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The lucky country

By Gerald Hayes
04 Sep 2013

Australia has ducked recessions through the Asian and global financial crises, buoyed by a stable banking system, good regulators, and plentiful commodities to ship to urbanising emerging neighbours. But are the good times coming to an end?

On September 7, Australia will vote for its next leader in a general election. He — and it will be a he this time, after Prime Minister Julia Gillard was ousted in June — will inherit an Australia that is in a less advantageous position than has been the case for many years.

Australia has undeniably fared better than almost any developed world peer through the treacherous last decade. It exited its last recession in 1991, getting through both the Asian and the global financial crises without slipping into another. Its financial system has been remarkably resilient, suffering not one bank failure, while American and European institutions fell by the wayside. That is largely thanks to the wisdom of smart, independent regulators and central bank. 

And Australia has been a vital engine of Chinese urbanisation, a quarry and a breadbasket at a time when Asia has needed both. It still is — and, if anything, its commodity picture gets better all the time. As well as its long-proven reserves of coal and iron ore, it is now set to become one of the world’s largest suppliers of liquefied natural gas, and is far closer to the energy-hungry nations of China, Japan and South Korea than its main rival, Qatar.

In fact, Australia has had so much on its side for so long — the lucky country, as Donald Horne, the Australian intellectual who died in 2005, had it — that it has been tempting to believe the party would never end. But while Australia still looks in much better shape than any European nation, it faces more headwinds than it has done for years. 

One challenge is that Australia’s fortunes have increasingly been hitched to emerging markets more than the developed world. That worked a treat when China was growing at 10% a year, but means the reversal in the last year of sentiment away from the BRICs and Asia and towards a reviving US have actually worked against it. 

Linked to this, the industrialisation of China and other Asian nations came at a time when industrial commodities had had years of underinvestment, pushing commodity prices up in what economists call a supercycle, from 2000 onwards. The combination of the two suited Australia perfectly, pushing its currency up dramatically through the last decade, from 48 US cents to the Australian dollar in 2001 to above parity with the US dollar last year, eventually touching US$1.10 per Australian dollar.

“All cycles eventually come to an end,” says Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors. “Several factors are now driving a reversal in the longer term secular cycle of developed country shares relative to emerging market shares and related trades.” 

End of the supercycle

The developed world — chiefly the US, but also, to varying degrees, Japan and the eurozone — is looking better after painful structural reform. Chinese growth is slowing while risk within it is rising, while India, Brazil and Indonesia are grappling inflation and South America and Russia have been hit by falling commodity prices. Those commodity prices appear to be falling from peaks, suggesting the end to the celebrated supercycle. And if, like Australia, 70% of your exports are commodities, this is something you are likely to watch very closely.

Partly because of this, the Australian dollar has started to fall. At the time of writing, the Australian dollar buys 90 US cents, an 18% fall from its highs, most of it in a five week period in May and June. As HSBC put it in its latest global currency report: “AUD: 0.90 the new normal.” 

Now that China takes 35% of Australian exports, compared to less than 10% in 2008, China’s decline is being felt in the currency. “I would say it’s the strength of China rather than domestic policy in Australia which is dictating the value of the Australian dollar,” says John Woods, chief investment strategist for Asia Pacific at Citi Private Bank.

It should be said, though, that the fall in the currency was largely engineered by the Reserve Bank of Australia (RBA) through a series of rate cuts, most recently to 2.5% in August. Australian exporters away from commodities hate the highly valued currency, and the Reserve Bank knows that the Aussie dollar needs to drop if those parts of the economy are to stand a chance — and if the mining boom is over, then the resilience of other exporters is going to be increasingly important to Australia. 

“When the RBA announced an unchanged cash rate they said the currency was high,” says Stephen Walters, chief economist for Australia and New Zealand at JP Morgan, speaking before the August rate cut. “That’s code for ‘we’d love it to be lower’. Ask a manufacturing exporter and they’d like it to be in the 60s. A tourism operator, even lower.” 

He suggests a realistic level of equilibrium for the economy in the mid-80s, not far from today’s levels. 

