Friday’s quarterly Statement on Monetary Policy from the Reserve Bank of Australia pointed to a steady-as-she-goes approach for the foreseeable future, with monetary policy judged to be “appropriately configured to foster sustainable growth in demand and inflation outcomes consistent with the target” (which in Australia’s case is annual CPI increases of about 2% to 3%).
No surprises there: Central banks always forecast achievement of their mandate, otherwise questions would be asked about monetary policy settings.
The RBA has pointed to risks for Australia in China's fragile property market. Photo: Thinkstock
However, to give themselves an out, central bankers outline upside and downside risks, often in relation to the global environment, an aspect they have no control over. This time around the RBA has identified as a “key risk” the condition of the Chinese property market. The Chinese authorities have been trying to engineer a slowing in the growth of property prices for some time and the market has now turned. So much so in fact, that restrictions on purchasing have been removed in most cities and authorities are now providing support to buyers and developers. The RBA says it is too early tell what the implications will be for Chinese commodity demand, economic activity or financial stability. Australia’s sensitivity to events in China is shown in the this chart. 
Australia’s exports to China are dominated by bulk commodities like iron ore and coal. The index of commodity prices has fallen 38% from its July 2011 peak and as a result Australia’s terms of trade have fallen sharply from a 50-year high. No wonder then that the RBA has been saying for some time that “notwithstanding the depreciation over recent months, the Australian dollar remains above most estimates of its fundamental value”.
Talk instead of action
Interestingly, the RBA has confined itself to periodic jawboning about the currency. In contrast, the Reserve Bank of New Zealand, looking at a less severe decline in commodity prices (14%) has been more strident in its comments and has backed up the talk with action, selling the Kiwi dollar over recent weeks.
Failure to adjust
The biggest problem confronting the the RBA over the last five years has been the 50% surge in the real trade weighted index (TWI) and its failure to subsequently adjust downwards in sympathy with commodity prices. The AUDUSD topped out at 1.1080 in July 2011 (the same time as the commodity price index) and has since fallen 22%. But the TWI has declined only half that amount because the AUDUSD makes up only 10% of the TWI and the Aussie has been rising against the yen (a 13% weight in the index) and the euro (9% weighting).
As indicated by the export destination chart above, China accounts for about a quarter of the index and with the Chinese currency linked to the US dollar, the AUDCNY has fallen in line with AUDUSD. But if the Chinese were to unlink from the dollar, in all likelihood the AUDCNY would rise, thereby hindering the RBA’s task of lowering the overall measure of the exchange rate.
A further complication is that the rise in the real TWI was not just caused by the cross rates that comprise it (AUDUSD, AUDCNY, AUDJPY, AUDEUR etc). A large part was due to the fact that inflation in Australia was – and still is – higher than its trading partners. Therefore the costs of production in Australia have been growing relatively faster.
Combining cross rate movements and relative inflation rates produces the best measure of a country’s competitiveness in the global market place and is the indicator central banks use to evaluate the exchange rate. It is called the real TWI (or sometimes the real effective exchange rate). This chart shows the Australian index. 
The outlook for the yen and the euro over the next few months is not positive, and therefore Australia’s TWI is unlikely to make much downward progress via the AUDJPY or AUDEUR. Furthermore, there is a risk the Chinese authorities untie the yuan from the US dollar, and this could also cause problems. Therefore, if the exchange rate is going to adjust in the manner called for the by Reserve Bank, the heavy lifting will have to done by the AUDUSD.
Disclosure: To subscribe to the Daily Shot letter by e-mail please enter your e-mail address here: Subscribe to the Daily Shot