Trade war | Aussie dollar could surge in worst-case scenario, RBA study finds

Australia’s real exchange rate could surge and gross domestic product drop in the event of an all-out global trade war, Reserve Bank research conducted in March suggested.

The study, released yesterday in response to a Bloomberg Freedom of Information Act request, ran three key scenarios. Under the worst-case third outcome, the U.S. applied a 20 percent tariff on goods imports from all countries, including Australia, and every nation except Australia then retaliated by slapping equivalent fees on their U.S. goods imports.

It found Australia could be less exposed under the worst scenario than economies that rely more on global trade flows for demand and have larger manufacturing sectors. As a result, it said the Australian dollar could in fact appreciate under such events, increasing the downside risks to the economy.

“When we allow the exchange rate to respond to the imposition of tariffs in the third scenario, it suggests that the real exchange rate would appreciate by 6 percent,” according to an analysis dated March 21. “GDP would then fall by an additional 2.5 percent. A lower cash rate could largely offset these effects in the long run.”

The Australian dollar has fallen more than 10 percent from this year’s high of just over 81 U.S. cents in January as concerns about a U.S.-China trade war mounted. Traders see little prospect of the RBA moving interest rates – which have stood at a record-low 1.5 percent since August 2016 – in the next year.

The potential for the Aussie to appreciate in response to a trade war flies in the face of its historic response to global upheaval. The currency has acted as an economic shock absorber in the event of a crisis – most recently following the collapse of Lehman Brothers Holdings Inc. in 2008 when it tumbled to about 60 U.S. cents. Together with scope to cut policy further, this has helped Australia avoid recession for 27 years.

RBA’s analysis was based on three scenarios: U.S. steel and aluminium tariffs only: Tariffs on U.S. imports of steel (25 percent) and aluminium (10 percent), with exemptions for Canada, Mexico and Australia Wide-ranging U.S. tariffs: Washington applies a 20 percent tariff on all goods imports from all countries Retaliation: All countries except Australia retaliate to the wide-ranging U.S. tariffs and impose tariffs of 20 percent on all of their U.S. goods imports

The study found that under the limited tariff scenario, the effects on Australian GDP “are negligible.” However, since the research was conducted, the U.S.-China dispute has intensified.

President Donald Trump this week ordered his administration to levy 10 percent tariffs on about USD200 billion in Chinese goods on Sept. 24 and to increase the rate in January to 25 percent if Beijing refuses to offer trade concessions. In retaliation, Beijing has announced plans to hit U.S. goods, ranging from wheat to textiles, with 5 percent to 10 percent tariffs.

Australia’s link to the trade war between the world’s largest economies is its status as the most China-dependent economy in the developed world; Australia’s economic ties to the U.S. are far smaller, though Washington is Canberra’s key defense ally.

On China, the RBA’s analysis showed net exports have contributed little to its GDP growth in recent years and that exports from the world’s second-largest economy have declined as a share of nominal GDP.

“Nonetheless, rough calculations based on the U.S. trade share and the ratio of exports to GDP suggest that if Chinese export volumes to the US fell by ¼- ½, that would subtract 1-2 percentage points from Chinese GDP growth, which is not insignificant,” the RBA documents showed.

The RBA said that while a negative shock to Chinese exports would weigh on commodity demand, “any compensating domestic stimulus – akin to the response to the global financial crisis export shock – could provide an offset, albeit at the cost of exacerbating longer-term structural problems and contributing to financial risk.” Michael Heath, Bloomberg