Putting the exchange rate fall in historical context

New Zealand’s exchange rate has fallen quite a way in the last few months. The fall was most dramatic from late April to the start of July, when the Reserve Bank’s TWI measure fell from just over 80 to just over 70, a fall of around 12 per cent. Using monthly average data the fall from April to July was almost as large as any three-month fall we’ve seen in the 30 years New Zealand’s exchange rate has been floating.

twi 3 month changes

But sharp as that fall has been, the total fall in the TWI so far still looks only moderate by the standards of past corrections in the New Zealand dollar. In this chart, I’ve gone back a bit further. The new Reserve Bank TWI data only go back to the start of 1984 at present, but using the BIS indices we can go back another 20 years, to give us just 50 years of data.

TWI largest falls

The first three adjustments were discretionary devaluations, two (1967 and 1975) in response to sharp falls in the terms of trade, and the last associated with the change of government in 1984. As I noted a couple of weeks ago, the fall in the exchange rate so far is similar in magnitude to the short-lived sharp fall in the first half of 2006, when a “growth pause” (still showing in the data as no real GDP growth from 2005Q2 to 2005Q4) sparked expectations of forthcoming cuts in the OCR.

Graeme Wheeler has been using the slightly odd terminology that the exchange rate “needs” to come down and I have already commented earlier on that.  He seems to have in mind some sense of an exchange rate which would stabilise the ratio of NIIP/GDP.  But it is not entirely clear why he thinks the exchange rate is likely to actually fall further. After all, he has been openly disagreeing with market commentators who think the OCR might need to fall to 2 per cent, suggesting that he doesn’t see that the need for the OCR to fall much further. Recall that the falls in the OCR he seems to be envisaging will be tiny when compared to previous policy rate cycles here and abroad. His story seems to envisage that perhaps last year’s OCR increases will be fully reversed, but no more –   but previous easing cycles have involved multiple hundreds of basis points moves.  And, on the Governor’s rather upbeat story, we might reasonably expect the negative NIIP position to widen, to act as the buffer for some of the loss of national income, over the next year or two.

niip to gdp

After all, in the last few years, the NIIP/GDP position has been less negative than it had been for most of the last 25 years (through some combination of the offshore insurance claims resulting from the earthquakes, not yet fully spent, and the high terms of trade). On his story why should we expect much more? If he is right about New Zealand’s monetary policy outlook, many in the market will be surprised and, if anything, the TWI might rise.

But I’m sceptical of the Governor’s story about the New Zealand economy and prospects for domestic monetary policy. When I filled in the Bank’s Survey of Expectations last week, I wrote down a prediction that implies an OCR below 2 per cent by this time next year, and I wondered afterwards if my number was low enough yet. I don’t think anything that weak is yet priced into the central market view. If so, most likely the TWI will move quite a bit lower yet.   Heightened periods of risk are also often bad for New Zealand’s exchange rate –  no one has to hold New Zealand dollar assets when times are risky –  and markets still seem remarkably relaxed about China and the euro-area as sources of economic and financial risk.

Finally, recall that the TWI fell to the lowest level in the last quarter century in 2000, the last (and only) time since liberalisation when US short-term interest rates matched those in New Zealand.  At the 2000 trough, the TWI was some 30 per cent lower than it is today.

The exchange rate “needs” to come down?

I’ve been continuing to reflect on Graeme Wheeler’s repeated observation that New Zealand’s exchange rate “needs” to come down. I’m still not entirely sure what he means. The exchange rate is an asset price and presumably should reflect all expected future relevant information, not just spot information about current dairy prices. And the market has no particular reason to focus on stabilising the net international investment position at around current levels. Indeed, although it is a convenient reference point, neither does the Reserve Bank.

“Need” or not, I’d have thought it was likely that the exchange rate would fall further.

The ANZ Commodity Price Index, which lags behind (for example) falling GDT and futures dairy prices, has already had one of the larger falls in the history of the series.

