Explain the determination of the Australian exchange rate under a floating regime, draw the foreign exchange market diagram, and analyse the structure of the balance of payments including the current account and capital and financial account

What this dot point is asking

QCAA wants you to explain how the AUD is determined under a floating regime, draw the foreign exchange market diagram, identify the determinants, and explain the structure of the balance of payments. Expect a 6 to 8 mark response in IA1 or the EA.

The answer

Exchange rate regimes

Three regimes:

1. Floating. Determined by market demand and supply. Australia floated the AUD in December 1983.
2. Fixed. Pegged to another currency or basket. Hong Kong dollar is fixed to USD.
3. Managed float. Central bank intervenes within bands. China manages the renminbi.

The trade-weighted index (TWI) is the AUD's value against a basket of trading-partner currencies, a better measure than any single bilateral rate.

The foreign exchange market

Draw the AUD price (USD per AUD) on the vertical axis and quantity of AUD on the horizontal axis.

Demand for AUD (downward sloping), from:

• Foreign buyers of Australian exports.
• Foreign investors making FDI into Australia.
• Foreign portfolio investors buying Australian shares and bonds.
• Speculators expecting appreciation.

Supply of AUD (upward sloping), from:

• Australian buyers of imports.
• Australian investors making FDI overseas.
• Australian portfolio investors buying foreign assets.
• Speculators expecting depreciation.

Equilibrium where demand equals supply.

Determinants of the AUD

Seven major drivers:

1. Terms of trade and commodity prices. Iron ore, coal and LNG dominate Australian exports. Higher commodity prices raise foreign demand for AUD.

2. Interest rate differentials. Higher Australian rates relative to overseas attract foreign capital, raising demand for AUD. The RBA-Fed differential is a key driver.

3. Expectations and speculation. About 90 percent of daily forex turnover is speculative.

4. Australian economic conditions vs trading partners. Strong Australian growth attracts capital.

5. Domestic inflation relative to trading partners. Persistent higher Australian inflation depreciates the AUD over time (purchasing power parity).

6. Political and risk factors. The AUD is a "risk-on" currency, weakening during global crises (March 2020 fall to USD 0.55) and strengthening during global recoveries.

7. RBA intervention. Rare. The RBA last intervened heavily during the 2008 GFC.

Recent AUD movements

The AUD/USD has been range-bound between USD 0.62 and 0.70 through much of 2024-25, reflecting high terms of trade (supportive) offset by US-AU interest rate differential (US rates higher) and China growth concerns.

The balance of payments

The balance of payments records all transactions between Australian residents and the rest of the world. ABS publishes quarterly (cat. no. 5302.0).

Two accounts:

1. Current account (CA): flows of goods, services, primary income and secondary income.
2. Capital and financial account (KAFA): changes in ownership of assets.

Identity: CA + KAFA = 0 (plus statistical discrepancy). A CA deficit is financed by a KAFA surplus.

Current account components

1. Balance on goods and services (BOGS)

Exports minus imports. Driven by terms of trade and the AUD.

2. Net primary income

Interest, dividends and wages paid to/from non-residents. Australia runs a persistent deficit of around 4 percent of GDP due to its net foreign liabilities position.

3. Net secondary income

Transfers without a corresponding good or service (foreign aid, remittances).

4. Capital account

Small balancing item: capital transfers and acquisition of non-produced non-financial assets.

Australia's CA position

Recent figures (ABS, indicative):

For most of the post-1980 period, Australia ran current account deficits financed by net capital inflow. Since 2019, deficits have given way to small surpluses, driven by record terms of trade and higher household savings.

The CA surplus may not persist if commodity prices fall.

Capital and financial account components

• Direct investment. FDI (10 percent or more equity stakes).
• Portfolio investment. Shares and bonds without operational control.
• Other investment. Bank loans, deposits, trade credit.
• Reserve assets. RBA foreign exchange and gold reserves.

A net capital inflow (KAFA surplus) finances a current account deficit. A net capital outflow (KAFA deficit) results from a current account surplus.

The savings-investment identity

The balance of payments can be expressed in macroeconomic terms:

where S is national savings and I is national investment. A current account deficit (CA < 0) means investment exceeds savings; foreign capital makes up the difference.

For Australia, this means:

• The mining boom (2003-2014) was investment-driven, producing a large CA deficit.
• The recent CA surplus reflects high household savings and a mature production phase of the mining cycle.

Effects of AUD movements on the economy

Depreciation:

• Exports more competitive; export volumes rise (BOGS improves over time after J-curve).
• Imports more expensive; imported inflation rises.
• Servicing costs on foreign-currency debt rise.

Appreciation:

• Exports less competitive (BOGS deteriorates).
• Imports cheaper; imported inflation falls.
• Cheaper to service foreign-currency debt.

The J-curve

When the AUD depreciates, the BOGS may initially worsen because:

• Import prices rise immediately in AUD terms.
• Import volumes adjust slowly (contracts, brand loyalty, search costs).
• Export prices fall immediately in foreign currency terms.
• Export volumes adjust slowly.

Over 6 to 12 months, volumes adjust and the BOGS improves. The path of net exports over time traces a J-shape: initially down, then up.

The Marshall-Lerner condition states that the BOGS improves after depreciation only if the sum of export and import price elasticities exceeds 1. For Australia, the condition holds.

Common QCE traps

Drawing the supply curve as horizontal

Both demand and supply are sloped.

Confusing the current account with the capital account

CA records goods, services and income flows; KAFA records ownership of assets.

Treating the J-curve as automatic

Marshall-Lerner condition is required.

Forgetting the persistent net primary income deficit

It is the largest negative item in the CA, around 4 percent of GDP.