Exchange rate variability and trade performance
Since 1985, New Zealand's currency has been freely traded in international markets. Our exchange rate is floating, as are the currencies of most developed countries: Norway, Sweden, Canada, Australia, the United Kingdom, Japan, South Korea, the euro area as a whole, and the United States. There are other ways of managing the exchange rate, and we discuss some of those below, but it is important to recognise that most developed countries - and the advanced commodity exporters among them - have exactly our sort of system.
Floating exchange rates tend to be quite volatile. Fluctuations in the exchange rate can usually be explained after the event, but all floating exchange rates are more variable than changes in the underlying economic fundamentals appear to warrant. That variability is both short-term (minute to minute, day to day, even month to month) and over the full course of the cycle.
- Figure 13: Exchange rate volatility (average absolute daily change against US dollar Jan 2000-Oct 2009)
- Sources: Reserve Bank of New Zealand, Datastream
The short-term volatility of the New Zealand dollar is now quite high. The Australian dollar is also quite highly volatile over short terms. The Australian dollar and the New Zealand dollar move quite closely together much of the time, so short-term volatility in that currency pair (a very important one for many New Zealand exporters and importers) is very low by international standards. But against other currencies, buying insurance against the short-term volatility in both the New Zealand dollar (NZD) and the Australian dollar (AUD) is quite expensive, a little more so for the NZD than for the AUD[28].
International evidence suggests that short-term exchange rate fluctuations matter more than might be expected. When countries moved to adopt the euro, the volume of trade between those countries, particularly intra-industry trade, increased noticeably, even when individual pairs of countries had previously had exchange rates that fluctuated only very slightly. That is consistent with the evidence that much more trade takes place within countries than across international borders, even when the physical distances involved are similar.
But there is probably less disquiet about the very short-term volatility in the exchange rate than about the size of the year-to-year swings, and the amplitude of the full exchange rate cycles. Those issues have been particularly prominent this year, when our currency - and many others - has fluctuated through an enormous range, as sentiment on the world economy and attitudes to risky assets have waned and waxed. This year has been unusual, although even this year the New Zealand exchange rate has not been at either record highs or record lows.
There is no unique way of measuring effective average exchange rates for countries. However, the Bank of England compiles a useful set of exchange rate indices for various developed countries, including New Zealand, calculated on a consistent basis. The graph below shows the range, from low to high, within which the (floating) currencies of various developed countries have fluctuated since 1992[29]. Over that specific period, the New Zealand dollar - at least on this measure - has been one of the more variable currencies: but even over that whole 17 year period, our trough to peak range was almost exactly the same as those for the United States, Canada, and Japan. The currencies of even the largest and most advanced economies can and do move through very large ranges.
- Figure 14: Amplitude of exchange rate cycles (peak to trough range, 1992-2009)
- Source: Bank of England, effective exchange rates.
The ranking of countries in this sort of comparison can change quite quickly. There have not been very many cycles in each country's exchange rate in the times since exchange rates were floated - 3 or 4 in New Zealand's case. Australia and the United Kingdom have experienced slightly smaller - but still large - exchange rate cycles than New Zealand has over that period. But there is no obvious reason to think that will be so in future. There is also no simple pattern: smaller countries don't seem to have larger cycles, and neither do commodity producers. Countries that have actively intervened in their exchange markets (Japan for example) do not seem to have had smaller cycles than those which did not.
In such a small and short sample, specific idiosyncratic events explain a lot. For example, in New Zealand the very large increase in government spending after 2005, funded by reducing budget surpluses, will have materially exacerbated the exchange rate cycle. The additional spending, and resulting pressure on resources, prompted the Reserve Bank to raise interest rates, in turn exacerbating the upward pressure on the exchange rate, undermining the competitive position of tradables sector firms[30],[31].
Do real exchange rate fluctuations matter? Intuitively it seems that they should - that the range of fluctuations is sufficiently large, and uncertain, that it must surely affect decisions to go into exporting, decisions on plant location etc, and that the uncertainty must mean that a higher than normal proportion of those decisions will prove, with hindsight, to have been wrong. Exports themselves aren't in any sense “better” than other production, but experience tends to show that fast growing countries achieve that fast growth through channels that involve faster than normal growth in exports, simply because the rest of the world is where the big pool of customers is.
In principle, there is some reason to think that exchange rate fluctuations could matter more for New Zealand than for exporters in many other advanced countries. New Zealand has few very large exporters like Air New Zealand. Its more typical exporter is an individual family farm (Fonterra is essentially just a tolling operation, passing all its net revenues back to farmer suppliers), a motel owner or an adventure tourism operator. None of these operators has much natural diversification. By contrast, Australian exports are much more heavily dominated by multi-national mining companies. Such companies, with operations (and costs) on several continents and in several currencies, have considerable in-built diversification against the impact of fluctuations in the Australian dollar.
