Flightless Dollars

The Australian and New Zealand dollars tumbled last week, the Kiwi falling harder after it was reported that New Zealand GDP had dropped in the final three months of 2005.

This week’s expected increase in the US cash rate to 4.75% will once again draw attention to the narrowing rate premium offered by these currencies. The New Zealand dollar has now depreciated 15% against the greenback since January, and we think it has further to go. The Australian dollar actually appreciated against the US dollar in the first six weeks of 2006, but since then it too has depreciated and at the end of last week was 7% off the mid-February high.

It also has a way to go. They are big changes, and although the decline was expected, the speed of last week’s moves was dramatic. We have long argued, however, that when they do happen the changes in currency values for both Australia and New Zealand could be quite rapid because both countries finance large current account deficits through offshore borrowing by domestic banks, which is then swapped into the local currency.

These transactions enable both Australia and New Zealand to effectively borrow in their own currencies, which is good for the financial stability of both economies. But it also means that when the foreign appetite for debt denominated in Australian and New Zealand dollars begins to pall, the currencies adjust quite quickly. That is part of what is happening now, and it will confer particular interest in Tuesday’s Reserve Bank of Australia Financial Stability Report material on the offshore exposures of the domestic banking system.

Although the Australian move is part of the continuing story of a narrowing rate premium with the rest of the world, together with a bit of contagion from its currency cousin, the New Zealand dollar decline is more directly related to data. NZ’s 0.1% GDP contraction for the fourth quarter, reported on Friday, was a somewhat weaker result than our forecast of a gain of 0.2%, and its components were surprising. Household consumption grew only 0.3% after expanding 0.6% in the previous quarter, a slowdown the Reserve Bank of New Zealand (RBNZ) wants. But house construction was up quite firmly, with a gain on the previous quarter of 2.5%.

The RBNZ didn't want that at all. Confirming the previous day’s balance of payments data, the GDP data showed a quite solid gain in volumes, up 1.6% on the previous quarter. Import volumes tumbled 4.7% in the quarter. We had thought business investment would be reasonably firm, but on these numbers fixed asset investment was down 0.2% for the quarter. Pleasingly for the RBNZ, the deflator for goods and services purchased in New Zealand was up only 1.6% for the year.

RBNZ governor Alan Bollard would certainly like the further and unambiguous evidence of overall slowdown in domestic demand, although he would no doubt have much preferred to see weaker residential construction and stronger business investment than the reverse. He would be pleased though perhaps a little sceptical of the moderation in economy wide inflation. He would be delighted by the increase in export volumes and the fall in import volumes '” but might well be very sceptical indeed that the trends there are as good as they appear.

REBALANCING GOAL

All up, the GDP numbers and the narrowing of the fourth-quarter current account deficit the previous day suggest the RBNZ is closer to its goal of rebalancing between domestic demand and exports than it thought, and that inflation pressures are not quite as strong as it feared. Accordingly, Bollard should be more willing to put rate cuts back on the agenda for the second half.

The actual, seasonal and trend trade deficits for NZ improved remarkably in the fourth quarter, a pleasant surprise that saw the New Zealand dollar firm briefly before being overwhelmed by the GDP release the following day. But it is too early to declare that the September quarter was the peak in the current account deficit in this episode, or even that the trade deficit will continue to narrow.

Although the trade deficit narrowed for the quarter, the net income deficit again widened '” as it had for the previous two quarters. It will most probably continue to grow, both because net liabilities are increasing by the amount of the current account deficit and because global interest rates are increasing. At $2.6 billion, the net income deficit was nearly four times bigger than the trade deficit, and accounted for more than two-thirds of the overall current account deficit of $3.4 billion. It may be expected to increase by an average of $100 million a quarter for some time to come.

Given the volatility of even the seasonally adjusted trade balance, it is certainly not impossible that sometime this year New Zealand could again see a current account deficit of the order of $3.8 billion, the September quarter record. Much depends on exports, which, on a balance of payments basis in the December quarter, were up 2% on the same quarter a year ago. As one would expect, the “conceptual adjustments” that increased recorded exports on a balance of payments basis in the December quarter, have a saw-tooth pattern with gains in one quarter withdrawn in another. New Zealand may also encounter a short-term increase in import values, before volumes adjust downwards to new and higher prices resulting from currency depreciation.

The currency and debt markets were startled by Friday’s New Zealand GDP result but it should be borne in mind that the apparent trajectory of the New Zealand economy is exactly the one Alan Bollard wishes to see. Household spending is slowing, house price growth is fading, and import growth is slowing. Exports appear to be rising. The New Zealand dollar has depreciated, another trend welcome at the NZRB. We expect a further decline in the currency and we doubt it will bother the RBNZ one bit.

Two numbers this week will register New Zealand’s progress towards the “rebalancing” Bollard is seeking. Today’s February merchandise trade numbers are not seasonally adjusted, and are therefore both difficult to forecast and not very informative. For what it’s worth, however, we expect the trade deficit to narrow on the previous month, with exports substantially up on the previous month and imports a little down. We expect Thursday’s February dwelling consents to show a gain of 1%, a small correction after the big fall in the seasonally adjusted outcome last time.

The really interesting NZ release this week is neither of those two indicators, but Tuesday’s productivity numbers for the period 1988 to 2005. They could go a long way to solving the puzzle of why New Zealand apparently lags productivity growth in the US and Australia, despite having an otherwise excellent economic performance.

We doubt any of the three big Australian numbers this week will be market moving. We expect to see a small increase in February seasonally adjusted building approvals out Friday, but it comes after a big dip in January and will be consistent with continuing trend weakness. We expect seasonally adjusted February retail trade turnover, out the same day, to be flat after two successive increases, consistent with subdued growth in household spending. Credit growth figures out from the Reserve Bank the same day will quite likely be about a 1.3% increase on the previous month, and with the same pattern of increasing growth for business lending and declining growth for residential mortgages.

All this is consistent with no move in the cash rate from the Reserve Bank of Australia next week. With the US Federal Reserve moving up again this week and increases on the way in Japan and Europe, the sensible refusal of the RBA to tighten will continue to be associated with a weakening currency.