Graeme Wheeler, Currency Intervention And Mean Reversion

Reserve Bank governor Graeme Wheeler is giving a speech to the Institute of Directors in Auckland today. It is interesting to see how our central bank, which pioneered inflation targeting and has maintained a credible monetary policy for some time, rationalises its inability to successfully intervene in the foreign exchange market.

For example, the challenges faced by producers competing against foreign low-cost producers, or multinationals with global supply chains, increase when our exchange rate overshoots.  On the other hand, the high exchange rate makes imports of capital goods cheaper and may encourage the take up of capital intensive technologies.

How successfully have exporters “captured” the mind of the Reserve Bank? Remember, everyone benefits from imports, but the benefits from exports primarily accrue to asset rich farmers and closely held manufacturing firms that export high value products. Yes, they earn the foreign exchange we need, but it’s no different to working people turning up at the office to collect their salary – it’s essential but not where the value in the economy is added.

Among the developed market currencies, the Kiwi has been the third strongest performing currency against the US dollar (after the Mexican peso and Swedish krona) over the past 12 months.

There is a global reach for yield going on. The Reserve Bank can’t do anything about it through playing with the Official Cash Rate. Imposing loan-to-value restrictions in the housing market are unlikely to have much effect on housing demand and will funnily enough make increasing the housing supply more difficult for people wanting to build on greenfield subdivisions on the outskirts of Auckland.

Our past exchange rate cycles have exhibited substantial overshooting followed by a sharp and rapid exchange rate depreciation.  Such rapid exchange rate corrections reflect the drain in market liquidity that can occur when a small market like New Zealand begins to turn down.

This happened in 2008 after the global financial crisis began in earnest after the collapse of Lehman Brothers. Since quantitative easing began, volatility in risky assets like those denominated in NZD has increased alongside their price – there is a global reach for yield that necessitates investors who don’t want to earn 1% buying foreign bonds like those on offer in New Zealand where yields range from 3% to 6% on bonds and equities that pay dividends.

The Federal Reserve is currently buying USD85 billion per month in assets. They are on track to have a balance sheet that is 25% of US GDP by the end of 2014 at this rate. If they taper off, there is the risk that interest rates will rise fast and high losses will be imposed on bondholders and equity holders alike.

In assessing whether to intervene in the exchange market, we apply four criteria. These are whether the exchange rate is at an exceptional level, whether its level is justifiable, whether intervention would be consistent with monetary policy, and whether market conditions are conducive to intervention having an impact. This last factor is especially important given the volume of trading in the Kiwi.  (In the most recent survey – April 2010 – by the Bank for International Settlements, the Kiwi was the tenth most traded currency in the world with daily turnover of spot and forward exchange transactions totalling around USD $27 billion.)

How do you define justifiable? The Reserve Bank’s intervention justifications are ridiculously broad. 4.4 million people against 44,000 farmers. In terms of societal welfare, in the age of the Apple gadget, all that matters is the price of imports. Hardly anything we actually want to spend money on is made here so now that we’ve made our bed (through not supporting NZ manufacturing at the point of sale, revealed preference people) the RBNZ can’t suddenly “fix things” for the tradable sector through selective intervention.

But we are also realistic in respect of potential outcomes given the strength of the foreign demand for the New Zealand dollar relative to the scale of our intervention capacity.  We can only hope to smooth the peaks off the exchange rate and diminish investor perceptions that the New Zealand dollar is a one-way bet, rather than attempt to influence the trend level of the Kiwi.  But we are prepared to scale up our foreign exchange activities if we see opportunities to have greater influence.

Careful, here be dragons. The list of central bank failures in currency intervention are legion. We have to realise that there is nothing inherently wrong with currency speculation. It’s a free market in currencies for the most part and the NZD is extremely liquid.

The Reserve Bank is basically saying that spending hundreds of millions of dollars or even billions of dollars to give people the appearance that they are doing something is better and more welfare-enhancing than simply realising they are powerless and letting the market work its way to a “fairly valued” exchange rate.

There is some extremely risky thinking going on here. The Reserve Bank are thinking like Long Term Capital Management, you know, the US hedge fund that employed a trading strategy that used mathematics to prove that the market was wrong and through buying long/selling short they’d profit from the market price of whatever they were speculating in as it reverted to the mean.

This is hilarious stuff – just because a financial asset (the NZD) has an historical mean does not mean one iota that it will revert to it at all! Every day is a new day, and it the age of global central bank intervention driving financial markets, there is a high risk of the RBNZ being on the wrong side of the trade with taxpayer money at risk.

How did Long Term Capital Management work out? Oh, it got bailed out. But the guys behind it still rationalise their trades! To paraphrase Keynes, the market can remain irrational longer than you can remain solvent or take advantage of a central bank bailout to keep carrying a losing trade.

Our society has made a lot of collective decisions over the past 20 years that have led up to this point. We abandoned a compulsory super scheme that could have led to the NZ Super Fund being the size of Temasek, we spent more than we earned while simultaneously wasting money on unproductive housing investments and ignored the risks of betting the farm on the farm.

The Reserve Bank and the exporting community may not like the “high” NZD but that’s the price. That’s the price we pay for having a reasonably non-crazy fiscal response to the global financial crisis, reasonable institutions and tax policy and reasonable levels of regulation relative to other countries.

It’s not because New Zealand is amazing, it is because we suck less on a relative basis to other OECD countries where people could park their hot money capital. We might as well enjoy it while we can with cheap stuff from ASOS. The NZD will not revert to the mean – next week 10 billion barrels of oil might be found off the East Coast – we don’t know, therefore risking taxpayer money on the NZD short trade is bad business for “NZ Inc”.