OVERSEAS DEBT

Address to Stonnington U3A Group

19th June 2006

I thought I would start by saying a little about my experience from 28 years as a federal Treasury officer and from my move to the world of think-tanks following my resignation from Treasury in 1987. I do this because that resignation and my initial work at a think-tank are relevant to today’s subject - that is, the resignation was partly related to the overseas debt situation that developed in Australia in the 1980s and that led me to publish in 1988-89 a pamphlet entitled “Debt: What Should Be Done” shortly after I joined the Institute of Public Affairs in Melbourne.

When I started in Treasury in 1958 I had a somewhat romantic belief that active interventions by governments in both economic and social relationships had considerable potential to improve society. I even imagined that my own advice from Treasury might be able to influence governments to adopt policies that would help achieve that. Obvious possible courses of action were to try to lift the rate of economic growth by measures through the budget to increase spending at times of economic slack or to redistribute income to improve the position of the poor.

It did not take long for me to realise that measures designed to achieve such objectives do not necessarily work out in practice as they are supposed to do. They can instead have undesirable side effects requiring corrective action that at least partially reverse the initial measures. For example, government policies designed to increase spending may achieve that by what economists sometimes call a first round effect but that increase may also lead to undesirable rises in prices or in deficits in the balance of payments while redistributions of income to the poor may discourage work and lead to undesirable dependency situations. In other words, policies that political parties adopt for use in government may have undesirable outcomes resulting from second round effects.

When a Labor Government was elected in 1972, Australia – and Treasury – soon faced a major crisis of governance because we had in Canberra a whole lot of politicians who had had no experience of government and who thought mainly in terms of first round effects. One of those politicians, for example, considered that now he was a minister he personally should be able simply to go ahead and borrow a very large sum of money overseas for projects he judged it desirable to pursue. His naïve attempts to arrange such borrowings from a Pakistani conman, and the failure of other Ministers to stop him, had adverse effects on Australia’s credibility in overseas financial markets and were a contributory cause of the fall of the government in 1975. More generally, that and other irresponsible ministerial decisions put enormous pressure on senior Treasury officers trying to persuade ministers to make decisions that were both consistent and in the national interest.

When the next Labor Government was elected in 1983, it had a more responsible set of Ministers. However, those Ministers also went through a hard learning curve. Initially, there were large real increases in government spending and large budget deficits, as well as other changes (such as financial deregulation) that encouraged additional spending. Surprise, surprise between 1980-81 and 1985-86 our current account deficit jumped from 4% to 6.2% of GDP, net external debt increased more than eight times to $78 billion, the net cost of debt servicing rose nearly four times and net foreign investment in Australia actually declined. The exchange rate also fell, by a massive 40%.

In other words, there were some rather nasty second round effects. In May 1986 that prompted Treasurer Paul Keating to make his famous statement that Australia was in danger of becoming a banana republic. This constituted a call to his ministerial colleagues to end the celebration of the 1983 victory. With finance minister Peter Walsh leading the way, real budget spending was then cut by about 7 per cent, budget surpluses were achieved and other reforms started.

As senior Treasury officer in charge of overseas loan raisings by the Commonwealth Government from 1981, I had increasingly been told during this period by my contacts in international banks that Australia would lose the confidence of foreign investors unless the government behaved more responsibly. This reinforced a process I had already started of re-thinking my earlier ideas about an increased role for governments.

That re-thinking led me to arguments being advanced, particularly in the United States, about some of the inherent problems with government. The development of public choice theory in the US had highlighted the problem developing in our political systems whereby politicians have an inbuilt tendency to increase the size of government by making promises to marginal voters (what might less politely be called vote-buying) while escaping adverse reactions from the electorate in general. I was also impressed by a book published in 1985 by a US political scientist, Steven Rhoads, on “The Economists View of the World”. This involved a careful survey of the changing views of economists by a non-economist and it concluded as follows:

“Two decades ago many economists optimistically imagined a federal government that would selectively intervene in the economy to correct for market imperfections once the principles of public finance were better developed and disseminated. Few today have such vision”.

My re-thinking was reinforced by a short period as a visiting fellow at two private sector think-tanks in Washington DC, following which I decided in 1987 to resign from Treasury. Before doing so I sent Treasurer Keating a detailed personal assessment of the economic situation suggesting that, unless the government made major changes in its economic policies, Australia was likely to experience a recession.

