Arming the Australian dollar for the global currency war

See the latest Australian dollar analysis here:

Macro Afternoon

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.

  1. High foreign demand for the dollar to fund mining infrastructure construction (the Terms of Trade effect – chart from here)
  2. Relatively high interest rates and stable government attracting yield-chasers (the carry-trade effect)
  3. 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.

How sensible.

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.

Tips, suggestions, comments and requests to [email protected] + follow me on Twitter @rumplestatskin


  1. I posted this under “Houses and Holes” article today, but thought it relevant to repost here. I think your suggestion of a sovereign wealth fund is interesting. I think we should use such a fund to house our reserves of gold (i.e. don’t let the miners export our gold). After all, gold has an integral part to play in the currency wars, and we don’t have enough of it in official reserves.


    “Houses and Holes” guy, why don’t you write some more about Australia’s ultimate Holes, our gold mines?Your article yesterday on central banks buying the AUD is a key part of the picture. The big creditor nations, especially China and Russia, and many other non-Western countries, are rapidly diversifying out of USD and into gold and, to some extent, AUD. I believe China is preparing the way to ultimately back its currency partly with gold, as part of its plan for RMB to replace USD as the major reserve currency. Of course, the US has plenty of gold and so does Europe, so they are both in reasonably good shape when gold starts to back currencies again. Now, let’s look at where Australia stands in the coming new gold-backed global monetary order. Not so good. We have bugger all, at least in official reserves. we do have some chance to compete in the new system is that we have gold in the ground. So, what are we doing with the gold we dig up? Selling all of it! And who’s buying it? Most likely China.Here’s one thing we could do: “nationalise” our gold mines by requiring all gold mined in Australia to be sold to the government at spot prices. The gold then goes into a true sovereign wealth fund, like Norway’s. A bonus is that every ounce of gold we keep is an ounce that some other country does not get. Do you think that China sells any of its gold output?We are in a bad spot, but not as bad as the UK, where Gordon Brown sold all the remaining gold. At least we have a chance, with our gold mines.I think you are in a good position to raise such topics at MB, because the mainstream media definitely won’t.Keep up the good work.

    • It would be interesting to discover just what percentage of our known in-ground gold reserves are presently controlled by majority foreign-owned mining / investment corps. Could it be that exactly the same dilemmas under discussion viz prime ag-land (and the produce thereof) already apply to the topic of “our” gold?

    • The RBA won’t buy, but there are CB’s buying as recent as last month, and the PBoC probably daily. Check the WGC for details.

      Western CB’s don’t like gold as we’re discussed many timnes.

    • I agree fully with GG-the first response.
      The Australian Govt should be purchasing or printing,to buy all the Gold produced in this Country. However they follow USA instructions closely & will be too stupid to do so -IMO .

      From a saved Note dated 23/2/2004

      Australia sold 167 tonnes of gold in the six months to July 1997 about
      2/3rds of its holdings. On October 25 1997 when the Reserve Bank revealed
      the sale we had noted, “In Aussie dollar terms, when gold was at $US350
      and the $A was at 76c, gold was worth $A460. Now with the $A at 69c and gold
      at$US310, the price of gold is at $A449, barely changed”.

      Currently( Feb 2004) with $A at 56US c, the value of gold is worth $A553.6.
      In$A terms,the RBA doesn’tlook so clever.
      This was all accomplished with the help of Peter Costello billed by the Libs as “The Worlds Greatest Treasurer” Ha Ha

      Imagine for a minute that the Oz $ slips to .60cents next month while Gold in US$ stays around $US1600. That would immediately put the price of Gold over A$2300!

      Gold is being restricted from rising in price at the moment(being a Political Metal) but that will change for sure – it’s something “they” can’t print.

      One of the few ways left to protect yourself is to stay out of the current Share Market & buy Gold. It’s worked perfectly for me over the past 10years & I see NO change in the near future.If it’s all bought & PAID for- No Risk.

  2. McKibbin also warned that intervention was risky, potentially dangerous either way I guess – and your final paragraph is a nice reminder that sometimes ‘doing nothing’ results in the outcomes not disastrous.

  3. It seems to me that one element missing from the justifications put forward in this debate, is that of Time.

    For example, how long does a mere ToT “shock” have to be, in the real world, before its effects become permanently and irrevocably deleterious to key strategic industries / sectors that are impacted by the “do nothing” “rely on the ‘automatic stabiliser'” ideological position of policy-makers?

      • Thanks Cameron, appreciated.

        “If you expect it to last forever, do nothing and get on the adjustment.”

        Says it all, really.

        Nothing lasts forever. Especially in trade and commerce.

        • I’m convinced most Australian policymakers believe the mining boom will last at least another 20 years, which may as well be forever. Therefore we do nothing, and the non-mining sectors are “adjusted” out of existence.

          If nothing else, a short, sharp crisis in China would shock our policymakers out of their complacency.

