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Dancing with the dragon
By Robert Gottliebsen
August 14, 2009
PORTFOLIO POINT: Investors need to realise just how closely Australia’s fortunes are tied to China.
This is the most import commentary I have written for Eureka Report this year. I want all subscribers to read it and then think about the implications for their investment portfolios and Australia.
Suddenly what has happened to Australia and what will happen becomes much clearer. Rather than stun you with a few bold sentences, I want you to spend time and come on the same journey as me. I normally file my Eureka Report commentary on Friday morning after Wall Street has closed and Australia has opened. But this week I had personal commitments on Friday morning so I filed late Thursday. Then at two o’clock this morning I woke up in a sweat and began thinking about the full implications of what I had written. I couldn’t sleep.
After an hour I got up, explained to my wife what had happened, and sat down to write again. The fact that Australia has raised 15% of the world’s new equity capital took on new meaning, as did the huge rise we are seeing in our stockmarket.
But that’s only the very beginning of what is going to happen. I have decided not to change a word of my original commentary but rather to write an additional commentary. By the middle of next week this will be a major discussion point in Australia.
The arrest of Rio Tinto’s iron ore negotiators in China and the spectre of the Chinese hacking into the Melbourne International Film Festival website because they didn’t like a particular film has clearly damaged Australia-China relations both at the Governmental and community levels.
But in the midst of these events some remarkable research has been undertaken by HSBC, which shows the Australian dollar has become the mirror image of Chinese economic activity. At the same time, I think it is also true that shares in our largest company, BHP, have a similar relationship to what is happening in China and therefore the Australian dollar.
This relationship between China and our currency/stockmarket is going to play an enormous role in the future of our country and investment strategies. And as this research reverberates around the world, it will become apparent to traders that while it is very difficult to speculate on the Chinese currency directly, you can now do it via the Australian dollar and perhaps to a lesser extent the Australian stockmarket.
This dynamic will add a whole new dimension to our currency and economy. Once Australians understand the influence China is now having on our fortunes, good and bad events between China and Australia will take on a new level of importance.
Traditionally, the Australian dollar has been linked to our interest rates and very often has been the reverse of the American dollar. In decades gone by we were also loosely linked to Japan. HSBC shows that there is a close link between the Australian dollar and global equity markets but it is not an exact correlation.
To prove its theory that the Australian dollar mirrored Chinese industrial activity, HSBC looked for a statistic that accurately measured the Chinese industrial sector. China’s conventional industrial production data was rejected because it often contains distorted figures.
HSBC chose Chinese electricity generation, which is reliable because what is produced must be used so supply and demand are very closely connected. In addition, electricity is directly billed for and does not have the same measurement errors seen in other Chinese figures. The bank found a three-month moving average of Chinese electricity generation was close to a mirror image of the Australian dollar.
Chinese electricity consumption and the Australian dollar
The relationship has become closer since the tech bubble recession in 2001-02.
So if the Australian dollar and the best measurement of industrial activity in China (electricity generation) track each other closely on a graph, what does that mean for our nation?
First, it means that our currency is going to move up and down in accordance with what takes place in China. The HSBC research has been upgrading its estimates of the likely level of Chinese economic activity for both 2009 and 2010, so the bank is now forecasting the Australian dollar will reach US86¢ in 2009 and rise further to US95¢ by the end of 2010. Interestingly, the head of foreign exchange strategy for BNP Paribas, Hans Redeker, who has reached a similar conclusion to HSBC, also says the economic situation developing in China will govern the future direction of the Australian dollar.
But Redeker has a different short-term view to HSBC. He warns that the recent rise in Chinese activity and the rise in the Australian dollar has stemmed from the dramatic amount of loans given by Chinese banks to Chinese enterprises.
Redeker believes China is now beginning to reverse its very liberal credit policies and although there will be no “rocking” of the boat before the October 17 Communist party conference, the Chinese Central Bank has told the bigger banks to be more careful of their loan provisions, which means that in the second half of this year loan growth will be significantly slower and Redeker believes this will affect the commodity markets and the Shanghai equity market.
Assuming this also affects industrial activity, and because what happens in China drives our dollar and stockmarket, we will be intimately involved.
