Determination of AUD in the foreign exchange market by demand and supply model

Discuss about the Australian Dollar.

The article talks precisely about the continuous fall of the Australian dollar against the U.S. dollar. Estimates indicate that Australia has lost over nine percent against the greenback since mid-May 2015 (Mark 2016). The RBA governor has confirmed the AUD has fallen and is expected to depreciate even further. However, he points out that there is positivity in the manner in which the AUD is well adjusting to the significant fall in the prices of the essential commodities and services.

Australia has lost almost 11 percent against the U.S. dollar but still boasts a lower than 7 percent loss on a trade-weighted basis which makes it globally competitive in the exportation of its key commodities. Experts have suggested that the exports a country become more competitive when its currency becomes relatively weak as witnessed in Australia Mark 2016). The AUD is currently being held up by investors’ interest in Australian assets, but the reality is that the determinants such as commodity prices and the different central bank policies between Australia and the U.S. will pull the AUD lower. Analysts forecasted that AUD would decline to US65c by the end of next year due to the expectation that US Federal Reserve will raise its interest rates Mark 2016).

Determination of AUD in the foreign exchange market by demand and supply model

The rate of exchange defines that extent to which a unit of a country’s currency is traded for another nation’s currency. Australia possesses a floating exchange rate (Wei 2012). The supply and demand factors dictate the equilibrium price of this floating exchange rate. The rate of the exchange rate is very sensitive to changes in demand and supply which in turn cause variations in the equilibrium exchange rate.

The demand for AUD is a derived demand (Michael Rosenberg, 2003) for its exports of goods, assets and services. This need comes in the following ways:

• Parties with the desire to purchase the exports from Australia.
• People are traveling to Australia as tourists.
• Potential investors with the ultimate intention of buying shares and assets in Australia. It also applies to investors who speculate that the AUD will rise hence giving them the opportunity to make good profits.
• Firms are seeking to set up their business branches or expand their businesses in Australia.

The demand for the dollar will be immensely affected by the size of financial inflows into Australia by the investors who wish to convert their currency into AUD. The interest rates in Australia in comparison to different rates will significantly affect the level of capital inflow. An increase in the demand for AUD as a result of increased capital inflow is said to be contributed to by the country’s strong confidence and relatively high-interest rates. Expectations of future appreciation of AUD will increase its demand by the speculators who believe in using opportunism to make profits by buying the dollar now and selling it later at a higher price.

An increase in the commodity prices combined with an improvement regarding trade is always expected to improve the current account deficit which translates to an increase in the value of AUD. The more competitive the Australian firms are in the international markets at the low levels of inflation, the more cheaply and attractive the Australian exports will be to the foreigners to buy. It is clear that the world economy is a point of an upturn, the demand for the Australian exports rises causing the currency to rise as well.

Demand

The AUD’s supply derives from the Australian private citizen’s desire to buy goods, services, and assets from foreign countries. They include the following:

• The Australian citizens with the desire to import goods from foreign countries.
• People are traveling out of Australia to tour other countries.
• Business institutions like the banks and firms that lend or invest their money overseas.
• Potential investors.
• Citizens in Australia that are paying for various services provided by foreign countries.

The level of financial flows out of Australia is to a large extent determined by the domestic interest rates about the international rates as well as the confidence level of Australia. Should the prices in Australia become weak and their trust deteriorate, capital outflow will increase thus increasing the supply of AUD. However, if the expectation is that the interest rates will rise alongside economic trust and growth then the supply of AUD will not be large.

Speculators who expect the price of AUD to fall in future will opt to sell now so as to minimize possible losses (Rayner and Bishop 2013). This will subsequently result arise in the supply of AUD and contribute to the anticipated depreciation. People in Australia who participate in the importation activities have to sell the AUD so as to obtain the foreign currencies required to pay for their imports. As the domestic economy grows, output employment and income grow as well thus raising the demand for imports which eventually contributes to the increase in the supply of AUD. If the rate of inflation in Australia is high and its firms are quite uncompetitive, imports become cheaper than the domestic produce hence leading to the rise in demand for imports. Whenever the supply of AUD increases, there is a general depreciation of the currency value.

For several years now, the Australia’s export versus import balance has been highly reliant on commodity exports such as mineral resources. This influences its value and strengthens its worth against the USD (Gao and Bryan 2016). The AUD happens to be in high demand due to the lack of Australian government’s interference in foreign exchange markets (Rose 2011). It is a highly sought after tender because its government and economy are relatively stable, sound and healthy. It has exposure to the Asian side of the market thus it offers portfolio diversification advantage when it comes to global currencies (Eichengreen and Razoâ€ÂGarcia 2013). One of the factors influencing the currency values is the interest rate differential existing between RBA and FED. Any arbitration or mediation by the FED in open market operations to make the US dollar stronger, results to a slight drop in the AUD (Chiew et al. 2015).

