A woefully weak tradables sector

The GDP numbers came out last week.   The media commentary, such as it was, seemed quite relaxed about the numbers (politicians’ attention was elsewhere) with a “not too bad” sense.  But here is a chart of the annual average percentage growth in real per capita GDP.

RGDP aapc

It has now been more than 18 months since the annual average growth rate was above 1 per cent.  That is the worst run of per capita GDP growth, outside recession periods, we’ve had in the three decades for which we have data.    It is the Labour/New Zealand First watch now, but the slowdown was well underway towards the end of the previous government’s term (0.8 per cent annual growth for the year to September 2017).

It has, it seems, been quite a few quarters since I last updated my chart showing an (indicative) split between the tradables and non-tradables sectors of the economy.  Here it is, in real per capita terms.

T and NT to Dec 18

Per capita growth in the tradables sector isn’t doing too badly at all (although even there, the growth rates are a bit lower than they were in the mid-90 to mid 00s period).   But what of the tradables sector indicator (recall that this is agriculture, forestry, fishing, mining, manufacturing, together with exports of services)?    The latest observation is 7 per cent lower than the peak, itself reached more than 14 years ago.     Growth in the GDP contribution of these sectors has been about 1 per cent, in total, in the 18 years from the end of 2000.

It is an astonishingly bad performance –  well, it would be “astonishing” if we hadn’t become so used to New Zealand’s underperformance, and ministers (in successive governments) hadn’t got so used to glossing over failure.  Successful economies –  and most especially small successful economies –  tend to succeed when firms that can take on the world markets and successfully compete find it profitable to develop, locate, expand and remain in the country in question.   That simply hasn’t been the New Zealand story (and consistent with that, our foreign trade shares of GDP –  exports and imports –  are little changed over almost 40 years; quite out of step with the experience of successful advanced and emerging economies).

More than a few economists don’t really like the way this chart combines components of the GDP production and expenditure measures, in ways that (while probably sound enough for illustrative purposes) aren’t quite kosher.   So here are components individually, again in real per capita terms.

components mar 19

In per capita terms, mining is smaller than it was in 1991 (despite that huge oil-related surge in 2007).  Agriculture etc and manufacturing are still a bit smaller than they were in 1997 –  and less than 10 per cent higher (in per capita terms) than they were in 1991.

Services exports were, once, a good story, recording very rapid growth –  in per capita terms – over the 1990s and until around 2002.  But that was then, almost a generation ago when our current Prime Minister had barely come of age.  The current level of services exports (per capita) is only about 4 per cent higher than it was in 2002.     And all that despite the export subsidies –  for that is what film industry grants and bundling immigration and work rights with study here really are.    Others might note that emissions from international air travel aren’t even captured in the commitments successive governments have made, let alone internalised.

Here is another way of looking at exports of services: in nominal terms as a share of GDP.

services X to dec 18

The current share (8.5 per cent of GDP) was first reached in 1995.

When the Minister of Finance, the Secretary to the Treasury (and even the Governor of the Reserve Bank) go on about a more “productive economy”, these are the sorts of underperformances they need to start openly engaging and grappling with.

That, in turn, might involve taking the real exchange rate more seriously

rel ULC RER

A 20 per cent plus sustained appreciation in the real exchange rate, unsupported by (say) independently-sourced acceleration in productivity growth, is rarely very positive for the economic health of a country’s tradables sector.  But none of our political parties seem interested.  A high exchange rate means consumption remains cheap, and domestic-focused firms (who now dominate most of the business bodies and lobby groups) do well.  But it simply isn’t a sustainable long-term foundation for New Zealanders’ material prosperity.    High real exchange rates are a good outcome when they stem from an economy with strong underlying productivity growth, catching up with the rest of the world. But our policymakers and advisers almost seem to act as if they think they can put the cart before the horse, as if having a high exchange rate is itself some mark of success.

Exchange rate: no rebalancing in view

It doesn’t seem long –  and, in fact, it isn’t long –  since people were squabbling over a bit of a fall in the exchange rate.  The National Party was blaming the Labour-led government, while the government seemed to be taking some credit for the fall and talking about a rebalancing of the economy that they claimed was underway.  To support their claims, they not infrequently invoked the support of the rather left-wing Governor of the Reserve Bank.

