I J Macfarlane: Recent influences on the exchange rate
Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to CEDA Annual General
Meeting Dinner, held in Melbourne, on 9 November 2000.
* * *
I am very pleased to have been asked to address CEDA's Annual General Meeting for the third time in
Melbourne. When deciding on a topic for tonight, I realised that it would be very difficult to discuss
the Australian economy without spending some time on the exchange rate and the various reasons
advanced for its recent fall. So I have decided to plunge in and devote the whole speech to this topic.
Obviously, we have been doing a lot of thinking about it, and I will see if I can say something useful
about it in the 20 minutes I have available tonight.
What has happened?
The exchange rate has behaved during 2000 in a way that noone predicted. There used to be some
elements of predictability for the Australian dollar in that its broad movements could usually be
explained by changes in our terms of trade (or its close relative, commodity prices) and the difference
between domestic and foreign interest rates. The relationship was not close on a month-to-month or
quarter-to-quarter basis, but it could explain the large swings. This broad relationship is shown in
Diagram 1 which compares the predicted exchange rate and the actual exchange rate using an equation
which has been used in the Bank over the years. (By the way, there is nothing unique about this
equation as several of the large banks active in the foreign exchange market have also used a similar
formulation.) What Diagram 1 shows is that, on the basis of previous experience during the floating
rate period, we could have expected a rise in the exchange rate in 2000. Instead, we have seen a fall
and the gap between actual and predicted is over three standard deviations - the largest in the past
fifteen years. Something therefore has changed, at least for the present.
Diagram 1
Real Trade-Weighted Exchange Rate
Index Index
Predicted*
125 125
Actual
115
115
105 105
1985-1999
average
95 95
85 85
1985 1988 1991 1994 1997 2000
* Shaded area represents +/- one standard deviation from predicted value.
Another way of making the same point is to say that the Australian dollar has never previously shown
a significant fall with economic conditions as they presently are. Over the course of 2000, we have had
a strong world economy, improving Australian terms of trade (rising commodity prices), a buoyant
domestic economy, a declining current account deficit, a fiscal surplus and rising domestic interest
rates. In the past, a significant fall in the Australian dollar has coincided with the opposite - a weak
domestic economy and world economy, and falling commodity prices. It has also usually occurred
against a background where there has been widespread public criticism of fiscal and monetary policy
for being too expansionary. None of these elements is present on this occasion.
The comments I have made so far have treated the year as a single development, but I think it is
possible to distinguish two phases. For the first seven months or so, the biggest influence on the
exchange rate was the expectation of what was going to happen to Australian and US interest rates.
The predominant view was that the strong US economy would mean that US interest rates would rise
more than those in other countries (including Australia), and this contributed to a strong US dollar and
falling Australian dollar. Any suggestion that the Australian economy was weakening (or the US
economy strengthening) led to a fall in the Australian dollar. In the first seven months of the year,
virtually all of the large movements in the Australian dollar could be explained this way. For example,
on two occasions, a weak monthly retail trade figure caused the Australian dollar to fall by more than
one US cent in a day. Our forthcoming Statement on Monetary Policy (due next Monday) examines
this in detail.
The irony of this situation was that this process actually involved a misinterpretation of the Australian
economy. The signs of weakness that were seized upon were anomalies; the underlying economy
remained very strong, incipient inflationary pressures were starting to appear, and during this period
our interest rates were raised, as it turned out, more or less by the same amount as those in the United
States. Nevertheless, the misinterpretation prevailed and the currency fell. Over the six months from
late January, the Australian dollar fell by 11% against the US dollar and 8% in trade-weighted terms.
The second phase occurred from around mid-year, when it became widely expected by the market that
the US economy was going to have a soft landing, and that no further increases in US interest rates
were likely. As a result, the market's expectation of future interest differentials moved in a direction
favourable to Australia. Had the foreign exchange market continued to behave as it did in the first half
of the year, the Australian dollar would have risen, but it did not. It steadied for a while, and then fell
appreciably from mid-August. It was this period that convinced a lot of people that some new factor
must be at work, which was overwhelming the normal determinants of the exchange rate. It was also
in this period that the alternative explanations were put forward most volubly.
