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”.

Why A High Exchange Rate Is Good

A high exchange is good because it increases New Zealand’s global purchasing power.

Because our grey-haired corporate elite have consistently failed to innovate outside of a handful of well run companies, we desperately rely on imports for the cool things we can’t make here.

This means that a high exchange rate papers over New Zealand’s pathetic track record in economic growth and “100-bagger” innovation.

It also means that the most marginal manufacturers will go to the wall because they’ve failed to add enough value to make exchange rate changes unlikely to erode their margins.

If I was a manufacturer in New Zealand, I’d be asking – how can I reimagine my entire business so it is still profitable if 1NZD = 1USD? How can I move from razor thin margins to fat margins that reflect enormous value creation?

We have no idea what will happen to the exchange rate because of the massive liquidity bubble sloshing around the globe because of quantitative easing in the US.

But if you fail to build in the possibility of dollar parity to your business model, you deserve to go to the wall. You have no right to blame a high exchange rate for your inept business management.

Hong Kong’s Exchange Rate Stability

Since 1983 the Hong Kong dollar has been linked to the US Dollar at a rate of HKD7.8/USD1.00. The Hong Kong Monetary Authority, through the Currency Board, has maintained this stable exchange rate through a plethora of macroeconomic shocks and against rising prosperity in Hong Kong that could easily justify a significant appreciation against the US Dollar.

While Hong Kong can be hurt by changes in US monetary policy, strong economic growth and a reduction in the rate of inflation has been achieved during the peg’s lifetime.

Hong Kong has unique characteristics including substantial assets with which to defend the peg, but in an age where dogmatic adherence to the idea that floating exchange rates are ultimately the best idea, countries with their act together (i.e. NOT New Zealand) are capable of choosing different tools to maintain exchange rate stability and reduce risk for importers and exporters alike.

Because the fundamentals of Hong Kong are strong, any revaluation of the Hong Kong dollar will see substantial increases in purchasing power for Hong Kong residents and firms with assets denominated in Hong Kong dollars.

Australia Is In For A Hard Landing

Starting in 2005 a resource boom in Australia has propelled their economy onwards and upwards. All good things come to an end, and I believe that Australia is in for a hard landing. The combination of a shock to commodity prices, piercing of a housing bubble and extremely poor productivity growth since 2005 could lead to a serious drop in Australian GDP when the day of reckoning arrives.

McKinsey Global Institute have produced an essential study that breaks down what has caused Australia’s growth spurt since 2005, and how the causes of growth have differed from previous growth spurts in the early 1990’s and early 2000’s. It’s called “Beyond the boom: Australia’s productivity imperative“.

Their analysis looks at five different contributors to growth:

Terms of trade: The effect of changing prices for imports and exports

The increase in terms of trade has been fuelled by massive increases in commodity prices. The Reserve Bank of Australia governor is quoted in the report that while one container of iron ore was worth 2,200 flatscreen TVs in 2005 it’s now worth over 22,000 flatscreen TVs. The Australian dollar is at very high levels and is currently at 1.03 USD/AUD – above parity!
Additional capital: The increase in capital stock

The increase in capital stock in Australia since 2005 is astonishing – some A$120 billion in additional capital investment has been made in iron ore and coal mines, roads, ports, natural gas exploration and other resource industry projects. That alone is responsible for 53% of the growth since 2005, meaning any reduction in capital investment would significantly reduce Australian economic growth.

Additional labour: The increase in the total number of hours worked in the economy

Since 1993 Australia has averaged 143,000 immigrants per year and its own growing population has led to a massive increase in the size of the workforce. Massive Kiwi immigration has thus played a key role in accelerating Australian growth. MGI state that the increase in labour is the steadiest contributor to Australia’s growth.

What does this mean if lots and lots of Kiwis return to New Zealand? Well, the Australian economy recovery could potentially be lower than if they stayed there. The same obviously applies to other sources of Australian immigration – Southeast Asia, UK, Ireland, South Africa. Birth rates in Australia seem to be propped up by the baby bonus they have there. If fiscal necessity means that has to be cut the rise in natural born population will decrease sharply and affect this contributor to growth by the 2020s/2030s.
Capital productivity: The amount of output generated per unit of capital stock

Between 2005 and 2011 capital productivity has plummeted and led to tens of billions of dollars in losses of national income. MGI argue that this is because of the massive time lags between planning a resource project and getting the first shipment despatched, which can feasibly take years because of the size of the projects.

This finding is amazing – all of this capital investment, yet the losing capital investments are essentially cancelling out many of the one-off gains from a resource boom. This does not bode well if commodity prices decline, because that would reduce the value of resource projects already committed to and underway even further.

Despite hundreds of billions in domestic wealth, hundreds of billions more is being borrowed from overseas to finance these capital investments. If Australia’s exchange rate plummets in the wake of reduced commodity prices the repayments on bonds issued in USD, EUR, JPY, RMB or even SGD will skyrocket and reinforce a downward spiral of investment.
Labour productivity: The amount of output generated per hour worked

Despite having 25% more capital at their disposal from 2005 to 2011, output only increased 7%. Over the past 6 years labour productivity increases have only contributed a roughly a third as much as they did between 1993 and 1999. (A$17 billion vs A$57 billion). Other sectors in Australia have been achieving lacklustre labour productivity growth of ~1% a year.

All in all, MGI conclude that at least 50% of the growth from 2005 to today is one-off effects of the mining boom. The reality is that Australian multifactor productivity is actually declining at 0.7% a year. McKinsey talk about four different scenarios for Australia, linked directly to how much they increase productivity. They call these scenarios “hangover”, “lucky escape”, “earned rewards” and “paradise”.

This is how they arrived at their numbers:


Using the methodology that MGI used to calculate these 4 scenarios, what happens if we make the assumptions slightly more negative? If the “hangover” situation occurs, there is not much breathing room until the total change of total income becomes negative.

In the “hangover” situation, if the relationship between additional capital and capital productivity (-43/120) holds the negative contribution of capital productivity would surely be (-43/120)*107= -$38.34 billion. That would change the “hangover” calculation to : -109+107+28-38+8= -$4 billion.

Any further deterioration in Australia’s terms of trade would make the reduction in total income even higher. Any decrease in additional capital would make the reduction in total income even higher. This report reinforces my bearish opinion of Australia – they’re squandering their resource boom resources and not focusing aggressively enough on improving multi-factor productivity.

And let’s not forget where a lot of this capital investment is coming from:

When Australia’s terms of trade decline, any foreign-denominated borrowings will be more expensive to repay. This could prove fatal to any recovery because a substantial proportion of national income will be spent on debt service instead of capital investment, further reinforcing the hard landing provided by a decline in commodity prices.

Australia is in for a hard landing because they’ve squandered their natural resource dividend on a housing boom and holiday homes in Bali. Their failure to address productivity issues in the resource sector and other sectors will make the inevitable recession far more painful than it could have been if a more responsible approach to shoring up the long-term prospects of Australia had been taken.