Bernard Hickey: Why we must try to dodge the currency elephants

Photo / Thinkstock

There's an old Swahili proverb that Alan Bollard mentioned this week when talking about New Zealand's economic predicament.

According to the African Proverb website it goes something like this: Ndovu wawili wakisongana, ziumiazo ni nyika. (When elephants jostle, what gets hurt is the grass)

The Reserve Bank Governor was trying to articulate how apparently helpless the New Zealand Kiwi dollar is amidst the Currency Wars sparked by the US Federal Reserve's money printing and China's reluctance to let its renminbi currency float higher.

Bollard denies that we're completely helpless and proved his point by jawboning the currency down by as much as half a cent after saying that markets had gotten out of line with the Reserve Bank's thinking about the economy in the last couple of weeks.

But he later pointed out that mass intervention in the currency markets to try to force down the New Zealand dollar when the driving forces were the US and other central banks was pointless. He referred to ultimately futile attempts by the Bank of Japan and the Swiss National Bank in recent months to try to drag their currencies lower.

Bollard also ruled out the use of capital controls or the sort of bond taxes imposed by Brazil and others in an attempt to stop newly-minted US dollars from boosting their currencies.

There's a lot going on behind the headlines in the Currency Wars that New Zealanders and their policymakers need to know about and prepare for. The debate is only starting and if the intensity of the questions for Bollard today are anything to go by then it shows this problem will keep coming back.

It's not a simple story and it doesn't lead to simple answers, but the implications are enormous and can't be ignored.

Here's what I think is going on and why I think New Zealand needs to investigate some clever ways to control its capital flows to prevent the destruction of the rest of its non-commodity export sector.

Print baby print

Firstly, the main headline is the US Federal Reserve's announcement last week of plans to buy up to US$600 billion of maturing longer dated US Treasury bonds. This is described as QE II or Quantitative Easing II. This is effectively a second round of money printing by the central bank in the world's biggest economy.

The US Federal Reserve or the Fed as it's known bought US$1.7 trillion worth of US Treasuries and securitised mortgages in late 2008 and early 2009 to stabilise financial markets and try to fire up the US economy after the shock of the collapses of Bear Stearns, Lehman Brothers and AIG, along with the slump in the US housing market.

Normally when a central bank wants to boost the economy it cuts interest rates, but short term American interest rates are already at or near to zero.

Meanwhile, American unemployment is stuck around 10 per cent because the domestic economy is stalled. About two thirds of the US economy is dependent on spending by households and they're not growing spending because they are up to their gills in debt.

The US Federal Reserve wants to encourage consumers and businesses to borrow more and spend more to start up the US consumption engine again. It also wants to boost export earnings for businesses by reducing the value of the dollar.

Given it has cut short term interest rates to almost zero, its only option is to try to reduce long term interest rates. Many American businesses and homeowners borrow at rates based off these market rates for long term Treasury bond yields.

That's why it is planning to buy longer term Treasury bonds, although not too long term. Long term US bond prices actually fell last week, meaning yields or interest rates rose, because the US Federal Reserve said it would mostly buy 2-10 year bonds.

The big demand and supply problems

The Fed's problem, however, is that US consumers and businesses and banks don't want to play the game.

Households already have too much debt. About a quarter of all American home owners with mortgages are under water, where their mortgage is worth more than their house.

About 10 per cent of those with mortgages are delinquent. About 5 per cent of all homes are in foreclosure and are either being sold through what we would call a mortgagee sale or are backed up waiting to be sold. US house prices are falling again. Households can't and won't take on more debt.

Secondly, the banks are reluctant to lend to households because so many are already delinquent on their loans or unemployed.

Thirdly, US companies are reluctant to borrow to invest more because they are so uncertain about the domestic demand, again because the unemployment rate is so high and spending is weak.

They actually have the capacity to borrow, but don't have the confidence to invest at home. One of the ironies of QE II and the low interest rates is it makes it cheaper for companies to buy each other to find efficiencies and reduce employment. It also makes it cheaper for them to invest in new factories and production offshore.

QE II does however help boost the balance sheets and profits of the big banks. They can sell their shorter term bonds to the US Federal Reserve and then lend their money out at longer terms for slightly higher interest rates to the government.

There is a risk QE II will be just as ineffective as QE I. Some commentators are saying the US Federal Reserve could have to print up to US$10 trillion or 60 per cent of US GDP to generate enough economic growth to significantly reduce unemployment.

Squirting out the sides

If the US Federal Reserve has to keep printing the risk is that much of the newly minted cash will squirt out the sides into assets seen as more stable or countries seen as having better growth prospects.

So commodity prices are surging, as are the currencies connected to them. Oil prices hit a two year high overnight. Cotton prices are at record highs. Coffee prices rose to 13 year highs and the price of copper is near a three year high. The Brazilian Real, the South African Rand, the Canadian dollar, the South Korean Won, the Australian dollar and the New Zealand dollar have all surged to multi-year highs vs the US dollar.

