Monday, October 27, 2008

Puzzles about the fall of the Aussie dollar - more economics 101

The gyrations in the Australian dollar continue to bemuse me. Three months ago it was closing on parity with the US dollar. Over the week-end it reached 60.57 US cents for a dollar.

I am very glad we went to China when we did. A little later, and we would be struggling to pay for things.

Like many, I am puzzled by the dollars gyrations and especially the size of the fall.

The problem is that the Australian dollar is one of the most traded currencies in the world, I think one of the world top five. This is far out of line with our share of the global economy, a bit under 2 per cent. The aussies's role in complex global currency markets with its myriad transactions means that its price is driven by often unclear factors that have little to do with our real economy.

I am not sure that we should complain, however. As I remember it, a similar dollar decline in 1997 was one of the reasons why we cruised through the Asian financial crisis with so few domestic impacts.

I hesitate to predict the future value of the aussie, my success rate in this area is very poor. I feel more confident about discussing the likely impact of a lower dollar.

The first point to note is that the impact of the lower dollar depends upon just how long it stays down. The longer its stays down, the greater the impact on the structure of the Australian economy.

The first effect of the higher dollar is higher import prices for both consumer and producer goods. The impact here depends upon the extent to which Australia's major suppliers reduce their prices to hold market share, the extent to which retailing in particular reduces profit margins on imported product to hold sales. The longer the lower aussie dollar value continues, the lower the ability of suppliers and retailers to contain price increases.

We can already see this in retailing where reduced domestic demand in combination with higher import prices is now affecting retail sales. Retailers are already restructuring strategies to increase focus on domestic products where they can.

We can also see it in producer prices - the cost of inputs - where rising producer prices have been feeding into inflationary pressures. Australia is heavily dependent upon imports, so the effect of a fall in the dollar is substantial. The extent to which this will flow into further inflation depends upon second round effects and especially wage responses. Weakened domestic demand will tend to suppress these effects.

On the export side, the fall in the value of the dollar means that our exporters receive higher returns on exports expressed in aussie dollar terms. The impact here depends importantly upon the combination of two things: the extent of international price falls for our exports because of reduced global demand, together with the relative importance of imported inputs in the final export product.

This combination means that a lower aussie dollar value has substantially varying impacts across export indutries.

Traditionally, changes in the external value of the aussie have provided an important buffer for our main commodity exports. International prices fall because of reduced demand. This is then offset by higher local dollar prices. We can already see this happening in iron ore.

The impact on some of our agricultural products is a little less clear cut because imported inputs have become relatively more important in some sectors. Still, in broad terms the pattern applies.

The impact on manufactured exports is far less clear cut because so many of our manufacturing exports depend upon imported inputs, as well as the exact markets those exports go to. I lack the data to make a proper judgement here.

The position on the services side is also variable.

Tourism is a major export earner, but also one where our imports (Australians going overseas) largely offset, sometimes more than offset, exports (those visiting Australia).

The lower aussie dollar cuts back international travel by Australians, but also makes it cheaper for overseas people to visit Australia. In the short term, the international downturn is cutting tourist visits to Australia. Qantas is already talking about the combined impact of the two on its international traffic.

Reductions in inward tourism means that the dollar value of tourism exports will fall. However, the net balance of payments effect is unclear because this will be offset to greater or lesser extent by reduced tourism imports.

Our exports of education services, a very big net contributor to the balance of payments, will benefit from the lower value of the aussie. I have been seriously worried about this area because lower global economic activity is likely to reduce the number of students studying internationally. I saw this having a major impact on an education sector now heavily dependent upon international student fees.

I remain concerned. However, the much lower aussie dollar does provide at least some short term protection.

The likely impact of the lower dollar on our exports of professional and financial services is unclear. As a general statement, the global economic downturn will obviously affect service activity since the volume of traded services is a function of economic activity. To maintain exports, Australia will need to increase market share.

Some service exports (and imports) depend in whole or part upon on-ground delivery. Higher Australian dollar costs for international travel and for accommodation will reduce Australia's ability to compete, although this may be offset to some degree by the reduction in hourly rates expressed in aussie dollar terms.

The position is different where the activity can be carried out remotely. In legal services, for example, Australian hourly rates are now 40 per cent less in US dollar terms than they were just three months ago. That's a very large shift. On the other side of the equation, major service import areas such as call centres are 40 per cent more expensive.

The best gut judgement that I can make is that our exports of traded services are likely to increase, our imports decline, for a net gain.

The position on the capital side of the balance of payments is very complex.

Australia has been a net importer of capital to fund the deficit on the balance of trade, as well as our own capital exports through direct international investment. If, as seems likely, a lower exchange rate leads to an improvement in the balance of trade, then our need for capital will decline. Further, the lower dollar also tends to choke off capital exports by making overseas investment more expensive in real terms. This holds also to some degree for overseas funds invested in the country - people may prefer to hold, rather than realise immediate capital losses.

On the other side of the ledger, the local dollar value of dividends and interest payments on existing investment stocks increases, although this will also be adversely affected by the impact on global profitability of the international downturn. In addition, the lower value of the dollar is likely to attract some investment because of the lower real price of Australian assets. Already some overseas investment advisers are recommending investment in Australian shares.

The longer the aussie dollar stays down in value, the greater the impact.

Expectations are critical here. Real investment decisions depend upon expected longer term profitability. If the present low value of the aussie dollar is perceived as short term, then the immediate impact on real investment will be reduced. The longer people expect the dollar to stay down, the greater the change in the real economy.

In all this, my gut judgement is that Australia continues to be a somewhat lucky country.

We are probably not going to cruise through this one as we did during the Asian financial meltdown or the end of the tech bubble. That would be hoping for too much. However, in the short term the lower dollar will at least cushion the financial impact, while the economy as a whole should emerge in a relatively stronger position in the longer term.


Australia's Reserve Bank has been obliged to enter the market to buy Australian currency in order to preserve market liquidity, thus easing fluctuations in the dollar value. Thinking about this made me realise that there was one part of the jigsaw that I did not deal with in this post.

Australia has very little Government debt. However, we do have high exposure in terms of private borrowings.

Where those borrowings have been expressed in US dollar or some other foreign currency, the effect of an exchange rate reduction is to increase the amount of local currency that must be paid to meet interest and capital payments, this places downward pressure on economic activity.


Ramana Rajgopaul said...

Boy are you lucky? US Dollar capital has been fleeing India and the rupee has been on a free fall. In one month, it has lost over 20% of its value in comparison to the USD.

I however believe that this is a temporary phase, and agree with you that we shall come out of this present phase stronger and wiser.

Jim Belshaw said...

That's interesting, Ramana. I hadn't focused on India.