Last week's “Economist” magazine produced a very timely reminder about the level of the NZ dollar over-valuation at 0.7600/0.7700 to the USD. The extreme difficulty with currencies that overshoot their “economic fundamental” values is that the time period the currency remains in “overshoot” territory is impossible to predict and measure. The “Kiwi” tops the overvaluation league table above, being 29% overvalued (mean of a range from 20% to 50%) based on a Morgan Stanley measure of “behavioural” equilibrium value. Morgan Stanley claim their measure of calculating fair values of currencies is more accurate than the classical Purchasing Power Parity (“PPP”) and Fundamental Equilibrium Exchange Rate (“FEER”) measures. Their method analyses economic variables such as productivity growth, net foreign assets and terms of trade through 13 separate economic models. Arguably, New Zealand is performing poorly on the first two variables, but much better on the terms of trade thanks to booming dairy prices.
In a world of mobile and liquid capital movement the economic theories on exchange rate can be horribly wrong for long periods of time, but in the end (medium to long term) the economics normally wins out.
The NZ dollar remains in the “twilight zone” of overshooting due to the massive interest rate differential to the rest of the world. How long we stay here is the debate.
Asia-Pacific Risk Management has recently completed a piece of NZD currency analysis that provides plenty of evidence that the interest rate gap, and thus the NZD strength, have reached their peaks and will reduce considerably over the next 12 months.