In an economic system of floating exchange rates, it must be true that the supply of any currency also equals its demand. Would it not, the exchange rate would rise or fall against other currencies until the two were equal.
In economics this truth is generally expressed by stating that the sum of the current account and the capital account must equal zero. That sounds like a complicated equation to wrap your brain around, but all it means is that transactions involving a specific currency can be divided into two categories. In the first category, the current account, goods and services are traded across countries that use different currencies and income on investments flow both ways as well. A current account deficit means that a country is purchasing more goods and services than it sells and/or that its earning less on its investments abroad than foreigners are earning on investments in their country.
The capital account has more to do with investment flows. If the current account and capital account are to be in balance, then a current account deficit must imply a capital account surplus and vice-versa.
This truth is playing out in Australia which has long maintained a current account deficit and capital account surplus. The current account, though, is moving closer and closer to being in balance. That has not occurred since the 1970s. A big reason why Australia has so consistently run current account deficits is that the country has required significant investment, in part to extract large quantities of natural resources such as coal, oil, and iron ore. The typical advanced economy invests about 20% of GDP into its economy each year. Australia’s rate of investment has hovered close to 30% for some time.
For investment to be made, capital has to be acquired. The normal route for this is savings. But, if a country does not save enough money to fully fund its investment, then the difference has to be made up from foreigners. And thus, the equilibrium between the current and capital accounts.
As Australia’s rate of investment has fallen to about 25% of GDP, the personal savings rate of Australians has risen following the financial crisis from essentially zero to about 6% today. Since corporations and the government are also large savers and borrowers, the personal savings rate presents an incomplete picture of national savings, but does directionally capture the slow changes taking shape in Australia – higher savings and lower investment have caused a large narrowing in the current account deficit, which this year should come in at only 1.5% of GDP and could even be in surplus next year.
The vanishing current account deficit was a key reason why Australia was able to report strong Q4 GDP growth and full year 2016 growth of 2.4%. The government hailed increases in consumption as the driver, but this is really another way of saying that Australia is slowly transforming from an investment-led to consumption driven economy. Growth in 2017 will undoubtedly also be predicated in a major way on the evolution of the current account.
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