Debate: What should be done about the high NZ dollar?

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Most people agree that the kiwi is overvalued and some say the solution is for the Reserve Bank to cut interest rates. But these two perspectives argue it's not that simple or easy. Join the discussion by leaving a comment below.

Illustration / P.K. Stowers
Illustration / P.K. Stowers

Don Brash: Answer lies with the Government

Most objective observers agree that, at its present level, the dollar is overvalued. Dr Alan Bollard certainly felt that, and I agree with him. Why? Because at its present level, New Zealand is not exporting remotely enough to cover the cost of the imports of goods and services we buy and the cost of servicing the capital we have borrowed from foreigners.

Our growth is unbalanced, and we're failing to close the gap between our income and that in countries we like to compare ourselves with, such as Australia.

But make no mistake: reducing the value of the New Zealand dollar means making exporters and those who compete with imports better off while making the rest of us poorer. In the short-term, a lower New Zealand dollar would reduce the real wages of New Zealand workers and it's important to remind those calling for a lower dollar that that's what they are advocating.

Accepting that a lower dollar is a desirable objective if we are to lift our living standards over the medium term, however, what can be done?

Unfortunately, there is a large amount of quite ill-informed commentary on this. Some argue that, if only the Reserve Bank were not so obsessed about inflation, it could quite easily cut the Official Cash Rate and so drop the value of the dollar. Other central banks are doing it, so why not the Reserve Bank here?

Yes, cutting the OCR would probably drop the exchange rate but if that resulted in more inflation - which all else remaining the same it would - what would be gained? Yes, the dollar might be lower, but how would that help exporters and those competing with imports if inflation took off?

After all, it is not the nominal exchange rate which is important but the real, or inflation-adjusted, exchange rate which determines whether exporters can compete. For several decades after 1945, the New Zealand dollar bought US$1.12, and in the early 70s the exchange rate actually rose as high as US$1.48 at one stage. Exporters would be killed at those exchange rates today because, in the 70s and 80s, New Zealand prices rose relative to those in our major markets.

We would gain only a very temporary advantage from a lower exchange rate if domestic inflation quickly eroded that benefit.

Well, why doesn't the Reserve Bank intervene in the foreign exchange market? The Bank of Japan has spent billions of dollars trying to stop the appreciation of the yen against the US dollar, and has engaged in very extensive quantitative easing as well, so far to no avail. The Swiss National Bank has had more success in capping the rise in the Swiss franc, but has had to spend an amount equivalent to 70 per cent of Swiss GDP buying euros to achieve that - the equivalent in New Zealand would be about $150 billion - and that despite Switzerland having much lower interest rates than New Zealand.

The fundamental question is why New Zealand interest rates need to be higher than those in most of the rest of the developed world to keep inflation under control: the answer can't lie with monetary policy, because inflation here has been around the inflation target over the past two decades, and that target is closely similar to that in other developed countries.

The answer almost certainly lies in what drives our collective desire to borrow which well exceeds our desire to save - and that relates to real factors, such as the restrictions on the supply of residential land (which create a perception that land always goes up in value), the very high rate of immigration, the way we tax the income from savings, and so on.

The surest way to bring the dollar down in the short-term (pending moves to change the underlying factors which drive our strong desire to borrow) would be for the Government to tighten fiscal policy by cutting government spending or increasing taxes, returning to surplus faster.

That would dampen domestic activity, and would effectively oblige the bank to cut the OCR to avoid the inflation rate falling below the floor of the inflation target. That would enable the exchange rate to fall without any risk of an increase in inflation.

But surely a further tightening of fiscal policy is politically impossible, Dr Brash?

I'll leave that for others to judge, but let nobody claim that getting the real exchange rate down is a simple or painless exercise. It's not. It can be done, but it can't be done by the Reserve Bank.

* Dr Don Brash was governor of the Reserve Bank from 1988 to 2002.

