Essay: Brexit & Exchange Rate's Impact On Australia-UK Trade Relations.

Brexit and its options

a) ‘Brexit’ is the term for Britain’s exit from European Union (EU). On June 23^rd 2016, citizens of Great Britain voted on the referendum on whether Britain should remain with EU or should leave it, and they chose to leave. Britain’s new Prime Minister Theresa May announced that she would trigger Article 50 at the end of March 2017, for negotiating terms and conditions for the formal exit procedure in the next two years and post-Brexit regulations. The post-EU arrangements can be categorized as ‘hard’ or ’soft’ Brexit options (Gamble 2017).

Theresa May has opted for hard Brexit. This refers to the terms and conditions that, UK would give up total access to the single market of European Union along with the customs and regulations of EU’s customs union, associated with the market to gain full freedom over its borders for making new trade agreements and applying their own laws within the territory. This predicts that UK would start following the rules of World Trade Organization (WTO) for new deals with former EU partners. Hard Brexit possess big risks and operational complication for UK (The Guardian 2017).

According to the International Trade Secretary, Liam Fox, the hard approach would make UK a global trading nation, but at the same time, it would impose tariffs of extra 10 per cent, as per WTO rules, on the British goods and services. Agricultural sector would lose protections against low cost imports from abroad. There would be increase in administrative checks on goods in the ports and airports of different nations (Ringe 2017).

The Brexit has hit hard the value of GBP against sterling, USD and AUD. The fears of hard Brexit are that, there would be strict laws for immigration, and since the value of GBP is falling, exports become cheaper and imports become costlier for UK. Hence, there would be a rise in exports of British goods and fall in imports of foreign goods. Thus, they would prefer to trade with EU than with UK under new regulations (Reserve Bank of Australia 2017).

b) Exchange rate is the price of a nation’s currency in terms of currency of another nation. It can be fixed or floating. Federal government decides the fixed exchange rate and floating exchange rate is determined by the market laws of demand and supply (Weale et al. 2015).

The AUD has a floating exchange rate. It is decided by the laws of demand and supply. The demand for a currency in the international market depends on the country’s level of exports and speculations on making profit from the changes in the value of the currency. The supply of a currency is determined by the imports from abroad to the country. For example, the greater the amount of imports to Australia, the more will the supply of AUD in the international market, while the greater the exports from Australia, greater is the demand for AUD in the market (Cavusgil et al. 2014). 

Exchange Rate Determination

Figure 1: Exchange Rate determination of AUD

(Source: Author)

Figure 1 depicts the determination of AUD exchange rate through the demand and supply forces of the market. Now, if the demand for AUD rises in the global market, there will be an upward shift of the demand curve D^A$, which would push the price of AUD higher. The opposite happens when there is increase in supply of AUD. The equilibrium between the two forces determines the exchange rate for AUD (Moosa 2016).

Fluctuations in the exchange rate of AUD are attributed to the following factors: inflation rate, growth rate of GDP, interest rate and government restrictions. Supply of AUD gets affected by the changes in the demand for purchases and sales of AUD depending on the international trade and flow of investments. Inflation rate and growth rate are related to the trade level and the other two factors are related to the investment portfolio of Australia (Reserve Bank of Australia 2017).

(Source: Reserve Bank of Australia)

The monthly data on Exchange Rates of AUD/GBP of last three years shows the trend in the exchange rate of AUD to GBP. In the last three years, since 2014, the exchange rate was more or less stable and it was upward rising in the last few months. 2016 onwards the exchange rate has risen (Bussière, Delle Chiaie and Peltonen 2014). This means appreciation of AUD in terms of GBP, or depreciation of GBP in exchange for AUD. After Brexit, there is a high devaluation of GBP in the international market. Hence, for UK, imports become costlier and exports become cheaper. On the other hand, for Australia, importing goods from UK becomes cheaper while exporting goods to UK becomes costlier (Sims 2016). The data shows that exchange rate has become favorable for Australia, especially after Brexit, as AUD has appreciated relative to GBP. With a higher price of AUD, there will be a fall in the exports from Australia (Reserve Bank of Australia 2017).

The hard Brexit fears lead to currency devaluation in UK. This indicates a rise in the volume of export from UK. As the AUD/GBP exchange rate rises and AUD appreciates after Brexit vote, the imports from UK to Australia will rise, while exports to UK will fall (Sheldon 2016).

AUD is considered as a risk currency due to higher rate of interest and correlation to global equity markets. Along with that, lower inflation rate, speculation, balance of payments, change in competitiveness, government regulations and economic growth contribute in the appreciation of AUD (Hassan, Salim and Bloch 2015).

Fluctuations in Exchange Rate and Its Effects

d) As the GBP has devalued after the Brexit referendum, the exchange rate has risen in favor of Australia. This implies appreciation of AUD relative to GBP. The overall impact of this situation is that the exports from Australia to UK become costlier, while the imports to Australia from UK become cheaper. The dealer who exports alcoholic beverages to UK will see a fall in his export volume. The currency depreciation of GBP leads to a fall in the prices of British products in the international market, that is, now less GBP is required to buy a British product. On the other hand, the price for Australian products will go up, as UK requires more AUD to buy the Australian goods due to AUD appreciation. Thus, the exports of alcoholic beverages to UK will fall after Brexit referendum leading to a fall in income in GBP (Harries 2016).

