Japanese torture for the Australian dollar

The Australian dollar's massive appreciation against the yen is potentially restrictive for Australian exports and the economy. For competition to rebound, a fall to around US95 cents is needed.

If you think the Australian dollar’s fall in the past few weeks to this morning’s level around $US1.03 is going to give a little help for our exporters, you are mistaken. To be sure, the Australian dollar is down around 3 cents from levels above $US1.06 in January, but the bulk of this decline has been against a rebounding US dollar and offset by the free-fall of the Japanese yen.

On a trade weighted basis, the Australian is stronger now at 77.5 points, than on December 31, 2012. It is higher now than in the middle of last year and it is just 2 per cent shy of hitting a 27-year high. So much for the depreciation.

A big issue in recent months that has buoyed the Australian dollar on the cross rates and kept the TWI at an elevated level has been the massive depreciation of the Japanese yen. This has been sparked as the new Japanese administration under Prime Minister Shinzo Abe works to reflate the economy with an increase in the inflation target, more money printing and more fiscal stimulus.

Against the yen the Australia dollar has risen from levels at or even a little below 80 in October 2012, to around 96 this morning. This massive appreciation of the Australian dollar against the yen has the potential to be restrictive for the Australian export sector and with it, the economy. In terms of merchandise trade, Japan is Australia’s second largest export market, taking just under 20 per cent of all merchandise exports.

The 20 per cent rise of the Australian dollar versus the yen in just four months will therefore hurt exporters. By value, around one third of all exports to Japan are coal, close to one-quarter are LNG, while roughly one-fifth are accounted for by iron ore. These three items account for 80 per cent of all exports to Japan.

Coal prices, in US dollar terms, have been generally weak, while the rebound in iron ore prices has been astronomical, which will ease the pressure for these exporters. LNG prices are broadly flat in US dollar terms so the fall in the yen will erode Australian exporter returns.

The Australian dollar has remained well supported for fundamentally sound reasons. Even though the economy has been slowing, the Reserve Bank has been slow to cut interest rates which is leaving a solid interest rate differential that will continue to support the local currency. The context of Australia’s 3 per cent cash rate and 3.5 per cent 10-year government bond yield is cash rates nearer zero in many other countries and bond yields in those countries being held lower by quantitative easing.

As importantly, commodity prices are rebounding and the international trade deficit is narrowing to the point where many are looking for surpluses in the months ahead. The Reserve Bank's own measure of commodity prices has risen by over 5 per cent in the last two months while the Reuters/Jefferies CRB Index, which is a broader index of commodity prices, is also moving higher. Stronger economic news in China and globally is underpinning Australian dollar gains.

What’s more, there are no immediate threats to Australia’s triple-A credit rating, with the return to surplus looking to be delayed by only a year and the level of net debt starting to fall from an ant-hill peak in June 2012 of 10 per cent of GDP.

For the Australian dollar to move to a level that delivers a true competitive boost to the economy, a fall of 10 per cent or more is needed. That is, a level around 95 US cents or around 70 on a trade weighted basis – and this assumes that commodity prices and the terms of trade are broadly constant. Not only would the Australian dollar need to fall by this order of magnitude, but it would need to stay at this lower level for some time to have a meaningful influence on the economy.

Such a move in the near term at least looks improbable, but a significant depreciation could occur if international investors start to price some political risk with the election just seven months away. Talk of draconian spending cuts, cutting government debt and reducing liquidity the bond market are risks, as is the prospect of a quick return to the polls if a hostile Senate blocks the reforms of the new government.

For now, the Australian dollar looks as strong as an ox and it pays to look at the trade weighted index rather than just the level against the US dollar to get the best feel for just how strong it is.

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