Currency movements are complicated. Many factors affect them, including interest rates, trade balances, and economic and national stability. But at risk of oversimplifying these shifts, the exchange rate of Australia’s currency is more often the result of just a few factors.
When it comes to the Aussie dollar, history tells us that some things are more likely to impact its value, like iron ore prices and our trade relationship with nations like China. After all, commodity exports are still a massive part of Australia’s GDP, and trade balance.
Supply and demand is key. If demand for the Aussie dollar falls while supply for exports like iron ore or coking coal increases or remains the same, its price will fall.
This held true through its highs in July 2011, when the Australian dollar peaked at US$1.10. From there, it took a considerable tumble in 2013, before stabilising in 2017.
What do these movements have in common? I’ll give you a clue, it’s not just interest rates.
It’s China. More specifically, the correlation between the Australian dollar and the health of the Chinese economy. We can consider the iron ore price as a proxy for Australia’s economic relationship with China. This relationship is the reason for the link between iron ore prices and the Australian dollar.
Iron ore is Australia’s largest export earner. When demand is high, iron ore prices are high, and it provides a huge income intake to the economy. Income wise, it’s the single biggest influencer nationally.
The Love Triangle Between the Australian Dollar, China and Iron Ore Prices
It doesn’t just stop there. Growth in China impacts the price of iron ore so much that it too can be considered a proxy. The spot price of iron ore can be thought of as a measure of China’s economic health.
When iron ore prices peaked in early 2011, it was followed by a peak in the Australian dollar only a few months later. However, one note of difference is that, when iron ore prices began to fall, the Australian dollar persisted to trade strongly in a range throughout 2012.
In late 2012, China announced a big infrastructure boom, and the iron ore price climbed back to US$155 in February 2013, only to begin a slow decline spanning 2014/15. And, you guessed it, the Aussie dollar loosely followed iron ore and China’s ups and downs.
When iron ore prices fell, Australia’s national growth came to a standstill. Government tax receipts fell, putting pressure on the budget and Australia’s AAA credit rating.
To combat the falling iron ore prices, Australia’s reserve bank did the thing that made sense — cut interest rates. This saw interest rates drop from 4.75% in 2011 to 1.5% in 2016.
This re-invigorated Sydney and Melbourne’s housing bubbles. Rising house prices fostered capital inflows, which in turn helped support the Aussie dollar.
Meanwhile, the state of the 2015 Chinese economy saw the government invest further in a credit based stimulus program. This meant more spending was poured into infrastructure projects. Unsurprisingly, iron ore prices followed suit and climbed higher, meaning the Australian dollar remained strong.
Since then, the Chinese economy has begun to slow again. This means a potential slowdown for demand of iron ore, with the expected impact on the Australian Dollar.
How Borrowing is Helping the Australian Dollar
Think of it this way. In order to retain our standard of living, Australia must borrow from other countries. And of course, these countries are only too happy lend to Australia as they have enjoyed relatively high interest rates here.
The current account deficit reflects the sum Australia must borrow. It reflects the amount of capital flowing out of Australia, as well as interest needing to be paid on the $1 trillion or more of foreign debt in Australia’s trade deficit. In 2017, this deficit was just below $30 billion.
Which means maintaining foreign capital inflows of no less than $30 million in this period is important to stabilise the Aussie exchange rate.
More capital inflows above the $30 billion mark means the exchange rate will increase to balance out the supply and demand disparity.
How does this tie into iron ore and the Australian dollar?
Well, when iron ore prices fall, it decreases the total income flowing into the Australian economy. And this isn’t lost on foreign investors, so we see more hesitant lending habits. In turn, foreign capital inflows slow down and the exchange rate drops.
A weaker dollar gives strength to a foreign currency’s purchasing power, leading to more foreign investment. But it also weakens our purchasing power for imports. As Australia imports many things that we don’t manufacture ourselves — including cars, these days — this can be a major drag on our economy.
In turn, when iron ore prices go up, the increased flow of capital once again looks good for Australia.
It’s likely iron ore prices and our trade relationship with nations like China will continue to influence the Australian dollar for many years to come. Other factors such as Australia’s own economic concerns, as well as interest rates and other global commodity prices, will also have their effects.
Here at Markets & Money, we always keep you up to date with all the latest factors influencing the Aussie dollar. You can find all the latest articles from our editors on this topic here.