And now they’ve all gone quiet again as the exchange rate has rebounded again.  On the Reserve Bank’s TWI measure, the rebound has been about 6 per cent.   Even by the standards of this decade –  when the exchange rate has been reasonably stable –  it isn’t that big a move.

TWI 18

The level now is about the same as the level at the time the choice of the new goverment was decided in October 2018.  It poses new fresh inflationary threat (which seemed to be the National Party concern when it was falling) and no greater buffering, or signal of rebalancing, as the government and the Governor had liked to claim.

What of longer-term comparisons?  Here I like to use the OECD’s real relative unit labour cost measure –  partly because there is a long run of data.     Here is how the longer-term picture looks (the dot representing today’s estimated level).

TWI 18 2

On average, the real exchange rate has been high since around 2003 (with a sharp but shortlived dip in the 2008/09 recession).   Even the lows the Prime Minister and Governor liked to talk up had still been a bit above the 15-year average (the grey line); current levels even more so.

But I’ve also shown (yellow line) the average for the entire period since 1980.  The current level of the real exchange rate is about 18 per cent above that long-term average.

That would make sense, and be welcome, if – for example – the last 35+ years had been ones in which New Zealand had been chalking up a stellar productivity growth performance, if New Zealand firms had been successfully many more foreign markets lifting the foreign trade share of the New Zealand economy.  But, of course, that hasn’t been the story at all.   There were short periods when it sometimes looked as if these sorts of developments were actually happening, but they’ve never lasted, and none of those periods have been in the last 15 years (when the real exchange rate has consistently averaged high).  Instead, our productivity levels have drifted further behind those in other advanced economies –  including, notably, over the last five years when there has been little productivity growth at all –  and foreign trade shares of our economy have stagnated and then shrunk.  Indicators of the relative size of the tradables sector of our economy have also not been encouraging.

These aren’t developments that should leave anyone very comfortable.  In the shorter-term, there isn’t much obvious impetus for strong domestic growth –  commodity prices are easing, confidence is weak, population growth is ebbing –  and the risks to the global outlook seem to be mounting, and perhaps even crystallising.  Then again, if things go badly wrong in the short-term, the exchange rate can –  and probably will –  move quite quickly.

The bigger concern is that there is no sign of an economy rebalancing towards some better – higher productivity, more outward-oriented, tomorrow.  And the persistently high exchange rate, over decades, seems to have been reflecting deeply misguided policies that have helped produce the last few decades of disappointing economic performance, all combined with a depressing indifference from the leading figures in all our main political parties.  There is little chance of breaking out of the slow spiral of continued relative decline without a quite materially different approach.  Part of making that work would be likely to involve the real exchange rate revisiting –  settling –  the sorts of lows we experienced at times in the first 15 or so years after liberalisation.    Even back then, when senior figures talked of rebalancing, it was mostly wishful thinking –  since the lows were purely the results of short-term cyclical forces.  These days, such talk bears even less relation to reality –  and to the scale of the challege before us.  But perhaps it generates a favourable news story for a day or two.

Exchange rate moves: trivial in historical context

I saw a curious story the other day which reported the Minister of Finance and the National Party spokesperson on finance arguing over who was to blame (or who could take the credit) for the fall in the exchange rate that followed the Reserve Bank’s Monetary Policy Statement.  From one side there seemed to be talk of the fall being part of the much-vaunted (but little seen) economic transition –  the Prime Minister herself has claimed this –  and from the other talk of loss of confidence in the economy, combined with some inflation risks.

Mostly it seems to be a difference about almost nothing.  Here is one of the OECD measures of New Zealand’s real exchange rate, for which data are available back to 1970. Obviously, we don’t have Q3 data yet, but I’ve taken the fall in the nominal TWI measure of the exchange rate for this quarter to date (latest observation for the RB website today) and applied it to the Q2 data to proxy a current observation.

