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Special Topic 1: Medium-term exchange rate variability and its impacts

Once again, attention has turned to the currency as the New Zealand dollar achieved a post-float high against the US dollar in June 2011 (although the TWI is still 10% below its 2007 peak). The high New Zealand dollar is unlikely to be welcome news for New Zealand’s export or import-competing firms (the so-called tradable sector). In addition to the level of the New Zealand dollar, the medium-term fluctuations (over a multi-year horizon) in the exchange rate - known as exchange rate variability or medium-term cycles - are often cited as a key problem for the tradable sector.

Two recent Treasury Working Papers take a close look at New Zealand’s exchange rate variability; how high the variability has been compared to others; what drives it; the impact it has on our tradable sector; and potential policy options for dampening the variability.

The short-term volatility New Zealand’s currency experiences is very high, but similar to that experienced in Australia and Japan. This makes it important for firms to hedge against this shorter-term risk. Recent studies confirm that many firms do in fact hedge their currency exposures (Fabling and Grimes, 2008).

New Zealand’s tradable sector performance stagnated in 2005 and then declined

The ratio of tradable to non-tradable sector output in New Zealand has been declining for a number of years. This is broadly consistent with several other countries in the OECD, including Australia, Canada and the United Kingdom (Figure 6).

Figure 6 - Real tradable/non-tradable sector ratio
Figure 6 - Real tradable/non-tradable sector ratio.
Source:  Statistics New Zealand, the Treasury

The decline in New Zealand’s tradable/non-tradable output ratio is largely due to a decline in tradable sector output from 2005, with non-tradable output showing consistent growth.

New Zealand’s exchange rate has been highly variable, but not uniquely so

Data limitations mean that assessing the medium-term variability of the New Zealand dollar is challenging: New Zealand floated its dollar in 1985. Consequently, there are only a small number of cycles to analyse. Our analysis shows the New Zealand dollar is highly variable but that other relevant currencies, including the Australian dollar, Canadian dollar, South Korean won and the euro, also face a similarly fluctuating exchange rate over the medium-term (Figure 7).

Figure 7 - Medium-term exchange rate variability
Figure 7 - Medium-term exchange rate variability   .
Source:  Bank for International Settlements, the Treasury

We can identify several key drivers of exchange rate variability, but the relative importance varies over time

Ultimately, the exchange rate is a relative concept and movements in bilateral rates are influenced by both global and domestic factors. The importance of global risk aversion was particularly apparent in the wake of the global financial crisis, when the New Zealand dollar temporarily depreciated. Interest rate differentials also play an important role - with many factors influencing these differentials. These factors include domestic drivers such as fiscal policy, housing cycles and migration cycles.

Figure 8 shows that the interest rate channel, while strong over the past two decades, has recently weakened. Currently, high commodity prices are playing a key role in supporting the New Zealand dollar. The New Zealand dollar tends to follow movements in commodity prices, which somewhat insulates commodity exporters from the effects of the exchange rate in both the upswings and the downswings.

Figure 8 - Interest rate differentials and the TWI
Figure 8 - Interest rate  differentials and the TWI   .
Source:  Reserve Bank of New Zealand, the Treasury

It is not clear that New Zealand’s tradable sector’s performance is the direct result of exchange rate variability...

Exchange rate fluctuations may impact negatively on export and import-competing firms because of the uncertainty they create. This uncertainty may discourage firms from investing, innovating and trading. Data limitations make it difficult to assess the extent of this impact of exchange rate variability on the tradable sector.

It is also difficult to determine the impacts of short-term exchange rate movements on the tradable sector, despite plentiful data observations. Empirical evidence to date is inconclusive on whether short-term exchange rate volatility has a negative impact on exporters, especially once hedging is controlled for. Some studies find no link, and of those that do, they tend to find only a small negative effect.

Assessing the extent of the variability of a currency and the performance of the respective tradable sector in a number of countries suggests that the link between exchange rate variability and the performance of the tradable sector is not automatic - tradable sector performance is influenced by a range of factors. This implies that exchange rate variability can explain some, but not the entire recent decline we observe in New Zealand’s tradable sector.

...but one likely factor is the sustained period of an overvalued exchange rate

Figure 9 shows the level of the real exchange rate relative to its long-run average, alongside tradable sector output. It illustrates a clear period from 2003 when the exchange rate was persistently above its long-run average (with the exception of a brief period following the global financial crisis). This has corresponded with the stagnation and then decline of the tradable sector.

Figure 9 - The level of the exchange rate and tradable sector output
Figure 9 - The level of the exchange rate and tradable  sector output   .
Source:  OECD

The persistent high level of the exchange rate was a common topic discussed at the Macroeconomic Policy Forum in June 2011. More information on this Forum can be found at: www.treasury.govt.nz/publications/research-policy/conferences-workshops/macroeconomicimbalances

For more information see:

  • Fabling, Richard and Arthur Grimes (2008) “Do Exporters Cut the Hedge? Who hedges and why” Ministry of Economic Development, Occasional paper 08/02;
  • Mabin, Gemma (2010) “New Zealand’s Exchange Rate Cycles: Evidence and Drivers” Treasury Working Paper 2010/10; and
  • Mabin, Gemma (2011) “New Zealand’s Exchange Rate Cycles: Impacts and Policy” Treasury Working Paper 2011/01.

Both Treasury working papers are available at: www.treasury.govt.nz/publications/research-policy/wp

 

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