external debt and monetary policy

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EXTERNAL DEBT AND MONETARY POLICY by KEVIN DAVIS* The growth of Australia’s external debt during the 1980s is only one feature of more widespread changes in the financing arrangements of the economy. Changes in the relative use of debt and equity instruments (in favour of the former) have been often noted. The roles of various inter- mediaries, and of intermediaries generally vis-2-vis direct financing, have been shifting, while a quite rapid expansion in the number of foreign owned financial intermediaries has taken place. To those changes we may add increased inter-sectoral imbalances between income and spending (the net Public Sector Borrowing Requirement and the balance of payments current account reflecting these) and greatly increased access to debt financing for households (e.g. by use of credit cards). The conduct of monetary policy has also changed. The use of monetary targets as intermediate objectives was dropped in 1985 in favour of the “checklist” approach. Direct control mechanisms have been abandoned in favour of open market operations. Interest rates generally have become more flexible, making “price” rather than “rationing” effects the most likely conduit for the transmission of policy. The objective of this paper is to take one aspect of those developments, the growth of Australia’s external debt, and to examine its implications for monetary policy. Quite clearly though, given that catalogue of changes, the paper is not a comprehensive evaluation of monetary policy in our new financial environment. Australia’s Debt Experience The growth in Australia’s external debt during the 1980s is well known. As Table 1 shows, the gross debt has grown from $13.6bn at June 1980 to $92.lbn by June 1986, over 75% of which was denominated in foreign currencies. Net external debt grew only slightly less than the gross figure, to a June 1986 total of $73bn. The causes of this growth in net debt are perhaps less well understood. Generally, Australia’s deficit on the current account of the balance of payments is recognised as a contributor, but the elasticity of the link between it and the change in net debt is not generally appreciated. As Table 2 illustrates, increases in the net external debt far outstripped the large current account deficit in 1984185and 1985186 in contrast to the preceding years. * Professor of Finance, Department of Accounting and Business Law, The University of Melbourne. 7

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Page 1: EXTERNAL DEBT AND MONETARY POLICY

EXTERNAL DEBT AND MONETARY POLICY

by KEVIN DAVIS*

The growth of Australia’s external debt during the 1980s is only one feature of more widespread changes in the financing arrangements of the economy. Changes in the relative use of debt and equity instruments (in favour of the former) have been often noted. The roles of various inter- mediaries, and of intermediaries generally vis-2-vis direct financing, have been shifting, while a quite rapid expansion in the number of foreign owned financial intermediaries has taken place. To those changes we may add increased inter-sectoral imbalances between income and spending (the net Public Sector Borrowing Requirement and the balance of payments current account reflecting these) and greatly increased access to debt financing for households (e.g. by use of credit cards).

The conduct of monetary policy has also changed. The use of monetary targets as intermediate objectives was dropped in 1985 in favour of the “checklist” approach. Direct control mechanisms have been abandoned in favour of open market operations. Interest rates generally have become more flexible, making “price” rather than “rationing” effects the most likely conduit for the transmission of policy.

The objective of this paper is to take one aspect of those developments, the growth of Australia’s external debt, and to examine its implications for monetary policy. Quite clearly though, given that catalogue of changes, the paper is not a comprehensive evaluation of monetary policy in our new financial environment.

Australia’s Debt Experience The growth in Australia’s external debt during the 1980s is well known.

As Table 1 shows, the gross debt has grown from $13.6bn at June 1980 to $92.lbn by June 1986, over 75% of which was denominated in foreign currencies. Net external debt grew only slightly less than the gross figure, to a June 1986 total of $73bn.

The causes of this growth in net debt are perhaps less well understood. Generally, Australia’s deficit on the current account of the balance of payments is recognised as a contributor, but the elasticity of the link between it and the change in net debt is not generally appreciated. As Table 2 illustrates, increases in the net external debt far outstripped the large current account deficit in 1984185 and 1985186 in contrast to the preceding years.

* Professor of Finance, Department of Accounting and Business Law, The University of Melbourne.

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TABLE 1 AUSTRALIA'S EXTERNAL DEBT

At Iune Gross Debt $bn

Net Debt $bn

1980 1981 1982 1983 1984 1985 1986

13.6 15.3 24.3 35.7 44.1 68.5 92.1

6 .9 8 .5

16.4 23.1 29.5 51.2 73.0

Source: Reserve Bank, Bulletin, April 1987. n b l e K10.

