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Some myths about currency union

But at the very outset I want to make it clear that any decision to abandon our own currency is fundamentally a political issue. Currency unions are generally formed as part of a larger strategic push to integrate the countries entering the currency union, often in combination with free trade agreements, harmonisation of legal standards, and liberalised migration laws.

Viewed in this way, entering a currency union is a major foreign policy decision, and thus a matter for elected politicians. It is not a matter on which a central banker should express an overall opinion, and I will not be doing so. But the choice of currency regime does have important economic implications which need to be carefully assessed, and I believe it is appropriate for me to comment on those.

One other point should be clarified at the outset. There are some differences between "currency union" implying a new central bank and a new currency to cover a range of countries and currencies, as in the case of the European Monetary Union and "dollarisation" implying the simple adoption of the currency of another country, whether in New Zealand's case that be the Australian dollar or the United States dollar.

And the most important of those differences for us is whether New Zealand would have any part in making the decisions about the monetary policy which would affect us. In a currency union, all the countries included in the union in principle have a say in forming monetary policy for the area covered by the union. All countries have a voice at the table, even if that is only a single voice among many. In the case of dollarisation, however, only the country whose currency is adopted makes the decisions about monetary policy.

The study by Sir Frank Holmes and Arthur Grimes suggested that a currency union with Australia involving a new central bank for both countries, and a new currency could have some useful benefits for New Zealand. And they suggested a currency union, rather than New Zealand's adoption of the Australian dollar, largely for reasons of political acceptability in New Zealand. Whether such an approach would meet the political acceptability test in Australia, of course, is a bit debatable. Preliminary comments from Australia suggest no interest whatsoever in abandoning the Australian dollar in favour of a new trans-Tasman currency.

But whether currency union with Australia, or the simple adoption of the Australian dollar by New Zealand, the outcome would in substance be very similar. With the exception of who gets the seigniorage income, on which I will comment in a moment, both options would involve New Zealand's relinquishing any effective control over monetary policy in New Zealand. In the case of the United States dollar, currency union is not even being raised as a possible option.

The only possibility in that case would involve New Zealand's adopting the United States dollar. And that too, of course, would mean relinquishing any control over our own monetary policy. Since the term "currency union" has been widely used in New Zealand to include both currency union as properly understood and the simple process of adopting another country's currency, I will for the most part use the term "currency union" in the balance of my comments, while recognising that for all practical purposes we are talking about "dollarisation", be it "Australian dollarisation" or "US dollarisation".

Before I comment on some of the economic advantages and disadvantages of currency union, it might be helpful to dispose of a few of the myths that have become rather prevalent. The first myth is that the Reserve Bank is opposed to currency union, perhaps because "Don Brash would lose his job". Certainly, if we "dollarised", using either the Australian dollar or the US dollar, there would be no need for anybody to be employed by the Reserve Bank of New Zealand and those now employed by the Bank would lose their jobs.

If we went into a currency union, presumably with Australia, it is also likely that many existing Reserve Bank staff would lose their jobs though I must admit that the European precedent perhaps suggests that job losses would not be great in that situation! Nor are we promoting currency union. As indicated a moment ago, the Bank's responsibility is to advise Ministers about the economic implications of currency union, both the pros and the cons, and to foster informed public discussion on the issue.

The pros and cons of currency unions

The second myth is that small countries are in some ways just too vulnerable to have their own currencies in the modern world. This is sometimes expressed in terms of the metaphor of a tiny rowing boat, tossed around in a turbulent ocean, with the turbulence arising from the vast flows of capital which every day wash backwards and forwards at the click of a mouse. But there are some extremely successful small countries with their own currencies - Singapore and Switzerland spring immediately to mind - and, contrary to popular mythology, the New Zealand dollar is not a particularly volatile currency.

Not a particularly volatile currency? The Reserve Bank has looked at this issue both in terms of short-term volatility and in terms of the big exchange rate swings which are, I suspect, of rather greater concern. Looking at short-term volatility measured as 30 day volatility against the United States dollar , the New Zealand dollar was more volatile than the Australian dollar, the British pound, the Japanese yen, and the German mark between the time of the float in March and August But for most of the period since September , and indeed on average over that whole 12 year period, the New Zealand dollar has been somewhat less volatile than any of those currencies.

Looking at the big exchange rate swings which made life difficult for exporters and those competing with imports at some stages during the last decade, we compared the size of the exchange rate appreciation from trough to peak for each of the same currencies. We found that the maximum appreciation which the New Zealand dollar experienced during the decade measured on an inflation-adjusted, trade-weighted, basis was, to be sure, at 29 per cent rather greater than that experienced by the Australian dollar at 20 per cent , but was closely similar to the maximum trough-to-peak appreciation experienced by the German mark 27 per cent , the United States dollar also 27 per cent and the British pound 31 per cent , and very substantially smaller than that experienced by the Japanese yen 62 per cent.

