4.2  Equilibrium level

The concept of an equilibrium exchange rate is difficult to pin down, and is often interpreted in different ways. Some analysts equate the level that the exchange rate has averaged over a long-term horizon with a concept of equilibrium. Others argue that, since the exchange rate is determined continuously in foreign exchange markets by the supply and demand for currencies, the exchange rate will always be in equilibrium. Another approach views the equilibrium exchange rate as a theoretical concept based on the idea that over some time period, the exchange rate will tend to move towards a level that reflects fundamental factors in the economy, e.g. productivity levels and the terms of trade. This section of the paper focuses on this last definition of the equilibrium exchange rate.

In practice, the equilibrium exchange rate cannot be observed, and there may be different equilibriums for different time periods (Driver and Westaway, 2004). Several analytical frameworks can be used to explain what the equilibrium level might be and what factors might lead the exchange rate to move away from or toward that level. Each framework depends heavily on assumptions that may not hold in practice.

Two main approaches are the Purchasing Power Parity (PPP)[18] concept and Macroeconomic Balance approach.[19]

PPP is based on the idea that in equilibrium, the prices of goods in one country will be the same in another country when denominated in the same currency. This then leaves no profitable opportunities for buying in one country and selling in another (known as arbitrage). At an economy-wide level, deviations of the real exchange rate from PPP will lead to changes in supply and demand which will move the real exchange rate back to PPP.[20] Competitiveness and cost factors also impact on PPP. In the longer-term, different labour and transport costs will have an impact on location decisions and there will tend to be movement in production from the overvalued to the undervalued economy i.e. capital arbitrage. However, sustained deviations from PPP are common, and the reversion back towards this equilibrium level is often very slow. For example, Rogoff (1996) found that half of PPP reversion typically takes three to five years for major currencies against the US dollar.

One potential reason for sustained deviations away from PPP equilibrium is the impact on the real exchange rate of non-traded goods in the economy. If the tradable sector experiences faster productivity growth in one country, then the ratio of non-tradable prices to tradable prices should grow more quickly. This higher productivity then raises wages in the tradable sector, which in turn ‘spills over' and results in higher wages in the non-tradable sector. The resulting impact is higher prices in the non-tradable sector. This is the idea behind the Balassa-Samuelson effect, which suggests that the real exchange rate should take into account the ratio of the relative prices of traded and non-traded goods in both economies, to capture this impact of the non-traded sector (Driver and Westaway, 2004).

The Macroeconomic Balance approach attempts to identify the level of the exchange rate that would be consistent with both internal and external balance (but asset stocks may still be changing). Internal balance is achieved when the economy is operating at potential output and inflation is stable. External balance is achieved when the current account balance is being financed by a sustainable rate of capital flow. According to this approach, any internal or external imbalances in the economy will lead to an adjustment, in either the exchange rate or in the domestic economy, until balance is achieved. For example, an unsustainable current account deficit (in the sense that the trade balance is not sufficient to service foreign debt) will imply that an eventual depreciation of the exchange rate would be required to restore balance, because the proportion of domestic production that is exported will need to increase.

The Macroeconomic Balance approach implies that the level of the equilibrium exchange rate itself may change over time if there are changes to underlying factors that influence a country's current account position or ability to service foreign liabilities. For example, any increase of the current account deficit reflecting a widening between national saving and domestic investment would lower estimates of the equilibrium exchange rate. Conversely, any increase in a country's ability to service foreign liabilities through, say, an increase in productivity or the terms of trade, would increase estimates of the equilibrium exchange rate. In practice it is difficult to distinguish exchange rate fluctuations around an equilibrium level from changes to the equilibrium level.

The equilibrium exchange rate for New Zealand is likely to be below what it has actually averaged for the past 40 years. Simply put, New Zealand's net international investment position has grown steadily more negative since the early 1970s, reflecting persistent current account deficits (figure 19)[21] and in particular a rising investment income deficit. This indicates that the goods and services balance has not been sufficient to offset rising servicing of New Zealand net external liabilities.

Figure 19: New Zealand's current account balance and net international investment position (quarterly data, Q1 2001 to Q3 2010)

Source:  Statistics New Zealand

The terms of trade is one determinant of the equilibrium exchange rate. It has risen about 50% over the past 25 years. The fact that this has not resulted in a reduction in the external imbalance, and therefore an increase in the equilibrium level of the exchange rate, suggests other factors have deteriorated enough to drive the equilibrium exchange rate below the average level actually experienced over the past few decades. Possible reasons include New Zealand's relative productivity performance, and factors that have led to the gap between national saving and investment widening on average over the past decade.

Recent IMF estimates of New Zealand's exchange rate suggest it is currently overvalued by up to 25% (the current deviation from its long-run equilibrium) (IMF, 2010). Cline and Williamson (2010) also find that the New Zealand dollar is currently overvalued by 25%. The fact that the exchange rate has not adjusted suggests that there are other factors at work.

Conclusions on the drivers

The concept of relative returns on New Zealand's assets is important in attempting to explain the behaviour of New Zealand's exchange rate cycles. Any factor that affects relative returns on New Zealand assets will drive the exchange rate, e.g. interest rate differentials and other global and domestic factors. More fundamental economic factors tend to influence the long-run equilibrium level of the exchange rate, e.g. productivity differentials and the terms of trade. The main driver is likely to change over time depending on developments in the domestic and global economy.