4  Drivers of the exchange rate

What makes New Zealand's exchange rate behave the way it does? In this section, the paper first examines the factors that cause the exchange rate cycles or medium-term variability that has just been examined. Secondly, it discusses the concept of equilibrium exchange rates.

4.1  Medium-term cycles

No one model of the exchange rate can adequately account for movements in the New Zealand dollar over all time periods. The exchange rate is a key relative price, but another perspective is that it can be viewed as an asset price (Munro, 2004). Such a view has become increasingly relevant as foreign exchange market turnover has come to be dominated by financial transactions.[15] This means that factors that influence capital markets are now likely to have a bigger impact on exchange rates.

Factors that affect the expected relative return on New Zealand dollar assets are found to explain a significant part of exchange rate cycles. These include interest rate differentials between New Zealand and other economies, relative growth performance and attitudes to risk. More fundamental drivers such as export commodity prices and the terms of trade, and productivity growth, will also drive New Zealand dollar returns, particularly over longer timeframes.

4.1.1  Interest rate and growth differentials and risk appetite

Interest rate differentials are an important driver of the exchange rate as they most clearly reflect the relative returns on holding New Zealand dollar assets. Figure 13 shows the broad relationship between the short-term interest rate differential[16] and the TWI over time. Other factors obviously play more or less of a role at different times such that the precise relationship is not stable over time. Particular instances include the late 1990s, and the late 2000s.

Figure 13: Short-term interest rate differentials and the TWI(quarterly data, Q1 1996 to Q4 2010)

Source:  Reserve Bank of New Zealand, the Treasury

Note: G3 refers to an average of 90-day interest rates in Germany, Japan and the United States.

The relationship between interest rates and the exchange rate also holds at the bilateral exchange rate level (see figure 14 for example). For instance, over the past year the decline in the NZD/AUD cross-rate is consistent with the interest rate differential moving negative, while the converse is true for the NZD/USD cross-rate.

Figure 14: Short term interest rate differentials and New Zealand dollar cross rates (monthly data, January 1991 to October 2010)

 

Source:  Reserve Bank of New Zealand, Reserve Bank of Australia, Datastream

Over the previous decade, a combination of high New Zealand interest rates (due to strong domestic inflationary pressures and a high neutral real interest rate[17]) and low global interest rates led to large amounts of inward capital flows (Dunaway, 2009). This contributed to the appreciation of the New Zealand exchange rate in the mid-2000s.

Low global interest rates over the past decade stemmed from a mix of factors. First, global liquidity increased considerably in the decade following the Asian crisis as investment levels, which fell following the crisis, were not sufficient to absorb the saving being generated. Second, policy interest rates were held low in key major economies in an attempt to boost growth. Third, investor risk appetite increased following a period of relatively stable global growth and low inflation. Amongst other affects, these factors contributed to the rise of the so-called “carry trade”.

The carry trade occurs when investors take advantage of interest rate differentials between countries. Carry traders would invest in an asset that has a higher expected rate of return than the costs of borrowing. In currency carry trading terms, investors would borrow in low interest rate countries (like Japan and Switzerland) to invest in higher interest rate countries (like New Zealand and Australia). In theory, the carry trade should not be able to work. Uncovered interest rate parity is a long-run concept, where the exchange rate would be expected to move to offset any arbitrage opportunities created by interest rate differentials. However, over a short-term horizon this does not hold. This means that the exchange rate can remain high for long periods of time, particularly in countries with high interest rates. It can even appreciate further, possibly for a number of years.

The inflows associated with the carry trade has exacerbated the New Zealand exchange rate cycle, as well as maintaining downwards pressure on local longer-term interest rates. Recent RBNZ work suggests that the carry trade has diminished somewhat in New Zealand in the wake of the global financial crisis, as other countries are now more attractive destinations for the carry trade (e.g. Australia, where rising interest rates have meant interest rate differentials have widened against funding currencies) (Cassino and Wallis, 2010).

Cassino and Wallis (2010) also find that risk appetites have at times played the key role in driving the exchange rate during the global financial crisis and its aftermath. For example, at the onset of the global financial crisis the Swiss franc (seen as a safe haven currency) appreciated while the New Zealand dollar (seen as a riskier currency) depreciated. To illustrate the impact of risk preferences Cassino and Wallis (2010) compare the NZD/USD exchange rate to the Standard and Poor's equity index in the United States (figure 15). This equity index is seen as a risk sensitive financial asset and therefore changes in this indicator are a good indication of risk preferences. Investors' risk appetite is a common driver of both the S&P equity index and New Zealand dollar denominated assets.

Figure 15: S&P 500 and the New Zealand dollar/US dollar cross rate(monthly data, January 2006 to October 2010)

Source:  Datasteam, Reserve Bank of New Zealand