1

Understanding currency

behaviour during the GFC

When you are struggling for an answer – it is volatility.

Prepared for Currency Hedging in Turbulent Times Executive Briefing Seminar

Justin Smirk, Chief EconomistSt. George Economics Sydney, March 26, 2010

Fast cars will go even faster with electric powerFrom The Economist print edition, March 18th, 2010

Look at the complexity of currencies

• Currencies are relative prices• If one is to rise, other have to fall• US dollar trends dominate…• …impacts on value of assets (such as commodities)• …but other currencies can still find their own path

relative to other.• It was a banking crisis…• …and so funding issues matter for the AUD.• There is more than just China is you are looking at

the AUD.

AUD with timeline of the GFC

0.6

0.7

0.7

0.8

0.8

0.9

0.9

1.0

1.0

Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09

AUD/USD

100

150

200

250

300

350index

Source: St George Economics

Credit crunchbegins

NorthernRock

bailout

BearStearnsfire sale

Lehmanfailure &

AIG bailout

US labour market

& global trade collapses Green

shoots?

AUD/USD

4

China is now seen as critical but…

Chinese demand as seen as being supportive for the AUD, but this is not reflected in all our assets.

AUD & Chinese industrial production

3

5

7

9

11

13

15

17

19

Jan-07 Oct-07 J ul-08 Apr-09 Jan-100.60

0.70

0.80

0.90

1.00AUD/USD (rhs )

Chines e Indus trialP roduction %pa12-month movingaverage (lhs )

0.6

0.7

0.8

0.9

1.0

J a n-03 J a n-05 J a n-07 J a n-093000

4000

5000

6000

7000

AUD vs. ASX200

AUD/US D (lhs )

AS X200 (rhs )

Global imbalances are still there

-3

-2

-1

0

1

2

3

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014-3

-2

-1

0

1

2

3

Germany and Japan Selected Oil Exporters Selected Developing Asia

United States Selected CAD Countries Rest of World

Per cent Per cent

ForecastSource: IMF WEO Database, Treasury.

6

Australia’s foreign debt is concentrated with the banks

0

20

40

60

80

Mar-90 Mar-94 Mar-98 Mar-02 Mar-06

% GDP

0

20

40

60

80% GDP

Government

Corporate

Financial

$A778bn

$A39bn

$A173bn

Sources: St George Economics, ABS

Foreign debt lies is largely private and mostly with the banks. It also needs to noted that mortgage are banks largest asset.

FX exposure & hedging by sector

0

100

200

300

400

500

600

Liabilities Assets Liabilities Assets Liabilities Assets

$Abn

Non-AUD unhedgedHedged into AUD

Source: RBA

Banks Non-financialsOther financials

Australia’s external position: FX status

0

500

1000

1500

2000

Liabilities Assets

$AbnNon-AUD unhedgedHedged into AUDAUD denominated

Source: RBA

Non-AUD denominated assets far out-strip liabilities of the same. Hence a depreciation of the AUD has a positive valuation effect on Australia's international investment position.

US dollar performance by bloc

60

70

80

90

100

110

120

130

140

Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09

indexindex

60

70

80

90

100

110

120

130

140

Commodity exportersJapanUSD broad nominal TWIEuropeFlexible EM Indices based at January 2008. Blocs weighted by FX turnover.

Sources: St George Economics

Forecasters miss turning points

The market is too timid to make the big calls or pick the major turning points even though the data release may lag events.

Should not we call parity given the strength in commodities?

In nominal terms, this is a commodity boom like no other since most of us were just wee bairns, if not just a twinkle in our Dad’s eye.

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

J a n-7 1 Jan -7 7 Jan -83 Jan -89 Ja n-9 5 J an -0 1 Jan -0 7

A U D /U S D

0

8 0

1 60

2 40

3 20

4 00

4 80

5 60

in de x

A U D/U S D (lhs )

C RB ind ex (rh s)

S o urc es : B lo om be rg,S t G e org e E c on om ics

Still large in a relative sense

40

50

60

70

80

90

100

110

120

130

1950 1958 1966 1974 1982 1990 1998 2006

index

0.4

0.6

0.8

1

1.2

1.4terms of trade

AUD/USD (rhs)

Sources: St George Economics, RBA - annual data

A longer run history suggest we should breakout the balloons for a parity party – or is it something more complex, and more far more interesting evolving?

Global IP growth & base metal prices

-20

-15

-10

-5

0

5

10

15

Apr-95 Apr-98 Apr-01 Apr-04 Apr-07

%6m saar

-300

-200

-100

0

100

200

%6m saar

Base metals (rhs)

Global IP proxy *

Sources: St George Economics, OECD, CEIC.* GDP weighted average of OECD and the BRICs.

Base metals volatility was not as large as the volatility in global demand.

