Australia’s luck runs out as China slows

March 25, 2014 4:35 am

Australia’s luck runs out as China slows

By Henny Sender

Reasons to be bearish on currency and country grow daily

There is only one good reason not to short the Aussie dollar: it is expensive. But the grounds for taking a bearish view on both the currency and the country become more compelling by the day.

Australia has long been the land of coal, iron and liquefied natural gas (LNG), which is even better than being the land of milk and honey thanks to the demand for these resources from China.

Australia was among the biggest beneficiaries of China’s voracious appetite for iron to turn into the steel skeletons of everything from cars and railroads to flats and office towers, as well as coal for the country’s power plants. As China prospered, demand for gold to decorate the necks, wrists and fingers of China’s plutocrats and their wives also soared.

China was a big reason why Australia’s economy has grown by 4 per cent a year for about 20 years. It escaped the Asian financial crisis 15 years ago and the global financial crisis five years ago. But last year, growth was only 2.4 per cent.

The Lucky Country may not be as lucky in future as it has been in the past two decades.

Contagion danger

As China gradually both slows and shifts underpinned by urban services, there will be less demand for Australia’s resources. “Almost all economic figures released so far this year were weaker than consensus,” China research from HSBC noted on March 21. “China’s manufacturing sector is losing momentum.”

The growth in industrial production slowed to the lowest reading in nearly five years for the first two months of 2014, according to HSBC.

When China’s growth rate slows by 1 per cent, emerging markets suffer a slowdown of 0.7 per cent. Australia is not an emerging market but it will also suffer disproportionately from any slowdown in China, along with Indonesia, Brazil, Chile and Peru, according to JPMorgan.

Recently, an official at one Asian sovereign wealth fund with a $30bn portfolio of Chinese shares sought advice from a big Hong Kong-based hedge fund manager on how to hedge that portfolio in the face of falling growth on the mainland. One answer: short Aussie dollars.

Today, the Australian dollar is the most exposed of the G-10 currencies to China.

Australia is plagued by a currency that is so overvalued it makes oil-rich Norway’s currency look cheap. But the price of oil is high while the prices of Australian commodities are under downward pressure, leading to deteriorating fundamentals.

The contribution of capital spending to GDP was negative in 2013 and is expected to remain negative this year. “We are facing the mining investment cliff,” notes research from Macquarie Securities.

Bechtel, the big US engineering and construction company, has three large LNG export terminals projects in Australia – contracts worth tens of billions of dollars. But everything is so expensive and the shortage of skilled labour so acute that people familiar with the projects say the company is unlikely to do much more in Australia when these projects are completed. Over A$110bn worth of resources related projects were cancelled last year alone, according to data from JPMorgan.

Meanwhile, the people who manage KKR’s new $2bn special situations fund say they are spending much of their time in Australia, meeting with the owners of smaller mines who need capital as their cash flow dries up, in the face of rising costs and weaker demand.

Manufacturing is not going to pick up the slack. Surveys of Australian business show no intention to increase spending in non-mining sectors of the economy. Toyota became the last car company to say it planned to stop making cars in the country.

“Private investment will be a material drag on growth in the next fiscal year and probably much longer,” according to JPMorgan.

Safe bets are off

Meanwhile, sitting in Hong Kong, it is easy to feel a mix of emotions at the prospect of a real slowdown in China. Hong Kong will be even more vulnerable than Australia if this happens. Residents of this Chinese territory have long maintained renminbi accounts on both sides of the border and enjoyed higher interest rates on their Chinese currency accounts than they could get on either US or Hong Kong dollar accounts as the renminbi appreciated.

Now, suddenly everything is going into reverse as China slows and its currency weakens – by about 2 per cent in the past few weeks. If that continues, it may be a better hedge for a big portfolio of Chinese equities to short the renminbi than to short Aussie dollars (and much less costly). The authorities in Beijing have indeed succeeded in their goal of injecting uncertainty into the trajectory of the Chinese currency.

Sadly, it is not clear what the safe bets are any longer.