Monthly Market Reports

November 2012

29 November 2012

This month we look at the impact that changes in foreign exchange (FX) rates have upon Australian woolgrowers, and we provide some insights into the future of the key FX rate comparison for Australian growers – the value of the Australian dollar against the US.

The importance of the AUD:USD foreign exchange rate

Since more than 95 per cent of the Australian wool clip is exported and ends up being consumed outside our borders, ours is an industry very exposed to fluctuations in our currency exchange rates – much more so that the sheep meat industry, for example, where about half of the product is consumed locally. And since most export contracts are denominated in US dollars (USD), one can argue that the true value of the Australian clip is its USD value – this is what the world pays for our wool.

Impacts of FX on our wool industry

Changes in the strength of the Australian dollar against the US dollar affects the returns to growers in a particular way. In general, a weaker Aussie dollar (e.g. a falling AUD:USD FX rate) acts to strengthen local Australian wool prices. In contrast, a stronger Aussie dollar (e.g. a rising AUD:USD FX rate) weakens local Australian wool prices.

When the Australian wool stockpile was finally acquitted in July 2001, the AUD was worth 52 US cents. A decade later, the AUD is worth around 104 US cents – a doubling of the strength of the Australian currency. This has had a profound effect on the price of wool received by Australian growers – largely hiding from their view the slow growth (5-8% per annum) in value of Australian wool on the international market post stockpile.

The following chart illustrates the point, showing the historical Australian EMI in AU (red line) and US dollar (blue line) terms since July 2001, but also a hypothetical AUD EMI if the AUD had stayed at 52 US cents since July 2001 (green line).

In short, if the AUD remained at 52 US cents today, the Australian EMI would theoretically be around AUD20 per kilogram clean!

Now, while it is rather nice to daydream about a 20-dollar EMI, the point of the exercise is to illustrate an important point – that the fortunes of our industry in Australia over the coming years depend in part on what happens to the strength of our currency. For this reason, it is important to understand what drives the strength of our currency.

What drives the AUD:USD exchange rate?

In a nutshell, the two major influences on our currency are (1) our terms of trade, and (2) the difference between our local interest rates and those in economies underpinning the major global ‘reserve’ currencies (the USD, and the Euro). Of these, our terms of trade are the most important.

When an economist speaks of our ‘terms of trade’, what is being referred to is the total value of the goods and services we export, compared to that which we import. During the past decade, Australia’s terms of trade have climbed steadily on the back of booming resource sector, and as a consequence, the value of the Australian dollar has risen. The following chart illustrates the point – since June 2001, there has been around a 96 per cent correlation between our terms of trade and the AUD:USD FX rate.

The second major influence are interest rate differentials – the difference between the reserve bank bond rates of the US or Eurozone, compared to ours.

Under the current global market conditions, a general trend is that currency investors are seeking to diversify their portfolios away from the EU and US. Currently, the European Central Bank rate is 0.75 per cent per annum, and the US Federal Reserve rate is at 0.25 per cent, as the central bankers try to stimulate economic growth and reduce systemic risks. By comparison, the Reserve Bank of Australia rate is 3.25 per cent with AAA investment rating. This significant interest rate differential has led to an increase demand for the Australian dollar, due to strong capital inflow into the safer investment of Australian government bonds (the so-called ‘carry trade’).

What does this mean for growers?

The general view among forecasters is that the decade of rapid strengthening of the AUD is now behind us, and the coming years will see the AUD:USD FX rate plateau, or decline. Our expectation is that AUD:USD FX rate will remain around $1.03-1.05 for the remainder of 2012/13 financial year, before slowly softening below parity over the following years.

For Australian woolgrowers, the likely plateauing of our currency against the USD will have a very positive impact over the coming decade – at the very least, the underlying upward trend in wool prices, driven by the emergence of affluence in countries such as China, will be far more tangible.

Paul Swan and Allan Wang