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Special Topic: A closer look at the competitiveness of the New Zealand economy

In June 2011’s MEI we published a special topic on the exchange rate. This focused on the drivers of the nominal exchange rate and how movements in the dollar impact on the economy.[1] One perspective frequently touched on with respect to the exchange rate is competitiveness. This gets us into the world of real exchange rates and is the focus of this special topic.

A country’s real exchange rate incorporates two components to give a wider sense of a country’s competitiveness:

  1. Nominal exchange rates unsurprisingly are a key element. Exchange rates are a relative price – the value of one currency expressed in terms of another currency.  The value of a currency can change either because it has changed or the value of the currency in which it is measured has changed.
  2.  Relative rates of inflation make the adjustment from the nominal exchange rate to the real exchange rate. The inflation rates can be either consumer price inflation as a proxy for inflation in the economy as a whole or some measure of inflation related more closely to the productive sector (or a part of it) in the economy. Unit labour costs are often used as a measure of competitiveness in the productive sector of an economy; unit labour costs (ULC) are the cost of producing one unit of output in either the entire economy or a specific sector, and are measured as wage growth adjusted for productivity increases. If unit labour costs in an economy are growing faster than in its competitor economies, all else equal, that economy is losing competitiveness relative to its peers. Such a loss of competitiveness could be the result of high wage growth and/or low productivity growth.
When assessing a country’s competitiveness it’s important to consider whom it is that you are measuring it against. Bilateral exchange rates can only show you so much. It is therefore common to think in terms of effective exchange rates – simply weighted averages of bilateral exchange rates in relation to a ‘basket’ of other countries. These help to look through sometimes volatile bilateral exchange rate movements to give a broad view of a currency’s strength. The Reserve Bank’s trade-weighted index (TWI) is a well-known example of an effective exchange rate.

Another thing to consider when assessing a country’s competitiveness is what part of the economy it is that you are looking at. Common measures frequently centre on the manufacturing sector, as a proxy for the total economy, reflecting the fact that this sector is usually the most involved with trade.

Figure 9 shows the IMF’s estimates for New Zealand’s effective exchange rate on both a nominal and a real basis from 2000 onwards. Both effective indices are measured relative to a group of 26 advanced countries.[2] The real effective exchange rate (REER) is calculated according to unit labour costs in the manufacturing sector only.

Figure 9 – New Zealand Effective Exchange Rates (Q1 2000=100)
Figure 9 – New Zealand  Effective Exchange Rates (Q1 2000=100).
Sources:  The Treasury

Interpreting the data

So far, so good. But what should we make of the data and, in particular, the divergence between the nominal and real effective exchange rates that has opened up since the early 2000s?

Starting with the nominal effective exchange rate (NEER), the chart shows that this is at least part of the story behind New Zealand’s loss of competitiveness. The nominal exchange rate has rebounded sharply since falling in early-2009 and is currently around 10% higher than its long-run average. However, it’s difficult to interpret much from the nominal exchange rate alone. To the extent that the strong nominal exchange rate reflects fundamental factors such as high commodity prices for NZ exports, it is difficult to ‘apportion blame’ as it were. Indeed, if you thought that the strength of the NEER was underpinned by a structural shift in the fundamental factors underlying the exchange rate, you may think that the current exchange rate is justified and reflects a new reality. Treasury is conducting research into the level of the exchange rate, building on the earlier working papers referenced above, which will touch on the concept of exchange rate overvaluation.

However, the wedge that has opened up between the NEER and the REER since the early 2000s gives another sense of New Zealand’s loss of competitiveness (at least in the manufacturing sector). This wedge captures the extent that the cost of producing a unit of manufacturing output in New Zealand (the unit labour cost) has risen relative to a basket of 26 advanced countries over the past decade. It follows that while a nominal exchange rate depreciation may help to lower the real exchange rate and increase the economy’s competitiveness on the whole, to assess the final impact on competitiveness you have to consider second-round effects on wages as well. Indeed, if a nominal exchange rate depreciation feeds through into even higher wages and ULCs in the economy (or in a specific industry), the initial boost to competitiveness may be offset.

Admittedly, by focussing solely on just one part of the New Zealand economy, this analysis paints only a partial picture of the economy’s competitive position. The notion of competitiveness is more complicated than can be conveyed on a chart and should recognise the composition of a country’s output and exports. Certainly, the manufacturing sector represents just a small part of total output in New Zealand.

However, this analysis highlights how improving competitiveness and productivity in the New Zealand economy requires an economy-wide perspective and wide ranging reforms. Treasury will be doing more work on this subject over the coming months.

 

[1] See Treasury WP 10/10, New Zealand's Exchange Rate Cycles: Evidence and Drivers; and Treasury WP 11/01, New Zealand's Exchange Rate Cycles: Impacts and Policy

[2] These countries are: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Australia, Canada, Denmark, Hong Kong SAR, Israel, Japan, Korea, New Zealand, Norway, Singapore, Sweden, Switzerland, United Kingdom, and United States.

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