Fluctuations in the Value of the Australian Dollar
David Richardson
Economics, Commerce and Industrial Relations Group
29 June 1998
Contents
Introduction
First the facts
$A - fallout from Asian crisis?
$A - a commodity currency or Asian currency?
Implications for the economy
Interest rates
Conclusions
Over the last eighteen months or so the $A has lost a
good deal of its value against the $US. The decline accelerated from early
May 1998 when it stood just above $US 0.64 through to mid June when it
fell below $US 0.58. Since then the $A rallied on 18 June following the
intervention of the US in support of the yen. At the time of writing the
$A stands just above $US 0.61. In the meantime the movements in the $A
have received extensive media coverage.
The Prime Minister has suggested that the fall in the
$A was due to 'some poorly informed, economically illiterate money market
people on the other side of the world.'(1) There seems to be a wide tendency
to blame speculators of one sort or another. In the present episode, the
hedge fund managers are getting the blame. One report said that it was
easy for the hedge funds to reach the conclusion that Australia faces
a currency crisis and so hedge funds can profit through speculation against
the $A. The report continues saying
[The notorious currency speculator and hedge fund
manager] George Soros and friends are said to be short the Australian
dollar to the tune of between $8 billion and $9 billion...The sheer
firepower available to the funds-they gear themselves about 50:1-means
the Reserve Bank can't out-spend them. Central Banks traditionally
don't use gearing, and the RBA has reserves of less than $15 billion.(2)
All this harks back to the Prime Minister of Malaysia,
Dr Mahathir, who in mid 1997 blamed, George Soros, and the other 'highwaymen
of the global economy'(3) for destabilising the Malaysian currency. Much
of the commentary, however, is inclined to focus on the mystique of international
funny money and speculation in preference to trying to work out what is
really going on at the moment.
Obviously there is a good deal of speculation/hedging
at present. Even ordinary traders and others are faced every day with
the question of whether or not to buy and/or sell the $A for other currencies.
People going overseas are engaged in speculation when they make decisions
about when to convert their currency. However, we have to face the question
of whether speculation is the driving force or whether it is the bubble
and froth hiding the fundamental determinants. The purpose of this brief
is to look at the recent $A movements in a more sober manner.
Figure 1 gives the movements in the $A against the $US
over the period since the beginning of 1997. This period was chosen deliberately
since it includes the Asian crisis that started to build up over 1997
and gave the rest of the world a jolt when Thailand was forced to float
in July 1997.
Figure 1 clearly shows that the $A has been on a downward
trend over most of the period under consideration, and certainly since
early February 1998. From the high $US0.70s in January 1997 it gradually
fell to below $US0.59 at the end of the period. (Not shown on the graph
is a period of relative stability in the high $US0.70s in the previous
year or so.) Towards the end of the period the $A seemed to be falling
rather quickly and reached twelve year lows against the $US, until 18
June with the turnaround mentioned above.
Taking Figure 1 at face value may well give a false impression.
We can never be sure that the fluctuations are actually fluctuations in
the $A or those of the $US. This is important when it is possible that
the 'measuring stick' is unstable. For that reason the following figure
shows the movements in the $A against the trade weighted index (TWI).
As its name indicates, the trade weighted index tries to measure the value
of the $A against a basket of currencies. Those currencies are chosen
to reflect the weight in Australia's trade with the countries issuing
the currencies in the index.
Figure 2 clearly shows that the movements in the $A have
been much more moderate against the TWI than against the $US alone. There
are similar movements in the $A against both the $US and TWI over the
last 3 months or so. However, this disguises the fact that for the period
under question the $A has nevertheless kept within a fairly tight range
of 58 cents plus or minus two. In fact the most recent movements below
57 cents seem to have followed the publication of the March quarter current
account deficit on 3 June. The stability against the TWI suggests
that the rise in the $A to $US exchange rate has been at least in part
a product of the increase in the value of the $US. The $US has probably
risen in response to the Asian crisis. In periods of uncertainty capital
tends to flow to the US as a safe haven. Some press reports suggest that
this is one of the factors contributing to the weakness in the Japanese
Yen. This question is taken up again below.
