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HSC Economics Student Conference

Wednesday 6 September 2017

The Exchange Rate and External Stability

Presenter- Peter Kennedy Head Teacher – Teaching & Learning Castle Hill High School

HSC Senior Marker

Economics Tutor – Macquarie University

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Australia’s External Stability at a Glance.. The 3 Speed Economy

(2005 – 11) Rebalancing the Australian

Economy (2012 – Present)

Economic

Environment

Mining Boom / Terms of Trade

Boom ( Terms of Trade grew by

45% between 2005 and 2011)

‘The Booming Sector’ = mining

sector

Mining boom fades out : Terms of

Trade start to deteriorate (fell by 10.2% in 2014-15).

The TOT rose again by 15.6% in the year to December 2016.

Australian

Dollar

Strong $AUD reaching US

$1.10(TWI 78.8)in July 2011

and averaging US 83.5c

between 2005 and 2011.

Effect on Export Competitiveness: Loss of export competit,iveness (services +manufactured exports)

‘The Lagging Sectors’

Third speed Note: ‘third speed’ = non-tradeable sector (between the booming and lagging sectors)

$AUD depreciates but still at US92.6c

(TWI 71.3) in Jan 2013. It reaches US71c (TWI 61.3) by Sept 2015.

Rises to around US76.6c/TWI 63.9 by Oct 2016 and reached US80.66c/ TWI 67.4 in August 2017.

Effect on Export Competitiveness:

Renewed competitiveness of

Australian Exports;

= Services (e.g. Education

&.Tourism}+Manufactures

Effect on Import Competitiveness Cheaper Imports =capital goods +- consumer goods – import competing sector suffers

Effect on Import Competitiveness

Improved competitiveness of

import competing sector

Current

Account

CAD decli nes (– 2.4% of GDP in 2010-11)

During the 2001 -2011 period Australia’s

CAD tended to vary between -2.5% and -

6.3% GDP

Balance of Goods and Services deficit

declines:

2008-09 = BOGS Surplus of $7.6bn

2010-11 = BOGS Surplus of $21.3bn

Net Primary Income Deficit rises :

2008 -09 = NPI deficit of - $45.4 bn

2010-11 = NPI deficit of - $54.1 bn

CAD stabilises (around -3% of GDP in 2013 -14) then rises to over -5% of GDP in 2015-16.

Balance of Goods and Services moves

back into deficit:

2014-15 = BOGS deficit of -$21 bn

Net Primary Income Deficit falls:

2014-15 = NPI deficit -$34 bn

2016-17 = BOGS back into surplus

= CAD falling again

Net

Foreign

Debt

Slow rise in Net Foreign Debt

2005-06 : $494.9 bn (51.8% of GDP)

2010-11 : $ 685.8 bn (49.4% of GDP)

Slow rise in Net Foreign Debt-

reaches $1 trillion in 2016

(61% of GDP)

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WHAT’S BEEN DRIVING OUR EXTERNAL STABILITY?

First, what actually is external stability? External stability can be defined as the ability of a country to meet its financial obligations arising out of international transactions. External stability is achieved when a country such as Australia is able to finance its import expenditure with its export income. Other aspects of external stability are containing the current account deficit to an acceptable level (under 5% of GDP), ensuring the servicing cost of net foreign liabilities is met and that the exchange rate is relatively stable over time.

There is no one index of external stability, but a number of indicators are used to gauge the state of the external sector, and monitor whether external stability is being achieved. It is necessary to look at:

o The level and stability of the exchange rate ($AUD) in the FOREX market. The TWI is an important indicator here.

o The size of the Current Account Deficit (CAD). The general aim is to keep the CAD below 5% of GDP

o The level of foreign debt (as a percentage of GDP) and the outflow of interest payments to service this debt.

An IMF assessment of Australia’s External Position (2015-16) The Current Account…. Australia has run current account (CA) deficits for most of its history, with deficits averaging around 4 per cent of GDP in the last three decades. The deficit narrowed to 2.8 per cent of GDP in 2014 but widened in 2015 following a sharp fall in the terms of trade (iron ore prices have fell) by over 50 per cent during 2014-15). To an extent, the effect on the current account is cushioned by the depreciation of the Australian dollar. Also, resource export volumes are increasing sharply as mining capacity comes on stream, mining related imports are falling back, and lower oil prices will improve the oil balance—overall the current account widened by 0.6 per cent of GDP in 2015. With over half of Australia’s exports going to emerging Asia, a key risk is a sharper than expected slowdown in China which could result in a further sharp decline in commodities prices. Australia’s persistent CA deficits reflect a structural saving-investment imbalance with very high private investment relative to a saving rate which is already high by advanced country standards.

The Capital & Financial Account…. The mining investment boom has been funded predominantly offshore. Net FDI inflows into this sector have partially offset the reduced need for the banking sector to borrow abroad. As investment in new mining projects winds down, related demand for imports will decrease, buffering the impact on the overall balance of payments. Australia also received large inflows in recent years into bond markets given its sound fiscal position relative to other advanced economies, owing to relatively high interest rate differentials. Credible commitment to a floating exchange rate and strong fiscal position limit the vulnerabilities. A free-floater since 1983. The central bank did brief but large intervention in 2007–08 when the market for Australian dollars became illiquid following banking sector disruptions in the U.S. The authorities are strongly committed to a floating regime, which reduces the need for reserve holding. Although domestic banks’ external liabilities are sizable, they are either in local currency or hedged with little or no counterparty risks, so reserve needs for prudential reasons are also limited.

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The Net Foreign Debt/ Net Foreign Liabilities …. Australia has a negative net international position (NIP) or -54% of GDP. The ratio has varied in a range between -45 and -60 percent of GDP since 1992. Liabilities are largely denominated in Australian dollars but assets are in foreign currency. Liabilities are split with around a quarter FDI, one half portfolio investment (principally banks’ borrowing abroad, and foreign holdings of government bonds) and one quarter other investment and derivatives. The current account deficit is expected to remain at 3-5 per cent of GDP over the medium term, resulting in n a gently rising NIIP to GDP ratio reaching around 60 per cent of GDP in 2020.

Changes in the global economy and Australia’s recent external stability – the state of play Over the past three decades Australia has become more highly integrated with the global economy largely due to increased economic integration through greater trade liberalisation. International trade is increasingly linked with investment as companies use foreign direct investment to gain access to foreign markets and generate exports from the inputs and expertise of the home country. The integration of financial systems to create a world financial system has to a significant degree facilitated this global economic transformation. This increased level of global financial integration has resulted from financial deregulation in most countries, leading to the integration of capital markets and greater mobility of capital on a global basis. Australia has been a vigorous participant in this process of globalisation benefiting immensely from the growth in trade volumes and foreign investment flows that has accompanied our economy’s own internationalisation. Efforts to remove structural impediments via financial deregulation, the floating of our currency and the removal of barriers to trade have paved the way for a period of unparalleled economic prosperity for Australian households. While the mining boom bestowed enormous benefits on the Australian economy, it was also to some degree, a disruptive influence on Australia’s external stability. It is important to look at each of these components separately, starting with the CAD. Australia has run current account deficits for most of its history with deficits averaging around -4 per cent of GDP over the past three decades. The deficit narrowed to -2.8 per cent of GDP in 2014 but widened to around -5% of GDP during 2016. This reflects the sharp fall in the terms of trade (iron ore prices fell by over 50 per cent during 2015) even though resource volumes were increasing as mining capacity comes on stream and mining related imports were falling. Over the medium term, the CAD was expected to stay below -4 per cent of GDP with a smaller trade deficit partly offset by a larger income deficit as global interest rates normalise and mining export accruing to foreign investors rises. With over half of Australia’s exports going to emerging Asian countries, there is still a risk that a sharper than expected slowdown in China could still cause a further decline in commodity prices which will lead to a further deterioration of our trade balance.. Regarding the Capital and financial Account, Australia’s mining investment boom has been predominantly

funded from offshore. Net Foreign Direct Investment (FDI) inflows into the mining sector have partially offset

the reduced need for the banking sector to borrow abroad. As investment in new mining projects winds down,

the related demand for imports will decrease, buffering the impact on the overall balance of payments and

Australia’s external stability. Australia has also received large inflows in recent years into bond markets given

its sound fiscal position relative to other advanced economies and owing to relatively high interest

differentials between Australia and its overseas counterparts.

