Fears about the health of the Australian dollar overblown

By:
Peter Garnham
Published on:

The death of the Australian mining boom has been exaggerated and should help the country’s currency recover after its recent sell-off.

 The Australian dollar, once the darling of the foreign exchange market, has come under pressure in recent weeks, dropping from $1.06 at the start of January to just over $1.02 against the US dollar amid downbeat commentary over the country’s resource sector, and building expectations for a sharp drop in investment levels in the industry.

The resources sector has, of course, been crucial to the outperformance of the Australian economy since the start of the recession sparked by the financial crisis.

Australian unemployment has remained low and growth at trend levels, with the surge in mining investment effectively insulating the country’s economy from the slowdown experienced by its peers.

However, growing fears about the Australian resource sector eased on Thursday, as the government’s capital expenditure survey showed that investment, while slowing, is not collapsing. Indeed, while the Australian mining boom might have peaked, forecasts of capital spending plans of A$152.5 billion for 2013/2014 suggest the sector remains in rude health.

The report helped remove expectations that the Reserve Bank of Australia (RBA) will move to cut interest rates at its policy meeting on March 5, with the market indicating that the central bank’s current easing cycle is now complete.

Andrew Salter, FX strategist at ANZ, says structural short positions in the Australian dollar are now likely to be unwound. “Expectations for mining investment, and indeed non-mining investment, are not falling off the proverbial cliff,” he says.

Adding to the supportive news for the Australian dollar were the results of freedom-of-information requests from the Bloomberg news agency.

That prompted the RBA to reveal it had hard or anecdotal evidence that as many as 34 global central banks hold the Australian dollar in their reserves.

This should not come as a surprise to currency watchers, especially given the outperformance of the Australian economy, but still highlights a medium-term positive for the currency.

Fair value

More interestingly, another freedom-of-information request revealed that RBA staff believe the Australian dollar is around fair value.

According to a report from the central bank’s staff to its board in August, the real trade-weighted exchange rate of the Australian dollar was estimated to be overvalued by about 5%.

In August, AUDUSD stood at around $1.03. A slight dip in the exchange rate since then, combined with a 70% rally in the price of iron ore – one of Australia’s main commodity exports – suggest the RBA’s valuation gap has now closed.

The central bank is, in other words, less likely now to cut rates or intervene to engineer weakness in the Australian dollar.

Australian dollar real effective exchange rate in past mining booms 
 


In any case, history suggests that a sharp drop in the Australian dollar should not be expected at the first sign of drop-off in investment in the country’s resource sector.

Research from ANZ reveals that in the past five Australian mining booms, it has taken the Australian dollar an average of 17 years for the currency to return to pre-boom levels.

“This staggering amount of time is due to the immense income gains and ongoing investment and associated export revenue that these events facilitate,” says Salter.

“Fears of a material fall in the Australian dollar are very much overblown.”

The scene would seem to be set for the Australian dollar to regain some of its popularity.