Whatand#39;s the fairest value of them all?

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

Pinning down the fair value of a currencyis a surprisingly difficult thing to do.   The classic method is based onpurchasing power parity – the notion that flows of tradable goods will equaliseprices in all countries.   However, based on OECD PPP figures, the kiwi is notoverwhelmingly expensive.   The New Zealand dollar is only 12% above its PPPvalue against the greenback and the yen.   Against our other major tradingpartners, the kiwi is undervalued.  

Another method for determining fairnominal value is to assume that real exchange rates tend to be stable.  However, this method requires a number of judgements about how to weightvarious 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 accountbalance might be.   Of course, this method requires a judgement on how muchexternal debt is too much – the current US current account deficit is regardedas unsustainable, but it could be sustained for decades before catching up with New Zealand’s existing external debt level (which is currently growing at aneven faster rate).   Even New Zealand, which has massive external debt by worldstandards (90% of GDP), devotes just 7.6% of national output to servicingdebt.   We’re a long way from being indentured slaves of global capital.  

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

Of course, the most crushing objection tofair value models is that their predictive power tends to be weak, withexchange rates better approximated by a random walk (ie today’s value is thebest forecast for future values) over short horizons (1-2 years).   Even overlonger 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 sincethe float.   But there is no reason why the New Zealand dollar’s fair value mustremain stable over time – differentials in inflation or growth and terms oftrade movements can all produce a permanent shift in the currency’s fairvalue.   On the other hand, the kiwi’s historical record also demonstrates the regularoccurrence of wild swings that seemingly overshoot the change in fundamentals.  

The recent appreciation of commodityprices is the best argument in some time for a permanent shift to a higher fairvalue for the kiwi.   Although the Reserve Bank believes that we are seeing acyclical commodity price peak, we believe that the long-run story for furtherterms 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 twotrends set to continue over the long-term, and both will sustain demand forcrops to provide alternative energy sources, raising the value of agriculturalland (which we are well endowed with).
  • The massive population concentration of China guarantees that theywill continue to excel at producing manufactured goods (our imports), whilestruggling to meet their internal demand for agricultural products (ourexports).   The result is a bias towards an increase in New Zealand’s terms of trade.  

The one solid foundation for the claimthat the kiwi is overvalued is the woeful current account deficit, whichimplies we cannot export as much as we import at the current exchange rate.   Ifthe exchange rate was the only thing that could adjust, it would seem certainthat it must.   But the current account deficit is also the flipside ofinsufficient national savings.   In that respect, it is unclear how much of thecurrent deficit is simply a short-term response to the rapid appreciation inNew Zealanders’ net wealth (via the housing market), which encouragesborrowing.      

A working paper from the European CentralBank on current account adjustments noted that one-third of historical currentaccount reversals (a one standard deviation improvement) took place through "aslowdown 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 mainlydue to buoyant domestic demand…   The internal adjustment is typicallyaccompanied by a pronounced slowdown of asset price inflation (e.g. houseprices) following a period of rapid increase".   This scenario should soundawfully familiar to New Zealanders, raising the possibility that the exchangerate may not be the variable that needs to adjust to fix our current accountdeficit.

In conclusion, the evidence suggests thatstandard models of fair value have limited ability to determine whether acurrency has deviated from fair value.   Even if we knew the kiwi was overvaluedrelative to fundamentals, there is reason to doubt that a correction will occurshortly, or that the adjustment process would necessitate a lower nominalexchange rate.   We live in a world where financial factors like interest yieldsdominate concerns about fair value or external deficits.   The overriding focuson interest rates may not always be the case: a prominent economic crisis orreduction 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 strongconviction in the kiwi’s overvaluation.

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