Tuesday, November 20, 2007

The Economic Environment - An Australian Perspective

An understanding of monetary flows in the economy, and specifically through the financial system, is fundamental to an understanding of how trading operates, and the influences on the price of money (interest rates).

Similarly, an understanding of monetary flows between economies is fundamental nto an understanding of how trading operates, and influences, the price of an Australian dollar expressed in terms of another currency (exchange rates).

Interest Rate Determinates - The flows of funds in the economy
The flow of funds is the process that facilitates the exchange of goods and services for money. A direct flow of funds is the transfer of funds directly from a saver (ie lender or investor) to a borrower, or a buyer to a seller, while an indirect flow of funds includes one (or several) intermediaries being interposed between these parties.

The flow of funds can essentially be viewed as involving the interplay between five broad operational sectors of the economy - one of which (overseas) is external. These sectors are:



  • Household
  • Business
  • Finance
  • Government
  • Overseas

Flows are of two different typesL those arising from the permanent transfer of funds from one party to another; and non-permanent transfers arising from one party lending to, or investing with, another.

Permanent flows include:

  • Taxation payments and refunds
  • Salaries and wages
  • Interest
  • Dividends
  • Purchases and sales

Non-permanent flows include:

  • Loans
  • Deposits
  • Investments

Flows of funds in the economy are complex, but a number of main characteristics can be identified:

  • The general public and housholders are net investors
  • Government and semi-government are net borrowers
  • The corporate sector is a net borrower
  • Financial intermediaries are net neutral, with funds borrowed and lent being approximately equal
  • The overseas sector is a net lender to the Australian economy.

The flow of funds within, and between each sector of the economy, results in a situation where some participants will have more funds than they need to meet their obligations (ie a surplus) or insufficient funds to meet their obligations (ie a deficit), or, rarely, a balance between their available funds and their obligations.

The financial system facilitates a credit allocation function (the process of distributing funds from lenders to borrower) to allocate funds from those who are in surplus to those who are in deficit. The interest rate at which this process is optimised is where the demand from funds from those in deficit, equals the supply of funds from those in surplus. Factors taken into consideration in determining this rate include the underlying rate of inflation, risk, liquidity and the transaction term.

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Economic Factors Affecting Interest Rates

Interest rate, being the price of money, are dependent on the supply of, and demand for, funds, which in turn is determined by:

  • The overall level of liquidity in the market, which is controlled by the RBA through its open market operations.
  • The level of fund deficits in particular sectors of the economy, which is largely driven by permanent flows, particularly expenditure.
  • The level of fund surplus in particular sectors of the economy, and the willingness of those in surplus to lend to other sectors of the economy, which will be influenced to a large degree by the perceived risk of funds due not being repaid, ie credit risk.
  • The period for which the funds are required, and the flexibility of the lenders in investing for different periods.

Four parts make up the term structure of interest rates:

  • The risk-free rate which is based on the overall supply of, and demand for overnight funds.
  • A credit risk premium which is added to the risk-free rate, being compensation to the lender for taking the risk that the borrower does meet all commitments as they fall due (the longer the term, the higher this premium).
  • The premium arising from the period for which funds are committed, (again, the longer the term, the higher the premium), to compensate for greater uncertainty.
  • An adjustment to reflect expectations as to likely future movements in the level of rates.

Policy Factors Affecting Interest Rates

Monetary Policy

Overnight Interest Rate.

The RBA's monetary policy decisions involve setting the target interest rate on overnight loans in the 'interbank' or professional currency market. Whilst this mainly impacts the short end of the yield curve (ie out to one year), it does impact all interest in the economy to varying degrees.

Inflation.

The inflation rate measures the change in prices over a given period. The most common measure is the quarterly headline Consumer Price Index (CPI) which measures changes in the price of a 'basket' of goods and services.

The level of inflation affects interest rates in two ways:

Firstly, whilst not the only driver, the RBA has low inflation as its key monetary policy target, as high inflation has adverse social and economic effects. These include declining living standards for fixed income earners, potential falls in the value of the Australian dollar and lack of confidence in the financial system - especially in the currency as a stable medium of exchange. Such changes often cause social hardship and unrest. An inflation rate continually above their current target of 2-3% would lead to an increase in interest rates by the RBA to stem demand.

