Is Australia a Reliable Ally?

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Is Australia A Reliable Ally? The Reserve Bank of Austalia is unique among the world's central banks in holding over half of its foreign exchange reserves in currencies other than the U.S. dollar.

Is Australia A Reliable Ally? By David Hale, Chicago USA. August 19, 2003

It is widely perceived that the Australian-American relationship is at a new zenith. Australia supported America’s interventions in Afghanistan and Iraq with troops. The Bush administration is reciprocating by aggressively promoting a new free trade agreement with Australia. The President has also invited Prime Minister Howard to his ranch in Crawford, Texas for a barbeque.

Australia and America have been close allies since 1941, so it is not surprising that they have been cooperating in the war on terrorism and Middle Eastern dictators. But there is one institution of the Australian government which is completely indifferent to the alliance and its implications for the economic relationship. It is the Reserve Bank of Australia.

The RBA is unique among the world’s central banks in holding over half of its foreign exchange reserves in currencies other than the U.S. dollar. The dollar share of reserves in all the world’s central banks is about 75%. In East Asia, the central banks of China, Japan, and other countries hold about 80-90% of their reserves in U.S. dollars. China and Hong Kong have purchased nearly $100 billion of U.S. government securities during the past seventeen months. Japan has purchased over $50 billion during the past three months.

Australia’s current policy is to hold 45% of reserve in the U.S. dollar 45% in the Euro, and 10% in the yen. Until recently, the yen weighting was 30% but the RBA reduced it because of concern about the Japanese government going bankrupt.

Australia has a history of irreverence for imperial powers in its currency management. After a long history in the Sterling area, it sold British pounds during the late 1960s over the protests of the British Chancellor of the Exchequer, Roy Jenkins. Australia abandoned the pound because of its growing trade links with Asia and Britain’s own movement towards the European common market. But Jenkins still regarded Australia as a traitor to commonwealth solidarity.

The only other country which has such a low weighting for the U.S. dollar in its reserves is New Zealand. New Zealand now has 51% of its reserves in the dollar and 48% in the Euro. It is ironic that New Zealand should have a higher weighting for the U.S. dollar than Australia because New Zealand left the western alliance during the 1980s and has become a strong critic of the Bush foreign policy. It would not be surprising if New Zealand placed all of its reserves in the Euro.

The status of the dollar as a reserve currency is one of the foundations of America’s role as a global super power. The U.S. is currently running large budget deficits ($500 billion) and current account deficits ($600 billion). It is able to sustain these large deficits for one simple reason. The dollar is the world’s dominant reserve currency. If private investors are unwilling to finance the U.S. current account deficit, central banks do it through intervention.

In the 1960s, one country resented the power which the U.S. enjoyed as a consequence of the dollar’s global role and tried to challenge it. Under General DeGaulle, France tried to undermine the dollar by selling it in return for gold. France also quit NATO. The French selling of the dollar was one of the background factors which led to the collapse of the Bretton Woods fixed exchange rate system in 1971.

The French still resent America’s economic power but they have little capacity to challenge it because Asia’s central banks now control 70% of the world’s forex reserves compared to 30% in 1990. Continental Europe now has only 8.6% of global reserves compared to nearly 40% in 1972. It is the resources of Asia’s central banks which now serve as the financial underpinning of the Bush foreign policy and America’s global military role. In 2002, Asian central banks financed nearly half the U.S. current account deficit. Asian central banks intervened because they want to protect the stability of their currencies against the U.S. dollar. China and Hong Kong have explicit exchange rate pegs to the dollar. Japan has been intervening to hold the yen in a trading range of 115-120. Other Asian countries also want to hold their currencies in a target band against the dollar/yen rate.

If the Asian central banks were to withdraw support from the U.S. dollar, the consequences could be devastating for the Bush administration. The dollar would fall sharply. Bond yields would rise. Mortgage rates would increase with bond yields. The American housing boom would turn into a slump. The property crash would depress consumption and plunge the economy back into recession. The President’s popularity would plummet and the Democrats would have a good chance of winning the Presidential election in 2004.

The Reserve Bank of Australia is aware of these risks. The secretary of the Treasury and member of the Reserve Bank board, Mr. Ken Henry, recently warned that America’s deficits pose "a substantial risk for international financial stability". He said,

"The United States has shown a capacity to address large fiscal deficits in the past but it never had a current account deficit this size".

"If the U.S. is going to remain in substantial deficit for some time and if the net savers of the world are not going to continue to fund the U.S. current account…then an economic adjustment of major proportions will have to take place".

When Mr. Henry neglected to mention is that the U.S. operates under different rules than other countries because of the dollar’s reserve currency status. If Australia had America’s fiscal policy, it would be heading for a replay of the Banana Republic crisis of 1986. But as America has access to financing from the world’s central banks, it can sustain large deficits for much longer than any other country. The risk will come only if other central banks imitate the Reserve Bank of Australia and decide to sell the dollar. If other countries follow Australia’s example, all of Mr. Henry’s pessimistic predictions would come true with catastrophic consequences for the world’s geo-political stability.

There has never been any great public discussion about how Australia should invest its foreign exchange reserves. In contrast to France, the Reserve Bank did not sell the U.S. dollar for geo-political reasons. But its currency exposure still places it in striking contrast to all of the central banks of the Asia-Pacific region at a time when America has huge balance of payments funding needs. In fact, Japan and China are so loyal to the U.S. dollar that there is a case for asking their central banks to register as Republican Political Action Committees. It would be impossible for Mr. Bush to win re-election without their help.

The Prime Minister appears to be unaware of the Reserve Bank’s views of the U.S. dollar. He reappointed Mr. Ian McFarlane as Governor without any discussion of the foreign policy consequences of the Reserve Bank’s currency views. But instead of apologizing to President Bush for the RBA’s aversion to the dollar, the Prime Minister should turn the Reserve Bank’s policy into an opportunity. When he returns to Washington, he should give Treasury Secretary John Snow the phone number of Mr. McFarlane. If the grim prediction of Mr. Ken Henry about the U.S. economy come to pass, Mr. McFarlane will be one of the few central bankers Mr. Snow can call to seek help in rescuing the U.S. dollar. In such a scenario, Mr. Howard will probably even invite Mr. McFarlane to join him for his next barbeque in Crawford, Texas.

The views and opinions expressed this article are his own and not necessarily those of Paul Renaud and We thank Mr. David Hale for this quality contribution and wish our best regards to our viewers,

Paul A. Renaud.