The Aussie dollar has risen sharply over recent years. This has given rise to a great debate about its long run exchange rate, that is, is this the new normal for the Aussie? If one looks out more than a few years, there little reason to suggest that the heights of the current dollar will be maintained.
Like so many analysts and economists, I’ve been fascinated with the rise and rise of the Aussie dollar. Such a rise will inevitably have an impact of those sectors exposed to trade, such as tourism and manufacturing. While these impacts on certain sectors of the economy are not in question, what is up for debate is how long these elevated exchange rates will last. I keep reading commentary that Australian businesses need to get used to the high dollar, but something tells me that this will not be the case.
My general impression is that the majority of factors that have conspired to push the dollar higher will not be as present in 5-10 years time. I will look at these factors in turn.
Commodities and China
Australia has been surfing a commodity boom for a numbers of years now and the insatiable demand for our commodities from China has helped to push up the dollar. This seems indisputable, but the question really is how long will this demand last? There is evidence mounting that the commodity supercycle is coming to an end. Iron ore prices have softened recently, but looking further out, the demand from China will eventually cool down, particularly as China rebalances its economy towards private consumption.
This process can be captured in the following diagram, taken from the International textbook of Krugman, Obtsfeld and Melitz (International Economics: Theory and Policy):
This diagram shows the relative demand and supply of output. With the commodities boom, the relative demand for our goods has risen, which pushed up the real exchange rate. As that process reverses, the real exchange rate will decline.
Interest rate differentials
Since the financial crisis, Australia has had a large interest rate differential with other Western economies. With such a differential, it is not surprising that a carry trade develops where investors borrow in low yield currencies, such as the Japanese Yen, and invest in the Aussie dollar, a high yield currency.
Again, however, I do not expect this differential to be so pronounced in 5 years time. Economies such as the US and UK will eventually recover and their interest rates will come back to normality – that is, away from the zero lower bound. Even though it is difficult to quantify the carry trade, this closing of the differential will take away a source of upwards pressure on the dollar.
This is seen in the following diagram (from the same textbook). Focusing on the top half of the picture, the shift in the green curve represents an increase in US interest rates. For fixed values of the expected future exchange rate and the USD interest rate, this ‘expected return on USD deposits’ curve is downward sloping. The intuition for this is as follows: for simplicity, assume an exchange rate and an expected future exchange rate of 1 – an appreciation of the currency today implies an expected future depreciation to return it to 1. Thus, an appreciation of the local currency today, all else equal, raises the domestic currency return expected of foreign currency deposits.
Safe Haven Status
A lot of commentary, see here and here, has discussed the Aussie dollar’s increasing role as a safe haven currency. This is demonstrated in the large proportion of foreign ownership of Australian Government bonds. This is not surprising as foreign investors, both public and private, have attempted to diversify their holdings as Europe has entered its crisis. Australia still has its triple-A credit rating, which is becoming a rare commodity itself. In this FT Alphaville post however, JP Morgan’s Australian economists make the case that this process has probably reached its limit, where it will be more about portfolio management of assets rather than portfolio broadening. Combine this foreign demand stabilisation with the assumption of a stable Euro zone in 5 years (with at least some countries seeing their credit ratings rise), and this is another source of recent upwards pressure on the aussie dollar that will not be there in future.
FDI & LNG
This post highlights the importance of FDI in determining the exchange rate. Richard Yetsenga, Head of Global Markets Research at ANZ in Sydney, presents evidence that the strength of the Aussie dollar owes more to the resources boom than to foreign demand for Aussie bonds. Following on from its mining boom, Australia is also experiencing an LNG boom, which is attracting a lot of foreign direct investment. This implies that the dollar will remain strong as long as this investment holds up. The Alphaville post cites the RBA claim that resource investment will peak at 9% of GDP in the next 18 months, meaning a weakening of the currency beyond that point. Despite this, however, this is one area that could maintain its upward pressure on the Aussie dollar into the medium term if the LNG boom persists.
Exchange rates are the most difficult of economic variables to attempt to forecast, so putting a precise figure on the aussie dollar in five years time is fraught with danger. But in general, I view the aussie dollar’s medium term rate closer to 0.80USD than it’s current level. Of course, there’s every chance that I’m wrong, but if the Aussie dollar is still around parity with its US counterpart in 5 years times, it will certainly have taught me something.