Secondly, inflation erodes wealth. As inflation increases, purchasing power decreases. To mitigate this, a higher level of interest income is demanded by investors to maintain real rates (the nominal rate adjusted for inflation), pushing up interest rates generally.

Inflationary pressures can result from:

  • A increase in manufacturing costs, eg through an increase in the cost of imports caused by a fall in the value of the AUD. It may also come from an increase in salary and wages. This is known as cost-push inflation.
  • An increase in demand for goods and services, stemming from excessive cash in the economy. This is demand-pull inflation.
  • Expectations of future inflation. If a company believes its costs will increase, it will tend to raise the price of its goods in anticipation.

Fiscal Policy

The government's fiscal policy, which centres on the annual budget, can be expansionary, contractionary or neutral. An expansionary policy is one where more money is put into, or left in, the economy. This is achieved by reducing taxation and/or increasing government spending, often resulting in a budget deficit. It will tend to stimulate the economy and may ultimately lead to an expectation of higher inflation and the need to increase interest rates.

A contractionary policy is the opposite. Fiscal tightening creates a curb on economic growth and hence on inflationary pressures with consequent falls in interest rates. Australia has had a tightening fiscal regime since the early 1990s and this is expected to continue for the foreseeable future.

A neutral fiscal policy is one where the budget is balanced.

Compared with monetary policy, fiscal policy tends to have little effect on the short end of the yield curve with its main impact being on longer maturities, although the effect is neither large nor quick. However, fiscal policy which is considered too extreme, eg. an excessive surplus, may engender movements. In this case, increases in short-term rates as market participants anticipate that changes to monetary policy settings will be required to counter the inflationary pressures, emanating from the perceived fiscal excess.

Key Economic Indicators

To forecast future changes in the flow of funds and the level of interest rates, it is necessary to monitor those economic indicators which influence rates.

Several main economic indicators can be identified:

Learn about the UK Economic Indicators

Learn about the US Economic Indicators

Learn about the Swiss Economic Indicators

Learn about the German and Euro Economic Indicators

Inflation - direct

  • Consumer Price Index (CPI), issued quarterly

This means changes in the price of a basket of goods and services which accounts for a high proportion of expenditure by metropolitan households.

  • Inflation expectations

Surveys are published which attempt to measure anticipated inflation, such as those conducted by the Melbourne Institute of Applied Economic and Social Research, the Confederation of Australian Industry and Westpac.

Inflation - indirect

  • Employment (monthly)

This provides an indication of likely pressure on wages and also is a general guide to overall economic activity and expectations.

  • Building approvals (monthly)

Strong demand for new housing, evidenced by rising building approvals, can lead to increases in demand for white goods, furniture and the like. This flow-on spend adds to the inflationary pressure of the new home building itself

  • Wage Cost Index (WCI) (quarterly)

This measures changes over time in wage and salary costs for employee jobs. The methodology used excludes the impact of hours worked, quality of output and changes in the composition of the labour market. It has largely replaced the traditional measure of Average Weekly Ordinary Time Earnings (AWOTE) as the forewarning of emerging wage push pressures. High WCI increases can indicate future inflationary pressures, as the higher wages are factored into both cost-push inflation through higher manufacturing costs, and demand-pull pressure from increased spending.

  • Retail trade (monthly)

The level of retail trade gives a direct indication of retail demand and may indicate demand-pull inflationary pressures.

  • Gross Domestic Product (GDP) (Quarterly)

GDP is the main indicator of the strength (growth) of the economy. High levels of GDP indicate strong growth, which in turn may lead to increased inflationary pressure, as growth is translated into demand through salaries and wages.

  • Balance of payments (quarterly)

This provides a measure of the value of transactions between residents of Australia, and non-residents. It is divided into a current account (goods, services, income and current transfers), a capital account (acquisition/disposal of non-produced, non-financial assets) and a financial account (foreign financial assets and liabilities). The immediate impact of an unexpectedly large current account deficit tends to be on the exchange rate, although a continuing deficit problem will filter through to interest rates.

CHECK OUT more about the Australian Economic Indicators!

The Global Economy

Australia plays a relatively minor role in total international trade and is therefore largely at the mercy of global swings and economic cycles. Slowdowns or rapid growth in sectors of the world economy (particularly in Australia's major trading partners), feed through, with varying lags, to domestic economic conditions.

