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About the project

The International Economy program aims to explain developments in the international economy, and influence policy. It does so by undertaking independent analytical research.

The International Economy program contributes to the Lowy Institute’s core publications: policy briefs and policy analyses. For example, the program contributed the Lowy Institute Paper, John Edwards’ Beyond the Boom, which argued that Australia’s transition away from the commodities boom will be quite smooth.

 

Latest publications

‘Choosing Openness’ grapples with the big questions

In Choosing Openness, Andrew Leigh makes an important and timely intervention in the Australian debate about globalisation, free trade and immigration. This is, of course, a debate raging around the world, one that has seen Britain exit the EU, Donald Trump elected US President, Marine Le Pen challenge for the French Presidency, and Nazi sympathizers enter the German parliament.

From the outset, Leigh provides the perfect contrast of the winners and losers of globalisation. Nathan, a shift worker in an automotive glass plant in Geelong, lives in an area with 20% unemployment. A barrister living in the eastern suburbs of Sydney charges $10,000 a day. Leigh meets them both, in the same country, within weeks. Yet their experiences of the modern economy could be separated by thousands of miles and several decades.

Building on his earlier work on inequality, Leigh notes that over the past decades the incomes of the top 1%, and even more so the top 0.1%, have risen strongly. Meanwhile, income for those in the middle have seen much less impressive growth. Indeed, in the US, the median worker's income has not risen in real terms for around 30 years. Australia is doing a little better, Leigh reminds us, but there is a glaring disparity between the experience of the top of the income distribution and the middle.

But the real gist of Leigh’s contribution is to link these economic forces to social ones. He wants to explain why 'openness makes us uncomfortable', and he contends that, though economic forces play a role, there is more to it than that. According to Leigh, to explain Trump and Le Pen we need to think more broadly. He identifies four forces.

The first is the terrible economic outcomes for a large share of the population. Second, he points to technology. This is in part linked to economics, through automation and the impact on jobs. But Leigh is more interested in media technology — how we get our information. For Leigh, the 'new media ecosystem' allows us to choose our news and our facts, and provides fertile ground for conspiracy theories. Third, he gives due credit to 'political entrepreneurs' like Trump. Finally, he points to the vacuum left by the shrinking centre.

This strikes me as a pretty good diagnosis. But Dr Leigh is rarely content with understanding a problem. He wants to solve it. And in his characteristically persuasive and upbeat fashion, he goes on to make the case for trade, migration, and foreign investment. And, as is his style, these arguments are filled with compelling evidence.

The unifying theme running through the case for all three things - trade, migration, and foreign investment - is that they make the 'pie' bigger. Trade allows us to benefit from comparative advantage, selling our resources, agricultural products, even education, to a burgeoning Asian middle class. It also allows us to buy things from overseas much more cheaply. Migration fills skill gaps and enriches Australian society socially. Foreign investment provides a capital-thirsty Australia with the fuel to develop our good ideas and take them to the world.

The real question is how to make sure everyone benefits from this expanding pie. In my opinion, this is the great political question of our time, and Leigh grapples with it. In the final chapter, Leigh outlines a range of specific ideas to help re-slice the pie and keep Australia open. From tying skilled migration to labour-market needs to reviewing thresholds for foreign investment, Leigh has a policy tweak for seemingly every problem.

If I have a criticism of Leigh’s brilliant monograph, it is here. He wants to tinker. A little less of this, a little more of that. An adjustment here, an adjustment there.

Perhaps that’s the right answer, but I suspect it will take more. There is a battle of ideas raging that arguably requires a bold call to arms, not a series of technocratic innovations. Leigh leaves me wondering if, while we rewrite Australia’s foreign investment review process, a Le Pen type will capture a chunk of the Australian public by appealing to its gut rather than its mind.

It is ten years since Thomas Friedman’s now classic characterisation of globalisation in The World is Flat. In those ten years the winners and loser from globalisation have become even clearer, and the predictable backlash has gained political traction. It has taken an ugly tone at times.

In this wonderful monograph Andrew Leigh has provided us with a clear and compelling reminder of the challenges involved in remaining open — with all the benefits that ensue — while addressing the concerns of those hurt by openness.

Managing economic risk in Asia: A strategy for Australia

Barry Sterland’s new Lowy Analysis explores the possibility of a future economic crisis in our region – this is not today’s problem, but something we should be prepared for. The paper benefits from his years of experience in the Australian Treasury and the International Monetary Fund. It sets out the weaknesses demonstrated by the historical experience, judges that things are much better now, and argues the case for further improvements.

