Shoulda, coulda, woulda: Just what 'should' our dollar be doing?

-Donal Curtin

Thursday 28th June 2007

The strength of the Kiwi dollar this year has come as a mightily unpleasant surprise to Kiwi exporters and Kiwi investors in overseas assets.

Less than a year ago, the Kiwi was actually below US60 cents, a level that exporters could at least live with. Since then it has soared by over 25% against the greenback, decimating profit margins.

And there have been even worse movements on some cross rates: the Kiwi has more than doubled in value against the yen over the past seven years.

Some of the sting might have been drawn if exporters had been warned by economists that this surge in the Kiwi dollar was coming down the pike, and had consequently taken out insurance by hedging their foreign currency earnings.

Sadly, the economists (and I include myself) have been as blindsided as everyone else. Forecasters didn't pick it, and it's interesting to examine why.

Some economists argue that trying to forecast exchange rates is a waste of time in the first place. Believers in the 'efficient markets hypothesis' argue the forex markets are huge, highly liquid, very efficient, endlessly analysed and heavily picked over, and any systematic chances of turning a buck by being cleverer than the other fellow have been exploited long ago.

And there's a 'smart alec' version of this theory that says if, against all odds, you've got some whizz-bang idea that others haven't already mined, then why aren't you rich?

Most economists wouldn't go that far. Most would argue there are some long-term regularities to exchange rates that you can identify and use, and in particular there is widespread use of 'purchasing power parity' calculations as a guide to whether a currency is too high, too low, or about right.

Essentially, this is the same test you'd use if you went shopping in Sydney or San Francisco: if everything seemed cheap in Sydney but expensive in San Francisco, you'd conclude that the Kiwi dollar was too high against the Aussie dollar, and too low against the US dollar.

Unfortunately, this has two problems. One is it leads you to make the same kind of forecast all of the time: if the currency is, on this relative shopping test, currently too high, your forecast will be that it might go a bit higher, but will then fall back towards its 'right' level where prices in Sydney seem much the same as at home.

And that's exactly what our local forecasters have been picking for the past few years; every time the Kiwi's gone higher, the conclusion has been that the odds are now even stronger that it will fall back to where it ought to be. The worse the forecast has been, in short, the more likely you are to persist with it next time.

The other problem is, even if you're right in the long run and the Kiwi finally does come back to where it 'ought' to be, you may have gone broke in the meantime.

The end result has been that some economists have started turning their minds to what actually drives the Kiwi dollar in the shorter-term world that matters to New Zealand exporters and importers.

In the past couple of weeks we've seen some interesting research results from the economists at First NZ Capital and the BNZ. Both of them, incidentally, did a purchasing power exercise first, and confirmed what we all know, that the New Zealand dollar is 'too high' against the US dollar, and by a wide margin of over 20% (it 'should' be around 60 cents).

But then they turned their attention to the shorter-term dynamics of the past few years.

First NZ chief economist Jason Wong found the overall value of the Kiwi was positively linked to local house prices (which he interpreted as a good surrogate summary of how well the domestic economy was doing), to world commodity prices, and to short-term and long-term interest rate differentials with the rest of the world, in that order of importance.

Danica Hampton at the BNZ went a step further and came up with a statistical model of the US dollar/New Zealand dollar exchange rate. She found a reasonably similar explanation: the important factors were commodity prices, interest rate differentials with the US (both also identified by Wong) plus investors' appetite for risk.

If they're comfortable with the world, they'll take punts on the likes of the Kiwi, and if not, they'll stay at home. Her statistical model enabled her to spit out where you'd expect the Kiwi to be given strong commodity prices, wide interest rate differentials, and the clear readiness of global investors to have a dabble: it came out with an expected level for the Kiwi of between 71.8 and 73.8 US cents, close to where it is now. What's more, the model does a remarkably good job of tracking what's actually happened over the past seven years.

The good news is that - however belatedly - we may be getting a better handle on one of the more important moving parts of the economy.

The bad news? Well, you've probably figured it out for yourself.

Do house prices look like they're weakening? Is the gap between our interest rates and everyone else's getting smaller? Are commodity prices dropping? Are investors getting more cautious? No, they're not.

nd until they start to, the evidence says the Kiwi won't move back to where it 'ought' to be.

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