Kiwi sets off on the rollercoaster

Richard Prebble still has a letter from his student days signed by the Governor of the Reserve Bank and by the Finance Minister agreeing to let him have the princely sum of $100 to go on a trip to Australia.

It is a curiosity from another age, the days of strict foreign exchange controls and a fixed exchange rate.

As Roderick Deane, Deputy Governor of the Reserve Bank when the dollar floated 20 years ago, recalled: "Travellers were allowed so much per day. Business travellers were allowed more than tourists but many business people found it wasn't enough and they would have to apply to the Reserve Bank for more."

Exporters were compelled to return their foreign exchange receipts to New Zealand.

Importers needed import licences, faced high tariffs and also needed an exchange control permit from the Reserve Bank to buy the foreign currency to pay for the imports.

Despite such measures the country still ran big balance of payments deficits and there were periodic painful devaluations of the currency in a vain bid to restore some sort of equilibrium.

The bank, on instructions from the Minster of Finance, set the exchange rate. It was a guaranteed buyer or seller of the New Zealand dollar at known prices.

A variety of fixed exchange rate regimes were tried: pegging the New Zealand first to the pound sterling, then to the United States dollar and later a basket of currencies.

Between 1979 and 1982 there was a "crawling peg" under which the exchange rate was adjusted almost month by month to offset the extent to which inflation in New Zealand was running ahead of our trading partners' inflation.

That system was aimed at protecting the competitveness of exports, says Murray Sherwin, who ran the bank's foreign exchange operations at the time of the float and now heads the Ministry of Agriculture. "But in fact what it was doing was indexing inflation into the system, so that wasn't sustainable either."

The problem with having officials rather than the market set the exchange rate was that it was subject to attack by speculators.

If market participants believed the official rate was too high to be sustained they could pull money out of the country in the expectation of being able to buy back in at lower rates. Indeed once a run began they would be foolish not to.

Just such a run on the dollar occurred in July 1984 when Robert Muldoon's National Party administration was swept away in a Labour landslide.

"The Reserve Bank had spent quite a lot of money under Mr Muldoon propping up the kiwi dollar. When the 20 per cent devaluation came it was assessed afterwards that it had cost the bank, and therefore the Government, about $750 million," recalled Grant Spencer, now Assistant Governor at the bank.

For Prebble, Associate Finance Minister in the new Labour Government, that episode reinforced his conviction that it was imperative to float the dollar.

"I enormously resented taxing people in order to give money to speculators," he said. "And I could see when the Reserve Bank and Treasury were debating whether we should devalue by 5 per cent or 10 or 15 or 20 or 25, that they didn't know."

The float was not just a matter of transferring risk from the public sector to the private sector.

It was also part of the larger task of stabilising the economy by bringing inflation and the Government accounts under control.

Economists were increasingly convinced that you could not simultaneously control interest rates, exchange rates and inflation. Two of them maybe; but not all three.

"By letting the dollar float we were able to remove the current account [of the balance of payments] as an objective in its own right and concentrate on getting inflation down," Deane said.

Prebble was also an advocate of an independent central bank, targeting inflation, and saw the float as making that goal easier. "My view is that workers never catch up on inflation. But that was not a popular argument within the Labour Party."

In the months before the float, maintaining a fixed exchange rate was frustrating the bank's attempts to get a grip on inflation through high interest rates.

On the one hand the bank was throttling back the money supply to combat inflation but at the same time it was inflating the money supply every time it had to buy US dollars and issue New Zealand dollars in exchange.

And it knew that that inflow of money could turn around at any time. Before long it did.

On February 26, 1985 Reserve Bank Governor Spencer Russell and Treasury Secretary Bernie Galvin reported to the economic ministers that another substantial run on the dollar was beginning.

By then the preliminary changes necessary to float the dollar were in place.

Exchange controls had been abolished just before Christmas and banks had been deregulated. Market expectations that a float was imminent were rife.

But Prime Minister David Lange was in Britain for the Oxford Union debate on nuclear policy.

Finance Minister Roger Douglas dispatched Deane to London and told him not to come back until he had persuaded Lange to back the float.

"He was just masterly," Deane recalled. "The rapidity with which he got a grip on all the economics was amazing and he said he had half-expected we would make this overture to him months before. So he supported it and got on to the phone to persuade and reassure the other ministers."

Three days later the dollar floated.

To the dismay of those banks which had bet that it would fall, it rose. They suffered serious losses and a salutary lesson was learned: the rules of the game really had changed.

The third argument for a floating dollar is that it is able to act as a buffer or shock absorber, acting to spread the impact of certain economic blows over the whole economy.

An example of such a shock would be the Asian crisis of 1997 and the steep fall in global commodity prices that followed.

The decline in the kiwi dollar over the same period mitigated the loss of income to exporters and spread some of the pain to consumers of imported goods and travellers heading overseas, who found the international purchasing power of their kiwi dollars reduced.

The tendency of the kiwi to rise and fall in line with world commodity prices also means that at least part of the export sector is insulated against the current high level of the currency by record high prices in commodity markets.

The dollar has been above US70c for the past three months.

"Previously such levels would have signalled problems for the economy by materially denting growth prospects for the external sector," the ANZ's chief economist, John McDermott, said.

However, with commodity prices sitting at about 15 per cent above their previous peaks, that had raised the threshold at which the currency becomes a problem.

It has pushed the "pain threshold" up to around US75c, a level the currency could reach by the middle of the year, said McDermott.

Since the float the real exchange rate has swung around in a range of around 20 per cent above and below its average level.

In an economy as small and open and therefore as exposed to the exchange rate as ours, that can feel like a rollercoaster ride.

But it is not an unusually wide range by international standards. The Australian and US dollars have swung around as much and the Japanese yen - despite episodes of massive intervention in the foreign exchange market by the Bank of Japan - by even more.

In the first three years of the new regime the dollar climbed as steeply as it has over the past three years, but the economy was far less able to handle it.

Farmers already grappling with the removal of their subsidies and sky-high interest rates, stopped spending. The export sector as a whole was hammered.

It would have been better, argues economist Brian Easton, to have run a managed float, intervening before the exchange rate rose to levels which destroyed the profitability of the tradeable sector.

But Deane has no regrets.

"Some people might argue that the New Zealand dollar is over-reacting at the moment to the weakness of the US dollar and that that is painful to exporters, particularly as the current account deficit is quite large," he said.

"But we have been floating for 20 years so everyone has experience in handling this sort of volatility.

"In my view it is much better for business to have to handle it than the poor old taxpayer to have to bear the burden, which is what used to happen."