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Australia's currency moves have limited upside.

Summary: It will only sharply cut into any gains foreign investors stand to make

Sydney skyline. Image for illustrative purposes only. Image Credit: Pixabay

(Bloomberg): Not everybody is observing the supposed ceasefire in the currency wars. The Reserve Bank of Australia lowered rates by 25 basis points each in June and July.

The moves were ostensibly intended to ease monetary conditions and boost flagging growth. Their unstated purpose was to bring down the value of the Australian dollar.

Since the currency rate was floated in the 1980s, the RBA has repeatedly sought to weaken the dollar to buffer the domestic economy, most recently during the 2007-08 financial crisis. The Australian currency has fallen roughly 36 per cent against the US dollar from its highs in August 2011, although most of the decline took place before the recent rate cuts.

There's only one problem: A weaker currency isn't necessarily good for the Australian economy.

This isn't only because tit-for-tat retaliation by other nations can negate such currency strategies. The effects of a weaker Australian dollar are themselves decidedly ambiguous, for several reasons.

First, devaluation is intended to make a country's exports more competitive. In practice, this may be difficult. It depends on the nature of the exports and the determinants of demand.

Demand for Australia's main exports -- coal, liquefied natural gas and agricultural products -- is not purely price elastic. Unrelated factors including quality, specifications, transport costs and so on also affect demand. For items such as tourism, education and medical services, which are also key Australian exports, cost is only one of a range of factors that determine purchase decisions.

Australian exports must also capture market share from competitors, which means the Australian dollar has to decline relative to those rivals' currencies as well, not just the US dollar. And many commodities are bought and sold using long-term contracts; short-term currency fluctuations may thus have no effect on sales.

The recent increases in Australian iron ore exports most likely have more to do with the shutdown of Vale SA's Brazilian mines than the level of the currency. Second, devaluation theoretically boosts the incomes of exporters, since any US dollar earnings translate into more Australian dollars. But those earnings won't improve cash flow unless they're converted. In practice, many exporters choose to keep their earnings in US dollars, for example to meet foreign currency costs.

Oil-and-gas and other commodity businesses generally use US dollars as their functional currency. Any income gains may thus remain on paper only.

No guarantee currency gains will stay put

Even when devaluation results in higher actual cash flows, the money may not stay in Australia. Many Australian exporters have significant foreign ownership; any gains may be transferred to overseas shareholders.

In fact, the major income benefit to Australia of devaluation has come in the form of higher government royalty revenues and taxes, which are calculated on converted Australian dollar earnings.

Third, devaluation should increase inflation, a key goal of central bank reflation policies, by making imports more expensive. The Australian experience suggests that this connection is weaker than it seems and depends on the mix of local and overseas-produced goods and services in a country's inflation basket. Even with imported items, competition for market share in a world with excess productive capacity means producers have often absorbed cost rises rather than pass them on to customers.

Finally, devaluation makes a country less attractive as an investment destination. Australia is an importer of capital, both equity and debt, and finances itself primarily in its local currency. A decline in the Australian dollar results in overseas investors suffering losses unless they are hedged.

The devaluation of the Australian dollar has roughly halved the return on Australian shares over the last 10 years. Since the start of 2018, devaluation has largely offset any appreciation in the stock market for overseas investors. The risk of currency losses may reduce availability of capital and increase its costs, effectively negating other benefits of devaluation.

Devaluation also has serious side effects. A lower currency reduces living standards. Australia imports a significant portion of its manufactured goods as a result of the decline in its industrial base.

To the extent that devaluation results in higher prices, Australian consumers and businesses have suffered a reduction of purchasing power. It's easy to see why the RBA might view the Australian dollar as a potential policy tool. Whether it's an effective one, however, isn't nearly so obvious.

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Publication:Gulf News (United Arab Emirates)
Geographic Code:8AUST
Date:Jul 15, 2019
Words:755
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