Brian Fallow: Diving dollar has a silver lining

"For this relief much thanks."

Shakespeare's Danish sentinel could have been speaking for New Zealand exporters watching the kiwi dollar's fall.

Against the United States dollar it has shed 4c or 5.5 per cent in the past fortnight, falling to around US67.8c yesterday after spending most of the past 18 months above the historic "pain threshold" of 70USc.

Several factors are at work.

The data which came out two weeks ago focused attention on the weakness of the economic outlook.

The current account has blown out to an utterly unsustainable 7 per cent of GDP, and the correction to such deficits inevitably involves a weaker exchange rate.

And economic growth is running at an annualised rate of 2 per cent of GDP, a marked slowdown from the 4 per cent pace of the previous three years. Growth over the past three quarters has been only half what the Reserve Bank had picked, a forecasting error which convinces the markets that the next move in interest rates - currently the highest in the Western world - is going to be down, however hawkish the bank's rhetoric.

Meanwhile, the interest rate differential (and more particularly the expected differential) which has attracted money into New Zealand and underpinned the currency is being eroded from the other side.

The kiwi dollar's fall in large measure reflects a rise in the US dollar as the financial markets give more credence than they had done to the prospect of continued rises in the US policy rate.

But the kiwi has also lost ground on other cross rates, notably the euro and the yen, reflecting a softening of support for "commodity currencies" like the New Zealand and Australian dollars.

"We have seen some reversal in commodities generally," says Westpac currency strategist Johnathan Bayley. "It's something else that adds to the rationale for positioning for short-term or medium-term weakness in the New Zealand dollar."

A Westpac index which tracks world prices for Australia's export commodities has fallen 4.5 per cent over the past 10 days.

"We tend to trade with the Aussie dollar as a bloc against the euro."

New Zealand export commodities also lost ground last month in world price terms, although the softening of the kiwi dollar, on a month-average basis, offset the decline, leaving returns steady in local currency terms.

The fact that prices for the major pastoral exports of meat and dairy products have been at or near historic highs has taken some of the sting out of the high exchange rate, but only for those sectors.

The tourist industry and the manufacturing and forestry sectors have had no such offset. And as the anaesthetic of currency hedging taken out at more comfortable levels has worn off, that pain has been increasingly felt.

Ironically, that might put something of a parachute on the kiwi dollar's descent. Bancorp director Earl White says that by historical standards, exporters are significantly undercovered. "The average hedging profile in the export sector would be less than half of what it normally is."

Exporters have been reluctant to lock in cover at the rates on offer.

But as the dollar falls, buying interest from exporters seeking to restore forward cover should increase.

Importers, by contrast, are carrying more forward cover than normal, locking in what are from their point of view advantageous rates. Although interest rate differentials may be contracting they are still wide enough to attract a lot of interest in eurobond issues where the legendary Belgian dentists and (more particularly) Japanese housewives buy debt securities paying New Zealand levels of interest rates and denominated in New Zealand dollars and carrying the exchange rate risk.

"So it looks as though [the kiwi] will have a look at lower levels, but it will be a slow grind down rather than a massive collapse," White said.

"Below 67USc it should start to see a bit of support. I suspect we will slide into a 65c to 70c range over the next three or four months until we decide what we are doing."

On average the kiwi moves in a range, high to low, of 17 or 18 per cent against the US dollar in a year. That suggests a low of around US64c this year.

ANZ National Bank economists have a long-run model of the currency which estimates fair value for the currency at 65c against the greenback. That reflects factors such as relative inflation, the terms of trade, current account balance and real short-term interest rates.

It has been boosted by what they consider a structural upward shift in the terms of trade - the ratio of export to import prices, a measure of the international purchasing power of a basket of exports.

The model suggests there has been a significant rise in fair value over the past three or four years.

The terms of trade have undergone a fundamental shift in New Zealand's favour, the bank's chief economist, Dr John McDermott, believes. Globalisation and the rise of China have made manufacturers the new commodities, while services and what you might call the foods of affluence are relatively more valuable.

Other economists also believe the structural reforms of the 1980s have produced an economy that can handle, and deserves, an exchange rate in the US60c to US65c range, compared with its post-float average of around US57c.

Economists' crystal balls are never cloudier than when they forecast the currency, but for what it is worth, Westpac sees the kiwi at US64c by the end of the year, while ANZ's target is US60c.

"But as we move into 2006 it is going to be harder to predict," McDermott says.

"Our economy will still be in a soft patch but when you look around the world it is hard to see who is going to have a strong currency. The US still has a massive [current account] deficit and everybody has gone sour on Europe. So the risk that we could get to US60c and then bounce upwards is quite strong."