NZ/Aussie Optimum currency area

There is a little bit of talk about a ANZAC currency I see.  Lets be honest here, this effectively implies that New Zealand would be adopting the Aussie dollar. I remember arguing about this with my brother a while back, he was pro I was against.  Nowadays, I’m not sure – I’d like to see a few studies on it first.

Now there are costs and benefits from such a currency union.  Pages 633-634 in “Foundations of international macroeconomics” by Obstfeld and Rogoff covers these off as follows:

Benefits

  1. Lower transaction costs.  As Aussie is our main trading partner this is a biggie.
  2. Removes exchange rate risk for trade between nations, both in terms of relative prices and account reporting.
  3. Prevents damage from exchange rate verring from fundamental level.
  4. Makes trade protectionism more difficult.
  5. Added I would also add that, in this case, having the Aussie dollar will reduce the risk premium we have to pay for credit

Costs

  1. Can’t use monetary policy to compensate for region specific shocks – dairy price crashes and we can’t use a lower interest rate to help buffer the fall.  This is the primary concern.
  2. Can’t use inflation to lower public debt – our monetary policy is now determined by Aussie.  However, we don’t do this so it doesn’t matter.
  3. As fiscal policy is independent it can cause issues with splitting “seigniorage revenue“.  With a low inflation target this is not a biggie at all.
  4. Speculative attacks prior to the union.
  • Miguel Sanchez

    “I would also add that, in this case, having the Aussie dollar will reduce the risk premium we have to pay for credit”

    Why? It wouldn’t make us a better credit risk. There’s no reason to think that NZ should be able to borrow at Aussie rates, any more than an Aussie company should be able to borrow at the same rate as State Governments, or that either could borrow at the same rate as the Federal Government, just because they’re using the same currency.

  • @Miguel Sanchez

    I agree. However, I was assume that since it would lower the volatility of the currency it would lower risk associated with exporting firms. Maybe I should be more explicit in the post.

    I 100% agree that, even though the risk free rate will be the same between countries, if systematic risk is higher here interest rates will be higher for firms.

  • Miguel Sanchez

    Sure it would remove the volatility against the AUD. But if we’d used the AUD in the last few years we would’ve had even greater volatility against the USD, and by extension China, Hong Kong, Singapore and parts of the Middle East, who all peg to the USD to varying degrees.

  • @Miguel Sanchez

    Indeed, it wouldn’t have removed it. However, it would have reduced it.

    Furthermore, Aussie is our main trading partner.

    However, I agree its a point a need to spell out more in the future.

  • Miguel Sanchez

    Aussie is our largest single trading partner, but by my count they take 23% of our exports; the other countries I mentioned take about 25%. So I’m not sure we would have been better off on balance by adopting the AUD.

  • @Miguel Sanchez

    In terms of exchange rate risk and volatility from this channel I think we would have been as:

    a) There would have been none of this against the Aussie,
    b) The Aussie dollar is less volatile than the NZ dollar.

    Again none of this means we would have been better off – as we have the enormous cost of losing monetary independence.

  • Andrew Coleman

    A couple of things

    (a) There needs to be a clear distinction between individual credit risk (counterparty risk) and currency risk. I don’t expect to be able to borrow at the same rates as the NZ Government or the Australian state governments even if we had a common currency. But it is possible that NZers have paid higher interest rates than Australian for the last decade and a half because of currency risk, not because of idiosyncratic counterparty risk. The question should be: would NZers pay less currency risk if we adopted the Australian currency. I would think so: or least the European evidence makes me think NZ interest rates would be lower if we adopted a different currency. Indeed, I thought the evidence fairly strongly suggested that European short term wholesale rates converged remarkably after the adoption of the Euro in 1999 – at least for the core countries Germany, Framce, Italy, and Spain. There was a remarkable reduction in the volatility and level of Italian and Spanish short term rates (see Menzie Chinn and Jeremy Frankel (2005) The Euro Area and World interest rates for a statement). It is true that retail mortgage rates have not converged so much, but this reflects idiosyncratic banking sectors across Europe and a death of competition inthe retail markets.

