Australias trade and financial flows

Value, composition and direction of Australias trade and financial flowsBy global standards, Australia is large in some respects and small in others. On size alone, the Australian economy ranks 13th in the world (In the middle ranks of advanced economies, relatively small)In contrast, in terms of living standards in 2011, Australia ranked 2nd in the world in terms of quality of life according to the UN HDI indexHowever, quality of life and economic size do not give a solid comparison between economies. To really understand the impact of changes in in the global economy on the Australian economy, one must understand the linkages between Australia and the global economy. This requires an analysis Australias trade patterns Australias financial relationship with overseas countries The influence of the exchange rate on the structural and performance of the Australian economy

Trends in Australias trade pattern Despite Australias geographic isolation from the rest of the world, trade represents a high proportion of Australias economic activity. In part, this is because there have always been overseas markets for Australia, primary commodities (mineral & agriculture) and Australia trends in order to obtain new technologies and items that it doesnt produce because of its relatively small population size While the Australian economy makes up a small proportion (2% GWP) of the global economy, trade is central to the Australia economy Australia exports around one fifth of what it produces, and imports around one fifth of gross domestic product. Hence, although Australia has little influence on the developments in the global economy, World economic development has a significant impact on Australia The changing direction of trade Prior to the formation of the European Union (EU) in 1973, the United Kingdom had been Australias major trading partner for agricultural products. Once the UK joined the European trading bloc, it was require to impose the same barriers on Australia and trade with European countries By 1960s, the Japanese economy was sustaining rapid economic growth and its demand for production inputs (minerals and energy products) increased rapidly. Australia responded to this opportunity and trade in japan expanded quickly During the 1980s, as Japanese economic growth rates began to slowdown, the direction of Australias trade shifted more towards other emerging economies in Asia. Since 2007 China has been Australias largest trading partner (imports + Exports) Yet, Australia still imposts a substantial amount of capital equipment and consumer items from advanced economies and sources greater amounts of manufacturing goods from China and ASEAN because of their comparative advantage The changing composition of Australias trade Primary industries have always been the main focus of Australian exports as Australia has a comparative advantage in commodities due to its vast natural resources. Australia has exported high volumes of agricultural products and mineral as they account for two-thirds of Australias export earnings. Australia has been less competitive in manufacturing Australia has continued to rely on its primary exports while importing large qualities of capital goods and manufactured goods Australia has experienced significant changes in the composition of its export base (the range of goods an economy export). The global commodities boom has impacted on the composition of trade. Agricultural and manufacturing have declined in relative importance as export earners such as mineral and metal which have increase rapidly A factor contributing to the decline of agricultural exports as a proportion of Australian trade is its severe volatility (fluctuations in world price) and its trade protection policies world wide Because of Australias inability to compete with low cost production and the vulnerability of relying on commodity exports, a long term alternative is to increase its service exports since three-quarters of Australias workforce is employed in service industries The composition of imports have changed moderately Exports have changed more than imports

Trends in financial flows While Australias trade flows have increased substantially over recent years the rate growth in financial flows have been much greater, as international businesses have bought Australian assets and invested. In Australian businesses, and as Australia companies have increased their overseas investments The rapid growth of financial flows was due to two reasons In 1970s, exchange rates around the world were floated and restrictions on the movement of capital across national borders were removed, opening up the international capital market Another reason is the advancement of technology and communication which made it easier to shift finance between countries Prior to the deregulation of the financial sector, most financial flows came into Australia in the form of direct investment (which includes the establishment of a new company, or the purchase of a substantial proportion of shares in an existing company (shares > 10%), because it brought the benefits of job creation and technology transfer. Portfolio investment (which is short term speculative movement of income for loans or to buy a small proportion for a company (shares < 10%) were not as important due to regulated financial system The removal of restrictions of financial flows injected money into Australian companies through loans and share purchases In the 1980s when Australian dollar was floated (when an economys currency is valued through the forces of demand & supply in the FOREX market) and the financial market was deregulated, the level of foreign investment into Australia grew rapidly. However, portfolio investment has been significantly faster than the growth of FDI flows Australia has always been a net capital importer as it has a small saving pool. Australia has relied on financial flows from overseas to make up for the shortfall between savings & investment in Australia. 2.1 trillion was invested into Australia and Australia has invested half as much overseas (1.2 trillion) Australia businesses & residents have a substantial amount of assets & portfolios due to the overseas capital market becoming more open

