In 2007 one GBP would buy you over 2.50 AUD’s. Since then, with...

In 2007 one GBP would buy you over 2.50 AUD’s. Since then, with the exception of a surge in 2008 the GBP has been steadily falling against the AUD to the point where it is now $1.47. This movement is a devaluation of 41% in less than 5 years. Why did this occur and is this trend likely to continue?

A number of theories have been put forward as to why this trend occurred. The main theory is the interest rate-differential argument. In essence this theory argues that the market has reacted to the interest rate differential between the key bank rate in the UK and the key cash rate in Australia. In the UK the current BoE key bank rate is 0.5% while in Australia the latest RBA cash rate is 4.25%. At the retail level savers can easily earn 5.0% in Australia but struggle to find 2.5% in the UK. But is it reasonable to attribute a movement of 41% to just a rate differential?

Both countries have retained their AAA credit ratings, so we cannot attribute the fall in GBP to a ratings changes. Something more fundamental must be going on.

For me the answer is quite simple. “It’s the economies stupid!” The Australian economy has been one of the few economies to have been a mass beneficiary of the gargantuan growth of the Chinese economy. While this resources boom continues, prospects for the Australian economy will stay strong, as will its currency. On the other hand there are few if any large reasons to be positive about the UK economy.

While the Australian economy is umbilically linked to the Chinese economy the UK economy is heavily exposed to the waning fortunes of the Euro zone.

When it comes to pure economic the Aussie economy looks relatively protected, whereas no one is saying that there is any chance of improving outlook for the UK economy. The only consensus about the UK seems to be that times are tough and are likely to get tougher.

Not only is the Australian economy in relatively robust health, its public finances are also stronger. IMF figures show that Australian public debt is 20.5% of GDP while the UK’s public debt is 75.5% of GDP. Looking forward the Australian government has plans to bring public finances into surplus whereas the UK government clutching to austerity, as if it were a lifebuoy, hoping that it will save them from drowning in under a sea of increasing pressures on the public purse; increasing benefits, a flat economy and a growing mountain of debt. The market is probably also sensing that the UK’s AAA rating is under imminent threat.

I am not suggesting that the AUD has become a safe-haven currency. The future of China’s booming economy is too uncertain for the trade umbilical cord that feeds Australia to be totally depended upon. As a material supplier to the world, Australia will always be subject to the uncertainties of the fortunes of others. Until all of the world’s great economies fall into recession Australia’s economic future looks secure.

What about the UK? Before we review the UK’s economic situation, let’s consider how over how the GBP has performed relative to the Euro.

In 2007 a Euro would buy you over 1.60 AUD. During the GFC the Euro strengthened and at its peak would buy you in excess of 2.00 AUD. As at the end of January 2012, a Euro would still buy you 1.30 AUD, a fall of 19% over 5 years. This is less than half of the GBP’s 41% fall over the same period. Given that, ‘everybody’ knows, the Euro zone is in crisis its superior currency performance is perhaps a surprise.

It is true that the Euro zone economic challenges are momentous, even life threatening; Greece is essentially bankrupt and may in the medium term default on most of its debts, Ireland and Portugal are in similar boats and there is a significant chance that Italian debt mountain could shortly be downgraded to junk. I therefore conclude that the market has less confidence in the UK than in the wider Euro zone. How can this be?

The answer seems to be that the UK economy, rather than being a material supplier to the world, has been a major market for the world, and it credit is now running thin. The UK used to have a glorious manufacturing base, a superior oil and gas industry; it's sophistication used to be the envy of the world. Even today its last world class industry, financial services, is under moral siege and must surely go the same way a its former glories. When we look towards the horizon for what could replace this loss, there is nothing material to be seen, not even a challenge to Facebook.

In the absence of a major black swan event the current path of GBP - AUD convergence looks like it will continue. Over the course of 2012 it is not unreasonable to expect the GBP to fall against the USD to say 1.45 (a 7.5% decline) and the AUD to strengthen against USD to say 1.12 (a 5.5% increase). These movements would result in a GBP/AUD cross rate of less than $1.30.

It is evident that diminishing the value of the pound is the markets way of quietly adjusting to the diminishing underlying economic realities. To date there hasn’t been a crisis and the ratings agencies have retained the UK’s status as one of the few remaining AAA countries. In order to stop their demise the UK authorities must bite bullets on mass and as they are biting make the necessary tough decisions to change the path of their history. It seems unlikely they will do this. Consequently the purchasing power of the GBP will decline further and their economy will soon be joined by the unceasing caustic abrasion of imported inflation.

It looks therefore that the GBP and AUD are in the medium destined for parity. A dreadful thought?

K