Archive for the ‘Exchange Rates’ Category

What is the Trade Weighted Index?

July 20, 2017 Leave a comment

Trade Weighted Index (T.W.I)

  • An index that measures the value of $NZ in relationship to a group (or “basket”) of other currencies. The currencies included are from NZ’s major export markets i.e. Australia, USA, Japan, Euro area, UK and China. – $A, $US, ¥, €, £ RMB
  • Each of the currencies included in the TWI is “weighted” according to how important exports to that country are ( = % of total exports)
  • From the TWI we can see if the $NZ has appreciated or depreciated against our major trading partners currencies overall.

TWI - NZ 17.png

The interpretation of the effective exchange rate is that if the index rises, other things being equal, the purchasing power of that currency also rises (the currency strengthened against those of the country’s or area’s trading partners). That will reduce the cost of imports but will undermine the competitiveness of exports.


Internationally, global growth is continuing to improve, suggesting that excess global supply is easing. However, offshore political uncertainty has grown and continues to cast a shadow on NZ’s inflation outlook. Further, the NZ Trade Weighted Index (TWI) is hovering around 78 again, in part due to NZ economic fundamentals but also in part due to the above offshore political events.

Source: ASB Bank



When the NZ Official Cash Rate exceeds the US Fed Rate.

July 1, 2017 Leave a comment

With Janet Yellen increasing the US Fed Rates to 1 – 1.25% and Graeme Wheeler keeping the OCR at 1.75% it is anticipated that the US Fed Rate will eventually become higher than the OCR. What impact might this have on the New Zealand dollar?

With higher rates (or expected higher rates) in the US money flows will be attracted into the US with higher interest rate returns. This is referred to as ‘Hot Money’ and for international investors there are significant amounts of money to be made.

A higher interest rate in the US would mean a higher return from saving in a US bank. Therefore, New Zealand investors may sell NZ dollars and buy US dollars so that they can gain more interest from their savings. This increased demand for US dollars will push up the value of the US dollar against the NZ dollar.

RBNZ v Fed Rates.png

However it is not just interest rates that influence Hot Money. In 2011the Swiss Franc appreciated on the back off the turmoil in the Eurozone as investors saw the currency as a safe haven. The NZ dollar and the AUS dollar appreciated for similar reasons post the Global Financial Crisis.

Problems of hot money flows

Hot money flows can be destabilising. A rapid rise in the currency can harm a countries with exports become more expensive and imports becoming cheaper. However the latter might be favorable depending on the import content.

Hot money flows can create excess liquidity fuelling a future asset boom and creating more long-term problems.

The Exchange Rate Mechanism and the Bank of England

June 8, 2017 Leave a comment

I was teaching managed exchange rates with my AS Level class and couldn’t get away from the events in Britain on the 16th September 1992 – known as Black Wednesday. On this day the British government were forced to pull the pound from the European Exchange Rate Mechanism (ERM).


The Exchange Rate Mechanism (ERM) was the central part of the European Monetary System (EMS) and its purpose was to provide a zone of monetary stability – the ERM was like an imaginary rope (see below), preventing the value of currencies from soaring too high or falling too low in realtion to one another.

It consisted of a currency band with a ‘Ceiling’ and a ‘Floor’ through which currencies cannot (or should not) pass and a central line to which they should aspire. The idea is to achieve the mutual benefits of stabel currencies by mutual assistance in difficult times. Participating countries were permitted a variation of +/- 2.25% although the Italian Lira and the Spanish Peseta had a 6% band because of their volatility. When this margin is reached the two central banks concerned must intervene to keep within the permitted variation. The UK persistently refused to join the ERM, but under political pressure from other members agreed to join “when the time is right”. The Chancellor decided that this time had come in the middle of October 1990. The UK pound was given a 6% variation

Black Wednesday

Although it stood apart from European currencies, the British pound had shadowed the German mark (DM) in the period leading up to the 1990s. Unfortunately, Britain at the time had low interest rates and high inflation and they entered the ERM with the express desire to keep its currency above 2.7 DM to the pound. This was fundamentally unsound because Britain’s inflation rate was many times that of Germany’s.

