Riding the currency waves

Over the past two years the New Zealand dollar has trampolinedspectacularly, plummeting almost 25% over the 12 months ended March 2009 andthen rebounding 23% since then. Many exporters and importers are exasperated, whilecurrency traders and economists have been made to look like chumps.   But thatwon’t stop them making currency forecasts; after all, some mug has to.

Sorry, you won’t get a currency pick in this column; thepurpose is to look at the volatility of the currency, what has pushed it aroundover the past few years, the remarkable stability of the currency over the long-term,and the cost of currency volatility for investment and to economic growth.

The $NZ has definitely been more volatile over the past yearor so. The standard deviation (a measure of how variable a series is) for the$US/$NZ exchange rate has increased significantly since mid-2008 and is aroundtwice what it was for most of the 1990s. In simple terms, the daily fluctuationsin the dollar have increased markedly with the $US/$NZ falling or rising fromone day to the next by an average of 1% this year, compared to just 0.5% overmost of the 1990s.

Interestingly, the dollar has tracked the slumps andrebounds in the US stock market remarkably closely (see graph) suggestingfinancial markets’ perception of risk has been the major factor driving ourdollar. In the midst of the financial crisis investors rushed to what theyperceived to be safe assets – fringe currencies such as the $NZ didn’t rate sothe currency fell almost as fast as share prices. However, as investorsrediscovered their appetite for risk they ploughed back into exotic currenciesand battered stocks. The $NZ and stock markets rose almost in lock step to thesoothing sounds of recovery. But risk has not always been behind the wheel ofthe currency.

Prior to the credit crisis, it was interest rates – NewZealand rates were higher than in most other developed economies so smartpeople borrowed (in, say, Japan) where interest rates were negligible, andinvested in New Zealand. The so-called carry trade was based on making moneyfrom the interest rate differential – a higher return on the funds investedthan on the cost of funds borrowed. Simple stuff really. But the carry trade meanta big inflow of capital chasing our high interest rates and that capital inflowdrove the $NZ higher, conveniently adding to the returns the smart people weregetting.

The $NZ is also part of the commodity currency club whosemembership includes Australia, Canada and South Africa. The argument goes thateconomies producing old-economy commodities will do particularly well in aworld increasingly dominated by raw-material hungry countries like China andIndia. And so it has proven to be over the last year or so – the Australiandollar has increased by around 45% against the $US and the Canadian dollar isup by 17%.

Fundamentals like the balance of payments seem almostirrelevant to the exchange rate. New Zealand runs one of the largest currentaccount deficits relative to GDP of any western economy and has done so for 40odd years.

So we have a vague idea of what drives the currency, butwhere have such factors driven it to since it was floated in 1985? Well theshort answer is…..nowhere. The trade weighted exchange rate has averaged 60.8since 1985 – almost exactly the same as it was when the dollar was floated 24years ago (61.79). That consistency hides some long periods when the currencywas either below or above this long-term average, most recently above as aresult of relatively high interest rates and more fundamentally a significantand sustained lift in the terms of trade. However, the data support the viewthat the real exchange rate tends to revert to fairly stable long term average,which suggests that as an economy we have made little or no progress over thelast 25 years in lifting the value of what we produce.

The volatility, or more correctly the large and sustainedswings in the exchange rate have increased the risks associated with investing forour major export businesses – agriculture and tourism. The currency gyrationshave also created havoc for many emerging manufacturing and high tech exportbusinesses whose profits have swung wildly on the back of the yo-yoing dollar. Currencyuncertainty is a killjoy for these industries.

If we are serious about lifting New Zealand’s growth rateand closing the gap with Australia, a more stable exchange rate is likely to beimportant in getting the required investment. Some countries, notably Brazil,have moved to discourage large speculative capital flows in an attempt to dampenthe swings in their currencies. There may be other more fundamental policyresponses that could help tame the swings. But short of going back to a fixedexchange rate, New Zealand businesses will have to rely on strategies (currencyhedging, for example) to cushion the worst effects of the currency jumps anddives – the government won’t come to their rescue anytime soon.

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