The influences
Before getting on to some of the newer explanations for the currency's movements, it is worth looking
at some more conventional explanations.
The first of these is the strength of the US dollar itself, which has been the biggest reason behind our
recent experience. This has affected us in a mechanical sense in that if the US dollar is rising, the
currency on the other side of the bilateral exchange rate must fall. We have been part of this, as is
shown by the fact that the Australian dollar has fallen more against the US dollar than in
tradeweighted terms. There has also been an indirect effect in that the rising US dollar has affected the
investment preferences of many market participants in an extrapolative way which I will discuss later.
The US dollar in 2000 has risen against the currencies of all other industrial countries, although its rise
against the Yen has been relatively small. These two currencies - the US dollar and the Yen - have
been the strongest currencies in 2000, and they happen to be our largest trading partners and so have
the largest weights in our trade-weighted index.
Interestingly, the newer explanations for currency movements are largely based on the assumption that
countries with strong currencies will have characteristics similar to the United States (see later). But
Japan is almost the opposite to the United States - weak economy, barely positive interest rates,
massive fiscal deficit, trade surplus and an economic culture based on conventional manufacturing. I
do not wish to dwell on these differences, other than to note that they show the dangers of coming up
with a general explanation of exchange rate movements which turns out to be only applicable to one
country or one period of time.
The second explanation relies on the well-known tendency for exchange rates to be driven by
momentum. That is - once a trend has been established, for example, by the events in the first half of
the year - it tends to continue and thereby to overshoot the level implied by fundamentals. There have
been many documented examples of this,1 and market participants often place weight on this factor
when explaining movements in exchange rates. I have no doubt that this has been an important factor
over recent months, as it has been on several earlier occasions in our past. A related market rule of
thumb that has appeared this year, but was entirely absent last year, is the one which relates
movements in the Australian dollar to movements in the Euro. The good thing is that these trends and
rules of thumb do not continue indefinitely, and the further the exchange rate departs from
fundamentals, the more likely it is that some unforeseen event will come along to jolt the rate into a
new direction.
The third conventional explanation gives prominence to Australia's external position - the current
account deficit and the accumulation of foreign debt and other liabilities. This explanation emerges
whenever the Australian dollar is falling, and then goes into hibernation whenever it is rising. The
problem with this explanation is that our external position has been relatively stable over the past
decade or more, and so it is difficult to use it as the explanation for an event that only occurred as
recently as this year. Over the past decade, the current account deficit has cycled around an average of
about 41⁄2% of GDP, and our foreign debt has stayed a little over 40% of GDP. It is true that total
external liabilities to GDP has risen, but against this, the ratio of debt servicing to exports has halved
over the past decade, and the current account deficit itself has been declining during the period of the
falling Australian dollar. I think it is very difficult to make the case that our external position has
recently deteriorated, or that it is the explanation for the falling Australian dollar in 2000.
While I am generally sceptical that this year's events can be explained by a sudden focus on trends in
the current account position, it may be more promising to think about developments from the
perspective of capital flows.
If, for one reason or another, investors found Australia a relatively less attractive destination for their
funds, compared with some other destination - eg the United States - we would expect that this will
have implications for the exchange rate. Some will want to assert that this occurred because people
suddenly focused on Australia's current account, but this seems unsatisfactory because the recipient of
the flows - the United States - is seeing its current account deficit expand to unprecedented size. In
fact, as a share of GDP, Australia's current account deficit is well on the way to being smaller than its
US counterpart, yet the US dollar has been rising, and the Australian dollar falling. So to make sense
of what has been happening, it is necessary to think in terms of capital flows being driven by changes
in the perceived returns in the different countries. In the remainder of this talk, I would like to examine
this apparent shift in capital flows, and to think about whether it is temporary or permanent.
Attitudes of international investors
There are two reasons put forward for why overseas investors may now have a smaller appetite for
investing in Australian assets - the first applies to debt and the second to equity.
