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Paulson may (or may not) have a strong dollar policy …. New Zealand, though, clearly doesn’t have a strong kiwi policy

by Brad Setser
September 27, 2006

It is perhaps a sign of the times that the US is encouraging China to provide the US with a bit less financing (the US of course, has a strong RMB policy, not a weak dollar policy) and New Zealand’s Finance Minister is practically begging for a bit of market discipline to help keep New Zealand’s 10% of GDP current account deficit from growing any larger. Gillian Tett and Steve Johnson in the FT:

“I think someone would have to be slightly strange to take a bet on the NZ dollar right now,” Mr Cullen told the Financial Times. “It is strange that with our current account deficit approaching 10 per cent, the market is not factoring it in.

“Just how badly do we have to do on the current account before [investors] notice?”

His comments follow a recent, sharp rally in the New Zealand dollar, which has left it hitting a seven-month high against the US dollar this week of about $0.67 – even though data last week showed the country running a current account deficit of 9.7 per cent of gross domestic product.”

Mr. Cullen's question is a good one.

Carry trades – borrowing in a currency with a low interest rate to buy a currency with a high interest rate – didn’t necessarily do all that well in the first half of the year.    Iceland blew up – and most carry trades had a rough May and June.  Turkey is the most prominent example. But things changed over the summer.  Most high-carry currencies bounced back – particularly in countries that raised interest rates after sell-off.  The Krona is one example.  The Turkish lira is another.   The Brazilian real too –  Brazil’s central bank has been intervening heavily to keep the real from rising even further.  And the Kiwi

The recent bout of turmoil in the emerging world – the Thai coup, the bout of honesty from Hungary’s prime minister and the like  – seems to have led some investors to conclude that they were perhaps under-pricing risk in the emerging world (See Danske Bank)

But it didn’t seem to dull investor’s appetite for the high-carry currencies of developed island economies.  At least not enough to satisfy New Zealand’s finance minister. 

Another potential explanation for the Kiwi’s strength? 

Yen-financed carry trades are still going strong, with investors borrowing yen to buy Euros, US dollars and New Zealand dollars.   But dollar financed carry trades – borrowing dollars to buy the currencies of high-yielding emerging economies – became just a bit less attractive recently

Or maybe it was Swiss franc financed positions that pulled back.

I am not close enough to the markets to have a great sense of precisely what has been happening …

11 Comments

  • Posted by Emmanuel

    Last June the kiwi fell precipitously and even went below 0.60 for a time. It was when rumors abounded that Japan would end the ZIRP. So, the kiwi-yen carry trade was supposedly in its death throes. You know what’s happened since then as the yen has been in the gutter for the past few months. Long live the ZIRP and the carry trade–economic fundamentals apparently mean nothing nowadays in “Special FX” land.

  • Posted by DOR

    Would those of you in the markets please engineer a collapse of the NZ$ in, say, late January or early February?

    I’ve got a trip to the wineries planned, and could really use an extra 20-30% purchasing power.

    Thanks. Appreciate it. Really.

    .

  • Posted by HK

    Brad–Small countries can have large currenct account imbalances, e.g., Singapore with currenct account surplus of more than 20% of GDP, and New Zealnd with current account deficit of more than 10% of GDP, without straining the international monetary system. Big countries cannot, so that the US deficit of 7% of GDP and the Chinese surplus of 10% of GDP are unlikely to be sustained for so long.

    It used to be said that surplus countries may be able to sustain imbalances longer than deficit countries from obvious reason. However, the US as a superpower and a key currency country, may be somewhat different, though even it may not be able to sustain this huge imbalance any longer.

  • Posted by MrBill

    Small countries with a positive interest rate differential that borrow have stronger currencies due to the demand for local currency to buy local denominated debt right up to the point that the market loses faith in their ability to either repay or until they start to payback those debts creating an outflow of currency.

  • Posted by Guest

    “…”Investors are recognizing currencies are an investable asset class… They have low correlation to equities and bonds, so they’re a good diversifier.” … The new fund is different from single-currency ETFs, such as those managed by Rydex Investments, another ETF provider. …Meg Browne, currency strategist at Brown Brothers Harriman & Co., said speculators and hedge funds have made money on this type of trade, but added many are unwinding positions as rate spreads contract. Some claim the so-called carry trade has artificially propped up currencies with higher interest rates. “I don’t think this new currency ETF is everyone’s cup of tea, but essentially it opens up this sort of strategy to anyone who wants to access it at a reasonable price,” said Jim Wiandt, editor of the Journal of Indexes. “It’s extremely interesting because it packages a well-known and historically very effective strategy into a tradable index product,” he added. …Although the product could be used as a long-term diversification tool for U.S. investors, fund analyst Arijit Dutta at investment research firm Morningstar Inc. noted that currencies are generally volatile and the temptation to engage in potentially damaging and costly trading could be high. In addition, using leverage ratchets up the ETF’s risk…”
    http://www.marketwatch.com/News/Story/Story.aspx?dist=newsfinder&siteid=google&guid=%7BE2194BDF-DBB7-4D96-89E1-A46F24D61EDC%7D&keyword=

  • Posted by Guest

    Might the growth in currency trading have severely constrained the abilities of small economies to control the printing presses for their own currencies? If that’s the case, might the impact of let’s say a New Zealand dollar crash be potentially much greater as a relatively larger quantity of that currency may be in circulation?

