Brian Fallow 's Opinion

The Economics Editor of the NZ Herald

Brian Fallow: Overvalued dollar sounds alarm bells

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Question is whether markets will react to a fall in our terms of trade as they appear to have done with Australia.

The Peterson Institute of International Economics rates the NZ dollar as the most overvalued out of 34 currencies. Photo / Brett Phibbs
The Peterson Institute of International Economics rates the NZ dollar as the most overvalued out of 34 currencies. Photo / Brett Phibbs

The exchange rate may have eased in recent weeks but two reports remind us of just how overvalued the kiwi dollar is.

The respected Washington-based Peterson Institute of International Economics rates the New Zealand dollar as the most overvalued of the 34 currencies it considers in its latest semiannual estimate of fundamental equilibrium exchange rates.

It reckons US74c, not US85c, would be more like it.

Peterson Institute economist William Cline works out the extent to which exchange rates need to change in order to curb any prospectively excessive current account imbalances back to a limit of plus or minus 3 per cent of gross domestic product. He uses the International Monetary Fund's forecasts of the current account balance five years ahead.

On that basis the kiwi looks to be around 15 per cent overvalued on a trade-weighted basis and only slightly less than that against the US dollar. Only the Turkish lira comes close.

The IMF itself, reporting on Tuesday the result of our latest annual check up, says that depending on how it is modelled the real exchange rate is between 5 and 15 per cent above the level consistent with medium-term fundamentals.

Stabilising the country's net external liabilities in the medium term would require the New Zealand dollar to be about 11 per cent weaker than its current level, it says.

The IMF forecasts the current account deficit, which was 3.4 per cent of GDP for calendar 2013, to widen to 6 per cent by 2019 (a marginal improvement on the previous forecast of 6.3 per cent available when Dr Cline crunched his numbers). By then it estimates the country's net external liabilities would be the equivalent of 83 per cent of GDP - a conspicuously high level.

Between 2001 and 2012 the current account deficit averaged 4.2 per cent.

But that period included the worst recession since the 1970s followed by an exceptionally slow recovery.

And right now, though probably not for much longer, we are enjoying the most favourable mix of export and import prices for 40 years.

The question is whether the financial markets will react to a decline in New Zealand's terms of trade as they appear to have done in Australia's case.

The Australian dollar has gone from being 13 per cent overvalued a year ago, on the Peterson Institute's measure, to just 2 per cent.

The IMF, like other forecasters, expects the current account deficit to widen as growth in private consumption and investment - the latter boosted by post-earthquake reconstruction - remains strong.

"Over the longer term, as reconstruction tapers off and if the exchange rate overvaluation recedes, the current account deficit could decline to below 4 per cent of GDP," it says, "stabilising the net foreign liability position at below 90 per cent of GDP". Forecasts of the current account balance, especially five years out, are hardly Holy Writ. It is the difference between two very big numbers with a lot of moving parts.

And stuff happens.

Five years ago no one would have expected an earthquake to lay waste great swathes of our second largest city.

We can't assume the inevitable uncertainty around current account forecast to be resolved in our favour, however. It might turn out worse than expected. At the end of the last boom the deficit was 7.9 per cent of GDP.

The statisticians measure the current account balance by the flows of payments from trade and investment.

But economists can demonstrate with a bit of algebra that it equals the difference between investment spending in the economy and national savings.

In the OECD's most recent economic outlook New Zealand sticks out like the dog's proverbials for its low, and often negative, household savings rate and for its high long-term interest rates.

These two facts are connected.

We can't expect foreign savers to provide about a third of the money we borrow without requiring some compensation for the additional risks they incur.

It is also a big risk for us, and not just that our international creditors go off us for some reason. The IMF report says market volatility associated with a "bumpy" exit from quantitative easing by the major powers could raise the cost of New Zealand banks' offshore wholesale borrowing.

So what can be done about it?

"Reducing pressure on the exchange rate and limiting the current account deficit in a lasting way will require structural measures to address the savings-investment gap, rather than being the task of short-term macro-economic management," the IMF says. We hear the same message from time to time from the Reserve Bank.

The IMF's comment might be seen as a swipe at the view, widely held on the centre left of politics and in parts of the business community too, that if only the Reserve Bank's statutory mandate and riding instructions (as embodied in the policy targets agreement) were amended it could deliver a sustainably lower real exchange rate. To be fair, Labour's monetary policy announcement last month does grasp the nexus between national savings and the current account on the one hand and the trend level of interest rates and the exchange rate on the other.

It was presented as part of a suite of policies aimed at raising national savings including running fiscal surpluses, making KiwiSaver compulsory and lifting the contribution rate progressively to 9 per cent.

The IMF's call for structural measures to lift savings could also be seen as a swipe at complacency on the National Government's part. The Government is entitled to point to a (still only forecast) return to fiscal surplus as a major contribution to national savings, but both major parties share that policy.

Another key issue is the loud signal the tax system sends that the best, or at least the most tax-efficient, way to provide for your old age is not to save money but to borrow money and engage in highly leveraged plays in the housing market.

New Zealand has by international standards an exceptionally lenient tax treatment of property investment on the one hand and exceptionally harsh treatment of saving through managed funds on the other.

Labour proposes a capital gains tax and ring fencing of tax losses on property investment.

The Government points to its move in Budget 2010 to eliminate the deductibility of depreciation on property, which has the merit of attacking the cashflows of landlords while they own a property rather than waiting to nibble at their profit upon sale.

The IMF is puzzled by New Zealand's low household savings rate.

"[It] might be partly related to ... factors such as New Zealand's tax, social security and welfare systems."

Finance Minister Bill English seems to agree: "I think New Zealanders see the payment of their tax as a guarantee of future consumption, so they know if they pay their tax they will get early childhood subsidies, free health care, free education, interest-free student loans and universal super. That isn't a bad package."

But Labour's finance spokesman David Parker points out that those social protections also exist in countries which have better saving records than we do.

English rejects the idea that our chronically low household savings rate shows New Zealanders to be inherently feckless and dumb.

Let's assume he is right and we are responding quite rationally to the set of signals policymakers send us.

If the result is to make life much too hard for exporters and firms competing with imports then those policies and those signals need to change.

- NZ Herald

Brian Fallow

The Economics Editor of the NZ Herald

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