aim at lifting savings rates are
designed to bring aggregate expenditure closer into line with
- Measures to influence exchange rates are designed to switch
local and international spending away from other countries towards
Australian goods and services.
The above is, of course, only a brief outline of the possible
policy responses. It is not possible here to fully discuss those
options. The aim here has been the more limited one of trying to
understand where Australia foreign debt is headed given the recent
performance of the CAD.
- The figures are taken from ABS, National Income,
Expenditure and Product, Australian National Accounts, Cat No
5206.0, 3 June 1998 and ABS, Balance of Payments and
International Investment Position, Cat No 5302.0, 2 June 1998.
- B. W. Fraser, 'Australia in Hock?' Reserve Bank of
Australia Bulletin, December 1995, pp. 1- 8.
- House of Representatives Standing Committee on Financial
Institutions and Public Administration, Inquiry into the Reserve
Bank of Australia Annual Report 1996-97, Hansard,
6 November 1997.
- I. J. Macfarlane, 'Some thoughts on Australia's position in the
light of recent events in Asia,' Speech to the Bull and Bear
Luncheon, 26 March 1998.
Deriving the formula for foreign debt
Let the current account deficit be written as
(i) CAD = d.GDP
where d is the ratio of the CAD to GDP. Now GDP is growing over
time so we can express GDP as
(ii) GDP = GDP.egt
Where e is the exponent, g the growth rate and t is time. This
formula is merely a convenient expression which gives GDP at any
point in time for a given growth rate.
From equations (i) and (ii) we have
(iii) CAD = d. GDP.egt
Now debt, which we can call D, is the accumulated value of past
CADs or ʃCAD where ʃ is the integration symbol. Hence
(iv) D = ʃ d. GDP.egt
and the solution is
(v) D = (d/g). GDP.egt + K
where K is the constant of integration.
Now to get D as a share of GDP we can divide the right hand side
of equation (v) by GDP.egt. That gives
(vi) D/GDP = d/g + K/ GDP.egt
which, in the long run, as K/GDP.egt heads towards
zero, simplifies to
(vii) D/GDP = d/g.
This formula now says the ratio of foreign debt to GDP
is simply the ratio of two numbers, the CAD as a share of GDP and
the growth rate for GDP. This is the number towards which
we are heading at any one time.
The constant of integration is unknown. The mathematics is
silent on the value it might take. Here we can interpret it as
given by history. It summarises all the reasons why we are not
presently at the ratio given in the right hand side of equation
(vii). But the constant of integration declines in importance as
time continues. Hence the constant of integration reflects our
starting point but it is the rest of the equation that tells us
where we are going.
Of course in any exercise like this there are a number of
assumptions in the mathematics which may influence the results. We
have assumed that the entire CAD is financed by new debt. However,
some of the CAD may be financed with equity and/or direct
investment and some old debt may be written off. Likewise the
exchange rate is assumed to remain constant in the absence of any
particular reason to believe the exchange rate is likely to
continue to change over time. However, these points do not affect
the fundamental insights we derive from the formula in equation
(vii). We just need to be careful not to overstate the precision
implied by the mathematics.
If we want to distinguish foreign debt from foreign direct or
equity investment then the increase in foreign debt itself will be
some proportion of the CAD. For example, if the trend is 80 per
cent of the CAD is financed by new foreign debt then equation (vii)
has to be re-written as
(viii) D/GDP = 0.8d/g.