With a simple statement calling for flexible exchange rates, the recent G7 meeting of global finance ministers and central bank governors appears to have set off the next leg in a multi-year downswing in the US dollar (US$). While the statement was really aimed at China (which has a fixed exchange rate to the US$), the Japanese yen and the New Zealand (NZ$) have been major "beneficiaries".

A change in policy - unlikely?

While the US$ has fallen, many Asian central banks have been intervening to prevent their currencies from rising versus the US$. China in particular maintains a fixed exchange rate. This in turn has put more pressure on freely floating exchange rates, such as the euro and NZ$, which arguably had to appreciate by more than if China and other Asian currencies were floating more freely. This frustration culminated in the G7 meeting calling for flexible exchange rates.

Resumption of US$ bear

Nevertheless, the G7 statement does appear to have resulted in a resumption of the downtrend in the US$, the basic driver of which is the huge US current account deficit, which is now around 5% of US Gross Domestic Product (GDP) and requires more than US$2bn of capital inflow every trading day to fund. Our view remains that the US$ is in a multi-year downtrend which has further to go.

With China unlikely to move to a floating exchange rate anytime soon, and many Asian central banks likely to continue intervening in their foreign exchange markets, the bulk of this adjustment will continue (at least, for the time being) to fall on the euro, yen and NZ$.

Global implications

Overall we see a resumption of the US$ downtrend as positive for the global economy and share markets. Firstly, by making US exporters more competitive, it is probably the best way to correct the US current account imbalance – the alternative is for the US to grow more slowly than the rest of the world, but this would probably lead back to global recession. Secondly, it forces the rest of the world to adopt/maintain easy monetary policies (low rates), whether by directly intervening to stop their currencies from rising against the US$ or just in an effort to offset the negative impact of currency appreciation. Thirdly, the key US share market also benefits from a weaker US$ via a boost to profit levels. Over 30% of US listed company sales are sourced offshore and these are boosted as the US$ falls.

The NZ$ – to infinity and beyond?

As the US$ continues to fall the NZ$ is likely to rise against it, if not against other currencies.

• Firstly, the NZ$, at around US$0.59, is marginally above fair value. This is more pronounced for the NZ$ versus other currencies, where the NZ$ looks more clearly over-valued.
• It is unclear whether the next move but the RBNZ is to raise or to lower interest rates. A tightening would clearly be more beneficial to the NZ$.
• Finally, the improving outlook for global growth is boosting commodity prices, and this normally supports our dollar.

Overall, we expect the sideways movement of the NZ$ apparent over the past six months to continue in the immediate future. Longer term we are more negative on the currency.

The local economy and shares

Clearly, the rise in the value of the NZ$ is negative for exporters and import-competing industries and this will act as a constraint on New Zealand growth going forward.

However, by keeping import prices down, it will reduce pressure on the RBNZ to raise interest rates.

The impact of a rise in the NZ$ on the local share market is ambiguous. About 30 per cent of New Zealand listed company earnings are sourced offshore, so each ten per cent rise in the value of the NZ$ against all currencies could knock three per cent off profits. However, this is a worst case assessment as it ignores the positive impact on profits experienced by some companies as import costs fall or as the cost of servicing foreign debt declines. It is also the case that the NZ$ normally strengthens when global demand recovers and thus global demand for New Zealand companies’ products rises and commodity prices improve, as is the case now. The local share market may also benefit from a stronger NZ$ to the extent that it may be a beneficiary of the stronger capital inflows associated with the NZ$.

The NZ$ strength has largely been against the US$ and consequently currencies pegged to the US$. Although hedging will provide a near term cushion, continued currency strength will adversely impact exporters (Fisher& Paykel Healthcare, Carter Holt Harvey, Fletcher Forest, Sanford, Skellmax) and tourism companies, (Auckland International Airport, Tourism Holdings). Companies to benefit include retailers (Briscoes, Hallensteins, warehouse) and importers (Sky Network, Steel and Tube).

The NZ$ and investors

For New Zealand investors the rising NZ$ is a pain, as each 10 per cent increase in the value of the New Zealand dollar detracts 10 per cent from returns from international shares (assuming that none of the portfolio is hedged back to New Zealand dollars). Naturally, the opposite is true for a 10 per cent decline.

The ideal currency investment strategy then, would be to fully hedge international share exposure back to New Zealand dollars whenever the NZ$ is rising and unwind the hedge whenever it is falling. However, there are several points to note regarding this.

• The difficulty in forecasting exchange rates is well known – just look at the dismal track record of economists’ currency forecasts!
• With the NZ$ up 40% from its record low over two years ago, most of the currency’s increase is already behind us.
• While there is much focus on the NZ$ against the US$ this is only relevant for about 55% of an investors’ global share exposure. Against other currencies the NZ$ has not been as strong and this is likely to remain the case.
• Most of the diversification benefits of investing globally derive from diversifying currency exposure away from the NZ$. Hedging fully back to New Zealand dollars would remove this.
• Finally, there is nothing to indicate that the long-term slide in the NZ$ (from US$1.35 in the early 1970s) is over.