    This issue is the big one – and was the big one a decade ago. NZers borrow in the order of 100% of GDP and pay interest rates margins much higher than those in Australia for the privilege of borrowing in NZ dollars. This is real money – at least a billion a year, or $300 per person per year. Every year with our own currency is another billion or more paid to foreign agents. The real question is whether the insurance benefits of having an independent currency are worth this huge fee.

    (b) In your list of potential costs, you could list the possibility of having poor quality monetary policy. Not that i am accusing the RBNZ of making more mistakes than others (although they have admitted a few)…. but it is a standard reason on the list.

    (c) The Australian dollar has been less volatile not more volatile against the US dollar than the NZ dollar since 1990. The ratio of the standard deviation to the mean for AU/US is 13.9%, while for NZ/US it was 15.9%. There is a similar difference in the TWIs of each country. So if we were to adopt the AU dollar, not only would we get rid of exchange rate variation with Australia, we would have less variation with the rest of the world as well. This of course does not say that having our own currency doesn’t provide us with variation when we want it. But even the RBNZ does not believe all exchange rate volatility is good volatility this any longer: their public statements and the fact that they intervene in the currency markets suggest that they don’t believe variation in the value of the dollar is always welcome.

    (d) It is true we sometime have idiosyncratic shocks, although most shocks are probably global these days. Interestingly enough, the last twice we had clearly identified idiosyncratic negative shocks (the El Nino droughts of 1997/8 and 2007/8), interest rates were raised by the RBNZ.

    I clearly don’t have much time for the argument that in practice we would be a lot worse off by adopting the AU dollar: frankly, i think we would be a lot better off. But since this debate isn’t likely to go anywhere – my sense is that the senior public servants in NZ have a strong belief that a country can’t be taken seriously without the ability to fiddle with the monetary levers – , perhaps it would be more interesting for us to suggest evidence that would make us change our minds. My first thought on this issue is that I would probably be less inclined towards using the Australian dollar if there was evidence we wouldn’t get lower interest rates.

    Andrew

  • Miguel Sanchez

    First, the AUD has actually been more volatile in the last few years, which is why I specifically said “in the last few years”. My feeling is it will continue to be the more volatile one in the future, to the extent that the market views Australia as being more leveraged into the China story than NZ. Joining the AUD right now would be like Dutch disease times two – bad enough when one export industry is so successful that it kills off all the others; worse when that successful industry isn’t even yours.

    Second, Europe doesn’t make that good a case for currency unions anymore. The idea that any nation who uses the euro should be able to borrow at a similar rate to the safest country (Germany) was promoted by LTCM, and appears to have been their single most profitable trade. They exhausted the profit opportunity in that trade long before they imploded, but the belief persisted for several years afterward, at a time when all risk premia were basically being bid down to zero. But the credit crisis has since shattered that belief – maybe permanently – and now basketcases like Italy have to pay substantial margins over the likes of France and Germany, as they should. There’s really no reason why a currency union should reduce currency risk from the lender’s point of view: as long as you’re a sovereign state, you always have the option to drop out of the union and start printing your own currency again if things get tough.

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  • Andrew and Miguel,

    You both have excellent points, good stuff.

    Surely to get some idea of what is the best option we could simply set up a DSGE model and compare outcomes in the case with a floating NZ$ and in the case where we fix against the Aussie with Aussie monetary policy.

    I don’t think the concept of a currency union is something we can figure out solely on the basis of theory.

  • Andrew Coleman

    We seem to be using different data. It is correct that the NZ/US rate is becoming less volatile, but it is not clearly less volatile than the AU/US rate.

    The following tables show
    (1) the standard deviation divided by the mean for the level of the AU/US and Nz/US exchange rates (under the assumption that the series are stationary so it make sense to calculate a standard deviation)
    (2) the standard deviation of the 3 month percentage change in the AU/US rate and the NZ/US rate (calculated on a rolling basis)
    (3 &4) the same for the 6month and 12month changes

    Each is calculated for 4 periods: 1990- 2009, 1999-2009, 2004-2009, 2007-2009. For the 1990- 2009 and 1999-2009 periods, the Au/US rate is less volatile than the NZ/US rate on all measures. For the most recent periods, the NZ/US is marginally less volatile on the 3month and 6month changes, but more volatile over 12 months and in levels.

