18/09/2012 - 09:04

Analysis: The high dollar explained, and it’s not for good reason

18/09/2012 - 09:04


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Not much is going right for Australia these days, which is why the high value of the dollar is such a mystery, or was until a Queenslander working for one of the world’s biggest fund managers provided this remarkable explanation – our second biggest export is paper.

Specifically, the paper being exported is in the form of Australian Government bonds, the current favourite of international investors and overseas governments seeking a safe haven for their spare cash.

Adam Bowe, a senior vice-president in the Sydney office of Pimco, a California-based business with $US1.8 trillion under management, explained the high-dollar puzzle in a technical paper which has just been published on Pimco’s Australian website (http://australia.pimco.com).

For anyone with an appetite for reasonably complex (but easy to understand) economic theory Bowe’s paper is highly recommended and is the second on the front page of the Pimco site, underneath the latest thoughts from one of his bosses, the often-quoted Mohamed El-Arian.

Essentially, the “paper export” explanation lies in the fact that for foreigners seeking the protection (and high interest rates) of Australian Government bonds must first buy Australian dollars.

It is the need to buy Australian dollars where the difference can be found from the conventional way that banks raise money in the international market where they attract deposits in foreign currency, bring the money back into Australia, and insure (hedge) that exposure in Australian dollars.

“As the banks were buying Australian dollars spot (short-term market), and selling it forward, there was minimal impact on the outright Australian dollar level,” Bowe writes.

But, with the latest fad in international money flows, the game is different because it is the Australian Government issuing bonds (printing paper) and to buy those bonds a foreign investor must first buy Australian dollars.

In Bowe’s words: “This change has critical implications for the Australian dollar because the Commonwealth of Australia issues bonds to offshore investors in Australian dollars, rather than in other currencies as the Australian banks often do when borrowing in global capital markets.”

It is probably incorrect to call this flow of international money into Australian Government bonds “hot money” as some of it is coming from the institutions of foreign governments, including the Swiss National Bank which has been seeking safety far from the slow-motion train wreck which is Europe.

But, the size of the funds flow into Australian Government bonds is not just massive, it is also starting to develop an erratic tone to it with the stampede abruptly reversing in the June quarter with more bonds sold by foreigner investors than acquired.

Until that reversal, which caused Bowe to wonder whether it was a “blip or a change in trend” the flow of money into Australian Government bonds had been enormous, prompting this observation:

“Investors accustomed to thinking of Australia as a high-powered commodities exporter might be surprised to learn that the nation’s second-largest export is actually, in a sense, printed paper. Australian Commonwealth Government Bonds (ACGBs), to be exact,” Bowe writes.

“In the 12-months through June, 2012, Australia sold $A58 billion worth of ACGBs to foreign investors (source Australian Bureau of Statistics). To put this staggering number into context, it eclipses the $A48 billion worth of coal exported over the same period, and is second only to the A$85 billion of iron ore exports.”

Other economic experts might argue with Bowe’s report but for me it is the best explanation yet of one of the world’s financial mysteries – how can the Australian dollar rise when the country’s terms of trade are in decline?

The next question, and the one we might have to face sooner rather than later if the bad news about troubled miners such as Fortescue continues to build, is what happens if the foreign investors soaking up ACGBs find a safer haven for their spare cash?

In theory, the Australian dollar will fall sharply with the only questions being when, how fast and how far.

So, if planning that overseas holiday, or stocking up with French wine for Christmas, now might not be a bad time to use some of our high-priced (dare they be called over-priced) Australian dollars.


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