RER ULC aug 18

Over almost 50 years, there have been lots of ups and downs in the series, even in the period (up to early 1985) before the exchange rate was floating.  Some have been the start of something pretty sustained –  see the falls in the mid 70s, or after 1987.  Others have been very shortlived (see for example the fall in 1986 or 2006 –  times when, for example, markets got a bit ahead of themselves in thinking our economy was slowing and interest rates would be falling).     Over the full period (and this is quarterly average data, which takes out some of the noise anyway) there have been at least eight episodes when this real exchange rate index has fallen by at least 10 index points (roughly 10 per cent).  The last occasion was in 2015, as markets somewhat belatedly realised –  not quite as belatedly as the then Governor – that the Reserve Bank’s OCR increases weren’t going to be sustained.

This episiode isn’t one of them.  The latest (estimated) observation is a mere six per cent below the most recent peak (18 months ago).  And the latest observation is nowhere near the low reached in the second half of 2015.

In fact, the current level of the TWI is 2.4 per cent below the average level for the June quarter.   Over the entire life of the series (fixed and floating periods) the average quarterly change (up or down) has been 2.7 per cent.  Taking just the floating period (since March 1985), the average quarterly change has been 3.1 per cent per quarter, and if we take just this decade (which, eyeballing things, has been a bit more stable, at least as regards big sustained moves) the average quarterly change has been 2.4 per cent.

Perhaps the fall we’ve seen so far this quarter (or even since the MPS last week) will be the start of something more.   If there is a serious global risk-off event, or a serious New Zealand downturn, that probably would happen.  But all we’ve seen so far is a change that is about the size of the change one sees, on average, each and every quarter –  some up, some down, and most not implying anything very much for the economy.

The idea that the fall foreshadows some promised rebalancing in the economy is pretty laughable.  There have been no policy changes to bring about any such rebalancing (any more than there were with the other –  larger –  falls in the previous 20+ years).  Then again, so is the notion that a lower exchange rate –  a modest fall at that –  is a material inflation risk.    The Reserve Bank itself published research a few years back suggesting noting that, in fact, a lower exchange rate has tended to be associated with lower non-tradables inflation, and often –  notably when commodity prices are also fallling –  with lower overall inflation.

 

The real exchange rate mattered in 1985, and it still does

In Christchurch tomorrow evening, Anne Krueger is giving the 2018 Condliffe Lecture.

Krueger is an eminent figure in economics, now in her 80s.  She had a distinguished academic career, specialising mostly in trade and development issues, and she also spent time as first Chief Economist at the World Bank, and then later (until 2006) as first deputy managing director of the International Monetary Fund.   (My lasting impression of her, as an international bureaucrat, was the day she declaimed at a Board retreat about the challenges the IMF faced as a small organisation –  at the time staff numbers totalled about 3000.)

According to Canterbury University

In the University of Canterbury’s 2018 Condliffe Lecture, Anne Krueger will explore the topic: “Is it harder or easier to develop rapidly than it was a half century ago?” in her talk on development and economic growth.

She will argue, we are told

“In this lecture, I shall argue that while the future is never entirely foreseeable, there are a number of considerations that point to greater ease of development now than in the past. These include: the diminishing rate of increase in populations in most low income countries; the fact that much more is understood now (albeit still imperfectly) about development (and especially how not to achieve it); that global markets are much larger; and obtaining information of all kinds is much easier.”

There are also some technological advances that make development easier: mobile phones; continuing discoveries of improved technology in agriculture; advances in materials sciences; and so on.

I hope a copy of her text is made available.

I’m not sure how often Professor Krueger has been to New Zealand, but there is a record of a visit in 1985, when she was at the World Bank.  She delivered a lecture under Treasury’s Public Information Programme, under the heading Economic Liberalization Experiences – The Costs and Benefits (if anyone wants a copy, it appears to be held in the University of Auckland library, but isn’t online anywhere).

As she noted

As a newcomer to the New Zealand scene, it would be foolhardy of me to attempt any assessment of the policies implemented in support of the New Zealand quest for economic liberalization.  It may be useful, however, to discuss what liberalization more generally is usually about, and to attempt to draw on the experience of other countries for lessons and insights that may potentially be applicable –  by those of you more knowledgeable about the situation here than I – in evaluating the progress of liberalization in New Zealand.

