An RBA recipe for Aussie dollar relief

The Australian dollar is overvalued. This morning, ahead of the RBA board meeting, it is hovering around $US1.0560 and on the RBA's trade weighted index, it is around 79.4 points.

The last time the Australian dollar was at this lofty level on the TWI was back in February 1985, a bit over a year after the start of the float and a time when foreign exchange markets were still adolescent.

The current Australian dollar bubble, which it increasingly seems to be, is inflicting damage on the Australian economy. Exporters are being undermined due to a loss of competitiveness and those local industries competing with imports are under even greater stress as prices for many imported goods and services fall. The high Australian dollar will see inflation remain very low, both directly through lower import prices but also via its dampening effects on the domestic economy.

For a good six months now it has been clear that the Australian dollar was not moving in line with the normal mix of fundamentals. Some recent discussion about whether there is anything anyone can do about it is refreshing.

There is a dilemma for those advocating some form of intervention to take some air out of the bubble. Since 1983, Australia has enjoyed the benefits of a floating exchange rate. It has fallen and risen according to swings in the terms of trade, interest rate differentials, risk, sentiment and the international trade position. Big swings from lows under $US0.48 in 2001 to highs above $US1.10 in 2011 have generally been well founded and, as a result, have acted as a textbook perfect pressure value cushioning the inflation effect from the global business cycle.

But free markets are not foolproof. It would be foolish to think that the Australian dollar, like the under-regulated mortgage and Libor markets, is always at the right level because its level is driven by market forces. Even efficient markets overshoot and misprice sometimes.

With commodity prices falling as lethargy dominates global economic conditions, Australia's terms of trade are falling. They are down around 15 per cent from the peak in the middle of 2011, yet the Australian dollar is hovering near 27-year highs. This decoupling is the critical point in identifying the Australian dollar bubble.

At one level, the Australian dollar overvaluation is easy to assess – with Australia's economic fundamentals without peer in the industrialised world, there is a flood of hot money in Australia. Australia is triple-A rated and therefore low risk. Sentiment towards Australia is extremely positive and Australia's yields are among the highest for any triple-A country. Then there is the dangerous position where 80 per cent of the Commonwealth government bond market is held by foreigners, with a further chunk of bonds issued by the state governments also held offshore.

As the custodian of Australia's currency, the RBA needs to do a couple of things.

The easiest and cheapest first step is to cut interest rates, thereby taking away some of the interest rate appeal. The recent inflation data showed inflation flirting close to 40-year lows. Credit growth has slowed to a level not seen since at least the mid-1970s. An interest rate cut would pose absolutely no threat to the RBA's inflation target, and it would remove a plank that is underpinning the massive capital inflows and the Australian dollar.

Interest rate cuts cost nothing to implement, can be reversed if the move unexpectedly leads to inflation risks and, at a time of global economic malaise, are low risk. Lower interest rates might help to crimp the Australian dollar.

The Reserve Bank can also enter the foreign exchange market and sell Australian dollars. While such a move may not have a direct or particularly large impact, it could influence the sentiment of investors towards the Australian dollar and if accompanied by interest rate cuts, could help see the currency deflate.

There is also a high probability that in selling Australian dollar when it is clearly overvalued, the RBA can make some money. No one would advocate the RBA act as a fund manager, punting in the foreign exchange market, but when it and everyone else knows that the Australian dollar is misaligned, a few billion of Australian dollar selling could be lucrative.

In times past, the RBA had a nice habit of "smoothing and testing” (code for intervention) – selling the Australian dollar when it is obviously overvalued and buying when it looked cheap. This strategy helped contribute to its profitability to the point where the RBA paid dividends to the government of around $2 billion a year for the 15 years up to 2010-11. More recently, the RBA has incurred huge losses on its foreign exchange reserves as the Australian dollar has risen and no dividend was paid to the government in 2011-12 and none is expected in 2012-13.

Selling the Australian dollar around 80 on the TWI and then watching it fall over the next few years could see a return to profit for the RBA and a dividend to the government.

But that should not be the motivation for any RBA action. The motivation to push the Australian dollar to a lower, more realistic level, is avoiding a hollowing out of the trade exposed sectors of the economy and aiming to restore some form of balance to the patchwork economy.

Stephen Koukoulas is an economist and financial market strategist who between October 2010 and July 2011 was economic policy advisor to Prime Minister Julia Gillard.