Saturday, 22 August 2015

The Australian Dollar: Drivers and Overlooked Implications

The Australian dollar has depreciated against the greenback over 30% from July 2011 where it peaked at $US1.10 to this month’s US$0.73. Its depreciation is slightly exaggerated against the US dollar as the US dollar also experienced appreciation over the past year, and the fall is lesser when expressed against a basket of currencies. According to the RBA’s announcement regarding the hold on the 2% cash rate, further depreciation is both likely and necessary given significant declines in key commodity prices.

Global markets
NAB revised its forecast this week for the Australian dollar to be at US$0.72 at the end of this year, down from US$0.74. This has been partly from the financial crisis of Greece, the deflating equity bubble in China and investor concerns over a slowdown in global growth. Once there is panic in the markets regarding potential crisis in the global market, low risk financial instruments whose values are historically unaffected become in demand, one of which includes US government bonds.  The Kiwi and Canadian dollar also fell this week as the US dollar and Japanese Yen appreciated from having attracted investors seeking safe haven assets.

Commodity exporters including Australia, Canada and New Zealand are at risk from depreciation due to commodity prices. The majority of commodities are priced in US dollars, and when the US dollar appreciates, commodity prices and the currency adjust accordingly. Therefore there is high correlation between the value of a metric tonne of iron ore and the Australian dollar. For instance, iron ore was $US55.26 per tonne last Friday and the Australian dollar was at $US75.23. On Tuesday iron ore was $US49.60 per tonne and therefore the Australian dollar adjusted to $US74.51.

As China’s growth is slowing, and given their position as Australia’s largest trading partner from their demand for our resources, the mining industry in Australia may attempt to gain revenue against the falling commodity prices by increasing production to export more, despite this driving prices even lower. Furthermore this could mean high cost producers lose market share, which can facilitate demand and supply returning to equilibrium at a lower price. I do not believe the recent volatility in the Sharemarket has directly influenced this fall in commodity prices as it does not indicate weakness in the real economy. Nonetheless China should play a role in the downwards pressure on the Australian dollar in this way.

Interest Rates
The current and expected difference between Australian and US interest rates is another driver of the Australian dollar depreciation. As the US interest rates are expected to experience a series of increases, 10 year US bonds should attract investors as purchasing them essentially indicates that they are buying an annual return that reflects where the real interest rate will be in 10 years. This has been the case since October 2014 where the US Federal Reserve formally stopped its bond buying/quantitative easing. Meanwhile the RBA has been cutting interest rates and this trend should continue given the domestic slowdown effects from lower commodity prices. Substitution of the long term Australian bond for the US bond is therefore on the rise, and less demand for both physical and financial Australian assets leads to a lower Australian dollar.

The RBA’s calculations demonstrate a 10% fall in the real exchange rate increases GDP growth by 0.5-1% and the annual inflation rate by 0.25-0.5% over two years. As Treasurer Joe Hockey described, “A lower Australian dollar is inevitably going to help the South Australian economy, the Victorian economy, it’s going to be of great benefit for tourism and education, exports. So the diversity of the Australian economy is working in our favour.” It is not just the tourism and mining industry that benefits. Shares that also benefitted from this fall include AMC (a global packaging company), BXB (a supply chain logistics group), CSL (global biotech), JHX (an Irish cement company).

Notice that these shares are affected from the exchange rate movements due to exposure either because of overseas operations, or from export relationships. The first would have its revenue and costs denominated in foreign currencies, translating to higher $A profit if the value of the Australian dollar relative to their currency falls. The exporter, typically wine producers and the resources sector, would have its costs denominated in a different currency from its revenues which leads to a strong correlation between exchange rate movements and profit margins. This can be positive or negative depending on where they source revenue and where the costs are mainly incurred and the exchange rate should be relatively more significant to the business than the overseas operator.

In theory, Australian wine producers should experience wider gross margins from the greater value of the revenue from its export markets, typically the US and UK, while costs remain stable. Sensitivity analysis is a means by which investors could forecast the impact of a change in the Australian dollar on earnings. For instance Treasury Wine Estates published in 2014 that a change in the Australian dollar by 10% against the US dollar has the potential to impact their EBIT by more than 20%.

Therefore, wine industry experts are expecting foreign investment in South Australian vineyards to increase despite growers exit the industry from prolonged unfavourable weather and poor prices in recent years. Although China’s austerity measures weaken foreign investment, the number of foreign investors seeking to purchase agricultural land has risen with interest in aquaculture ventures. China’s currency devaluation leads to a reduced competitive advantage for Australia however, but not when attracting US investors, who comprise of the majority.

However for exporters like TWE where product pricing is in the currency of the destination market, there are other factors that should be taken into account, such as retailer bargaining power and the competitive environment that a currency depreciation does not improve. Wine competitors in other nations such as Argentina, Chile and South Africa benefit further from depreciating currencies as these have depreciated 21%, 12% and 9% against the US dollar respectively in the 12 months to June 2015 while the change in the Australian dollar was on par with South Africa. This suggests Australia did not gain a unit profit advantage relative to many of its competitors. Retailers are also in a stronger position to negotiate for reduced local prices as they can directly calculate the additional revenue the falling Australian dollar offers to the producer, and with such a large competitor base fuelling their leverage, the potential gains in earnings are offset by squeezed margins. For instance, Australian Vintage reported that the margin profit from the lower $A against the pound was offset by the UK competitive environment.

Overall prices of iron ore and interest rates are consistent with the Australian dollar further depreciating against the US dollar for the foreseeable future. Capital Economics Australian economist Paul Dales notes that if iron ore prices were to fall from $US52/tonne now to US$40/tonne by the end of this year, the Aussie should be around US70 cents. Furthermore if the RBA cuts rates to 1.5 percent while the US Federal Reserve raises theirs, an Australian dollar rate of US65 cents is possible. 

RBA, ABC News, CBA, Sydney Morning Herald, Australian Financial Review, The Australian

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