Sterland makes the sensible case for the centrality of the IMF in any crisis management preparations. The Fund has the experience, expertise and objectivity to play a central role. But this may not be enough.

First, the next crisis might not be caused by external-sector problems which is the type the IMF has traditionally faced. In the days when most exchange rates were fixed, crises often took the form of current account unsustainability. More recently, with most exchange rates floating, the problem has been volatile capital flows: excessive inflows followed by sudden reversals, such as the 1994 Mexican Crisis and the 1997 Asian Crisis. But economies can get into trouble for reasons which don’t fit the IMF crisis protocols. The Fund was largely irrelevant in the 2008 financial crisis. It’s hard to see a key role for the fund if China’s financial sector gets into serious trouble or Japan’s huge government debt proves unsustainable (although in both cases the spill-over onto other countries might see a role for the Fund).

Second, in those cases where the problem does originate in the external sector, the Fund’s resources are quite modest, considering the size of current global capital flows. The Greek rescue in 2010 illustrates that even a small country can require far more support than the Fund can provide (its contribution is just over 10% of the total, with the bulk of the funding coming from the European Commission and European Central Bank). Asian economies’ own reserves-holdings are far greater than the Fund drawings that might be available to them in a crisis. Indonesia, for example, has reserves four times its potential IMF drawings.

There are additional resources potentially available – from the Chiang Mai Initiative Multilateralization (CMIM) and various other bilateral arrangements, set out in Table 2 of Sterland’s paper. However the formidable operational problems of coordinating these different sources have not yet been settled.

Third, even 20 years after the Asian financial crisis, memories of the Fund’s errors still rankle. Perhaps if a crisis is serious enough, a country in trouble would have to bear the political cost of going cap-in-hand to the Fund, but by that stage the crisis would be way beyond low-cost solutions. Speed is of the essence in responding to a crisis. The stigma of 1997 will prevent the Fund from being in the forefront of the response.

Keeping the focus just on external-sector crises, what more might be done? Prevention, of course, is better than cure. Much more active capital-flow management would reduce the likelihood of crisis. The Fund has come a long way in acknowledging a role for capital-flow management, but still sees this as being at the very bottom of the policy toolbox, to be used only when all other measures have failed. This lukewarm acceptance needs to be replaced by extensive exploration in policy papers of all the operational issues involved, to make it clear that the Fund endorses such policies. Pre-crisis, what types of foreign inflows have the best risk/benefit trade-off, and what can be done to tip the mix of inflows to favour these? What domestic borrowers are likely to attract stable foreign inflows and which borrowers are the most likely to get into trouble? What are the most effective forms of capital-flow management?

If the crisis does arrive and, as suggested above, there is not enough assistance to fund the outflow, what next? The answer in 1997 was that GDP had to fall far enough to turn the current account deficit into a surplus big enough to fund the outflow. This is, to say the least, not ideal.

The better answer is to take measures which reduce the volume of crisis outflow. A temporary stand-still on foreign capital outflow is enough to solve a liquidity crisis. This was the measure taken, belatedly, in the case of South Korea in 1997. Where the foreign debt is unsustainable, the amount has to be reduced with a ‘bail-in’ of creditors, reducing the size of the liabilities through a ‘haircut’. This was the still-incomplete response in Greece, again arrived at only after a two-year delay which made matters much worse.

This type of response is hardly novel, but has often been resisted, including by the Fund. At the August 1997 donors’ meeting, Fund Deputy Managing Director Sugisaki, chairing the meeting, specifically banned discussion of this possibility, whether because of Fund doctrine at the time or to help Japanese creditor banks. In 2010, pressure from European authorities prevented a timely bail-in of Greek creditors.

Morris Goldstein summed this up in his post-mortem of the Asian crisis:

Relying more and at an earlier stage on ad hoc debt rescheduling to handle private sector debt insolvencies is the only way to get these rescue packages back to a reasonable size.

Sovereign debt ought to be the easiest to resolve in a crisis, but the Fund’s strenuous effort to put in place rescheduling procedures has fallen afoul of the Wall Street lobby, which wants to see debt as sacrosanct, always repaid in full. This is a fine principle, but every country has its domestic bankruptcy procedures, which allow a failed enterprise to restructure debt. Why not have the same for international debt? We are still a long way from any proper resolution process: just last year Elliot Management, a so-called ‘vulture fund’, successfully used US courts to obtain full repayment (with interest) for the Argentine defaulted debt that Elliot had purchased at huge discount.

