A depreciating exchange rate sometimes gets interpreted as a ‘vote of no confidence’ in that economy or currency. In fact, it is often a necessary and welcome shock absorber.
Exchange rates are often seen as a judgement. A depreciating exchange rate gets interpreted as a ‘vote of no confidence’ in that economy or currency. People sometimes forget that an exchange rate necessarily involves two currencies. As we have already highlighted, the recent sell-off in the Australian dollar against the US dollar is more about the strength of the US dollar than anything specific to Australia. Likewise, on the days the sell-off has reversed, it has mostly been the result of US news.
We have, of course, seen these periods of ‘American exceptionalism’ – and a weak Australian dollar – before. The period around 2000 is a case in point. Back then, both the exchange rate against the US dollar and the TWI were around the 50 mark – much lower than even current levels. Indeed, the Australian dollar appeared to be undervalued relative to the fundamentals that were thought to drive exchange rate movements normally.
There were several reasons for this apparent undervaluation. The then RBA Governor, Ian Macfarlane, discussed this in a speech at the time. Market participants’ expectations about interest rates played a role then as now. So did bullish expectations about new technologies and their implications for productivity. Australia compared poorly when the focus was on the producers of the new technology, rather than on how it was being adopted by users. We were seen as an ‘old economy’ that dug things out of the ground rather than manufacturing semiconductors as a ‘new economy’ would. Looking at developments in the relative price of iron ore to semiconductors since then, though, being an ‘old economy’ turned out to not be such a terrible thing.
There are some crucial differences between the turn of the century and now, though. Back then, Australia’s productivity performance actually outstripped that of the United States, though many observers seemed to ignore this point at the time. Growth in private sector demand was strong, especially consumption; real household incomes were rising; and the housing market was booming. Perhaps more importantly, the turn of the century was just before the entry of China into the WTO, and the exceptional period of Chinese economic growth that followed. China’s share of Australia’s total trade more than tripled over the following decade.
The Australian dollar responded to these shifts. After hitting a low point soon after 9/11 in 2001, the TWI had by 2005 already appreciated by 25%. While the GFC induced some volatility, before too long, the AUD appreciated above parity with the USD for a time.
These outcomes highlight the floating exchange rate’s role as a shock absorber. ‘Risk off’ events such as 9/11, the GFC and the pandemic lead market participants to sell the AUD. So do longer-run developments that are believed to weigh on Australia’s prospects more than those of peer economies. But that sell-off does not last forever. It can also become a positive: Australian production becomes more price-competitive relative to foreign alternatives, which boosts domestic activity over time. The domestic-currency values and income of Australia’s foreign assets (Australia has net foreign-currency assets) rise, so too the profits of externally-focused Australian firms such as our mining companies. These in turn boost tax revenue for the Australian government.
The Big Pivot ahead
Even with the exchange rate acting as a shock absorber, though, there are times when an economy needs to pivot in the face of shocks and shifting trends.
Back in the 1950s and 1960s, it was said that Australia rode on the sheep’s back. Wool was the top export, with wheat coming in second. In the 1980s and 1990s, coal topped the export rankings, before iron ore took first place this century. Currently, the three next most important exports are coal, LNG and education-related travel services. LNG exports only came to prominence recently, with the volume exported more than doubling since the early 2010s. Meanwhile education exports increased steadily in importance through the 1990s and early 2000s, ramping up further in the mid-2010s to reach more than 8% of total exports. (On a current price basis, it’s now a little below that share.)
The prominence of iron ore is a direct result of the entry of China into the global trading system. China’s demand for steel increased roughly eight-fold as it developed, and without much existing scrap to use in arc furnaces, most of that steel was made in blast furnaces using fresh iron ore. Australia was well-placed to supply the iron ore, less so the steel. This was a good outcome for Australia: starting from just about any date in the past, imported steel prices have increased by less than the price of the iron ore that went into it. This is part of the reason why Australia’s terms of trade – the prices of exports divided by the prices of imports – has averaged a much higher level over the past fifteen years than in prior decades.
That incredible ramp-up is not going to be repeated, however. As we have highlighted previously, China has reached ‘Peak Steel’. Even if additional iron ore supply weren’t coming online in other countries, there is no material upside from here for Australia’s iron ore export volumes.
Coal production, as we have previously noted, is already declining. This is by design: the climate-related energy transition implies that global demand for thermal coal will fade away at some point. Metallurgical coal may have longer to run, but this depends on how long China and other producers stick with blast furnaces.
Like iron ore, LNG exports expanded following a significant increase in Australian supply capacity. That investment has completed and there are no major plans to expand capacity further; most of the currently underway or planned projects fall into the category of ‘sustaining investment’, without which production volumes would fall. While gas is likely to remain part of the energy mix for longer than coal in most countries, existing capacity and investment plans imply little scope to expand Australia’s LNG export volumes much from here.
Education services exports, as we have also learned recently, has its capacity limits, too. While global demand for university education in Australia could increase over time, the resulting population growth runs up against a housing stock that is inherently slow to react, being a stock of mostly already existing homes.
Australia’s top four exports are therefore all more or less capped in volumes terms. There is no crisis here: the run of large trade surpluses Australia recorded in recent years were historically unusual, and partly driven by the effects of the pandemic and Russia’s invasion of Ukraine on iron ore and energy prices. That said, it does mean that future growth in export volumes is mostly going to have to come from somewhere other than the current top four exports.
Australia is going to need to pivot. The good news is that history shows that it can, and the behaviour of the exchange rate will help it navigate that period of change.