Following these capital movements Australia’s Net Foreign Liabilities or Net International Position (NIP)

has moved to 54% of GDP with Net Foreign Debt alone reaching the $1 trillion mark by July 2016. This ratio

has varied between 45 and 60 per cent of GDP since 1992. While our foreign liabilities are largely

denominated in Australian dollars, our foreign assets are in foreign currency with liabilities split around a

quarter FDI and one half portfolio investment (mainly banks borrowing abroad and foreign holdings of

government bonds) and one quarter derivatives and other investment. According to the International

Monetary Fund (IMF), given that our CAD is expected to remain between at 3 to 4 per cent of GDP over the

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medium term, this should result in gently rising Net Foreign Liabilities reaching around 60 per cent of GDP in

2020.

The component of Australia’s external position that seems to get the most attention is the exchange rate.

Given the tumultuous conditions continuing to prevail in global financial markets, it is not surprising that

Australia’s currency continues to be volatile. The Australian dollar was pushed close to the US75c(TWI 63.6)

level in early March 2016, a rise of more than 10 per cent from the six year low it hit back in January. By

December 2016, the Australian Dollar was trading at around $US 0.74c (TWI 64.7). One of the key reasons

for the Aussie dollar’s strength is that the RBA is one of the few central banks not manipulating interest rates

in an effort to weaken the currency. The ECB, Bank of Japan and the central banks of Switzerland, Denmark

and Sweden have all moved to negative rates.

As noted by Philip Lowe (governor of the RBA),”monetary easing abroad tends to put downward pressure on the currencies where the easing is taking place and thus upward pressure on the Australian Dollar”. Also in 2015, the improved outlook for China, spurred recovery in commodity prices and rekindled interest in buying the Aussie dollar. The Australian dollar hovered around the $US0.78 mark (or at least below US$0.80) for the first half of 2015, before starting its slow decline to just under $US0.70 ($US 0.69/ TWI of 59.9) by January18 (2016). This slow weakening of the currency followed the pattern set in 2014 where the dollar finished the year at around $US0.82 after hovering around $US 0.93 in June (TWI of 71.1). The Australian Dollar averaged $US 0.77 from 1993 until 2014, reaching an all- time high of $US 1.10 in July of 2011 and a record low of $US 0.48 in April of 2001. Assuming the exchange rate is expected to remain somewhere near its current level, it is likely to show some continued volatility during 2017 as it responds to a multitude of influences including:

o unanticipated changes to the outlook for growth in leading economies such as China and the European Union,

o global commodity prices o the monetary policy decisions of overseas central banks, and of course, o US interest rates and the policy decisions of the new US (Trump) administration.

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Factors Influencing Australia’s External Stability…….

Negative Factors:

The anemic outlook for the global economy – IMF forecast of only 3.4% for 2017

after 3.1% for 2016. In particular, the slowing of output growth has been most

pronounced in the emerging or less developed economies. As growth in middle-

income emerging economies (BRIC) lacks strength this is likely to lead to slower

growth for commodity prices which is not good for countries exporting raw

materials and energy exports (e.g. Australia).

Evidence that globalization is reversing as trade and capital flows are sluggish and

migration is increasingly being restricted. This is not helped by renewed support for

protectionist policies and anti – globalisation sentiments most noticeably in the US

and Europe and as evidenced by the recent ’Brexit’ and ‘Trumpism’ developments.

Despite the proliferation of Bilateral Trade Agreements and the attention given to the

benefits of big Multilateral Agreements (eg the TPP and the RCEP), global

protectionism is on the rise. Australia has free trade agreements with key trading

partners such as Japan, Korea and China although the real benefits of such

agreements may be difficult to determine. For example, with the China FTA dairy, beef

& wine tariffs are to be slashed from 20- 25% to zero in coming years . The catch here

is that agriculture makes up only around 8% of total exports to China - of that 8%,

about 20% is dairy, beef or wine. The bulk of the rest is wool and the China FTA

included no change in tariffs for wool (as with oil seeds & grains).

The unorthodox monetary stimulus policies adopted by central banks in an effort to

boost growth and jobs in the wake of the global financial crises; including ultra – low

interest rates (some below zero) and massive bond buying programs. Critics have long

argued that these policies have failed to stimulate sustainable economic growth, instead

their main impact has been to inflate asset prices, which has been of huge benefit to

wealthier members of economies that own most of the assets resulting in growing social

and economic inequality. Subsequently, inappropriate monetary policy has built a

disconnect between asset markets and real economic activity.

The IMF has warned that ultra- low interest rate policies of the world’s major central

banks, has resulted in an explosion in global debt which is a threat to global financial

stability. In 2015 total public and private debt threat to global financial stability. In 2015

total public and private debt climbed to a record high of US$152 trillion or twice the size

of the global economy. Around US $100 trillion of this debt is owed by the private sector.

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POSITIVE FACTORS:

Australia remains an attractive destination for foreign investment. Our AAA rated

government debt securities combined with a relatively high official cash rate (1.5%)

ensures continued foreign investment into Australian financial markets. Although

ongoing Federal Budget deficit blowouts (which could lead to the loss of the AAA rating)

coupled with the expected December 2016 tightening of US monetary policy could

undermine this position by pushing up deficit financing and debt servicing costs.

The Australian economy is transitioning from the recent mining boom phase of

heightened economic growth to a restructured economy with greater emphasis on

service exports (e.g. tourism and education) and an emerging high tech manufacturing

export sector (e.g. medical technology with exporters Cochlear and Res Med).

Service sector productivity gains have been higher than in manufacturing in recent years.

Improved computing power and software sophistication in areas such as health and

education will continue to improve output per worker in key service sectors enabling the

accessing of larger overseas markets (particularly in South east Asia and North east Asia)

enhanced through regional trade agreements (bilateral and multilateral). Australia’s

skilled migration program has helped to curb the growth in the cost of healthcare,

higher education and technology services further boosting our competitive advantage in

the provision and export of these services.

Australia also maintains an advantage in the production of clean and safe agricultural

and processed food products which is increasingly sought after by middle income

consumers, most noticeably in the North East Asian economies (China, Korea and Japan).

A CLOSER LOOK AT THE MAIN COMPONENTS OF AUSTRALIA’S EXTERNAL POSITION

i) Australia’s recent trade Performance.. The past decade’s export success has been led by minerals and fuels. Export values of minerals and fuels have grown at an average rate of 16.3 per cent per annum over the past ten years, more than double the rate of exports overall. From 23.7 per cent ten years ago, minerals and fuels now makes up 50.1 per cent of our total exports, more than rural exports did in the 1960s. Iron ore and Coal are currently Australia’s top two export commodities and drivers of export growth. Iron ore and Coal’s share of goods and services exports rose from 11.1 per cent to 34.7 per cent over the past decade and Australia is now the world’s largest exporter of iron ore (accounting for around 48 per cent of world exports) and metallurgical coal. Exports of Natural gas have also grown significantly in the past decade. Australia has become the world’s third largest Liquefied natural gas exporter, with over 90 per cent exported to Japan in 2013-14.

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The position of Education-related and Personal travel services as the fourth and fifth largest export commodities signifies the rising importance of services exports in the Australian economy. They also demonstrate the increased diversity of exports from the services sector. In 2013, over 410,000 international students studied in Australia, and 6.4 million foreigners visited Australia (compared to around 12,000 and 125,000 respectively in 1963).

Source DFAT 2016

Figure 1: Australia’s Goods and Services Exports

ii) Recent trends in Australia’s CAD.

