The value of the Australian dollar is an important issue for business and for policymakers. A crucial source of additional demand to replace the loss in investment demand at the end of the resources boom would normally be through higher net exports.
This should occur through a loss in the terms of trade weakening the currency and lower interest rates weakening the currency further. Thus the impact of a disappearing mining boom on aggregate demand could be managed more easily with a weaker currency. A range of factors are complicating this process.
In assessing where a currency is likely to head or whether Australia is likely to run a current account deficit or a current account surplus can only be analysed relative to what is happening in other countries. Too often analysts make forecasts based on the state of the economy relative to Australia’s recent past when the key issue is the state of the Australian economy relative to other countries.
Empirically, the Australian currency tends to weaken when commodity prices fall or when domestic interest rates fall relative to those in the United States. It is reasonable to expect the fall in commodity prices since 2011 would weaken the Australian dollar. Similarly the announcement of tapering or an end of quantitative easing in the United States would herald a rise in U.S. interest rates relative to those in Australia and thus weaken the Australian dollar.
However, looking at the global economy, there are good reasons to believe the Australian dollar will appreciate over the next five years or so.
In the near term a key issue for global investors is where returns are likely to be generated in future years. The more foreigners want to buy Australian physical and financial assets relative to other countries, the higher the demand for Australian dollars. This shift in portfolio preferences has recently become important. My research suggests a 100 basis point reduction in the risk of investing in Australia would appreciate the exchange rate by 10 per cent. A cut in the short-term policy rate has an order of magnitude smaller effect on the currency. In addition to lower risk, capital gains in a variety of assets because of loose Australian monetary policy will tend to attract foreign capital.
Flight from emerging nations
With the end of quantitative easing in the United States, investors are pulling their money out of emerging economies, worried about the state of these economies in a world of higher interest rates. This capital is likely to move back into the U.S. economy but investors are also likely to diversify that reallocation of capital into well-performing countries like Australia. In the medium term there are other even stronger forces that are likely to strengthen, rather than weaken, the Australian dollar.
Many countries in the world will have to reduce their fiscal deficits and indeed run substantial fiscal surpluses in order to bring government debt down to sustainable levels. A cut in the budget deficit raises national savings.
If private investment absorbs this increase in saving then there is no implication for the current account.
However, in most economies, a fiscal contraction tends to weaken private investment, thus fiscal rebalancing tends to lead to a capital outflow because savings rise relative to investment.
With many large countries adjusting fiscal policies, there is likely to be a significant amount of global savings looking for a safe home. Even though Australia has to embark on its own fiscal adjustment thanks to a large increase in government debt under the Labor government, this adjustment is less than most other advanced economies and therefore more capital is likely to flow to Australia. The likely upward pressure on the Australian dollar is clear.
The result is that a policy of waiting for the Australian dollar to fall or to encourage it by cutting interest rates further and generating further capital gains in a wide range of assets will not solve the problem of a strong currency during the current transition from a resources boom.
Businesses are already focusing on cost cutting and productivity-enhancing change. Government policy needs to support this, especially through provision of productivity-enhancing infrastructure (which fortunately should be relatively cheap to finance).
The need for flexibility in the Australian economy will only increase as the wave of global savings surges in coming years.
It is notoriously difficult to predict the exchange rate but the signs are that a weak Australian dollar is not the most likely outcome in coming years.