China may have fired the first shots in a currency war that unbalances the automatic stabilisers that were just starting to power New Zealand's export rebound

By Bernard Hickey

It was the best of times. It was the worst of times.

The fall in the New Zealand dollar to 65 USc from 85 USc a year ago has been both a blessing and a curse, and in several different ways.

Firstly, it’s wonderful news for exporters, particularly those selling wine, apples, kiwifruit, beef, lamb and holidays at still-high prices. These farmers and moteliers can thank their neighbours on dairy farms. A 42% slump in the US dollar prices of dairy commodities triggered the New Zealand dollar’s 14% fall over the last three months. It was fastest fall for the Kiwi dollar since the Global Financial Crisis. The irony for cow cockies is that just down the road in the orchards and the shearing sheds, it feels as if it’s boom time, or at least time for a quiet few celebratory beers after a long dry spell.

Secondly, of course, it’s not great news for consumers, Kiwi (overseas) holidaymakers, online shoppers, car buyers and businesses buying imported equipment. It means they’re having to pay much higher prices and in effect makes them that little bit poorer, although buyers have had it very good for almost six years. The currency’s slump has done some strange things. Sales of goods bought online from offshore websites were up 29% in June from a year ago, largely because of higher prices.

Thirdly, the currency’s fall has been helpful for the Reserve Bank and the Government in helping to both cushion the blow of the dairy shock and to try to boost inflation back towards the 2% mark that Governor Graeme Wheeler is supposed to target. The combination of lower interest rates and the lower currency are ‘automatic stabilisers’ for the economy and are the great benefits of our flexible exchange rate and inflation targeting system. The moves in the Official Cash Rate and the Trade Weighted Index measure of the currency have egged each other on. The faster commodity prices fall, the faster the OCR has to fall, which in turn accelerates the fall in the currency.

Finance Minister Bill English and Prime Minister John Key are even arguing that these automatic stabilisers are enough to soften the blow from dairy crash and there’s therefore no reason yet to “hit the panic button” and unleash a Government spending programme to stimulate the economy.

“Given our debt objectives, we’d be reluctant to reach for the fiscal lever rapidly when there’s other tools there that can have a more direct affect,” Mr English said this week.

“There’s still plenty of room for further adjustment that would have a more direct impact, and that’s around further depreciation of the exchange rate, further drops in interest rates,” he said.

That’s all fine when exchange rates are freely floated and responding to movements in commodity prices and the relative fortunes of economies. It hasn’t always seemed that way. 

Even Mr Wheeler has bemoaned for most of the last two years how the New Zealand dollar was unsustainably and unjustifiably high relative to commodity prices and our foreign debts, particularly last year when dairy prices fell 50% and the currency hardly fell at all. Critics would argue the currency rose in the face of commodity prices because of the very rate hikes Mr Wheeler unleashed in mid 2014, partly to slow Auckland’s housing market, and that he is having to unwind now, but he was right about the currency’s unfairness.

But now the currency and interest rates are moving in the same direction so the last thing New Zealand needs is for some sort of screwing of the scrum in the world of currency trading.

Yet that is what some argue we saw this week, and from New Zealand’s largest trading partner — China.

The Peoples Bank of China, which tightly manages the yuan (or renminbi as it’s often called), allowed (or forced) the currency to drop 4% in two days on Tuesday and Wednesday. This unwound more than half of the yuan’s appreciation seen in the last five years. There is debate about whether the Chinese Government is deliberately engineering a devaluation to boost its flagging export sector, or whether it is simply allowing market forces to work, and therefore the deprecation is natural.

Whatever the case, the sharp fall in the yuan against the US dollar shocked financial markets and raised even more fears about the health of the world’s second largest economy. For years the Chinese Government has been saying it needed a stronger yuan to help rebalance its economy away from investment in infrastructure and export factories and towards consumption and the services sectors. So the sudden about-face reinforced suspicions that all was not well behind the opaque facade represented by China’s economic statistics.

Some feared it would spark a tit-for-tat series of competitive devaluations across Asia as countries worried that China’s exports would become more competitive than theirs without an even lower currency. This is often described as a ‘beggar thy neighbour’ policy leading to ‘currency wars’. The early signs were not good. Currencies across Asia slumped, including in Vietnam and Malaysia. 

The yuan’s sudden also raises fear about capital flight out of China as investors hurry to get their money out and into assets in other currencies such as the Canadian, Australian, US and New Zealand dollars before the yuan falls further. The People’s bank said on Tuesday its 1.9% devaluation, which was the biggest one day fall in the yuan’s modern history, was a one off. The next day it fell again and by the same amount. Trust in Beijing’s edicts is ebbing away fast, particularly after the debacle in China’s stock markets.

A full scale currency war across Asia and into the rest of the world would be incredibly damaging for New Zealand’s exporters, given we can’t realistically fire our own shots and would have to simply live with a higher-than-natural currency. The New Zealand dollar rose 4.4% this week agains the yuan, despite last week’s 10.3% fall in milk powder prices.

Any such war should increase the pressure though for the Reserve Bank to cut its OCR faster and harder than it otherwise would have, and for the Government to consider accelerating infrastructure investment into the regions. 

The story of the New Zealand economy was a simple one up until this week. It has been a tale of one commodity (dairy) and one city (Auckland). Now there may be a third player — the People’s Bank of China.

* Apologies to the ghost of Mr Dickens.

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A version of this article was first published in the Herald on Sunday. It is here with permission.