Brian Fallow: Giving kiwi a shove in the right direction

When many exporters are hurting from a dollar close to 20-year highs it might be thought callous, even cruel, for the Reserve Bank to hint that it is thinking about intervening in the currency market unless it plans to do so.

But its declared criteria for intervening are only partly satisfied and, therefore, any non-verbal moves aimed at triggering a fall in the exchange rate are unlikely - for the time being.

When the bank decides it is time to ease monetary policy, however, it may be a different story. Maybe.

Governor Alan Bollard has been ramping up his rhetoric on the exchange rate.

In a speech on October 14, he noted "a growing sense among analysts and commentators that the exchange rate is materially overvalued and that a substantial fall is desirable and inevitable at some stage in the next couple of years".

Two weeks later, when he raised the official cash rate to 7 per cent, he was prepared to join the ranks of the analysts and commentators: "We also expect a significantly lower exchange rate."

In a speech the next week, he went further, using two of the key words in the bank's criteria for intervention.

He said the exchange rate was exceptionally high and that was unjustifiable, although the latter term was qualified with an "in some respects".

By last Thursday's monetary policy statement and further rate rise - and by this stage the kiwi dollar had just hit post-float highs on a trade-weighted basis - Bollard was unequivocal: "We think the dollar is exceptionally and unjustifiably high."

But he added that he would expect the market to look at all of the bank's criteria for intervention.

And there's the rub.

For there are two other criteria the bank has laid down before it would consider intervening.

One is that intervention would have to be consistent with the bank's policy targets agreement, that is, with monetary policy.

A paper by bank staffers Kelly Eckhold and Chris Hunt in last March's Reserve Bank Bulletin explains: "Intervention should be timed to roughly coincide with the broad thrust of interest rate settings. It makes little sense to intervene to try to push the exchange rate lower when the bank believes that higher interest rates may be required in the near future to control inflation pressures. In this situation, a successful intervention would inappropriately loosen monetary conditions."

Yet that is exactly the situation now. The bank has just raised its policy rate and warned that more of the same may be needed.

It does not make sense for it to hit the brakes and the accelerator at the same time. This is likely to reduce vital bits of the vehicle to metallic paste.

That is not to say that the bank would not prefer its desired tightness of monetary conditions to be delivered through the combination of (even) higher interest rates and a weaker currency.

But it is a given that the bank can only determine the overall tightness or looseness of monetary conditions, not how that is split between interest and exchange rates.

Frustration with the present mix and concern about what is happening to exporters and firms competing with imports may explain why Bollard would try to talk the dollar down.

Talk is cheap. By their deeds shall ye know them.

The bank has just delivered a couple of rate rises and a hawkish monetary policy statement; all else being equal it has made kiwi dollar-denominated debt more attractive to overseas investors.

In that context, says Bancorp's Earl White, for Bollard to try to talk people into selling the dollar is a bit like telling your children they can't drink while handing them a bottle of whisky.

Most market economists think that Bollard has finished raising rates for this cycle and that by the second half of next year will be cutting them.

That prospect imparts added interest to this passage from the Bulletin paper on currency intervention: "Normally, the bank would look to adjust its main policy lever - the official cash rate - when overall conditions seem too tight or easy. However, there might be occasions when the bank is reluctant to move the OCR," Eckhold and Hunt say. "They might conclude that further interest rate tightening to offset domestic inflation pressure is inappropriate but that it is too soon to begin actually cutting interest rates. The bank could intervene in response to an overvalued exchange rate that is extreme and unjustified, thereby effectively loosening monetary conditions without prematurely beginning an interest rate easing cycle."

Other central banks have been known to kick off an easing cycle in that way.

The final hurdle that has to be cleared before the bank would consider intervening is more daunting, however.

Conditions in the foreign exchange market have to be right for intervention to make a difference.

Assistant Governor Grant Spencer told MPs last week: "If there are big flows in the market buying the kiwi dollar then what we would do would be a drop in the ocean, so there is limited scope for us to actually have an impact.

"So if we were going to intervene, the timing would have to be carefully chosen."

An opportune time is likely to be one when the balance of capital flows is shifting towards pushing the exchange rate back towards, rather than further away from, fair value and when market participants are becoming less confident that the trends which have taken exchange rate further away from fair value will persist.

It would also be more opportune if market participants' positions made them vulnerable to a sudden move in the exchange rate so that they would need to reduce their exposures by trading in the direction the bank sought.

Westpac currency strategist Johnathan Bayley says market conditions right now are not favourable for intervention.

Big overseas institutional investors are already bearish about the kiwi dollar, because the economic fundamentals - faltering growth and a gaping current account deficit - tell them it is seriously overvalued.

Bayley said: "They have been spending the whole year positioned for a significant decline in the kiwi dollar and, by and large, are still positioned that way. They would welcome a move [by the Reserve Bank] and would probably go with it.

"But that is also a reason not to intervene, because you would not be squeezing them out of a long position."

What has propped the kiwi dollar up this year, even as the weight of fundamental economic reasons to sell it has grown, is overseas retail investors buying eurobonds, especially the Japanese version, uridashis.

Eurobonds are debt securities offered offshore, denominated in New Zealand dollars and paying New Zealand interest rates, which are exceptionally high by international standards.

The investors bear the risk that by the time they get repaid the exchange rate will have moved against them.

Lately that has not been their experience however. The kiwi dollar has appreciated more than 15 per cent against the yen and almost as much against the euro since the start of the year.

Add the interest rate differential on offer and you have hefty returns for the investor.

And that tsunami of capital - more than $25 billion this year - has been greeted with open arms by home buyers signing up for the fixed-rate mortgages it funds.

This has frustrated Bollard's efforts to dampen down the housing market and its spillover effects on general inflation.

It also creates a discouraging environment for currency market intervention by the central bank.

"By and large people who are buying the currency are not going to be squeezed out of their position by intervention because their position is a eurobond rather than cash," says Bayley.

And unlike the big institutional investors, their sentiment towards the kiwi remains quite positive.

It will take a large adverse movement in the cross rate between the kiwi dollar and the yen - 5 or 6 off the first number of the exchange rate - to stem that flow, he believes. "For my money, the most likely source of such a move would be a sharp move down in the US dollar/yen leg of the exchange rate. And when that happens no one will be happier than Bollard."

In the meantime, however, he is likely to remain frustrated and exporters burdened by an overvalued exchange rate.

They are caught between two amorous elephants: local households' eagerness to borrow and Japanese housewives' willingness to lend.