8 FEBRUARY 2012 INSIDE BoP data 1 Hypotheses 2 Conclusion 4 CONTRIBUTOR Andrew Salter WHY IS THE AUSSIE SO HIGH? FX RESEARCH ANZ RESEARCH • Yesterday’s RBA decision and reaction highlights growing divergence between the highly-rated, high-yielding countries and those other industrialised nations with weak economies and highly expansionary monetary policies • As a result the Australian dollar is pressing levels that could be seen as unjustified given the mild outlook for the global economy. We find one explanation is indeed the increase in global liquidity. But we also cite a new key driver: credit-related capital flows from both public and private investors • Combined, these factors are likely to keep the Australian dollar stubbornly high over the next few years. Our optimistic forecasts for the currency reflect this INTRODUCTION Commentators are bemoaning the high level of the Australian dollar relative to the outlook for the global economy. Interest rates are the focal point. They have narrowed relative to the rest of the world as Australia’s once-rosy macroeconomic outlook has become less so. Instead of re-hashing well-known material on the terms of trade and Asian industrial revolution, this note looks to the other side of the balance of payments, the capital account. We find the most likely explanation is related to the level of global liquidity, and a critical change in the supply of highly rated AAA-assets caused by the credit downgrade of the US last August and several EU member states this January. Our outlook for the high level of the Australian dollar is simple: get used to it. Neither liquidity nor the choice by investors to invest in Australia is likely to reverse any time soon. A NOD TO THE DATA The ABS provides data on Australian capital flows on a quarterly basis in the balance of payments release. Although a survey-based measure, the data are of reasonable quality and can provide some insight to past trends (despite their volatility). FIGURE 1. AUSTRALIAN CAPITAL FLOWS (NET, PER CENT OF GDP) -10 -5 0 5 10 15 2000 2002 2004 2006 2008 2010 -10 -5 0 5 10 15 FDI Portfolio debt Portfolio equity B&MM (inc US$ swaps) Official reserve assets Current account deficit * % % Sources: ABS, ANZ *Data to September quarter Why is the Aussie so High? / 8 February 2012 / 2 of 5 WHY IS THE AUSSIE SO HIGH? Figure 1 suggests two trends over the last few years. The first is that portfolio debt inflows have once again become the primary funding vehicle for the current account. However, these flows have stabilised at lower overall levels. This is due to two factors (a) the current account position has narrowed alongside the boom in commodity prices and the sharp pick up in the national savings rate, meaning there is less need for total overall inflows and (b) debt issued to foreigners under the government guarantee scheme of 2008/09 has started to roll off. FIGURE 2. AUSTRALIAN CAPITAL FLOWS (4-QUARTER ROLLING SUM, SHARE OF TOTAL) 600 -500 -400 -300 -200 -100 0 100 200 300 2000 2003 2006 2009 2012 -200 -100 0 100 200 300 400 500 600 700 Net Portfolio Debt Banks & Money Markets (excludes US$ swap lines) % % FDI Net Portfolio Equity 200 100 0 -100 -100 % % 100 0 100 -200 Sources: ABS, ANZ The other trend evident in the data is that bank & money market flows have been persistently negative for the last three years. This reflects the global deleveraging cycle, the lower need for financing, and Australian banks moving towards longer term, more stable instruments. It has come against a backdrop of lower global interest rates with Australia standing out as an investment of some quality. Net debt flows are actually around their highest share of total flows since the series began in 1989 (Figure 2). SOME POSSIBLE EXPLANATIONS The balance of payments data are not a timely release. Markets have to wait until early March for the release of data for the fourth quarter of 2011. Since that time investors have negotiated a number of game-changing events in the global financial system. To recap just a few: the flow-on effects of the US credit ratings downgrade, the European sovereign debt crisis deteriorating and partially stabilising, and the downgrade of several euro-zone states. All these impacted capital flows around the world, Australia included. But we will not know the official record for another month (probably even longer since the quarter-to-quarter volatility will likely be too strong to draw firm conclusions). In this vein we put forward some possible explanations for the present. 1. Safe haven status? One suggestion is that the Australian dollar has some element of “safe haven” status: as investors reallocate capital to Australia on the basis of preservation the currency is bid up. We have some sympathy with this view. But we disagree with the implication that the currency is a haven in times of market stress. Simple correlation analysis suggests the Australian dollar still falls when indicators of risk rise. This relationship has not changed and, given the currency’s perceptions as a barometer of global growth, we do not expect it to (Figure 3). FIGURE 3. AUSTRALIAN DOLLAR CORRELATION WITH RISK INDICATORS (6-MONTH ROLLING) -0.8 -0.6 -0.4 -0.2 0.0 Jan-2011 Jul-2011 Jan-2012 -0.8 -0.6 -0.4 -0.2 0.0 ? ? vs 2-year Treasury price vs high-yeild corporate bond spread to Treasuries vs VIX Sources: Bloomberg, Datastream, ANZ 2. Foreign direct investment A more credible idea is that the last