      • Cameron, his ACE2012 paper is a slightly modified perhaps more exploratory revision of the above paper.

        ps He also recommends ‘do nothing’ if it is expected mineral prices will decrease in the near future. In brief correspondence with Professor Corden he acknowledged the difficulty of successfully implementing fiscal options may sway greater emphasis overall to the ‘do nothing’ option. However, ideally an combination of options 1 and 3.


        • “Implementing fiscal options” would be a whole lot easier if a fiscal savings SWF (which was out of reach of politicians) existed.

  4. “Keating grabbed the page endorsing the floating of the dollar as soon as he saw it and moved it swiftly towards law on the night of December 9,(1983) saying: “Speculators can now speculate against themselves and not against the Australian government.” If Australia has emerged from the GFC as the Best Man Standing, then why muck about with a system that put it in that position in the first place? Do we, in effect, go back to pre Keating and accept that the RBA/Government can decide the level that the currency should be, better than the market? I, for one, don’t think so.

    • Rumplestatskin

      Do we, in effect, go back to pre Keating and accept that the RBA/Government can decide the level that the currency should be, better than the market?

      Nope. But the whole point of this debate is that there are multiple intertwined effects determining the value of the AUD, and they are not solely market outcomes. More so now the exchange rate is the result of foreign policy decisions – the competitive devaluation effect that has concerned McKibbin.

      • But, surely, all intertwined effects ARE part of the market? Are we saying that those who trade the A$ can’t make informed judgements as to what the possibilities are? Now, they may be right or wrong, but at least they are market-based judgements. Interference in the value of the currencies in the market is exactly what ‘people’ are complaining about! And yet, McKibbin suggest we do likewise. As I posted yesterday, becoming part of the problem will not make us part of the solution.

        • Perhaps I’m coming at this from the wrong angle. It’s not the currency that needs the attention of the RBA etc. it’s other, more easily controlled but politically unpleasant factors, that need addressing, such as the wasted resources tied up in the housing market.

        • Rumplestatskin

          “…but at least they are market-based judgements.”

          I wouldn’t call foreign central banks increasing AUD reserves to devalue their own currency a market-based outcome. And if punters expect more of this, they might just jump in with the herd to make the price moves more severe.

          • ” they might just jump in with the herd to make the price moves more severe.”

            This is where we are now IMO and what is causing this latest strength in AUD along with Point 2 of your piece R.

            There are structural adjustments underway in FCB reserves effecting our currency, along with the big carry trade.

            What to do? Interest rates must be seen to be headed lower and then do so. Supplementary IR policies to free up labour flexibility need action immediately.Intervention then is another option in the extremes.

            There are no meaningful inflationary pressures in the economy for the time being. We could get to .80 AUD before we see anything of inflationary concern.

          • Exactly.

            If foreign CBs are intervening, why should the RBA stay on the sidelines? For moral purity?

    • We will discover anew just how much of the strength in the dollar is a market based outcome should the interest rate differential be pulled out from underneath the carry trade being played on behalf of pension funds worldwide.

      Speculators can now speculate against themselves and not against the Australian government. But the speculators are still gaming the Australian economy, nonetheless, and those negative impacts are borne by sectors who then visit their unhappiness upon the Australian government. There is no way to stay ideologically pure in all of this – one sector or the other is going to be hurt and pissed off whether we endeavor at a political level to make a judgment that things are not in balance, or otherwise permit the functioning of ‘free’ markets to decide whether this is so.

      No, we can’t have the RBA correct what is seen to be unbalancing some sectors of the economy, but on the other hand what government will dare unfurl the web of vested interests that are the economy who reap the benefits of a policy framework that effectively stays the RBA’s hands. The incentives throughout the system are stacked against long-term decision making. Really, the whole thing is just a cluster fuck.

  5. “Speculators can now speculate against themselves and not against the Australian government.”

    Love to see a cordinated dollar dump , encourage the dollar up, meanwhile the RBA is taking positions for it to fall, and then have a policiy out of left field, like tightening FIRB or currency restricitions, money flows out and dollar drops.

    The big issue is though is a lower dollar going to give us more pain than where it is currently. Self interest would suggest that Australians dont want to be paying more for that imported petrol

  6. Cool post Cameron +1. I agree that we’ve in for war of sorts now that we’re this safe haven until we’re not. Still a bit of monetary policy left, the the RBA never seems to act quickly so let’s see what they do.

  7. Here’s a reason why the A$ is so high (your story)”From SQM Research this morning comes the news that housing stock on market fell significantly in July” – the property market.What’s going to happen to the funding needs of the banks WHEN the property market gets going again? The only solution, and agreeing with GSM, is to lower interest rates ( helps real business) and reform the regulations surrounding the property market. Lower interest rates will cushion the blow of, say, the removal of negative gearing, and dampen the need for funds if the property market reverses its insatiable thirst for foreign funds. The value of the A$ is an indicator of ‘something’s wrong’ with the economy if its at the wrong level; it’s not wrong of itself. Fix the underlying problems, and the A$ will look after itself – CB buying or not.