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Professor Roger Bowden

The NZ Dollar: End game or new game altogether?

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Just as expected, Dr Bollard has announced a rise of 0.25% in the official cash rate (OCR), to bring it to 8.25%. Thursday’s announcement also contained another bit of information, that the Reserve Bank thought it had gone far enough for the time being, and yet another hike down the track is not anticipated. Provided, that is, the economy kept itself in restraint.

Quibbles aside, one of the problems in previous rounds had been that the Bank also signalled further possible rises down the track, which was just what the currency speculators had wanted to hear at the time. This time round, Dr Bollard seemed to be heeding the point, and telling the Japanese grannies and Californian hedge funds not to rely on him for their future profit taking. Unsurprisingly, therefore, the profit taking has begun, immediately driving the dollar down 50 basis points, possibly helped on its way by the Bank’s own currency intervention team.

It would be nice if all this means that the Reserve Bank has pulled off a consummation devoutly to be wished, taking the top off both the dollar and the housing market at the same time. What are its prospects for doing so?

To answer that question, we have to go back to the fons et origo of the whole problem. This is going to call for a bit of concentration, so pop one of your last party pills at this point and give yourself an (inconsequential) smack on the other cheek, just to wake up properly.

The difficulty has been that the OCR is certainly an instrument of monetary policy, but actually a pretty limp one. Its impact on the interest rates that matter is very indirect, can take a lot of time to work, and in some circumstances might not even work at all. The OCR impacts primarily on floating interest rates and not on the 2 to 5 year fixed rates that now serve to fund the bulk of Kiwi homeowner mortgages. It is the latter that serve to fund not only home buying, but a lot of consumer spending as well.

In a larger and more liquid capital market, expectations of higher OCR rates in the future become quickly translated into the required fixed rates. But in NZ it doesn’t quite work that way. Most of our housing mortgages are funded by Japanese housewives who invest in uridashis, which are NZD denominated bonds. Foreign banks and corporations like to issue such bonds into the Japanese market because the housewives do like the high coupons that they carry. After all if you can get 7% on a NZD uridashi and 1% on an equivalent JY (yen) bond, it looks like a bit of a no-brainer.

At this point a bit of financial legerdemain takes over, according to which the issuing bank swaps its NZD uridashi liabilities for coupon and principal with a NZ bank, in exchange for its preferred currency liabilities, which might be US dollars or euros. In turn, the NZ bank gets the loan proceeds and uses these to fund their mortgage book here in NZ. They pass the mortgage payments from the NZ homeowner along to the US bank which in turn passes them through to the Japanese housewives. (Actually there’s a haircut extracted along the way, so that what the Japanese housewife gets is less than what the NZ homeowner pays. The difference helps to support needy causes like swap dealers’ bonuses).

If you’re feeling a bit glassy eyed at this point, not to worry. But you might have noticed that although they are getting a nice high NZD coupon very six months, the Japanese housewives inherit a currency exposure. If the Kiwi dollar falls out of bed, the housewives will end up on the floor with a thud. It is via the risk of the NZD that the OCR finally works. If the housewives think that the Kiwi has risen too far, or has otherwise become less certain, then they will demand higher interest rate on their bonds. That will ultimately flow through to what Kiwi homeowners have to pay when they renew their fixed rate mortgages.

And that is what finally seems to be happening right now. In a recent paper, Dawn Lorimer and I noted that forward rates, basically the second year rate built into two year uridashi bonds, have been rising along with our soaring Kiwi dollar. So monetary policy is at last getting to bite.

Paradoxically it needed another bit of Reserve Bank magic to turn the trick, namely the failed currency intervention of June. This awakened the Kraken. Speculators knew what was up, for we had the spectacle of a central bank trying to put the lid on a currency while simultaneously offering the comfort factor I described above, of a higher future OCR. In addition all the chartists climbed on board, people who trade on mystical price patterns. Straight out of Terry Pratchett, the whole thing.

I think we are at a top, but it might be only temporary. The dairy payout next year is going to be enormous, and everyone knows it. Bugger all this education, I should have been a farmer.

Of course, much also depends on the US dollar independently, for with currencies it always takes two to tango, and the US economy is starting to show a few cracks. That said, we are stronger against all major currencies, so we need to look to ourselves at home before worrying about those abroad.

In fact, the NZ dollar is just about the wobbliest currency in the world (and the Aussie dollar one of the most stable). That is a consequence partly of our narrow industrial base, but exacerbated by our dismal personal savings record, and also by poor coordination of fiscal and monetary policy. Kiwisaver came far too late. In fact our tax regime discriminated against long term contractual saving in favour of tax free assets like houses. The Aussies have shown a lot more common sense in theirs.

We could solve the currency problem as such by hooking up with the Australian dollar in a common Tasman currency, but that would probably be at the expense of some local inflation. I suspect that a higher Kiwi dollar is here to stay, for a number of reasons that I will be developing in a forthcoming paperback. If I’m right on this, it will herald some major changes in NZ’s industrial structure, with some far reaching implications. And it might be a good time ahead of next year’s election for a bit of lateral thinking about how we can collectively manage to survive and prosper, for we are on the cusp of interesting times.

Some of the previous work underpinning this letter can be accessed on www.wellesley.org.nz or www.kiwicap.co.nz.