Monday, May 14, 2012

AUD below parity points to China-Australia link

China's one-year SHIBOR swap, an instrument that works just like the LIBOR based USD rate swap, provides a window into near term market expectations of rates in that country. And these expectations have adjusted down sharply in the past few days, revisiting the December lows.

1-year SHIBOR swap rate

After a string of weak economic numbers from China, PBoC cut the bank reserve ratio. It is fully expected that the interest rate will be cut as well (as the SHIBOR swap rate shows), but that requires authorization from the central government and takes time. For now PBoC will keep cutting the reserve ratio - possibly quite aggressively.

But there is something familiar about this SHIBOR swap rate chart above. It happens to look similar to the chart below of AUD/USD exchange rate - which just broke parity. And that's not a coincidence.

AUD/USD FX rate

The currency markets are concerned about a material decline in investment growth in China. The resource focused Australia is particularly vulnerable to China's fixed asset investment trends.
The Australian: - The lowest investment growth in China in a decade, reported on Friday, along with other data issued last week showing the weakest industrial production, retail sales and trade growth for more than a year have forcefully brought the Chinese slowdown to the market's attention.
China Fixed Assets Investment (Excluding Rural Households) Cumulative YoY

Some have been refusing to believe that fixed investment growth in China will stall, although this has been expected by a number of economists (see this post on forecast from CS and one from Capital Economics). It was hard to imagine that the good times may end - particularly in Australia, whose economy benefited tremendously from this growth. But now Australians can wake up to read the following the the paper:
The Australian: - " ...China's share of global demand for such commodities as iron, cement and copper is completely disproportionate to its size and almost wholly a function of its very high growth in investment. As investment growth drops sharply, as it must, global demand for non-food commodities will plummet."

This prediction from Peking University's Michael Pettis would so transform the economic outlook for Australia, were it to come to pass, that it bears some reflection.
So what's the solution? China will obviously continue to try stimulating the economy (including lowering rates), but it's not clear just how much effect that would have on investment growth. Instead Australians are suggesting that China open up to foreign investments to allow Australian firms to potentially facilitate more commodity imports into China.
The Australian (different article from the one above): - As fears grow about the sharpness of the slowdown in the Chinese economy, Foreign Minister Bob Carr is pushing for the lifting of restrictions on Australian companies investing in China as he meets with senior leaders, including Premier-elect Li Keqiang, in Beijing this week.
Good effort on the part of Bob Carr, but is unlikely to yield significant results.

To be sure, relative to the rest of the world Australia's economy is still booming. And as AUD weakens, it may in fact provide further stimulus to the nation's near-term growth. The long-term outlook however has now become far less certain.

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