Effective international debt-resolution procedures would also discipline the pre-crisis excessive inflows, reminding investors of the risk of default. The German and French banks which invested so enthusiastically into Greek government debt before 2010 might have been less eager if they had been more conscious that they might lose some or all of their money.

Using economic diplomacy to reduce financial risks in Asia

If Australia’s economic future lies in Asia, then managing the risk of financial crises in the region should be a top concern. Especially as any crisis could also have significant geopolitical consequences.

In an analysis for the Lowy Institute, Barry Sterland looks at what Australia can do about this. It raises some interesting issues about how Australia can best pursue such interests in a changing global environment.

A quick scan across Asia reveals that macroeconomic fundamentals are mostly pretty good. However, China, where risks have been building for some time, is the big exception. A crisis in China is still a tail risk at this point. But even if China’s risks eventually abate, new threats will undoubtedly emerge over time.

A fragmenting financial safety net

The International Monetary Fund (IMF) is intended to be the global economy’s financial safety net. But its central role in managing crises is diminishing and the system is becoming more fragmented.

When the global financial crisis struck, it wasn’t the IMF but rather the US Federal Reserve that acted as lender of last resort to the world’s major economies. In Asia, only a few had access to the Fed’s dollar swap lines. But others were able to rely on their own large stockpiles of hard currency reserves as well as ad hoc bilateral arrangements to weather the shock.

In Europe, where deeper crises set in, the IMF did get involved. But even here, within the so-called ‘troika’ it was relegated to junior partner to the European Commission and European Central Bank. This marked an important departure from normal practice where the IMF typically serves as lead crisis manager.

A central issue is the IMF’s legitimacy problems. Larger emerging economies have systematically avoided it since the crises on the late 1990s and continue to search for viable alternatives. This is especially true in Asia where bitter memories of the Asian financial crisis persist. The Greek debt crisis has since only reinforced perceptions of undue political influence in IMF decisions and policy prescriptions.

Since 2008, the scale and number of central bank currency swaps have continued to expand, estimated to have a total value of US$1 trillion (similar to the IMF’s total lending capacity); and that is without including the Fed’s unlimited swap lines with several advanced economy central banks.

Regional financial safety nets have also been further developed. In Asia, the Chiang Mai Initiative was strengthened in important ways, including by multilateralising and substantially increasing its commitments, de-linking more of its financing from the IMF, and establishing the ASEAN+3 Macroeconomic Research Office (AMRO) to provide support akin to the IMF’s technocratic role.

No going back

Sterland suggests that Australia should, in the first instance, advocate for a more integrated global financial safety net centred around a strong IMF but also plan for operating in a second-best world. Unfortunately, we are more likely to be facing the latter.

Rebuilding the IMF’s legitimacy and ensuring it has adequate lending capacity are essential. However, the incumbent powers are reluctant to give up their dominant positions to make room for emerging economies, notably China, and securing additional financial commitments is always difficult.

Yet, even if these issues are resolved, it is unlikely to reverse the trend towards greater fragmentation. The IMF will remain important, particularly for dealing with deeper crises. But it risks becoming less central and an increasingly last resort.

For instance, while China undoubtedly wants more influence at the IMF, it is also clearly interested in developing alternative mechanisms, preferably ones that give it more influence.

Chinese currency swaps have rapidly expanded, now totalling US$550 billion, and this will likely accelerate. China has also been active in developing alternative multilateral mechanisms, including the Chiang Mai Initiative Multilateralisation (CMIM) and the Contingency Reserve Arrangement amongst the BRICS.

One can draw an instructive parallel here with China’s approach to official development financing, where it focuses heavily on direct bilateral financing, secondarily on China-led multilateral development banks, and lastly on seeking more influence at the World Bank.

Meanwhile, within Asia more broadly there is likely to be a growing desire for alternatives to the IMF. Not only does the region continue to attach a negative stigma to the IMF, but as Asia grows richer it will naturally want, and be able to afford, to have a stronger say over its own affairs, including how crises are managed. To see this, one need only look at how Europe chose to lead its own regional crisis response and establish the European Stability Mechanism.

There are thus likely to be continued calls to further strengthen the CMIM and move it further along the spectrum towards the Asian Monetary Fund idea that Japan initially floated in the late 1990s. The CMIM still has a long way to go and there are important questions about its operational readiness. But the direction of travel seems clear.

The US for its part has closed its swap lines to emerging economies and resisted calls to institutionalise a Fed role as international lender of last resort. Yet, in the event of another major international liquidity crisis, it may well be compelled to step in again.

What should Australia do?