It is a very substantial lecture (18 pages of text), drawing on the experiences in previous decades of a wide range of other countries grappling with twin challenges of stabilisation (inflation, fiscal etc) and liberalisation..   The small bit I wanted to highlight –  which saddened me when I first read it a few years ago, and still does, from a “what might have been” perspective –  was about the exchange rate.

Two important lessons emerge from the Southern Cone [of Latin America] experience: failure to maintain the real exchange rate during and after liberalisation is an almost sure-fire formula for major difficulties and the defeat of the effort.  The reason for this is that a liberalization effort aimed at opening up the economy must induce more international trade; it is not enough that there be more imports, there must be more exports.  Since the exchange rate is the most powerful policy instrument with which to provide incentives for exporters, its maintenance at realistic levels which provide an incentive to producers to export is crucial to success.

and a few pages later she returns to the theme

“In particular, the exchange rate regime must provide an adequate return to producers of tradable goods, particularly to exporters”

At the time, this would have resonated strongly with senior New Zealand officials.  One of the starkest memories of my first year at the Reserve Bank, fresh out of university, was being minute secretary to a meeting in late 1984 attended by the top tiers of the Reserve Bank and The Treasury.  It was a just a few months after the big devaluation that ushered in the reform programme: senior officials were explicitly united in emphasising how vital it was to “bed-in” the lower exchange rate, and ensure that the real exchange rate stayed low.

You can see that 1984 devaluation in this chart of the real exchange rate I ran a few weeks ago.

ULC jun 18

In fact, the gains from the devaluation were swallowed up very quickly by inflation.    When we finally got on top of inflation, the real exchange rate did average lower for some time –  and during those years the tradables sector of the economy (and export and import shares) were growing relatively strongly.  But for the last 15 years, the real exchange rate has averaged even higher than it was prior to the start of the liberalisation programme.  It hasn’t been taken higher by a stellar productivity performance.

It shouldn’t be any surprise that the export and import shares of GDP have fallen back, and that there has been no growth at all in per capita tradables sector GDP this century.    Successful sustained catch-up growth –  of the sort New Zealand desperately needs – doesn’t come about that way.

Perhaps some attendee might ask Professor Krueger for any reflections on her 1985 comments about the importance of the real exchange rate in light of New Zealand’s disappointing economic experience since then.  And linking back to the topic of her 2018 lecture, can we now catch-up fast, having failed so badly to do for the last 30+ years?  Fixing the badly misaligned real exchange rate, a symptom of imbalances but which is skewing incentives all over the economy, seems likely to be imperative.  New Zealand just isn’t that different: wasn’t then, isn’t now.

 

 

Some more real exchange rates

A couple of recent posts have highlighted the really significant sustained increase in New Zealand’s real exchange rate.  I illustrated that with this chart

ULC jun 18

which shows the OECD’s relative unit labour costs measure.

Measures such as this, working back from a nominal exchange rate index, tend to be quite cyclical (around whatever longer-term trends are underway).  But there is another approach to the real exchange rate, an internal measure that looks at developments in the prices of non-tradables relative to the prices of tradables.    A rise in the ratio of those two sets of prices suggests, all else equal, that the tradables sector of the economy is becoming relatively less competitive.

Unfortunately, good long-term series of tradables and non-tradables prices are pretty few and far between.  The official series in New Zealand only date back to 1999 (and the Reserve Bank doesn’t publish the earlier versions that we calculated ourselves using highly disaggregated SNZ data).    Here is the chart of that measure of the real exchange rate, and the same derived series for Australia.

internal RER 1

To look at that chart, one might suppose that non-tradables almost always increased in price faster than tradables (although even at the start of the series –  when both countries’ nominal exchange rates were very weak –  there are hints otherwise).

Fortunately, Australia has these data back to 1982.

internal RER 2

For the first 20 years of the series it was fairly flat –  the difference between tradables and non-tradables inflation rates was only around 0.5 per cent per annum.   Since around 2001, the annual difference has been more like 2.5 per cent per annum.   Such differences have come to be taken for granted, but it isn’t a normal state of affairs.