TABLE 2 DEBT GROWTH AND THE CURRENT ACCOUNT DEFICIT

Year ending lune

Change in Current Account Net Debt Deficit

$bn $bn

1981 1.6 5.6 1982 7.9 9.1 1983 6.7 6 .8 1984 6.4 7.3 1985 21.7 11.0 1986 21.8 13.8

Source: Reserve Bank, Bulletin. December 1986, Table K1; April 1987, Table K10.

One cause of that difference can be found in the valuation effect of changes in the exchange rate upon the $A value of outstanding external debt denominated in foreign currencies. (See Dixon and McDonald, 1986, for a calculation of this and other causes of the difference.) Another is that net debt represents only one of several forms which net external liabilities could take. Portfolio changes between debt and equity could, for example, lead to a change in net debt independently of the size of the current account deficit. In this respect it is worth noting that Australian holdings of overseas equities increased in 1985186 by $8.9bn: although some, perhaps a large, part of this reflects valuation effects.

The increase in external debt outlines in the preceding two tables is just one aspect of a marked increase in overall debt levels in the economy. Gross private sector debt increased from $87.lbn in June 1980 to $208.7bn in June 1986, and public sector debt from $51.0bn to $112.6bn over the same period. The increase in gross private sector debt needs to be placed in perspective

1. See Reserve Bank, Bulletin, April 1987, Table K 9 .

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since much of it is held by the private sector itself, either directly or indirectly via financial intermediaries. For example, broad money, which would appear on the other (asset) side of the private sector’s balance sheet, increased from $77.9bn to $169.3bn over the six years referred to above. Figures on net private sector debt are not readily available, but my rough calculations suggest a much more modest increase.

Since the focus of this paper is upon external debt and monetary policy, the links between these various debt measures will not be pursued here. Nor will the important question of the relevance of credit (debt) aggregates vis-a-vis monetary aggregates as indicators of the impact of monetary policy. Instead, we focus upon the meaning of the external debt statistics before considering their implications for monetary policy.

Interpreting Australia’s External Debt Position

position needs to include clear answers to the following questions: (a) Who is liable for the debt? (b) What is the overall balance sheet position of the debtor? (c) What are the risks associated with the debt position? (d) What are the implications of current and projected income-outlay flows

My concern is that many discussions about Australia’s debt “crisis” have not even addressed the first two of these questions. In what follows we consider questions (a) and (b) directly and (c) and (d) indirectly in our subsequent discussion of monetary policy.

Any rational assessment of statistics purporting to represent a debt

for the future debt position?

[aJ Who is Liable? Suppose a US company established a wholly-owned subsidiary in

Australia. The subsidiary borrowed on world capital markets a sum which it used to purchase property in Australia, or perhaps even gave away as gifts to Australian citizens. Should that debt be regarded as a burden upon the Australian government or Australian citizens? Surely not, but the debt will be counted as part of the official statistics on Australia’s external debt. This hypothetical company is treated as an Australian resident, even though its owners are foreigners.

It would be inappropriate to suggest that transactions such as the preceding example explain all or even most of the rapid growth in Australia’s external debt. Nevertheless, the message should be clear. When foreign companies establish in Australia and borrow from overseas to finance their operations, Australia’s recorded external debt can be expected to increase. In this respect it is perhaps worth noting that the sector showing the largest growth in foreign debt in recent years was that of “finance, property, etc.”, from a June 1984 figure of $9bn to $35bn by September 1986. Some part of that presumably reflects the establishment and consolidation of foreign- owned financial institutions (rather than on-lending to other Australian

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residents) and should not be thought of as a debt of the Australian people.2 More generally, should foreign debt incurred by foreign-owned multinationals operating in Australia be thought of as Australia’s external debt? To put the question in a different way, do external debt statistics including foreign debt of multinationals operating in Australia have any economic significance?

The answer is, as always I suspect, that it depends. Those private financing decisions might ultimately spell ruin for those making the decisions, and they may have consequences for Australian employment, prices, exchange rates, etc. But those consequences cannot be judged solely by looking at the size of the debt mountain. It is necessary to consider the problem in more detail.