Australias Balance of Payments

Structure Current Account The current account shows the money flows (receipts & payments) from all exports and imports of goods & services, income flow and non-market transfer (transfer payments) between Australia and the rest of the world for a period of one year which covers all external transaction that are non-reversible Net good This refers to the difference between what Australia receives for its exports and payout for its imports of goods (credit debit[for goods]) There are three possible outcomes for Net good Australia could be in surplus (receipts exceed payments) Australia could be in balance (where export receipts equal import payments) Australia could be in deficit (where payments exceeds receipts) Net service This refers to services that are bought and sold without people receiving a good (i.e. transport, insurance, telephone) Services sold are credit and services bough are debt Balance of goods and services The balance of goods and services (BOGS) is the amount derived by adding net good and net service together Net primary income This refers to earnings on investments. It covers interest payments on borrowings and returns on other foreign investment (i.e. foreign owned companies or land in Australia) When foreigners invest in Australia, income in the form of rent, profit, interest and dividend flow overseas When Australian invest overseas, there is a flow of income back into the economy in the same forms The net primary income refers to the difference between the income flow out of Australia (debit) and the income flow into Australia (credit) The net primary income is a major contributor to the current account deficit (CAD)

Net secondary income This refers to non-market transfers. These occur when products or financial resources are provided in return (i.e. insurance claims, foreign aid, foreign working in Australia) This is a small and technical account, which has little importance in the scope of the overall balance of payments Other examples include funds given overseas to other governments as gifts (debt) or pensions received by residents in Australia from foreign governments (credit) Balance on current account This refers to the addition of the balance on goods and services, net primary income and net secondary income A negative figure would result in a Current Account Deficit (CAD) A positive figure would result in a Current Account Surplus (CAS) Capital and Financial AccountThe capital and financial account records the financial assets and liabilities (money inflow that results from international borrowing, lending and purchases of assets such as shares and real estate) between Australia and the rest of the world over a periods of one yearThe CFA is reversible meaning that borrowing can be repaid, and assets that are bought can be sold again Capital Account The capital account has little bearing on the overall balance of CFA The capital account consists of two main components: The first item is capital transfer, mainly in the form of conditional or tied foreign aid grants or debt forgiveness (this may be in the form of assistance to other countries to build up their infrastructure or capital stock The second item is entries for the purchase and sale of non-product, non-financial assets, mainly in the form of intellectual property rights (patents, copyright, trade mark and franchises) Financial account The financial account shows Australias transactions in foreign financial assets and liabilities It is categorised by five types of investments: Direct investment: which covers foreign financial transactions to funds new investment in Australia or overseas or to buy more than 10% of existing company (FDI) Portfolio investment: which refers to the buying of land, shares and other marketable securities (easily sold securities) in existing companies (short-term, speculative) Financial derivatives: which are a category of complex financial assets which are valued by the performance of specific assets, interest rates, exchange rates, or indices Reverse assets: which refer to foreign financial assets that are available to be controlled by central authorities for financing or regulating payment imbalance (RBA with gold) Other investments: which are transactions that dont classify in the categories above Credit entries are caused by an increase in foreign investment into Australia or a reduction in Australia investment overseas, they represent net inflows Debit entries represent net outflows Each year, the rise in Australias liabilities to the rest of the world is higher than the increase in liabilities of the rest of the world is higher than the increase in liabilities of the rest of the world towards Australia (Australia draws on the savings of the rest of the world to finance deficits on its current account) Balance on capital and financial account The overall CFA is determined by adding all categories together. Net errors and omissions refers to statistical discrepancies

Links between key Balance of Payments categories Current account and capital and financial account up to zero The deficit on the current account is equal other surplus on the capital and financial account. An increase in the current account deficit (CAD) will result in a rise in the capital and financial account surplus The floating of the Australian dollar plays a key role of ensuring that there is a balance in the Balance of payments

Strongest link between the current account and the capital and financial account can be seen on the net primary income. In the long run, a capital and financial account surplus will result in large deficits on the net primary income account. This is because, regardless of its form, any foreign financial flow that comes to Australia must earn some kind of return for its owner, and these earnings are a debt(outflow) recorded on the primary income account Financial inflows can create debits on the primary income category of the current account in two ways: International borrowing (foreign debt) will require regular interest repayments. These interest payments, or servicing costs are not recorded on the capital and financial account; they are recorded as debit on the net primary income part of the current account Foreign investment (foreign equity will require returns on the equity investment. Equity financial inflows are related to the foreign purchases of Australian assets )land, shares, companies)(rent, dividend and profit) Over a period of time, a high level of capital and financial account surplus will result in widening CAD because of line servicing costs associated with increased foreign liabilities (higher foreign debt and foreign equity). In some extreme cases, may lead to a debt trap (extreme levels of debt) By examining savings and investment, another perspective on the links between the two sides of the balance of payments is given. Australias low savings level (relative to investment demand) makes it necessary to attract a large financial inflow on the financial account. Australias lack of international competitiveness on the current account was blamed for the balance of payments problem, because low savings results in the need for foreign capital inflow to fund investment within Austria (making CAD a CFA problem)

