Australian Dollar Crash: Why It's Falling & Future Forecast

Over the past decade, the Australian dollar (AUD) has experienced a significant decline, impacting the financial well-being of those who live, work, or study in Australia. This article will delve into the reasons behind this depreciation, examining both short-term and long-term factors, and consider potential future scenarios.

Understanding Currency Appreciation and Depreciation: Purchasing Power Parity

Before analyzing the fall of the Australian dollar, it's crucial to understand the basic principles of currency valuation. The purchasing power parity (PPP) theory is a well-known economic theory that attempts to explain the relationship between exchange rates and inflation.

• The core idea of PPP is that the exchange rate between two currencies should equalize the prices of an identical basket of goods and services in both countries.

• If an item costs significantly less in one country, arbitrage opportunities will arise, eventually driving prices and exchange rates toward equilibrium.

• Countries with higher inflation rates tend to see their currency depreciate faster, as the purchasing power of their currency declines.

While the PPP theory provides a useful framework for long-term equilibrium, it relies on numerous assumptions (such as no trade costs or barriers) that don't fully reflect real-world conditions. Therefore, it is not a definitive forecasting tool.

Currency as a Commodity: Supply and Demand

A more practical approach to understanding exchange rate fluctuations is to treat currency like any other commodity. The exchange rate is simply the price of that currency. The foreign exchange market sees daily trading volumes exceeding \$7 trillion USD, making it one of the most liquid and difficult-to-manipulate markets globally.

Factors Influencing Demand for the Australian Dollar

The exchange rate, like the price of any commodity, is determined by supply and demand. Demand for a currency arises from various sources:

• Tourism: International tourists need AUD to pay for accommodation, meals, and other expenses within Australia.

• Exports: When countries import goods from Australia, they need to purchase AUD to pay for those goods. Australia's exports, especially in the mining sector, significantly influence the demand for the Australian Dollar.

• Asset Purchases: Foreign investment in Australian assets, such as real estate, stocks, and bonds, requires the purchase of AUD. Central banks also purchase Australian government bonds to diversify their international reserves.

Factors Influencing Supply of the Australian Dollar

Conversely, the supply of AUD increases when:

• Australians travel abroad and need to exchange AUD for foreign currencies.

• Australians purchase goods and assets from other countries, necessitating the sale of AUD.

The continuous depreciation of the AUD since 2011 indicates that the supply of AUD has consistently exceeded demand.

Key Long-Term Factors Driving the Australian Dollar's Depreciation

Several long-term factors have contributed to the persistent decline of the Australian dollar.

1. Commodity Currency: Iron Ore Prices

The Australian dollar is heavily influenced by commodity prices, particularly iron ore. As a major mining exporter, Australia's export earnings are intrinsically linked to global commodity demand.

• Mining exports account for a significant portion of Australia's total exports and GDP.

• The price of iron ore, Australia's largest export, has historically shown a strong correlation with the AUD/USD exchange rate.

• Forecasts from institutions such as the Australian Ministry of Industry suggest a mild downward trend in iron ore prices, projecting a potential 30-40% decrease by 2030.

This projected decline in iron ore prices is attributed to:

• Slowing urbanization and increasing steel recycling in China, potentially reducing Chinese demand for iron ore.

• Growing global iron ore supply, particularly from new high-quality sources in Guinea, which is expected to significantly impact Australia's exports.

2. Shrinking Manufacturing Industry

Unlike the mining sector, Australia's manufacturing industry has been steadily declining. Its contribution to the national economic structure is considered relatively low compared to other OECD countries.

• Manufacturing accounts for a small proportion of Australia's GDP.

• Government initiatives to support the manufacturing sector, while present, are small in comparison to investments made by other countries.

The Australian manufacturing industry faces significant challenges:

• High Costs: Manufacturing costs in Australia are significantly higher than in countries like China, impacting competitiveness.

• Lack of Strong Products: Australia lacks a significant presence in high-tech manufacturing sectors which yield the kinds of irreplaceable products that overcome cost disadvantages.

This results in a vicious cycle, as low investment leads to lack of scale and innovation, further decreasing returns and investment. This makes it difficult for the manufacturing industry to support the Australian dollar.

3. Declining Treasury Bond Interest Rates

Treasury bond interest rates play a crucial role in attracting foreign investment. Higher interest rates make a country's bonds more attractive, increasing demand for its currency.

• The interest rate of Australia's 10-year treasury bonds has declined relative to other major countries, making them less attractive to foreign investors.

• Compared to China, the interest rate gap hasn't translated into a stronger AUD against RMB due to China's foreign exchange controls.

China's foreign exchange controls and interventions by the People's Bank of China (PBOC) in the foreign exchange market make predicting the future AUD/RMB exchange rate challenging.

4. Continuous Capital Outflow

Australia experiences continuous capital outflow due to:

• Pension Fund Investments: Australian pension funds invest a significant portion of their new contributions in overseas assets, leading to a net outflow of AUD.

• Current Account Deficit: Despite significant earnings from mining exports, Australia's current account often experiences a deficit due to a substantial investment deficit. A significant portion of profits from Australian companies are distributed as dividends to overseas investors, leading to capital outflows.

These structural and long-term factors contribute to the consistent selling of AUD in the foreign exchange market, further pushing down its value.

The Role of Monetary Policy

While monetary policy does have a short-term impact on the exchange rate, it is not seen as a primary driver of long-term trends. In the long run, central banks tend to maintain monetary policy near a neutral interest rate.

Potential for Rebound

Although the outlook for the Australian dollar is currently bearish, a rebound is not entirely impossible. Sudden surges in iron ore demand, a resurgence of the manufacturing industry, or widespread interest rate cuts by other major countries could provide opportunities for the AUD to strengthen. However, sustained appreciation of the AUD will require deep structural adjustments within the Australian economy.

For individuals, diversifying investments into overseas assets remains a prudent strategy to mitigate the risks associated with the declining Australian dollar.