Another way of getting a fix on the internal real exchange rate was suggested a few years ago by former Victoria University academic Geoff Bertram, in his chapter on the modern economy for the New Oxford History of New Zealand.  His measures calculates the real exchange rate as the ratio of the GDP deflator (prices of all the stuff produced in New Zealand) relative to the average of export and import prices.   Stuff that is exported is captured in both the numerator and the denominator, but all the non-tradables are in the numerator only, so that this measure will rise (fall) when non-tradables prices rise faster (slower) than tradables prices.   For New Zealand there are estimates of all the relevant deflators back to 1914.   Here is the resulting chart.

internal RER 3

For 70 years, there was no trend in the series. On average, over that full period tradables prices and non-tradables prices seem to have increased by about the same amount.  The cycles were quite prolonged, but no trend was apparent.   And then everything changed, and the sort of appreciation we’ve seen on this measure over the last 30 years is unlike anything seen before.

What about Australia?  Here is the same chart, going back to 1900.

internal RER 4

Much the same sort of picture –  a flat trend for 80 years, and then a sharp sustained move upwards (although not quite as large a move as that for New Zealand).

(It isn’t a universal pattern: the official US data go back to 1929, and although there has been an increase late in the period, the current level is not even 10 per cent above the previous peak.)

To be honest, I’m not sure quite what is going on in New Zealand and Australia, although the numbers would be consistent with both countries having experienced very weak productivity growth in their non-tradables sector (thus economywide cost increases spill into prices).  In New Zealand, weak productivity growth translated into weak overall economic performance, while in Australia the windfall of huge newly-tapped mineral resources has kept their overall economic performance looking better.  It is, after all, a real income gain.

Export volume growth in the last 30 years as a whole has outstripped the growth in real GDP in both countries, but that margin has been far larger in Australia than in New Zealand.  In Australia, export volume growth over that period was almost twice as fast as real GDP growth.

I noted that even on those internal real exchange rate measures, the increase in New Zealand has been larger than in Australia.     The same thing shows up, much more starkly, with a simple calculation of a New Zealand/Australia real exchange rate, taking the nominal exchange rate and adjusting for inflation differentials.    This chart shows that measure going back to 1914.

rer nzd aud

Again, a reasonably flat trend for 70 years, and then the move up to the new much higher level from the late 1980s.   And this, even though our productivity growth has continued to drift further behind Australia’s.

And for those keen to fall back on terms of trade stories, they don’t help.  This chart shows the terms of trade for New Zealand and for Australia back to the early 20th century.

TOT aus and NZ jun 18

Over 100 years, the two countries’ terms of trade have done much the same thing, ending up almost in an almost identical place.

So Australia was able to bring to market huge new mineral resources, and managed much faster productivity growth than New Zealand, and yet New Zealand has had much the larger real exchange rate appreciation.

Beginning to make inroads on New Zealand’s dismal productivity performance seems almost certain to require getting to the bottom of what has given rise to such an appreciation –  on almost any measure one cares to look at, internal or external.

(Meanwhile our bureaucrats avoid the real issues, while looking busy.  Yesterday I stumbled on this on an MBIE website, touting a new panel of experts –  half academics, a third public service economists –  to help fix businesses.

It’s common for small businesses in New Zealand to be passionate about what they do, but pressed for time. So working “on” the business instead of “in” the business often stays at the bottom of a long to-do list.

Business owners and operators tell us they would love to improve their systems and processes to get better results, and to save time and money. But getting these up and running takes time they just can’t spare.

This lack of time to work “on” the business is one reason why New Zealand’s productivity is comparatively poor. This poor productivity is a problem, whether you want happier workers, bigger profits or a better work/life balance — or a combination of these goals.

To help Kiwi businesses find practical ways to improve their performance, we’ve brought together a panel of experts from New Zealand and around the world, and combined their insights with our own research with small businesses.

I suspect small business owners are often rather busy whichever country they are operating in (high productivity or low), that we are better off assuming that private sector people make the best of their opportunities, and that the answers to the question of why New Zealand now lags so badly behind lie rather more with the politicians and their public service advisers than with the private sector.  Skew the playing field, and it is hard to get a good game.  Perhaps –  as in areas of financial conduct –  the (self-proclaimed) physicians should “heal themselves” (fix things they are directly responsible for) rather than touting their alleged skills in fixing private businesses.  Apart from anything else, there are professionals running their own businesses offering advisory services, and they actually face a market test.)

