Australian Dollar: Its Appreciation and Policy Implications

Australian Dollar: Its Appreciation and Policy Implications

Reasons for the Appreciation of AUD

Figure.1: Movements in the Australian dollar since the floating of the exchange rate in 1983
Source: Reserve Bank of Australia
The Australian Dollar (AUD) has been appreciating in the late 2013 despite the recent trends of interest rate cuts by the Reserve Bank of Australia (RBA). Various reasons may explain why the Australian Dollar (AUD) has been appreciating in the late 2013 despite the recent trends of interest rate cuts by the Reserve Bank of Australia. The primary reason for this appreciation in AUD is that Australia’s terms of trade have been increasing because of the rising world prices of Australia’s commodity exports. Another reason that might have contributed to the appreciation of the AUD in the late 2013 is the economic weakness and increased risk in other advanced economies. At the same time, the appreciation in AUD value might have been as a result of overvaluation of the AUD (Garton, Gaudry & Wilcox, 2013).
Regarding the Terms of Trade (TOT), a rise in commodity export prices within a real economy perspective such as Australia’s raises the equilibrium real exchange rate due to the resulting higher demand for Australia goods which requires the goods prices to go up relative to foreign goods. As commodity prices increase, there is increased investment to expand in the resources sector. At the same time, the resulting higher aggregate following the rise in TOT generates an increase in consumption spending especially on domestic goods. This is to say that higher exchange rate is vital in enhancing the reallocation of the factors of production in meeting these demands through reducing returns in other tradable sectors. But this adjustment may either occur through the increased nominal exchange rate, or through higher domestic prices. Thus, regardless of holding down of the nominal exchange rate, the situation of high inflation will still lead to the increase in real exchange rate over time (Gruen, 2011).
Another reason for the appreciation of the AUD would be the happenings in other markets in which the exchange rate plays an important role. Looking at this from a financial market view point, an increase in resource prices generates a rise in equilibrium exchange rate first because the rate of return on capital invested in the resources sector increases, and second, because higher incomes stimulates domestic demand thus requiring tighter monetary policy than before, hence the need for higher interest rates. But if looked at from the foreign exchange view point, an increase in the export commodity prices will have the effect of causing a rise in demand AUDs through both increased export receipts and increased capital flows. These activities occur in response to the higher returns on Australian assets (Garton, Gaudry & Wilcox, 2013).
Regarding circumstances in other advanced economies, there are two reasons why this would cause the AUD to appreciate. First, interest rates in other advanced economies have tended to remain at significantly low levels due to prolonged period of economic weakness. Consequently, the differential between Australian interest rates and interest rates of the other developed economies has been unusually high. However, Australian interest rates have seldom been high. As mentioned earlier, some Central banks have undertaken Quantitative Easing measures alongside holding policy interest rates at near the zero lower limits. The monetary expansion policy (quantitative easing) practice serves to put more downward pressure on the currencies of the respective economies hence contribute to the high AUD (Woodington, 2013).
The second way is that some of the other advanced economies have weak economic growth, high levels of government debt, and fragile banking systems. Consequently, these advanced economies are judged as more risky. One the other hand, Australia is regarded as being among the few countries having a stable AAA credit rating. Therefore this, together with the first set of factors has boosted the risk-adjusted returns on Australia’s assets comparatively, and thus boosted the demand for AUD assets by global investors (Australia Office, 2014).
Finally, appreciation of the AUD may have been as a result of overvaluation of the AUD compared to its medium-to-long run equilibrium value. This is a result of uncertainty involved in AUD exchange rate estimation approaches caused by cyclical divergences in economic activity and relative interest rates. The reason behind the recent overvaluation of the AUD is the weak monetary policy in the United States and Japan as well as in Europe. Considering fact that the Australian economy has remained relatively strong, together with Australia’s interest rates remaining above those of the rest of the West, the Australian economy attracted money inflows which kept Australia’s exchange rate strong (Henry, and Olekalns, 2002).

 

Policy Challenge: Why Intervention may not help RBA
The Australian Dollar (AUD) has been appreciating in the late 2013 despite the recent trends of interest rate cuts by the Reserve Bank of Australia (RBA). Consequently, the RBA is in a tricky situation because there are two antagonistic economic influences requiring two opposite approaches to interest policy. The first obvious scenario involving the low domestic interest rates implies that property prices in Australia capital cities have gone up significantly. The second scenario involving the appreciating AUD presents the RBA with problems maintaining Australia’s export market. This export market challenge arises out of the uncertainty from a Chinese focused slow down whose impact is to reduce raw material demand and therefore significantly hurt Australia’s major export markets (Australia Office, 2014).
RBA is in a dilemma situation because on the one hand, the appropriate policy action necessary to counteract a slowdown in exports demand and jobs growth is the interest rate cuts. In other words, the RBA has had valid reasons to implement interest rate cuts, making borrowing cheaper hence inject capital into businesses. At the same time, interest rate cuts are ideal in weakening the Australian dollar thus making Australian exports cheaper and more appealing to the global community. On the other hand, however, raising interest rates would be an ideal policy option for RBA because doing that would help counteract asset price appreciation, especially in the housing market. Increasing interest rates would have the effect of increasing domestic borrowing costs thus reducing affordability of domestic credit. Indeed interest rates in Australia have significant bearing on affordability considering fact that Australia’s house prices in major cities like Sydney are so high relative to annual income (Crosby, 2013).