During 2015-16 Australia’s CAD rose to around -$72.6 billion (-4.6% of GDP) a substantial increase on the 2014-15 figure (-$56.98.5b or -3.5% of GDP) which in turn was significantly higher than the 2013-14 figure of -$47.5b (-2.8% of GDP). The balance on Goods and Services remained in deficit for the March and June quarters of 2016 (-$9.3 b and -$8.7b respectively) while the Net Primary Income deficit was slightly lower at -$7.8b and -$6.5b for the same periods. It is apparent that the CAD is set to continue following a rocky path as we negotiate the global resources boom and bust cycle of the past decade and the weak global growth trend which is expected to continue for some time yet. Australia’s CAD had remained around the same level in 2013-14 as in 2012-13 - just over -$47 bn. It fell slightly as a percentage of GDP (from -3.2 % to -2.8%). The balance of trade (goods and services) remained in deficit during 2014 (around -$3.6bn for the second half of 2014) mainly due to the continued fall in commodity prices (iron-ore in particular). During 2015, the balance of payments showed increased volatility compared to 2014 with a 35.7% increase in the CAD from Sept 2014 to September 2015. This was driven by a 5.3% increase in Australia’s imports of goods and an 18.3% increase in the net primary income deficit. In the September quarter of 2015 alone, the net income deficit widened by $1.1bn to -$10.1 bn. In the year to September 2015, Australia’s exports of goods and services rose by 1.3% while our imports of goods and services rose by 5%.

A$b Chart 6: Australia's goods & services exports 1945-46 to 2014-15 (a) 350

300

Resources boom

250

200

150

Post war boom

Deregulation of the Aust. economy

Global financial crisis

100

50

Korean War

0

(a) Goods and services in 2013-14 dollars

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Australia’s General CAD Trend……. During the 2001 -2016 period the Australian economy ran persistent deficits in the current account which tended to vary between -2.5% and -6.3% GDP. Australia’s CAD has averaged -4% of GDP over the past 3 decades.

AUSTRALIA’S MORE RECENT CURRENT ACCOUNT BALANCES…

Australia’s CAD improved substantially in the December Quarter of 2016 with a deficit 0f -$5.4 b being attained (a 43.8% improvement on the previous quarter).

The Balance of Goods and Services remained in surplus during the month of January (2017) of around $2.2b after reaching $3.3b in December (2016).

The goods and services balance went into surplus during November 2016 after being in deficit for 2.5 years.

The improvement was largely due to an increase in the value of mineral and fuel exports (30% and 15% respectively). Australia’s terms of trade improved by 15.6% over the year to December 2016.

iii) The Terms of Trade Australia’s terms of trade grew 87.6 per cent between 1990-91 and 2010-11. This increase was mainly driven by the export price index, up 97.6 per cent. The export price index grew particularly strongly since 2004-05, underpinned by price rises for commodities. The import price index was 13.2 per cent higher in 2010-11 than in 1990-91 but has declined since 2000-01. By January 2016, the terms of trade had hit a decade low, down more than 50 per cent from the peak in 2011 – and 30 per cent below the long term average, mainly due to falls in commodity prices (iron-ore, coal and LNG in particular). This represented a significant decline in the purchasing power of Australian households. Export prices were down more than 10 per cent over the year. Import prices were relatively stable, but 2.4 per cent higher over the year largely due to the falling Australian dollar. The terms of trade did however recover during the June, September and December quarters, rising by 2.3%, 4.5% and 9.1% respectively. This was once again due to shifting commodity prices for coal and iron –ore, in this case they rose substantially during the second half of 2016. Australia’s terms of trade improved by 15.6% in the year to December 2016.

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Source DFAT 2016

Figure 2: Australia’s Terms of Trade

iv) Australia’s Foreign Debt and Foreign Liabilities

Due to persistent current account deficits over a number of decades, Australia remains one of the largest international debtors in the world for its size. Australia's net foreign liability position was $1,035.9b at 30 June 2016, an increase of $28.1b (3%) on the revised March 2016 position of $1,007.8b. This increase was mainly due to the increase in Australia's net foreign debt which itself increased $22.7b (2%) to $1,044.5b. Australia's net foreign equity decreased $5.4b (38%) to a net asset position of $8.6b at 30 June 2016.

The link between persistent current account deficits and the build- up of net foreign liabilities and net foreign debt through ongoing capital and financial account surpluses is depicted in Figure 5. The growth in foreign borrowings (both private and public) has continued since the 1980's when foreign debt replaced equity investment as the main source of foreign capital and the net income deficit started to grow dramatically. Australia’s stock of net foreign liabilities has continued to build passing the $500 billion mark during 2004- 05 and passing the $700 billion mark in 2008-09. The continued growth of our net external liabilities has been required to

Index - 2013-14 = 100 Chart 14: Australia's terms of trade 120

110

100

90

80

70

60

World War 1

1920s wool boom

Great Depression

World War 2

Korean War wool boom

1975 oil shock

Resources boom

50

40

30

Index = 2013-14 = 100

130

120

110

100

90

80

Terms of trade

peaked in Sep qtr 2011

at 122.3

70

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finance persistent current account deficits. Australia’s net foreign liabilities (consisting of net foreign debt and net foreign equity) grew from $170 billion (46% of GDP) in 1989-90 to $517billion (60% of GDP) during 2004 – 05 and $923 billion (around 52% of GDP) by 2014- 15. Australia’s net foreign debt alone, had reached an astonishing $430 billion (50.6% of GDP) by the end of 2004-05 and $1044.5 bn or 61% of GDP by July 2016.

Figure 3: Australia’s Net Foreign Liabilities

v) The savings-investment gap, the CAD and Net Foreign Debt. The CAD is associated with both negative domestic net savings {(T-G) + (S-I)} and positive net capital inflow (Capital & Financial Account Surplus). The capital account surplus is required to finance the current account deficit which in turn reflects the tendency for domestic expenditure to exceed the level of domestic output. Australia has persistently run a current account deficit (CAD). This reflects high levels of investment that have consistently exceeded national saving, even though Australia’s saving rate has been around the OECD average (see figure 4, Australia’s Savings – Investment Gap). The recent increase in household saving has reduced the impact of the mining boom on the CAD. Large increases in commodity prices, which pushed the terms of trade to their highest sustained levels in 140 years, increased profits in the resources sector and led to a surge in mining-related investment. As a result, national investment during the extended mining boom phase (2003 -2012) averaged around 28 per cent of GDP, 3 percentage points higher than its average over the preceding decade. As the CAD is the difference between a country’s gross investment and gross saving, this large increase in investment would have resulted in an increase in the CAD in the absence of a matching increase in saving. Due to persistent current account deficits over a number of decades, Australia remains one of the largest international debtors in the world for its size.

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Australia’s level of net foreign liabilities reached above the $A870 billion mark (60.8% of GDP) in 2011-12, although it fell slightly to around $816 billion in 2012-13. By June 2016 Australia’s net foreign liabilities stood at $A1035.9 billion. Net foreign debt continues to climb already moving past the $A1 trillion mark, so it is not surprising that concerns about the external viability of the economy, are continually resurfacing. The link between persistent current account deficits and the build- up of net foreign liabilities and net foreign debt through ongoing capital and financial account surpluses is depicted below (Figure 5)..

Figure 4: Australia’s Savings – Investment Gap

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Figure 5: The Link Between the Current Account and the Capital & Financial Account

Capital & Financial Account Surplus

Increased Increased

Foreign Debt + Foreign Equity

Increased Net Foreign Liabilities

Interest + Dividend

Payments OS Payments OS

Net Primary Income Deficit

CURRENT ACCOUNT DEFICIT

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vi) What has been happening with Australia’s capital flows? Net capital inflows to the Australian economy were equivalent to 3½ per cent of GDP in the June quarter 2016, around 1 percentage point lower than the average of net capital inflows over the past 15 years (see graph below). Consistent with the pattern of capital flows observed since 2007, recent net capital inflows have largely reflected flows to the private non-financial sector. Most of these net inflows were directed to the mining sector (which is majority foreign owned). Net inflows to the general government sector have continued at a moderate pace over recent years. Notwithstanding this, the foreign ownership share of Australian Government Securities declined by around 4½ percentage points (to around 60 per cent) over the first half of 2016, as net issuance was larger than foreign purchases; the foreign ownership share of state government debt increased slightly.

