The Australian dollar started the new year above 75US cents, and although it is off its recent 52-week high of 78.14US cents it remains strong with a positive outlook. A key reason for this is around the word reflation.
Reflation is the intentional use of policy to release controlled inflation to drive economic growth and increase employment, wage growth and b+usiness investment to meet rising demand. There are many instruments at the government's and central bank's disposal to achieve this, including interest rates, increasing money supply, infrastructure spending and tax cuts.
If it can be achieved without inflation getting away from policy makers the result is a controlled growth path we achieve a gradual rise in inflation in a manner that dosent threaten
and is around its two-and-a-half year high as investors ramp up bets on a successful vaccine roll-out and improving global growth.
It gained almost seven per cent against the US dollar last year as a rebound in China’s economy and recovering iron-ore prices bolstered demand for our dollar, which the world refers to as a commodity currency.
However, the diplomatic trade relationship between Australia and China has deteriorated, and as our economy is so dependent on trade, it may be considered likely out dollar would fall if our largest trading partner started shutting it doors to our goods and services.
To date trade sanctions have focused on agriculture exports, but risks are increasing for bulk commodities. In its first salvo China imposed an 80 percent tariff on Australia barley exports in May last year, while it also conducted investigations into Australian meat for labelling discrepancies.
Since then news reports and government statements show there have been eight abattoirs and four major been exports blocked from selling red meat to China, wine sales have effectively ground to halt from a 200 per cent tariff, an unofficial ban on lobsters, timber bans from four states and Chinese state media reports indicating Australian coal imports have been blocked.
Other industries that have been rumoured to be targeted next include wheat, cotton, sugar and copper.
According to Citi economists, the current trade restrictions point to a 10 percent drop in total exports to China over the next 12 months, or just a 0.33 percent of Australian gross domestic product.
This suggests for now it’s manageable for Australia and unlikely to derail our growth because agricultural goods to China account for four per cent of total Australian exports but risks are definitely rising.
The biggest risk is iron ore trade
In 2020, iron-ore exports helped offset the decline in other bulk commodities. Continued steel demand in China is expected to buttress iron-ore prices over the coming year. Iron ore surged to a seven-year high late last year and is trading above A$140 a ton on strong steel demand from China’s steel mills.
Elevated prices have brought a number of smaller Australian mines back to life; meanwhile, billions of dollars are being invested in new mines due to come online this year from BHP Billiton, Rio Tinto and Fortescue Metals.
China has few alternatives as it seeks to stimulate its economy post Covid-19 through infrastructure investment, with Australia accounting for more than half of iron ore shipments globally. If Beijing were to try to purchase solely from non-Australian producers, at best it could get 56% of the volumes it typically imports.
With action against iron ore unlikely, Beijing’s ability to bring Australia to heel through economic coercion is being undermined, at least for now.
Impacts on the dollar
We have forecast the Aussie Dollar to reach 76US cents within the next twelve months, amid the global consensus view that the USD will depreciate over the period as the US keep on piling up debt in the fight against COVID-19. The deterioration of the country’s financial position will bring weakness to its own currency.
China has been trying to give itself greater flexibility by buying ore carriers that improve the economics of long-distance shipping from Brazil and purchasing Guinea mines. Yet, ongoing production problems after an accident at a Vale SA mine mean Brazil is unlikely to be back at full output before the end of 2022, and the output potential of the latter has been heavily questioned.
What if a downside scenario happens amid Australia-China trade relations?
In our downside scenario of a trade impact from China that includes iron ore, we would anticipate a 50 per cent drop of exports to China. This could cause Australia’s total merchandise exports to decline by 20 per cent, leading to a $76 billion loss in export earnings, and causing a sizeable 3.8 per cent hit to nominal GDP.
We think this scenario unlikely, but the impact could cause the dollar to correct to around 60US cents. The lower dollar would act as a shock absorber and aid growth in the medium-term, but there would be an undeniable hit to export earnings, income, and growth over the short term.
The tug of war between Australia and China trade relations are still underway. We believe it is unlikely to derail growth in the short term but risks are rising in the medium term.
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