Don't bet on the Australian dollar

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Australian dollar coins

A commonly expressed witticism in the currency markets is that there are two types of traders in the Australian dollar: those who don't know what it will do and those who know they don't know what it will do.

The mysteries of the Australian dollar remain as deep as ever. The currency is trading at about US$1.04, close to its highest level since being floated in 1983 and a 48 per cent rise since the end of 2008 — the biggest gain among more than 150 currencies, according to Bloomberg. It is trading well above the trade weighted index of 77.8, which is as close as there is to a benchmark of what the currency is 'really' worth.

The strength of the Australian dollar is being variously attributed to aspects of what is happening in the 'real' economy: the AAA rating of Federal government bonds, the country's close trade links with China, Australia's comparatively high interest rates compared with the rest of the developed world, the carry trade with Japan (whereby Japanese traders take low interest yen and 'carry' it into Australian dollars with higher interest rates) or Australia's reasonable growth prospects.

These factors are influences, but they are not the true cause of what the Australian dollar does. What determines the direction of the currency is not what happens in the domestic economy. Rather, it is driven by sentiment in the financial markets. In this sense, it is arguably the most 'unreal', or virtual currency in the world.

A feature of the global financial markets over the last decade has been the decoupling of finance and what finance is supposed to be facilitating. More than $US4 trillion is exchanged each day in the global capital markets according to the Bank for International Settlements (BIS). This amount vastly exceeds world GDP, foreign direct investment or trade. In about 100 days, it is the equivalent of all the capital stock in the world.

The decoupling of finance and the real economy is especially extreme with the Australian dollar. It is the fifth most traded currency in the world (after the US dollar, the Euro, the yen and the British pound).

The activity is heavily skewed towards Australian-United States dollar transactions, despite the fact that China and Japan are the nation's biggest trading partners. According to the BIS, the average daily turnover between the Australian dollar and US dollar is over $US250 billion, 6 per cent of global turnover (the Australian economy is only about 1 per cent of the world economy).

Compare this figure with annual figures from the real economy and it quickly becomes clear that the Australian dollar has developed a life of its own. The Australian economy is about $1.3 trillion a year, or the equivalent of five days trading. Australia's yearly trade is only $600 billion, less than three days trading.

Australia's total investment in the US is only $410 billion and its foreign direct investment a mere $97 billion. America's total investment in Australia is $555 billion and foreign direct investment $122 billion.

If economic activity or investment patterns cannot account for Australian dollar activity, what does impel it? The answer is perception among financial traders, who like the Australian dollar because it is seen as safe and the market is deep (liquid), which means it is easy to make transactions. To these investors economic and financial indicators are important, but only as signs to be read for the placing of bets.

The Australian dollar, for example, is often used as a proxy for investing in China. It is not possible to invest directly in China because the yuan is fixed, not freely floated, so traders instead buy Australian dollars reasoning that the Australian economy is heavily linked to China's. They then make punts that mostly come in the form of derivatives (activity 'derived' from more conventional transactions).

To add to the sense that currency markets are a law unto themselves, the markets are also being computerised at high speed — micro-seconds or even nano-seconds — through the use of algorithms, a practice known as high frequency trading. This has the effect of amplifying movements and sometimes increasing volatility.

This disconnecting of finance from what it is supposed to be facilitating has consistently caused havoc. The global financial crisis of 2007 and the subsequent Euro crisis are only the most recent instances of the harm that can be done. It is a consequence of the pernicious ideology of financial deregulation, which has shifted the power to set the rules of money from governments to traders and private banks.

Harm can come in different forms; it can lead to an over valued as well as an under valued currency. The irony of Australia's situation is that because Federal government debt is low, the banks are solvent and the Australian economy has strong economic links with China, currency traders are interpreting the signs as bullish and are driving up the currency. This is impeding Australia's capacity to compete with its exports, and is likely to cause lasting harm to Australia's manufacturing, education and tourism sectors.

Short of identifying the relevant finance traders (or algorithms) and hunting them down, little can be done about the Australian dollar's strength. Reducing interest rates further might have a marginal effect, but the AAA rating will remain. Australians will simply have to get used to the fact that their economic destiny is partially ruled by financial traders in New York, London and Tokyo. That is the price of financial deregulation.


David JamesDavid James has been a business journalist for 25 years and is the author of Managing for the Twenty First Century and The Business Devil's Dictionary. He has a PhD in English Literature from Monash University.

Topic tags: David James, economics, Australian dollar

 

 

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Existing comments

Perhaps we should revert to black tulips as currency?
janice wallace | 08 February 2013


But perhaps this is the real worth of the Australian dollar, devalued for so long, and now amongst the top 5 traded currencies; if this were mere currency speculation, the bubble would've burst long ago.
walter p komarnicki | 08 February 2013


Very interesting article shedding some light on this mysterious phenomenon. I'd love to know why the forex commentators are almost always bearish on the A$ & talk it down at every opportunity. Yet time proves them wrong again & again. Is it part of an even more mysterious conspiracy?!
Guy Tate | 08 February 2013


Here is the most credible explanation of the incredibly strong -- but baffling -- strength of the Aussie dollar. No conspiracy. Perhaps a shade undervalued in the past. But all down to algorithms. Thank you!
Jacky Hyams | 05 May 2013


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