By Peter Redward*
Since March 1985, the New Zealand dollar has floated freely in foreign exchange markets. The Reserve Bank of New Zealand has, from time to time, guided the NZD stronger or weaker in line with its management of overall monetary conditions, but with the exception of a brief period in mid 2007, the RBNZ has not physically intervened to alter the level of the currency.
In March 2005 the RBNZ published a list of four criteria for considering FX market intervention: 1) the exchange rate must be exceptionally high, or exceptionally low; 2) the exchange rate must be unjustified by economic fundamentals; 3) intervention must be consistent with the Policy Targets Agreement; and 4) conditions in markets must be opportune and allow intervention a reasonable chance of success.
The Reserve Bank’s reticence to intervene in the FX market has been understandable. Over much of the past 25 years, the RBNZ’s primary focus has been to lean against strong credit creation and rising asset prices, and their associated inflationary pressures.
Keeping short-term interest rates well above the country’s trading partners helped wring inflation from the economy and at the same time provided a strong rationale for steering clear of FX market intervention.
Intervention to bring down the value of the NZD would run counter to the Reserve Bank’s monetary policy objectives while simultaneously eroding the bank’s profitability, potentially leading to significant capital losses and the need for capital injection from the Treasury.
In this environment, intervention was not credible, nor was it consistent with the PTA (Policy Targets Agreement). It simply would have provided speculators with more attractive levels at which to buy the NZD, meaning intervention would have had little chance of success.
The situation confronting the country today is quite different. New Zealand is experiencing a shallow, long-lasting recession in economic activity. GDP growth, which averaged 3.4%p.a. in the decade to 2005, but has averaged a mere 0.9%p.a. since. Significant underutilised resources need to be put to work. Unemployment has risen by 25,000 (since 2008), with the unemployment rate now standing at 6.8% of the labour force.
The Reserve Bank estimates that the economy is operating around 2.6% below its rate of potential GDP while the New Zealand Institute of Economic Research highlighted in its March survey of business opinion that sales are the key constraint in the economy.
Credit growth is anaemic, as households and businesses, notably farmers, attempt to pay down debt. This is proving a slow process, hampered by asset price deflation, as businesses and households faced with cash flow problems are forced to liquidate investments in a depressed market.
'Inflation under control'
Headline CPI inflation rose to 4.0% y/y in Q4 2010, but much of the acceleration in inflation can be attributed to the 2.5% increase in the GST, and higher administrative charges and petrol prices, with the Reserve Bank forecasting inflation dropping to 2.1% in 2012. Given the weak state of the domestic economy, workers have limited wage bargaining power and firms have limited pricing power.
Against this backdrop, and given the recent earthquake in Christchurch, the RBNZ chose to cut lower official cash rate by 50bp, to 2.5%, at its March Monetary Policy meeting. While the rate cut will provide some welcome relief to the mortgage belt, we wonder whether households and businesses will chose to spend the modest extra income they receive, or whether it will simply get swallowed up in debt repayment.
In our opinion, the current environment is such that FX market intervention can be contemplated in a manner that is credible, consistent with the RBNZ’s monetary policy objectives and not injurious to the central bank’s balance sheet. Given the weak state of the New Zealand economy, intervention that suppresses the value of the NZD can temporarily lower both the nominal and real (ie, inflation-adjusted) exchange rates. In other words, an artificial weakening of the NZD via FX market intervention would result in only a modest pass-through to domestic prices, at least until the economy recovers.
'Bigger bang than a rate cut'
This weakening of the exchange rate would support exports, assisting both the aggregate growth rate of the economy and employment, especially in manufacturing and tourism, sectors that have not benefitted from improving commodity prices. It should also boost government tax revenues through higher PAYE and company taxation. In the current environment, this form of monetary stimulus is likely to have a higher money-multiplier effect than simply cutting interest rates.
We believe FX intervention would assist in rebalancing New Zealand’s economy away from domestic consumption, providing a boost to tourism and manufacturing exports, two sectors that have not benefitted from the surge in global commodity prices but are significant employers. A weaker NZD would help to narrow the current account deficit and reduce New Zealand’s large net external debt/GDP ratio. Moreover, at a time when international credit rating agencies are increasingly concerned about New Zealand’s fiscal outlook, rising foreign reserves should assist by improving the country’s external solvency.
Higher FX reserves would raise the import-cover ratio (the number of days imports that can be paid for by FX reserves), as well as our short-term debt cover ratio (the ratio of FX reserves to short-term debt). Both of these indicators typically have a significant effect on sovereign credit ratings, and may act to hold off a potential downgrade of New Zealand’s international debt ratings.
A key factor determining whether FX intervention will have a reasonable chance of success is its impact on the central bank’s balance sheet.
This will be determined by three factors: 1) the yield on foreign securities purchased; 2) the yield on bonds issued in the domestic money market to sterilise the intervention; and 3) the degree to which the intervention is sterilised in the domestic money market.
'Affordable for RBNZ'
Historically, intervention would have proven non-credible on this count because of New Zealand’s high short-term interest rates relative to foreign interest rates and because FX intervention would have required complete sterilisation. Speculators would correctly surmise that the RBNZ could not sustain losses and consequently they would happily use any temporary weakness in the NZD to buy.
These dynamics do not apply today. Assuming that the Reserve Bank buys 2 year government bonds weighted by the five currencies in our trade-weighted exchange rate index, the yield on these assets would be 1.94%, compared with a domestic 90-day bill rate of 2.64% (returns could be raised to 2.63% by reducing Japanese government bond purchases and increasing purchases of Australian government bonds).
This implies a net loss of 69bp assuming complete sterilisation. However, given the current macroeconomic environment, the Reserve Bank does not need to completely sterilise intervention, instead it can allow the money supply to expand. A sterilisation ratio of 74% would be enough to cover the cost of intervention, with a lower sterilisation ratio likely to assist in boosting base money, providing somewhat of an offset to the contractionary forces associated with the current de-leveraging.
We recently talked with global foreign exchange traders to gauge their reaction to the possibility of FX market intervention in New Zealand. To our surprise, the arguments outlined above were unanimously supported. Intervention in the FX market to weaken the exchange rate is clearly not sustainable on a longer-term basis, as many central banks in Emerging Asia are discovering, but under the right conditions, intervention it can be a powerful tool.
We believe the time is right for the RBNZ to contemplate this policy.
* Peter Redward is a New Zealand expatriate living in Singapore who is the Head of Emerging Asia Research at Barclays Capital.
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