[b) The Overall Balance Sheet Those concerned about the size of Australia’s external debt might dismiss

the preceding argument by pointing to the mechanism whereby debt growth occurs. By definition, net debt increases when outlays exceed income so that Australia’s external debt growth has been mirrored by a string of deficits on the current account of the balance of payment^.^ The suspicion must exist that the current generation of Australians has been mortgaging the future, running down Australia’s net worth by overconsumption. Has that happened?

Australia’s external debt needs to be placed in perspective as only one part of a national balance sheet. On the asset side of that balance sheet would be the market value of Australian real estate, the capital stock, and possibly government debt (which we shall ignore). National income accounting conventions do not record increases in the real value of existing assets as income. Yet, in an open economy where real estate and corporate equities (reflecting partially the value of the capital stock) are priced by world-wide forces of supply and demand, and can be sold to foreigners, increases in the market value of those assets enable their holders to increase consumption above other income without reducing their net worth. Current account deficits do not necessarily mean that Australia’s net wealth is declining.

In the current context it is worth pointing out that over the period from June 1984 to June 1986, when Australia’s net external debt increased from $29.5bn to $72.0bn, the market capitalisation of listed equities increased

Explanations of the growth of multinational banking typically emphasise servicing of multinational trading companies, so that on-lending to “residents” may be concentrated upon “multinational residents“. making the equation of that debt with a debt of the Australian people inappropriate. The mirror image is not precise. Foreign investment in equities is not reflected and changes in the $A value of outstanding debt due to exchange rate variations are not reflected in the current account figures.

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from $60bn to $130bn.4 The difference, a component of Australia’s net wealth, effectively doubled to $70bn. Even if converted into foreign currencies, an increase occurred.

This is not the place to examine in more detail what has happened to Australia’s net wealth (see Piggott 1987 for comprehensive estimates). The point made here is that examining one component of a balance sheet in isolation cannot be expected to provide much useful information. At current market values the net wealth position of Australia would not appear to have deteriorated, as a focus upon the external debt alone might suggest. However, given the volatility of asset prices, the higher debt level may involve a higher degree of risk. A collapse in stockmarket prices would significantly reduce the “net wealth’ of Australian residents, but to the extent that private sector entities have taken a decision to adopt such a riskier portfolio position it is not clear that it is a matter for government concern. That I think is an uncontroversial position if, for example, we consider a foreign-owned Australian resident company which has borrowed overseas to invest in the Australian stockmarket and which has no other activities within Australia. But in other circumstances it may matter. One is where the portfolio decisions taken reflect anomalies arising from the differences between the Australian and overseas tax systems which give an incentive to incurring debt (versus equity financing) from overseas. With the myriad of recent changes to Australia’s tax laws that issue is too complicated to consider here.5 The other circumstance in which the accretion of private external debt may be of social concern is when private decisions do not reflect adequately the social costs and benefits of those decisions. This may occur if the aggregate of Australian debt is an indicator watched and used by international markets and if individual borrowers take no account of the effect of their borrowings upon the aggregate.

In the following section we initially turn to the question of how the existence of a stock of external debt might affect domestic monetary policy. This is followed by an analysis of how monetary policy might be influenced by the implied change in external debt arising from a current account deficit.

External Debt and Monetary Policy In discussing the impact of Australia’s external debt on monetary policy

it is useful to start with an equation linking domestic and international interest rates.

(1) id = if + FP

4. Some of those equities are held by foreigners but, as argued above, part of the net external debt is attributable to foreign-owned multinationals.

5. It should also be noted that the removal of exchange control regulations when the $A was floated could have influenced the desired size and nature of Australian residents’ obligations to the rest of the world. as indeed might the switch from a pegged to a floating exchange rate regime.

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In this equation,6 known as the Covered Interest Parity condition, id is the domestic interest rate, if is “the” world interest rate and FP is the forward premium on foreign currency. Where forward cover for international transactions is available this relationship can be expected to hold because of the existence otherwise of arbitrage possibilities for riskless profits.

An immediate question which arises is that of whether the growth in Australia’s external debt has altered the nature of equation (1). Table 3 suggests that possibility, since the interest differential has grown con- temporaneously with the size of the debt.’

