You have to love FX markets, well at least I do. They always keep you honest both in intellectual terms and also on your profit and loss account. Just when you think the AUD is going to go down support holds and it bounces a cent or so. That’s what we’ve seen so far this week even though the outlook is turning negative for the “Aussie Battler” in a more uncertain world. But this week’s strength in the face of usual short term negative drivers gives us a chance to discuss the relationship between the AUD and China and explore perhaps why, in the short term at least the AUD has done a little better.
As we noted a few blogs ago back in the late 1990’s investors fell out of love with the AUD and its “old economy” status in favour of all things technological. But the re-emergence of China as a global economic power, the GFC and China’s voracious appetite for Australian exports together with the massive positive impetus she gives to global growth has changed perceptions about the AUD and our economy. But using our test of correlation are these perceptions reasonable to hold?
Certainly the RBA thinks China is a key. They are on the record in many different fora as saying this is probably a long boom and although RBA Governor Stevens said just the other day that we can’t be sure how long this boom last they have consistently voted with their interest rate raising feet over the last year or so that it is impacting the Australian economy. But the chart below shows starkly just how important the Chinese economy is now to Australia.
Speaking at the NatStats 2010 Conference back in September 2010 RBA Assistant Governor Phil Lowe said:
These developments in China are being closely observed in Australia, including at the Reserve Bank. A decade or so ago, we spent a lot of time puzzling over why quarterly movements in Australian GDP were so highly correlated with quarterly movements in US GDP. We don’t puzzle over this anymore – not because we solved the puzzle, but because the correlation has fallen (Graph Below). At the same time, the correlation between quarterly movements in Australian and Chinese GDP has steadily increased. Clearly what happens in the Australian economy is now more dependent upon what happens in China than has been the case at any time in our past.
So where China goes, to a significant other extent, so goes Australia.
But tying the China story back to the commodity story we know that China, and at present to a lesser extent India, are buying a lot of raw materials and earlier in the same speech Dr Lowe said:
All this development requires raw materials. In particular, it requires steel to build the apartments in which the new city dwellers live and to build the infrastructure that supports those cities. For example, a typical 90m2 apartment in China requires about six tonnes of steel, and 10km of metropolitan subway requires around 75,000 tonnes. On average, every tonne of steel that is produced requires around 1.7 tonnes of iron ore and over half a tonne of coking coal, and Australia is in the fortunate position of having ample low-cost, high-quality supplies of both. And with higher energy consumption also a feature of industrialisation, we are in the fortunate position of having large reserves of natural gas.
So we can see how the China story of this blog and the commodity story previously have a very strong correlation with Australia, our economy and our dollar. This is potentially one of the reasons why the AUD has held up so much better this week than is usual in a risk off trade.
Two things here though. Firstly, correlations are not constant through time and move through degrees of strength in their relationship. Secondly because the China relationship and positive sentiment that flows from that is so strong it resonates more than the risk off trade. That’s potentially a double edged sword though and we’ll discuss Gary Shilling and Huw McKay’s view of a hard landing in China and its impact on Australia and the AUD.
In his February 2011 “Insight” Newsletter Shilling spent a lot of time discussing the Chinese situation and why he thinks it is in for a hard landing. Now we know that the Chinese central bank has been hiking rates and increasing reserve requirements in order to slow the economy and especially to knock the speculation that is happening at present. Shilling thinks the tools the Central Bank uses a bit crude but in my humble opinion reserve requirements (when these are tightened the amount of money in circulation would fall by a multiplication factor of the leverage of the banking system) seem to me to be a very effective tool if there is not a strong shadow banking system. But leaving that aside China has slowed and is slowing as the next chart shows.
Why this is important for the AUD and Australia will obviously be apparent from the increased correlation and chart noted by Phil Lowe above but also your blogger reckons he can see a little bit of correlation and causality in the relationship between the Chinese Leading indicator and RBA Cash Rate (and home loan rates) in the next chart.
Even though Australia is a consumption based economy as we saw above China is our “Significant Other” when it comes to GDP correlation these days. So I do find this relationship appealing based on the two charts above, leading indicators suggest a weakening of the Chinese GDP, which in turn suggests a weakening of Australia’s GDP all other things equal and potentially, probably, lower interest rates at some point.
So what does it mean for the AUD? Slower Chinese growth, and a Chinese Central Bank intent on slowing further, will ultimately weigh on the Australian economy. Weaker domestic growth leads to lower rates eventually, or at least a reduction in the spread longer term as other countries hike, so that’s a negative. Weaker, or at least slower, China changes the outlook for the global growth equation to the downside and would impact the AUD. A weaker global growth profile would also ultimately feed into commodity prices.
At present Australia is the beneficiary of a China dividend. It is feeding into infrastructure investment in our economy but this is concentrated on non-renewable resources so how we capture value for the generations to come is an important consideration longer term. From a currency point of view it is reinforcing all of the positive indicators in our 5 Driver model and negating other things such as risk aversion in times of strife as we have seen this week.
To make the point a bit firmer here is the AUD and Chinese leading indicators in the chart above. For all of the reasons we have talked about here I can see both correlation and causality. Indeed this chart seems to capture all our inputs. But for the moment the hope and hype about the long term prospects of China are outweighing any warning signs that Gary Shilling, Huw McKay and others are highlighting. This is sustainable in the short term but if these guys are right and China does have a hard landing in 2012 the AUD will be under real and sustained pressure.
There are two sides to every coin.