Brian Fallow: Foreign demand keps kiwi aloft

The exchange rate for some time has resembled an arm-wrestling contest between two brawny but evenly matched opponents: economic grounds to sell the kiwi dollar pushing against avid demand from foreign investors for high New Zealand interest rates.

Consider the economic score card.

Growth has been below average since the middle of last year.

Inflation is forecast by the Reserve Bank to average 4 per cent over the first half of next year and not to get back below the top of its 1 per cent to 3 per cent target band until 2007.

Little wonder then that inflation expectations have been drifting up and are above 3 per cent in the National Bank's latest survey. That is the sort of trend that sends alarm bells clanging at the central bank.

And the external accounts are hideously bad. The current account deficit, relative to the size of the economy, is the widest among developed countries and the worst it has been for 19 years.

The trade deficit in August was a record for the month and the year.

Finally, there is the prospect of a weak and unwieldy Government.

All in all, not a good look.

Why then, hard pressed exporters are entitled to ask, does the kiwi dollar remain so stubbornly overvalued?

In a word: eurobonds.

These are debt securities, called either eurokiwis or uridashis depending on whether they are issued to investors in Europe or Japan, which are denominated in New Zealand dollars and which pay New Zealand (high) interest rates.

They are an important source of funds for the banks, especially for fixed rate mortgages, without exposing them to the risk that when they have to repay the money the exchange rate will have moved against them. That risk is borne by the investors, commonly labelled as Belgian dentists and Japanese housewives.

Demand for kiwi dollars from this source has been running strong.

Westpac currency strategist Johnathan Bayley says there has been $2.5 billion of eurobond issuance this month, making a whopping $8.8 billion for the September quarter. That compares with just under $11 billion for the whole of last year.

But, over the past six months, the kiwi dollar's basically gone sideways, on a trade-weighted basis.

In other words, all that buying power from eurobond investors (and exporters of course) has been matched by selling by importers seeking to lock in favourable exchange rates and international speculators "shorting" the kiwi, that is betting that it will fall over the medium term as the macro-economic indicators imply.

"Eurobond issuance doesn't have to slow very much from these record levels for the kiwi to soften further," Bayley says.

Over the past two weeks, the money markets have changed their collective mind about the likelihood of another interest rate hike by the Reserve Bank.

After shrugging off a string of hawkish statements from the bank over the past six months, the market has now upgraded the chances of another rise in the official cash rate by the end of the year from an "it's possible" 20 per cent before the September monetary statement to an "it's probable" 80 per cent now.

And the expected timing of a start to the next easing cycle has pushed back towards the end of next year.

But despite this support from the yield curve, the kiwi dollar has fallen 2c or 2.5 per cent against the US dollar over the past fortnight.

Only part of that is a recovery in the US dollar's fortunes. On a trade-weighted basis, which reflects other cross rates as well, the kiwi has fallen 2 per cent over the past two weeks.

"The implication is the market is increasingly reluctant to sponsor the kiwi dollar on higher yields when they come against the backdrop of slowing growth and higher inflation," said Bayley. "It's not exactly your ideal mix."

A depreciating currency, making imports more expensive and exports more competitive, is one of the things that needs to happen if the current account deficit is to come back from its disreputably bloated proportions.

The other thing is a shift to more saving and less spending on households' part.

We need to do that anyway. The Reserve Bank estimates households are collectively spending about 15 per cent more than their disposable (after-tax) incomes - 10 times the rate of "dis-saving" going on at the start of the decade.

The cumulative legacy of decades of current account deficits is that New Zealand is a net debtor to the rest of the world to the tune of $124 billion or around $30,000 for every man, woman and child.

Servicing that liability cost $10.3 billion in the year to June and that is net of what New Zealand earned on its investments abroad.

Put another way, it required three-and a-half weeks worth of that year's output to provide a return to the foreign suppliers of capital that we depend on. That is a pretty big wedge between what we produce and what we get to keep.

The Reserve Bank's latest forecasts have growth in private consumption slowing almost to a halt over the next couple of years to get inflation back within bounds. But this week's trade figures gave no sign that that slowdown is under way. Bank of New Zealand chief economist Tony Alexander said last week's current account figures showed that one day the kiwi dollar would drop like a stone.

But he said it was likely to stay hugely overvalued until the Reserve Bank felt inflation was under enough control to start forecasting an easing in monetary policy.

Or, the dollar might drop sharply if we saw a string of really weak data for the domestic economy or commodity prices collapsed. His best guess is that life will not get a lot better for exporters for another 18 months.