Yesterday we discussed credit and credibility. Today we want to explore how this relates to currencies.
We've been marvelling lately at the strength of the Australian dollar. Apparently, Aussie dollars are in demand. The IMF recently included the Aussie in its 'appendix' of reserve currencies. Dan Denning wrote about it earlier in the week.
It got us thinking about currencies and what determines value. Is it really as simple as supply and demand? Who supplies the currency? When a country has a demand for 'Aussie dollars', what does that actually mean?
We don't really know the answers to these questions. But we'll have a crack at answering them. Feel free to weigh in if you think we've got it wrong.
You know that because of near zero interest rates in much of the developed world, the Australian dollar is becoming increasingly popular as a reserve asset. But foreigners are not piling up Aussie coins and notes in the vaults, they're buying Australian government debt, which is DENOMINATED in Aussie dollars.
We think it works like this. For a foreigner to purchase the debt, it must first purchase (digital) Aussie currency via their foreign exchange dealer. It then swaps the currency for the debt security, and credits the government's spending account with the Aussie dollars. So does that mean the Aussie government 'prints' dollars when foreigners buy its debt?
No, the dollars already existed. They were in 'digital existence' in the first place. Although the government turned those digital dollars into real spending power by issuing the debt.
So where do the dollars come from in the first place? The Reserve Bank? That seems logical, but when you look at the RBA's balance sheet, it's only $82 billion. That's peanuts compared to the size of the FX market. Does the commercial banking system create the supply of dollars? Well, sort of. But it only creates credit (a supply of dollars) to the extent that there is demand for them. So demand for a currency creates its own supply, does it?
In a closed economy yes. But in a highly integrated and inter-connected financial world of mind-boggling complexity, it's fair to say we have no idea how it all works.
So let's bring it all back to credit and credibility. A currency value is not absolute. It's relative, merely an exchange value. Domestically, you want to know how much of 'X' your dollar will buy. (Answer: increasingly less.) And internationally you also want to know what you can exchange your dollar for in terms of other currencies (so you can then purchase 'X' in that country).
Strangely, while the Aussie dollar buys you less at home (reflecting domestic inflation) it buys you more overseas (reflecting international deflation). As far as we can tell, this is all due to the way foreign investors see Australia. The exchange rate is just a monetary representation of how international investors see us. It's a reflection of Australia's credit and credibility relative to all the other basket cases in the world.
So on that front, we're not looking too bad. And it's enough for foreigners to overlook our gaping current account deficit and huge reliance on their capital to sustain our standard of living. They ignore the deplorable state of politics here because it's all relative to their own shambolic situations. And they ignore our high cost of living because, well, they don't have to live it.
Of course, they won't ignore all this when they realise that Australia's relative credit and credibility is simply due to the fact that the slow-burning fuse that is the global financial crisis has yet to really hit Australia.
But it will. And when it does...well, we're sure you know the implications.
Greg Canavan The Daily Reckoning Australia