In yesterday’s Money Morning, I discussed a few key indicators to keep an eye on to gauge the health of the Chinese economy.
The main indicators, I said, were the Aussie dollar and the price of Brent crude. I should also have added the price of iron ore to the list. At some point it won’t be such a big deal. But right now, in the midst of China’s urbanisation phase and rise as an industrial power, iron ore is still a crucial ingredient.
Iron ore, of course, is the raw material that goes into the steel making process. If China makes and consumes a lot of steel, then chances are its economy is humming along nicely.
Prices are currently around US$75/tonne. Over the past year or so, the price has traded within a broad range roughly between US$90/tonne and US$60/tonne.
So it’s in the middle of the range right now. Which suggests China is not running too hot, nor too cold.
That’s good for Australia. Iron ore is our most important export. It brings in a huge amount of export dollars. I don’t know the exact amount, and time and motivation constraints prevent me from looking it up. But believe me, it’s important.
When the iron ore price plunges, as it did in 2013 and more so in late 2015, it’s like Australia has to take a wage cut. No one likes getting a wage cut, especially when you have a big debt you’re trying to service.
Remember how I mentioned yesterday that Australia has net foreign debt of more than $1 trillion? When our ability to service that debt is called into question — like when everyone freaks about China and the iron ore price plunges — then people get nervous about Aussie assets. They get especially nervous about the banks.
For example, if you look at the chart below, you’ll see (and maybe remember) that Aussie stocks endured a decent, if relatively short lived bear market from March 2015 to January 2016.
[Click to enlarge]
You can put that down to a falling iron ore price, and a commodity bear market in general. Banks were particularly weak and, along with the big miners, dragged the overall market down. That’s because the banks hold a great deal of our $1 trillion debt burden on their balance sheets.
So when Australia’s income takes a hit via weaker iron ore and commodity prices, it’s the banks the market worries about.
The beautiful thing about the Aussie dollar
This is where the Aussie dollar comes into play as a worthy shock absorber. It’s why I nominated it as my number one ‘China indicator’. When the rest of the world starts to worry about our ability to service debts, what happens?
Australia, as an investment destination, suffers from an increase in risk perceptions. Foreign capital is less willing to invest here, or buy debt issued by the banks to fund the mortgages of Aussie battlers (every mortgage owner is a battler, right?).
As a result, the Aussie dollar falls. The ‘magic’ of a falling dollar is that it increases the purchasing power of foreign currency. If the dollar falls enough, it entices foreign capital back in and the whole rotten (and brilliant) system of debt and credit creation continues.
The point is, under a floating exchange rate system, currencies are a great shock absorber. They take the pressure off asset prices having to do all the work.
In late 2015, when the iron ore price fell to nearly US$40/tonne, the Aussie dollar fell to around 68 US cents. From the peak of US$1.10 in 2011, that’s a fall of nearly 40%.
So from a foreign investor’s perspective (using US dollars), over four years Aussie dollar denominated assets lost 40% of their value in currency alone. Add in the nominal dollar falls in the local currency and to many, our market would’ve looked like a bargain at that point.
All easy to say in hindsight, I know. But it’s worth keeping in mind the impact that flexible exchange rates have on asset values.
Why do you think the Dow Jones index plunged 80% in the Great Depression?
Because the US was on a quasi-gold standard. Its currency was fixed and therefore couldn’t take the brunt of the adjustment. Stock prices had to do it all.
That’s why one of Roosevelt’s first measures was to devalue the dollar against gold.
Anyway, this is all important background information to understanding why it is unlikely Australia will suffer a housing crash anytime soon. That was kind of the whole point of going down this path today…
But I’ve run out of time and motivation to continue with the story…so you’ll have to wait for next week. Barring another Wall Street meltdown, I’ll return to the topic on Monday.
Editor, Crisis & Opportunity