Through 2012 commodity prices crashed, but the usually commodities-sensitive Australian dollar didn’t budge; indeed, it kept nudging higher.
Economists have declared Australia the victim of a global currency war: struggling nations, including the US, have been devaluing their currencies to stimulate their economies at the expense of better performers such as Australia.
The result? The Australian dollar, which used to be weaker than the US dollar, has appreciated from US$1.0057 and €0.7627 at the beginning of 2011 to US$1.0498 and €0.786 in the week of January 21.
The high valuation is hurting several parts of Australia’s economy outside of mining, including manufacturing, tourism and education. Each industry should be picking up as the mining boom that has benefited Australia for the past decade peaks and begins to fade; instead the strong currency has limited their competitiveness on the international stage.
Some are now calling for Australia’s central bank, the Reserve Bank of Australia (RBA), to follow the lead of the Swiss central bank and intervene to prevent the Australian dollar rising further from its current level of US$1.05.
The RBA has already cut official rates to try and stem a surge in inflows into Australian assets, without much effect. But given the enormous cost, most economists and business leaders say direct intervention is unlikely.
“It can be a very expensive exercise pushing against the tide when it comes to exchange rates,” says Peter Mace, general manager of the Australian Institute of Export.
The Australian government is now being urged to look at other strategies, including economic reform and selling massive amounts of bonds, to soak up demand for Australian assets. But this will take time to put into effect.
In the meantime local industries have little choice but to adapt to the Australian dollar’s uncomfortably strong valuation, because it looks unlikely to change anytime soon.
A perfect storm
The Australian dollar’s popularity among investors is due to a combination of conditions in recent years.
High commodity prices and mining-related investment inflows have helped underpin the currency’s strength; more recently, central banks have been adjusting their reserves and buying increasing amounts of Australian dollars.
But the major factor now is a portfolio shift that is ramping up demand for Australian assets. Warwick McKibbin, an academic at the Australian National University and a former RBA board member, says a “wall of money” is hitting Australia and its currency.
That wall of money is a direct result of the fallout from the international financial and economic turmoil. Central banks, including the US Federal Reserve, European Central Bank, Bank of Japan and the Bank of England have increased their balance sheets by US$5 trillion since the global financial crisis hit in 2008-2009.
Central bank bond buying has pushed up bond prices and lowered yields. But the institutions that have sold bonds to central banks have more and more money earning little or no interest. So they have looked around the world for higher-yielding assets.
Australia has been a natural target: the country’s 10-year government bonds are yielding more than 3% (after falling to historic lows in 2012), a lot higher than the 1.76% yield on 10-year government bonds in the US, 1.82% in the UK and 0.79% in Japan.
Other countries including Canada, South Korea, Switzerland, New Zealand and some Nordic countries are facing the same dynamic of low nominal rates but relatively high exchange rates.
The high Australian dollar is having a big impact on the non-mining sector at a time when many economists and analysts say that, despite a recent rebound in iron ore prices, the “price” phase of the mining boom is over, and the end is in sight for the investment phase.
Other sectors that should be taking up the slack and expanding and investing are hurting from the high Australian dollar, which makes their goods more expensive and imports cheaper. The country’s trade deficit in November blew out to AUD2.64 billion, the eleventh straight month of deficit and the biggest gap in more than four years.
“The impacts of the high dollar have been felt across a wide range of trade-exposed industries,” says Innes Willox, chief executive of the Australian Industry Group.
He notes that low-margin industries have been most affected, but industries the most clearly impacted include inbound tourism, steel, aluminium, clothing and footwear, the auto industry, industrial equipment and consumer appliances.
One industry particularly affected is Australia’s education sector, the nation’s third-largest export earner. “There is no doubt that the high Australian dollar has acted as a disincentive to those considering university study in Australia,” says Belinda Robinson, chief executive of Universities Australia. She adds that the strength of the Australian dollar will continue to be a challenge.
The RBA has acted to dampen the flow of inbound capital and its impact on the value of the Australian dollar, cutting official interest rates by 1.75% to 3% since November 2011.
Yet despite these cuts, the value of the currency continues to rise. Saul Eslake, chief economist at the Bank of America Merrill Lynch, says if recent cuts haven’t made any difference to the level of the Australian dollar it’s hard to see what another 0.5% to 1% reduction in rates would do.
“Even if the RBA cut the cash rate to 2%, as some are now forecasting, the Australian cash rate would still be 2% higher than the corresponding rates in global money centres and that would still be attractive to international investors, central banks and others,” he says.
ANU’s McKibbin says that the RBA can’t offset the wall of money from the shift in portfolios by using monetary policy, so it is better off not cutting interest rates and risking asset bubbles down the track.
But what about intervening directly in the currency like the Swiss central bank has done? Since September 2 last year the Swiss National Bank has staged a direct intervention to peg the Swiss franc at CHF1.20 per euro in a bid to halt massive capital inflows and currency overvaluation.
