RBNZ's Bollard says money printing by other central banks spilling over as capital inflows into small, open economies, causing 'problematic' pressure on NZ$

By Bernard Hickey

Outgoing Reserve Bank Governor Alan Bollard has commented in a speech in Australia that quantitative easing by major central banks was spilling over as capital inflows into small, open economies such as New Zealand, which was proving problematic because of the resulting upward pressure on exchange rates.

"Unconventional policies can have unconventional side effects," Bollard said in the Sir Leslie Melville Lecture at the Australian National University in Canberra

"We are currently observing spillovers from large economy QE (Quantitative Easing) impacting capital flows and exchange rate pressures in small open economies," Bollard said in the speech titled: "Learnings from the Global Financial Crisis".

"Continuing exchange rate pressure is problematic for a country like New Zealand," he said.

Bollard went through the history of the Global Financial Crisis and then talked about the resulting policy challenges for central banks and policymakers in this part of the world.

"Australia and New Zealand escaped the worst of the financial crisis, but not without extraordinary policy actions of our own at various times, and not without a certain legacy of issues to deal with in our own neighbourhood," he said.

The New Zealand dollar has firmed in recent weeks to four month highs despite a 6% fall in commodity prices over the same period, prompting some to call for Reserve Bank intervention. Former Reserve Bank of Australia (RBA) board member Warwick McGibbon also called in an Australian Financial Review opinion piece for the RBA to intervene to offset pressures of foreign central banks buying Australian bonds with their freshly minted reserves.

Bollard pointed to the QE programmes carried out by the US Federal Reserve and the Bank of England, which had tripled and quadrupled the size of their balance sheets respectively.

He then went on to describe a 'new world' where the threat of deflation was real for some countries and inflation was low in others. Real per capita GDP growth had been insipid at best in most advanced countries since the crisis.

"The risk aversion in global credit markets is still reaching our shores via bank funding markets, in the form of elevated funding spreads and a heightened demand for local deposits," Bollard said.

"Although these developments at least partly reflect a transition to “new normal” balance sheet structures, it is also possibly a sign that the pre-crisis model of highly leveraged and interconnected banking may no longer attract investors That of course could be a helpful thing for macro-financial stability and for the rebalancing of non-bank balance sheets – provided it persists when good times return," he said.

'Could last a generation'

Bollard then went on to changes in household spending and borrowing behaviour, which could last a generation.

Global spending and investment appear very cautious, and seem likely to remain so for some time, given the overhang of debt from before the crisis. In advanced economies, deleveraging in the private sector appears to have started, but will take a long time – perhaps a generation. Very cautious households are a large part of the story of a slow and fragile recovery. They have been hit hard by sustained labour market weakness, and in the US and some other advanced economies this has been compounded by loss of housing wealth and balance sheet weakness.

The apparently lower appetite for debt among New Zealand and Australian households is an interesting departure from the recent past, or perhaps a return to the more restrained standards of post-war years. In New Zealand, this continues, despite an emerging pickup in housing market activity (albeit off a very low base). For example, New Zealand household credit growth has traditionally tracked the value of house sales, but this relationship has loosened since the crisis.

He also went on to refer to how strong demand from emerging Asian nations for commodities had boosted the high real exchange rates in Australia and New Zealand and was hitting the non-resources sectors, a process often referred to as the 'Dutch Disease'.

The high exposure of Australia and New Zealand to emerging Asian demand for industrial raw materials and protein has sent the relative prices of those products, and hence our real exchange rates, to high levels. While that shift has encouraged labour and capital to move to those sectors, high real exchange rates are also promoting expenditure switching towards foreign goods and away from domestic ones. Non-resources sectors and regions are squeezed as a result.

Moreover, the pressure of the high nominal exchange rate is not the only relevant “headwind” for our economies. Sectors other than those directly exposed to resources are seeing their relative productivity and cost-competitiveness decline. This reflects the ongoing and rapid industrialisation of Asia, and perhaps globalisation more generally. In New Zealand, the most obvious relative decline is in import-substituting sectors.

'Destabilising herds and the need to be humble'

Bollard said the GFC had reoriented the economic research agenda.

Beliefs that self-stabilising processes in the economy and financial system generally dominate destabilising herd behaviour have been shaken up. The potential and proper roles of financial, fiscal and monetary policy, have also been seriously challenged by experience.

The management of tail risks is the supposed province of regulators, financial experts and insurance contracts. Yet the industry’s extensive risk-management apparatus failed to anticipate and struggled to cope with the financial crisis. Some markets that locked up involved recent financial instruments such as complex mortgage derivatives, whose behaviour under stress had never really been tested.

When markets struggle to clear at any price, and when cross-border exposures grossly multiply the number of relevant variables, formal modelling to support risk management becomes difficult. By definition, tail risk analysis is about extrapolation of observed behaviour to speculate about scenarios never before seen. We should be humble about our frameworks’ ability to capture these scenarios.

Economists have yet to get fully to grips with the complex roles of the financial system, financial frictions, asset prices and credit flows in international macroeconomic dynamics. The research and policy communities are now busy introducing richer financial behaviour in models. Some promising avenues include study of how financial margin behaviour can propel economic booms, financial incapacity can exacerbate busts, and diffusion of bad news can generate panics. Experimental economics is using lab settings to study human reactions to imperfect information and discontinuous events.

'Weak banks holding the economy to ransom'

Bollard then went on to talk about financial regulation and the moral hazard problems created by taxpayer bailouts of failing banks.

The crisis confirmed that the financial system’s central economic role, and sudden escalation of systemic problems, make it politically very difficult to ensure that a bank’s shareholders and creditors bear the full costs of the bank’s failure when the entire system is under threat. Weak banks, effectively holding the economy to ransom, readily pass their liabilities and risks on to governments. Authorities’ priority in the midst of a financial crisis tends to be focused on ensuring that the liquidity crunch conditions sparked by bad banks do not drag good banks under.

