Currency gives clue to coming recovery

OPINION: Back in the early part of this year, things were looking very bad for the world economy and less bad though still recessionary for our economy, writes Tony Alexander this week.

At the time, our central piece of advice was that eventually there would be a recovery but it was impossible to know when this would happen, therefore people should continue to focus strongly on cashflows and hold fire on extra borrowing until the outlook became clearer.

We also said that given the way the New Zealand dollar was falling, we would probably eventually have a traditional export-led upturn with farmers, and therefore the regions, enjoying a combination of a low currency and improving commodity prices.

What has happened since March has been slightly different. There is a global recovery under way and businesses are putting their expansion plans back into place. Some sectors of the economy are growing again. But this is not an export-led upturn, even though there are some quite positive signs emerging overseas.

For instance, the Japanese, German and French economies all grew during the June quarter, manufacturing indicators are moving back into positive territory, and the United States housing market is recovering. In fact the most important thing of relevance to the financial markets this past week has been the upbeat comments from the US Federal Reserve chairman regarding the US economy recovering. And we do have New Zealand export commodity prices generally rising.

But the New Zealand dollar has risen way beyond any level a reasonable person could have written about near the start of the year and currently is flirting with US69 cents. If this were a normal economic cycle, the New Zealand dollar would still be back somewhere close to US50c, mainly because our economy would still be weak while the rest of the world was recovering, and investors would be seeking exposure to good upturns in those economies rather than buying the currency of a still relatively depressed economy.

One gauge for the traditional poor New Zealand economic sentiment would be the fact that net migration flows would almost certainly be negative.

But as we forecast last year, (and should have translated this into a currency forecast one sees now) our net migration inflow is above average at 14,500 from 3500 back in November. Our economy looks good to people on the ground deciding where to live, so it also looks good to investors overseas.

This in itself is not enough to make the New Zealand dollar jump, it is more that the absence of depressing domestic negatives has given global investors the green light to buy our traditionally volatile, risky, and also higher yielding currency during a period of global recovery.

The New Zealand dollar has soared mainly as part of the simple global movement toward riskier assets.

The early New Zealand dollar rise means our upturn for the next two years is going to be more domestically based than usual. And that means this is what you need to pay attention to. The Reserve Bank invariably raises interest rates and further boosts the New Zealand dollar not when they see the export sector booming, but when they see the domestic economy including housing starting to strain the economy's resources. That is the path we are on now and that brings extra upside risks to New Zealand interest rates and the exchange rate next year.

Hence our very strong theme since the third week of March warning borrowers to fix three years and beyond and exporters to hedge. That remains our warning.

Between the middle of next year and early 2012, borrowers should budget for their floating rate costs they currently find so attractive jumping 3 per centage points or more while exporters should anticipate the New Zealand dollar eventually reaching US80c though it is impossible to pick when.

» Tony Alexander is the chief economist for the Bank of New Zealand.

- © Fairfax NZ News

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