Markets are still digesting the decision by the Reserve Bank of New Zealand (RBNZ) to leave the Official Cash Rate (OCR) at 2.5 percent. The first reaction was one of pleasant surprise to a market which had expected a cut and, as such, the Trade-Weighted Index (TWI) rose by 60 points to 60.1 and the 90-day Bank Bills rate rose 10 points to 2.82 percent. As we go to press the NZ$ is stronger at 60.5 on the TWI, and 63.5 US cents, with the 90-day rate still at 2.8 percent. 

In economic terms this is not good news, coming at a time when exporters were already suffering from an exchange rate which had risen from the 53 to 59 on the TWI in the previous three months. The RBNZ Governor nobly called on the banks to sacrifice some profits for the national benefit, but nobody was expecting any response other than perhaps some short-term window dressing.

Of more importance have been conditions in the major money markets where there has been significant easing as a result of the Federal Reserve and Bank of England measures to increase liquidity in their respective financial systems. Just as oil, other commodity and share prices have risen, so has the NZ$ as more US and UK funds have become available to invest in currencies.

Whether or not this will translate into more funding of business – the true engine of growth – is yet to be seen but the outlook is not favourable for the following reasons:

1. As we have pointed out previously, the banks’ balance sheets remain in poor shape with capital and reserves at less than 5 percent of liabilities at a time when assets remain “distressed”. This level compares, for example, with an 8 percent reserve objective as one of the “stress test” criteria required by the US Treasury for bailing out US banks. It seems likely that something similar will be aimed at by our banks if only to be able to borrow at lower rates of interest.

2. Another drain on available funds is the financing of NZ’s current account balance of payments, already adversely affected by lower terms of trade and a higher NZ$.

3. The Government has a large deficit to fund which will be a preferred form of lending and will “crowd out” domestic borrowers to the extent that the Government fails to raise funds from overseas. Despite the retention of an AA+ credit rating, funding the whole deficit from abroad is unlikely in view of the competition for funds from local borrowers and countries in greater need.

All of this suggests firms should not rely on availability of additional bank funding for the foreseeable future. Already, according to the latest RBNZ figures (April), total credit expansion is close to zero on a month on month basis. The business sector, in particular, has been hard hit – with credit expansion being in negative territory continuously since December and at an annualised rate of -11 percent in both March and April.

Regarding “green shoots” optimism, we note authorities around the world are sceptical and we share that view. Alleged signs of recovery in the housing market, for example, are more likely to be the “catch up” effect of buyers and sellers simply running out of time and patience rather than a sign the market is reaching a new equilibrium.

Interest rates

As we go to press, the 90-day rate has risen about 10 points to 2.8 percent following the zero change in the OCR well down from 3.4 percent three months ago. The 10-year bond rate has also risen by a few points to 6.3 percent on the OCR decision, which is well up on the 5.0 percent level of three months ago but in line with foreign trends.

The RBNZ’s calls for the major banks to reduce retail rates hardly needs comment here. Suffice to say that banks appear to be considering their response as we go to press.

We note the latest RBNZ figures in a new data series show that in May the average rate for business was down less than 2.5 percent-points over the period during which the OCR has been reduced by 5.75 percent-points from 8.25 percent to 2.5 percent.

The banks maintain they borrow at higher rates offshore, but the RBNZ appears not accept this as a sufficient explanation.

As to the future, we expect the RBNZ to lower the OCR to 2.00 percent in a couple of 25-point steps. This is in line with previous signals, but more to influence the exchange rate at strategic times than to have any effect on domestic demand.

Exchange rates

The NZ$ has strengthened over the past three months from 53 to 61 on the TWI, i.e. by about 14 percent. On the cross-rates it is clear that the US$ and linked currencies (including Japan) are the main movers (24 percent) followed by the Euro (13 percent) and Sterling (4 percent). Australia is the only currency to have appreciated against the Kiwi (1 percent).

What appears to be happening is that the causation of the NZ$ depreciation discussed in our March issue has gone into reverse. In the period following the crash, funds were being transferred back to their liquidity-starved bases. Now, more normal flows are returning as major financial markets have liquidity restored by the bailouts put in place by the monetary authorities.

Previous beneficiaries of the excessively liquid markets, notably New Zealand, Britain, Australia and South Korea, have experienced suppliers of credit repatriating their investments to fill liquidity shortages at home. The recent behaviour of the US$ following improved expectations regarding the health of US financial system illustrates the likely movement in the NZ$ if and when normality in the credit markets is resumed.

That time is not yet, and in the meantime we expect the NZ$ is likely to drift gently downwards until the BOP deficit is markedly reduced by a lower level of imports and an increased level of exports. On past experience, the present rate looks high for long-term equilibrium. Further, some downward “overshooting” could still occur and, of course, there are all the other factors, especially concerning the US dollar, that will be influencing the overall structure of rates.

We do not share concerns that we are already observing the resumption of another inflationary bubble. The financial instruments that facilitated the last bubble are in disrepute and even Wall Street whiz kids will take some time to develop new ones. Indeed, as discussed above, our view is that world liquidity is more likely to be in short supply than excessive.

However, we are concerned that New Zealand is ill-equipped to handle the exchange rate volatility that is likely to accompany the structural changes inevitable as the world economy negotiates a new international trading economic order. As we have advocated many times, there needs to be greater intervention in the foreign exchange markets to reduce the volatility of our dollar. But, we are not confident our authorities will be up to the task.

We believe the NZ$ is more likely to weaken than strengthen in the long run, but it is so much a cork on the raging sea of international uncertainty that anything could happen. As usual, the only advice we can give is that full forward cover should be taken out regardless of currency or whether the deals are receipts or payments.

We retain our previous forecasts of a nadir near 47 on the TWI in mid-2010, returning to about 50 over the latter-half of the forecast horizon. But, admittedly, with even more emphasis on the usual caveats.

- Reprinted from BERL Forecasts June 2009