With Janet Yellen increasing the US Fed Rates to 1 – 1.25% and Graeme Wheeler keeping the OCR at 1.75% it is anticipated that the US Fed Rate will eventually become higher than the OCR. What impact might this have on the New Zealand dollar?
With higher rates (or expected higher rates) in the US money flows will be attracted into the US with higher interest rate returns. This is referred to as ‘Hot Money’ and for international investors there are significant amounts of money to be made.
A higher interest rate in the US would mean a higher return from saving in a US bank. Therefore, New Zealand investors may sell NZ dollars and buy US dollars so that they can gain more interest from their savings. This increased demand for US dollars will push up the value of the US dollar against the NZ dollar.
However it is not just interest rates that influence Hot Money. In 2011the Swiss Franc appreciated on the back off the turmoil in the Eurozone as investors saw the currency as a safe haven. The NZ dollar and the AUS dollar appreciated for similar reasons post the Global Financial Crisis.
Problems of hot money flows
Hot money flows can be destabilising. A rapid rise in the currency can harm a countries with exports become more expensive and imports becoming cheaper. However the latter might be favorable depending on the import content.
Hot money flows can create excess liquidity fuelling a future asset boom and creating more long-term problems.
The aim in many developed countries is to stimulate economic growth and to raise inflation within the target bands as stipulated by many government’s central banks. For some countries the immediate objective has been to prevent their currency from rising making their exports more expensive and imports cheaper. Therefore the thought of negative interest rates discourages investors from buying your currency which would push up its value. The EU, Denmark, Sweden, Switzerland and Japan, central banks have decided to have a negative rate on commercial banks’ excess funds held on deposit at the central bank. In effect, private sector banks have to pay to park their money – see graph below.
New Zealand is currently in a bit of a predicament in that the OCR (central bank rate) is at 2.25% which is relatively high compared to other central banks and therefore does attract ‘hot money’ into the economy – money that ‘parks’ to earn interest. However if they drop interest rates to ease the pressure on the NZ$ they run the risk of further inflating the housing market by making borrowing cheaper.
For the consumer as soon as the rate banks offer fall below 0%, savers have an incentive to withdraw their money and put it under the mattress. By charging negative rates the central banks are hoping that the trading banks will keep more of their money and therefore lend it out to investors. However the desire to reduce a banks reserves is futile as if someone borrows money from a bank and buy a new car the money is paid to the car company who will then deposit the money in their account which increases the reserves of the bank.
Overall negative rate reflect the constant state of weak aggregate demand in many developed economies since the 2008 financial crisis. Central banks have kept their policy interest rates very low to stimulate economic growth and more recently to get higher inflation. However, how low can they go?
Below is a very good cartoon from the FT looking at negative interest rates.
The recent job summit called by Engineering, Printing and Manufacturing Union (EPMU) focused on the strength of the NZ dollar and the impact it is having on manufacturing jobs in the New Zealand economy. This has been area that the opposition parties have targeted especially the Greens. Although a weaker dollar would make exports more competitive there are concerns about the mechanism used to achieve. Certain procedures to reduce the value of a currency have been well documented. They are as follows:
1. Quantitive Easing – printing money.
You need to look no further than the US economy to to see what has been the impact of 3 rounds of QE. Although the US dollar fell after QE1 in late 2008 a lot of could be said to have been caused by the collapse of Lehman Brothers and others around that time. QE2 in November 2010 correlated with the fall in the US dollar but again some have indicated that this was a result of the US economy being energised by the Federal Reserve and therefore it was safe to buy risky investments (US dollar seen as safe). You don’t have to look for another example where QE has had a limited impact – Japan since 2001. Here the Japanese authorities have found that QE has seen the Yen strengthen.
2. RBNZ enter the foreign exchange market and buy NZ dollars with currency reserves
This has been tried before with little success – equilibrium is restored at pre-intervention levels and the venture has proved very costly. Furthermore, there is the specter of inflation to contend with in years to come. The currency value has been more influenced by which stage of the business cycle the NZ economy is sitting at. In the 1990’s the Bank of Japan has spent billions of dollars trying to stop the appreciation of the Yen against the US dollar. The Swiss National Bank had to spend the equivalent to 70% of its GDP buying euros to cap the Swiss franc.
