I Introduction The deterioration in Australia’s current account position since the mid-1980 s, and the associated increase in net foreign liabilities, has been accompanied by a vigorous debate as to the major causes, consequences and potential remedies required (if any).
In an influential contribution, Pitchford (1989 a, 1989 b, 1989 c) used the intertemporal approach to argue that Australia’s recent current account position should be of little concern, as under the assumption of a virtual absence of market failure (distortions and externalities), which could be viewed as reasonable in the context of Australia’s open and competitive credit markets, the current account deficit (which has largely comprised an addition to the external liabilities of the private sector) was merely a result of optimizing behaviour by forward-looking firms and individuals, with no implication of a need for corrective policy measures. A similar argument had been made earlier by Pope (1977, 1986) in the context of New Zealand’s current account balance. Pitchford argued that because in Australia’s case most of the current account deficit could be attributed to the difference between private investment and private saving (where the former is driven by profit opportunities and the latter by intertemporal consumption smoothing), there was little role for government intervention (by such instruments as fiscal tightening) designed to inhibit the creation of private liabilities (debt) by altering the dynamic path of domestic investment and consumption. 1, 2 The Pope-Pitchford view ran counter to those arguing that Australia’s burgeoning current account deficits, and consequent rising stock of external debt, needed to be curtailed before they became economically unsustainable (Arndt 1989, The Economist 1995).
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This more conventional view recommends that tight monetary / fiscal policy is needed to restrain aggregate demand and rein in the current account deficit.
Using a Mundell-Fleming framework with limited international capital mobility, the conventional case for macroeconomic action on the current account rests on the existence of externalities (more generally market failures) in the borrowing process which are not amenable to resolution at the source of their incidence. Other more sophisticated defenses of the conventional view have argued that current account deficits and the associated build-up of external debt can be matters of public concern if they arise from unsound private borrowing, or if public and private borrowers create externalities for one another (country risk) because this additional risk is not wholly internalized by individual borrowers (see Har berger 1986, C orden 1991, 1996 and Wells 1992).
Using only a theoretical model to draw the conclusion that the current account does not matter, without examining the actual data, is an unsatisfactory approach to answering this important policy question. Similarly, merely examining the data without reference to some objective criteria is also unsatisfactory. The contribution of this paper is to test whether Australia’s actual current account imbalances are sustainable, by comparing them to the optimal path of external imbalances derived from an intertemporal model. The intertemporal model of the current account, which has gained popularity in recent years, views the current account as the outcome of forward-looking dynamic saving and investment decisions, and thus has the advantage of yielding more reliable policy conclusions than estimates from ad hoc econometric specifications.
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3 The intertemporal (or consumption-smoothing) approach to the current account is derived from the permanent income theory of consumption and saving. In predicting what capital flows should be if agents consume in accordance with their permanent income, the approach assumes a high degree of capital mobility, an absence of capital market imperfections, and that agents follow consumption-smoothing behaviour. According to the intertemporal model, countries may undertake external borrowing (run a current account deficit) to smooth the path of aggregate consumption in the face of temporary adverse shocks (which could be productivity shocks, changes in government consumption spending or fluctuations in investment), yet will permanently lower aggregate consumption (leaving the current account unchanged) in the face of permanent adverse shocks. This implies that temporary shocks may result in larger fluctuations in net national saving and the current account than permanent shocks, and that the current account acts as a buffer to smooth aggregate consumption in the presence of temporary disturbances. The key prediction of the consumption-smoothing model is that a country’s current account will be in deficit (surplus) whenever national cash flow (defined as gross domestic product minus government consumption spending minus investment) is expected to rise (fall) over time.
The concept of sustainability we use in this paper concerns whether current account balances are ‘excessive’. 4 As noted by Miles-Ferretti and Raz in (1996), the question of whether given current account balances are ‘excessive’ can only be answered in the context of a model that yields predictions about the optimal (equilibrium) path of external imbalances. The intertemporal model of the current account provides a benchmark to enable a judgement as to what capital flows should be, given the shocks affecting an economy. According to the intertemporal model, the optimal value of capital flows (equivalent to the current account position) is that amount which allows agents to fully smooth their consumption in the presence of shocks to national cash flow. Actual current account imbalances can then be compared to the predicted optimal path of the current account, to determine whether the former have been excessive or not. Moreover, the optimal current account imbalances (derived from the consumption-smoothing model) are sustainable by definition, because along the optimal path for private consumption, net wealth remains constant.
