AUSTRALIA'S PLACE IN THE GLOBAL ECONOMY

Trends in the Exchange Rate and its Impact on the External Stability

Insights

What Has Happened?

The Australian dollar has been fairly volatile since the introduction of the floating exchange rate (ER) in 1983.

Fluctuations in the Exchange Rate

During early 2009, the dollar hit a 6-year low of $0.63USD as a result of the GFC. The mining boom in mid 2011 precipitated a historic high exchange rate of US$1.10. Between 2015 and 18, the dollar largely fluctuated between 0.75 and 0.85. At the time there was declining mining investment and less favourable interest rate differentials with the federal reserve raising interest rates from 0.75% in 2016 to 2.5% by 2019. During 2018-19, the exchange rate hovered around 0.70-0.75USD. Australia’s ER was hurt by trade war tensions between the US and China, which significantly affected Australia as a small open economy, with China being Australia’s largest trade partner (China was demanding less of Australia’s iron ore exports due to dampened economic growth). On the 20th of March 2020, the Australian dollar fell to a 17-year low, hitting US$0.57. This was largely in response to both the RBA’s expansionary cash rate decision, and the announcement of a major stimulus package by the US government. Further risks that may see the dollar continue to depreciate include the growing political tensions between Australia and China, which has manifested in an 80% tariff of Australian barley.

 

The depreciating dollar in recent years (2015-2020) has had a varied impact on Australia's external stability. The lower exchange rate has most importantly improved our international competitiveness by making exports cheaper and imports more expensive. Australia’s score on the competitiveness index increased from 50.8 in 2015 to 78.75 in 2019. In late 2015, the Balance of Goods and Services surplus stood at a deficit of -$5.28 billion, but our increasing international competitiveness has boosted the trade balance into a surplus of $10.602 billion as of March 2020. However, demand for Australia’s service exports have been shelved due to the coronavirus pandemic, with tourism and education taking the largest hits due to travel bans. This has been blunting the benefits of a weaker dollar.

Syllabus Links

International Competitiveness/Dutch Disease:

Lower Exchange Rate tends to improve international competitiveness as it makes imports more expensive, and exports cheaper. This can stimulate economic growth as consumers switch to domestic products. On the other hand, a higher exchange rate can make imports cheaper, suppressing the consumption of domestic products. However cheaper imported inputs can reduce production costs for domestic industries, generating larger profits and potentially improving their international competitiveness

Dutch Disease- A sustained appreciation due to strong growth in one industry (mining in 2011) can erode the international competitiveness of other sectors e.g. tourism, manufacturing and services due to higher prices. It can cause the long term “hollowing out” of these sectors such as 20 000 people retrenched in the car manufacturing industry between 2013-16. This then resulted in structural unemployment.

Balance on Goods and Services:

The exchange rate can affect the trade balance. The depreciation in 2009 where the dollar dropped from $0.96USD to 0.60USD boosted the competitiveness of mining exports, contributing to Australia’s return to strong growth. Also reduces imports as they’re more expensive.

The J-Curve captures the impacts of a depreciating exchange rate on the trade balance. Short term worsening of BOGS due to inelasticity. Medium term improvement in BOGS as exports become cheaper and more competitive, imports become more expensive, thus less imports are demanded. The turning point is known as the “Marshall-Lerner” condition whereby the price elasticity of exports plus the price elasticity of imports is equal to or greater than 1. In the long term the highly competitive exports help boost the trade balance into a surplus.

 

Purchasing power  

Appreciation leads to cheaper imports, and therefore lower imported inflation. Cost-push inflation is also reduced due to cheaper imported inputs. In 2010-12 the exchange rate appreciated to $1.1USD due to the mining boom. This helped to contain inflationary pressures through lower import prices. Inflation remained below 3% despite high GDP growth of 4.2%

Buffer for economic shocks

Flexible exchange rates help insulate the economy from external shocks.

This was illuminated during the depreciation of the ER during the GFC of 2008-09 improved the international competitiveness of exports and supported export revenue, preventing a larger increase of domestic unemployment. Unemployment remained below 6% despite initial projects in 2008 of 10%. A technical recession was avoided with 1.2% growth in Australia in 2009. Global economic growth at the time was -1.3%.

Christopher Kent (assistant RBA governor); “Since floating, Australia has demonstrated considerable resilience in the face of external shocks”

Valuation Effect

Since a significant amount of Australian debt is denominated in USD, a depreciating AUD increases the servicing costs of repayments denominated in foreign currency (net foreign debt is 60% of GDP). This worsens the Net Primary Income component of the Current Account. CAD has worsened from 4% of GDP to 4.6% of GDP (2014-16) because of the sustained depreciation. However, in recent years most (90%) of private sector debt is hedged against currency fluctuations.

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