ESSAY

Introduction
Exchange rate refers to the rate at which a unit of domestic currency is exchanged for a given
amount of foreign currency. The exchange rate of different currencies are determined by the
supply and demand of those currency pairs which is called a flexible (floating) exchange rate
system. Sometimes the exchange rate is controlled by the government or central bank which is
a fixed or managed exchange rate system. Trade-weighted index (TWI) is a common form of
exchange rate index with each currency weighted to its share in trade. The supply and demand
forces of a currency pair tend to move their exchange rate to an equilibrium: (graph)
Australian dollar over the past 5 years has ranged between USD 65c and USD 75c (TWI between
57 and 66). There have been a variety of factors causing AUD to appreciate against other
currencies particularly during mining boom (2005-2011) and after covid crisis. The biggest driver
of changes in the AUD’s value is the interest rate differentials. A relatively higher interest rates
in Australia encourage more demand towards a currency by investors due to better possible
yields on Aussie bonds. Recently in January 2023, AUD had climbed back to US71c (TWI 63)
from around 67c in December 2022. Optimisms concerning the Chinese economy and the US
federal reserves being less inclined towards large increases in interest rate led to prospects of
higher interest rates in Australia which renewed the strength of AUD.
Another key driver of changes in AUD exchange rate are the commodity prices. Higher
commodity prices lead to more export income earned by Australia which is sourced by
foreigners. The buyers of Australian exports need to buy more AUD to finance Aussie imports,
so the demand for AUD will rise, appreciating AUD against other currencies. Iron ore prices
reached 12 years high of 200$ dollars in December 2020 from 100$ per tonne in May 2020 and
subsequently AUD was being traded at US 79.13c (TWI 65) for the first time in more than three
years. Rise of commodity prices also encourage mining investment and associated FDI pushing
up the value of Aussie dollar in the second half of 2020 and during 2021.
The other key driver of this appreciation was the higher confidence in Australian economy. Both
China and Australia’s faster reopening of their economies after covid and performing better
than US lead to investors becoming increasingly willing to hold Australian currency and convert
from the ‘safe haven’ US dollar (it is safe-haven as USD tends to be stable in times of crisis). The
risk-on nature of Aussie dollar was also responsible for higher demand for AUD as it is “pro-
cyclical” and its value is linked to commodity prices which rises during periods of economic
growth.
Aussie dollar also reached a new peak of US74.03c in early March 2022 due large trade
surpluses ($12.9bn BOGS surplus for January 2022) boosted by 7.6% rise iron ore and coal
exports. The AUD was benefiting from the geographical remoteness of Australia, given the
Russian invasion of Ukraine impacting Europe. The prospect of higher commodity prices was
also giving AUD a boost.
There are also factors responsible for depreciation of AUD in the past 5 years. As mentioned,
the intervention of the central bank can shift the value of exchange rate. RBA can perform a
devaluation policy such as reducing interest rates or buying bonds using AUD to increase the
supply of AUD leading to depreciation. As AUD was going above US 79c in the February 2021
the RBA decided to purchase an addition $100bn bonds to keep a lid on the rise of local
currency. This increases demand for other currencies against AUD and supplies Aussie dollar
leading to a stemmed appreciation.
Economic uncertainty involving covid-19 pandemic caused a massive depreciation of AUD to
55.10c (TWI 54.7) which was expected in times of crisis. Investors rushed to convert to USD as it
has a reputation of “safe haven” and also a likelihood of RBA cutting interest rates in response
to COVID pandemic. The value of USD remains relatively stable during crisis so a surge in the
supply of Aussie dollar and fall in its demand lead to this depreciation. However it was short-
lived and went back to US 63.14c (TWI 56.2) by April 22 and US 73.8c (TWI 62.3) by September
2020 due to purchase parity power and rise of commodity prices. This economic uncertainty for
AUD during times of crisis also caused AUD to depreciate 33% against US dollar during GFC at
the end of 2008.
The shift in the exchange rates brings about a number of impacts on the economy as well.
Historically high values of dollar during mining boom reduced the prices of imported consumer
and capital goods which helped to contain the imported inflation. During December quarter of
2012, imports rose by 2%. Higher value of AUD also makes the exports more expensive for
foreign buyers which impacts Australia’s export competitiveness leading to reduction in export
volume and income. Generally higher import expenditure and lower export income tends to
worsen the BOGS deficit of the current account. However in short term, high demands for
Aussie minerals with strong dollar lead to a BOGS surplus of $21bn in 2010-2011.
The loss of export competitiveness also leads to decrease in unemployment in export
industries, lower production thus decreased national income which in turn leads to lower
demand for non-tradable goods and services. Strong AUD because of mining boom also led to
Dutch disease where the loss of competitiveness in other exporting industries such as
manufacturing leads to the closure of some of these industries such as car manufacturing – an
unfavorable structural change for the economy.
On the other hand, a depreciation of AUD leads to a more competitive export. The position of
education and personal travel services as the fourth and fifth largest export commodities have
signified the importance of service export bring about a structural change in Australia’s export
base due to sustained fall in Aussies dollar in recent years. This helps to diversify Australia’s
narrow export base to make it more competitive. Depreciation of AUD can also act as a shock-
absorber effect as was evident during GFC. It makes import more expensive so firms and
households shift to domestically produced goods and prompt foreigners to buy Australia’s
exports. So, a depreciation can insulate the economy from the financial shock.
As a in fall AUD makes imports more expensive, personal travelers and online shopper struggle
for overseas purchases which may bring about the risk of inflation. However, as it makes
exports more competitive, a lower AUD helps rebalance the economy from mining into housing,
tourism, agricultural exports and educational services. A fall in the AUD also improves profit and
returns from the investments overseas which is good news for unhedged investors and firms
who generate profits overseas as they convert their profits back to AUD. Conversely a sustained
fall in the AUD is to the sentiment of the retailers who source their products from overseas
(import goods).