MAE101 Economic Principles: Is the Australian Dollar Overvalued?

Questions:

Article: Is the Australian dollar overvalued?

From the article titled ‘Is the Australian dollar overvalued?’ (Sydney Morning Herald February 10, 2017), answer the following questions.

• Briefly summarise the main issues discussed in this article?

• Using Demand and Supply model of exchange rate determination briefly explain how AUD is determined in the forex market, and what factors influence its fluctuations.

• Using nominal exchange rate data and trade weighted index from Reserve Bank of Australia and graphs (monthly data of last three years) analyse the movement of AUD relative to that of the USD? Is it in line with the world commodity price movement during this period? Are there any other factors contributing to this behaviour of the AUD?

Answers:

a)

The article ‘Is the Australian dollar overvalued’ by Myriam Robin was published in Sydney Morning Herald on February 10, 2017. The main issue of the article was an analysis of the value of the Australian dollar in recent times. The article starts with the fact that, although the Australian dollar is one of the best performing currencies of the world, economists say that trading at the sustainable level does not happen. The RBA Governor supports the growth in the exchange rate of the AUD. It is seen that the AUD has improved 6% against the USD. However, according to RBA Governor, the growth outcomes are not satisfactory. As per the Westpac’s model, the AUD is a little undervalued. RBA also said in its statement that the lower AUD since 2013 was helpful for the growth of the economy, when the mining boom ended. A rising exchange rate would have complicated the growth scenario.

The author further added that, the currency was appreciating steadily since 2015 September. The banks of the country uses Trade-weighted index to measure the appropriate level of the AUD. The exchange rate between the AUD and USD has not changed significantly over the past year, but the trade-weighted index value of the AUD has improved significantly, reflecting a rise of 4%. The improvement in the terms of trade results in currency appreciation, although the increase in trade weighted index is more than the expected rise in terms of trade. The chief currency strategist of Westpac, Robert Rennie has used a different technique, fair value econometric measure, based on commodity prices, interest rate differentials and risk measures to check the appropriate position for the currency. According to Rennie’s models, the AUD is undervalued. Thus, the experts believe that the currency is not overvalued, but this could change if the Federal Reserve of US increases the rate of interest and RBA does not.

b)

Exchange rate refers to the price of one currency in terms of another currency. It is determined by the demand and supply of a currency. The demand for a currency is generated from the level of the country’s exports and from outward flow of FDI. The supply is generated by the level of imports in the foreign market (Magud, Reinhart and Vesperoni 2014). For example, in the above case, when the level of imports from USA increases in Australia, the supply of AUD increases in the foreign exchange market. On the other hand, when the demand for exports from Australia increases in the USA, the demand for AUD rises. The level of demand and supply of the currency determines its price in the foreign exchange market, which represents the exchange rate (Sturm 2017).

Figure 1: Exchange Rate determination for AUD

(Source: Author)

From the above figure, the exchange rate determination is shown. In figure 1(a), the demand side fluctuations are shown and in figure 1(b), supply side fluctuations are shown for AUD in terms of USD. When the demand for AUD rises against USD, the demand curve for the AUD shifts to the right, from D_A$1 to D_A$2, supply remaining the same. Thus, the price for AUD rises to P_A$2 from P_A$1. AUD appreciates in this case. At the same time, supply of USD falls due to fall in demand for the US exports in the Australian market. Hence, the price of USD falls against AUD. The exchange rate for AUD against USD is the equilibrium where the demand and supply for AUD becomes equal in terms of USD.

The following factors determine the exchange rate fluctuations in Australia:

Prices of commodity and terms of trade: The terms of trade of a country is influenced by the commodity prices, as it is dependent on the commodity exports. Hence, fluctuations in the commodity prices lead to fluctuations in the exchange rate (Ghosh, Ostry and Chamon 2016).

Relative inflation rates: If the inflation rate rises in USA, the commodities become more expensive, hence, its demand falls. The level of trade changes leading to exchange rate fluctuations.

Relative national income growth rates: The country with a higher income growth demands more imported goods, thereby increasing the supply of home currency in the international market. Hence, exchange rate improves in favor of this country.