Australia thus increasingly needs to be able to work within a more fragmented architecture. This will require us to be more engaged and proactive. Importantly, despite our limited financial firepower, the marginal value of Australian support during a crisis could be higher in this context, if we can respond flexibly and quickly to unfolding crises.

Sterland’s suggestions to strengthen Australia’s operational readiness and revisit the legal and policy framework guiding Australian crisis support are thus worth considering. Particularly the idea of removing the need for a request from the IMF (or another multilateral) for Australia to provide financial assistance. This could greatly facilitate the ability to provide the kind of early support that can help contain a crisis.

Prevention, through better policies in Asian economies themselves, is of course better than cure. Sterland’s suggestion here is to focus on policy dialogue through various international forums and also bilaterally.

Another tool that could be more actively tapped are technical cooperation programs, of the kind typically funded under the government’s overseas aid program.

Indonesia is a good example, where Australia has been doing this for some time and having good influence – helping Indonesia get through the 2008-09 crisis and the 2013 ‘taper tantrum’ relatively well.

Technical cooperation programs like this could be extended to other countries in the region. Importantly, this needn’t be restricted to those eligible for our aid, but rather based on our interests in maintaining regional economic stability. One option would be to extend such support on a regional basis, perhaps working with AMRO which would allow us to both strengthen an important nascent institution and deal us more into regional stability discussions, without necessarily joining the CMIM.

Such work would need to be closely integrated with the enhanced policy dialogue by economic officials that Sterland suggests to ensure it is as effective as possible and the two are not operating in silos.

Australia’s influence with Asian policymakers will be much higher if we also offer support to actually devise and implement the reforms needed, and also if our own views are informed by an appreciation of the complexities faced in these generally less developed and more difficult institutional environments.  

As a small economy with key interests in the region, this could be worth the added investment.

Ten years after the GFC, are we safe?

Ten years ago this month, Northern Rock experienced the first depositors' run on a British bank for 150 years and failed shortly afterwards. This was not the first manifestation of the global financial crisis: French bank BNP Paribas had frozen withdrawals from mortgage funds the month before; US bank Bear Stearns had bailed out two of its hedge funds in June; and a large US sub-prime mortgage broker had failed earlier in 2007. The worst of the crisis was still a year into the future – the failure of Lehman Brothers and the rescue of insurance giant AIG in September 2008. But Northern Rock's failure revealed many of the vulnerabilities that were to prove widespread.

The decade since has seen major changes in regulation and prudential supervision. Everyone agrees that the financial system is much stronger. But one of the unexpected lessons of the decade was just how fragile and vulnerable the sector had been, how imperfect was prudential supervision and how ill-motivated were financial market participants. It's easy to say that things are better, relative to that dismal standard – there is less agreement on whether the global financial system is now strong enough to be immune from a new crisis.

The main global reform has been to increase substantially the capital which banks must hold. Shareholders' capital is the loss-absorbing buffer which is available to keep banks solvent when things go wrong. In the careless pre-crisis world, many banks operated with dangerously high leverage – small losses were enough to bring them, cap in hand, asking for taxpayers' assistance to avoid bankruptcy. Not only have capital requirements been raised but as well the measurement and definitional issues which banks had used to game the rules have been tightened.

But is this increase enough? Admati and Hellwig, Morris Goldstein, William Cline and others have argued that a crisis such as 2008 does so much damage that substantially higher capital is justified. Banks, for their part, are reluctant to expand expensive equity capital. The G20 was instrumental in achieving a compromise approach in which the biggest global banks would strengthen their balance sheets by issuing debt that could be converted into equity if needed. But if this loss-absorbing debt is held by vulnerable holders such as households or pension funds, governments will be reluctant to see those asset-holders bear the losses when a crisis arrives.

These measures to increase bank capital have been designed to address 'too-big-to-fail' (TBTF) – governments will not allow banks to fail, because one failure will trigger contagious runs on other banks. Thus, the taxpayers end up absorbing the losses of the financial system. TBTF has also been addressed directly by making it much harder for US and European central banks to provide 'lender-of-last-resort' support. This is an understandable response to the public anger at the bank bail-outs, but restricting the use of this powerful crisis-management tool has made the financial system more vulnerable in a crisis.

What of the many other regulatory changes incorporated on the 2010 US Dodd-Frank Act? These certainly put greater compliance obligations on banks, adding to their costs. Wall Street's powerful lobby inside both the White House and Congress is busy white-anting as much of this as possible. The key test here is whether the 'Volcker Rule' provisions survive. The original Volcker Rule enforced a separation between banking business and riskier financing (such as derivatives and market trading). It was repealed in 1999 at the behest of Wall Street, with the result that banks then took on a smorgasbord of high-risk exposures that proved an element in their 2008 undoing. Banks benefit greatly from being able to use their government-protected status to raise money cheaply to fund these high-risk activities, and will work hard to water down the Volcker provisions.