  • Posted by MrBill

    “”Might the growth in currency trading have severely constrained the abilities of small economies to control the printing presses for their own currencies? If that’s the case, might the impact of let’s say a New Zealand dollar crash be potentially much greater as a relatively larger quantity of that currency may be in circulation?””

    No. Currency trading does not increase or decrease the currency in circulation.

    If I buy NZD against USD or JPY in the interbank market, my nostro account in USD or JPY is credited, while my NZD account is debited. That NZD nostro account is ultimately in New Zealand just like all USD nostro accounts are in the USA, and all JPY nostro accounts are in Japan, regardless of who you trade with or where your retail bank is located, say at a bank in London or Frankfurt.

    The demand for NZD causes the rate to rise against the USD or JPY, for example, but until I actually buy an asset or invest in a security with those NZD then they sit in a low interest bearing account likely earning overnight interest.

    But I am buying an existing supply of NZD unless the central bank decides on their own they would like to print more NZD for use in the real economy.

  • Posted by bsetser

    Agree with Mr. Bill.

    one interesting factoid — the supply of NZD or Icelandic krona denominated assets can be independent of the size of the New Zealand or Iceland economy … nothing keeps a bank or firm domiciled outside Iceland or New Zealand from issuing debt denominated in those currencies. that happened with the krona (and some european banks have issued in turkish lira). I understand why the banks issued in lira (raised lira to buy turkish assets by placing lira debt with retail investors). I don’t have as good a sense why anyone issued in high-yielding krona if you didn’t have krona revenues.

  • Posted by Guest

    Ok – but the introduction and trade of these products has to change the fundamentals of the underlying assets in some way.

  • Posted by MrBill

    “”I understand why the banks issued in lira (raised lira to buy turkish assets by placing lira debt with retail investors). I don’t have as good a sense why anyone issued in high-yielding krona if you didn’t have krona revenues.””

    I do not know specifically about the lira or krona, but I have certainly issued a lot of SKK, CZK, PLN, HUF denominated eurobonds for the likes of the WB, EIB, EBRD, etc., and they certainly did not need those currencies for their own portfolio. It was all based on issuing in a currency that investors are seeking, maybe an EEMEA bond fund in Germany, and then swapping out of the local currency back into dollars or euros to achieve a lower spread against LIBOR. But kids, don’t try this at home. It depends on the swap window that can slam shut pretty quickly in these smaller, less liquid markets, so it is pretty much done on an opportunistic basis if and when there is an arbitrage opportunity.

  • Posted by Gheorghius

    The NZ Official Cash Rate is 7.25% + the central bank announced that they will probably tighten further: no wonder that the NZ currency is firm! What a strange idea (Emanuel & Brad) to exclude interest rates from the “fundamentals” that should determine the equilibrium ex-rate !

    HK – You wrote: “Small countries can have large current account imbalances… Big countries cannot, so that the US deficit of 7% of GDP and the Chinese surplus of 10% of GDP are unlikely to be sustained for so long”.

    But facts prove the opposite. Month after month, for many years now, the US deficit stays large and grows larger; and global financial mkts do finance the deficit. What matters here is debt sustainability (the ability of the US to repay the debt), and the balance with interest rates. Thus applies to any country, small or big. And the US debt ratios are not so awful!! (That is why, by the way, I believe Nouriel and Brad are overstating the threat posed right now by global imbalances, and I keep the hope that a prompt dollar devaluation will rebalance everything without too much disruption. Admittedly, the housing bubble is worrisome, but it is not too late to rebalance smoothly!).

    Of course the big US CuA deficit will end soon or later: but not because the US is a large country. Rather, because debt ratios (ForeignDebt/GDP, etc.) cannot grow too large without making it increasingly difficult to service the debt: in that case, and in my view we are not yet there, even such nice high US interest rates may not be enough to compensate the risk of holding US assets from abroad.

    Theoretically too, what may be the difference between one big debtor country (US) and a group of 15 small countries that – added together – have the same dimension of the US? None. So I don’t see the rationality of your “big countries cannot” argument. Even less if we add, on top, the notion that the US is a reserve currency (as you remind us)!

    G.