A review of the Australian dollar

In the Australian market much greater capital mobility has caused the relationship between the current account and the exchange rate to become more complex. In the short run, currencies are determined in financial markets, essentially by the portfolio decisions of international investors.

This does not mean that the exchange rate can be permanently de-coupled from its current account-based fundamentals. However, in a world of mobile capital, countries might be able to sustain large current account deficits for longer than they could in the past.

According to HSBC Research, in the case of Australia its currency is reaching a point where it needs to realign with the long run fundamentals. This realignment points to a large downside risk to the Australian dollar.

With imports becoming cheap through the appreciating currency and with falling consumer goods prices, and despite the rising prices of commodities, the trade deficit has deteriorated substantially. Indeed commodities or primary products only account for 50 per cent of all exports and exports are only 20 per cent of GDP.

However, commodities do boost domestic demand through the terms of trade and this causes the Reserve Bank of Australia to respond by raising interest rates, which in turn appreciate the currency.

There are some who would argue that the rise in the currency is the normal mechanism that rebalances the domestic economy and keeps domestic inflation at bay. The Reserve Bank of Australia may have kept inflation under control, but it has been at the expense of a huge imbalance in the external sector.

The currency appreciation is a rebalancing item for the domestic economy as the boost in real income growth through commodity prices causes domestic conditions to become very robust and this excess demand in a closed economy would result in a rise in inflation.

Instead what is happening is that the Australian dollar rises, cheapens imports and supplies the domestic economy with the goods it needs. The domestic balance is achieved at the expense of the external imbalance.

If the deterioration in the trade balance were the end of the story, it would be negative for the Australian dollar but not massively problematic. However, the situation is far worse than just a deterioration of the trade balance.

Of equal concern is the fact that the income deficit has also deteriorated. The income deficit is actually bigger than the trade deficit and, combined, the external deficit is now the worst in history.

The Australian dollar is looking more and more like an interest rate play. The rest of the world is earning high yields in the fixed income markets in Australia due to the higher interest rates.

On the other hand, due to relatively lower interest rates abroad, Australians are borrowing in foreign currencies, possibly swapping back into Australian dollars. This worked well when US Federal Reserve rates were low and the Australian currency was rising, as this represented a capital gain for foreigners and capital depreciation on foreign borrowings by Australians. However, the picture is now changing.

At present the US Federal Reserve is raising rates and the interest rate differential between Australia and the US is narrowing. The market may not think that the extra few percentage points that Australia is offering is worth the risk associated with the disequilibrium in the external sector.

Indeed, the swap mechanism requires continuous issuance of Australian dollar financial instruments offshore, and depends on the global appetite for Australian dollar securities. At some time this appetite may fade, especially if this Australian interest rate premium is compressed.

The Australian dollar could see foreigners pull their funds out fast and this could see the currency fall very rapidly. If rates peak, or worse still are cut, the fall in the Australian dollar could be brutal.

Here we would have a situation of foreigners waiting to withdraw their capital from a depreciating currency and bring home their funds. At the same time it would start raising the cost of Australian dollar borrowings in foreign currencies and the Australian currency would have to adjust drastically downwards.

Also the argument that a stronger Australian dollar was needed to keep inflation at bay also falls away and the prolonging of the domestic cycle at the expense of the external sector becomes viciously exposed.

With a large growing trade deficit, coupled with fast growing net income payments that are now larger than the trade deficit, the current account deficit has hit a record. So it is these rising income payments that have become of particular concern and the true nature of the Australian currency's positive story is being revealed.

This is being revealed as net external liabilities are now over 60 per cent of GDP, while the income balance deficit is bigger now than the trade deficit. The increase in net foreign liabilities as a share of GDP cannot be halted except by running a small but permanent trade surplus.

However, the move to even a small but persistent trade surplus will require a major depreciation of the Australian currency.

Taking these facts into consideration and with the present economic outlook it is highly likely that we will soon witness a fall in the Australian dollar.

This report was compiled by Peter Calleya, manager Corporate Strategy and Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.