Figure 6: Australia’s capital flows

Australia's recent lower-than-average current account deficit, corresponding to the below-average capital inflows, has partly reflected a longer-term decline in the net income deficit. The net income deficit, which largely comprises payments made on Australia's net foreign liabilities, has fallen to historically low levels. In the past few years, the decline has reflected higher receipts from foreign equity assets owned by Australian entities. Australia's net foreign liability position increased to a little over 60 per cent of GDP at the end of the June quarter, with recent increases mostly reflecting valuation effects.

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vii) Finally – what about international competitiveness?

Australia up in Global Competitiveness Ranking….

Australia has climbed one place this year to rank 17th out of 61 economies in the latest global

competitiveness rankings, according to the Institute for Management Development’s World

Competitiveness Yearbook (IMD WCY). This was the first increase in Australia’s ranking following

a sequence of five years of decline. The outcome reflected improvements in factors such as labour

regulations, government decision-making, fuel prices and workforce productivity. Our most

attractive feature perceived by global business leaders continues to be an effective legal

environment and high quality of corporate governance, both rated the second best in the world.

Other key attractive indicators for Australia according to this year’s survey include open and

positive attitudes, high education levels, access to financing, political stability and predictability,

and a business-friendly environment.

Overall, Australia ranked number five in the Asia-Pacific region, after Hong Kong, Singapore,

Taiwan and New Zealand in the competitive rankings. More importantly, our place has continued

to improve in the sub-group of economies with a population of more than 20 million, at the fifth

position out of 28 economies this year, up from sixth last year and seventh in 2014 (see table

below). Australia’s world competitiveness strength in this group is also rated well above most

Asian major economies, such as Japan (26th) and South Korea (29th globally), and all the member

economies of the BRICS grouping, including China (25th), India (41st) and Brazil (57th).

Source: AUSTRADE 03 Jun 2016

Labour Productivity and Multifactor Productivity – important indicators of competitiveness

In the years 2009-14, Australia’s labour productivity averaged 1.2% p.a. while in the year 2013 -

14 it increased by around 2%. This compared favourably to the OECD average of around 1% p.a.

for 2009 -14 and 0.5% for 2013-14.

Perhaps a more useful indicator of international competitiveness is multifactor productivity

Multifactor productivity growth measures an industry’s output relative to the value of all of the

inputs of labour, capital and materials and is a way to track overall efficiency in production

Multifactor productivity is the measure that comes closest to the underlying concept of

productivity. Growth in multifactor productivity is the growth of output over and above the

growth of labour and capital inputs. Australia’s multifactor productivity growth is falling – by an

average of 1% p.a. for 2009-14.This reflects a tendency towards high capital investment, which

has not yet been matched by the rate of growth in actual output. Australia is not alone here, there

has been a slowing of multifactor productivity across most advanced economies in recent decades.

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Part B - the Exchange Rate…

What is an exchange rate?

An exchange rate is simply the rate at which you exchange one currency for another. For example,

Australian dollars for US dollars or say UAE dirhams for US dollars. Since two currencies are being exchanged this means there are two ways of defining the exchange rate. We can define the $A –US$

exchange rate either as the number of US$ you get in exchange for each A$ or alternatively, the number of A$ you get in exchange for each US$. The most common way of reporting an exchange rate in a country is to define the amount of a particular

currency you get in exchange for each unit of the home country’s currency. For example, the number of $US you get for each unit of $A. In other words , in Australia when you wake up in the morning and

listen to the financial news, the latest exchange rate is defined as one Australian dollar (A$1) equals say seventy five US cents (US$0.75). This is referred to as the foreign currency price of the A$. Alternatively,

the A$ - US$ exchange rate could be reported as the A$ price of the foreign currency (i.e. how many A$ are needed to buy US$1). These different ways of expressing the same exchange rate between two countries are set out below:

If the foreign currency price of the A$ is:

A$1 = US$ 0.80

Then the A$ price of the US$ will be:

US$1 = A$ (1/0.80)

US$1 = A$1.25

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When does a currency depreciate/ appreciate and when does it devalue/ revalue?

When a country uses a flexible (floating) exchange rate system, it allows the value of its currency to be determined by supply and demand. When a currency becomes more valuable, it buys more units of

another currency and is said to have gained appreciation or appreciated. When it loses value, it is described

as a depreciation or we say the currency has depreciated in value.

A depreciation of an exchange rate (e.g. the A$ exchange rate) is defined as a fall in the foreign currency price of the $A while an appreciation of the exchange rate entails an increase in the foreign currency price of the $A.

EXCHANGE RATE REGIMES OR SYSTEMS There are two pure types of exchange rate regimes or exchange rate systems: o A floating or flexible system in which the exchange rate is free to vary, and o A fixed or managed system in which the exchange rate is controlled or regulated. Generally speaking, the floating/flexible system offers flexibility while the fixed system offers stability. Countries such as the United States, Australia and Japan use flexible exchange rates and have avoided adopting explicit exchange rate targets. The central banks of these countries have shown themselves quite willing to let their exchange rates fluctuate quite considerably. At the other extreme are the countries that operate under fixed exchange rates. These countries maintain a fixed exchange rate in terms of a particular designated foreign currency. This will usually mean the currency is pegged to the US dollar, two examples being Argentina and China. In practice, exchange rate systems are rarely either purely fixed or purely floating because neither system is able to offer an adequate combination of flexibility and stability. Most real systems are variations of either the fixed or floating type of regime in which the characteristics of one system are dominant but modified by the presence of some of the properties of the other. This has given rise to a third type of exchange rate regime, which sits somewhere between the extremes of the fixed and floating (flexible) systems. Two of these ‘hybrid’ forms of exchange rates are known as the ‘pegged exchange rate’ and the ‘managed float’. In the case of the pegged exchange rate, the currency is pegged to some band or value of another currency and there is scope for periodic adjustment of the exchange rate. The managed float approach involves the central bank occasionally buying or selling currency in order to induce an adjustment of the floating exchange rate.

Factors leading to an Appreciation of Australia’s Currency

Movements in the exchange rate in a floating (flexible) system are brought about by changes in

economic, political and psychological factors influencing foreign exchange markets. There are many

factors determining the market demand for national currencies such as the Australian dollar. We will now

look at the demand factors influencing Australian exchange rates.

The level of GDP in overseas economies and the state of the global economy: If economies overseas are

experiencing high levels of economic growth this will lead to an increase in consumption expenditure in those

countries. The countries (like Australia) who export goods and services to these countries will experience

increased demand for their exports and a greater capacity to penetrate export markets. This will lead to an

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increase in the demand for Australian currency as overseas buyers convert their local currency into Australian

dollars in order to import Australian goods and services.

The level of inflation: When consumers and producers overseas are considering whether to purchase

goods and services either locally or in foreign markets, they will compare prices. A general rise in prices

in an overseas economy (say the United States or the United Kingdom) is likely to lead to an increase in

the demand for foreign – produced goods on the part of consumers and producers in those countries.

When a country (e.g. Australia) supplies products to meet this demand it will experience an increase in

the demand for its currency in the foreign exchange market as overseas buyers purchase our exports.

Hence, if prices are rising faster in the global economy than in the Australian economy our inflation rate

will be relatively lower, demand in the overseas economy will switch to our locally produced goods and

away from foreign produced goods. Subsequently, there will be increased demand for the Australian

dollar and our exchange rate would be expected to appreciate.

Interest rate differentials: The interest rate differential is also a major factor influencing the demand for

Australian currency. The lower the foreign interest rate or the higher the local interest rate (in Australia), the

larger will be the demand for financial assets in the Australian markets and the Australian economy will

experience a higher degree of foreign capital inflow. This increased capital inflow will in turn lead to a larger

quantity of domestic currency being demanded in the local (Australian) financial market.

The expected value of a currency: Other things remaining equal, an increase in the expected future value

of a particular currency (in our case, Australian dollars) will make it more attractive to investors and

increase demand for it. If foreign speculators expect the Australian dollar to appreciate in the future they

may buy Australian dollars and sell foreign exchange to make an expected capital gain. This will increase

the supply of foreign currency into the Australian foreign exchange market and raise the demand for

Australian dollars.