TABLE 3 INTEREST RATE DIFFERENTIALS AND EXTERNAL DEBT

At lune Debt@) $ bn

1981 - 1.4 8.9 1982 3.0 16.8 1983 3.1 23.0 1984 1.4 29.3 1985 7.0 51.4 1986 6.2 70.2

(a) Australian 3-month Treasury note yield minus US 3-month Treasury bill yield. (b) Australia’s net external debt. Source: Reserve Bank, Bulletin, various issues.

Other factors can, of course, be advanced to explain that growth in Australian interest rates vis-3-vis world rates. The most obvious is the difference in our inflation experience and expectations of its persistence. Where exchange rate expectations are based upon the notion of purchasing power parity, the forward premium on foreign currency will reflect the differential in expected inflation rates, as will nominal interest rates. But for that hypothesis to provide the whole explanation, real interest rates must be equal internationally and that does not appear to be the case. Some part of Australia’s recent high interest rate experience appears to reflect a relative increase in its real interest rate, at least when current inflation rates are used as proxies for expected rates.

Of course, current inflation is not necessarily the best predictor of future inflation and an alternative explanation for the movements in the interest rate differential could look to movements in other variables which might herald future inflation. Here the high growth rate of Australia’s monetary aggregates around 1985 could have a role to play-although to forecast inflation on that basis would seem to involve an irrational disregard for the

6. This is an approximation to the true relationship (given in equation 3 later in the paper). 7. In examining Table 3 it should be remembered that exchange control arrangements

prevented the interest rate parity condition (1) from operating precisely prior to the floating of the dollar in December 1983.

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reintermediation then taking place. Alternatively, the growth in the net Public Sector Borrowing Requirement post-1982 could have been interpreted as putting pressure on resources and prompting inflation. In my view, that hypothesis is unproven but, more generally, it is not clear that the deficit spending of the Australian public sector has increased vis-5-vis that of the US-which is the condition which would be necessary to explain the relative interest rate movement.

Public sector deficit spending could have contributed in another way, for there is a view that such deficits find reflection in the external accounts. Drawing upon the well-known national income identity

(2) the “twin deficits” view associates increases in (G-T) with increases in the external deficit (M - X).B In this view the succession of positive net PSBRs has been a major contributor to the growth of external debt and thus indirectly a cause of any changes in the interest rate differential attributable to the size of external debt.g

How might the size of the external debt affect the interest rate differential (or equivalently the forward premium)? Two mechanisms appear possible, one involving exchange rate expectations and the second the risk premium required by international capital markets to hold Australian dollar assets.

If we temporarily ignore the possibility of a risk premium on $A assets, the forward premium can be equated with the expected depreciation of the $A. Herein lies one mechanism for the external debt to have an influence. The larger the debt the greater is the implied interest bill for future years and thus the higher the surplus on the goods and services balance necessary to meet those obligations in an equilibrium where debt has ceased to grow. An improved level of competitiveness is thus necessary and achievable via a depreciated $A. That conclusion is, though, one about the equilibrium value for the exchange rate and does not explain the path followed to the equilibrium and thus the expected rate of depreciation. Nevertheless, the path followed by the debt ratio to an equilibrium could be accompanied by an (expected) depreciating value of the $A to a new equilibrium value. Alternatively, the monetary authorities may endeavour to prevent an instantaneous depreciation to the new equilibrium by tightening monetary policy and raising domestic yields above those overseas. By either of these effects, the emergence of a previously unnoticed debt problem would increase the interest rate compatible with any current exchange rate.

(S - I) + (M - X) = (G - T)

~

8. In using equation 2 it is important to be consistent in the terminology employed. On a national accounts basis M - X is the goods and services deficit (i.e. excluding transfers of interest) so that G - T cannot be equated exactly with the NPSBR which includes interest payments.

9. It is worth noting that adherents to the twin deficits view should find difficulty in simultaneously claiming that government deficits “crowd out” private investment. As equation 2 indicates, if the external account moves in line with movements in the government deficit no change in S - I is implied.

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The preceding analysis of the effect of external debt upon the exchange rate hinged upon the changing net wealth of the Australian economy. It did not, for example, matter whether Australian residents accumulated debt denominated in $A ‘or other currencies. The changing net wealth position, though, could be expected to affect the demands for particular assets denominated in different currencies and thus the equilibrium exchange rate.

