The Australian dollar (AUD) appreciated about 40 percent against the US dollar (USD) from March 4 to October 6, the day the Reserve Bank of Australia (RBA) became the first G-20 central bank to boost its benchmark interest rate since an agreement was reached to coordinate monetary policy in response to the global recession.

Currency traders bid the AUD from late winter because they understood the Australian economy’s strengths relative to its developed-market peers. These strengths, many of which it shares in common with Canada, suggested Australia would recover faster and stronger than typical developed-world economies.

Traders were essentially betting that the Reserve Bank of Australia (RBA), acknowledging that extraordinary measures were no longer necessary, would be the first G-20 central bank to boost borrowing costs and thus the value of the AUD.

Confirming this forecast, Governor Glenn Stevens’ statement supporting the October 6 decision to move up and away from a half-century-low benchmark noted that the “basis for such a low interest rate setting has now passed.” Stevens also said it was now prudent to “begin gradually lessening the stimulus provided by monetary policy.” On November 2, Monday, the RBA, which makes interest rate decisions on a monthly basis, boosted another 25 basis points to 3.5 percent.

On November 3, Tuesday, the Federal Open Market Committee (FOMC) of the US Federal Reserve gathered for the seventh of its eight scheduled two-day meetings of 2009. On Wednesday the Fed left its benchmark interest rate at the lowest possible level:

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

The FOMC statement provided more detail than previous statements about where and what type of shoots it’s looking for before it will begin tightening, and it also revealed that one of the Fed’s extraordinary easing measures would be scaled back ahead of schedule.

But as long as there’s no perceived change in the “low rates of resource utilization, subdued inflation trends, and stable inflation expectations” expect rates to stay in the easy-money, zero-to-25 basis-point zone.

Whether the Fed perceives an inflation threat or not, the AUD is poised to outperform the USD because the economy backing it is stronger. Much was made of the fact that retail sales in September fell unexpectedly, but Myer Holdings Ltd (Australia: MYR) and David Jones Ltd (Australia: DJS, OTC: DJONF), Australia’s largest and second-largest department-store chains, respectively, both posted higher sales in the fiscal first quarter ended October 24.

Myer, which went public November 2, reported a 5.2 percent revenue increase to AUD717.1 million during the three months ended October 24. The initial public offering, Australia’s largest thus far in 2009, was priced at AUD4.10 per share but began trading well below that number on Monday, at AUD3.88. It’s still trading below the IPO price. David Jones’ sales rose 2.2 percent to AUD452.1 million.

The IPO priced Myer stock at 15.1 times forecast earnings. David Jones is trading at 15.8 times earnings.

Australia is experiencing an increase in hiring and a rise in confidence. Unemployment fell in September to 5.7 percent, the first drop in five months, and wages rose last quarter. Consumers and businesses are feeling better than they have in more than two years.

The Reserve Bank of Australia will go higher, but the Fed’s benchmark will stay the same; USDs will be cheaper than AUDs.

For US-based investors looking for ways to hedge against the long-term threat of inflation, to take advantage of the present reality of a declining USD relative to currencies of resource-rich, financially stable countries, and to grab a little China-levered growth, Australia is worth a deeper look.

Financial Foundation

The Australian banking system is, much like Canada’s, essentially an oligopoly. While The Big Five sit at the top in the Great White North, the Land Down Under is subject to The Big Four.

The Commonwealth cousins share more than similar nicknames: Australian banks, too, entered the financial turmoil with only limited direct exposure to the alphabet soup of securities that made many banks abroad sick with losses.

And their income isn’t dependent on the casino-type activity that characterizes what passes for major players in the Western financial system. Trading income only accounted for around 5 percent of Australia’s four major banks’ total income prior to the turmoil.

Wealth management operations were affected by market developments, but the major banks still reported net income of around AUD2.3 billion from these activities in the first half of the most recent fiscal year, before the post-March 9 rally had endured long enough to lift all boats. The RBA noted in its September 2009 Financial Stability Review:

One reason why Australian banks garnered a relatively low share of their income from trading and securities holdings is that they did not have as much incentive as many banks around the world to seek out higher-yielding, but higher-risk, offshore assets. In turn, this was partly because they were earning solid profits from lending to domestic borrowers, and already required offshore funding for these activities. As a result, Australian banks’ balance sheets are heavily weighted towards domestic loans, particularly to the historically low-risk household sector.