In July 1997 one Asian currency after another seemed
to be weakening. Commentators have referred to this as 'contagion' among
the various Asian economies since there was no obvious reason other than
proximity why one after another of the Asian countries seemed to be under
pressure in the international currency markets. Foreign investors became
wary of Asia as a whole. In that context there was some concern that the
$A would be caught up in the massive currency speculations and devaluations.
The following graph allows a comparison between Australia's experience
and the experience of some of the countries most affected by the Asian
crisis.
Figure 3 shows that the $A movement against the $US was
reasonably moderate compared with some of the other currencies illustrated.
By comparison note that the Hong Kong dollar is fixed against the $US
under a currency board arrangement. The Singapore and Taiwan currencies
were also reasonably stable against the $US.
It is something of a paradox that non-Japan Asian countries
do not trade much with each other yet they suffered rather severely from
contagion, once the Thai baht began to fall. By contrast, Australia is
one of the countries most heavily exposed to trade with non-Japan Asia.
Yet as the graph clearly shows, the instability in Thailand quickly spread
to other Asian countries so that all suffered similar declines with similar
timing. The fall in Indonesia's rupiah was, of course, more severe. Australia's
dollar had a more gentle experience by comparison.
Figure 3 indicates that the Malaysian ringgit and some
of the other currencies were experiencing a good deal of volatility at
times during 1997. This behaviour is certainly suggestive of widespread
speculation, though of course it is not conclusive evidence. By contrast
the movement in the $A looks to be much smoother without showing major
instability or overshooting. While the behaviour of the ringgit and other
currencies does indeed suggest speculation, those currencies eventually
bounced back to more reasonable levels. That bounce back is likely to
have hurt anyone speculating for too long against those currencies. Before
leaving the topic of speculation it is worth observing that the speculation
against some of the Asian countries was encouraged by governments trying
to defend over-valued fixed exchange rates for too long.
All of these countries had traditionally fixed their
currencies against the $US. In earlier years they tended to under value
their currencies as part of their export strategies. However, by early
1997 some of the Asian currencies came under pressure and the economies
concerned were experiencing deteriorating current account balances. Part
of the reason for that was intensified competition from China in Asia's
export markets. China had significantly devalued in 1995 as part of its
own export strategy. Japan was also becoming more competitive as the yen
had begun to fall against the $US. Arguably Thailand, Malaysia, Indonesia
and Korea should have allowed their currencies to devalue much earlier.
Nevertheless, by mid 1997 each economy was seen to be in the unsustainable
position of defending over valued currencies in the face of enormous market
pressure.
An important feature of the Asian crisis is the way it
quickly spread from one country to the next. Some of the reasons used
to explain the contagion related to the common experience of fragile financial
structures and the bursting of the speculative bubbles that developed
prior to the crisis. The above graphs clearly show that Australia suffered
only very slightly from contagion, if indeed, it could be called that
in the case of Australia. Of course the other way the Asian crisis can
affect Australia is through the balance of payments, especially Australia's
imports and exports. For this reason it is useful to look at the relationship
between the $A and Australia's current account deficit.
Certainly figure 4 shows a relationship between the $A
and the CAD. This and the earlier arguments suggest that the Asian crisis
has had an effect not via 'contagion' but through the ordinary workings
of the economy through imports and exports. In this way the effect of
the Asian crisis on Australia is similar to any other event which might
depress the level of world economic activity which in turn affects Australia's
fortunes in world trade.
Over many years commentators have maintained that the
$A tends to be influenced by commodity prices with rises in commodity
prices producing rises in the value of the $A and vice versa for falls
in commodity prices. The following graph attempts to examine whether that
relationship still holds. Commodity prices are here expressed in $US.
The graph clearly shows a strong relationship between
commodity prices, especially non-rural prices and the value of the $A.
So it would appear that the old relationship still holds. Of course, changes
in commodity prices will show up in the balance of payments. So to some
extent, the current account might be regarded as the intermediate step
in the relationship between commodity prices and the $A. For example,
a fall in commodity prices will reduce the value of exports and so widen
the current account which then tends to produce a fall in the $A. An implication
of that outcome is that when commodity producers in Australia suffer a
fall in international prices, the $A also tends to fall thereby insulating
commodity producers from the full impact of the price falls. As an example,
one report noted that the 27 per cent devaluation in the $A over the last
18 months has added about $700 million to BHP's after tax profits.(4)
BHP has of course suffered a good deal through low international commodity
prices and on 26 June announced a loss of $1.47 billion.
