Betting on China Via Australia

There are plenty of investors that think betting on China is as close to a sure thing as there could possibly be. The only problem is that investing directly in China’s economic freight train is complicated, opaque, and sometimes impossible. The Chinese government maintains strict capital controls, prohibits foreigners from directly owning certain types of investment vehicles, and prevents the Chinese Yuan from appreciating too quickly, if at all. For those that want exposure to China without all of the attendant risks, there is a neat alternative: the Australian Dollar (AUD).
Those of you that regularly read my posts and/or follow the forex markets closely should be aware of the many correlations that exist between currencies and other financial markets, as well as between currencies. In this case, there would appear to be a strong correlation between Chinese economic growth and the Australian Dollar. If the Chinese Yuan were able to float freely, it might rise and fall in line with the AUD. Since the Yuan is fixed to the US Dollar, however, we must look for a more roundabout connection. HSBC research analysts used Chinese electricity consumption as a proxy for Chinese economic activity (why they didn’t just use GDP is still unclear to me), and discovered that it fluctuated in perfect accordance with the Australian Dollar.

Before I get ahead of myself, I want to explain why one would even posit a connection between China and the Aussie in the first place. There are actually a few reasons. First, Australia is economically part of Asia: “Today, 43 per cent of Australia’s total merchandise trade is with north Asia. A further 15 per cent is with Southeast Asia.” Second, Australia’s economy is driven by the extraction and sale of natural resources, of which China is a major buyer and investor: “In 2008-9, China was the biggest investor in the key resource sector with $26.3bn involvements approved, 30 per cent of the total.” Third, Chinese demand has come to dictate the prices of many such resources, causing them to rise continuously. Thus, Australia’s natural resource exports to countries other than China still draw strength (via high commodity prices) from Chinese demand.

As one analyst summarized, “China is buying raw materials from Australia in leaps and bounds, and that’s what’s driving that currency’s growth.” Sounds like an Open and Shut case. In fact, this presumed correlation has become so entrenched that any indication that China is trying to cool its own economy almost always prompts a reaction in the Aussie. To be sure, warnings that China’s annual legislative conference (scheduled for October 17) would produce a consensus call for a tightening of economic policy have made some forecasters more conservative. Still, as long as the Chinese economy remains strong, the Australian Dollar should follow.
It’s worth pointing out that the correlation between the Aussie and the Chinese economy doesn’t exist in a vacuum. For example, the Australian Dollar has also closely mirrored the S&P 500 over the last decade, which suggests that global economic growth (and higher commodity prices) are as much of a factor in the Aussie’s appreciation as is Chinese economic activity. The Aussie is also vulnerable to a decline in risk appetite, like the kind that took place during the financial crisis and flared up again as a result of the EU Sovereign debt crisis. During such periods, Chinese demand for commodities becomes irrelevant.

On the other hand, part of the reason the Australian Dollar has surged 10% since September and 20% since June is because other countries’ Central Banks (such as China) have increased their interventions on behalf of their respective currencies. Australia is one of a handful of countries whose Central Bank not only hasn’t actively tried to depress its currency, but whose monetary policy (via interest rate hikes) actually invites further appreciation. As the Aussie closes in on parity and Australian exporters and tourism operators become more vocal about the impact on business, however, the Reserve Bank of Australia (RBA) might be forced to act.

May Have Peaked in 2010

When offering forecasts for 2011, I feel like I can just take the stock phrase “______ is due for a correction” and apply it to one of any number of currencies. But let’s face it: 2009 – 2010 were banner years for commodity currencies and emerging market currencies, as investors shook off the credit crisis and piled back into risky assets. As a result, a widespread correction might be just what the doctor ordered, starting with the Australian Dollar.
By any measure, the Aussie was a standout in the forex markets in 2010. After getting off to a slow start, it rose a whopping 25% against the US Dollar, and breached parity (1:1) for the first time since it was launched in 1983. Just like with every currency, there is a narrative that can be used to explain the Aussie’s rise. High interest rates. Strong economic growth. In the end, though, it comes down to commodities.

If you chart the recent performance of the Australian Dollar, you will notice that it almost perfectly tracks the movement of commodities prices. (In fact, if not for the fact that commodities are more volatile than currencies, the two charts might line up perfectly!) By no coincidence, the structure of Australia’s economy is increasingly tilted towards the extraction, processing, and export of raw materials. As prices for these commodities have risen (tripling over the last decade), so, too, has demand for Australian currency.
To take this line of reasoning one step further, China represents the primary market for Australian commodities. “China, according to the Reserve Bank of Australia, accounts for around two-thirds of world iron ore demand, about one-third of aluminium ore demand and more than 45 per cent of global demand for coal.” In other words, saying that the Australian Dollar closely mirrors commodities prices is really an indirect way of saying that the Australian Dollar is simply a function of Chinese economic growth.
Going forward, there are many analysts who are trying to forecast the Aussie based on interest rates and risk appetite and the impact of this fall’s catastrophic floods. (For the record, the former will gradually rise from the current level of 4.75%, and the latter will shave .5% or so from Australian GDP, while it’s unclear to what extent the EU sovereign debt crisis will curtail risk appetite…but this is all beside the point.) What we should be focusing on is commodity prices, and more importantly, the Chinese economy.
Chinese GDP probably grew 10% in 2010, exceeding both economists’ forecasts and the goals of Chinese policymakers. The concern, however, is that the Chinese economic steamer is now powering forward at an uncontrollable speed, leaving asset bubbles and inflation in its wake. The People’s Bank of China has begun to cautiously lift interest rates, raise reserve ratios, and tighten the supply of credit. This should gradually trickle down in the form of price stability and more sustainable growth.
Some analysts don’t expect the Chinese economic juggernaut to slow down: “While there is always a chance of a slowdown in China, the authorities there have proved remarkably adept at getting that economy going again should it falter.” But remember- the issue is not whether its economy will suddenly falter, but whether those same “authorities” will deliberately engineer a slowdown, in order to prevent consumer prices and asset prices from rising inexorably.

The impact on the Aussie would be devastating. “A recent study by Fitch concluded that if China’s growth falls to 5pc this year rather than the expected 10pc, global commodity prices would plunge by as much as 20pc.” [According to that same article, the number of hedge funds that is betting on a Chinese economic slowdown is increasing dramatically]. If the Aussie maintains its close correlation with commodity prices, then we can expect it to decline proportionately if/when China’s economy finally slows down.