Feature Stories | Apr 11 2011
(This story was originally written and published on March 30, 2011. It has now been repeated to make it available to non-paying members at FNArena and to readers elsewhere).
– The USD began a structural depreciation in 2002 from which it is unlikely to break out of for at least a decade
– The AUD is now in a simultaneous structural appreciation thanks to China
– Put the two together, and the AUD can only rise
By Greg Peel
There are a couple of important points to note at the outset here.
While foreign exchange traders talk about “buying” or “selling” the Aussie, or a traveller might “buy” some local currency beforehand for the holiday destination, currencies are more realistically “exchanged” – hence the expression “exchange rate”. The “Aussie dollar” exists only as a measure against other currencies, and the benchmark is to measure against the reserve currency, being the US dollar.
Knowing what the benchmark “Aussie” is against the greenback helps little if you are travelling to, for example, the UK, given the pound's relationship with the Aussie is strictly unrelated to the US dollar. The Aussie to the pound is a different exchange rate.
The fact the Aussie has passed parity with the US dollar does not for a moment suggest the Australian economy is now bigger than the US economy. Just as stock prices are dependent on the number of shares on issue, so too are exchange rates dependent on the relative money supplies of both countries. Australia's economy might currently be in better relative shape, but in 2010 the US GDP was still twelve times bigger than Australia's. (Not a bad result given the US population is about fifteen times bigger.)
In relation to the above, parity is just a number like any other number, and has no other special significance.
The reserve currency is historically the currency of global trade, which is why, for example, Australia sells coal to Japan in US dollar terms rather than in yen terms.
While the benchmark for the Aussie is the US dollar exchange rate, the benchmark measure of the US dollar is the trade-weighted “dollar index”. The dollar index is composed as 57.6% euro, 13.6% yen, 11.6% pound, 9.1% Canadian dollar, 4.2% Swedish krona and 3.6% Swiss franc. What is the first thing that stands out? No Aussie.
(Why krona? Because Sweden, along with the UK, are the two major members of the European Union who have chosen not to join the euro common currency. Thus one really should count, the euro, pound and krona as “Europe”.)
In 1971, America abandoned the gold standard. From the end of WWII to 1971, all major currencies were pegged to the US dollar which itself was pegged to gold. After 1971, the US dollar represented only an IOU from the US Treasury and its value reflected the strength of the US economy. It was in the seventies when (analogously) Toyota started to chip away at the dominance of General Motors. By the mid-eighties, Americans were starting to borrow excessively to support consumption of products no longer only produced in the US.
Having settled all that, let's move on.
While there is a certain pride which may be felt by Australians in a currency that was once known as “The Little Aussie Battler” now being more “valuable” than the US dollar, the truth is an overly strong Aussie is a drag on the Australian economy. With a relatively tiny population on a relatively vast land, Australia's domestic consumption is not the major driver of the economy. Our driving force in the twenty-first century is commodities export, and as such the higher the Aussie, the less income Australia receives in local currency terms for selling, for example, the same amount of iron ore to China. Tourism – once Australia's second largest “export” – is also severely impacted by a strong Aussie. Televisions are cheaper now, but that's a luxury of minimal impact.
The US is the other way around. Domestic consumption drives some 70% of the US economy, and America's significant natural resources are mostly consumed by its own population. That is not to say the US is not a significant exporter, of everything from Boeing planes to McDonalds hamburgers to Apple iPhones and Hollywood movies, but domestic consumption still soaks up the bulk of these products. The US is nevertheless a significant importer, mostly of manufactured products from Europe, Japan and now China, all of which goes to satisfy the seemingly insatiable American consumer.
Thus one can conclude that America prefers a “strong dollar” to increase the purchasing power of consumers. Australia actually prefers a “not too strong Aussie” to maximise income. It is generally accepted that an AUD-USD exchange rate of around US$0.67 is a nice balance between export income and domestic purchasing power from Australia's point of view.
The Structural Depreciation of the USD
Since 2002, the US dollar, as measured by its index, has been in a structural decline. Indeed, notes Commonwealth Bank's Global Markets Research team, the USD has really been in decline since 1985, but 2002 represented a sudden point of acceleration to the downside. Between 2002 and 2008, just before the fall of Lehman turned what seemed like a localised US crisis into the GFC, the USD depreciated 40%. The GFC sparked a bounce of only 8% as money flowed back to the “safe haven” of the reserve currency.
