Chapter 32
Currency Profile: New Zealand Dollar (NZD)

Broad Economic Overview

New Zealand is a very small economy with GDP valued at approximately US$183 billion in 2013. In fact, there are less people living in New Zealand than in New York City. It was once one of the most regulated countries within the OECD (Organization for Economic Co-operation and Development), but over the past two decades the country has been moving toward a more open, modern, and stable economy. With the passing of the Fiscal Responsibility Act of 1994, the country is shifting from an agricultural farming community to one that seeks to become a leading knowledge-based economy with high skills, high employment, and high value-added production. This act sets legal standards that hold the government formally responsible to the public for its fiscal performance. It also sets the framework for the country's macroeconomic policies. The following are the five principles outlined under the Fiscal Responsibility Act:

1. Debt must be reduced to “prudent” levels; by achieving surpluses on the operating budget every year until such a level is reached.
2. Debt must be reduced to “prudent” levels; and the government must ensure that expenditure is lower than revenue.
3. Sufficient levels of Crown net worth must be achieved and maintained to guard against adverse future events.
4. Reasonable taxation policies must be followed.
5. Fiscal risks facing the government must be prudently managed.

New Zealand also has highly developed manufacturing and services sectors, with the agricultural industry driving the bulk of the country's exports. The economy is strongly trade-oriented, with exports of goods and services representing approximately one third of GDP. Due to the small size of the economy and its significant trade activities, New Zealand is highly sensitive to global performance, especially of its key Asian trading partners, Australia, China, United States, and Japan. Together, Australia, China, and Japan represent 42% of New Zealand's trading activity. It is also extremely sensitive to exchange rate fluctuations, particularly against the Australian dollar. The following lists are a breakdown of the New Zealand's most important trading partners:

Leading Export Markets

1. Australia
2. China
3. European Union
4. United States
5. Japan

Leading Import Sources

1. European Union
2. China
3. Australia
4. United States
5. Japan

Monetary and Fiscal Policy Makers— Reserve Bank of New Zealand

Monetary policy in New Zealand is determined by the Reserve Bank (RBNZ). The Monetary Policy Committee is an internal committee of bank executives who review monetary policy on a weekly basis. Meetings to decide on changes to monetary policy occur eight times a year, or approximately every six weeks. Unlike most other central banks, the decision for rate changes rests ultimately on the bank's governor. The current policy target agreements set by the minister and the governor focus on maintaining policy stability and avoiding unnecessary instability in output, interest rates, and the exchange rate. Price stability refers to maintaining the annual CPI inflation at 1.5%. If the RBNZ does not meet this target, the government has the ability to dismiss the governor of the RBNZ. This is rarely done, but this serves as a strong incentive for the RBNZ to meets its inflation target. The most common tools used by the RBNZ to implement monetary policy changes are the following.

Official Cash Rate (OCR)

The Official Cash Rate is the rate set by the RBNZ to implement monetary policy. The Bank lends overnight cash at 25 basis points above the OCR rate and receives deposits or pays interest at 25 basis points below this rate. By controlling the cost of liquidity for commercial banks, the RBNZ can influence the interest rates offered to individuals and corporations. This effectively creates a 50 basis point corridor that bounds the interbank overnight rate. The idea is then that banks offering funds above the upper bound will attract few takers, because funds can be borrowed for a lower cost from the RBNZ. Also, banks offering rates below the lower bound will also attract few takers, because they are offering lower yields than the RBNZ. The official cash rate is reviewed and manipulated with the goal of maintaining economic stability.

Objectives for Fiscal Policy

Open market operations on the other hand are used to meet the cash target. The cash target is the targeted amount of reserves held by registered banks. The RBNZ prepares forecasts of daily fluctuations on the cash target and will then use these forecasts to determine the amount of funds to inject or withdraw in order to meet the cash target. The following government objectives provide a guideline for fiscal and monetary policy measures:

• Expenses: Expenses will average around 35% of GDP over the horizon used to calculate contributions toward future New Zealand Superannuation (NZS) costs. During the buildup of assets to meet future NZS costs, expenses plus contributions will be around 35% of GDP. In the longer term, expenses less withdrawals to meet NZS costs will be around 35% of GDP.
• Revenue: Raise sufficient revenue to meet the operating balance objective. A robust, broad-based tax system that raises revenue in a fair and efficient way.
• Operating balance: Operating surplus on average over the economic cycle sufficient to meet the requirements for contributions toward future NZS costs and ensure consistency with the debt objective.
• Debt: Gross debt below 30% of GDP on average over the economic cycle. Net debt, which excludes the assets to meet future NZS costs, below 20% of GDP on average over the economic cycle.
• Net worth: Increase net worth consistent with the operating balance objective. This will be achieved through a buildup of assets to meet future NZS costs.

Source: New Zealand Treasury

Important Characteristics of the New Zealand Dollar

Strong Correlation with AUD—Competition with Australia

Australia is New Zealand's largest trading partner. This coupled with their geographic proximity and New Zealand's high dependence on trade, creates strong ties between the economies of the two countries. When the Australian economy is healthy and Australian corporations increase their importing activities, New Zealand will be one of the first to benefit. When it is weak, New Zealand suffers but in recent years its sensitivity has diminished because of the country's growing trade with China and other nations. Nonetheless, 22% of trade is still conducted with Australia, and this explains why there is a positive correlation between the two currencies. Figure 32.1 shows how closely AUDUSD and NZDUSD have moved between 2005 and 2015.

