The New Zealand Dollar may be trading 29% above its ‘fair value’ against the Pound - but this no reason to expect the Kiwi currency to fall anytime soon argue strategists at BNZ.
Pound Sterling is well below the level is should be versus the New Zealand based on valuation metrics at New Zealand's BNZ bank.
BNZ’s preferred model uses ‘Purchasing Power Parity’ or PPP to estimate what the exchange rate would be in an ideal scenario.
The best way to explain PPP is to start with the assumption that two identical goods should be the same value in two separate countries allowing for the effect of the exchange rate.
This means, for example, that a car which costs £10,000 pounds in the UK should cost $12,687 in the US, given today’s exchange rate of 1.2687.
However, If in reality, the car in the US costs more than $12,687 it suggests the Dollar may be overvalued, if less, then undervalued.
This is the basic principle behind PPP.
Clearly, PPP is also influenced by inflation as inflation will raise the cost of items in the country where it is rising most rapidly.
Unless that country’s currency depreciates at the same rate as inflation, the PPP will rise above the exchange rate suggesting the currency is overvalued.
In the case of NZD/GBP the pair’s exchange rate is 29% above fair value using PPP and suggests the Kiwi is overvalued and the pound is undervalued.
BNZ strategist Stephen Toplis tells clients though that he does not expect the NZD to weaken and fall back to ‘fair value’ anytime soon:
“Just because a currency trades significantly above long-term fair value doesn’t necessarily mean it is over-valued or expected to correct.
“Our projections suggest 'more of the same'.
“NZD/EUR, NZD/GBP and NZD/JPY are all expected to trade significantly above long-term fair value over the next year, so exporters hoping for some relief are likely to be disappointed."
The reason he gives for this is that central banks in all three of the most overvalued pair counterparts with NZD - of Europe, the UK and Japan - are expected to continue with accommodative monetary policy, which is generally negative for their currencies.
At root, however, is the distorting effects of the new global capitalist economy which enables investors to move vast sums of money around more freely.
This leads to much larger flows to countries such as New Zealand which have stable economies and higher interest rates than economies such as Japan which has below-zero interest rates.
This is because investors seek higher returns on their money, however, it means the countries with higher inflation often have overvalued currencies.
New Zealand has seen record inflows from investors using a strategy called the carry trade, in which they borrow in a cheap funding currency, such as the Euro which benefits from very low interest rates, starting from zero and invest their money in a currency with higher interest rates, such as the New Zealand dollar where base interest rates are 1.75%.
They then pocket the difference as profit.
This has artificially raised the value of the Kiwi above what it would be according to PPP.
Part of the reason why Toplis see no change likely in the overvaluation of NZD is due to BNZ’s optimistic forecasts for the NZ economy.
Not only does he see the government running a budget surplus in the next couple of years but he sees the country’s already low gross debt of 23% coming down to 18.5% in 2020.
The increase in revenue is likely to be invested back into the economy as tax cuts or child benefits, which in turn is likely to provide further stimulus.
Apart from the positive view of rating agencies and therefore foreign investors, the effect of increasing fiscal stimulus, will probably be to let the Reserve Bank of New Zealand (RBNZ) take a less hands on approach to monetary stimulus.
Toplis actually sees the next move by the RBNZ as being to raise interest rates in 2018 – or even earlier - according to what markets are pricing in.
This is likely to further support the currency and limit downside.
Forecast for NZD/GBP
NZD/GBP’s exchange rate is unlikely to alter much over the next few years according to BNZ’s forecasts - in line with their analysis.
They see NZD continuing to outperform GBP at the start of 2017, rising from 0.57 to 0.58 by July 2017, and then declining from there on.
In 2H 2017, they expect it to fall to 0.56 where it will pretty much remain until the end of 2018.
From a GBP/NZD perspective this equates to 1.7544, 1.7241 and 1.7857.