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Cash in Hand

By Spear's

Commodity currencies have been increasingly in demand as a whole host of emerging economies have been industrialising fast, says Chloé Koos Dunand of Pictet et Cie

The so-called ‘commodity currencies’ are currencies of those countries whose exports of natural resources comprise a sizeable proportion of export income and whose value relative to other currencies has been heavily influenced by the price of the commodities they export. In the developed world, typical commodity currencies are the Australian, Canadian and New Zealand dollars, often referred to in shorthand as ‘ComDolls’.

This trio are, however, far from being the only commodity currencies. We could easily include the Norwegian krone, with oil generating two-thirds of Norway’s export earnings, the boliviano, with half of Bolivia’s exports being raw materials, or even the Malawian kwacha, with tobacco accounting for 90% of Malawi’s exports. All in all, some fifty or so currencies could be labelled as commodity-based currencies. With the self-evident exception of the Norwegian krone and the ‘ComDoll’ trio, all are currencies of developing nations.

But not all commodity currencies are the same

The craving for commodity currenciesintensified as it became clear thatChina’s rapid industrialisation wasfeeding through into a voraciousappetite for raw materials. At this point,the spotlight began to fall on many ‘commodity currencies’. Investors became convinced that the links between currencies, commodities and, by osmosis, China were enough to guarantee these currencies a glowing future.

This extrapolation was inevitably taken too far in some instances. For example, although China is indeed Australia’s main trading partner, Canada exports a mere 3% of its goods to China while Norway’s percentage is even lower, at 2%.

Link between exchange rates and commodity prices not always obvious

At this point, with macroeconomists beginning to dissect the subject, a clearer definition of what is understood to be a ‘commodity currency’ was established so as to pinpoint a more formal correlation between exchange rates and prices of raw materials. A currency is deemed to be a ‘commodity currency’ if its real trade-weighted exchange rate1 moves over the long term in step with the real price of those commodities exported by the relevant country.

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Using this definition as the yardstick, the IMF’s Commodity Currencies report by Cashin, Cespedes & Sahay (2003) demonstrated that the Australian dollar, boliviano and Malawian kwacha could indeed be classified as ‘commodity currencies’ whereas the label was not deemed applicable to the Norwegian krone or Canadian dollar.

A similar study published by the European Central Bank in December 2007, focusing particularly on the Norwegian krone, Russian rouble and Saudi riyal, corroborated these findings. The ECB economists concluded that the oil price is a significant influence for the rouble over the long run, but its impact on either the Saudi or Norwegian currency is marginal, even non-existent.

Other factors, like monetary policy in particular, come into play

This differentiation can be put down, above all, to varied policy approaches. Norway differs radically from Australia on this score. The bulk of revenues earned by Australia from exporting commodities are ploughed back into the domestic economy, whereas Norway, through its sovereign fund, seeks to reinvest its oil earnings abroad.

As the latter’s export earnings are neither converted at home into krone nor invested locally, Norway avoids not just a direct rise in its exchange rate as a result of the flood of earnings being converted into krone, but also any over-stimulation of a domestic economy already boosted by positive fallout from increased oil prices. This approach to redeploying export revenues explains, in part, why the krone’s value has risen much less steeply than the oil price over the past four years.

In contrast, the Australian dollar’s value has been firming in sync with the surge in commodity prices. The non-stop flood of export-generated earnings into the domestic economy has allowed Australia to enjoy 18 uninterrupted years of economic growth in spite of the severity of the recent crisis.

Differing tactical and strategic approaches

In January this year, the Chinese authorities announced that they wanted to put a brake on the rapid expansion in the construction sector. This remark triggered a slump in commodity prices, dragging several currencies down with it.

Now, with prices of many raw materials having already bounced back by over 60% since the trough of the crisis, the prospect of commodity prices consolidating looks quite plausible, particularly as some semblance of equilibrium is restored to the global economy – with emerging countries seeking to rein in their economic expansion and the developed world striving to get their economies moving again.

In order to describe an accurate picture of what is happening, we need to be able pinpoint exactly where things stand in the commodities cycle. Prices had soared because the supply of natural resources was failing to keep pace with the surge in demand. As not only China, but other emerging-world economies still have a long way to go in industrialisation, demand is likely to go on stimulating supply in the coming years. The problem lies in trying to assess how quickly production can respond to this demand.

Supply is obviously constrained by physical factors, making it inelastic. Moreover, this inelasticity has be exacerbated by years of under-investment in mining industries. High commodity prices are, however, incentives to invest, explore, drill, mine, research and develop, but they also encourage the search for substitutes, moderation and greater efficiency in consumption.

Commodity prices cannot go on climbing indefinitely. The same can be said for commodity currencies. For the time being though, China’s fast-paced industrialization augurs well for both commodities and the countries that produce them. Although volatility can be expected to be an everyday fact for investors over the short term, the longer-term outlook remains particularly bright.

In light of these arguments, we would favour those countries that re-invest their export earnings in the domestic economy. Initially, our preference is for those economies not plagued by serious imbalances and whose real trade-weighted exchange rates genuinely move in step with commodity prices. This leads us to favour Australia for its diversified array of goods exported to China, backed up by its sensible monetary and fiscal policy mix.

Moving to emerging-market currencies, the Indonesian rupiah looks an outstanding prospect, since Indonesia exports as heavily as Australia to other emerging economies in Asia, particular oil and petroleum products. Furthermore, domestic investment has been rising fast, advancing from 20% to 30% of GDP since 2000.

Among currencies considered to be genuine ‘commodity currencies’, our selection would focus on two countries roughly one-quarter of whose exports head for Asia: New Zealand, mainly because of associative effects from the Australian dollar, and Chile on account of the country’s pre-eminence in the copper market.

The ‘Loonie’ can also be regarded as an attractive prospect, as Canada is rich in natural resources even if its export exposure to emerging Asian nations, though rising, is not yet that significant. Lastly, the Russian rouble looks an interesting play too, although its domestic investment rate is low compared to other countries cited above, while Russia is dogged by certain macroeconomic imbalances that do carry some elements of risk.

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