where's the interest wednesday, page-23

From Andrew Salter

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. This will
keep the Australian dollar stubbornly high against
most crosses and certainly high relative to the
currently mild outlook for global growth and against
the traditional ‘fundamentals’.
1 McKinsey Global Report (2012)
Why is the Aussie so High? / 8 February 2012 / 5 of 5
IMPORTANT NOTICE
Australia and New Zealand Group Limited is represented in:
AUSTRALIA
Australia and New Zealand Banking Group Limited
ABN 11 005 357 522
ANZ Centre Melbourne, Level 9, 833 Collins Street, Docklands
Victoria 3008, Australia
Telephone +61 3 9273 5555 Fax +61 3 9273 5711
UNITED KINGDOM BY:
Australia and New Zealand Banking Group Limited
ABN 11 005 357 522
40 Bank Street, Canary Wharf, London, E14 5EJ, United Kingdom
Telephone +44 20 3229 2121 Fax +44 20 7378 2378
UNITED STATES OF AMERICA
ANZ Securities, Inc. is a member of FINRA (www.finra.org) and
registered with the SEC.
277 Park Avenue, 31st Floor, New York, NY 10172,
United States of America
Tel: +1 212 801 9160 Fax: +1 212 801 9163
NEW ZEALAND BY:
ANZ National Bank Limited
Level 7, 1-9 Victoria Street, Wellington, New Zealand
Telephone +64 4 802 2000
This document (“document”) is distributed to you in Australia and the United Kingdom by Australia and New Zealand Banking Group Limited
ABN 11 005 357 522 (“ANZ”) and in New Zealand by ANZ National Bank Limited (“ANZ NZ”). ANZ holds an Australian Financial Services
licence no. 234527 and is authorised in the UK and regulated by the Financial Services Authority (“FSA”).
This document is being distributed in the United States by ANZ Securities, Inc. (“ANZ S”) (an affiliated company of ANZ), which accepts
responsibility for its content. Further information on any securities referred to herein may be obtained from ANZ S upon request. Any US
person(s) receiving this document and wishing to effect transactions in any securities referred to herein should contact ANZ S, not its
affiliates.
This document is being distributed in the United Kingdom by ANZ solely for the information of its eligible counterparties and professional
clients (as defined by the FSA). It is not intended for and must not be distributed to any person who would come within the FSA definition of
“retail clients”. Nothing here excludes or restricts any duty or liability to a customer which ANZ may have under the UK Financial Services and
Markets Act 2000 or under the regulatory system as defined in the Rules of the FSA.
This document is issued on the basis that it is only for the information of the particular person to whom it is provided. This document may not
be reproduced, distributed or published by any recipient for any purpose. This document does not take into account your personal needs and
financial circumstances. Under no circumstances is this document to be used or considered as an offer to sell, or a solicitation of an offer to
buy.
In addition, from time to time ANZ, ANZ NZ, ANZ S, their affiliated companies, or their respective associates and employees may have an
interest in any financial products (as defined by the Australian Corporations Act 2001), securities or other investments, directly or indirectly
the subject of this document (and may receive commissions or other remuneration in relation to the sale of such financial products, securities
or other investments), or may perform services for, or solicit business from, any company the subject of this document. If you have been
referred to ANZ, ANZ NZ, ANZ S or their affiliated companies by any person, that person may receive a benefit in respect of any transactions
effected on your behalf, details of which will be available upon request.
The information herein has been obtained from, and any opinions herein are based upon, sources believed reliable. The views expressed in
this document accurately reflect the author’s personal views, including those about any and all of the securities and issuers referred to herein.
The author however makes no representation as to its accuracy or completeness and the information should not be relied upon as such. All
opinions and estimates herein reflect the author’s judgement on the date of this document and are subject to change without notice. No part
of the author's compensation was, is or will directly or indirectly relate to specific recommendations or views expressed about any securities or
issuers in this document. ANZ, ANZ NZ, ANZ S, their affiliated companies, their respective directors, officers, and employees disclaim any
responsibility, and shall not be liable, for any loss, damage, claim, liability, proceedings, cost or expense (“Liability”) arising directly or
indirectly (and whether in tort (including negligence), contract, equity or otherwise) out of or in connection with the contents of and/or any
omissions from this communication except where a Liability is made non-excludable by legislation.
Where the recipient of this publication conducts a business, the provisions of the Consumer Guarantees Act 1993 (NZ) shall not apply.