Earlier in the year, the UK announced a referendum, asking whether the UK should remain or leave the EU. When initially proposed, arguments concerning the UK’s trade relations with the EU and the global economy arose as exiting the EU would be to remove themselves from a large trading bloc. On 23 June, the UK chose to leave. Since then, the pound has depreciated to 31 year lows and uncertainty surrounds how the UK will exit. Speculation of a ‘hard exit’ is permeating the market, causing significant fluctuations. Theresa May, the British PM, has indicated that the exit would begin in March 2017.
How does this relate to the HSC syllabus?
- The UK is a part of the EU which is a trading bloc. This means that the UK benefitted from the multilateral free trade agreement between the EU members which have lowered their trade barriers (HSC Topic 1 – The Global Economy). Exiting the EU means that the UK no longer benefits from the established trade agreements between EU members and would need to renegotiate its trade agreements.
- Note: Negotiating trade agreements can take a long time since members try to come to a compromise that benefits their economy most. For example, Australian and China’s free trade agreement took 10 years (negotiations started by the Howard government in 2005 and signed by the Abbot government in 2015). Multilateral agreements tend to take longer than bilateral trade agreements.
- Without a free trade agreement in place, the UK will face higher import and export costs in the form of tariffs and other protectionist policies (HSC Topic 1 – The Global Economy). The UK has a current account deficit with the EU totalling 6.5% of GDP. Assuming that protectionist policies apply to both the EU and UK, a Brexit is expected to improve the goods deficit (since the UK is a net importer of goods and will be deterred from buying more expensive goods) and deteriorate the services surplus (since the UK is a net exporter of services) in the short term (HSC Topic 1 – The Global Economy).
- Lowered trade barriers between the UK and other EU members has been particularly important to the UK. The UK is a financial hub (41% of the world’s foreign exchange and 49% of the world’s derivative trading takes place in the UK) since any financial service company based in the UK is allowed to operate across the EU through passporting. Without membership in the EU passporting may no longer be possible since trade barriers will be re-erected. The prospect of limited passporting has become more likely since given the discussion of a ‘hard exit’ which entails strictly eliminating most benefits from being in the trading bloc. There have been predictions that approximately a third of financial services companies would consider relocating their operations to the EU. Goldman Sachs has evinced an intention to relocate its European base if a ‘hard exit’ eventuates. Given that the financial services sector is a major sector in the UK, this could damage their economic growth prospects (HSC Topic 3- Economic Issues). Since labour is a derived demand, there may be unemployment within this sector which may see skilled employees in financial services emigrate as the banks move to other countries (Preliminary Topic 4 – Labour Markets; HSC Topic 3 – Economic Issues).
- Despite arguments for economic growth slowing as a result of the exit, the IMF has indicated that the UK would be the fastest growing economy out of the G7 this year. Growth is predicted to be 1.8%. This is a result of the confidence the Bank of England has helped maintained in the economy by implementing expansionary policy to help stimulate the economy.
- There has been criticism of trading blocs such as the EU which is premised on the fact that these agreements promote regionalisation rather than globalisation of trade. This is because members of these agreements tend to impose protectionist barriers to non-member economies (HSC Topic 1 – The Global Economy). The UK cites breaking away from the protectionist policies imposed by Brussels (considered the capital of the EU).
- Foreign direct investment into the UK has partially been due to its membership in the EU. This is because the UK has been viewed as a ‘gateway’ to Europe. Some have argued that the potential for foreign direct investment would be stronger with the repeal of the EU’s protectionist policies. However, there is also a strong argument that a Brexit could damage the UK’s foreign direct investment since half of the UK’s current investment comes from the EU. Since companies would have less incentive to invest in the UK, exiting could put an estimate $128 million of EU investment at risk every day. Furthermore, the uncertainty surrounding the UK’s regulatory environment could also deter investment (HSC Topic 1 – The Global Economy).
- Depreciation of the pound (GBP) has been a major implication of the Brexit vote. After Theresa May’s announcement that the formal process for an exit would start in March 2017, the pound has sharply depreciated. This reflects the uncertainty that continues to plague the UK because the details and implications of the exit are unclear (HSC Topic 2 – Australia in the Global Economy). However, it has been argued that the depreciation of the GBP will have positive effects for the economy as exporter experience an increase in international competitiveness (HSC Topic 2 – Australia in the Global Economy).