Trends in the size and composition of Australias Balance of Payments international competitiveness, terms of trade, international borrowing, foreign investmentThe balance of payments is an important indicator of the health of an economy. It reflects key features of the structure of the economy, and highlights imbalances in the relationship between Australia and the global economy. Balance of payments figure are watched carefully by financial markets

The main focus of analysis of trends in the balance of payments is the current account deficit (CAD), and in particular its main components (balance on goods and services (BOGS) and net primary income) It was the large shifts in the CAD in the 1980s that promoted a range of major structural reforms to restore the competitiveness of the Australia economy Australias CAD is among the highest of all advance economies Australias CAD moves in cycles, reflecting a mix of short and long term, domestic and external influence The size and movements on the balance on goods and services and primary income account are influenced, to varying degrees, by cyclical and structural factors Cyclical factors: are those which vary with the level of economy activity (i.e. demand on commodities, Australias term of trade and the value of exchange rate Structural factors: are those which are underlying or persistent influences on the balance of payments (i.e. the structure of Australias export base, the international competiveness of Australias and the level of nation savings) Balance on goods and services Consumer goods are extremely volatile Import cause deficits in the BOGS and exports cause surplus in the BOGS. The BOGS varies from occasional surpluses to deficit of around 2% of GDP Cyclical factors (that influence BOGS) Movements in the exchange rate affect the international competitiveness of Australias exports and the relative price of the goods and services that Austria import (i.e. Australia experienced a surplus in BOGS dur to the deprecation of the Austrian dollar, reaching a seven-year low of $US 0.62 in late 2008) A depreciation decreases the foreign currency price of Australias exports increasing the international competiveness of Australian dollar export on world market. At the same time, a depreciation increases the Australia dollar price of imports and discourages consumers from purchasing imports also improving the BOGS account In contrast, an appreciation generally worsens Australias international competitiveness, decreasing demand for Australias exports and increasing import expenditure as consumers switch to imported substitutes (e.g. when the Australian dollar reached an all-time high of $US 1.11, to substantially worsened the international competitiveness of Australias non0mining exports and encourage consumers to purchase imports) Changes in Australias Terms of trade is the greatest influence on Australias balance of payments Terms of trade shows the relationship between the price Australia receives from its exports and the prices it pays for its imports over a period of time If export prices are increasing relative to import prices Australia receives from its exports and the prices it pays for its imports over a period of time If export prices are increasing relative to imports prices, Australias term of trade will improve. On the other hand, if import-prices are increasing relative to export prices, the terms of trade would deteriorate An improvement in the terms of trade means that the same volume of exports can but more imports and vice versa Since the beginning of the boom in 2003, Australia has experienced a doubling of its terms of trade. Despite the GFC, Chinas quick recovery is the reason for the surge in Australias term of trade. This trend appears to continue in the future, with large prices for commodity continues and improve trade balance (BOGS) Higher terms of trade means that exports receive higher prices from the same output, which increases export revenue and improves the BOGS As the terms of trade rose over the mid-2000s it encourages foreign investment in the Australian mining. The higher Australian dollar weakened the international competitiveness of Australias non-commodity exports. On the other hand, because Australias commodity export are mostly priced in US dollars, the appreciation of the dollar had very little effect on overseas demand for those exports, but it reduced the extent to which higher global commodity prices translated into higher export earnings in Australian dollars Dutch Disease is a phenomenon whereby growth in one export industry results in a higher exchange rate, and slowly chokes off the other export industries as they lose their international competiveness (when commodity export revenue increased in Australia, the appreciation of the exchange rate also caused non-commodity export revenue to disease) Term of trade index is calculated by

The level of domestic economic growth also influences the BOGS balance by affecting demand for imports An upturn in the domestic business cycle results in higher disposable income which leads to higher consumption, some of which spills over to imports (since a moray of Australias exports are consumer goods), worsening the BOGS Changes in the international business cycle impacts on the BOGS by affecting the demand for Australias key regional trading partners both increased demand for Australias exports improving the BOGS. (for example, the boom in Chinas economy provided a large boost to Australias export revenue, and the global financial crisis only held a temporary impact on the value of Australian exports