The RBA can credibly continue to invoke the phrase “historically low-risk” to describe its household sector because lending standards weren’t eased to the same extent as elsewhere and those charged with the responsibility of managing the system–fiscal as well as monetary authorities–seem to have taken the mandate at least a little more seriously.

Riskier types of mortgages, such as non-conforming and negative amortization loans, that became common in the US weren’t features of Australian banks’ lending. All Australian mortgages are “full recourse” following a foreclosure–households generally understand that they can’t just hand in the keys to the lender to extinguish the debt. At the same time, the legal environment in Australia places a stronger obligation on lenders to make responsible lending decisions than is the case in the US.

The level of interest rates in Australia did not reach the levels that made it temporarily possible for many borrowers with limited repayment ability to obtain loans, as in some other countries. As for the regulatory environment, the Australian Prudential Regulation Authority (APRA) has been relatively proactive in its approach to prudential supervision, conducting several stress tests of banks’ housing loan portfolios and strengthening capital requirements for higher-risk housing loans. No banks under APRA’s watch have collapsed.

Nonperforming loans for residential mortgages–which account for more than half of Australian banks’ loan books–was 0.62 percent as recently as the end of June, according to the RBA. That compares with 5.7 percent in the US and 2.4 percent in the UK.

Although Australian fiscal authorities, too, threw massive amounts of taxpayer money at problems created by the global financial crisis and subsequent recession, their efforts will have far different consequences than those initiatives taken in the US and the UK, for example.

Primarily, authorities in the US and UK had to spend billions bailing out damaged financial institutions. What money wasn’t used in recipients’ own trading accounts covered up the holes caused by deteriorating CDSs, CDOs, RMBSs, CMOs and other such synthetic assets, not to consumer or business lending.

The Big Four–Westpac Banking Corp (Australia: WBC, NYSE: WBK), Australia and New Zealand Banking Group Ltd (Australia: ANZ, OTC: ANZBY), National Australia Bank Ltd (Australia: NAB, OTC: NABZY) and Commonwealth Bank of Australia (Australia: CBA, OTC: CBAUF)–proved with its latest reporting season that Australian banks are among the soundest in the world. 

Although numbers across the board were down for the fiscal year concluded September 30, all four were profitable and earned combined underlying cash profits (“underlying cash profits” strips out one-time items and is the standard measure used by Australian analysts) of AUD16.3 billion. The banks earned combined of AUD18 billion in 2006-07 and AUD17.5 billion in 2007-08. Although bad debt expenses grew more than five-fold to AUD13.2 billion from AUD2.4 billion in 2006-07, the banks managed to limit the fall in underlying earnings to 2.4 percent from 2008 levels.

The banks limited the decline by increasing margins. For the first time since 1995, aggregate net interest margins rose in the full year, from 2.07 percent to 2.22 percent. The consensus forecast is the underlying cash earnings will increase by just under 14 percent in 2009-10.

Westpac led the way with a profit of AUD4.6 billion, 8 percent lower than last year, solid results at its retail and business holding the line with 9 percent growth.

The Big Four raised approximately AUD120 billion in new capital in 2009 and are reported to have AUD20 billion of excess capital. (This excess is, in part, the result of dividend cuts that have now proven to be prudent moves and evidence that Australian bankers place balance sheet strength at the top of the priority list.) This would put them in position to grab cheap assets in the last days of the downturn and to take advantage of a turnaround in the economy.

Australia will use almost half of its stimulus package to fund construction of roads, railways and ports, education infrastructure and a national broadband network. The government also plans to extend increased cash grants for first-time home buyers of as much as AUD21,000 by six months until Dec. 31 to bolster construction.