An alternative possibility can be seen from recognising that $A and foreign currency assets may not be regarded as perfect substitutes. If, for example, the international financial community demands a risk premium for holding $A assets, the covered interest parity conditions (equation 1) no longer equates the interest differential to expected exchange rate changes. Instead, the differential reflects the risk premium on $A assets as well. Even though Australia’s external debt is primarily foreign currency denominated, recognition of the size of the debt may have created a perception of riskiness surrounding investment in $A assets. One such effect would be through the downgrading of Australia’s international credit rating. Even with no change in exchange rate expectations, this would cause an increase in, for example, Australian 3-month Treasury note yields vis-A-vis US 3-month Treasury bill yields. That specific channel is only one (possibly small) part of the overall effect of an increased perception of risk associated with investment in $A assets.

It is beyond the scope of this paper to discover which of the preceding hypotheses (or perhaps of others) best explains the current interest rate premium on $A assets. And in any event, it is ultimately the authorities, through their choice of policy, who determine that premium. By, for example, easing financial conditions, the authorities can allow interest rates to be lowered, the exchange rate to depreciate and, unless longer run exchange rate expectations are adversely affected, the interest rate premium to be reduced. The questions which thus need to be addressed are why and how particular combinations of interest rates and exchange rates enter the monetary authorities’ “checklist”, the relevance of the external debt situation to this, and the options open to the authorities to influence interest rates and exchange rates.

External Concerns and the Conduct of Monetary Policy Recent discussion of Australian monetary policy has been dominated by

the perceived target zones which the market believes the authorities have set for the $A and the need for monetary policy to adapt to that requirement. Interest rates were held high to prevent excessive depreciation of the $A and the consequent threat to wages policy while the J curve took effect to correct a current account deficit in large part due to the worsened terms of trade. Some two years after the J curve effect was first brought to prominence as underpinning the Government’s economic strategy such an effect is occurring, although the slowdown in Australia’s economic growth has undoubtedly also contributed to the current account improvement. Within a year the $A has appreciated by almost 20% against the $US and

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by over 10% on a trade-weighted basis. Consistent with the view that the authorities have an aversion to too much appreciation (and consequent negation of previous gains in competitiveness), interest rates have been. allowed to subside somewhat.

Tho obvious questions arise from these events. First, how should the exchange rate enter into the “checklist” of indicators with reference to which monetary policy is conducted? Second, where policy has the objective of influencing the exchange rate, how is that influence best exerted? Should the float be kept “clean” or should direct intervention in the foreign exchange market be a policy instrument?

Taking the first of these questions first, unexpected movements in the exchange rate provide information that some type of economic disturbance is occurring. But for that information to be of use to policymakers, it is necessary to be able to ascertain what type of disturbance it is, and what, if any, policy reaction is necessary. In the exchange rate arena, perhaps the most critical of these disturbances is that relating to changes in the expected future exchange rate. This is best seen by rewriting the interest parity condition (equation 1) in its exact form as

or rearranging to give id = -1 + (I + if] fls (4)

where id is the domestic interest rate if is the foreign interest rate s is the spot exchange rate (the domestic currency price of a unit

of foreign currency, so that an increase in s is a depreciation of the domestic currency)

f is the forward exchange rate.

Equation (3) indicates that for a given value of the foreign interest rate (if] and a given forward exchange rate (f) which we will for convenience equate with the expected forward rate, an inverse relationship exists between id and s. The authorities can increase interest rates at the expense of appreciating the exchange rate. But an increase in f shifts the trade-off between id and s to the right, confronting the authorities with a choice between allowing id to increase with s constant, s to increase with id constant, or some combination thereof. Recent Australian experience suggests two clear examples of such shifts, the first in February 1985 and the second in mid-1986. Since then, the trade-off has shifted back more gradually, as evidenced by the decline of interest rates and appreciation of the exchange rate during most of 1986187.

