Listener: 4 August, 1984

Keywords: Macroeconomics & Money;

Devaluation is one of those topics, like sexual relations, about which it is extremely difficult to have a sensible discussion in public and which, as a result, is surrounded by mystery and mysticism.

The trouble is that any public mention of the topic by a person with only a modicum of economic authority can easily lead to rumours that devaluation is “on”. That this column is written about four weeks before it is published by an economist outside the public sector; who is careful not to discuss with government economists and politicians short-term exchange rate issues, will do little to quell such rumours. However, the runs on the dollar which commenced with the calling of the snap election are a convenient excuse to discuss the general issue without any possibility of the reader presuming I have inside information.

First, how the exchange rate is determined? For all its economic history New Zealand has run a fixed peg exchange rate, that is, the price of the New Zealand dollar has been set at a fixed rate in relation to some other currency or currencies. For much of that time it was set in relation to the pound sterling. In the 1970s we switched over to the US dollar and later to a basket of currencies. The way the peg was fixed has changed (mostly it has been a “nominal” peg, but between July 1979 and May 1982 it was a “real” peg). However in all cases, the underlying mechanism is that the Reserve Bank sets the exchange rate and then enforces it by buying and selling foreign currencies at that rate. To do this it has its own stock of foreign currencies called, to simplify slightly, the foreign exchange reserves.

This is not the only way the exchange rate may be determined. For instance, since December 1983 the Australians have had a “floating” exchange rate. In this case there is no official exchange rate and their Reserve Bank, as a rule, does not intervene in the market buying or selling currencies. Instead, dealers in the markets negotiate rates for their customers. If more demand foreign currency than are willing to supply it at the current price then the price of the foreign currency in Australian dollar terms will “float” up (ie a devaluation or “depreciation”). And conversely. if there is an excess supply of foreign currency its price will go down and there will be a revaluation/appreciation.

Consider the situation when a snap election is called, and market operators believe that a new government will take measure which have the effect of devaluing/depreciating. Under a fixed peg regime, the operators would believe that their New Zealand currency would be much less valuable in terms of foreign currencies in the near future, so they would convert their local dollars into foreign currencies. Since everyone is doing this, they would purchase the foreign currencies from the Reserve bank, who finds its foreign exchange currencies being drawn down.

This would set off the panic button, and shortly there would follow earnest consultations between the Ministers, the Reserve Bank, and the Treasury, as to whether to devalue now or to impose exchange controls, credit squeezes, or whatever to “protect” the reserves, Meanwhile, standby credit lines, which all Reserve Banks have arranged, would be activated to supplement their stock of foreign currencies.

Under the float, the operators who believed that New Zealand currency was going to become less valuable would start selling it for foreign currencies, Since everyone would be doing this, there would be few purchases, so the price of foreign currency would move up until some operators thought it was at the right level, and start selling, The Reserve Bank would not be affected, and no doubt they would go about their normal business of hosting IMF delegations and writing learned treatises upon the fall of the rupee.

Rather than rehearse the cases for fixed and floating and exchange rates, I want to focus on the management mechanism,

The: first issue is that I do not think it is helpful to criticise the market operators. Their “speculating” on the dollar is not very different to any of us buying up beer, cigarettes, and petrol before a budget because we believe the tax on them is going up,

When operators speculate. they do so for good reasons, because it can be very expensive to get it wrong. Note. however, that it is much less expensive to speculate and fail under a fixed peg regime than a float, and more profitable to succeed.

Any government which had a fixed exchange rate policy and was expecting to experience a series of speculative attacks should consider succumbing to the devaluation at an early stage. Fending off speculative wave after speculative wave is wearying and expensive.

It is worth reflecting on the constitutional implications of a speculative attack under a fixed exchange rate regime occurring just as (or perhaps precipitated by) the Prime Minister and the Minister of Finance were incapacitated (perhaps through a common accident). What measures could the public servants legally take? In contrast, the floating exchange rate market regime functions even when politicians cannot.

While this may seem timid today, it was unusual back in 1984 to be so explicit, as the opening paragraph explains. The column was written before the 1984 election day, and before the currency was devalued a week later.