AUD's Role in the Weakening Chinese Economy

This month the pair has traded at its lowest level since July 2010 as a combination of concerns over growth in China allied to persistent verbal intervention from the central bank have continued to weigh on the local currency. At the last Reserve Bank of Australia (RBA) meeting in November, the central bank kept rates on hold at 2.50% for the 12th consecutive month with the bank repeating the statement that the ‘most prudent course is for a period of rates stability’ and that ‘on balance the AUD is above most estimates of fundamental value’. Most recently the RBA Governor Glenn Stevens has been explicit in indicating that interest rates can go down if needed and that it is likely further declines in AUD are to come. Rhetoric of this kind have now become commonplace in terms of the central banks communication strategy and further jawboning of this nature from either the governor or his fellow policymakers is likely to continue for the foreseeable future. Given the lack of movement in more blunt monetary tools (interest rates), the central bank continues adopt the methodology of verbal intervention in order to weaken their currency, a method of which at this point has been greeted with moderate success. Therefore, any commentary specifically on the AUD or the country’s relationship with China is to be closely followed in order to capitalise on day-to-day price movement.

Looking at the RBA specifically, the governor Glenn Stevens has reiterated at a press conference most recently the mining investment is continuing to fall and that the decline has a long way to run. However, his general assessment of economic conditions was slightly more upbeat, noting the economy has the capacity, inflation is well under control, and that those conditions look set to continue to be the case over the next couple of years. Stevens said “in such circumstances monetary policy ought to be accommodative, and it is, and on present indications is likely to be that way for some time yet.”

In terms of downside levels to be aware of, the early November low comes in a 0.8541 and a break below would open up a run toward the 0.8067 printed back in May of 2010. If the latter level gives way then the pair could well trade a sub-0.8000 level for the first time in five years. Another factor to contemplate when assessing the outlook for the pair is the performance of the USD as of the world’s major central banks the Federal Reserve looks set to be one of the first Western CB’s to commence rate lift off some time in the Autumn of 2015. As such, further signs of lower unemployment and sustainable growth in wages in the US may place additional pressure on the pair as the USD index has touched upon four and half year highs in November.

Additionally, the AUD is often seen as a proxy for the performance of the Chinese economy given the large dependency the country has in exporting its goods to mainland China. As such, monitoring Chinese economic data and commentary out of the People’s Bank of China (PBOC) is of the utmost importance when understanding the health of the Australia. One of the key factors that has been weighing on AUD in recent months has been concerns that China may not be able to maintain its extremely high GDP target which the government has set at a staggering 7.5%, a level in which most tier 1 investment banks view as inflated with consensus seen more toward the 7% level, and with the Chinese President, Xi Jinping, highlighting downside risks.

Looking at the data, October flash Chinese HSBC Manufacturing PMI printed at a six-month low with the output index its lowest in seven-months. In the report HSBC noted that disinflationary pressures remain strong and the labour market showed further signs of weakening, alongside weak price pressures and low capacity utilization which points to insufficient demand in the economy. As such, due to this bearish assessment many market participants have been questioning on whether the Chinese central bank will step in and support economic growth given their tendency to provide fiscal stimulus measures especially in an environment of falling house prices and lower Foreign Direct Investment (FDI).

On the 21st of November 2014 the PBOC decided to cut its one-year deposit and lending rates by 25 bps and 40 bps respectively, a move which instantly supported global stock futures upon release as the announcement was unscheduled and the first rate cut from China since 2012, this prompted the E-mini S&P 500 to once again print fresh record highs. Despite this surprising move from the Chinese central bank, some have questioned whether it will have long lasting effects, with analysts at Goldman Sachs suggesting that the move is unlikely to have a big direct impact because rates are not subject to lower limits. Meanwhile analysts at JP Morgan say that further cuts will probably be accompanied by reductions in the reserve requirement ratio (RRR), which currently stands at 20%, allied to targeted lending, and more liquidity injections.

To put Australia’s dependence on its trading partners in some perspective, China accounted for 31.9% of all goods and services produced by Australia in 2013 with Japan accounting for 15.5%. Therefore, it is not only China’s economic performance that is critical to the future of Australia, but the risk of a considerable period of slow growth in a deflationary environment in Japan may have the potential to knock the Australian economic recovery off course. To put the recent news into direct market impact terms, when the PBOC delivered their surprise rate cut last week AUD/USD saw an immediate hundred pip move higher upon the release and with analysts at JP Morgan and UBS expecting further easing to come more intraday volatility is a distinct possibility.