Structural factors The structure of Australias export base (composition of exports) has an important influence on the long term behaviour of the BOGS. Australia has a narrow export base, in the sense that Australias exports are heavily weighted towards primary commodities. Australia comparative advantage lies in low value-added products (minerals & agriculture) which together account for around for around to thirds of Australias export earnings. ( In other words Australias narrow export base of minerals and agriculture are more volatile than manufacturing & services, which contributes to the large fluctuations in BOGS year to year) By contrast, Australias lacks international competitiveness in manufacturing and trends to import more expensive high value-added products (consumer goods and capital goods). As a result, in the long run the BOGS trends to be in deficit rather than surplus because import payments very often exceed export revenue The global commodity boom appears to have reversed that trend for minerals and energy exports. This has led to significant improvements in Australias term of trade and extraordinary growth in export revenue. At the same time, the price of many of the manufactured goods that Australia imports have also fallen due to increased global competition, especially from low-cost production in China. For a long time the agricultural sector had experience a trend decline in prices as global trade has shifted to sophisticated manufactured goods and services. Because agricultural production is often labour-intensive, it is easy for many (especially developing) countries to produce agricultural exports. Also agriculture is in high levels of protection so Australia would find it difficult to access global export market Many economists argue that Australia would benefit by diversifying its export base towards high growth sectors of global trade, including high-tech and elaborately transformed manufactured goods or commodity exports. Other economist now do not see an immediate need for Australia to diversify its export base as commodity prices are at a record high and there is high demands from emerging economies (China). however economist disagree that Australia shouldnt put all eggs in one basket as fossil fuels are non-renewable Another structural factor that has emerged over the past decades are capacity constraints on Australias mineral exports due to poor transport Infrastructure (infrastructure bottle necks) and skills shortages. Poor transport infrastructure, such as a low capacity at the nations port and inefficient roads and railing networks physically prevents Australian exporters from taking advantage of favourable cyclical conditions by increasing export volumes

The primary income account The net primary income account is comprised mainly of payments of interest and dividend on Australias net foreign debt and equity (tends to be 3 4% of GDP) Cyclical factors The relative size of Australias interest repayments to overseas are affected y two main cyclical factors The value of exchange rates: movements in the exchange rate will alter the Australian dollar value of debt denominated in foreign currencies (variation effect). An appreciation will decrease the Australian dollar value of debt denominated in foreign currencies, decreasing the value of Australia debt service (in Australian dollar terms) reducing the value of net primary income outflow and improving the Australian dollar value of debt denominated in foreign currencies, increasing the value of Australias interest repayment and worsening the net primary income deficit. However, many economists argue that in practice, the variation effect only has a very small impact upon the net primary account. This is because a large amount of Australians foreign debt will be hedged in some way (meaning that the lender and borrower will agree to fix the exchange rate over the course of the loan to reduce the risk of large exchange rate fluctuations) in other worlds, the majority of Australias servicing costs are fixed Changes in domestic and global interest rates: the interest repayments on foreign debt are set by an interest rate. Hence changes to the interest rate will impact on the level of debt repayment. Australian borrowers might borrow under an overseas interest rate or under an Australian interest rate. The GFC decreased the value of Australias interest repayment obligations and should improve the net primary income deficit. However, despite low global interest rate in recent years, Australia has still recorded relatively large net primary income deficit The most significant cyclical factor affecting the net primary income deficit is the performance of domestic business cycle through its influence on equity servicing costs. Equity (ownership of assets) entitles the owner to a share of profit from the assets. When the domestic economy experience strong growth, domestic company profit rise, and these profits redistribute to shareholders as dividends (40% of Australian public share market is foreign owned), hence domestic growth results in an outflow from the economy to overseas shareholders

Structural factors The main reason for Australias ongoing net primary income deficit is the underlying structural characteristics of the Australian economy (the savings and investment gap). The problem is that Australia is a relatively small economy with a historically low level of national savings. At the same time, Australia has a high investment economy, in particular Australias commodity export industry Since Australia is an open economy, firms are able to look at foreign sources of finance to fund their investment. This means that Australia tends to find a large part of its investment through international borrowing (which increases foreign debt) or selling ownership in Australian assets (which increases foreign equity). the interest repayment costs are recorded as outflows on the net primary income account, and are the maker cause of Australias persisting current account deficit (CAD)

