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Jumping off the currency rollercoaster

Jumping off the currency rollercoaster

By Expert Panel 24.06.2013


By Paul Mazzola

The rollercoaster ride of our Australian dollar reminds us how crucial it is to our export competitiveness. Our dollar is inextricably linked to commodity prices as well as the interest rate differentials between Australia and other countries.

Whether the strong link to commodity prices is technically justified is not the issue – the fact is many large money movers around the globe perceive Australia’s fortunes linked explicitly to the commodity price cycle and therefore sell the Australian dollar when commodity prices are in decline. This is happening now.

The lower dollar will alleviate pressures on our exporters; however given its volatility, can our export manufacturing and mining industries rely on the dollar remaining low to justify further investment?

And what happens to their investment strategies when the dollar climbs to historically high levels again? It seems our export industries, their profitability, the level of employment and furthermore our country’s prosperity no longer rides on the sheep’s back but largely on the volatile commodity price cycle. So how do we jump off this rollercoaster?

The “liquidity trap”

Many economic commentators are currently advocating a massive reduction in interest rates and look to the monetary policy lever of the RBA to initiate this tactic.

Common wisdom is that a lower interest rate will stimulate the economy by lowering the cost of borrowing and this should encourage exporters by lowering their overall costs and render new projects profitable which were previously economically unviable.

There is no denying that the RBA’s monetary easing during the height of the global financial crisis provided some economic stimulus and helped Australia avoid a recession.

However when an economy is in a slump and interest rates are very low and close to zero, no matter how much the RBA reduces the cash rate target, cash stays relatively trapped in financial institutions.

This is known as a “liquidity trap” – a concept developed by Keynes where any reduction in interest rates from a position of very low or negative real interest rates does not sufficiently induce companies to borrow and invest in productive projects until the economy recovers and aggregate demand increases. This problem is further compounded when consumer and investor confidence are low. We can therefore say that investment demand is inelastic based on pessimistic expectations.

Therefore the question for Australia presently is whether any further reduction in interest rates from an already historical low level will be beneficial.

If we take a look at Japan which has had interest rates close to zero for almost 20 years we find that even following the height of the global financial crisis (GFC) in 2007/2008 when the Bank of Japan returned interest rates to zero, there was a negligible impact on loans to the private sector and GDP growth.

 

www.tradingeconomics.com Bank of Japan

Furthermore, the US Federal Reserve’s strategy of quantitative easing (QE) following the onset of the GFC has also had a benign effect on credit growth and GDP growth.

Instead it seems to have further fuelled the US equity markets where the S&P 500 index has increased by over 100% from 797 in January 2009 to 1669 in May this year. There are also signs that the US housing market is also on the increase.

www.tradingeconomics.com US Federal Reserve

www.tradingeconomics.com US Federal Reserve

www.trading economics.com Bureau of Economic Analysis

Therefore we can see how quantitative easing policies have had minimal impact on credit growth of these advanced economies which are experiencing a combination of recessionary conditions and low interest rate environments.

Is this the case for Australia?

Since November 2011, the cash rate has declined 2%, from 4.75% to 2.75%. While inflation in Australia is 2.5%, our real rate of interest is a meagre 0.25% – very close to zero. In the meantime credit growth in the business sector measured by the RBA as a percentage of GDP has in fact been in decline since this period of monetary easing. So how can economists prescribe further monetary easing with this background?

 

www.tradingeconomics.com Reserve Bank of Australia

In fact while business credit has been in decline, personal credit has been growing and GDP has been relatively static. Personal credit (excluding home mortgages) is often used for personal consumption, which is a non-productive purpose and does little to improve our export competitiveness.

 

Reserve Bank of Australia