Hedging Australia’s $A risk


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.


6 Responses to "Hedging Australia’s $A risk"
  1. The basic idea sounds good to me. I’m not sure what the big deal is about the RBA v Treasury actually implementing this idea. To hedge risk you don’t need to buy foreign assets as you suggest, just foreign currency, which the RBA has done many times in the past. Hence the calls for RBA intervention. I would be happy with any action taken to reduce this very likely currency risk.

    A second point, and I would appreciate some elaboration here. You say
    “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.”

    Let’s be honest for a moment. This is the kind of nonsense economists say when they don’t know what to do. I have no problem improving skills, investing in infrastructure, cutting red tape etc. No one would. Nor would I suggest that these things wouldn’t help us be more productive. But the big question is, how do we do this better than everyone else? We need to do a fair bit of this just to keep up with our trading partners.

    Really, imagine the sheer scale of infrastructure and other capital investment required to outpace any of our Asian neighbours? It is a bogus idea that is distracting us from the real issue, which is currency imbalance from large foreign inflows.

    For example, say the currency is 20% overvalued. Our productivity improvements would have to outpace most of Asia and the US at a rate of 1% for about 18years – and that 1% is never going to happen anyway. In fact just keeping pace is unlikely.

    In any case, improving productivity in non-mining sectors requires lots of capital investment – the exact thing that is not happening because of the high currency, lack of export markets, import competition etc. And that capital investment would have to be from domestic sources as well (otherwise you just make the problem worse).

    So we should scrap this idea completely and focus our attention at the source of the problem – capital flows an their effect on the currency.

  2. Rumple
    The entire balance sheet of the RBA is only about $80 billion. So, issuing of $750 billion of new $A would expand the balance sheet of the RBA 10 fold. Even the The Fed and the ECB have only expanded their balance sheets (so far) by about 200 percent.

    • Yes, it’s a big move. A ten-fold increase in the balance sheet is about the same increase as the SNB foreign currency investments since 2009, which have kept the Franc pegged to the Euro.

      So it’s not like this sort of thing by a central bank is without precedent, but either institution could make it happen if the political will was there.

      I guess the question is, what sort of immediate impacts do you think $15billion/qtr capital outflows would have on the AUD? Where would we end up in the short term?

      You seem to want a high AUD, but suggest action that not only immediately bring the AUD down, but provide a hedge against a sudden collapse in the currency. So maybe you want a stable, but lower dollar? There are many ways to achieve that. I like your idea, but I reckon some combination of lower interest rates, higher lending standards, FX intervention by the RBA, and Treasury direct foreign investment might provide us a more flexible position from which to counter any sudden shocks.

  3. Sounds like a call for a renewed mining tax in disguise! To service our 3% interest-paying debts (the current 10-year bond yield) of 750 billion would need around 24 billion per year in more taxes. Where else but the resource sector is that going to come from? We’d effectively be setting up a future wealth fund before we have taxed the fixed resource yielding the wealth!

    I am of course all for a renewed mining tax since we botched up the last one. Not sure about investing its proceeds before we get them though. If the mining boom turns sour in 2 years we’d be stuck with a large debt to pay off.

  4. Paul
    Interest payments on the debt would be net of income from the foreign assets. The expected value of that net payment depends on how much appetite for risk the Government has. If we had no appetite for risk, and invested in only risk free foreign assets, then yes, about $25 billion per year.
    But if we are that risk averse then doing nothing about Dutch disease is irrational. We either need to make the economy more productive or put in place a portfolio that will benefit from a fall in the $A, so we can use the proceeds to smooth the adjustment to the end of the commodities boom in a hollowed out economy.
    The net payment of $25 billion per year could come from any part of the tax base.

  5. This isn’t a smart idea because the extra money created by the RBA would create inflation and devalue our currency making imported raw materials, energy, food, etc., more expensive.

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