The Australian Dollar (AUD) is gaining on the strength of the Chinese economy and commodity prices. If you take a look at the chart for the AUD/USD relationship and then compare that to a chart of commodity prices, this becomes more apparent. The relationship is not a perfect reflection but the trends are the same. Specifically, please look at the overall shape of the charts (both covering five years).
Now compare those charts to the annual growth rates in China's GDP. The 2014 rate of 7.7 percent is still very impressive, but with much of the developed world economies struggling China is carrying the ball for commodity prices these days (includes an extra five quarters at the beginning so try compare the shape without those first five bars).
You can find the above chart and supporting data here. Without adequate demand growth for commodities from the U.S. and Europe China become the default driver of demand and pricing for most industrial commodities such as copper and aluminum. Notice the trend in the 5-year copper price chart below:
Now look at the 5-year price chart for aluminum:
There is a similarity in all of these charts, rising from the March 2009 lows to a high in 2011 and then trending lower to the current time. The exception is that the China GDP growth peaked earlier in 2010, but the Chinese speculators continued to buy up industrial metals (especially copper) and place it into warehouse storage for future sale hoping for higher prices. I do not believe that the similar pattern is coincidence but rather related. And I believe that the impact will continue to be felt in the AUD for several more years. But it could get ugly fast as new events unfold in China this year (more on that later in the article).
The Australian economy growth is heavily weighted toward mining because the country is rich in natural resources. Therefore, reductions in demand for the commodities it produces will create a drag on economic growth in Australia. Australia is not alone in this boat, but I believe that since the currency has gained greater acceptance than the South African Rand, the Brazilian Real, or the Russian Ruble (to name a few other major exporters of commodities), I suspect that there are more investors willing to invest in Australian companies. The government is more stable and inflation is less also. It would seem the perfect place to take advantage of the ravenous appetite of China for raw materials; and it has been. But things change in our global economy.
Not many years ago it was the U.S. economy and Europe that were the drivers of the world economy, consistently increasing their respective demands for copper, oil and other raw materials consumed in industrial and other forms of economic growth. Now both of these developed economies are finding new alternatives and becoming more efficient (not to mention the slower growth which is more easily offset). The U.S. is evolving from being an energy importer to becoming a future energy exporter. Things change in our global economy.
The China miracle has inspired leaders of other undeveloped nations around the world to explore the possibilities ushering in more change for the future. How many of us thought that GDP growth in Mongolia would be as strong as or stronger than that of China for several years? Well, that is another astonishing fact of our changing global economy.
The thing is that as China's economic growth slows the price of commodities drop. China derives in increasing percentage of its export revenue from developing countries as the government has intentionally focused its efforts to expand exports to faster growing economies. That being the case, as commodity prices fall many of China's customers (resource rich developing countries) feel the pain and those economies grow more slowly. This, in turn, causes a decrease in demand for China exports. As the demand for China exports is diminished it consumes fewer commodities from its trading partners causing commodity prices to fall further. It can become a vicious cycle. But that is just part of the trend. There are two other pieces to this puzzle that require our attention.
Since the prices for copper and other industrial commodities are trending lower, Chinese speculators are holding assets in warehouse storage facilities that are losing value. Banks are not loaning money as freely as before, especially for the purchase of assets for which prices are trending lower. After the financial crisis in 2008 copper prices looked like a bargain; not so much now. Expectations were for the U.S. and Eurozone economies to recover more strongly than has happened. When it became obvious that this expectation was not being met, the loans for speculative buying were cut off. So, the first puzzle piece is that speculative demand for industrial commodities has dried up in China. This change in course occurred in 2011 as denoted in the charts and is a contributor to lower prices.
The second piece of the puzzle is just beginning to unfold. As to how much of an impact it will have, I can honestly say I have no clue. But, I do believe that is has the potential to be significant and, thus, I recommend caution in dealing with investments denominated in AUD. This one is a little more complicated, but could become very interesting over the course of 2014 and 2015.
Remember the copper that speculators bought and stored hoping for higher future prices? Well, the value of all that copper was not earning any income on those significant investments. So what did the owners do (remember these are speculators)? They borrowed money (loans from banks) against the copper (collateral) to invest in other investments that would provide higher returns that the interest being paid on the loans. The term for borrowing against collateral is called hypothecation. Securities brokers do this all the time with the stocks held in our taxable accounts (but that is another story).
