Many call for a devaluation of the $AUD. Whilst this is possible under applied policy, there seems little understanding of what drives the value of the currency. In simple language, the value of the currency is being driven by three forces.
- The historic deficit on the current Account
- Inflation targeting by the RBA.
- Currency speculators
Free trade in Australia has been possible only through long term cross subsidization of balance of payments accounts. An historic and entrenched deficit on our current account has been offset by capital inflow on the capital account. Between 1967-68 and 2010-2011, the current account deficit has averaged 3.2% of GDP annually. Broken into non-free trade and free trade periods between 1968 and 1982, the current account deficit averaged annually 1.7% of GDP which includes a -4.7% outcome in 1982-83. Post free trade policies pursued from 1982-83 to 2010-11, current account deficits have average 4.2% of GDP annually. This is 147.1% deterioration in Australia's external current account balance under free trade policies. Given these figures, it becomes difficult to defend free trade policies perceived to drive efficiency and productivity improvements in the production base.
Current account balance of payments deficits arise because the value of imports exceeds the value of exports. The current account balance though is much broader than trade balance which is the popular media measure of external balance. There is another important component of the current account which in net income flow. This comprises net interest on debt and dividend flows related to external borrowings; and, foreign investment.
Between 1976 and 1983, net income flow averaged annually a negative 1.7% of GDP. From 1984 to 1999, net income deficit averaged 3.1% of GDP. Between 2000 and 2012, the net income deficit deteriorated further to average 3.4% of GDP. The worst performance was 2007 when the net income deficit was 4.6% of GDP. This deficit in net income flow is largely the consequence of Australia's need for foreign capital inflow to offset the entrenched current account deficit. Theoretically, after a certain point, dependence upon capital inflow to provide an overall balance across both capital and current accounts becomes self defeating. The more dependent upon capital inflow a nation becomes, the more inflow is needed to plug the net income outflow of dividends and interest payments generated by ongoing capital inflow. It is very much akin a to a drug addicts insatiable appetite for a "fix".
Australia's political rhetoric about strong terms of trade does not ensure a surplus on the current account. A terms of trade index is simply an index ratio of export prices to import prices. The other determinant of current account balance is volume of both imports and exports. High commodity prices do not ensure a trade surplus if the volume of imports is such that the value of lower priced imports is greater than the value of higher priced exports. The attached page gives current account outcomes from 1967-68 onwards. External policy failure post 1983 cannot be denied.
The significance of the net income deficit can be traced in the column of rising external debt. External debt comprises both private and public debt. The fact that private debt is the major component is of no consequence in the current account accounting. Both private and public debt is responsible for the external net drain on GDP. Annual GDP growth must cover the net income deficit before Australians begin to benefit from growth.
For currency stability under a market determined exchange rate, the capital account inflow must equal any deficit on the current account. This means that RBA monetary policy must keep an eye upon capital account inflow to ensure it is sufficient to "cross subsidise" the free trade deficit on the current account. To do this, domestic interest rates are held above international rates. This creates a "tiger by the tail" syndrome. Once currency speculators (euphemistically referred to as currency traders) realise what is happening, they "bet" against central bank policy by borrowing in cheaper international interest money markets to invest in the higher interest currency. This is known as the interest rate differential.
Discretionary central bank policy that maintains an overvalued currency through interest rate differentials becomes the target currency for speculators. This is known as the "carry trade". International literature names the Australian currency as a "carry trade" currency as far back as 1996. This is interesting as it was in 1996 that the RBA was granted independence to manage monetary policy. But, currency speculators are not the only operators in the "carry trade". Financial institutions also borrow in cheap interest money markets to lend at higher domestic interest rates. A broader definition of the "carry trade" includes domestic financial institutions borrowing in cheap money markets to lend domestically at higher interest rates. Consequently, the value of the currency becomes determined in asset markets- not commodity markets. It is all about yield.
Inflation targeting creates problems for the value of the currency. Since deregulation central banks cannot influence the money supply. They resort to setting the price of domestic credit to manage aggregate demand. The price of credit is influenced through the cash rate. But, since the GFC, "the originate" to distribute banking model, has demonstrated an increasing disregard of official cash rate settings. The influence of central bankers on domestic interest rates in recent times appears very much diminished. Nonetheless, speculators in liquid and semi liquid asset markets still bet against central bank policy. Just follow the reaction of traders in international asset markets around the world on the days leading up to central bank interest announcements.
So the call for lower interest rates has some merit; but, is a complex call. Lower interest rates should lower the value if the dollar; but, by how much. That would depend on the international interest rate differential. However, a lower currency means higher cost of imports. Inflation is stimulated. Unless there is excess capacity in the domestic production base to replace expensive imports, the national standard of living falls. The central bank then faces a dilemma. Do they raise interest rates and hurt exporters and domestic employment, or, do they pursue an expansionary monetary policy stance and generate inflationary forces and stability in employment markets.
Modern fiscal policy has become increasingly a "bean counter" function since smaller government has become the order of modern economic orthodoxy. There is little fiscal policy can do. To increase expenditure to force a lower currency would require international borrowings to finance an expansionary fiscal policy. This would "feed" the net income deficit "habit". The difficulty lies in the diminution of government involvement in economic management under contemporary orthodox economics.
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