Mr. Macfarlane discusses Australia's position in light of recent events in Asia
Speech delivered by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, before
the Australian Stock Exchange, the Australian Institute of Company Directors and the Securities
Institute of Australia in Brisbane on 26/3/98.
It is a pleasure to be here in Brisbane addressing the Australian Stock Exchange,
the Australian Institute of Company Directors and The Securities Institute of Australia at their
combined Bull and Bear Luncheon. I do not know whether I should nominate myself as a bull or
a bear. Members of this audience will be able to make up their own minds after they have heard
my story today.
1. Introduction
In the period since the collapse of Asian currencies - roughly since the floating of
the Thai baht on 2 July 1997 - I have spent a fair amount of time, as have many others, trying to
understand the reasons for that collapse. It has been a salutary experience, and it has caused
many of us to re-examine some cherished views. I have already spoken twice on this subject, so
I do not intend to cover the same material today. What I hope to do, however, is to draw some
lessons from it, and to apply them to Australia.
In a previous speech1, I tried to identify the list of economic characteristics that
would make a country vulnerable to a currency crisis or, worse, to a full-blown economic crisis.
As you probably know, there is no definitive list that enables us to forecast these events with any
precision, but there are about a dozen factors that seem to increase a country's vulnerability. If a
country scores a very low mark on all of these factors, or at least most of these factors, there is a
good chance that it would be subject to an international loss of confidence and ensuing economic
problems. You will not be surprised to hear that Australia is not in this category; indeed,
Australia scores a very high mark on most of these factors and thus should be in a very secure
position. But we can never be complacent. Like all countries, we do not achieve a perfect score,
and therefore it is worthwhile to go through a systematic examination of our strengths and
weaknesses in light of the recent events.
2. Criteria for vulnerability
The list of factors identified from our research2 on the Asian crisis that pointed to
the likelihood of a currency crisis or a wider economic crisis was as follows:
1. Does the country have a fixed exchange rate and free movement of
international capital?
2. Is the exchange rate over-valued?
3. Has a country with similar economic characteristics recently experienced a
currency crisis?
4. Is there a large budget deficit and a lot of government debt outstanding?
5. Is there loose monetary policy and high inflation?
6. Is the domestic economy in, or at risk of, a recession?
7. Is there a large current account deficit?
8. Is there a large amount of foreign debt?
9. Is there an asset price boom (especially credit-driven) occurring?
10. Are there a lot of bad debts in the banking system, and a poor system of
bank supervision?
11. Has there been a lot of unhedged foreign currency borrowing?
12. Are there poor accounting standards, few disclosure requirements,
ambiguous bankruptcy procedures, etc.?
A brief scan of this list should reassure people that Australia is in good shape.
That is, it would receive a very favourable mark on the vast majority of these indicators, and so
should be able to handle the current international turmoil without too much disruption. But we
are not perfect, and there are two items on the list - the current account and external debt - where
our score is low by international standards. In the remainder of my talk today I would like to set
out in more detail how Australia stacks up against the above list, starting with the ten factors on
which we receive a very high score, and following roughly the same order as in the list above. I
will cover the factors where we receive a high score quite quickly in order to leave room for a
closer examination of the two weak points.
3. Australia's strengths
Australia allows the free movement of international capital, but we certainly do
not have a fixed exchange rate. The Australian dollar was floated in December 1983, and after a
few years of turbulence in the mid 1980s, has generally behaved as a floating rate should in the
period since then. While it was more volatile in the 1980s than the major currencies such as the
US dollar, yen and Deutschemark, in the nineties it has generally been less volatile than they
have. It has varied cyclically over the past dozen years, but around a flat trend.
There is no evidence to suggest that it is over-valued. Opinions will always differ
on such a subject, but at the moment there are probably more, including some influential
offshore institutions, inclining to the opposite view. Like most currencies, it has depreciated
against the US dollar over the past 18 months, but against the Trade-Weighted Index it has been
relatively stable. Judged by other measures of the exchange rate designed to capture competition
with imports or against export competitors, it has shown a small increase in competitiveness.3
The issue of contagion can be addressed by asking whether another country with
similar economic characteristics has recently experienced a currency crisis. The answer is in the
negative: all the countries that have recently experienced a currency crisis have been at an earlier
stage of economic development than Australia, particularly in respect of the depth of their
financial infrastructure and the degree of prudence exercised by borrowers and lenders. The
financial markets have made a clear distinction between troubled Asian economies like Thailand,
Indonesia and Korea and countries like Australia.
