Credit and Credibility II: The Aussie Dollar

dailyreckoning.com.au / By Greg Canavan / November 30th, 2012

Yesterday we discussed credit and credibility. Today we want to explore how this relates to currencies.

We’ve been marvelling lately at the strength of the Australian dollar. Apparently, Aussie dollars are in demand. The IMF recently included the Aussie in its ‘appendix’ of reserve currencies. Dan Denning wrote about it earlier in the week.

It got us thinking about currencies and what determines value. Is it really as simple as supply and demand? Who supplies the currency? When a country has a demand for ‘Aussie dollars’, what does that actually mean?

We don’t really know the answers to these questions. But we’ll have a crack at answering them. Feel free to weigh in if you think we’ve got it wrong.

You know that because of near zero interest rates in much of the developed world, the Australian dollar is becoming increasingly popular as a reserve asset. But foreigners are not piling up Aussie coins and notes in the vaults, they’re buying Australian government debt, which is DENOMINATED in Aussie dollars.

We think it works like this. For a foreigner to purchase the debt, it must first purchase (digital) Aussie currency via their foreign exchange dealer. It then swaps the currency for the debt security, and credits the government’s spending account with the Aussie dollars. So does that mean the Aussie government ‘prints’ dollars when foreigners buy its debt?

No, the dollars already existed. They were in ‘digital existence’ in the first place. Although the government turned those digital dollars into real spending power by issuing the debt.

READ MORE