From the AFR:
Empirically, the Australian currency tends to weaken when commodity prices fall or when domestic interest rates fall relative to those in the United States. It is reasonable to expect the fall in commodity prices since 2011 would weaken the Australian dollar. Similarly the announcement of tapering or an end of quantitative easing in the United States would herald a rise in US interest rates relative to those in Australia and thus weaken the Australian dollar.
However, looking at the global economy, there are good reasons to believe the Australian dollar will appreciate over the next five years or so.
In the near term a key issue for global investors is where returns are likely to be generated in future years…My research suggests a 100 basis point reduction in the risk of investing in Australia would appreciate the exchange rate by 10 per cent. A cut in the short-term policy rate has an order of magnitude smaller effect on the currency. In addition to lower risk, capital gains in a variety of assets because of loose Australian monetary policy will tend to attract foreign capital.
Correct! But one has to wonder why this is stated as fait accompli? One should be wary of pitting oneself against an economist of the calibre of Warwick McKibbin but I will do so today. Australia should neither endorse nor is likely to achieve this kind of high currency.
There are three reasons why McKibbin is wrong about a perpetually high dollar. The first is his last point. Let’s say monetary policy remains where it is for the next year. How big will the Australian housing bubble be in that time? We’ll clearly be at the most expensive housing market in our history. Can that run for five years? Of course not. When it stalls, consumption will ease off. If it falls, so will consumption. With the capex cliff and high dollar that will mean more rate cuts. The recent history of the dollar shows it remains very sensitive to the interest rate spread and it will fall too. If housing responds again then it’ll be rinse and repeat.
The second reason is that so long as the dollar stays in the mid-nineties (and McKibbin appears to be arguing it’ll go higher still) the budget will be toast as nominal growth falls. We’ve already seen this play out under the last Labor government. It’s why Hockey is bashing the RBA today. For any hope of a return to a balanced budget the dollar must be much lower or nominal growth and revenues tumble. If so, the Government will be forced to pursue austerity to the extent that deficit forecasts do not get worse. That will hit growth. Either way, growth slows and interest rates fall again. For the Government, there is no way out if the dollar does not fall.
The third reason is that global macroeconomic settings are shifting, albeit slowly. In two years, China is likely to be growing at 5%, in five years 3%, and the US likewise. I don’t dispute that this process of structural change will take time but markets will adjust to it long in advance. They already are, in fact, which is why the dollar is no longer at $1.10 and high-beta investment in the US are becoming very volatile as higher interest rates approach.
McKibbin argues that Australia can outperform economically through a combination of government spending on productivity-enhancing infrastructure and asset price capital gains and that will keep the dollar high. But the Government’s infrastructure agenda has already failed its own scrutiny test in not allowing the Productivity Commission to influence its list of projects and the housing bubble that McKibbin himself argued would be the outcome of low rates is clearly out of control. Neither of these represents a sustainable recovery (for five years).
Basically, the question before us is do we let the dollar fall slowly and let it hollow us out on the way down, or, do we act and force it down sooner? Either by are own hand or by crisis (chronic or acute), the dollar is going fall over McKibbin’s chosen term.