In other words, as I have indicated on other occasions and contrary to much current mythology, the big exchange rate swings experienced by the New Zealand dollar during the nineties were not in the least unusual by the standards of other currencies. This suggests rather unambiguously that, while currency union would eliminate nominal exchange rate uncertainty for New Zealand traders trading within the currency union, there is no currency which we could adopt which would eliminate big exchange rate swings against countries outside the currency union.

And since New Zealand's trade with Australia amounts to little more than 20 per cent of the total, a currency union with Australia would still leave most of our exporters facing currency uncertainty. In other words, currency union with Australia would buy nominal exchange rate certainty for those handling little more than 20 per cent of our trade perhaps especially those in the manufacturing sector , while leaving those handling the other 80 per cent of our trade still facing such uncertainty.

And I say currency union would buy some traders "nominal exchange rate certainty" to make it clear that currency union would not buy anybody real exchange rate certainty, or in other words, certainty of a constant exchange rate after inflation has been taken into account. This is something which Hong Kong has discovered over the years. Although it has had a currency which has been tightly tied to the US dollar since the early eighties, its real, or inflation-adjusted, exchange rate has appreciated quite strongly, both because the US dollar has appreciated against most other currencies and because Hong Kong's inflation rate has been markedly higher than that in the United States.

This has led to the steady erosion of the competitive position of Hong Kong's manufacturing sector, and indeed has been one of the factors leading to a move of manufacturing out of Hong Kong into southern China. The third myth is that a currency union with Australia would greatly increase competition in the New Zealand banking sector, to everybody's benefit. I find it very hard to see why this might be the case given that all of the large Australian banks are already actively involved in the New Zealand market.

Moreover, New Zealand already has an open and contestable banking sector. There are few regulatory obstacles to foreign banks entering New Zealand, provided that they meet certain minimum qualitative criteria. It is clearly not necessary to enter a currency union in order to derive the benefits of foreign competition in the banking sector. In this regard, I was struck by the figures released by KPMG earlier this month, which suggested that the net interest margin earned by the major banks in New Zealand has been falling steadily in recent years, and is now markedly lower than the net interest margin earned by Australian and US banks.

The fourth myth is that currency union with Australia would somehow suddenly enable the New Zealand economy to grow as quickly as the Australian economy, or enable New Zealanders to be instantly richer. That perception appears to drive quite a lot of the public comment on this matter. But of course that is nonsense. The fundamental driver of living standards in New Zealand is the rate at which we can improve productivity. Currency union may have a modest bearing on our productivity performance, as I will argue in a moment, but fundamentally productivity is about the quality of our education system, the quality of New Zealand management, the incentives provided by the tax and benefit system to work and acquire skills, attitudes to work and leisure, the pace of innovation, and so on.

Currency union would have little effect on these matters. Currency union within Australia itself has certainly not guaranteed that economic growth in Tasmania and South Australia will match that in Queensland - any more than currency union within New Zealand has guaranteed that Southland will enjoy Auckland growth rates. Other factors, and other policies, are very much more important for our long-term growth than whether we are part of a currency union.

And my final myth is the argument that, because other countries are forming currency unions, or dollarising, New Zealand should do the same. But the reasons why other countries are forming currency unions or dollarising have very little relevance to New Zealand. The countries of Latin America have, in some cases, locked themselves to the US dollar, and in some cases are thinking of full US dollarisation, after decades of extremely poor money management and hyper-inflation.

Neither of these situations has any relevance to New Zealand.

Moreover, in the last few years a large number of countries, particularly but not exclusively in Asia, have moved away from tying their currencies tightly to some other currency, in favour of a floating exchange rate. Certainly there has not been a generalised international move towards currency union or dollarisation. To begin with, a currency union seems certain to reduce the transaction costs incurred now by traders and travellers exchanging New Zealand dollars for other currencies.

This would probably not produce a huge saving in a currency union with Australia - although there would be worthwhile benefits for tourists in both directions - but, because so much international trade is conducted in US dollars, the savings would be rather greater if we were to adopt the US dollar as our own currency.

Second, a currency union with Australia might reduce average New Zealand interest rates a little. Over the last decade or so, Australian long-term interest rates have been pretty similar to those in New Zealand, but for much of that period though not currently Australia's short-term interest rates were appreciably lower than those in New Zealand.

Adopting the US dollar would currently reduce interest rates in New Zealand by rather more. Although the differences are much less now than they were a decade ago, US interest rates are currently lower across the entire range of maturities than those in New Zealand. By adopting either the Australian dollar or the US dollar, we would avoid the need to pay the currency risk premium which savers currently demand for holding New Zealand dollar assets.

