Currencies | Jul 02 2012
– Australian dollar becoming increasingly resilient
– Cyclical and long-term factors at play according to Westpac
– Retaining a floating exchange rate the key to adjustments
By Chris Shaw
Since October of 2010 the Australian dollar has averaged just under US$1.03, on five occasions breaking below US98c and fives times moving up through US$1.06 over this period.
Westpac notes there have been 8.5 trough to trough pricing cycles with an average magnitude of around 7% over that time. This implies the currency has become more resilient during risk aversion phases and more responsive during risk-seeking phases.
Looking at this increased resilience for the Australian dollar, Westpac senior international economist Huw McKay suggests there are a number of contributing factors. One is the currency is simply attractive to foreign exchange reserve managers given the currency is highly traded and quite liquid.
A further attraction of the currency is Australia's improved external financing position, which in part reflects a narrowing of net external financing requirements thanks to an improved trade position. While McKay cautions some of this improvement may be cyclical, some will also be long lived.
Pre-GFC, McKay notes it was primarily the financial system that took on the task of current account financing as portfolio debt inflows were needed to fund the gap between Australia's savings and investment needs.
This gap is now much smaller, while along with banks the corporate sector and Commonwealth and State governments are accessing a mix of direct and portfolio debt and the proportion of local credit demand being met by offshore debt issuance is declining. This has created a more resilient capital flow picture for the Australian economy.
As well, the size of the current account deficit narrowed from around 6% of GDP in December of 2009 to less than 2% in September of last year, as there was a shift from trade deficits to surpluses as both households and corporations chose to save rather than spend.
As savings levels improved the ratio of stock of foreign debt to GDP has declined from more than 54% in December 2008 to 47.8% in June last year. As this ratio had acted as an anchor on currency appreciation, the improvement saw Westpac add US5c to its estimate of AUD fair value between 2010 and 2011.
Looking forward, McKay suggests some of the factors that have helped improve Australia's external financial resilience are expected to become less favourable, As an example, he notes the current account deficit has already begun to widen again and could be back to 5.8% of GDP by the end of 2012 as the trade position has swung back into a deficit.
The mining investment boom, which is again on the rise at present, will be a multi-year phenomenon and will have a long-lasting impact on potential output. But McKay cautions the mining industry impact on Australia's current account and external financing dynamics will remain highly volatile as the process moves from the investment phase to when the supply dividend becomes apparent.
With respect to foreign exchange reserve allocation, McKay notes there is a difference between periods when the EUR/USD is moving higher and the USD/Asia is steady and when Asian currencies are moving in line with the euro and in favour of the US dollar.
The former indicates appreciation resisting intervention, which implies reserve accumulation and fresh recycling and diversification demand for the Australian dollar. The latter implies the reverse with the respect to the currency.
China remains a major impacting factor, McKay expecting at some point the moves towards liberalisation of capital flows and less stringent control of financial markets will mean lower reserve accumulation going forward.
McKay's conclusion is as the forces noted above continue to shift the Australian dollar's resilience during times of financial stress will reduce, which is no bad thing. The floating exchange rate achieves this, at different speeds at different times and with various levels of impact on different sectors of the Australian economy.
But not having a floating exchange rate would cause greater problems, which McKay sees as putting some pressure on policy makers to achieve a more desirable mix of financial conditions if the currency on occasion temporarily pushes too much of the adjustment burden onto the inflation rate.
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