It's time to think about hedging

REUTERS

TOLERATING THE UNPREDICTABLE: Many southern European countries have substantial budget deficits and rapidly growing levels of debt.

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The big story of last year was a huge sigh of relief sweeping across the planet as data in March showed a Depression scenario would be avoided – significantly, as a result of huge easings of fiscal and monetary policies, writes Tony Alexander this week.

The sigh of relief saw sharemarkets soar as investors moved back into growth assets.

The New Zealand dollar also soared as commodity prices rose and investors sought out higher-yielding currencies.

The kiwi peaked above US76 cents in October but since then has retreated to near US69c. Why the fall? It can largely be put down to the initial wave of euphoria passing and more realistic attitudes setting in regarding the nature of the global road ahead.

There remain many obstacles to good global growth and one of them which is scaring investors back slightly from risky assets at the moment is the government debt problem afflicting a number of European countries.

The PIIGS – Portugal, Ireland, Italy, Greece and Spain – all have substantial budget deficits and rapidly growing levels of debt. The revelation that Greece outright lied about the true state of its finances has unsettled confidence generally in governments with high debts and hence the wave of selling causing interest rates on bonds issued by those governments to soar.

This jump in risk aversion explains the kiwi's fall and the weakness in sharemarkets. Plus there are plenty of other things to worry about – the growing discord between China and the United States, Japan's economy and the reputation of Toyota, the unwillingness of banks overseas to lend, the unwillingness of businesses overseas to borrow and invest, still weak labour markets (including our own) and uncertainty about how smooth the path will be once central banks start raising their cash rates.

For New Zealand exporters this bout of concern has brought more good than bad in the form of the lower kiwi. However, we do not expect the kiwi to stay down at these lowish levels.

Over the year as the world economy improves – that is the most common assumption/forecast overseas – commodity prices are likely to creep higher and risk-tolerance by investors will recover.

More especially, we expect our central bank to raise its cash rate from 2.5 per cent in June, taking it eventually to above 5.5 per cent come the end of 2011.

These rises will start before rises in the likes of the United States and the widening of the interest rate differential is likely to generate buying of the kiwi.

For these reasons we think exporters may do well to consider getting some more hedging on board at current exchange rate levels.

However, it pays to keep in mind that as much as we may write about our expectations of the exchange rate doing this or that, the simple truth is that forecasting exchange rates is all but impossible.

Sure, there will always be someone who predicted the latest move up or down and one may think they know what they are doing.

But consistent accuracy in exchange rate forecasting is unheard of.

So exporters need to work out their hedging not with an eye towards where the currency is likely to go, but with their ability to tolerate unexpected exchange rate movements foremost in mind.

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

- © Fairfax NZ News

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