Opinion: Does the high kiwi risk dumping the economy to a hard landing?

By Simon Louisson of NZPA

Friday 26th November 2004

Is the economy in danger of a hard landing due to the rise of the New Zealand dollar to near post-float records?

Some economic commentators believe the Reserve Bank and private sector economists may be far too complacent about the prospects of a gentle easing back from New Zealand's extended economic expansion.

"Given the volatility of the New Zealand cycle, we would watch for indications that the extraordinary recent domestic strength is fading rapidly," said Jim O'Neill, head of global economic research at influential investment bank Goldman Sachs.

"Without a weaker currency, a soft landing will hard to pull off."

In the 2000s the New Zealand economy has been basking in one of the most sustained and powerful periods of economic growth since the second world war.

The kiwi has risen on a combination of US dollar weakness - based on concern about the US budget and trade deficits - and kiwi strength - based on the highest interest rates in the developed world and the strong local economy.

The currency this week hit a 16-year high of US71.75 today and is now just a cent from its post-float high of US72.75c touched in 1988.

Previously when the kiwi has scaled these heights, exporters have screamed. This time they have been insulated by commodity prices at their highest levels in 30 years.

The kiwi has been strongest against the US dollar but it is not far from historic highs against the euro, is at a seven-year high against sterling, is close to a six-year high against yen and is still considered over-valued against the Australian dollar at over A90c.

There seems a strong chance the kiwi will head higher, at least against the greenback, in the short-term.

In Santiago at this week's Apec summit, US President George W Bush stated support for a strong US dollar. But you have to wonder if this is a strong dollar policy, what would a weak one look like?

The kiwi has nearly doubled in value against the greenback in four years while the euro has climbed 57%.

O'Neill said the US Treasury's support for its strong dollar policy could only be characterised as "benign neglect".

"The Bush Administration is interested in a weaker dollar, but they cannot say as much because this would likely trigger a much feared disorderly depreciation," he said.

The hands-off approach of key policymakers towards the dollar at last weekend's Group of 20 meeting in Berlin encouraged markets to sell the dollar lower.

There is widespread concern about the US deficits. Princeton economics professor Paul Krugman recently argued President Bush's policies had set the US on a dangerous course that will likely end in crisis.

"This is a group of people who don't believe that any of the rules really apply," said Krugman. "They are utterly irresponsible."

Stephen Roach, chief economist at investment giant Morgan Stanley this week was reported as privately telling selected clients that American has no better than a 10% chance of avoiding economic "armageddon".

Roach sees a 30% chance of a slump soon and a 60% chance "we'll muddle through for a while and delay the eventual armageddon".

He notes that the US needs $US2.6 billion a day to fund its current account deficit - equivalent to 80% of the world's net savings. If his bearish scenario plays out, maybe the 1970s nirvana of a kiwi dollar worth more than a buck may rerun.

A slump in the US certainly won't help New Zealand. And while most New Zealand companies have been reporting higher profits, it is clear many exporters are already feeling pain.

Fishing company Sanford essentially lost money in the year to September despite on Wednesday reporting a $53.8 million profit and experiencing buoyant prices for squid, tuna and orange roughy. It's foreign exchange hedging gains amounted to $55.2m.

Based on an exchange rate of US67c, hedging gains next year will return Sanford $40.8m next year. But by the end of September 2005, Sanford will basically have run out of hedging contracts as none have been taken since the kiwi rose above US60c.

Many New Zealand companies will be in a similar, or worse position than Sanford. Bancorp Treasury Services director Earl White says the widespread expiry of hedging contracts makes him agree with Goldman Sach's view that the New Zealand economy could be in for a hard landing.

"The bell rings sooner or later because you can't hedge forever. The longer the New Zealand dollar stays up here, the more risk that we have a hard rather than a soft landing," he said.

He says half of Bancorp's 150 clients are exporters and most of those are experiencing grief from the currency.

"From a domestic point of view, current levels are problematic for the tradeable sector," he said.

What he fears is the currency will overshoot, as tends to happen during long-term trends, and that could coincide with a sharp fall in commodity prices. The commodity boom has been fuelled by China's economic boom but that could quickly evaporate if Roach's ugly scenario is anywhere near the mark.

Exporters in New Zealand, when the hedging runs out from the middle of next year, will be bringing receipts back at prices north of US65c compared with the US50c to low 60c in calendar 2004, said White.

"We need continuing increases in commodity prices to just stand still.

"There's this toxic mix out there - if the currency is close to record highs, commodity prices are close to record highs, especially dairy and meat, the risk is that those come back on a weaker world outlook, and the currency doesn't come down, then there could be some problems out there."

He agrees it is not as serious as in 1996 when the kiwi dollar climbed on its own. This time, the euro, yen, Australian dollar and some South America currencies have also climbed and business models have adjusted as well.

This time last cycle, there was already serious stress in the tradeable sector. The Reserve Bank was slow to react and consequently had to ease heavily to get things back on track.

"They had to engineer a massive undervaluation of the kiwi to rebuild and that's why we went down to US39c," said White.

He rates the chances of the RB exercising its new powers of intervention in the forex market as negligible as the bank knows it could not turn the market around.

"At the moment they would be standing in the way of a freight train because it is not a New Zealand dollar story."

The Bank of Japan last year spent $US340 billion ($NZ485b) to try and prop the US dollar up, and today the yen is lower than when the intervention started. The RB has less than $10 billion to play with and it is unlikely to spend that on a sure loser.

"If they are that concerned about the value of the New Zealand dollar, there is a very easy solution - cut interest rates," said White.

"A nice scenario would be to surprisingly ease in December and sell a bit of kiwi as well - that would get things going.

"If they were concerned, and I think they should be, that would be a very smart tactical move."

But White rates the chances of a courageous decision on December 9 by the economist-dominated RB as "a snowball's chance in hell".

However, he did take heart from an apparent slip of the tongue by RB Governor Alan Bollard on Wednesday. When asked at a book launch what his concerns were about the currency, he said: "You'll see that reflected through in whatever decision we come to on our next monetary policy statement."

Goldman Sach's Mr O'Neill, who predicts the kiwi will dive to US66c within a year, would not be surprised at a rate cut early next year following a "relatively sharp adjustment in the domestic economy.

"We think the risk is that the switch to easing could occur sooner than expected as domestic adjustment begins to unfold."

White said the RB had been the world's most aggressive central bank in tightening "so it's got some pretty good potential to ease if required".

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