On fiscal policy, little needs to be said other than that Australia has a very low
underlying budget deficit by world standards and is expecting a surplus next financial year. The
stock of government debt to GDP (which effectively measures the extent of accumulated past
deficits) is exceptionally low by international standards. On monetary policy, seven years of low
inflation has finally received the international recognition it deserves. The international bond
markets have expressed their confidence in Australia's fiscal and monetary policies by reducing
the spread between Australian and US yields to the lowest margin in a generation.
In the aftermath of the currency crisis which resulted in the partial breakdown of
the European Monetary System in 1992, the view developed that if a country was in or near
recession, it would be particularly vulnerable to a currency crisis. This is because it would not
be able to resist the currency crisis with tighter policies. (Whether it should, of course, would
depend upon the circumstances.) Whatever the strength of this argument - and it is strongest for
fixed exchange rate cases - it clearly does not apply to Australia, as we have a buoyant domestic
economy. Furthermore, Australia is recognised internationally as having had one of the best
growth records among OECD countries this decade. (Only Ireland and Norway - two very small
economies - have done better.)
I will delay discussion of the current account, the balance of payments and foreign
debt until after I have completed the list of positive factors for the Australian economy. The next
factor on my list was whether the country was in the midst of an asset price boom. The problem
with asset price booms is that they are usually followed by asset price busts, which can give rise
to company insolvencies and banking problems. Clearly, this is not the case in Australia at
present, although we do have fresh in our memories the events of the late eighties and so cannot
be too censorious of recent Asian events. While the Australian share market has risen over
recent years, it has done so by a smaller amount than the United States or most of Europe.
Commercial property prices have also been relatively restrained, and while house prices are
rising, the large rises have been confined mainly to inner Sydney and Melbourne.
I think we can be confident that our system of bank supervision is at world best
practice, and the ratio of bad debts to total loans, at 0.9 per cent, is at its lowest level since
statistics have been collected (admittedly, the collection only dates back to 1991). Of course,
what currently seems to be a good loan can become a bad debt if circumstances change. Even
so, I have a lot of confidence that our figures are a good guide to the health of our banking
system.4
I think it is true to say that there has not been a lot of unhedged foreign currency
borrowing occurring among Australian corporates since the days of the "Swiss franc loans" of
the mid-eighties, but I will postpone discussion of that topic until I deal with foreign debt in the
second half of this talk. Accounting standards, disclosure requirements and bankruptcy
procedures are what might be termed financial infrastructure. So is the existence of a large
group of equity analysts and financial journalists, the ASC and stock market listing
requirements. We tend to take a lot of this for granted, but it is very important that they be up to
best international practice. Again, we should not feel too superior to our Asian neighbours in
this respect; it takes decades or more to develop these, and as recently as the late eighties we still
had some glaring deficiencies. I think we are now at international best practice, but it still
involves continued improvement to stay there.
4. Australia's weaknesses
While I am satisfied that the underlying structure of our economy, particularly its
financial underpinning, is sound, there is no sensible way we can avoid a widening of our current
account deficit in the short term. It is virtually inevitable because a significant number of the
countries that make up our major export markets are likely to contract, or not grow as quickly,
over the next 18 months. It is what economists call an "external shock". It is also true, of
course, that if exports are weaker, then GDP growth will also be lower than it would have been
without the "external shock". These "real" effects on exports and growth are already occurring,
though their full effects will take some time to be clear. In the case of financial prices, such as
the exchange rate, bond yields, commodity prices and share prices, of course, the adjustments
occur at once, as market participants can immediately adjust prices to reflect their expectations
of what is to come.
What I wish to do in the remainder of this talk is to try to address two questions.
First, how will the Australian and international financial community accept the widening of the
Australian current account? This is important because it has implications in the first instance for
financial prices. Second, what are the prospects for our exports, and hence economic growth? I
will not answer this question in a quantitative way, which may disappoint those who want
numerical forecasts; in fact, I will be making a few criticisms of the simple models that are often
employed for this purpose.
4(a) Reaction in financial markets
In the mid-eighties, Australian financial markets - particularly the foreign
exchange and bond markets - experienced a major reaction to the widening current account
deficit. The reason the reaction was so large was that doubts began to emerge about whether the
economic situation was sustainable, particularly in view of the implications for foreign debt.
There is always the possibility that the same or similar doubts will re-emerge over the next 18
months, but I am inclined to think that will not be the case. The reasons for my view are set out
below.