Once out of the public service, I set about producing my 1988-89 publication on “Debt: What Should be Done”. My conclusion was that, while there was not a debt crisis as such, a serious overseas debt problem existed that could lead to a crisis unless the government took action to deal with the situation. I based that conclusion on the data I have just quoted on the increase in net external debt and the cost of servicing Australia’s overseas liabilities since 1980-81. The immediate problem was that, whereas servicing had absorbed only 4% of exports of goods and services in 1980-81, it had progressively increased to the point where by 1988-89 it was taking 17%. Australia was exporting more and more simply to service its liabilities (the official data published then suggested that the servicing costs were quite a bit higher than those now published).

In my publication I pointed out that, on the basis of Australia’s own historical experience in the 1890s and 1920s, if servicing costs were to reach about 25% of exports there was a high risk that a recession or depression would follow because foreigners would become increasingly reluctant to lend to us or invest in the country. Moreover, while Australia had not yet reached that particular danger point, some other early warning signals had actually been flashing red. Such signals affected judgments by private sector financial institutions involved in international lending to countries, and wanting to avoid involvement in rescheduling of debt payments.[1] For a country that had long been a net importer of capital Australia was particularly vulnerable to downward pressure on the exchange rate and on domestic growth if there was a continued upward trend in apparent reliance on foreign debt.

I argued that the remedial action taken by the government since the banana republic statement was insufficient and that it was not simply a matter of reducing or stopping government borrowing overseas. Such borrowings had in any event accounted for only about half the increase in overseas debt since 1981, the other half coming from the private sector. Basically, I suggested, it was a matter of dealing with the underlying causes of the excessive overseas borrowing, which were the continued faster growth in domestic spending relative to national income or output. That required, I argued, a much broader program of reform, including a monetary policy that targeted a progressive reduction in inflation from around 7 to 2 per cent per annum. The major difference between the course of interest rates in the US and Australia in the 1980s, shown in the accompanying table, brings out the failure in Australia to deal with that problem.

In short, the Government did not take sufficient remedial action and, after overseas debt servicing costs reached a peak of 19.6% of exports in 1989-90, Australia did experience a recession in 1990-91, when GDP fell by 0.6% and remained virtually unchanged the following year. According to Treasurer Keating, that was “the recession we had to have”. In reality we would not have had it if the government had been up to the mark.

You may by now be wondering whether I have been contradicting myself in arguing for less intervention by government while at the same time calling for more remedial action by the same institution. This is something we could pursue further in discussion time perhaps. Suffice to acknowledge here that there is justification for various forms of government intervention but that such intervention should concentrate on areas where the private sector left on its own would not necessarily maximise the benefits to the community as a whole, such as from education, or where it would impose unnecessary costs, such as on the environment. By contrast, intervention attempting to micro-manage the economy, or particular sectors of it, has been shown to be largely unsuccessful.

This is not to overlook that from time to time the private sector has behaved in a totally irrational way, and continues to do so, with adverse effects on the economy and society generally. The most notorious examples of such inexplicable human behaviour are the Dutch Tulip craze of the 17^th century, the South Sea bubble of the 18th century, and the Japanese land price boom of the late 1980s. In each case the behaviour was financed by borrowings. However, although the respective governments did attempt remedial intervention in each case, this did not stop many lemmings throwing themselves over the cliff.

My plea for remedial action in the 1980s was based on an assessment that the attempts by the government to micro-manage the economy, combined with insufficient action to improve the competitive capacity of the private sector, had created another lemming-like situation with potential for serious adverse economic effects for the economy and society. In summary, the experience of the 1980s suggests that, if governments pursue policies that either directly or indirectly lead to increasing levels of overseas debt and increasing servicing costs relative to other parts of the economy, that is likely to create situations that can lead to a recession.

That leads to the question of whether developments since the early 1990s have eliminated or at least significantly reduced the risk of an overseas debt problem requiring remedial government action.

