Business leaders love to rail about the uncompetitive effect of a high Australian dollar. The Reserve Bank has indicated repeatedly that the currency is not too strong and that it has no intention of leaning on interest rates to change it. The banks are left to tinker with interest rates to protect their profits, to widespread comment.
In fact, it’s not easy to work out who or what controls exchange rates. Under the current global floating exchange rate system, it is impossible for the government, the individuals and the businesses that make up the economy to make sensible capital allocation decisions based on an exchange rate that is volatile.
Average daily turnover in global foreign exchange markets has more than trebled over the past decade, reaching around $4 trillion in 2010, according to the 2010 BIS Triennial Central Bank Survey and the increased volume is widely associated with increased volatility.
What is remarkable about exchange rates in general — and they are a cornerstone of the economy — is that exchange rate movements are removed from the amount of trade countries actually do with each other. It is estimated less than one in six global currency transactions are actually trade related.
But at the same time exchange rates affect trade enormously. Imports and exports are affected by them and they shift vast sums of capital between different areas of the economy, such as manufacturing and services.
Not so long ago when the world was on the gold standard, it meant what is said; you could take your paper currency to the bank and receive gold bars in exchange. Crucially the whole money supply was backed by gold and there was limited scope for the trade imbalances we are currently experiencing.
But while the gold standard protected a country’s citizens and foreign investors from the current monetary policy abuses seen in Europe and the US, it was inadequate as a basis for a modern financial economy.
The supply of gold could not keep up with the growth in the world’s money supply. It was undesirable not to be able to increase the money supply. Finally, the US could not live up to the onerous economic responsibilities of being a reserve currency nation.
With respect to this last point, not much has changed.
While the currency markets appear to exist to service trade and direct investment, the number of transactions that actually take place in respect of this overarching purpose is relatively minor. It is not trade or even the central banks that make exchange rates move, it is capital.
And as long as capital is free to flow around the world the exchange rates remain uncontrolled. Even hedge funds and the like are highly leveraged and can generally only keep open positions for a matter of weeks or even days.
Do central banks determine exchange rates?
Absolutely not, but they do have considerable short term firepower in the form of their foreign currency reserves. But defending the currency is like fighting a guerrilla war — a limited amount of ammunition is available and the enemy forces vastly outnumber yours.
Australia has around US$47 billion in foreign currency reserves, which sounds like a heck of a lot — but trails Peru which has about US$53 billion.
To put these reserves into perspective there is $170 billion in capital investment just in LNG infrastructure projects are underway at the moment and a significant proportion of this amount will be sourced from overseas. So it matters little how big your currency reserves are — the market can always knock you out.
Anyway investing all of a country’s wealth in foreign reserves is not a great use of taxpayers’ funds. The foreign reserves need to be kept in short term/liquid instruments to be useful in manipulating the currency. Not to mention the great irony of deploying foreign reserves to weaken a currency — deprives taxpayers of a profit from the value of the reserves increasing as the local currency depreciates.
This is one of the reasons sovereign wealth funds have sprung up.
The Reserve Bank does set prevailing interest rates (to a degree), which have some bearing on the strength of a currency, but not necessarily a definitive one. The Indian rupee cash rate is at an all-time high of over 9 per cent — anyone for their next pay check in rupees? — but the rupee is currently one of the world’s weakest currencies, probably in part thanks to inflation and other concerns.
The United States has persistently spent more in trade overseas than it earns, leaving surplus dollars sloshing around the world. This has been the case since the 1960s and the world’s investors have had plenty of practice at sopping them up — which is just as well given the $2.7 trillion dollars thrown at them in the form of quantitative easing recently.
Or to put it another way, there is such a demand for US dollars outside of any transactions with America, that what is going on in America has surprisingly little bearing on the value of its currency.
There has been a growing global disconnection between the strength of a currency and the underlying features of its economy including its balance of payments. This is overwhelmingly the case with regard to all the world’s reserve currencies such as the US dollar, the euro and the yen.
Monetarists argue that it is the money supply and changes in the money supply that determine economic variables, but the real world evidence for this is diminishing. What appears to be far more important is whether any central bank intervention is credible in the eyes of the market.
The current global system of floating exchange rates works okay when governments can credibly be trusted to keep a currency’s value. But when they can’t the world’s investors look for rabbit holes — and trusted rabbit holes are few and far between.
Which brings us to another unusual feature of currencies: they are traded in pairs. If you hate one currency it means you have to love another: it’s all very binary. And with the major reserve currencies in a slump, it is difficult for most market observers to foresee a vastly weaker Australian dollar any time soon.
But so long as capital is free to flow around the world, free market efficiency reigns supreme and exchange rates are outside anyone’s control — who knows for sure?
In practice technology, capital mobility and investors looking for global diversification have combined to allow vast amounts of capital to shift around the world and across currencies at great speed, resulting in exchange rates that are at times highly volatile.
A key advantage of a quasi-fixed exchange rate system is that it gives business and government predictability (ask the Chinese). But for such a system to work requires finding a reserve currency that is free of political interference, accepted without question and able to grow in line with the world’s needs. It is a difficult challenge. But to paraphrase Bertrand Russell perhaps the greatest challenge for global leaders is to state the problem in a way that will allow a solution.