ANZ Commodity

Meanwhile, the fall in the exchange rate, while material, remains pretty small by the standards of past New Zealand adjustments since the float in 1985. At the moment, the adjustment is comparable to what we saw in the shortlived growth (and risk) scare in 2006.

And here are the BIS real exchange rates for the five OECD commodity exporting countries, and South Africa. Each has experienced rather different commodity price pressures and opportunities. Here the exchange rates are each based to 100 at the average for each country in the year to June 2008 just prior to the global recession and crisis.

bis exch rates

New Zealand’s exchange rate doesn’t stand out dramatically, but it remains higher, relative to pre-recession levels, than in these other countries. In part that is likely to reflect yield differentials. New Zealand is the only one of these six countries still to have policy interest rates higher than they were 18 months ago. That is Graeme Wheeler’s choice, and while data may eventually force him to change his view, it is his view that for now determines short-term interest rates on offer in New Zealand

Productivity growth worse than in Greece

In the interview with Richard Harman I noted that one of my main interests and (rather more importantly) one of the bigger challenges for New Zealand was its disappointing economic performance over the last 25 years.    The liberalisation of the economy in the 1980s and early 1990s was generally expected to have reversed the earlier decades of relative decline.  Not everyone shared that optimism, but among the advocates of reform within government and the public service, and among most international observers (for example, the IMF and OECD, and financial markets), that sort of re-convergence was generally expected.

But it didn’t happen.  For a while there was a “the cheque is in the mail” hypothesis doing the rounds –  it hadn’t happened yet, but it surely wasn’t far away.   But 25 years is a long time, and it just has not happened.  Around 1990, the former eastern-bloc countries started serious liberalisation.  Their economies had been much more heavily distorted than New Zealand’s (notwithstanding the Bob Jones crack in 1984 about the New Zealand economy resembling a Polish shipyard), but they have subsequently seen considerable convergence.

Here is my favourite summary chart of our underperformance over that period.  Using the Conference Board data, it is total growth in real GDP per hour worked for 42 advanced countries (OECD, EU, and Singapore and Taiwan) since 1990.  Only five countries had had slower growth over that period than New Zealand –  and two of them (Switzerland and the Netherlands) had had among the highest levels of labour productivity in any of these countries in 1990 (so one might have expected unspectacular growth subsequently).  No cross-country comparative measure is perfect, but I don’t this one is particularly unrepresentative of New Zealand’s relative performance  On this measure, Greece and Portugal have done less badly than us  (but recall that this is GDP per hour worked, and in the current Greek Depression total hours worked have dropped away precipitously).

GDPphw since 1990

I’ve been running a story about the role of immigration policy in explaining that failure to converge –  total GDP has grown a lot, even if GDP per hour worked hasn’t.  In this wider sample of countries, New Zealand has had among the faster rates of population growth, despite the huge outflow of New Zealanders (around 525,000)  over that period.   Singapore (86%) and Israel (77%) have had much faster rates of population growth than New Zealand (30%) over this period.

My argument has been that in a country with a low savings rate, rapid population growth has put considerable sustained upward pressure on real interest rates and the real exchange rate, squeezing the share of GDP devoted to business investment and preventing the emergence of new tradables sector firms/products at the rate that (a) convergence would have required, and (b) the rest of NZ’s microeconomic policy framework might have suggested/warranted.  A few weeks ago, I showed how our real exchange rate against Australia had failed to decline despite the deterioration in our relative economic performance over decades.

Here is another way of looking at the same point.  The two countries with the fastest growth in the chart above were Taiwan and Korea.  Singapore has also done impressively well.  In 1990, Taiwan and Korea were well behind New Zealand, and Singapore had about the same level of real GDP per hour worked as New Zealand  (precise comparisons depend on which set of relative prices are used, but on any measure all three countries have had growth outstripping that of New Zealand).

