Reserve Bank Governor Glenn Stevens has again weighed in on the value of the Australian dollar, telling a group of economists the bank is open to the idea of intervening to bring its value down.
With the Australian dollar having been plus or minus ten cents from parity with the US dollar for most of the past six years, many of us may have forgotten that only a decade ago Australians were complaining about how stubbornly low it was.
At that time the exchange rate was only a little above 50 cents, and some pundits were predicting worse was to come. Imported goods and holidays were expensive, but of course the beneficiaries of this low exchange rate were exporters of goods, as well as service exporters in the education and tourism sectors in particular.
Movements in the Australian dollar since the floating of the exchange rate in 1983 have been volatile and unpredictable, so that there is in fact nothing particularly unusual about the past decade, as the chart below shows.
Most Australian companies now know how to deal with exchange rate volatility through using hedging, which allows companies to deal with uncertainty about future exchange rates. While volatility might seem to be undesirable, there is remarkably little empirical evidence that the kind of volatility in the exchange rate that we suffer in Australia has significant costs.
Despite this, the majority of economists, including those within the Reserve Bank and the Treasury view the current exchange rate as too high. My view is a fair value for the Australian dollar would be in the range of 70 to 80 US cents, and there has been little to suggest that this range has moved in the past decade. This range would enable the competitiveness required for an even balance of trade over a long period.
In the early 2000s I was arguing that the AUD was significantly undervalued, and today the exchange rate is overvalued to the tune of at least 15%. However, the undervaluation of the AUD lasted for several years, and the current overvaluation is likely to continue for at least the next year or two.
There is no doubt that exchange rates can be misaligned, sometimes for very long periods of time. The exchange rate is an asset price, and as with other asset prices there is reasonable debate about what constitutes fair value, and how to estimate this value.
Misalignments can be driven by a number of factors. The recent overvaluation of the AUD has been largely to do with loose monetary policy in the United States, and also Europe and Japan. With Australia’s economy being relatively strong, and our interest rates remaining above those in the rest of the West, money has flowed into Australia and kept our exchange rate strong.
What can we do about it?
At the moment there are a number of countries that have floating exchange rates that are suffering from similar problems with overvaluation to those facing Australia. These include emerging economies such as Brazil, middle income countries such as South Korea, and richer countries such as Switzerland. Some of these countries have tried to stop appreciation of the exchange rate, with mixed success.
The first means of addressing an overvalued exchange rate is to fix the exchange rate. We could for example, ask the RBA to fix the exchange rate at 75 US cents.
This would require the RBA to buy and sell as many AUD as the market required at this fixed rate. At the moment that would have the RBA dramatically increasing its holdings of US dollars, as the supply of USD to buy AUD at that price would greatly exceed market demand. Many economists argue that fixed exchange rates are too inflexible and should not be considered.
My view is that fixing the exchange rate should not be completely ruled out, but the problem is that this limits flexibility at times when this is required, and in the case of Australia, why would we fix to the US dollar, when that currency is clearly in such a decline?
At the moment such a peg would require ultra low Australian interest rates, which would no doubt lead to problems such as further overheating in property and other asset markets.
A less extreme form of intervention by central banks involves them buying and selling currency to try to limit exchange rate movements. The RBA for example, sometimes “leans against” big movements in either direction of the AUD. The problem with these interventions is that there is limited evidence of their effectiveness in having a lasting effect on the exchange rate. The reason for this is that the size of the foreign exchange market is huge, even relative to the size of central bank asset holdings.
In the latest survey, turnover in the AUD averages around US$180 billion per day, a very large amount even for central banks to create a dent in. For example, the central bank in Switzerland began intervening to try to limit Swiss Franc appreciation in 2009, and in the subsequent 4 years these interventions had at best a minimal impact on the exchange rate.
Many countries have tried to limit exchange rate movements by imposing “capital controls.” These controls can take various forms, but the idea is to tax or put some other kind of constraint on foreign money coming into a country, with the aim being to reduce the value of a currency. China has had capital controls as part of its managed exchange rate system, and Chile and Malaysia have also imposed capital controls in recent years.
As with central bank intervention, the evidence on the effectiveness of capital controls in managing exchange rates is mixed. Capital controls can work in a strong economy, but in a country such as Australia that requires significant capital inflow each year, putting costs on these inflows runs the risk of putting off foreign investors. At a minimum that is likely to lead to much higher interest rates, along with running a risk of recession as a result.
Another way to try to limit exchange rate overvaluation is to loosen monetary policy. The Reserve Bank long ago decided that the prime objective for monetary policy was to keep inflation low and stable. Other objectives should be secondary, and should not interfere with this inflation focus. I would agree with this focus, and to cut interest rates to weaken the exchange rate at the current time would not be appropriate.
Are there other options? The IMF lists six types of exchange rate regimes, and classifies countries accordingly. Aside from floating exchange rate systems such as Australia’s, all of the other regimes involve forms of intervention or controls such as those above.
There is only one other possibility. We could of course apply for admission to the Euro, so as to give that system a boost, or adopt the US dollar. Currency unions are not always a bad idea, though they seem to be a bit out of fashion, and in the case of Australia the big question is who should we form a union with? The Europeans? The Americans? Maybe we should cosy up to the Kiwis?
There is no doubt that our overvalued exchange rate is costly. When the US, Japan and Europe unwind their unusually loose monetary policy there is little doubt that the AUD will weaken. Unfortunately in the meantime the best we can do is hope that those days come sooner rather than later.