At first glance the warning signals suggest that another serious debt problem is looming. Since 2001-02 the current account deficit has blown out to higher levels than in 1985-86, with the much faster growth in imports than exports raising the question as to whether the rapid increase in credit[2] has again financed an excessive growth in domestic spending as it did in the 1980s. Net foreign debt has also increased more than three fold since its level at the end of the 1980s and has reached the very large figure of over $500 billion, equivalent to about 50% of GDP and over 300% of exports. Australia is now highly geared, with net debt being almost five times larger than net foreign equity investment whereas it was less than half of equity at the start of the 1980s. That makes us more exposed to higher interest rates and exchange rate pressures than in the 1980s if overseas growth slows or domestic policies become less conducive to private sector development. Indeed, although Australian interest rates are much lower than in the 1980s, we already have higher interest rates than in most other OECD countries. That could be taken as a signal that overseas investors are demanding a higher return for investing in Australia because of our high CAD. If that were the case, in due course it could have adverse economic effects unless the CAD falls.

However, there are a number of reasons why there is much less basis for concern about the present situation than there was in the 1980’s. I will outline these briefly and in the process attempt to put the debt situation in a broader perspective than is sometimes seen in the Australian media.

First, it is important to recognise that it is “normal” for Australia to run a current account deficit because we have been, and remain, a country that has required the use of overseas capital to allow us to increase the size of the economy. Although we are categorised as a “developed” country, in reality we are still “developing”, with our extensive natural resources making us particularly attractive to foreign investors. The result is that, since European settlement the current account has been in deficit for nine years out of ten and, over the past twenty years, that deficit has fluctuated between 3 and 6 per cent of GDP.

To look at the situation in another way, we have been a net importer of capital for most of the years since European settlement. Without the import of such capital we would not have had sufficient savings to finance the investment that has occurred and which, in turn, has enabled us to expand our population and our economy. We would have been a much smaller country.

In short, the size of the CAD is not in itself necessarily an indication of an external debt problem. The question is whether the borrowings have been put to good use.

Second, since the 1980s there has been an improvement in Australian government policies, to which both major political parties have contributed, and in the international competitiveness of businesses. That makes it less likely that overseas borrowings are being used in ways that result in progressively increasing servicing costs. Let me mention three important improvements that are relevant.

* First, Australia now has a monetary policy committed to keeping average inflation in the 2-3% range and that effectively gives the central bank prime responsibility for achieving that. This is a very important change compared with the 1980s when the bank played second fiddle to wage awards made by the Industrial Relations Commission, that is, the bank then effectively accepted the inflation rate implied by the Commission’s wage awards, which were made with limited regard to their economic implications. The eventual lowering of inflation and its maintenance at a low rate has undoubtedly reduced borrowings designed largely to obtain speculative capital gains derived from high inflation, which were considerable in the 1980s. That means that borrowings by businesses are now more likely to be for productive purposes and more carefully assessed in regard to capacity to repay. Banks have also improved their loan assessments generally compared with the 1980s when they were faced with a deregulated financial system for the first time and a central bank was unable adequately to interpret the implications of the rapid growth in credit in the immediate aftermath of the deregulation;

* Second, the federal government’s budgetary policy has changed from the attempted micro-management of the economy in the 1980s to an approach that emphasises the desirability of a relatively stable budget result over a period of years. It is now recognised that the way to lift economic growth is not through Keynesian deficit financing but by improving efficiency and competition. The movement away from budget deficits to budgeting for a surplus in “normal” years may also have increased total domestic saving and thus reduced the call on overseas capital;[3]

* Third, there has been a major move away from protection against import competition to a more free trade approach. While this has undoubtedly reduced the relative contribution of manufacturing industry to GDP,[4] the overall effect has been to improve the efficiency of Australian businesses. That means we are better able to service borrowings;

To return to points relevant to increased optimism about the existing overseas debt situation, a third point is that although the net servicing cost of our overseas borrowings has increased since 2002-03 to 9% of exports (compared with the low since the 1980s of 7.9%), this 9% is only about half what it was in the late 1980s and is not close to the point where warning signals are likely to start flashing. Moreover, although debt servicing is higher than at the start of the 1980s, comparisons need to take account of the restricted capacity of the private sector to undertake overseas borrowings before the removal of exchange controls in 1983. Those controls meant that Australia’s gearing was relatively low in 1980-81, with equity investment playing the major role in the contribution of foreign capital. Debt servicing was therefore lower then than it would have been if the foreign exchange market had been liberalised.

