The Australian economy, so long viewed as a one of the great success stories of the developed world, is struggling and things look likely to get a lot worse as it faces fast deteriorating terms of trade, the slowdown of its mining and gas investment boom and the prospect of government fiscal problems.
Despite this the currency, though at US$1.03 some 7 percent off its peak, is looking massively overvalued to many, even including the normally cautious International Monetary Fund. One IMF official put the over-valuation at 10 percent and while other analysts suggest that a value closer to 75 cents to the US dollar would be more appropriate.
So why is this, and what impact is an overvalued currency having on the economy? For sure, the still large capital inflows into mining may be one reason. Another may be that in an uncertain world Australia and its banks are still seen as safe havens. But there is one over-riding reason: interest rates remain relatively very high at a time when they are at rock bottom in dollars, yen and euros.
They are high because the Reserve Bank of Australia (RBA) wants them high. And that raises the issue of the role of RBA policy makers in keeping them there despite the squeals of agony from many manufacturers and the tourism and education industries that that their businesses have lost competitive edge, and the deterioration in Australia’s external position, already characterized by a huge private sector debt burden.
The RBA is solely responsible for Australia’s monetary policy and supervising the banking system. It is an autonomous body, not directly accountable to the Australian people. However its board’s obligations with respect to the formulation and implementation of monetary policy are laid out in the Reserve Bank Act, which states it is the bank’s duties to ensure that policy best contributes to currency stability, full employment and “the economic prosperity and welfare of the people of Australia.’
However, over the past two decades the RBA has mostly been focused on one issue – inflation, the aim being to keep it within the 2-3 percent range apparently regardless of whether that particular goal is in line with the statutory goals.
In December 2007, following the change to a Labor government, a new Statement on the Conduct of Monetary Policy was jointly issued by the new Treasurer Wayne Swan, and the Governor of the Reserve Bank, Glenn Stevens. This statement incorporated substantive amendments enhancing the independence of the Reserve Bank and covered practices regarding transparency and communication. A revised statement was issued following the 2010 election, which explicitly covered the Reserve Bank’s mandate for financial stability. Effectively the Reserve Bank of Australia became fully autonomous.
The Reserve Bank Board is made up of nine members which include the three ex officio members of the board, consisting of the Governor and Deputy Governor of the Reserve Bank, the Secretary to the Treasury plus six external members who are appointed by the Treasurer for a period of five years. The board normally meets 11 times each year, where one of the main responsibilities is to set official interest rates (the overnight bank cash rate).
The RBA’s power over Australia’s economy is immense. Public pronouncements by the bank governor can stir stock and currency markets. Those decisions are made by an independent board who get their advice from both formal and informal sources that are undisclosed. This lack of transparency in decision making can run potential conflict. Former Prime Minister John Howard blamed the Reserve Bank for his election loss in 2007, accusing the bank of meddling in domestic politics by announcing a rate rise.
Current RBA board members, it will be found, have links to multinationals, media, right wing think tanks and foreign interests. Governor Glenn Stevens, portrayed by the Australian Financial Review as the most powerful man in Australia, is an avid New American Standard Bible reader.
There is no provision that the RBA board have any representative to specifically look after the public interest. Nor are there any representatives to represent small business and Australian wage earners.
So what is the state of the economic and financial environment the RBA has been stewarding on behalf of the Australian people?
Making imports cheaper keeps a check on domestic inflation. However this is putting exports in a precarious position, devastating industries, costing thousands of jobs in manufacturing in particular but also in rural industries competing against cheap primary produce imports. This could cause the shutdown of many rural industries altogether in the not too distant future. Local manufacturers have been crippled in many industries, while import-oriented businesses have flourished. Australian business models today are more focused on developing overseas supply chains rather than innovating new technologies.
The higher Australian dollar is also making universities more expensive for foreign students, cutting into enrollment. The number of foreign tourists is also declining, with increasing Australians holidaying overseas.
There is no doubt that the high-valued currency is forcing a restructuring of the economy, if not society as a whole. The resources boom saved the country from a recession in 2008 and is keeping the economy buoyant today even as commodity prices teeter precariously. However allowing the economy to become too narrowly focused on resource exploitation also squeezes the manufacturing and farm sectors. This to some degree has been replaced by a large service sector to absorb employment.