    AU/US
    std/mean std std std
    level 3mnth 6mnth 12 mnth
    1990-2009 0.139 0.057 0.082 0.116
    1999-2009 0.176 0.067 0.097 0.132
    2004-2009 0.099 0.077 0.113 0.133
    2007-2009 0.122 0.104 0.149 0.174

    NZ/US
    std/mean std std std
    level 3mnth 6mnth 12 mnth
    0.159 0.057 0.086 0.133
    0.199 0.070 0.103 0.152
    0.099 0.076 0.114 0.149
    0.133 0.097 0.140 0.191

    A similar story holds with the respective TWIs; over 3 or 6 months, changes in the NZ TWI have lower variability (in the last five years) than changes in the AU TWI, but over longer horizons this is not true. This suggests that the NZ dollar may have some positive autocorrelation (or the AU dollar some negative correlation) Either way, it seems difficult to suggest that the NZ dollar is clearly less volatile than the Australian dollar. Put differently, if we used the AU dollar we would gain by eliminating the volatility against our most important trading partner for manufactured goods, and have almost the same (possibly a bit better, possibly a bit worse depending on the horizon) volatility against other currencies. And a spare billion a year or more on the interest differential to boot.

    More to the point, exchange rate volatility can be good or it can be bad, so a comparison of standard deviations is not clearly the relevant measure. We want to know if the exchange rate is helping offset shocks or if it is a cause of shocks. The 1970s case for floating currencies was that the exchange rate would help adjustment. Empirical evidence since then is much less supportive of the idea, and there is a decent theoretical case on why an exchange rate can be a cause of shocks rather than a means of offsetting then. Globally, there is considerable evidence that real exchange rate volatility is excessive, and on empirical grounds the NZ case is by no means clear (and tick tick tick goes the billion a year 3 million a day $2000 per minute interest differential clock). We know the exchange rate changes in inexplicable ways to CPI announcements and the RBNZ often complains that the exchange rate is not where they want it to be. It seems to me that the default case should be that exchange rate volatility is probably not useful unless it is shown to be useful; and even then, the onus should be on supporters of an independent currency to show that the benefits are likely to exceed the costs. Historically this is difficult, for there have not been a lot of obvious benefits to NZ, although if the primary benefit is one of insurance against a very large adverse shock, and this shock has not yet occurred, such a test will typically fail even though a currency union might be justified. But this largely relies on faith: faith that we understand the probability of these large, idiosyncratic shocks, faith that in the event of these shocks monetary policy and the exchange rate will deliver the correct pallative, and faith that in the mean time unwanted exchange rate volatility and interest rate costs don’t impose excessive costs.

    Mind you, I have long been in the Friedman camp that having the ability to fiddle with the monetary levers to fine tune an economy sounds a lot better in principle than it is in practice: and I suspect that in NZ this is a small camp, there being a lot of “true believers” who believe that having an independent monetary policy is a sufficient condition for ensuring that monetary policy actually delivers positive results.

    I shall disagree with your last point. Joining a currency union substantially reduces although does not eliminate currency risk, even though it might not (probably does not) reduce counterparty risk. It is much more costly for a government to exit a currency union that it is to either devalue a currency or debase the currency through inflation. Consequently, a government must be in much worse straits to consider leaving a currency union than it would be to debase the currency and let its value fall. The Euro is yet to provide any evidence on this point. I am quite happy to believe that NZers might face different counterparty risk than Western Australians, Queenslanders, Tasmanians, Victorians South Australians, residents of ACT or New South wales (do we just call them blondis?) and thus might face higher interest rates than residents of these places. But I doubt if they would face different currency risk, just as residents of these states don’t have differnet currency risk (or counterparty risk, I believe.)