Compounding the underlying problems inherent in the pound’s inclusion into the ERM was the economic strain of reunification that Germany found itself under, which put pressure on the mark as the core currency for the ERM. Speculators began to eye the ERM and wondered how long fixed exchange rates could fight natural market forces. Britain upped its interest rates to 15% (5% in one day) to attract people to the pound, but speculators, George Soros among them, began heavy shorting* of the currency. Spotting the writing on the wall, by leveraging the value of his fund, George Soros was able to take a $10 billion short position on the pound, which earned him US$1 billion. This trade is considered one of the greatest trades of all time.

* In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to that third party. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as the seller will pay less to buy the assets than it received on selling them. Wikipedia.

AS Economics Unit 4 – Fixed exchange rates and the end of the Gold Standard

September 26, 2016 Leave a comment

Currently doing some revision on fixed exchange rates which is now part of Unit 4 in the new CIE AS syllabus. The following post is an explanation of how fixed exchange rates worked. For many years after the Second World War most countries operated a system of fixed exchange rates. The external value of a currency was fixed in terms of the US$ and the value of the US$ itself was fixed in terms of gold. In effect, therefore, the values of the currencies were fixed in terms of gold. The ‘fixed’ rate was not absolutely rigid. The value of a currency was allowed to vary within a narrow band of 1 or 2% on each side of the ‘fixed’ rate or parity. For example, if the value of the NZ$ were fixed at NZ$1 = US$0.50, a permitted deviation of 2% would allow it to vary between NZ$1 = US$0.51 and NZ$1 = US$0.49. These limits are often described as ‘the ceiling’ and ‘the floor’. Central banks were responsible for maintaining the values of their currencies within the prescribed bands. They are able to do this by acting as buyers or sellers of the currency in the foreign exchange market. For this purpose each central bank must have a fund containing supplies of the home currency and foreign currencies.

The way in which the Reserve Bank of NZ can use its funds of currencies to influence the exchange rate can be explained by making use of the diagram below. Let us assume that the value of the NZ$ has been fixed at A and, initially, the market is in equilibrium at this exchange rate. The permitted band of fluctuation is PP1 and the value of the pound must be held within these limits. A large increase in imports now causes an increase in the supply of NZ$’s in the foreign exchange market. The supply curve moves from SS to S1S1 causing a surplus of NZ$’s at the ‘fixed’ rate (A). If no intervention takes place, the external value of the
NZ$ will fall to B which is below the permitted ‘floor’.

The Reserve Bank will be obliged to enter the market and buy NZ$. In doing so that will shift the demand curve to the right and raise the value of the NZ$ until it is once again within agreed limits. In the diagram below intervention by the Reserve Bank of NZ has raised the exchange rate to C.

When the Reserve Bank of New Zealand is buying NZ$’s, it will be using up its reserves of foreign currencies; when buying NZ$’s it exchanges foreign currencies for NZ$’s. ‘Supporting the NZdollar’, that is, increasing the demand for NZ$’s, therefore leads to a fall in the nation’s foreign currency reserves. In the opposite situation where an increased demand for NZ$’s tends to lift the value of the NZ$ above the permitted ‘ceiling’, the central bank will hold down its value by selling NZ$’s. This will increase the supply of NZ$’s and lower the exchange rate. When the Reserve Bank is selling NZ$’s it will be increasing its holdings of foreign currencies.

The main argument for a fixed exchange rate is the same as that against a floating rate. A fixed rate removes a major cause for uncertainty in international transactions. Traders can quote prices which will be accepted with some degree of confidence; buyers know that they will not be affected by movements in the exchange rate. The risks associated with international trade are lessened and this should encourage more trade between nations and more international borrowing and lending.

The arrival of the floating exchange rate system – 15th August 1971

Under the Bretton Woods regime, world currencies were pegged to the dollar, which in turn was tied to a set price of gold. Central banks had the right to convert their dollar holdings into bullion. But on August 15th 1971 Nixon, in the face of economic difficulties, closed the gold window, devalued the dollar against bullion and imposed a 10% surcharge on imports. The era of paper money and floating exchange rates had arrived. Below is a news clip of President Nixon announcing the end of trading gold at the fixed price of $35/ounce. At that point for the first time in history, formal links between the major world currencies and real commodities were severed.