If the Volcker rule (and its European equivalents) holds, that still leaves a problem. Tighter rules on banks encourage more financial transactions to move into the less-regulated shadow banking sector, where many of the 2007-08 problems appeared. The Fed's Vice-chair Stan Fischer, while affirming that 'the soundness and resilience of our financial system has improved since the 2007-08 crisis', also acknowledges that 'we still have limited insight into parts of the shadow banking system'.

So much for the response through new rules and regulations. Far more important in avoiding another crisis are the environment and behavioural standards of the financial sector as a whole. The experience of 2008 revealed that banks were willing to finance borrowers without proper regard for capacity to repay; market operators were ready to bend the rules; credit rating agencies would put commissions ahead of competent evaluation; financial salesmen were looking to unload risky assets onto unsophisticated investors; risky derivatives became a game of 'pass-the-parcel'; and prudential supervisors were either too sanguine or too constrained to do a competent job. Low standards were contagious – if others were doing it, you had to join in.

Abetting these low standards was the prevailing doctrine of 'efficient markets' – financial markets should be allowed to operate with minimal regulation and light-touch prudential supervision. Former Fed Chairman Alan Greenspan has issued his mea culpa, but it's hard to see much change in Wall Street's mindset.

The other critical factor is the macro-environment. After a decade of abnormally low interest rates and massive quantitative easing, investment decisions and portfolio choices have been biased and prices distorted. Low interest rates have encouraged 'search for yield', down-playing risk. Earnings in pension funds have been inadequate. If a new crisis arrives, monetary policy is in no position to offer further stimulus and fiscal policy is constrained by accumulated debt. And in most countries credit has continued to grow faster than GDP, leaving borrowers more exposed.

Considering this compendium of imperfect reforms and unaddressed vulnerabilities, why does Fed Chair Janet Yellen say that another financial crisis like 2008 is 'not likely in our lifetime'? The short answer is that memories of the post-crisis trauma are a powerful antidote against a repeat, strengthening the hand of prudential supervisors and restraining the risk-takers. Yellen is affirming that, for the foreseeable future, there will still be enough people around in positions of authority who remember 2008. Memory, however, offers limited protection against new crises with different characteristics (perhaps beginning with China's over-extended financial sector or Japan's huge government debt). It won't be like 2007-08, but the tirelessly ingenious financial sector will find new ways of getting into trouble.

Addressing global capital flows

International capital flows present serious policy challenges. In textbook economics, such flows are unambiguously beneficial. But volatile flows were a key cause of the 1997 Asian crisis, cross-country financial linkages exacerbated the 2008 global crisis, and capital flows were once again central in the 2010 Greek crisis. There has been substantial shrinkage of financial flows since 2008 – the McKinsey Global Institute sees these reduced flows as strengthening the benefits and reducing the risks. But the policy challenge of coping with volatility remains. The International Monetary Fund should do more to make capital-flow management a routine element in the toolbox of policymakers in emerging economies.

It's hardly surprising that the 2008 crisis changed global capital flows. In the period leading up to the crisis, the unrestrained expansion of financial balance sheets often involved complex layering of transactions with multiple institutions in different countries. These excesses have been wound back, with overextended banks retreating to their home turf and contracting their balance sheets, spurred on by fear of insolvency or by the requirements of prudential supervisors. Banks have had to raise their capital ratios substantially, which has meant abandoning non-core operations, with their foreign adventures the first to go.

McKinsey analysts, ever the optimists, see this retreat as beneficial.

These developments do not signal an end to financial globalization—although there will be risks. Rather, we see a healthy correction from pre-crisis excesses, and a return to a potentially more stable and risk-sensitive era of financial globalization.

The gross flows are now 65% below 2007. Most of the fall is in bank lending, leaving foreign direct investment (FDI) and investment in equities stronger than before, with these two components now making up 69% of flows.

The aberrant period was the 2008 crisis and the pre-crisis period. In this pre-crisis period European banks, in particular, became lenders to the world, caused a 'global banking glut' and got themselves into trouble. Flows have now returned to a more normal pace, but with FDI a much larger component. FDI has long been considered to be notably more stable than other flow components. McKinsey sees this as a more stable environment, and probably more beneficial as well: FDI brings with it technology and managerial know-how.