A fourth point of optimism is that the relative size of the current account deficit seems likely to be reduced over the next few years.[5] The large increase in investment in export industries over recent years, coupled with the large increase in export prices, should lead to a faster growth in exports and a slower growth in imports. It is relevant that the recent rapid growth in imports is in part a reflection of the large increase in such investment ie the CAD would not have been as large if the increase in investment had been less.[6]

Fifth, although our interest rates are relatively high, this does not appear to reflect concern amongst foreign lenders and investors about Australia’s debt situation. International institutions are full of praise for the government’s economic policies and there are no signs of downwards pressure on the exchange rate from hedge or other funds. Indeed, the appreciation of about 30 per cent in the $A over the last three to four years suggests that foreigners have been willing investors in Australia and, hence, willing purchasers of the $A.[7] Similarly, Australia’s relatively high interest rates do not appear to reflect a view by foreigners that the exchange rate is vulnerable.

How do we conclude?

There is no doubt that the size of a country’s current account deficit remains a live issue of economic policy and amongst financial institutions. This is illustrated by the on going debate about the CAD of the United States. Although Australia’s CAD is if anything a little larger relatively than that of the US, we are not being told by economic commentators to take corrective policy action whereas that country is. On his visit to Australia last week the Managing Director of the International Monetary Fund referred to our high deficit as reflecting “high investment” but reportedly claimed that the US deficit is being used to finance consumption.[8] He stated that the US deficit is “a problem that needs to be addressed” because, according to a report in The Australian on 14 June, “if investors suddenly became unwilling to hold US financial assets the $US would plummet and rates would rise, causing global financial turmoil and recession.”

This is not the place to pursue the debate about the US CAD[9] except to observe that the distinction being drawn between the relative “merits” of our CAD and that of the US appears to be based on an assessment that our government policies, particularly related to budgetary positions, are in better shape than those of the US Government. In addition, of course, an attempt by foreigners to sharply reduce their extensive holdings of $US assets would, as the IMF MD points out, have global implications whereas a similar attempt to reduce holdings of $A assets would probably have implications only for us. It is worth noting, however, that our net external liabilities (debt plus equity) are relatively larger than those of the United States.

Australia’s existing external debt situation is not a cause for current concern but it could become one if government policies went off track as they did in the 1980s. It could also become a problem if, for any reason, the global economic situation took a sharp turn for the worse. Neither of those possibilities appears likely at present but circumstances can change quite quickly and our high gearing makes us vulnerable.

DATA RELEVANT TO OVERSEAS DEBT

[1] These warning signals included reaching situations where gross external debt exceeded 200 per cent of exports of goods and services or when the current account deficit exceeded 30 per cent of exports. In 1988-89 Australia had reached both such situations.

[2] Credit figures published by the Reserve Bank has been growing at 12-14%

pa over recent years. “Credit” includes loans by financial institutions other than banks.

[3] In Treasury Roundup for Summer 2006, “Perspectives on Australia’s current account deficit”, David Gruen, suggests that the increase in the general government budget balances and the compulsory superannuation levy have increased the overall national saving rate in net terms ie there has been no offsetting reduction in private sector savings rates. However, the chart of the net saving rate shows little if any change over the last ten years.

[4] The manufacturing industry now contributes only about 12 per cent of GDP compared with 22.4% in 1950-51. However, in 1900-01 the contribution of manufacturing was only 12 per cent as agriculture then contributed 20% compared with only about 4% now.

[5] However, the budget forecast for 2006-07 is for a slight increase in the CAD.

[6] Business investment increased in real terms by 11.7% in 2004-05 and is estimated to increase by a further 14% in 2005-06. The 12% increase in the volume of imports in 2004-05 is estimated to be only about half that in 2005-06 and 2006-07.

[7] Most of the overseas borrowing in recent years has been by banks who have eliminated the currency risk by converting the borrowing obligation into a $A liability ie foreigners have been buying $A assets in one form or another.

[8] This statement is incorrect. The proportion of US investment to GDP is much larger than the CAD proportion.

[9] For an examination of this issue, see “Might the United States continue to run large current account deficits?” by David Gruen, Treasury Roundup, Winter 2004.