There's no clear answer to the question of what the right level of foreign currency reserves the Reserve Bank (RBNZ) should hold is, says its Assistant Governor and General Manager of Economics, Financial Markets and Banking, Karen Silk.
In a speech to the UBS Australasia Conference in Sydney on Tuesday, Silk notes the new Foreign Reserves Management and Co-ordination Framework setting out expectations around the management and use of foreign reserves in New Zealand and the respective roles of the RBNZ and Minister of Finance. This was required by the Reserve Bank Act 2021, and was published in January.
Following that the RBNZ increased its foreign currency assets, and thus intervention capacity, by almost NZ$4 billion during July by selling NZ dollars in what was likely a move of unprecedented scale. This increased the RBNZ's foreign currency intervention capacity to NZ$16.699 billion at the end of July.
This led to speculation over how much more the RBNZ may increase its foreign currency intervention capacity by. Silk was coy on this in her speech.
"As episodes of intervention are rare there is no clear answer as to what the right level of foreign reserves is. In determining what an appropriate level of foreign reserves for New Zealand might be, we considered a range of metrics, including import volumes, debt outstanding and FX [foreign exchange] turnover, as well as international central bank comparisons, and scenarios including previous interventions in New Zealand and overseas."
"We will not be commenting on the target level of reserves agreed as that information is considered market sensitive but will note that achieving it is a process that will occur over a number of years. This is because we seek to avoid undue risk to market liquidity from our actions in reaching agreed levels," says Silk.
As of the RBNZ's last disclosure, in late September, its foreign currency intervention capacity stood at NZ$17.725 billion.
Like many other central banks the RBNZ holds foreign reserves on its balance sheet that it can use to intervene in the foreign exchange market to support both financial stability and monetary policy objectives, she adds.
"This could include intervening when market functioning is impaired, and liquidity is limited – or when the level of the exchange rate is at extreme and unjustified levels relative to economic fundamentals and thereby working against the desired stance of monetary policy," says Silk.
"The introduction of the new framework does not fundamentally change the approach to foreign exchange interventions. Periods of intervention are still expected to be rare, and we remain committed to maintaining a free-floating exchange rate, with this being reflected in the internal decisioning frameworks we apply."
"For example, in assessing the appropriateness of FX intervention for monetary policy purposes, the Monetary Policy Committee utilise four key criteria that set a high hurdle for intervention to occur with all four required to be met. These include: 1) Exceptional – the exchange rate should be exceptionally high or low 2) Unjustified – the exchange rate should be unjustified by economic fundamentals 3) Consistent – intervention should be consistent with our monetary policy objectives 4) Opportune – market conditions should be opportune and allow intervention a reasonable chance of success," Silk says.
"The foreign exchange market is very important for New Zealand, as a small open economy. In conjunction with Treasury and the Minister of Finance, the RBNZ determined through the Foreign Reserves Coordination Framework that a higher level of foreign reserves holdings was appropriate. We are building towards that now."
Central banks such as the RBNZ can use their balance sheets to support financial stability objectives, Silk adds, with the balance sheet in all cases "an instrument of policy and not profit."
"Interventions for financial stability might happen at the same time as monetary policy interventions, for example during COVID-19, or they may occur independently, in fixed income or currency markets."
Hedged & unhedged
Meanwhile, Silk points out the RBNZ holds two main portfolios of foreign reserves, hedged and unhedged. The distinction between the two reflects how the NZ dollar (NZD) is converted into a foreign currency.
"Unhedged reserves are raised by selling NZD in exchange for foreign currency in the spot foreign exchange market. This transaction results in us owning foreign currency, and the value of these assets will fluctuate in line with increases or decreases in the exchange rate," says Silk.
"The hedged reserves are raised by lending NZD in exchange for foreign currency, generally in the cross-currency basis swap market. We effectively borrow foreign currency under long term contracts and are not exposed to movements in the exchange rate, because all the foreign exchange rates are agreed at the start of the contract."
"Historically the RBNZ has chosen to hold a mix of both unhedged and hedged reserves. In addition to the different exchange rate exposures, there are other considerations taken into account when determining the mix. These include the relative costs, risk appetite, refinancing risk and intervention needs. While we will not comment on what the composition will look like in the future, we expect the mix of portfolios to carry flexibility and be influenced by market conditions over time," Silk says.
Under the Foreign Reserves Management and Co-ordination Framework the RBNZ must also manage investment of the foreign reserves.
"Like most central banks, the primary considerations when looking to invest our reserves are safety and liquidity. This ensures that when they are needed our reserves maintain their value and can be easily converted into cash. Subject to satisfying safety and liquidity requirements, return is then considered and optimised and like other central banks around the globe, the RBNZ is also evaluating alternatives for the incorporating sustainability considerations in our investment criteria. While the purpose of the reserves will always require safety and liquidity as primary criteria, risks such as those posed by climate change will impact upon those over time and transition and mitigation likewise may add to investment opportunities," says Silk.
Silk also notes the RBNZ and Treasury reviewed the RBNZ’s financial resources, deciding on top of those required to support the increase in foreign reserves holdings, current and potential future balance sheet activities, such as interventions for financial stability, "carry a degree of financial risk and would also benefit from additional prepositioned financial resources."
Pre-positioned financial resources, such as capital and indemnities, provide several benefits beyond mitigation of risks to credibility, she says.
"It can support the Crown’s ability to manage overall Crown exposure to financial risk well in advance of a crisis, support fiscal and monetary policy coordination, provide clarity around decision-making structures to enable quick action in a crisis, and support the RBNZ’s operational independence, which is critical for our credibility in achieving our objectives. Following the review, the RBNZ has received an additional $1.8 billion in capital plus additional indemnities from the Crown."
Two new indemnities have been provided. One's for forex interventions, the other for bond buying programmes. The latter has a $5 billion cap, but the size of the forex intervention indemnity hasn't been released as it's considered commercially sensitive.
"The first indemnity specifically supports foreign exchange interventions related to the Foreign Reserves Management and Co-ordination Framework. The second indemnity relates to losses that may be incurred on bond purchase programmes, in the future," Silk says.
"Bond purchase programmes, which can be useful in supporting financial stability, may be needed in instances of market dysfunction, such as that we encountered at the onset of COVID-19. It is important to note that interventions will not necessarily lead to losses, and in some cases, can be profitable."
"Larger risks, for example for bond purchase programmes intended to provide ongoing monetary policy stimulus on the scale of the COVID-19 Large Scale Asset Purchase (LSAP) programme, may require additional financial resources, beyond that currently provided. However, we expect that in such situations, there would be more time to formulate policy and seek additional financial resources once immediate crisis concerns have been alleviated," Silk says.
"As such, we have not sought pre-positioned financial resources to enable interventions of this scale. We have a Memorandum of Understanding (MOU) on Additional Monetary Policy tools with the Minister of Finance which lays out a process for seeking an indemnity beyond our existing financial resources if needed. This MOU further provides the Crown with a role in promoting fiscal and monetary policy coordination."
*There's more on the RBNZ's capital and indemnity top-ups here, and also see our podcast with Ex-Bank of England Deputy Governor Paul Tucker on how quantitative easing, such as the RBNZ's LSAP, has impacted public finances here.