By Geoffrey Garrett
The response to US Federal Reserve Ben Bernanke’s comments about the possibility of ending its policy of quantitatitive easing has helped evoke a global sell-off as markets question his upbeat assessment of the US economy and express concern about a withdrawal of cheap money.
Weaker manufacturing figures from China have also helped send the Australian dollar below 92 US cents, its lowest level in nearly three years.
Professor Geoffrey Garrett, Dean of the Australian School of Business at the University of New South Wales, outlines four reasons why we might expect a lower Australian dollar in the future.
Reason 1: Money will get more more expensive in the US the better the economy does
Bernanke’s announcement indicates that the US is going to try to return over the next 12 months to more “normal” monetary policy. “Quantitative easing”, the Fed’s large bond buying program, has made money even cheaper than the near zero interest rates the Fed has set for several years. The fact that the market has reacted so negatively to an ending of QE tells you that there are lots of investors in the US who believe that the big run-up on the Dow Jones is a function of very cheap money, not improved fundamentals in the US economy. Any signal that the near free money’s going away will have a negative impact on Wall Street.
The headline unemployment rate in the US has been coming down, slowly but steadily, for a long time and will probably continue to do so. But I think the important thing to remember is that the standard unemployment rate is not as useful as it used to be because a lot of people are still counted as “employed” – that is, not showing up on the “unemployed” statistics – even if they’ve been moved from full-time work to part-time work involuntarily.
But even at 6.5% – which Bernanke has used as the trigger for a return to normal monetary policy – two things would be true. First, that’s a much higher equilibrium unemployment rate than the US has had in the past. The old figure used to be about 4.5%, so the US is going to be living with structurally higher unemployment now. Second, as I said, even at 6.5%, the number would conceal the fact that a lot of people want to be working full-time but only have part-time work.
What that tells us is that since the GFC American firms have figured out that they can make money employing fewer Americans than they used to. They’re outsourcing more to Asia and using technology more to reduce labour costs. So higher unemployment is going to be a big social challenge in the US, even when the conventional macroeconomic statistics look good.
So when Bernanke says “the economy’s doing well so we can think about returning to normal monetary policy”, the markets say, “Oh my god, free money’s going away. We’d better pull back”.
Reason 2: A slowing Australian economy means lower interest rates here
If and when US monetary policy returns to more normal, the interest rate differential between Australia and the US will go down.
In the past few years foreign investors have moved money into the Australian dollar because they can get a higher interest rate on lending than they can in the US. So if the interest rate differential goes down because money becomes a bit more expensive in the US, people who are lending money in the US will get higher rates of return, and money will flow out of the Australian dollar, lowering the exchange rate.
The less incentive people have to park their money in Australian dollars, the lower the dollar will go.
On the other side of the interest rate equation, the Australian economy is slowing down. That is why the Reserve Bank has lowered interest rates here. This also reduces the difference between US and Australian interest rates, again putting downward pressure on the Aussie dollar.
So there are two financial drivers pushing down the A-dollar: cheaper money in Australia and more expensive money in the US.
Reason 3: America’s shale gas booms means a lower Australian dollar
But there are also two structural reasons for a lower Australian dollar. The first structural one is lower commodity prices. We know about iron-ore and coal, but the biggest story going forward is natural gas.
All of that investment in Australian natural gas in Queensland and Western Australia was predicated on a pretty high global price for natural gas, which Australia is now going to export in huge quantities over the next decade.
The problem for Australia is that natural gas prices are going down globally because the recent US shale gas revolution has just put a lot more gas on the world market. Demand for natural gas is high around the world. But there is now much more supply than when the Australian natural gas investment boom started. Just like lower iron ore prices, lower gas prices also reduce the value of the Australian dollar.
Reason 4: China is slowing down and the Chinese government may not respond with more infrastructure stimulus
And the last reason is China. We know that in an important respect, the global market has viewed the Australian dollar as a proxy for Chinese demand for raw materials. If China is slowing down in general, that is bad for the flobal economy. But if the Chinese government isn’t going to respond with another massive infrastructure spend, that is particuarly bad for Australia, and the Australian dollar.
China was hit harder than other countries by the GFC because its growth was so dependent on exports. The Chinese government responded with a massive program of lending and fiscal stimulus, focused on big infrastructure projects—new cities, new airports, new high speed rail networks. This all required steel, made from Australian iron ore and coking coal. Australia escaped the GFC and the dollar boomed – both because of what the Chinese government did.
Now China is slowing again, but it is just not clear that the government has the appetite for another massive infrastructure stimulus. That will slow Australian commodity exports and economic growth. It will also put downward pressure on the dollar.
So all four factors point to a lower Australian dollar. In fact a lot of people in the market have been thinking that there’s a new rate for the dollar. It’s not 105 cents to the greenback as it has been for the past few years. It will probably be closer to 85 cents.
Is that good or bad for Australia? I think the answer depends on whether the dollars decline is orderly and gradual or chaotic and rapid.
Say it’s orderly, and the Australian dollar gradually reaches an equilibrium of 85 cents – everyone’s happy because the problems associated with a high dollar will have been reduced. Australian exporters like Holden win, although people taking holidays or buying BMWs would not be.
The bad scenario is if the dollar plummets global financial markets might lose so much confidence in the dollar that they will stop lending Australia money, or at least charge much higher interest rates to do so. A disorderly, chaotic, uncertain decline of the dollar where you don’t know where the new floor would be, that’s a very bad news story.
But we don’t see evidence of that at the moment. Yes, the decline’s been appreciable in the last six weeks or so. But there is no reason to think we are facing anything like the dire conditions associated with the Asian financial crisis 15 years ago.
Geoffrey Garrett does not work for, consult to, own shares in or receive funding from any company or organisation that would benefit from this article, and has no relevant affiliations.
This article was originally published at The Conversation.