Comments

David Thompson Posted:
So very, very true. It beggars belief that we consider ourselves to be a developed nation when so much of our economy is based on selling milk powder or logs. BTW, I own a Plinius amplifier (my second) that drives a set of Theophany speakers.
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David Thompson Posted:
A robust but sobering report. It concerns me that confidence is rising, yet sales and exports are down and "manufacturers and exporters are still lagging behind other sectors". Surely we should wait until we're earning more money before we start spending more?
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siemens Posted:
Yes true! The only thing that will never die in this world is the nature and its science behind it. Great post.
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Kieran Ormandy Posted:
Thanks for the question Steven, Germany has seen increases in manufacturing employment since 2009, and Switzerland has had stable manufacturing employment between 2006 – 2011, even in the face of ongoing Euro-zone issues. Korea has seen increases in manufacturing employment since 2008 and Israel experienced large increases since 1998, while being stable over the last 4 years. Singapore has had increases in manufacturing employment over the last two years. These countries all value their manufacturing sectors and work to protect them, this is reflected in the above numbers and their performance through the GFC. Note data around the above examples was sourced from OECD labour market stats.
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John Walley Posted:
Point one: you should have no doubt what our Association says publically represent the views of our members. Point two: we don’t knee jerk responses, if you trace back our comments around NZPower you will see them link all the way back to our research in 2004 and 2005. All that material is fully linked from our comments above. Point three: you will note our comments on major users, sadly the same advantage does not accrue to smaller industrial users. The perverse incentives of the LRMC approach in all this are well known. Point four: the NZMEA is not like any other Association in New Zealand we admit only manufacturers and exporters into membership, and our public expressions are the views of that restricted membership.
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5/12/14

Currency Viewpoint


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Since 1985 New Zealand has operated with a floating exchange rate, meaning our currency it is traded on the market, responding to changes in economic conditions here and around the world: subject to global events, interest rates, prices and a range of other factors that affect the demand for our currency. It is normal for the exchange rate to be somewhat over or undervalued for periods of time, deviating from its “fair value”, however this can become a major problem and a long term economic risk if these periods of an excessively high or low currency are sustained.

Currency changes influence our economy in different ways, over different timeframes. In the short term, a strong currency makes imports or offshore consumption attractive: foreign holidays, electronic goods and imported capital goods for example. In the long term uncertain returns around a high dollar will impact investment and employment in the export or import competing sectors.

Where ever the currency value might be, there will be winners or losers at that point. There is no right answer but if the currency is valued persistently above or below it’s “fair value” that displacement has the capacity to substantially distort economic development. Too high and the export sector is damaged, to low and the domestic sector carries too great a cost. A currency at fair value brings appropriate and balanced economic development in the medium and long term.

This problem was highlighted recently in a conversation with the CEO of a large exporter “if this business was not in New Zealand it would be five times bigger” he then went on to say that uncertain returns demanded a conservative approach to growth and balance sheet management to carry his business through the hard times of overvalued currency.

This highlights the largely invisible economic impact of currency: as profits are hit by a rising currency and future profits are more uncertain, investment can be foregone, along with the growth that would flow from such investment, lost to the need for ever more careful management of uncertainty. The immediate benefits we all feel from a strong currency tend to outweigh the more subtle and long term impacts on investment and jobs in the tradable sector. Care is needed ensure a balanced long term response to the currency issue.

In the graph above you can see a comparison of exchange rates at their nominal average annual rates since our currency was officially floated in 1985. Firstly, while the current cross with Australia (AUD) is high, you can see the average annual rate has been higher through the early 2000’s and 1995 – 1997.

In contrast, for both the USD and GBP, 2013 saw the highest post float average annual exchange rate, and so far 2014 looks set to be no different. This tells us that even from an historical standpoint our currency is high, particularly against the USD and GBP, and although the current cross rate with the AUD is very high, in an historical context, the levels have been experienced before.

It is normal to show cross rates in how much of the foreign currency can be bought by one New Zealand dollar, however for exporters repatriating sales to New Zealand they are buying New Zealand dollars with foreign currency so representing the number of New Zealand dollars bought by sales currency better indicates the exchange rate impact from the perspective of exporters or those competing with imported goods.

So looking at the same data from this perspective, we can see the effect the currency has on the tradable sector. The graph below shows us the return of each of the currencies in New Zealand dollar terms. For example, looking at the Great British Pound (GBP), in 1999, 1 GBP would have returned 3 NZD, where in 2011; the same GBP would return only 2 NZD. This change would represent a direct and substantial effect on returns for exporters.