It has been established that the current US rates are low hence maintaining the high potential for traders to borrow in US dollars and invest in Australian debt. This has been a significant and long-term driver of AUD strength, and it looks set to remain that way for some time shortly. The RBSA has forecasted that the terms of trade will continue to be close to the existing levels (Carmignani, Colombo and Tirelli 2008). This means that the terms of trade are not expected to have a near-term negative influence on the AUD going forward leaving the interest rates between Australia and the US as the major influence. It is clear that a 1percent increase in the short term interest rate of the U.S lowers the AUD to around US70c. Should the models be right, then the AUD may not find it easy to break through US70c anytime soon.

Supply

Historical relationships suggest that the fair value of the AUD is closer to US65c.If the U.S. holds right there or lifts further as a result of its high-interest rates, then the AUD will fall further. Given the recent AUD resilience, I expect a decline to around US68c by the end of 2016. The main advantages of Australia having this level of currency is that it allows its citizens to buy more imports as they wish from foreigners as evident in the past mining boom. A rising currency reduces the inflationary pressures since the prices of imports decline in AUD thus allowing the RBA to set the interest rates at a lower level.

At US65c, the country is experiencing a low level of money and therefore, it needs serious action to pull it back to the expected high levels. Firstly, the rate of inflation in the country should be dealt with to ensure it remains small (Rodríguez-López and Rodríguez Mendizábal 2002). This boosts the economic confidence and attracts high-interest rates which lead healthy demand for the AUD. The high demand leads to an appreciation in the value of the currency. There is also dire need to improve the terms of trade which allows for the prices of commodities to increase significantly hence, increase the current account deficit which in turn enhances the value of the currency (Downes, Hanslow and Tulip 2014).

The country should work at making it easier for private citizens to export more products than they export. This is the key to reducing the supply of the AUD since the more the amount of currency, the more the value depreciates with time (Stockman 1999). Clearly, it is economically right for a country’s currency to be high. It sets it up nicely for financial investments and invites partnership opportunities with some of the world’s financial giants who apparently is every country’s dream (Kulish and Rees 2015).

References

Downes, P., Hanslow, K. and Tulip, P., 2014. The effect of the mining boom on the Australian economy. Reserve Bank of Australia.

Stockman, A.C., 1999. Choosing an exchange-rate system. Journal of Banking & Finance, 23(10), pp.1483-1498.

Rodríguez-López, J. and Rodríguez Mendizábal, H., 2002. On the choice of an exchange regime: target zones revisited (No. E2002/10). Centro de Estudios Andaluces.

Rose, A.K., 2011. Exchange rate regimes in the modern era: fixed, floating, and flaky. Journal of Economic Literature, 49(3), pp.652-672.

Eichengreen, B. and Razoâ€ÂGarcia, R., 2013. How reliable are de facto exchange rate regime classifications?. International Journal of Finance & Economics, 18(3), pp.216-239.

Carmignani, F., Colombo, E. and Tirelli, P., 2008. Exploring different views of exchange rate regime choice. Journal of International Money and Finance, 27(7), pp.1177-1197.

Wei, J., 2012. Implications of a managed floating exchange rate system on the interest-rate behavior of Singapore. Lingnan Journal of Banking, Finance and Economics, 1(1), p.5.

Mark, M., 2016. RVA Happy with Australian Dollar but further falls expected in 2016. The Sydney Morning Herald.

Hatfield-Dodds, S., Schandl, H., Adams, P.D., Baynes, T.M., Brinsmead, T.S., Bryan, B.A., Chiew, F.H., Graham, P.W., Grundy, M., Harwood, T. and McCallum, R., 2015. Australia is ‘free to choose’economic growth and falling environmental pressures. Nature, 527(7576), pp.49-53.

Gao, L. and Bryan, B.A., 2016. Incorporating deep uncertainty into the elementary effects method for robust global sensitivity analysis. Ecological Modelling, 321, pp.1-9.

Rayner, V. and Bishop, J., 2013. Industry Dimensions of the Resource Boom: An Input-Output Analysis. Economic Research Department, Reserve Bank of Australia.

Kulish, M. and Rees, D., 2015. Unprecedented Changes in the Terms of Trade. Reserve Bank of Australia Research Discussion Paper RDP, 11.