Brian Fallow: Free-floating kiwi remains our best bet

The Reserve Bank's ability to manipulate the exchange rate is like a tug boat trying to haul a supertanker around. Photo / Thinkstock

A dollar above US80c, if it persists, threatens to retard what is still a tentative export-led recovery.

And it is certainly no help when it comes to the structural challenge of rebalancing the economy by redirecting its resources away from consumption and towards earning the country's living as a trading nation.

Inevitably, then, eyes swivel towards the Reserve Bank and its mandate to intervene in the foreign exchange market.

It is a tool it has rarely employed, in mid-2007 and again early the following year.

Rarely and secretly. Its reporting cycle means it can be up to two months before it is clear whether it has intervened.

Currency strategists doubt whether the bank will think the criteria it has set for intervention are met right now.

The first question is whether the exchange rate is exceptionally high (or low).

The kiwi is certainly exceptionally high against the United States dollar, but the US dollar makes up only 30 per cent of the trade-weighted index or TWI.

The TWI is designed to reflect the overall strength of the New Zealand dollar against a basket of currencies, weighted by their respective countries' importance to us as trading partners and the relative size of their economies.

The TWI is high too, having topped 70.

But it is not at unprecedented levels. It spent a full year from April 2007 to April 2008 around the same levels it is now.

The TWI is still below the levels at which the bank intervened in July 2007 (77) and March 2008 (74).

On balance, though, it would probably tick the exceptionally high box.

Whether it is unjustifiably high, the second test, is more debatable.

Estimating fair value, in the sense of some long-run equilibrium level of the exchange rate, is an arcane business. ANZ's economists put it at US67c.

But cyclical factors can push and pull fair value around.

Right now New Zealand is enjoying record prices for its commodity exports. The terms of trade - export prices relative to import prices - are the most favourable for 37 years.

They have risen 11 per cent in the past year, boosting national income, and are 9 per cent above where they were when the Reserve Bank intervened in 2007.

So no tick in that box.

The bank's third test is whether intervention would be likely to be effective.

It accepts that the best it can hope for is to moderate the exchange rate cycle a little - shaving a bit off the peaks or the troughs.

Think of it as a tug boat with a limited fuel supply, trying to haul a laden supertanker around.

It would need to be pretty confident that a peak in the exchange rate was near.

So the question is whether the high exchange rate reflects US dollar weakness or the kiwi dollar's strength.

It seems to be both.

Evidence of the latter is that the kiwi appreciated 4 per cent or nearly 3c against the Australian dollar over the course of May.

So it can't all be put down to investors being out of love with the United States.

But a lot of it can. Right now when investors look at the US they see uncertainty about monetary policy (what happens after the imminent end of the Federal Reserve's quantitative easing?) and fiscal policy (that huge deficit and political wrangling over a looming breach of the debt ceiling).

The euro remains overshadowed by sovereign debt issues in some of its weaker members, Greece especially.

And while investors would no doubt love to be long renminbi, China is a long way from acceding to calls to allow its currency to float.

No wonder the commodity currencies, including ours, look relatively good to institutions searching for somewhere to park their money. These are powerful forces about which nobody in New Zealand can do anything.

Another box unticked.

The fourth test is whether intervening to lower the value of the kiwi dollar would be consistent with what the Reserve Bank is trying to do with monetary policy.

Its most recent move, of course, was to ease, when it cut the official cash rate by 50 basis points to bolster confidence in the aftermath of the February earthquake, and perhaps correct a premature tightening in the middle of last year.

But the bank made it fairly clear that this was a temporary measure and that it expected the next move in interest rates to be up, though not until it sees the whites of the recovery's eyes.

Since then the exchange rate has risen 9 per cent on a trade-weighted basis, which represents a significant tightening of monetary conditions.

It ought to reduce inflationary pressure, by making imported goods, including oil, cheaper.

How much good it does on that front will depend on how much the distributors and retailers of imported goods use the exchange rate relief to rebuild margins. But with consumer spending subdued competitive pressure ought to encourage a high degree of pass-through to consumers.

We will discover next week when it delivers its June monetary policy statement whether the Reserve Bank is taking a less sanguine view of the inflation outlook than it did in March.

If so, it will reinforce the markets' increasing tendency to expect the next OCR rise to occur before the end of the year.

That is one of the factors which has propelled the dollar higher lately.

If the bank's serenity levels about inflation have not changed, there are a few market economists around who think they should have.

The irony is that the more that hawkish view is reflected in an inflow of money, which pushes the exchange rate up, the more it does the bank's tightening work for it, allowing it to leave the OCR at its all-time low for longer.

Jury out, then, on the last box.

So where does this leave us?

We cannot take too much comfort from the fact that April saw a record monthly trade surplus.

Finance Minister Bill English pointed to it as as evidence that "our export sector has got used to a dollar over [US]70c and is performing pretty well".

It takes time for spot exchange rates to flow through to the prices of goods crossing the wharves and a dollar over US80c would be a lot harder to live with.

The ANZ commodity price index shows the exchange rate starting to weigh more heavily on export returns.

While world prices for a basket of New Zealand's export commodities hit a record high last month in the 25-year history of the index, they have risen only half as much in New Zealand dollar terms over the past year as they have in world price terms.

But that works in both directions.

A floating exchange rate softened the blow of the collapse in commodity prices in the wake of the global financial crisis, absorbing a third of the decline.

You don't hear calls these days to adopt the aussie dollar. Manufacturing exporters are currently enjoying a 24 per cent discount to the aussie, the best for many years.

And a dollar that was 25c higher against the US dollar would be pretty hard for New Zealand exporters to live with.

That would be serious pain.

So a freely floating exchange rate still looks like what Winston Churchill said about democracy - the worst system apart from all the others.