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The Australian dollar is a lot softer than it was at the height of the export commodity price boom earlier in the decade. The fall in the Australian dollar has been particularly impressive against the US dollar, down from around $US1.10 at the recent peak, to around $US0.76 currently. Yet, as the Reserve Bank keeps stressing, the Australian dollar still needs to fall much further if it is to help rebalance the Australian economy in the wake of the huge dent in Australian national income caused by one of the biggest collapses in commodity prices ever to impact Australia. If the Australian dollar does not fall much more to compensate for the decline in commodity prices (and the further decline that still seems to lie ahead) something else will need to adjust to assist the economy – most likely interest rates.

Looking first at commodity prices, the Reserve Bank’s measure of commodity prices important to Australia has declined by 41.9% in SDR (a currency basket measure) terms since their peak in June 2011, through to the end of February 2015. The fall in commodity prices has been driven primarily by economic growth in China – peeling back from 12% y-o-y to around 7% currently – as well as by a changing configuration of growth, with less emphasis on urban investment spending and industrial production – both of which are heavy consumers of energy and industrial commodities.

Australia’s huge investment in resource projects to meet China’s seemingly insatiable demand, increasingly looks like wild over-investment. Supply of commodities is burgeoning from the earlier additions to Australia’s export capacity, but is running into slower growing demand from China which is adding to downward pressure on commodity prices. Moderating demand for industrial commodities from China, and increasing supply from Australia, spell a protracted period of softer commodity still to come. The next big China-like boost to commodity demand will potentially be India, although this is contingent upon extensive economic reforms to allow the Indian economy to live up to its strong growth potential. It looks like a 2020 event at earliest before Indian commodity demand starts to generate the next commodity price boom.

Meanwhile, on the currency front, between July 2011 and February 2015, the Australian dollar fell by 27.4% against the US dollar, but by a much lesser amount of 17.6% against a basket of currencies (TWI) weighted according to Australia’s international trade. As is often remarked, any fall that there has been in the Australian dollar, has been more a function of US dollar strength rather than Australian dollar weakness. The Australian dollar has actually appreciated against currencies such as the euro and British pound over recent months.

The Australian dollar has not depreciated enough to offset the damaging impact on the economy of falling commodity prices. Against the US dollar, the Australian dollar needs to fall another 14% to match the decline in commodity prices on an SDR basis, but it really needs to depreciate much more than that to compensate for the appreciation of the US dollar against the currencies of Australia’s trading partners. In effect, the Australian dollar depreciation against the US dollar needs to be nearer to 24% – an exchange rate of around $US0.58! However, such an exchange rate would only compensate for the decline in commodity prices since mid-2011, not the potential weakness in commodity prices that still lies ahead.

The key reason why the Australian dollar has not adjusted to reflect changing international trade fortunes is that international foreign exchange transactions cover not just trade but also capital flows too and these are far bigger than trade transactions these days. Notwithstanding the diligence of senior Reserve Bank officials talking about the need for a weaker Australian dollar, Australia is still something of a magnet attracting capital inflow.

Our interest rates are still high by international comparison and the risk investing in Australian government bonds in particular is comparatively low. Australia is one of only seven standing AAA sovereign risks in the world and with no real prospect of downgrade over the next few years. Yields on Australian shares and property are also high by international comparison. In a world where abnormally low yields are the norm, Australia still stands out, and the periodic attraction to international investors is slowing the needed depreciation of the Australian dollar.

We see the failure of the Australian dollar to depreciate anywhere near enough as another reason for the RBA to keep tweaking the dial lower on Australian interest rates. The cash rate is likely to be lowered below 2.00% later in 2015. Also, it is reasonable to expect that the Australian dollar will trade below $US0.70 later this year, possibly a long way below.