RDP 2006-09: Limiting Foreign Exchange Exposure through Hedging: The Australian Experience 5. Conclusion

At face value, Australia's overall net foreign liability position could be interpreted as a substantial source of vulnerability to sudden exchange rate depreciation. In this paper, we show that foreign currency-denominated assets exceed foreign currency-denominated liabilities, even before accounting for hedging, thereby conferring a transfer of wealth from the rest of the world to Australian residents in the event of exchange rate depreciation.

Furthermore, overseas demand for Australian dollar assets has allowed Australian residents to further hedge their net foreign currency exposures back into local currency terms through the use of derivatives, insulating the economy against the wide fluctuations that can be observed in the exchange rate. As a result, Australia's external position is less sensitive to exchange rate depreciation than it might otherwise be. We have shown that after taking into consideration the currency composition of foreign assets and liabilities in conjunction with off-balance-sheet hedging, a 10 per cent depreciation in the exchange rate confers a transfer of wealth from abroad to Australian residents amounting to as much as 3 per cent of GDP.

While this paper restricts itself to a particular aspect of how the exchange rate interacts with the macroeconomy, focusing only on the risks to balance sheets and trade flows, it argues that hedging helps to remove one of the most important potential sources of foreign exchange risk to the economy. As a result we observe that despite wide swings in the Australian dollar, the economy and, specifically, the banking sector, have proved resilient to variability in the nominal exchange rate.