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What's the fairest value of them all?
Wed 27 Jun 2007 by Infometrics Ltd in Monetary policy

The Reserve Bank’s recent intervention in the currency clearly signals their belief that the current New Zealand dollar exchange rate is unjustified by economic fundamentals.   But how much confidence can we store in the statement that the kiwi is "overvalued"?

Pinning down the fair value of a currency is a surprisingly difficult thing to do.   The classic method is based on purchasing power parity — the notion that flows of tradable goods will equalise prices in all countries.   However, based on OECD PPP figures, the kiwi is not overwhelmingly expensive.   The New Zealand dollar is only 12% above its PPP value against the greenback and the yen.   Against our other major trading partners, the kiwi is undervalued.

Another method for determining fair nominal value is to assume that real exchange rates tend to be stable.  However, this method requires a number of judgements about how to weight various currencies, and the kind of deflator to be used (consumer prices, labour costs, producer prices, etc).

A third alternative is a judgemental one, based on an assessment of how sustainable a given level of current account balance might be.   Of course, this method requires a judgement on how much external debt is too much — the current US current account deficit is regarded as unsustainable, but it could be sustained for decades before catching up with New Zealand’s existing external debt level (which is currently growing at an even faster rate).   Even New Zealand, which has massive external debt by world standards (90% of GDP), devotes just 7.6% of national output to servicing debt.   We’re a long way from being indentured slaves of global capital.

A recent US Treasury paper on exchange rate misalignment concluded that any of these methods involves (by necessity) a simplification of the factors determining a currency’s fair value, and that a very wide range of fair value estimates can emerge depending on the framework chosen.   Another criticism is that most of these models tend to assume that trade is eventually an equalising factor for exchange rates when, in the real world, financial flows are far more prominent in currency markets.

Of course, the most crushing objection to fair value models is that their predictive power tends to be weak, with exchange rates better approximated by a random walk (i.e. today’s value is the best forecast for future values) over short horizons (1-2 years).   Even over longer periods, reversion to fair value can be painfully slow.

This conclusion is hard to accept from New Zealand’s vantage point, given the strong apparent cycle seen in the New Zealand dollar since the float.   But there is no reason why the New Zealand dollar’s fair value must remain stable over time — differentials in inflation or growth and terms of trade movements can all produce a permanent shift in the currency’s fair value.   On the other hand, the kiwi’s historical record also demonstrates the regular occurrence of wild swings that seemingly overshoot the change in fundamentals.  

The recent appreciation of commodity prices is the best argument in some time for a permanent shift to a higher fair value for the kiwi.   Although the Reserve Bank believes that we are seeing a cyclical commodity price peak, we believe that the long-run story for further terms of trade growth is sound:

  • Higher demand for protein from a rapidly swelling middle class in China and India is a pressure that will continue over the next century.
  • Efforts to fight global warming and increases in oil prices are two trends set to continue over the long-term, and both will sustain demand for crops to provide alternative energy sources, raising the value of agricultural land (which we are well endowed with).
  • The massive population concentration of China guarantees that they will continue to excel at producing manufactured goods (our imports), while struggling to meet their internal demand for agricultural products (our exports).   The result is a bias towards an increase in New Zealand’s terms of trade.  

The one solid foundation for the claim that the kiwi is overvalued is the woeful current account deficit, which implies we cannot export as much as we import at the current exchange rate.   If the exchange rate was the only thing that could adjust, it would seem certain that it must.   But the current account deficit is also the flipside of insufficient national savings.   In that respect, it is unclear how much of the current deficit is simply a short-term response to the rapid appreciation in New Zealanders’ net wealth (via the housing market), which encourages borrowing.

A working paper from the European Central Bank on current account adjustments noted that one-third of historical current account reversals (a one standard deviation improvement) took place through "a slowdown in real GDP growth but not much change in the real exchange rate"  This type of adjustment seems to be typical when the deficit "widened mainly due to buoyant domestic demand".  The internal adjustment is typically accompanied by a pronounced slowdown of asset price inflation (e.g. house prices) following a period of rapid increase".   This scenario should sound awfully familiar to New Zealanders, raising the possibility that the exchange rate may not be the variable that needs to adjust to fix our current account deficit.

In conclusion, the evidence suggests that standard models of fair value have limited ability to determine whether a currency has deviated from fair value.   Even if we knew the kiwi was overvalued relative to fundamentals, there is reason to doubt that a correction will occur shortly, or that the adjustment process would necessitate a lower nominal exchange rate.   We live in a world where financial factors like interest yields dominate concerns about fair value or external deficits.   The overriding focus on interest rates may not always be the case: a prominent economic crisis or reduction in global liquidity would force investors to reconsider New Zealand dollar risk.   But until such reconsideration happens, New Zealand’s cyclically high interest rate gap remains the only solid foundation for any strong conviction in the kiwi’s overvaluation.

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