Global IP growth & the Aussie dollar

-20

-15

-10

-5

0

5

10

15

Apr-95 Apr-98 Apr-01 Apr-04 Apr-07 Apr-10

%6m saar

-80

-60

-40

-20

0

20

40

60%6m saar

AUD/USD Global IP proxy *

Sources: St George Economics, OECD, CEIC.* GDP weighted average of OECD and the BRICs.

But the AUD did respond to the demand shock despite commodities being relatively more supported.

Letters of credit in North Asia

-40

-20

0

20

40

Dec-88 Feb-93 Apr-97 Jun-01 Aug-05

% deviation from trend

-40

-20

0

20

40% deviation from trend

letters of credit, Korea and Taiwan, seasonallyadjusted

Source: CEIC.Trend and seasonal adjustment calculations by St George

Global trade was hit not just by a demand shock but also a funding shock as letters of credit dried up.

Base metals peaked long before AUD

0.6

0.7

0.7

0.8

0.8

0.9

0.9

1.0

1.0

Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09

AUD/USD

100

150

200

250

300

350index

Source: St George Economics

Credit crunchbegins

NorthernRock

bailout

BearStearnsfire sale

Lehmanfailure &

AIG bailout

US labour market

& global trade collapses Green

shoots?

Base metals

AUD/USD

Commodities peaked first and were the first to correct as the crisis started to unfold.

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Factors for the Euro/USD

Euro is difficult to explain on a relative growth basis but look a little more sensible in regard to ToT, for now.

EUR/USD vs. Eur-US annual growth differential

-4

-2

0

2

4

Mar-90 Mar-94 Mar-98 Mar-02 Mar-06 Mar-100.80

1.00

1.20

1.40

1.60

1.80

EUR/USD (rhs)

GDP Growth Differential (lhs)

0.73

0.91

1.09

1.27

1.45

1.63

Mar-90 Mar-94 Mar-98 Mar-02 Mar-06 Mar-10-6

-3

0

3

6

8

EUR/USD (rhs)

Eurozone-US Terms of Trade differential (rhs )

index

Euro Zone-US Terms of Tradeeuro

The asset side of the Fed’s balance sheet

0

400

800

1200

1600

2000

2400

Jan-08 Mar-08 Jun-08 Sep-08 Dec-08 Feb-09 May-09 Aug-09

USDbn

OtherReposOther loansAIGBear StearnsFX SwapsCP purchase facilityTerm auction facilitySecurities held outright

US funding shifted rapidly from short-run repos to outright purchases of securities – this should have been USD negative.

The increase in liquidity US$ positive?

7072747678808284868890

Jun-08 Sep-08 Dec-08 Mar-09 May-09 Aug-09

%

-20020406080100120140160180

% 6 month

6 month change inFed assets (rhs)DXY (rhs)

Sources: St George Economics, Bloomberg

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Market pricing for RBA compare to Fed pricing

-500

-400

-300-200

-100

0

100200

300

400

Jun-04 Jun-06 Jun-080.60

0.70

0.80

0.90

1.00one monthpricingAUD/USD

prob

Sources: ABS, St George Economics

Jun-04 Jun-06 Jun-08-1000-800-600-400-2000200400600800

AUD/USD

6 monthpricing

prob

When you look at relative interest rate expecations, the interest rate market shifted position on the RBA in 2008 before the FX market.

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Australian dollar model

0.40

0.50

0.60

0.70

0.80

0.90

1.00

Jan-91 Jan-97 Jan-03 Jan-09

USD

Fair value bandAUD/USD actual AUD/USD forecast

Sources: St George Economics

Jun-88 Jun-94 Jun-00 Jun-0620

25

30

35

40

45

50

55% GDP

net foreign debt

Linear (net foreign

Sources: ABS, St George Economics

AUD peaked in July 2008 in monthly averages – net debt found a low point in the September quarter of 2008

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Volatility reigns supreme for now.

• All factor at play impacting on currencies• You can simplify by looking at summary variables…• …such as commodities and interest rates…• …but unless you are confident of getting all this right…• …included capital flows…• …then you can still get things wrong.• Forecasters will lag turning points.• All we can honestly say with any certainty is that when

there is volatility in financial markets…• …the AUD will be even more volatile than normal due to

our significant funding requirements.

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When you have no idea, revert to the new. “there were more buyers than sellers” line

Alex - Feb 24, 2010

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Disclaimer

The previous presentation is our most likely scenario – there are, however, always more than one possible scenario.

A massive ToT shock for the AUD…

30405060708090

100110120130

Jun-70 Jun-76 Jun-82 Jun-88 Jun-94 Jun-00 Jun-06

index

60

80

100

120

140

160

180

200

real terms of trade

real trade weighted index

Sources: St George Economics, RBA

Does not the terms of trade, our relative income, tell us it should be a one way bet?