Locked in: The state of the Australian dollar

Locked in: The state of the Australian dollar

Australia’s three largest trading partners are locked in a currency war, with Japan (the latest to enter the fray) embarking on a mission to stoke its inflation and devalue its currency in a way that has economists classing it as more of an experiment than an economic plan.

This all started when the United States enacted emergency measures to keep it out of a deep and ongoing recession (or depression) following the sharp economic contractions felt most painfully in 2008. The series of interest rate cuts, new money issuance and subsequent government bond purchases (quantitative easing) that characterised this emergency period of economic stimulation has upset the playing field for the world’s largest trade economies. Why? It has been five years and six months and it is still going.

From the charts above, you can see that the four US quantitative easing programmes (QE1, QE2, Operation Twist and QE3/4) have helped weaken the US dollar and, in turn, strengthen the Australian dollar. Since the Bank of Japan announced its intent to intervene in the value of the yen (‘JOB Action’), the value of the yen versus the US dollar has plummeted, as seen in the top chart. All the while, the US Federal Reserve has been pumping new money into its economy, diluting the value of the US dollar.

When US stimulation kicked off in true ‘emergency’ style, as some of its largest financial institutions began to implode due to rapidly declining asset values linked to bad mortgages, it was in the world’s interest for its Treasury department and Federal Reserve to do what it must to ensure its economy didn’t fall hard, and drag the global economy with it. Now, however, that the ‘emergency’ is over and the US has kept its quantitative easing practices in place, these measures become much less forgivable by countries who are suffering due to a devalued US dollar, and the whole process of devaluing currencies has become extremely contagious.

By definition, due to its US currency peg, China is going along for the ride and maintaining a low yuan that is in step with the US dollar, but Japan has now taken a proactive stance and has begun systematically targeting inflation, which is, in turn, devaluing the value of the Japanese yen. With the knowledge that the value of the Japanese yen will erode if it is successful in creating inflation, investment flows from Japanese to Australian assets are inevitable.

Why do countries engage in the practise of devaluing their currencies?

As an exporter of resources, Australia knows that a strong currency hinders our ability to compete in a global market. Consumers of commodities will have noted that, for instance, while the Australian dollar has risen by nearly 20% versus the US dollar in the last three years, the Brazilian real (the currency of the world’s next largest iron ore producer after Australia) has fallen by over 15% in the same period. So, over time as currency hedges expire and resource consumers consider the medium to long-term nature of these exchange rate trends, the sustained, elevated level of the Australian dollar will continue to hurt.

In the case of the US, having a depressed dollar value for them has encouraged exports and, in turn, local manufacturing, tourism and internationally-shipped retail, for example. And this weak currency is compounded by zero interest rates, whereby business and consumers can use credit products to borrow and leverage themselves to the growth being stimulated by the entire process. It’s a big win for the US (so long as it can keep inflation at bay), but the externalities of the process create an unfair playing field for its trading partners.

Specifically, the benefits of aggressive, prolonged downward interest rate pressures and currency devaluation are:

  • Incentivises banks to lend more aggressively to both business and consumers, (hopefully) creating demand
  • Makes exports more attractive and encourages ‘in-sourcing’ of manufacturing
  • Devalues the outstanding debt of the country performing quantitative easing, as the money being supplied in the form of interest and principal repayments is less valuable to the debtor
  • The knock-on effect of rebuilding the local manufacturing sector

The risks to an economy in doing this are:

  • It can cause above-target inflation, meaning higher interest rates must be used to combat higher prices and stave off hyperinflation
  • Creditors (i.e., those countries that traditionally purchase the issuing country’s bonds) may be deterred due to the perception that their investment will erode in value, causing funding issues for the issuing country
  • Asset bubbles can form from aggressive use of low interest rate credit, creating excess risk in an economy
  • Encourages combative responses by trading partners (tariffs, more currency wars), affecting free trade 
Can Australia devalue its dollar?

It is possible that, by reducing interest rates toward zero and making our assets no more attractive than those in the US and Japan on an interest rate differential basis, we could create selling and thus downward pressure on the Australian dollar. However, with a relatively healthy economy, low unemployment and inflation not needing to be pushed any higher, this would be a destabilising move in an otherwise ‘goldilocks’ economy, where things are not too hot, not too cold.

So the responsible thing for the Reserve Bank of Australia (RBA) to do is to ignore the politics, focus on its mandate of contributing to “the maintenance of price stability, full employment, and the economic prosperity and welfare of the Australian people” while it waits for the aggressive moves of others to abate. The Australian government, which wins votes from an electorate taught to accept budget surpluses and nothing less, won’t be spending money it doesn’t have to stimulate sectors affected by the strength of the Australian dollar. And unlike Japan, which has US$1.25 trillion in reserve assets that can be used to fund a currency war, Australia has US$45 billion in reserves. So, despite many calls for the RBA and Treasury to do more, the answer to the question of whether we can devalue our currency—in practice—is no.

Conclusion

The split that we’ve seen in the performance of Australian listed financial companies versus resource stocks is symptomatic of two sectors that are subject to the inflows and outflows of local and foreign investment that is, among other things, sensitive to this issue of medium to long-term Australian dollar strength.

The painful reality is that we are helpless to intervene in the Australian dollar’s popularity, and the latest kick in the guts by Japan and its aggressive objective to target 2% inflation (after three decades of close to 0% inflation and nearly two decades of 0% interest rate policy) means that our three largest trading partners—USA, China and Japan—have postured themselves economically to export, while our economy supports the importation of goods, services and investment – all catalysts for a higher Australian dollar.

Absent a change in US monetary policy, a circa US$1.05 Australian dollar value is the new normal, and Japan’s two-year time horizon for its inflation target is a reminder of the unfair economic externalities created by the US rolling its ‘emergency’ monetary policy into an economic status quo.

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