The effect of these trends (high CAD) on Australias Balance of Payments An import question whether there is a negative effect associated with sustaining a high current account deficit: Some argue that if the government is not contributing to the CAD and foreign liabilities problem, any external imbalances are simply the result of normal market transactions in a global economy Others argue that the CAD and foreign debt can be beneficial because borrowing from overseas can increase investment and help the economy to grow faster However, there are clear risks associated with a sustained high CAD. This includes: The growth of foreign liabilities Over a period of time high CAD will contribute to an increased level of foreign liabilities. A deficit on the current account presupposes financial inflow on the capital and financial account, either in the form of borrowing from overseas (foreign debt) or through selling equity items such as property and companies (foreign equity). This will mean that lenders may become reluctant to lend to Australia or to invest in Australia Increased interest repayment Increased servicing costs associated with high levels of foreign liabilities lead to large outflows on the net primary income account. Widening CAD. Higher levels of foreign debt may result in foreign lenders demanding a risk premium on loans, forcing up interest rates Increased exchange rate volatility High current account deficit may undermine the confidence of overseas investors in the Australian economy and, by reducing demand for Australia currency, may result in a depreciation of the Australian dollar Constraint on future economic growth In the long term, a high CAD may become a speed limit on economic growth. Higher levels of economic growth generally involve an increase in imports and deterioration in the CAD. Economies with a CAD problem are therefore forced to limit growth to the level at which the CAD is sustainable. This is known as the balance of payments constrain More contractionary economic policy If they find it necessary to reduce a high CAD in the short term, governments may use tighter macroeconomic policies and accelerate the implement of microeconomic reform. In the short run, tighter fiscal and monetary policies will reduce economic growth and contribute to a lower CAD A sudden loss of international investor confidence During recent decades several countries have experienced economic crises that have been triggered by a sudden loss of investor confidence. This is often related to sustaining a high CAD (Asian crisis).Exchange RatesExchange rates play a central role in the relationship between individuals and global economy. All of the trade and financial relationships between countries are mediated through the exchange of currencies. For this reason, exchange rates movements have a significant impact on international competitiveness, trade flows, investment decisions, inflation and many other factors in the economy Measurement of relative exchange rates to other individual currencies The exchange rate is simply the price of Australias currency in terms of another countrys currency. This currency conversion occurs in the Foreign exchange markets (FOREX), where the forces of demand and supply determine the price of one countrys currency in terms of another (floating exchange rate). In the case of a fixed exchange rate the government or RBA use monetary policy or by dirtying the float to determine the price of one countrys currency in terms of another Because Australia has many exchange rates (for each country that transacts with Australia), Australias exchange rates appreciate against some currencies, and depreciate against others Trade Weighted Index However, a comparison of the value of the dollar against a single currency, such as $US, can create a misleading impression of trends in the Australian dollars value. This is because there are unique factors influencing the value of the foreign and Australian currencies The Trade Weight Index (TWI) gives an indication of how value of the $A is moving against all currencies in general. TWI is calculated by measuring the value of the $A against the currencies of Australias major trading partners compared with a based year. (One limitation of the TWI measure of exchange rate movements is that it is weighted according to volumes of trade regardless of the currency in which export and import contracts are invoiced) [Two-thirds of Australias exports and around half of imports are priced in US dollars]

