Lunch still costs (FX intervention edition)

There is a lot of soft headed piffle that’s published on the subject on the Australian Dollar. This week’s article by the Australian’s David Uren is a rare exception.

In particular, Uren is the only popular pundit I have seen who points out that RBA sales of the AUD are not cost less. This is an important point.

IF the RBA were to sell the AUD, they would exchange high-powered money (reserves) for foreign currency. In the trade, the RBA’s counter-party would obtain an AUD deposit at some clearing institution, and the RBA would obtain a foreign currency deposit at some clearing institution.

While the RBA has unlimited ability to supply Australian Dollars, the transactions create a ‘cost’ for the Bank – in the form on interest bearing deposits at the RBA.

Like all central banks, the RBA’s balance sheet must balance (see here so the AUD reserves it creates to pay for the foreign exchange it purchases on the open market must re-appear as deposits at the central bank.

These reserves cannot leave the system. The central bank’s balance sheet must balance, so they must re-appear as a deposit at the central bank, in the form of exchange settlement balances (by the way, this is why it is total nonsense to look at Fed and ECB deposit balances and declare that the balance sheet expansion isn’t being lent). Thus, they ought to be thought of as a loan from the banking system.

The RBA has the privilege of choosing the rate it pays on those liabilities (that’s what’s so special about central banks), so it has some control over this cost – however it can only move this rate in a way that’s consistent with its inflation target. Appreciating this is what distinguishes the Swiss and Australian cases.

Before the SNB started selling CHF, it first lowered its cost of funds to zero to fight deflation. Once that step had been made, it had access to zero nominal interest rate loans – and it used this cash to buy foreign exchange (and ultimately, foreign bonds).

In executing this policy, the SNB purchases EUR at the 1.20 ‘cap-rate’, which is 0bps loan from the CHF banking system, and invests in foreign assets. It is hoping to make a profit both from the positive carry (the difference between their cost of funds, and the yield on the asset they purchase) and FX gains when the foreign exchange value of the CHF eventually declines.

What’s its risk? That the EUR collapses, and the bonds it is purchasing are not repaid in full; and that it becomes appropriate to allow the foreign exchange value of the CHF to rise.

In Australia’s case, the RBA would be selling AUD with a cost of funds of 25bps below the target overnight cash rate. Assume for the moment that the RBA’s policy rate is steady at 3.5% (a weaker AUD would mean that there is little prospect of further rate cuts), and that the RBA needs to sell about 500bn of AUD to make a meaningful impact.

The RBA is likely to purchase a mix of highly rated foreign Bonds with about a 5yrs maturity — on that portfolio it would be lucky to earn an annual yield of 1% per annum.

If this were the case, the RBA would be paying 3.25% on 500bn (~16.25bn per annum), and earning 1% on the amount (~5bn per annum) – for a total cost of 11.25bn per year.

Who pays this? The Australian Taxpayer — for the RBA’s balance sheet forms a part of the Australian Government’s consolidated accounts.

And that’s not the final cost to the tax-payer — most taxpayers are net importers, and the weaker value of the AUD would lower their real consumption wages.

In reality, this policy would be a huge tax on Australian households – for the benefit of a narrow range of exporters. And once we re-open FX intervention as a policy option, I guarantee that we are going to have to re-open tariffs, quotas, and other trade subsidies – for the losers from interventions to move the foreign exchange value of the AUD will certainly be looking for ‘compensation’ from the Treasury.

A free float and free(er) trade have served us well. It would be a grave and costly mistake to re-open this Pandora’s box.

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16 Responses to Lunch still costs (FX intervention edition)

  1. Manny says:

    Nice post.

  2. On your Marx says:

    yeah agree on that and the major premise.

    Let the market solve the value of the $A

  3. ssec says:

    Yes, very nice post …. and a nice subject!

    What about printing money to pay for that 11.25bn ? It’s inflationary, yes…. but inflation is not a problem right now? Printing could be the alternative to cutting rates? Interest rates around the world are in an exceptional situation that may require exceptional measures.

    I am wondering why direct FX intervention is considered such a dogma… can it be considered just another monetary tool?

    “for the benefit of a narrow range of exporters”…. I think you are really underestimating this. Just this week the average salary figures were published by the ABS, and if I recall correctly they printed at 73k for the average full time worker… now convert this amount into any other currency in the world, and tell me how Australia is supposed to be competitive? And housing? And the share market? (it still hasn’t recovered after GFC becuase of the high dollar). Just let the high dollar run for another few years to fully appreciate its full impact! Nothing is free! :)

    cheers

    • Ricardo says:

      Yep, they sure could just print to pay the interest, and that is an alternative to cutting rates -but obviously if they stick to their 2.5% inflation target that delimits the boundaries of this policy option. That is the key difference between our case and the swiss case – the RBA’s inflation mandate limits their ability to do this whereas the SNB’s mandate pressed them into action.

