KEY POINTS:
A widely used investment strategy, called "carry trade", is having a major impact on the New Zealand dollar and the domestic economy.
Carry trades, which have become increasingly popular in recent years, are when an investor borrows money in a low-interest-rate country and invests the proceeds in a
country with high interest rates.
A particularly profitable example of this at present is to borrow in Japan, where overnight rates are less than 1 per cent, and invest in New Zealand, where call rates exceed 7 per cent.
This interest-rate spread is extremely attractive, particularly for investors who can use their balance sheet to borrow and don't have to commit much of their own funds to the transaction.
These carry trades have also had a major impact on the Japanese yen.
The two main types of carry trades, as far as New Zealand is concerned, are:
* An investment in New Zealand denominated bonds by retail investors in low-interest countries. These bonds offer New Zealand interest rates and are particularly popular among retail investors in Japan. Most of these, which are mainly called Uridashi bonds in Japan, are issued for more than a year and investors carry the currency risk.
* Short-term carry trades, predominantly undertaken by hedge funds. Hedge funds borrow in low-interest-rate countries and invest in high-rate areas, often for as little as one night. Short-term trades are also subject to the currency risk as the cost of hedging eliminates almost all of the interest-rate differential gains.
The Uridashi bond market is relatively easy to analyse because the Reserve Bank collects a wide range of data on new issues, maturities and the amount of bonds on issue. The short-term carry-trade market is much more difficult to assess because there is no reliable information on its participants and size.
Nevertheless most experts, including central bank economists, believe that the huge increase in currency trading in recent years has been strongly influenced by hedge-fund-driven carry trades.
As far as New Zealand is concerned, these short-term carry trades have become far more important than the Uridashi bonds or other retail bonds and could have a much bigger influence on the New Zealand dollar in the years ahead.
The accompanying table illustrates why retail investors in Japan and hedge funds have either sold yen to purchase New Zealand dollar securities or borrowed yen to invest in the kiwi.
Japanese overnight call rates remained at 0.001 per cent between August 2001 and June 2006 and had risen to 0.24 per cent by the end of last month. Ninety-day rates did not go above 0.16 per cent in the August 2001 to June 2006 period and had reached only 0.55 per cent at the end of January.
When the Reserve Bank of New Zealand started raising interest rates at the beginning of 2004, the rate gap with Japan widened and the NZ dollar-denominated securities became extremely attractive to retail investors around the world and to hedge funds.
The total amount of Uridashi, Eurokiwi and Samurai retail bonds on issue has risen from only $13.7 billion in June 2003 to $53.3 billion last month. This gives a clear indication of the attractiveness of New Zealand's high-interest-rate structure.
Overseas investors have done particularly well from their NZ dollar investments because the interest rate differentials have been large and the kiwi has appreciated against most currencies.
There is no accurate information on the amount of short-term carry trade but the latest Bank for International Settlements foreign-exchange-turnover survey showed that daily trading in the NZ dollar rose by 152 per cent between 2001 and 2004, one of the highest increases in the Western World.
The survey concluded that the short-term carry trade had been a major driver of the 51 per cent increase in total worldwide currency transactions over the three years.
The US dollar, Swiss franc and yen have been the main sources of carry-trade funds and British sterling, the Australian dollar and the NZ dollar the principal destinations.
There are a number of reasons why the short-term carry trade is believed to be extremely significant as far as New Zealand is concerned:* The kiwi's share of total world currency turnover has risen from 0.2 per cent in 1995 to 0.3 per cent in 1998, 0.6 per cent in 2001 and 1.0 per cent in 2004. This reflects an increase in speculative, rather than trade-related, currency transactions.
* New Zealand has an inverse yield curve (short-term interest rates are higher than long-term rates). This is particularly attractive to hedge funds.
* New Zealand has the highest interest rates among the 30 OECD countries, with the exception of Hungary.
* The NZ dollar has appreciated over a number of years and the hawkish stance of Reserve Bank Governor Alan Bollard indicates that interest rates are more likely to rise than fall over the next few months. This is an extremely attractive proposition for short-term carry-trade participants.
Between $100 billion and $150 billion is probably invested in the New Zealand dollar through carry trades in the form of retail bonds and short-term positions taken by hedge funds. This is about twice the value of the New Zealand sharemarket.
In light of this, it is incredible that our main way of fighting an overheated housing market is through monetary policy and higher interest rates.
This approach is ineffective because the majority of borrowers have fixed mortgages.
More importantly, the high-interest-rate policy is a bonanza for overseas carry-trade participants while it has a negative impact on exporters and domestic producers who compete against imports.
Our monetary regime was established in the 1980s when currency trading was limited and there were no hedge funds and carry trades. Our inability to adjust policy settings for a changing world is having a negative impact on the export sector, particularly as attractive currency hedging opportunities have almost totally disappeared.
The huge increase in carry trades is having a distorted impact on currency values.
For example, Japan has a substantial current account surplus, its economy is improving, yet the yen continues to fall.
By contrast, New Zealand has a massive current account deficit, the economy is slowing but the kiwi remains firm.
What happens if Japanese interest rates rise or NZ rates decline?
Under either of these scenarios the Japan/New Zealand carry trade becomes less attractive and hedge funds will unwind their positions. This could have a major impact on the New Zealand dollar.
The other development to look for is a rise in currency volatility as the carry trade is highly dependent on relatively stable exchange rates.
A major international crisis, either political or economic, could trigger a rush to major currencies and an unwinding of short-term carry trades with high-interest-rate countries.
This could lead to a sharp - and painful - readjustment in the value of the New Zealand dollar.