Factors affecting the demand for and supply of Australian dollars Australias floating exchange rate system This diagram demonstrates how exchange rates for $A in terms of $US is determined Demand for the Australian dollar represented by all those people who wish to buy $A Supply for $A is represented by all those who wish to sell the $A Just as market forces establish the equilibrium price for a good, they can also determine the equilibrium price of the $A in terms of another countrys currency ($US 1.10). This equilibrium will change regularly Demand for the $A currency is affected by: The size of financial flows into Australia from foreign investors who wish to invest in Australia and need to convert their currency into $A. The level of Australian interest rates relative to overseas interest rates has critical influence on the demand for $A. relatively higher Australian interest rates make Australia more attractive location for foreign savings and thus increase the demand for $A The availability of investment opportunities in Australia will also strongly influence the demand for $A. if there are more opportunities for investors overseas to start new businesses or buy into existing businesses via the share market, the demand for $A will increase Expectations of a future appreciation of the $A will increase current demand for $A by speculators, thus contributing to the expected appreciation The demand for Australian exports, since the foreigner who buy Australian exports need to convert their currency into $A to pay Australian exporters Changes in commodity prices and the terms of trade have tended to have an immediate effect on the dollar. A rise in commodity prices and an improvement in terms of trade are generally associated with an increase in Austrian exports. Financial markets will often respond to these changes by increasing the value of the dollar with an expectation that exports will increase over the short to medium term The level of international competitiveness of domestic exporters and Australias inflation rate relative to overseas countries is another influence on the demand for exports. If domestic firms are competitive in the world markets and Australias inflation rate is relatively, low, Australias exports will generally be cheaper and more attractive to foreign buyers Changes in global economic conditions will also influence the overseas demand for exports. The demand for Australias commodity exports is highly dependent on the growth rates of Australias trading partners. When the world economy is in an upturn, demand and prices for Australian exports rise and vice versa (international business cycle) Taste and preference of overseas consumers will also affect the demand for Australias exports Supply for the $A currency is affected by: The level of financial flows out of Australia by Australian investors who wish to invest overseas and who will need to sell $A and purchase foreign currency The level of Australian interest rates relative to overseas interest rates will also be critical factor influencing financial flows out of Australia and the supply of $A. relatively lower Australian interest rates will make investing savings overseas more attractive and hence increase the supply of $A Speculation Speculators in foreign exchange market who expect the value of the $A to go down will sell $A, increasing the supply of $A and thus contributing to the anticipated depreciation The exchange rate will be affected by the domestic demand for imports since Australian importers who you from overseas need to sell $A in order to obtain foreign currencies to make import payments Demand for imports will be determined by a range of factors with in Australia. One of the most important is the level of domestic income. When domestic economy is growing out, employment and income are rising and the demand for imports will also rise, increasing the supply of $A The domestic inflation rate and the competitiveness of domestic firms that compete with imports will also influence import levels. If Australias domestic inflation rate is higher and its imports-competing firms are relatively uncompetitive, imports will be relatively cheaper than domestic products and demand for import will be higher Taste and preference of domestic consumers change overtime, and an increasing preference for goods and services from overseas will raise the supply of Australian dollar on the foreign exchange market

Changes in exchange rates appreciation/depreciation

AppreciationDepreciation

An increase in Australian interest rates or decrease in overseas interest ratesA decrease in Australian interest rates or increase in overseas interest rates

Improved investment opportunities in Australia or deterioration in foreign investment opportunities Deterioration in investment opportunities in Australia or improvement in foreign investment opportunities

A rise in commodity prices and an improvement in Australias term of tradeA fall in commodity prices and a deterioration in Australias terms of trade

An improvement in Australias international competitiveness A deterioration in Australias international competitiveness

Lower inflation in AustraliaHigher inflation in Australia

Increased demand for Australias exported goods and servicesIncreased demand for imported foods and services

Expectation of a currency appreciation based on forecast of one of the above factorsExpectation of a currency depreciation based on forecast of one of the above factorsCopyright 2013 | Majd Abdulwali

Determination of exchange rates including fixed, flexible and managed rates Fixed exchange system The government can attempt to maintain a fixed exchange rate by either buying or selling foreign currency in exchange for $A. In this case It would be buying the excess supply of $A (Q1Q2) at the price of $US 1.20 Hence, in order to intervene in the FOREX market under a fixed exchange rate system, the government would need foreign reserves of foreign currency or gold The risk with this system is that in order to prop up the value of the $A the RBA could exhaust its foreign reserves by continually exchanging them for the excess supply of $A, which could lead to a complete collapse of trade in the currency The RBAs ability to intervene through buying $A is limited by the size of its foreign currency holdings and gold reserves. The RBA has a relatively small foreign currency reserve Under a fixed exchange rate system, devaluation (reduction) and revaluation (increase) are official changes in the value of a countrys currency relative to other currencies. For example, since China is heavily reliant on export-led growth, a low exchange rate would allow China to maximise earnings. Hence, china has adapted a fixed exchange rate by buying its own its own currency and devaluating it exchange rate

The managed flexible peg Under a flexible peg system the RBA would peg the value of the $A at 9am each day and the price would operate throughout the day. A flexible peg system provides more flexibility than a fully fixed rate, but it can still allow the official rate to drift away from that which would exist under a pure market force.

