THE WEEKEND ECONOMIST: Our resilient dollar

The story of the Australian dollar's newfound resilience is not just that other currencies have fallen away. There is a more subtle tale around our changing external financing mix.

The Australian dollar has averaged just under $1.03 since October of 2010. Over that period it has broken below 98 cents on five occasions. It has also risen above $1.06 five times.

The extremes of its trading range over this period – using Bloomberg daily closes – have been 0.9527 on October 3, 2011 and 1.1020 in late July of the same year. It has completed 8½ trough to trough pricing cycles with an average magnitude on the upswing (9 trough to peak observations) of 7.2 per cent and an average magnitude on the downswing (8 peak to trough observations) of 6.8 per cent.

On the surface, this would appear to provide empirical backing for the accumulating evidence of the senses that the Australia dollar has become more resilient during phases of risk aversion and more responsive on the upside during risk seeking phases.

The most publicised reason for this newfound resilience is the sharp increase in the Australian dollar’s attractiveness to foreign exchange reserve managers. This narrative is now well established and is clearly documented by the flow databases maintained by Westpac’s strategy teams in both the foreign exchange and fixed income spaces.

Less well publicised is the improvement in the aggregate mix of external financing that the Australian economy is now attracting, plus the substantial narrowing of its net external financing needs via an improved trade position.

To stylise, in the pre GFC world, Australia’s current account financing task was essentially shouldered by the financial system.

Today, the gap itself is smaller (of which more below) and the financial system (as of now, almost exclusively banks) are joined in sourcing international capital by the Commonwealth and state governments, and by the corporate sector, who are accessing a mix of direct and portfolio debt and equity liabilities.

Furthermore, with loan to deposit ratios moving favourably for the banking system as national savings rise, the proportion of local credit demand being met by offshore debt issuance is waning, and the term of the funding being sought has lengthened.

In effect, Australia has come through a period where AAA issuers (the public sector, banks with covered bonds to sell) have increased their call on international investors, AA financials have reduced their relative demands and have replaced short term and securitised funding with longer term bonds, and the non-financial sector has been sourcing a great deal of ‘sticky’ direct equity capital. The sum of these trends has been ‘higher quality’ external financing and a more resilient capital flow picture.

In terms of the size of the external financing requirement itself, the current account deficit has narrowed appreciably from 6 per cent of GDP in December 2009 to just 1.7 per cent of GDP in September 2011. Recalling that the CAD is the gap between gross investment and gross savings, the 4.3 percentage points improvement in the CAD over that period can be attributed to the combination of a 0.6 percentage points decline in the investment share of GDP and a 3.7 percentage points improvement in the savings share.

The latter shift was associated with a sharp rise in national income via the terms of trade, a rising proportion of which was squirrelled away by both households and corporations. This was reflected in the move from goods trade deficits to goods trade surpluses, as the rise in commodity prices buoyed export values, but imports were not increased to the full extent accommodated by the rise in national purchasing power. So, despite a rapid rise in the public sector’s borrowing requirement over this period, the national net savings position improved enormously.

Looking ahead, some of the factors that have done much to improve the Australian economy’s external financial resilience are expected to be less favourable. First of all, the CAD has already begun to widen again and the public balance sheet is moving towards surplus.

So there will be more foreign capital required and the public sector will be doing less of the work.

Some elements of the improvement in Australia’s external financing position are cyclical (i.e. non-permanent) while some will be long lived, having a large secular component. Australia’s current account financing dynamics have already begun to shift back towards historical norms (the cycle is turning) – although it is extremely unlikely that the situation will go all the way back (secular elements remain).

The shifting balance of these forces will serve to reduce the currency’s present level of resilience during times of stress. That is no bad thing. The flexible exchange rate is a key pillar of Australia’s counter cyclical response mechanism.

At times it needs to depreciate swiftly to play its part effectively. A situation that prevents depreciation when cyclical fundamentals are in decline is potentially damaging. The resultant financial conditions would be overly tight. A ‘recalcitrant’ nominal exchange rate pushes the burden of boosting competitiveness onto domestic prices. That sort of adjustment is never pleasant.

Huw McKay is Westpac's senior international economist.

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