Hedging instruments are, of course, readily available from banks for a range of terms. But hedging a relatively volatile currency is not a costless option. Either a firm pays a large upfront premium (for an option, akin to an insurance policy), or has to have the borrowing capacity and credit lines to absorb the at-times very large mark-to-market fluctuations in the value of forward foreign exchange contracts. To absorb the sorts of large fluctuations seen in currencies such as the New Zealand dollar would encourage firms to have more equity and less debt than they would otherwise need. There is a general perception that a higher proportion of equity finance raises a firm's overall cost of capital.
New Zealand's rate of export growth has been quite modest over quite long periods of time. But New Zealand is not unique by any means. Australia, the United States, the United Kingdom, and Canada have also all recorded only relatively modest growth in export volumes (as a share of GDP) in the decade prior to the recent recession[32].
Meaningful international comparisons are not as easy as they seem. Export statistics record the total value of the goods or services exported. Those exports often include substantial imported inputs. Cross-border trade in components for manufactured goods has grown extremely rapidly in the last 20 years as trade barriers have fallen. Both the exports of the components and then the total value of the final product show up in respective countries' official export statistics[33].
This rapid growth in trade in components is not a particularly important factor for either New Zealand or Australia. Most of our exports aren't manufactured, and using more imported components is much less easy when the distances between countries are large than it is between countries such as Belgium, France and Germany. Measures of the value-added domestically from exporting are more meaningful. In countries where trade in imported inputs has grown rapidly, value-added will have grown much less rapidly than the headline figures for gross trade. It is difficult to get good consistent reliable data through time, and this is an area where more up-to-date work would be valuable, but it is not obvious that New Zealand's value-added export performance in the last 10-15 years has been materially different from that in other developed countries[34]. But that performance hasn't been good enough to contribute to even begin to close the income gap. Exporting looks much like the rest of the New Zealand economy, and the same factors that would improve the overall business environment (discussed in the following chapters) are likely also to be what matter in terms of lifting the overall export performance.
The economics literature has had a surprising degree of difficulty in isolating the economic impact of exchange rate movements. There is a variety of reasons for that including, in particular, the fact that the exchange rate does not move in isolation from everything else that is going on in economies and financial markets, here and abroad. At one level - but not a terribly helpful one - it is clear that if a less variable exchange rate could descend from heaven, achieved without changing anything else, the overall performance of our economy (and those of other countries with quite variable exchange rates) would be improved. Later in the report we outline why we do not consider that such options are open to New Zealand policymakers.
Notes
- [28]Our short-term exchange rate variability was not always so high. In the 1990s, movements in the exchange rate were factored directly into the day-to-day management of monetary policy. As a result, the exchange rate was less variable over very short terms, but short-term interest rates were more volatile. There are choices about how to manage monetary conditions, but the current New Zealand model is entirely conventional internationally.
- [29]1992 is chosen because from around then all the countries shown had floating exchange rates and reasonably low and stable inflation rates.
- [30]But it is worth highlighting that, whether or not our exchange rate was floating, these sorts of spending increases would have induced substantial pressure on the real exchange rate. In a floating system, the pressure is apparent in a rise in the nominal exchange rate. But in a fixed exchange rate system, the effects show through in high wage and price inflation, which undermines firms' international competitive position in quite as potent a manner. The experiences of Spain and Hong Kong, with firmly fixed nominal exchange rates but sustained periods of large real exchange rate overvaluations, are salutary.
- [31]One recent empirical paper highlighting the link between increasing government consumption spending and the over-valuation of the real exchange rate is V. Galatsyn and P. Lane, The Composition of Government Spending and the Real Exchange rate”, Journal of Money, Credit and Banking, Vol 41, No 6, (September 2009)
- [32]Exports as a share of GDP in the three years prior to the current recession (2005 to 2007), compared with the same series for 1995 to 1997.
- [33]Consider two firms operating respectively in France and Belgium. Initially they source all their material inputs locally and export all their output. Then, still making the same final output, each moves to source its material inputs from firms a few miles away in the other country, before exporting the finished product as before. That change in business practice will be recorded as a significant increase in the total exports of both countries, but the real economic gain (the rise in GDP) would be small.
- [34]Evidence for the period to 2001 is presented in Black, M, M Vink and B White (2003) ‘An evaluation of the contribution of exports to economic growth’, paper presented to the New Zealand Association of Economists’ Conference, June 2003.
