The collapse in commodity prices and fall in the Australian dollar in recent years demonstrates just how quickly economic conditions can change. But although both commodity prices and the $A have fallen a long way from previous peaks, it may surprise some investors to know just how potentially low the $A could go.
When economists try to gauge the “fair-value” for the Australian dollar, the first two points of reference are inflation differentials and the terms of trade.
As regards inflation, if Australian costs and prices are rising faster than those of our trade partners, it means we are losing trade competitiveness even if the nominal exchange rate remains unchanged – which is tantamount to a rise in Australia’s “real” exchange rate. All else constant, fair-value for the $A would be the level of the nominal exchange rate that restored the “real” exchange rate to some long-run normal or “average” level – after allowance for differing cost and price trends between us and our major trading partners over time.
As seen in the chart below, Australian consumer prices have risen by around 40% more than those of the United States since the late 1980s. As a result, the “real” exchange rate has risen by 40% more than the nominal exchange rate over this period. Another way of looking at this is that, deflating by current prices levels, the real exchange rate has averaged US66c over this period, so it is now 5.5% “overvalued” based on the current exchange rate of around US70c. By contrast, the nominal exchange rate has averaged US76c over this period, meaning on this basis the exchange rate is 8% undervalued.
Terms of Trade
Especially in the case of a major commodity exporter like Australia, however, the terms of trade – or price of exports relative to imports – is also important. When the terms of trade are rising – boosting Australian incomes and economic growth – it usually places upward pressure on the real exchange rate, and vice-versa. In turn, these cyclical swings in the real exchange rate serve as a useful shock absorber for the economy – helping slowdown the economy (by hurting international competitiveness) during boom times, and boosting competitiveness when commodity prices are weak.
As seen in the chart below, broad swings in the real Australian dollar (against the $US and allowing for inflation differentials with the United States) have had a reasonably close relationship with the broad swings in the terms of trade. Prior to the floating of the $A in the early 1980s, these changes in the real exchange rate were brought about by adjustments in local costs and prices. Since the float, more of the adjustment in the real exchange rate has come via the nominal exchange rate.
Where are we today?
That said, if the above relationship holds, whether the $A drops further naturally depends on what happens to the terms of trade. In this regard, while the terms of trade have fallen notably from their peak in the September quarter of 2011 (33.8% to be exact), they still remain 32% above their longer-term average from 1970 until the China-led commodity boom took off in mid-2004. If the terms of trade fell all the way back to their average prior to the China boom (which is not inconceivable) – and allowing for higher Australian inflation over time – then the exchange rate could fall back into the US50c range. Indeed, the average real exchange rate (based on today’s price levels) averaged US57c from the late 1980s until mid-2004.
In short, although the $A seems to have already fallen a long way in recent years, further downside is entirely possible as it turns out the China boom did not indeed usher in a new period of permanently higher commodity prices.