Australia And The J-Curve

Australia is another country that has experienced a substantial depreciation of its currency in recent months. The Australian dollar (AUD) has declined more than 22% versus the US dollar over the past 12 months, with a steady decline since September 2014. Barclay’s Bank estimates the “real exchange rate” (the weighted average of a country's currency relative to an index or basket of other major currencies, adjusted for the effects of inflation) has fallen 15% from its 2013 high. This decline has been welcomed by the Reserve Bank of Australia (RBA), Australia’s central bank. Initially the argument was that the AUD was significantly overvalued relative to Australian economic fundamentals. Now, the overvaluation is small by most measures. Still, Assistant Governor Kent recently stated that “The exchange rate remains relatively high given the state of our overall economy.” In this note we take a look at the Australian economy and the extent to which the AUD’s depreciation appears to have helped Australia’s net exports (exports minus imports) thus far.

The Australian economy experienced 2.7% growth in 2014, slowing to 2.5% in the fourth quarter and, further, to an estimated 2.2% in the first quarter of this year. This is actually pretty good performance considering the headwinds Australia has faced, namely, the slowdown in its most important export market, China, which accounts for almost 35% of Australia’s exports; the very modest growth in its second most important market, Japan, which accounts for 12% of Australia’s exports; and the continued weakness in global commodity prices. Another negative was the substantial decline in mining investments, which will continue to be a factor constraining growth this year. Growth should strengthen somewhat in the remainder of this year and next year, exceeding 3% for the year 2016. The main risks to this outlook are a further slowdown in the Chinese economy and a further decline in global commodity markets.

It is difficult to separate out the effects of currency depreciation on trade from the other factors listed above. According to the J-curve theory of the effects of a currency depreciation on trade balances, one would have expected a devaluation to lead first to a temporary worsening of the trade balance as imports immediately became more expensive; then, as traders adjusted contracts, exports should have strengthened and the trade balance improved. That has not been the case for Australia. According to the Australian Bureau of Statistics, the seasonally adjusted trade balance this February was -1.256 billion AUD, much worse than the February 2014 figure of +1.464 billion AUD. It is better than the September 2014 low of -1.912 billion AUD. While the currency depreciation should help Australia’s trade balance, since the country’s commodity export contracts are denominated in US dollars, the exchange rate effects are being more than offset by larger falls in world commodity prices and export volume reductions due to China’s growth moderation. The most recent bad news for export earnings was a 23% decline in iron ore prices in March.

Still, had there not been a depreciation in the currency, the trade balance and economic growth would have been even worse. Net exports account for about 21% of Australia’s GDP. In separate and somewhat different analyses, both the RBA and Barclays (LONDON:BARC) Barclays Bank have estimated that a 10% reduction in the real exchange rate would increase Australia’s GDP by about 1.2%. That implies that the 15% drop in the real exchange rate that has occurred could boost Australia’s growth by 1.8 % above what it would have been in the absence of the devaluation.

The Australian equity market has continued to underperform this year, due in part to the currency depreciation effect on US dollar returns. As of April 10, the largest Australian ETF, iShares MSCI Australia (ARCA:EWA), is up 6.22%, compared with an 8.18% advance for the benchmark, iShares MSCI All Countries ex-US (NASDAQ:ACWX). In view of the absence of an Australian ETF that is hedged against further depreciation of the Australian dollar versus the US dollar, we have been reluctant to add an Australia position to our International and Global Portfolios.