I had this piece in The Australian during the week. I became interested in the topic during my visit to Switzerland. I conclude that the RBA will not, and probably should not, intervene but it is an interesting topic.
The value of the Australian dollar is putting many of our trade-exposed industries under real pressure. This week, Alcoa of Australia announced that it was placing its unprofitable Port Henry aluminium smelter under review. The reasons cited by the company are “a combination of factors, including metal prices, input costs and exchange rates”.
The plant is located just outside Geelongand employs some 600 workers.
A number of other trade-exposed businesses have announced job cuts over the past few months, including: Heinz, Toyota, Holden and Reckitt Benckiser.
A reasonable question to pose is this: should the Reserve Bank intervene to lower the value of the Australian dollar? The Australian dollar crashed through the $US1.08 mark on Tuesday, partly in response to the surprise decision of the bank to keep the cash rate unchanged.
Its most recent peak is close to $US111, a value that was reached in July 2011. But during the GFC, the Australian dollar traded as low as $US64c, in 2008.
There is actually a prior question that needs to be answered: can the Reserve Bank intervene to affect the value of the currency? The short answer is that there is no technical reason why this could not occur. There is effectively no limit to the purchase of foreign currency by the bank.
Should the value of the Australian dollar continue to climb even after intervention, there would be a mark-to-market loss on the foreign currency accumulated. But this would not really matter, as there would be no intention of selling down. Indeed, to do so, would simply drive the currency up.
The bank can also intervene when the currency is heading in the opposite direction. Indeed, intervention occurred in 2008, but the principal reason for this action was to support liquidity.
A key issue is whether the Australian dollar is currently overvalued. Certainly, the terms-of-trade now appear to have peaked (September quarter 2011) and have come off somewhat. Yet the value of the Australian dollar has continued to climb. The Economist magazine puts the Australian dollar in the class of overvalued currencies.
So let us assume that the Australian dollar is overvalued, is its value sufficiently high to justify intervention? The Reserve is likely to take a cautious approach before acting. After all, its value could drift down.
The key criteria a central bank is likely follow are as follows: rapid upward movement of the currency; extreme overvaluation; and threat of deflation.
Switzerland provides an interesting example of central bank intervention aimed at lowering the value of the currency. Recall that Switzerland is not a member of the EU and has its own currency, the Swiss Franc.
The high value of the Swiss Franc has had a major impact on the economy, particularly the manufacturing sector and tourism, which latter competes directly with eurozone countries. And there has been (and is) a real danger of deflation.
The Swiss monetary authorities have now instituted a currency peg (it’s really a cap), the value of which is higher than many Swiss would regard as comfortable but is guaranteed as the maximum conversion rate of the Swiss France to the euro.
Is Australia’s case parallel toSwitzerland? The short answer is ‘no’ – there is no imminent risk of deflation, for instance.
In all likelihood, trade-exposed businesses inAustraliawill continue to have to deal with a relatively high $A.
No
.
11 Feb 12 at 10:14 am
Judith,
Owen Humpage at http://www.clevelandfed.org/research/economists/humpage/ writes extensively on exchange rate intervention, frequently with Anna Schwartz and Michael Bordo, including a book on the history of U.S. foreign exchange market intervention. Many of the chapters are online at Humpage’s web site.
The three of them concluded in a joint October 2011 paper that:
• The United States all but abandoned its foreign-exchange-market intervention operations in late 1995, when they proved corrosive to the credibility of the Fed’s commitment to price stability.
• They view this decision as the culmination of the evolution of U.S. monetary policy over the past century from a gold standard to a fiat money regime.
• The abandonment of intervention was necessary to secure monetary policy credibility.
Official foreign exchange intervention sometimes produce temporary changes in exchange rates, but intervention does not permit countries to avoid or substantially modify trends in the movements of their exchange rates. At best, intervention is of very limited value.
Good to see that Anna Schwartz is writings books aged 96 young. Coase published a book on China at 100. May we all! many of the leading chicago and monetarist economists lived to a great age.
