Learn to live with a deviant dollar

Earlier this week Reserve Bank governor expressed, not for the first time, some surprise that the Australian dollar hasn't declined to reflect the fact that the terms of trade peaked a year ago and have now fallen about 15 per cent. The continuing strength of the dollar has been a source of rising interest and concern within the Reserve Bank as this year has progressed.

The fact that the dollar hasn't responded to the falling terms of trade and plummeting commodity prices is an historical aberration. There has traditionally been a very clear correlation between commodity prices and its value.

The dollar is one of those key "automatic stabilisers" that helps the economy to adjust to changing circumstances.

During the investment phase of the resources boom, which is now waning, it played a role in the reallocation of resources within the company to accommodate the extraordinary surge in business investment by chilling growth in the non-resource sectors of the economy.

Its failure to behave as anticipated as China's economy has slowed, commodity prices have tumbled and the terms of trade have begun sliding is more than an academic conundrum.

It raises the prospect that the pressure on the non-resource side of the economy will remain even after the investment boom is over, continuing to hollow out manufacturing industry and the trade-exposed areas of the economy without the compensating growth from the resource sector.

In fact the strength of the dollar has played a role in the significant cost inflation that is threatening to undermine the competitiveness of the growth in the resource sector ignited by the period of China-driven high commodity prices.

There has been quite a lot of discussion recently about what the Reserve Bank could or should do to try to do to influence the value of the dollar, even though it has in the past made it clear that it has neither the resources nor the inclination to do much more than "lean" against perceived over-shooting and under-shooting in its value to smooth fluctuations rather than change its course.

There has been considerable excitement in recent weeks about a modest build-up in the RBA foreign exchange holdings, which could be interpreted as direct intervention – the bank hasn't offset those inflows with matching purchases of Australian dollars – but Stevens played that down in comments after his speech to the Committee for Economic Development of Australia.

Stevens described the build-up as "customer business that we decided to keep on the balance sheet because the prices seemed attractive to do that at this time." At the margin, the scale of the transactions would have only a minimal impact on the exchange rate.

For those concerned about the strength of the dollar there was further bad news this week, with the IMF indicating that it was considering including it in its official currency reserve data, essentially conferring on it the status of a reserve currency. As Stevens said, the dollar has been in reality had that status for some time, although there has been a marked increase in foreign central bank purchases of the dollar since the crisis.

With a diminished number of AAA-rated economies left after the crisis and question marks over the real strength and stability of number of those countries with that rating, it isn't surprising the Australian dollar is in greater demand.

The depth and liquidity in the market for the dollar – next to the yen it is the most heavily traded currency in the region – and the indirect but relatively safe exposure it provides to China's economic growth is another factor in perception of the currency.

With positive interest rate differentials against the other major economies and with Europe and the US pursuing large-scale quantitative easing programs that undermine their currencies there are also strong fundamental reasons why the Australian dollar should be seen as attractive. Exchange rates are driven by relativities as well as absolutes.

The other strand of the layers of explanation for the stubbornness of the dollar in refusing to conform to its historical patterns is the peculiar calm that has settled over global markets as this year has progressed.

In the post-crisis period markets have been extremely volatile and driven by perceptions of risk. When the eurozone appeared on the verge of meltdown, capital fled to the perceived safety of US treasuries. The instant risks were seen to have receded, capital poured out into assets and jurisdictions regarded as riskier in search of positive returns.

At the moment, despite the unresolved issues in the eurozone, where the structural fissures have yet to be tackled, and despite the rapidly diminishing timeframe for the US to avoid its 'fiscal cliff', global capital flows, while still nervy, appear to be in 'risk off' mode.

There is nothing much the Reserve Bank, or anyone else, can do directly to try to take some of the edge off the value of the dollar, other than continuing to lower official interest rates and perhaps taking a few more central bank transactions onto its own balance sheet.

The working premise within the Reserve Bank and elsewhere appears to be that while the dollar may ultimately fall back modestly it isn't actually grossly over-valued and in any event, because its value is determined by a confluence of influences beyond policymakers' control, is something we have to live with and respond to.

As Stevens noted, with the impact of the resource investment boom now receding, that inevitably means focusing on the things that we can do, the most important of which is lifting the overall productivity of the economy.

If that doesn't happen, if the dollar remains where it is for the next few years and the wave of resource projects still under construction continues to wind down and peters out in three or four years' time, the winnowing out of the rest of the economy that will have occurred isn't going to leave us with much of an economic base and policymakers, and politicians, are going to face a quite nasty challenge.