This is causing all sorts of havoc on global markets and will spill over into economies. Brazil has tried to protect the real from being shunted through the ceiling by imposing a tax on foreign investors in local bonds. South Korea is looking to do the same.

India and Ukraine are looking at intervening in currency markets. There's even talk of capital controls being imposed in Japan, and China has started imposing such controls.

The World Bank itself is saying that Asian economies need to respond to America's quantitative easing with capital controls.

So why are we staying hands off?

Bollard was determined in his defence of the status quo in New Zealand in his appearance before Parliament's Finance and Expenditure select committee on Wednesday.

He pointed out that farmers were receiving record high commodity prices, helping to offset the pain of a high currency. He said that currency intervention rarely worked to force currencies when the big drivers were weakness in other major currencies.

He dismissed talk of capital controls as being only marginally effective and inappropriate for New Zealand.

He essentially said we needed to tough it out, as we have in the past.

Bollard dangled the remote prospect of some new tools in a suggestion of a discussion about Supplementary Stabilisation Tools with Treasury in the New Year, but he was virtually immovable.

The problem now is that America seems determined to do whatever it takes to keep printing and devaluing its currency.

What happens if it has to do QE II or QE III or QE IV and print the US$10 trillion that is feared?

It would unleash a wave of commodity price inflation and currency appreciation throughout the freely floating emerging and commodity currencies, including ours. Parity between the NZ dollar and US dollar is not out of the question in that sort of environment.

The assumption is that QE II will work and eventually the US dollar will rebound with the US economy, allowing the New Zealand dollar to fall back to its long term sustainable level under 70 USc.

But what if the US dollar is permanently devalued? What if some sort of Bretton Woods II shakeup of the global currency system locks in a New Zealand dollar north of 80 USc?

Get used to being a farmer or a barmaid

A currency north of 80 USc for a sustained period would wipe out whatever is left of our manufacturing sector that doesn't export to Australia.

Farmers, foresters and fishermen would be OK because the money printing is driving commodity prices higher, softening the pain of the US dollar.

A world of a permanently weak US dollar and the refusal of China and its neighbours to let their currencies rise vs the US dollar essentially sentences New Zealand to being a farm and tourist destination, and a foreign owned one at that as foreign investors look to spend their newly minted US dollar on hard assets in stable, food-rich democracies with proper legal systems.

Any manufacturer trying to sell to Asia, America or Europe would have no hope. Any that remain would have to focus on exporting to Australia, assuming of course the Australians leave their hands off and allow their currency to rise even further above US dollar parity than ours.

Some would argue that the world wouldn't end if New Zealand had no manufacturing base exporting outside of Australia.

However, I think this would be a mistake. Manufacturing implies factories employing lowly paid manual workers, but in a modern sense manufacturing actually refers to higher wage jobs that will keep our youngest and brightest from leaving the country permanently.

The Hobbit was a perfect example. Fisher and Paykel Healthcare and the other companies in the TIN 100 technology companies that produce NZ$5 billion in exports annually, just behind Tourism and Dairy as one of our biggest export industries.

These are the jobs and businesses we need. Can we really build incomes and repay our debts with the promise jobs on dairy farms pumping out commodity products or more jobs in cafes and hostels cleaning up after Australian tourists?

Doing nothing is not an option

There are plenty of ways New Zealand's government and its Reserve Bank can try to stop our currency and high wages jobs from being stomped on by the elephants.

It could move much faster to reduce consumption and improve savings, reducing the need to borrow or sell assets in a way that pushes up our currency.

Introducing a capital gains tax or land tax would make a good start. Such a move to improve our national savings rate would also allow lower interest rates, which would encourage investment in exporting businesses.

The government could impose limited forms of capital controls to discourage big lumps of freshly minted US dollars (or their proxies) from entering the country. Big farm and property sales to foreigners could be banned or limited. Other asset sales to foreign interests could be discouraged or blocked.

New Zealand's savings institutions, particularly the ones with government mandates or subsidies (the NZ Super Fund and the KiwiSavers funds), should be encouraged or forced to invest in New Zealand.

Foreign investments in New Zealand government or corporate bonds could be taxed.

Government companies could be directed to buy goods and services from New Zealand companies.

The IRD could be much more aggressive in forcing foreign owned companies to pay their fair share of taxes. Its success in forcing the Australian-owned banks to pay a fair tax rate sharply reduced our current account deficit.

Allowing Google to make $150 million of revenues in New Zealand and to pay just $7,726 in tax here last financial year would be a good place to start.

In a world where it's every country for itself, New Zealand needs to look after itself.

We can at least try to tip-toe between the stomping elephants.