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The dollar race: edging closer to parity

By Saul Eslake - posted Tuesday, 3 November 2009

The Australian dollar seems once again to be making an assault on parity with its US counterpart, after having stopped 2¢ short of that mark in July last year and then plummeting almost to US60¢ during the darkest phases of the global financial crisis.

Assuming that the global financial system isn't on the cusp of another meltdown - and that seems a reasonable assumption if only because of the determination of leading governments and central banks to prevent the failure of another systemically important financial institution - this upward trend in the Australian dollar seems more likely to be sustained, and to reach higher levels, than the last one.

About a third of the rise in the Australian dollar against the US dollar since March reflects a decline in the value of the US dollar against most other currencies. This resumes a trend that was interrupted when banks were scrambling to replace sources of US dollar funding that dried up during the global financial crisis (prompting the US Federal Reserve to provide as much as $US582 billion in US dollar liquidity through swap arrangements with other central banks). In trade-weighted terms, the US dollar is almost back where it was before this phase of the global financial crisis began. The US dollar is likely to keep falling. It is highly desirable that it does, provided it does so in an orderly fashion. This would be one of the necessary conditions for the emergence of more sustainable global economic activity, in which the United States (in particular) consumes less and exports more, and China (in particular) exports less and spends more on domestic consumption and investment.


Shriller voices on the fringes of the global investment community notwithstanding, there's no compelling reason to think the US dollar's decline is likely to become disorderly. The fundamentals for other major currencies (such as the euro or the yen) are hardly more compelling; and developing countries (such as China), which peg their currencies to the US dollar, are obliged to buy US dollars for as long as they continue to run current account surpluses.

Ideally, China would allow the yuan to return to gradual appreciation against the US dollar, which it suspended in July last year. But for now, at least, it shows no sign of being willing to do so, and the rest of the world has no feasible means of forcing the issue.

The Australian dollar has also risen against other currencies such as the euro, the yen, the pound, the Canadian dollar and the Korean won. So there have been other factors beyond renewed weakness in the US dollar that have contributed to the Australian dollar's strong appreciation since March. Three factors would seem to be of particular importance.

First, since Australia's financial system came relatively unscathed through the global financial crisis, and its economy experienced only a mild downturn, interest rates didn't fall as much as in other advanced economies and are now on their way back up again. By contrast, rates in the large advanced economies are likely to remain at their present levels (close to zero in the US, Japan and Canada, 0.5 per cent in Britain and 1 per cent in the euro area) for some time. Australia's relatively high interest rates are thus likely to continue to attract capital inflows from overseas, as they have done for most of the past decade.

Second, the Australian dollar has been buoyed by the recovery in commodity prices, although in the short term, at least, this leg of support for the currency is arguably weaker than the others.

The Reserve Bank's index of Australian export commodity prices has risen by less than 6 per cent (in US dollar terms) from its low in May, and remains almost 32 per cent below its peak in July last year. This reflects falls in the prices of most agricultural commodities, as well as coal and iron ore. But prices of metals, in particular copper, have risen much more sharply from their lows of late last year, and these have been reflected in large gains in the indices more commonly used in northern hemisphere financial markets as proxies for commodity prices in general.


However, the rise in metal prices has been paralleled by a steady rise in metal inventories. This suggests that metal supply has been rising faster than metal demand, in turn implying that a good deal of the spectacular rise in metal prices this year may reflect speculation rather than demand. Similarly, anecdotal evidence suggests that at least some of the apparently strong Chinese demand for coal and iron ore this year has been driven by inventory building and speculation. Thus, to the extent that commodity prices have been driven by speculation, any sudden reversal of this year's gains could interrupt the Australian dollar's march towards parity with the US dollar.

Third, and notwithstanding the possibility of commodity speculation, it seems probable that strong demand from China and, to a lesser extent, India, for Australia's mineral and energy resources will exert a substantial influence over the pattern of economic growth in this country over at least the next two decades.

The likely expansion of the resources sector will boost the overall level of productivity and returns to investment in the Australian economy, attracting additional foreign capital and underpinning a stronger Australian dollar in much the same way that the ''IT revolution'' attracted foreign capital to the US and boosted the value of the US dollar in the second half of the 1990s.

One of the challenges facing policymakers will be to ensure that the resources boom doesn't end up being a bubble as did the IT revolution in the US. Another will be dealing with the adverse consequences of a persistently strong Australian dollar for the non-resources sectors of the economy, such as manufacturing, agriculture, tourism and education. But they are subjects for future columns.

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First published in The Age on October 29, 2009.

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About the Author

Saul Eslake is a Vice-Chancellor’s Fellow at the University of Tasmania.

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