I checked my files and found that the last time I wrote about trying to stop the exchange rate appreciating was 7 years ago and the exchange rate was in the 80s. There are lots of difficulties with capital controls, but the big question at the moment is whether these difficulties are greater than the difficulties to our many industry sectors that cannot cope with an exchange rate well above fundamentals. My piece in today’s AFR follows:
Bluescope Steel’s announcement of 1000 job cuts highlights the difficulties facing manufacturing firms in our two speed economy, but at the heart of these problems lies an overvalued Australian dollar. The dollar is overvalued not because of poor policies in Australia, but because our two major trading partners have undervalued currencies. China chooses to manage its exchange rate in a very careful way, and in the past few years its exchange rate has been consistently undervalued. Meanwhile the United States had kept interest rates near zero in the wake of the GFC, and the Fed recently announced that rates will stay there until 2013. Very low interest rates repel international capital from the US, and keep the USD undervalued. Policies in China and in the United States make sense from a domestic perspective, but have adverse consequences for many other economies and in particular Australia.
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What can Australia do about our high exchange rate? Policies such as trade protection, or buy Australia make little sense and in the latter case are likely to have very little effect. In Japan and Switzerland a response to the weak USD has been to try to limit the appreciation of the Yen and Swiss Franc by intervening in currency markets. But there is a very large literature which suggests that in general such interventions have very limited impact.
We can also just wait for the currency to turn around. Eventually the US will return to having normal – or at least positive – interest rates, and the USD will then appreciate as a result. The problem is that it is likely to be at least a couple of years before this normalisation occurs, and quite possibly longer given structural flaws in the US economy. Waiting more than two years for the exchange rate to depreciate will lead to many more announcements such as that made by Bluescope, causing considerable long term damage to our economy.
A policy that Australia ought to consider is a tax on capital inflows. A major reason for the strong AUD is “the carry trade.” Investors in Japan, or Europe or the US receive near zero interest on their investments in those countries, while in Australia investments in bank deposits earn around 6 percent. In addition investments in our share market might do better assuming the commodity boom is indeed longer and stronger. As long as the AUD does not depreciate, these carry traders make a higher return investing in Australia than investing at home.
In October 2009 Brazil introduced a 2 percent tax on money entering the country to invest in equities or in fixed income instruments, with the tax raised to 6 percent in 2010. At the time that the capital controls were introduced the exchange rate was 1.71 Reals per USD, and since that time the Real has appreciated by a further 5 percent or so to 1.6 per USD. Over this same period the AUD has appreciated by around 15 percent. Brazil is, like Australia, a commodity exporter and is subject to strong capital inflows as sentiment about the global economy improves. In late 2010 South Korea and Thailand also introduced taxes on capital inflows to try to limit the rise in their currencies.
It is hard to know exactly how much a small tax will slow exchange rate appreciation, but such a tax is likely to do little harm, and also raise some government revenue as an additional spin-off benefit. Managing flexible exchange rates has always been challenging, but the damage to our economy from watching our exchange rate appreciate is too great to sit idly by.[/DDET]