Supply and Demand: The Case of the Australian Dollar
Published 25 March 2020
By Dr Peter J Phillips, Associate Professor (Finance & Banking) University of Southern Queensland
A slow and steady decline
In early 2020, in the midst of the coronavirus outbreak and cast against the backdrop of an uncertain world economy, the Australian dollar fell to its lowest level in more than a decade. A few years after the Global Financial Crisis (GFC), Australia’s economy had recovered well on the back of strong demand from China. In 2012, one Australian dollar purchased more than one US dollar. The AUD/USD exchange rate was 1.08. The Australian dollar was similarly strong when compared with the Euro. In 2012, the AUD/EUR exchange rate was 0.86.
From this peak, there was a slow and steady decline. In February 2020, the AUD/EUR exchange rate was 0.60 (a 30% decline) and the AUD/USD exchange rate was 0.65 (a 40% decline). While commentators have proposed various reasons for this (see the ABC’s story, February 28 2020), the fundamental reason that we cannot lose sight of is: supply and demand. The reason for the fall, fundamentally, is that the demand for Australian dollar is weaker than supply. The price, as measured by the exchange rates with other currencies, must fall until supply and demand reach an ‘equilibrium’.
Why is there is an imbalance between supply and demand?
Once we have this fundamental explanation understood, it makes it easier to interpret the other parts of the story. Why is there is an imbalance between supply and demand? One factor that has driven the fall in the Australian dollar since 2012 is interest rate differentials. In 2012, the yield on Australian government bonds was almost 6%. At the beginning of 2020, the yield on the same bonds was around 1%. By contrast, US government 30-year bond yields was around 2% (twice a high). When investors can earn a higher return elsewhere, they exchange their currency for the currency of the country where yields are higher. There was less demand for the Australian dollar because less people wanted to invest in Australia relative to elsewhere.
However, this cannot be the only factor since Australian government bond yields are still much higher than the near-zero rates that characterise European government bonds. The 30-year bond yield in Germany is negative. What might explain the weakness in the AUD/EUR rate?
Low demand for Australian dollars
A bigger part of the explanation must lie in the underlying strength (or weakness) of the Australian economy relative to competing economies. Australia’s markets were sluggish in their recovery from the GFC, only reaching pre-GFC levels in 2019. In the United States, the rebound in the markets was sustained and much stronger, showing a steady rise since 2009 compared to Australia’s flatter and more stuttering recovery. In Germany, too, markets recovered quickly and strongly compared to Australia. Investors were much better off shifting funds into the US markets or European markets after the GFC than into the Australian markets. In so doing, investors had less need for Australian dollars and more need for US dollars and Euros.
The financial markets are excellent sources of information about the perceived risks in an underlying economy. Australia built its economic recovery, such as it was, on the basis of real estate construction. The result has been high household debt and some of the most expensive real estate in the world. The government also relied heavily on population growth to support the economy (more people = more demand). Beneath the headline unemployment rate, which has been quite low, is a story of underemployment (people unable to get enough hours of work) and a constant struggle to meet living expenses and service debts. These factors have kept international demand for the Australian dollar relatively low and that is all that is necessary for a sustained fall in the exchange rates.
Discussion Question
What factors need to emerge for the Australian dollar to strengthen? Is this likely?
Further Reading
For those interested in researching this topic further, see part 5 of Financial Institutions, Instruments and Markets 9e, which presents an in-depth discussion of the foreign exchange markets.