Balancing acts

Australia and New Zealand both suffer from structural current account imbalances owing partly to their geographical isolation. Despite being important commodity exporters, both economies are highly developed and driven by consumer spending. Given the relative wealth of Aussie and Kiwi consumers and the largely commodity-based nature of the local economies, many consumer goods are imported from the U.S., Europe, Japan, and Emerging Asia. In contrast to other developed nations, Australia and New Zealand’s structural trade deficits are inflexible to foreign exchange rates because of this lack of domestic production of substitute consumer goods.

Australia’s current account has been in deficit for more than 40 years, and has varied between -2 to -7percent of GDP over the past twenty years. This measure cycles every four to five years with changes in the economy and value of the currency.

New Zealand’s current account deficit is less well behaved owing to the economy’s high degree of geographic isolation and dependence on imported goods. Over the past 15 years it has varied from -3 to -8 percent of GDP. Concerns have emerged recently over both the pace of the current account deterioration as well as the level.

In both instances, structural current account imbalances are financed by structural net inflows of both direct and portfolio investment. One reason for this is interest rates in New Zealand and Australia typically offer a 100-200 basis point premium over rates in countries with similar risk and inflation. This interest rate premium attracts foreign investment into deposits and fixed income instruments that serve to finance the structural current account imbalances in both countries.

The two factors that have a material impact on this balance — and therefore on the value of the local currencies — are growth and interest-rate differentials. As interest rate differentials rise, there is an increased attraction for local deposits and fixed income instruments. The AUD/USD and NZD/USD rates thus tend to rise as interest rate differentials rise. A countervailing factor is the pace of economic growth. As the economy accelerates, the current account deteriorates. Unless interest-rate differentials correspondingly widen, the local currency comes under pressure.

This is in fact what happened during 1996 to 2001. Economic growth was strong while interest-rate differentials were narrow. AUD/USD fell below 0.50 in 2001 from 0.80 in 1996. Similarly, NZD/USD fell to 0.40 from 0.70 in 1996. The depreciation in the NZD was so severe that by late 2000, the AUD/NZD cross-rate had risen to 1.30. This prompted calls in some quarters for a currency union between the AUD and NZD. Steady improvement in the AUD/NZD cross-rate to 1.10 by 2002 buried such talk. Nonetheless, this demonstrated how growth and interestrate differentials can impact antipodean currency valuation.