Crikey has been linking to the www.henrythornton.com.au website for economic coverage for three months now and this discussion on the piss-weak Aussie dollar has elicited an excellent response from a Crikey subscriber in London who works in the forex game. The whole debate is worth a run so let’s open with what PD Jonson and Alex Erskine had to say.

The Aussie dollar continues to wallow near the “half price” level of US50c. Together with the Euro’s introduction, this has created some year end/year opening questioning. If our dollar does not recover now, when the Australian economy is “defying the world recession” as some leading politician no doubt put it during a cheery festive dinner, when will it? If the world is forming into major currency blocks, should Australia not join in? These are two big questions.

The stubborn weakness of the Aussie dollar has been the subject of much discussion, not least by me. (See The Currency Question, published in late 2000.) Economists have still not come up with a convincing explanation of our dollar’s chronic weakness, although the Reserve Bank have recently opined that some gradual recovery is likely, which implies that it understands the issue. I hope it is right, but fear it is not, for the following reasons

Globalisation has had many benefits, but a major consequence is that “big is beautiful” in the minds of global investors. Australia seems big when one is here, but the reality is that we are both small and distant from the major centers. We have made many improvements to our economy, to the point where we are far freer than most economies, having decisively thrown off the protectionism that so bedeviled much of our first century as a nation. But we have still done nowhere enough to make us a “must buy” for global investors, and certain unhappy features of our commercial past linger in the minds of investors. (As a newly deregulated stockbroker I was trying to interest a canny Scottish investor in Australian stocks, I think in 1990. He listened politely enough, but concluded our discussion by saying: “I remember the Posiedan debacle, laddie”.) For many investors, including the smarter Australian investors, the attractions of the big international stocks are simply overwhelming.

Australia needs to be so dynamic that it commands a share of a sensible global portfolio, more dynamic than the benchmark US economy and competing far more convincingly with the best of the small economies. This would be possible but would require hard policy decisions that we seem to lack the political courage or cohesion to implement.

So should we join a major currency block? Joining a currency union is only one step away from complete immersion in a larger political and economic entity, so great caution is required on this ground. Even if the loss of sovereignty could be accepted, one needs to ask who would have us? “We should take the lead in creating an Asian currency block” one innocent guru commented on the ABC news. We are barely tolerated in ordinary economic and political discourse in Asia, and in any case currency union for such a diverse group of nations is a long way off. The UK said “cheerio” to us when it first joined the EEC, and the Euro-peans would not want us in any case. The US is the only sensible possibility, and they also might not want us.

But if one thinks far enough ahead, joining the US federation might be the least-worst option, and no doubt some far-sighted econocrats are thinking about this by the shores of Lake Burley Griffin. Whether we could cope with the fierce competitive pressures that full membership of the US economy would bring is another question. The Australian Senate, if such an entity had any residual power after Australia joined an expanded US federation, would no doubt do its best to block sensible economic reform. To the extent it were successful, Australia would languish as a larger version of Tasmania, and equally charming in its old-fashioned state. (What the Governor and Premier of the sub-states of Tasmania, Victoria, etc, would do with their time is another question of course.)

If joining a bigger economic and political unit is out of the question, as it seems to be, what are we to do? “Work as hard as we can to succeed as a small, independant economy with a floating currency” is the answer. Please work harder, fearless leaders.

ends

Alex Erskine’s response

I hope that PD Jonson (1/1/02) is right that some farsighted bureaucrat is thinking through the issues about currency unions and whether the A$ should join. But this is much too big a question to be left to the bureaucrats. You just can’t expect an unbiased answer. The central bank is hardly going to promote the end of its own cosy sinecure. I vividly remember the Treasury’s determination in 1983 to cling onto its role in pegging exchange rate and avoid floating, despite all the evidence that the operation of the peg was robbing Australians blind. Power – or in this case the illusion of power – corrupts. So any push for the entry of the A$ into a currency union or some other arrangement that involves ceding monetary independence will have to come from outside the bureaucracy.

And any such push is going to have to confront the deeply-embedded conventional wisdom, that floating is perfection for Australia. There is no doubt that economic management and economic performance have improved since the move to float the A$ in December 1983. How much of this improvement was due to the float is unknown, but most would grant the float an important role. In the face of some serious scepticism, including from me, the Australian economy has managed to grow quite robustly through the Asian crisis of 1997-98 and the US and Japanese crisis of 2001, and the fact that the A$ has weakened and therefore boosted exports has been a huge contributing benefit. And there have been prominent examples of countries that fixed their exchange rates and failed – Argentina is only the latest in a long saga (in which it features often).

But there must be some serious disquiet with the weak valuation of our currency and the outlook for the currency. Our experience with floating may have been the same as the London drunk who inadvertently pee-ed in his pocket – surprised to find it warm and comfortable, but only to begin with. Though it may not be apparent to those holidaying in Hawks Nest, Australian welfare is reduced by the currency depreciation. Daily the media forces us to read of share market spruikers claiming they can entice foreign predatators to buy Australian business assets “on the cheap”, even though there is no evidence that our share market is undervalued. More worryingly, there are only two possible future paths for the A$ (against the US$, which is increasingly the world standard). Either the A$ will “mean-revert” to Purchasing Power Parity (in 2000, still around US$0.75 according to the OECD), or it won’t. In the latter case, eventually PPP will edge down to the market rate, eroding welfare. But if the A$ does appreciate in nominal terms, how are our export heroes to survive? By ingenuity alone, or assisted by improving the productivity-enhancing infrastructure of the country (human and physical capital, the regulatory framework and the incentives to prosper)?

