RBA dilema – solution to the AUDUSD threat

Story of AUDUSD

…. its the 28th of September 2012 and I have a very interesting dilema in my mind. Ive been shorting the AUD recently, because all fundamentals simply support that idea. Australian economy struggles the overvalued currency and that is shown in decreasing local credits and possibly hurting the economy in the future – if we accept the theory that aussie mining boom is going to the end soon. Well, nothing lasts forever and we must consider that all worlds economy is running in circles, so if …for example China expands at double digit pace, then this cant last for decades and decades. And if we look at the aussie budget, we see a serious part of the GDP as an export to China, mostly production of the local mining companies. Australia consists of 22.6 M inhabitants, unemployment rate is currently at 5.1% and yesterday Ive read a news headlines that „Australians are actually 331B AUD richer than we thought, because a statistics mistake was found“ … everything looks like a paradise and investors happily transfer their money into this stable economy. It is also important to mention that australian banks are not broadly exposed and their risk assets stay at very low or zero levels – that gives them another advantage from the outer world.

Question is now: „Why should we invest elswhere if we found a paradise?“ …we have 3.5% IR economy, stable background and booming mining industry. Well, that actually can be the problem. If too many people target their investments into such a well performing economy (while the rest of the world struggles!!!), its currency gets too strong. It gets stronger than it is supposed to get in a natural way and in the end there is a currency bubble occured.

Expensive currency makes less attractive for tourists to come – is it funny to mention this in context of the whole economy? If american tourist doesnt spend the whole week on the seaside, instead he spends only a weekend or four days. The same tourist doesnt go to a fine restaurant and instead he chooses much cheaper variant. Next time he doesnt go to the country anymore. This is just a begining, a detail, one piece of a puzzle. Expensive currrency makes mainly exports less competitive!! Economy like Australia really needs to be competitive if it wants to stay on the top of the range with its GDP.

So in nowadays we face several major factors potentially dangerous for Australia:

  1. China slowdown – are we going to ask ourselves „how come this is happening?“? …only total ignorant could ask this question. They call it a „China slowdown“, but in fact its nothing else than just return to the reality. China has been producing enormous amount of cheap goods only because local labor work was doing its job for hourly earnings lower than the last mad man in a mental hospital can imagine. Nation which lives on rice and other vegetables cannot look on ongoing differencies acros the society forever. Even in a communist country people cant work for nothing for too long. When some Chinese become wealthy, the poor majority sees the difference. It would take hours to describe this problem to the detail, but smart reader knows what I mean to highlight. It has become natural to consider China as a country with the lowest labor costs. Another matter is a quality of goods produced this way. We can buy almost anything made in China, but if we concentrate on quality, the outcome is not so bright. Third argument is that cheap chinese goods displaces goods which could possibly be produced in other countries and support local economy creating the whole circle of employment – production – taxes. There are two main reasons why China „must“ slow down in the future – one is so often mentioned global slowdown and second is local conditions change. We must take into account both these issues.
  2. lower commodity prices – this is a very interesting theme to discuss. Since almost anyone 18yo or older around the world, owning a ridiculous capital, can trade global commodity prices, there is very difficult to hold these in the range of natural low of offer and demand. Commodity prices suffer high choppy swings simply because too many people trade them and these traders often follow stupid technical indicators instead of looking on the markets as fundamentally based organisms. Result is that commodities can go too low or too high. Problem is when big investing funds include commodities in their portfolios. This leads only to higher prices of these, although consumption doesnt go up in a proportional way. This creates the big disproportions between the real value and actual price. Actually, in my personal opinion, the prices are all over the board still too high and could go down by another 20-30% to achieve the real offer/demand level. As I have already mentioned above – reason why this can never happen is that there are many institutions in the world which buys the commodity prices futures, but they never consume the commodity as itself. This fact affects the price, it makes it higher by the relative amount of commodity futures owned by non-consuming buyers. In case of Australia we must look at the price of coal and iron ore mainly. If the prices go too low, Australian mining industry suffers – that makes sense.
  3. strong currency – was also mentioned already. Strong currency makes the economy less competitive in the broad markets. Especially all ore mining industry will be hit significantly if current AUD strength prevails.
  4. highly mining industry exposed export oriented economy – almost 30% of total aussie GDP is created in this market area. Its obvious that it can become a bit threat for the economy if production swings lower because of loss of competitiveness
  5. high interest rate – when all outer world keeps its basic benchmarks low, Australia keeps its major IR at 3,50%. In fact, this is a big market mover and reason to decide whether to invest in financial assets or not. Lowering this number to 3.00 or 2.50% would definitely help to calm down the situation.

 

Proposals for the RBA?

… its easy, very easy …. lower the basis IR by 0.25 – 0.50% and this way react adequately in advance. It is generally known that if a central bank or a government wants to avoid the crisis, it must act in advance. Problem of many central bankers around the world is that they react when the economy cycle is already too high or too low and they only help it to fluctuate even more. Right now, RBA has a very good chance to act in advance and ease the situation by small depreciation of the local currency. In the conditions of global markets, it is not recommended to keep interest rates too high – simply because investors will face this as a „safe haven“ opportunity – lots of money will flow in the economy  – and this amount will be higher than needed – effect is too strong currency and lower competitiveness …. this process can last from several months to more than a year and in the end there is economy which losts some part of its momentum only by this artificial way. Not naturally, but by artificial inflow of capital which only harvests the interests.

Economy which is so much export-based, should really control the prices of its production and if there is an alarm from the most important industry (mining in Aus.), then central bankers are supposed to act and make steps towards effective solution. Australia is in a very good position, because there is enough space to lower the IR to prevent lower competitiveness.

If RBA reacts in advance enough – which means right now, it can save lots of money from mining industry. The country will produce the same amount of ore, but will be paid more nominal price. Small businesses like local tourist areas will also generate higher profits and their services will become attractive for local citizens and tourists as well. Just the only thing is that RBA must react at the moment when the general economy performance cycle is not low, because if it reacts too late, it will only deepen a potential crisis or lower output.

Even lower global commodity prices wont hurt the economy if the local currency reacts to these price shocks. It is obvious that global economy is in a deep recession now and there is no reason not to accomodate this fact to the monetary policy. Australia, right now as it is, can only benefit from the current situation – if it adapts itself for the actual price trends.

…simply said: “make the economy affordable” …

 

 

…Aleš Knupp, MSc