Back in March 1985, New Zealand allowed its dollar to float freely against other currencies, with its value being determined by trading activity in the world's financial markets. Since this time the dollar has fluctuated and it has had an historical average valuation of about 58 cents to the US dollar (i.e. $US1 = $NZ1.72)
Against a backdrop of the Asian financial crisis and the dotcom boom, the NZ dollar fell substantially against the greenback in the late 90's, reaching a low in late 2000 at under $US0.40. But from those low levels the Kiwi began a phenominal climb, reaching over $US0.70 by the end of 2004, putting strain on New Zealand's export economy as NZ goods and services became proportionally more expensive to foreign buyers.
Conventional wisdom would say that NZ's foreign exchange rate moves in cycles and that it should tend to move back towards its historical average. But with the currency currently about 26% overvalued (compared to historical norms) it only looks like moving higher still. The higher it moves, the larger the risk is that it will eventually come plumeting down, damaging the economy in the process.
The Kiwi dollar has been pushed higher by overseas investors seeking to take advantage of New Zealand's relatively high real interest rates, and with interest rates being increased in an attempt to curb inflation, seeing a higher NZ dollar is viewed as a fairly safe bet. That's where the Reserve Bank's intervention comes in to play.
By selling some of New Zealand's currency reserves on the money markets, the Reserve Bank is able to temporarily lower the value of the dollar - the real aim of this is not to directly push the currency down substantially, but to scare speculative currency traders into thinking that the NZ dollar is no longer a one-way ride to riches. But the Reserve Bank's decision does not come without risks. Foreign investors and hedge funds control huge amounts of money and if the Reserve Bank gets this wrong, traders may actually push the dollar up even higher in a cat-and-mouse sort of game.
What New Zealand really needs to control its overheated currency problem are higher interest rates abroad, to reduce the benefits of investing in the New Zealand dollar.
- Reserve Bank Monetary Policy