NZ's 2007 Budget and the Overvalued Dollar
by Keith Rankin
17 May 2007
One of the biggest questions that arises from this budget is what impact, if any, will it have on our number one economic problem in 2007, the chronically overvalued exchange rate. The Budget had no impact on the exchange rate on Budget Day (17 May). In the longer run there may be a substantial impact, although it probably won't be seen to be a result of the increased savings rates mandated by this Budget.
Given that the exchange rate is substantially determined by monetary policy (by the Reserve Bank's interest rate settings), a part of the question posed is "what effect will the 2007 Budget have on monetary policy?". But that effect, if any, is only a partial answer to my question.
The key point of this Budget is its "tight" stance on aggregate expenditure. Any new "handouts" will be locked up, as contributions to the new quasi-compulsory retirement savings scheme. For all practical purposes, Kiwi Saver is a tax increase. The Kiwi Saver scheme is being set up so that most people will feel morally obliged to participate (much like the War Bonds of the early 1940s, which were essentially an anti-inflation measure and not really about paying for World War 2).
The tight stance of the Budget is an invitation to Reserve Bank Governor Dr Alan Bollard to reduce interest rates. The problem is that there are other forces which will make it hard for Dr Bollard to ease monetary policy; forces such as ongoing growth of retail spending, and house price appreciation. The exchange rate has got itself into a new cyclical pattern that actually seems quite stable, and Dr Bollards tinkering with interest rates may not matter much.
This new pattern, which dates back to 2004, is that the trade-weighted index (TWI, the main measure of the exchange rate) tends to sit in the 70-73 range (roughly equivalent to ($US 0.72), but dives every 18-months or so, down to a TWI of about 60. This dive can be regarded as a "market correction". Following such corrections, which are driven by the fear of an exchange rate fall, the logic of higher interest rates in New Zealand takes over, bringing the exchange rate back to around 73 before the fear of another correction takes hold.
The reasons for this pattern of chronic currency overvaluation are fourfold: (i) high monetarypolicy- determined interest rates in New Zealand that seduce international investors (including the swelling compulsory retirement savings funds of other developed economies), (ii) low monetarypolicy- determined interest rates in many other countries (especially Asian countries), (iii) high savings rates in these low interest countries, (iv) the overwhelmingly favourable experiences that international investors have had (for over two decades now) from supping in New Zealand's debt and real estate markets.
In other words, the tendency for substantial capital inflows to come into New Zealand is something that our Reserve Bank may not be able to do much about, other than to spark one of these temporary "corrections" that I've noted.
The key relationship, that must be true because it’s a law of mathematics, is that a net capital inflow into a country must be matched by an equal current account deficit.
So, if foreign investors (speculators, pension funds, carry traders, banks, Belgian dentists etc) decide to send their savings here, then (unless an equal amount of New Zealand money is used to purchase overseas assets) there must an excess of spending from New Zealand (a current account deficit exactly equal to the capital account surplus) to balance that capital inflow.
The rising $NZ exchange rate is simply the mechanism through which this "balancing" takes place. That balance, in the 2000s' decade, has taken place at an exchange rate of around 73. If the balance of payments is disturbed by an additional capital inflow (eg from China), the $NZ will rise until an equal but opposite fall in the current account balance is achieved. New Zealand's balance of payments relationship, driven by capital inflows, requires that our exchange rate be set at levels that render uncompetitive New Zealand's tradeable sector while sucking in imports.
So what would happen if New Zealand households take the savings message of this Budget to heart, and reduce their expenditure on imports by saving more? It would mean just one thing: that at an exchange rate of 73 there would be excess demand for the $NZ. That means the $NZ would rise further (eg to a rate of 80) until the further cheapening of imports persuades us to return to 2007 levels of spending on imports, or until further export carnage brings about the required current account deficit. It might seem hard to believe, but spending on imports keeps the dollar lower than it would otherwise be, and thereby helps our exporters.
There is a way out of our exchange rate problems that does not involve a risky cut in interest rates. The Reserve Bank can actively build up New Zealand's official overseas reserves by buying foreign assets (preferably low-risk items such as foreign government debt) to the extent that the net capital inflow falls within an acceptable range (eg 3-4 percent of GDP). In other words New Zealand's gross capital inflow could be offset by a substantial Reserve Bank initiated capital outflow, funded by newly created New Zealand dollars.
This "exchange-rate targeting" approach to monetary policy would not be a perfect solution, because the interest yields on the foreign assets that Reserve Bank acquires will be lower than the interest rates we will be paying to those who "invest" in us. But, by raising New Zealand's official overseas reserves, it would give us the means to manage our way through any financial crisis that we might find ourselves involved in the future.
To summarise, the Budget's emphasis on increased savings is, in the medium term, likely to aggravate New Zealand's exchange rate problem. Increased savings will reduce imports and thereby raise the exchange rate to higher levels than it would normally be at today's levels of imports.
So long as central banks across the world prevent convergence of countries' interest rates, then destabilising capital flows from low interest rate countries to high interest rate countries will create huge imbalances in the global economy. Low interest rate countries for the most part will experience tight monetary conditions, domestic deflation (combined with inflation in the tradeable sector), falling exchange rates, and substantial and rising current account surpluses. High interest rate counties for the most part will experience easy monetary conditions, high domestic inflation (combined with deflation in the tradeable sector), rising exchange rates, and substantial and rising current account deficits. New Zealand is at one end of this spectrum of countries; Japan is at the opposite end.
The irony is that countries trying to create easy monetary conditions are, as capital exporters, achieving the very opposite. Likewise countries like New Zealand that are trying to create tight monetary conditions are, as capital importers, achieving the very opposite of what they are seeking. The 2007 New Zealand Budget seeks to soak up excess liquidity as quasi-compulsory savings. Instead it will aggravate existing imbalances within New Zealand, and between New Zealand and Asia.