Implications of currency depreciation for residential markets

Jason Anderson, Chief Economist Australia’s strong currency remains an emblem of our economy’s relative strengths. As the relative performance gap narrows, we expect that the AUD will weaken further. If our economy comes back to the pack in a gradual manner, then the currency depreciation may prove to be a staged process.

A downturn in mining construction activity is on the horizon. Our expectation is for a moderate, extended slowing, rather than a sharp drop. The rate of recorded decline will probably not reflect activity on the ground. Nevertheless, this data will raise doubts about the medium-term prospects for Australia’s growth. This outcome would trigger downward pressure on the Australian dollar. A gradual decrease in mining construction will be an ongoing drag on national economic growth. Australia has weathered shifts in the global environment through a combination of flexible exchange rates and monetary policy.

In particular, interest rate cuts have been used to stimulate housing construction when times get tough. However, the recent track record is not encouraging. National detached house approvals have flatlined for the past 9 months, sitting at low levels by historical standards. At the state level, the downturn in Victoria has been offset by recoveries in NSW and Western Australia. Property prices have shown moderate growth, but trading volumes remain low by historical standards. Low trading volumes limit the pace of upgrader demand for new houses.

At an aggregate level, the housing sector has been solid, due to the strength of apartment project approvals. The switch to apartments is sometimes attributed to the reward of inner city living over the culturally & physically distant city fringe. Or a response to high prices for established houses.

Our analysis indicates that the preferences of local residents are a minor factor. The reality is that Australia’s apartment market has evolved to become one of the economy’s most direct linkages with Asia. A boom in overseas students over the past decade was the first phase, boosting rental demand and greater direct investment purchases. As understanding of the Australian property market percolated through Asia, and evidence of strong rentals and price growth was clear, investor demand expanded. A strong AUD has sweetened the deal.

With local policies impeding new apartment projects in several countries, more and more Asian developers have shifted their attention to Australia. Very large balance sheets have enabled winning bids for major sites, and direct connections with Asian investors provide an edge for off-the-plan marketing. It is estimated that Asian developers have accounted for 30% of all projects marketed in the past 12 months.

The relative strength of apartment approvals reflects overlap in the Venn diagram of developer, investor and tenant interests — with actions of all parties founded on the AUD-USD exchange rate. Consequently, our residential building activity has never been more dependent on currency market conditions.

This juncture makes for complexity when considering monetary policy. As the cash rate is cut further, there will come a point where the ardour of global money markets for the AUD will begin to cool. Currency depreciation will be dependent on the pace of the mining construction downturn, and the extent of debt burden from budget deficits (state and national) mounts. As an aside, both of these forces distinguish Australia from New Zealand (which currently enjoys a global agriculture cycle, and fiscal rectitude).

In turn, a staged depreciation of the AUD-USD presents as a challenge for new projects. Developers will face an asset with declining USD value, and this is likely to lead to a hiatus in purchases. This outcome would lead to delays in project commencements and lead to a leg down in apartment building. A gradual depreciation would exacerbate this problem.

On the other hand, depreciation of the AUD would be beneficial for Asian investors who have purchased off-the-plan and are yet to settle. A weakening AUD would make the apartment cheaper at settlement. If the depreciation is significant, then this effect would offset any decline in the apartment value that might have occurred since the initial contract was struck. In this way, a weakening AUD could work to the benefit of developers, by reducing the risk of defaults on settlement by Asian investors.

If the depreciation proves to be short and sharp, then the market impacts on the rate of development may not extensive. Australian sites would be cheaper in USD terms, and this improves the purchasing power for Asian developers. However, the depreciation would be occurring in a period of weak Australian economic growth, which would raise doubts about the future prospects for selling an apartment (given that only residents can buy a ‘second-hand’ property).

With further housing rate cuts, we expect that turnover of established properties will improve, and FHB demand will recover, leading to a gradual rise in demand for new detached houses. If rate cuts combine with a mining construction downturn and rising government debt, then currency depreciation seems inevitable, which might lead to a decrease in apartment construction by Asian developers.

If you would like more information about this article please contact Jason Anderson, Chief Economist on 02 9221 5211 or via email.