Economy: Stronger NZ Dollar Threatens Growth In 2004

Despite the combined buffeting of a strong currency appreciation, SARS, a generally weak global environment and an electricity crisis, the NZ economy on reflection has shown amazing resilience in 2003.

Wednesday, February 4th 2004, 10:59AM

Despite the combined buffeting of a strong currency appreciation, SARS, a generally weak global environment and an electricity crisis, the NZ economy on reflection has shown amazing resilience in 2003. While growth has fallen from the 4.5% pace of 2002, the slowdown has been quite modest helped by strong inward migration and a booming housing industry. Growth in the third quarter rose a strong 1.5% after a 0.2% rise in the difficult June quarter, to leave the annual rate at 3.9%. Not bad for a year in which net exports subtracted around 2% from growth.

The external sector was the hardest hit by weak global demand and a stronger NZ dollar. Export volumes fell 2% in the third quarter of 2003, while imports rose 0.8%, helped by a booming domestic economy. But looking forward, the latest migration data suggests that one of the factors that has been driving domestic economic activity – namely, strong population growth – is now waning quite quickly. In November there was a seasonally adjusted net inflow of just 1,020 people, the weakest monthly inflow for over 2 years. This is down on the average net inflows of around 3,500 per month during the peak inflow period. Part of the decline is due to an increase in departures by New Zealanders on the back of a recovering world economy and some easing in geopolitical risk. But at the same time the number of new arrivals has also declined, reflecting a tightening of entry criteria. These trends are likely to continue in 2004, taking some of the heat out of both the housing market and the need for higher interest rates.

Meanwhile, the biggest risk to growth in 2004 is the strengthening NZ dollar. The NZ dollar is at a three and a half year high against the US dollar after recently breaking through the US$0.68 mark, and a three year high on a trade weighted basis. As a major exporter, the NZ economy will come under increasing pressure from a higher currency. However, to date the impact has been fairly muted. This is because currency hedging has shielded exporters from the full impact of a strengthening NZ dollar. For example, Fonterra’s hedging policy is based on a rolling forward cover of 15 months. This means that the average conversion rate for this season is US$0.52 compared with US$0.68 currently. However, the continued strengthening of the NZ dollar means the average conversion rate next season (starting September 2004) is likely to be substantially higher. While some exporters have natural hedges ie: they export to Australia where the NZD/AUD cross rate has been easing and import raw materials in US dollars, the overall impact is predominantly negative.

In 2004 we expect more NZ dollar strength. This is based on the assumption that US authorities will be keen to see more US dollar weakness to rein in the burgeoning current account deficit (at record levels of around 5% of GDP). Also NZ interest rates will still look attractive, particularly if news on alternative investments (ie: equities) worsens. We have recently revised up our NZD/USD forecasts to US$0.70 by mid 2004, with the increasing likelihood that the currency will remain at these high levels throughout 2004, despite a rising current account deficit.

Currency strength will also be an important influence on monetary policy in NZ. It implies a tightening of monetary conditions even without any change in official interest rates. With question marks over the durability of the global recovery and still low inflation rates, there is a good chance that the Reserve Bank of New Zealand will not raise interest rates this year. Indeed there is a possibility that the next move will be down, not up, particularly if the global recovery disappoints.
Geoff Mason

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