One of the lessons of the past two decades is that it not just the flow that can be volatile ('sudden stops'): when things go wrong, the market focus turns to the stock of liabilities – the accumulation of the flows. The stable elements (FDI and equity) account for around half the stock of foreign liabilities, so there is still plenty of room for the other volatile elements to cause problems.

For the emerging economies, the vulnerability from capital flow reversals remains a policy concern so long as a country is running a significant external deficit. In the textbook world, emerging economies should run external deficits to enable them to invest more than they save, speeding economic development. In the real world, external deficits have to be kept within whatever bounds the financial markets impose. In aggregate, the total global external deficit has shrunk since 2007, from 2.5% of global GDP to 1.7% in 2016. Not only has the composition of current flows become more stable, but the smaller deficit suggests that the global system is safer – at least in aggregate.

But even with bank lending greatly reduced, both the flow and the stock of volatile portfolio flows are still substantial. Government debt is now much larger than before 2008, and more is held by foreigners – 22% in aggregate. For countries like Indonesia, the percentage is higher still – over one third. McKinsey understands the ongoing vulnerabilities:

However, risks remain. Gross capital flows—particularly cross-border lending—remain volatile. Since 2010, in any given year one-third of developing and two-thirds of advanced economies experience a large decline or surge in total capital inflows. The median change is equivalent to 6.7 percent of GDP for developing countries and 10.8 percent for advanced economies. These fluctuations create large swings in exchange rates and could reduce macroeconomic stability. Cross-border lending is particularly volatile. Over the past five years, more than 60 percent of developing countries and over 70 percent of advanced economies experienced a large decline, surge, reversal, or recovery in cross-border lending each year, making volatility the norm rather than the exception. New tools to cope with volatility are needed.

The IMF, previously a vocal advocate of unrestricted free capital flows, has now accepted that these flows create vulnerabilities. The IMF even accepts that capital-flow management (the acceptable term for what used to be condemned as 'capital controls') may be appropriate in some circumstances. But this possibility is right at the bottom of the policy toolbox, and there is no discussion how it would be applied in practice. The implication is that such measures still don't have a full endorsement by the IMF, and hence will be seen by financial markets as a measure of policy weakness. It's time for the IMF to develop some operational guidelines for capital-flow management for emerging economies and promote them as a normal element of good policy-making.

Taxing global capital

Over the past quarter-century, global capital has become far more mobile and some foreign investors have become more sensitive to company tax issues. Much ingenious effort has been devoted to shifting company profits to tax jurisdictions with low rates and to avoiding company tax entirely. Perhaps in response, the global trend has been to reduce company tax rates. Australia has lagged this downward trend, although the current government has used substantial political capital to begin moving in this direction. But why bother? The reductions envisaged won’t have much effect on foreign investment.

In international comparisons of company tax, Australia is always shown as having a rate of 30% (compared with an average OECD level of around 25%). But nothing is simple in the world of tax. Since 1987 Australia has had a system of company tax imputation, whereby Australian shareholders get a credit or refund for the tax which their company has paid: for Australians, the effective company tax rate is zero. Foreigners, however, cannot claim these imputation credits. Thus a foreign company contemplating investment in Australia might be tempted to shift its investment to a country with a lower rate.

For some, this anxiety about discouraging foreign investors might be a hangover from the days before the 1983 float of the Australian dollar, when funding our chronic current account deficit was a constant policy concern. Since 1983, if the attraction of Australia for foreign investors diminished for whatever reason, the exchange rate would adjust, depreciating to keep the current account and the capital inflow balanced.

The 2010 Henry Tax Review was concerned about Australia’s attractiveness for foreign investors, but put forward a more esoteric argument for reducing company tax. In a world of perfect capital mobility, the cost of capital would be set in global financial markets and any corporate tax imposed by Australia would impinge ultimately on the other factors of production: labour and land.

We are very far from this world of perfect capital mobility. Foreign companies invest in Australia for a variety of reasons. They identify above-average investment opportunities (where ‘economic rents’ are available), often based on their own profitable know-how and intellectual property. For portfolio investors, they similarly identify characteristics of the Australian market that they find attractive. Separated from global financial markets by our exchange rate (and a multitude of other factors), the real world is far distant from the textbook-perfect capital market.

Of course there are many other real world factors at work. To start with, it looks like the large tech companies such as Facebook, Amazon and Alphabet (and perhaps many others as well) don’t pay much tax here anyway. Offering a lower rate will make no difference. And for those foreign investors who pay tax in their home country, lowering our company tax rate would often just mean that foreign investors pay more tax at home.