      It is worth noting that having a high cost of funds does not mean you must use rates: brazil, for example, was recently a big seller of real to buy USDs when their coat of funds was double digits and USTs yielded low single digits. They also used taxes to partially close their capital account.

      I think staying out of FX intervention is a good plan, because it re-opens allthe trade and assistance questions that we know from recent history /experience that politicians and the public service are so bad at managing in the National Interest.

      I think the other reason that central banks like floats is that it permits them fairly free use of interest rates. And rates are a target they can hit. Fixing the FX and letting rates float is a much harder task…

      • ssec says:

        I think anyway that we are at the top of AUD appreciation and at the bottom of USD and EUR depreciation. The signs are all there. The question remains how long we’ll be staying up here.

        Some other exporters in a bit of trouble (not only due to high AUD):
        http://www.adelaidenow.com.au/news/education/international-students-desert-south-australia/story-fn3o6nna-1226442576410

      • ssec says:

        Yes, I think both the EU, but especially the US, will find / have found a bottom, and the high AUD plus China slowing will keep a lead on Australian economic performance. Short AUD + long ASX is my medium-term bet. I would be very surprised if AUD can break above 1.10 vs USD or go under 1.15 vs. EUR

        • Ricardo says:

          A sound / reasonable view. I think the Euro recession deepens and spreads and that the AUD rallies further as a result, revisiting the 1.12 range top.

      • ssec says:

        Simple naked shorting of AUD is too risky… the medium play is to short AUD and go long ASX200…. usually they both go up in tandem, but the balance will shift in favor of ASX200 IMO. And in a major crisis, they will both fall, but AUD will fall faster. So to clarify my market position is long ASX200 / AUD. cheers

        PS please keep these interesting FX posting coming!

        • Ricardo says:

          Seems like a decent trade idea. Without looking carefully, my gut is to underweight the FX leg at this point. I feel like this risk on move is going to push PEs higher, and lift the AUD. Call it a global reach for carry.

  4. Pingback: @thekouk, the SNB, and Carry… (more on FX intervention) | ricardian ambivalence

  5. Of course it’s true that there is a cost involved printing money to buy foreign currency. But the RBA has done pretty well out of their intervention in the past, picking when the AUD is under or overvalued. Remember, if the RBA sells AUD high, and buys low at a later time, it makes money.

    An overview here http://www.rba.gov.au/publications/rdp/2004/pdf/rdp2004-06.pdf

    And I think you are confusing money cost with opportunity cost. When we look through the veil of money, the Australian taxpayer only pays through inflation – which is currently below the target level in any case. If the RBA makes a loss, well, it makes a loss. The policy outcome is a lower FX rate, which hopefully preserves a more diverse production base.

    I guess the flip side here is to ask if there is a AUD exchange rate that would worry you? Say USD$2.00? Surely a high dollar has its own costs on the taxpayer, in terms of our inability to improve the external accounts?

  6. b_b says:

    Wrong wrong wrong!

    The RBA is a monopoly currency issuer and as such financial losses are irrelevant. Just like any individual who had the power to issue his / her own currency, a financial loss can be corrected with a couple of keystrokes on a computer.

    By being a slave to “efficient markets”, the RBA is blithly standing by and watching Australia export production to other countries at the expense of its own citizens. And you think this is ok because otherwise the RBA may make a financial loss?

    Truely bizzare!

  7. A couple of points.

    1. The RBA has intervened many times, and did so during the financial crisis to arrest the fall in the AUD when it reached USD$0.60. Was that a mistake?

    2. If the RBA sells the AUD high, and buys low, doesn’t it actually make a profit? Do you expect the AUD to stay at this level of higher for an extended period (say >5years?) THe evidence seems to be that the RBA has been pretty good at making money from FX intervention, even when they defended highs around USD$0.80 – what’s changes in the past 20 years to justify a 40% higher currency?

    http://www.rba.gov.au/publications/rdp/2004/pdf/rdp2004-06.pdf (RBA made $5billion from its FX interventions since the float).

    3. You confuse money costs with opportunity cost. The balance sheet of the RBA, and hence the government must balance, but like money itself, it is a mere tool for implementing policy goals. The costs involved, in terms of actual resources and opportunity cost, aise from any inflation – which is at historic lows.

    4. You ignore any costs that arise from our external position. If we measured Australia’s economic performance with a national balance sheet you might find that running perpetual CADs is costly. So which cost is greater – the one we might risk intervening in FX markets, or from selling off more domestic assets?

    5. IF the AUD was USD$2.00 would you still be happy with the “market” outcome? Or are we just arguing about the degree of market failure?

    6. if FX intervention is so costly, why is everyone (Swiss, China, US etc) trying to devalue their currency? Surely external account imbalances need to be considered.

    7. If the RBA makes a loss, can they write-off the debts to themselves? Is there a law/regulation prevention this?

    I genuinely would like your answers and opinions.
    Cam

  8. Pingback: FX Intervention QnA | ricardian ambivalence

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