RBA has a delicate balancing act because the international markets are flooded with liquidity resulting from Quantitative Easing (money printing) practice of the Western Central Banks. At the same time, it is apparent that international markets are starved of secure interest bearing investments due to the fact that cash rates remain close to Zero in the majority of developed nations. Although at record lows, Australia’s cash rate is still at a premium to many other Western counterparts. In addition, the commonwealth securities still have the highest AAA credit rating. For Australia, it means that any move to increase interest rates further with a view to cool down the hot housing market will result into an improved Australia yield differential hence push the AUD value higher, increase cost of credit for business and this then will hurt exports and job security. On the other hand, any move to lower Australia’s cash rate will have the effect to add more heat into Australia’s housing market (Australia Office, 2014).
The foregoing policy challenge means that RBA may find it difficult to intervene using either the monetary policy or even intervention in foreign exchange markets to stabilize the AUD. This is because either of this policy options leads to the problem of incompatible policy objectives. When the Central bank targets inflation, it will be forced to raise interest rates in order to offset the stimulatory impact of the lower exchange rate. This would in turn have the impact of pushing the exchange rate back up (Australia Office, 2014).

Figure 2: Impact of Falling Rates
Source: http://users.chariot.net.au/~mjarrett/Devel/Demand/Defex12d.htm
In Figure.2, if the RBA was to pursue an expansionary monetary policy thereby either reducing the cash rate or using open market operations to reduce the interest rates in Australia, the effect would be to have both consumption and investment rise. This is due to fact that household consumption is largely base on borrowing and therefore when interest rates fall, households borrow more while businesses also increase the levels of investment because they can borrow more too. Consequently, as both lending and spending increase, production for both goods and services will increase hence lead to increased aggregate demand Increased aggregate demand will have an inflationary effect on the Australian economy (Australia Office, 2014).
Recommended Policy Approach for RBA
If I were to advice the RBA during this time, I would suggest that a tighter fiscal policy be used in order to achieve a lower exchange rate without sacrificing macroeconomic stability. A tighter fiscal policy would mean either cutting government spending or increasing taxation. The effect of this would be to dampen economic activity and, thereby, inflation. If a sufficiently large fiscal tightening is adopted by Australia, it will allow for easing of the monetary policy and depreciation of the exchange rate without causing increased inflationary pressure (Garton, Gaudry & Wilcox, 2013).

Figure 3: Illustrates the effect of tight fiscal policy.
Source: http://www.economicshelp.org/macroeconomics/fiscal-policy/fiscal_policy/
In figure.3, the tight fiscal policy has the effect to decrease aggregate demand [AD which is given as AD = C+ I + G + X – M)]. The consumer expenditure is reduced by existence of higher taxes. The use of a tight fiscal policy has an overall effect of improving the government budget deficit (Gruen, 2011).
Social/Cultural Impact of the Recommended Policy:
If the effect of a tighter fiscal policy is to stabilize economic growth, avoiding a boom and bust economic cycle, it means that the ideal situation would be one that will lead to a net impact of change in both aggregate demand and aggregate supply such that both production and income increase while prices decline. This would lead to a rise in exports and by extension, to a decrease in imports (if Australia made substitutes become cheaper than imported alternatives) (Gruen, 2011). Figure.4 illustrates this scenario.
Figure 4: Changes in both Aggregate Demand and Aggregate Supply
Source: http://users.chariot.net.au/~mjarrett/Devel/Demand/Defex12d.htm
In Figure.4, Production and income (i.e. GDP) will move from Ye to Ye2 and the price level (that is, inflation) will fall from Pe to Pe2. Consequently, unemployment will fall, and the exchange rate will not depreciate. A fall in unemployment means improved standards of living among Australians as the dependency ratio declines among other social issues.

References
Australia Office, (2014). RBA’s future monetary policies may prove stagnant. Retrieved on 2/5/2014 from http://audnews.com.au/rbas-future-monetary-policies-may-prove-stagnant/1137
Crosby, M. (2013). Intervene or wait? The RBA faces tricky path to a lower dollar. Retrieved on 22/5/2014 from http://theconversation.com/intervene-or-wait-the-rba-faces-tricky-path-to-a-lower-dollar-20091
Garton, P., Gaudry, D., & Wilcox, R. (2013). Understanding the appreciation of the Australian dollar and its policy implications. Retrieved on 22/5/2014 from http://www.treasury.gov.au/~/media/Treasury/Publications%20and%20Media/Publications/2012/Economic%20Roundup%20Issue%202/Downloads/03_Appreciation_of_the_Aust_dollar.ashx
Gruen, D. (2011). ‘The macroeconomic and structural implications of a once-in-a-lifetime boom in the terms of trade boom’, Address to the Australian Business Economists Annual Conference.
Henry, O.T, and Olekalns, N. (2002). Does the Australian dollar real exchange rate display mean reversion? Journal of International Money and Finance, 21, 5, pp 651-666.
Woodington, M. (2013). The High Price of the Australian Dollar. Retrieved on 22/5/2014 from https://www.mywealth.commbank.com.au/economy/how-the-australian-dollar-rose-to-the-top-hottopic201303

 

 

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