The CBA researchers have pinpointed five factors which simultaneously occurred in 2002 (a year of recession in the US following the Tech Wreck and 9/11) to generate a major depreciation trend in the USD.
Factor One. In 2002 the amount of money flowing out of the US and into foreign equities and direct foreign investment accelerated exponentially. For seventeen years until 2002 the surplus level of foreign investment as a percentage of GDP had averaged 3.8%. Today that level is 20%. (Surplus being net of investment flowing into the US from offshore.)
CBA suggests the turning point came with the passage of the famous Sarbanes-Oxley bill in 2002 which improved internal reporting controls in the wake of the collapse of Enron and WorldCom, among others, which had flouted disclosure and accounting standards. With a greater confidence in financial systems, US investors now felt safe in investing in less traditional markets offshore and not be taken for a ride by local firms.
One might also argue that it was around this time the term “emerging markets” began emerging as a legitimate investment alternative. The US market had just seen the dotcom bubble-and-bust, so investment in the likes of an underdeveloped China seemed like a viable option given what had just happened in overdeveloped America. US companies around this time began the great outsourcing rush and created the “platform company” model, in which expensive and low-margin manufacturing was shifted to China and call centres to India leaving the high margin design and sales elements at home.
One can also point to, in the ensuing years from 2002, the rise of the exchange traded fund (ETF) which allowed direct investment in a greater range of asset classes from commodities to, for example, the Brazilian stock market. And as China emerged as a major consumer of commodities, American investors started to take a lot more notice of a safe and secure investment proxy in the form of the Australian stock market.
When Americans invest offshore, they must exchange US dollars for the local currency, thus undermining the value of the US dollar.
Factor Two. In 2002, US net foreign debt surpassed 20% of GDP for the first time.
It seems to CBA that 20% marked some kind of “line in the sand” for foreign investors previously happy to invest in the US, and as such in US dollars. America had always been the global economic powerhouse so one can forgive a bit of excessive borrowing to maintain a level of lifestyle to which Americans had become accustomed. But 20% was getting a bit much.
At this point the USD as a reserve currency began to lose its appeal. While foreign investors had already started diversifying away from USD as debt built, 2002 saw an acceleration of that diversification push.
One is reminded that 2002 was the year the euro officially replaced the individual currencies of the eurozone members. Note that the economy of the European Union (which includes the UK and Sweden) is roughly equivalent in size to that of the US.
While it might have been notable that US net foreign debt passed 20% of GDP in 2002, it is probably more notable that the figure now stands at 42%.
Factor Three. In 2002, the US current account deficit first widened to above 4% of GDP and remained above 4% until the 2008 GFC.
While a country's current account includes interest payments and dividends from foreign investment, the bulk is represented by a country's balance of trade. A surplus means exports exceed imports (in dollar terms) and a deficit means imports exceed exports.
While Americans were still turning away from Chevrolets in 2002-08 to buy Corollas instead, the period also saw the great flood of cheap Chinese manufactured imports. Ironically, China learned how to make fridges, for example, because US fridge companies had outsourced their manufacturing arms to China to exploit the cheap cost of labour. Intellectual property laws? What intellectual property laws? They might have been cheap and nasty fridges, but they were still cheap.
The more China exported cheap manufactured goods to the US, the more China “exported low inflation” given China's currency was and is pegged to the USD. Chinese goods were cheaper than American or Japanese goods, so in preferring “Made in China” America's cost of living was effectively reduced. This gave then Fed chairman Alan Greenspan the excuse to reduce the cash rate further and further in the wake of 9/11, all the way to an unprecedented 1% in 2003. China recycled its US dollar receipts into US Treasuries, thus “lending” the US more money to buy more Chinese goods (see Factor Two). With money so cheap, credit card spending accelerated, as did house prices. We all know what happened next.
Since the GFC, the forced devaluation of the US dollar (zero cash rate plus quantitative easing) has improved US export sales and reduced US import demand, the latter also simply impacted by recession. Hence the US current account deficit has now fallen to only 2.7% of GDP. But as CBA notes, an ongoing recovery of the US economy (reduced unemployment, house price stability etc) would only see that figure start to blow out again.
Factor Four. In 2002, the real US Fed funds rate turned negative and stayed there for three years.