Bernard Doyle: It's an issue for everyone

Why should we care about the currency? If there has been one lesson from the Global Financial Crisis it is that a small imbalance left unchecked can snowball into something far more sinister. For a small, export-reliant economy like New Zealand, currency plays a critical role in either mitigating or exacerbating financial imbalances.

In the past, debt fuelled growth has left New Zealand with high interest rates, feeding a high dollar and contributing to widening current account deficits and a legacy of excessive debt. This is a well-known vulnerability in our economy.

There is a new, concerning twist to this tale now that the major central banks are reinventing their rules of engagement with financial markets. Near-zero interest rates, money printing and currency intervention are now commonplace.

Take the US Federal Reserve, which last month indicated the US cash rate was likely to stay at 0.25 per cent until 2015. By comparison, the NZ cash rate sits at 2.5 per cent. Similarly, in Europe, massive intervention by the Swiss National Bank is creating ripples through financial markets.

The Reserve Bank of New Zealand is well aware of these developments. In an August lecture outgoing Governor Alan Bollard said "big players lowering their domestic interest rates ... will tend to promote capital flows to other countries and appreciation of their exchange rates".

We are in the early stages of a housing upswing in Auckland, and rebuilding in Christchurch is beginning in earnest. Both of these influences will add to our current account deficit.

An artificially inflated New Zealand dollar and a local housing market buoyed by low interest rates is an unhealthy mix. The probability of New Zealand achieving balanced growth is diminishing. The risk of a worrying current account deterioration is rising.

So what to do? Currency intervention is one possibility: that is, the Reserve Bank could sell New Zealand dollars on the open market to try to lower the exchange rate. However the bank is rightly reluctant to intervene in currency markets. Far bigger central banks than ours have been tamed by ill-conceived battles with markets.

Against that, a passive approach in a world of policy activists may leave us vulnerable to importing the very problems other economies are trying to rid themselves of. I believe there are several ways the Reserve Bank can push against this, without taking undue risk:

Be more activist. The Reserve Bank runs strict criteria for intervening in markets. One criterion is that intervention must have a chance of meaningfully impacting the exchange rate. This is potentially too narrow, and forces the bank to think like a profit-seeking hedge fund.

If the NZD goes to say, US85c and the Reserve Bank doesn't intervene because it believes the probability of influencing the rate is low, it is doing two things: Firstly, it diminishes the bank's role as a highly respected signal to market participants. Secondly, it sends a signal by omission. By not intervening when the dollar has risen well above generally accepted ranges, the bank might be inadvertently telegraphing a belief that further appreciation is likely.

Be less risk averse. The Reserve Bank is acutely aware of its thin capital base. The bank would rightly be reluctant to go cap in hand to the Government for more capital after losing money in the currency market.

However, the Government could choose to give the bank more freedom (or "risk budget") to push against overvaluation. Why? When the dollar is rising above fair value, the Government is bearing costs in other parts of the economy: business closures, job losses, risk of future instability.

Moreover, if the Reserve Bank makes a mistake because the dollar is actually rising for fundamentally sound reasons, there should be a natural offset from the Government's perspective, as any fundamental improvement in the economy should also have a positive impact on the Crown's tax revenues.

Be holistic. Asking the bank to be more active in currency markets will be pointless if the root problem is, for example, a poorly functioning housing market, which keeps supply tight and is conducive to price bubbles.

The Reserve Bank has been quite open that it is investigating the use of "macro-prudential" tools. These seek to improve stability of the financial system by targeting factors such as how much lending is going into the housing market.

However, these can only do so much, and may make it more difficult for people to borrow and build a home - a perverse outcome if we are concerned about a shortage of affordable housing. Thus there is also an onus on other policymakers. The 2012 Productivity Commission inquiry into Housing Affordability made a broad range of recommendations that encompassed state and local government, industry bodies and the private sector.

This underlines a key message for currency intervention. Yes, there is probably a greater role for the Reserve Bank to play. But ultimately, a mispriced NZD is an issue for all New Zealanders.

* Bernard Doyle is an investment strategist with JBWere.

- NZ Herald

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