The strong lift in the exchange rate
over the past month comes after more than a year bouncing along the bottom of
one of the biggest plunges in the currency in 50 years. Just as economists,
markets and companies were caught out by the extent of the fall, there may be
some surprises in terms of how far the currency will now climb.
We have argued in the past that 55 on the TWI would represent fair value for
the kiwi dollar. The currency is now virtually at that level. Others have argued
that a cross rate with the $US of 50c would also represent fair value. The
problem with just looking at one cross rate is that changes in it could be
driven more by circumstances in the other country than by those in New Zealand.
Indeed that has been one of the issues over the past month - the US dollar has
headed down and so at the other end of the see-saw the New Zealand dollar has
risen.
But many commentators probably held the same view 18 months ago when the
dollar was dropping. That did not prevent it falling 10-20% beyond the so-called
fair value, so what is there to say it won't climb well past its fair value over
the next year? Not much.
The pick-me-ups
In fact there are some important arguments pointing to the currency swinging
well beyond its fair value. These include:
- A more aggressive lift in interest rates in New Zealand than elsewhere.
Since March the RBNZ has lifted the Official Cash Rate by 75 basis points with
a clear indication that it will raise it further over the remainder of this
year. The only other relevant central bank to have raised interest rates this
year has been the Australian Reserve Bank - they lifted their base rate 25
basis points on May 8th. Currently New Zealand's interest rates are 100 basis
points above Australia's, 375 points above federal funds rate in the US, and
225 points higher than the Euro base rate. The interest differential is an
important factor in a world still wary of equities. The increased interest
differential is re-igniting interest in Eurokiwi bond issues.
- The US economy has been a major magnet for the world's capital over the
past five or more years. However, the stagnant equity market and low interest
rates, in combination with worries about the integrity of markets and
companies (Enron and now General Electric), have shaken investor confidence.
Add to this scenario the fact that the US must attract around $US35bn of the
world's savings every month simply to cover its gaping current account
deficit, and it is clear there is considerable potential for a slide in the
$US. A few years ago one might have argued that the current account deficit
simply reflected the world's appetite for US investments. The problem is that
the US has become addicted to this capital inflow, and trying to wean it off
that addiction will put downward pressure on the $US, and therefore cause our
dollar to appreciate.
- A third factor that could become significant for the value of the New
Zealand dollar is the likely entry of the pound into the single European
currency, the euro. Part of the entry strategy will be to force down the value
of the pound relative to the euro, or, less likely, force the euro up. Britain
would struggle to compete against the rest of Europe if it were to enter the
euro at the current exchange rate between the two. Again, any decline in the
pound would result in further upward pressure on the New Zealand dollar.
Depressants
There are some arguments to set against the above factors including:
- An election by November - the left-leaning Labour Party will easily win a
second term at the helm of government. But this will not be as scary for
financial markets as in 1999 because there will be little in the way of
dramatic new policy.
- A new Reserve Bank governor must be appointed by mid November - given the
political hue of the current and next government, the new governor could be
more of a dove than a hawk. Certainly the government will be concerned about a
possible repeat of the mid-1990s phenomenon of rising interest and exchange
rates crippling many exporters, but the real issue here is the Reserve Bank
Act and the Policy Targets Agreement - neither will change.
- Commodity prices have sagged and the outlook for the current account looks
bleak - any rise in the currency will eventually be tempered by these
important adverse trends.
But these factors will serve, at most, to dent the rise in the currency
rather than defeat it.
Summary
So will the currency rise? We have previously argued that the upside for the
currency might be relatively small. The purpose of this paper is not to abandon
that view, but rather to shake your thinking about the exchange rate.
Getting the direction right is a good first step. Trying to pick the timing
and extent of any rise is virtually impossible to get right consistently.
A TWI averaging 58 over the December quarter of this year would mean the
currency appreciating by over 17% in a year. Even over the strongest period of
appreciation in the mid-1990s we did not experience that sort of appreciation
over a two-year period. Indeed it would amount to the biggest one-year
(quarterly average data) rise in the currency since the early 1970s. That does
not mean it can't happen - remember it is coming off historically low levels.
The Economist's Big-Mac currency index would suggest the currency's fair value
would be a TWI of 66 or $US0.63!
