is the CAD a problem?
The value of the CAD on an annual basis provides an indication of the extent to which Australia is spending beyond its means. Just like a household that borrows to finance current expenditure, the excess of expenditure over income (i.e. the deficit) need not necessarily be a problem if the borrowed funds are generating sufficient income to repay the debt. However, persistent and growing deficits as a percentage of national income (equivalent to GDP) can be worrisome because it means more and more of our current income is used to repay foreign liabilities (debt and/or equity). Accordingly, the value of the CAD as a percentage of GDP provides a guide as to the proportion of our total income (or production) that is effectively being financed by overseas countries.
The government tries to ensure that 'current account pressures' do not emerge in a climate where the government is trying to maximise economic growth and reduce unemployment. When these 'pressures' do emerge is debatable. In recent years, the RBA Governor indicated that a deficit to GDP ratio of about 5 per cent is not sustainable in the longer term. Some texts may tell you that a sustainable level would be 2 to 3 per cent of GDP, but this is arguably too low.
There is growing acceptance that a large CAD is a structural feature of the Australian economy - i.e. it is with us for the longer term and need not be problematic. Just like it is not necessarily a problem if a household or individual has a cash deficit the requires financing. So long as the acquired funds (either debt or equity) are put to productive use and the debt or equity can be adequately financed over time, a deficit can actually help to boost long term wealth. For example, a household might spend $200,000 in any given year when household income was only $150,000. If the additional $50,000 was used to renovate their house before going to market, then this ‘investment’ should actually help to create wealth for the household in the longer term. In this respect, the cash deficit of $50,000 would not be a problem. However, if the $50,000 was spent on parties and holidays (i.e. it was consumed rather than invested), then it could be problematic if this spending pattern is continued into the future.
In Australia’s case, if spending is greater than income it means that Australia has to find money to finance that additional expenditure. This money comes from overseas typically in the form of borrowing or the purchase of Australian assets, such as shares. The corresponding increase Australia's net foreign liabilities (i.e. debt and foreign equity) will not be a problem if the debt and equity can be adequately serviced (i.e. repaid) over time. The ability to service this debt or equity, just like a household, and depends on how Australia has spent the money. If the bulk of the funds have been used to invest in mines, build infrastructure, grow businesses, etc., then this is ‘investment’ that is wealth generating, increasing future levels of income for Australians and enabling us to adequately service the debt or equity (i.e. pay the interest and/or dividends).
The government acknowledges that the CAD is highly cyclical in nature, growing during times of strong economic growth and falling during downturns. This is why Australia’s CAD falls to approximately 3% of GDP when economic growth is well below trend (such as 2009) and balloons to more than 6% of GDP when economic growth is strong (such as 2007).
It is worth repeating that that the incoming funds are recorded in the CAFA (specifically the Financial Account), this time as a credit. In this respect, the CAFA summarises and records the financing of the CAD. Further, the interest or dividends paid to service these foreign liabilities flows out through the current account. Consequently, students should note that 'spending greater than income' worsens the CAD for two reasons. First, the increased expenditure on imports worsens the Balance on Goods and Services section of the current account. Second, the interest paid to service the NFD (or dividends to finance equity) worsens the Net income section of the current account.