There has been a lot of talk lately about what Australia’s central bank can do about the high $A. In particular there have been calls for the RBA to create $A and sell them for foreign currency. However, it is not the RBA that should be exchanging $A claims on itself for foreign currency — it is the Federal Government. The Federal Government should exchange $A bonds for foreign assets to hedge Australia’s long term currency risk.
Imagine that the $A stayed high forever. That would be terrific. That is what we want — a strong currency so that the income of Australian residents has substantial buying power in the market for globally traded goods and services. It will only happen if Australia can maintain global competitiveness in the long run and / or if our terms of trade remain permanently high. So, a permanently high dollar would be a very good outcome. When I say a high $A I mean a trade weighted index above 75 in nominal terms (where 1970=100).
A bad outcome would be as follows. Imagine the $A stays high in the medium term — held up by high commodity prices and Australia’s safe haven status. But Australia does not improve its competitiveness, so industries in the traded goods and services sector of the economy, such as manufacturing, tourism and education, are hollowed out. Then, when the commodities boom comes to an end, the $A falls and Australia has a low currency with little buying power and a small traded goods and services sector. Unfortunately, this “Dutch disease” outcome is looking quite likely.
To protect ourselves against this second vision we should make ourselves more competitive by: upskilling Australia’s labour force through better education and expanded skilled migration; improving labour force flexibility; building infrastructure; restructuring our tax system and reducing taxes; and cutting red tape and green tape at every level of government. But don’t hold your breathe waiting for any of those structural changes.
So, instead let’s thing about macro-level hedging. How could Australia directly hedge the danger of a very high currency in the medium term followed by a much lower level? Here is my plan.
1. The Federal Government begins issuing $A15 billion of Treasury securities per month. The securities will have a range of maturities, from 3 year treasury notes to 30 year treasury bonds to build out a balanced term structure of debt.
2 The Federal Government announces that it will continue the program indefinitely and may issue as much as 50% of GDP (about $750 billion over 4 years or more).
3. The entire proceeds of the debt will be used to purchase a balanced portfolio of foreign assets. The portfolio will be balanced across currencies to match the weights in the trade weighted index (TWI). Moreover, it will be balanced across asset classes including: equities, treasury bonds, corporate bonds, commercial real estate, infrastructure and cash.
4. Income and capital gains from the foreign currency assets will be used to make the $A interest payments on the Treasury debt. Tax revenue will be used to make up any shortfall. Some shortfall should be expected since interest rates are higher in Australia — that is the price of hedging. You don’t get anything for free in finance.
5. The portfolio will be managed by the Future Fund, which will be expanded to become Australia’s currency hedging fund. The Future Fund will become a division of the RBA — just as Norway’s sovereign wealth fund is a division of its central bank.
Imagine that the portfolio is built to $A750 billion in liabilities (Government debt) and matching foreign currency assets when the TWI is at 75. The portfolio then has a net value of zero. If the $A then fell by 25% then the net value of the portfolio, other things equal, would rise to $A25o billion. The Federal Government could then use the $250 billion to help the Australian economy to restructure.
If the $A stayed permanently high, then good, that is what we want. The competitive Australian economy that is supporting the $A would also generate the extra income needed to pay the interest on the debt.
The portfolio would have a negative value if the $A went higher, or the risky foreign currency assets lost value, but those two outcomes have a strong negative correlation, so the risk of big losses on the portfolio are low. In any case a higher $A in the long term is what we want and is consistent with a high tax base.
It is not obvious what effect of exchanging $A15 billion per month of treasury securities for foreign currency assets would be on interest rates in Australia and the exchange rate. Most likely $A yield curve would have to move up in the mid and longer maturities to attract sufficient demand for $A bonds. That would steepen the yield curve (remember the yield curve is anchored by the RBA’s cash rate on the left) which would make monetary policy more efficacious.
Calls for the RBA to act on the $A are misguided. We want an exchange of long term risk free $A claims for risky foreign currency assets, not short term claims. That means we need Treasury action to hedge against Dutch disease not the RBA action.