Monetary policy and negative interest rates
Various economies, such as that of Japan, England and the EU have adopted negative interest rates this year in an effort to stimulate growth which has significantly slowed globally. The use of significantly expansionary policy is also a response to global fears of deflation as a result of low growth and low oil prices throughout the year. Along with the rest of the world, Australia has adopted expansionary monetary policy although the central bank has not resorted to negative rates. Negative interest rates come in addition to other extreme monetary policy decisions such as quantitative easing and the prospect of using ‘helicopter money’ has also been raised.
How does this relate to the HSC syllabus?
Negative interest rates
- Deflation is extremely undesirable.
- First, when people expect falling prices, they become less willing to spend and borrow because holding cash is a positive investment.
- Second, deflation worsens the situation of those who have debt, since they have to pay the same dollar amount in interest, but that money is worth more in real terms. This leads them to spend less.
- Third, there is downward pressure on wages, and due to downward nominal wage rigidity (difficulty in reducing wage rates), this means that employers fire their workforce instead, causing unemployment.
- Decreased interest rates (loosening monetary policy) mean that individuals and businesses can more capital more cheaply to fund investment (Preliminary Topic 2 – Consumers and Business, HSC Topic 4 – Economic Policies and Management). This would therefore increase economic growth (Y = C + I + G + X – M). Despite this theoretical argument, there has been no evidence that growth has increased which means negative interest rates has been ineffective. In fact, growth remains at the lowest level since the GFC.
- Japan’s policy in particular has not been successful. Negative interest rates have reduced consumer spending which has reduced growth.
- Implementation of negative interest rates may not be as effective as believed as it also means that lenders pay for the banks to hold their money which may cause bank runs (everyone quickly withdrawing their money which can cause solvency problems for banks). Another argument against negative interest rates is that the decreasing profit margin for banks (since banks are receiving less revenue for lending) may make banks reluctant to lend.
- Quantitative easing involves the central bank buying government bonds back from the market to further lower interest rates and increase money supply.
- Many economies around the world including the EU, Japan and UK have adopted quantitative easing, which is an unconventional form of monetary policy. By increasing the maturity of the bonds they purchase, the bank can lower the yield curve further into the future. Simply put, this means that long term interest rates will fall which will theoretically stimulate the economy as borrowing becomes significantly cheaper to increase consumption and investment (HSC Topic 3 – Economic Issues; HSC Topic 4 – Economic Policies and Management).
- While quantitative easing was successful in the US and has been a driving factor in its bullish market over the past 7 years, results are yet to be seen in the current implementation of quantitative easing as global growth remains sluggish.
- The ECB has also began buying commercial bonds to continue lowering longer term rates. Government bonds are generally safer (i.e. less likely to default) than corporate bonds. The fact that the ECB is expanding eligibility of bond purchases to corporate bonds reflects the drastic action it is taking to stimulate the economy.
- There has been much talk about ‘helicopter money’ from Japan and the EU. Helicopter money is a direct injection of cash into the households that would increase money supply. It is argued that monetary finance, that is, money created by the central bank, would be effective in stimulating demand which is desirable given the low interest environment the global economy currently operates in. Helicopter money is a form of monetary policy involving the direct transferral of funds to households which has the effect of increasing income. As a result, consumption is expected to increase, which will increase aggregate demand as AD = C + I + G + (X – M). Therefore, economic growth should theoretically increase (HSC Topic 3 - Economic Issues).
- There is been much criticism of helicopter money as it is perceived as highly inflationary. Since money is being created and injected into the economy, the extra money circulating will cause prices to increase, resulting in inflation (HSC Topic 3 – Economic Issues). Since there are limited ways to retrieve this money, the resulting inflation would be more difficult to control.