More recently commentators have drawn attention to the
link between the $A and the yen. The next graph explores this relationship.
Figure 6 is very interesting. From mid-May 1997 the $A
has stayed in a very tight range against the yen. It has rarely moved
outside the 84 to 88 range and when it has it has quickly returned. Financial
commentator Max Walsh observes that not only has the $A closely tracked
the yen, but so have the New Zealand and Canadian dollars. Each of these
has been virtually put on a yen standard by the financial markets.(5)
The $US yen relationship has also been interesting. The
US has been running large current account deficits while the Japanese
have been running huge surpluses. That alone would be expected to produce
an appreciation in the Yen against the $US. In fact the Yen has declined
quite dramatically against the $US. Surpluses on the Japanese current
account seem to have been offset by the desire of the Japanese to put
their money into mainly $US and other safe haven currency assets. Japanese
interest rates are very low and there are concerns about the viability
of the Japanese financial system. The result is a capital flow from Japan
to the US that has more than offset the current account positions of the
two countries.
Movement between the $US and yen accelerated over recent
weeks, putting pressure on China's trade and that of other regional economies
by threatening another round of devaluations. On the afternoon of 17 June
1998 (New York time) the US Federal Reserve System intervened to support
the yen and sent it up to 137 from 142 yen to the $US. Treasury Secretary
Robert Rubin was reported as saying the US was ready to continue supporting
the yen.(6) Rising bond and equity markets in the region as well as in
Wall Street and European markets soon followed this news.
In this section an attempt is made to indicate how the
economy is likely to move in the future, given the fall in the $A, and,
in particular, how Australia's exports are likely to perform.
Exchange rate adjusted unit labour costs provide a good
measure of the competitiveness of Australian industry on world markets.
Figure 7 does not contain much information on how competitiveness has
behaved since the Asian crisis. However, it is clear that the earlier
trend towards increasing costs, as suggested by the index, has been reversed
beginning about the time of the Asian crisis.
Table 1 is illustrative. While the $A has been relatively
stable against the TWI, it has heavily depreciated against some currencies
and appreciated against others. In the case of those currencies against
which we depreciate, exports will be encouraged and imports deterred.
As it happens, those countries against which Australia has depreciated
include some of our major export markets. In the case of currencies against
which Australia appreciates, exports will be deterred and imports encouraged.
The main countries against which Australia has appreciated are the badly
affected Asian economies. The depreciations will assist those countries
to export their way out of their present difficulties. Normally Australia's
exports to the badly affected Asian countries could be expected to suffer
as a result of the exchange rate movements, as indeed some have. However,
that might be offset to some extent since Asian exports to the rest of
the world will be stimulated by the depreciation of the relevant currencies.
Of course, exports from those Asian economies often involves putting value
added onto commodities supplied by Australia. To the extent that that
happens in the future, export growth from Asia could boost Australian
exports to Asia.
Already there has been some change in Australia's trade
in the direction suggested by individual currency movements. Based on
the twelve months ended in the March Quarter 1998, compared with the previous
twelve months, Australia's imports from the Association of South East
Asian Nations (ASEAN) increased substantially along with imports from
Korea and Japan. Most significant among the ASEAN nations were Indonesia,
Malaysia and Thailand. However, exports to these nations were either stagnant
or falling in the case of Korea and Thailand. These nations are of course
those that have depreciated against Australia. Areas where Australia has
appreciated have shown the opposite response to some extent. Exports to
the US have increased from $5.1 billion to $7.1 billion, a 38 per cent
increase. While imports also increased by 11 per cent, this is probably
due to valuation effects and it is unlikely that physical volumes of imports
have increased. Over the same period Australia has substantially increased
its exports to the major EU countries, France, Germany, Italy and the
UK while imports from those countries have grown only slowly and probably
declined in volume terms.(7)
The point is often made that movements in individual
currencies are of little relevance since international transactions tend
to be invoiced in the major trading currencies. For example, the ABS estimates
that 64 per cent of Australia's exports and 52 per cent of imports are
invoiced in $US. Only 0.2 per cent of exports and 2 per cent of imports
were invoiced in other Asian currencies such as the currencies of China,
Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan
and Thailand. The tendency to invoice in $US may impart some rigidity
into the system. For that reason Australian car buyers noticed that the
price of Hyundai cars actually increased around late 1997 despite the
fall in the Korean won. Since then the invoices or contracts in $US have
been adjusted to reflect won/$A movements and now Hyundai cars sell at
lower prices in the Australian market.(8)
It is important to make the point here that imports and
exports are responding to the signals contained in the exchange rate movements.
