Why the Aussie Dollar Battler Is Going Down

I’ve been warning this would happen for a while now. Is it the beginning of the end…or no big deal?

What am I talking about?

Yesterday, the credit ratings agency Standard and Poor’s (S&P) formally put Australia on notice about its AAA credit rating. It changed the credit rating outlook from ‘stable’ to ‘negative’. It means that, unless the government does something about its structural deficits, there’s a good chance we’ll lose the prized rating within two years.

The outcome (or lack of one) from the weekend’s election played a major role in S&P moving Australia to a negative credit watch. From S&P’s press release:

The negative outlook on Australia reflects our view that prospects for improvements in budgetary performance have weakened following the recent election outcome, and that general government sector deficits may remain material over our forecast period, with government debt continuing to rise, unless more budget savings measures are legislated or there are improvements in the revenue outlook.

That’s the problem, isn’t it? How is any government going to legislate decent savings measures when it doesn’t have the numbers to do so? For the next few years at least, don’t expect any meaningful budget reform. Deficits will continue and they will likely be greater than forecast.

So while S&P says there is only a 33% chance of a downgrade occurring in the next couple of years, a realistic interpretation suggests the probability is much higher.

Some say the government’s debt levels are relatively low, so there is no need for concern. But as I have often argued, it’s not just about government debt. It’s about our very high level of overall debt, which the government would have to backstop in the event of a crisis.

S&P said as much in their statement (with my emphasis):

We consider that Australia’s general government sector fiscal outcomes need to be stronger than its peers’, and net debt needs to remain lower, to remain consistent with the current ‘AAA’ rating. This is because Australia’s economy carries a high level of net external debt. Several ratios reveal this weakness. Australia’s external debt net of public and financial sector assets (our preferred stock measure) is over three times current account receipts (CARs). The current account deficit will reach nearly 5% of GDP this year and only moderate slightly during the forecast horizon to just over 3%.

Australia’s 2016 gross external financing requirement of US$630 billion is over half of GDP.

As I’ve mentioned on a number of occasions, Australia carries net foreign debt of more than $1 trillion. Our gross debt level is much higher than that. And as S&P says, we need to borrow or roll over US$630 billion of debt this year, which amounts to 50% of annual GDP.

A good deal of this borrowing requirement occurs via the banking system:

A portion of Australia’s external debt has also funded a surge in unproductive household borrowing for housing during the 1990s and 2000s, which was intermediated by the banking sector. Household debt (including debt for small businesses) now stands at more than 180% of household income.

If Australia suffers a credit downgrade, it could restrict the amount of capital that flows to our banks. If that happens, the price we pay to get our hands on this capital will increase.

Now here is where it gets interesting…

A credit downgrade doesn’t necessarily mean interest rates will rise to reflect the higher risk brought about by the downgrade. And remember, the market will have priced in the worsening financial position well before the credit rating agencies make it official.

Look at what just happened in the UK. The vote to leave the EU resulted in a credit downgrade for Britain. But it didn’t stop government bond yields trading down to record lows in the days after the announcement. It had no effect.

Where it did have a big effect was on the value of the currency. The pound crashed on the Brexit vote. It is still weak, and will remain weak in the future.

Think of a currency as just another price. When the value of a currency falls, it represents a broad based fall in the value of a nation’s entire asset base in the eyes of foreigners.

When those assets become riskier to invest in, a falling currency is a way to reflect this risk.

In a country like Australia, which relies heavily on inflow of foreign capital, the exchange rate is the signal that tells you whether enough capital is flowing in. When the exchange rate rises, we’re getting more than enough. The price of the Australian dollar rises to reflect this. When the dollar falls, it means we’re not getting enough capital in. A falling price is a way to increase foreigners’ purchasing power of Aussie based assets.

Here’s the bottom line: If the government doesn’t manage its finances properly in the next 12 months, the Aussie dollar will continue to weaken. If it falls below last year’s lows, at around 68 US cents, it will suggest Australia is well on the way to losing its AAA credit rating.

As far as rising interest rates go, that comes later. A persistently lower dollar will eventually feed through into higher import prices, which makes it harder for the RBA to keep interest rates low. If the dollar falls too much, we could even be in a situation where the RBA has to raise rates to support the currency.

We’re a long way from that point now. But with the political deadlock we’re in, and with no willingness to curb spending, it’s the direction we’re heading in.

It’s all about the dollar and, in the years ahead, I think it’s going down. While a falling dollar will reflect problems in the domestic economy, it will benefit our export sector.

Resource stocks are obviously a big part of this. If you want to get the inside scoop on this beaten down sector, and find tomorrow’s winners, click here.


Greg Canavan,
For Markets and Money

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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