australia current account
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. 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). 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 [next page]