Getting the exchange rate below parity.

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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.

 [DDET Read more.]

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]

12 Responses to "Getting the exchange rate below parity."
  1. I think the Australian dollar has just hastened what was already happening in steel.  Imports have had a huge price impact on that market for years (view various ACCC competition assessments that waved through previously unheard of mergers in the Australian steel sector).
    The scale of steel operations in China was always going to mean producing stuff here was going to get harder and harder to justify, even with a more ‘favourable’ exchange rate.

    I think a more in depth look at that proposed tax would probably reveal it also is a waste of time.  But it still might be less of a waste than the money being sent Bluescopes way.

  2. If less capital is attracted to the country the exchange rate should depreciate but interest rates locally – not subject to the tax – will rise won’t they?  I am not sure that replacing an overvalued currency with higher interest rates is saleable. Bluescope are worried about high interest rates and the currency.

     

  3. sounds like a good idea to me. Capital that flows around too quickly is not invested in long-term productivity-increasing projects anyway.
    I dont see why a tax on capital imports should raise interest rates. Because of various capital rigidities in Australia, domestic interest rates are tied to the RBA rates, not long-term capital returns or time-preferences. What the tax effectively does is reduce the interest rates foreign investors get on short-run investments.

  4. If less foreign funds arrive won’t that reduce the demands for equities and bonds driving up yields?

    I worry about this only because, in other respects, it seems an excellent suggestion. 

  5. Chile imposed a capital on short term flows and there is evidence that short term flows were discouraged, while long term flows increased…so the impact on rates would be unclear (other than affecting the slope of the yield curve). I agree Harry that we should worry about this, but am sure that there are ways to implement that should minimise such an impact. My overall point would be that we are in a very second best world – lots of other countries are intervening in one way or another in the currency markets, and we are getting caught in the crossfire. A tax on portfolio flows has got to be better than trade protection or buy Australian. Interestingly Brazil has recently implemented tax cuts for export exposed industries. That would be an alternative, but the politics would be fun!

  6. Mark, as I understand it bluescope is withdrawing from the export market citing unprofitability – and you are asserting that the exchange rate is at the heart of their unprofitability. However isn’t it the case that the effects of an appreciating dollar have been offset by rising steel prices, and therefore the lack of profitability is more due to high costs of production? My concern is that protectionist policies get introduced to support fundamentally uncompetitive industries which is surely not good economic policy

  7. This may have an adverse impact on the major domestic banks? They source a large volume of funding from overseas along the yield curve

  8. Interesting consideration, surely the impact of Treasury issues (new Govt Debt) on issue must also drive currency appreciation:
    Year2005200620072008200920102011
    $Bn46.949.845.958.4107.1156.7202.3

    Since 2007, Govt Debt on issue has grown 4 x and continues to grow (just have a look at the treasury monthly accounts).

    Alongside the other factors you mention, this can only support demand for AUD.

    Just my 2c worth!

     

  9. Sorry, the numbers didn’t come out well:

    Year      $Bn Treasuries (Debt)
    2005     46.9
    2006     49.8
    2007     45.9
    2008     58.4
    2009     107.1
    2010     156.6
    2011     202.3

  10. “A policy that Australia ought to consider is a tax on capital inflows.”
     
    What a very stupid idea. We have a current account deficit and you want to drive up the cost of domestic funding by taxing capital imports when the issue is an incredible hike in the terms of trade. So in effect you are peddling for higher domestic funds.
     
    Wow. Are you an academic because I can only think this would come from an Australian academic economist .
     
     

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