 

 

 

Competitiveness indicators well out of line

In my post yesterday, buried well down amid long and fairly geeky material, I showed this chart.

wages and nomina GDP phw an unadj.png

Using official SNZ data, it suggests that over the last 15 years or so nominal wage rates in New Zealand have risen materially faster than the income-generating capacity of the New Zealand economy (nominal GDP per hour worked –  a measure that takes account of the terms of trade).   Since a big part of what New Zealand firms are selling when they try to compete internationally is (the fruits of) New Zealand labour, it probably shouldn’t be too surprising that our tradables sector producers have been struggling. As a reminder, we’ve had no growth in (a proxy measures of) real tradables sector GDP since around 2000 –  two whole governments ago.

The OECD publishes a real exchange series, all the way back to 1970, using real unit labour cost data.  Unit labour costs are, in effect, wages adjusted for productivity growth.  The real exchange rate measures compares how our economy has done on this competitiveness measure.

OECD real ULC

(There are other real exchange rate measures in which the fine details are less stark, but the picture is very similar.)

Broadly speaking, our real exchange rate was trending gradually downwards for the first 30 years of the series.  And each trough was a bit lower than the one before it.  That was, more or less, what one might have expected.  New Zealand’s productivity performance had been lousy relative to those of other OECD countries, and countries with weak relative productivity performance should expect to experience a depreciating real exchange rate.   On one telling, the weaker exchange rate helps offset the disadvantage of the lagging productivity.  On another, given that tradables prices are set internationally, a country with a weak productivity growth performance will tend to have weaker (than other countries) non-tradables inflation.    Another way of expressing the real exchange rate is the price of non-tradables relative to the (internationally set) price of tradables.

But over the last 15 years or so, we’ve seen something quite different.  The real exchange rate isn’t trending downwards any longer.   In fact, there has been a really sharp increase.   Competitiveness, on this measure, has been severely impaired.

It is not as if, after all, productivity growth has suddenly accelerated in New Zealand relative to other advanced countries.  We’ve done no better than hold our own against the median of the older advanced economies, and we’ve been achieving much less productivity growth than, say, the former communist eastern and central European OECD countries.     But on this measure, the real exchange rate recently has been 40 per cent above the average level in the 1990s, and even higher than it was in the early 1970s.

But aren’t the terms of trade extraordinarily high too?  Well, in fact, no.     They’ve increased quite a lot in the last 15 years or so, but here is a chart showing the terms of trade back to 1914 (using the long-term historical research series on the SNZ website and, since 1987, official SNZ data).

TOT back to 1914

Current levels aren’t much different from the average level for the quarter-century after World War Two.

On this OECD measure, the real exchange rate is higher than it was in the early 1970s (the previous peak in the terms of trade).  But since then, productivity growth (real GDP per hour worked) is estimated to have been far less than the median advanced economy experienced over that period.  In other words, the median OECD country (those 22 for which the OECD has data for the whole period) managed productivity growth  of around 150 per cent over 1970 to 2015 (the most recent year for which there is data for all countries) and New Zealand managed productivity growth of only 75 per cent.  It would take almost a 50 per cent increase in New Zealand’s productivity –  all other countries showing no growth –  to recover the relative position we had in 1970.

Competitiveness is a really major issue for the New Zealand economy.  It isn’t so much of an issue for the firms that operate here now –  they’ve survived and adapted.  It is more about the firms that never started-up, or which started up and couldn’t make it, or which started, flourished and found that they could prosper rather better abroad.   As trade shares (of GDP) shrink, in many respects this is a de-globalising economy.

Which made it rather odd to hear the (economist purporting to be the) “acting Governor” of the Reserve Bank declare that he, and the Bank, were comfortable with the level of the real exchange rate after the recent 5 per cent fall.  He declared that the exchange rate was now close to “sustainable, fair value”.    Taking a real economic perspective, it is anything but.

