Since the Aussie dollar was floated in 1983 its value closely followed that of its commodity exports – see graph from The Economist. However since 2003 commodity prices have increased 400% but the dollar rose by much less and no longer had a direct relationship to commodity prices. There are 3 possible reasons for this:
1. The deregulation of financial markets which facilitates the ease of currency trading
2. The current account deficit in Australia which got to 6.2% of GDP in 2007
3. Interest rates in Australia up to the GFC were realtively low compared to other developed countries
2011 saw commodity prices drop but the Aussie dollar has remained strong. As most economies employed a lose monetary policy and proceeded to drop interest rates aggressively after the GFC, the Aussie economy didn’t in fact go through a recession and its interest rates remained relatively strong – see below.
Although a weaker exchange rate could help the Aussie economy especially as it has been susceptible to the resource curse – the strength of the exchange rate and higher interest rates is already putting pressure on some industries, particularly the tourism, manufacturing, education exports and retail industries.
The graph from National Australia Bank below shows the components of Australian GDP from 2007-2013 with forecasts for 2014 and 2015. GDP consists of C+I+G+(X-M) so from the graph you can see that:
C = Private Consumption
I = Business Investment
G = Government Demand
(X-M) = Net Exports
* There is anticipated an increase in non-mining investment with investment in the mining sector slowing down as completion nears.
* An increase in private consumption as well as net exports holding its own.
* The relationship between business investment and the increase in net exports
* Pace of growth is below the trend over 2014-2015 which means that that population growth will be greater than the number of new jobs created.
The standoff between the President and the US Congress continues after the Government was forced to shut down non-essential services and stand down more than 800,000 employees.
US politicians appear no closer to resolving the deadlock. But while markets remain frustrated with the current situation, a resolution is hopefully not too far away. For Australia, the impact on the local economy is unlikely to be significant if the issue is resolved before too long. With over 80% of Australia’s exports destined for Asia, any hit to Australia’s trade accounts will likely be undetectable. Source: BNZ Australian Markets Weekly
Here is a graphic from the National Australia Bank which shows a good correlation between the demand for full-time and part-time workers and business confidence. In Australia for five of the last six months, full time employment has fallen. This is a sign that employers lack of confidence in the outlook makes them reticent to hire on a full time basis. Instead they are preferring to hire people on a part time or casual basis which gives them a lot more flexibility in uncertain times.
Here is a list of the latest ratings by the three main rating agencies. Notice that Australia and the three Scandinavian countries have top ratings. The UK lost its top rating from Moody’s but maintained the top rating from the other two. New Zealand comes in further down with a top rating from Moody’s but has lost its top grade from the other two. When you get to B status your are talking high risk or junk status and this is quite evident with the PIGS counties.
If you have watched the movie documnetary ‘Inside Job’ you will remember that these 3 credit rating agencies also rated high risk investments – sub-prime mortgages – as AAA, up to a week before they failed. The same could be said about their rating of investment company Bear Stearns.
Ultimately they could have ‘stopped the party’ but delayed ratings reports and made junk status investments AAA rated. But as they testified in front of congress their advice to clients are opinions ‘just opinions’ – I wonder do they share the opinions of those that lost huge amounts of money, including sovereign investments. Recently they downgraded Greece and Spain in the knowledge that the servicing of the debt would now become more costly for those countries and stifle any sort of recovery in the near future.
A little over a decade ago the Australian dollar was being dismissed as the Pacific Peso but today some are referring to it as the Swiss Franc of the south. This is an indication of its safe-haven status as central banks worldwide start to diversify their reserves away from US dollars and Euros into Aussie dollars.
The IMF recently announced that they intend to make the Australian dollar and Canadian dollar Global Reserve Currencies. Both will be included in the COFER (Currency Composition of Official Foreign Exchange Reserves) surveys, which currently consists of the:
The IMF is asking member countries from next year to include the Australian and Canadian dollar in statistics supplied by reserve-holding nations on the make-up of their central banks’ foreign exchange reserves. In previous years the world has had just two reserve currencies:
1. Sterling up to 1914
2. US dollar since the WWI
Notice the drop in the Australian dollar during the start of the financial crisis but its strengthening since 2009. Australia is just one of only seven countries in the world with a AAA-rating from all three global credit ratings agencies – Moodys, Standard & Poors, and Fitch.
The table below from the Australian Markets Weekly (Published by National Australia Bank) shows the fiscal position of euro-zone and other developed nations. As you can see the PIIGS (Portugal, Ireland, Italy, Greece, Spain) of the euro-zone countries have very high gross debt to GDP levels except for Spain. Japan has the highest but is also the only economy involved in fiscal loosening – see column 4. Notice the severity of tightening in some euro-zone countries as austerity measures start to be implemented. It does seem a little strange that Australia’s tightening in fiscal policy is greater than that of the UK and the US and not that far from the IMF‟s estimate of “austerity” announced for Italy.
The memo items are also of interest in that they show the nominal GDP, debt and budget balance in $USbn. In nominal GDP you have USA, China, Japan, Germany as the leading economies by output levels. China overtook Japan this year.
