Would a fixed exchange rate save NZ?

According to the Standard, having a free floating exchange rate puts New Zealand at the mercy of speculators – I take this to mean that the author would prefer New Zealand having a fixed (or at least semi-fixed) exchange rate.

What does having a fixed exchange rate mean? Well, if we have a fixed exchange rate we are setting the value of our dollar compared to the value of other countries currencies. In this case, we have certainty about the future export and import price of goods – which is a good thing.

However, in this case our currency is just as open to currency speculation (if not more so, as the price of the currency is fixed, making yield focused attacks more of a “sure thing”), implying that this perceived benefit does not exist – it merely moves on to influence another economic variables. In fact what it does (as long as we don’t close the country off to all capital markets) is removes New Zealand’s ability to control its interest rate (as the government has to print money at a level required to keep the exchange rate fixed) . In economics this is termed the impossible trinity.

Without the ability to control interest rates, we also lose our ability to stabilise prices – thereby implying that the domestic price of goods will become more volatile, and inflation expectations are likely to become unanchored.

We then have to ask, for New Zealand what is more important, price stability or exchange rate stability? New Zealand is an open economy so the exchange rate is important. However, the fact that firms can hedge against changes in the exchange rate more effectively than households can hedge against changes in the rate of price growth implies that stabilising growth in the price level and anchoring inflation expectations is more important for the nation.

The author also states that:

we could keep the exchange rate lower, which would deliver far greater increases in export earnings than even the China FTA

I hope he realises that keeping the exchange rate artificially low will benefit exporters but at a cost to New Zealand households. Although such a policy may make sense in the case where we have “infant industries” in the export sector, I think it is inappropriate in New Zealand’s case (given that our industries that have a comparative advantage with the rest of the world are already highly developed).

As a result, fixing the exchange rate artificially low will make New Zealand households poorer, and ensure that these households have to face high levels of volatility in the price level (with an upward trend as doing so involves printing “extra money“, which is likely to dis-proportionally hurt the poor) – a surprising policy recommendation from a left-wing blog.

  • Steve Pierson

    Thanks for an insightful critque.

    I wouldn’t say I’m advocating moving away from a floating exchange rate myself, I was more trying to explain Peters’ thinking and saying he does have a point, and you fairly acknowledge some of the good points in having a non-free floating exchange rate.

    I’m not necessarily saing a fixed exchange rate would be the way to go either. Eastern European countries have done well with currency boards keeping the exchange rate within reasonably broad ranges against a basket of currencies and taking a flexible, active stance to exchange rate management (which neither fixed rate set at ministerial level nor a clean float can deliver). Now, we’re in some kind of weird halfway house with the Reserve Bank occassionly making seemingly random interventions according to unknown criteria with unspecified goals.

    I’m aware that a lower exchange rate would mean more expensive imports and a deadweight loss but there are other negative consequences that flow from too many imports as well. And the long-term consequences of exports struggling to be competitive while cheap imports flow in should not be forgotten.

    It’s certainly not a clean cut case one way or the other.

  • I think certainty of prices for exports and imports is not a big advantage of a fixed exchange rate, as this certainty can easily be bought in financial markets by using forward contracts. If certainty is what’s needed, the real question is whether a fixed exchange rate could provide it more ‘cheaply’ (in terms of national welfare for example) compared to the premium that the financial market charges for hedging risk. Given the efficiency of financial markets, I highly doubt that a fixed exchange rate would be more effective.

  • Hi Steve,

    Thanks for the reply.

    “Now, we’re in some kind of weird halfway house with the Reserve Bank occassionly making seemingly random interventions according to unknown criteria with unspecified goals”

    I’m not completely keen for the ad-hoc way we have entertained the policy of exchange rate intervention either. As far as I can tell, the RBNZ is only entertaining exchange rate intervention at the margin – so if the dollar gets frothed up as the result of speculation, they will look at baiting it downwards by selling NZ$. As long as the intervention is sufficiently small, they hope that the impact they have on the exchange rate (by cooling peaks and picking up troughs) will exceed any impact on their ability to perform domestic monetary policy.

    All in all, I think the type of policy they have is probably best practice – however I’m not sure how clear their internal policy goals are.

    “I’m aware that a lower exchange rate would mean more expensive imports and a deadweight loss but there are other negative consequences that flow from too many imports as well. And the long-term consequences of exports struggling to be competitive while cheap imports flow in should not be forgotten.”

    Negative consequences from imports? We are getting goods more cheaply, and of a higher quality than we could of ourselves. The only time we have a negative impact from imports is when we have an infant industry that needs to be developed and will in time have a comparative advantage. However, I don’t think we have any of those – so imports seem pretty good to me.

