Exporters and investors feel the pinch of $US

by Michael Coote

Friday 13th February 2004

Exporters are starting to squeal about the rising Kiwi dollar. The Reserve Bank's recent decision to increase the official cash rate to 5.25% boosts the dollar when the three major currency blocs persist in keeping their base interest rates at 2% or less.

Significantly, the US Federal Reserve recently changed the wording of its monetary policy position from saying that low interest rates "can be maintained for a considerable time" to that it "can be patient in removing its policy accommodation." Thus it is not if but when the Fed will hike interest rates.

But New Zealand will still have a high differential between its own interest rates and those of the US.

Not just exporters but also New Zealanders investing overseas are feeling the pinch, especially if they hold US dollar-denominated assets.

Those who yet have money to invest abroad get more bangs for their buck when the Kiwi is up and the greenback is down. But those who have already invested in US assets must be galled to see US shares on the rise combined with low New Zealand dollar returns.

According to Goldman Sachs J B Were, as of December 31 a share portfolio of the top 1000 US listed companies had a gross return of 29.6% to the US investor, excluding tax and fees.

Over three years, which covers the 2000-03 bear market, the US investor was down by a gross 10.9%. By contrast, as at the same date, a New Zealand investor in the same portfolio made only 3.6% over 12 months and lost 39.7% across three years. Ouch.

The difference was due to changes in the New Zealand dollar/US dollar exchange rate. Over the 12 months to the end of 2003 the greenback depreciated 20.1% against the kiwi and over three years the figure was 32.3%. Local investors could add their cries to the pleas for mercy emanating from exporters.

Currency volatility could add an interesting dimension to imposition of the risk-free rate of return method (RFRM) of taxation on New Zealand investments overseas. A New Zealander could make a profit in US dollars but a loss in New Zealand dollars, such as occurred in the two years to December 31, when a 1.6% gross return on the US shares portfolio translated into a 35.5% loss in New Zealand. If the investor had accessed the shares through a New Zealand-domiciled managed fund, there would be tax losses to carry forward. But with RFRM, the investor would be stung with tax to pay.

Fund managers had a hard enough time retaining clients when international shares nosedived over 2000-03. If these clients have a tax bill to face besides, they are likely to sell out of their funds to cut the liability. Investment flows could become highly volatile.

One method for avoiding currency-induced losses is to invest in funds hedged to the New Zealand dollar. International bond funds are usually hedged passively 100% but share funds vary as to hedging policy. Some, like index-tracker funds with binding IRD rulings on tax exemption of capital gains are barred from hedging. Actively managed international equity funds may be hedged anywhere between zero and 100%, or some lower ceiling.

Hedging does come at a cost. There are fees to pay for it, and a hedged fund could underperform an unhedged one if the kiwi falls. Possibly the fund manager could make a blunder on the hedging. In theory, over the long run currency cycles should not make much difference to returns but in practice investors are not likely to hang in there on the bet that if they live to be 100 they will see the proof.

There is one bright spot on the bleak horizon of a strong kiwi for investors. Many international equity funds will be sitting on big tax losses. Provided they have not included much of these losses as assets in unit price, they can offer investors a significant tax holiday gratis.

The lack of tax drag should accelerate rebound in these funds, although there is still the problem of an appreciating currency. If the US dollar rises or the kiwi falls, the combination with accumulated tax losses should see some robust returns.

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