Up by the stairs, down by the lift

Up by the stairs, down by the lift

Long suffering investors who have held overseas shares received an overdue bonus during August, with the sharp decline in the Australian dollar ($A) providing a corresponding steep rise in investment values. For those Australians holding their overseas investments on an unhedged basis (ie where there is no protection built into the investment structure to neutralise currency movements), a decline in the $A automatically increases the value of overseas investments, which are domiciled in the more expensive foreign currency.

During August, Australian international equity investors recorded their biggest one-month return since March 2000, with average returns being 7.9%. With further falls in the $A being recorded in early September, there is a prospect of additional currency related returns being generated.

The pattern of currency movement

The Australian dollar has often followed a path of long gradual increase followed by sharp falls or corrections in value. This pattern can be seen on the chart below.

Source: Reserve Bank of Australia

It should be noted that part of the recent fall in the $A can be attributed directly to a recovery in the value of the $US. None-the-less, the table below shows that the value of the $A has declined against all major currencies in recent weeks, albeit not to the same magnitude as the decline against the $US.

Source: Reserve Bank of Australia. Period from 16^thJuly to 5^th September 2008

Causes of the exchange rate decline

The reasons for the sudden drop in the value of the $A are largely related to a turnaround in two of the main drivers of the currency’s strong appreciation over the past 6 years.

Firstly, there has been some softening in commodity prices on global markets. When the price of commodities (eg coal and wheat) falls, the demand for $A’s tends to fall as less of our currency is required to purchase our exports.

Secondly, the change in outlook for interest rates in Australia has made investments domiciled in $A less attractive to overseas investors. When interest rates in Australia fall relative to those available overseas, there is less return produced by investing in $A’s and the demand for our currency falls.

Although interest rate movements and commodity prices can normally explain the direction of the movements in the $A, it is somewhat more difficult to explain the size of movements in the currency. The $A has a history of being particularly volatile, with relatively small changes in underlying fundamentals triggering large changes in value. This particularly seems to be the case with downward movements in value. Over the past 25 years, 8 out of the 10 months in which the $A has had its largest monthly movements have been months of a fall in the $A. This suggests that the $A may be vulnerable to a sudden loss of support or sentiment on global markets.

The impact of a lower dollar on investors

As mentioned above, the lower dollar has an immediate positive impact on the value of unhedged overseas share investments held by Australians. In addition, the fall in the dollar will also be positive for those domestic share investments made in companies that are heavy exporters. A lower $A makes Australian exports cheaper for foreigners to purchase and this will normally lift export demand. For mining companies, the fall in the dollar acts to offset the impact of declining commodity prices on profitability.

The lower dollar does, however, make imports into Australia more expensive. This could impact the profitability of those companies relying in imports for inputs into production or those companies involved in the re-selling of imports. Department stores, for example, may be negatively impacted by a falling dollar due to a rise in the cost of many of the items that they sell.

With the cost of imports rising, a lower $A can also be associated with additional inflationary pressure. This may restrict the extent to which the Reserve bank could cut interest rates, which would have negatively implications for bond prices and fixed interest investments.