- Analyses of the effects of helicopter money make simplifying assumptions, including that the economy is at full employment. When this is the case, any additional demand caused by increased money supply would be hugely inflationary as prices in the economy increase as a result of excess demand for goods and services. However, in the current state of the economy, nominal demand is required to drive growth. As a result, if it can be argued that helicopter money would be redundant policy to address the current issues in the economy, quantitative easing and traditional monetary policy can be argued to also be unhelpful. Since low growth is a major concern in the economy at the moment, helicopter money should be an option.
- A major risk in using helicopter money is that the government will become reliant on it as a policy measure. Since helicopter money is not sourced from the budget, but from creation of money by the central bank, it does not involve worsening of the budget balance.
Australian monetary policy
- In light of the wide adoption of negative interest rates, Australia has also lowered its cash rate from 2% at the beginning of the year to 1.5%.
- In May, the RBA cut the cash rate from 2% to 1.75%.
- In the week before the RBA decision, inflation figures were released which indicated deflation within the economy. While deflation was only evident in the headline rate, the more important core inflation figure was below expectation and brought the year on year inflation rate to 1.3%. With inflation significantly under the RBA’s target range of 2% - 3%, the RBA’s cut was expected in the market to stimulate inflation given that one of its goals is to maintain price stability (HSC Topic 4 – Economic Policies and Management). Core inflation is generally viewed as more influential than headline inflation since it removes price sensitive items such as food and fuel from the basket of goods and services so that a more stable and veritable inflation rate is reached.
- The Australian dollar was appreciating over early 2016 to levels that have made its exports uncompetitive (HSC Topic 2 – Australia in the Global Economy). Given that Australia is attempting to transition from the mining boom to the services industry, the high Australian dollar is slowing this change as demand for Australian services decreases as a result of the increasingly uncompetitive prices they are provided at. A decrease in the cash rate has caused a depreciation and is therefore expected to boost growth in exports since investors will be receiving less yield from investing in Australian bonds. Therefore, they would sell AUD, causing supply to increase, and therefore the AUD to depreciate. As a result, on announcement of the cut in the cash rate, the Australia dollar depreciated by approximately 2.6%.
- Another reason for the rate cut was the risk of slowing global economic growth and its potential impact on Australia’s economic growth. Especially noted was China’s growth which has further moderated this year. Given that Australia’s growth is significantly linked to that of China since China is the largest importer of Australian exports, taking into account China’s economic growth is crucial in determining Australia’s economic growth. With China’s growth being relatively weak, a cut in the interest was seen as a requirement to increase output in the economy by increasing access to credit which will enable consumers to borrow more, increase consumption and therefore increase economic growth (HSC Topic 3 – Economic Issues).
- In August, the RBA cut the cash rate from 1.75% to 1.5%.
- The cut in August, similar to the cut in May, came as a result of the release of the Q2 inflation figures. Core inflation, measured year on year, came in at 1.5%, increasing by 0.45% which was above expectation of 0.4%. However, at 1.5%, core inflation remained under the RBA target of 2 – 3% (HSC Topic 3 – Economic Policies).
- Another reason for the cut in the cash rate was to depreciate the Australian dollar which was threatening to go above $US0.80. Given that the rest of the world implemented significantly loosened monetary policy, with near-zero rates, negative rates and quantitative easing, Australia’s previous cash rate of 1.75% was considered relatively high. As a result, investors were moving their investments into Australia to earn a higher return, causing the Australian dollar to appreciate since Australian dollars are required to make investments in Australia. As a result, demand for Australian dollars increased, causing an appreciation in the Australian dollar (HSC Topic 2 – Australia in the Global Economy). Although a depreciation is predicted to occur in theory after a cut in the cash rate, the Australian dollar appreciated by 0.9% in the next day may be an indicator for the fact that Australia’s cash rate, at 1.5%, is still considered relatively high. Note that the Bank of England in the same week announced numerous monetary responses to the Brexit, including a rate cut and increased quantitative easing to increase the pass through of the rate cut to the banks.
- One of the reasons why the RBA was reluctant to cut rates was that the housing market was growing extremely quickly which was increasing price levels as demand for property increased (Preliminary Topic 3 – Markets). Recall that monetary policy is a blunt policy instrument which indiscriminately affects all activity in the economy. With the housing market now experiencing lower growth (although prices are still rising), a cut in the cash rate which will provide consumers access to cheaper credit to buy more property will not accelerate inflation to undesirable levels, further justifying the rate cuts (HSC Topic 3 – Economic Issues).