According to Paul Bloxham, chief economist at HSBC in Australia and New Zealand and a former RBA economist, it’s highly unlikely Australia’s central bank would follow suit.
“It would be an enormous change in the RBA’s approach to monetary policy; I don’t think we’re likely to see that change,” he says.
One reason for this is that the RBA doesn’t want to fix something that it doesn’t consider to be broken. The Australian economy is generally performing well at the moment. The unemployment rate is fairly low, economic growth is close to trend, and inflation is in the middle of the target band.
“From a macro perspective there is little need to have an aggressive stance in the way policy is set,” says Bloxham.
The cost of printing
The key question is whether the RBA would be capable of getting the Australian dollar to a particular level without great expense.
It could be tricky. The Australian-US dollar is the fourth-largest traded currency pair in the world, making it a major foreign exchange market.
Central banks have unlimited capacity to hold down currency if they so wish. They can simply print money, creating new currency to meet foreign demand, and collect the foreign currency reserves. But there are costs to holding those reserves.
“It’s not free,” says Bloxham.
The Swiss have accumulated foreign exchange reserves equivalent to 70% of their GDP in recent years. They have been able to do this at no cost because the interest rate on the Swiss francs that the Swiss central bank creates to accommodate increased demand for its currency is zero, while it earns a positive carry on the foreign assets in which it invests, including the Australian dollar.
But the RBA would lose money (or, in financial parlance, incur “negative carry”) on the analogous transactions: it would have to pay the cash rate (3%) less a margin on any deposits it created to buy foreign assets, while it would earn less than 0.5% per annum on those foreign assets.
Intervention on the scale that Switzerland has undertaken would entail the RBA holding foreign assets of the order of US$1 trillion, Eslake says, compared with the present actual holdings of around US$50 billion. That would put the central bank at substantial risk of capital loss in the event that the effort failed.
The RBA itself has said direct intervention is unlikely. In a mid-year speech, Philip Lowe, the central bank’s deputy governor, said conditions were not right for large-scale intervention, and that while it was surprising the Australian dollar hadn’t come down it was not fundamentally overvalued.
“The argument for doing that would arise if we thought the currency was fundamentally overvalued and was having a really adverse affect on the Australian economy,” Lowe said.
When to step in
The RBA has made short-term interventions in markets when there have been dislocations. The most recent episode was during the global financial crisis when it intervened to stablise what it said was “market dysfunction” and “disorderly trading conditions” when liquidity rapidly deteriorated in the spot market.
Lowe didn’t rule out the possibility of intervention, but said it would be a huge step away from a system that has served Australia well for a long period. “A decision to intervene by the Reserve Bank would be a very big one,” he said.
In the absence of direct intervention, businesses could be saddled with a high Australian dollar for some time. Australian Industry Group’s Willox says since the post-GFC rebound in the currency, expectations of the dollar staying high for an extended period have become much more widespread and many business models are being more fundamentally reformulated than before.
Businesses and industries have been adapting. Australian universities, for example, have been working with the Australian Trade Commission on a marketing strategy, “Future Unlimited” under the umbrella of “Australia Unlimited” to promote Australian education around the world. The campaign focuses on the many competitive strengths of Australian higher education, including innovative research and teaching and equipping students with globally recognised qualifications, skills and knowledge as a future career foundation.
Some argue there are other options available at both the macro and micro levels to weaken the currency.
One would be for the RBA to supply Australian dollars to central banks who want to hold the Australian dollar.
“They [the RBA] should identify that particular demand for currency, then they should supply it,” says McKibbin. “Then you don’t get it going though the market. But I don’t believe in intervening any more than that.”
He believes the RBA is doing it already, noting that they accumulated US$800 million of foreign-exchange reserves in August and September last year, in what has been dubbed a “passive intervention”.
Aside from cutting interest rates and direct intervention, the central bank has other options to affect the currency’s valuation. McKibbin says that with a fixed supply of assets foreign buying will push up asset prices “all over the place”.
A way to solve this would be for the Australian government to increase supply and print “massive amounts” of 30- to 50-year government bonds and sell them at low interest rates. It could then spend this huge stock of capital on infrastructure that pays a high rate of return.
McKibbin says that would be an “optimal” strategy. “But you can’t trust them to do that; they’ll just buy marginal votes,” he says. “What’s right is very different to what’s going to happen.”
The other focus to offset a lack of competitiveness is on lowering input costs through economic reform. That includes more flexible labour markets and lower energy costs. Right now the opposite is happening, with input costs into industry rising faster than the exchange rate.
That lack of movement means calls will continue for RBA intervention in currency markets, in addition to cutting rates. But it is very unlikely to happen.
“The RBA intervention on lowering interest rates should be effective in reducing the inflow of funds for interest-rate plays,” the Australian Institute of Export’s Mace says. “However the rates are so low in other developed economies it hasn’t had a real impact. I’m not sure there is much else they can do.”
In other words, don’t expect Australia’s dollar to weaken any time soon. It’s simply too hard to make it happen.