Whatever the intellectual attraction of this ‘global capital’ argument, even its economist proponents accept that the effect of lower company tax on Australian national income would be minuscule.

Instead of lowering the company tax rate for everyone, why not give the foreign shareholders the benefit of imputation, allowing them a credit against any income tax they might pay in Australia? After all, the core logic of imputation is that the company structure is just a legal veil: to tax both the company and the shareholders amounts to double taxation. In practice this would be complicated and probably few of them pay Australian tax anyway.

If the foreign shareholders pay little or no Australian tax, then taxing the foreign company here seems a good - if imperfect - answer. Foreign companies have the benefit of Australia’s governmental and administrative infrastructure, protecting their physical security and providing legal backing for their contracts and intellectual property. They should make a contribution to the upkeep of this system, just as Australian shareholders do.

So the status quo might be judged to be a reasonable and fair outcome, with little reason for the government to assign such priority to reducing the corporate tax rate (and finding replacement revenue). Could there, however, be other motivation?

Ken Henry, who led the review, noted that it had long been a desirable tax principle that the top marginal income tax rate should be close to the company tax rate, so as to negate the incentive for high-tax-bracket Australians to shift their personal income into a company or trust structure, in order to delay taxes (benefiting from the time value of money). Some measures were taken to address this, but they seem to have left considerable loopholes. Perhaps some of those lobbying for lower company tax rates are the beneficiaries of such schemes.

The other conclusion we might draw is that, as this is a global problem reflecting the rootlessness of mobile capital, then a global solution may be needed. There are vexed issues of deciding where the tax obligation should lie: in the country of the shareholder; where the goods are produced; or where they are sold. As a starting point, however, we can leave aside this complexity to make a simple point: an enterprise that benefits from the deep social and legal infrastructure needed to make its operations possible should pay a fair tax somewhere. This is clearly not the case at present, with daily press reports of derisory amounts of company tax paid by large multinationals because of transfer pricing and accounting arrangements in tax havens and low-tax jurisdictions.

The OECD has struggled valiantly with its Base Erosion and Profit Shifting (BEPS) measures. It may be that this G20-promoted effort to force greater transparency on some of the most blatant tax havens - such as Switzerland, Luxembourg, Singapore and Ireland, to name just a few - might have some impact over time. But vested interests, particularly in the large economies with loud voices in the BEPS negotiations, will delay and limit what can be done. As globalisation becomes more deeply entrenched, the paucity of consistent global rules will limit equitable solutions to problems such as company tax. In the meantime, awaiting these global rules, there seems no strong case for lowering the company tax rate in a misguided attempt to attract more foreign investment.

Indonesia: ‘Twin deficits’ still a brake on high growth ambitions

Things are gradually improving for Indonesia’s economy. Policymakers have successfully assuaged financial markets of their macroeconomic stability credentials (for now) and economic growth seems to have stabilised at a still robust 5%.

Hopes are high that the bottom of the cycle has been reached and growth will start to accelerate. Some expect growth to lift towards the mid 5% range over the next few years. President Jokowi is of course hoping to do much better to reach the 7% plus target he originally set upon winning office.

His agenda of deregulation and infrastructure investment is certainly on the mark in terms of policy focus - there’s no doubt these are among the most pressing issues. Much will depend of course on successful implementation. So far there appears to be good progress on the former while progress on the latter may be improving.

This gives some hope. But even if Jokowi is very successful in this agenda, the economy may quickly run into another constraint – its current account (balance of trade and other income) and fiscal deficits. These ‘twin deficits’ played a key role in the growth deceleration that started a few years ago and have so far only been partially unwound.

The fiscal deficit is now the problem

The current account deficit (CAD) has fallen from a peak of 3.2% of GDP in 2013 to just under 2% today. A common rule of thumb is that Indonesia needs to keep the CAD below 3% of GDP to avoid instability risks, so there is now some head room but not a lot. Meanwhile the fiscal deficit has become even bigger and is now virtually at the legal limit (3% of GDP), expected to come in at 2.6% of GDP this year. 

The two deficits are of course interrelated. Many blame the still large CAD on supply side problems limiting the response of manufacturing exports to a more competitive exchange rate. That’s certainly part of the story. However, the fiscal deficit seems to be the bigger culprit.

To see why, recall that a current account deficit implies that national savings are insufficient to finance total investment, with the difference made up by tapping foreign savings. A fiscal deficit means the government is a negative source of net savings in this equation.