Global economic growth
Economic growth around the world has been sluggish, with growth being at the lowest levels observed since the GFC.
How does this relate to the HSC syllabus?
- The IMF has called for the G20 to implement a coordinated stimulus plan to boost growth of the slowing global economy. The IMF cut its global growth forecast from 3.6% to 3.4% in 2016 given that the global economy has suffered from instability caused by falling commodity prices and slowing growth from China. Of the most affected by this instability are the emerging markets which have suffered from capital outflows. The stimulus plan is intended to help these emerging markets as investors continue flee these markets and invest in the US.
- The IMF has also encouraged advanced economies to rely less on monetary policy compared to fiscal policy to support growth while emerging markets should float their exchange rates when appropriate.
- The call for economies to be less reliant on monetary policy as a stimulatory policy has been echoed by Glenn Stevens, former RBA governor. Monetary policy has been less effective in stimulating growth and fiscal policy options should be investigated (HSC Topic 4 – Economic Policies and Management).
- The IMF’s encouragement for a global stimulus plan in the face of slowing global growth is reflective of its role to maintain global financial stability (HSC Topic 1 – The Global Economy).
- It is not the IMF’s role to promote economic development in developing economies. However, the proposed stimulus plan is largely intended to support developing economies. This is because the developing economies grow more quickly than advanced economies and contribute most to global economic growth. These economies have been underperforming since their main exports are commodities which have suffered from falling prices as well as capital flight to the US. Without capital inflows, these developing economies will face slowing growth and contribute to the instability already experienced in the global economy.
- Advanced economies have been wary of sustaining fiscal deficits given the external stability issues faced by European countries such as Greece (HSC Topic 3 – Economic Issues). This has seen them rely on monetary policy to encourage economic growth while tightening fiscal policy. It was in response to this trend that the IMF has been calling for more use of fiscal policy to support economic growth.
Low oil prices
The global economy has been plagued by low oil prices throughout the year. Low oil prices have been a major factor in low inflation observed worldwide as oil is a major input to production.
How does this relate to the HSC syllabus?
- Oil prices in 2016 fell as a result of excess supply in the market as oil producers significantly increased production. This supply outstripped faltering demand from the market for oil, causing prices to fall (Preliminary Topic 3 – Markets). Oversupply was a result of a number of factors:
- Iran had gotten its sanction removed. The sanction meant that the world boycotted buying exports from Iran, causing its market share in oil to go down. With the sanction removed, Iran sought to regain its market share by increasing production, causing supply to increase.
- Economies such as Kuwait and Saudi Arabia were trying to maximise their production by expanding their oil fields.
- Talks about an oil production freeze in April failed. An oil production freeze would have limited supply. With supply staying flat, demand for oil throughout the world economy was expected to gradually increase and ‘catch up’ to supply, bringing oil to equilibrium at a higher price (Preliminary Topic 3 – Markets).
- Low oil prices have had significant ramifications upon various economies:
- In the US, low oil prices have contributed to flat inflation and the risk of deflation. Since oil is used in the production of most goods and services, the cost of production has significantly decreased, causing the prices of goods and services to decrease therefore lowering the price level (HSC Topic 3 – Economic Issues). Decreasing price levels, a sign of deflationary pressures is more harmful to the economy than inflationary pressures since monetary policy is better equipped to reduce inflation.
- In emerging economies which produce oil, lower prices have damaged their exports and economic growth. Given that oil prices are lower, revenues from exports are lower, causing the value of exports to decrease in the short term and therefore aggregate demand to decrease. Saudi Arabia, as the second largest oil producer had less to lose from failure of the April OPEC talks since it benefits from economies of scale causing its costs for production of a barrel to remain low. Other OPEC members, such as Venezuela and Algeria, however, have not been able to reduce their costs and are suffering from lower export profits.
