The Great and Powerful Oz: How Long Can Things Go Up in the Land Down Under?

Having just returned from a two-week tour of Eastern Australia, I can confidently tell you that the Land of Oz is blessed with many great things: sunshine (a novelty for a Londoner like me), beaches, vineyards, and great food. But these blessings all come at a very high price. Everything – from food to clothes – seemed mighty expensive. And coming from a Londoner that’s saying something!

The very sharp appreciation in the Australian dollar goes some way to explaining the tremendous rise in prices. In the span of four years, the Australian dollar has strengthened from US$0.63 to US$1.05. All else being equal, that implies a virtual doubling of prices! So whereas a pizza in Australia may have cost around US$15 in 2009, it now goes for around US$25.

The incredibly powerful performance of the Australian economy over the past few years has contributed to this sharp strengthening of the Aussie dollar; meanwhile, the European and U.S. economies have been redefining the term “tepid recovery.” Australia has maximised its gains from the mining boom, taking advantage of its abundant resources. Unemployment stands at around 5.5% – compare that to the 11.7% average in the Eurozone and the approximately 8% average for the UK and the U.S. What’s more, without a doubt, Australia is strongly positioned to take advantage as economic power shifts to Asia. It has already benefitted from strong exports to China.

While the Federal Reserve and the Bank of England have wedged rates close to zero, Australian policy rates have not fallen below 3%. The Australian currency has reaped the benefits.

However, there are vulnerabilities in the Australian growth story. The latest GDP growth figures show that the economy is now growing below trend – and worse is expected to come given the significant fiscal austerity being implemented at both state and federal levels. The drop in commodity prices has taken its toll and the mining boom is set to peak earlier and at a lower level that previously expected. While the unemployment rate is low by international standards, it is at its highest level since 2009 and the labour market is still softening. Chinese growth has slowed and, if that trend continues, things could get very bumpy for Australia’s resource-heavy economy. And while the tremendous rise in property prices in recent years has added to wealth levels, a housing market crash could spell very uncomfortable times for leveraged homeowners.

The strong exchange rate certainly has a part to play in a potential Aussie slowdown scenario. Indeed, not only are tourists being deterred by the strong Aussie dollar, even businesses in Australia are feeling the pain of the strong exchange rate as they struggle to compete with their international counterparts. Global consulting firm KPMG reports that Australia has become the second most expensive place to do business among the major economies – just behind Japan. (The original KPMG survey in 2010 found Australia was the third cheapest location for business of the nine Western economies).

The Reserve Bank of Australia seems to share these concerns. Its decision earlier in the week to take policy rates back to their previous low of 3% was accompanied by a statement that showed little indication that the RBA’s easing cycle is complete. The market is pricing in a further 25 basis points of cuts. Lucky Australia – unlike the U.S., UK, Japan, and most of Europe – still has room to cut policy rates in order to provide a boost to its ailing economy.