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Currencies down (and) under

Can the falling Indian rupee learn something from the similar experience of the Australian and New Zealand dollars? V. Anantha-Nageswaran looks at some of the factors that cause currencies to fall and rise against one another.

IN INDIA, the plight of the Australian and New Zealand dollar normally would not attract much attention. However, the anxiety caused by the recent drop in the Indian rupee against the US dollar should make us examine the factors that cause currencies to fall and rise against one another. Unfortunately, economic research does not provide a clear direction. In fact, economic fundamentals have not provided a consistent explanation for most currencies.

On the one hand, deteriorating trade account (rising oil prices and insipid export growth) and the lack of appreciable foreign direct investment flow dictated a weaker rupee. However, strengthening foreign reserve position, robust economic growth and rel ative political stability called for the rupee to maintain its levels. At another extreme, Purchasing Power Parity estimates suggested that the bilateral rupee exchange rate against the USD was undervalued by a considerable margin.

If we examine the trade-weighted real effective exchange rate of the rupee (see chart), it appears to be undervalued than overvalued. Hence, the recent gyrations in the exchange rate cannot be attributed to its overvaluation. It is instructive to note th at our export growth has been low despite the currency's undervaluation. Clearly, it takes more than a cheap currency to boost exports and the sooner we realise that the better. A large domestic economy surely is no excuse. It did not prevent China from achieving high double-digit export growth.

Explaining the Kiwi dollar first

Coming back to the Australian and New Zealand dollars, these two currencies have lost more than 10 per cent of their value against the USD since the beginning of the year. Both were widely expected to appreciate this year, against the US dollar.

Both New Zealand and Australia are commodity exporters. While Australia exports wool and metals, New Zealand's export basket consists of food commodities. Hence, their currencies have moved in tandem, in the past, with the export price movements of commo dities. One has to be careful in choosing the appropriate commodity basket to measure their currencies against. For New Zealand, it has to be predominantly food and for Australia, it has to be metals. Fortunately, such indices are available.

Contrary to most expectations, the rebound in prices of global commodities stalled in the first few months of the year. Except crude oil, prices of other commodities stagnated. That appeared to explain the stalled recovery of the Australian and New Zeala nd dollar. However, in recent weeks, prices of these commodity groups have resumed their journey north. Yet, the currencies have weakened.

The chart showing the NZD/USD exchange rate and the ANZ commodity price index for key New Zealand export commodities clearly reveals that the trends in the world price of the commodity index and the exchange rate are tightly correlated. However, there ar e episodes during which they have diverged. That is what makes exchange rate forecasting difficult.

What exactly matters for exchange rate?

In 1990-93, the commodity index moved sharply up and yet the currency weakened. One could attribute it to the steep recession in the economy in 1990 and 1991 in New Zealand. In 1995-96, the index dropped but the currency continued to appreciate against t he USD because GDP growth was strong. Strangely, the current account did not seem to matter. In 1990-93, New Zealand's current account deficit, as a percentage of GDP, actually improved from around -4.0 per cent to less than -2.0 per cent. In 1995-96, wh en the currency strengthened against the USD, the current account deficit kept widening.

Right now, most people attribute the currency's weakness to the large current account deficit. However, first quarter data are likely to show that the deficit peaked as a percentage of GDP in Q4-1999. This data is due on June 15.

So, does only growth matter? If so, there should be no reason for the currency to be weak. The economy grew by nearly 9.0 per cent in the last quarter of 1999 and growth remains solid. First quarter estimates are not due until late in June. Right now, th e commodity price index has begun to move up and GDP growth too is quite brisk. Is it growth or commodity prices or current account deficits? What matters exactly more than the other and why? What is holding the currency back? We don't seem to know of an ex-ante clear answer.

In hindsight, many refer to the Centre-left government's anti-market bias (strengthening the bargaining power of labour unions, etc.) and the euphoria over the US economy's clear technological leadership over the rest of the world. On the former, it is p ossible to envisage that both financial markets and the government would come to terms with each other. The government is bound to realise that not all the reforms of the early 1990s in New Zealand need to be undone. The market will also realise that the government did not have such an agenda in the first place. Right now, both are feeling each other out.

It is the same for AUD

The AUD is in a similar position. The Reserve Bank of Australia's commodity price index (for 18 major commodities exported by Australia) and the AUD/USD have a close correlation, even tighter than the NZD and its relevant commodity index. Right now, the commodity price index had begun to move up. Yet, the currency found few takers in international markets. Again, this is not new.

In 1994, the currency weakened despite the index moving higher. Tracing the cause to other factors, we find that growth was strong at that time. Hence, no problems on that account. However, the current account deficit shot up very sharply in 1994. That p robably explains the currency weakness. But, then, when we fast-forward to the present, the current account deficit peaked in the last quarter of 1999 and that should begin to support the currency. On the contrary, the AUD had started weakening in 2000!

We are not ready to give up

Bilateral purchasing power parity estimates of these currencies against the US dollar show that they are undervalued by over 30per cent. We have arrived at this estimate by using relative annual inflation differentials as the appropriate change in the no minal exchange rate. Obviously, there is the heroic assumption that the exchange rate value on our arbitrarily chosen starting date was `fair'. That assumption could be misleading.

For instance, on our starting year of 1980, if the exchange rates of the AUD and the NZD were overvalued against the US dollar, the subsequent depreciation does not indicate undervaluation but a correction of the initial overvaluation. Examining the conc lusion by using several starting points mitigates the risk of wrong judgments.

Therefore, despite the obvious embarrassment caused to my forecasts made at the beginning of the year, I hold on to my view that the AUD and the NZD are massively oversold against the USD and for no justifiable fundamental reason. If we have the courage, we should be buying. Actually, New Zealand dollar bond real yield is too high compared to long-run historical average.

We are frustrated by the continuous decline of the AUD and the NZD against the USD. However, on a critical examination of the fundamentals, we feel that the currencies do not deserve their current valuation. They deserve better. The overwhelming reason a ppears to be the foreign exchange market's fascination with the US. The US could do nothing right in 1994-95 as far

as the foreign exchange market was concerned. That was extreme. Now, it is the other way around. It is a dull conclusion but worth remembering that truth, more often, lies somewhere in between.

The US economy may have a veritable lead over the rest of the world on development and assimilation of new technology but the question is how far should the market go in pricing that. Investors in Nasdaq stocks had realised that they had gone too far too soon and the same may well apply to the US dollar. Even as I write this, the EUR had broken free of its technical `resistance' points on Friday and traded above 0.93 (EUR/USD). May be, it is the beginning of the end of the bullish phase of the USD that began in 1996.

Our next call (whenever it is) may be to predict a US dollar recovery if the market, mercilessly and shamelessly, dumps it!

(The author is the Regional Head of Investment Consulting in Credit Suisse, Asia-Pacific. He writes here in his personal capacity. Feedback may be sent to nageswar@singnet.com.sg)