The high dollar has created wealth, as the pundits claim, although wealth is also being redistributed away from middle Australia, which is reflected in slowly rising unemployment. Although a high dollar keeps down inflation, the costs of this are starting to show.
The big four banks are having a bonanza from their guaranteed bonds. With AAA credit ratings, the big four are able to borrow from the RBA at the best rates. The big banks are able to issue bonds secured with assets where smaller banks cannot, thus greatly disadvantaging the smaller ones. Over the last few months the major banks have been able to raise more than A$20 billion of new funding through their AAA-rated covered bonds to government and other investors around the world.
The government guarantees for private banks has created a moral hazard where the banks are insured on the assumption of being too big to fail. History has shown this as a recipe for irresponsible behavior. Today a scenario exists where the tradeoff between risk and return has been eliminated. The lower risk banks with the highest credit ratings are able to provide higher returns than the smaller banks with the lowest credit ratings, a complete reversal of the inverse relationship between risk and return that taxpayers have guaranteed.
Today responsibility for economic policy is divided between an elected government that exercises fiscal measures and the RBA, which exercises monetary ones. The rationale is to remove the temptation for elected governments to manipulate monetary policy for electoral advantage. However in the light of the recent EU financial crises, this division should be reviewed to prevent any potential financial crisis occurring in Australia, no matter how remote this possibility may appear.
The underlying reality is that despite a decade of resources boom and strong terms of trade, only briefly interrupted by the 2008 global meltdown, Australia runs a huge external deficit being financed more by debt than by direct investment. Net debt now stands at A$759 billion and the net international investment position at a net A$870 billion. While Australia has traditionally had net capital inflows, it is now a mature economy facing falling terms of trade.
Policy conflict is likely between the government and RBA in the coming months. Even within the RBA board signs of disagreement are emerging. One member, John Edwards, a former journalist who became chief economist for HSBC in Australia, has recently been quoted denying that manufacturing was suffering due to the exchange rate. But another, Heather Rideout, was quoted doubting that the economy as whole had made the necessary adjustment to the strong currency.
Due to the election this year, the government is under great pressure to deliver a surplus budget. The RBA policy on maintaining a comparatively high interest rate at a time the government is cutting spending may lead to an economic slowdown, if the RBA board doesn’t take action to lower rates further to compensate for the government’s fiscal actions. How the RBA handles this will be interesting.
This leaves Australia in a medium to long term predicament, in need of national debate. Today the economy is being driven by the longest commodity boom the country has seen. This is being driven by urbanization in China, but this will not last forever, just like the gold rushes of the 1800s, and the wool boom in the 1950s.
Australian society has changed into a service society without much of an innovation base. The nature of the economy has become dangerously narrow. The increasing relative wealth covers up the need for policy makers to discuss the direction of the economy. New industries that maintain high levels of employment need to be created.
As it is, capital inflows have helped mining and helped the rapid expansion in mortgage lending but had a negative impact on other sectors. The RBA seems to think a strong currency was affordable because of the mining boom and would spur productivity in the rest of the economy. But in reality optimism over the duration of the boom looks excessive and the currency has done little to spur productivity in other sectors.
Today, it is apparent that structural change has been left entirely up to the board of the RBA to decide. There is not much time to prepare for the end of the mining boom. Coal prices have already fallen a long way and iron ore looks likely to go the same way as new mines in Australia as well as in Africa and South America come on stream.
If Australia faces an economic downturn from a resource bust, then the economy would most likely lunge into a deep recession, with no sector capable of driving the economy back out — at least until the currency falls so far that investment in manufacturing again becomes attractive. Do not forget that the A$ fell below 50 US cents little more than a decade ago when commodity prices were very weak. While that would have some benefits, the high level of foreign debt, only about half of which is denominated in Australian dollars, would be a huge constraint at a time of deteriorating terms of trade.
Although interest rates are heading down, closing the parity gap between Australia and the rest of the world, this will probably have little short-term effect on the currency. Manufacturing and construction will continue to decline, putting more pressure on unemployment over the next 12 months. Cutting interest rates will have little effect on consumers already high in debt.
In Australia today, there is very little concern about how much influence the RBA has over the structure and future directions of the Australian economy. The future shape of what the Australian should be like in the future is a matter for national discussion. These issues are outside the brief of the RBA, but are of concern to every Australian.
(Murray Hunter is an Australian academic teaching at a Malaysian university.)