Reserve Bank Governor Graeme Wheeler has used a speech to an international audience to talk up the central bank's policies restricting banks' low equity mortgage lending and forcing them to use more deposits and longer-term wholesale money for funding.
Wheeler also dismissed the idea of capital controls as rarely being a desirable option for open economies like New Zealand's.
He reiterated what Reserve Bank Deputy Governor Grant Spencer told interest.co.nz in July, in that restrictions on banks high loan-to-value ratio (LVR) residential mortgage lending will be reviewed, along with their implications, in next month’s Financial Stability Report. The report's due out on November 12.
"While LVRs have a financial stability goal, they have been an important consideration in our monetary policy assessment. We believe the dampening impact of LVRs on house price inflation and credit, and the diminished ‘wealth effects’ on spending associated with it, have reduced consumer price inflation pressures by an amount similar to a 25-50 basis point increase in the OCR," Wheeler said.
"In essence, the reduction in housing pressures allowed us to delay the tightening in interest rates, thereby reducing the incentive for any additional capital inflows into the New Zealand dollar in search of higher yields."
"We have seen little financial sector disintermediation to date, and have indicated that the LVR speed limit is not intended to be permanent. It will be removed once housing market pressures have moderated and when we are confident there will not be a resurgence in house price inflation. We will be reviewing these criteria and their implications for LVR restrictions in next month’s Financial Stability Report," added Wheeler.
The 25-50 basis points impact on the OCR is in line with what Spencer said in March when he said the LVR restrictions were worth up to 50 basis points of OCR hikes. Prior to that the Reserve Bank had said the presence of LVR restrictions would mean that the OCR would need lifting by 30 basis points less than would otherwise be required.
The Reserve Bank has increased the Official Cash Rate four times this year by a combined 100 basis points to 3.5%. It next reviews the OCR next Thursday, October 30, but most economists expect the OCR to remain on hold well into 2015.
Wheeler noted the LVR restrictions, introduced on October 1 last year, led to a significant reduction in high-LVR lending, a decline in house sales, and fall in house price inflation.
"While other factors, such as subsequent interest rate increases over the period March 2014 to July 2014 are also helping to constrain demand, annual house price inflation fell from around 10% to 5% currently, despite high levels of net immigration," he said.
Banks must limit high LVR lending, defined as LVRs over 80%, to an average of no more than 10% of their mortgage commitments. (See more on the LVR "speed limits" here).
"Vulnerability of NZ banks to problems in offshore wholesale funding markets substantially diminished'
Wheeler also talked up the success of the Reserve Bank's core funding ratio (CFR), which was introduced in April 2010 to help wean New Zealand's big banks off shorter-term overseas wholesale borrowing. The CFR requires a minimum proportion of total bank lending to be funded by more stable "core funding" instruments such as retail deposits and long term borrowing of more than one year.
"In New Zealand, the commercial banks’ core funding ratios fell to around 60% prior to the Global Financial Crisis. Today the banks’ core funding ratios stand at around 85% against a minimum (requirement) of 75%, and the vulnerability of New Zealand banks to developments in offshore wholesale funding markets has been substantially diminished," Wheeler said.
On the broader issue of cross-border financial integration, Wheeler said there was much more to this than capital flows.
"It also embraces trade linkages, incipient flows, remittances, price arbitrage, and risk transfer instruments. In its broadest form financial integration offers enormous benefits, particularly when it finances efficient resource allocation, smoothes consumption, and distributes and diversifies risk. It is especially important when linked to the global transfer of skill-enhancing technologies, and the financing of innovation and catch-up technologies."
Nonetheless he said cross-border flows can present challenges for monetary policy and financial stability.
"Cross border financial linkages can present difficult challenges for monetary policy for two main reasons. First, although the exchange rate is often the primary transmission channel for monetary policy, this channel is often stronger than we would wish. Second, and just as problematic, we often do not know what factors are driving the exchange rate and how efficient this transmission channel is," said Wheeler.
"In an economy with an open capital account, with active arbitrage it is possible to have either a stable exchange rate or an independent monetary policy capable of delivering price stability."
"Like New Zealand, many of the Asian economies have experienced an appreciation in their real exchange rate in recent years. In a floating exchange rate environment, this lowers inflation in the tradables sector and raises the real disposable incomes of many consumers. It also makes it cheaper for firms to acquire imported capital goods and new technologies, and can spur greater innovation and productivity in the tradables sector," Wheeler added.
"However, large swings in the real exchange rate impose significant adjustment costs for firms that are forced to exit and re-enter markets due to large movements in competitiveness. And it can generate particularly difficult headwinds for those export producers not experiencing high prices for their products, and for firms competing against cheaper imports."
An important issue for policy makers, he said, is whether the appreciation in the real effective exchange rate is justified and sustainable.
"A real effective exchange rate is unjustified when its level is inconsistent with the economic factors (such as commodity prices, economic growth, interest rate differentials) that can normally explain its movement during the business cycle. The level of the real effective exchange rate can be considered unsustainable when it is clearly deviating from its long-run equilibrium at the level that it would be expected to settle when business cycle factors have fully dissipated. In such a situation, persistent deviations from equilibrium are likely to result in external debt ratios that become unmanageable and cause misallocations of resources that can inhibit the country’s long term growth potential," said Wheeler.
'Capital controls seldom a desirable option for countries with open capital accounts'
And, he said, domestic monetary policy and changes in exchange rate regimes can't do much to alleviate an overvalued real exchange rate.
"New Zealand has tried a variety of exchange rate regimes over the past 40 years – including a fixed exchange rate, crawling peg and floating exchange rate. However, the medium-term level and volatility of our real effective exchange rate has been largely unaffected by the type of exchange rate regime in place," Wheeler said.
"Often the appropriate policy response lies with measures to reduce demand pressures, or improve competitiveness and raise potential output growth. Such measures might include a better balance of fiscal policy, addressing impediments that distort saving and investment decisions, and undertaking reforms that raise productivity and improve competitiveness. They might also include prudential policies that address rising vulnerabilities directly."
He noted commentators such as the International Monetary Fund have suggested capital controls might play a role.
"But this is seldom a desirable option for countries with open capital accounts. An open capital account provides powerful incentives for improving productivity as it signals to domestic producers that they need to be competitive if they wish to attract capital and financing domestically and from offshore," said Wheeler.
"Opening the capital account is therefore one of the most powerful economic reforms that a government can undertake. This is partly because of the benefits of the policies that are usually pre-conditions for removing capital controls. Such pre-conditions include achieving a reasonable degree of economic stabilisation, some liberalisation of the domestic financial market, and lower border protection so that domestic savings do not flee offshore from a highly protected domestic capital market, and offshore capital does not flow into domestic sectors with high effective rates of protection."