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Accordingly, if (for example) the difference between the actual path of current account deficits and the optimal path of current account imbalances is non stationary (growing over time), then the actual path of current account deficits is unsustainable. The paper contains a number of innovations over previous empirical analyses of the consumption-smoothing model. It emphasizes the recent literature on the sustainability of external deficits, and the place of the consumption-smoothing approach within that literature. In an advance on previous work, the econometric analysis reported in this paper uses techniques (Phillips-Hansen FM estimator) for the estimation of cointegrating vectors which are robust in the presence of serial correlation and endogeneity. This is important as empirical estimation of the consumption-smoothing model is likely to occur in the presence of endogeneity and serial correlation. Finally, drawing on the discussion of the sustainability of external deficits, calculations are provided to determine what change in net national savings is required for Australia to satisfy its external borrowing constraint.
The remainder of the paper is organized as follows. In Section II we review some general benchmarks of external liabilities and the servicing of these liabilities, such as: the ratio of net external liabilities to exports; the cost of servicing liabilities as a share of exports; and the current account deficit as a share of exports. While these benchmarks are arbitrary, they are useful in placing Australia on the OECD spectrum marked by Mexico and Japan as extreme cases. In Section III we present an intertemporal model that is essential in discussing whether current account deficits are excessive. The econometric methods used to estimate this intertemporal model are summarized in Section IV, and the results of the estimation, as well as an analysis of whether Australia satisfies its external borrowing constraint, are set out in Section V.
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Section VI contains some concluding comments. II Conditions for Sustainable International Indebtedness The problem of determining a sustainable level for the current account balance is one involving the allocation of real resources over time. For example, if an increment to net foreign liabilities adds more to net investment payments than to the capacity to make such payments, then future net exports must be generated. If they are not, and conditions do not change, then external debt will grow faster than debt service capacity.
For this to be avoided, the real interest paid on additional debt must grow at a rate less than or equal to the rate of growth of exports. This suggests that a condition of sustainable international indebtedness could be that the real rate of interest on national debt be less than the rate of growth of export receipts. Similar conditions could be based on the rate of output growth or the rate of growth of output per capita. Such conditions imply that running a zero current account balance will yield a declining debt to real resource ratio, and consequently a long-run current account balance given any level of initial indebtedness.
5 Moore (1990) provides several debt ratios used by international banks in making country risk assessments, to ascertain when a country can be regarded as having over borrowed. He argues that ‘danger points’ are reached when, as a percentage of the exports of goods and services: gross external debt exceeds 200 per cent; the cost of servicing gross debt exceeds 20 per cent; and when the current account deficit reaches 30 per cent. Pitchford (1990) criticizes such conditions on several grounds: ratios to exports are not the complete picture, as current account deficits can be reduced just as readily by a relative increase in the import-competing sector; and he argues that such arbitrary benchmarks for debt ratios do not take into account cross-country heterogeneity and intertemporal variations in any given country’s optimal path of aggregate consumption smoothing (as indicated by the path of its current account position).
6 Table 1 provides various ratios that have been used as indicators of sustainability, both for Australia and other selected OECD countries.
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The indicators for Australia show a relatively high level of net foreign liabilities. Consequently, Australia has a high servicing requirement, even higher than Mexico’s in 1994. Australia’s 1994 current account deficit (5 per cent of GDP) is significantly larger than most industrial countries during the last decade, but is smaller than Mexico’s 1994 deficit-to-GDP ratio of nearly 8 per cent. While these indicators are useful in some respects, they fail to convey any information as to whether Australia can repay these debts and whether Australia is using its access to world capital markets to increase its productive capacity.
For example, about 30 per cent of Australia’s foreign liabilities are in equity and other investments, while the remaining 70 per cent represent foreign debt that must be repaid (Australian Bureau of Statistics 1995).
7 As mentioned above, fixed benchmarks for debt ratios are unlikely to be useful in determining the riskiness of lending to particular countries, as they do not take account of heterogeneity across countries in the optimal rate of investment and in the optimal extent of intertemporal consumption smoothing. A better way to tackle the question of the appropriate level of Australian indebtedness is to use a model-based approach to determine what Australia can afford to repay, given its macroeconomic fundamentals. III The Model The intertemporal approach to the current account is derived from the permanent income theory of consumption and saving. In the context of a small open economy with access to world capital markets, the permanent income theory implies that temporary shocks (which by definition have a larger impact on current resources than on lifetime resources) may lead to large fluctuations in national saving and the current account. 8 As Sachs (1982) has pointed out, movements in the current account can be decomposed into two components.
First, the consumption-tilting motive, whereby a country tilts its consumption toward the present or the future (driven by differences between the subjective discount rate and the world real interest rate).
