The Aussie 30 years on!
One of the impacts of globalisation has been the massive increase in currency trading. According to the Bank of International Settlements (BIS), trading worldwide averages US$5.3trillion a day. This trading can be for commercial purposes – such as selling iron ore to China or buying an iPhone from the US or investing in UK listed shares or simply for taking a trading position.
Every foreign exchange (FX) trade involves two currencies – for instance selling A$ to buy US$ or selling Euros to buy A$. The US$ is currently the world’s most traded currency being on one side of 87% of the foreign exchange trades. The next most common currencies in trades are the Euro, the Japanese yen, the British pound (GBP) and the Australian dollar (known worldwide as ‘the Aussie’).
All the major currencies are ‘floating’ – this means that their value is determined by supply and demand just like any other market. Globally the major exception is the Chinese yuan where the Government controls the degree of movement.
Floating the Aussie
The A$ was first floated in December 1983 and it was one of the key factors that opened up the Australian economy to global competition. The following chart shows the value of the A$ from 1983 to June 2014 against the US$, the Euro and the GBP.
The A$ exchange rate against the US$ is the most widely reported. When floated the Aussie was at US$0.901c. As the chart shows it dropped to a low of US$0.4745 in April 2001 and had a high of US1.108 in July 2011. It is currently trading at just under US$0.90 and is currently widley tipped to fall further. However predicting currency movements is not an exact science.
The pattern against the GBP and the Euro (which was introduced in 1999) is broadly similar.
Another FX statistic that is commonly reported is the ‘trade weighted index’. This creates one figure that reflects the value of the A$ against a basket of currencies weighted according to the value of our imports and exports. It started with a value of 100 in May 1970 and was 81.6 in 1983. It has not reached that level since, with a high of 77.8 in 2011 and a low of 48.4 in 1995.
Volume of trading in the Aussie
The mining investment boom and the popularity of the A$ as a trading currency has meant the volume of trade in the A$ has increased dramatically. The chart shows a midyear snapshot of daily trading volumes where the A$ was on one side of the trade.
In 1990 average daily trades involving the A$ totalled $48,686m a day. Australia had a reputation as a safe harbour in the Global Financial Crisis and combined with the mining investment boom daily FX trade exceeded $200,000m on a number of occasions between 2007 and 2011. The highest daily average was $226,507m in August 2007. The latest reported figure for July 2014 was $156,384m.
What influences exchange rates?
A key point to recognize is that an exchange rate depends on the relative attractiveness of two currencies. For example the Euro/A$ exchange rate will rise and fall depending on the actual (and perceived) economic differences in Australia v Europe. So it is not just what is happening in Australia that matters – Australia could be stable but if the situation in Europe is changing then exchange rates will likely be affected.
The main factors currently affecting the Aussie are:
- Commodity prices. As a major exporter of mineral and agricultural products the demand for the A$ rises with increases in the volume sold and the prices of those commodities.
- Relative interest rates. The US, Europe, Japan and UK currently have very low interest rates. While interest rates in Australia are also historically very low they have been an attractive destination for investors.
- Economic stability. Australia is popular with currency traders because of the stability of our economic and political systems and the lack of government intervention in the FX market.
- Ties to Asia. Our trade with Asia provides diversification benefits for investors because the A$ fluctuates with demand for commodities. Via the A$ investors can gain exposure to Asian economies without actually investing directly in Asia.
A popular strategy for investors has been the ‘carry trade’. An investor borrows money in a country where interest rates are very low (Japan for example) and invests in countries where interest rates are higher (Australia for example). The carry trade increases the demand for the $A making the exchange rate rise. However the opposite occurs when the tables turn and investors sell their A$ to exit their positions and move elsewhere.
In recent times the Aussie has become a ‘reserve currency’. It is recognised as a strong currency, widely used in international trade and is held by central banks in other countries as part of their foreign exchange reserves.
The US$ is the prime reserve currency for the world because the US has a relatively stable government, a historically dynamic economy and low inflation over time. The US$ is accepted for payment from Mongolia to Argentina and across Africa – it is a de facto universal medium of exchange.
The A$ serves as a reserve currency in parts of Oceania and the Asia-the Pacific region
Why do exchange rates matter?
A strong currency may make us feel good about ourselves and our country. But there are more practical consequences.
A strong A$ means it buys more overseas currency and so imports become cheaper. Consumers buying imported cars or electronic goods and businesses buying aeroplanes or machinery will benefit from a strong Aussie. Australians travelling abroad will find a strong Aussie making their holidays overseas cheaper.
Cheaper prices generally means lower inflation and lower interest rates.
On the other hand a strong A$ means it costs more for overseas residents and businesses to buy Australian products and services. This makes manufacturers (like cars) and service providers (such as education and tourism) less competitive compared to global competitors. A consumer may get a better deal on a car made in Brazil and get a cheaper holiday in South Africa.
Further a weaker A$ means that debt obligations in a foreign currency just got bigger!
Predicting the future movement of exchange rates is very difficult because there are so many factors at play. At the start of 2014 well known economist Chris Caton was pitted against a tarot card reader to predict the state of the economy at the end of the year. Chris predicted an exchange rate of US$0.82 whilst the tarot card reader came up with US$0.80. We will have to wait until January to see whether economics or clairvoyance wins out.