Sorry Doctor Henry – Australia is not a safe haven

May 16, 2012


Cross posted with MacroBusiness.

There has been much written over the past year or more about Australia’s status as a safe haven. People point to the fact that the Australian dollar climbed to the dizzying height of 1.1080 to the USD, against a post float average around 74 cents, and the fact that it has held there for the best part of a year and a half as evidence that this assertion must be true.

I have written many times in these pages that I just don’t buy this theory – firstly because I have seen scant evidence of the Aussie dollar rallying at any time global market and economic risk aversion has intensified. Secondly, because my analysis framework tells me that much of the Aussie dollar’s strength has been related to two factors – USD weakness and yield pick up.

So when I saw Ken Henry on the 7.30 report last night claiming that Australia will benefit if Europe blows up I almost fell off my chair. On this topic in the interview with Chris Uhlmann this is what Ken had to say:

CHRIS UHLMANN: And what does that mean for us?

DR KEN HENRY: And that is also a very good question. Interestingly enough if you look at global capital movements and how they have been affected in the post-war period, how they’ve been affected by shocks. Typically what’s happened is when a shock has affected investor confidence, irrespective of where that shock originates, capital has flowed into the United States the US dollar has depreciated (DFM here, he meant appreciated). This is what we’ve seen, in crisis after crisis after crisis. Ironically, when the global financial crisis hit, when Lehman’s collapsed, even though the source of the problem was the United States – guess what? The US dollar appreciated because people had always when they got afraid they always put their money into the United States ,perverse in that case, probably perverse in earlier cases but nobody bothered to ask the question whether it was perverse or not, money just flows into the United States seeking a safe haven.

Now, the events occurring in Europe will also predate large capital movements, indeed they are, this extreme capital market volatility, not extreme I shouldn’t overstate it but there’s considerable market volatility at the moment, very important question. If the worse thing happens where does the capital go? It is quite possible of course on this occasion some of that capital will come into Australia, it is quite possible, it is quite possible on this occasion Australia will be seen as offering something of a safe haven for global capital movements. That’ll be the first time in the post war period but it’s possible to imagine it now.

Let’s be clear – in the context of the answer to Uhlmann’s question, Henry is saying that money will flow towards Australia and that the Aussie dollar will go up.  As he says, that has never happened before:

The first box on the chart above represents the 1997-98 period which covers the Asian Crisis, Russian debacle and LTCM implosion. The second box is the GFC. I could also add last years run into the mid to low 0.90 cent region as an example of the Aussie dollar selling off as global markets melted down. It’s low was at almost exactly the same time as the global equity low in October 2011.

So it would be certainly unusual to say the least for anyone to expect that the Aussie dollar will be bid higher if a catastrophe eventuates. Uhlmann asks the obviously strange question that flows from Henry’s last answer

CHRIS UHLMANN: So, Europe’s collapse could be a good thing for Australia?

DR KEN HENRY: Well, depends, I’m an economist Chris so I’m always going to say on the one hand Chris but on the other hand no because what it’d mean is a high valued Australian dollar, that’s what it would mean. Now it would mean, when you asked me earlier about the things I worried about when i was thinking about how the GFC would impact Australia, and we spoke about fiscal response, the other thing I was worrying about and this was the matter for Prime Minister Rudd that he was asking me about on that flight to Gladstone in 2008 was what happens if Australia is denied access to international capital? What happens if we can’t actually fund out current account deficit? So the good news side of it is that it is possible, it’s maybe even likely that any capital flow associated with problems in Europe would make it easier for Australia to fund it current account deficit, on the other hand it would mean a high valued Australian dollar and as you know that’s an issue already causing some concern for some sectors of Australian…

My bolding but he genuinely believes that Australia will achieve positive flows associated with a debacle in Europe – to which I say bunkum.

When I started out in the currency strategy business I had this revolutionary idea, although I didn’t realise it – seemed common sense to me – to include the US Dollar in my Aussie dollar model. My argument was, and remains, that as the other side of the AUD/USD its reasonable to include it in the model and as you know it is one of my key 5 drivers.

I would argue that what people call “safe haven” over the last few years is really just USD weakness manifest in a higher Aussie dollar and the extra positive feedback of higher commodity prices that are also priced in US Dollars – the double counting, double whammy effect.

So let’s have a look and see if the evidence stacks up as a USD weakness story or if it truly is Aussie Dollar strength:

This first chart above  is the AUD/USD rate versus the AUD/EUR rate since the start of the GFC in July 2007. You can see that there is a directional correlation between the two but it doesn’t make my point very strongly.

But if I index both exchange rates to 100 as at July 1st 2007 so we can see the percentage moves in each of them we get, I think, a clearer picture of what is really going on:

In the very early stages of the GFC when Australia was unaffected, when mining boom Mark I was chugging along, and when the Reserve Bank was tightening the interest rate screws, the Aussie dollar did appreciate under its own steam – of that I have no doubt. But since the intensification of the GFC post Lehman, for the most part when AUD/USD has risen or fallen so has the AUD/EUR rate. It’s not perfect as these correlations never are. But the key driver behind both of these is the moves in the USD and the fact that the Aussie dollar, as the world’s favourite punt and tied into the risk/growth trade, has a higher Beta to USD moves, is where the noise comes in.

Now there is no doubt that things like the fiscal position, net government debt, interest rate differential and the positives accruing to Australia from the Chinese economic linkage have increased foreign central bank and investors exposure to Australia, our bonds and our currency. But I would, and have, argued the notion that Australia is a safe haven and is going to receive net capital inflows as a result of a re-intensification of the GFC  to be a bridge to far.

Indeed Henry understands this when he says earlier in the interview:

Because the global financial crisis people in financial markets globally are asking the question of everything – is this sustainable? And when they look at Greece they say for heaven’s sake, that can’t possibly…

Financial markets are asking these very same things about the Australian economic miracle, RBA interest rates, fiscal position and China growth and maybe, just maybe they might also conclude, “for heaven’s sake, that can’t possibly…”

Have a great day

Gregory McKenna

Please remember these are not recommendations for you to trade these are my views and I have my risk management tools and risk parameters that you do not have access to. Thus, this blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.

If however you do need advice on Investments, Economics, Funding and Liquidity, Interest Rates and Forex and Derivative markets we are happy to help.

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One Comment on “Sorry Doctor Henry – Australia is not a safe haven”

  1. The Blissful Ignoramus Says:

    Spot on Greg, agree 100%. Indeed, I’ve had the same argument publicly on Twitter post-GFC with various prominent political journos. This bogus line by Henry has been bought unchallenged by the opinion-shapers. Not good.


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