As noted above, in 2003 the Fed dropped the Fed funds rate (equivalent of the RBA cash rate) to what was then an historic low of 1% on a nominal basis. On a “real” basis, meaning adjusting for inflation, the funds rate fell into the negative in 2002, notes CBA, as the Fed shifted down the nominal rate post 9/11. Thereafter the Fed began shifting the nominal rate back up again as the economy (and house prices) boomed but it was not until 2005 that the real rate again turned positive.
The nominal rate peaked in 2006 but by late 2007 the Fed had begun what would become a desperate slashing of the nominal funds rate down to a 0-0.25% range, where it is today. QE2 is calculated to affect a negative nominal funds rate of minus 0.75%. Subtract inflation, which is mildly positive, and the real rate is well negative.
It was in 2001, notes CBA, that the real Fed funds rate fell below 3.0%. It has never been above that level since, and with the Fed expected to keep rates “exceptionally low for an extended period”, it won't be for a long time yet. Fed chairman Ben Bernanke has suggested it will take “four to five years” to significantly reduce the US unemployment rate.
Factor Five. In 2002, foreign central banks started to diversify out of their significant holdings of USD reserves.
Europe (mostly Germany), Japan and now China are all, and have been for some time, net exporters to the US. Those countries thus long built up current account surpluses (irrespective of fiscal budget deficits in the case of Germany and Japan) and those US dollar receipts had to be reinvested somewhere by the respective central banks. The most obvious investment, so it seemed, was to buy the sovereign bonds of the world's largest economy, which meant recycling USD into US Treasuries.
As was the case in Factor Two, the major central banks were effectively lending money to the US which the US could then use to justify further consumption of foreign imports. The more imports consumed, the more money lent back, the more imports consumed and so on. This is the basis of the slippery slope which led us to a world of “global imbalance”. The euro and the yen nevertheless appreciated in value over this time, putting imports from Germany and Japan further out of reach of the average American, but the Chinese renminbi remained stuck in its peg (with only minimal sanctioned appreciation), meaning Chinese goods never became more expensive.
Hence China is now America's biggest creditor. Everyone in the world can see that this symbiotic relationship cannot continue ad infinitum because the US must eventually “blow itself up” with debt. The risk would then be a collapse in the value of US Treasuries, and thus the foreign investments of Germany, Japan, China and others. The sensible thing, from a central banker's point of view, would be to start reinvesting USD and other foreign receipts elsewhere.
In 2002, such diversification notably began. The share of USD in reserves held by foreign central banks fell from 72% and by last year had fallen to 61%. CBA acknowledges the devaluation of the USD in the period impacts on the percentages by itself, but suggests the reduction rate is greater than that implied by currency depreciation.
To the layman, it probably doesn't seem like a big shift. But one has to appreciate the internecine risk of a foreign central bank aggressively selling out of US bonds. A global stampede out of US bonds would follow, thus destroying the value of remaining foreign investment. Softly, softly is the only way such an exit can be achieved – something China is very adept at. CBA also notes that the share of USD in reserves held by “developing” countries rather than “developed” countries fell from 74% to 58% in 2002-10. Latin America has driven the bulk of the exit.
These are the five factors which CBA sees as being responsible for the acceleration of USD depreciation from 2002. From a technical perspective, CBA suggests the USD needs to appreciate 16% from its current level in order to break out of its long term downward trend. The researchers can't see this level of appreciation occurring because the US is basically caught between a rock and a hard place.
The end of QE2, which is scheduled to occur in June, should affect a USD bounce because the US Treasury will no longer be printing fresh new dollars to give to the Fed to buy US bonds with. But to withdraw QE is to take the risk that the US economy is ready to once again stand on its own two feet, and for US banks to pick up where the central bank will let off in providing credit to stimulate economic growth. Will this occur? The jury is still out.
Let's say it does. With unemployment set to remain high for years, and little in the way of any meaningful recovery in sight for the US housing market, the US consumer is not going to be much help, however. Foreign consumers, particularly those discovering plane travel and Maccas and iPads and Hollywood movies for the first time, are where earnings growth for US companies lies. But if the US dollar appreciates, the export recovery the US has been enjoying begins to be undermined.
