Does the A$ need taming?

PORTFOLIO POINT: If the A$ moves further above its ‘fair value’ against other currencies, the Reserve Bank may soon need to follow the lead of the Swiss central bank.

The A$ is benefiting from the global hunt for safe assets. I think safe haven flows have added around US10-15c to the A$.

Suggestions that the RBA will intervene to cap the currency make sense, in my view, but I don’t think Reserve Bank action is imminent.

How the world has changed. Twenty years ago the A$ was mocked as the South Pacific peso; now it’s the southern Swiss franc: a globally recognised safe haven. Safety is not stability, of course. The A$ remains a high-beta currency. But when investors are concerned about credit risk – or, on a long view, deliberate currency debasement – then the A$ does deserve a premium.

Exhibit 1

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Not only is the A$ safe in an increasingly unsafe world, but it offers yield in an increasingly low-yield world. Australia is one of only seven ‘super’ AAA countries: sovereigns with a triple triple-A rating (rated AAA by all three major rating agencies) and stable outlook. The yield on Australia’s 10-year Treasury bond is double the average of the 10-year yield provided by other super-AAA 10-year government bonds (Exhibit 1).

Yield and (credit) safety have led to unprecedented foreign demand for Australian Commonwealth Government Securities (CGS). Foreign portfolio investors purchased A$62 billion of CGS over the year to March quarter 2012. This is 4.3% of GDP; the current account deficit over the same period was 2.6% of GDP.

Exhibit 2

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Note, however, that total foreign demand for Australian debt is far lower than in the halcyon days of the credit super-cycle: flows routinely ran at over 10% of GDP in the latter part of the 2000s (Exhibit 2). The bulk of those purchases were debt issues by the financial sector.

Exhibit 3

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Foreigners now hold around 77% of the stock of CGS. Their holdings have jumped from 3% to 14% of Australian GDP over the past four years (Exhibit 3).

Exhibit 4

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The demand for yield has had little flow-on to Australian equities. Foreigners bought almost no Australian equities, in net terms, over the past year (Exhibit 4).

Exhibit 5

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As an aside, Australian equities do offer a relatively high yield by global standards (Exhibit 5).

Exhibit 6

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But that higher dividend yield is largely explained by Australian corporates’ higher payout ratio (Exhibit 6). The trend to a higher payout ratio started after the introduction of dividend imputation, which effectively removed the double-taxation of dividends. (Double taxation occurs when companies pay corporate tax on their profits, and then dividends are subject to tax in the hands of shareholders. Dividend imputation means that shareholders get a credit for the tax paid by corporates.)

Although the purchase of Australian assets has been concentrated, it seems to have been largely price insensitive, and uncorrelated to typical investor flows. More to the point, it appears to have had a material effect on the dollar’s value, driving a wedge between the A$ and its usual fundamentals.

Exhibit 7

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Exhibit 7 shows the historical correlation between the Australian trade weighted index and short-rate differential (based on four quarter-ahead futures pricing).

Exhibit 8

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Exhibit 8 shows the A$/US$ and the correlation with base metal prices (in US$ terms).

The correlation between the A$ and rate differentials and commodity prices appears to have broken down over the past two years. This roughly corresponds to the period of strong inflows into the CGS market. The A$ is not impervious to changes in rates or commodity prices, but it seems fair to think that the A$ would be US10-15¢ lower if not for the foreign demand for CGS. This demand has gone hand-in-hand with clear signs of foreign central banks diversifying their foreign exchange reserves into non-traditional reserve currencies, such as the A$. It seems plausible that the foreign demand for CGS may understate this demand. For example, there have been recent press reports of China’s currency reserve managers looking at the purchase of state government debt.

The high A$ is having a material effect on trade-exposed sectors. The RBA has argued that the high currency is to be expected, given elevated commodity prices. More to the point, the bank sees the high currency as encouraging the structural changes needed to accommodate sustained growth in mining.

However, Warwick McKibbin, an academic economist and ex-member of the RBA board, has argued that if the A$ is pushed above ‘fair value’ by safe haven buying, there is a case for the RBA to intervene. As Professor McKibbin puts it, “if foreigners want to hold more Australian dollars in order to park these dollars in foreign exchange reserves and will not be using dollars to buy Australian goods and services, then the best response is for the Reserve Bank to print more Australian dollars”.

In short, if the A$ is now the South Pacific Swiss franc, the RBA should follow the Swiss National Bank – which is intervening to put a ceiling on the Swiss franc versus the euro – and aim to reduce the economic impact of the A$ overshooting fair value.

Currency intervention has several benefits compared to offsetting the growth-dampening impact of a high currency by easing conventional monetary policy. First, while monetary policy is ‘one size fits all’, currency intervention has the greatest benefit for the sectors now disproportionally affected by currency strength. Second, to the extent that the A$ is above its medium-term fair value, this could be a very profitable strategy for the RBA. (The RBA has in the past made significant profits on its currency intervention – profits ultimately paid to the federal government.) Third, the intervention could be calibrated to the perceived degree of over-valuation. A SNB-style cap on the currency would not be required.

On the other hand, RBA currency intervention is relatively rare and typically designed to ‘smooth and test’ disorderly markets. The A$ may be overvalued, but the market is orderly. In addition, while it seems that the currency is overvalued, the RBA may be uncomfortable specifying by how much, or on what time horizon. Finally, the bank may be reluctant to create the perception that it would regularly use currency intervention as a tool of macro-economic policy management.

While I see merit in Professor McKibbin’s comments, I doubt that RBA intervention is imminent. If the apparent gap between the A$ and fundamental fair value widens, or if the unevenness of the domestic economy intensifies, then the RBA may consider intervening.

I have been surprised by the A$’s resilience over the past 18 months and have underestimated the impact of safe haven flows. I am cautious on the global outlook, and, in a normal environment, that would point to material declines in the A$. The irony now, of course, is that greater global caution could accelerate the safe haven flows. On balance, I still think the A$ will likely be lower in a year’s time – around US$0.90 as a ballpark forecast – but the risk is that foreign flows continue to keep the A$ above its fundamentally based ‘fair value’.

These are medium-term issues for the A$. In the near term, our foreign-exchange team, led by Hans Redeker, sees the prospect of a global risk-on rally, led by the euro. To the extent that Europe has been the key source of global risk aversion, even a temporary respite could see a material euro rally. This would likely see the $A fall against the euro in coming months.

Gerard Minack is head of global developed market strategy at Morgan Stanley.