See the latest Australian dollar analysis here:
As readers know the AUD/USD exchange rate hit a new post float high of 1.0290 on Friday night and it seems that traders and investors just can’t get enough of what I used to call the “battler”. This non de plume was one that many of us in currency land used to call the Aussie because in that period back before the re-emergence of China the AUD always seemed to climb the stairs on strength but when it fell it fell off a cliff. But if everything you read is right, even the bears only reckon its going into the low .90’s. So it seems like it is going to battle no more as the affection of Central Banks, Sovereign Wealth Funds, traders and Investors sees a floor of buying underneath the current levels as we saw last week.
But the question I want to pose today is whether or not this strength in the AUD is actually a good thing and whether the RBA should seriously consider selling the AUD up here above 1.02.
A little history first. The RBA has a pretty good little site where it discusses the history of the exchange rate. Asking itself the question:
Why does Australia have a floating exchange rate” the RBA talks about the history of the AUD noting that
Between the early 1970s and 1983, exchange rate policy in Australia moved through several regimes. The first major shift occurred in 1971, when exchange rate policy shifted from pegging the Australian dollar to the UK pound to pegging to the US dollar. This was followed by a period of pegging to the TWI, from 1974 to 1976. During each of these regimes, there were occasional revaluations and devaluations. A crawling peg against the TWI was subsequently adopted, until the Australian dollar was eventually floated in 1983. The history is shown below.
Now the RBA says one of the reasons it floated the Currency back in 1983 was that it could more effectively run domestic monetary policy because it did not have to conduct the purchases and sales of Aussie which had the effect of
Subtracting from or adding to liquidity in the Australian money market. Domestic monetary conditions were therefore affected by the behaviour of international trade and capital flows.
Floating the exchange rate addressed this problem. After the float, the exchange rate was able to adjust to clear any excess demand or supply. The Reserve Bank no longer cleared the market, so foreign exchange flows ceased to have such a large effect on domestic liquidity.
The RBA then goes on to talk about the natural shock absorbers as another reason for the move to a floating exchange rate. Specifically:
But this is not the only reason why there was a case for the floating of the Australian dollar. Economic theory tells us that the choice of exchange rate regime can also influence the way in which economies cope with external shocks. Countries which are susceptible to real external shocks will generally fare better with a floating exchange rate…This market-driven reaction means, in principle, that there is less pressure to adjust monetary and fiscal policies in response to the initial shock. By contrast, a country with a fixed exchange rate would need to ease fiscal policy or adjust the exchange rate peg to avoid the contractionary effect of such a shock. This is a difficult problem for policymakers and, over the longer term, it would result in domestic policy settings being more volatile.
In summary, the floating exchange rate regime that has been in place since 1983 is widely accepted as having been beneficial for Australia. Such a regime is particularly well suited for the Australian economy, given it is relatively small, reasonably open and subject to sizeable shifts in its terms of trade. The floating exchange rate has acted as a buffer to external shocks, particularly shifts in the terms of trade, allowing the economy to absorb them without generating the large inflationary or deflationary pressures that tended to result under the previous fixed exchange rate regimes.
It is true that the exchange rate has been a boon for management of the economy in the period since the float. There have been more periods of extreme pessimism than irrational exuberance so for the most part when the currency needed to fall it was associated with the Australian economy needing the extra impetus that a weaker Aussie gives.
But the situation is very different now. The strength of the Aussie may be related to our “fundamentals” but it is referenced in a very narrow set of drivers and not broad based. Indeed the RBA is on the record as believing that the Chinese and Indian commodity spurt is generational in nature so the Terms of Trade shock that the Australian economy has received over the past few years looks set to be less of a shock and more of a step change.
There is little debate about this in the mainstream media as everyone seems to be seduced by the mining boom and its income effects. Indeed Julia Gillard’s comments about Dutch Disease fell through the media cracks except for HH’s blog on her comments.
That has some pretty important structural impacts on the economy as a whole and not necessarily for the better. Impacts that by definition will hollow out some of the diversity within the economy and leave us with a less adaptive, less responsive more volatile economy in the years ahead. One that by definition must therefore be less resilient to these shocks when they come.
So, is the strength of the Aussie currently undoing the good work that has been done in the Australian economy over the past 30 years. I’d say there are signs that this is occurring already.
Take this chart above for example on tourism which shows we are all headed overseas (I got the idea from my old boss at NAB, Head of Research – Peter Jolly). This chart shows outbound locals on trips of less than one year departing versus arrivals from non-residents on holidays. Clearly the trend to offshore holidays is apparent with arrivals flat-lining over the past 5-6 years. So if we were holidaying at home in the past we are not now, not as much anyway. No wonder I get so many emails for cheap holiday’s on the Gold Coast and in Cairns. It’s not just the recent weather, Tourism is suffering, as are our education sector, which relies on overseas students, our domestic manufacturers likewise. All being priced out of the market by a currency that is far too strong to support them.
But this Aussie strength is more braod based than many realise. While all the focus is usually on the AUD/USD exchange rate when you look at the TWI you see that this Aussie strength is all the more scary for exporters. There is nowhere to hide in this economy if you are an exporter of goods and services and you aren’t in mining.
So far I’d argue that the Aussie’s strength has been a good thing because it has both reflected the relative strength of the Australian economy globally and has tempered the the RBA’s need to increase rates. However going forward if it stays up here it is going to change the structure of the economy by replacing domestic industry with imports and net external transfers.
It has always been the case that the RBA to stand aside unless the AUD’s value is “out of whack” with the fundamentals and at present the fundamentals support a value around here. Indeed John Kyriakopoulos, NAB Head of Currency strategy, has fair value at present at 1.0040 but potentially as high as 1.0440. His model tells us where AUD/USD should be trading based on its historical relationship with a interest rate differentials, industrial metals and risk-appetite. It’s similar to lots of models out there but I reckon fair value models reflect “investment fundamentals” more so than economic fundamentals due to the key import of trading and investment in the currency market. Now John has one of the best track records of any FX forecaster on the Planet over the past few years and he doesn’t believe the AUD is overvalued.
And therein lies the rub. The Aussie is not overvalued based on its historical relationships or investment fundamentals. But if we want to retain a diverse and flexible economy, one that allows the natural shock absorbers to work next time the downside comes to our economy then we need to be tempering the impact of the Aussies strength on our economy here and now. It won’t be popular with other Central Banks or Governments but in the absence of a Sovereign wealth fund investing offshore I think the RBA should be selling Aussie up here above 1.02.