The comparative advantage is that Australia was able to afford tax breaks and spending programs designed to boost aggregate demand because it doesn’t have the structural budget problems besetting the governments of so many developed countries. The country will register record budget deficits in the near term, but at its peak the shortfall will represent only 4.9 percent of GDP. The US fiscal deficit is nearly twice that.

Eliminating the budget deficit is a function of returning to above-trend growth, and Australia is poised to do so ahead of its G-20 peers. Its financial system provides a solid foundation; its resource wealth and its proximity to the economy one celebrity pundit described as the winner of the great recession combine to provide the essential elements of economic growth: supply and demand.

Chistralia

Canada enjoys a maturing bilateral relationship with China as well as the indirect benefits–higher commodity prices–the Middle Kingdom’s remarkable and accelerating growth conveys to it. Compared to Canada’s, Australia’s ties to the new engine of global economic growth are enormous.

Only 3 percent of Canadian exports go to China; more than 70 percent head for the US. Australia sends 24 percent of its outbound shipments to China, only 6 percent to the US. Relative to Canada, Australia enjoys eight times the Chinese exposure and has only one-twelfth of the exposure to the US market.

Australia’s is a resource-based economy, just like Canada’s. The race to grab a chunk of the Pilbara iron ore deposit in the remote northwestern part of the island nation is the most recent manifestation of this fact.

Pilbara, the world’s biggest iron ore deposit, covers more than a half-million square kilometers. More than 300 million tons of iron ore have been mined there and shipped to steel mills around the world in 2009. Forecasts that this trend of growing demand will continue are based almost entirely on steel-making activity in China. Projections of an iron-ore price rise of 15 percent are based on the fact that China’s imports rose 30 percent in October. The world’s third-largest economy takes almost 80 percent of Australian iron ore exports by volume.

BHP Billiton’s (Australia, BHP, NYSE: BHP) recent AUD204 million all-cash offer to acquire United Minerals Corp (Australia: UMC, OTC: UMDNF) was designed to stave off an effort by China Railway Materials Commercial Corp to buy a stake in the company.

UMC is attractive to BHP and the Chinese because it’s sitting on an estimated 158 million tons of ore, which is equal to about a year of output for BHP. Its deposits are located near BHP’s and Rio Tinto Ltd’s (Australia: RIO, NYSE: RTP) deposits and also in close proximity to rail lines controlled by BHP and Rio, which would make it easy to transport the ore to the west coast of Australia for export.

China has been trying to expand its footprint in Australia, offering funding at a time when Australia’s prospectors and miners are hungry for new capital to dig new mines and build new rail lines to get mined ore to market. The effort to grab United Minerals was unsuccessful, but China will continue to look for similar “minnows” to buy.

This isn’t the first time China’s efforts to directly own Pilbara iron ore have been frustrated. BHP and Rio Tinto announced the formation of a USD100 billion joint venture in June to combine efforts on certain aspects of the respective operations in the deposit. This was a direct alternative for Rio to a deal with Aluminum Corp of China (Chinalco). Chinalco would have bought minority interests in certain Rio assets; Rio would have used the cash to pay down debt. The arrangement with BHP seems to have provided the same type of relief for Rio.

BHP and Rio Tinto, recognizing it’s not sound to aggravate your largest customer, reportedly attempted to bring Chinalco into their Pilbara deal. The Australian reported earlier this week that Chinalco turned down the invitation:

It is understood that as early as May this year, Chinalco was offered a shareholding of up to 5 per cent in the still-controversial iron ore joint venture. Based on the valuations implicit in the June 5 deal, that level of ownership would have required an investment of at least $US5.8bn.

But Chinalco ultimately turned down the invitation because the restructuring of the original deal meant that the Chinese company would no longer be offered board seats at Rio.

This is important because it signals the Australians, despite recent evidence to the contrary, are open to Chinese capital. And the Chinese are too shrewd and need the resource too much to let it bother them for too long.

Details of the BHP-Rio JV are still being ironed out, and the final arrangement must still pass regulatory muster. The usual concerns about European regulators have already been aired. Until government approval is forthcoming and a binding agreement is executed, BHP and Rio are proceeding with caution.