USD parity

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Follows is a piece I was asked to write for the AFR on the AUD hitting parity – something that I think is a big medium term challenge for our economy…

Among the biggest challenges facing Australian companies is managing exchange rate risk. In the past two years the dollar has fluctuated in a range from around 61c early last year to near parity today. While the level of month to month volatility has been unprecedented, managers have had to deal with significant volatility since the time the Australian dollar was floated in 1983.

 The cause of exchange rate volatility is exceptional volatility in the supply and demand for Australian dollars. As with goods, the value of a currency depends on supply and demand. If the demand for Australian dollars increases, then its value increases. Too much supply and value decreases. Demand for Australian dollars arises from two sources. Firstly, foreigners demand Australian dollars to buy our exports. A chinese buyer of our iron ore creates a demand for Australian dollars in the foreign currency market. On the supply side, when we buy imports we supply Australian dollars to the market and create a demand for foreign currency. So as our trade prospects improve so too does the value of our currency. [DDET Read more]

 The other source of supply and demand for currency comes from asset demands. As foreign companies seek to buy Australian companies, or mutual funds buy shares in Australian companies, a demand for Australian dollars is created. Recent strengthening in the AUD has arisen in part because of stronger demand for our commodities, but more important has been the stronger demand for our commodity based companies.

 There are a couple of tweaks on this basic theory of currency value that are worth noting. Firstly, the price of AUD is a relative price. Our currency increases in value if there is more demand for AUD, or more correctly if the relative demand for AUD versus other currencies increases. If demand for US dollars falls, as has happened in recent months, then this will cause a strengthening of our currency. Secondly, expectations about currency values are critical. Expectations about future trade trends will affect asset demands today, and so affect the currency value today.

 Economists theories about currency value tend to treat trade as the dominant driver of value. A country’s exchange rate is said to be overvalued when imports exceed exports for example. But on a day to day and month to month basis trade flows are not the dominant factor affecting currency values. At the moment the spot trade in Australian dollars in foreign exchange markets is about $24 billion per day. Exports and imports together are only a little more than $1 billion per day, so the vast majority of currency trades are related to asset trades of various forms. Add in trades in currency derivative markets and the trade related transactions are dwarfed by speculative and other asset related trades. The fact that sentiment can change quickly regarding the value of a currency means that currency values can also move quickly.

As sentiment regarding the strength of the Australian dollar is clearly on the up, what are the implications for our economy? Most obviously non-commodity export competing sectors are going to continue to find things tough. Manufacturing, tourism, and services exports in areas such as education will find the going difficult, and unfortunately it is impossible to predict whether our exchange rate will return quickly to a more competitive level.

 With the exchange rate around parity an obvious question is whether policymakers can take action to mitigate the adverse impacts of a strong currency? Unfortunately the short answer is not really. The strong currency reflects a strong economy, with interest rates higher than in other countries such as the United States, and strong demand for our exports. Or to flip it around the weak US dollar reflects the grave weakness of that economy.

 It is possible that the RBA could try to limit exchange rate appreciation, but the evidence is that any such action is likely to have only a very limited impact. China manages its currency against the USD, but it does so by putting severe limits on assets demands and supplies involving China’s currency. In Australia capital flows are not regulated and so the ability of the RBA to lean against currency moves is very limited. Compared with daily spot trades in the AUD of $24 billion the RBA holds about $48 billion in foreign exchange reserves – two days worth of spot trade. So the RBA can try to intervene in the foreign exchange market, but the reality is that they just don’t have very much ammunition relative to currency traders as a group. The RBA recognise this, with their official policy being that they lean against rapid moves up or down of the exchange rate, but they take an agnostic view as to the value of the currency.

 The government could withdraw fiscal stimulus more quickly to try to give the RBA more room to leave rates on hold with the hope that this will weaken the currency, but as we saw this month with the RBA unexpectedly leaving rates unchanged, the impact of this on the exchange rate was very short-lived. At least for the short to medium term the Australian economy is in a much stronger position than the US or European economies, and the value of our currency reflects that fact.

 A final possibility might be for the government to invest funds offshore to counteract the strong demand for AUD, but this runs into the same problem as RBA intervention. Unless the government invests billions of dollars per day overseas, their impact on the currency value is likely to be very limited. And well before that point I would worry about the government’s ability to invest wisely offshore to such an extent.

 So unfortunately the best that we can do is grin and bear the strong dollar. And if you have enough of those strong aussies, you can grin and bear it in the south of France or in California at a lot less cost than this time last year![/DDET]

5 Responses to "USD parity"
  1. Mark,
    I think your argument about the size of the RBA’s size of FX reserves is relevant when it comes to them buying the currency, but not when it comes to selling it. So this is not really the issue.
    The main issue why the Bank hasn’t intervened is that the strong currency, which you point out, reflects the strong aggregate performance of the economy, and economic theory (such as the ‘Balassa-Samuelson effect). This is consistent with Australia’s strong terms of trade even after adjusting for the FX translation effect
    Alan

  2. The “strong $” story is another reason not to intervene. But my point is just that intervention would be pointless anyway, in the sense that it would be hard to influence the exchange rate by enough to make any significant difference from a competitive perspective. There are two RBA discussion papers on exchange rate interventions in recent years – one by Kearns and Rigobon which finds that interventions do affect the exchange rate, but that paper used data in the 1990s when the forex market was much smaller. The basic point of their paper was that leaning against the wind seemed to work. Another paper by Becker and Sinclair in 2004 found that the RBA made profits in the long run on their “leaning against the wind” policy which they take as evidence that the RBA strategy helped stabilise the exchange rate. While both these papers take the view that interventions can stabilise the exchange rate they do not support the view that it would be possible to move the exchange rate by 10-15 cents permanently, say, which is presumably about the minimum you’d need to get any real impact on competitiveness.

  3. You report daily trades in our currency at $24Billion yet imports and exports together are $1billion per day?
    The volatility is caused because the speculative trades swamp the “real trades”. So a possible solution is to charge the speculators for trading.  That would reduce the amount of speculation which is almost all unproductive noise in the system.

  4. Kevin,
    The point is that the real and nominal exchange rate appreciation of the Aussie is behaving precisely as predicted by standard textbook theory, in particular the sharp rise in the terms of trade.
    We can debate about whether the pace of appreciation is entirely consistent with theory, but to (at least) a first-order approximation, the evidence is consistent with theory. We don’t really need recourse to speculative vs “real” trades and taxes on speculation to rationalise the Aussie’s movements (although your point may be true for other asset markets).
    Alan

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