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RBNZ cut OCR but NZ$ on the rise

August 15, 2016 Leave a comment

Last Thursday it was no real surprise that the RBNZ cut the official cash rate to 2%. With this cut you would have expected some fall in the value of the $NZ but instead it appreciated. So why did the $NZ appreciate? Graeme Wheeler was interviewed by NZ Herald reporter Liam Dann and explained to him that we live in a phenomenal situation. Global interest rates have been incredible low especially in countries like Japan, the UK and Australia – see table below. Add to that the impact of quantitive easing since 2009 and negative interest rates in countries which account for 25% of world GDP and you have a very unusual situation.

CB Rate Aug 16

Some key assumptions from the RBNZ are that:

The global economy will start to pick-up which will mean that there will be less pressure on the NZ$ as investors look to other currencies to invest in. Remember that the NZ$ is the 10th most traded currency in the world and at uncertain times in the global economy it is seen as safe place to ‘park’ your money. This therefore increases the demand for NZ$’s appreciating its value.

Also the growth of the domestic economy with GDP expanding by 2.4 percent over the year ended in the March 2016 quarter, could mean a rise in inflationary expectations which should bring the inflation rate closer to the 2% mid point method in the policy target agreement. However this is a drop from 3.2% from the previous year.

According to Stephen Toplis of the BNZ 

Clearly, the NZD is already higher than anticipated and inflation expectations could well be constrained for longer as annual headline inflation falls, potentially, sub-zero. It was also interesting that the RBNZ did not repeat its upside scenario for interest rates due to higher house prices. This reaffirms the Bank’s easing bias.

All things considered then, and noting there is still significant uncertainty as to the exact way ahead, we can reasonably comfortably conclude that:

–  There will be at least one more rate cut;

–  The balance of risk is for even more;

–  The cash rate is going to be at least as low as it is now for a long time;

–  Inflation is likely to continue surprising to the downside in the near term;

–  Only when the rest of the world plays ball will the NZD wilt.

Bank of Japan sits on its hands

May 15, 2016 Leave a comment

Central Bank Rates 6th May 2016Been teaching a lot on the problems that economies have in trying to stimulate more growth to get out of the deflationary threat that is prevalent in many countries. Central Banks around the world running are out of ammunition (cutting interest rates – see rates below) and one wonders what is the next step that economies can take?

Back in February the Bank of Japan (BOJ) pushed interest rates into negative territory with the uncollateralised overnight rate being -0.10%. After saying that it would do everything in its power to get inflation to reach 2% (its target rate) and with inflation expectations moving down from 0.8% to 0.5%, markets were very surprised that it didn’t ease rates further. Two of Japan’s measures of inflation are moving away from the the target rate of 2% – see graph below.

Japan inflation 2016

With this decision the Yen strengthened and it is becoming exceedingly difficult to tell if a central bank has run out of ammunition especially when it doesn’t fire a shot. So why have the BOJ held off on easing?

  1. When rates are cut – especially if they go negative – it takes six to twelve months to judge its impact on the economy. This is something referred to as the ‘Pipeline Effect’.
  2. Governor Haruhiko Kuroka may be concerned with the strengthening of the Yen after the last cut in February. This makes exports more expensive and imports cheaper.
  3. The Governor is waiting for the government fiscal stimulus to kick in with the impending cancellation of an increase in value-added-tax.

There is plenty of room to push interest rates further into negative territory and with the next scheduled BOJ meeting in June they will be watching what the US Fed reserve do. An increase in the US Fed rate will mean a stronger US dollar which might achieve more for Japan than further negative interest rates.

Commodity Currency – Aussie dollar overvalued.

May 12, 2016 Leave a comment

Below is a video from the FT that I showed my A2 class this morning. The significance of it is the Australian dollar and how its value is strongly linked to iron ore prices. Recent growth in China has exceeded expectations and this has led to a rebound in commodity prices especially iron ore. The belief is the AUS$ is higher than the equilibrium level suggests and that this rate will not be sustainable. There are two reasons for this:

  1. Commodity prices have accelerated which has led to more demand for AUS$ which might not be sustained.
  2. Higher relative interest rates has made the AUS$ strong as ‘hot money’ has been attracted in the country. The Reserve Bank of Australia (central bank) has recently cut the cash rate (interest rates) to 1.75% and there is talk of a further cut this year.

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