Brian Gaynor: The Las Vegas of the currency world

Iconic New Zealand sports clothing brand Line 7's demise was partly due to the volatile dollar. Photo / Brett Phibbs

The collapse of Line 7, which was at least partly due to the volatile New Zealand dollar, has put our currency back in the spotlight again.

Why is the kiwi so volatile, why is it so difficult to forecast and should the Government try to control it?

Currency markets are characterised by a lack of transparency and poor disclosure, particularly when compared with sharemarkets where price and volume statistics are freely available.

There are no disclosure requirements regarding currencies and the New Zealand dollar can be traded in Beijing, Warsaw or Santiago or through any electronic system.

There is no comprehensive information on daily trading volumes.

However, every three years the Bank of International Settlements, a Swiss-based organisation that serves as a bank for central banks, undertakes a major study of foreign exchange activity.

The results of the latest study, which was undertaken in April 2007, are shown in the accompanying table along with data from the 2004 and 2001 surveys.

The first point to note is the massive increase in daily turnover from US$776 billion in 1992 to US$1174 billion in 2001 and a phenomenal US$3081 billion in 2007.

Daily activity on currency markets was nearly seven times greater than the average daily turnover on all of the world's sharemarkets during 2007.

The huge increase in foreign exchange turnover has coincided with the deregulation of financial markets, electronic trading, financial innovation, the rise of emerging countries and widespread globalisation.

Currency markets are made up of three components; spot transactions, forward contracts and swaps. Spot transactions represented 51 per cent of total transactions in 1992 but as forward and swap markets developed spot transactions declined to 35 per cent in 2004 and 33 per cent in 2007.

The New Zealand dollar has been the high flyer in terms of turnover growth and is now ranked 11th in the world compared with 13th in 2004 and 16th in 2001.

The Kiwi's share of global turnover increased from 0.6 per cent in 2001 to 1.0 per cent in 2004 and 1.9 per cent in 2007 (the percentages and individual currency totals in the table add up to 200 per cent of the final total because each transaction involves two currencies).

The NZ dollar's growth between 2001 and 2007 has surpassed the Russian rouble, which went from 0.4 per cent to 0.8 per cent of global turnover, the Indian rupee, from 0.2 per cent to 0.7 per cent, and the Chinese renminbi, from 0.0 per cent to 0.5 per cent.

According to the Bank of International Settlements, the Kiwi had a daily average turnover of US$59 billion in April 2007. This was $80 billion in NZ dollar terms at April 2007 exchange rates.

The US$59 billion comprised $17 billion or 30 per cent in spot transactions, US$7 billion or 11 per cent in forward contracts and US$35 billion or 59 per cent in swaps.

This US$59 billion daily turnover figure is amazing when compared with the following figures:

The total value of all shares traded on the NZX in the 2007 calendar year was US$24 billion or the equivalent of US$0.1 billion per day

The total value of all bonds traded through the NZX in 2007 was just US$1 billion

New Zealand had total imports and exports of US$59 billion in the twelve months ended May 2009. This indicates that the country's total annual trade related foreign exchange transactions could be undertaken in just 24 hours or, if undertaken in spot transactions only, could be completed in just over three days.

Daily currency activity to GDP ratios also illustrate the huge size of the Kiwi dollar market compared with the domestic economy.

The US dollar daily turnover to US GDP ratio in 2007 was 19 per cent and the currency/GDP ratio for the Yen was 12 per cent, UK pound 17 per cent, Swiss franc 49 per cent, Australian dollar 25 per cent, Hong Kong dollar 42 per cent and Kiwi 43 per cent.

The Swiss and Hong Kong ratios are high but they are both major financial centers whereas New Zealand is not.

Two other points are worth noting;

Only US$12 billion or 20 per cent of daily Kiwi turnover was transacted in New Zealand in 2007 compared with US$4 billion or 57 per cent in 2001

More than 90 per cent of NZ dollar trades are against the US dollar yet the Reserve Bank estimates that only 59 per cent of New Zealand's overseas trade is transacted in this currency.

These figures clearly indicate that the NZ dollar has great liquidity, is widely traded, overseas investors dominate trading activity and only a tiny percentage of the transactions are trade related. In other words the Kiwi is one of the world's most speculative currencies and is the Las Vegas or Reno of the currency world.

The NZ dollar is a highly traded and speculative currency because it is totally deregulated, it is volatile, our economy is perceived to be commodity based, the NZ Government and Reserve Bank are too small to undertake effective intervention and there isn't a large enough pool of local private capital to influence the market.

This makes the NZ dollar extremely difficult to forecast because it is primarily driven by speculation - rather than fundamentals - and many of these speculators are relatively uninformed about New Zealand.

A recent study by the Reserve Bank of New Zealand - "Exchange rates and export performance: evidence from micro-data" - revealed that small exporters are adversely impacted by volatile currency markets and only 60 per cent of firms were still exporting after one year.

The author believes that the use of long-term forward contracts could reduce the risks but these contracts can be expensive and may even increase risk.

Many small companies do not have the resources or expertise to acquire forward exchange contracts.

The following sentence in the report could easily apply to Line 7: "If a firm is already in a fragile economic position, unexpected variation in its export income may be the last straw."

The Reserve Bank study concluded that big firms are in a better position to deal with currency volatility than smaller ones.

Currency volatility stifles the growth of small companies and their ability to contribute to the country's foreign exchange earnings in the longer term.

There is little doubt that our speculative and volatile currency curtails long-term export growth, which is going to be extremely important in helping the country exit from the current recession.

But the Reserve Bank report didn't discuss the prospects of putting some kind of controls on the NZ dollar.

This is clearly not up for discussion even though a number of major exporters, including China and Hong Kong, have currency controls to assist their export sectors.

Currency controls are not an option for New Zealand because it would be impossible for our Government to set the right exchange rate level and then support this against potential attack from US and European hedge funds.

However, the collapse of Line 7, and the difficulties faced by the dairy sector, shows that the NZ dollar market offers great potential for international speculators while hindering the country's exporters.

Clearly, there should be far more high level discussion on the state of the NZ dollar market and any measures we can introduce to reduce its volatile and speculative characteristics while assisting our export sector.

Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.