May 1990

EXCHANGE RATES AND AUSTRALIAN COMMODITY EXPORTS

by

Kenneth

w.

Clements

Economic Research centre The University of Western Australia and John Freebairn centre of Policy studies Monash University

PREFACE

This paper is the introductory chapter of K.W. Clements and J. Freebairn (eds) Exchange Rates and Australian Commodity Exports. Melbourne and Perth: Centre of Policy studies, Monash University, and Economic Research Centre, The University of Western Australia, 1990. The contents of and contributors to the book are given in the appendix of the paper.

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Events of recent years once again have highlighted the volatility of prices for agricultural, energy and mineral commodities, the volatility of nominal and real exchange rates, and the importance of fluctuations of these

variab~es

for the Australian economy.

Prices of most commodities often rise or fall at least 20 per cent and sometimes by more than 50 per cent within a year. large fluctuations of exchange rates, not just of the $A relative to other currencies but also between the currencies of the major trading blocks, have been key features of the 1980. What are some of the reasons for this volatility, what are the future prospects and what action and decisions can be taken by businesses and governments to modify adverse effects and to capit.alise on opportunities in the future?

The papers in this volume analyse a number of interrelated questions about Australian commodity prices and the exchange rate. While there remains much that is little understood, there is evidence of important linkages between commodity prices and exchange rates, and vice-versa. The papers investigate old and new ways of explaining past movements and current levels of these variables. With this background, some of the papers proceed to assess the outlook for the production, export and prices of important Australian commodities and for the real exchange rate. Attention is drawn to ways in which business and government can make more effective use of available knowledge on interrelationships between commodity prices and exchange rates in improving their decisions.

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Overview of the Papers

It seems to be conventional wisdom that if world commodity prices were to rise by, say, 10 percent, then the Australian dollar will appreciate by about 5 percent. Thus, in terms of domestic currency, Australian exporters benefit by only about a half of the world price increase. As this could be expected to work in reverse for a fall in commodity prices, it can be seen that the co-movement of the $A and commodity prices serves to buffer exporters. According to this model of the behavior of the exchange rate, the $A can be described as a commodity currency. John Freebairn investigates the extent to which the commodity-currency model applies to the $A and its economy-wide implications.

To set the scene for this investigation, Freebairn first articulates the workings of the commodity-currency model. In its simplest form, a boom in world prices leads to a current account surplus and to a boost in domestic spending due to the increased incomes of exporters. This higher demand leads to an increase in the prices of nontraded goods which flow into the overall price level. Consequently, the initial boom in world prices leads to an appreciation of the $A due to the current account surplus and to a rise in Australia's rate of inflation. These two effects restore external balance via a loss of competitiveness or a real appreciation of the $A.

As Freebairn points out, an important extension of this simple model is to allow for forward-looking behavior whereby expectations of future commodity prices are paramount. If it were widely believed 4

that the boom were only temporary, then it may be that a good part of the initial current account surplus would be saved in the form of foreign assets. These assets would then be available to be drawn upon to smooth consumption in those years when commodity prices slump. This type of savings behavior would, of course, lead to the $A being less of a commodity currency. In Freebairn's view, while these aspects are no doubt important, they do not completely eliminate the co-movement of the $A and commodity prices.

Freebairn then shows that the evidence, both direct and indirect, supports the view that the $A is a commodity currency (modified for the role of other factors). The paper finally analyses the implications of the model for profitability in different sectors of the economy. As all sectors are shown to be linked to commodity prices by one means or another, this analysis clearly illustrates the .fundamental importances of these prices to the Australian economy.

John Brunner' s paper analyses world trends in the demand for metals and energy. He focuses on the concept of metals (and energy) intensity, that is, metals consumption per unit of GDP or the growth in metals consumption relative to GDP growth.

In the industrialised countries, metals intensity has been falling since the mid 1970's. Brunner argues that for industrialized countries GDP must grow by at l.east 3 percent per annum if metals consumption is not to fall. This is needed to offset an underlying downward trend due to the shift in the structure of consumption patterns towards services which have low metals intensities and

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to the use of lighter metals together with the substitution of plastics etc. for metals.

