The rapid fall in the iron ore price in the past few weeks has exposed the core risk to the Australian economy: the currency needs to fall, but the banks still need foreign funding.

The rising terms of trade and/or high Australian interest rates have kept the money flowing in for three decades to cover a persistently negative current account, despite the resources export boom.

Banks are now desperately trying to increase domestic deposits, with some success, but still need to get 40% of their funding from offshore. If that dried up because of a run on the Australian dollar, the Reserve Bank would have to step in and support the banks.

Three weeks ago the spot price of iron ore fell below the supposed “floor price” of $US110 and then kept going down — to below $US90 on Friday. So far the currency has more or less held — drifting from 106 US cents to 103 — but a report late last week from a US-based research house called Variant Perception highlighted its vulnerability.

The essential point made by Variant Perception is that Australia’s currency is overvalued and needs to be undervalued for an extended period to unwind the effects of “Dutch disease”, or what Treasury and the Reserve Bank call the two-speed economy: that is, the process by which a resources boom increases the currency and stifles the tradeable sector, principally manufacturing.

However, the Australian banking system relies on external funding because of an extended period of household borrowing, caused by the housing boom and debt-funded consumption.

Australia’s current account has been negative for a long time now, and has never caused much of a problem because foreign capital has been readily available due to high interest rates here and Australia’s exposure to China via resource investment.

However, we are now in the rare position of cutting interest rates at the same time as the Chinese economy slows, leading, among other things, to a sudden meltdown in the iron ore spot market.

Of course, this is not the end of the world. Most of the resource investment is for LNG exports, and the oil price is strong and rising thanks to the expectation that Ben Bernanke will soon launch QE3.

But QE3 will not materially change the global economy’s prospects and the oil and gas prices are likely to weaken eventually, especially with all the shale gas coming out of the US.

Australia’s terms of trade may now be in structural decline. If so, the Reserve Bank will soon have a choice: raise interest rates to defend the currency or directly support the banks with a European-style LTRO operation — printing money and supplying liquidity to them.

It’s more likely to be the latter. As the RBA itself has pointed out, defending the currency, either directly by buying it or by raising interest rates, is a mug’s game and usually doesn’t work anyway.

As Variant Perception points out, the main problem for Australia lies in the structural slowdown we are likely to see in China.

At the same time “there is considerable deleveraging ahead for the Australian consumer with household debt still at significant levels”. However, unlike China and Japan, the demographics here are “relatively sound” and the savings rate has increased substantially, which are positives.

*This article was first published at Business Spectator