Relative interest rate: The country with a relatively higher interest rate draws more money in terms of investments. The citizens keep the money within the country and thus, the flow of money and exchange rate change (Levy-Yeyati and Sturzenegger 2016).

c)

Figure 2: Exchange rate for AUD - USD (2014-2016)

(Source: RBA 2017)

Figure 3: Trade Weighted Index for AUD (2014-2016)

(Source: RBA 2017)

The above two figures show the monthly exchange rate for AUD against USD and the TWI for the AUD for the last three years, from 2014 to 2016. It is seen that, the exchange rate has witnessed some fluctuations in the three years. In 2014, the average rate of exchange between Australia and USA was 0.9, while it declined to 0.7 in 2015. It further improved in 2016 to 0.75 in an average. On the other hand, there have been very less fluctuations in the Trade Weighted Index for AUD. The nominal value of TWI is quite higher than that of the exchange rate. However, the trend or pattern of movement for the both the variables are quite similar in Australia (RBA 2017).

This indicates that the exchange rate between the two countries has fallen. The impact is favorable for Australia. The currency has depreciated in the past three years, hence, exports became cheaper and imports became costlier. The Australian market became more competitive for the US customers, as exports increased and imports decreased (Charles and Marie 2016).

Figure 4: Commodity prices movement (2014-2016)

(Source: RBA 2017)

Figure 5: Brent crude oil price movement (2014-2016)

(Source: RBA 2017)

Figure 6: Gold price in international market

(Source: RBA 2017)

Since Australia is a resource based economy, its economy is heavily dependent on the export sector. Hence, the global economic conditions influence the trade conditions of Australia. From the above figures it can be seen, that the Energy, Metals, and Agriculture sector, Brent Crude Oil Price and Gold (industry benchmark) price movements are considered to get an idea about the commodity price movements in the last three years. The above figures show heavy fluctuations in the prices. The prices were high in 2014 for almost all the commodities and sectors, which gradually declined in 2015 and 2016, except for gold, whose price increased in 2016 significantly. The trends in exchange rate and TWI for Australia also followed the patterns of the commodity price movement for the three years from 2014 to 2016.

The global financial condition is a major contributory factor in the movement of AUD. The fall in the exchange rate indicates the declining growth of the major sector of the country, i.e. resources and mining. However, the trade weighted index value was quite good, as mentioned by the RBA Governor (Sturm 2017).

d)

Overvaluation of currency occurs under fixed exchange rate. A currency is said to be overvalued if the private demand for the currency is less than the private supply at the existing exchange rate. Overvalued currency leads to overvalued rate of exchange. This implies that the country’s value of currency is too high for the state of the economy. This results in costlier exports and cheaper imports (Grossmann, Love and Orlov 2014). This can also be understood with the help of Purchasing Power Parity (PPP). An overvalued currency makes the goods of that country relatively costlier. Hence, if a producer exports alcohol to the United States during overvaluation of AUD, then he would earn less than what he could have earned in case of undervalued or depreciated currency. The income from exports gets reduced (Frenkel and Johnson 2013).

Due to overvaluation, the imports from other countries will become cheaper. Thus, level of imports will increase; the supply of AUD will increase in the US as well as in the international market, improving the rate of exchange for Australia. The high value of the currency forces the domestic producers to enhance their efficiency and productivity for becoming more competitive in the global market (Gabaix and Maggiori 2015).

One of the major disadvantages is that, the exports from Australia become more costly and hence, its demand would fall in the US market. Thus, revenue from exports to USA will decrease. This makes the exports less competitive in the international market, which hampers the growth of the export sector. The higher demand for imported goods will reduce the growth of the domestic industries (Rossi 2013).

e)

Maintaining the exchange rate at a certain level implies the fixed exchange rate in the country. If RBA maintains the exchange rate at US 72c, then Australia is following a fixed exchange rate system. The purpose of this exchange rate system is to maintain the currency value of a country within a narrow band. RBA should use the open market mechanisms to establish the fixed exchange rate in Australia. In this system, RBA becomes committed to buy and/or sell the AUD at the fixed price for maintaining the pegged ratio. For financing any payment imbalances or to raise funds from international market, the RBA needs to buy or sells its assets and currencies (Anderson 2015). In this situation, RBA should maintain the pegged exchange rate.

Figure 7: Fixed Exchange Rate system

(Source: Author)

The above figure shows the fixed exchange rate determination by RBA. The equilibrium or sport rate under floating exchange rate is at point E, where the demand and supply for AUD is equal. However, under fixed exchange rate system, RBA may fix it higher than the market equilibrium rate or lower than equilibrium. According to the question, the value of E is US 76c, while RBA has fixed the rate at US 72c. Hence, it is lower than the market determined rate.

