Brian Fallow: Parties poles apart on currency control

Right now it would be tough to make the case that the kiwi dollar is exceptionally or unjustifiably high. Photo / Greg Bowker

Exchange rate intervention has joined the growing list of economic policy differences between the Government and the Labour Opposition.

In 2004 when the Reserve Bank sought, and was given, a wider mandate to intervene in the foreign exchange market, John Key was squarely in the sceptical and critical camp.

And at the Prime Minister's post-Cabinet press conference on Monday it was clear his views have not changed.

As a forex dealer he had seen repeated interventions by the Bank of Japan aimed at pulling the value of the yen down.

"It never worked," he said. Over the years he had seen the yen climb from 330 to the US dollar all the way to 80.

"Intervention does not work as a policy."

Labour's response would probably be that whether it works or not depends on what you are trying to achieve.

"We would favour the Reserve Bank intervening more actively to reduce the volatility of the currency. The volatility has made it very hard for exporters to plan and to hedge," Labour's finance spokesman David Cunliffe said.

"We are not saying we should, or could, peg the currency. We are not going back to Muldoon days. What we are talking about is sporadic but more active tactical intervention to impose risk and cost on speculators and thereby dampen off the speculation."

It is part of a general move towards a more hands-on approach to economic management by Labour.

The issue is of more than theoretical interest right now, amid fears that currency and trade wars could derail the global recovery.

It is not difficult to imagine the following scenario:

The US Federal Reserve next month announces plans for quantitative easing that go beyond what the market is already anticipating and has baked into rates. The US dollar falls further than it already has.

China remains unmoved by calls for it to allow the yuan to appreciate faster against the US dollar and its effective or trade-weighted exchange rate falls too.

With the two conjoined twins at the centre of the world economy devaluing, everyone else's exchange rate goes up.

As countries' pain thresholds are exceeded they resort, one way or another, to weakening their own currencies. Soon people are jammed in the doorway marked "competitive devaluation".

In such a case what should New Zealand do?

To some it is a no-brainer. We would have to follow suit.

It would be no time to stand aside, all pure and disapproving. The Reserve Bank would have to sell as many New Zealand dollars as it took to bring the exchange rate down again.

But intervention is not costless.

All those extra dollars would not just evaporate. If that was all the bank did it would be classically inflationary: too much money chasing too few goods and services.

It would erode the benefit to exporters as they faced higher costs for their domestic inputs. Ultimately it is real exchange rates that matter.

In the context of a weak labour market they might be able to pass on some of the cost to their workers via lower real wages.

But when we are already staring down the barrel of a spike to around 5 per cent in the inflation rate arising from the increase in GST, the Reserve Bank would be likely to want to offset the inflationary impact of large-scale intervention by "sterilising" it.

The most likely way of doing that would be to mop up the extra liquidity by borrowing it back. The risk is that becomes self-defeating if it raises interest rates and attracts even greater capital inflows, pushing the dollar up again.

Whatever the effect on interest rates and the cost of capital, it would at the very least expand Government debt and increase the interest bill taxpayers face going forward.

So the costs would be some combination of higher prices, lower real incomes, higher interest rates and an additional claim on future tax revenues.

That is not to say there are no circumstances in which the benefits would outweigh the costs.

But it would have to be the lesser evil to something pretty evil.

Cunliffe says he cannot yet answer the question of what to do in a scenario like the one outlined above.

"It may be that after thorough consideration a government of the day might decide there is no intervention available to them which, risk-weighted, would improve the national interest and would answer the question with the status quo," he said.

"That's legitimate but it is not legitimate, going into these turbulent and uncharted waters, for the Government to assume the market will self-correct.

"It is not sufficient for the Government to assume that in this environment the markets working independently will meet our national interests."

The Reserve Bank's mandate to intervene in the foreign exchange market is intended to shave the peaks and troughs off the currency cycle. The New Zealand dollar has to be exceptionally and unjustifiably high or low.

It intervened to sell New Zealand dollars in mid-2007 and again early the following year. It sold some of its holdings of foreign currencies early last year and again early this year.

Its annual report for the year to June 2010 says that since 2007, when it began to hold foreign currency reserves that are unhedged (that is, not matched by liabilities in the same currencies) it has made gains of $544 million, of which $446 million has been realised.

However, that is relative to purchase costs and has to be offset by funding costs, because the foreign assets generally earn less interest than the New Zealand dollar denominated assets funding them. Over the last three years the funding costs were $278 million, so the net return has been $266 million.

And this arises from interventions measured in hundreds of millions of dollars a month, not billions.

Right now it would be tough to make the case that the kiwi dollar is exceptionally or unjustifiably high.

Compared with the vertiginous highs of mid-2007 it is still 6 per cent lower against the US dollar and 12.8 per cent lower on a trade-weighted basis.

Compared with a year ago it has appreciated 2.4 per cent against the US dollar but just 0.9 per cent on the trade-weighted index.

Compared with the Australian dollar, which has been buoyed by a dramatic lift in its terms of trade and a series of official cash rate increases by the Reserve Bank of Australia, it has fallen 5.3 per cent over the past year. This is helpful for manufacturers exporting across the Tasman, even as commodity exporters enjoy high prices.

ANZ's commodity price index last month was just 0.9 per cent off the all-time high it reached last May.

In New Zealand dollar terms it has fallen 3.4 per cent since May but it has only been higher in four months - all of them this year - in the 25-year history of the index.

It is 27 per cent higher than it was a year ago.