Trying to make sense of a rising exchange rate.
Listener: 3 April, 2004.

Keywords: Macroeconomics and Money.

The conventional wisdom, like generals, fights the last war. Its complaints about the high exchange rate are from the perspective of the late 1980s. You may recall a few intrepid souls then arguing that the hike in the real exchange rate undermined the profitability of the tradeable sector, which generates foreign exchange by exporting or conserves it by import substitution. The weakened sector would slow overall economic growth, as happened. Meanwhile, the generals, fighting the earlier Muldoon war, ignored the exchange rate, completely failing to predict the poor economic performance.

This time the conventional wisdom is concerned about the high exchange rate, pointing out – correctly – that the exportable sector is suffering (there is hardly any importable sector left). Compared to two decades ago, this is an advance in understanding, but again they are fighting the last war.

They are using the wrong map. They focus on the New Zealand to US dollar exchange rate, which had risen from December 2001 (when things were last settled) to early March by over 60 percent. But not all New Zealand trade is in US dollars. The yen rate appreciated by only around 40 percent, sterling by less than 30 percent, the euro by under 20 percent and the Australian dollar by around 10 percent. The conventional wisdom should be using the “trade weighted index” that reflects the economy’s trading patterns. (They will in the next war.) The TWI has risen by about half the rate of the US dollar. (The TWI based only on exports has risen even less, because we export relatively more to non-dollar economies and import more from dollar-based economies.)

The conventional wisdom is also fighting the wrong enemy. Today’s currency appreciation is for different reasons. In the 1980s the hike was caused by our domestic policies, as both monetary and fiscal policy pushed up the exchange rate. The bulk of today’s appreciation is coming from events outside New Zealand’s control. The substantial US Government deficit (in 2001 it was a surplus) requires it to borrow overseas. The sucking of foreign savings into the US monetary system has depressed the US dollar, so all currencies are rising. (This is the opposite reaction to most economies, because the US dollar is the currency of international preference – the New Zealand dollar is not.)

There is not a lot New Zealand can do when the world’s largest economy misbehaves. During the 1980s when the local dollar appreciation was our fault, the conventional wisdom said there was nothing that could be done. It was the market determining the exchange rate, they said. This time the appreciation is occurring primarily by forces outside our control and the conventional wisdom is demanding the government do something. Ironic, isn’t it? Do they want our Finance Minister to tell President Bush to get as disciplined a fiscal position as we have in New Zealand?

The Reserve Bank has been more thoughtful. In a January 2003 speech, the Governor of the Reserve Bank indicated a willingness to grapple intelligently with exchange rate management. The speech was in a context of an exchange rate close to its 10-year average measured in TWI terms. By early March 2004 it was about 16 percent above. An exporter used to getting seven dollars is getting only six today. It is no surprise that the tradeable sector, its profitability undercut, has been slowing down. So is the economy.

Last month, the Reserve Bank announced that it may intervene in the foreign exchange market by purchasing foreign currency “when the New Zealand dollar is exceptionally and unjustifiably high”, selling in the opposite circumstance. The details of the intervention have to be worked out (when is “high” too high?), but already the foreign exchange market has responded, and the New Zealand dollar has fallen.

The new weapon is hardly revolutionary – the Australian Reserve Bank has had it since it floated its dollar in 1983. In that time its per capita GDP has grown one percent a year faster than New Zealand’s – faster than the OECD average. They are securely in the top half of the OECD, while we drifted from the middle to almost 20 percent below.

When asked, the Rogernomics generals supported cavalry over tanks. They said that the new arrangements would not work because the government would lose money. Of course, it may: the Reserve Bank will be buying at the top of the market and selling at the bottom. But those losses can be offset by the gains from a stronger tradeable sector, stronger economic growth, more jobs and the additional tax revenue that will all generate. We don’t observe the Australian economy being brought to its knees by two decades of their Reserve Bank intervention, which is more than we can say for the generals’ policies.