Jim Rose
11 Feb 12 at 10:15 am
The floating exchange rate is an automatic stabiliser which insulates the economy from overseas shocks(good and bad)It removes the need(and the excuse)for fiscal
blowouts.Also,it allows us to maintain an independent monetary policy.
Tom Valentine
11 Feb 12 at 10:36 am
It works for China!
m0nty
11 Feb 12 at 10:57 am
China are not a “small, open economy”.
.
11 Feb 12 at 11:02 am
Why are we not buying military stores such as artillery shells, spare motors, aircraft, missiles etc from OS whilst it is advantageous to do so? Lots of OS suppliers would give good deals to top up our war stocks, which I understand have been run down to the bare minimum over the last decade.
Winston Smith
11 Feb 12 at 11:13 am
Intervention won’t work if it’s sterilized.
JC
11 Feb 12 at 11:16 am
If the RBA cut interest rates to reduce the value of the $A but commodity prices remain where they are what happens to the $A?
The most important reason why the $A is where it is is the level of commodity prices.
the RBA cannot offset or control this.
I do not believe the RBA uses mark to market.
They usually make a ‘profit’ as they hold it for long periods.
On your Marx
11 Feb 12 at 11:17 am
Come on now we all know Gillard can’t even pay for the current budget with a heap of off balance sheet trickery.
.
11 Feb 12 at 11:17 am
monty, see http://www.clevelandfed.org/research/commentary/2005/0815.pdf The Chinese Renminbi: What’s Real, What’s Not by Humpage
China’s recent devaluation and liberalization of its exchange-rate policies will, at best, have a temporary impact on its trade competitiveness.
The exchange-rate regime a country adopts matters little for its long-term international competitiveness. In addition, the recent focus on China’s exchange rate diverts attention from the real problem: China’s command economy.
To understand exchange rates, view them as two parts – a real exchange rate (driven by factors like productivity differences) and the component reflecting the domestic and foreign inflation differentials.
Monetary policy ultimately determines only the domestic inflation rate, so central bank that wants to engineer a depreciation of its currency must create more money than its trading partners and thereby generate a higher inflation rate.
Any resulting exchange rate depreciation will ultimately offset the inflation differential, a monetary induced depreciation cannot secure a
competitive trade advantage.
China is increasingly worried about its inflation rate, as it was also back in the early 1990s. By 2003, China’s foreign reserves accumulation started to accelerate and inflation warmed up. Between 1998 and 2003, prices in China frequently fell, suggesting that money growth was not keeping pace with their economic expansion.
A renminbi float would allow China to adopt a monetary policy focused on domestic price stability. That is what floating exchange rates do.
Jim Rose
11 Feb 12 at 11:19 am
The Australian dollar in the long run is dominated by US GDP. In the shorter run, US then, less importantly, Australian inflation and likewise in the very short run money supply affect rates.
I found this out with some exploratory number crunching well into the boom and so until someone provides me of causation of commodity prices and the dollar, I remain unconvinced.
However, the Australian Government either has to control the US economy or world commodity prices to manipulate the currency.
This is of course impossible and a soft dollar policy is limited in effect and duration. It is futile at best and worse still most likely damaging.
.
11 Feb 12 at 11:25 am
dot,
yes, the RBA must control world productivity and trade flows and Australian productivity too to affect the real exchange rate. the RBA has enough trouble controlling the domestic inflation rate.
Jim Rose
11 Feb 12 at 11:29 am
Of course I was being facetious, the RBA shouldn’t intervene. As Judith says, though, it’s an interesting topic.
m0nty
11 Feb 12 at 11:30 am
thnaks Monty,
more than a few academics, Fx dealers, and politicians make a career out of exchange rate policy.
Jim Rose
11 Feb 12 at 11:36 am
Swiss pegged their Franc to the Euro just before I went to Zurich in early October 2011. (Not a related event).
General feeling there then was that it was a Good Thing to pull the overblown economy back into line.
Switzerland maybe a special case? Also, haven’t kept track of how it is working out now or what plans are for the future given developing European crisis.
Elizabeth (Lizzie) B.