HSBC points out that in the longer term, China is going to grow and as the Australian dollar moves up with the Chinese growth so our balance of trade will improve and we will benefit. But as we have seen in Europe and Latin America, where a country’s currency is tied to events in another country that are very different to what is occurring in the domestic economy, it can have unfortunate repercussions. A large number of Australian industries will simply become uneconomic, with severe domestic consequences.
HSBC does not point out that the dramatic reversal of all the Howard industrial relations laws will give unions greater power and almost certainly lower Australian productivity. Chinese events will be boosting the Australian dollar at the same time, which will give the Australian domestic economy – particularly in New South Wales and Victoria – a lot of difficulties.
The BHP share price and the Australian dollar are not the same graph, but they are closely linked because industrial expansion in China sets commodity prices and commodity prices have a big influence on the price of BHP shares. So if HSBC is right about China’s long-term expansion, then BHP is a clear way to ride the upward journey.
But it means that companies that export from Australia, whether they are services (including tourism) or manufactured goods, are headed for a new level of difficulty. This of course includes the motor industry, but covers a much wider area. For example, our tourism sector could be priced too highly for most countries, except China. At the moment, our bureaucrats don’t understand these forces and promote our tourism in the US and Europe and have draconian visa requirements for the Chinese
Have a look at your long-term investment portfolio and see if there are stocks that have a high Australian labour content, and which are vulnerable to imports. If China has a setback these companies maybe be boosted, but if it keeps expanding then they face harder times.
Conversely, this is good news for retailers selling imported goods. They have done particularly well in recent times because Chinese prices have been reduced reflecting the collapse of the American market. At the same time, the Chinese stimulus package has boosted the Australian dollar so retailers that didn’t currency hedge their purchases have obtained their goods at much lower prices.
And even if the purchases were currency hedged, those goods that are being purchased at the moment are being secured at much lower prices in Australian dollars than a year ago. All this is very new territory and it is not understood in either the community or in our national parliament. But in the next few months it will become one of the widest discussion points and there is little doubt that the work of HSBC and BNP Paribas is going to play a big role in investment strategies in coming years.
Sit back and think again about what you have just read. We are living in a country where, rightly or wrongly, the world markets are seeing us as a proxy for China. Where China goes we go. That means that when China is in favour, as it is now, our currency rises and we will be able to raise as much capital as we like. China now has a country (Australia) in which it can invest and where there is no currency risk. China is currently making many of the big bids for Australian resource operations, but what will be just as big will be their purchase of Australian property and Australian debt. We are currently seeing Chinese interests buy residential property and already that is spreading to commercial property. These trends will accelerate.
That’s the good side. On the bad side we will need to keep interest rates high to avoid Australian inflation exploding. Many big employers are going to go to the wall because they can’t compete in a high dollar environment, particularly given that the new industrial relations regime means a lowering of productivity in areas where there is militant unionism or managers that can’t handle the new environment.
As I mentioned earlier, we must really move on Chinese tourism. But overall this is going to be a very exciting time for Australia as we become the “safe haven” way of investing in China. This opens a whole new vista for the Australian stockmarket and as long as China keeps going well our shares will soar to new highs. In the slump, the Australian stockmarket was one of the worst-performing markets in the world because not only did it fall but that fall was multiplied by the decline in the Australian dollar. Now it is working the other way, with the stockmarket driving ahead and, in the eyes of overseas investors, the rise is multiplied by the increase in the Australian dollar.
I have prepared a graph that shows the Australian market rise in US dollar terms. We are doing much better than Wall Street but not as well as Shanghai. Australian investors investing overseas in unhedged assets are not doing well.
Relative outperformance of Chinese and Australian indices
But the China road is a roller coaster and Australia must be prepared to hang on tight on the dips. As BNP Paribas points out, Chinese banks are beginning to slash lending and a setback is possible, which will see our currency and stockmarket fall dramatically. But remember that China must keep growing and creating jobs or it will not be able to handle the social implications. The toughening of China’s stands on global issues is partly about the government tightening security because 20 million Chinese lost their jobs in the global recession that endangered the nation’s security.
All this underlines the fact that Australia is a far safer place to ride the Chinese roller coaster than China. Fasten your belts and enjoy the ride.
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