The situation in developing countries is different. Their lower per capita incomes lead to higher metals intensities than in industrialized countries. In developing countries there is a positive underlying trend in metals consumption. Brunner uses the experience of the

us

and South Korea over the last 10 years to

illustrate the contrast in metals intensity between developed and developing countries.

Brunner' s overall assessment of the future prospects for Australian mineral exporters is, however, one of quite good prospects. Nearby developing countries will provide rapidly-growing markets; and for some minerals there is real scope to increase Australia's market share.

Brunner also notes that Australian mineral exporters have been disadvantaged by our exchange rate. In real terms, the =rencies of competitor countries depreciated substantially over the 1980s. For example, the =encies of Chile (a copper exporter) and Indonesia (aluminium, tin, coal, oil and gas) both depreciated by more than 60 percent over the decade. By contrast, Australia's real exchange rate was about constant over.this period. Brunner points to the increased competitiveness for the minerals industry of lowering our real exchange rate.

The situation for world energy intensity and demand growth 6

is much the same as for minerals.

Ray Trewin and Paul O'Mara highlight the i!lilact of the macroeconomic

environment on Australian commodity exporters. In addition to factors specific to individual markets, they point to the important role of the general state of the world economy on commodity prices. They argue that international co-ordination of macro policies is required to ease current account imbalances and avoid the mounting protectionist pressures. If this co-ordination does not take place, Trewin and O'Mara predict a lowering of annual OECD growth by 1 to 2 percentage points per annum, and this lower growth in turn would lead to a 6 percent fall in commodity prices over a two-year period and a 10 percent fall over the medium term. It is to be emphasised that this is only a •worst case' scenario, one which the authors think unlikely.

They predict a modest fall in OECD growth to 3 percent per annum and that growth in China and S.E. Asia will remain strong. They also forecast Australia's real exchange rate to be considerably lower than its value in the early 1980s, which would maintain the competitiveness of exporters.

Trewin and O'Mara present the following outlook for Australian commodities. A continuing long-term downward trend in world prices in general, this downward trend will be ameliorated for Australian producers by a weaker $A. Rising export volumes, particularly for minerals and

energy. A recovery in rural exports in 1990-91. A

continuing dominance of livestock in the 1990s due to improved 7

market prospects in Asia and the US. A positive long-term outlook for mineral and energy exports; over the next 5 years the main sources of increases in theo:;e exports will be LNG, coal, uranium, aluminum, iron ore, and zinc.

The Trewin and O'Mara paper also reviews a number of recent explanations of the large depreciation of the $A in the mid-l980s. These explanations include long-term factors such as the current account deficit, foreign debt and the terms of trade and short-term phenomena like overshooting, risk premia and speculative bubbles. Trewin and O'Mara conclude that long-term factors could account for only a little over one half of the 35 percent depreciation. This may help explain why the $A has been strengthening over the last couple of years.

Larry sj aastad 's paper presents a new model for pricing internationally-traded commodities. It emphasises the role of changes in real exchange rates between the major trading blocks of the us, Western Europe and Japan in determining world commodity prices. Thus the large and sustained variations in real exchange rates that have occurred in recent years are seen as being an important part of the explanation of unstable relative commodity prices.

In essence, Sjaastad's model works as follows. Suppose the Australian dollar depreciates in real terms against all the major currencies by 10 percent. As this raises the returns of Australian exporters they would take advantage of the opportunity by producing and exporting more. If Australia has no "market power" in a particular 8

product, then world prices for this product remain unchanged and Australian producers receive a 10% price increase. However, if it has 'market power' in the world market, for example the case of wool, then these additional exports depress the world (or foreigncurrency) price. Consequently, the depreciation has the effect of increasing the price in Australian dollars, but by less than 10 per cent, and depressing the world price. When converted to a common currency using the prevailing exchange rate, arbitrage ensures that foreign and domestic wool prices are approximately equalized (purchasing power parity). Consequently, the 10 percent devaluation means that the sum of the price increase at home and the price decline abroad is also about 10 percent.