And here is the picture over 50 years, again using the Conference Board data
gdpphw asia
All three Asian countries have had some of the more dramatic catch-ups in productivity levels seen anywhere.  New Zealand, by contrast, in 1965 was among the advanced countries with the highest levels of labour productivity, and has been in relative decline since.

But what has happened to the countries’ real exchange rates since?  As ever, there is no unambiguous way to measure that, but the BIS have real exchange rate indexes for each of the four countries going back to the 1960s.  Of course, real exchange rates can move around a lot from year to year, so in this chart I’ve shown the percentage change in the real exchange rate from the average for 1966-70[1] to the average for the 10 years to May 2015.

bis rer asia

The countries that have had such dramatic productivity improvements have all recorded modest falls in their real exchange rates, and by contrast New Zealand has had an increase in its real exchange rate.  That is opposite of what one might initially have expected.  One might have expected a strong real appreciation in the Asian currencies (as has happened in Japan), as much higher incomes supported more and cheaper consumption in these countries.  Fewer resources now needed to be devoted to the tradables sectors in those countries.   And in New Zealand one might have expected the deteriorating productivity performance, and hence declining (relative) future consumption opportunities, to have been met by a declining real exchange rate. That would have increased the returns to productive investment in New Zealand –  helping to reverse the decline – and raised the relative price of consumption.

How does my story explain what went on?

In last 25 years, Korea and Taiwan have had materially slower population growth rates than New Zealand has, and much higher savings rates.  That meant both less pressure on resources simply to maintain the capital stock per person, and more domestic resources available to meet investment demand.  The net result: little upward pressure on real interest rates and the real exchange rate, despite the continuing productivity gains.

Singapore is at the extreme.  The national savings rate has averaged 46 per cent in Singapore over the last 25 years, roughly double the rate for advanced countries as a whole.  With so many resources available (earned but not consumed) even the investment needs of an average population growth rate of 2.5 per cent puts no pressure on domestic resources, or hence on real interest rates and the real exchange rate, despite the continuing productivity gains.

And that is my story in a nutshell: with very high saving rates your country might need lots more people to make the most of the savings.  But in a country with only a rather modest savings rate (for whatever reason) then having lots more people –  and especially bringing them in as a matter of policy – simply looks wrongheaded.  It undermines what policy is setting out to achieve.

It isn’t that migrants somehow “take away jobs”, but rather that rapid population growth (whether migrants or high birth rates) tends to divert resources (jobs) away from growing the bits of the economy that sell to the rest of world (a huge and diverse market, and probably where our future prosperity is to be found) to ensuring that the physical infrastructure (houses, roads, shops, factories, schools) keeps pace with the needs of the growing population. It makes it very hard to catch up with the richer countries.   Israel has found something much the same.

No comparison of any pairs of countries, in any particular period, is ever going to be conclusive.  I use the examples in this post simply to illustrate the story.

[1] Starting the comparison from the start of the BIS series in 1964 would result in an even larger fall for Korea

China: the composition of the RB TWI really doesn’t matter for monetary policy

The BNZ’s Raiko Shareef has a research note out looking at the impact of including the Chinese yuan in the Reserve Bank’s trade-weighted index measure of the exchange rate. He argues that the inclusion of the CNY will increase the sensitivity of New Zealand’s monetary policy to developments in China.

I think he is incorrect about that. China has, of course, become a much more important share of the world economy in the last couple of decades. It has also become a much more important trading partner for New Zealand. Both of those developments, but particularly the former, mean that economic developments in China, including changes in the value of China’s currency, have more important implications for New Zealand, and other countries, than they would have done earlier. The Reserve Bank recognised the importance of the rise of China in setting monetary policy, and assessing developments in the exchange rate. But the Bank was quite slow to include the CNY in the official TWI measure. There was a variety of reasons for that, some more persuasive than others. But as far back as 2007 the Bank started publishing supplementary indices that included the CNY. If the Reserve Bank had used the old TWI in some mechanical way, then perhaps it would have been misled, and perhaps there would have been policy implications from the change in weighting schemes, But not even in the brief bad old days of the Monetary Conditions Index was the TWI used mechanically for more than a few weeks at a time. Every forecast round, the Bank comes back and goes through all the data, not just a reduced-form equation feeding off a particular TWI.

