FX International Payments
By Frances Coppola
But the evolution of Australia’s monetary policy has been so stormy, and the value of our dollar so sensitive to changes in international commodities prices, that Australian businesses have become among the most adept in the world when it comes to managing FX risk. In fact, during the particularly volatile early 1970s, Australian banks invented a kind of hedging product – non-deliverable forwards (NDFs) – that today are used by international businesses all around the world.
While other Western countries were dismantling capital controls and floating their currencies, Australia maintained a currency peg along with capital and exchange controls, particularly on inflows.1 From 1931 until the collapse of the Bretton Woods managed exchange rate system in 1973, AUD’s exchange rate was pegged to the British pound; subsequently, it was pegged to the U.S. dollar.2 During the 1930s, while the British pound was floating against other currencies, Australia did not use exchange controls. But during World War II, Australia imposed a range of “emergency” exchange rate and capital controls.3 These – or their successors – were to remain in place for the next forty years.
From 1945 onwards, the Australian dollar’s value depended on the international value of gold – and crucially, on the stability of both the British pound and the U.S. dollar relative to gold. The relationship got off to a bad start. The British pound was devalued by 30 percent in 1949,4 and AUD fell with it. The following year, the Korean War broke out, and the U.S. government’s attempt to stockpile wool drove up the international price of wool to unprecedented levels. At that time, wool made up almost half of Australia’s exports; the enormous appreciation in world wool prices caused an enormous – and unfortunately short-lived – economic boom.5
Coming so soon after devaluation, the wool price boom caused Australia’s inflation to spike, peaking at nearly 20 percent in 1951.6 Reversing the devaluation was discussed but rejected: Australian authorities eventually imposed sharp tax rises to calm domestic demand and bring down inflation, in the “horror budget” of 1951-2.7
But world wool prices were already falling. The value of Australia’s wool exports collapsed, causing a widening trade deficit. The combination of tax rises with the bursting of the wool price bubble in 1951 pushed the Australian economy into recession.8 However, Australia’s FX reserves proved substantial enough for it to cope with this “terms of trade” shock; it maintained the exchange rate peg by selling foreign currencies. There was no run on the currency and no “sudden stop”, which happens when international banks and investors suddenly withdraw financing from a country, and trade with businesses in other countries is therefore forced to stop abruptly.
The 1951-2 recession was mild and short-lived. But worries about the balance of payments and the possibility of foreign exchange crises persisted. In 1952, Australia imposed strict controls on imports. These remained in place well into the 1960s.9
After the terms of trade shock, Australia found it increasingly difficult to maintain AUD’s exchange rate peg to the British pound. During the 1960s, the price of wool continued to fall as cotton and synthetic substitutes attracted market share, which caused persistent balance of payments deficits that drove Australia several times to obtain funding from the International Monetary Fund (IMF).10 Nevertheless, the Australian government never devalued its dollar, though its value fell when the British devalued the pound in 1967. Australia preferred to rely on extensive capital and exchange controls along with tight regulation of the banking system.
However, tight regulation of banking caused problems. Caps on the rates banks could offer to depositors restricted their access to external funding, while controls on lending rates limited their profits. Most importantly of all, lack of access to international markets impeded the development of sophisticated FX risk management techniques and products. When the Bretton Woods system of fixed exchange rates failed in 1973, Australia’s banks and capital markets were underdeveloped compared to those in America and the U.K. Fearing instability in the Australian banking system, authorities decided to retain a fixed exchange rate. Reflecting the growing importance of Australia’s trade with the U.S., they re-pegged AUD to the U.S. dollar.11
From the start, the new peg proved problematic. The early 1970s commodities boom caused rising inflation in Australia; to curb it, the Australian dollar was revalued upwards three times between 1972 and 1974. But in 1974,12 terms of trade started to fall, putting downwards pressure on the Australian dollar’s exchange rate. In September 1974, AUD was devalued by 12 percent and re-pegged to a basket of currencies.13 But despite this, speculative attacks in 1976 forced a much larger devaluation. After this, the fixed peg was abandoned in favour of a “crawling peg”, in which a currency is allowed to float within a band around a chosen rate.14
The fact that the Australian dollar was pegged to a floating currency created FX risk for businesses. During this period on the 1970’s, therefore, demand for FX hedging products that did not violate Australia’s exchange controls led to the development of a market in non-deliverable forward contracts (NDFs).15 NDFs are still important FX risk management products for international businesses today, particularly those doing business in Asian countries.16
The Iran War of 1979 caused a sudden appreciation of global oil and commodity prices. This caused an inflationary shock in most developed countries. Australia was no exception, although as a commodity exporter the real problem was – once again – an unsustainable rise in the terms of trade. The Australian dollar’s exchange rate against most Western countries appreciated during the early 1980s as investment flowed into Australia in expectation of increased income from commodity exports. But a brutally tight monetary policy in Australia’s major trading partners damped demand for commodity exports, and the expected export boom never materialised.17
In the first half of 1983, the Australian dollar was devalued by 12 percent.18 But the devaluation proved insufficient: speculative pressure simply intensified. As outflows of capital threatened to drain Australia’s FX reserves, the authorities were faced with a stark choice: significantly tighten capital and exchange controls, or float the currency.
