Since the beginning of the new year, Australians have received around a 10 percent pay rise. But this is not your typical pay rise. This pay rise does not result in more dollars in your bank account. Nor does it mean you can afford a bigger Australian home. So what kind of a pay rise is it exactly?
Around the time of new years eve at the end of 2016, one Australian dollar could buy around 72 US cents. Today, one Australian dollar will buy you around 10 percent more US cents than it did back then. This is not a mirage. This is a genuine increase in wealth for Australian households. With this “pay rise” Australians can buy foreign assets more cheaply than they could eight months ago. And buying foreign assets is the only way to “bank” this pay rise before it potentially disappears.
This can be a strange concept. What sort of a pay rise requires the recipient to use it, or else potentially lose it? A relative one.
Consider a publicly listed company whose stock price rallies harder than it should have. Stock prices can overshoot and undershoot the fair value of their underlying businesses all the time. For managers of overpriced businesses, a typical strategy is to acquire a competitor business – but with the consideration paid in the form of company stock, rather than cash. The idea is to use the company’s stock as a form of currency. To the extent the stock is overvalued, the acquisition is effectively cheaper than it would normally be if the stock was fairly valued. That is, the company with the overvalued stock had to use it or lose it. The same is true for the Aussie dollar.
Now, this all assumes the Aussie dollar is relatively overvalued and will probably fall. Could it rise instead? Absolutely. No one can predict with any sustainable accuracy how a free-floating currency exchange rate will move. And this would equate to an even larger “pay rise” for Australians.
But the balance of probabilities suggests there is a higher-chance of a medium term decline in the Aussie dollar rather than an increase. There are a number of reasons for this.
First, according to a simple theory called Purchasing Power Parity (PPP), exchange rates between currencies will approximately tend towards the levels that result in roughly equivalent levels of purchasing power of goods and services. Said another way, take the values of an equivalent good or service in two countries and divide them by each other: that is the PPP exchange rate. According to the OECD, on this basis, the Aussie dollar is around 14 percent overvalued against the US dollar. This means around 70 US cents is the about the right level for the Aussie dollar, according to this method.
Another way to assess the future direction of the Aussie dollar is to consider the trajectory of Australian interest rates versus those of foreign interest rates. Projecting the direction of interest rates is not much easier than projecting currencies. That aside, if one were to believe that foreign economies were set to improve while the Australian economy could face some headwinds, then a declining Aussie dollar would be a sensible conclusion.
The 2017 rally in the Aussie dollar has been viewed by many as a negative. For exporters, this is certainly the case. But households are, in effect, net importers and a stronger Aussie dollar represents an effective pay rise. The only catch is: you have to use it, before you potentially lose it.
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