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NZ Dollar - Too Far, Too Fast?

WestpacTrust currency manager Greg Wilson puts the fall of the New Zealand dollar into perspective.

Wednesday, July 15th 1998, 12:00AM

by Philip Macalister

Since June 1997 the performance of the New Zealand dollar has been anything but impressive (unless you were short!). This is demonstrated by a quick look at the statistics - down 25 per cent against the United States dollar, down 7.1 per cent against the Australian dollar and Japanese yen and down 14 per cent on a trade weighted basis. At that time, while most commentators agreed that the dollar was overvalued, few would have believed it possible to see our dollar fall below 50 US cents less than 12 months later. Indeed it is not the fall that has surprised but the speed and depth of the fall.

 

As is usual in financial markets, it was a shock (unforeseen occurrence) that provided us with that surprise in the form of the Asian economic crisis sparked by the devaluations of the Asian currencies. The timing of this external shock was a little nasty for the New Zealand dollar which had just begun playing its part in easing monetary conditions to spur the slowing New Zealand economy. In the end the external shock dwarfed domestic considerations as the New Zealand dollar was "lumped in" with the rest of Asia and speculators sold any Asian currency that showed signs of liquidity.

Ironically during the last year New Zealand's high interest rates, which were heralded as the great support for the dollar during 1995-96 and the key reason for its strength, failed to provide any support at all.

After such a dramatic fall the obvious questions are being asked: "is the New Zealand dollar undervalued?", "will it fall further?", etc. Firstly looking at the domestic scene, some of the recently released economic data has been a bit of a mixed bag. While the current account deficit for the March quarter was much better than expected, the merchandise trade numbers for May disappointed and the GDP figures for the March quarter were worse than the worst forecast. This means that New Zealand will almost certainly experience a technical recession (two consecutive quarters of negative GDP growth). On this information the knee-jerk reaction would be to expect further New Zealand dollar weakness - bad numbers, bad currency.

But that data is now one quarter old and things have changed in that time, e.g. the currency has fallen 10 per cent which should give an extra boost to the export sector (notwithstanding currency hedging already in place). Domestic demand has diminished and business and consumer sentiments are low which should curb imports of consumer goods. Typically the effects of a lower exchange rate should take some 9-12 months to feed through to improvements in the merchandise trade balance. Also one could argue that the fall in the dollar that we have seen to date accurately discounted the economic situation before the data were announced, so further falls in the currency are unnecessary.

On the international front, the Japanese yen can be expected to continue to drive the gyrations of the Australasian currencies. But for the yen to experience any revival of fortunes the markets will need to see some concrete affirmative action to lift the country out of the economic mire. Once this becomes apparent a major weight will have been lifted from the shoulders of both the New Zealand and Australian dollars, allowing them both to rely more on their own fundamentals.

Using Purchasing Power Parity (PPP) to view the New Zealand dollar from a different perspective, however, the New Zealand dollar now looks very attractive. The charts below show a large deviation from what, under this measure, is considered fair or equilibrium value according to this measure.

- -

It should be noted that PPP is not an exact scientific measure but provides us with reasonable idea as to whether a currency is fundamentally undervalued or overvalued from a medium to long term perspective. Also PPP does not provide turning signals for the currencies although extreme deviations from equilibrium typically do not last more than a year or so.

In conclusion, it appears that while we are not entirely out of the woods as an economy, our dollar is probably close to its nadir. But, as usual, it will probably be events which are completely out of domestic control which will change the outlook for the New Zealand dollar.

Greg Wilson is the currency manager at WestpacTrust Investment Management

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