Finally, they chose to float. The Australian dollar was floated on 12 December 1983, and virtually all exchange restrictions were lifted. For the remainder of the 1980s, the Reserve Bank of Australia continued to intervene in FX markets to smooth out volatility in the AUD exchange rate.19 But Australia has never returned to a pegged currency exchange rate regime.
The transition from fixed to floating exchange rates took longer in Australia than in many other developed countries and was more turbulent than most, spurring Australian banks and FX providers time to develop expertise in FX management that is very valuable today. Now, Australian international businesses can use a range of hedging products to manage the FX risk that has become a normal part of doing business in today’s volatile world of floating exchange rates.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1.“Inward Direct Foreign Investment in Australia: Policy Controls and Economic Outcomes,”Hanratty; http://www.aph.gov.au/About_Parliament/Parliamentary_Departments/Parliamentary_Library/pubs/rp/RP9596/96rp32
2.“The Exchange Rate and the Reserve Bank’s Role in the Foreign Exchange Market,” Reserve Bank of Australia; http://www.rba.gov.au/mkt-operations/ex-rate-rba-role-fx-mkt.html
3.“The New Europe: Evolving Economic and Financial Systems in East and West,” Fair & Raymond; http://catalogue.nla.gov.au/Record/2791528
4.“Pound devalued 30 percent,” Guardian; https://www.theguardian.com/century/1940-1949/Story/0,,105127,00.html
5.“’A Quite Unprecedented Achievement?’ Responding to the 1950s terms of trade boom,” Goldbloom, Hawkins & Kennedy; https://www.researchgate.net/publication/242326775_%27A_QUITE_UNPRECEDENTED_ACHIEVEMENT%27_RESPONDING_TO_THE_1950S_TERMS_OF_TRADE_BOOM
6.“Australia after the terms of trade boom,” Reserve Bank of Australia; https://www.rba.gov.au/publications/bulletin/2014/mar/pdf/bu-0314-6.pdf
7.“’A Quite Unprecedented Achievement?’ Responding to the 1950s terms of trade boom,” Goldbloom, Hawkins & Kennedy; https://www.researchgate.net/publication/242326775_%27A_QUITE_UNPRECEDENTED_ACHIEVEMENT%27_RESPONDING_TO_THE_1950S_TERMS_OF_TRADE_BOOM
10.“Australia and the International Economic Architecture – 60 years on,” Treasury of the Australian Government; https://archive.treasury.gov.au/documents/710/HTML/docshell.asp?URL=06.asp
11. “Deepening Reform for China’s Long-Term Growth and Development,” Song, Garnault & Fang; https://books.google.co.uk/books?isbn=1925021777
12.“Major influences on the Australian dollar exchange rate,” Reserve Bank of Australia; https://www.rba.gov.au/publications/confs/1993/pdf/blundell-wignall-fahrer-heath.pdf
15.“Forward currency markets in Asia: lessons from the Australian experience,” Bank for International Settlements; http://www.bis.org/repofficepubl/arpresearch_dev_200609.01.pdf
17.“Major influences on the Australian dollar exchange rate,” Reserve Bank of Australia; https://www.rba.gov.au/publications/confs/1993/pdf/blundell-wignall-fahrer-heath.pdf