Photographer: Prashanth Vishwanathan/Bloomberg

Aussie Devaluation Best for RBA in Extreme Scenario, Eslake Says

  • Veteran economist says lowering long-term rates less relevant
  • Best step would be buying foreign bonds with new money: Eslake

Devaluing Australia’s currency would be the best option for the central bank if conventional monetary policy reached its limits, according to Saul Eslake, a veteran economist of the nation’s financial markets.

Australia’s advantage is that its dollar is largely irrelevant in a global context, so targeting a lower level shouldn’t draw the magnitude of opposition that a bigger developed economy would, according to Eslake, who has previously studied the concept of quantitative easing in Australia. By contrast, even the potential for Japanese currency intervention this year already stirred U.S. and European opposition.

“It’s likely that no other central bank -- except perhaps New Zealand’s -- gives a stuff about what happens to the Australian dollar, ” Eslake said. “Australia isn’t a major trading partner for anyone else, except New Zealand. And the Reserve Bank of New Zealand may well choose to match what the RBA does, if market forces don’t push the New Zealand dollar down in parallel.”

News that the Reserve Bank of Australia has studied the experience of counterparts in conducting unorthodox monetary stimulus has put a new focus on potential options for the RBA, in the unlikely event of having to take such steps. RBA Assistant Governor Christopher Kent said in an interview with Bloomberg that the central bank favors a multi-pronged stimulus -- using various unconventional policies simultaneously -- rather than one in isolation.

While the RBA still has room for traditional interest-rate cuts, with its benchmark at 1.75 percent, markets see a better-than-even chance of another reduction next month and some economists forecast a 1 percent rate as early as the second quarter of 2017. Deputy Governor Philip Lowe -- who will take the RBA’s helm in September -- indicated in 2012 that lowering the rate on its own would lose effectiveness as it approaches 1 percent.

For more on the RBA’s thinking on unconventional monetary policy, click here.

Not only has Australia been able to learn from the successes and failures of QE and other policies adopted by foreign counterparts, but more importantly it’s been able to to think about what might work in local circumstances, said Eslake, who has served as an economist at a number of investment banks, starting in the 1980s.

“QE has been most successful in getting long-term interest rates down to lower levels. That matters in economies where a lot of borrowing is done at long-term rates,” as in the U.S. and Europe, he said. “This is less relevant in Australia because very little private sector borrowing is done at long-term rates.”

Low Yields

Moreover, Eslake noted, Australian long-term rates have already fallen to record lows without the RBA having to do any QE, because of the impact of such policies in other parts of the world -- pulling down rates abroad and stoking demand for higher-yielding Australian bonds.

While balance-sheet expansion via securities purchases was one policy the RBA had assessed in its studies, it noted that the local government bond market wasn’t large. The Australian market is less than the size of its gross domestic product, while Japan has more than double its GDP outstanding.

In the event the RBA reached the limits of conventional policy and the government wasn’t prepared to use fiscal stimulus, Eslake’s preferred option would be for the bank to buy foreign bonds paid for with newly created Aussie dollars. 

Foreign Bonds

“This would be very similar to what the Federal Reserve or the Bank of Japan have done, with the important exception that it would be holdings of foreign bonds, rather than domestic government bonds, that would increase significantly on the assets side of the RBA’s balance sheets,” he said.

The RBA concluded that such a strategy would be seen internationally as exchange-rate depreciation. The Australian dollar has climbed 4 percent this year, buying 75.84 U.S. cents at 11:26 a.m. in Sydney.

If policy makers did manage to drive down the currency, not only would it boost economic activity, but it would also likely be “an important antidote to any deflationary pressures there might be” at the time, Eslake said.

Eslake also surveyed other policies, saying negative interest rates would be “a very bad idea” for the RBA to try to imitate, echoing the RBA’s own conclusions. From Eslake’s perspective, the move would amount to a tax on banks, and hurt the incomes of savers including retirees.

As speculation swirls about Japan potentially considering so-called helicopter money, Eslake agreed with the RBA that direct financing of government spending was a tricky proposition for a central bank. "In such circumstances there is, I think, the potential for the ‘independence’ of the central bank to be seriously compromised."

"Action to drive down the exchange rate is the most likely course for the RBA to adopt in the event that they felt some kind of ‘unconventional’ measures were required," Eslake said, based on the reported findings of the RBA’s studies.

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