The collapsing value of the Australian dollar appears to reflect a combination of fear about the outlook for global economic growth and the continued unwinding of trades conducted in calmer times.
The simple, perhaps simplistic, explanation for the battering the dollar has received is that commodity prices have fallen apart as expectations of a severe slowdown in global growth have strengthened and the hope that China might somehow be relatively immune to the slowdown has been undermined.
Australia is regarded as a resources-driven economy. The dollar strengthened massively as commodity prices soared. It is now in freefall as commodity prices have tumbled.
Disturbingly, however, the fall in the dollar has out-stripped the fall in commodity prices, which has nasty implications for our terms of trade – the benefits to the resources sector of a lower dollar won’t offset the higher cost of imports. The resources sector won’t be able to put quite the floor under a slowing domestic economy that had been anticipated.
While there are some fundamental reasons to explain the dollar’s fall, there are also some technical issues.
The Japanese yen-Australian dollar carry trade had, until relatively recently, been a licence to make money, borrowing at negligible cost in Japan to invest in Australian dollar assets against the backdrop of an appreciating currency.
For some months that carry trade has been unwinding but it was given real impetus when the Reserve Bank dropped official rates by 100 basis points earlier this month and created an expectation of further rate cuts. That ignited a sell-off that creates a self-reinforcing impact on the dollar.
The informal liquidation of hedge funds around the world as investors seek to extricate their funds is having a similar effect.
For a time, the most popular macro hedge fund trades were to be long commodities, long commodity-rich countries and long emerging markets.
As it became apparent that developing economies were going to be hurt by the fallout from the credit crisis, the funds have all rushed for the same exit doors at the same time, which helps explain the severity of the implosions occurring in commodity prices.
Lower levels of hedging activity by fund managers (because the value of their funds has been decimated, leaving less to hedge) might be another contributing factor, as would be the repatriation of funds by US investors to their home markets to build liquidity. There has been a global shortage of US dollars as banks and other institutions have become acutely risk-averse and insular.
While there are economists who think the sell-off of the Australian dollar has been over-done, global markets are so fear-laden and skittish that there is no certainty that it won’t fall further.
The need to continue to finance the current account deficit – which will now be bigger than looked probable only a few months ago – will complicate the Reserve Bank’s deliberations on future rate reductions even as the dollar’s decline sharply lowers the outlook for domestic economic growth.