External stability essentially refers to the ability of the government to service our net foreign liabilities and the volatility of the exchange rate
Accordingly we have to consider the Net Foreign Liabilities, Current Account and Exchange rate whenever discussing external stability
So our CAD is sometimes seen as a structural issue as it reflects our domestic savings/ investment imbalance. According the twin deficits hypothesis, investment in Australia far exceeds our national savings and as a result we often seek to borrow from overseas to supplement our savings. This further deteriorates our CAD and increases net foreign liabilities deproving our external stability. Yet with
sustained fiscal surpluses and policies such as compulsory superannuation the government effectively increases our national savings ensuring that they do not further contribute to external instability
Also the government as of 06/07 is in a position of negative govt debt (they are sligth lenders atm) this position of strong fiscal consolidation allows them increased flexibility in times of external shocks. Eg with a no govt debt and a strong underlying cash surplus of 1.8% of GDP, the Rudd govt has been able to inject a 10.7 billion fiscal stimulus into the Australian economy to increase spending and buoy eco growth. This means the government does not unnecessarily add to external instability.
Conversely a budget deficit may also have severe consequences on external stability in the “crowding out effect” This is where a government has run consecutive fiscal deficits resulting in a need to borrow from the overnight money market. This increased government borrowing tends to increase market
interest rates. Yet although governments can always pay the market interest rate, corporations and individuals may no longer afford to borrow. Here economists argue that the private sector will turn to borrowing from overseas to fund investment. This will further deteriorate the CAD resulting in external instability and possibly increased likelihood of debt traps, downgrading credit etc.