    Also the balance of payments deficit illustrates a preference of New Zealanders – consume now, pay back later. It will mean we have to repay this debt at some point – however individuals in New Zealand choose to consume at this level. Hopefully a slowing in the economy will help to reduce this a bit. It is inappropriate to blame the avaliablity of imports for this – its like blaming the chocolate company for “making me” eat Moro bars 😉

    “And the long-term consequences of exports struggling to be competitive”

    The export industries should be viable in the case where we have our “average” exchange rate. If they are not, then there is a better use for those resources (opportunity cost and all that). That is part of the argument for having “large” export companies – they have a good ability to hedge against exchange rate fluctuations, and longer lines of credit when we are in a situation with a high exchange rate.

  • “Given the efficiency of financial markets, I highly doubt that a fixed exchange rate would be more effective.”

    Agreed. However, you could make a case for a fixed exchange rate giving a benefit in this case for a place like New Zealand, where financial markets are relatively thin, and large numbers of exporters are small firms which may struggle to set up long term contracts with their clients.

  • Sounds like you might have found a business opportunity there Matt … a financial intermediary that aggregates the fx needs of small exporters and importers to buy forward contracts, and then sells simple standardised risk-hedging products to those small businesses.

  • “a financial intermediary that aggregates the fx needs of small exporters and importers to buy forward contracts, and then sells simple standardised risk-hedging products to those small businesses”

    Sounds hot – I’d be incredibly out of my depth though and everyone involved would probably go bankrupt 😉

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  • Sinner

    For a country has small as NZ, having a fixed exchange rate is just inviting trouble. Didn’t work for the Pound, won’t work for the NZD.

    if we’re serious about this, just adopt the aussie dollar, or go the whole hog to the USD or Reminbi.

    But having the govt bet against George Soros? Priceless!

  • Eastern European currency boards?

    So let’s ignore the fact that Eastern European countries sit on the doorstep of the EU. Same with currency boards in South America having the US next door.

    The currency board arrangement in HK means that its monetary policy is run by the US.

    There are always pluses and minuses for any type of regulatory framework. But just because one plus exists does not mean it is the best, nor does the existence of a minus mean that it is the worst.

    Put aside for a moment the question of sustainability and credibility. The conventional view of the fixed vs. floating debate is that floating means that more of the adjustment that follows from a shock is done by the exchange rate whereas with a fixed exchange rate more of the adjustment is done via the real economy. Indeed, those who are concerned about the plight of the lower income groups should reflect on who would be worse off if there are significant fluctations in output and employment.

    Finally back the sustainability/credibility issue. We live in a world of highly mobile capital. Unless we go the route of autarky and severe capital restrictions, we must recognise that any attempt to control our exchange rate will have limited effect unless it is credible. A managed float? The RBNZ’s last foray into this area has clearly shown that the effect is temporary when market consensus is against it. Although our economy is considerably more flexible than it was 24 years ago, a little reading of our economic history should show advocates of a fixed exchange rate that a stubborn resistance against international capital flows would rapidly bankrupt our country. Of course, that was a period when the pressure was for a depreciation in the NZ dollar. And while the RBNZ can easily “print money” to fund intervention on the top side (selling NZ dollars to cap its appreciation) it must sterilise this by issuing debt to take money out of the domestic system. Bang goes debt management.

    Arguably the most successful “fixed” exchange rate is the Chinese Yuan. Yet even there there are signficant capital impediments. The implication is that if you want to control the exchange rate, you must also control (or at least tightly limit) capital flows. All well and good if you are willing to turn your back on the international markets and pay only lip service to economic freedom.

    By the way Matt, I’m afraid the business opportunity has already been taken by things called banks!

    Steve – it is only clear cut when you want all arguments pointing in one direction. Economics (and especially financial market economics) would not exist if things were like that. Sure the arguments are not etirely in favour of a floating exchange rate but on balance they point more to a floating than a fixed regime.

  • “By the way Matt, I’m afraid the business opportunity has already been taken by things called banks!”

    I didn’t realise that banks allowed small businesses to hedge against exchange rate risk. Thats a good thing then.

    Just to make sure, my post was pro-floating like your comment Dismal. I was just trying to be as positive about fixed as I could so I could make a clear argument about some of the fundamental problems 🙂

  • I guess it depends on your definition of small. Westpac offers currency insurance for contracts of at least $50,000.

  • “I guess it depends on your definition of small. Westpac offers currency insurance for contracts of at least $50,000.”

    Cool, thats good stuff to know!

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