Australian Dollar Exchange Rate Analysis 2012–2015

Introduction: AUD Reserve Currency Status

In November 2012, the International Monetary Fund (IMF) announced that the Australian and Canadian dollars would be added to its list of reserve currencies. This status is the highest designation for any currency and implies that the currency is a very reliable store of value. A reserve currency is backed by a nation's assets, like any fiat currency, but reserve currencies also require the conditions of good governance, economic diversification, free float, and other attributes that define the world's strongest and most widely traded currencies. These are also currencies traded widely in their regions — the Australian dollar serves as a reference currency in the South Pacific — and they are held by foreign central banks as part of those banks' currency portfolios. The relative strength of the AUD and CAD has been cited as the reason for those currencies' popularity with central bankers, and also reflects the volume of trade conducted in those currencies (Marsh, 2012).

After it was named a reserve currency, the Australian dollar went on a run for approximately six months, adding around 8 cents to its value versus the USD over that period (The Australian, 2013). The new status increased the appeal of the AUD around the world, not just with central banks but with other investors as well. Arguably, Australia faced a worsening external environment during this time, yet its currency still gained — which supports the idea that the currency appreciated on the strength of its newfound status. This paper begins its examination of the Australian dollar in September 2012, when the AUD traded at 0.9557 against the USD — over par — through to the end of September 2015, when the AUD traded at 1.4265. The graph of monthly rates confirms what these numbers already indicate: the Australian dollar has fallen almost continuously over those three years.

Underlying Assets and the Australian Economy

Any fiat currency derives its value primarily from what people are willing to pay for it, rather than from physical commodities (Investopedia, 2015). Yet this simplistic explanation, as common as it is, misses the point. A currency's value is based on the value of the assets of the country from which it is issued. There are a few reasons for this. First, "what people are willing to pay for it" implies supply and demand, and demand for a currency is determined by the demand for goods and services priced in that currency. Thus, the stronger an economy, the more valuable its currency will be, all other things being equal. The supply side reflects the country's money supply, which is controlled by the central government. Currencies strong enough to be considered reserve currencies are supported by a robust central bank — one that has demonstrated the ability to successfully manage the supply side — and by a nation and government capable of generating demand.

The world's reserve currencies prior to 2012 reflected four major diversified economies (the U.S., UK, European Union, and Japan) as well as a major trading currency (the Swiss franc). The Australian and Canadian dollars were both currencies of medium-sized, trillion-dollar economies that had a reasonable degree of diversification, but which were primarily considered resource economies. Both countries are dependent on resource extraction, and both are major mining nations. Australia's key assets include coal, iron ore, gold, and aluminum, much of which is shipped to China, Japan, and South Korea (CIA World Factbook, 2015). The resource sector still drives a substantial share of Australia's foreign exchange earnings.

The composition of Australia's foreign trade is an important part of understanding its exchange rate. While the country's GDP has been growing slowly but steadily, 75% of the Australian economy is in the service sector. GDP growth is therefore not necessarily a driver of the exchange rate, since most services trade is domestic. The export commodities sector, and to a lesser extent the manufacturing sector, are the major contributors to demand for Australian dollars.

Regional Trade and China's Slowdown

As is the case with most commodities-based countries, Australia's economy is dependent on demand for key export commodities. The values for the past five years of the three most important export commodities — iron ore, coal, and aluminum — are all down, with iron ore falling substantially. Knowing that Australia's currency is traditionally regarded as a commodities currency, and that commodities markets are in a prolonged slump, provides significant explanatory power for the long-run slide of the AUD. The country's major trading partner is China, which accounts for one-third of all export value (CIA World Factbook, 2015), and China's economy has slowed considerably over the past three years. While economic growth in China remains relatively robust in absolute terms, it has decelerated to levels not seen in decades. The overheated property market has slowed construction output as many buyers cannot afford real estate, and sluggish exports have reduced manufacturing activity. As a consequence, China's economy has slowed, negatively impacting demand for goods from supplier nations, of which Australia is one of the most prominent (Inman, 2015). This slowdown is also having a negative impact on other Asian economies, which make up most of the remainder of Australia's foreign trade (Pandey, 2015).

If China's slowdown is having such a negative influence on commodity prices, and demand for the AUD is tied to demand for those commodities, then understanding the future of the AUD means understanding the future of Chinese demand. Unfortunately, the conditions that have caused the Chinese economy to slow are persistent and structural. The Chinese central bank is relatively inexperienced at handling these problems — for example, it retains rules against the export of money out of China, limiting individuals to a maximum of $50,000 per year. By constraining the ability of wealthy Chinese to invest outside the country, China has created a hyperactive domestic property market, as domestic investors seek yield wherever they can find it. There does not appear to be much flexibility with respect to currency export policies, which are tied to the exchange rate stability of the yuan — something on which much of the country's economic growth is predicated. China has essentially accepted the overheated property market and is seeking a "soft landing" for its economy, rather than risk a shock by allowing unlimited capital exports. This structural issue is therefore likely to persist over the medium and long runs, and current demand levels for commodities are likely to continue in the absence of a new emergent buyer. The outlook for the Australian dollar should reflect this status quo.