But reducing the currency and the yield at the same time may have other consequences. The Australian dollar had reached such dizzy heights partly because of China and commodities, but also because it had become a safe haven: a AAA-rated economy in a world which has less and less of them to choose from, and a high yielding currency to boot. 

The combination of these fundamentals and a trusted legal system, with low default rates on bonds and high corporate governance among blue chip stocks, made it a favourite of inbound capital flows on the debt and equity side. 

But as rates have fallen, the yield differential between the Australian dollar and other currencies has narrowed too. There is a risk of capital flight as Australia’s advantages diminish, which must give the country pause, since over 70% of the owners of Commonwealth government securities are based overseas. 

In an interview elsewhere in this report, the CEO of the Australian Office of Financial Management (AOFM), Rob Nicholl, says he does not fear capital flight since so much of the investment in government bonds is from central banks who are invested in Australian debt as part of a long-term allocation rather than an opportunistic play. 

Bankers and economists tend to agree. “Over the next six to 12 months, we think the Aussie still has a lot of friends,” says JP Morgan’s Walters. “Our interest rates are still among the highest in the world. When you look at interest rates in Japan, the US and Europe close to zero, our cash rate and 10 year bonds yielding quite a bit more look very attractive.

“The pool of AAA government bond markets has been shrinking for quite some time,” he adds. “There are only nine or 10 left in the world that are still AAA-rated. And a lot of central banks and sovereign wealth funds are looking for these characteristics: high yield, moderate risk, AAA-rated, decent budget and debt positions. It’s simple arithmetic.”

RBA can still cut

Australian GDP growth is flagging. In August, the RBA cut its calendar 2013 forecast for economic growth from 2.5% to 2.25%. AMP’s Oliver says that is well below trend for Australia, which would be 3% to 3.25%. 

“More significantly, demand in the economy has fallen for two consecutive quarters as a result of subdued consumer spending, subdued housing investment and falling business investment,” he says. “Were it not for a bounce in exports and fall in imports, the economy would be in recession.” A worst case scenario being discussed increasingly in Sydney and Melbourne is exactly that: recession and a collapse in house prices.

But it has to be remembered that the RBA has a lot more levers at its disposal than countries already at zero interest rates: there can be many more cuts to spur growth if necessary. Australia has low public debt (indeed, until recently bankers spent years lobbying the government to borrow more in order to build a better yield curve to price other instruments off), low inflation, and fairly low unemployment. 

Oliver argues that the combination of RBA cuts, a falling Aussie dollar aiding exports, a pick-up in housing construction and a pick-up in consumer spending “should be enough to avert recession and the much talked about house price collapse.”

Most economists do not expect further rate cuts in the near term, while recognising that the RBA has space to make them if it needed to. The RBA statement that reduced growth forecasts “emphasized the role of a lower AUD in supporting the rebalancing of Australia’s growth and suggested that the AUD ‘could appreciate further’,” said HSBC’s chief economist for Australia and New Zealand, Paul Bloxham, in a research note after the statement. “While the RBA has room to cut further, we still expect that they may not need, as the AUD may do much of the work for them.” 

The RBA expects growth to pick up in 2014, to 2.5-3.5%; its inflation forecast for 2013 is a manageable 2.25%, while unemployment is expected to edge upwards in the next quarter, then stabilise and decline. Unemployment stood at 5.7% in July.

The outcome of the Federal Election is unlikely to make a huge difference to Australia’s economic prospects, as so much of it is out of the country’s hands (and in, most obviously, China’s).

There is not a huge gulf in economic policy between opposing candidates Kevin Rudd, the prime minister, and Tony Abbott, though at the margins there are interesting commitments. Shadow treasurer Joe Hockey, for example, has pledged to encourage the AOFM to launch bonds as long as 40 or 50 years if he makes it in to power.

One suspects that Australia will duck recession once again, as it has for 20 years, making up for declines in mining with a revival in other parts of the economy boosted by a falling currency.

And by then, the country’s great investment in LNG should be paying off, with export earnings from the liquefied gas expected to increase five times over from A$12bn in the last fiscal year to $60bn by 2017-18, before becoming the world’s biggest LNG exporter by 2020. Donald Horne was right: Australia is, without doubt, the lucky country.    

By Gerald Hayes
04 Sep 2013