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February 25, 2020, 02:11:05 pm

Author Topic: Why is a CAD bad?  (Read 615 times)  Share 

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DavidDenik

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Why is a CAD bad?
« on: May 26, 2019, 11:45:50 am »
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Hey everyone,
I have been looking over AOS3 and was really confused with the main concept. Everything that ive read says that a CAD needs to be financed by a surplus in the CAFA, and due to the savings/investment gap, we are often forced to borrow money from overseas in order to fund our high investment, which directly contributes to NFD by creating a liability, and also creates a debit in Net primary incomes which adds to the CAD. However, I dont understand why a CAD needs to financed at all? The way I see it, if we have a CAD that means that we are generally importing more then we are exporting, or paying more money to foreign ownership of our assets (Net primary income). Why does a CAD HAVE to be financed for? Why cant we just leave it the way it is, why is importing more a bad thing that has to be counteracted?
Similarly, most of the CAD is due to consumers (Eg. buying a bag from overseas) that dont invest overseas... they just choose to spend their disposable income on imports, so how does a surplus in the CAFA even help fund the CAD for consumers?
Im not sure if what ive written makes sense as im pretty confused about the main concept, but please try to help me if you guys can  :)

NomotivationF

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Re: Why is a CAD bad?
« Reply #1 on: May 26, 2019, 12:49:30 pm »
+1
Hey everyone,
I have been looking over AOS3 and was really confused with the main concept. Everything that ive read says that a CAD needs to be financed by a surplus in the CAFA, and due to the savings/investment gap, we are often forced to borrow money from overseas in order to fund our high investment, which directly contributes to NFD by creating a liability, and also creates a debit in Net primary incomes which adds to the CAD. However, I dont understand why a CAD needs to financed at all? The way I see it, if we have a CAD that means that we are generally importing more then we are exporting, or paying more money to foreign ownership of our assets (Net primary income). Why does a CAD HAVE to be financed for? Why cant we just leave it the way it is, why is importing more a bad thing that has to be counteracted?
Similarly, most of the CAD is due to consumers (Eg. buying a bag from overseas) that dont invest overseas... they just choose to spend their disposable income on imports, so how does a surplus in the CAFA even help fund the CAD for consumers?
Im not sure if what ive written makes sense as im pretty confused about the main concept, but please try to help me if you guys can  :)

Hey David,

This AOS study is verrrry hard (in my opinion) so it's understandable to be confused. The way that i'm being taught about the CAD, is that it is a positive thing in Australia, and not something that we need to be worried about. Here's why;

Australia is an open capitalist economy that encourages investment from overseas. The Australian economy has attracted a lot of foreign investment in the last 15 years due to the mining boom, comparatively higher interest rates, sustained economic growth, corruption-free government and a AAA credit rating. We are considered a safe place to invest. Overseas investment creates jobs in Australia, increases incomes, economic growth and material living standards. This has led to a higher living standards in Australia, but this investment has produced a CAD, which is not a problem provided the foreign investment creates more wealth in Australia than the income we must return overseas.
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DavidDenik

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Re: Why is a CAD bad?
« Reply #2 on: May 26, 2019, 12:58:54 pm »
+1
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.

NomotivationF

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Re: Why is a CAD bad?
« Reply #3 on: May 26, 2019, 01:09:26 pm »
+2
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.

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Seamus Wong

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Re: Why is a CAD bad?
« Reply #4 on: May 26, 2019, 05:08:22 pm »
+2
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.

Think of it in very simple terms.
Let us suppose there exists two people.
One of them, which we'll call X, has $100 in savings, but wants to spend $150 during a period.
The other person, which we'll call Y, has $200 in savings, and only spends $150 during the same period.
X doesn't have enough money to finance his expenditure, so he decides to call Y and say, "can you please loan me $50 dollars?"
Y says "yeah k" and gives the $50 to X.
X is happy now, because he can buy the shit that he wants to buy.

It doesn't matter if the debt is good or bad - i.e. if it is used to finance the expansion of X's productive capacity or if it is used to finance a PlayStation. What you need to focus on is the fact that as a nation, we cannot spend more than we have, so we have to get other countries to give us the extra money we need.

The CAD doesn't require us to invest more overseas, so try to forget about that idea. The CAD actually requires foreigners to invest more domestically through purchasing our bonds or providing us with credit, all of which result in inflows of capital (financial account credits) but are also liabilities (they represent an obligation to pay back the capital + interest at a future date).
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DavidDenik

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Re: Why is a CAD bad?
« Reply #5 on: May 26, 2019, 09:47:49 pm »
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Hey Seamus,
What if X has 200$ in savings, and spends 100$ on a phone shipped from China. X doesnt 'borrow' any money since he has his own and has decided to spend it on an import. So in this case he does have enough money to finance his expenditure so why does it state that we have to 'finance' our expenditure when X is using his own funds without borrowing?. In terms of the CAD, this would result in an entry of -100.. Why does this need to be counteracted by a CAFA surplus creating a liability?
Hope this makes sense again (Im sorry if it doesnt)

Seamus Wong

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Re: Why is a CAD bad?
« Reply #6 on: May 26, 2019, 10:38:39 pm »
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Hey Seamus,
What if X has 200$ in savings, and spends 100$ on a phone shipped from China. X doesnt 'borrow' any money since he has his own and has decided to spend it on an import. So in this case he does have enough money to finance his expenditure so why does it state that we have to 'finance' our expenditure when X is using his own funds without borrowing?. In terms of the CAD, this would result in an entry of -100.. Why does this need to be counteracted by a CAFA surplus creating a liability?
Hope this makes sense again (Im sorry if it doesnt)

Good that you're asking questions, so don't be sorry at all. Seriously, I'm sure no one else in my own class has a clue how it works, and none of them are asking any questions.

if X has $200 and only spends $100, then he doesn't have a CAD, he has a CAS (Current Account Surplus), therefore he doesn't need to borrow anything from overseas. He would probably now be the one who is lending the extra $100 he has to countries overseas, which we would see as a debit on CAFA.

Continue asking questions (even if u think they sound dumb) until you fully understand everything.
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