few months have seen a wave of foreign direct investment. Some respected commentators have certainly been anticipating it for some time. Much capital for the mining sector’s capacity expansion is expected to enter through this channel. But it is not just the mining sector. If recent rumblings are to be believed, Japanese investment in the domestic mortgage market could underpin very strong capital inflows now and in the future. Why is the Aussie so High? / 8 February 2012 / 3 of 5 WHY IS THE AUSSIE SO HIGH? 3. Liquidity? Another possibility is that the Australian dollar’s strength is a liquidity phenomenon. Over the last few years the Australian dollar has performed most strongly against those currencies with an explicit or implicit regime of quantitative easing. In contrast, the currency has rallied less against those currencies without QE. Let’s talk metrics. Using an equallyweighted basket of five QE currencies (the US dollar, euro, yen, pound and Swiss franc), the Australian dollar has rallied by 42 per cent since the start of 2009. Against a basket of five non-QE currencies (the NZ dollar, Canadian dollar, won, kroner and krone) the currency has rallied by only 25 per cent. Of course this out-performance could simply reflect the natural weakness of the economies operating a QE regime. To wit, the currencies have QE because their economy is weak, and the currency is reflecting that weakness (the results show correlation but not causation). But even allowing for the weakness of these economies by the use of a proxy such as the interest rate, the Australian dollar still appears to have outperformed relative to that suggested by macroeconomic divergences. FIGURE 4. AUSTRALIAN DOLLAR & INTEREST RATES (DAILY) 70 83 95 108 120 133 145 158 170 2009 2010 2011 2012 1 2 3 4 5 6 7 8 9% % 1 2 3 Index 83 95 108 Index vs equal weighted basket of non-QE currencies* vs equal weighted basket of QE currencies† 2-year swap spread (RHS) Spot FY2009/10 =100 (LHS) Sources: Bloomberg, ANZ *NZD, CAD, KRW, SEK, NOK †USD, EUR, GBP, CHF, JPY 4. Credit & diversification What is unexpected is that this out-performance has also come against non-QE currencies as well. So there would seem to be another factor than just excess liquidity. We think the missing link is global portfolio re-allocations based on credit and diversification. Both major public and private global investors are now known to be investing in Australia. Never before has the Australian dollar featured in global reserve and private portfolios to the extent it does today. This flow therefore represents a new key driver for the currency. Everyone is aware that the downgrade to sovereigns such as the US and some euro-zone states has caused the global supply of highly rated AAA assets to shrink. What is not well understood is just how colossal the implications are for currencies such as the Australian dollar. Take the amount of debt underwritten in the US and Australia (Figure 5). In 2011 in the US there was US$123 billion less investment grade debt underwritten than in 2007. In Australia, there is almost no change. In fact the broad amount of debt & related instruments underwritten is slightly higher in 2011 compared to 2007 (see Figure 5). With the US credit downgrade in late 2011, and the implications that come from the sovereign ceiling, US issuance of highly rated investment grade debt is set to fall even further in coming years. FIGURE 5. UNDERWRITING OF INVESTMENT GRADE DEBT INSTRUMENTS* (LOCAL CURRENCY TERMS) 0.0 0.2 0.4 0.6 0.8 1.0 1.2 2007 2011 0.0 0.2 0.4 0.6 0.8 1.0 1.2 US Australia trn trn Sources: Bloomberg, ANZ *For US – all debt instruments, for Australia – all debt, loans, preferreds & warrants Further, because the Australian dollar enjoys relatively strong liquidity in the foreign exchange market, has reasonably deep capital markets and a stable macroeconomic environment, and efficient legal and public institutions, it is a prime target for global investors. Why is the Aussie so High? / 8 February 2012 / 4 of 5 WHY IS THE AUSSIE SO HIGH? The country is also exposed to the historic industrial revolution occurring in Asia. Direct investment in Asia is not perceived as safe as investment in Australia (given the macroeconomic and legal institutions). Nor is it possible with many Asian countries limiting access to their capital accounts. Australia serves as the great Asian proxy. What is more, this allocation will continue for the foreseeable future. As long as the global deleveraging cycle continues credit ratings are likely to come under pressure, and returns in Asian economies vis-à-vis the industrial economies are likely to diverge. A recent consultant’s report suggested the progress of deleveraging in the US is expected to have at least 2-4 years left to run. In the UK and Europe the estimate is more like 5-10 years.1 CONCLUSION Although the terms of trade have peaked and the interest rate differential is narrowing (notwithstanding yesterday’s RBA decision), the implications for the Australian dollar from both liquidity and recent changes to the global credit environment are clear. Liquidity is having an effect especially with regard to the Australian dollar against QE currencies. But with both public and private investors channelling capital to Australian dollars on the basis of diversification and credit, the currency is likely to find substantial support on dips. 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