A story in this weekend’s NBR outlined how the exchange rate was still the major concern for NZ exporters. With the NZ$ at 52p and 0.65 Euros, it’s not hard to see why that is the case. On the other hand, strong commodity prices over the last few years have helped the trade balance into positive territory on occasions, negating the effects of the strong currency. So on balance, although the currency is clearly too high, it is not so out of whack that our trade balance is deeply negative.
Currencies are primarily a method for exchanging goods and services between different nations and, therefore, an important component of international trade. When countries have a surplus or deficit in their trade accounts, they need to deal with the foreign currency surplus or deficit. Theoretically, the exchange rate should adjust to rebalance any surplus/deficit and so restore an overall balance. That’s the general idea behind floating exchange rates. It was certainly the crux of the plan that Keynes proposed at Bretton Woods back in 1944, as he knew that trade imbalances had contributed to general global political instability in the previous world wars. However, the US, with its tail up, insisted on the US$ as the centre of global trade, and thus we have seen the global imbalances continue for the last 70 years.
Prior to the 1980s deregulation bonanza, a serious balance of payments deficit could see a country on its knees, going cap in hand to the IMF to borrow the deficit, as was the case with the UK in the 1970s. There was some form of censure and limit to imbalances, with draconian lending measures, added to a sharp devaluation in the currency, bringing about the appropriate rebalancing. Fast forward to 2012 and we see many countries running persistent current account deficits (ultimately accumulated balance of payments deficits plus borrowings to fund them) without a care in the world. New Zealand is a prime example of this. So why is NZ not being called in to see the IMF to explain its large overseas debts and why is the NZ$ not 15-25% lower?
Therein lies the modern conundrum. As the financial system has been flooded with surplus currency, the demand for safe ports has increased. This has seen deficits overlooked as surplus countries have sought to keep funds out of their domestic systems, this keeping their currencies weaker than they should be and actually reinforcing the imbalance in trade. In effect, they have lent back the surplus to the deficit countries, in return for a nice yield. The obvious problem is that surplus countries have amassed too great a surplus and so created instability in what is, at best, a volatile international system. At some point, one would reason, there must be some major adjustment as we saw in the late 1980s with the Plaza and Louvre Accords, but instead, a dependency is created, where deficit countries become addicted to debt…debt they have been fed by surplus countries. This metaphor of addiction is all too real. In the end, when repayment in demanded, what can deficit countries offer? They cannot sell their goods, as the currency is too high. All they can offer is their assets….land, companies and other resources. That’s generally not too popular, as we have seen here with the Crafar Farm sales debacle but in the end the piper must be paid.
Added to this is the new headache of currency reserve diversification. The Euro and the $, not to mention the Pound, are not in favour at the moment. The SFr has a line underneath it as well, and this leaves few options for liquid currency investments for major holders of cash, namely sovereign countries and major corporates. An example of this is the A$, another major deficit country, which has seen major inflows in recent times from all manner of investors, including Apple and Google. This really is madness: Major US corporates having to store cash outside the US because of a loss in faith in their domestic currency. This is set to continue and cause serious problems for Australia, a country where growth is slowing and commodity prices, which normally support the currency, falling. Thus, the capital account has overwhelmed the trading account, with investment flows having more impact on currencies than the simple price of goods and services. Foreign direct investment is lauded as both necessary and positive for an economy to prosper, yet it indicates that countries are not in a position to finance their own activities. The irony of this contradiction seems to be lost on policymakers, who have clearly drunk too much of the global capital kool-aid.
At some point, and when is anyone’s guess, these flows will reverse. Recent and past history tells us that this is not likely to be an orderly event. For the foreseeable future, the real economy will continue to struggle as currencies are priced on a non-production related basis. More and more, we will see jobs being exported from deficit countries, rather than goods and services. Some central bankers, the RBA and RBNZ in particular, seem to believe they can do nothing about this problem. This is primarily due to the over earnest and somewhat naive adherence to strict inflation targeting and singular focus on monetary policy to the detriment of the real economy. The world of global finance has shifted considerably in the last 20 years and a fresh look at the problem of a persistent current account deficit is warranted. To simply ignore this is a recipe for further financial disaster, as Keynes clearly predicted back in 1944, and with every possibility that the wheels of the global financial system will completely fall off.