Thankyou for replying,
If a CAD isnt bad, then why does it need to be 'financed for' by the CAFA? I dont understand why a CAD requires us to invest more overseas.
Hope that makes sense.
Ah, sorry I think I misinterpreted your question. The CAD doesn't actually require us to invest more overseas, it's more the fact the the CAD and CAFA must balance. It's sort of an accounting thing. I'm just gonna explain it all so you might understand it a bit better.
The Financial account records the inflows (credits) and outflows (debits) of debt and equity investments.
- The investments include shares, loans, bonds and property.
Any income earned from the ownership of these investments is recorded as primary income in the current account.
The Financial account also records how Australia finances its CAD
Typically, a CAD is financed by:
o Loans (debt), and
o Assets (equity)
and leads to an increase in our net foreign liabilities
The financial account includes
i. Official capital flows:
- Inflows: eg the Australian government selling bonds to foreign residents ie foreigners are lending to the Australian government
- Outflows: The Australian government lending to foreign residents
ii. Non-Official (Private sector) capital flows:
- Borrowing and lending between Australian and overseas economic agents
a) Net direct investment – eg. setting up a factory or purchasing more than 10% of a companies shares
b) Net portfolio investment – eg. less than 10% investment in shares
c) Net debt flow – eg. Loans
Capital & Financial Account Surplus
- A CAFA Deficit occurs when:
o Payments (debits) > Receipts (credits)
- A CAFA Surplus occurs when:
o Receipts > Payments
CAD = Capital & Financial Account Surplus
- The current and capital accounts should balance (BOP = $0)
- Any difference is a measurement error – this is recorded in the Financial account as ‘net errors and omissions’.
- If the Current Account is negative - it must be financed by an equal Capital and Financial Account Surplus
- This must happen because the Balance of Payments always balances in countries that have a floating exchange rate.
To be completely honest I don't fully understand it yet myself, but the key thing to remember is that the CAD must = the CAFA.