In the new TWI, the CNY has the second largest weight (20 per cent), just behind that on the Australian dollar.(22 per cent). But for the time being, that is likely to be high tide mark for the weight on China’s currency. Here is what has happened to goods trade – imports from China have kept on rising, but export values have plummeted (mostly on the fall in dairy prices).

A bigger question is one about what the appropriate weight on the CNY (and other currencies) is. I’ve argued that the CNY is important to New Zealand not because in a particular year we happen to sell lots of milk powder there, rather than in some other market, but because China is a large chunk of the world economy.  If we had no direct trade with China, it would still matter quite a bit.  In that sense, I reckon the new TWI understates the economic importance of the USD and the EUR, and overstates the importance of the AUD. We trade a lot with Australia, but Australia has very little impact on the overall external trading conditions our tradables sector producers face.

There are no easy answers to these issues. In a sense, that was why the Bank settled last year on a simple trade-weighted index. It wasn’t necessarily “right”, it wasn’t what everyone else did, but it was easy to compile and easy for outside users to comprehend. And without spending a huge amount of resources, on what was (probably appropriately) not a strategic priority, it wasn’t clear that any more sophisticated index would provide a better steer on the overall competitiveness of the New Zealand economy.

An issue of the Bulletin, written by Daan Steenkamp, covered some of this ground last December.

As already discussed, the new TWI has appreciated much less than the old TWI over the past decade or so. It is natural to ask whether the difference has, or should, affect how the Reserve Bank interprets or assesses the exchange rate. For example, are recent judgements about the ‘unsustainability’ of the exchange rate around recent levels affected? The exchange rate, however measured, is never considered in isolation from everything else that is going on in the economy. The Reserve Bank has, for example, recognised the rising importance of Asia in New Zealand’s trade and has taken that into account in its analysis and forecasting over the past decade or more. Exporters and importers deal with individual bilateral exchange rates, not summary indices. And New Zealand’s longstanding economic imbalances have built up with the actual bilateral exchange rates that firms and households have faced over time. How those individual bilateral exchange rates are weighted into a summary index therefore does not materially alter the Reserve Bank’s assessments around competitiveness and sustainability. Applying the macro-balance model (Steenkamp and Graham 2012) or the indicator model of the exchange rate (McDonald 2012) to the new TWI there are inevitably some changes, but the conclusions of those models, about how much of the exchange rate fluctuations are warranted or explainable over the past decade or so, are not materially altered.

There is no single ideal measure of an effective exchange rate index. Different TWI measures are useful for different purposes. In trying to understand changes in competitiveness it is likely to be prudent to keep an eye on them all. Developments in specific bilateral exchange rates will also have different relationships with economic variables and will be useful for different types of analysis. The focus of the Reserve Bank’s approach is on assessing the impact of the exchange rate on the competitiveness of New Zealand’s international trade, and the implications for future inflation pressures. Developing a full indicator of competitiveness, that reflected the specific nature of New Zealand’s international trade, and in particular the importance of commodity markets would require a very substantial research programme. It is difficult to be confident that the results would offer a materially better summary exchange rate measure than the simpler approaches the Reserve Bank has customarily adopted.

Of course, if China continues to grow in significance in the world economy, and if its currency becomes more convertible and is floated, it will become increasingly important to New Zealand. At the moment, the risks around China look somewhat the other way round – the influence of China may be more about the nasty aftermath of one of the biggest, least-disciplined credit booms in history. Growth looks to have fallen away much more than many (including the Reserve Bank) seem to have yet recognised.  But whatever the correct China story, the influence on New Zealand has little or nothing to do with how the Reserve Bank’s trade-weighted index is constructed.