Such imbalances don’t have anything much to do with monetary policy, but they are symptoms of policy failures that need addressing urgently if we are to finally begin to turn around many decades –  stretching back even 20 years before 1970 –  of sustained economic underperformance.

 

Exchange rate volatility: the New Zealand story

When Winston Peters talks about the exchange rate two things tend to be emphasised: the average level of the exchange rate (too high –  relative to some benchmark presumably based something like on tradables sector performance or external indebtedness), and the volatility of the exchange rate (too volatile).

Not everyone would agree with him on the first point, but many would.  Graeme Wheeler, former Governor, certainly did, often highlighting structural concerns about the real exchange rate.   With slightly different emphases than Wheeler, I also agree, and have been highlighting for years how our real exchange rate has diverged markedly from the sort of path that differences in productivity growth between us and other advanced economies might have predicted.  But the other common ground between Wheeler and I would be that these imbalances aren’t ones monetary policy can do anything much to fix.

By contrast, I think pretty much everyone would accept that monetary policy choices and regimes make a difference to the volatility of the exchange rate.   New Zealand’s exchange rate –  against the currency of by far its largest trading partner, the UK –  changed only once in the first 30 years of the Reserve Bank’s history.   There was some variability in the real exchange rate –  adjusting for inflation differences –  but not much.

Countries make choices about their exchange rate regimes –  and thus about their monetary policy regimes.   Some choose to fix their exchange rate, some to float, some to form common currency areas, and some to manage a non-fixed exchange rate (eg Singapore).  Of course, choices about exchange rate regimes are influenced by real structural features: it might make a lot of sense to fix to a major trading partner if your two economies are very similar, but it probably wouldn’t if your two economies were regularly exposed to very different shocks, or if there was no dominant trading partner at all.  Exchange rate regimes may change trade patterns a little, but they won’t change the underlying structural differences in two economies.

And there is a difference between short-to-medium term perspectives and longer-term ones.  In the short-to-medium term, all else equal, floating exchange rate countries will tend to have more variable real exchange rates than other countries.  In the longer-term, real structural forces will out.  We had some pretty large adjustments in the last two decades of our fixed exchange rate era.   Often it was good that we did.  When the terms of trade fall (rise) sharply, a substantial drop (increase) in the exchange rate can be a useful part of how the economy adjusts to that change in fortunes.

As a simple illustration of differences in real exchange rate volatility, I took the first two countries on an OECD table (Australia and Austria) and showed their real exchange rate since the start of 1999 when the euro began.

aus and aus rers

The point isn’t that Australia had Austria’s options –  it didn’t (most of its trading partners weren’t simultaneously forming a common currency area) –  or even that it would have wanted that option (in the face of very big terms of trade swings), just that there are huge differences.

And what about New Zealand?  The Reserve Bank did a useful paper a few years ago looking at the volatility issue.   In that paper, they looked back as far as the 1960s.  That had the advantage of looking through specific choices about how the exchange rate is managed –  over that period, we’ve had almost all the types of exchange rate regimes known to man, other than a common currency.     The results suggested that the volatility of the New Zealand exchange rate had been relatively high –  less so for short to medium term horizons, but more so if one focuses on longer-term exchange rate cycles.

But since Winston Peters has been talking about the potential for monetary policy regime changes to affect exchange rate volaility, here I wanted to look at a couple of shorter periods.    The current monetary policy implementation system –  the OCR –  has only been in place since the start of 1999, and as late as 1996/97 we were still using exchange rate “comfort zones” to manage the very short-term variability in the TWI exchange rate.

And who to compare us to?    The BIS has monthly broad real exchange rate indexes dating back to the start of 1994 for 60+ advanced and emerging countries.  The OECD has a couple of quarterly real exchange rate series for its 35 member countries, with complete data for all countries since 1996.  Of course, many of these countries are part of the euro, and I’ve shown results below for both all the individual countries and excluding the individual euro-area countries and including just the euro area as a whole.

There are more sophisticated ways of looking at volatility, but here I’ve just used two measures: the standard deviation of each country’s exchange rate index, and the range (high to low) expressed as percentage of the average value of the respective country’s real exchange rate index.

