The Complex World of Fixed Interest
October 28, 2014The Australian dollar has been accused of inflicting all sorts of economic ills as it traded above US$1 for most of the past three years.
People would be forgiven then for thinking that the dollar’s drop from its post-float record high of US$1.10 in 2011 to below 90 US cents will be a big relief. Alas, it’s not so simple. As with most things economic, there are pluses and minuses whatever the value of the Australian dollar. Those who whinged about the “overvalued†Australian dollar crushing exports overlooked its benefits. They may well be the ones who moan loudest about a falling dollar. One upshot of a declining dollar is that it reinforces one of the most basic principles of investing – diversifying.
There are two main benefits of a mighty dollar. The first is that a higher currency, in effect, means that every Australian has had a pay rise. For a stronger dollar allows us to buy more imports. This is the mechanism by which all Australians benefited from the mining boom. The second benefit is that a rising currency reduces inflationary pressures as the prices of imports decline in Australian dollars. That allows the Reserve Bank of Australia to set interest rates at a lower level than otherwise.
In theory, a lower dollar helps Australian exporters (and adds to output) because our goods are cheaper for foreigners. This is the break exporters have been pleading for, even if in practice exporting is more complicated than just hoping the currency drops a bit.
We may not want our dollar to fall too far too fast, however, as side effects emerge. These disadvantages are, in fact, the opposite of the advantages of a rising dollar. Inflation could emerge as a threat if the dollar slumps too much. That would mean higher interest rates. Ouch for those with home loans. Some businesses might scrap plans to invest, thus lowering employment prospects.
Bad as that might be for many, the big hit for all of us from a lower dollar is that we have effectively just had a pay cut as import prices go up.
This hit to living standards from a declining Australian dollar forms one of the most basic cases for why Australians should invest in foreign assets such as equities. If your portfolio only holds Australian assets, your ability to purchase imports drops in line with the dollar’s decline. If you own some foreign assets, however, the value of these foreign investments rises in Australian-dollar terms when our dollar drops. This mechanism compensates, to some extent, for your reduced ability to buy imports. In more technical terms, it’s called diversifying currency risk.
Financial information comes from Bloomberg unless stated otherwise.
Source: Fidelity, May 2014