The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Friday, July 8, 2011

Is the Aussie dollar becoming a global reserve currency?

In the throes of the Euro debt crisis last year the Aussie dollar plunged from over 93 US cents to around 80. This time around it has found it hard to grind below 104 US cents (see chart). The resilience of this growth/commodity proxy has been quite remarkable. And that's really the point: the Aussie is migrating away from its old growth/commodity status to become something 'different': let's call it a 21st Century reserve currency. This is a function of two things that actually have little to do with Australia:

(1) the desire of US authorities to debase their currency to give domestic exporters a comparative price advantage irrespective of the inflationary consequences (indeed, inflation is a good thing for the US given its debt burden and the fact it still tenuously possesses the global reserve currency); and

(2) the rational reaction of sovereign holders of US dollars who see the writing on the wall (ie, that the value of their US assets is likely to fall) and, furthermore, recognise that we are currently experiencing a major shift in the global centre of economic gravity away from the North Atlantic economies to Asia.

This means that the 21st Century global reserve currency is likely to move away from the current US hegemon to a multi-polar SDR or Bancor-style basket of currencies. (Bancor was the global currency that Keynes had hoped would be created via the Bretton Woods process.)

And since it is hard to trade the Chinese currency, one of the next best things is a proximate, lowly leveraged, and politically stable economy that has a liquid exchange rate and is highly integrated with the Middle Kingdom's fortunes. Yes, you guessed, it: the Sunburned Country.

For mine, the resilience of the Aussie during the second round of the Euro debt crisis suggests that it may test its highs again depending, crucially, on what happens to the US dollar. I had been looking for an appreciation in the US dollar in the second half of this year as inflation pressures mount, and US yields rise. But this thesis is being challenged by the desire of the US authorities to depress the nation's debt servicing burden (ie, yields) and currency in combination with the evident trepidation foreign investors have holding US assets.

An alternative scenario could be that we see spiking US yields in response to rising inflation and a dearth of investor appetite for US securities, but no sustained appreciation in the greenback (in light of the absence of demand). This view of the world is more consistent with those betting on a structural upward re-rating of the Aussie, which also has ramifications for the RBA's target cash rate given the disinflationary effects of an appreciating currency.

Naturally the Aussie-US cross does not tell us the whole story about our economic station. Indeed, it might tell us more about the US's relative economic decline. Arguably more important insights are yielded via the RBA's Trade Weighted Index (TWI), which is an index of Australia's exchange rates weighted by the significance of our trade with each major partner (see next chart). The conclusion for the Aussie is broadly the same no matter which measure you consider: we are at near-record highs.

In the Sydney Morning Herald today I am quoted in response to yet another survey by The Economist that claims Australia is one of the most expensive countries in the world in which to live.

I note that this survey is materially distorted by the 20-30 per cent surge in the Australian dollar from its 2010 lows, and the fact that it evaluates the global cost of living in US dollars, which makes domestic prices appear relatively more dear compared with most other nations.

Yet Australians earn Aussie dollars, so the purported 'increase' in the cost of living in Australia vis-a-vis other countries that is attributable to the currency has had no impact on local residents. In fact, it improves Australians' purchasing power, which means there has been a cost of living decrease because we can buy goods and services more cheaply from overseas than we could before (think travel and all those online purchases). It also means that the price of goods imported from offshore has fallen, which is one reason why we are seeing the discounting war amongst the big retailers.

On the other hand, it is true that Australia is now a more expensive destination for immigrants who have not been paid in our currency. And Australia's inflation and cost of living indices have been running at a healthy 3-4 per cent annualised clip, which is higher than many of our developed counterparts. The bad news is that our cost of living is only likely to rise as the resources-induced private investment boom squeezes out the economy's remaining spare capacity and further fuels price pressures.