Why There is Foreign Appetite for the Australian Dollar

Yesterday I talked about the persistently strong Australian dollar as a major economic challenge for Australia. Part of the reason for that is because interest rates here are attractive relative to other parts of the world. But are they really?

Today I’m going to explain why they are not. When you take into account the risks, foreigners are playing a dangerous game by chasing ‘yield’ in Australia.

Before I get to that though, what about iron ore? It fell another 2% overnight and is now trading at US$89/tonne. Where’s this bounce that everyone (especially the iron ore miners) is expecting? It will come at some point, but it’s likely to be weak when it does.

The great hope of the iron ore bulls is that a lower price would take out uneconomic Chinese production, freeing up supply for Australia’s relatively low cost producers (both large and small). I never bought this argument, which is why I have long thought the price would hit US$80/tonne before the year was out.

Think about it. The Aussie iron ore industry has for years relied on China’s uneconomic production of steel feeding uneconomic construction of property and all types of infrastructure. Yet they have faith that Chinese iron ore miners will somehow adhere to economic principles and shut down when the price falls below their cost of production.

Don’t they know that China is different? China produces stuff to maintain full employment, not to generate an economic profit. Sure mines will close eventually (after the government gets sick of subsidising losses) but that could still be some time away. The cost of subsidising a loss is likely to be much less than dealing with rising unemployment and potential unrest in certain communities. So the subsidies will go on and the supply glut will intensify.

By the way, the lack of concern for economic profit is the fundamental reason why I’ve been bearish on China for so long. When economic profit is below the cost of capital in so many areas, which it is in China, problems must emerge somewhere. Parts of the economy must bear the cost for the profligacy of the other parts. That’s what you’re seeing now with slowing growth…and it will get worse.

Let’s get back to interest rates and the dollar. Foreign investors remain happy to buy Aussie dollars and assets because the yield is more attractive here than in their home countries…whether it’s Japan, Europe or the US.

And keep in mind, these foreign investors don’t really have to care about local inflation. Savers like you and me do, but no one gives a hoot about you and me, so pipe down. After taking inflation into account, the real official interest rate is 0%. On the other hand, for the foreign investor experiencing very low inflation at home (as in Japan and Europe, for example) the nominal yield in Australia looks good.

But buying Australia because the yield looks good is akin to buying a stock because it pays a good dividend. Such an action doesn’t take into account the underlying risk. When it comes to a company, you look at the business model and determine whether revenues and profits are sustainable…and therefore whether the current dividend is sustainable.

When it comes to assessing a nation, it’s a little different but essentially the same principle. That is, you have to assess the nations’ business model to determine whether the yield you’re receiving is sustainable.

Read the rest of this article at The Daily Reckoning