The important element of this piece is into what those speculators were investing those borrowed Renmimbi. The answer in really various investments, but the important part of the answer is that a significant percentage of it went into wealth products offered by Chinese banks. These wealth products promised (not guaranteed) returns well above normal market returns in the form of interest regular payments and repayment at the end of a specific period. The banks did not originate these products, nor are those products backed by the banks that sold them. The investors assumed an implied backing by the banks because the products were marketed by the banks. But the fact is that the fine print states that the bank(s) are not liable for losses incurred by the wealth fund products. The backing of these products is solely the responsibility of the companies that hired the banks to market them on their behalf.
Who are those companies? The companies offering these great returns were those who could not qualify for bank loans. In effect, these were junk bonds called by another name to make them sound like great investments. And, of course, there were very good reasons that these companies could not get loans directly from the banks. The banks decided that the companies' abilities to repay the loans at the end of the term were very questionable. Some would survive but too high a percentage would not to justify the loans.
So, where are we today? Until recently those few wealth products that came due for repayment where the originator was unable to repay in full were backstopped by government sponsored banks. But in the last month three of these funds have been allowed to fail leaving the investors with little or nothing to use to pay back those loans against their copper in storage. It also forced bankruptcies of the Chinese companies that originated the wealth products. So, on the face of these facts so far it would seem that the banks are going to come out of this mess owning the copper which can be sold to cover much, if not all, of the loans now in default. But wait, there is more!
There is one more twist to this pretzel piece that makes it even more interesting. The banks allowed many of those speculators, all of them very wealthy Chinese with excellent credit and other substantial assets, to re-hypothecate. What this means is that the speculators used the copper in storage to borrow a second, third, or maybe more times as collateral for additional loans. Of course, since the price of copper has fallen and the value of the copper has been used as collateral multiple times there is no possible way for the banks to get all of their money back.
In the end, copper and whatever other commodities that Chinese speculators have used as collateral in this scheme will be sold by the banks, most likely to end users of the commodities, at or below the spot price created a glut in China and reducing demand for additional imports.
In reality this phenomenon will probably play out over the next couple of years until the central government officials take some form of action if the bleeding gets too bad. However, the banks, investors, and many of the unprofitable companies will suffer for a time. Currently, about $500 billion (USD value) of these wealth products mature in 2014 and additional hundreds of billions will come due next year. I expect Chinese banks to step in and backstop those funds originated by companies that have a chance of survival. But there is a growing probability that the poorly run companies that are bleeding cash will be allowed to die. How many are in each pot? I do not claim to have any idea. But the fact that there were three failures in less than a month amounting to tens of millions of dollars in value tells me that we can expect more of the same fairly regularly as the vast majority of these wealth products have yet to mature. Until the last three weeks the banks had been coming to the rescue. It was not until recently that the first wealth funds were allowed to fail.
The amount of damage this activity will do to the Chinese economy could vary from very little to a measurable amount. The key to that answer will be the perception that is created within and outside China. The real damage, if allowed to unfold without fear being factored into the equation would probably be minimal. Only a fraction of the wealth funds will fail. If that fraction is above ten percent then the damage could be extensive as speculators try to unload their wealth fund assets early driving down the values and potentially creating panic in other areas of the economy. Additionally, if the problem becomes widespread, demand for copper and other industrial commodities well fall resulting in more price erosion. This, in turn, will mean lower demand for imports of those commodities from developing nations that are dependent upon industrial commodity exports for GDP growth and jobs. Of course, this could lead to reduced demand for Chinese exports, and so on. We are back to the vicious cycle again.
Australia's economic growth has become more and more deeply tied to the fate of China since it exports much of its natural resource output to China. Falling demand from China will have a negative impact on Australia's economy. A slowing economy is often reflected negatively in a countries currency. Since there impact on the U.S. is likely to be insignificant I would contend that the value of AUD relative to USD should continue to slide further. How much? I cannot even guess.
But the good news is that I believe that China has a lot more strong growth in its future. It will experience bumps along the way and this is likely just the first such bump in the road that will eventually see China regaining its balance and growth for a long time to come. Thus, the impact on AUD will be temporary, but it is my opinion that now is not the time to making sizable investment in Australia without hedging against potential currency exchange losses.
Another article about AUD by a different author her on SA can be found here for another point of view.
As always, I welcome comments and will try to address any concerns or questions, either in the comments section or in a future article, as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.