Strategy: Currency Union and Convergence

Data Flash (New Zealand)

Strategy Currency Union and Convergence

Introduction

A topic that has raised its head in recent weeks is the possibility of currency union between Australia and New Zealand. The NZ Prime Minister has mentioned it on a number of occasions as an idea worth considering, while a recent poll shows a majority of New Zealanders are in favour of it (though there is considerable uncertainty about what “
it” means).

A study by Arthur Grimes and Frank Holmes, "An ANZAC Dollar? Currency union and business development", has looked at the economic arguments for and against currency union and whether the US dollar is a more sensible choice than union with Australia. They back the AUD given the closer links between the two economies. Ultimately, however, the assessment of the economic merits of currency union comes down to a judgement call about the impacts since valid arguments can be made both for and against. It is important to note that all the NZ advocates of currency union with Australia are talking about a joint currency with a joint central bank.

Any Australian "dollarisation" of the NZ economy is likely to be completely unacceptable for political reasons (if not economic). The Australian Government has made it quite clear that it has no interest in considering the replacement of the AUD with a joint currency. Thus, the possibility of currency union must be many years (if not decades) away. It seems to this writer that much of the discussion on currency union has left out the key aspect of such a move: that it MUST be forever. Any hint that currency union is not permanent will lead to many of the benefits disappearing.

Yet history shows that NZ governments have been loath to accept the disciplines imposed by fixed exchange rates. To the writer it simply stretches credibility to believe this won't be a problem in a union between two countries where NZ is clearly the junior party. Below this issue is discussed in more detail. As an aside, this note also takes a look at the issue of interest rate convergence between Australia and NZ in the event of currency union.

Is permanent currency union realistic (let alone desirable)?

It is not my intention to consider the detailed economic pros and cons of currency union. Suffice to say that there are arguments both for and against. Perhaps the most important point to make is that at the end of the day currency union will not be a magic bullet for the economic issues facing NZ. It would be very unfortunate if debate on this issue detracts attention from those areas on which NZ's economic performance really depends - such as education and the costs of doing business. For countries such as NZ that do not face hyperinflation and the collapse of their economies, the decision to enter a currency union will be driven as much by political considerations as economic. Yet political considerations have not received much attention to date. This note looks at some of these. First, lets consider the differences between a fixed exchange rate regime and currency union. In theory, the economic implications of the two regimes are the same. Certainly, the macro economic disciplines imposed are, in theory, identical. Namely, the absence of a flexible exchange rate to adjust to economic shocks. Instead the adjustment must occur elsewhere such as via real asset prices and in the labour market.

However, no advocate of currency union sees a fixed exchange rate as a substitute. The reason? It is simply too easy for governments to change the rules of fixed rate regimes, i.e. to devalue.

This immediately creates uncertainty and can invite speculative attack. Why might governments change the rules? Because the disciplines imposed by such regimes in the face of economic shocks eventually prove intolerable to withstand. The answer to this problem? Simply remove the ability of governments to change the rules. Currency union ensures this. It doesn't change the economic discipline facing the country, it simply ensures that no government can opt out.

The key aspect of currency union is that it MUST be forever. If the possibility of opting out remains in any form then many of the benefits of currency union will quickly disappear. Second, let's consider whether a permanent commitment to currency union between Australia and NZ is likely? Or, perhaps more correctly, is a permanent commitment to currency union without eventual political union likely? Perhaps it is, but it requires that the NZ Government accept there will be periods when there is a need for substantial economic adjustment to occur in labour markets and on real assets when there is little such need in Australia.

Could the NZ Government tolerate a divergence in the economic performance of Australia and NZ without considering breaking away from currency union? Our experience under fixed exchange rate regimes offers little faith in this regard. Certainly one can imagine considerable political debate about opting out of currency union should NZ be hit by a negative shock that has less impact on Australia. The mere possibility of such debate could ensure a healthy premium on NZ interest rates.

Note that a comparison with the Euro at this point may not be particularly relevant. The political dynamic of a currency union between two countries where one is clearly the junior partner is likely to be quite different to that of the Euro.

No doubt the debate over currency union will continue for a while yet, at least in NZ. It is barely on the radar screen in Australia. It will be helpful if this debate will clearly articulate that once the decision has been made it cannot be reversed. Given the merits of currency union are open to debate are NZ politicians prepared to go this far? I suspect not.

Only limited room for further interest rate convergence

While it may be years away if it ever happens at all, a number of investors have already asked about the interest rate implications of currency union.

These are briefly outlined below.

Unfortunately for bond investors looking for gains similar to those on offer in European markets in the years leading up to the introduction of the Euro, NZ and Australian interest rates have already largely converged. The official cash rates of the two countries are presently only 25 bp apart. The gap between 10Y Government bond yields is presently just over 50 bp.

Relative to this level, however, there is potentially some room for convergence under currency union. 10Y semi-government issues in Australia trade some 40 bp over 10Y ACGBs. One might expect 10Y NZGBs to trade somewhere between ACGBs and semi-government bonds. New Zealand's domestic credit rating after currency union is likely to be AAA (equal with NSWTC and QTC) and the market is likely to be somewhat more liquid. Given that the gap between 10Y ACGB and NZGB yields has already been as low as 20 bp this year, this degree of convergence is fairly limited. The possibility of divergence in bond yields cannot be completely ruled out.

This could arise because of uncertainty about the degree of political commitment to currency union. It is also possible that currency union makes NZ's present fiscal policy settings unsustainable. In particular, the NZ Government taxes a much higher share of national output than the combination of the Australian Federal and State governments: 35% versus 30%. Currency union may drive convergence in these ratios by, for instance, forcing the NZ Government to match the forthcoming reductions in Australia's corporate tax rate. Without a matching reduction in government spending, NZ's fiscal position would deteriorate.

Of course, this is all speculation. Currency union is years away, if it ever happens at all. Given this, we would be surprised if the remote possibility of currency union drove the 10Y ACGB/NZGB spread away from the levels we would predict based on the expected differential in short term interest rates.

However, it might become a factor at some stage.

David Plank Fixed Income Strategist

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