Figure 32.1 AUDUSD versus NZDUSD

Commodity-Linked Currency

New Zealand is an export driven economy with commodities representing over 40% of the country's exports, and as a result the New Zealand dollar has a strong correlation with commodity prices, particularly dairy. Fonterra is one of the world's leading dairy producer and also largest company in New Zealand. Twice a month the Global Dairy Trade will conduct an auction and if prices rise, it will be positive for the New Zealand dollar. If prices fall, it will be negative for the currency because it can mean reduced payout and profit for dairy producers. The correlation between Australian and New Zealand dollars also contributes to the NZD's status as a “commodity linked” currency. Therefore, the New Zealand dollar's correlation with commodity prices is not only limited to its own trade activities. Therefore, as commodity prices increase, the Australian economy benefits, translating into increased activity in all aspects of the country's operations, including trade with New Zealand.

Carry Trades

Of the industrialized countries, New Zealand tends to maintain the highest interest rate as it needs to offer investors a higher yield to compensate for the risk of investing in a small economy. This yield advantage along with its secure credit rating has made the New Zealand dollar one of the most popular currencies to purchase for carry trades. A carry trade involves buying or lending a currency with a high interest rate and selling or borrowing a currency with a low interest rate. The popularity of the carry trade has contributed to the rise of the New Zealand dollar in an environment where many global investors are looking for opportunities to earn high yield. However, this also makes the New Zealand dollar particularly sensitive to changes in interest rates. That is, when the United States begins increasing their interest rates, while New Zealand stays on hold or reduces their interest rates, the carry advantage of the New Zealand dollar would narrow. In such situations, the New Zealand dollar could come under pressure as speculators reverse their carry trade positions.

Interest Rate Differentials

Interest rate differentials between the cash rates of New Zealand and the short term interest rate yields of other industrialized countries are closely watched by professional NZD traders. These differentials can be good indicators of potential money flows as they indicate how much premium yield NZD short-term fixed-income assets are offering over foreign short-term fixed income assets, or vice versa. This differential provides traders with indications of potential currency movements, as investors are always looking for assets with the highest yields. This is particularly important to carry traders who enter and exit their positions based on the positive interest rate differentials between global fixed-income assets.

Population Migration

As mentioned earlier, New Zealand has a very small population, less than half of New York City. Therefore, changes in migration can have significant effects on the economy. Between 2013 and 2014, the population of New Zealand increased by 78,800 people, which was the largest net migration in at least 90 years. Between 2011 and 2012, for example, the population only grew by 26,400 people. Although these absolute numbers appear small, it is fairly significant for New Zealand because of the size of the population. In fact, this strong population migration into New Zealand has contributed significantly to the performance of the economy, because as the population increases, the demand for household goods increases, leading to an increase in overall consumer consumption.

Drought Effects

Since the bulk of New Zealand's exports are commodities, the country's GDP is highly sensitive to severe weather conditions that may damage the country's farming activities. In 2013, droughts cost the country over $1.3 billion. In addition, droughts are also very frequent in Australia, New Zealand's largest trading partner, and when they occur it can have a negative impact on the New Zealand economy.

Important Economic Indicators for New Zealand

New Zealand does not release economic indicators often; however, when they do, the following items are the most important:

Gross Domestic Product

GDP is a quarterly measure of the total production and consumption of goods and services in New Zealand. GDP is measured by adding expenditures by households, businesses, government, and net foreign purchases. The GDP price deflator is used to convert output measured at current prices into constant-dollar GDP. This data are used to gauge where in the business cycle New Zealand finds itself. Fast growth often is perceived inflationary, while low (or negative) growth indicates a recessionary or weak growth period.

Consumer Price Index

The Consumer Price Index (CPI) measures quarterly changes in the price of a “basket” of goods and services that account for a high proportion of expenditure by the CPI population group (i.e., metropolitan households). This basket covers a wide range of goods and services, including food, housing, education, transportation, and health. This is an important indicator to watch, as monetary policy changes are highly influenced by this index as it is a measure of inflation.

Balance of Goods and Services

New Zealand's Balance of Payments statements are records of the value of New Zealand's transactions in goods, services, income, and transfers with the rest of the world, and the changes in New Zealand's financial claims on (assets), and liabilities to, the rest of the world. New Zealand's International Investment Position statement shows, at a particular point in time, the stock of a country's international financial assets and international financial liabilities.

Retail Sales Ex Inflation

Credit card spending numbers are released for New Zealand on a monthly basis but the retail sales data is quarterly on an ex inflation basis. This measure tracks the resale of new and used goods to the public for personal or household consumption. It is also an important input into GDP.

Producer Price Index

The Producer Price Index (PPI) is a family of indexes that measures average changes in selling prices received by domestic producers for their output. The PPI tracks changes in prices for nearly every goods producing industry in the domestic economy, including agriculture, electricity and natural gas, forestry, fisheries, manufacturing, and mining. Foreign exchange markets tend to focus on seasonally adjusted finished goods PPI and how the index has reacted on a m/m, q/q, h/h, and y/y basis. New Zealand's PPI data is released on a quarterly basis.

Figure 32.2 illustrates the 10-year performance of NZDUSD.

Figure 32.2 NZDUSD 10-Year Chart

Source: eSignal