Fluctuations in the Value of the Australian Dollar


Current Issues Brief 21 1997-98

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

Introduction

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.

First the facts

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. $A/$US exchange rate

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. $A/TWI

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.

$A - fallout from Asian crisis?

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.

Figure 3. Exchange rate indices against $US

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.

Figure 4. $US/$A and seasonally adjusted 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.

$A - a commodity currency or Asian currency?

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 5. $A and commodity prices

Figure 6. Yen per Australian dollar

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.

Implications for the economy

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.

Figure 7. Unit labour cost index

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. Exchange rate movements against top 20 Australian trade countries

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.

Interest rates

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.

Conclusions

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

  1. The Sydney Morning Herald, 19 May 1998.

  2. S Bartholomeusz, 'Comment,' The Age, 10 June 1998.

  3. The Economist, 13 June 1998.

  4. The Sunday Age, 7 June 1998.

  5. 'The bottom line,' The Sydney Morning Herald, 9 June 1998. That begs the question of whether BHP will indeed declare a profit.

  6. 'US helps prop up yen,' CNN news report at http://cnnfn.com/markets/9806/17/yen

  7. ABS, International Merchandise Trade, Cat no 5422.0, 21 May 1998.

  8. Economist Barry Hughes from Credit Suisse First Boston made this point in The Australian Financial Review 17 June 1998.

  9. The June issue of the Reserve Bank Bulletin confirmed foreign exchange interventions to defend the $A took place in May 1998.

  10. The Australian Financial Review, 9 June 1998.