Exporters welcome a lower currency because, all else equal, it improves their competiveness abroad, but the size of the benefits differ among exporters. Agricultural exporters are the largest beneficiaries of a weaker exchange rate; the effect on mining is less pronounced.
Australia’s trade weighted index (TWI)—which tracks the AUD’s performance against a basket of major trading partner currencies—is down 20% since its peak in July 2011, led by falling commodity prices and the stronger USD.
Over the same period, the real TWI fell by 13%. This index adjusts for inflation in Australia and its major trading partners, to give an idea of the combined impact on competitiveness of the exchange rate and inflation. The smaller fall occurs because Australia has higher inflation than its trading partners.
The weaker currency, if it persists, will benefit exporters. Using the historical relationship between export volumes, trading partner growth and the real exchange rate as a guide, we find that, all else equal, a permanent 10% depreciation in the real exchange rate potentially lifts export volumes 5 ½ % (Chart 1) within three years (Chart 2). But magnitude and timing differ across export industries.
The homogeneity of agricultural exports and stiff competition from exporters in Brazil, the US and Europe make Australia a price taker in world agricultural markets. And this in turn means the exchange rate plays an important part in maintaining farm competiveness. Our model suggests a 10% fall in the real exchange rate could lift farm export volumes 7% over time (Chart 1).The boost is felt more quickly than for most other export industries with the weaker exchange rate completely passing through to stronger agricultural exports within 12 months of the depreciation (Chart 2). (1) This is probably due to the shorter inventory cycle and perishable nature of most agricultural exports.
The weaker Aussie also provides a significant boost to service exporters. Our model predicts that the 10% decline in the real exchange rate will boost service exports almost 7% with adjustment complete within 4 ½ years of the initial fall in the exchange rate (Chart 2).
Tourism and education are Australia’s main service exports, both of which have come under pressure from the high Aussie over the last five years. Granted there are factors besides the exchange rate that influence where individuals holiday or study (eg. rising per capita income in China – see Emerging Asia presents opportunities for agriculture and tourism at the end of article). Nevertheless, significant movements in the exchange rate do alter the cost of visiting Australia and thereby tourist and foreign student numbers (Chart 3).
Notice that our model tends to understate the boost to service exports from depreciation. This is because it scrutinises export data that overlook Australian businesses based abroad that deliver their services in market. For example, an Australian university with a campus in Vietnam educating local students would not be counted in the service export data. But like Australian-based service exporters, it would gain from a weaker AUD through a lift in the AUD value of its Vietnamese earnings.
Manufactured export volumes are highly responsive to exchange rate movements. Our model suggests a permanent 10% decline in the AUD would lift volumes almost 7% over time. The importance of the exchange rate is confirmed by numerous surveys, with over 60% of manufacturers citing the elevated currency as a significant barrier to exports; compared to 40% of mining exporters.(2)
Arguably manufacturing exporters receive less of a boost from a weaker exchange rate now than two decades ago. This is because the import content of their products is now higher, thanks to the globalisation of supply chains. With higher import content in exports, they now face roundabouts as well as swings. Their AUD revenues receive a boost from the weaker exchange rate, but their import costs rise as well. As long as the value of their exports exceeds the value of their foreign inputs, they will experience a net gain. But this net gain is lower than it would be if it sourced all inputs domestically.
How big is this effect? Australia’s import penetration in manufacturing has increased from 25% in the mid-1980s to 35% in 2010. (3) The higher import content would explain why the fall in the exchange rate initially has a negative effect on export volumes in our model. But over time the weaker AUD starts to lift the competitiveness and profitability of manufacturing exporters. Full adjustment from depreciation takes almost 6 ½ years (Chart 2).
Australia’s softer manufacturing productivity growth relative to the US and Asia has also weighed on Australia’s competitiveness (Chart 4). The weaker Aussie that prevailed before the commodity super-cycle got underway in the early 2000s partly offset low productivity growth. Regrettably, the stronger currency over much of the last decade has not been offset by stronger productivity growth.
As such the recent depreciation of the Aussie will be particularly welcome relief for manufacturing exporters. PMI data suggest the benefits of the weaker currency are already starting to flow through to manufacturing exports (Chart 5).
For minerals, the benefit of 10% currency depreciation is an eventual 4% expansion of volumes. This is smaller than for other export industries and takes around 7 ½ years to flow through, the longest of any sector, reflecting the longer resource investment cycle. The commodity super cycle in the early-2000s drove higher resource investment as firms tried to capitalise on elevated commodity prices. But the significant lag between investment and production has meant mines have only been able to ramp up exports over the last three years.
The slowing Chinese economy combined with oversupply in most commodity markets has put downward pressure on commodity prices. Even so, we expect volumes will remain robust as low cost miners boost production by opening new mines to maintain market share and force high cost producers out of business.
All things considered, the real currency depreciation that has followed the downturn in the commodity super-cycle should buoy non-resource exports considerably. They should also receive a boost from rising per capita income in ‘Chindia’ – particularly agricultural exporters and tourism operators.
Emerging Asia presents opportunities for agriculture and tourism
Australian sends 70% of its agricultural exports to Asia and as the region gets richer, households will consume higher quality produce. The following chart suggests that as household incomes in poorer countries rise, their consumption of proteins increases rapidly. In populous China and India, rising incomes and an expanding middle class are expected to increase demand for proteins and quality produce, presenting opportunities for Australian exporters of raw and processed agricultural goods.
China is our largest service export destination. The 32% depreciation of the AUD against the yuan since July 2011 has supported Chinese visitor arrivals, which have grown 15% p.a over the last three years. China was the largest consumer of tourism services globally in 2013. But the number of Chinese travellers relative to the overall population remains low. Rising Chinese incomes and a correspondingly expanding middle class suggest the number of Chinese tourists will rise rapidly, providing a boon to Australian tourism over coming years.
Our model assumes export volumes are a function of trading partner demand and the exchange rate. Using a model of real export volumes by sector, trading partner growth (weighted by trade) and the real exchange rate we were able to estimate long run ‘elasticities’, showing the responsiveness of export volumes to real exchange rate changes. The model was estimated in log levels using fully modified least squares. After we estimated the long run relationship for each export industry, the next step was to embed it into a model of short run dynamics to quantify the adjustment period. We used an Autoregressive Distributed Lag model consisting of lagged differenced terms of trading partner GDP, the real exchange rate and export volumes. The following table shows the coefficients from each of the export regressions.
Fred Gibson, Economist
(1) Chart 2 measures the speed at which export volumes adjust to a 10% fall in the real exchange rate. For example total export volumes take less than 3 years to rise 5.5%—put another way it takes less than 3 years to achieve 100% pass through.
(2) Data from forthcoming 2015 AIBS survey
(3) Our model suggests that exports were twice as sensitive to currency movements between 1985 and 1994, although this was not statistically significant.