Australian Dollar short opportunity remains intact

Over the last few months, we have alerted our readers’ attention to the opportunity that has been forming to bet against the Australian Dollar.

The so called “Aussie” has been rising against most other currencies since 2008, recording a stunning 35% rise against both the US Dollar and the British Pound and being way out of kilter on a PPP basis against both pairs.

The growth in Australian exports in recent years has been mainly due to the ever increasing appetite for raw materials from China but there are several challenges on the horizon for the Australian economy that is likely to curb the currency’s strength in the immediate & medium term.

The years of almost 10% GDP growth in China are most likely over as the country’s massive infrastructure works slows down and the leaders there try to reposition the economy more towards domestic consumption. Demand for commodities will very likely ease and we are already seeing this in the price of certain commodities like copper and steel. This will contribute to a deterioration in the Australian trade balance and that, as we British holidaymakers are sadly only too aware of, can only be rebalanced by an adjustment in the currency value.

China has evolved from an emerging economy over the last 40 years as the succession of Chinese leaders from the early 90’s have increasingly embraced their own unique version of Western capitalism. From 1970 to 2011, GDP grew at a blistering 9.3% pace per year, while the rest of the world grew at 3.1%, the US at 2.8% and the European bloc at just 2.3%. With such a stunning growth rate, and given that the Chinese economy has been growing through investment which represents 50% of GDP, demand for raw materials, especially those related to infrastructure building such as iron ore, has not surprisingly, boomed. The Chinese have been the most important buyers of almost every commodity and in a stark illustration of just where the Australian economy’s own growth has come from during the last 15 years, you will not be surprised to learn that Australia tops the developed world’s dependency on China with an economic dependency of 30%, amazingly higher than that of Japan – China’s closest trading partner.

In 2011, Australia exported $77bn of goods to China while it had exported just $8.8bn in 2001. Besides the growing dependency from just one country’s demand, Australia is also too dependent on iron ore exports, which represent a massive 57% of its total exports to China. Where iron ore goes it seems so goes the Aussie economy…

The table below also shows GDP composition (in percentages) for China, UK, US and Australia. As you can easily spot, China depends heavily on investment and much less than any other country on more healthy internal consumption.

The Chinese have developed their economy through large scale infrastructure building, but that is now changing. The threat of a bursting of their own property bubble continues to hang over the economy with stories of legion ghost towns. This will be a drag on growth going forward.

As relayed earlier, the 9.3% growth pace of the last forty years simply cannot be sustained nor the dependence on continued infrastructure build out to generate this growth. Crafting all this together lead us squarely to the conclusion that demand for commodities and raw materials like iron ore are likely to moderate over the next several years. With the Australian economy so dependent upon China and with an overvalued currency crimping export competitiveness with other trade partners, this can only spell trouble for the currency in our opinion. Its trade balance can only continue to deteriorate.

A rough calculation we have made reveals us that Australian GDP will shrink around 0.65% for each 10% drop in demand for Australian exports from China. That’s huge!

The Aussie has benefited not only due to demand for its raw materials but also from the higher yield it has been offering (higher interest rates). Since mid 2011, the this interest rate advantage has also been eroding however with the Australian central bank cutting base rates from 4.75% to the current 3%. Even after these cuts, the USD and the Pound have continued to trend lower against the Aussie but, as the interest rate differential drops, the pressure is on the Australian dollar to drop.

Even after taking inflation into account, we can’t justify a rate anywhere near 1.4750 for GBP/AUD or 1.0235 for AUD/USD and nor can other PPP measures. In the US Dollars case, there has in fact been a mild correction during the last few months but in Sterling’s case, it has continued to strengthen to near 40 year highs as the British economy continues its sanguine performance and many expect the BOE to potentially increase its quantitative easing program. Nevertheless, we believe the RBA will also ease further notwithstanding the markets’ recent reassessment of this assumption in the last couple of weeks following new relatively robust economic stats out of Australia.

We maintain our Conviction Long trade through 2013 of long GBP against the AUD and believe the current levels provide an even more attractive entry point than in the New Year.