Also there has been considerable improvement in the overall index of competitiveness,
based on exchange rate adjusted unit labour costs. The pattern of adjustment
against individual countries goes in the direction of promoting growth
in countries adversely affected by the Asian crisis while the movements
in the $A against most OECD countries should have the effect of promoting
Australian exports in OECD countries.
Until the $A became headline news in June 1998 the markets
had been expecting a cut in official interest rates. For some time adjustments
in interest rates had been downward, but there had been no cuts in official
interest rates since July 1997. Further cuts were anticipated however.
Evidence that the markets were anticipating a further cut in official
rates was indicated by the fact that short dated government bonds were
being traded at interest rates below the official 5 per cent. The $A falls
in June changed the market's expectation of an interest rate cut, especially
with evidence that the Reserve Bank of Australia was intervening in the
currency market in order to defend the $A.(9) It became a small step to
envisage a scenario in which the Reserve Bank would also use higher interest
rates to defend the $A. John Edwards, chief economist at HSBC Australia,
published an article in the Financial Review suggesting the Reserve Bank
was likely to increase interest rates by 200 basis points.(10) (The financial
markets divide one percentage point into 100 basis points.)
An increase in interest rates could work against the
$A falling to values that might give Australia a better balance between
our imports and exports. Recent declines in the $A are the market's solution
to the widening of the current account deficit. So long as the $A is not
departing markedly from the levels dictated by the sorts of factors examined
in this paper, strong defence of the $A is unnecessary. Of course that
argument would not follow if it was believed that the low commodity prices
and other factors causing a widening balance of payments was going to
be quickly reversed.
One important conclusion to emerge from all of the above
is that the $A is not doing anything which cannot be explained according
to the ordinary forces at work in the Australian economy. These are the
'economic fundamentals' often referred to in the present debates. Essentially
the fall in the $A relative to the $US has been associated with the following
inter-linked factors:
- the balance of payments current account outcomes of Australia and
other countries
- exchange rate movements, especially the change in the value of the
yen, and
- commodity price movements.
These factors come through quite clearly and strongly
in the above. Speculators may well have been active while the $A has been
fluctuating wildly. However, there is nothing in the above analysis to
indicate that the $A has been out of line with the factors that ultimately
determine its value. It would be safe to conclude that if there has been
speculation against the $A it has not been destabilising. That conclusion
would not necessarily follow in the case of the Malaysian ringgit and
some of the other Asian currencies. The discussion above pointed to major
overshooting of some of those exchange rates.
The future could be interesting if the commodity prices
and the yen move in different directions. Our analysis suggest the $A
follows both the yen and commodity prices quite closely. The yen relationship
is recent and might be expected to break under pressure with the result
that commodity prices would be restored to their historic role as a regulator
of the $A's value.
Endnotes
- The Sydney Morning Herald, 19 May 1998.
- S Bartholomeusz, 'Comment,' The Age, 10 June 1998.
- The Economist, 13 June 1998.
- The Sunday Age, 7 June 1998.
- 'The bottom line,' The Sydney Morning Herald, 9 June 1998.
That begs the question of whether BHP will indeed declare a profit.
- 'US helps prop up yen,' CNN news report at
http://cnnfn.com/markets/9806/17/yen
- ABS, International Merchandise Trade, Cat no 5422.0, 21 May
1998.
- Economist Barry Hughes from Credit Suisse First Boston made this point
in The Australian Financial Review 17 June 1998.
- The June issue of the Reserve Bank Bulletin confirmed foreign exchange
interventions to defend the $A took place in May 1998.
- The Australian Financial Review, 9 June 1998.
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