External Stability Objectives
Expert reviewed • 14 August 2024 • 10 minute read
What is External Stability?
External stability is a crucial objective of economic policy, referring to the ability of a country to meet its international financial obligations and maintain sustainable economic relationships with other countries. Achieving external stability involves managing the balance of payments, maintaining a stable exchange rate, and ensuring manageable levels of foreign debt. Before exploring this chapter on Australia's external stability objectives, read the chapter on Australia's External Stability. That chapter will cover the components of Australia's external stability you will need to understand. Additionally, reading the chapter on Australia’s Balance of Payments will also help your understanding of this chapter.
What is the Importance of External Stability?
Maintaining external stability is important for several reasons:
- Stable external conditions promote economic growth by encouraging foreign investment and trade. By promoting a stable platform for growth, it enhances international investor confidence in the economy. This, in turn, supports long-term economic growth by ensuring access to global markets and capital.
- Maintaining external stability helps stabilise an economy's exchange rate, facilitating international trade and investment. This, in turn, aids in maintaining a low and stable inflation rate, by preventing excessive fluctuations in the exchange rate.
- By maintaining external stability, an economy reduces its vulnerability to external economic shocks and financial crises.
What are the Challenges in Achieving External Stability?
Several factors can threaten a country's external stability:
- Australia's reliance on commodity exports makes it vulnerable to price swings. For example, Iron ore prices have fluctuated from 100/tonne in November 2023. As a result, it is hard to achieve external stability, as fluctuations in prices and exchange rates make it hard for Australia to maintain a beneficial terms of trade rate.
- External stability can be influenced by global economic conditions, such as changes in commodity prices, global financial crises, and trade policies of major economies. Events like the COVID-19 pandemic can dramatically impact trade and capital flows. For example, during the COVID-19 pandemic, Australia's exports of services fell by 44.5% in 2020 due to travel restrictions.
- Fluctuations in the exchange rate can impact trade competitiveness and foreign debt servicing costs. A significant depreciation of the Australian dollar can increase the cost of servicing foreign debt and make imports more expensive, worsening the current account balance. Australia in recent times has had a relatively unstable exchange rate, with the AUD/USD exchange rate ranging from 0.57 to 0.76 between 2020 and 2023.
- High levels of foreign debt can pose risks to external stability, particularly if the debt is short-term and subject to rollover risk. Australia's net foreign debt has increased over the years, reaching around 50% of GDP in 2023. Managing this debt is crucial for maintaining external stability.
What Policies are Used to Maintain External Stability?
Australian policymakers employ various strategies to achieve and maintain external stability:
Exchange Rate Policies
Australia maintains a floating exchange rate, allowing market forces to determine its value. However, managing the exchange rate can help stabilise the balance of payments and control inflation. As such, the Reserve Bank of Australia (RBA) monitors the exchange rate and intervenes in the foreign exchange market when necessary to prevent excessive volatility.
Foreign Reserve Management
In addition to implementing exchange rate policies, the RBA also maintains adequate foreign exchange reserves to manage external shocks. This involves maintaining stable foreign exchange reserves, around USD 60-65 billion in recent years, to manage external shocks, ensure liquidity, and stabilise the Australian dollar. The RBA diversifies these reserves across various currencies and invests in highly liquid, low-risk assets to ensure availability during economic disruptions. While generally allowing market-determined exchange rates, the RBA only intervenes when necessary to smooth excessive volatility.
Trade Policy
Australia employs trade policies to promote export diversification and maintain open trade. This includes negotiating and implementing free trade agreements (FTAs) to expand market access for Australian goods and services. A notable example is the AUKUS partnership, which enhances economic ties and trade opportunities between Australia, the UK, and the US. By fostering diverse export markets and reducing trade barriers, these policies aim to bolster Australia's external stability.
Fiscal and Monetary Policy Coordination
Australia maintains stable domestic policies to support external stability through coordinated fiscal and monetary strategies. The Reserve Bank of Australia's (RBA) inflation targeting framework, aimed at keeping inflation within a specified range, indirectly supports exchange rate stability. By ensuring low and stable inflation, these policies help create a predictable economic environment, fostering investor confidence and mitigating external vulnerabilities.