Australia’s policy makers seem to have been hiding in the trenches while the global currency war is being fought around them.
Although here at MB we have discussed the high dollar at length, only now that former RBA Board member Warwick McKibbin has suggested that direct intervention is justified by policy changes abroad, has the issue of the high dollar, its drivers, and policy actions, been properly considered in the public debate.
To move the debate along it is worth dissecting exactly what is driving the dollar, the current thinking on currency intervention, and some of the options at hand to reduce volatility.
For simplicity, we can categorise the interdependent drivers of our high currency into three main effects.
- High foreign demand for the dollar to fund mining infrastructure construction (the Terms of Trade effect – chart from here)
- Relatively high interest rates and stable government attracting yield-chasers (the carry-trade effect)
- Debasing of currency by other nations, and their subsequent accumulation of AUD reserves (the competitive devaluation effect)
McKibbin’s comments were directly aimed at point 3, arguing that if foreign central banks have decided to accumulate AUD, our central bank should simply supply it to them, rather than have them bid up the value of the AUD.
Well, if it is purely a portfolio shift so foreign central banks are buying Australian dollars to hold Australian dollars then the Reserve Bank should just supply those Australian dollars and increase our reserves in the process.
That is not a real economy effect that is going on. It is something in the financial sector and that part of the strong dollar I think could be taken out.
We know from statements by former RBA Governor, Ian MacFarlane, that the Bank considers the first two points to be ‘fundamentals’ that don’t warrant intervention. McKibbin is still holding the bank line in these points.
Here are MacFarlane’s own words:
Sometimes, when the exchange rate takes an extreme value, it is because there is something wrong with domestic policy. In this case, the domestic policy deficiency should be corrected.
A second cause may be because a fundamental factor has changed, for example, a sustained change in the Terms of Trade.
In this case, a large part of the exchange rate change may have to be accepted.
There is a third category, however, where the movement in the exchange rate is difficult to explain in terms of objective considerations such as policy imbalances or fundamental factors.
There is ample evidence that the foreign exchange market does not always throw up a path for the exchange rate that is tightly defined by such objective factors.The exchange rate is partly a function of objective factors and partly a result of the accidental accumulation of information, impressions and expectations.
To me it is not at all clear why the same types of ‘non-fundamental’ foreign policy decisions that lead to the accumulation of AUD reserves don’t also explain the carry-trade and ToT effects. After all, we know that foreign stimulus boosted demand for resource exports in 2009, yet this is treated as some kind of optimal, rational, perfect market outcome. We also know foreign domestic monetary policy is accentuating the interest rate differential.
One wonders why the strong attachment to this hands-off approach, given the global trend is heading the other way. This is especially curious given the decade of ‘testing and smoothing’ the currency by the RBA following the float of the dollar. Stability seemed important then, but not now.
For interests sake, the full data of RBA interventions currency markets is available here (.xls). Also, the chart below shows the three distinct periods of intervention – the first mostly containing the upside and defending a $USD0.80 level, and the latter two containing the downside at around a $USD0.60 level.
The RBA justifies their hands-off approach, particularly on the upside, because of the now well developed markets for hedging. Market participants now have the tools to deal with a more variable exchange rate, that was not as easy to manage two decades ago.
Indeed, given the legislated objectives of the RBA, the major risks arise from short periods of a under-valued dollar, with the associated risk of importing inflation. The financial crisis demonstrated that the AUD is no safe haven under extreme conditions, and it is this scenario that appears to worry the RBA.
In the short run upside risks for the RBA are minimal, even if the long run interests of the country as a whole may not be served well in this scenario.
In any case, MacFarlane explains the RBA’s position quite clearly, which although was written in 1993, is just as relevant today:
The short answer to this is that we recognise that Australia is subject to quite large real shocks and a floating exchange rate is well suited to this situation.
It has been well documented that the most important real shock in Australia’s case is a change in the terms of trade. Any attempt to hold a relatively fixed exchange rate in the face of these large real shocks would be costly and involve extreme movements in domestic policy.
Of course, we don’t get a definition of costly. My interpretation is the MacFarlane thinks that the Bank will make a wrong call when the ToT is high. Evidence so far is that the Bank’s currency intervention to date has been quite profitable. If the ‘Friedman profit test’ has any merit (if central banks sell high, buy low and vice-versa, they are effectively correcting the market through their profit-making investments), then a ‘market failure’ can be corrected though central bank currency intervention.
Indeed, other suggestions to contain financial flows that are detached from actually production and trade, such as a Tobin tax on foreign exchange transaction, are rapidly gaining support. Brazil introduced their own Tobin tax last year, and just this week France introduced a 0.2% Tobin tax on financial transactions. But according to reports, the French have failed to gain international cooperation for enforcement. While there is support from Germany’s Angela Merkel, the tax faces strong opposition from the UK government. Without proper international support, enforcement of such a tax is problematic. A good read on enforcement of Tobin taxes is here (from p101).
The establishment of a sovereign wealth fund is a proven alternative to controlling upside pressure on the exchange rate. The fund offsets foreign demand for the AUD with Australian demand for foreign assets, would directly address the ToT effect, particular if it was funded with revenues from the sector causing the ToT boom. Indeed, because tax revenues from mining typically eventuate after the ToT boom from new investment, a SWF could itself be debt funded, with repayments from later taxes on mining production.
A sovereign wealth fund is probably a more balanced alternative to direct currency intervention, automatically reacting in proportion to ToT shocks given an appropriate funding arrangement.
There are plenty of tools available to intervene in the currency market in the long run interests of a stable and diverse economy. But it is a tough decision to get out of the trenches. Possibly too tough in our political environment.
As a final note it is worth considering whether hiding in the trenches has been a beneficial policy. Unemployment remains low, the ToT are already falling, and the dollar may slip down to a more reasonable level on its own. But I am pretty sure the battle is not over yet.