Bubbles are rarely purely domestic affairs. When a country’s assets are booming, money tends to flow in from abroad, attracted by rising prices, high returns and a strong economy. That inflow pushes up the value of the country’s currency or, where the currency is fixed, floods the economy with foreign funds. A strong exchange rate is one of the characteristic features of most bubbles.
The connection works in both directions. Foreign money helps inflate the bubble, and the bubble attracts more foreign money. When the bubble bursts, the flows can reverse abruptly, and the currency can fall as quickly as it rose. For countries with fixed exchange rates, the reversal can force a devaluation and a financial crisis.
This article explains how bubbles and capital flows interact, why a strong currency tends to accompany trade deficits, what happens when flows reverse, and what all this means for Australian businesses that import, export or compete with imports. It is part of GoCore’s series on bubbles.
Why money flows into booming economies
International investors constantly look for the best combination of return and risk. A country experiencing a boom offers several attractions:
- rising asset prices, in shares, property or both
- strong economic growth, with rising profits and incomes
- higher interest rates than in other countries, if the central bank is trying to restrain the boom
- a compelling story, such as a new technology, a resources boom or an economic “miracle”
As money flows in, it must be converted into the local currency, increasing demand for that currency and pushing up its value. Rising asset prices and a rising currency together produce large gains for foreign investors measured in their own currencies, which attracts still more money.
Capital inflows and trade deficits
There is an accounting relationship at the heart of this. A country’s balance of payments records all its transactions with the rest of the world. Broadly, it has two main parts:
- the current account, which records trade in goods and services, plus income flows such as interest and dividends
- the capital and financial account, which records investment flows, including purchases of shares, property, bonds and businesses, and borrowing from abroad
These two parts must balance. If foreign money flows in as investment, the country must, by definition, run a current account deficit of roughly the same size: it imports more goods and services than it exports, or pays out more income than it receives.
The mechanism that brings this about is often the exchange rate. A strong currency makes imports cheaper and exports more expensive. Consumers and businesses buy more from abroad, exporters find it harder to compete, and the trade balance moves towards deficit. In a sense, that is the purpose of the strong currency: it allows the net inflow of capital to be matched by a net inflow of goods and services.
Fixed exchange rates
Where a country fixes its currency to another, such as the US dollar, capital inflows cannot push up the exchange rate. Instead, they flow directly into the domestic economy, swelling bank deposits and lending. This can fuel credit growth and asset prices even more powerfully than a floating currency, because there is no rising exchange rate to dampen the boom.
Fixed exchange rates also encourage borrowing in foreign currencies. If a local business can borrow in US dollars at a lower interest rate, and the exchange rate is fixed, the foreign loan seems cheaper and safe. The danger appears only if the fixed rate breaks.
The Asian financial crisis
The Asian financial crisis of 1997–98 illustrates these dynamics vividly.
In the decade before the crisis, several East and South-East Asian economies grew rapidly, a period widely described as an economic miracle. Foreign capital poured in. Many of these countries kept their currencies fixed or tightly managed against the US dollar. Banks and businesses borrowed heavily in foreign currencies, often short-term, and lent the proceeds into property and share markets that boomed.
In July 1997, Thailand, under pressure as investors withdrew funds, abandoned its currency’s link to the US dollar. The baht fell sharply. The crisis spread to other countries in the region, including Indonesia, Malaysia, the Philippines and South Korea. Currencies collapsed, and borrowers with foreign-currency debts found those debts had grown enormously in local-currency terms. Property and share prices fell, banks failed, and several economies went into deep recession.
The crisis showed how capital inflows, fixed exchange rates, foreign-currency borrowing and asset bubbles can combine into a powerful boom and an even more powerful bust.
When flows reverse
Capital flows can reverse quickly. Triggers include:
- a fall in the booming asset’s price, which reduces expected returns
- rising interest rates elsewhere, which make other countries more attractive
- a loss of confidence, sometimes triggered by events in another country
- concern about the size of a country’s current account deficit or foreign debt
When money flows out, the currency falls. For a floating currency, the fall can help the economy adjust, by making exports more competitive and imports more expensive. But it also raises the local-currency cost of foreign debts and of imported goods, which can hurt borrowers and push up inflation. For a fixed currency, outflows drain reserves until the peg breaks, often suddenly.
Australia and its currency
Australia has had a floating exchange rate since 1983. Its currency is often influenced by commodity prices, because resources are a large share of Australian exports, and by differences between Australian and overseas interest rates.
During the resources boom of the 2000s and early 2010s, strong demand for Australian commodities, high commodity prices and large investment inflows pushed the Australian dollar up strongly. It rose above parity with the US dollar around 2010–2011, its highest level since the currency was floated. The strong currency helped keep inflation down and made imports cheaper, but it put considerable pressure on manufacturers, tourism operators, education providers and other industries that export or compete with imports.
When commodity prices fell and mining investment declined, the Australian dollar fell substantially. Exporters and import-competing industries found conditions easier, while importers and Australians travelling abroad found costs rising.
This pattern is a reminder that, for a country like Australia, exchange-rate swings associated with booms and busts in particular sectors can be large, and they affect businesses far beyond the booming sector itself.