The influence of the Reserve Bank of Australia on exchange rates Reserve Bank intervention in the foreign exchange market Although Australia relies primarily on market forces to determine the exchange rate, the Reserve Bank of Australia (RBA) sometimes plays a role in influencing the value of the currency. While the RBA cannot change the value of the $A is the long term, it is able to smooth out swings in the $A relating to short term factors. The RBA can achieve this in two ways: Driving the float: The RBA may step into the FOREX market if it fears that a large short-term change in exchange rate (possibly due to excessive speculation) will be harmful for the domestic market In order to curb a rapid depreciation of currency the RBA will buy $A, putting upwards pressure on the exchange rate In contrast, in order for the RBA to prevent rapid appreciation it would sell $A Monetary policy: Monetary policy initiates are an indirect way to influence the exchange rate and are rarely used for this purpose If the RBA wants to curb a rapid depreciation, it may increase the demand for $A by raising interest rates. Higher interest rates will attract more foreign savings (interest baring accounts), which must be converted into $A. this will increase the demand for $A and put upward pressure on the exchange rate. However, the policy will generally be temporary effective

The effects of fluctuations in exchange rates on the Australian economy The effects of a change in the exchange rate An AppreciationPositive EffectsNegative Effects

Australian consumers enjoy increased 'purchasing power' they can buy more overseas produced goods with the same quantity of $A.By increasing the value of the $A in terms of other currencies, Australia's exports become more expensive on world markets and therefore more difficult to sell, leading to a decrease in export income and a deterioration in Australia's CAD in the medium term.

An appreciation decreases the interest servicing cost on Australia's foreign debt because Australians can buy more foreign currency with Australian dollars. This would reduce outflow on the net income component of the current account in future years and help reduce Australia's CAD.Imports will be less expensive, encouraging import spending and worsening Australia's CAD. Domestic production of import substitutes is likely to fall.

An appreciation will also reduce the $A value of foreign debt that has been borrowed in foreign currency - a phenomenon known as the 'valuation effect'.Higher import spending and reduced export revenue will reduce Australia's economic growth rate.

Inflationary pressures in Australia will be reduced as imports become cheaper. This is likely to reduce pressure on the RBA to raise interest rates to defend its inflation target.Foreign investors will find it more expensive to invest in Australia, generally leading to lower financial inflows.

An appreciation reduces the $A value of foreign income earned on Australia's investments abroad and would cause a deterioration in the net income component of the CAD.

An appreciation will also reduce the value of foreign assets in Australian dollar terms a phenomenon known as the 'valuation effect'.

A Depreciation Positive EffectsNegative Effects

By decreasing the value of the $A in terms of other currencies, Australia's exports become cheaper on world markets and therefore easier to sell, leading to an increase in export income and an improvement in Australia's CAD in the medium term. (boosts competitiveness)Australian consumers suffer reduced 'purchasing power' - they can buy fewer overseas produced goods with the same quantity of $A.

Imports will be more expensive, discouraging import spending and potentially improving Australias CAD. Domestic production of domestic production should also riseDepreciation increases the interest servicing cost on Australia's foreign debt because Australia can buy less foreign currency with its domestic currency with which to pay interest. This increases income outflow on the net income component on the current account and thus increases Australia's CAD.

Lower import spending and greater export revenue will increase Australia's growth rate but this may not happen if Australia is unable to replace its imports with domestically produced goods.A depreciation will also raise the $A level of foreign debt that has been borrowed in foreign currency as expressed in Australian dollar terms a phenomenon known as the 'valuation effect'.

A depreciation increases the $A value of foreign income earned on Australia's investments abroad.Inflationary pressures in Australia will increase as imports would now be more expensive. This may increase pressure on the RBA to raise interest rates to defend its inflation target.

Depreciation will also increase the value of foreign assets in Australian dollar terms a phenomenon known as the 'valuation effect'.

Foreign investors will find it less expensive to invest in Australia, generally leading to greater financial inflows.

How the balance of payments influences the exchange rate If the value of imports increased, while exports remained unchanged, this would result in deterioration in the current account deficit (CAD). This would cause an increase in the supply of $A (importers will be selling more $A in order to buy more foreign currency, resulting in a depreciation of the currency). Also, because of the depreciation a given level of financial inflows would be able to buy more $A. Therefore, the positive balance of the capital and financial account would increase in $A terms to match the bigger deficit on the current account In contrast, if the value of exports increases relative to imports, the current account would be surplus. This would cause a decrease in the supply of $A (foreigners buying Australian exports must buy $A in order to do so), resulting in an appreciation in the current account However, if financial market participants believe that the rise in CAD is justifiable by some other factor, the high CAD may not have a significant effect on the currencyFree trade and ProtectionAustralias geographic isolation from the rest of the world, and the relatively high proportion of output that is traded, means that barriers to trade have a significant effect on the economyAustralia is moving towards a resource-export oriented economy as mining and energy industries now account for more than half of Australias export earningsAustralias agriculture industries have faced mixed outlooks, although global food prices have increased significantly, high exchange rates and trade barriers have hindered Australias international competitivenessAustralias services industries account for three quarters of economic activity.The governments main aims in reducing protection are to: Forces domestic industries to become internationally competitive by exposing them to foreign completion Encourage resources to move away from industries and firms that cannot improve their competitiveness to those that can become more competitive (focus on Australias comparative advantage) Allow Australia to benefit from greater integration with the global economy by giving consumers and businesses access to goods and services available on global markets at the lowest possible price Promote structural change in the economy, with the long term aim of encouraging efficient firms to product what the global economy demands

