Monday, 25 November 2013

Why the Kiwi dollar is so high

Last Friday John McDermott, the Reserve Bank's Head of Economics, gave a speech, 'Understanding the New Zealand exchange rate'. Most of the media coverage focussed on John's idea that the best way to get the Kiwi dollar down from its current overvalued level is to increase our domestic savings rate. None of the coverage, though, appears to have reproduced an interesting graph (below) that John had included, and which in turn is an updated version of the results found in a 2012 Analytical Note from the RBNZ, 'Kiwi drivers: the New Zealand dollar experience'.

The red line is the real exchange rate (i.e. the exchange rate after allowing for relative inflation differentials with our trading partners - you can think of it as our export price competitiveness if you like), expressed as a percentage deviation away from its long-run average. So the first take-away point, obviously enough, is that yes, the (real) Kiwi dollar is unusually high.

The second take-away point is that two factors (those green and blue contributions) explain virtually all of the Kiwi dollar's high value (I know, I know, and John said so too, strictly speaking these are correlations and not necessarily causation, but I'm quite happy to believe the causation story, too).

The green one is the biggie, and that's the unusually high level of world commodity prices. No surprise there - and that makes for the next take-away point, which is that barring any unexpected shock to world economic activity (and to China's in particular), high world commodity prices and the high Kiwi dollar aren't going away anytime soon. Which is consistent, by the way, with some other RBNZ research - 'New Zealand’s short- and medium-term real exchange rate volatility: drivers and policy implications' - which found (p2) that "Departures of the exchange rate from its longer-run trend can be quite large and prolonged".

The blue contribution is 'Relative real house price inflation', but before you get on your high horse and start thinking, "It's all those blasted [insert your least favourite foreign bogeymen here] buying our houses - that's what's killing our exporters", what's actually happening here is that the house price inflation measure is standing in effectively as a proxy for the expected strength of domestic demand. In one hit it's capturing elements of expected demand, expected inflation, and expected interest rates. You'd also conclude that nothing is going to change on that front either, any time soon.

As John said, in one sense the Kiwi dollar isn't overvalued - from one perspective, as the graph shows, it's pretty much where you'd expect to find it, given our commodity export prices and the strengthening economy - but from other important perspectives (notably, rebalancing the economy more towards exports), it is. From those perspectives, it needs to be substantially lower - but on this evidence, I can't see it happening anytime soon.

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