How Canberra’s strained relations with China leave the Australian dollar vulnerable

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Australia is often described as the “lucky country”, but luck may be in short supply for the Australian dollar. Markets might decide that a weaker Aussie dollar would be a natural corollary to any further volatility in emerging market (EM) currencies, especially with diplomatic relations between Beijing and Canberra strained.

In recent years, Australia’s economy has undoubtedly become increasingly interlinked with those of Asia in general, and China in particular.

That has influenced the fortunes of the Aussie dollar (AUD), as succinctly summed up in a recent research note from National Australia Bank. “Australia’s exposure to China as well as AUD liquidity means that the AUD is often used as a hedging tool for EM exposure with speculators also playing an amplifying role,” the bank wrote.

It has a valid point. The currency markets have, in the past, bought the Australian dollar as a surrogate play on rising economic prospects for China and other countries in Asia. But, by the same logic, if Asia’s emerging market currencies start to come under broader pressure, the Aussie dollar could equally come under scrutiny.

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National Australia Bank believes that “a few bad apples in EM markets (Turkey, Argentina, Venezuela) at this stage suggest contagion risk remains relatively low” but that “if cracks begin to appear in other countries, such as those with low (foreign exchange) reserves and large external debt (Poland, South Africa, Chile and Indonesia), then the risk is that the flight out of EM will not differentiate between the good and the bad apples.”

In this case, “the AUD is also likely to be a casualty”, it argued.

That said, within Asia, the reality is that Australia’s economic wagon is essentially hitched to China and so the Aussie dollar, it could be argued, might be relatively immune to emerging market currency volatility as long as market participants perceive China’s economy and Beijing-Canberra relations to be sound.

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The importance of China to Australia’s economy is huge. “Australia’s economic relationship with China has grown rapidly in recent years, going from something minuscule, to where China now represents one-third of this nation’s exports”, former Australian prime minister Kevin Rudd said in February. “China is also now either the largest, or second-largest source of foreign direct investment in this country each year.”

Raw material exports from Australia to power China’s economy are, of course, a major facet of the bilateral trade relationship but the links go further, as was referenced last month in an International Monetary Fund working paper.

It focused not only on commodity sector trade but also on how the Australian economy has been benefiting from the expansion of China’s demand for services.

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For example, the working paper noted that China had “increased its share of total tourism spending in Australia from 3.5 per cent in 2000 to 22 per cent in 2015” while in education, “the number of students from China has risen by 340 per cent since 2006-07, accounting for over 53 per cent of the increase in foreign students, now totalling over 182,000 for 2016-17”.

Rudd said in February: “The strength of China’s economy, its demand for what we have to sell, what we import from China, as well as the investment capital which flows here, radically shape the future direction of the Australian economy, the future strength of Australian employment and the future living standards of the Australian people.”

Yet relations between the two nations have become strained over a number of issues recently, such as Australia’s vetoing of some Chinese-led attempts to acquire Australian companies. Beijing lays the blame squarely at Canberra’s door and while there are two sides to every story, markets tend to look at the likely consequences and adjust accordingly.

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“Due to the Australian side’s reasons, the relationship between China and Australia has encountered some difficulties”, China’s top diplomat, Wang Yi, said on May 22, arguing that to get relations back on track “Australia should discard its traditional thinking and take off its tinted glasses to take a proactive approach towards China’s development”.

Those “difficulties” haven’t, as yet, irrefutably affected trade, though there have been reports recently of customs-related entry delays at Chinese ports for Australian wine exports, but the Australian dollar would be likely to come under pressure if markets decided China-Australia trade relations had become materially impaired.

Australia’s economic pivot towards Asia in general, and specifically China, has proved to have been a source of support for the Aussie dollar in recent years. But times can change. That pivot could now prove a source of Australian dollar weakness.

Neal Kimberley is a commentator on macroeconomics and financial markets

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