    Does anyone have figures on per capita net debt/income ratios across Australia? I would bet the ratios in Tasmanian are much lower than elsewhere (if only because the average age of Tasmanians must be 74 by now) yet I doubt they have different mortgage rates.

    tick tick tick a billion here, a billion there soon you have a real net foreign liability position

  • Andrew Coleman

    Matt, that presupposes a belief that the current generation of small DSGE models are useful for analysing monetary policy……a somewhat debatable proposition since most don’t have a realistic way of modelling price setting, and have a rudimentary financial sector if they have a financial sector at all. It also depends on how exogenous exchange rate shocks are modelled, and whether they can simultaneously track a changing trade pattern with Australia and the rest of the world.

  • Miguel Sanchez

    Tick tick tick yawn… seems your view is that the real benefit of a currency union would be lower interest rates, in which case let’s see some evidence that lower rates would have actually led to better outcomes here. When I was at school I was taught that prices are determined by demand as well as supply, and there’s precious little sign that existing interest rates have retarded our demand for debt. Our current RBNZ Governor has already done a real-life experiment with lowering rates to match Australia, and look where it got us.

    The example of Australian states is irrelevant for currency risk, since they would find it just about impossible to secede from the rest of the country. On the other hand Europe, while it hasn’t provided any concrete examples yet, is still instructive. Berlusconi has made noises many times over the years about ditching the euro, but there’s been widespread agreement that they’d never do it, because Italy would then be confronted with the ‘true’ cost of funding its bloated public debt – effectively an admission that the cost of borrowing has been mispriced within the euro mechanism, allowing them to rack up so much debt in the first place.

  • @Andrew Coleman

    But in terms of tools I can’t really think of many other ways we can try and “objectively” cost such a proposal.

    An Australia/New Zealand CGE model of some sort what be able to figure out, at least, the long-run consequence of such a change on NZ.

    However, I do agree that either a CGE model or a DSGE model would not give us sufficient direction regarding the transition costs associated with any change – which are likely to be important

  • @Miguel Sanchez

    We can’t quite infer that lower rates would have implied looser monetary policy in NZ – because we would have had a stronger currency through the union.

    I think the main question we have to ask is how our internal rate of exchange would change. If lower rates drove the housing market on further, and increased non-tradable price pressure, then I suspect that general outcomes would be worse.

    However, I have a strong anti currency union bias which I am willing to admit because:

    1) I believe exporters are strongly able to hedge against exchange rate risk
    2) I believe the exchange rate does compare to some underlying fundamentals, and that these fundamentals are merely more volatile than we would like – and hence lower exchange rate volatility would imply higher price level volatility, something that has a higher welfare cost. [I just realised how much that logic makes me sound like a new classical economist 😛 ]

    Even so, I am willing to be turned the other way – given that I recognise there is a trade-off in any currency union situation (hence why Auckland does not have its own currency).

    For me it is a question we can only answer empirically.

  • For me “Can’t use monetary policy to compensate for region specific shocks” is the absolute killer for two reasons. First, New Zealand’s export economy is substantially different to Australia’s and works on different cycles. Second, the region specific shocks are something of a hot potato inside Australia with some states whinging about New South Wales economic dominance. If it’s a problem for Tasmania or Queensland, it’s going to be worse for NZ.

    Having said that, I like the idea of paying Australian interest rates.

  • I think we all like lower interest rates in the short term, until we see the other side of it which include high rates at any one point…..when the economy is at a standstill circa California 2008 it will be a different conversation!

  • Andrew Coleman

    There are at least two difficulties with the type of empirical evidence you suggest, Matt. The first is conceptual: If NZ were to join a currency union, the structure of the economy would be different than if it did not. If NZ used the Australian dollar, NZ would almost certainly trade more with Australia, meaning the economic cycles would be more synchronised; NZ would probably have a different inflation dynamic because wages would adjust differently to inflation; NZ might well have a different monetary transmission mechanism. On the latter, for example, NZ’s monetary transmission is different because far more NZers use short term fixed rate mortgages than Australians, leading to additional lags in the transmission process; in turn this is a response to the steeply inverted yield curve that is often seen in NZ but not elsewhere in the world. Asking whether NZ’s past history of interest rates would have been better for NZ than Australia’s past history of interest rates presupposing NZ’s historical economic structure will obviously bias you towards saying NZ interest rates were more appropriate. Sure; but if NZ had been in a currency union, and had a different economic structure than that which we had, Australia’s may have been more appropriate. For instance, Australian can probably get away with smaller changes in interest rates than NZ because the transmission of monetary policy is much quicker, and hence any interest rate change is more effective. If we had a joined a currency union, Dr Bollard may not have needed to raise rates to 8.25% in late 2007/ early 2008, because a smaller number might have done the job (as it did in Australia.) Similar, it might not have been necessary to cut interest rates so low in 2009, because smaller cuts may have been sufficient if we had evolved a transmission mechanism like Australia’s.

