At last, the dollar debate has arrived

The PM has indicated the high-dollar handbrake will be a key election issue, rightly dismissing speculation the currency is due for a major fall. It sets the stage for the productivity debate we had to have.

While it will be overshadowed by Julia Gillard’s nomination of the date for the next federal election, her comments on the Australian dollar occupied a meaningful slab of her address to the National Press Club today, indicating that the continuing strength of the currency is a front-of-mind issue in Canberra.

The prime minister, noting that the dollar had appreciated by about 60 per cent in the past three years, said the dollar lay at the intersection of her concerns about economic diversity and competitiveness.

The dollar has, of course, held up despite a terms of trade that has been falling for more than a year and lower interest rates, damaging both the trade-exposed non-resource sectors of the economy as well as the resources sector, where the underlying commodities are priced in US dollars. As Gillard said, that defies economic orthodoxy (and the history of correlations between the value of the dollar and commodity prices).

While the resources investment boom is likely to peak within the next 12 months – which will cause a significant fall-off in jobs and activity associated with the construction of mines and LNG projects – there is no certainty that the dollar will weaken. Its strength has more to do with global financial flows, some of them purely speculative, and international relativities than the economic fundamentals of this economy.

Given that neither the government nor the Reserve Bank has the levers or capacity to shift the dollar and that the working assumption has to be that the dollar will remain persistently strong the government, as the PM acknowledged, has to have a plan that can respond to a continuing strong dollar.

Whether it’s the "five pillars" she described – increasing skills, building a culture of innovation, rolling out the national broadband network, improving regulation and leveraging our proximity to Asia – or some variations on those themes the obvious bottom line, as economists and others have been saying for quite some time, is an urgent focus by government and business on improving productivity.

It is interesting that while Gillard’s assumption was that the dollar would remain stronger for longer the Financial Times ran an article this week which talked about the weakening of the Australian and Canadian dollars as investors switched back into eurozone assets and cited analysts who highlighted the long positions of traders in Australian and Canadian dollars, weakening conditions in both economies and the prospect of further Reserve Bank rate cuts this year as creating the potential for further unwinding of "carry trades" involving the currencies.

Ever since central bankers flooded the markets with cheap liquidity and reduced real rates of return close, or even below, zero in the US and Europe, and more recently Japan, there has been a proliferation of carry trades using the cheap credit available in those economies to fund trades in the stronger developed economies like Australia and Canada.

The modest falls in the value of the dollar against the euro and US dollar so far this year might, as the FT article suggested, reflect changing perceptions of the eurozone and the outlook for rates there and a consequent reversing of the carry trades involving the euro, although the dollar has in recent years been quite volatile within an historically high range and the recent fluctuations have plenty of precedents.

More significant than the euro carry trade is probably the prospect of a big increase in the yen-Australian dollar trade now that the Japanese have embarked on a program of fiscal stimulus and unconventional monetary policy. The dollar has strengthened quite significantly – about 6 per cent – against the yen this month. Japan, of course, is a key trading partner and consumer of our commodities so that’s not good news.

The likelihood of the dollar collapsing back to historical levels, or even below parity with the US dollar, is probably slim.

While the US Federal Reserve board has started debating internally the timing of the ending of its still-expanding quantitative easing program (while continuing with purchases of Treasury bonds and mortgages that will add another $US1 trillion or more this year to a balance sheet already expanded by $US1.5 trillion from earlier purchases) there is no suggestion that the low-rate policies will be abandoned within the next couple of years. The same holds true for the eurozone.

Indeed, there are real concerns about how the authorities in the US and Europe will manage an eventual withdrawal of the massive infusions of cheap liquidity they have poured into their systems since the financial crisis erupted without causing dramatic and potentially disastrous shockwaves to flow through global markets. Even subtle shifts in their language send ripples through markets.

Given their vast debts and deficits and the anaemic, near-recessionary states of their economies it isn’t likely that there are going to be abrupt changes to their monetary policies over the next few years.

While more RBA rate cuts might further trim the yield differentials that have underpinned the carry trades, the production phase of the resources boom is getting underway and Australia’s proximity and exposure to the largest growth economy on the planet, China, is likely to underwrite the appeal of Australian dollar assets relative to those of most other developed economies.

The prime minister has, by focusing on the implications of a continued strong dollar even as she announced the election date, put the government’s policy response to it – and the opposition’s – on the table as an issue for debate and policy comparisons.

For a lot of businesses, large and small, it is a critical, even existential, issue but one that has produced a lot of words but no real policy response. The protracted election campaign will give both the major parties an opportunity to develop one.

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