Royal Bank of New Zealand Sells Kiwis

In an interesting exercise and a possible case study for business and economics students, the Royal Bank of New Zealand intervened in the foreign exchange markets earlier this week. The kiwi dollar had reached a 22-year high against the US dollar thanks to an unexpected interest rate hike last week from 7.75% to 8%. This comes on the heels of general weakness in the US dollar. Although the sale of kiwi dollars by the New Zealand central bank did knock 2% off the value of the local currency, the situation demonstrates the limits of central bank powers in the 21st century.

There are two main tools that policy makers have to influence the exchange rates: market interventions and interest rate changes. An intervention merely affects supply and demand by dropping a quantity of currency on the market. In days past, say the 1980s, this was enough to rein in any excessive exuberance in the forex markets. No longer. These markets are now too big for an intervention to have anything but a temporary effect. More often, it is a signal that interest rates may be employed next.

By raising or lowering interest rates, a central bank affects the rate of return. Currencies rise when foreigners want to invest in an economy to participate in its success and drop when they want to move their money elsewhere to exploit other opportunities. Unfortunately, interest rate fluctuations are usually driven not by exchange rates but by inflation concerns. Here, the New Zealand policy makers have been very determined – in fact the RBNZ was among the first in the world to gain its independence from the government to fight inflation. It’s been exceedingly successful.

However, when interest rates in Japan are at 0.5%, it makes good investment sense to borrow yen turn it into kiwi dollars and then enjoy the advantages of 8% interest rates. This so-called “carry-trade” appears not to have been affected by the intervention, largely because the New Zealand authorities can’t drop enough kiwi dollars into the market to affect perceptions without undermining their own anti-inflation policies. More kiwis in the market will drive up prices.

Unfortunately for the RBNZ, the New Zealand economy is going at quite a clip. Retail sales rose at a record pace in the first quarter of 2007, especially spending on cars and appliances. And in a nation that still has a significant agricultural sector, an expected increase of 27% in dairy farmers’ income next season only heightens expectations of more spending. Thus, a central bank is reduced to sending a signal to the market, which the market promptly ignores (after booking its profits and taking up new positions in the kiwi). There are more than a few theses waiting to be written on this matter.

© Copyright 2007 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

Home