Movements in Australia’s terms of trade: A change in the terms of trade (the ratio of export prices to

import prices) will affect the demand for Australian exports. A rise in global economic growth and

income usually result in higher commodity prices and increased export income being earned in the

domestic economy. An increase in the demand for Australian dollars would be expected to coincide with

more favourable conditions in overseas commodity markets where Australian commodities are fetching

higher prices.

Central bank intervention into foreign exchange markets: The Australian central bank (the RBA) or

other central banks may purchase Australian dollars to influence its value or to manage their holdings of

foreign exchange reserves. Central bank activity by the RBA or any other central bank can result in

increased purchases of Australian dollars in foreign exchange markets thereby raising demand for our

currency.

Effects of an Appreciation of Australia’s Currency

In effect, an appreciation of the domestic currency lowers the domestic price of foreign goods and raises

the price of exports. A sustained appreciation of the Australian currency can have a number of positive

and negative effects on the domestic economy.

On the positive side an appreciation may lead to:

A lowering of the cost of imports and an increase in the price of exports in the short run. This may

mean that higher export income is earned from a given volume of exports and a lower level of

expenditure is required to finance the purchase of a given volume of imports. Subsequently, the goods

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balance of the current account will improve and the current account deficit itself should be reduced, at

least in the short run.

An appreciation may lead to lower domestic inflation through lower import prices. This will raise

the real income of consumers and enable them to purchase a greater volume of cheaper imported goods

thereby improving material living standards.

One of the immediate impacts of an appreciation is to reduce the value of that part of the net foreign

debt denominated in foreign currencies (mainly the $US) against which the Australian dollar will have

appreciated.

An appreciation of the exchange rate will reduce the debt servicing ratio (i.e. interest payments as a

percentage of export income). Lower interest payments on foreign debt overseas could lead to a lower

income deficit and decrease the size of the current account deficit.

The negative effects of an appreciation can include:

In the long run, an appreciation of the exchange rate reduces the competitiveness of the tradeable

goods sector (i.e. export and import competing industries) by making Australian goods and services less

price competitive relative to foreign produced goods and services.

This has been evident in the Australian economy during recent years (most recently 2010 – 2013). We

have faced the awkward situation where the appreciation of the Australian dollar has caused concern due

to the potential loss of export sales. This is the down-side of currency appreciation; locally produced

goods and services mainly from non- mining sectors such as tourism, education and manufacturing, may

have been priced out of competitive markets overseas.

A sustained appreciation of the domestic currency may lead to lower export revenue and higher

expenditure on imports in the long run, resulting in a deterioration of the balance of payments as the

current account deficit increases.

An appreciation of the domestic currency may lead to higher levels of capital outflow from

Australia as domestic assets become more expensive and less attractive relative to foreign assets. This

may lead to a decline in foreign direct and portfolio investment in Australia.

A sustained appreciation of the Australian dollar may also lead to higher unemployment in export

and import competing industries as they are forced to restructure in an attempt to remain internationally

competitive.

A large and sustained appreciation could lead to the Reserve Bank indirectly intervening in the

foreign exchange markets to the reduce the exchange rate by lowering interest rates in order to reduce

demand pressure on the Australian currency. A lower interest rate structure may have positive feed back

effects through the stimulation of private investment and economic growth. However, this may also lead

to higher inflation in the domestic economy.

Effects of a Depreciation of Australia’s Currency

On the positive side, a depreciation may lead to:

In the long run a depreciation of the exchange rate improves the competitiveness of export and

import competing industries (the tradable goods sector) as they become more price competitive relative to

overseas produced goods and services. This is likely to improve the balance of trade and subsequently the

current account deficit in the medium to longer term (‘J curve effect’- long run)

A sustained depreciation of the domestic currency may lead to higher levels of capital inflow

(direct and portfolio investment) into the domestic economy as our assets become cheaper relative to

foreign assets. This may reduce the level of foreign debt borrowings.

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A sustained depreciation may also encourage structural adjustment and enable new and emerging

firms (sunrise industries) to gain traction in both domestic and overseas markets, eg Australian bio

technology and medical technology firms.

The negative effects of a depreciation can include:

A depreciation of the Australian dollar may lead to higher levels of inflation as higher prices for

imported goods are experienced reducing the real incomes of consumers. If higher prices are incurred for

production inputs that are imported (eg petroleum, diesel or aviation fuels) firms may attempt to pass

these higher costs onto consumers.

In the short term, currency depreciation raises the price of imports and lowers the price of exports

subsequently export income may fall while the cost of imports rises. This may in turn lead to a

deterioration in the goods balance (J curve effect)and increase the current account deficit.

The component of the foreign debt denoted in foreign currencies (mainly US dollars, Japanese Yen

and Euros) will increase in value. Given that most of this debt is backed through hedging contracts.

Debt servicing costs may rise for domestic holders of foreign debt contracts following the

depreciation of the Australian dollar

Table 2 summarises the nature of exchange rate appreciations/depreciations and revaluations/ devaluations.

Table 2: Exchange Rate Appreciations/Depreciations and Revaluations/Devaluations.

Type of exchange rate regime Type of adjustment Effect Exports /Imports*

Flexible /floating Appreciation -Unit of currency buys

more units of another

currency

- Increase in the foreign

currency price of

currency

- Decrease in demand for

exports.

- Increase in demand for

Imports.

Flexible /floating Depreciation - Unit of currency buys

less units of another

currency

- Decrease in the foreign

currency price of

currency

- Increase in demand for

exports.

- Decrease in demand for

imports.

Fixed /pegged Revaluation -Unit of currency buys

more units of another

currency

- Increase in the foreign

currency price of

currency

- Decrease in demand for

exports.

- Increase in demand for

imports.

Fixed /pegged Devaluation - Unit of currency buys

less units of another

currency

- Decrease in the foreign

currency price of

currency

-Increase in demand for

exports.

- Decrease in demand for

imports.

* In theory these are the adjustments that should eventuate – the reality at any point in time may be different.

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WHAT’S BEEN HAPPENING WITH THE AUSSIE DOLLAR? – A BRIEF CHRONOLOGY…..

2016-17 - The Resilience of Australian Dollar Continues – but 2017 is looking like a return to uncertainty….

The Australian Dollar was trading at around $US 0.74 (TWI 64.7) in early December 2016 and by mid March 2017 it had reached $US0.76 (TWI 66.8). It then pushed through the US 80c mark($US80.66/ TWI 67.4) in early August 2017. This meant that the Australian Dollar had risen by more than 11 per cent since the start of 2017.

The outlook for the Australian currency over the next year is once again clouded by global influences, most notably, the monetary tightening expected to be undertaken by the US Federal Reserve and the uncertainty surrounding the growth prospects for the Chinese economy.

At the start of 2017, most currency market analysts expected the Australian Dollar to head back to around $US0.70 during 2017 (TWI < 60). This was mainly due to low commodity prices and the lifting by the US Federal Reserve (the US central bank usually just referred to as the ‘fed’) the Federal Funds Rate by a quarter point into the 0.5 to 0.75 per cent range in December (2016) and then to the 0.75 – 1.00 per cent range in early March 2017. These adjustments affirmed the Fed’s determination to

move US interest rates back towards their pre GFC level which started with a quarter-point increase in its

target funds rate on December 16/ 2015 (after seven years of the most accommodative monetary policy in

U.S. history). Here the target rate went from 0 percent to 0.25 percent. Further rises in the Federal Funds Rate are expected over the next 12 months largely in response to promised increased budget spending driving up US interest rates as the Trump administration puts its economic stimulus agenda into effect.

