Monday, October 20, 2008

$A in the caught in the crossfire of the crisis

We are continually staggered by the speed at which markets move. In the course of completing our quarterly grain price forecasts, the $A has moved from the mid 80sUS¢ to the mid 60sUS¢.

While there were good reasons why the $A failed to reach parity, we can’t help but think that the $A has been caught in the crossfire of the current crisis. The $A is a heavily traded currency and is often seen as a proxy for global growth and commodity prices. As traders have seen markets melt in front of their eyes, the $A has been an easy target. These traders don’t have time for detailed analysis and revert to type in the heat of the moment.

This same sell-first-ask-questions-later attitude is similar to the scenario that unfolded at the height of the Asian currency crisis in 1999/2000. In that instance, the $A was sold down heavily to 47US¢. Within a year, it was well on the road to a very strong recovery that saw it challenge parity before the most recent troubles.

The current situation is much more serious and will lead to a sharp slowing in growth across developed economies. But while a developed market recession may have given the Australian economy heart palpitations in a previous life, we think there are good reasons it may be a little different this time.

The Australian economy is favourably exposed to China and in some perverse way, the slowing in global growth may allow the Chinese economy to grow in a more sustainable fashion. Over the next couple of years, China will increasingly become the major source of global growth. In the first half of the year it accounted for one-third of global growth and its contribution will rise as the developed world looks set to slip into recession.

Sure, China will not be immune to all the world’s problems. Export demand will slow considerably. There are signs that production is slowing sharply (although this may be largely due to the closure of many factories for the Olympics) – car sales have fallen and housing prices are easing.

But unlike in the US (where the Chinese banking regulator labeled lending practices as ‘ridiculous’), China is well equipped to deal with such imbalances. Housing affordability is rising and the Chinese are not hocked up with debt. A 20-30% deposit is required on housing loans, giving the banks plenty of wriggle room and total household debt is one-eighth that of the average US consumer.

Plus, the Chinese Government has plenty in its arsenal to deal with a slowing economy. It is the largest saver on earth and has the biggest cash reserves of any country. In contrast to last year, when inflation was running rampant and the Government needed to raise rates to cool the economy, inflation is now on the retreat, which gives it the ability to ease monetary policy. As the external sector slows, watch for the Government to start to turn its guns on domestic demand – maybe by reducing tax rates. It may also find that investments in infrastructure within China might be a better bet than chasing rainbows outside its borders.

While the $A was due a fall, 60% of our exports are heading into Asia, which will come out of this mess as good as anyone. Sure, commodity prices are tanking, but very strong coal iron ore prices have been locked in a year ahead and many of the major producers are likely to have hedging programs on.

Output is now ramping up as new mining projects come on stream, and the cooling in our domestic economy might help ease some bottlenecks to allow output to expand further.

The Rudd Government will lower interest rates and deploy the surplus to counter the global slowing in growth, and this will apply further pressure in the medium-term. But our bet is that once this mess settles down, the $A will steady somewhere in the low 70s.

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