Issue: 183
Sent: 20-10-2009 10:31:01
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Australian Dollar Strength RevisitedEmail Marketing Business Opportunity - Helen BairstowDiversity, Good for Business or Not?The Easiest way to do a Client NewsletterWhy Warren Buffett won't buy a NewspaperRevised Stats, Tax Agents and Tax Efficiency
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Australian Dollar Strength Revisited

Click here to buy - A How To Book of SMSF's by Tony Negline
John Robertson

The strength of the Australian dollar is again looming as an important investment market variable. It will affect flows of investment funds, output growth rates, interest rates, inflation and relative equity market performance.

My travel commitments have prevented me from preparing something original this week. Back in May 2008, I urged a change to our mindset of expecting a permanently weakening currency. The global credit crisis temporarily interrupted some of these pressures but they have re-emerged. This is what I said 19 months ago.

Many commentaries on the currency continue to imply that the Australian dollar is only temporarily inflated. It could go much higher and stay aloft for several more years.

A recent report by financial valuation experts KPMG Corporate Finance is just one example highlighting the culture surrounding the Australian dollar. To value a company, that firm forecast a one-off drop and then a steady and indefinite decline in the Australian dollar. According to the report's authors, the long term decline in the currency was because Australia's inflation rate would be permanently higher than U.S. inflation.

This purchasing power parity view of the Australian currency, which was only infrequently evident when the currency was moving just as sharply in the opposite direction, suggests that short term, largely unsustainable factors are diverting the currency from its true equilibrium.

The chart at shows this relationship since 1960. It does offer some strong support for the view that the broader trend in the currency has been associated with relative inflation performance.

That said, we need to take care that we do not slip unthinkingly into the view that Australia's inflation rate must always be higher than the inflation rate in the USA and that Australia will always be prone to currency weakness.

Australia's inflation was higher in the 1970s and 1980s as the currency slipped lower. However, Australia's potential inflation was lowered dramatically once the Hawke-Keating-Howard microeconomic reform programs removed many of the causes of that relatively poor inflation performance.

When Australia is near the top of its economic cycle, its inflation rate will almost certainly be higher than the inflation rate of the USA when it is at the bottom of its cycle. That is what we are measuring today. The outcomes from two decades ago and what is happening today go nowhere near proving that Australia's inflation will always be higher.

The chart shows that this has not been so for the past 15 years. It also shows that there are lengthy periods when the currency departs from the relative inflation track.

In the very short term, simple momentum and interest rates will continue to have an effect.

In a world of traders measuring performance daily and afraid to miss any movement from which their competitors are benefiting, the currency tends to be higher (or lower) today simply because it was higher (or lower) yesterday. Momentum sets the pace.

In a world on the brink of recession, Australia's relatively high interest rates should eventually bring down its inflation rate but offer the prospect of a lengthy period of relatively high real interest rates.

Ultimately, capital flows to where the risk adjusted returns are likely to be greatest. Australia is being recognized more widely for its above average growth prospects because of its proximity to Asia and its abundant endowment of natural resources.

Chinese and Indian interests have already begun recycling a portion of their burgeoning economic surpluses toward Australia. This is almost certainly not simply a reaction to current interest rates.

Investment security is highly cherished. This is, in part, about the size of the reward for investing successfully but also about having an agreed set of rules applied even-handedly, something Australia can claim to have done well over many years.

These attributes are all worth something. Foreigners pay for having access to such an investment environment. This is one reason the currency rises.

At the beginning of 1972, one Australian dollar bought US$1.20 with pressure to revalue. The world was already changing and the economic dam walls broke very soon after the election of the Whitlam government later that year.

Subsequently, it took 20 years to bring about the necessary policy changes and for them to have their desired effect. By then, information technology, biotech and global finance were the themes grabbing attention in investment markets. These were not Australia's strong suits but those phases passed soon enough. Now, the rest of the world actually needs Australia more than ever. Why shouldn't the exchange rate reflect this?

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