With continued global weakness the RBA is becoming increasingly worried about the prospects for the Australian economy. According to the National Bank of Australia there are 3 factors that the RBA are concerned with:
1. Although house prices are stabilising there are some sectors of the economy that remain in a depressed state – residential construction has a record low capacity utilisation (see graph).
2. A tightening of state and federal fiscal policy has meant that there is less aggregate demand in the economy.
3. The high value of the AUS$ affects the competitiveness of exports. However business now see the high AUS$ as permanent rather than cyclical. This is important as the RBA is not expecting lower rates to significantly lower the AUS$ but rather is trying to offset some of the economic damage to the economy.
It could be that a rate cut by the RBA is an insurance policy in an environment where inflation appears stable. The graph below looks at the RBA Cash Rate and the Taylor Rule.
The Taylor Rule
This is a specific policy rule for fixing interest rates proposed by the Stanford University economist John Taylor. Taylor argued that when:
Real Gross Domestic Product (GDP) = Potential Gross Domestic Product and
Inflation = its target rate of 2%,
then the Federal Funds Rate (FFR) should be 4% (that is a 2% real interest rate).
If the real GDP rises 1% above potential GDP, then the FFR should be raised by 0.5%.
If inflation rises 1% above its target rate of 2%, then the FFR should be raised by 0.5%.
This rule has been suggested as one that could be adopted by other central banks – ECB, Bank of England, etc for setting official cash rates. However, the rule does embody an arbitrary 2% inflation target rather than, say 3% or 4%, and it may need to be amended to embody alternative inflation targets at different times or by different central banks. The advantages of having such as explicit interest rate rule is that its very transparency can create better conditions for business decisions and can help shape business people’s and consumers’ expectations. Central banks prefer to maintain an air of intelligent discretion over the conduct of their policies than to follow rules, but to some extent they do unwittingly follow a Taylor rule. This makes the rule a useful benchmark against which actual policies can be judged.
For many years China has been trying to guarantee resources for its growing economy. The FT in London recently looked at the Chinese mining company Citic Pacific which has invested huge funds into the Sino Iron mine in Western Australia. Originally hatched in 2006 the level of expenditure has gone significantly higher than expected – from US$2bn to US$7.1bn today. However some have suggested that a US$10bn will ultimately be the cost and this is especially prevalent in that they are two years behind schedule.
It seems that Citic Pacific have put down too much money to pull out – barriers to exit. China imports about 60% of its iron ore and the Sino Iron mine is an attempt by the Chinese to break away from the dependency of foreign suppliers, which Chinese steelmakers accuse of driving prices too high. However Chinese companies have found it difficult to adjust to the foreign working conditions compared to the protected environment in China. Chinese enterprises are often unprepared for the rigours of foreign competitors especially with regard to employment laws and the nature of contracts. China’s mining plans involve the use of Chinese labour as they are cheaper and have a higher productivity. However, overseas labour laws and visa requirements make the use of Chinese labour all but impossible. In Australia truck drivers can earn US$2000,000 a year with three-home housing, free home leave. By seeking control negotiations can become confrontational.
The Chinese were desperate for iron ore when the demand for steel was very high. However Chinese developers realise now that the demand for steel has dropped and prices have fallen. In 2010 China imported less iron ore than the previous year and by 2011, higher interest rates and strict restrictions on property and construction continued to put downward pressure on steel prices. Also for Citic Pacific miscalculations over currency have played a role in increasing costs. The AUS$ has appreciated over the life of the project and controversial hedges that Citic bought went wrong causing a $2bn loss.
Yesterday official GDP figures out of China showed that growth has slowed to 7.6% for the second quarter. This was predicted but as building and infrastructure development accounts for 55% of China’s GDP growth this has a significant impact on demand for iron ore which is a key ingredient in steel.
Further to Jim O’Neill’s talk at the Tutor2u conference one wonders how the Chinese economy is going to land over the next few months. According to the National Australia Bank most believe it is going to be a soft landing given that:
1. The slowdown is desired
2. Policy makers are looking at an expansionary policy to ease the fall
3. Policymakers have a lot of ammunition left to stimulate growth – currently high interest rates (which can be cut) and large surpluses.
Australia’s links with China
The National Australia Bank’s markets weekly looked at the how Australia and China have been closely linked over the last 10 years. They have come up with the following:
Australia is joined to the hip (see graph – Australian GDP Growth – Correlations
Rolling correlations of real quarterly growth) with China given they are its largest export destination. China growing at 8% or 7.5% is probably inconsequential and to materially change the direction of the Australian economy China would need to land so hard that commodity prices would fall sufficiently to turn off many of the big resource projects that are underway. It is naive to think that a recession in China will bring a similar scenario in Australia.
In a small open economy like Australia, the floating $A exchange rate is arguably the most important macro stabilising tool – more so than interest rates. So a Chinese hard landing should mean lower commodity prices and a much lower $A which in turn would help promote growth in some sectors (like tourism) just as the high exchange rate is now curbing these sectors.