Industry Focus

REAL ESTATE SERVICES Looking at that potential current account trajectory from an external financing point of view, our net call on global savings will fall to a mere sliver of that seen for the majority of the floating exchange rate era. Going back to the most recent balance of payments report, we note that the stock of net foreign liabilities (equity plus debt) have declined consistently from the all-time high of almost 60% of GDP in Dec 09 to around 53½% of GDP in Dec 13, while the net foreign equity position was positive for the first time ever. So while net foreign debt has continued to increase, Australia's aggregate call on external financing has been reduced, and the trends currently in place indicate that this basic direction of change will persist for a considerable period of time. A smaller stock of net foreign claims on Australia will make it easier for the nation to navigate phases in global financial markets when capital is difficult to entice from its home jurisdiction, necessitating substantial 'discounts' by deficit countries: i.e. currency depreciation. That implies that the dynamics observed in 2012, when the AUD was unusually composed during episodes of broader stress, may become more prevalent in future. While the reasons behind the stability will be different—FX reserve managers were ubiquitous buyers on dips back then, and as credit growth was unusually subdued, the public sector was the main borrower via debt—the currency should exhibit a more stable facade under the future balance of payments situation described above. Turning to the composition and scale of recent capital flows to and from Australia, we note that gross international financial activity picked up sharply in the December quarter. Indeed, the scale of gross flows was reminiscent of levels observed in the pre-GFC era. Debt inflows were particularly pronounced, with public sector fund raising accounting for about half of net foreign borrowing in the quarter and debt investment in the direct category also very prominent. Gross outflows by Australian parties were also large, spread relatively evenly across debt and equity, which is not the norm. Equity is usually the favoured vehicle, given the known behaviours of superannuation funds, who dominate outflows. The improvement in the current account ... ... is an evolving theme ... ... to comprehend. ... that markets would do well ... Now to the December quarter balance of payments report. The current account deficit was $A10.1bn in Q4, equivalent to -2.6% of GDP, a significant narrowing from -4.5% in the corresponding quarter a year ago. That is only the seventh time in the past 33 years that the deficit has come in at 2.6% or less. Booming resources exports and weak import demand have pushed the trade account into a substantial surplus. While we expect this to dissipate over the course of 2014 as import demand normalises to a degree, ongoing increases in supply capability (notably gas) will push the trade surplus as high as 3% of GDP by 2016—very close to the current level of the income deficit, implying that the overall current account will approach balance at this stage. Fair value is in the high 80¢ area. Our views on the level of the currency are that it is about fair value in the high 80¢ area. We think that the RBA probably broadly agrees with that assessment, even though 85¢ has been nominated as their true 'comfort level' under the current mix of fundamentals. Fair value models of the Australian dollar are a 'dime a dozen' inside the 'official family' and in the markets, with the terms of trade (commodity prices) and interest rate spreads doing the heavy explanatory lifting. (Recent Freedom of Information requests regarding the RBA's internal currency research confirms that not much has really changed since the pioneering work of Gruen and Blundell-Wignall back in the early 1990s). However, an additional input to our fair value model that gets only scant attention from markets is Australia's external financing situation, which we proxy through the net debt position. Improvements in this position were a silent source of support for the currency in its parity plus era, and with the current account position looking formidably strong relative to history going forward, markets would do well to educate themselves on this matter. ... despite no lack of new information. That is not to say that there was a lack of news. There was a geopolitical flare thrown up in the Crimean; the Chinese data (and negative press coverage of the debt situation) periodically weighed; erratic US data left questions open; and monetary policy in the European Union (the ECB and the BoE) was an active space in terms of shifting expectations. Locally, the tone of incoming information has been mixed, but arguably tilted towards the positive, with the obvious and major exceptions of the labour market and consumer sentiment. Additionally, after conspicuously refraining from talking the currency down in its February statement, in a departure from its late 2013 posture, the RBA re-inserted a (diluted) comment on its level in March. The $A has been quite stable ... Since we last went to press on February 7, the daily closes of AUD/USD have been contained in a relatively narrow range of approximately 2¼%. The low was around 89.2¢ and the high was 91.2¢. However, the low and high were separated by just one week at the end of period. The currency's relative stability against the US dollar prior to this mini spurt was primarily a function of the lack of monetary policy surprises at either end of the chain, with the RBA's "on hold" stance, and the Fed's "a tapering pause has a high threshold" positions basically unchallenged by the markets. Australian dollar HUW MCKAY, SENIOR INTERNATIONAL ECONOMIST 14 Industry Focus

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