Here's How Japan Can Bring Down the Aussie Dollar

Ian Waldie | Bloomberg | Getty Images

The recent weakness in the resilient Australian dollar, which is down from its multi-month highs, is not due to talk of a rate cut or worries over China's patchy economic recovery. The drop is thanks to Japanese investors.

Heavy selling of Australian assets by Japanese investors, who have traditionally been big buyers of Australian bonds, has led to a fall in the Aussie, said analysts.

The Japanese pulled out A$5.9 billion ($6 billion) invested in Australian assets over November and December, the largest on record, according to data from Japan's finance ministry.

The downtrend in the yen together with a strong Aussie dollar likely pushed Japanese investors to sell their Australian assets. Plus improving sentiment for Europe late last year could have prompted the Japanese to sell assets in Australia and use that cash to buy in the euro zone instead, said analysts.

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"There was a clear shift back into European debt late last year, and Japanese investors were enthusiastic buyers," said Sean Callow, senior currency strategist at Westpac Bank.

The Australian dollar is down almost 4 percent from the four-month peak set in January near $1.06. Still, the currency, trading around $1.02 on Friday, remains above parity with the dollar and is 6.5 percent higher from its 2012 low. Analysts said the selling of Australian assets by Japanese investors has significant implications for the currency's outlook.

"Naturally, some investors make the connection between the two and have become concerned that Japanese investors will pull more funds out of Australia and cause its bonds and the currency to weaken further," analysts at Bank of America Merrill Lynch said in a research note published Thursday. "Given the high percentage of foreign ownership in the Australian bond space, such a concern is justified."

According to the note, Japanese investors held some A$178 billion worth of Australian bonds and notes at the end of 2011. Bank of America Merrill Lynch estimates that the holdings fell to A$155 billion at the end of 2012, with the bulk of the fall coming late last year coinciding with the sharp fall in the value of the yen.

Australian Dollar Three-Month Chart

Bank of America Merrill Lynch analysts said that for now, they were interpreting the outflow of Japanese funds from Australian markets as profit taking and a shift to other assets, rather than a fundamental shift in the perceived attractiveness of the Australian currency by Japanese investors.

"We continue to expect the Australian dollar to end the first quarter at $1.03 and a small move lower to parity by end-June," they said in the note.

They added that because of Australia's triple-A credit rating, Australian bonds remained attractive to Japanese investors especially if risk appetite took a hit as it has done this week amid jitters about instability in Italy following inconclusive elections and concerns about U.S. budget cuts.

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"About 38 central banks globally hold Aussie government bonds, which is significant," said David Green, senior corporate foreign exchange dealer at Western Union Business Solutions in Sydney.

"Because there is a healthy level of demand even if Japanese investors continue to sell Australian assets and that pushes the Aussie dollar lower, those central banks are likely to see that as an opportunity to buy bonds and the Aussie," he added.

Relatively high interest rates in Australia compared with other major economies have helped support its bond market adding to Aussies dollar's strength even in the face of slowing economic growth.

- By CNBC.Com's Dhara Ranasinghe; Follow her on Twitter @Dhara CNBC