On Australian debt, whether at the short or long end or whether private or public, current interest rates
are now lower than formerly was the case. For a good part of the past two decades, Australian interest
rates were well above US rates, as we struggled to get Australian inflation back to a respectably low
rate. Even when inflation fell, a number of years passed before the fall was finally reflected in
inflationary expectations and interest rates. As a result, it was only over the past three or so years that
Australian interest rates lost their significant premium over US rates (Diagram 2).
Diagram 2
Ten Year Bond Yields
% %
10 10
Australia
8
8
6
6
US
4 4
l l l l l l l
2
2
1993 1994 1995 1996 1997 1998 1999 2000
The argument essentially says that, since Australian interest bearing securities no longer contain a
premium, investors' appetite for them has declined, and so the demand for Australian dollars to buy
them has fallen. On the surface, this sounds plausible, but we should ask why have rates fallen. Surely
more
they fell because Australian debt became attractive to investors. Whereas in 1994 rates of
300 basis points above US rates were required to get investors to hold our bonds, they now do so
willingly at rates only slightly above US rates.
Clearly, the simple form of this argument has a few logical gaps. However, there does seem to be
something at work here - perhaps due to differing appetites for Australian bonds on behalf of local
compared with foreign investors - because there has been a reversal in recent years of the former high
levels of capital inflow into Australian bonds. In the five years between June 1992 and June 1997,
these inflows averaged $4.3 billion per year, whereas over the past two years there have been outflows
of $5.2 billion per year.
The second argument, namely that there has been a change in preference by equity investors, is a
relatively recent one, but it has been put forward very forcefully. It essentially says that equity
investment (direct and portfolio) is less attracted to Australia than formerly since we are viewed as an
"old economy" because we do not have a big enough exposure to the new growth areas, particularly
the information and communications technology sector (ICT). The contrast is drawn between the
United States, which is seen as the "new economy", and other countries, including Australia and
Europe, which are seen as the "old economy".
Let me say at the outset, there are two questions at issue - first, do a substantial number of providers of
capital think this way? - and second, is there economic substance to the contrast between the two types
of economy? There can be little doubt that the answer to the first question is in the affirmative - this
line of thinking is very widespread at present, and therefore has no doubt been an important recent
influence on our exchange rate.2 The answer to the second is, in my view, in the negative - the
differences between the two types of economy - "old" as applied to Australia and "new" as applied to
the United States - have been greatly exaggerated and the similarities ignored. This is important
because if there is not fundamental economic substance to the view, it will not last - it will be seen as a
phase through which capital markets passed. I would like to spend the remainder of my time tonight
explaining why I believe this is so.
The thing that stands out about the economic performance of Australia and the United States over the
past decade or the past few years is not the contrast, but the remarkable similarity. For an investor, the
most likely place to make money is where there is strong growth and a rapid increase in productivity.
The United States is justly proud of its performance in these two areas, but the one comparable
country in the OECD area that can match it - in fact, exceed it - has been Australia. I have shown the
growth and productivity figures before, so I will not repeat them again, but will rely on a US source to
make my point.
An article in the US Federal Reserve Board's October Bulletin sets out to explain the remarkable
recent pick-up in US productivity and to contrast it with 16 other OECD countries. It is an excellent
and thoroughly researched article which broadly achieves its objectives, but it keeps finding an
irritating exception.3 Whether it is growth of labour productivity, growth of multi-factor productivity
or the extent of capital deepening, Australia matches or exceeds the excellent US performance, rather
than sharing the lacklustre performance of the majority of other countries.
But proponents of the "new economy" view would reply that they are not interested in the whole
economy, they are interested primarily in the ICT part where the United States unquestionably is the
world leader. But only 3.9% of the US workforce is employed in the ICT sector (the comparable
figure for Australia is 2.6%). Why you should make an assessment of a country by concentrating on
the 3.9% and ignoring the other 96.1% is a question I cannot answer. On a similar note, the
willingness to adopt new technology is surely the key to improving productivity, and here there are a
number of indicators that place Australia very high in the world rankings. A recent OECD publication4
on this subject finds that, among the 27 or so OECD countries, Australia is:
• third highest in ICT expenditure as a percentage of GDP;
• sixth highest in PC penetration;
• eighth highest in internet hosts per 1000 population;
• third best in internet access cost;
• third best in secure web-servers for electronic commerce.