If we look at the history of the current account since the early 1980s (Diagram 1),
it is apparent that the deficit has varied between about 3 1/2 per cent and 6 1/2 per cent of GDP,
with an average of 4 3/4 per cent. Most importantly, there has been no on-going trend
deterioration - the trade account has improved at a rate sufficient to offset the increase in net
income payable abroad. The widening in the current account deficit that we expect in 1998/99
will be the fifth such cyclical widening in the past 20 years, and I think that people now accept
this as a part of our economic cycle.
You will note that I am only talking about cyclical movements in the current
account. The broader issue of whether we should accept an average current account deficit of
4 3/4 per cent of GDP in the long run would require another paper as long as the one I am
presenting today. It would focus on our national savings performance, both in respect to
governments and to the incentives that are provided to the private sector. But that is for another
day.
On previous occasions, the cyclical widening of the current account deficit usually
reflected a mixture of external influences, such as a fall in the terms of trade, plus some
significant internal imbalances or policy deficiencies. As examples of the latter, domestic
demand in the earlier widenings ran at unsustainably fast rates, usually in excess of 7 per cent
per annum for a time. Similarly, in all but one of the earlier widenings, Australia's inflation rate
was higher than the world average, and again on two occasions, we were running a significant
budget deficit. On this occasion, we have none of these imbalances. The widening of the
current account deficit will be essentially the result of an external contraction of demand, with
domestic demand running only slightly faster than trend.
The foreign debt situation is not as threatening now as the most pessimistic people
in the mid-eighties feared. Looking at a graph of the ratio of foreign debt to GDP (Diagram 2)
shows that it nearly tripled between 1982 and 1986 (from 12 per cent to 33 per cent). Many
people feared that it would continue to rise at this rate, but it has not. In the nineties, it has
averaged a little over 40 per cent, where it currently is. Another widely used measure of debt
sustainability - the ratio of debt servicing to exports (Diagram 3) - showed a somewhat similar
pattern. It rose from 6 per cent to 22 per cent in the 1980s, but then reversed sharply in the early
nineties, and is currently at about 12 per cent. The strong growth of Australian exports and the
fall in world interest rates are largely responsible for this favourable development.
In the 1980s, when the sharp rises in foreign debt and its servicing costs were
occurring, the Australian economic debate was, not surprisingly, pre-occupied with these issues.
At the time, there were no official statistics comparing foreign debt levels in developed
countries, and in their absence there was a tendency for people to assume the worst - that is, to
assume that Australia was the highest on the list. Now that the IMF and OECD publish official
statistics on the subject (Table 1), we see that we should not have assumed the worst. While
Australia is certainly in the top quartile of countries ranked by the net foreign debt to GDP ratio,
it is not the highest - New Zealand, Sweden and Canada are higher. Looking at the gross
external debt to GDP ratio, Australia is in the bottom half of the table.5
Table 1: External Debt as per cent of GDP
Greece [1993] 33.3 Netherlands [1994] 88.3
Finland [1996] 31.6 Canada [1996] 77.7
Denmark [1995] 29.9 New Zealand [1996] 75.6
Ireland [1996] 29.8 Finland [1996] 74.0
United States [1996] 20.2 Austria [1996] 73.4
Austria [1996] 12.3 Greece [1993] 62.4
Italy [1996] 6.0 France [1995] 57.2
Spain [1995] 3.8 Germany [1995] 57.2
Norway [1993] 3.7 Australia [1996] 55.9
Germany [1995] -2.1 Italy [1996] 54.0
France [1995] -2.8 Norway [1993] 49.0
Portugal [1993] -6.7 Portugal [1993] 48.6
Netherlands [1994] -19.7 Spain [1995] 44.3
Japan [1996] -19.9 United States [1996] 42.6
Switzerland [1995] -99.0 Japan [1996] 33.0
United Kingdom n.a. United Kingdom n.a.
Source: IMF, Balance of Payments Statistics Yearbook 1997
The other aspect of foreign debt that has received a lot of attention in the light of
recent Asian developments is the extent of unhedged foreign currency borrowing. Official
figures only tell us that 60 per cent of Australian borrowing is denominated in foreign currency.
Of that, a significant proportion has been borrowed by banks, and this is virtually all hedged.
Our assessment is that major Australian corporates normally hedge their foreign currency
borrowing unless they choose not to because they have a natural hedge through their exports.
As I mentioned, financial markets tend to be forward looking, and it is likely that
a significant deterioration in the current account is already factored into important financial
prices. The reaction of financial markets to date has been more measured than was the case in
the 1980s, no doubt reflecting their assessment of the much improved "fundamentals" of the
Australian economy. But we should not take this for granted. We have seen in Asia over the
past year just how fast the international capital markets can react if they come to the judgment
that a country is not being managed in a sustainable way.
