For the last several days, television networks have treated viewers to repeated images of swaying and swinging oxygen masks inside the cabin and a gaping hole in the fuselage of a Qantas aircraft en route to Melbourne from London. Is the aircraft saga symbolic of the fact that the Australian economy is running out of luck, after an unprecedented 14-year run of uninterrupted growth? The Qantas incident occurred the day after the National Australian Bank announced a big rise in its bad debt provision, a bit more than Australian dollars 800 million, against the securities it is holding.
Till the 1990s, Australia’s economy displayed boom and bust characteristics. Then, the economy was released from the stranglehold of militant and unproductive labour unions, interest rates were deregulated, inflation fighting was made a priority, and the fiscal deficit was reined in. The result has been a long period of moderate to strong growth, and moderate to low inflation, combined with fiscal surpluses. The Australian dollar had nearly doubled in value against the US dollar in the last six years.
In 2003-04, the Reserve Bank of Australia (RBA) warned of a mortgage boom and bust cycle and leaned against the wind. It raised interest rates and used moral suasion as well. The result was that Australian home prices softened, but they revived again, this time due to the commodity boom and import demand from China. In recent times, China has grown to be the most important trading partner for Australia with its heavy import of commodities. Politically too, Australia is moving closer to China. But, putting all of Australia’s economic and political eggs in the China basket could turn out to be a costly error for Australia.
China’s economic policy in recent times has become somewhat schizophrenic. It recently capped the price of coal and other essential resources. It has clamped down on foreign capital inflows. These moves address the symbols and not the substance of China’s unbalanced economy. The core issue is China’s muddled monetary policy that is keeping exchange rates and interest rates well below natural levels that are consistent with years of double-digit growth rates. China likes to maintain high economic growth rates while treating inflation symptomatically. This may work for a while, but it raises the risk of inflation resurgence and a more severe and prolonged slowdown in the economy. Global economic stagnation, with substantial contributions by G-3 economies and China in 2009, remains a serious and significant risk. Australia’s economy is likely to be left rudderless.
Despite the touted structural improvements, Australia has been unable to get rid of its cyclically waxing and waning trade and current account deficits. Huge improvement in the country’s terms of trade could not prevent the current account deficit from rising to 6.5% of gross domestic product in the first quarter of this year. With the public sector running a budget surplus, its domestic counterpart has been a rather persistent and big deterioration in private savings.
True to Anglo-Saxon traditions, Australian households have low savings, as they had grown used to expanding job opportunities, rising real incomes and asset prices and low interest rates. Some of these underlying favourable factors have begun to reverse. The central bank, fighting inflation, has pushed up interest rates to 7.25%. Rating agency Standard and Poor’s said that arrears (payments more than 30 days late) on prime mortgages rose to a record in May. Further, recent data suggest that employment might also be about to peak. If the oncoming global economic slowdown in 2009 brings the boom in commodities prices to a temporary close, then household income and spending prowess would be severely tested. The result would be slower growth, falling inflation and falling interest rates in Australia.
With its high interest rate, the Australian dollar is viewed as a high-yield currency. Hence, it has been favoured by Japanese investors who borrow cheaply in yen and earn high interest rates in Australian dollar deposits. This practice, known as “carry-trade”, has not been fully abandoned by investors, although returns from such a strategy peaked a year ago. Its persistence is one more indication that investors have not grasped the coming global economic slowdown yet. Falling interest rates Down Under would eventually cause investors to flee the carry trade. Thus, the outlook for the Australian dollar (and other high-yielding currencies) over the next two years is one of weakness rather than strength, not only against the unloved Japanese yen but also against the Singapore dollar and the Swiss franc.
So this article is a warning to those still looking for high yield in currencies to quit doing so. Capital preservation requires that smart investors panic before the crowd does.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org