Here is how we’ve done relative to other countries on the BIS index.  (I’ve shown both the full period of data since 1994 and also just the last 10 years –  in case something is materially different about the most recent decade, but bearing in mind that 10 years is typically only about one exchange rate cycle).

BIS real exchange rate
standard deviation high-low range as % of average
Since Jan 1994
NZ 10.5 46.5
Australia 12.3 54.5
Canada 9.4 40.3
Japan 17.9 54.3
Israel 8.3 32.3
USA 9.2 33.1
Median of all countries 10.4 42.2
Median excluding individual euro countries 11.9 52
Last 10 years
NZ 7.1 36.8
Australia 8.5 41.5
Canada 8.1 34.3
Japan 12 40.8
Israel 4.8 23.9
USA 7.1 23.7
Median of all countries 5.5 23.2
Median excluding individual euro countries 7 28.5

Overall?   Well, our experience looks a lot like that of the median country and a little less variable than Australia’s real exchange rate over this period.   Since I first noticed the phenomenon almost a decade ago now, I’ve also been struck by the fact that exchange rate variability in New Zealand has been less than that in Japan and quite similar to that in the United States.     Over just the last decade, the amplitude of the exchange rate cycle has been larger for New Zealand and Australia than for most of these countries, but that just reflects the fact that both exchange rates fell so far in the 2008/09 crisis/recession –  surely a welcome, buffering, development.  Officials certainly thought so at the time.

I didn’t show Singapore separately, but the variability of its exchange rate over this period was similar to that for the euro-area as a whole, but materially larger than that for most individual euro-area countries.

What about the OECD measure?

OECD real exchange rate (ULC)
standard deviation high-low range as % of average
Since Dec 1996
NZ 14.6 56.7
Australia 16.3 66.4
Canada 12.4 44.5
Japan 18.8 75.1
Israel 11.2 42.6
USA 12.0 36.7
Median of all countries 10.1 40.5
Median excluding individual euro countries 12.1 48.0
Last 10 years
NZ 8.4 33.8
Australia 10.4 41.8
Canada 7.3 23.9
Japan 12.6 48.0
Israel 6.9 26.7
USA 8.6 26.7
Median of all countries 6.8 23.5
Median excluding individual euro countries 7.6 31.7

Still less variable than the exchange rates of Australia or Japan.  And at least over the last decade, little to mark us out from the median of the floating exchange rate countries (ie the series excluding the individual euro-area countries).

This chart is just one index for just one period, but it helps illustrate a few points.

oced rer variability

Notably:

  • all the countries to the far left of the chart are in the euro (or pegged to it –  Denmark),
  • among the floating exchange rate countries, the variance of our real exchange rate hasn’t stood out over the last decade,
  • even being in the euro is no protection from considerable real exchange rate variability if the fundamentals of your economy aren’t closely aligned to those of the large country(or countries) you are pegged too –  see Ireland and Greece.

I wouldn’t want anyone to go away from this post with a sense that I’m indifferent to real exchange rate volatility.  I’m not.  The extent of the variability in many real exchange rates is something of a puzzle, even when dressed up in “the exchange rate is an asset price” language.  On the other hand, not all real exchange rate variability is a bad thing –  many of the biggest moves see the exchange rate acting as a helpful buffer.   Exchange rate variability may also be more of an issue in a small country, where firms probably have to take their products international at an earlier stage than might be the case in a larger country.

But, equally, New Zealand’s realistic options are quite limited.  We don’t have a single dominant trading partner, with whom our economic fundamentals are well-aligned.    And with structural demand pressures so different from most of the advanced world (ie interest rates that average persistently higher), attempting to solve the problems by simply choosing a big currency to peg to would, most likely, have been a recipe for an Irish mess.

The biggest constraints on growth in the New Zealand tradables sector are the relative scarcity of good opportunities in such a remote location, compounded by the persistently high level of the real exchange rate.  Considered against that backdrop, the volatility of the exchange rate –  real or nominal –  which isn’t that unusual by the standards of countries in our sort of position is likely to be (a) a second or third order issue, and (b) one where attempted fixes could easily leave us worse off than we are now.