Australia’s relationship with China is much like the relationship between Canada and the United States, so any analysis of Australia's mid-term economic prospects hinges upon the dynamics occurring within the Chinese economy. Chinese stimulus efforts have had an outsized impact on commodity markets, as heavy government spending on resource-intensive infrastructure projects has boosted demand for raw materials over the last year. This has translated into strong export growth in Australia, and has contributed to rising employment and inflation numbers in recent months. The outlook for Chinese stimulus efforts is quite uncertain; while a political mandate clearly exists to support economic growth, inflationary pressures and lending excesses represent significant challenges to future spending. As is the case elsewhere in the world, Chinese authorities are beginning to call for a reduction in stimulus expenditures, and many observers expect to see government-driven spending slowing through the early part of next year. According to several commodities analysts, Chinese importers have largely rebuilt depleted inventories of metallurgical coal and iron ore used in steel production, and stockpiles of other raw materials are rapidly approaching capacity. Over the long run, commodity demand should remain strong as China and many other Asian nations build the infrastructure needed to support future economic growth, but it seems that a shorter-term demand-side correction is coming, and this may manifest itself in lower imports.

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Australia’s domestic housing market is quite frothy. In contrast to the huge declines seen elsewhere in the developed world, new home sales surged almost 25% this year, and prices have risen 6.1% since February. Values are sitting well above their 2008 peaks, treble their values in 1996, contrasting with the declines seen in much of the rest of the developed world. Much of this is due to government intervention; tax cuts, grants, and lowered interest rates have all played significant roles in driving the frenzy. In common with their Canadian counterparts, officials at the Reserve Bank of Australia (RBA) have repeatedly issued warnings of overheating in the real estate markets, and both rate hikes over the last month were accompanied by statements expressing concern about asset price increases. Most analysts see “neutral” interest rates in the 5 – 6% range, and the central bank is rapidly tightening policy. Roughly 90% of Australian mortgages are indexed to prime rates, meaning that interest rate hikes are directly translated into costs for most homeowners, unlike the fixed rate regime in Canada. This capacity and commitment towards reducing asset price inflation should help to cool the market over time without recourse to regulatory pressure, making an outright housing price collapse unlikely.

While a close relationship with China and an overheating real estate market do represent short-term risks, Australia's fiscal position is extremely strong, putting the economy on a strong footing in the long term. Treasurer Wayne Swan recently forecast net government debt levels peaking at around 10% of GDP in 2014. This is in marked contrast to the rest of the developed world, where debt levels will hit an average 80% of GDP over the same time period. Canada will be closer to 90% and the United States will hit 115%. This means that Australians are in the enviable position of having the governmental resources to adapt to changing economic fortunes relatively quickly, and paying much less to maintain the debt burden over time. With benchmark interest rates sitting well above those in other countries, the RBA has plenty of ammunition to fire in the event that exports to Asia drop or the world economy takes a turn for the worse.

Interest rate differentials continue to widen as the RBA tightens, and counterparts around the world pledge to maintain loose monetary conditions. Commodity prices continue to strengthen, and Chinese growth continues apace. Currency traders have anticipated and considered these conditions for some time, and the Aussie’s outperformance has been the result. The Aussie has appreciated 30% against the Canadian dollar and 50% against the US dollar since the credit crisis hit, and further strength seems to be in the cards over the next few months. However, at this point in time it seems that much of the short-term good news has been priced into the currency and very little of the medium-term risk has been ignored. If our recent prognostications with regards to asset price bubbles and the worldwide carry trade prove to be accurate, commodity prices may drop substantially at some point during the next year. In such an event, the Aussie may fall 10 – 15% as trade balances with Asia are temporarily adjusted downwards. Either way, a break through par against the US dollar looks quite unlikely for now.

On balance, demand should prove durable over longer time periods and the outlook for the Australian economy is strongly favourable. Much of the Australian dollar’s recent appreciation has been driven by speculative flows, so any reversal would simply nurture future competitiveness. Prudent fiscal management and a willingness to act against asset bubbles have built a strong foundation for economic growth. Australia will play in a league of its own for some time yet.

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Chris Lori

Forex Trading, Forex Workshops