Australia's Central Bank Faces Currency Quandary

A significant increase in the pace of foreign currency accumulation at the Reserve Bank of Australia (RBA) over the past three months has attracted plenty of comment and analysis, even though it amounts to a mere blip in the country's foreign exchange flows.

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It has been called everything from passive intervention to targeted money printing by local analysts, who attribute the A$1.3 billion ($1.35 billion) pile-up in foreign currency holdings at the RBA since August to purchases of Australian dollars by an "old-fashioned" central bank that prefers dealing directly with counterparts rather than via a broker.

Glenn Stevens, RBA governor, indicated that theory is probably correct in his answer to an audience question after a speech on Tuesday in Melbourne: "Let's say that was customer business that we decided to keep on the balance sheet because the prices seemed attractive to do that at this time."

By choosing not to offset the inflows via purchases of Aussie dollars in the spot market, the RBA has highlighted not only an important shift in global reserve allocations but also the difficulty central banks face in dealing with these powerful currency flows.

Australia's standing as one of only seven countries rated 'triple-A' with a stable outlook by all three major international rating agencies has made it an increasingly popular choice for central banks and sovereign wealth funds looking to diversify their holdings away from the U.S. dollar and the euro. A relatively high official cash rateof 3.25 per cent is a further attraction.

(Read more: Why Hedge Funds Like the Australian Dollar)

The Aussie's popularity with foreign central banks is set to solidify with its inclusion from next year in statistics handed to the International Monetary Fund by reserve-holding nations. David Marsh of the Official Monetary and Financial Institutions Forum says this seemingly "innocuous" move marks a new era in world money: the shift to multi-currency reserves.

"The technical-sounding measure, reflecting the growing diversification of the world's US$10.5 trillion of reserves, is likely to exert wide-ranging impact on world bond and equity markets," he says. The IMF estimates the U.S. dollar and euro make up 61.9 per cent and 25.1 per cent respectively of global central bank currency reserves.

The effects, of course, have already been felt in Australia. Offshore investors currently hold more than three quarters of outstanding Australian government securities and the Aussie has remained above parity against its U.S. counterpart in spite of falling commodity prices, slowing global growth and the RBA lowering the cash rate by 150 basis points since last October.

Indeed, the RBA governor this week expressed surprise that the Aussie had not "declined much" given that Australia's terms of trade – the ratio of export prices to import prices – peaked more than a year ago. The Aussie has averaged US$1.030 since moving to trade above parity with its US counterpart for the first time over two years ago.

The strong Aussie is creating problems for large swaths of the Australian economy, including the all-important resources sector, where large mining and gas projects are facing spiralling costs.

Chevron, the U.S. oil company, is expected to confirm in the next couple of weeks that costs at its Gorgon liquefied natural gas (LNG) project, Australia's biggest-ever resources development, have ballooned by more than A$20 billion to A$60 billion in part because of the high Australian dollar. Analysts say a second wave of LNG projects worth an estimated A$150 billion are under threat if costs cannot be controlled.

Analysts say that by choosing not to offset the recent foreign exchange inflows and letting them pile up on its balance sheet, the RBA is signalling its unease with the strength of the currency and reminding investors that it does have the ability to act, albeit in a limited way.

(Read more: Is Surging Aussie Dollar Out of Whack With Fundamentals?)

"The RBA is not actively attempting to influence the level of exchange rate. But by electing to reduce additional demand for the currency in the market, it is 'leaning against' the [Australian] dollar's appreciation," says Andrew Salter, FX strategist at ANZ in Sydney.

To bring the exchange rate down in any material way would require overt intervention, says Mr Salter. He thinks that is unlikely because the RBA is aware of its balance sheet limitations and the credit risk of investing in U.S. dollars or euros compared with the Aussie.

In any case it is not clear that the Aussie is so overvalued that direct intervention, for example, could be justified given that Australia's terms of trade remain at a historically high level. At a recent appearance before the House of Representatives in Canberra, Mr Stevens said the Aussie was probably overvalued but not dramatically so: "We're not talking 20 cents' worth."