Australias policies regarding free trade and protection Australia has transitioned from being a highly protected economy to an economy with relatively low trade barriers. This is demonstrated by the gradual decline in the average tariff level in Australia and the gradual phasing out of non-tariff barriers to trade (quotas and subsidies Austrade (the Australian trade Commission), provides assistance for exporters including financial assistance, information and potential export markets and marketing advice. The main program that is administered is the Export Market Development Grants (EMDG) scheme, which reimburses exporters for some of their costs in promoting their exports in new markets Australia is one of the least protected economies in the world, reducing its protection levels well beyond the requirements by international trade agreements (WTO)Average Tariff levels in Australia

1968-91977-8182-31986-71994-5200220062010

36%2325%`19%93.7%2.5%1.9%

Australias multilateral and bilateral free trade agreements (overview of two example of each type of agreement) Australias free trade agreements Bilateral trade agreements Bilateral trade agreements involve just two nations. They are the easiest trade agreements to negotiate because they can be designed to suit the conditions of the two participants. The most significant bilateral agreement for Australia is the 1983 Closer Economic Relations agreements with New Zealand (CERTA). This agreement has led to free trade between the two countries and increased standardisation of laws, business particles and commercial structure The Singapore-Australia Free Trade Agreement (SAFTA), is Australias first free trade agreement with an Asian country (2003). The trade agreement covers the elimination of tariffs and improves market access for service exports (telecommunication, financial and professional services) The Australia-United States Free Trade Agreement of 2005, provided significant tariff reduction in a number of goods (i.e. agriculture, manufacturing) While bilateral trade agreements reduce overall protection for Australian industries, they do so on a country-by-country basis, depending on the origin of the imports. As a result, they generate fewer economy wide benefits and broad trade liberalisation Multilateral trade agreements Multilateral trade agreements is sometimes referred to as agreements administered by the WTO, that is global agreements, and other times used interchangeably with regional trade agreements (e.g. EU & NAFTA) Australias main multilateral trade agreement is the ASEAN-Australia-New Zealand Free Trade Agreement (AANZFTA) of 2010. This agreement covers 20% of Australias trade in goods and services and effectively creates a free trade area of over 600 million people with combined GDP of US $3.2 trillion. (complementary economies) In the 1990s Australia regional trade negations focused on the Asia Pacific Economic Corporation Forum (APEC). In 1994, the APEC forum set a targe of free trade by 2020 (2010 for developing economies). APECs focus has shifted away from trade liberalisation and now acts as a forum for discussion on issues such as terrorism and climate change

The implications of Australias policies for individuals, firms and governments Individuals Short run Structural unemployment increases as inefficient firms close due to restructuring of industries and cuts in local production Consumers gain access to wider variety of goods at lower prices Long run Job opportunities increase in internationally competitive sectors Firms Short run Import competing industries go out of business Lower tariffs provide lower input costs for firms Long run Efficient firms restructure operators to compete on global stages

Governments Short run Cutting tariffs will reduce government revenue (indirect tax revenue) Reducing protection may have adverse political consequences Government spending on structural adjustment programs may increase Long run Sustainable economic growth should raise revenue Other economic effects The phasing out of protection can have significant effects on Australias trade performance and current account deficit. The CAD is likely to worsen as import rise, because some imports will be cheaper due to lower tariffs and quotas, or of a higher quality than local products. However, lower protection should improve international competitiveness and reduce CAD over the long-term as exports grow

Implications for Australia of protectionist policies of other countries and trading blocs The impact of international protection levels on Australia When foreign economies place tariffs on Australian goods and services, Australian exports become less competitive and struggle to penetrate foreign markets When other economies subsidies their exports, they raise the supply and reduce the price of those goods on global market, reducing the income for producers in Australia selling the same products Australia has been less competitive in the agricultural industries due to high protection by the European union and United States and economies taking advantage of complex loopholes in WTO regulations Australia has been more competitive in manufacturing and mining and resource sector due to fewer barriers to tradeCopyright 2013 | Majd Abdulwali

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