Maintaining independent monetary policy is thus often difficult, and adjustments to cash rates by bodies such as the US Federal Reserve, can rapidly change expectations in Australia.

Exchange Rate Determinates

The Flow of Funds Between Economies

The exchange rate is a price which, like all parties when flexible, serves to keep a market in equalibrium - in this case, it is the equalibrium in our balance of payments with the rest of the world.

Foreign exchange transactions occur for different reasons. They arise from international trade, capital flows, intermediation and specualtion.

International trade is the most fundamental reason for foreign exchange transactions. Importers buy foreign currencies to pay for imported goods. Exporters sell foreign currencies received from the sale of goods to foreigners.

Companies in Australia import products from a manufacturing country. Typically, an overseas manufacturing company would have no desire to hold AUD, so it requests payment in either their local currency or a readibly convertable currency such as USD. Much of the worlds trade is priced and settled in USD.

Capital transactions include investments by a company or individual in an asset denominated in another currency; and borrowing of funds by a government, company, or individual in a foreign currency.

Banks act as intermediaries between customers that buy and sell foreign currencies. Frequently, a bank that buys foreign currency from a customer or from another bank will lay off its risk by selling the currency to another bank. Typically, interbank turnover is four to five times greater than customer turnover.

Foreign exchange speculation refers to buying a currency against another currency, with a view to reversing the deal and gaining a profit. Positions can be taken for very short periods of for long periods, although long-term positions in the speculative market are normally closed out before maturity.

Speculative positions may also be taken against interest rate movements. These can be done through either the forward market or the Eurocurrency market. There are many forms of speculation involving foreign exchange and interest rates, whether they are against eachother or other commodities and they are limited only by the perceived risk/return expectations.

The exchange rate is therefore sensitive to all of the influences that typically affect trade and investment decisions, especially expectations about future asset prices - including expectations about the exchange rate itself. These expectations can dominate in the short-term and can change quickly in response to such things as changing news about the economy, changing prospects for the current account, changing perceptions about policy, or even to political events. The exchange rate can be driven by market psychology to levels that are difficult to explain in terms of underlying economic conditions.

Type of Exchange Rate Regime

The term foreign exchange means a transaction that exchanges one country's currency for that of another. A foreign exchange rate is the price of one currency expressed in terms of another. The rate is quoted as a ratio of the value of one currency to another ie AUD/USD 0.91000 means AUD 1 equals 0.9100 USD.

A fixed exchange rate system means that exchange rates are kept constant. A floating exchange rate system means that exchange rates vary with supply and demand. The Australian dollar was floated and exchange controls were lifted on 11 December 1983.

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Terms of Trade

The real value of the Australian dollar is influenced over the long term by the terms of trade, the long-run real interest differential and net foreign liabilities. Australia is a small commodity exporting country, subject to significant terms of trade shocks driven by the world commodity price cycle. Among OECD countries, Australia - together with New Zealand and Japan - has a very high level of volatility in its terms of trade. This arises mainly because in these countries the composition of imports differs from that of exports. In Australia and New Zealand, exports are concentrated in primary products with volatile prices, while imports are largely of manufacturers with stable prices - while in Japan the opposite is true.

Economic Policy

Economic factors can move a market in both the short-term and long-term. For instance, it is well known what reaction can be generated in AUD market the current account or CPI figures are released. While the figure for any given month can be positive or negative, it is the trend for any given month or quarter can be positive or negative, it is the trend figure that finally influences the state of the economy. However, as the monthly or quarterly figures are released, the currency is more often than not subjected to larget movements.

These movements may not always be logical. For instance, Balance of Payments (BOP) figure released in June 1999 showed a current account deficit for the first quarter of AUD $8.829 billion (5.9% of GDP, up from 5.1% a year earlier). Most observers considered this a negative factor for the AUD. However, the market reaction was to buy the currency. This was mainly because the market had been conditioned by analysts to expect a higher number, so a figure of more than AUD $8.829 billion had already been 'built into' the exchange rate.

Political Factors

Exchange markets can be dramatically influenced by political factors. A famous example was the decision by the Group of Five nations (GF) in September 1985 to collectively intervene in the market for the first time to stop the USD appreciation. However, a frantic rush to liquidate long dollar positions caused major falls in the USD's value and wide spreads were quoted by those market-makers still left in the market. Continued intervention over the following months turned the market from being bullish for the dollar, to being completely bearish.