The “Dutch disease”
Economists have a name for the pressure a booming sector can place on the rest of an economy through the currency: the Dutch disease. The term was coined in the 1970s to describe the Netherlands, where large natural gas discoveries strengthened the currency and made other export industries, particularly manufacturing, less competitive.
The mechanism is straightforward. A boom in one sector attracts investment and raises export earnings, pushing up the currency. The stronger currency makes every other export more expensive abroad and every import cheaper at home. Industries outside the booming sector face tougher competition on two fronts, and some shrink or move offshore. When the boom ends and the currency falls, those industries may not easily return, because skills, supply chains and customers have been lost.
For businesses outside a booming sector, recognising this pressure helps separate problems caused by their own performance from problems caused by the currency, and encourages planning for a period when the currency, and their competitiveness, may change again.
Signals worth watching
A few signals suggest that a currency’s strength may be tied to a boom and could reverse: a rapid rise in the currency alongside surging prices for the country’s main exports or assets, a widening current account deficit, heavy reliance on short-term foreign funding, and commentary describing the currency as a proxy for a single industry or theme. None of these predicts the timing of a reversal, but together they indicate that exchange-rate risk deserves attention.
What this means for Australian businesses
Importers
Businesses that import goods or materials benefit from a strong currency, because foreign goods are cheaper in Australian dollars. But the benefit can reverse. An importer that sets prices, signs contracts or builds its business model around a strong currency can be squeezed if the currency falls.
Exporters
Exporters face the opposite pattern. A strong currency makes their products more expensive for foreign buyers, or reduces the Australian-dollar value of their foreign-currency sales. During periods of currency strength associated with a boom elsewhere in the economy, exporters can lose competitiveness through no fault of their own.
Import-competing businesses
Businesses that sell locally against imported products, such as many manufacturers, are also affected. A strong currency makes imported competitors cheaper, putting pressure on local prices and margins.
Businesses with foreign-currency debts or costs
Any business with costs, debts or contracts in foreign currencies is exposed to exchange-rate movements. Borrowing in a foreign currency because interest rates are lower can look attractive, but a fall in the Australian dollar can increase the debt substantially in local terms.
Managing currency risk
Small businesses cannot predict exchange rates, but they can manage their exposure.
Know your exposure. List the costs, sales, debts and contracts that depend on foreign currencies, and estimate how a 10% or 20% move would affect profit.
Use natural hedges. Where possible, match foreign-currency costs with foreign-currency revenue, so that movements offset each other.
Build currency into pricing. Contracts can include clauses that adjust prices for large exchange-rate movements, or prices can be reviewed regularly.
Consider hedging instruments. Banks and payment providers offer forward contracts and other tools that fix an exchange rate for a future transaction. These have costs and require understanding, so professional advice is worthwhile.
Avoid foreign-currency borrowing without matching income. Borrowing in a currency in which you do not earn revenue adds a risk that can overwhelm the interest saving.
Do not build the business on one exchange rate. A business model that only works at a particular exchange rate is vulnerable. Testing it at different rates reveals how robust it is.
A worked illustration
This is an illustration with round numbers.
An Australian business imports equipment priced at US$100,000 each year and sells it locally.
| Exchange rate (US$ per A$) | Cost in Australian dollars |
|---|---|
| 1.05 | about $95,200 |
| 0.75 | about $133,300 |
| 0.65 | about $153,800 |
When the Australian dollar is strong, at 1.05, the equipment costs about $95,200. If the currency falls to 0.65, the same equipment costs about $153,800, an increase of more than 60%. A business that set its prices and customer expectations during a period of currency strength could find its margins disappear when the currency falls.
The business protects itself by reviewing prices quarterly, including an exchange-rate adjustment clause in large contracts, and using forward contracts to fix the rate for orders already committed.
Common mistakes
Assuming the current exchange rate is permanent. Currencies can move substantially over a few years.
Building pricing around a boom-time currency. Margins can vanish when it reverses.
Borrowing in foreign currencies for lower interest rates. Currency moves can outweigh the saving.
Ignoring indirect exposure. Local competitors’ import costs and customers’ export earnings also move with the currency.
Hedging without understanding. Hedging tools reduce some risks but carry costs and obligations.
Questions to ask
- Is the currency strong because of a boom that may not last?
- How large is the country’s current account deficit, and how dependent is it on capital inflows?
- How much of your business’s costs, revenue or debt depends on exchange rates?
- How would a 20% move in the currency affect your profit?
- For your own business: what would you do if the exchange rate returned to its long-run average?
Bringing it together
Bubbles and capital flows reinforce each other. Booming asset prices attract foreign money, which pushes up the currency or swells domestic credit, which in turn fuels further booms. By accounting necessity, capital inflows are matched by current account deficits, often brought about by a strong currency that makes imports cheap and exports expensive.
When bubbles burst, flows can reverse quickly. For countries with fixed currencies and foreign-currency debts, the result can be a crisis, as the Asian financial crisis showed. For businesses, the lesson is to recognise when a strong currency reflects a boom, to understand their own currency exposure, and to avoid building a business model that only works at one exchange rate.
Sources: an introductory chapter on asset bubbles written in the mid-2000s and widely documented economic history. Figures in the worked illustration are not data. This article is general information, not financial or investment advice; seek professional advice before using hedging products.
