Explanation Of The Australian Exchange Rate System Economics Essay

The exchange rate reflects the purchasing power of one currency against another currency. With a strengthen in Australian dollar against US dollar, it might mean that less Australian currency need to be cost to buy one US currency. In this paper, it will analyse the trend of AUD/USD exchange rate for the past 10 years and forecast the exchange rate for 1 year ahead. Finally, there will be some advices to a funds management firm based on the analysis and forecast of the AUD/USD exchange rate.

The trend line in the graph above shows a trend of AUD/USD exchange rates for the over past ten 10 years. At the first glance, an increased in trend could be easily seen although some fluctuations exist. The exchange rate goes up from 0.658 on January 1st 2000 to 1.067 on May 13th 2011, which is recorded a 68.16% increase since January 1st 2000. Although it shows a strong increased trend during this 10-year period, there are some salient points need to be paid attention to.

The first significant period is the period A in the graph above. It is a recession of Australian currency that from the second half of 2000 to 2001. This is a post-crisis period after the 1998 Asia financial crisis. It hit the lowest point within the past 10-year on March 30th 2001 by 0.4890 due to a weak demand of Australian dollar. Although the Olympic Games had impacts on boosting the economy, the economy turned down sharply after the Olympics.(OECD, 2001)

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After the recession in 2001, continues strengthen in the Australian currency compared with US dollar until 2008. The exchange rate had reached 0.9786 on 16th of July in 2008, which is shown as point A in the graph above. But this would seem like a turning point, the exchange rate continued weaken due to the global financial crisis after that point.

However, the Australian dollar only stayed at a low level in a short period. After point C which is approximately the second quarter in 2009, the Australian dollar is keeping as a strong currency. Until now, it moves up fast and continues to hit a highest point relative to US dollar. This trend may suggest that Australia is facing a strong recovery and a strong demand of Australian dollar after the global financial crisis.

Economic and financial explanations of the past trends

Exchange rate is determined by the supply and demand under the floating exchange rate system. The domestic economic growth slowed down and went to a recession from the second half of 2000 to 2011. The may suggest that there was a decrease in domestic demand. Although the 2000 Sydney Olympic Games has boosted the economy in the first half of 2000, the economic growth turned down sharply after the Olympics. (OECD, 2001) These economic factors also had impacts on the exchange rate. During this period, the exchange rate of Australian dollar again US dollar was staying at a low level and had reached the lowest point for the past ten year.

The main cause might be the introduction of ten percent Goods and Services Tax (GST). (OCED, 2001) The proposition is that the GST is paid by consumers, not by the businesses. (Cooper and Vann, 2000) Therefore the consumer confidence would be affected by the GST as their purchasing power decreased. This could be reflected by the table below, it was recorded the total domestic demand growth rate fell a lot from 1999 to 2001. The significant drops in the growth of domestic demand might lead to a decrease of demand of domestic currency. Therefore, the exchange rate would be decreased as the domestic currency has weakened.

In addition, the interest rate differentials might give another reasonable explanation. Although the domestic interest rate went up at in 2000, the exchange rate still went down. This might caused by other factors. At the same time, the US government raised the US interest rate dramatically by adopting a high interest rate policy. (Jia, 2010) Therefore, it led to a decrease in exchange rate even if the interest rate of Australia increased.

The second salient point could not be ignored that is happened in 2008, which is a year suffered global financial crisis. The exchange rate movement seems unusual during the GFC. As can be seen in the graph above, it shows unusual movements during the crisis. A dramatic drop in exchange rate of Australian dollar against US dollar. During the GFC period, the capital typically flowed to the countries and transferred into safe haven currencies, such as US dollar. (Kohler, 2010). It may suggest that the lots of Australian dollars would transfer to the safe haven currencies. It may cause a dramatic decrease in demand of Australian currencies. As a result, the Australian would depreciate against US dollar.

The export and import changes could also affect the exchange rate. As the export index graph below, the real export weighted index has a huge decrease although the export index increased from 2008 to 2009. That might indicate that the imports increased faster than exports in that period. As the real exports fell down, the demand of Australian currencies might go down then the exchange rate may go down as well.

(Source: Jia, 2010)

However, from the second quarter of 2009, the Australian shows a strong increasing trend against US dollar. Firstly, such increase may caused by the high commodity prices. The following graph of RBA index of commodity prices shows a trend of commodity prices clearly. It can be easily discovered that the commodity prices rose really fast from 2009 to 2010. Higher export commodity prices may lead to more amounts of Australian currencies for overseas to by Australian products. Hence, the demand of Australian dollar would go up and cause the exchange rate goes up.

(Source: Ravimohan, 2010)

In addition to this, the foreign capital inflows would be another factor that boosts the exchange rate increased. High interest policy is always adopted by the Australian government. Australia stays a high level of interest rate compared to most of other countries. Large amount of capital would attracted by the high interest rate and come into Australia market. Then it might stimulate the Australia currency.

Forecasting of future paths (1 year ahead) of the exchange rate

The interest rate parity may be a helpful technique to forecast the interest rate. If the interest is different between two countries, the future exchange rate may vary from the spot exchange rate. From the graph of the spread of the RBA cash target rate and US federal funds rate below, it shows a increased trend from 2010 to 2011. And the gap between the interest rate of these two countries seems continue to be larger. If other situations are hold, and this difference continues to be larger, the Australian currency would continue to be stronger in the following year. Because the difference is going to be increased, a higher interest rate difference might attract more capital come into Australia market and then push the demand of Australian currency up.

In addition, the expectation of growth of interest rate could have impacts on the change of exchange rate. The following table shows the expected growth of interest of US and Australia. The growth rate of interest in US market is expected to be zero while the expectation growth rate of Australian market is 0.02. With a larger expected growth rate of interest in Australia, more foreign investors might be attracted to invest in Australian market and it might drive up the value of Australian dollar against US dollar. Therefore, the exchange rate of AUD/US could be expected to be higher in the following year.

The purchasing powers of 2 countries’ currencies also affect the exchange rate between these two countries. The inflation rate would be an effective indicator that could reflect the consumer’s purchasing power. From the forecast of RBA statistics, the expected inflation in 2011 would be reaching 3%. (RBA, 2011). And the long term inflation target set by the US federal government is 1.7-2% which is expected to be a bit lower than the Australian expectation. (US inflation calculator, 2009) These figures might indicate that if the commodity price of Australia would be higher than US commodity price, then the Australia dollar should appreciate against US dollar in the future. Therefore, the exchange rate would be expected to be going up from the past trend information and the forecast.

According to the analysis and forecast above, the AUD/USD exchange rate is forecasted to be going up in the future. Based on this, if I advice a funds management firm, to borrow the funds in US, and invest them into Australian market would be a sensible choice. Borrow money today in US and convert them into Australian dollar, then invest them into Australian market. When this investment mature in the future, with a higher exchange rate compared to today, the appreciation of Australian dollar would give more profit if these funds convert back to US dollar. If the company is hold US liabilities, the best choice would be hold them and pay back afterwards. The higher the Australian dollar, the less need to pay back for the US debts.