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Explainer: What a strong Australian dollar actually means

Manufacturers may be forced to accept profit margins will continue to narrow.

The Australian dollar has been striking new post-float highs against the US dollar in recent weeks, and according to a number of prominent market economists could reach US$1.10 before the end of this year.

The Australian dollar’s persistent strength partly reflects the on-going weakness of the US dollar itself, but it also owes a lot to the elevated level of commodity prices, to Australia’s relatively high interest rates, and to the preparedness of global investors to take on ‘risk’ in order to enhance returns in a very low-interest rate environment.

What are the main consequences of this persistent upward trend in the value of the Australian dollar?

Perhaps the most obvious is the difficulties it is creating for many of the ‘trade-exposed’ sectors of the Australian economy – that is, those who compete in export markets, or at home against imports.

A rising Australian dollar means that a given stream of revenue denominated in US dollars (or almost any other foreign currency) is worth less when converted into Australian dollars than previously, which for producers whose costs are incurred in Australian dollars means narrower profit margins or even losses.

It means that goods or services priced in Australian dollars are more expensive when converted into foreign currencies – potentially disadvantaging those products in overseas markets, or obliging Australian exporters to cut their prices (and hence narrow their profit margins).

And it means that goods and services produced overseas and priced in foreign currencies are cheaper when imported into Australia.

The strength of the Australian dollar is of no great concern to resources exporters – for them, it takes a little icing off the cake, but there’s still an awful lot left on what is a very large cake. It’s also not too much of a concern at the moment for wheat, sugar and beef exporters, since the high US dollar-denominated prices they’re currently getting for their products still leave them with good margins even with the Aussie at its current levels.

But for rural producers facing competition in the Australian market – including pork and fruit producers – or selling into highly competitive foreign markets – such as wine exporters, the strength of the Aussie is a serious problem. It is the same for many manufacturers, making Australian-made goods more expensive in foreign markets, and imported goods cheaper here.

The upward trend in the Aussie is making life even more difficult for tourist operators, as it makes Australia an even more expensive destination for foreign tourists, while making foreign destinations even cheaper for Australian holiday-makers.

And it is also bad news for Australian universities, many of which have become increasingly dependent on foreign students for a large proportion of their income, as it makes the cost of tuition fees (and living) in Australia more expensive relative to alternative locations such as Britain or the United States.

A stronger Australian dollar is a mixed blessing for retailers. The merchandise they source from overseas becomes cheaper; and if they can get away with not passing on all of the savings they make on imported products to their customers, then their profit margins will be wider. But the stronger Aussie is adding to the already rapidly-growing appeal of purchasing through overseas websites, something about which local retailers have become increasingly vocal.

Certainly, the stronger Aussie is helping to contain inflationary pressures, as explicitly noted by the Reserve Bank last week in explaining its decision to leave official interest rates ‘on hold’ for yet another month. Were it not for the strength in the Aussie, prices of many goods, including petrol, would have risen more than they actually have. And that almost certainly would have meant higher interest rates.

Although those sectors of the economy which have been hurt by the stronger Aussie don’t welcome the thought, the rising exchange rate is helping Australia cope better with the pressures associated with what is turning out to be the largest and most sustained commodities boom we have ever known.

During previous commodities booms, such as the (very brief) boom in wool prices induced by the Korean War in the early 1950s, and the boom of the late 1960s and early 1970s which ended with the first oil shock of 1973-74, Australia’s fixed exchange rate regime (and the reluctance of governments of the time to adjust the exchange rate upwards, for fear of the political backlash from farming and manufacturing interests) helped to generate the highest inflation rates Australia has ever experienced.

The Reserve Bank was obliged to ‘print’ Australian dollars and sell them in the foreign exchange market to offset the same upward pressure on the Aussie arising from high commodity prices that we are experiencing now; and because in a fully employed economy the ‘competition’ between an expanding commodity-producing sector and other sectors of the economy drove up wages and other prices.

Under a ‘floating’ exchange rate regime such as Australia has had since late 1983, the rising exchange rate is helping to prevent this regrettable piece of history from being repeated.

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