Since the imports from UK become cheaper, Australia could now import more goods from UK. It leads to lower inflation in the country. As the imported goods become cheaper, people will have to spend less to enjoy foreign goods (McDougall 2016). The demand for imported goods rises. On the other hand, as the export volume reduces, the manufacturers have more incentives to stay competitive in the domestic market and reduce their prices. It has a long term effect on the manufacturing sector as it improves competitiveness. This also leads to a fall in the inflation level in the country. This can help to improve the living standards. Hence, there are some advantages for Australia also if the currency devaluates in UK (Franklin 2016).

e) If the Reserve Bank of Australia wants to maintain the exchange rate at 0.60 pounds, then the exchange rate of Australia becomes fixed. It is done to stabilize the value of a currency against the other. In a fixed exchange-rate system, the central bank of a country prefers to use open market mechanism. It is committed to buy and sell its currency at the pegged ratio which makes the currency stable against other currencies. However, any particular monetary policies will have no effect on the fixed exchange rate system; rather the exchange rate would have effect on the economy. The central bank loses its autonomy in case of fixed exchange rate. When the AUD/GBP exchange rate is fixed at 0.60 pounds, then the country must make FOREX transactions at that rate only (Gabaix and Maggiori 2015).

Exports and Imports of Alcoholic Beverages from Australia to UK

There are some effects of fixed exchange rate. It helps to reduce the inflation in the country. If the inflation rate is high, the currency might fall below the fixed rate, which is not desired. Fixed exchange rate also helps to increase the level of investment and reduce uncertainty. In such a scenario, the investors and manufacturers already know the exchange rate and they can plan accordingly to decide the level of imports and exports. Competitiveness increases due to stable currency. Hence, uncertainty in the business is reduced to some level and this stimulates investment in the economy (Afxc.rba.gov.au 2017).

Australia had a fixed exchange rate system till 1983. It was pegged against GBP till 1931 and after that it was pegged against USD. Australia’s exchange rate system followed the Bretton Woods system till it broke down in early 1970s, when almost all major economies started to follow floating exchange rate system. The fixed exchange rate has some costs, such as; under this regime it was difficult to control the money supply. As the demand for AUD increases in the international market, RBA faces challenges to meet the demands. Hence, trade and capital flow may get hampered for Australia (Reserve Bank of Australia 2017).

References:

Afxc.rba.gov.au., 2017. AFXC: Questions and Answers. [online] Available at:

https://afxc.rba.gov.au/qa/ [Accessed 24 Mar. 2017].

Sims, A. (2016). What is the difference between hard and soft Brexit? Everything you need to know. Independent. [online] Available at:

https://www.independent.co.uk/news/uk/politics/brexit-hard-soft-what-is-the-difference-uk-eu-single-market-freedom-movement-theresa-may-a7342591.html [Accessed 23 Mar. 2017].

Bussière, M., Delle Chiaie, S. and Peltonen, T.A., 2014. Exchange rate pass-through in the global economy: the role of emerging market economies. IMF Economic Review, 62(1), pp.146-178.

Cavusgil, S.T., Knight, G., Riesenberger, J.R., Rammal, H.G. and Rose, E.L., 2014. International business. Pearson Australia.

Franklin, C., 2016. Lessons From The Conservative Party: A Hard Brexit And New Fiscal Policies. The Market Mogul.

Gabaix, X. and Maggiori, M., 2015. International liquidity and exchange rate dynamics. The Quarterly Journal of Economics, 130(3), pp.1369-1420.

Gamble, A., 2017. British Politics after Brexit. Political Insight, 8(1), pp.4-6.

Harries, M., 2016. Britain’s Dangerous New Politics. Survival, 58(6), pp.31-42.

Hassan, K., Salim, R. and Bloch, H., 2015. Demographic transition and the real exchange rate in Australia: An empirical investigation. New Zealand Economic Papers, 49(1), pp.62-77.

McDougall, D., 2016. Australia and Brexit: Déjà Vu All Over Again?. The Round Table, 105(5), pp.557-572.

Moosa, I., 2016. Exchange rate forecasting: techniques and applications. Springer.

The Guardian, (2017). 'Hard Brexit' fears hit pound and Asian stocks ahead of Theresa May's speech. [online] Available at:

https://www.theguardian.com/politics/2017/jan/17/hard-brexit-fears-hit-pound-and-stocks-ahead-of-theresa-mays-speech [Accessed 26 Mar. 2017].

Reserve Bank of Australia. (2017). The Exchange Rate and the Reserve Bank's Role in the Foreign Exchange Market | RBA. [online] Available at:

https://www.rba.gov.au/mkt-operations/ex-rate-rba-role-fx-mkt.html [Accessed 24 Mar. 2017].

Ringe, W.G., 2017. The Irrelevance of Brexit for the European Financial Market.

Sheldon, I., 2016. Expected Macroeconomic Effects of a “Hard” Brexit (No. 252432). International Agricultural Trade Research Consortium.

Weale, M., Blake, A., Christodoulakis, N., Meade, J.E. and Vines, D., 2015. Macroeconomic Policy: Inflation, Wealth and the Exchange Rate (Vol. 8). Routledge.