Limited evidence of damage by exchange rate volatility

Tuesday 15th March 2011

A Treasury study has found only limited evidence to back the theory that New Zealand's exchange rate volatility and variability have a damaging impact on exporters and those who compete with imports.

Empirical evidence on whether fluctuations in the exchange rate hindered economic growth via the areas involved, known as the tradable sector, was inconclusive, a new Treasury working paper said.

While theoretical evidence found some more support for a negative impact, it was difficult to isolate the impact of the exchange rate, as many factors affected exporters.

New Zealand and Australia had large exchange rate cycles, and a non-tradable sector that had grown faster than the tradable sector, but South Korea also had large exchange rate variability and its tradable sector had grown much faster, the Treasury paper said.

There was also no strong link between countries with low variability in their exchange rates and stronger performance of their tradable sector relative to their non-tradable sector.

The divergence between this country's tradable and non-tradable sectors that emerged in the mid-2000s was more likely to be explained not by high exchange rate variability but by the sustained high exchange rate in the past six years.

Periods of exchange rate depreciation tended to be associated with rising tradable sector output, while the sustained high exchange rate since 2003 had resulted in an absolute decline in tradable sector output, the paper said.

It concluded that the freely floating exchange rate remained the most viable regime for this country, providing an important safety valve in times of extreme events.

In particular it played a significant role in buffering New Zealand against external shocks following the 1997 Asian financial crisis, and also fell significantly at the height of the recent global financial crisis.

The exchange rate could be credited with helping insulate the economy from a more severe downturn during the global crisis, the paper said.

"When financial turbulence was as its peak at the end of 2007, New Zealand's exchange rate depreciated for a short period of time to a position below its long-term average.

"This buffered the impact on exporters who experienced a drop in global demand for their goods, allowing exporters to retain more of the revenue they received from overseas."

Higher world prices for New Zealand exports typically led to the exchange rate rising, reducing the amount in NZ dollars that exporters received. When global demand fell the exchange rate tended to fall also, so NZ dollar exporting revenues were not typically greatly affected.

Thus, the exchange rate could act to smooth the revenues received by commodity exporters to some extent. The manufacturing sector often lost out because if world commodity prices rose manufacturing exporters faced a higher exchange rate, yet could still face the same world price for their exported goods.

The paper also noted that the exchange rate often tended to "over buffer" - moving to a level that was beyond what was justified by economic fundamentals relevant to the medium term competitiveness of tradable producers.

NZPA

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