Earlier today, the Reserve Bank of Australia released its monthly statement on monetary policy. As widely expected, there was no change to the policy interest rate (2.5%) and the language around the exchange rate being “above most estimates of its fundamental value” remained intact.
The RBA has been trying for many months to tell the markets that they have got it wrong on the Australian dollar, arguing that its overall value should be substantially lower than it is today. The central bank’s point is that over time there is a significant correlation between the commodity prices that are important to the economy and the exchange rate.
Iron ore makes up a third of the RBA Commodity Index. Photo: Thinkstock
In that regard, yesterday we saw the latest reading on the RBA Commodity index (iron ore makes up a third of the index). See the chart below. The AUDUSD and the Commodity index topped out together in 2011 – which does tend to support the RBA’s assertion of correlation – but since then the index has fallen 40% while, the AUDUSD has come off only a bit more than half that. 
Source: Reserve Bank of Australia
But while most observers tend to equate the exchange rate with AUDUSD, in reality that cross makes up less than 10% of the trade-weighted-index (TWI), the measure the RBA refers to when it discusses Australia’s “exchange rate”. So because the US dollar is just one of many balls in the air, to make much of a dent in the TWI we need to see decent falls against index heavyweights, the Chinese yuan (25% weighting) and the Japanese yen (13%).
But a strong rally in AUDJPY has effectively offset the Aussie’s 25% decline versus the US dollar, leaving it up to AUDCNY to do the lions share of the RBA’S work in leading the TWI down. But because of the yuan’s link to the US dollar, the AUDCNY is only down by a little more than the AUDUSD, and therefore nowhere near the fall in commodity prices.
The AUDEUR also has a decent (9%) weighting in the TWI but, unhelpfully, it is up so far in 2014. As an aside, because the AUDUSD is not particularly significant in the overall measure of the exchange rate, this probably explains the RBA’s reluctance to put money where its mouth is when bemoaning the current overvaluation. These days there are too many other balls in the air besides the AUDUSD, the traditional vehicle for intervention. So where does that leave the overall value of Australia’s exchange rate? The chart below shows the real effective (or trade weighted) exchange rate, which is the best measure of overall competitiveness, because it corrects the nominal exchange rate for differences in relative prices (or relative unit labour costs) between Australia and its major trading partners.
If inflation in Australia is relatively high, as it has been, this pushes up the real exchange rate. However, reducing labour unit costs is not easy; so in reality, the only way to get the real effective exchange rate down is via the various cross rates.
Real effective exchange rate (click to enlarge)
It’s clear from the chart that combining both factors impacting Australia’s international competitiveness – the TWI and relative cost of production – that the real exchange rate is actually higher today than it was at the beginning of the year. And from its peak the decline is only about 12%. This is the number that keeps RBA governor Glenn Stevens awake at night when he compares it with the 40% decline in his commodity price index. He is concerned that it’s not enough to help the economy transition from reliance on the mining sector to domestic driven growth. Today’s monetary policy statement said “a lower exchange rate is likely to be needed to achieve balanced growth in the economy”.
But with Japan engaging in all out quantitative easing and the Eurozone soon to follow suit, the RBA faces an uphill battle to get what it wants. Stevens still has one trump card to play: interest rates. At 2.5%, there is plenty of room for a cut in the policy rate. But he wants to keep that particular card up his sleeve in the meantime.
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