Please fasten your seatbelts

George W. Bush

Some economic commentators believe the Reserve Bank and private sector economists may be far too complacent about the prospects of a gentle easing back from New Zealand's extended economic expansion.

"Given the volatility of the New Zealand cycle, we would watch for indications that the extraordinary recent domestic strength is fading rapidly," said Jim O'Neill, head of global economic research at the influential investment bank Goldman Sachs.

"Without a weaker currency, a soft landing will be hard to pull off."

In the 2000s the economy has been basking in one of the most sustained and powerful periods of economic growth since World War II.

The kiwi has risen on a combination of US dollar weakness - based on concern about the US Budget and trade deficits - and kiwi strength - based on the highest interest rates in the developed world and the strong local economy.

The currency recently hit a 16-year high of 72USc, just short of its post-float high of 72.75USc touched in June 1988.

Previously when the kiwi has scaled these heights, exporters have screamed. This time they have been insulated by commodity prices at their highest levels in 30 years.

The kiwi has been strongest against the US dollar but it is not far from historic highs against the euro, is at a seven-year high against sterling, is close to a six-year high against the yen and is still considered over-valued against the Australian dollar at over 90Ac.

There seems a strong chance the kiwi will head higher, at least against the greenback, in the short term.

At the Apec summit in Santiago, US President George W. Bush stated support for a strong US dollar. But you have to wonder if this is a strong-dollar policy, what would a weak one look like?

The kiwi has nearly doubled in value against the greenback in four years while the euro has climbed 57 per cent.

O'Neill said the US Treasury's support for its strong-dollar policy could only be characterised as "benign neglect".

"The Bush Administration is interested in a weaker dollar, but they cannot say as much because this would likely trigger a much feared disorderly depreciation," he said.

The hands-off approach of key policymakers at the Group of 20 meeting in Berlin encouraged markets to sell the dollar lower.

There is widespread concern about the US deficits. Princeton economics professor Paul Krugman recently argued Bush's policies had set the US on a dangerous course that will likely end in crisis.

"This is a group of people who don't believe that any of the rules really apply," said Krugman. "They are utterly irresponsible."

Stephen Roach, chief economist at investment giant Morgan Stanley, was reported last week as privately telling selected clients that America has no better than a 10 per cent chance of avoiding economic "Armageddon".

Roach sees a 30 per cent chance of a slump soon and a 60 per cent chance "we'll muddle through for a while and delay the eventual Armageddon".

He notes that the US needs US$2.6 billion ($3.6 billion) a day to fund its current account deficit - equivalent to 80 per cent of the world's net savings. If his bearish scenario plays out, maybe the 1970s nirvana of a kiwi dollar worth more than a buck might rerun.

A slump in the US certainly won't help New Zealand. And while most Kiwi companies have been reporting higher profits, it is clear many exporters are already feeling pain.

Fishing company Sanford essentially lost money in the year to September despite reporting a $53.8 million profit and experiencing buoyant prices for squid, tuna and orange roughy. Its foreign exchange hedging gains amounted to $55.2 million.

Based on an exchange rate of 67USc, hedging gains will return Sanford $40.8 million next year.

But by the end of September 2005, Sanford will basically have run out of hedging contracts as none have been taken since the kiwi rose above 60USc.

Bancorp Treasury Services director Earl White says the widespread expiry of hedging contracts makes him agree with Goldman Sach's view that the New Zealand economy could be in for a hard landing.

"The bell rings sooner or later because you can't hedge forever."

He says half of Bancorp's 150 clients are exporters and most of those are experiencing grief from the currency.

What he fears is the currency will overshoot, as tends to happen during long-term trends, and that could coincide with a sharp fall in commodity prices. The commodity boom has been fuelled by China's economic boom but that could quickly evaporate if Roach's ugly scenario is anywhere near the mark.

Exporters in New Zealand, when the hedging runs out from the middle of 2005, will be bringing receipts back at prices north of 65USc compared with the 50USc to low 60USc in calendar 2004, said White.

"We need continuing increases in commodity prices to just stand still.

"There's this toxic mix out there - if the currency is close to record highs, commodity prices are close to record highs, especially dairy and meat. The risk is that [if] those come back on a weaker world outlook, and the currency doesn't come down, then there could be some problems out there."

He agrees it is not as serious as in 1996 when the kiwi dollar climbed on its own. This time, the euro, yen, Australian dollar and some South America currencies have also climbed and business models have adjusted as well.

This time last cycle, there was already serious stress in the tradeable sector. The Reserve Bank was slow to react and consequently had to ease heavily to get things back on track.

"They had to engineer a massive undervaluation of the kiwi to rebuild and that's why we went down to 39USc," said White.

He rates the chances of the Reserve Bank exercising its new powers of intervention in the forex market as negligible as it knows it could not turn the market around.

"At the moment they would be standing in the way of a freight train because it is not a New Zealand dollar story."

The Bank of Japan last year spent US$340 billion to try to prop up the US dollar, and the yen has been lower than when the intervention started. The Reserve Bank has less than $10 billion to play with and it is unlikely to spend that on a sure loser.

"If they are that concerned about the value of the New Zealand dollar, there is a very easy solution - cut interest rates," said White.

"A nice scenario would be to surprisingly ease in December and sell a bit of kiwi as well - that would get things going."

But White rates the chances of a courageous decision on December 9 by the economist-dominated bank as "a snowball's chance in hell".

However, he did take heart from an apparent slip of the tongue by governor Alan Bollard recently. Asked at a book launch what his concerns were about the currency, Bollard said: "You'll see that reflected through in whatever decision we come to on our next monetary policy statement."

Goldman Sach's O'Neill, who predicts the kiwi will dive to 66USc within a year, would not be surprised at a rate cut early next year following a "relatively sharp" adjustment in the domestic economy.

"We think the risk is that the switch to easing could occur sooner than expected as domestic adjustment begins to unfold."

White said the Reserved Bank had "got some pretty good potential to ease if required".

- NZPA

* Fran O'Sullivan is away.