Why the Australian dollar is unexpectedly strong

The floating of the Australian dollar in 1983 is among the most significant economic changes implemented by our policymakers over the past 40 years, even arguably the most substantial.

A market-set currency carries the advantage that it helps insulate Australia from foreign economic shocks, as economists call such events. The China-inspired mining boom, a positive shock, would have created far higher inflation in Australia if a rising currency hadn’t trimmed the price of imports.

What has surprised many, though, is that the reverse isn’t occurring now that commodity prices have fallen more than 25% since their peak in 2011 – a negative shock.1 From a record post-float high of 110.20 US cents in July 2011, the currency has only dropped as low as 88.83 US cents since (in January this year) and is around 93 US cents now. Against the Reserve Bank of Australia’s trade-weighted index, the decline is even smaller.2

There are numerous reasons why the Australian dollar is stronger than expected and they are often intertwined. The first is Australia’s trade numbers are improving because an increase in volume has more than compensated for price declines. Australia, for instance, recorded a trade surplus of $2.6 billion in the first two months of this year, its best start since 1971. Trade performance is a fundamental determinant of exchange rates for it governs the balance of demand for a currency between importers and exporters.

The second reason is that Australian interest rates are higher than elsewhere. Australia’s cash rate, even at a record low of 2.5%, is higher than its equivalents in the US, Europe and Japan, which are close to zero. Investors boost the Australian dollar when they buy Australian-dollar financial assets to take advantage of these higher returns.

Another cause is that Australia’s economy is performing better than most western counterparts. This has two important repercussions. The most important is that it drives up expectations that interest rates will go higher still. The other is that it boosts confidence that Australian shares will offer reasonable returns. Buying stocks has the same upward effect on the currency as purchasing financial assets.

Then, there is perhaps a reason that may surprise; Australia’s currency has recently enhanced its reserve status. This means that it’s a currency widely held by governments and institutions among their foreign-exchange reserves because it is seen as a store of value. About 2% of the world’s reserves were held in Australian dollars at the end of 2013. Only 18 months earlier, the IMF judged that reserves held in Australian dollars were too negligible to track.3

The fifth reason is that a currency’s strength is often more a reflection of weakness elsewhere. The US dollar has dropped over the past year against most currencies because the country’s disappointing recovery has lengthened expectations of when US rates will rise. Japan’s yen is falling because its central bank is pursuing an ultra-loose monetary policy to defeat deflation.

The Australian dollar’s refusal to decline in line with the tumble in commodity prices has complicated efforts to manage our economy. Our policymakers are even under pressure to engage in the so-called currency wars; to match efforts by their foreign counterparts (which are often unintentional) to undermine their currencies to help exporters. Our policymakers, though, are still true to the spirit of 1983 when it was decided that market forces know best.