PD Jonson in the past has called for an inquiry into the exchange rate. We are within cooee of 20 years of experience with floating. It is time for that inquiry. Today, as a year ago, I would be disposed to argue for serious consideration of dollarisation, with the entry-point as weak an exchange rate as we can get away with. US$0.50 looks pretty good to me.

London-based Forex professional responds to both

Here is my two cents on the A$, in response to the Henry Thornton link you posted yesterday. He raised two issues in the link you enclosed – firstly a query as to why the A$ is where it is, defying rational convention, and secondly the notion of dollarisation.

In relation to valuing the $A, there are a number of things that need to be said. The first thing to note is that the AUD has been a victim of a strong USD since its early 1997 high at .8215 cents, just like almost every other developed economy, the real issue is one of extent. Although it is now about 40% lower than 1997, the Euro (if it had been issued then) would have fallen by 22%, the Pound by 26%, and the JPY by 19%.

So what drives this roughly 20% underperformance compared with the other major G3 currencies? A number of things, namely economic and asset market size, capital flows from Australia and globally, and the composition of our economy.

In relation to size, the fact of the matter is that offshore investors (whether they be corporate direct investors or asset investors like real money funds) don’t care about Australia, its asset markets or its dollar. As a % of global bond and equity indices, Australia is tiny at between 2-3%, so bond and equity based inflows aren’t a huge driver. Every offshore investor knows that the Australian bond and equity markets mimic the US markets, and as such they can get the same performance without the currency hassles.

In addition, most of the one off direct investments by overseas corporations are made in exporting companies (Woodside would have been one of them, BHP and Normandy are prime examples), those that rely on external growth cycles and commodity demand, rather than those that operate internally and rely simply on domestic growth. The domestic market is often viewed as simply too small to generate huge returns on capital for large overseas corporations. This is one of the reasons why the currency/economic union argument is so strong within Europe, and one of the reasons there is speculation of such a union for Australia and the $A. In short and as illustrated above, offshore investors don’t want to buy a part of Australia, they want to buy a company who’s operations are reliant on the bigger world market.

In relation to capital flows, there are two dynamics. Firstly, when global investors become risk averse, and expected returns on capital especially in equities fall, they do a couple of things. Buy bonds for safety usually, and sell other fringe assets such as emerging market debt and equity. In this sense, Australia and New Zealand are classed in the same way as South Africa, risky Emerging European economies, and latin American currencies to a lesser extent. Basically the rest of the world views Australia as a risky emerging economy style place to invest, and when the rest suffer so do we. This leads to outflows from the currency.

In addition, countries reliant on importing capital (current account deficit countries) also suffer during increases in risk aversion, as global investors also tend to bring their money home during such periods of contracting capital flows. And in a world of lower global yields, at those times there is little in the way of yield spread to justify the AUD$ attracting capital either. You guessed it, the AUD loses again.

Note, that over the last 2 months since October, investors globally have not been risk averse, but have sought out risk. Equities have rallied, bonds have fallen and the AUD$ has rallied. Hasn’t it? Nope it hasn’t. If in a period when Australia enjoys a 3% growth differential to the US and investors are risk seeking the AUD still hasn’t rallied, ask yourself when it will.

One reason why it won’t is because of a crisis of confidence domestically in investors, and hence flows out of Australia to offshore markets. Australian investors have only seen the AUD$ go one way over the last 5 years, and since the 1970s it has fallen even further from its 1.50 plus level. The expectation among investing Australians is probably that it will fall further, in a similar way to the notion of inflationary expectations. If people think there is inflation, they buy more goods now to prevent losing purchasing power in 1, 3 or 5 years time. If people think the AUD$ will be lower in 1, 3 or 5 years time, they will vote by selling dollars. 1998/2000 saw $21 billion in net equity outflows from Australia to foreign markets – the issue is whether that flow dynamic will remain the same or not in the next year or so.

In relation to economic composition, the Australian economy still produces mainly commodities rather than value added goods, though this percentage is reducing. Global commodities are yet to show a significant or lasting increase, and until they do, the AUD$’s value will remain at low levels.

So the preconditions for the AUD$ going higher and moving towards valuations such as PPP, and an assessment of whether those preconditions are met) are probably the following.

A weaker USD (has the US passed its most susceptible period in terms of growth and equity market underperformance? Maybe). Expanding the size and scale of our economy and financial markets to justify direct and financial asset investment. (a problem given low population, and size of the economy.)

A sustained period of risk seeking by global investors, or an alteration in the way the rest of the world groups Australia with emerging markets. (risk seeking periods may be shorter given the extended period of interest rate easings over the last year or more)

Restoring domestic confidence in the currency and as such domestic capital flows.(collapse in Nasdaq may have reduced the prospects for US assets, but do investors now see value in the US?)

Sharp increases in commodity prices (supply cutbacks and mine closures suggest a possibility, but demand is not yet at levels to justify this)

Hence, the report card does not look that good going forward.

In relation to the issue of a currency union, the problem of economic size would probably be remedied by an economic and currency union. This could shift perceptions of our economy by offshore investors. Such a union with New Zealand makes economic sense, would go part of the way, and would retain Australian control over monetary policy. A union with Asia though is a different ballgame, and would result in such a loss of domestic control.

Dollarisation has proved to be an unworkable solution, as Argentina shows, when you link two structurally different economies together, and would not be an option for Australia.

Of all these choices, a union with New Zealand is the easiest and most likely in the next 5 or 10 years. And in the short term, the AUD$ still has significant hurdles in front of it if it is even going to get close to Purchasing Power Parity levels around .65/.75 cents.