The Reserve Bank of Australia (RBA) is correctly focused on addressing a tough economic environment. They are hellbent on stabilizing the Australian Dollar (AUD) and are being forced from all sides. As the RBA is a key practitioner of quantitative easing and quantitative tightening, its effects on changing broad credit conditions are instructive. Their objective is to influence loan interest rates and keep the economy’s inflation rate between 2–3%. Add in recent dramatic turns in trade relations, particularly with China, and the picture becomes that much more complex. As Australia’s largest trading partner, China has an outsized effect on what the AUD is worth.
Australia’s trade balance has become very dependent on how well the Chinese economy does. Importantly, commodity prices – especially iron ore — are a key part of this economic equation. Iron ore is Australia’s largest export commodity, generating an awesome $118 billion annually. Consequently, any movement in its price can have massive effects on the AUD’s value.
The Role of the RBA in Economic Stability
The RBA, as Australia’s central bank, has more power and control over monetary policy than most central banks. The RBA controls the rates of interest at which banks lend funds to one another. This is a decision with direct implications for how much it costs everyday Australians to borrow money. A cut in the federal interest rate creates more incentive to borrow money and spend it, whereas an increase has the opposite effect of dampening economic activity.
In its efforts to achieve its goals, the RBA employs quantitative easing and tightening as strategies to manage credit conditions effectively. Quantitative easing increases the money supply in order to encourage consumption and investment. With tightening, the Fed is removing money from the economy in an effort to combat inflation. Both methods are able to tweak the cost of borrowing, encouraging consumers to cut back on spending, which will eventually strengthen the value of the AUD.
The RBA’s overarching goal is to foster a sound economy with low inflation. By keeping inflation within the target range of 2-3%, the central bank aims to foster an environment conducive to economic growth. This increased economic stability serves to drive up the value of the Australian dollar (AUD). Therefore, it draws plenty of domestic and international investors.
Trade Relations and Their Impact on the AUD
Australia’s Trade Balance is another key indicator that can show how strong or weak the AUD will be. The Trade Balance is the difference between what Australia earns from exports. It shows how much the country has spent on imports. Positive Trade Balance Surplus A positive Trade Balance means that Australia is selling more overseas than it is buying, a favorable position that appreciates the AUD.
China being Australia’s number one trading partner plays a major role in this ongoing cycle. The vitality of the Chinese economy is one determinant of demand for Australian exports, notably Iron Ore. As China develops and grows wealthier, its demand for commodities, particularly Iron Ore, isn’t going anywhere. As a result, the AUD often rises and falls with every small change in how well China’s economy is doing.
Over the past few years, trade tensions between the United States and China have added volatility to already uncertain global markets. Such tensions inevitably increase the risk of volatility in demand for Australian exports, especially if Chinese economic growth starts to weaken. Meanwhile, a continuing slowdown in China can dampen the demand for iron ore. This change will improve Australia’s trade balance and depreciate the value of the AUD.
Iron Ore Prices as Economic Drivers
Iron Ore is important not only as Australia’s largest export, but as the foundation stone of Australia’s economy. The mineral is worth a shocking $118 billion /year in exports, China is the mineral’s largest customer. Therefore, fluctuations in Iron Ore prices have big ramifications not only for Australia’s economic fortune but for the AUD.
When worldwide demand for iron ore increases, it is almost always driven by the pace of industrial activity in China. This increase in demand can greatly increase export dollars coming in. This further increase reduces Australia’s Trade Balance and strengthens an already strong AUD. Conversely, if Iron Ore prices decline—perhaps due to decreased demand or excess supply—the negative effects on export revenues could worsen the Trade Balance and weaken the AUD.
The relationship between Iron Ore prices and the AUD is especially pronounced during times of market uncertainty. For instance, if China’s manufacturing sector contracts or if there are geopolitical tensions affecting trade flows, Iron Ore prices may drop sharply, leading to adverse effects on Australia’s economy. In these circumstances, the RBA would typically intervene by raising interest rates. They can deploy other monetary policy tools to stabilize the economy and their currency.