Having looked at how the currency affects exporters, it is now worth considering the extent of which the currency affects consumer prices. A Reserve Bank of Australia (RBA) report entitled “The exchange rate and consumer prices” explores the level of pass-through the exchange rate has on import prices, manufactured good prices and consumer prices. This found that a 10 per cent appreciation of the Australian dollar reduced overall consumer prices by around 1 per cent; an effect which was spread out over around three years.

Above you can see this effect shown in graphs, separated to show the relationship between the exchange rate and import prices, manufactured goods prices, and consumer prices. As you can see, consumer prices are the least effected by the exchange rate, as you might expect, but it does highlight how relatively small the pass through of the exchange rate is on consumer prices.

Westpac modeling suggests that in New Zealand a 10% fall in the TWI would increase consumer prices (CPI) by 0.9% - the bulk of this impact takes 2-6 quarters to show up.

In recent years, the New Zealand Dollar has commonly been referred to as “overvalued”, but what does this mean? Traditionally an economy with low domestic inflation, strong domestic and export economic performance experiences exchange rate rises. The theory goes that a strong currency tracks a strong economy, and weak economies see their exchange rates fall - so the exchange rate should roughly track the performance of the real economy.

When the exchange rate gets out of step, e.g. a strong exchange rate but a weaker economy, the idea of over or under valuation takes shape. This also brings in the idea of “auto-stabilisation”, where currency trades react to changes in economic indicators or other factors, moving the currency and stabilising it relative to the changing economic landscape. For example, strong commodity prices mean a strong currency for commodity dependent economies, and weak commodity prices see the currency fall to buffer returns to commodity producers. Does this happen in practice?
 


The graph above demonstrates how in recent years, particularly 2011 and onwards, our currency has gotten out of step with dairy prices, failing to react to substantial falls in dairy prices, both in 2011-2012, and in 2014.

How does our current monetary policy interact with the exchange rate?

The RBNZ has recently discussed the interaction between monetary policy, the exchange rate and the corresponding effect on inflation in numerous speeches. Most recently in a speech entitled “Cross-border Financial Linkages: Challenges for Monetary Policy and Financial Stability”, Graeme Wheeler said:

“although the exchange rate is often the primary transmission channel for monetary policy, this channel is often stronger than we would wish.”

And later in the speech saying:

“Like New Zealand, many of the Asian economies have experienced an appreciation in their real exchange rate in recent years. In a floating exchange rate environment, this lowers inflation in the tradable sector and raises disposable incomes of many consumers.”

This is describing how monetary policy decisions (for example an increase in the OCR) drives the exchange rate (which appreciates due to interest rate differentials etc.), when then in turn lowers tradable inflation. This is the primary mechanism by which inflation has been controlled in recent times, as evident in the graph below. Continuing to rely on depressing tradable inflation in order to control domestic inflation is not sustainable in the long run, and damages the tradable sector.
  

In the above graph, since towards the end of 2011, tradable inflation, even deflation as prices fell, has been significantly lower than domestic inflation.

How overvalued is the New Zealand Dollar?

A recent IMF report on New Zealand suggested our currency is currently 5 – 15% above the level that would be consistent with medium term fundamentals (economic performance, commodity prices, interest rates, etc). One of their models estimated an overvaluation of 13%, 9% of which is not explained by medium term fundamentals and policy drivers in our economy.

Another report by the Peterson Institute of International Economics also estimated that our currency is overvalued by 15%. Bill English was also quoted saying, "Almost anyone who has looked at it comes to the conclusion it's somewhere 10 to 15 percent overvalued”. John Key also agreed that our currency is currently overvalued, and saying “Goldilocks” level of our currency might be around 65c against the US.
 

Above the graph shows our exchange rate against the USD, compared to the “fair value”. We can see a consistent and sustained overvaluation (actual above fair value), since around 2004. In this case “fair value” is determined by relative inflation, interest rates, current accounts, and terms of trade, productivity and economic volatility – the economic fundamentals. While currencies do deviate from their fundamental fair value at times, the NZ$ has had a sustained and significant deviation from this in recent years.

In recent months the RBNZ has repeated expressed concern over the level of our currency, calling it “unjustified and unsustainable”. In a recent speech they outlined exactly what is meant by this:

“A real effective exchange rate is unjustified when its level is inconsistent with the economic factors (such as commodity prices, economic growth, interest rate differentials) that can normally explain its movement during the business cycle.”