This example combines political effecfts and central bank intervention: but political problems and statements can also cause market reaction on their own. The then Treasurer, Paul Keeting's 'banana republic' statement added impetus to a market already bent on selling AUD. The shooting of President Reagan, and the September 11 terrorist attacks also caused the exchange markets to react.

Speculation

Speculative trades can dramitically move the market. The 1997 Asian economic crisis was generall attributed to large-scale selling of Asian currencies by hedge funds. However, the impact of speculative trading depends on the supply-and-demand factor. For instance, speculation against a certain currency may meet resistance from a corporate transaction and if the size of the corporate transaction provides sufficient supply to counteract the speculative forces, for even a short period, it may be enough to reverse the trend as the speculators liquidate their position. This reversal can have a domino effect as traders scramble to take profits of limit losses. If the rate moves too far, however, the speculators may see it as a better point at which to re-establish their positions and thus the currency will find a 'level' - and the trading range will narrow.

Central Bank Intervention

If an exhange rate moves too quickly or too far in one direction it may be the subject of central bank intervention. Exchange rates affect such things as the cost of imports, the competitiveness of exports and the cost of maintaining and servicing foreign debt. Therefore, it is sometimes in the government's interest to maintain certain levels of stability in the market place.

Intervention can be direct, either by selling or buying the currency directly in the market or by altering fiscal policy, thus changing the market perception of the currency's trend. However, if the central bank wishes to smooth market conditions, its intervention will be less pronounced and may be done anonymously through through a bank or brokers, are under the strictest confidence, but sometimes central banks choose to increase the impact of intervention by making public statements or 'jawboning'.

Central bank intervention is most effective when done on a concerted basis. The combination of jawboning and concerted intervention is almost invariably successful. For example, if the G7 announces that it considers USD/JPY too high at 112 - and the Fed, the Bank of England, the European Central Bank, the Bank of Japan and other central banks, including the Reserve Bank of Australia, are all seen selling USD - the market would quickly realise that the best opportunity to make money is to be short USD at around JPY 112.

Interrelationship Between Interest Rates and Exchange Rates

Interest rates affect economic activity via a number of mechanisms. They can affect savings and investment behaviour, the spending behaviour of households, the supply of credit, asset prices and the exchange rate - all of which affect the level of aggregate demand. Developments in aggregate demand, in conjunction with developments in aggregate supply, in turn have an effect on the level of inflati0n in the economy. Inflation is also influenced by the effect that changes in interest rates have on imported goods prices, via the exchange rate, and through their effect on inflation expectations more generally in the economy.

One important determinant of the country's exchange rate is whether it has a higher or lower inflation rate than its trading partners, its exchange rate will tend to depreciate to prevent a progressive loss of competitiveness over time.

The exchange rate plays an important part in considerations of monetary policy in all countries. However, since the exchange rate also plays such an important part in adjustment to external shocks in Australia, the case for an exchange rate target - and setting monetary policy accordingly - is weak. This approach would also forgo one of the important aims of floating, which was to regain monetary control. Thus, the exchange rate has not served either as a target, or an instrument, of monetary policy in Australia since the float.

However, to achieve its overall monetary policy objectives, the Reserve Bank does undertake FX transactions:

  • To maintain internal inflation and external currency stability and to preserve orderly conditions in the Forex market. The Reserve Bank's role is to ensure that any market adjustment to the currency rate is orderly and well-based. Markets can occasionally lose focus with underlying economic fundamentals and overshoot; on such occasions the Reserve Bank can provide the contrary trade to slow the market and give it time to reassess the appropriateness of the exchange rate to prevailing fundamentals.
  • To cover sales of FX to its customers, principally the Commonwealth Government (eg. payments for defence equipment, funding of embassies and servicing of overseas debt). In this role, the bank also acts as advisor to the Government on the intraday timing of its purchases of FX from the Reserve Bank.
  • The RBA manages Australia's FX reserves which amount to over AUD 40 billion invested in a range of currencies. From time to time, the RBA deals in the market to adjust the mix of the currencies it is holding.
  • To assist daily management of liquidity in the domestic money market, or implementation of monetary policy, the RBA may undertake FX swap transactions to use foreign assets as opposed to domestic securities, to impact on domestic money supply.

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1 comment:

Unknown said...

This can have effect on my KLSE Stock Analysis, and thus some times market fluctuates.