There are benefits as well as side effects of this system. Fixed exchange rate is generally used to stabilize the value of a country’s currency by fixing the value directly at a predefined ratio, with a different and more stable or internationally dominant currency. As a result, the exchange rate between the two currencies does not change depending on market conditions. This helps in making the trade and investments between the countries more easier as well as predictable. Hence, the uncertainties of business and economies are reduced. These are helpful mostly for the small economies (Kal, Arslaner and Arslaner 2015).

The side effects of fixed exchange rate are as follows. This system is expensive for maintenance. A country should have sufficient amount of foreign reserves to manage the value of its own currency. There is a chance for the country’s currency becoming a target for the speculators. They can hold the currency and drive the value further down. Hence, to prevent this practice, RBA must convert the AUD into USD and increase its foreign exchange reserves. If the reserve is not enough, RBA has to raise the interest rate (Kal 2013).

Fixed exchange rate system provides more certainty to the importers and exporters. This helps in maintaining the inflation at a lower level. In the long run, this helps in keeping the interest rate lower and stimulate the trade and investment activities in the economy. However, Australia had a fixed exchange rate from 1931 and AUD was pegged to GBP. In 1971, it was pegged to USD. When the country became developed in the mid 1970s, the country started to follow the flexible exchange rate system. The fixed exchange rate would not be effective as it becomes difficult to control the money supply, and the country cannot take advantage of favorable economic conditions under fixed exchange rate (Gomis-Porqueras, Kam and Waller 2013).

References

Anderson, K., 2015. Rewriting the rulebook. Superfunds Magazine, (398), p.42.

Charles, S. and Marie, J., 2016. Hyperinflation in a small open economy with a fixed exchange rate: A post Keynesian view. Journal of Post Keynesian Economics, 39(3), pp.361-386.

Frenkel, J.A. and Johnson, H.G. eds., 2013. The Economics of Exchange Rates (Collected Works of Harry Johnson): Selected Studies (Vol. 8). Routledge.

Gabaix, X. and Maggiori, M., 2015. International liquidity and exchange rate dynamics. The Quarterly Journal of Economics, 130(3), pp.1369-1420.

Ghosh, A.R., Ostry, J.D. and Chamon, M., 2016. Two targets, two instruments: monetary and exchange rate policies in emerging market economies. Journal of International Money and Finance, 60, pp.172-196.

Gomis-Porqueras, P., Kam, T. and Waller, C., 2017. Nominal Exchange Rate Determinacy under the Threat of Currency Counterfeiting. American Economic Journal: Macroeconomics, 9(2), pp.256-273.

Grossmann, A., Love, I. and Orlov, A.G., 2014. The dynamics of exchange rate volatility: A panel VAR approach. Journal of International Financial Markets, Institutions and Money, 33, pp.1-27.

Kal, S., Arslaner, F. and Arslaner, N., 2014. Bond Markets, Stock Markets and Exchange Rates: A Dynamic Relationship (No. 18).

Kal, S.H., 2013. Global Capital Flows, Time?Varying Fundamentals and Transitional Exchange Rate Dynamics. Journal of Forecasting, 32(3), pp.247-255.

Kal, S.H., Arslaner, F. and Arslaner, N., 2015. The dynamic relationship between stock, bond and foreign exchange markets. Economic Systems, 39(4), pp.592-607.

Levy-Yeyati, E.L. and Sturzenegger, F., 2016. Classifying exchange rate regimes: 15 years later.

Magud, N.E., Reinhart, C.M. and Vesperoni, E.R., 2014. Capital inflows, exchange rate flexibility and credit booms. Review of Development Economics, 18(3), pp.415-430.

RBA (2017). Exchange Rates. [online] Reserve Bank of Australia. Available at: https://www.rba.gov.au/statistics/frequency/exchange-rates.html [Accessed 15 Sep. 2017].

RBA, 2017. The Exchange Rate and the Reserve Bank's Role in the Foreign Exchange Market | RBA. [online] Reserve Bank of Australia. Available at: https://www.rba.gov.au/mkt-operations/ex-rate-rba-role-fx-mkt.html [Accessed 15 Sep. 2017].

Rossi, B., 2013. Exchange rate predictability. Journal of economic literature, 51(4), pp.1063-1119.

Sturm, J.E., 2017. The Alleged Asymmetry in Maintaining a Fixed Exchange Rate. In Economic Ideas You Should Forget (pp. 141-143). Springer International Publishing.