4(b) Slowdown in exports
We would all like to know how large the current slowdown in exports will prove
to be. But, because we have not been through this type of situation before, there is a lot of
uncertainty about how to go about this.
To date, those trying to be scientific and quantitative have tended to use a model
which I would term a "fixed co-efficient input-output model". This approach starts by
forecasting the fall in import volumes which each of our trading partners will experience and
assumes that the volume of our exports to each country will fall by a similar amount. After
adding together the results for each country, it arrives at a figure for Australian exports to the
region. This is a time-honoured approach, but I am sceptical of how appropriate it is for a
country in Australia's position.
Despite Australia's impressive export diversification of the past decade, about 60
per cent of our exports are still essentially rural and resource commodities which are sold onto
world markets. Most of these are fungible - they are sold to wherever the demand is. If Korean
demand for base metals falls, Australia will still probably sell the same amount of base metals
worldwide as before, but with more sales to countries other than Korea. Of course, if world
demand has weakened, the price will have to fall to clear the market. That is what has been
happening - commodity prices are now 9 per cent lower than at their March 1997 high in SDR
terms. Thus, from Australia's perspective, the Asian slowdown may have its biggest effect not
through lower export volumes, but through a fall in commodity prices, some (or, conceivably, a
lot) of which has already happened because these markets are forward looking. There is still an
effect on the economy, of course, since lower prices, other things being equal, mean lower
export income, which in turn means lower demand and so on. It is important to note, however,
that other things have not been equal: the Australian dollar has depreciated such that in $A
terms, commodity prices are actually higher than a year ago.
A good example of exporters seeking other markets is shown when we consider
the recent history of our exports to Japan, by far our largest export market during the 1990s. As
you know, the Japanese economy has been extremely weak over the past five years, and our
exports to Japan have been flat over most of that period.6 But this has not stopped overall
Australian export volumes growing strongly; they have risen at an average annual rate of 7 1/2
per cent in real terms over the past five years. Where has the growth come from? Just about
everywhere but Japan, including, until recently, the other Asian countries that are currently in
trouble. The most striking feature, however, has been the growth in a group of countries we
have always called "other". As you can see from Diagram 4, this is our fastest growing market
in recent years. To satisfy your curiosity, "other" is what we have left after we exclude Asia, the
United States and Europe: that means it includes the Middle East, New Zealand, the Indian
SubContinent, the Former Soviet Union, Eastern Europe, South America, etc.
Another reason why the conventional approach to estimating the effects of Asia
on Australian exports may overstate the slowdown is that a significant proportion of our exports
are inputs into Asian exports, rather than final consumer or investment goods. This seems to be
the case particularly for the two largest Asian markets - Japan and Korea. The situation is not as
clear for some other countries, but as a general rule, we are probably better off in current
circumstances than most suppliers because of the weight of commodities, foodstuffs and "inputs
into exports" in our mix. After the transitional export finance problems are solved, we should
expect to see strong growth in Asian exports as a result of their large increase in
competitiveness. I would be a lot more worried if Australian exports consisted of consumer
products. Incidentally, this is one of the reasons why tourism has been hit so hard - it is probably
our biggest export that is aimed directly at households, and is considered by them something of a
luxury.
I hope I have not gilded the lily too much in the above discussion. There is no
doubt we will find the going tough on the export side, and we will not be able to repeat in the
short term the sort of figures we have become used to over the past five years. But I think not
enough account in popular discussions has been taken of our particular mix of exports and our
capacity to find new markets.
5. Conclusion
The events in Asia have confronted us with a challenge that was not foreseen a
year ago. In deciding how to handle it, the first step is to recognise that the outlook for the
economy is less favourable than it would have been in the absence of these events. The optimal
policy response will be to accept that the effects should be spread across several economic
variables, rather than attempting to adhere closely to earlier aspirations for any one variable, and
letting the others do all the adjustment. It is clear that we should be prepared for a higher current
account deficit in the short run - to try to avoid it would place intolerable strains on the rest of
the economy. Similarly, we will have to accept a somewhat lower rate of economic growth and
slightly higher inflation than seemed likely not so long ago. Notwithstanding these changes, we
feel that over the next 12 months, Australia will continue to experience an economic outcome
which will place it among the better performers in the OECD area. We also believe that our
economic fundamentals will hold us in good stead, and that we will retain our hard-won
reputation as a country with responsible economic and financial management.