Causes:
1. Savings-investment gap due to Australia's low population and being an attractive destination for investment due to its natural endowment (coal, iron ore). This means foreign net financial inflows are required to finance domestic investment. Repatriations of profits on this foreign investment are recorded as debits on the net primary income.
2. A narrow export base causes vulnerability to external shocks as seen in the declining terms of trade since 2013 due to slower growth in China worsening the BoGS deficit which has widened the CAD. This has represented a significant proportion of the CAD in the last 3 years.
3. A lack of international competitiveness in exporting and import-competing industries due to higher wages and regulations than foreign producers, has contributed to the BoGS deficit.
Effects
1. a) A sustained CAD will increase net foreign liabilities, leading to a loss of investor confidence as they question Australia's ability to repay its debts (solvency). This may result in the withdrawal of foreign investment, reducing AD and reducing growth and increasing unemployment.
b) As investors lose confidence in Australia, they may charge higher interest when Australian firms try to access foreign capital in the future due high higher perceived risk. This reduces the marginal efficiency of capital and the quantity of investment. A high CAD and high net foreign liabilities may cause Australia may also lose its AAA credit rating which is necessary for financial markets and foreign investors to hold confidence in Australia. A worsening of the credit rating will increase interest rates when Australian firms borrow from overseas.
c) As foreign investors withdraw their funds from Australia to other countries, the supply for AUD increases and the currency depreciates. This increases exchange rate volatility, as seen in the Asian Financial Crisis of 1997.
2. a) Under the floating exchange rate, the CAD is equal to the surplus on the capital and financial account. Interest and principal must be paid on these financial inflows, tightening domestic capital markets, which comes at the opportunity cost of domestic public investment and borrowing by firms.
b) Intergenerational inequity is a problem as future generations may need to reduce their consumption and standard of living in order to pay back debts accumulated due to a persistent CAD.