The chart below shows how Indonesia’s CAD has evolved, including how different sectors have contributed. The sectoral breakdown for 2016 is not yet available so I have just shown the overall CAD and the government contribution as these are readily available. The relative contributions from corporates and households in 2016 probably did not change much in any case.

As the chart shows, a large deficit emerged in 2012 following the end of the commodity price boom in late 2011. At first the deficit was driven primarily by the corporate sector, as ultra-easy global liquidity conditions allowed Indonesian firms to binge on external debt. Government net savings also worsened as lower commodity prices weighed on resource-based public revenue.

Markets were willing to finance the CAD for a while. But Indonesia’s inability to sustainably finance a large CAD quickly reasserted itself with the ‘taper tantrum’ that began in May 2013. Indonesia managed the adjustment quite well (through tighter monetary policy and allowing the exchange rate to fall) but this was of course achieved through slower growth.

Importantly, the entire adjustment was borne by the corporate sector while the government fiscal position continued to worsen. Recent reforms to cut energy subsidies have only contained, rather than curtailed, the fiscal deficit.

Source: Indonesia Central Statistics Agency

No easy ways around stability-growth trade-off

Thus, Indonesia has basically stuck to the confines of the well-worn trade-off between maintaining stability and pursuing faster growth. If markets have been assuaged, it largely reflects the continued adherence by Indonesian policymakers, particularly the central bank, to a paradigm which prioritises stability over growth. Much has changed, but memories of the Asian Financial Crisis still loom in the background for policymakers and markets alike.

So what does this mean for Jokowi’s hopes of using deregulation and infrastructure to spur much faster growth? In a nutshell, it would likely see the CAD quickly returning to the warning territory of 3% of GDP. Unless, there is deep fiscal reform and in particular tax reform to significantly raise public saving.

Consider Jokowi’s infrastructure agenda. The World Bank estimates this will involve an increase in public spending of about 2.6% of GDP a year. But government ambitions are much higher. Recognising its limited fiscal resources, even more is to be financed via capital raisings by state-owned enterprises and public private partnerships.

This ostensibly gets around the budget constraint but it does nothing about the CAD constraint. Regardless of the funding source, the increase in investment will directly add to the gap between national investment and savings, and thus the CAD. To prevent a rise into danger territory, or alternatively a significant crowding-out of private investment, national savings need to rise.

The same logic means that thoughts of relaxing the legal budget deficit limit to allow more growth enhancing investment (sometimes suggested since public debt levels are quite low) will also not work.

Increasing government saving through fiscal reform is thus the obvious solution. Cutting poor quality spending like energy subsidies is a useful starting point which government is pursuing. But there is simply not enough there to provide the level of funding needed. Especially once the need to increase funding for other growth priorities like education is added to the mix.

Increasing Indonesia’s low tax take will thus need to be a big part of the solution. Currently it sits at a mere 11% of GDP. It should be several percentage points higher. There is plenty of scope through both policy changes and better enforcement. Unfortunately, reform in this area is progressing slowly, undoubtedly due to the politics involved.

What about higher private net savings? If anything, this would likely deteriorate in the event of a marked growth acceleration. Faster growth would increase the return on investment, encouraging higher investment, and higher expected future incomes would reduce the imperative to save. This same dynamic would likely hold if the growth acceleration was primarily driven by successful deregulatory reforms.

Accelerating the development of the financial sector could help mobilise higher private savings, but takes time to bear fruit, especially without sparking instability risks of its own.

All this means that even deeper fiscal reform would be needed if the CAD were to be contained while creating room for a private sector response to any significant growth acceleration.

Risk it?

Perhaps Indonesia doesn’t need to worry so much about the current account? For instance, greater reliance on foreign direct investment (FDI), rather than more volatile ‘hot money’ portfolio flows, could provide much more stable CAD financing. Deregulation and better infrastructure should help attract more FDI, though the liberalisation of FDI restrictions themselves has been limited so far. Still, a large CAD would require large portfolio inflows, with their attendant risks.

Markets might be more lenient towards Indonesia in the future. It has built up some policy credibility and a reform-driven widening of the CAD would be interpreted more positively. Global liquidity conditions are also still very accommodative.

But the problem with a large CAD is not that it cannot be financed at all. Rather, it’s that sudden changes in market sentiment are common and tend to have destabilising effects. A large CAD leaves the economy exposed. For instance, uncertainties about the path of future monetary tightening by major central banks means the prospects of a re-run of the ‘taper tantrum’ is a real risk.

As long as stability is prized over growth, twin deficits it would seem are still a binding constraint.

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