    For this reason, one needs to ask a different set of empirical questions. Were NZ’s overall outcomes from having monetary independence demonstrably better than other countries? Did monetary policy help cope with exogenous shocks? Was the pattern of shocks different (better/worse) because we had separate monetary policy? I fail to see the evidence on the first. Over the last decade, compared to Australia, we have had higher interest rates on average, similar but on average higher exchange rate fluctuations, inflation that has only been 0.2- 0.3% worse (although bad enough) and no clear pattern that monetary policy has helped us avoid house price cycles or recessions. The interest rate question is vexed, but it seems silly to ignore the fact that interest rates are much higher in NZ than elsewhere. Per capita costs equate to over $10,000 for average family of 4 over a decade: the least that can be said about this number is that isn’t the average Australian family of 4 lucky that they can have monetary policy that delivers similar outcomes to NZ and costs them $10000 less over a decade. Numbers this large suggest it is at least worth asking if indeed NZ has the best possible monetary policy

    On the second question, – did NZ’s monetary policy help cope with idiosyncratic shocks – it is necessary to clearly identify the shocks. That is the other problem with using a CGE or DSGE model: the identification of time series macro models is always difficult. One needs incredible faith to believe most identification schemes – which is why time series models are mainly used for forecasting, not structural analysis. (Most economists in other fields (eg labour, development) don’t use these techniques precisely because they don’t believe the identification, and they spend an inordinate amount of time developing datasets/ techniques in which a shock is identified.) But in the last few years there have been some idiosyncratic shocks hitting NZ: two droughts, and the migration boom in 2001/3, for example. So it seems legitimate to ask: did monetary policy help NZ adjust to these shocks? I haven’t studied any of these cases in any depth at all, but as a first stab I would say “Monetary policy wasn’t much help.” Interest rates were raised as the droughts struck, monetary policy wasn’t appreciably tightened to help cope with the migration influx and the resultant housing boom (and there was a stage in 2003 when interest rates were cut before being rapidly increased in 2004). These episodes do need to be explored properly so the empirical question of whether an independent monetary policy actually helps a lot in practice can be answered.

    On interest rates: who really knows why they are so high in NZ. It could be a foreign issue: while there is no shortage of foreigners wanting to lend money, they may be a shortage of foreigners wanting to lend in NZ dollars and we might be able to get cheaper loans in a different currency if we used one. Or it could be a domestic issue: the RBNZ clearly controls short term rates, it may simply have chosen to have had very high interest rates over the last 15 years in order to “achieve” its inflation and other (stabilisation) goals. I am not opposed to having moderate interest rates: one of the reasons I admire the RBA so much is precisely because they resisted the international trend of ultra low interest rates in the mid 2000s. But the question still remains: isn’t it unlucky that NZers can’t have a monetary policy that delivers low inflation and a stable economy without having interest rates much higher than elsewhere in the world (in particular Australia), because the current arrangements are very costly. But perhaps, as Dr Pangloss might have said, that is just bad luck; we do live in the best of all possible monetary worlds, and should count ourselves fortunate for having monetary independence, for without it things would have surely been much worse.

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  • Rhino

    Though Aus is our biggest trading partner from memory they are only 30% of our exports. Which is relatively low compared to other currency unions.
    That is always worth remembering.
    All these discussions though is irrelevant as there is no substantial reason for Aus to join in on a currency as they dont get anything out of it really.

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