Brian Fallow: Bank watches as kiwi flies

It is remarkable that with the kiwi dollar around 20-year highs, calls for the Reserve Bank to use its newly acquired powers to intervene in the foreign-exchange market are nowhere to be heard.

For 20 years, the Reserve Bank has not intervened in the foreign-exchange market, buying or selling the dollar to affect its value.

But, with considerable fanfare last year, it was given the mandate and the wherewithal to intervene to at least shave the peaks and troughs off the exchange-rate cycle.

Despite that there has been no clamour to intervene.

"Over the last six months I've heard no call at all for intervention," says Auckland Chamber of Commerce chief executive Michael Barnett.

Two possible explanations suggest themselves.

One is that after 20 years of a cleanly floating currency, exporters and importers know they have to live within an exchange-rate cycle, just as farmers live with a certain range of climatic conditions.

They manage the risk as best they can and know they need the operational flexibility and balance-sheet strength to ride out the bad times.

The other explanation is that it may be like the joke about a man falling from the top of a tall building and who is heard to say as he hurtles past the 20th-floor balcony: "Okay SO far ... "

In other words, only when currency hedges taken out at more comfortable levels run out, or world commodity prices weaken, will the impact of the high dollar be felt.

Michael Cullen seems to favour the first explanation. Appearing before Parliament's finance and expenditure committee, he said this was the third time since the float that the dollar had been above 70USc and it seemed to him that each time businesses coped with it better.

Research that Reserve Bank economist Phil Briggs has done on hedging behaviour found a growing sense among exporters that what goes up will come down.

This meant that exporters were less willing to hedge when they saw the exchange rate reach high levels, say 65USc or more.

Firms are reluctant to lock in these levels, preferring the use of options, which are more expensive insurance against further upside but which let them off the hook if the exchange rate falls.

However, Briggs said the recent reduction in hedging meant exporters were exposed if the dollar continued to appreciate. Continued appreciation would be particularly problematic if it was accompanied by a fall in commodity prices.

So it may be timely to recall what the Reserve Bank has said about its prerequisites for intervening in the foreign-exchange market.

It has said that it would only sell dollars, in a bid to lower the exchange rate, if the currency was "exceptionally and quite clearly unjustifiably high".

Intervention would also have to be consistent with its overriding mandate, to run monetary policy to keep inflation low.

And it would only intervene "when it assesses that there is a material prospect of influencing the exchange rate and in ways that seek to avoid destabilising speculation".

So is the dollar exceptionally high? Yes, says Westpac currency strategist Johnathan Bayley. Since it floated it has been above 70USc only 5 per cent of the time.

But is that level unjustifiable?

That is a more subjective question. One thing you would look at in addressing that question is interest rate differentials.

There has been a reasonable correlation over the years between the gap between New Zealand and world interest rates and the level of the dollar.

And certainly some of the kiwi's recent strength has been driven by the demand engendered by offshore borrowers issuing debt denominated in New Zealand dollars and paying New Zealand interest rates.

"But bond spreads generally across the curve are well off their highs," Bayley said.

The interest rate gap should narrow further. While New Zealand's economic growth was stronger than that of the United States last year, we are likely to underperform it this year.

All this suggests that reaching this level on the exchange rate could be seen as justified. But maintaining it as the year goes on would be less so.

To the extent that the kiwi dollar's rise reflects an enfeebled US dollar, it could be argued it is justified. The US is running fiscal and balance of payments deficits which, in theory, should mean a weaker US dollar and higher US interest rates.

The trouble is the kiwi dollar is not just a US dollar weakness story. It is not far from its highs on all the major cross-rates and on a trade-weighted basis.

That means factors specific to New Zealand have to considered.

The fact that world prices for major export commodities are at or near historic highs again suggests the exchange rate is justified. It also takes the sting out of the high dollar for at least some exporters.

While it lasts, that is.

What about the condition that intervention be consistent with monetary policy? Here, the Reserve Bank has a dilemma.

If it only wanted to lower the exchange rate it should cut interest rates.

But with many inflation indicators in the danger zone it is more likely to raise them.

If the high dollar was not already doing a lot of its work for it, it probably already would have pushed interest rates further than it has already (to so far limited effect).

Much as it might like to achieve the same degree of monetary tightness through the combination of a lower dollar and higher interest rates, experience tells it that it cannot control the mix.

And, in the meantime, the brakes on the exchange-rate side of the vehicle may be working better than those on the interest-rate side.

Finally, there is the question of whether intervention would be effectual at this time. This is vital.

The bank is keenly aware of the risk to its reputation if it intervened and did not get much of a move in the exchange rate, Bayley says. Any subsequent interventions would be much less credible.

He says the international evidence is that the best time to intervene will be when the market is "long the kiwi" ( that is, a lot of speculative money was parked in New Zealand dollars) but a question mark has arisen over the future direction of the exchange rate.

He believes the first of those conditions has been met, but we are not quite there on the second.

"The trend hasn't really faltered yet, but it is at the point where the market has become heavily long and is wondering, if the trend will continue to provide them with returns, whether they should be squaring up."

In this it is reminiscent of the position a year ago when the Reserve Bank did, in effect, engineer a drop in the exchange rate merely by announcing it was seeking a mandate to intervene.

But even though it might be tempted to intervene, on balance the bank should probably keep its powder dry in case the exchange rate goes higher still or stays at present levels for too long.