There could well be on-going differences in interest rates between New Zealand on the one hand and Australia or the United States on the other, of course, arising from credit and liquidity risks, but the differences would be smaller than currently. But it is also the case that a currency union would remove any chance of New Zealand interest rates falling below those in Australia or the United States, if it was the US dollar we adopted. While it might seem unlikely that New Zealand interest rates would ever fall below those in Australia and the United States, it is worth recalling that New Zealand's long-term interest rates were somewhat lower than those in Australia through the first half of the nineties and slightly lower than those in the United States for a time in ; and that most interest rates in Canada, Singapore, Switzerland and the European Monetary Union are below those in the United States today.

The main reason why New Zealand interest rates have been so high in the last decade is that through much of that period we have been coping with the hang-over of high inflationary expectations, especially in the property market, the result of two or three decades of high inflation bingeing.

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The United States had very high interest rates in the early eighties , as it grappled with high inflationary expectations. If New Zealand continues to keep inflation well under control, and continues to maintain the confidence of financial markets by following a prudent fiscal policy, it seems entirely reasonable to expect that in time New Zealand interest rates could fall below those in both Australia and the United States.

In forming a currency union, we would in effect be betting that, no matter with whom we formed that currency union, their policy performance would be better than our own could have been for the indefinite future. Third, while currency union, with Australia or any other single country, would not eliminate the exchange rate uncertainty which New Zealand exporters face, it would clearly eliminate the nominal exchange rate uncertainty for trade with the country or countries forming part of the currency union and probably reduce the real exchange rate uncertainty also.

As indicated earlier, a currency union with Australia would eliminate nominal exchange rate uncertainty on only a relatively small part of our total trade, but it is quite an important part of our trade in a qualitative sense. A much larger part of our manufactured exports go to Australia than to any other single destination, and the Australian market is particularly important as a "testing ground" for small companies just getting into the business of exporting. As a result of this reduction in exchange rate uncertainty within the currency union, it seems very likely that currency union would stimulate trade with other parts of the currency union.

Monetary Union

Empirical research on the effects of currency uncertainty on trade is, unfortunately, not very conclusive, with some studies suggesting that the effects of currency uncertainty are actually pretty small and others suggesting that they are quite significant. My own rather subjective view is that a currency union would indeed increase trade between New Zealand and other parts of the union, and that seems to be the view of the business community also. The euro-system has two elements - the European Central Bank ECB , which is responsible for all monetary policy in the eurozone euro area , and the National Central Banks CBs of the 19 member countries.

Other European countries are free to join the euro area if they meet the criteria laid down in various treaties. The two most important criteria for entry are that the applicant country has demonstrated price stability, and that its public finances are well managed. Co-ordination of policy was designed to enable the original 12 economies of the euro-area to converge.

A key feature of this was the Stability Pact, which involved members agreeing to keep their economies stable, and keeping their budget deficits under control. This restriction was designed to prevent any unnecessary fiscal stimulus which might de-stabilise the economy, even in the face of high unemployment. However, several countries, including Germany, France, and most notably, Greece, have broken this rule, and this has cast serious doubts about the ability of the euro area to maintain this rule.

The EFSF was formed to help stabilise the European economies after the financial crisis, recession and sovereign debt crisis, and now forms a key element of the reformulated euro-system.


In attempt to prevent EU countries from running up further debts, the majority of the EU states signed a fiscal compact which opened up their domestic budgets to collective scrutiny. It remains to be see how successful this measure will be, and whether its leads to a full fiscal union. There are several significant benefits of having a single currency area.

These are primarily derived from the benefits of fixed exchange rates, and include the following:. Producers and tourists can more easily compare the prices of international goods, services and resources. Transaction costs are reduced because there are no commission payments to financial intermediaries. The Euro creates certainty because firms can predict the cost of imported raw materials and can set the price of their exports, which means they can plan, and are more likely to invest.

Trade between members of a single currency area is likely to increase because of the benefits of sharing a currency. Increased trade is likely to generate jobs in those industries that experience increased exports. Once a country become a member of the euro area, National Central Banks, including the Bank of England, lose their ability to use interest rate policy to achieve independent macro-economic objectives. Following the financial crisis and global recession, recession-hit countries like Greece were not able to reduce interest rates unilaterally.

The pros and cons of currency union: a Reserve Bank perspective - Reserve Bank of New Zealand

Many European countries, including the UK, may never be able to converge fully with the euro area. In the UK in particular, convergence is difficult because of the uniqueness of its housing market and financial services sector, and because of the closeness of the UK's trade cycle to that of the USA.

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In addition, the UK labour market is highly flexible in comparison with France, Germany, and Spain and this also makes convergence difficult. Having only one interest rate is not sensible when dealing with a diverse range of economies and economic circumstances. Even within a single currency area, great diversity can exist, suggesting that a common economic policy might be unproductive.