Stress on Australian Dollar - Assignment Example

RBA Happy with Australian Dollar but Further Falls Expected in 2016 Student Name: Course: Tutor: Date: RBA Happy with Australian Dollar but Further Falls Expected in 2016 Main Issues in the Article The article is mainly focused on the state of the Australian dollar and the expected behavior in the near future. The Australian dollar has depreciated notably and experts are concerned that the fall in value against the US dollar may increase. Several factors have been discussed as the reasons for the fall. These include buying by funds looking to hedge bets that the decline will continue sudden increase in Australian corporate and state bond buying by Japanese investors, mergers and acquisitions, end year book balancing and currency-hedging by Australian exporters, and bets in the market that RBA is done with cash rate cutting in the current cycle. Some people also argue that the Australian dollar may not depreciate further than it currently is and that several market factors will combine to ensure the Australian dollar recovers its value against the US dollar. The mentioned factors include the position of Australia as the major exporter of coal and other services like tourism and higher education. There is also interest by the investors in the Australian assets. These have kept the Australian dollar afloat. The Australian dollar has also developed demand from unlikely quarters like real time money investors which include sovereign wealth funds, infrastructure funds and equity investors. Exchange rate determination Supply and demand are the two forces that determine the prices of goods and commodities, as well as the exchange rate. The interaction of these forces occurs in an open market. The law of supply and demand indicate that; scarcity of a commodity leads to increase in price of the commodity; highly supplied commodity tend to cost less while high demand of a commodity leads to the increase in the price of the commodity; abundant supply of a commodity leads to fall in its price. The above scenarios lead to the conclusion that when the price of a commodity increases, the commodity appreciates in value, whereas increased supply of a commodity makes it decrease in value. The value of the Australian dollar is therefore determined by the interaction of supply and demand. An oversupply of the dollar would definitely lead to its depreciation. Figure 1 below shows the demand and supply curve of the US dollar against the Australian dollar: Chart 1: Demand – Supply Curve (AUD/USD) The chart above represents the demand of the Australian dollar in relation to its supply. The exchange rate is on the vertical axis. A decrease in exchange rate indicates the decrease in value of the Australian dollar against the US dollar. Movement up the vertical axis indicates the increase in the value of the Australian dollar, which is equivalent to the fall in price of the US dollar. Movement down the vertical axis indicates the depreciation of the Australian dollar and the appreciation of the US dollar. The equilibrium point is where the supply of the USD equals that of AUD. The exchange rate can be affected by inflation rate, growth rate, and interest rate and government restrictions on either side. The above factors are categorized into trade related factors (inflation rate and growth rate) and portfolio related factor (interest rate), depending on how they affect the exchange rate. The chart below shows the exchange rate against the US dollar for the previous three years. Chart 1: Exchange Rate of AUD/USD for the previous three years Source_RBA From the data provided by thee the RBA, it is evident that the exchange rate has shown a steady trend with the Australian dollar getting stronger against the US dollar. The upward trend shown by the Australian dollar against the US dollar can be attributed to the fact that the Australian currency is supported by the position of Australia in the world market. The demand of the commodities traded by Australia in the world market had steady demand. There was therefore steady demand as traders scrambled to buy the Australian dollar (Reserve Bank of Australia 2016). Commodity prices were adversely affected in the period between 2011 and 2014. This is the time when the commodity of prices such as iron ore, coal and crude oil hit an all time high due to their increased demand. Iron ore and coal are the major export commodities from Australia. This situation put pressure on the Australian dollar due to its increased demand. The exchange rate against the US dollar did not falter even though no measures were put in place to prepare it to this situation (Reserve Bank of Australia 2016). The stability of the Australian currency was again made better by the increased investment in Australian assets. Investors brought about stable exchange rate as the supply of the US dollar matched that of the Australian dollar. The tendency by Australia to trade on service also came to the aid of the Australian dollar. The year 2011 in particular presented a time when the Australian dollar was strongest. This is the time when it traded in parity with the US dollar for the first time since it became a freely traded currency. It actually traded above the US dollar for a few seconds. This period of time presented the point when the Australian dollar enjoyed a large share of the market against the US dollar (Yeates 2010). Some speculators commented that this may have been due to Europe’s sovereign debt crisis and the fact that Australia enjoyed strong ties with material importers in China. Economists argue that the Australian dollar is dominantly driven by commodity prices. This is the main reason why the exchange rate against the Australian dollars tend to occur against the trend of the other world currencies. The economy of Australia is mainly leveraged on the export of commodities like minerals and agricultural products (Evrensel 2016). This makes the Australian dollar to vary during the business cycle. The value of the dollar increases during the time when the prices of exports like iron ore and coal are high, and slumps when the prices of these exports go down. This trend is opposite of what other currencies like the US dollar which become stronger when the prices of raw materials slump. This situation is brought about by the tendency of traders to move from