A great opportunity to short the Aussie

With its biggest export market slowing down fast, an overheated property market, and an overvalued currency, Australia's economic bubble could be about to burst. So it's time to short the Aussie dollar, says Matthew Partridge. Here's how.

At the start of the year, our view that China would suffer a hard landing' was unusual.

Now that hard times for China have materialised, of course, it's become a much more widely-accepted view.

And no wonder. The latest data has made for grim reading. Both industrial production and retail sales continue to fall. Export growth in July was weaker than economists had expected. And that's even if you take the figures at face value.

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It doesn't bode well. Yet there's another economy that, if anything, is in an even worse position. It shows all the classic warning signs of an imminent collapse. The property market is set to implode, its largest firms are reporting falling profits and experts think that its currency is one of the most overvalued in the world.

Yes, I'm talking about Australia...

China catches a cold Australia gets the flu

Australia's economy is dependent on China. Last year, exports to the country were equal to 27.3% of Australia's GDP. Overall, minerals and fuel account for just under half of total exports.

So a Chinese slowdown, or a fall in commodity prices, will hurt the Australian economy and expand the trade deficit (the gap between what it exports and what it imports).

Unfortunately for Australia, that's exactly what's happening. Iron ore is the country's largest single export. Yet prices have fallen to the lowest levels since December 2009. Meanwhile, Reuters reports that one of Australia's biggest iron ore terminals saw exports drop by 9.3% in a month. Coal prices have seen similarly sharp falls, with an excess of supply from other parts of Asia set to make things worse.

Meanwhile, the Australian house price bubble seems to have popped. All four major national house price indices are now showing annual price falls. The nation's largest property developer, Stockland, is bearish, saying that conditions are the weakest its seen in two decades, reports the Sydney Morning Herald.

As Britain knows only too well, a bursting property bubble spells disaster for consumption. It suggests that credit is drying up, and consumers will have to cut back.

And prices could have a very long way to fall. Professor Steve Keen of the University of Western Sydney claims that the Australian bubble was worse that America's. "Real [inflation-adjusted] house prices peaked at 2.6 times the level of 1986, whereas the US market peaked at 1.7 times the 1986 level". He thinks that prices could fall by as much as 40%.

Why the Aussie is overvalued

With these two nasty problems looming, you might expect the Australian dollar to be a pretty weak currency by now. But it's anything but.

As M&G fund manager Mike Riddell points out, various key indicators suggest the currency is overvalued. One measure that economists like to look at is purchasing power. The rationale for this is simple: in a global economy, differences in prices should lead to people buying goods in one country and selling them in another.

So in theory, the exchange rate between two currencies should reflect differences in prices. Using this measure, comparative prices in Australia are 57% higher than in the US, and nearly 20% higher than in the UK.

Of course, this approach is simplistic. Many goods are non-tradable. If you live in Sydney and you want to get a haircut, you can't hop on a plane to New York to get a cheaper one.

There are also still some barriers to trade, and many global brands have enough market power to vary their prices by region. This is why most rich countries tend to have currencies that seem overvalued. However, even when you take this into account, Australia's currency stands out as expensive.

There are other warning signs. According to the JP Morgan 'Real Effective Exchange Rate', the Aussie has shot up rapidly since 2008. It is now higher than it has been in over 42 years. Riddell notes that in the past, rapid increases in this measure "increase the risk of a currency crisis".

Foreign ownership of Australian government bonds is also very high. Indeed, more than 75% of its debt is now in foreign hands. This is bad news. It means the country is dependent on 'hot money' from abroad.

'Hot money' gets its name from the fact that foreigners tend to be much more short term in their thinking than domestic investors. If a country gets into trouble, these flows can reverse rapidly as the experiences of Portugal and Ireland show.

Of course, Australia isn't tied into a single currency like the euro. This means that it can cut interest rates and print money. However, that solution would involve trashing the value of the Aussie anyway.

How to short the Australian dollar

Harvard University professor Ken Rogoff, one of the gurus' of the financial crisis, has shown that over the medium term, all currencies revert to the mean in other words, overvalued ones fall back to fair value, and usually below.

So it's clear that it's time to short the Aussie. If you are comfortable doing it, you can do use a spread betting firm.

However, when you trade currencies you still have to choose the second half of the pair' ie the one that you think will go up against the Australian dollar (AUD).

We'd suggest that the best option is the US dollar. While further quantitative easing may hit its value in the short run, US domestic prices are very cheap given its income levels.

As we've pointed out before, spread betting is high risk. This is because it is highly leveraged you can lose more money than you bet. Sign up for our free MoneyWeek Trader email to learn more about spread betting tips and tactics.

One alternative that my colleague John Stepek has suggested in the past, is to buy the ETFS Short AUD Long USD (LSE: SAUP). Do bear in mind that there is an extra layer of currency risk here, as the fund is denominated in US dollars, then converted into sterling. So you have exposure to the sterling-US dollar rate too. We're not overly concerned about that, as we suspect sterling won't see a rampant recovery against the US dollar, but it's worth being aware of the potential effect on your returns.

Follow John on Twitter||Google+ John Stepek

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri