Alt+0 to show this section, Tab to navigate forward, Shift+Tab key to navigate backward, Enter to access link, and Esc to reset


12 Nov 2013

Big test for floating Australian dollar

Paul Bloxham

by Paul Bloxham

Chief Economist, Australia and New Zealand, HSBC

Big test for floating Australian dollar (Getty Images/Nick Koudis)

Australia’s annual GDP has risen for 22 consecutive years

Next month is the 30th anniversary of the floating of the Australian dollar. This should be a celebration. The floating currency has been one of the key reasons why Australia’s economy has been more stable in the past two decades than at any time in its history. It has helped Australia to enjoy a long boom, with annual GDP rising for 22 consecutive years, a feat unmatched by any other developed economy in this period.

Indeed, Australia’s recent history is rich in examples of how the floating currency has acted as a global shock absorber and helped to stabilise domestic growth and inflation.

Australia’s recent history is rich in examples of how the floating currency has acted as a global shock absorber

During the Asian financial crisis in the late 1990s, the “tech” bubble in the early 2000s and the global financial crisis of recent years, the Australian dollar fell sharply and supported local growth. This worked through many channels. It made local exporters more competitive and more profitable. Local retailers and hotels were also supported by a lower currency as Australians took fewer international holidays and spent more money at home. Even the housing market received some support as a lower currency encouraged more international buyers.

At the other end of the scale, the recent mining boom saw the AUD appreciate to extraordinarily high levels. This was a key reason why Australia got through the largest mining boom in its history without wages and inflation getting out of control, as had occurred during every other Australian mining boom. The strong currency slowed down other sectors, such as manufacturing, tourism and retail, to make way for a rapidly expanding mining sector.

Last year provided a clear example of the way the strong Australian dollar protected the economy. GDP growth in Australia was 3.7 per cent, well above trend, but at the same time inflation fell from 3.3 per cent in 2011 to 1.8 per cent. This is extraordinary given the strength of the mining boom in that year. High GDP growth and low inflation were the envy of the rest of the world.

Indeed, there are lessons here for other economies about the benefits of having a free-floating currency. Many of the problems faced by the euro area are due to having a shared currency and a fixed exchange rate. As many European nations are learning, when negative shocks happen the adjustments that need to occur through lower local wages and prices can be far more painful than a big move in the exchange rate. While it is often uncomfortable to have a volatile currency, the costs associated with not having currency flexibility can be enormous.

But the Australian dollar now probably faces one of the bigger challenges in its history as a floating currency. The country’s growth has slowed this year, commodity prices are down from their peaks and the Royal Bank of Australia (RBA) has cut its cash rate to an historical low. In the past, these factors have typically encouraged the Australian dollar to fall and act as a shock absorber. But the currency is not behaving as it has in the past. Extremely low interest rates in the major developed economies have encouraged investors to seek alternative safe havens. Given Australia’s low government debt and AAA sovereign rating, global investors have taken increased interest in holding Australian government bonds, helping to underpin the Australian dollar.

The strength of the currency has been a major bugbear for the RBA. With the mining boom slowing down, RBA officials have been seeking to rebalance growth and had hoped that the currency would do some of the work for them. But because the currency has stayed uncomfortably high, they have been forced to support growth by cutting their cash rate to an historical low of 2.50 per cent. While this has seen house prices begin to boom, overall growth is still below trend. A lower currency would help to further rebalance growth in the economy.

The trouble is that there is little the RBA can do about the high Australian dollar without a wholesale change to their current monetary policy approach. Cutting interest rates has so far had only a modest effect, with the action by other global central banks a far more important factor in determining the level of the Australian dollar.

The Reserve Bank Governor, Glenn Stevens, appears to remain optimistic that the currency will fall from here, and we agree. But if it doesn’t, the RBA may face an uncomfortable trade-off: cutting rates to further support growth while at the same time potentially overinflating the housing market. Let’s hope it doesn’t come to this and that the Australian dollar remains the country’s great shock absorber.

This article originally appeared in The Australian on 7 November 2013.

Related content

Melbourne port

Australia developing ties

29 May 2013

The Australian Prime Minister’s recent visit to China cemented the…