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The Economy: Get Used To High Dollar

For quite a while now many investors, analysts, business people and commentators have assumed that the current high value of the Australian dollar will be a passing fad, with the currency dipping under the $US 90c level in the near future.

In fact the dollar could remain around its current level for the best part of the next decade, or more, according to the new head of Federal Treasury, Martin Parkinson.

In fact our record terms of trade could decline by only 20% between now and 2025!(See above graph).

His views directly challenge commentators and others who reckon the dollar will start falling soon as the Chinese economy tanks, leading to a fall in demand for our iron ore, coal and LNG, or a housing debt crisis in Australia.

In both cases the dollar would fall as our terms of trade slump, or so the ‘temporary’ dollar theory goes.

It is a popular view in the Federal Opposition and some in the media and the commentary industry, and among quite a few foreign investors, especially of the hedge fund variety.

But now, in his first public speech since becoming the head of Treasury in Canberra, the new Treasury Secretary Mr Parkinson has strongly disputed the "temporary" high dollar theory.

In fact he told a lunch of the Australian Business Economists group in Sydney yesterday that the Australian economy is facing sustained strength in the dollar, not a short-term spike.

And this high dollar will continue for so long that it will permanently change the Australian economy and its make up.

Mr Parkinson said the Australian dollar was strengthening in line with the terms of trade, which have hit their highest in more than a century (highest in 140 years) and are expected to stay elevated for years to come.

The 2011-12 Federal budget was built around a dollar about $US1.07 (the Reserve Bank used the same assumption in its most recent economic and inflation forecasts released on May 6).

(The dollar has weakened in the past few days to under $US1.06. it is now back over that level.)

Mr Parkinson said in yesterday’s speech:

As noted in the Budget, our terms of trade are currently at 140 year highs and we assume they come off only slowly, falling by around 20 per cent over a 15 year period.

Visually, the impact of this is striking. Substantively, even more so. (See chart).

Not only has the terms of trade driven great increases in national income, but also in the nominal exchange rate.

The Australian dollar, which is currently at record levels, can be expected to move roughly in line with the terms of trade over the longer term. It is therefore expected to also remain persistently high for some time.

The implications of a sustained increase in the terms of trade and a persistently high exchange rate are significantly different to those of a temporary shock — particularly for the structure of the economy.

Most Australian businesses are well equipped to deal with short-term volatility of the exchange rate.

But what we are dealing with now is a very different type of event —not a temporary appreciation, but a sustained shift.

This will challenge a number of existing business models.

Inevitably, this will see calls for support for producers that are suffering from a lack of competitiveness due to a "temporarily" high exchange rate.

Higher resource prices will see capital and labour shift towards the mining sector, where they are more valuable. This shift will be facilitated by the appreciation of the exchange rate, which shifts domestic demand towards imports and reduces the competitiveness of exports and import-competing activities.

The manufacturing and other trade-exposed sectors that are not benefiting from higher commodity prices will come under particular pressure, but all sectors will be affected.

The longer-term shift away from parts of the traditional manufacturing sector, which began in the middle of the 20th century, will continue, although it would be wrong to automatically assume all manufacturing will be adversely affected.

And while the mining and related sectors can be expected to continue to grow – drawing resources from the rest of the economy – they will be overshadowed by the longer-term shift towards the services sector.

This change to the Australian economy – its structural evolution – reflects a prolonged shift in our comparative advantage that began in the second half of the 20th century, as rapidly industrialising Asian nations emerged as labour-abundant competitors.

Our evolution is common to the economic development of virtually all advanced economies, including those in Asia.

To date, the economy has demonstrated the flexibility to deal with significant structural change.

In particular, a flexible exchange rate and labour market have helped facilitate the reallocation of resources across the economy.

Without a flexible economy we could expect higher inflation (and interest rates) and, somewhat perversely, a rise in unemployment.

So what, then, is the challenge in this?

The first challenge is to recognise and understand that this analysis can give rise to understandable concerns in significant sections of the Australian community. Such as:

How will the benefits of the boom in the terms of trade be shared through the community? – After all, today we are swapping a non-renewable capital asset – mineral and energy reserves – for an income stream.

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