With much turmoil in international financial markets, rising oil prices, and a US dollar that has depreciated considerably in recent times, we turn our focus down under and look at the currencies of Australia and New Zealand.
The Australian dollar (AUD) has managed to climb back up towards the 26-year highs it hit in July against the US dollar, despite the carnage of July and August. One of the main features has been that the impact of the global financial turmoil has been minimal on Australia (and New Zealand, for the matter). The AUD was expected to be bruised in this sort of dislocation.
This is because Australia not only runs a large current account deficit, but also has very large external liabilities. However, with calmer market conditions, investors have a newfound craving for carry trades (a strategy where an investor borrows in another country with lower interest rates and invests the funds in the domestic market, usually in fixed-income securities). This has seen the AUD perform better than any other major currency with the exception of the New Zealand dollar (NZD).
One reason for the Australian economy's resilience to the ongoing financial market problems is due to the low number of subprime loans present in the economy. According to the Reserve Bank of Australia, these make up "about 1 per cent of the total stock of mortgages... and arrears rates on these loans are considerably less than those on US subprime loans." This has meant that Australian economic performance has continually surprised to the upside for some time now, which gives support to the AUD.
The Reserve Bank of Australia believes that: "Given the macroeconomic situation of the Australian economy thus far, some additional restraint would perhaps not be unwelcome."
Clearly this suggests that interest rate hikes would not be necessary in the immediate future as the extra restraint would be provided by a global market slowdown. However, since then the global market turmoil has eased somewhat. If this worry continues to fizzle out and confidence continues to grow, the Reserve Bank of Australia may be forced to hike sooner than they would like, which would lend additional support to AUD.
Australia has not been without worry though, as it has - along with the rest of the global economy - seen a dislocation in its money markets. If these conditions were to re-emerge, then AUD would once again start to look more vulnerable. The threat to the AUD is if the international community retrenches and the overseas funding the AUD relies on dries up. However, such a situation seems remote, especially with the Australian equity market making new all time highs.
New Zealand took the decision to float its currency in 1985 in line with other developed economies, as this reflected a growing consensus that it is impossible for a country to choose the level of the exchange rate, the rate of domestic inflation, and the level of interest rates simultaneously. New Zealand took the policy decision that its main objective was to achieve and maintain low and stable domestic inflation.
Today the NZD is one of most traded currencies in the world and forms part of an international system known as continuous linked settlement (CLS) by which both legs of financial transactions can be settled simultaneously.
Since the NZD began to float, the exchange rate has played an important buffering role for the New Zealand economy, tending to depreciate in tough times and appreciate in good ones. However, last June the New Zealand Reserve Bank decided to sell an unidentified amount of New Zealand dollars in an attempt to drive down its value.
This was the first intervention in the markets by the bank since the NZD became a floating currency. Two suspected interventions followed, but they were not as successful as the first. While the NZD did drop in value initially, within a little more than a month it had risen to new post-float highs against the US dollar.
However, after experiencing the global market turmoil and draw-down from the carry trade, the NZD has been fighting back over recent weeks, much like the AUD. With broad US dollar weakness, NZD has risen sharply. It has strengthened substantially since the draw-down in August but, unlike the AUD, it has not retraced the full draw-down. However, NZD remains very much at the mercy of the global economy. When conditions look shaky, NZD falls as risk aversion rises, but when things settle down, NZD rebounds.
In a pure carry world, the NZD was the darling of the markets. However, the market is more cautious nowadays. The AUD represents a better commodity and carry play and so, in the eyes of the market, represents lower risk than the NZD.
Whereas before recent events these AUD positive drivers were not seen enough to compensate for the yield differential that NZD has. However, in today's more carry cautious world, it is enough.
This report was compiled by Peter Calleya, Manager Corporate Strategy & Research, HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.