All the various forms of official support involve unpalatable market distortions and incentives for further bad behaviour (moral hazard). While equity stakes capture some upside from the rescue for the government, they also involve difficult governance problems. Junior debt leaves the government with credit risk but no influence over risk-taking. Senior bank debt limits the government’s credit risk, but can make the bank’s fragility worse by scaring off private investors. Government guarantees of deposits and other liabilities might limit the upfront cashflow implications of financial support, but cast the shadow of moral hazard very broadly.

Moral hazard can probably never be eliminated, only reduced, especially after the widespread bailouts and government guarantees seen in the crisis. Some level of regulation and supervision to constrain the extremes of risk-taking behaviour will therefore always be necessary.

Macroprudential policy

Bollard then went on to talk about the need for 'macro-prudential' policies to control bank balance sheets across the financial system. However, his comments were cautious and appeared not to commit his successor, Graeme Wheeler, to anything in particular.

Macro-financial policy settings are intended to deliver automatic stabilisation akin to that of fiscal (tax and benefit) systems, as well as larger buffers against system-wide shocks and some degree of leaning against strong credit upswings. The settings would be reviewed from time to time to suit changing financial and economic circumstances. Macro-financial settings would be expected to change much less frequently than monetary policy.

Like most policy interventions, macro-financial measures (such as capital and liquidity buffers or restraints on certain kinds of risky lending) involve costs in the form of potential distortions to financial activity. Such interventions are likely to complement monetary policy, but this cannot be guaranteed. Indeed, we have very limited practical experience of macro-financial policy.

These concerns suggest that macro-financial policy should not seek to be too activist. Distortions will be most likely to occur where a policy intervention creates an opportunity for regulatory arbitrage between the regulated and unregulated sectors, or between regulated and unregulated activities. And the incentives for arbitrage will be greater under strong credit demand conditions, suggesting the likelihood that any restraining effect of macro-financial tightenings on business cycle upswings is likely to be small.

Under such conditions, the appropriate response to a future credit-fuelled upswing could well be a combination of measures. Macro-financial tightening would counter banks relaxing credit standards and undermining the stability of the overall system, while monetary policy tightening would address rising inflationary pressures associated with the strong credit demand. But in comparison with other policy areas, macro-financial policy knowledge is still immature, and we have a lot to learn.

'Zero-bound problem'

Bollard then went on to talk about vulnerabilities in the banking systems in Australia and New Zealand and the potential problem of the 'zero-bound' on interest rates, where the effectiveness of interest rate cuts diminishes the close interest rates get to zero.

Local issues include the relatively heavy dependence of our economies on bank lending, the relatively heavy dependence of the banks on foreign funding, and the high degree of concentration of the banking sectors. We therefore seem to face a similar priority to other advanced economies in reducing the risk that investors will progressively tighten constraints on the room for fiscal action. Countries with high debt/GDP positions remain exposed to the longer-term economic outlook, putting a premium on structural reform measures to promote growth. Of course, implementing such reforms is easier said than done, especially when their short-term effect on demand is usually adverse.

The fiscal balancing act over the next few years is to restore headroom through consolidation where possible, while taking into account any adverse short-term impacts on activity. This should help reduce the chances of getting backed into the very difficult and constrained space in which a number of advanced economies now find themselves. However, this is of course yet another policy challenge in the category of things easier said than done. Moreover, the link to monetary policy is particularly important in the current environment, because of the zero lower bound on interest rates. Fiscal austerity is probably not as contentious when monetary policy loosening can offset its short-term effects on economic activity.

'Plumbing not neutral'

Bollard said monetary policy had been effective in reducing the high inflation of the 1970s and stabilising it through the 1990s and 2000s, but now it faced new concerns.

First, financial cycles are evidently able to destabilise the economy without necessarily implying large inflation fluctuations. Second, the financial system is far from neutral “plumbing” for the real economy. Instead, it substantially modulates economic shocks and can generate shocks itself. It can also materially affect monetary policy’s effectiveness in stabilising economic activity. We can probably expect that, for some time, risk premia on private and public debt will remain much more variable and differentiated, and a source of noise in the policy formulation process.

How monetary policy strategy should account for these complications is not at all settled. It does not help that monetary policy settings and interventions themselves have been highly unusual in many countries. Many researchers are studying the possible adverse effects of very low interest rates on investor risk-taking, and the effects on global financial conditions of large-scale QE activities by major central banks.

There are other questions, such as how to set interest rates in a deleveraging environment. Increased saving promotes the longer-term stability objectives of stronger balance sheets, but its impact on demand needs to be accounted for. In addition, the exchange rate effects of monetary policy are no doubt important, but distinguishing these impacts from other influences is far from straightforward.

'Unsafe territory'

Bollard acknowledged the zero-bound problem was not that far away in New Zealand and Australia, where official cash rates were 2.5% and 3.5% respectively.

Conventional monetary policy is safer known ground, but central banks, including in our region, are realising they may be pushed by events into unsafe territory.

 The large expansion of the central bank’s balance sheet under QE markedly increases the central bank’s financial risk, and its dominance in the targeted markets distorts market pricing (indeed, the distortions are one means by which QE is believed to work). These factors place limits on how much QE can be relied upon as an additional tool.

In a globalised world, big players lowering their domestic interest rates, whether by QE or any other tool, will (all else equal) tend to promote capital flows to other countries and appreciation of their exchange rates. As a small open economy, New Zealand has often seen the effects of carry trades on the exchange rate. This can be distortionary and problematic, because an economy relies on its exchange rate as a signalling price.

(Updated with more detail, charts)