Australian Dollar Set for Tough Year

The Australian dollar is likely to be dominated by global risk conditions for much of 2012 and looks set for a renewed decline at the start of the year. Asian economic doubts are set to intensify and financial sector de-leveraging remains an extremely important issue at a global level, both key factors which work against the Australian currency. Throughout the year, selling into strength looks to be the best approach as it heads towards the 0.82 area against the US dollar.

Bearish bets on the Chinese economy are hazardous at the best of times, especially given the opaque nature of data collection and reporting. It has also become extremely fashionable to look for bad news in the Chinese property sector as media stories of ghost towns multiply. It is, therefore, easy to gain a distorted impression. Nevertheless, alarm bells are ringing very clearly surrounding the housing sector, lending and the banking sector. There is also increasing stress surrounding local-government finance as bad-debts escalate.

Throughout history, is has proved impossible to engineer a soft landing from the size of credit boom seen in China since 2007. Maybe the Chinese leadership can defy the historical odds and guide the economy to a controlled slowdown, but it does not look an attractive bet. If China heads for a hard landing then the Asian dominoes will feel the full effect as regional demand slows and there will inevitably be an increase in trade tensions.

There is likely to be a further phase of deleveraging within the global banking sector which will also slow potential growth as lending is curtailed. All the BRIC economies are likely to face tough challenges during 2012, especially with Russia again facing increased political risk.

There will be an important negative impact on the Australian economy, especially if trade disputes increase and there is likely to be downward pressure on commodity prices. The Reserve Bank will be prepared to cut interest rates further which would also push the currency lower.

The domestic economy is unlikely to provide strong support for the currency with spending and investment growth set to slow as the housing sector remains under pressure with property levels still substantially above the long-term equilibrium level.

Working in the Australian dollar's favour will be the fact that interest rates in the G7 area will remain at rock-bottom levels during the year. The Federal Reserve, at this stage, is committed to keeping short-term rates below 0.25% throughout the year and there will be strong pressure for the ECB to cut rates again from 1.0% now. The lack of attractive alternatives and low G7 interest rates will certainly give the Australian dollar significant support at times. The currency will also be supported by Australia's AAA credit rating which will attract sovereign reserve managers as the number of AAA-rated countries is set to dwindle still further in 2012.