At the same time, a stronger dollar means imports into the US become cheaper again for US consumers. So the 90% of Americans with a job and the 70% of mortgage holders not in negative equity can once again start buying “stuff”. Thus a further blowout of the current account deficit would follow (Factor Three), as well as a further blow-out of net foreign debt (Factor Two).
In other words, a post-QE stronger USD would not stay strong for very long, and would not achieve the 16% bounce CBA requires to break the downtrend before the downtrend resumes.
The same “rock and hard place” problem is being experienced by the US on a fiscal basis. To reduce burgeoning US debt, the Obama Administration needs to reduce government spending. But to reduce spending would be to derail any downward shift in unemployment. To reduce unemployment, the government really should increase spending, but that means increasing debt.
Everything points to a structurally weaker US dollar over time, as far as CBA is concerned. With little scope for a reduction in net foreign debt, pressure will eventually be brought to bear on America's AAA sovereign rating. If that is lost, downward pressure on the USD would only be magnified, the researchers note.
The Structural Appreciation of the AUD
The AUD-USD exchange rate will rise in value if the USD declines in value, all other things being equal. All of the above points to a stronger Aussie dollar over time. But the AUD-USD will also rise in value if the AUD rises in value, all other things being equal. If both occur simultaneously, look out.
From WWII to the end of the twentieth century, the greatest impact on the Australian economy was that of the US economy. We had found a significant trading partner in Japan, but basically our fortunes were tied to that of the US as the world's major consumer of everything. In the twenty-first century, that relationship has been shifting.
It comes as no surprise that for the last five years the main driver of global economic growth has been Asia (ex-Japan) led by China. The contribution from the North Atlantic economies (US, Canada, eurozone and UK) has been “modest at best,” CBA notes. Asia (ex-Japan) is the largest regional consumer of commodities in the world and 73% of all Australian exports now end up there, 65% of which are raw commodities.
Fifteen years ago, global commodity prices were determined by US consumption. The stronger the US economy, the higher commodity prices. In the past fifteen years the correlation between US economic growth and commodity prices has declined, notes CBA, and the flipside is the rise in correlation between commodity prices and Asian economic growth, to the point where now the two follow in an almost one-for-one trend.
Thus while the structural depreciation in the USD since 2002 must, by definition, affect a stronger AUD, CBA suggests that we must also consider the AUD to be in a simultaneous structural appreciation. And it doesn't hurt that Australia also maintains an AAA rating which is currently under less threat than that of the US.
Economic growth curves never maintain a straight line, and it is expected that the Asian economies will see some ups and downs ahead. Beijing is still in the process of trying to pull China's economic growth back to more sustainable levels, which often has investors in Australian commodity producers worried. But sustainably solid growth is better in the long run than risking boom-and-bust cycles, so there's little benefit in being greedy. What is nevertheless agreed across the globe is that the economic emergence of China, the rest of Asia (ex-Japan but including India) and other emerging nations (from Russia to Indonesia to Brazil) is a story that will not stop being played out for maybe two decades or more, just as Japan emerged after WWII and didn't blow it all away until 1990.
It is a fact not lost on Australian commodity producers such that significant additional commodity supply is set to come on line over the next few years. Additional supply will ease the current pressure on commodity prices, notes CBA, but when the US begins to see cyclical economic improvement in earnest (and Europe et al for that matter) then we are brought back to where we were. It is thus hard to see anything but upward pressure on the AUD for at least the next decade.
The only real problem is that the higher the AUD-USD exchange rate rises, the less the benefit to Australia in local currency terms.
Conclusion
All of the above points to a “stronger for longer” AUD. Of course all of the above also ignores myriad of possibilities in the interim both currently feasible and that which could never be foretold. In the former camp, one could throw in a systematic collapse of a debt-ridden eurozone, a nuclear apocalypse in Japan, and an all-out, pan-Islamic war. The unseen possibilities are boundless.
The other question that must be asked is: for how much longer will we keep selling iron ore to China in US dollars?
Well, Problem One is that the renminbi is still pegged to the US dollar and needs to appreciate substantially. But then we could sell coal to Japan via the AUD-JPY and cut out the USD problem, for starters.
That leads us to Problem Two, in that just how happy will our most important ally be if we dropped its currency, and in so doing effectively “de-recognising” the USD as the global reserve currency? It might be fine for China to deal with the likes of Brazil and Russia and Iran on a cross-currency basis, but can Australia really go down that path?
