- Money Morning Australia

How the Aussie Dollar is Caught in a Worldwide Game of Currency Chess

Written on 03 November 2012 by Callum Newman

How the Aussie Dollar is Caught in a Worldwide Game of Currency Chess

The worldwide game of currency chess on means you need to reckon with the world’s central planners before buying stocks. This week’s Money Weekend will tackle why.

Before we do, we must consider Australia’s second largest trading partner, Japan.

There’s no getting away from it, the news just keeps getting worse for Japan.

This week car maker Mazda downgraded its profit forecast on slumping sales in the Chinese market. Other big car companies like Toyota and Honda have also copped a pasting from lower Chinese sales.

Why? Well, the spat between China and Japan over the disputed Senkaku/Diaoyu islands hasn’t helped.

But it gets worse…

Japanese electronics giant Panasonic lost 765 billion yen (US$9.6 billion) this year. That’s the second year in a row of big losses.

To give you an idea of the scale, Panasonic is Japan’s third largest employer. And according to Bloomberg, the company cut its dividend for the first time in 50 years. It has also cut 39,000 jobs in the last year and the share price has ‘plunged the most in at least 38 years in Tokyo trading.’

Not only that, but fellow electronics company Sharp is a rumored to be on the verge of bankruptcy. It’s been in business for a hundred years.

Part of this story is the loss of market share to companies like Samsung and Apple. They’ve successfully outmaneuvered the big Japanese technology companies. But the other part to this story is the Japanese yen. There’s no doubt the strong yen is seriously hurting the Japanese export sector.

That’s bad news for Japan, because the only genuine chance it has to grow is if it can export to foreign markets. That’s because it won’t find much joy at home. The domestic economy is shrinking, as is the population.

The Bank of Japan tried to lend a hand this week by expanding its asset purchase program. It didn’t seem to help. You’d think they’d learn after twenty years.

But looking ahead, the more important question is whether the Chinese central bankers will learn from Japan’s mistakes…

Medicine that Can’t Heal

One thing Chinese leaders have done is engineer a weak currency. They have done this by loosely pegging the renminbi to the US dollar. But anytime a central bank intervenes, it always creates an unintended outcome. First, holding down its currency hurts Chinese savers.

But it also shows the risk that a rising renminbi poses for China. One of these is the realization that China’s foreign exchange reserves aren’t simply an enormous slush fund they can dip into whenever they want.

This is something Greg Canavan, editor of Sound Money. Sound Investments, points out in his recent white paper .

But he’s not the only one to warn about China’s financial position. British hedge fund manager Hugh Hendry made the same point in a recent speech. Hendry has a reputation as an unconventional thinker and someone who calls things as he sees them.

He warned that China was in a difficult financial position because the government had directed spending to so many marginal and dubious projects. Plus, he says it’s wrong to think of China’s trillion-plus US dollars in reserve as some sort of medicine that can fix the economy. He says it’s more like poison.


His position is that any move by China to sell its US Treasury holdings would immediately put upward pressure on its currency and wreak havoc on the Chinese export sector. He put it like this:

‘If we don’t have a sustained world economic recovery, then I’m very fearful of the events that could befall the Chinese. And don’t tell me that they’ll sell their US Treasuries. It’s not an asset. An asset is something you can sell to protect yourself. If they sell Treasuries, the renminbi goes higher and higher and higher…and their little companies that export go bust.’

China wants a weaker currency to protect the domestic economy. But as Hendry points out, the market wants China to adjust the renminbi’s value…except the Chinese government prevents this by maintaining a loose peg to the US dollar.

In order to maintain the peg with the USA, the People’s Bank of China must print money at the same rate the US Fed prints money. Thanks to the Bearded One, Ben Bernanke, that means printing a lot of money. This means the renminbi falls as the USD falls, rather than the renminbi rising.

But printing money leads to inflation, which raises prices and has the potential to unleash civil unrest as the Chinese people lose purchasing power. As Greg points out in his white paper , the main aim of the communist party is social stability. Inflation threatens social stability.

So what does all this mean for Aussie investors?

The Cost of a High Aussie Dollar

Foreign currency values are important to Aussie investors because they affect the value of the Aussie dollar. This in turn affects earnings and the value of stocks. Look at the chart below. Greg Canavan showed this to his subscribers back in September.

It shows the Reuters/Jefferies CRB index (a US dollar index) priced in Aussie dollars. The index includes commodities such as base metals, agriculture, energy and precious metals. It DOESN’T include iron ore and coal. But it helps explain why the Aussie share market index is at about the same level it was back in late 2005.

Source: StockCharts

Here’s what Greg wrote at the time:

‘For many Aussie based commodity producers (who denominate revenues and costs in Aussie dollars) there has been no price boom. Making things worse, cost inflation over the decade, coupled with a price collapse since 2009, means profitability for many producers must be near all-time lows.

‘The other obvious conclusion to draw is that if other commodities are in the doldrums, the bulk commodities — coal and iron ore — must have been doing all the heavy lifting. In other words, the commodity boom, especially over the past few years, has been dangerously narrow…

‘In my view the iron ore and coal bubble is in the process of going bust. A bubble bust is a process where prices ALWAYS overshoot on their mean reversion journey. Those hoping that bulk commodity prices will rebound strongly or that further Chinese stimulus will come to the rescue are unwittingly churning out that well-worn phrase…this time is different.’

Now, if the Aussie dollar goes down, Aussie producers might see an increase in profitability. But what could drive the value of the Aussie dollar down? In Greg’s view, understanding the Chinese government holds the key.

After all, the central planners in Japan thought they could engineer a recovery after the Nikkei bubble burst back in 1989. Over twenty years later, the world is still waiting.

But there’s much more to this story, including which stocks Greg thinks stand to benefit. To check out his thoughts, go here .

Callum Newman
Co-Editor, Scoops Lane

From the Archives…

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23-10-2012 – Merryn Somerset Webb

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Callum Newman
Callum Newman is editor of the Money Morning weekend edition and co-editor of Port Phillip Publishing’s subscribers-only email Scoops Lane. (To have Money Morning delivered straight to your inbox you can subscribe for free here). If you're already a subscriber to these publications, or want to follow Callum's financial world view more closely, then we recommend you join him on Google+. It's where he shares investment insight, commentary and ideas that he can't always fit into his regular Money Morning essays.

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