The Australian dollar was pushed close to the US75c(TWI 63.6) level in early March 2016, a rise of more than 10 per cent from the six year low it hit back in January. One of the big reasons for the Aussie dollar’s strength is that the RBA is one of the few central banks not manipulating interest rates in an effort to weaken the currency. The ECB, Bank of Japan and the central banks of Switzerland, Denmark and Sweden have all moved to negative rates. As noted by Philip Lowe (deputy governor of the RBA),”monetary easing abroad tends to put downward pressure on the currencies where the easing is taking place and thus upward pressure on the Australian Dollar”. Also, the improved outlook for China, has spurred recovery in commodity prices (iron-ore and coal in particular) and rekindled interest in buying the Aussie dollar. The Australian dollar hovered around the $US0.78 mark (or at least below US$0.80) for the first half of 2015, before starting its slow decline to just under $US0.70 ($US 0.69. / TWI of 59.9) by January18 (2016). In January 2016, the currencies of nations that depend heavily on commodity exports (such as the Australian Dollar) were being hit by reductions in the reference rate for the Chinese Yuan which was spooking financial markets. Nevertheless, the Australian Dollar managed to rise back to just over $US0.70 (82.44 yen) by mid- January and had reached the $US0.75 mark by March. The Australian Dollar was trading at around $US 0.74c (TWI 64.7) in early December 2016 and by mid -March 2017 it had reached $US0.76 (TWI 66.8).

Further back in early February (2015), the Australian dollar was trading at $US 0.77 (TWI of 63.6) which was a five and a half year low - although it had risen back up to $US0.80 just a week earlier before falling to $US0.78 the next day. This slow weakening of the currency followed the pattern set in 2014 where the dollar finished the year at around $US0.82 after hovering around $US 0.93 in June (TWI of 71.1). The Australian Dollar averaged $US 0.77 from 1993 until 2014, reaching an all- time high of $US 1.10 in July of 2011 and a record low of $US 0.48 in April of 2001.

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Recent trends in the Australian Dollar

2015- Relief through a weakening $A…

During 2015, the Australian dollar (AUD) fell almost 20 per cent from 88 cents to just under 73 cents against the US dollar (USD). In fact the Australian dollar against most currencies has fallen almost as fast as it did during the volatile times of the GFC in 2008-09. Excepting that abnormal period, the value of the dollar against the US currency and against the basket of currencies in the Trade Weighted Index, has fallen by more during 2015 than it had in any such period this century.

The weakness in the AUD had been driven by multiple factors including:

the weakness in both the Australian economy and its major trading partner (China)

the differential outlook for interest rates between the US (raising rates) and Australia

(falling rates)

lower commodity prices largely due to falling demand for our resources from emerging

markets (particularly iron ore and coal demand from China),

While the AUD had weakened against many currencies, its weakness against the USD that had been most pronounced.

It comes as little surprise that the main cause of the falling dollar was the fall in iron ore and coal prices. In the past two years the price of iron ore has fallen by about 45 per cent, and coal by 29 per cent. As these commodities account for just over a third of all of Australia's exports, it is to be expected that our dollar would depreciate strongly following the slide in the price of these global commodities.

The falls in the Australian dollar during 2015 were largely attributed by analysts to falling interest rates in Australia as well as disappointing economic news from China, the largest buyer of Australian commodities. The lowering of the cash rate by the RBA (our official interest rate in relation to other economies) was also significant.

Once again, the traditional volatility of the Australian dollar seems to have come into play here. Given that the Australian Dollar is the fifth most traded currency in the world, it is very easy to transact and our currency not only attracts a large number of speculative traders, but is also frequently is used as a “proxy” for hedging or un-hedging investments in the Asian region and also for gaining or reducing exposure in resource commodities.

The Aussie $ stops defying gravity and slowly falls…

As already noted, the Australian dollar hovered around the $US0.78 mark for much of 2015 before starting its slow decline to just under $US0.70 by in early January (2016) . The main factors responsible being:

The strengthening US dollar following the announcement by the US Federal Reserve on January 29 that it would start lifting interest rates later in 2015.

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the weakening outlook for the terms of trade, in large part owing to weaker-than-expected commodity prices over recent months, particularly for iron ore. This has been marginally offset by the effect of falling oil prices on import prices. Overall, the terms of trade continued to fall through the last quarter of 2014 and early 2015 (hitting a low of 82.6 by July 2015), reflecting gradual pass-through of recent declines in spot prices for bulk commodities and further increases in global capacity.

2009 - 2013 The mighty Aussie $ becomes a burden …. The Australian dollar recorded a trend appreciation against the currencies of its major trading partners

between 2009 and 2011 reaching a post float high of US$1.10 (TWI of 79) in 2011. This strength of the Australian dollar, particularly between 2009 and 2011, was due to three main factors:

Rising world commodity prices arising due to the growth of the global economy which was expanding by between 4 - 5% during 2010 and 2011. Australia’s main trading partners (including China, India and Korea) were experiencing even stronger economic growth rates creating high demand for our commodity exports, most noticeably iron ore and coal. Australia’s favourable terms of trade were a by – product of the high demand for our commodity exports. Commodity export prices lifted the terms of trade by 20% between 2010-11, meaning that our terms of trade were now 95% higher (on average) than levels experienced during the 1990’s. Sustained direct (FDI) and portfolio investment into the Australian economy by foreigners in

part due to the export boom which was creating the opportunity for higher corporate profits but also due to the high interest rates on offer in Australian financial markets. In particular, foreign investors, including central banks were buying into Australian Government bonds at a feverish rate now the international ratings agencies had removed the AAA status of European governments.

The appreciating dollar of 2010 – 12 was in sharp contrast to the depreciating currency we experienced following the onset of the Global Financial Crises in late 2008. Here the Australian dollar traded as low as $US65 (TWI of 54) in November 2008 as global commodity prices collapsed and financial market panic set in as the GFC deepened. During 2013 the Australian Dollar has maintained its strength reaching US $1.05 in mid April and a five year high against the Japanese Yen despite the Bank of Japan’s move to pump 7 trillion Yen a month into its economy as part of its current reflating policy (this is the act of stimulating the economy by increasing the money supply). The Trade Weighted Index rose to 79.9, its highest level since 1985, during this period of global currency uncertainty. However, by June 2013 the dollar had dropped to close to a three – year low (against the US dollar) of US91.64c. This most recent correction reflected a resurgence of the US currency following the Federal Reserve’s (US central bank) upgrade of US economic growth expectations and announcement of a plan to wind back its quantitative easing (bond- buying program also known as QE3)to between $US70 billion and $US70 billion a month from $US85 billion. By early July, the Australian dollar had begun trading at US 91c for the first time since September 2010. The Aussie $ was now in a race with the Japanese Yen to become the weakest of the G10 currencies in 2013 with the $A down 12 per cent and the Yen down 14 per cent.

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Table 3: Recent Factors Influencing the Australian Dollar Appreciating $AUD (2009-12) Depreciating $AUD (2013-16)

Rising world commodity prices/ Stronger economic growth rates of Australia’s main trading partners

Slowing global economic growth

rates and declining commodity

prices

Australia’s favourable terms of trade following strong global commodity prices

Declining terms of trade /declining global commodity prices

Sustained direct (FDI) and portfolio investment into the Australian economy

Lower foreign investment into Australia’s resource sector

Relatively high interest rates on offer in Australian financial markets

Lower Australian interest rates and rising US interest rates

foreign investors purchasing Australian Government bonds (AAA rated)

Fig 7 Australian Dollar against US Dollar, Euro and Yen (1987 – 2017)

Australian Dollar yen US$,

euro

Yen per A$ (LHS)

1.60

1.20

0.80

1987 1993 1999 2005 2011

ECU per A$ until31 December 1998

Sources: Thomson Reuters;WMIReuters

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Figure 8 : The Australian Dollar /TWI

Impacts of the falling Aussie Dollar…

During 2015 the value of Australia's currency fell at an almost unprecedented speed. A low dollar brings with it numerous swings and roundabouts - our export industries are more competitive, but our industries and consumption reliant on imports becomes more expensive. The pick - up in exports previously chastened by the strong Australian dollar during the mining boom period has been most noticeable. The position of education-related and personal travel services as the fourth and fifth largest export commodities signifies the rising importance of services exports in the Australian economy. They also demonstrate the increased diversity of exports from the services sector. Also natural gas exports have also grown significantly with Australia becoming one of the world’s largest liquefied natural gas exporters. The Reserve Bank of Australia has previously been quite vocal in its view that the AUD was overvalued and that a lower AUD would help rebalance the economy from mining into housing, tourism, agricultural exports and educational services. This is now occurring, but at a slower than optimal pace

The days of people contemplating what they could buy online at cheap prices and those cheap international holidays are long gone.When the dollar plunged more than 10% in May and June in 2015, the hearts of many Australians contemplating overseas travels sank with it. Stories from people travelling to the US with empty suitcases subsided while the gloss started to rub off the bargains being picked up by online shoppers buying from overseas websites.