Changes in third country exchange rates can also have important implications for returns to Australian exporters. Suppose for the purposes of illustration that Germany has substantial market power for gold and that Australia has none. Then an appreciation of the Deutsche Mark against the American dollar will increase gold prices in $US (and lower them in DM). If the $A remains unchanged vis-a-vis the $US, Australian gold producers will have gained; they have gained from what may appear to be a phenomenon originating in the us, but in truth it is the Germans who are responsible. This example illustrates the general principle that producers of a commodity dominated by a country whose currency appreciates will be better off, and that producers of a commodity dominated by a country whose currency depreciates will be worse off.

sjaastad's empirical results deal with the macroeconomic 9

implications of the framework for Australia and the determinants of the prices of four major Australian exports, viz. coal, iron ore, wool and wheat. The macro results highlight the role of foreign influences on inflation in Australia as well as showing that the $A was substantially overvalued in the second half of 1989. The individual commodity results are generally supportive of the model. The

us

and Australia are found to dominate the world markets for

coal and wheat; for iron ore the

us

dominates; and for wool it

is Australia which dominates. The controversial finding, however c is the relatively minor role played by Japan in the markets for coal and iron ore. This is in contrast to the widely-held belief that the Japanese at times, have used this dominance . dominate and, . to squeeze Australian producers. on the other hand, if Japan truly has only a minor influence, this would be a finding of major importance, one that would have implications for price negotiations between Australian producers and the Japanese.

No

doubt, the role of Japan

will be examined further in future research.

Acknowledgements

Preliminary versions of the papers in this volume were presented at conferences held in November 1989 which were organised by the Economic Research Centre, University of western Australia and the centre of Policy Studies, Monash University. We are grateful to the following people who helped with the conferences: Linda Batey, Chris de Fries, Mark Duncanson, Hazel Ramsden, Silvia Schauer, Jan Smith and Kate Spooner. In addition, Louisa Towie, Hazel Ramsden 10

and Glenys Walter assisted with the preparation of the papers for publication. We also acknowledge with gratitude i:he generous financial support of the Minerals and Energy Research Institute of WA, WA Chamber of Mines and Energy, WA Fanners Federation and the Confederation of WA Industry.

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APPENDIX

TABLE OF CONTENTS

1.

Clements, K.W. and J. Freebairn.

2.

Freebairn, J.

3•

Moy, P.

4.

Brunner, J. "World Demand for Minerals Under Conditions of Declining Intensity."

5.

Meaton, M.

6.

Trewin, R. and P . o 'Mara. "Commodity Exports and the Exchange Rate: ABARE Outlook and Research."

7.

Hooke, G.

8.

Sjaastad, L.A. "Exchange Rates and Commodity Prices: The Australian Case."

9.

Snape, R.H.

"Introduction."

"Is the $A a Commodity Currency?"

"Comments on Freebairn."

"Comments on Brunner."

"Comments on Trewin and O'Mara."

"Comments on Sjaastad."

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THE CONTRIBUTORS John BRUNNER was Chief Economist at BHP for many yars and now lives in Perth. Kenneth CLEMENTS is Professor of Economics and Director of the Economic Research Centre at The University of Western Australia. John FREEBAIRN is Deputy Director of the centre of Policy studies at Monash University. Gus HOOKE is Director of Research at the National Farmers Federation. Murray MEATON is Director of the Royalties and Policy Development Division of the W.A. Department of Mines. Paul MOY is Chief Economist at the Confederation of W.A. Industry. Paul O 'MARA is Assistant Director of the Economic Policy Analysis Branch of the Australian Bureau of Agricultural and Resource Economics. Larry SJAASTAD is Research Associate at the Economic Research Centre, The University of Western Australia, and Professor of Economics at The University of Chicago. Richard SNAPE is Professor of Economics and Chairman of the Department of Economics at Monash University. Ray TREWIN is Senior Economist at the Australian Bureau of Agricultural and Resource Economics.

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