Why the dollar is defying commodities

How has the Australian dollar's strength defied falling commodity prices and declining terms of trade? The explanation, which has important rates implications, lies in changing funding of the current account deficit.

Pimco

With growth in China now moderating, and the price of commodities and Australia’s terms of trade now declining, many investors are questioning how the Australian dollar has managed to remain well-supported.

We believe the explanation lies mainly in the changing structure of the funding of the current account deficit. Going forward this will likely have important implications for monetary policy in Australia if the decline in national income growth is not offset by a similar decline in the Australian dollar.

Investors accustomed to thinking of Australia as a high-powered commodities exporter might be surprised to learn the nation’s second-largest export is actually – in a sense – printed paper: Australian Commonwealth government bonds, to be exact. In the 12 months through June 2012, Australia sold $58 billion worth of ACGBs to foreign investors, according to Australian Bureau of Statistics balance of payments data. To put this staggering number into context, it eclipses the $48 billion worth of coal exported over the same period, and is second only to the $85 billion of iron ore exports (see figure 1).

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The tremendous extent of Australia’s sovereign bond exports has likely contributed to the resilience of Australia’s currency without providing the same direct economic benefits as its other large exports. However, as figure 2 illustrates, recent data suggests this capital tidal wave may be subsiding: For the first time in four years, foreign investors were net sellers of ACGBs in the second quarter of 2012.

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Iron ore and coal are widely recognised as Australia’s primary exports, and the surge in Chinese growth and infrastructure investment over the past decade has seen the demand and subsequent price of these commodities rise dramatically. This trend has pushed Australia’s terms of trade to record levels, and we have seen a commensurate rise in the value of the Australian dollar.

With growth in China now moderating, and the price of commodities and Australia’s terms of trade now declining, many investors are questioning how the Australian dollar has managed to remain well-supported. We believe the explanation lies mainly in the changing structure of the funding of the current account deficit. Going forward this will have important implications for monetary policy in Australia if the decline in national income growth is not offset by a similar decline in the Australian dollar.

Funding the current account deficit

For over three decades Australia has persistently run a current account deficit, averaging close to 4 per cent of GDP over the period. Australia has been buying more things than it sells to foreigners, and this trade deficit has to be either funded on credit (foreigners lend to Australia) or via equity (foreigners purchase Australian assets). Because Australia has run a trade deficit for such an extended period, the ongoing liability payments on the buildup of foreign capital (i.e. interest or dividend payments) have reached the extent that even if the trade account were now in balance, the current account would still remain in deficit to the tune of 3 per cent of GDP.

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As figure 3 shows, the current account deficit has not changed much in magnitude over recent years (grey bars); however, the structure of how it is funded has changed dramatically. Up until recently, a large portion of the current account deficit has been funded by the Australian banks borrowing in global capital markets and on-lending that foreign capital in the domestic market (light blue bars). This debt was raised in foreign currencies such as the US dollar, the euro and the British pound, the proceeds of which were then brought back into Australian dollar.

As the banks appropriately hedged their forex exposure, the Australian dollar proceeds were then re-sold to a forward date. This last step is important in terms of the impact of this offshore funding on the level of the Australian dollar: As the banks were buying Australian dollar spot, and selling it forward, there was minimal impact on the outright Australian dollar level; instead, the effect of this offshore funding was felt primarily in the cross-currency swap market in the form of an elevated Australian dollar/US dollar basis spread (see figure 4).

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Figures 3 and 4 illustrate how Australian banks’ net offshore funding has changed significantly in recent years, and is now actually negative: Banks are repaying offshore borrowing faster than they raise new debt. Historically there has been a valid concern that global investors may at some stage stop or reduce their lending to Australian banks, which would entail a painful structural adjustment across the economy as credit becomes less available. However, the current situation is just the opposite. With pressure from ratings agencies to raise more bank funding in the form of deposits in addition to a significant slowdown in domestic credit growth (it has sunk to levels last seen in the early 1990s recession), Australian banks simply require much less capital from offshore to fund their operations.

However, the magnitude of the current account deficit hasn’t changed meaningfully over the past decade or so, and therefore still needs to be funded in some capacity. Fortunately for Australia, this change in the funding of the current account deficit has coincided with a period when the global economic outlook is highly uncertain and many sovereign balance sheets around the world are facing significant challenges – precisely when the health of Australia’s balance sheet at the federal level remains strong. This global backdrop has seen offshore demand for ACGBs rise significantly as investors chase "safe haven” assets – this demand has facilitated the decline in offshore bank borrowing (light blue bars), as they have been largely offset by foreign purchases of government debt (dark blue bars) (see figure 3).

This change has critical implications for the Australian dollar because the Commonwealth of Australia issues bonds to offshore investors in Australian dollar, rather than in other currencies as the Australian banks often do when borrowing in global capital markets. Therefore to purchase ACGBs investors must first purchase Australian dollar, and importantly many of the offshore investors, such as central banks, do not always hedge their forex exposure as they are specifically attempting to diversify their foreign exchange reserves. Therefore, in contrast to banks hedging their Australian dollar proceeds – which causes the Australian dollar/US dollar basis to rise but has minimal impact on the level of the exchange rate – foreign investors buying Australian dollar to invest in ACGBs on an unhedged basis has a positive impact on the level of the currency.

China, commodity prices and Australia’s terms of trade

As China’s fiscal focus shifts from public investment to tax cuts and consumption subsidies, we expect their demand for steel to diminish. Additionally we see significant excess capacity in China’s steel industry, which would likely lower their demand for iron ore going forward and, in turn, place downward pressure on iron ore prices. With iron ore prices now down approximately 50 per cent from their peak, Australia’s terms of trade are facing a meaningful decline into the end of the year (see figure 5).

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Investment implications

The fall in Australia’s terms of trade has resulted in nominal GDP growth collapsing through real GDP growth (see figure 6). Given the historical relationship between iron ore prices and the terms of trade, we expect this downward pressure on nominal growth to continue into the end of 2012. Fundamentally, this supports being short the Australian dollar. However, if foreign purchases of ACGBs limit the extent to which the currency can depreciate in order to offset this negative income shock (and the red bar in figure 2 turns out to be a blip rather than a trend change), then a policy response will likely be required to help bolster nominal growth. With the federal government about to embark on a sharp 3 per cent fiscal consolidation over the coming financial year, the burden of any required policy response will likely fall on the Reserve Bank of Australia. We expect this response would be in the form of a lower cash rate in the first instance, rather than direct intervention in the forex market. The combination of these dynamics should continue to support Australian bond prices over the cyclical horizon.

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Adam Bowe is a senior vice president and fixed income portfolio manager in Pimco's Sydney office. © Pacific Investment Management Company LLC. Reprinted with permission. All rights reserved.

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