Email of the day (2)
Comment of the Day

August 31 2012

Commentary by Eoin Treacy

Email of the day (2)

on China and the Australian Dollar:
“With the Chinese economy slowing down, how worried should we be about the value of the Australian currency?”

Eoin Treacy's view Thank you for this relevant question which may be of interest to other subscribers. Another subscriber kindly forwarded this rather sanguine article by Stephen Roach which may also be of interest. Here is a section:

All of this is part of China's grand plan. The producer model, which worked brilliantly for 30 years, cannot take China to the promised land of prosperity. The Chinese leadership has long known this, as Premier Wen Jiabao signaled with his famous 2007 “Four ‘Uns'” critique – warning of an “unstable, unbalanced, uncoordinated, and ultimately unsustainable” economy .

Two external shocks – first from the US, and now from Europe – have transformed the Four Uns into an action plan. Overly dependent on external demand from crisis-battered developed economies, China has adopted the pro-consumption 12th Five-Year Plan, which lays out a powerful rebalancing strategy that should drive development for decades.

The investment and construction requirements of large-scale urbanization are a key pillar of this strategy. Urban per capita income is more than triple the average in rural areas. As long as urbanization is coupled with job creation – a strategy underscored by China's concomitant push into services-led development – labor income and consumer purchasing power will benefit.

Contrary to the China doubters, urbanization is not phony growth. It is an essential ingredient of the “next China,” for it provides China with both cyclical and structural options. When faced with a shortfall of demand – whether owing to an external shock or to an internal adjustment, such as the housing-market correction – China can tweak its urbanization-led investment requirements accordingly. With a large reservoir of surplus savings and a budget deficit of less than 2% of GDP, it has the wherewithal to fund such efforts. There is also ample scope for monetary easing; unlike central banks in the West, the People's Bank of China has plenty of ammunition in reserve.

It has been our position at Fullermoney for a number of years that the Chinese economy crossed a Rubicon when it became clear that it could generate greater economic growth from enhancing the productivity of its labour force than from infrastructure development. Everything that has happened since in terms of government policy can be framed by this evolution. It is important to point out that this transition is impossible without hitting the occasional speed bump.

The monetary and fiscal authorities engineered the current economic and property slowdown. They will need to rein in their efforts to contain speculation if they are to have any hope of avoiding a hard landing. Meanwhile the consumer sector remains on a secular growth trajectory. The current weakness in demand for industrial resources can probably be best defined in terms of decrease in demand growth rather than a turndown in absolute levels of demand.

Per capita consumption of industrial resources increases in tandem with higher per capita disposable income. China has dominated demand growth figures for a decade and continues to make most headlines. However China is by no means the only country going through a process of urbanisation. India, South East Asia, the Middle East and Africa are all witnessing an exodus from the land to cities.

When investors valued mining operations, I suspect they mostly took account of Chinese demand growth forecasts. We are now seeing expectations being pared back with regard to China but demand is picking up elsewhere. The question is whether new supply will overwhelm this slower demand growth from new sources.

The Australian Dollar has benefitted from its safe haven status as a AAA rated sovereign, yield of 3.5% and strong balance sheet. The dichotomy between the commodity exporting regions and the domestic demand portion of the economy highlights the reliance of the country on commodities at the margin. A decline in absolute demand for commodities rather than slowing demand growth would be more of worry from the perspective of the Australian Dollar.

The Australian Dollar has been trading in the region of $1 since late 2010 and has exhibited a mild downward bias since mid-2011. It encountered resistance near the upper boundary three weeks ago and has returned to test the three-month progression of higher reaction lows. Provided this sequence remains intact, potential for some additional higher to lateral ranging can continue to be given the benefit of the doubt. A sustained move below 95¢ would be required suggest medium-term top formation completion.

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