While Australians travelling abroad and buyers of overseas goods are generally the first to feel the effect of a falling Australian dollar, there are also less obvious but equally important ways it

May 1970 = 100 for nominal; real indexed to equate post-float

averages; latest observations for realTWt are estimates

Sources: ASS;RBA; Thomson Reuters;WMIReuters

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can affect our hip pockets. A rise in the price of imported consumer durables such as TVs, computers, mobile phones, clothing and other imported goods on shop shelves is anticipated if the dollar stays down against the US dollar. Some economists say these price rises may even pose the risk of inflation down the track.

However, as noted by BT Financial Group Chief Economist, Chris Caton, the news is not all bad.

“a sustained fall in the Australian dollar tends to have a positive effect on our economic growth. As a rule of thumb, a 5-cent drop in the currency has a stimulative effect on the economy about equal to a quarter-point interest rate cut. It makes our exports easier to sell, and makes domestically produced goods more competitive with those from offshore. Thus the decline in the currency to date should do the work of two rate cuts.”

A falling Australian dollar is also great news for investors with un-hedged international investments. This is particularly relevant to investors in super funds which tend to have a significant component of un-hedged international shares, bonds and real estate.

The effect on Australian share investments is less clear-cut. It’s generally good news for listed companies who generate most of their profits overseas, such as Coca Cola Amatil, Amcor, Brambles and Westfield, since they are convert their overseas profits back into Australian dollars. Conversely, a sustained fall in the Australian dollar is generally bad news for listed retailers such as Harvey Norman, The Reject Shop and JB Hi-Fi since the price they pay in Australian dollars for products sourced overseas is likely to rise.

However, the effect on interest rate sensitive investments such as term deposits and bonds is also mixed. If the falling dollar translates to a rise in inflation, then it’s more likely the Reserve Bank will start to raise interest rates – generally bad news for bond investors and those locked into low term deposit rates

Below is a list of some of the people and companies who will generally gain and lose from a fall in the value of the Australian dollar.

Table 4: Winners and Losers from the Falling Aussie Dollar

Winners Losers

Investors in unhedged international investments Overseas travellers

Companies with majority of assets overseas Online shoppers buying from overseas websites

Companies who export (services, manufacturers , farmers and miners)

Shoppers buying goods made overseas (eg computers, TVs, phones, cars)

Australian tourism and education sectors Companies who import

Manufacturers Companies with overseas suppliers

Farmers

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Impacts of the high Aussie Dollar (2004-2014)

In many respects the recent strength of the Australian currency was a double edged sword. On the one

hand, the appreciation of the dollar lowered the cost of imported consumer and capital goods helping to contain imported inflation. On the other, a higher Australian dollar eroded the competitiveness of

local exporters including those in the manufacturing, tourism and education sectors of the economy lowering their sales and levels of profitability (see box below – the real impact of the high Australian dollar).

The latter effect becomes more of a problem when (as during the first part of 2013) the terms of trade

fall and the dollar failed to fall as well causing a real appreciation of the exchange rate. This meant that

the local producers of internationally traded goods and services (the traded goods sector) missed out on the

benefit of a depreciating currency which would normally accompany a decline in the terms of trade. This problem is compounded by the relatively more attractive option for local investors of moving their capital into the non – traded sector (e.g. the retail and personal services sectors).

It appears that the mining or resources (terms of trade) boom (2004-2011) brought about both an increase in domestic spending in the non – tradables sector which was expansionary and an exchange

rate appreciation that was contractionary. The first effect raised the output of the non – tradables sector and the second effect, reduced the profitability and outputs in the lagging industries (manufacturing

and service exports), this is the ‘Dutch Disease’ effect( see below).

On the positive side, it appears that businesses (including farmers) and consumers were able to take

advantage of the high Australian dollar and spend up on imported goods, which in turn led to a widening of Australia’s deficit in goods and services. During the final quarter of 2012, imports rose by 2 per cent, led by a 3 per cent advance in consumption goods. Purchases of foreign – made cars surged

(rising by $7.1 billion during July to December) up 14 per cent on the same period a year earlier. There were also strong increases in the imports of civil engineering and contractor’s plant and equipment

mainly destined for the mining industry and telecommunications sector. Also, industrial transport equipment, which includes farm machinery, grew by 57 per cent.

By June 2013 when the Australian Dollar was trading at around US92c (June 2013), 13 per cent below its peak in January 2013, the falling dollar was welcomed by struggling export industries such as tourism and manufacturing. This enabled the value added of manufacturing and education to rise to

$42 billion in the March quarter which exceeded the value of mining ($38 billion). Nevertheless, the much needed decline in the Australian dollar has been too slow for many producers,

particularly exporters and import competitors outside the mining sector. By March 2015, the strain was still evident, with the strength of the Australian currency relative to rapidly falling commodity prices

and despite the currency’s slide against the US dollar, being cited as one of the main obstacles to Australia’s pivot away from resource-related investment. It seems that exporters and import exposed industries set to benefit from the lower currency had been

stymied by falling exchange rates and currencies around the world and by capital flows into Australian financial assets such as bonds. While falling sharply against the US dollar, the Australian dollar had

dropped much less on a trade weighted basis - as measured by the TWI(the TWI is compiled as a

weighted average of exchange rates of home versus foreign currencies, with the weight for each foreign

country equal to its share in trade). It now appears that while the TWI should have mirrored the huge

drop in commodity prices experienced since mid -2014, it has been distorted by extreme monetary

easing around the world and Australia’s continued attractiveness to foreign investors

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The RBA’s Response…..

There are two main ways that the RBA can influence the exchange rate:

It can intervene directly through the foreign exchange market as a buyer or seller of foreign currency. This form of direct intervention is usually to smooth or test the market to reduce excessive volatility caused by speculators or market behaviour not in line with the market fundamentals.

The RBA can use indirect intervention by the changing the level of interest rates through its market operations, thereby changing the market differential between Australian interest rates and global interest rates.

It is apparent that the Reserve Bank of Australia (RBA) has had little choice but to join the so called ‘global

currency wars’. As noted by reputed AFR commentator Christopher Joye; “ almost every cut(in the cash rate) since

the RBA started this monetary policy easing cycle in November 2011 has been rationalised by citing the overvalued exchange rate – an assessment that remains a prominent part of its post- meeting

statements”(AFR12/3/2015).

How did Australia suffer from the ‘Dutch Disease’ phenomena?

Let’s start with the mining sector and the terms of trade boom that ensued in the 2004 –

2011 period. Export income of the Australian mining sector- called the Booming Sector

here – increases sharply owing to higher international prices, and this appreciates the

exchange rate. A by- product is that foreign capital flows into the sector, to finance its

development. This capital inflow also appreciates the exchange rate.

Spending of the sector rises thus both because of the higher incomes caused by the higher

prices and (to a lesser extent) higher outputs and because of the increased capital

investment, substantially financed by foreign capital inflow. Some of the spending goes

on imports, on the remittance of dividends abroad, and on the purchase of foreign assets

of various kinds. These involve an outflow of funds from Australia and thus depreciate

the exchange. But there is still a net appreciation. Imports and the various other outflows

just moderate the initial appreciation

The appreciation affects all sectors of the economy is some way but not equally. The

Tradable Sector can be divided between the Booming Sector and the Lagging Sector. In

Australia the Booming Sector consists of the mining industries, principally iron ore and

coal producers and exporters. The Lagging Sector consists of the export and import –

competing industries that lag behind. This sector – which is the focus of the Dutch Disease

problem – consists of a part of manufacturing industry, of part of agriculture and of certain

services, principally those provided by the tourism industry and the export –of- education

industry. Their prices are given in the world market and have not risen in the way that

the booming sector prices have. Hence an exchange rate appreciation lowers their prices

in terms of Australian dollars. These Dutch Disease industries are the losers in the three

speed economy.