Should the authorities endeavour to influence the exchange rate by adjusting interest rates? That, I think, depends on whether it can be argued

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that the market has inappropriate expectations of the forward exchange rate, which will ultimately be reversed but which would impart temporary undesirable movements in the spot exchange rate in.the absence of offsetting policy actions. My personal view is that the authorities are better able to assess the appropriate forward exchange rate when, for example, a large change in the terms of trade occurs or general recognition arises of the servicing implications of a growing stock of foreign debt. Estimating the quantitative impact of such events on the long-run real exchange rate is a complex problem involving the devotion of significant resources to its solution. Where the authorities believe the market “has it wrong”, it is far from clear that they should allow the spot exchange rate to carry the full burden of adjustment, rather than varying interest rates. The relative social costs of temporary fluctuations in each is the criterion which should underpin the policy reaction.

If we accept that monitoring, reacting to, and influencing the spot exchange rate is acceptable behaviour on the part of the authorities, the question remains of how they can best achieve their objectives. Is direct intervention in the spot market appropriate? Here three comments need to be made.

First, there is in practice no such thing as a “clean float” when the monetary authorities act as banker for a government which engages in overseas (foreign currency) transactions. Decisions must be made about the timing of overseas borrowings, timing of expenditures, whether to fund such expenditures out of foreign exchange reserves or buy the foreign currency in the market, and so on. The appropriate discretion allowed to the authorities in making these decisions enables them to exert an influence over the exchange rate by these means.

Second, it might be argued that the authorities really are no better at forecasting exchange rates than the market, so that intervention ultimately serves no useful purpose. The standard response to this is that market outcomes provide a simple test. If Reserve Bank intervention is based on superior information and succeeds in stabilising the exchange rate, that activity will be rewarded by the profits accruing from buying cheap and selling dear. Judging by recent experience of Reserve Bank profitability, it might be thus argued that intervention has been stabilising. Unfortunately, the argument is not that simple, since Reserve Bank control over the $A money supply, which in turn influences the exchange rate, enables it to move the odds in its favour. An irresponsible central bank, for example, could resist upward pressures on its currency by selling it on the foreign exchange market and then, by unexpectedly accelerating monetary growth, push the exchange rate down to ensure a gain on its foreign exchange dealings.

The third and final comment which needs to be made concerns the effect of foreign exchange market intervention on the exchange rate. Evidence overseas generally points to the result that sterilised intervention, in which the money supply effects of intervention are offset by domestic open market

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operations, has little effect on exchange rates!O Unsterilised intervention, though, appears to have significant effects. The inefficacy of sterilised intervention hinges upon domestic and foreign securities being perfect substitutes so that such intervention is effectively a substitution of foreign securities for domestic securities for which they are perfect substitutes. Whether that is applicable to Australia is an open question, and it would be inappropriate, at this stage, to rule out intervention as a separate policy instrument to open market operations.

As these comments suggest, I am not averse to the current policy strategy of monitoring exchange rules as part of the “checklist” and intervening or altering interest rates to achieve an exchange rate regarded by the authorities as more appropriate for the fundamentals. Particularly over recent years, with large movements in the terms of trade and the emergence of the external debt servicing requirement, the ability of market participants to reach a fully informed judgment on the appropriate future exchange rate must be questioned. The resources and expertise of the authorities directed to this task would appear to give them an advantage.

That support in principle does not, however, imply that the actual strategy followed has necessarily been the correct one. Quite high interest rates were necessary to support the $A during 1986 and these may have impeded the restructuring of industry necessary to respond to the lower exchange rate.” It is an open question as to whether the costs of such high interest rates justified whatever gains on the exchange rate occurred.

REFERENCES Dixon, P.B. and McDonald, D. (1986). “Australia’s Foreign Debt 1975 to 1985”. Australian

Humpage, Owen F. (1986), “Exchange-Market Intervention: The Channels of Influence”,

Piggott, John (1987). “The Nation’s Private Wealth-Some New Calculations for Australia”.

Economic Papers, 2.

Economic Review, Federal Reserve Bank of Cleveland, Quarter 3.

The Economic Record, March.

10. See Humpage (1986) for a recent review of this evidence. Humpage suggests that sterilised intervention may affect the exchange rate by affecting risk premium, or by affecting the flow of information to the market, but does not find the evidence to be strong. Weber is much more assertive that no lasting effects occur.

11. Standard competitiveness indices are based upon marginal cost considerations. Potential new entrants into the traded goods area must also consider the interest costs in putting in place capital goods necessary to enter the area. High interest rates may thus offset apparent competitiveness advantages.

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