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Keith Rankin - Exchange Rate Blues?

Keith Rankin's Thursday Column
Exchange Rate Blues?
25 May 2000

It should be a matter of acute embarrassment to the Reserve Bank that the foreign exchange value of the New Zealand dollar should fall in response to its latest jacking up of interest rates. Instead of blaming Governor Don Brash for his lack of understanding of financial markets, it was Deputy Prime Minister Anderton who was to shut up in case he 'spooked' the markets even more. Further, we are meant to assume that it is 'bad' in some way if spooked financial markets are selling down our dollar, and that it is 'good' if our dollar is highly valued in the world's financial markets.

In 1984, we were told by Bob Jones and Roger Douglas that a floating exchange rate would automatically cure New Zealand's balance of payments problem. When it soon became obvious that such claims were naïve in the extreme, we came to accept it as a truism that interest rates determined the exchange rate, and that a high exchange rate might be worth a deterioration in our balance of payments.

We came to assume without question that a rise in interest rates would attract foreign money looking to make a quick profit, and would help to deter New Zealanders from exporting their savings. Adopting these beliefs, the Reserve Bank came to believe that it could directly manage the exchange rate (and indirectly manage inflation) through its ability to raise or lower short-term interest rates. It was, we thought, just monetary mechanics; Dr Brash would push button A and B would happen much as day follows night.

Throughout the 20th century, it has generally been seen as a matter of national prestige that a country should have a 'strong' currency. New Zealand was no exception. A rise in our country's currency was interpreted as round of applause from all those foreigners we were so eager to impress.

Until Roger Douglas resigned in 1988, the last time a Minister of Finance resigned was in 1933. William Downie Stewart had fought a losing battle through the depths of the Great Depression to retain the parity of the New Zealand pound with the British pound sterling. The recovery in New Zealand can be dated to the 25% devaluation in January 1993 that precipitated Stewart's political hara kiri. In the 10 years from January 1933, New Zealand's gross national product per capita doubled, thanks to an environment of an undervalued exchange rate, low interest rates, and rising wages and benefits.

We in New Zealand haven't changed much in our attitudes to the exchange rate. A depreciation is taken, without question, to be bad news. The world, we think, is giving us the thumbs down. A falling dollar is bad news in particular for the Reserve Bank, which has been guilty of using a rising exchange rate, with its effects on import prices, to disguise unacceptably high levels of domestic inflation.

So why did the dollar flop rather than soar, following the latest round of wholesale interest rate increases? Don Brash has hinted that the dollar might have fallen even further had he not raised interest rates. That explanation doesn't work. The raising of the official cash rate (OCR) did not slow down a fall; it precipitated a fall in the price of the New Zealand dollar.

There are some special circumstances. Interest rate increases in the USA will have reduced international interest in New Zealand dollar denominated financial assets. And foreign investors, having been burnt in Thailand and Indonesia, might have balked at investing in a country with an external debt in excess of its gross domestic product.

Certainly the global capitalists we seek to lure are wising up to New Zealand's economic unsoundness. The downside risks they face increase when the Reserve Bank raises interest rates. When that risk rises faster than the potential return, money flows out of rather than into New Zealand.

There's another more prosaic reason for the exchange rate fall. Much of the capital that flows in and out of New Zealand is invested in the transferable fixed interest bonds that are bought and sold on the wholesale bond market. Governor Brash has signalled to the financial community that there will be a steady rise in interest rates over the next year or so. That means bond prices are being subject to a slow but persistent fall. Who wants to buy New Zealand assets that are virtually being guaranteed to fall in value? Better to invest in Moldova.

The bad news for us is that the Reserve Bank may adopt a strategy of denial. If so, it will attempt to stem the fall in the exchange rate by raising interest rates further. That may further aggravates the fall in the exchange rate. The result would be a rapid increase in the inflation that the Bank is contracted to eliminate. We would end up with very high interest rates, a heavily depreciated dollar, and high inflation.

Something must give. That thing should be the requirement to suppress inflation.

Despite its links to imported inflation, the falling dollar is actually good for us. In Australia in 1986, Paul Keating created a massive economic boom by uttering just two words: "banana republic". The rapid but shortlived fall in the Australian dollar that followed Keating's words created the conditions for an economic growth cycle that is still going on today. Something similar happened in Britain in 1992, after George Soros and others forced a major depreciation of the overvalued pound.

The fall in the New Zealand dollar is in fact the best economic news for us this year. Exporters and would-be exporters will produce more. Importers will import less. Employment will rise, especially in provincial New Zealand. A depreciating dollar may create more jobs in the West Coast than will be lost on account of the government's conservation-oriented logging policies.

The greatest source of risk to New Zealand's economic renaissance is the Reserve Bank itself. It's time for the bemused Dr Brash to put away his whistle, and to let the game flow for a while. With a cheap dollar, low interest rates and rising disposable incomes (made possible in part by the forthcoming Employment Relations Act), the New Zealand economy could enjoy a state of buoyancy and productivity growth for the whole of the 2000s' decade, much as the USA's economy did in the 1990s.

© 2000 Keith Rankin

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