Currencies | Sep 26 2012
By Greg Peel
Prior to about the last twelve months, the Aussie dollar has always traded as a “risk currency”, reflecting price movements in our major exports – commodities. Yet more recently, commodity prices have fallen and the Aussie has remained elevated above parity. The common explanation is that while yields on Australian bonds are low by Australian standards, they are still world-beating on a AAA-rated basis compared to yields in the US, Europe, UK, Japan and elsewhere. The world has been parking its money downunder.
A couple of points to note here.
The first is regarding what I believe is a common misconception outside of forex dealing rooms. In dealer-speak, the word “dollar” refers only to the US dollar. The nickname “Aussie”, by itself, refers to the Australian dollar. Thus when we say the “Aussie dollar” exchange rate, we mean the Australian dollar to the US dollar, and the “dollar” in “Aussie dollar” refers to the greenback.
The second is that while the Aussie has long been a commodity currency, the correlation of movement is still a reflection of interest rate differentials. If commodity prices rise, Australia's GDP should rise, then the RBA will put up rates, and thus we have a greater interest rate differential to the US (assuming we fix the US). It's just that the final outcome is a slow moving one, and forex traders are fast movers.
On that basis, we would have expected that as commodity prices have fallen in 2012, and most notably the iron ore price over recent weeks, the Aussie dollar should have fallen. Lower commodity prices imply lower GDP growth and lower RBA rates, leading ultimately to a lower interest rate differential (particularly as the Fed has now extended its “zero” rate to mid-2015). But the yield on an Australian government AAA-rate two-year bond is 2.5% and the equivalent (AA+) yield in the US is 0.25%, with both country's inflation rates around the 2% mark. Even if the RBA cuts again, the differential will remain attractive to big low-risk funds looking for any sort of positive return.
It is for that reason Australia has been recording record foreign ownership ratios of Aussie bond holdings of late. The world has been lending Australia money against its current account deficit like never before. And commentators have cited these inflows as the obvious reason why, despite weak commodity prices, a weak global economy, and particularly a slow China, the Aussie just won't fall. It all makes perfect sense.
Only problem is, the explanation is incorrect.
The following chart from the ANZ Bank foreign exchange analysts tells the true tale:
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The dark blue line represents net in/outflows of foreign portfolio allocations to Australia. The light blue line represents foreign direct investment (FDI). The former represents financial instruments such as bonds and stocks, and the latter represents “real” assets such as, most notably, mines. We see that net flows have actually been negative most recently, despite record foreign bond purchases. FDI, on the other hand, has gone to the moon.
ANZ points out that one cannot isolate “naked” foreign purchases of Australian bonds alone. There are more elements to the greater funds flow equation. For one, it appears a lot of those bond positions have been hedged using derivatives (such as futures positions), which provide an offset. Then there's the small matter of the Australian stock market's underperformance to Wall Street. Americans might be buying bonds but they are also withdrawing from Australian stocks. And finally, Australia's banks have been reducing their dependence on offshore funding (eg issuing bank bonds in the US) and building up their domestic deposit bases instead. This again results in reduced inflows.
At the end of the day, foreign portfolio allocations do not justify the strong Aussie dollar.
But the FDI “boom” is historically significant as it has provided Australia with its first “basic balance surplus” since the early 1970s, ANZ notes. Another lesson is required here.
The surplus Wayne Swan is so determined to provide this financial year is a budget surplus – the balance of government inflows (eg taxes) against outflows (eg welfare) in one financial year. Each month we also take note of the trade balance, being the balance of export receipts and import payments in that month. If the former is greater than the latter, it is a surplus for the month. These are two different “surpluses”.
Even if both of the above are in surplus, Australia is still running, and has been for a long time, a current account deficit. This implies that after netting both the public and private sectors, we are in a net debt position. The US runs a current account deficit, on a scale that is difficult to even fathom. China, as an exporter of manufactured goods, runs a current account surplus. Most of that surplus it lends to the US.
The “basic balance” equals the current account plus FDI. Countries currently running a basic balance surplus include Norway and Switzerland. Japan used to, but not recently. Australia hasn't since the early seventies (the time of another mining investment boom) but it is now.
If a Chinese-Japanese consortium wishes to buy Cubby Station, it must pay in Australian dollars. The consortium must thus “buy” Aussie before it hands over the cheque. The reserve currency (US dollar) is the currency of international transactions. Every new foreign stake in an Australian asset will incrementally force the Aussie higher. It works the other way when Australian companies acquire stakes in offshore assets, which they do, but as the graph above shows, net flows are very much weighted inward at present, not outward.
That's why the Aussie dollar is so strong. And the bad news is, it's also why we can't expect any meaningful move to the downside in the short term, no matter what the RBA does.
It is “almost unheard of,” notes ANZ, for a commodity exporter to run a basic balance surplus. A basic balance surplus currency will tend to be reasonably stable, the analysts point out, and less cyclical, than the currencies for which portfolio flows dominate the capital account. Sound familiar? (Note that the current account equals the capital account plus the trade balance).
Foreign portfolio allocation decisions can turn on a dime. Foreign direct investment in Australian mining projects represent long term investment decisions, requiring constant inflows of foreign currency to cover the cost of development. FDI does not respond to day to day newsflow, notes ANZ, nor even to monetary policy decisions in the short term. The Aussie is now trading, and will continue to trade, with a lack of volatility. There will be no sudden collapses, such as that which we saw in 2008. Movements up and down will be smooth and balanced. After taking a closer look at FDI, ANZ has decided the Australian dollar is unlikely to weaken substantially against the US dollar until after the FDI pipeline has turned sharply lower, which at this stage would not be until at least mid to late 2013.
On that basis, all this speculation about whether the RBA will cut rates next month, or at least before year-end, based solely on the currency, is moot.
Were a punter wishing to establish a currency trade based on RBA expectations, one would be best to play the crosses. ANZ suggests selling the Aussie against the Kiwi if you want to back a rate cut. Selling the Aussie dollar will get you nowhere in a hurry.
Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
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