Foreign Exchange In November of 2012, the International Monetary Fund (IMF) announced that the Australian and Canadian dollars would be added to its list of reserve currencies. This status is the highest for any currency, and implies that the currency is a very reliable store of value. A reserve currency is backed by a nation's assets, like any fiat currency, but with reserve currencies there are also the conditions of good governance, economic diversification, free float and other such attributes that define the world's strongest and most widely-traded currencies. These are also currencies that are traded widely in their regions -- the Australian dollar is a reference currency in the South Pacific -- and they are held by foreign central banks as part of those banks' currency portfolios. The relative strength of the AUD and CAD has been cited as the reason for those currencies' popularity with central bankers, and also reflects the amount of trade conducted in those currencies (Marsh, 2012).

After it was named as a reserve currency, the Australian dollar went on a run for about six months, adding around 8 cents to its value versus the USD over that period (The Australian, 2013). The new status increased the appeal of the AUD around the world, not just with central banks but with other investors as well. Arguably, Australia faced a worsening external environment during this time, but its currency still gained, which would support the idea that the currency gained on its newfound status. This paper starts its examination of the Australian dollar in September, 2012, when the AUD traded at .955657, over par with the USD, to the end of September, 2015 when the AUD traded at 1.426534 (Appendix A). The graph of monthly rates confirms what these numbers already indicate -- the Australian dollar has fallen almost continuously for the past three years.

Underlying Assets

Any fiat currency derives its value primarily from what people are willing to pay for it, rather than by physical commodities (Investopedia, 2015). Yet this simplistic explanation, as common as it is, misses the point. The currency's value is based on the value of the assets of the country from which it is issued. There are a few reasons for this. First, "what people are willing to pay for it" implies supply and demand, and the demand for a currency is determined by the demand for goods and services priced in that currency. Thus, the stronger an economy, the more valuable its currency will be, all other things being equal. The supply side reflects the country's money supply, which is controlled by the central government. Currencies that are strong enough to be considered reserve currencies are supported by a strong central bank, one that has demonstrated the ability to successfully manage the supply side, and by a nation and government capable of generating demand.

The world's reserve currencies prior to 2012 reflected four major diversified economies (U.S., UK, European Union and Japan) as well as a major trading currencies (Swiss franc). The Australian and Canadian dollars were both currencies of medium-sized, trillion-dollar economies, economies that had a reasonable amount of diversification, but which were primarily considered to be resource economies. Both countries are dependent on resource extraction for their economies, and both are major mining nations. Australia's key assets include coal, iron ore, gold and aluminum, much of which is shipped to China, Japan and South Korea (CIA World Factbook, 2015). The resource sector still drives a substantial amount of Australia's foreign exchange.

The composition of Australia's foreign trade is an important part of understanding its foreign exchange rate.. While the country's GDP has been increasing slowly but steadily, 75% of the Australian economy is in the service sector. Thus, GDP growth is not necessarily an influencer on the exchange rate, if most of the services trade is domestic. The export commodities sector, and to a lesser extent the manufacturing sector, are major contributors to the demand for Australian dollars.

Regional Trade

As is the case with most commodities-based countries, the economy is dependent on demand for key export commodities. Appendix B illustrates the values for the past five years of the three most important export commodities. They are all down, in the case of iron ore substantially so. Knowing that Australia's currency is traditionally seen to be a commodities currency, and knowing that commodities markets are in a prolonged slump, has some explanatory power for the long-run slide of the AUD. The country's major trading partner is China, which...

While economic growth in China is still robust, it has slowed to levels not seen in that country in decades. The overheated property market in China has slowed construction output as many buyers cannot afford real estate, and sluggish exports have resulted in reduced manufacturing. As a consequence, China's economy has slowed, and this has had a negative impact on demand for goods from supplier nations, of which Australia is one of the most prominent (Inman, 2015). This slowdown in China is also having a negative impact on other Asian economies, which form most of the rest of Australia's foreign trade (Pandey, 2015).
If China's slowdown is having such a negative influence on commodity prices, and demand for the AUD is tied to demand for those commodities, then understanding the future of the AUD means understanding the future of Chinese demand. Unfortunately, the conditions that have caused the Chinese economy to slow are persistent and structural. The Chinese central bank is inexperienced at handling these problems -- for example it retains rules against the export of money out of China, limiting people to a maximum of $50,000 per year. By constraining the ability of wealthy Chinese to invest outside of the country, China has created this hyperactive property market within China, as domestic investors seek yield any way that they can get it. There does not appear to be much flexibility with respect to the currency export policies, which are tied to the exchange rate stability of the yuan, something on which much of the country's economic growth is predicated. Thus, China has essentially accepted the overheated property market and seeks some form of "soft landing" for its economy, rather than risk a shock by allowing unlimited capital exports. This structural issue is therefore likely to persist over the medium and long runs, and the current demand levels for commodities are likely to persist in the absence of a new emergent buyer. The outlook for the Australian dollar therefore should reflect the status quo.

Parity

The purchasing power parity approach theorizes that the ratio of domestic prices to foreign prices governs the long-run equilibrium exchange rates. The hypothesis, as outlined above, is that the current rates are at the long-run equilibrium, based on trade flows. The text notes that "although PPP seems to possess a core element of common sense, it has proven to be quite poor at forecasting exchange rates." The book explains that this is because PPP assumes that only the difference in prices of goods matters for exchange rates, not the other factors that contribute to the relative demand and supply of a given currency. Nevertheless, taking the prevailing f/x rate and the prevailing inflation rates of Australia and the United States and applying them to the PPP formula, we get the following:

1.4265 * (1.025/1.002) = 1.4592

Because the inflation rate in Australia is higher than the inflation rate in the United States, the PPP approach predicts a continuing decline in the Australian dollar. This condition will continue until there is a change in these inflation rates. U.S. exchange rates are likely to remain suppressed, but so are Australian rates. The difference is that while the Federal Reserve has kept its target rate near zero, the Bank of Australia has some room to lower its rates, should it so desire. The current target rate for the Bank of Australia is 2%, and that is propping up inflation. The Bank of Australia actually has a preference to increase its rates in the coming months, but has refrained from doing so mainly to keep its policy of holding steady in line with that of other major economies (Stevens, 2015).

Balance of Payments Approaches

The balance of payments approach is more in line with the idea that supply and demand for a currency dictate its exchange rates. When the net inflow of foreign exchange is greater than the net outflow, that reflects a situation encouraging the increase of a currency's value. The balance of payments theory has explanatory power for Australia, in that as commodity prices decline, the country's balance of payments will deteriorate. It is still reliant on Chinese manufactured goods, and foreign sources of oil (Australia imports over 400,000 bbls of refined petroleum products per day), and that has not changed with the demand for other commodities, even if the value of the petroleum has declined.

The balance of payments approaches hints that as long as China's economy continues to…