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How Low Can The Aussie Dollar Go?

How Low Can The Aussie Dollar Go?

By Expert Panel 15.07.2013


By Gillian Terzis, The Conversation

After weeks of rapid depreciation, many commentators are wondering just how low can the Australian dollar go. Slowing growth in China and signs of a recovery in the US have renewed pressure on the dollar, with some predicting that it could fall below US90 cents as encouraging US jobs figures strengthen the greenback. Analysts from investment bank Credit Suisse have been more bearish in their 12-month outlook, forecasting that the dollar could slide to a low of US75 cents.

Below are three academics' views on the fundamental value of the Australian dollar and what the future might hold for our exchange rate.

Mark Crosby, Associate Professor of Economics at Melbourne Business School:

Short-term estimates of the exchange rate are notoriously unreliable. A large amount of research, with an original paper being one in 1988 by the former chief economist at the IMF, Michael Mussa, has suggested that the exchange rate is a random walk.

A pure random walk is completely unpredictable. No variable helps predict movements in a random walk, and past behaviour is no guide to future trends. With the AUD, I still believe that a random walk forecast for the currency is your best bet at horizons out to a year or two. In other words, with the current value for the AUD being 91 cents, the best forecast for the AUD in a year or two would be 91 cents. Having said this, expect to be wrong! One year in 10, a forecast of 76 cents to $1.06 would still not contain the value of the exchange rate in a year.

In the current environment, the further weakening of China’s economy and commodity prices would increase the likelihood of the lower value, while improvements in the outlook for China would move the AUD back towards parity or above. At a longer horizon, it does make some sense to think about a fundamental value for a currency. The fundamental, or equilibrium exchange rate, is a value that will maintain a sustainable trade and current account balance.

This fundamental value will move around with things like a country’s rate of inflation, and also will change as the terms of trade moves. Higher export prices will tend to make a higher value of the currency sustainable. I’m not aware of any estimates for a fundamental exchange rate for Australia, but my back of the envelope calculations would have the fundamental for the AUD at around 75 cents to 80 cents. However, one should not necessarily expect the dollar to return to that kind of level any time soon.

Graeme Wells, University Associate at the University of Tasmania:

When we buy a pie at the football on Saturday afternoon, it’s a simple transaction. The pie was baked somewhere up the road using Australian labour and Australian ingredients. The price is quoted in Australian dollars and the seller expects to be paid in Australian dollars.

With international transactions, things are not so simple. Some bulk commodities are priced in US dollars even if an American company is neither the seller nor the purchaser. Some goods and services are priced in the sellers’ currency, and some in the purchaser’s currency.

So it’s not helpful to focus on just one currency. For example since January 2 this year, the $A has depreciated by 14.8% against the US dollar, by 16.8% against the Chinese renmimbi (our biggest trading partner), and by 0.19% against the Japanese yen (our second biggest trading partner).

Australian prices of traded goods don’t respond straight away to changes in exchange rates; nor do firms, consumers and longer-term investors respond immediately to changes in prices. In rough and ready terms, the “appropriate” exchange rate, after those lags have worked through the system, is one where Australian producers can earn enough to stay in business and provide something close to full employment.

If we were honest as economists, we would say that the appropriate exchange rate “is probably a bit lower than it is now”. For those who think they know better, there are plenty of opportunities to put their money to work on foreign exchange markets.

Jakob Madsen, Xiaokai Yang Professor of Economics at Monash University:

There’s definitely a fundamental value for our exchange rate. A simple way of looking at it is by comparing price levels in Australia to price levels abroad. When we go travelling, we find that it’s much more expensive here — even more so than countries in Western Europe, where it has traditionally been much more expensive.

Clearly, we need to be achieving similar price levels to the countries we compete with. That fundamental value will not be far from US80 cents, assuming that the European and Asian currencies stay at par with the American dollar in the long run. If you look at Australia’s real effective exchange rate for the past 50 years, it has been fluctuating nicely around this constant trend that’s determined by the price levels of our competitors — against Europe and the food producers of the world, such as the United States.

We don’t want the exchange rate to fall too much because our foreign debt will go up. We look like a Third World country that has been living off selling commodities for two decades. We need to get a competitive edge on education and agriculture; that’s where the future is for Australia. The future is not in commodities. If we are going to compete in these areas, we are going to need a lower exchange rate.

The Conversation

This article was originally published at The Conversation.

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