Source: Max Corden, University of Melbourne, April 2012

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Likewise in its April 2015 post - meeting statement, the RBA referred to the importance of current global

monetary conditions for Australian monetary policy by stating:

“The Australian dollar has declined noticeably against a rising US dollar over the past year

though less so against a basket of currencies. Further depreciation seems likely particularly given

the significant declines in key commodity prices. A lower exchange rate is likely to be needed to

achieve balanced growth in the economy”.

The significant easing of monetary policy by the RBA from November 2011 (cash rate of 4.75%) through to

August 2016 (cash rate reduced to 1.5%) this has brought interest rates to a historic low point enabling

downward pressure to be exerted on the exchange rate. The Australian dollar has fallen by nearly 30% over the past two years (2014-15) giving a much welcomed reprieve to local exporters and import competing industries.

Since the Australian dollar was floated in 1983, the RBA has tried to avoid making direct interventions in

the currency markets to either bring the Australian Dollar up or down to a preferred level. However more recent times have seen continuing pressure mounting on the RBA to act in this regard especially when the Australian Dollar surged again to just below $US1.06 in December 2012. Despite the move by the RBA to

lower the official cash rate from 4.25% in May 2012 to 3% in December which would have been expected to make the exchange rate fall, the Australian Dollar rose by US 2cents(on average) over this period.

Some observers had suggested that the stubbornly high level of the Australian Dollar would strengthen the need for the RBA to cut interest rates during 2013, By early January 2013 the Australian Dollar was still

trading at $US1.05 as investors had once again returned to it after briefly showing greater interest in buying US Dollars in the closing days of 2012. There was a growing sentiment for the need to bring the Australian

currency to a lower level with strong views being expressed by business leaders, trade unionists and academic economists.

Chief economist (ANZ Bank) Warren Hogan summed it up when he stated: “ the big problem in Australia is that the persistent strength of our dollar has a slow- draining effect on the economy. The predicted tail-off in mining capital investment this year would create a “hole” in the economy that would

make it necessary to have lower interest rates to cushion the impact.

The Australian 4/1/2013

Further weight was given to this line of argument by academic economists like Ross Garnaut

who proclaimed that the “Reserve Bank of Australia needed to keep cutting interests until businesses could have

confidence that a much weaker currency would be sustained”.

A Final Comment on the Aussie Dollar…

Global perceptions of the Australian economy have undergone substantial change following the GFC

and the ‘debt crises overhang’ that continues to spook global financial markets. Australia is

no longer viewed as a simple commodity exporter but rather a safe haven to move funds

into given our relatively robust economy and low level of public debt.

It appears that more than 20 years of sustained economic growth, low unemployment, effective

monetary policy and a safe financial system has made our capital markets and in particular the

market for our AAA rated Commonwealth Government bonds, extremely attractive to overseas

investors. This has helped maintain strong levels of demand for the Australian dollar and kept our

currency trading at an average rate of $US 0.77 between 1993 until 2014.

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The Mining Boom, Economic Growth &

the 3 Speed Economy – how it was!!!

From 2005 to 2011 the Australian mining industry (gross value added) grew by

about 85%. This was by value measured in Australian Dollars. During the same

period the value of Australian GDP grew 41%. Exports of the mining industry’s

products – principally iron ore and coal – grew by 100% in value. This reflected,

to a great extent, increases in prices – in fact a 45% increase in Australia’s terms

of trade. The cause was primarily an increase in demand from China. With GDP in

the rest of the economy growing by 39% over this period, all this is summed up

by the popular Australian term – “ the two speed economy”.

The mining boom was the principal – but by no means only – cause of a

substantial 31% real appreciation of the Australian dollar over the period, (as

measured by an index of the trade weighted exchange rate). In turn this real

appreciation had an adverse effect on at least some (and perhaps many) import

– competing and non- mining export industries. These were the losers from the

mining boom.

Thus Australia is now really not a “two speed” but a “three speed” economy. The

fast moving part is the Booming Sector, the slow moving or even declining part is

the Lagging Sector, and the rest – which is the largest part and where – there are

almost certainly net gains – is the Non – tradable Sector

Source: Max Corden (April 2012), University of Melbourne

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The Impact of Exchange Rate Movements on

Australian Industry - RBA Analysis

Our model indicates that foreign sector variables, including the terms of

trade, are the major cause of movements in the real exchange rate. In

contrast, exchange rate shocks themselves are a minor contributor to the

volatility of domestic economic variables. This is consistent with the idea

that exchange rate movements typically serve as a shock absorber for the

Australian economy, rather than acting as a source of shocks in their own

right.

Our results confirm that the mining, manufacturing, personal services and

other business services industries are particularly sensitive to exchange rate

movements, while social services output is somewhat less affected.

Although exchange rate shocks can have a large effect on economic activity,

these shocks explain only a small proportion of the volatility of Australian

macroeconomic variables. Instead, most exchange rate movements, at least

over the medium- and long-run, are a response to more fundamental

economic changes, and the resulting movements in the real exchange rate

are a stabilising influence on the economy.

As expected, highly trade-exposed industries like manufacturing and mining

are among the most responsive to exchange rate movements. However,

large responses are not limited to the parts of the economy with direct

trade exposure. For example, business services industries generally cater to

the domestic market, have little imported competition and yet display a

large response to exchange rate movements. Many of these industries do,

however, have considerable exposure to trade-exposed industries.11 For

example, around a quarter of the output of administrative & support

services is ultimately consumed by trade-exposed industries. So, while

business services firms typically have little direct trade exposure, they have

considerable indirect exposure to foreign trade. This may explain their

responsiveness to exchange rate movements.

Source: Manalo, Perera and Rees (2014) RBA Research Discussion Paper

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Australia’s External Stability… Lessons from Past HSC Essay Questions-

Let’s start with Section IV (2016 HSC Exam) –

2016 HSC – Analyse the influence of different factors on Australia’s trade

and financial flows.

HSC Topic 2 – Examine Economic Issues

• assess the impact of recent changes in the global economy on Australia’s trade and financial flows

HSC Topic 3 – Examine Economic Issues

• assess the key problems and issues facing the Australian economy.

Australia’s External Stability / Balance of Payments

Another past HSC question –

2012 HSC – analyse the impact of changes in the global economy on

Australia’s Balance of Payments.

Examine economic issues: HSC Topic 1 • examine the effects of globalisation on economic growth and the quality of life, levels of unemployment, rates of inflation and external stability Examine economic issues: - HSC Topic 2

• assess the impact of recent changes in the global economy on Australia’s trade and financial flows

•

Australia’s External Stability

More past HSC questions:

2010 HSC – Analyse the causes and effects of fluctuations in Australia’s

external stability.

2009 HSC – Analyse the impact of changes in the global economy on

Australia’s economic growth and external stability.

HSC Topic 1 - Examine economic issues:

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• examine the effects of globalisation on economic growth and the quality of life,

levels of unemployment, rates of inflation and external stability

From the HSC Syllabus….

Examine Economic Issues (Topic 2):

• assess the impact of recent changes in the global economy on Australia’s trade and financial flows

• examine the effects of changes in trade and financial flows on Australia’s economic performance

• analyse the impact of changes in the components of the balance of payments on the value of the Australian dollar

Apply economic skills (Topic 3)…..

• assess the key problems and issues facing the Australian economy. Students Learn About External stability

• measurement – Current Account Deficit (CAD) as a percentage of Gross Domestic Product net foreign debt as a percentage of Gross Domestic Product net foreign liabilities as a percentage of Gross Domestic Product – terms of trade

– exchange rate

– international competitiveness

• trends • positive and negative causes and effects