By Frances Coppola
Internationally traded commodities are typically priced in U.S. dollars, not in each country's domestic currency, so non-U.S. exchanges rates are influenced not only by the market price of the principal commodity export, but also the U.S. dollar's exchange rate. We have previously explained how this works for Canada, which is one of the world's largest oil exporters.
Australia is the world's largest exporter of iron ore1. Its floating exchange rate typically tracks the price of iron ore. However, the international price of iron ore partly depends on the oil price, because it includes shipping cost. And it also depends on demand for steel, for which iron ore is the principal raw material. Steel's price is in turn influenced by the price of coking coal, used in its manufacture, of which Australia is also a major exporter.2 Oil, coking coal and steel are all internationally traded and priced in U.S. dollars. The Australian dollar's exchange rate therefore has multiple external influences.
Many commodity-exporting countries – especially developing countries – have adopted fixed or managed exchange rate systems to help them manage commodity price volatility. Developed countries such as Australia and Canada, however, have opted for freely floating exchange rates.
Fixing the exchange rate prevents it rising and falling in line with the commodity price. This stabilizes the currency, making it easier for businesses to trade internationally, and helping to control domestic inflation.
Additionally, when commodity prices tend to rise, fixing the exchange rate can help to prevent "Dutch disease." Dutch disease occurs when the currency exchange rate rises in parallel with the price of the principal commodity export, as international demand for that commodity export increases. In such cases, exchange rate appreciation benefits importers at the expense of domestic industries and makes the country's other export businesses uncompetitive. A country suffering from Dutch disease may be very rich, but it has little industry other than the production of the commodity on which its exchange rate depends.3
However, fixed or managed exchange rate systems have an important downside. When the commodity price falls sharply, maintaining the exchange rate peg burns through the country's FX reserves, raising the risk of FX crisis. This is because unless the country imposes strict exchange and capital controls – which can be highly disruptive to international trade – managing an exchange rate means buying and selling foreign currencies to control the market price.
When the currency exchange rate is tending to rise, as it does when the commodity price is rising, the central bank can always sell its own currency, buying up foreign currencies and assets denominated in those currencies. The central bank's balance sheet balloons, of course, but if there is no restriction on the size to which it can grow, a central bank can always prevent its own currency exchange rate from rising.4
But no country can create another country's currency, so when its own currency exchange rate is falling, it can only prop it up for as long as it has foreign currency reserves to sell. When the reserves run out, the central bank is forced to allow the currency exchange rate to fall to its market rate. A sudden sharp fall in the exchange rate due to FX-reserve exhaustion is highly disruptive.5 It is often accompanied by a "sudden stop," when international investors abruptly pull funding from the country's banks and businesses due to fear of debt default and imposition of capital controls.6
Many economists argue that floating exchange rates offer better economic protection from changes in commodity prices, even though it means a more volatile currency.7 When the price in U.S. dollars of the country's principal export falls, the country's currency exchange rate also falls in parallel, raising the value of USD relative to the local currency and thus supporting export revenues in local currency. Additionally, exchange rate depreciation increases the relative price of imports, encouraging domestic households and businesses to substitute cheaper domestically produced alternatives.
However, when both exports and imports are invoiced in the same foreign currency – usually USD – exchange rate depreciation cannot offset worsening terms of trade due to commodity price falls. It can, however, benefit the economy through higher business profits, and it can also encourage diversification.8
During the oil and commodities price declines of 2014-16, some Latin American commodity exporting countries maintained floating exchange rates. The International Monetary Fund found that these countries suffered a less severe terms-of-trade shock than countries with fixed exchange rates. Much of the benefit of floating exchange rates seems to have come from import substitution, which boosted local businesses and helped to offset falling export revenues.9
Like other commodity exporters, Australia experienced worsening terms of trade in 2014-16, as the price of iron ore and related products dropped.10 The Australian dollar's exchange rate fell in parallel, both against the U.S. dollar and on a trade-weighted basis.11 However, because of a turbulent exchange rate history, Australian businesses have become adept at managing FX risk, while the exchange rate depreciation helped the country to rebalance away from mining and towards manufacturing and services.12 Australia sailed through the end of the oil and commodities boom without a significant fall in GDP growth.13
International businesses can use FX risk management strategies and FX hedging products to manage currency volatility. Additionally, there are measures that countries may adopt to reduce the impact of sudden sharp swings in exchange rates on government, households and businesses.
The economist Jeffrey Frankel identifies two financial products that can help commodity-exporting countries to manage high currency exchange rate volatility:
He also recommends counter-cyclical monetary policy. If a country prefers a fixed/managed exchange rate system, including the principal commodity export in a basket of currencies and commodities to which the exchange rate is pegged can keep the currency exchange rate flexible enough to prevent FX reserve strain. For countries with floating exchange rates, replacing the inflation target with nominal GDP growth can help to buffer terms-of-trade shocks.15
Flexible exchange rates can help to protect a commodity-exporting country's economy from terms-of-trade shocks due to commodity price volatility. However, for international businesses, exchange rates that move with commodity prices create higher FX risk. Businesses doing import-export trade with commodity-exporting countries may wish to devise FX hedging strategies that incorporate commodity price movements.
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. “Resources: Iron Ore,” Australian Government; https://www.industry.gov.au/resource/Mining/AustralianMineralCommodities/Pages/IronOre.aspx
2. “Australia’s Major Export Commodities: Coal,” Australian Government; https://industry.gov.au/resource/Mining/AustralianMineralCommodities/Documents/Australias-major-export-commodities-coal-fact-sheet.pdf
3. “Dutch Disease: wealth managed unwisely,” International Monetary Fund; http://www.imf.org/external/pubs/ft/fandd/basics/dutch.htm
4. “Has the Bank of Japan Started Another Round of Central Bank Wargames?,” Forbes; https://www.forbes.com/sites/francescoppola/2014/11/01/has-the-bank-of-japan-started-another-round-of-central-bank-wargames/#531713035c55
5. “What causes currency crisis?,” Investopedia; https://www.investopedia.com/articles/economics/08/currency-crises.asp
6. “The simple economics of sudden stops,” Calvo, Journal of Applied Economics; http://www.columbia.edu/~gc2286/documents/ciecpp5.pdf
7. “Terms of trade and exchange rate regimes in developing countries,” New York Federal Reserve; https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr148.pdf
8. “Rethinking Macroeconomic Policy: International Economic Issues,” Gopinath, Peterson Institute for International Economics; https://piie.com/system/files/documents/gopinath20171012paper.pdf
9. “How flexible exchange rates helped Latin American countries adjust to commodity price shocks,” International Monetary Fund; https://blogs.imf.org/2017/05/25/how-flexible-exchange-rates-helped-latin-america-adjust-to-commodity-price-shocks/
10. “Australia’s commodity currency at the end of the commodity super-cycle,” FocusEconomics; https://www.focus-economics.com/blog/australia-commodity-currency-iron-ore-aud
11. “Exchange Rates,” Reserve Bank of Australia; https://www.rba.gov.au/statistics/frequency/exchange-rates.html
12. “After the Boom,” Reserve Bank of Australia; https://www.rba.gov.au/speeches/2016/sp-ag-2016-09-13.html
13. The Australian Economy and Financial Markets Chart Pack November 2017, Reserve Bank of Australia; https://www.rba.gov.au/chart-pack/pdf/chart-pack.pdf?v=2017-11-13-22-24-08
14. “Policies to Cope with Commodity Volatility,” Jeffrey Frankel; https://scholar.harvard.edu/frankel/commodities-terms/commodities-developing-countries-and-resource-curse