Not surprisingly, we do not match the United States in most of these measures, but we are almost
always in the top quartile or higher, suggesting that among OECD countries we should be regarded as
being towards the top end of the range in willingness to embrace new technology.
Again, the proponents of the "new economy" view find this reasoning unconvincing. They tend to
concentrate on the production of the ICT sector, and give Australia low marks for not having more
resources in this area. While there is no doubt that the very sophisticated fringe of ICT, as exemplified
by Silicon Valley, would be an asset to any country, most of the production side of ICT is much more
humdrum. In fact, the country with the highest share of GDP derived from ICT is not the United
States; Korea and Hungary, for example, both have higher shares. The United States has outsourced a
good deal of the production to less sophisticated countries with lower cost structures, with the result
that the United States now has the largest deficit in trade in ICT of all countries.5 This, I think, helps
make the point that a policy of trying to direct resources into ICT, particularly its production at the
expense of other aspects of the economy, could be self-defeating. It would be all the more
disappointing if such a policy were sold on the grounds that it would be a constructive response to the
current fall in the exchange rate.
Perhaps the biggest weakness with the "new economy" argument as an explanation of exchange rate
movements can be found in the recent behaviour of the US dollar and US investments. It is frequently
asserted that the reason the US dollar is rising is because everyone wants to buy US equities,
particularly tech stocks, because that is where the high returns are. In fact, anyone who followed this
approach this year would have been disappointed. Not only were they buying into something with an
already high price and low yield, they would have seen the prices fall noticeably over the year - the
Dow by 5% and the NASDAQ by 16%. (In Australia, the all-ordinaries has risen over the same
period.) To the extent that the US investments made positive returns, it would have been only due to
the appreciation of the US dollar itself, not to the assets purchased, which turns the underlying
reasoning on its head.
Conclusion
The Australian dollar has shown some big swings in both directions since it was floated in 1983. This
is the fourth time in that era that the Australian dollar has fallen by more than 10% in trade-weighted
terms in a year. On each of the earlier occasions, it seemed at the time that the fall would go on
forever, and there were plenty of people who had explanations to support its continuation. However,
on each occasion, it recovered and it will do so again this time.
The principal reason for the fall over recent months has been the rising US dollar, which has affected
us directly and indirectly. Another reason is to be found in the interaction between the early fall based
on expectations of interest differentials plus the intrinsic tendency for foreign exchange markets to
continue to go in one direction, ie to overshoot, and to come up with explanations to justify the
overshooting. Finally, over recent months, there has been a tendency for markets to judge countries
and their exchange rates by the "new economy model". Ironically, this is exactly the period when
US technology stocks have languished.
I should now conclude by saying something about the implications for monetary policy. Monetary
policy will continue to be conducted according to the medium-term principles contained in our
inflation-targeting approach. This means that the exchange rate will be taken into account, along with
the other variables that contribute to our inflation outlook (where this is appropriately defined to
exclude once-off factors such as petroleum prices and the GST). On the other hand, as can be seen
from our current behaviour, we have no intention of departing from our medium-term approach in an
ad hoc attempt to push up the exchange rate for its own sake.
The period ahead will contain many uncertainties, both here and abroad, but we have coped with
uncertainty before. Over the past year, we have had the unusual combination of strong domestic
growth, a falling current account deficit and a declining exchange rate, all of which are conducive to
future growth. We still have to ensure that the medium-term outlook for inflation stays on track
which means making sure that several temporary factors have only a "once-off" effect and are not
reflected in the ongoing inflation rate. If we succeed in doing that, we will be in a good position to
continue the expansion we have had since 1991.