Australia's Place in the Global Economy

Topic 2 is worth about 13 to 14 of the 60 marks in Sections I and II, and exchange rates and the balance of payments appear in an essay question most years. It is the most calculation-heavy topic, so practise the arithmetic until it is automatic.

• Australia's trade and financial flows: the value, composition and direction of trade and financial flows, and how they have changed.
• The balance of payments (BOP): the structure of the current account and the capital and financial account, and why they balance.
• Foreign debt and foreign equity: net foreign liabilities and what drives them.
• Exchange rates: how a floating exchange rate is determined, what moves it, the effects of appreciation and depreciation, the trade-weighted index and the Reserve Bank's role.
• The terms of trade: what they measure and how changes affect the economy.
• Free trade and protection in Australia: Australia's move from high protection to trade liberalisation; multilateral, regional and bilateral trade agreements.

• Value: the dollar amount of exports and imports. Trade (exports plus imports) has been worth roughly 40 to 50% of Australia's GDP in recent decades, higher when commodity prices are high.
• Composition: what is traded. Australia's goods exports are dominated by resources and energy, especially iron ore, coal, natural gas and gold, plus rural goods such as beef and wheat. The largest services export is education-related travel (international students). Imports are mainly manufactured goods (vehicles, machinery, electronics), refined fuel and services such as overseas travel.
• Direction: who we trade with. Over the past 50 years trade has shifted from Britain and Europe towards Asia. China has been Australia's largest trading partner since 2007, and Japan, the United States, South Korea and India are also major partners.

The reasons behind these trends are more important than the numbers: Asian industrialisation raised demand for Australian resources; trade liberalisation made imported manufactures cheaper; and Australia's comparative advantage lies in resources, agriculture and some services.

Financial flows

Foreign investment comes into Australia because domestic saving has historically been lower than investment. Inflows are either debt (loans, bonds) or equity (shares, FDI). Major sources include the United States, the United Kingdom and Japan. Australia's superannuation funds also invest heavily overseas, so outflows have grown strongly.

The balance of payments records all transactions between Australian residents and the rest of the world over a period. It has two parts.

Current account

Australia has run a deficit on net primary income for decades because foreigners own much more Australian capital than Australians own abroad, so interest and dividend payments outward exceed income received. This is a structural feature.

Capital and financial account

• Capital account: capital transfers (for example debt forgiveness) and buying or selling non-produced, non-financial assets such as trademarks, brand names, licences and land bought by foreign embassies. It is small.
• Financial account: flows of foreign investment: direct investment, portfolio investment, financial derivatives, other investment and changes in reserve assets.

Because every transaction is recorded twice (double-entry), the BOP always balances in principle:

A current account deficit (CAD) is therefore matched by a net inflow on the capital and financial account: when Australia spends more than it earns from the rest of the world, it finances the gap by borrowing or selling assets to foreigners. Another way to see it: a CAD means national investment exceeds national saving.

Worked example: current account

In a year a country records (in $ billion): goods exports 480, goods imports 455, services exports 95, services imports 110, primary income credits 62, primary income debits 118, net secondary income $-2$, and a capital account of $-0.6$. Find the current account balance and the implied financial account balance (assume no errors and omissions).

The balance on goods and services is $10 billion, and the current account deficit is $48 billion. For the BOP to balance, the financial account must be a net inflow of $48+0.6=48.6$, that is $48.6 billion. Notice that a trade surplus did not prevent a CAD: the primary income deficit was much larger. This has been Australia's pattern since 2017, when high commodity prices pushed the trade balance into surplus; before that, Australia usually ran a deficit on both goods and services and primary income.

Recent Australian trends

From the 1980s until 2019 Australia ran a current account deficit every year, typically 3 to 6% of GDP. In 2019–20 Australia recorded its first annual current account surplus since the 1970s, driven by very high iron ore prices and a fall in imports, and the surplus continued for several years before the current account returned to deficit around 2023. When you use data like this, always explain the cause: the surplus came mainly from the terms of trade, not from a sudden rise in national saving.

• Net foreign debt: what Australians owe to foreigners minus what foreigners owe to Australians. It grows when we borrow to finance a CAD, and it brings interest payments that show up in the primary income deficit.
• Net foreign equity: foreign ownership of Australian assets minus Australian ownership of foreign assets. It brings dividend payments but no repayment obligation.
• Net foreign liabilities (NFL): net foreign debt plus net foreign equity.

Because superannuation funds have bought large amounts of foreign shares, Australia now owns more foreign equity than foreigners own of Australian equity, so the net equity position is an asset (negative) and Australia's net foreign liabilities are mostly debt.

Example. Net foreign debt is $1450 billion and net foreign equity is $-\$310$ billion (a net asset). NFL $=1450-310=1140$, so $1140 billion. With GDP of $2650 billion, that is about 43% of GDP. Ratios to GDP are what matter: a debt that grows more slowly than the economy becomes easier to service.

The debt servicing ratio is net interest payments on foreign debt as a percentage of exports of goods and services. It measures how much export income is used to pay interest. If net interest payments are $38 billion and exports are $575 billion, the ratio is $38/575=6.6\%$.

The exchange rate is the price of one currency in terms of another. Australia has had a floating exchange rate since December 1983, so the value of the Australian dollar (AUD) is set by demand and supply in the foreign exchange market.