falling stock in to cash. The strength of the Australian dollar is also brought about by the fact that the central bank does not intervene and the Australian government and economy is relatively stable (cms 2014). Advantages of the Australian Dollar At the times when the economies of other countries face a turn down and the other major currencies are facing uncertain times, the Australian dollar remains stable or experiences unnoticeable changes. The dependence of the economy on exports of raw materials as well as trade on services like higher learning and tourism cushions the Australian currency against the uncertain world economy. Furthermore, the economy of Australia has enjoyed long time of stability. This can be attributed to the stability of the government of Australia and the favorable environment that it brings. Investors can rest easy because they are assured of security of their property and investments. Investors have developed interest in trading on Australia assets. The country has enjoyed a period of steady investor influx even during times when other world economies experience turmoil. The influx of foreign investors translates to the availability of foreign direct investment which helps in easing the pressure on the Australian dollar. In addition, the central bank lacks any intervention on the currency and the economy of Australia. Traders can therefore trade on the Australian dollar without fear of interference from the central bank. The lack of interference has also made the Australian dollar to enjoy great interest margin in comparison to the US dollar. Traders prefer such currency because they tend to show stability at all times. It would be difficult for the Australian dollar slump to US 65C. The factors mentioned above, coupled with the strong ties that Australia has with the Asian continent, especially china, gives it an edge over any precedented difficulties. As the major trade partner, China has been a strong economic power house, consuming majority of raw materials exported from Australia. The strong trade relations ensure that there is always demand for the Australian dollar (Kneoma 2011). The US Federal Reserve can also lift interest rates in the middle of December for the first time in a decade. The move will ease pressure on the Australian dollar as more US dollars will be available for trade. Since the adoption of floating exchange rate in the 1980s the Australian currency has been able to cope with much of economic shocks that hit the world. The floating interest rate enabled put an end to the speculative pressure on the exchange rate. Floating gives the RBA stronger control over domestic monetary conditions. Exchange rates also give economies an upper hand when dealing with economic shocks. For instance, the mining boom presented a challenge where the policy to be adopted would determine the overall state of the Australian economy. There was a combination of a flexible exchange rate and independent monetary policy. This led to an increase in exchange rate and increased interest rates in comparison to the other major economies. Both measures ensured the preservation of the stability of the economy of Australia. The RBA was therefore successful in averting any negative effects that may be brought about by such situations. Typically, these situations would lead to runaway inflation. The Reserve Bank can adopt the above measure which has been successful in the previous times. Contrary to fixed rate approach, the floating rate approach provides a buffer against external shocks. The economy is thus able to cope without any negative economic situations like inflation or deflation. Inflation particularly leads to the increase in prices domestically due to the expensive dollar. An expensive dollar would make imports very expensive. Locals would therefore prefer using locally manufactured products. There would be less demand for the Aussie due to its lack of competitiveness against its peers like the US dollar. There would be over supply of the Aussie making it to lose value. The Reserve Bank can also use the cash rate as an instrument to control the flow of funds in the Australian economy. These cash rates are closely monitored by the central bank. The cash rate is usually an interest rate on overnight funds. The cash rate helps regulate money-market rates for both banks and intermediaries. The introduction of cash rate as an instrument of regulating cash flows can have effects on the economy and thus exchange rates. This happens when this rate regulate the funds that banks and other financial institutions can use to settle transactions within the industry. Such funds as used by banks are referred to as settlement funds. The reserve bank has custody over these funds and releases them according to the market demands (Reserve Bank of Australia 2016). The release of more settlement funds than the banks can hold results to such banks lending out the more money in to the market in order to shed the extra funds. This causes cash rate to fall. On the contrary, release of less settlement funds than the banks require, would lead to a situation where banks borrow in order to bridge this deficit. This leads to the increase of cash rate. In this way, the reserve bank can have direct control on the cash rate and by extension, the exchange rate. References Reserve Bank of Australia 2016, The Exchange Rate and the Reserve Bank's Role in the Foreign Exchange Market. Available from http://www.rba.gov.au/mkt-operations/ex-rate-rba-role-fx-mkt.html [October 6, 2016] The Sydney Morning Herald 2010, Aussie now fifth most-traded currency. Available at http://www.smh.com.au/business/aussie-now-fifth-mosttraded-currency-20100901-14nma.html [October 6, 2016] Kneoma 2011, World Bank Commodity Price Data (Pink Sheet), Monthly Update. Available at https://knoema.com/WBCPD2015Oct/world-bank-commodity-price-data-pink-sheet-monthly-update [October 6, 2016] CMS 2014, Exchange Rates and Supply and Demand. Available at http://www.cmsfx.com/forex-education/online-forex-course/chapter-2-fundamental-factors/exchange-rates-supply-and-demand/supply-and-demand/ [October 6, 2016] Evrensel A 2016, How to Determine Exchange Rates through Supply and Demand. Available at http://www.dummies.com/education/finance/international-finance/how-to-determine-exchange-rates-through-supply-and-demand/ [October 6, 2016] Read More