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Foreign Exchange

Australian currency could halve as commodities bubble bursts

China’s desire for iron ore has peaked and as mines spring up across the globe, the Australian dollar is likely to see a sharp decline in value, Andy Xie, former chief economist of Morgan Stanley, tells Asiamoney, a sister publication to EuromoneyFXNews.

The global financial crisis has sent investors worldwide scrambling for safety, forcing Australian bond yields to record lows. But what was once a safe haven is now a vulnerable economy, dependent in large part on China for funding. Iron ore, as Xie points out, is recyclable. That fact, combined with a global rush to open mines, means an oversupply of iron ore is very likely, which would lead the Australian economy to see either a gradual decline or an outright bust.

This means that the Australian dollar could fall to $0.50 against the US dollar, according to Xie. It was trading at $0.9850 to the US dollar on Monday.

“One scenario is that there’s going to be a gradual decline,” says Xie. “The price of iron ore won’t collapse, because the Chinese production cost is high [around $140/ton] so what a lot of people like to say is, if the price drops, Chinese production has to drop, and this will increase the room for Australian miners.”

That situation assumes that China and Australia will retain their positions as two of the biggest global mining players.

Xie’s other scenario is less savoury for holders of Australian debt.

“The alternative scenario is a bust,” he says. “That will happen if a lot of mines in other countries open and there’s an oversupply problem. China iron ore consumption has basically peaked now and there are mines now all over the world opening. So you could have a crash.”

He explains that essentially Australia benefited 10 years ago from the commodity price rally, which led to its strong currency. The Australian dollar rose from a low of $0.4775 in April 2011 to an all time high of $1.11 in July.

“The currency value has doubled,” says Xie. “At the same time the nominal GDP doubled. So you have this struggle with the increase in the GDP value in foreign currencies.”

If commodity prices drop due to oversupply, it would have a serious impact on the value of the Australian dollar and, by extension, the value of debt denominated in that currency.

Sovereign debt devaluation

Almost all Australian government bonds are denominated in the Australian currency and most are held by overseas investors, who have flocked to gain exposure to what appears to be attractively priced, high-quality debt denominated in a strengthening currency.

Ten-year Commonwealth Government Securities (CGS) were yielding 5.39% this time last year, but on May 17, it was yielding a low of 3.23%, according to Bloomberg data.

“[There has been] a substantial and sustained increase in foreign investor demand, especially from central banks and sovereign wealth funds, ” according to a research paper on Australian government bonds by First State Investments. “This has taken foreign ownership of the CGS market to a record high of just under 87%.

“This not only reflects Australia’s relatively high real yields, but is a strategic decision to increase diversification of FX reserves away from currencies such as the USD, EUR, JPY and GBP.”

The report argues that further sizeable Australian dollar purchases in the years ahead are a real possibility.

“There do not seem to be many reasons to expect the very strong demand for CGS from foreign investors to come to an end,” it states. “This is especially so, given that much of the increased demand for CGS is from a structural shift in FX reserve management from a number of central banks.”

If Xie’s warning comes good, central banks could find their Australian bond holdings halving in their US dollar value.

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