What drives demand and supply for the AUD

The AUD is often described as a commodity currency: it tends to rise when commodity prices rise. It also tends to fall during global crises, when investors move money to safe assets such as the US dollar.

Effects of appreciation and depreciation

A depreciation makes Australian exports cheaper in foreign currency and imports dearer in AUD. Over time, export volumes rise and import volumes fall, improving the trade balance. It also raises import prices, adding to inflation, and increases the AUD value of foreign-currency debt. An appreciation has the opposite effects.

The trade balance may worsen at first after a depreciation and improve later, because contracts are already signed and buyers take time to adjust volumes. This is the J-curve effect.

Worked example: a depreciation

The AUD falls from US$0.70 to US$0.63.

An Australian machine priced at A$50 000 cost US$35 000 before and US$31 500 after, so it is more competitive overseas. A US product priced at US$2000 cost about A$2857 before ($2000÷0.70$) and A$3175 after ($2000÷0.63$), so imports become dearer.

The trade-weighted index and the RBA

The trade-weighted index (TWI) measures the AUD against a basket of the currencies of Australia's main trading partners, weighted by their share of trade. It gives a better picture of competitiveness than the AUD/USD rate alone. China's currency has the biggest weight.

Under a float the Reserve Bank of Australia (RBA) does not target a level for the dollar, but it can intervene in the foreign exchange market (buying or selling AUD using its reserves) to calm disorderly markets, as it did during the 2008 global financial crisis. Interest rate decisions also influence the dollar indirectly. Know the contrast with a fixed exchange rate, where the central bank must buy or sell its currency to hold a set value, and a managed or crawling peg.

The terms of trade (ToT) compare the prices of a country's exports with the prices of its imports:

A rise means a given volume of exports buys more imports, so national income rises. Australia's terms of trade are volatile because exports are concentrated in commodities whose prices swing widely.

Example. From a base year, export prices rise 12% and import prices rise 3%. The ToT index becomes $100\times 1.12/1.03=108.7$, an improvement of 8.7%. If instead export prices fell 8% and import prices rose 1%, the index would be $100\times 0.92/1.01=91.1$.

Effects of a terms of trade boom: higher export income and profits, higher tax revenue, a stronger AUD, more investment in the mining sector and a better current account balance. It can also squeeze other trade-exposed industries such as manufacturing and tourism through the higher dollar. Australia's mining boom of the 2000s and early 2010s is the classic example.

Australia moved from high protection, especially for manufacturing, in the decades up to the 1980s to a largely open economy. The dollar was floated in 1983, and from the late 1980s governments made large unilateral tariff cuts (cuts made without waiting for other countries to reciprocate). Most tariffs are now 5% or less, and several hundred nuisance tariffs were removed from 1 July 2024.

Australia pursues trade liberalisation at three levels:

Effects of liberalisation on Australia: cheaper imports and lower inflation, more efficient firms, a shift of resources towards industries with comparative advantage, and greater export access. Costs fall on workers and regions in formerly protected industries (for example car manufacturing, which ended in 2017), which is a strong argument for adjustment assistance and labour market programs.

• Saying a CAD is matched by a "capital account surplus". It is matched mainly by the financial account.
• Putting interest and dividends in goods and services. They belong in net primary income.
• Confusing net foreign debt with net foreign liabilities. NFL includes equity.
• Saying a depreciation immediately improves the current account. Remember the J-curve and the effect on the AUD value of interest payments.
• Mixing the direction of a change: a rise in AUD/USD is an appreciation of the AUD.
• Treating the TWI as the exchange rate against one currency.
• Saying the RBA sets the exchange rate. It floats; the RBA only intervenes occasionally.

• Calculate: write the formula, substitute and give units ($ billion, %, index points). One mark often goes to working.
• Explain (3 or 4 marks): for a change in the AUD, trace the full chain, for example more investment overseas by Australian super funds means they sell AUD to buy foreign currency, which raises the supply of AUD and depreciates it.
• Distinguish between: say what each term is and the key difference in one sentence (current account versus financial account; debt versus equity).
• In stimulus questions, quote the data (with the year and units) and say what trend it shows before you explain it.
• Use correct terms: "the AUD appreciated", not "the AUD got stronger".

Writing a 20-mark extended response

Essays on this topic often ask you to analyse trends in Australia's balance of payments or the impacts of exchange rate changes. A strong plan for "Analyse the causes and effects of changes in Australia's exchange rate":

1. Introduction: define the exchange rate and floating; state that the AUD is volatile and driven mainly by commodity prices, interest differentials and capital flows.
2. Causes: terms of trade, relative interest rates, capital flows and speculation, each with a recent example and year.
3. Effects on the external sector: trade balance, J-curve, primary income and foreign debt valuation.
4. Effects on the domestic economy: inflation, growth, sectoral effects.
5. Policy: the RBA's role and the link to monetary policy.
6. Conclusion: a judgement about which causes and effects matter most.

If the question comes with stimulus (Section III), integrate the data in every body paragraph rather than describing it in one block.

• Topic 1: Australia's trade policy applies the theory of free trade, protection and FTAs. Global commodity prices come from world demand, especially from China.
• Topic 3: external stability (CAD, NFL, debt servicing ratio, exchange rate volatility) is one of the economic issues; a depreciation affects inflation.
• Topic 4: monetary policy affects the exchange rate through interest rates; the conflict between growth and external stability is a classic policy conflict.