I’ve raged against the fact that the AUD is hollowing out our import competing industries and our non-mining exports but today, as the AUD careens towards 1.10, I want to focus on whether the RBA is going to do anything about it.
Just now, the dollar is being buoyed by two major themes. The $US is falling and the investment world can’t get enough of Chinese growth. With its rich commodity exposure, Australia is a leveraged bet on China. Throw in high interest rates, low sovereign debt and rocket-like technicals and we have the recipe behind the current tearaway rise.
So against this backdrop there is little the RBA can do to stop the AUD from rising. I’ve always known that, but it doesn’t mean it’s right. I continue to believe that there should be a debate on the impact of the higher Aussie and some concern/help for the industries impacted. Wayne Swan more or less suggested in yesterday’s speech that we have a bex and lie down. Kevin Rudd appeared on Bloomberg today to, unbelievably, talk the dollar up, saying we don’t intervene. This is a red rag to a bull.
So when will the RBA try to slow the freight train? It’s a hard question to answer but they offer us some clues. First, they specifically state that they favour a “free float”. That’s code for leave it to the market. But there are some rules of engagement set out.
The RBA’s approach to intervention has evolved over the past two decades. Broadly, there has been a shift away from concern about short-term volatility in the early post-float period to a focus on episodes where the exchange rate has clearly overshot. This change in emphasis has resulted in intervention strategy moving from generally small daily interventions with frequent changes in direction (often described as ‘testing and smoothing’) to less frequent but larger scale intervention once the exchange rate had moved a long way.
So Rule 1: Save your bullets, don’t intervene too often and only when it has moved a long way. Back to the RBA:
Of course, the important issue is to identify in practice when the exchange rate has in fact overshot. Typically, the RBA has come to regard overshooting as unlikely to be occurring unless the exchange rate has moved a long way and, as noted, the move does not appear to be supported by economic and financial factors. This approach effectively means that the bulk of the RBA’s intervention takes place around the cyclical highs and lows in the exchange rate.
Rule 2: Don’t intervene unless it has overshot (either side up or down) and its move isn’t supported by economic and financial factors. “Financial factors” are likely to be investment fundamentals, not just economics. Back to the RBA:
In addition to circumstances where there appears to be misalignment, the RBA will also consider intervening in the market when conditions threaten to become disorderly. Persistent volatility, a sharp widening in bid-ask spreads or erratic movements of the exchange rate (especially at times of uncertainty about macroeconomic policy) may result in intervention to help restore order. Having said this, the RBA has become more comfortable with the ability of the market to cope with shocks of various types, so episodes when intervention is motivated by the desire to avoid disorderly conditions have become much less frequent.
Rule 3: Intervene if the market gets disorderly. This is what’s called smoothing and testing. They don’t draw a line in the sand but just ensure the market functions. I’ve seen them do this many times and they used to have to be particularly active at the end of the trading week in New York, our Saturday morning. I also saw them do this one morning around 10am when the market hits a raft of stops and traders couldn’t clear. The resultant gap got them in and clearing. Back to the RBA:
Neither of the two reasons for intervention discussed above suggests that intervention could be used as an effective instrument of policy for achieving a particular level for the exchange rate. Nor does it imply the use of intervention to correct a monetary policy imbalance or to resist changes in the exchange rate which are in line with broader economic or financial developments.
Rule 4: This is the freight train rule. The market is the market, we don’t draw lines in the sand and we don’t stand in the way of a freight train unless any or all of the above 3 rules are satisfied.
So how does the AUD stack up at the moment?
1. Has it gone a long way? Yes.
2. Has it overshot? The dollar is supported by economic and investment factors and is at the high end or above most fair value models. So we’re getting there. However, Glenn Stevens is on the record describing a $1.10 scenario in which the RBA would not intervene. Having said that, he also described $1.10 as “way up“.
3. Is the market disorderly? It’s rising fast but disorderly generally means “gapping”. Big moves of 0.6 or 0.8 cents. So, no, not yet.
4. Is it a freight train? Yes and we haven’t satisfied the above rules yet so get out of the way.
So the RBA will not yet intervene. And with producer prices out today showing higher than expected inflation from oil, they may even think this surge has an upside. Though I reckon above $1.10 the finger will quiver on the trigger.
In the mean time, the best we can hope for is that the government doesn’t make it worse by jawboning the dollar higher. Markets love a dare.