- Recently, oil prices have increased again which has buoyed markets around the world. These gains came as a result of Saudi Arabia and Russia, the top two crude oil producers in the world, pledged that they would be willing to cooperate to limit output to stabilise the market. Although no agreement has been reached yet, it is expected that one will be laid out by December and going onto the first quarter of 2017. Prices are expected to rise to $US60 per barrel from lows of under $US30 in February.
Australia’s potential credit rating downgrade
Australia’s credit rating has been put under a negative outlook since July, with S&P’s rating hinging on whether Australia could manage the budget and achieve a fiscal surplus by 2020-21.
How does this relate to the HSC syllabus?
- A credit rating is an evaluation of a party’s credit risk, or ability to pay back loans. Standard & Poor’s rating scale uses AAA to represent an excellent credit rating, followed by AA+, AA and AA-, which represent a ‘high’ credit rating. Australia’s credit rating is AAA (HSC Topic 3 – Economic Issues).
- A credit rating determines the interest rate that governments need to pay on their debt. An economy with a higher credit rating is deemed to be safer and hence they are able to pay a lower interest rate. The potential downgrade of Australia’s credit rating may lead to rising interest costs.
- Australia’s budget has remained in deficit since the global financial crisis, when Kevin Rudd, the prime minister at the time, issued fiscal stimulus to boost economic growth in the economy. The Australian government has since struggled to consolidate the budget back to a fiscal surplus.
- The current account deficit reflects an economy’s external stability, which is an economy’s ability to pay back overseas obligations. S&P has indicated an increased likelihood of downgrading Australia’s credit rating if the current account deficit remains at a higher end of historical range of approximately 3-6 per cent of GDP.
China’s currency issues
China has experienced significant capital outflows over the year as a result of fears that the yuan would experience further depreciation since its sharp fall in January. Individuals anticipating further declines sold yuan for foreign currency, causing further declines. As a result, the People’s Bank of China (PBoC) used its foreign reserves to stabilise the yuan. In August, PBoC announced that it would allow market forces to influence the currency more.
How does this relate to the HSC syllabus?
- A proportion of the sell-off was due to speculators fearing that the yuan would further depreciate. Since holding the yuan would not be profitable as a result of an anticipated depreciation, investors sold the yuan in the market, causing supply to increase and therefore, the yuan to depreciate further (HSC Topic 2 – Australia in the Global Economy).
- It has been argued however, that the majority of the depreciation was not to be attributed to speculation, but to Chinese borrowers paying off their debts. It is believed that 40% of the outflows was due to the repayment of foreign-exchange liabilities. Therefore, the issue may not be as significant as originally perceived.
- To stabilise the currency, PBoC sold significant amounts of foreign currency for their foreign reserves, causing the reserves to fall to $3.19 trillion in May, the lowest level since December 2011 (HSC Topic 2 – Australia in the Global Economy). Sale of foreign currency to buy the yuan increases the demand for the yuan, which causes the price of the yuan to increase.
- Given that China has announced that it would exert less control on the currency, such intervention is unlikely to be observed again. However, it has been argued that China is taking less control of the currency because forces at the moment are pointing to depreciation of the yuan. This means that its exports would be more internationally competitive which would increase its growth from increased exports (AD = C + I + G + (X – M)) (HSC Topic 2 – Australia in the Global Economy; HSC Topic 3 – Economic Issues). However, it was noted that at the time the announcement to loosen control on the currency was made, China’s trade surplus was already at record highs.
- The announcement in August created panic in the market concerning further depreciations, causing investors to sell more yuan which forced the PBoC to intervene once more.
Theresa Dang is an economics mentor at Keystone Education. She attended Sydney Girls High and achieved an ATAR of 99.70 in 2012. She is now studying Commerce and Law at the University of Sydney. She has experience in a global technology firm and a mutual fund.
Gary Liang is the founder and director of Keystone Education. He attended Sydney Boys High and achieved an ATAR of 99.95 in 2012. He achieved 5 state ranks in Mathematics, Mathematics Ext 1, Mathematics Ext 2, Chemistry and Economics. He is now studying Economics and Science (Advanced Mathematics) at the UNSW Australia, where he is the recipient of four scholarships.