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How the Falling U.S. Dollar Exchange Rate May Affect Australia's Economic Outlook

By Frances Coppola

In recent months, the U.S. dollar's exchange rate has fallen against the currencies of most of its trading partners, including the Australian dollar.1 For countries such as the U.K., which is a net importer of goods priced in U.S. dollars, the falling USD exchange rate reduces the sterling price of imports. This helps to moderate inflationary pressures from an otherwise weak pound. It can also benefit U.S. businesses exporting to Australia. But for Australia, which is a net exporter of goods priced in U.S. dollars, the effect is not quite so positive.

In a statement on September 5, 2017, the governor of the Reserve Bank of Australia (RBA), Philip Lowe, observed: "The Australian dollar has appreciated over recent months, partly reflecting a lower U.S. dollar. The higher exchange rate is expected to contribute to the subdued price pressures in the economy. It is also weighing on the outlook for output and employment. An appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast."2

 

How AUD's Floating Exchange Rate Helped Australia Recover from the End of the Mining Boom

 

Exchange rate dynamics surrounding the end of Australia's mining boom are instructive in understanding the RBA's concern.

 

Australia's exports of commodities such as iron ore and coal are priced in USD and traded on international markets. During the first decade of this century, the international market prices of Australia's commodity exports tripled. This generated an economic boom, as business investment flowed into mining and related activities, and resource production and exports soared. The economic boom continued despite a severe world recession in 2008-9: the RBA estimates that in 2013, the mining boom raised real GDP (after accounting for inflation) by 6 percent, increased real household disposable incomes by 13 percent and reduced unemployment by 1.25 percent.3

 

The Australian dollar's real effective exchange rate rose significantly during this time. Although the economy escaped the severe deindustrialization known as "Dutch disease" (negative effects of a sudden rise in foreign currency inflow), sectors such as agriculture and manufacturing suffered a decline relative to mining. The mining boom ended early in 2013: by November 2013, this had resulted in a falling real exchange rate, slowing GDP growth and increasing unemployment.4

 

The end of the mining boom was followed in 2014-15 by a sharp fall in global oil and commodity prices. During this time, the Australian dollar's floating exchange rate enabled its value to fall against the U.S. dollar in line with the U.S. dollar prices of its principal exports. This helped to protect the Australian economy from the severe terms of trade shock suffered by other resource exporters that did not have floating exchange rates.5 ("Terms of trade" are the relative price of a country's exports in terms of its imports.)

 

After the end of the mining boom, the challenge for Australian policymakers was to manage a successful transition away from reliance on commodity exports and towards a more diversified economy. This transition was helped by a significant fall in the Australian dollar's real effective exchange rate, which encouraged the growth of new export industries and business services.

 

Why the Falling U.S. Dollar Exchange Rate Could be Bad for Australia's Economy

 

Despite recent diversification, Australia's economy remains export-led. Australia is the world's premier exporter of iron ore and a major exporter of coke, both important inputs for steel production. It also produces a range of manufacturing and agricultural products for export.

 

Export-led economies can be vulnerable to terms of trade shocks: when international market prices of exports fall, the incomes of exporters also fall, which can cause financial distress to businesses, households and even to governments. The Australian economy weathered the commodities terms of trade shock in 2014-15 well, all things considered. However, the RBA expects Australia's terms of trade to decline again, though not by as much. The RBA believes this could depress Australia's GDP growth to some degree in coming years, especially if it is accompanied by exchange rate appreciation against USD, as might be the case if the current trend for the U.S. dollar continues.6

 

A rising exchange rate might also mean lower inflation. Currently, inflation is hovering at around 2 percent, which is the RBA's target. The RBA says that "based on historical relationships, a 10 percent appreciation of the trade-weighted exchange rate (that is not associated with higher commodity prices) would be expected to lower year-ended inflation by a little less than ½ percentage point over each of the following two years or so. Output would be expected to be lower by ½–1 per cent in around two years' time." If inflation and output fall due to continual appreciation of the Australian dollar's exchange rate, therefore, the RBA could cut interest rates further.7

 

The

Takeaway:

The ongoing increase that experts expect in the Australian dollar's exchange rate versus USD reduces the price of imported goods and thus tends to reduce inflation. This is good news for Australian import businesses, and for U.S. exporters selling into Australia. But a rising Australian dollar exchange rate reduces the incomes of Australian exporters. In Australia's export-led economy, this could result in lower GDP and wage growth, and higher unemployment.

Frances Coppola - The Author

The Author

Frances Coppola

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.

Sources

1. “Trade Weighted U.S. Dollar Index: Broad,” FRED Economic Data; https://fred.stlouisfed.org/series/TWEXB
2. “Statement by Philip Lowe, Governor: Monetary Policy Decision,” Reserve Bank of Australia; http://www.rba.gov.au/media-releases/2017/mr-17-18.html
3. “The Effect of the mining boom on the Australian Economy,” Reserve Bank of Australia; https://www.rba.gov.au/publications/bulletin/2014/dec/pdf/bu-1214-3.pdf
4. Statement on Monetary Policy, November 2013, Reserve Bank of Australia; https://www.rba.gov.au/publications/smp/2013/nov/pdf/1113.pdf
5. “Falling dollar, rising fortune: how the currency is helping the budget,” ABC; http://www.abc.net.au/news/2015-08-05/jericho-a-falling-dollar,-a-rising-fortune/6673074
6. Statement on Monetary Policy, August 2017, Reserve Bank of Australia; https://www.rba.gov.au/publications/smp/2017/aug/pdf/statement-on-monetary-policy-2017-08.pdf
7. Ibid.

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