Strong Currency Limits Australian Economic Growth

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On March 21, the Australian dollar (commonly referred to as the “Aussie”) traded at US$1.0537, the highest value with respect to the U.S. dollar in three decades. The Aussie exchange rate has risen over the last three years primarily because Australia has higher interest rates than other advanced economies. A higher interest rate attracts foreign investors who are able to get higher rates of return on their investments than they can elsewhere. The influx of investment to Australia creates a demand for Aussies, which raises the currency’s value relative to other currencies. Another reason why the value of the Aussie has risen is that in the wake of the European sovereign debt crisis, investors have viewed Aussies as a safe investment, which leads investors to buy Aussies, thereby increasing demand and raising the currency’s value. Furthermore, developing countries such as China are looking to diversify their holdings of foreign currency away from the U.S. dollar to minimize their exposure to a potential downturn in the U.S. economy, and the Aussie is viewed as a good alternative given the relatively higher growth rate in the Australian economy compared to the United States.

The higher value of the Aussie has limited the country’s exports (which are a primary driver of economic growth) as Australian products are more expensive for foreigners. Australia’s economy grew by 2.3% in 2011, but only by an annualized growth rate of 0.4% in the fourth quarter—both of these figures are much lower than the average growth rate of 3.25% over the last several years. Furthermore, Australia’s economic growth has been limited because Australian households have increased their savings over the last two years to pay down household debt. With less money being spent in the local economy, businesses are discouraged from expanding their operations which limits economic growth.

Perhaps more concerning to the Australian economy is that demand from China for Australian commodities has decreased and is likely to continue falling. Mining is the main economic sector in Australia and will account for over 40% of total business investment over the next few years. Much of Australia’s mining exports go to China. However, Chinese food and oil prices have been rising over the last several months, which has created inflationary pressure as producers pass on higher costs to consumers in the form of higher prices. With higher inflation, China may tighten its monetary policy by raising its interest rates, thereby encouraging Chinese to save instead of spend, which could decrease demand for Australian goods.