Is the dollar danger over? And what happens if it isn’t?

While conventional wisdom and forecasts have the dollar going lower in coming months and easing the pressures on the economy and the federal budget, we should ask if that will necessarily happen?—?and what will happen if it doesn’t.

A surprisingly sharp 4% rise in the value of the dollar last week is a reminder that its link to an improving Chinese economy and economic outlook remains the biggest danger to the ability of a new government to boost the sluggish local economy and manage the transition from the mining investment boom.

The RBA believes the currency will go on depreciating for a while and has staked a lot on the favourable impact of that helping the economy from 2015 onward. It all depends on the flow of data and other reports from China?—?iron ore prices are a very important indicator. A year ago this month they hit a low of $US86.40 a tonne (was that a forward indicator of the weakness in China in the first half?). Last week, iron ore prices were around $US130 a tonne and looking to push higher.

And as we have also seen in the past three years, there is little we in Australia and the Reserve Bank (which desperately wants a lower dollar) can do about it. The simple fact is that Australia and the currency are hostage in some respects to China and its economic strength. And, as we saw last Thursday and Friday, when good data and news comes out of China, traders chase our currency higher.

That is not a fanciful point?—?a week ago today the dollar hit a three new low of around 88.50 US cents. By the close of business early Saturday morning it was 92.06 (and back to around 91.80 this morning). The currency’s near 4% surge last week wiped out the 4% fall of the week before, after Reserve Bank Governor Glenn Stevens lifted the prospects of the rate cut which we saw last Tuesday.

It is a new reality that the value of the dollar has little to do with the fundamentals of the Australian economy and much to do with offshore sentiment about China, and the progress of its economy. Plenty of analysts have made the point that Australia’a fortunes are firmly joined to China’s, but few have gone on to make the point that this then means we have to accept whatever the value the market places on our dollar. (Our triple A stable credit rating helps drive the currency higher at times, or limits its fall).

“A return to near parity in the next year could make all those worthy forecasts very unreliable and “non core”.”

That huge turnaround in the value of the currency last week came as a surprise to a lot of people, especially after they read the RBA’s quite explicit cheering of the economic joys of a lower dollar.

The bank went as far to put into its Statement on Monetary Policy what’s called a sensitivity forecast?—?that linking the size of the fall in the value with the dollar with economic growth over the following two years. The bank estimated that a 10% fall in the dollar could boost GDP by a half to one per cent over the next two years. Therefore a 20% fall (which is what the Bank apparently wants to see to match the realities of the economy at the moment) could boost growth by one to 2% over the next couple of years.

“Further depreciation of a similar magnitude to that already experienced to date could, for example, deliver above-trend growth sooner than currently forecast,” the RBA said. It predicted that “GDP growth is expected to remain a little below trend at close to 21 per cent through to mid-2014, before picking up to above-trend growth by the end of the forecast horizon as the global economy experiences above-trend growth and the stimulatory effects of the recent exchange rate depreciation and current low level of interest rates lead to an improvement in business conditions and so investment.”

So what happens if the dollar ignores all the forecasts and refuses to fall much further, and instead edges back towards parity? After that 4% rise last week, such a question can’t be ignored by the Federal Treasury or the Reserve Bank. Such a move might be good for inflation, but as we have seen in the past three years of a dollar at or above parity with the greenback, a higher currency will again exert enormous pressures on exporters, retailers, tourism, the budget, tax revenues and consumer confidence.

Kevin Rudd has been warning that our dependence on Chinese economic growth means transitional challenges as Chinese growth flattens out. But if Chinese growth continues to push the dollar higher, the same problems that beset the Gillard-Swan government as it tried to return to surplus and help manufacturing will be encountered by whoever wins on September 7. Bear that in mind when you read about the Pre-Election Fiscal Outlook forecasts tomorrow.

A return to near parity in the next year could make all those worthy forecasts very unreliable and “non core”.

Everyone hopes the RBA’s enthusiasm for a weaker, declining dollar proves to be right. It will solve a lot of problems and alleviate a lot of financial and political pain. If the dollar starts rising and refuses to devalue the way the RBA thinks it will, then the pain will remain.

This article originally appeared on Crikey.


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