China and the Australian Dollar

The high Australian dollar is a source of joy for many Australians, especially those travelling overseas or buying goods overseas via the Internet. To be honest, I dig it in a big way. I get that lovely feeling of schadenfreude every time some British person complains about how expensive everything is here in Australia and I love buying books from the UK's Book Depository at reduced rates with no shipping costs and an inflated exchange rate.

(Nevertheless try as I might I couldn't buy the running shoes I wanted from the US either because the stores didn't ship to Australia or they did, but didn't have the size or style I wanted. I eventually found an Australian online store that sold shoes much cheaper [for Asic Kayano 18s about $70 cheaper than the retail outlets like Rebel and Super Amart]. For an analysis of the Internet and bricks and mortar retail see here)

But these pleasures just serve to highlight that a high dollar is a major problem for Australian (non-resource) exporting and import-competing businesses. Resource exporters aren't suffering yet, because demand remains high for the things that they export, especially coal, iron ore and gas.

As most educated Australians will understand, a high Australian dollar makes imports cheaper and exports dearer, which eventually causes many businesses, especially those with options to make things in other countries to reassess whether it is worthwhile continuing production in Australia. This is what has been happening in recent weeks with Toyota and Holden announcing job cuts and before that Bluescope Steel announcing that it was abandoning exports and cutting jobs.

Expect these announcements to become more frequent in coming months, especially given the fact that economic policy-makers in Australia seem to think that nothing can or should be done about the high dollar.

The exchange rate is a key enforcer of structural change in a resources boom. This phenomenon has been called variously 'Dutch disease", the two-, three- or multi-speed economy, and the patchwork economy.

Current concerns go beyond the banal fact that economies are always multi-speed. But right now the higher prices for Australian resources and the inflow of capital to fund investment and to take advantage of interest rate differentials between Australia and most countries with very low, zero, or effectively negative, interest rates is bolstering the Aussie. Borrowing at low interest rates and then investing in Australia with relatively high interest rates is rather attractive at the moment. Also a factor is growing foreign purchases of Australian bonds, especially by central banks and sovereign wealth funds.

According to another report in the FT, foreign ownership of Australian government securities has reached 80%.

While this makes some bond traders nervous, the real problem for Australian government bonds at the moment is a lack of supply. Still one trader argues:

this is worrying as heavy foreign ownership of government bonds can be very dangerous, particularly when this is combined with a country running a current account deficit (i.e. the country is reliant on capital inflows from abroad).

These concerns seem to be overdone - Australia's CAD is as low as it has been for some time, but I suppose things could change if China fell in a hole.

Right now, the worry is the high exchange rate's negative impact on key sectors of the economy, particularly those that employ large numbers of people and help to create a more diverse economic structure for Australia.

As I have noted many times before on this blog and elsewhere, exchange rate-induced structural economic change has a lot to do with whether the high Australian dollar is sustained over the medium term or whether it falls against our major trading partners and, especially, the US Dollar.

According to Hume in the FT, most economists expect a fall in the Aussie, but not back to its long term post float average of around 75 US cents. Instead the consensus view is that it will be supported at about the mid 90s. But at the moment Australians going overseas are doing pretty well compared to the early 2000s:

Australians planning to visit London for this summer’s Olympic Games will get bang for their buck. The Aussie, which recently hit a 27-year high of 67.96p against sterling, has appreciated by more than 80 per cent since Sydney hosted the Olympics in 2000.

Given that he is a long-term bear about China's medium-term economic prospects (increasingly becoming more short-term) Michael Pettis questions whether the Aussie should be currently so strong:

I am actually much more pessimistic about Chinese growth prospects, commodity prices, and the pace of European recovery ... but even so we would have expected that the obvious prospective problems in Europe and China should have made themselves felt in the Australian dollar. So why has it remained so strong?

The answer he suggests might have something to do with the amount of capital flowing out of China as cashed up Chinese worry about the potential for wealth destruction in China in coming years.

I just had coffee earlier in the week with one of my PKU students. He told me that he and his business-owning father are trying to take money out of the country as quickly as possible. He says it has become harder recently (I don't know why) but everyone they know is setting up businesses abroad and trying to do the same, in part, he said, so that they can get foreign passports if they ever need it. On that topic there was an interesting article last week in the New York Times:

A recent survey of 980 Chinese millionaires found that 46 percent of them were considering leaving China and another 14 percent had already emigrated or were completing the paperwork for relocating. The survey by the Bank of China and the Hurun Report said 40 percent of the would-be émigrés — they’re known as “migratory birds” in China — would aim for the United States, followed by Canada (37 percent), Singapore (14 percent), Europe (11 percent), Hong Kong (5 percent) and Britain (2 percent). 

The leading reasons for taking flight: better educational opportunities for their children, advanced medical treatment, worsening pollution back home (especially urban air quality) and food safety concerns. But many potential émigrés, not surprisingly, are working on a Plan B in case China’s economic growth begins to slow, widespread social unrest takes hold or the political winds begin to blow against them.

We are seeing this process most vividly in Hong Kong. In spite of a recent video showing a fight between Hong Kongers and mainlanders in the Hong Kong subway, which went viral and inspired real anger and mutual recriminations among even some of my most laidback Beijing and Hong Kong friends, mainlanders are scooping up apartments in Hong Kong. This is from an article in Saturday’s South China Morning Post:

Data compiled by Midland Realty shows individual mainlanders spent HK$62.3 billion on residential properties in Hong Kong last year, or about 20 per cent of the value of all sales excluding those involving corporate buyers. That was almost double the 10.8 per cent in 2010. The agency expects the figure to jump to about 25 per cent this year.

Rich mainlanders are clearly eager to take money out of the country. And what is just as clear, the debate on the limits of state capitalism we have been hearing and reading about a lot recently is not just of academic interest to them. According to my student, it is becoming harder and harder for non-SOEs [state-owned enterprises] to do business in China, and more necessary than ever to have friends in high places.

As an aside, for those watching the real estate market, my student also mentioned that two very large real estate projects that his father runs are having trouble selling units. He said his father has decided to sell as quickly as he can, even at very low prices, rather than wait for prices to recover.

One of the places that Chinese capital could go is, of course, Australia. which may account for the continuing strength of the Aussie:

a lot of Chinese capital is flowing into Australia. He, for example, has traveled to Australia nine times in the past year, mainly looking after business for his father, who has also been to Australia many times. The family has large investments in food, real estate and construction, and my student tells me he often arranges to meet in Sydney or Melbourne school friends of his who also happen to be in Australia for similar purposes. My guess is that at least part of the reason for a strong dollar, in spite of weakening growth expectations, may be that a lot of Chinese capital is flowing into Australia.

What would happen if growth in China slows significantly? This would probably result in a sharp drop in non-food commodity prices, which should cause much slower growth in Australia. But if a Chinese slowdown coincided with an increase in private Chinese capital outflows, it might be difficult for the Australian dollar to adjust downward sufficiently to help absorb some of the cost of the slowdown. In that case Australia might suffer low growth and an expensive currency – not a very good combination.

Let's hope that this doesn't eventuate!

Let me finish this already long post by noting that this is not an argument against the floating exchange rate, which has been overwhelmingly beneficial for Australia since the early 1980s and has helped Australia to adjust to international shocks and keep inflation in check during the boom. But let's not pretend that it doesn't have some costs that the government and the RBA will need to manage.