11 Feb 12 at 11:38 am
lizzie,
countries that peg choose to import their monetary policy. currency boards such as in HK do this too.
A currency board’s foreign currency reserves must be sufficient to ensure that all holders of its notes and coins (and all banks creditor of a Reserve Account at the currency board) can convert them into the reserve currency.
A currency board does not act as a lender of last resort to commercial banks, and does not regulate reserve requirements.
see http://en.wikipedia.org/wiki/Currency_board for a list
Jim Rose
11 Feb 12 at 11:45 am
Jim, HK at present is facing possible hyper-inflation due to not having the ability to regulate monetary policy, Being tied to the USD and US interest rates in the face of massive inflows of Chinese cash may well cause problems.
One thing not mentioned is that sure, from a demand side, a high AUD hurts our competitiveness, though what of the flip side, an improving CAD and a better ability to service foreign debt?
nic
11 Feb 12 at 1:03 pm
On another aspect, should we have sympathy for Toyota? The workers involved, yes, however, in terms of resource allocation a stronger dollar makes them less competitive, leading consumers to buy cheaper (and better quality) cars from overseas. Surely this is a benefit of the market system. Cheaper big ticket consumables gives people more to spend on their more expensive mortgages for example
nic
11 Feb 12 at 1:07 pm
A German view on exchange rates.
“in his office at the top of Deutsche Bank’s twin towers (known in town as Haben und Soll, or Profit and Loss), Thomas Mayer, the bank’s chief economist, warns against the view, common among nonspecialists, that a weak exchange rate makes an economy more competitive. “A weak exchange rate is good for old industry,” Mayer says. “They can sell outdated products at cheaper prices. A strong exchange rate forces you to continuously adapt to new technology and consumer tastes.”
Deutsche Bank
Wayneofperth
11 Feb 12 at 1:44 pm
Trust the Germans to have an efficiency based view of the firm!
.
11 Feb 12 at 1:45 pm
Marx:
Of course a central bank can push and maintain a currency to where it wants. All it needs to do is either add more currency or reduce the amount of currency which can be done through open market operations of unsterilized intervention.
You really need to think before you post… or avoid posting altogether.
We unbalanced here because the government is placing so much demand as a result of it’s borrowings, which indirectly impacts on the exchange rate.
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CB interventions are fabulous opportunities for traders as they were so much fun. The Fed was far more active before , in the mid 90′s and we used to see them.
We had a direct line to the Fed from the trading desk. We of course knew which way they were going to intervene, so we would be buying or selling a truckload before we picked up the flashing line where one of their traders would ask us to make a price in 20/50/100 million at a time. The size depended on how aggressive they wanted to be.
The other form of intervention was the quiet style, where they would call us to go out and hit the market on their behalf without disclosing it was them.
They actually had a number of rules we had to abide by depending on the style of intervention they wanted to conduct.
Always a guaranteed money earner for the day.
JC
11 Feb 12 at 2:03 pm
I think the RBA should buy a squillion canadian dollars. You know it makes sense!
bwwaahahhahahhaa!
entropy
11 Feb 12 at 8:35 pm
No, the RBA should not intervene to maintain a particular exchange rate. Australia has a floating dollar – which brings a number of advantages. Once the RBA intervenes, it moves away from a float – perhaps to a dirty float etc. More importantly, what is the ‘right’ exchange rate? Do we really think that the RBA can (and should) have a view on what should be the exchange rate? I don’t. Its job is to maintain low and stable inflation. Once we start adding additional tasks (including, for example, trying to lower unemployment), then these will conflict with the inflation objective. Moreover, attempts to maintain a particular exchange rate are a thinly disguised attempt at protectionism. Better to focus on micro economic reform to boost multi-factor productivity growth and ultimately living standards.
Samuel J
11 Feb 12 at 9:17 pm
JC
Low interest rates are the result of economic conditions. Its no badge of honour to have a cash rate at near zero.
sdfc
12 Feb 12 at 12:20 am
Thanks Jim. A really helpful Wiki.
Elizabeth (Lizzie) B.
12 Feb 12 at 11:17 am