“The level of the real effective exchange rate can be considered unsustainable when it is clearly deviating from its long-term equilibrium at the level that it would be expected to settle when business cycle factors have fully dissipated.”

They also explain some of the effects of this sustained overvaluation:

“In such a situation, persistent deviations from equilibrium are likely to result in external debt ratios that become unmanageable and cause misallocations of resources that can inhibit the country’s long term growth potential.”

Are there any specific factors which are driving this high value of the New Zealand currency?

While many factors determine this, perhaps the biggest and most easily identifiable factor is the interest rate differential between New Zealand and the rest of the developed world. Since the GFC, New Zealand held rates at 2.5%, which is low from a domestic standpoint, but very high when compared to rates around the world which held around zero, and also saw significant additional stimulus, particularly from the Federal Reserve.

This disparity in interest rates is largely what appreciates our currency, with overseas investors seeking more NZD’s in order to take advantage of higher interest rates, particularly when there is a vast amount of low cost money in international markets resulting from the policy approaches chose in the USA, UK and Japan. The fact that New Zealand is seen as relatively safe and stable also adds to this pressure.

This situation has been exacerbated by the new Governor of the Reserve Bank of New Zealand (RBNZ), Graeme Wheeler, taking a stronger stance on inflation than his predecessor, and raising our OCR an additional 1% to 3.5% in 2014. This outlines the problem with this current single minded focus on inflation, which causes trade-offs elsewhere in the economy (often the tradable sector is the hardest hit through the exchange rate mechanism).

There is a general expectation that our currency will fall back and correct itself in time, the question is if and when will this happen, what people think and do in the meantime and, as a consequence, what all these effects mean for our economy?

Below is a graph of the TWI, including RBNZ forecasts until 2017. As you can see, this forecast does show a downward correction over the coming years. However this is over some time, and remains relatively high even at the end of the forecast period (TWI of 73.4 for Sep 2017 quarter).
 

If we take the view that the NZD is current 15% overvalued, the RBNZ expect this to only be corrected by less than half over the next three years. This suggests that following our current path alone is not enough to fully correct the currency, at least over the medium term. If this correction could be accelerated, conditions for manufacturers and exporters would be greatly improved and the natural consequences of a misplaced exchange rate ameliorated – this leads to better margins that allow for higher investment to fuel future growth, innovation and employment, which has huge benefits for the wider economy.

Going back to our first consideration, looking at who benefits from a high currency, and who benefits from a lower one, we know for currency sensitive producers a lower currency is better, while for consumers a higher dollar increases their purchasing power for imported goods. This gets more complex when consumers have jobs that are dependent on exporting (either directly or indirectly) - a high dollar means imports and holidays are cheap but employment is under pressure. This is the “it depends” group, and this expands based on the extent and duration of currency deviation from fundamental value - ultimately everyone is exposed.

Over the last year, those defending the high level of our currency have pointed to our “rock star” economy, with improving economic growth and a record terms of trade due to high commodity prices as factors justifying the sustained high level. However over recent months this has slowed; most notably with the large decrease in global dairy prices which have fallen 48% from highs in February. This drop in our main commodity prices without a significant drop in the New Zealand dollar to counteract has even led to openly expressed concern by Federated Famers.

While our currency is somewhat a hostage to global factors, such as Quantitative Easing stimulus and devaluation efforts of other central banks, our central bank does in fact have some power to influence it. In September the RBNZ announced that they had intervened in the currency market during August, selling a net NZ$521m. Before this was revealed, the RBNZ also released a speech entitled “Why the NZ exchange rate is unjustified and unsustainable”, which appeared to be a pre-justification for their announcement using currency intervention, and also an attempt to talk the exchange rate down.

This action from the RBNZ followed many months of repeated expressions of dissatisfaction towards the level of the currency in nearly every OCR and MPS statement since the new Governor came to office, but they had previously failed to action a substantive response.

The RBNZ could be more active in tackling the issue head-on to explicitly drive a more balanced and fair value currency. Macro-prudential interventions are available and seem to work - more effort in this area rather than relying only on interest rates (higher rates relative to offshore puts upward pressure on the NZ$) would help accelerate the correction of our currency towards fair value. Maintaining a currency closer to fair value, without unnecessary volatility is vital to support the competitiveness of our exporters and manufacturers so they can invest in the traded sector with some confidence. It is clear an expanding traded sector is important from the standpoint of innovation, creating value and jobs that New Zealand needs.
 



tags: currency, exchange rate, monetary policy, fair value, overvalued, macro prudential

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