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Second, the consumption-smoothing motive, which smoothes aggregate consumption in the presence of shocks to output, investment or government spending. As the emphasis of this paper is on the current account as a buffer for consumption, the main focus will be on the consumption-smoothing component of the current account. Enlarge 200% Enlarge 400% Enlarge 200% Enlarge 400% Enlarge 200% Enlarge 400% Enlarge 200% Enlarge 400% Enlarge 200% Enlarge 400% Enlarge 200% Enlarge 400% Enlarge 200% Enlarge 400% Enlarge 200% Enlarge 400% In deriving the intertemporal model of the current account, consider an economy composed of a large number of similar-lived consumers, each maximizing V Empirical Results The data used to estimate the parameters of the model are annual national accounts for the period 1954 to 1994, expressed in billions of 1990 Australian dollars, and were obtained from the International Monetary Fund’s International Financial Statistics database. 18 All data are converted into real terms by dividing by the implicit GDP deflator.
19 Enlarge 200% Enlarge 400% TABLE I (i) Estimating the Consumption-Tilting Parameter The estimated consumption-tilting parameter from the cointegrating regression of national cash flow (less interest payments) on consumption is reported in Table 2 for the full sample period 1954-94, and for two subsamples, 1954-74 and 1975-94. The break at 1974 was used because this is when Australia’s GDP growth rate fell below the world interest rate. 20 In all three samples the estimated parameter is significantly less than unity, implying that Australia is consuming more than its permanent cash flow and must be running down its stock of foreign assets or increasing its foreign liabilities. The preference for current consumption over future consumption has become more pronounced in the later part of the sample (1975-94), which includes Australia’s move to a floating exchange rate in late 1983, and the simultaneous removal of remaining capital controls and relaxation of restrictions on financial markets. The results of Phillips-Ouliaris (1990) Z (t) residual-based unit root tests for cointegration, and three Hansen (1992) tests of parameter stability (mean-F, sup-F, and Lc), are also shown in Table 2. 21 The parameter tests all indicate a stable relationship between national cash flow and consumption at the 5 per cent significance level.
Cointegration is accepted at the 5 per cent significance level in the full sample and in both subsamples. However, a note of caution is warranted here. The parameter stability tests are prone to low power problems due to the fact that potential change points are unknown. Assuming that we know that there was a change point in 1974 we can formally test whether the tilting parameter is different in the two sub periods 1954-74 and 1975-94 by using a Chow test, which has an F distribution when based on a suitably corrected standard variance estimator. The computed value of this test statistic was 40.
5, which implies that the hypothesis of a common tilting parameter in both periods is rejected at the 1 per cent level. The estimated value of theta is lower in the latter subsample, indicating a strong secular tendency towards current account deficits in this period. (ii) Hypothesis Tests The standard F-test for the absence of ‘Grangercausality’ from the current account to national cash flow is rejected at the 5 per cent significance level for the full sample, implying that the current account ‘Granger-causes’ changes in national cash flow (Table 3).
The nonlinear restriction on the VAR parameters of equation (7), examining whether the model implies a close association between movements in the actual and optimal current account measures, is not rejected at the 5 per cent level of significance in the full sample and the later subsample, but was rejected in the early subsample. The rejection in the early part of the sample indicates the model is more suitable for Australia in the later period, which includes the period when restrictions on capital flows had been reduced. In the early part of the sample capital controls were in place, restricting the use of international borrowing and lending to smooth consumption over time.
As predicted by the model, CA^sub t^- (Delta) z ^sub t ^ – (l+r) CA^ sub t^-^sub I^ is largely uncorrelated with lagged changes in national cash flow and lagged current accounts (Table 3).
22 The most telling result that indicates the improved performance of the intertemporal model is the reduction in the variance ratio of the estimated actual (CA^sub t^) and estimated optimal consumption-smoothing (CA^sub t^^sup ^) current accounts between the early and later subsamples (from 3. 499 to 2. 965).
23 This ‘excess volatility’ implies that capital flows to and from Australia have been more volatile than would be justified by expected changes in national cash flows. Figure 1 shows that in the early subsample, when the excess volatility in the current account is the greatest, the actual current account balance (as a ratio to GDP) is consistently higher than the optimal current account balance (as a ratio to GDP).
24 The excess volatility in the early subsample seems to stem from the need for the actual current account deficit to return to a zero balance, due to the presence of capital controls. In the later subsample, the actual current account path criss-crosses the optimal current account path.
25 The results from the consumption-smoothing model reveal that there was excessive net national savings prior to the liberalization of capital controls in the early.