3. Drop the Reserve Bank’s Official Cash Rate (OCR)
When an economy’s interest rates are relatively high compared to other economies there is the incentive to park your currency where you get higher returns i.e. borrow from Japan at near 0% and investing in Australia at 5%. However lower interest rates doesn’t necessarily mean a lower exchange rate – the Reserve Bank of Australia has dropped rates from 4.75% to 3.25% over the last couple of years but the Aussie dollar hasn’t moved. This is most likely due to the mining boom.
4. Contractionary Fiscal Policy
As Don Brash (Former RBNZ Governor) stated in the NZ Herald, the best way of reducing the value of the NZ dollar would be for the government returning to a surplus by reducing government spending and increasing taxes. This would take money out of the circular flow and therefore reduce aggregate demand. With inflation nearing the bottom of the target range the RBNZ would be forced to reduce the OCR and ultimately the NZ dollar without the threat of inflation.
Getting the exchange rate down is a very complex task and it seems that the foreign exchange market doesn’t punish negative figures of economic indicators i.e. high inflation. I suppose a increase in the value of the NZ dollar is due to our desire to fund our spending from overseas borrowing.
There is no doubt that Turkey has grown considerably over the last decade – in 2011 the economy grew by 8.5%. However, like other countries, this growth does have its side effects when you delve deeper. The main concerns are as follows:
1. With this growth comes pressure on prices – inflation was 10.4% in March this year which is well above the target by the Central Bank
2. In order to create the demand in its economy Turkey has put a growing reliance on foreign capital and hot money which has not been generated in Turkey itself.
3. Furthermore the capital itself seems to be quite fickle and doesn’t lend itself to major industrial developments.
4. As with most growing economies the reliance on overseas goods becomes very pronounced. Turkey’s trade deficit in 2011 was 10% of GDP
As long as the global economy is bouyant there are significant funds (hot money) which find there way into emerging economies like Turkey. However, once the clouds appear on the horizon hot money tends to depart which forces the Turkish Lira down and domestic consumption to fall. Turkish interest rates (approx 6%) have attracted hot money but the real problem here is that there is a significant shortage of domestic saving. Furthermore businesses don’t want to grow in size as there are a myriad of regulations and therefore are less efficient than if they were larger and able to achieve economies of scale.
To be more stable over the next few years the Turkish economy needs to reduce its current account deficit (see graph below) and its reliance on capital inflows. Persistent deficits will mean serious problems when money flees the economy.
Brian Fallow wrote an interesting piece in the NZ Hearld this week. He outlined the different policy stances by both National and Labour with regard to exchange rate intervention.
*National still maintain that intervention is not a viable option to reduce the value of the NZ$. They cite the experience of the Bank of Japan in the 1990’s and their attempt to devalue its currency – the Yen went from 330 to 80 against the US$.
*Labour favour the RBNZ intervening more actively to reduce volatility of the currency as it becomes difficult for exporters to plan ahead.
The recent QE2 by the US Fed has caused the US$ to fall against all major currencies. This with the Chinese resisting moves to allow the Yuan to appreciate faster against the US$ leads to the appreciation of everyone else’s currency. If NZ embarks on a competitive devaluation to make exports more competitive, by the RBNZ selling NZ$ on markets, there will be costs:
1. The extra dollars would be inflationary
2. The weaker NZ$ would make imports more expensive which may impact on higher input costs
3. With a weak labour market firms may pass on some of cost to their workers via lower real wages.
4. With inflationoary pressure a tightening of monetary policy might be required – higher interest rates. This will attract capital inflows and increase the value of the US$.
5. This would increase Government debt which puts pressure on the taxpayer.
However it is hard to conclude that there would be no benefits from a weaker NZ$. In 2007 the RBNZ did intervene in the foreign exchange market and sold NZ$. At present it would be hard to make the case that the NZ$ is unusually high – it is still 6% lower aginst the US$ than it was in 2007.