Russia's Central Bank Could Boost the Australian and Canadian Dollars

The world’s third-largest foreign exchange reserve is about to become even more diversified.

First Deputy Chairman Alexei Ulyukayev of the Russian central bank said it is looking to move into other currencies in the near term. The biggest beneficiaries are likely to be Australian and Canadian dollars – opening a door for long-term appreciation for both.

Of course, the Russian announcement is hardly surprising, given the market volatility and mounting losses from euro positioning. Europe’s single currency has lost an overwhelming 21% against the US dollar this year alone. And with concerns over Spain’s infrastructure and Greece’s junk status, people are still not too keen on the region’s currency.

Russia in particular has felt the sting. It currently ranks third when it comes to overall foreign exchange reserve holdings. And approximately 41%, or $188 billion, of those holdings remain in euros. So Russia’s move to diversify makes complete sense. But why choose Canada and Australia?

It might seem like a bad move based on the past few months. Both currencies have seen their recent strength sapped. The Australian dollar has sold off a bit against the US dollar, from the 0.9400 high seen earlier this year. Meanwhile, the Canadian dollar has bounced back from parity with the greenback. In April, one Canadian dollar could be exchanged for one US Dollar – but that’s fallen to C$1.08.

Still, over the long term, that’s earth shattering – in 2000 that same Canadian dollar could only afford 60 US cents. And the forces that pushed the Canadian dollar up so high are still in play – both in Canada and Australia.

Both Australia’s and Canada’s economies are expected to do very well in the coming quarters – with growth rates poised to come in at annualized rates of 4% and 5.5 % respectively. By comparison, expansion in the United States is expected to rise 3% by the end of the year.

Part of the reason for their outstanding growth is their commodity production. While gold production slowed in top producers like the United States and South Africa because of the financial crisis, Australia’s gold market is stronger than ever. It recently became the world’s second-largest gold producer, just behind China. And with the price of gold hitting new highs, Australia’s financial position looks pretty secure.

Canada, on the other hand, is known for its crude oil exports. One of the world’s top 10 oil producers, Canada is a major enabler to America’s addiction to oil. Canadian exporters furnish the United States with approximately 2 million barrels a day. With economic fundamentals positive, expectations for the countries’ currencies remain equally high. Commodity demand will help to prop up both the Australian and Canadian dollars as US fundamentals pale in comparison.

Furthermore, interest rates are expected to rise in both Australia and Canada – while European central bankers may be forced to cut rates even lower. In fact, Canada was already the first G8 nation to raise rates, and Canadian central bank representatives have hinted at further rate increases if growth continues to fan inflation. The Bank of Canada is expected to keep consumer price increases in the range of 2-3%. That rate is currently running at 1.8%.

Comparably, the Reserve Bank of Australia has also raised rates over the last couple of months to help fight inflation. Its inflation rate is expected to top 5% by next year – 2% higher than the maximum pace the country’s central bank allows.

The allure of rising interest rates in both countries will continue to make their currencies attractive to investors. Investors ultimately holding these currencies can reap higher interest rates – through bonds or savings accounts denominated in Australia or Canada.

Obviously Russian policymakers know that and are looking to cash in. And if the euro remains a cellar dweller, more central banks may choose to mimic Russia’s diversification efforts.

There is precedent. Central banks have been known to cut currency holdings if the currency creates losses to the overall reserve. For example, banks took action in 2006 when the US dollar was suffering under a skyrocketing euro. Sweden’s central bank – the Riksbank – cut approximately 40% of their dollar holdings to minimize any further losses to their reserve portfolio. The UAE wasn’t far behind, formally stating their reduction in US dollars soon afterwards. Incidentally, the euro appreciated by another 28% that year, creating gains for both of the central banks’ reserves.

So now the big question is, which central banks are likely to follow Russia’s lead and dump euros in favor of higher yielding currencies like the Australian and Canadian dollars?

Will it be other BRIC members Brazil and India? Both countries have moved up in rank when it comes to economic growth and global clout. Additionally, their reserves have swelled immensely – both nations have now topped the $250 billion mark. Of course, Brazil and India’s euro reserves are not as immense as their European counterparts. But if losses continue to mount on a weaker currency, leaders will surely look to another country’s denomination in order to support stable reserves. This will do nothing but help both commodity currencies make moves higher in the long term.

There is a saying in the markets, “Always go where the big money goes.” And thanks to central banks’ need for reserve diversification, demand is sure to mount for the Aussie and Loonie. As they flood in, other institutions and investors will be more than happy to jump on the bandwagon.

Throw in the fact that foreign exchange markets tend to overshoot quantitative targets, and both currencies may revisit record highs very soon.

Richard Lee
for The Daily Reckoning