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Speech by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Rotary Club of Auckland, Auckland, New Zealand, 21 May 2001
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Donald T Brash: Should the Reserve Bank of New Zealand have eased as fast as the Federal Reserve? Speech by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Rotary Club of Auckland, Auckland, New Zealand, 21 May 2001. * * * Introduction Over recent days, the Reserve Bank of New Zealand has puzzled a lot of people – indeed even angered a few! – because we have been slower to ease monetary policy than they have expected or wanted, and slower than central banks in some other countries. Surely, it is argued, the Reserve Bank must be able to see that the world economy has slowed sharply, and monetary policy should be eased. Surely, it is argued, the Reserve Bank must be able to see that the domestic economy has been sluggish, business and consumer confidence are down, and monetary policy should be eased. Surely, it is argued, the Reserve Bank must be able to see that the drought has been serious and will have a potentially big impact on production next season, and monetary policy should be eased. Surely, it is argued, the Reserve Bank must be able to see that the US central bank, the Federal Reserve, has eased policy by much more than has been the case in New Zealand. Given the record of growth with low inflation which the US economy has achieved over the last decade, surely this suggests that the Reserve Bank of New Zealand should be following the Fed's example, and easing monetary policy more aggressively. Certainly, the American central bank has cut its official interest rate by 250 basis points since the beginning of the year. The Australian central bank has cut its official interest rate by 125 basis points since the beginning of the year. And to date the New Zealand central bank has cut its official interest rate by a rather more modest 75 basis points since the beginning of the year. And forecasts of the parts of the global economy of most relevance to New Zealand, compiled in London by an organisation called Consensus Forecasts, continue to be revised down. Back in November, as we prepared our December Monetary Policy Statement, the Consensus forecast for the 14 countries of most relevance to us had growth in those countries this year at 3.5 per cent. Three months later, that forecast had been revised down to 2.9 per cent. Now, the forecast is only 2.3 per cent. Surely, it must be obvious to the Reserve Bank that the world economy is going to continue to get weaker, and monetary policy must be eased urgently. The most important point I want to make to those who run these arguments is that, just because other central banks have eased monetary policy substantially, the Reserve Bank of New Zealand is not necessarily remiss in taking a somewhat different course. Why? Simply because every national economy is unique. Monetary policy is not a race, with every central bank trying to get to the finishing line first. It is about adjusting interest rates to influence demand within a specific economy to ensure price stability in that economy. What is right for one country might well be entirely wrong for another. So while of course it is important that we in New Zealand are aware of what other central banks are doing – because their actions may say something about their economies which could be relevant to inflationary pressures within New Zealand – matching the decisions of other central banks point for point will often make no sense at all. Should we in New Zealand have been easing monetary policy more quickly than we have been doing? Or in other words, will the slow-down in the world economy reduce inflationary pressures in New Zealand so much that some time in the next year or so inflation will fall towards the bottom of the agreed 0 to 3 per cent target band? Still plenty of risks in the world economy It is certainly possible to imagine some very pessimistic scenarios which would warrant a major further easing of interest rates in New Zealand, or indeed make us wish that we had eased more quickly over the last few months. In June 1999, I was one of three central bank governors who gave speeches in answer to the question "Is deflation a risk?" at a seminar held in conjunction with the annual meeting of the Bank for International Settlements in Basel, Switzerland. My task was to sketch out a situation in which the world economy found itself in a situation of generalised deflation. I found it disturbingly easy to do. Two years later, there are still considerable risks. While the high-tech parts of the US equity market have fallen from stratospheric levels to more moderate levels over the last year, the market capitalisation of the stocks in the S & P 500 index, which reached a peak of 132 per cent of US GDP in March 2000, remains at around 110 per cent of US GDP, compared with an average for that ratio of just 50 per cent over the last 75 years. Or to put the matter differently, the US share-market appreciated between 1982 and the year 2000 at a rate five times faster than underlying corporate earnings growth. There is plenty of scope, in other words, for US equity markets to fall much further yet, and US business confidence and consumer spending to fall with them. Indeed, after by far the longest uninterrupted economic expansion in US history, a fairly marked slowdown in the US economy might not even need the trigger of a further fall in US equity markets. The Japanese economy continues to experience serious difficulties, its banking and insurance sectors fragile, its public debt very large and increasing, and its immediate prospects clouded. And inevitably, with the outlook for the American and Japanese economies uncertain, the prospects for the economies of non-Japan Asia are also unclear – with banking sectors still showing the open wounds of the crisis of three years ago and their biggest markets slowing sharply. The Australian economy, of great importance to our own economy as our largest single trading partner, saw a fall in GDP in the December quarter of last year, while in recent months unemployment has been rising and business confidence falling. So let me make it quite clear: because of the impact of a slowing world economy on inflation in New Zealand, it may well be necessary to ease monetary policy in New Zealand substantially further than we have done so far. We are as keen to avoid having inflation go below the bottom of our 0 to 3 per cent target as we are to avoid its going above. But in a situation where the New Zealand economy has recently been operating near to full capacity – with unemployment near a 13 year low, and some measures of capacity utilisation back to levels last seen in the period of strong growth in the mid-nineties – three things have led us to ease policy more slowly than some other central banks have done, and more slowly than some New Zealanders would like. So far, the world economy continues to grow First, and despite the slowing which has occurred, the world economy continues to grow. In the United States, growth in GDP in the March quarter was stronger than most observers had expected, and only a few commentators are expecting the US to experience a recession this year. Indeed, many commentators are predicting that the US economy will "bounce back" in the second half of this year, or at least by the fourth quarter. Interestingly, US equity markets, which must be assumed to reflect sentiment about the future of corporate earnings, have recently advanced, and the S & P 500 index is less than 20 per cent below the all-time high it reached in March last year. The narrower Dow index is less than 5 per cent below its all-time high. In Japan, the prospect of a new political determination to deal with the problems which have beset that economy for more than a decade has improved sentiment, and the Nikkei stock index is well up from the low point reached in the middle of March this year. In Australia, it has been pointed out that the modest fall in GDP in the fourth quarter was mainly the result of a very sharp fall-off in the construction sector following the introduction of GST in mid-year, with most of the rest of the Australian economy continuing to grow at an annual rate of around 4 per cent. Although not too much should be made of it at this relatively early stage, Consensus forecasts for our 14 major export markets suggest growth next year of 3.6 per cent, well up from the 2.3 per cent expected for the same markets this year. If we eased policy too much now, and that easing had its biggest effect next year, as we expect, we might find that policy would be stimulating the economy at the very time that the world economy was picking up. New Zealand's export prices continue to hold up Secondly, and contrary to much past experience, the slowdown in the world economy which has occurred to date has not had an obviously negative effect on the world prices of many of New Zealand's exports. Of course, the prices of some exports have been seriously affected. The world price of our seafood exports is well down over the last year for example. But many other prices have held up well, and that has been particularly true of major exports such as meat and dairy products (both up by more than 22 per cent in world price terms in the 12 months to April). In aggregate, the world price of New Zealand's commodity exports rose almost 14 per cent in the year to April 2001, and almost 23 per cent over the two years to April 2001. This means that an important channel through which weakness in the world economy typically affects New Zealand has so far, on this occasion, been blocked. The New Zealand dollar is sheltering the economy from foreign chills Thirdly, as we assess the impact of the relatively subdued world economy on the New Zealand economy, and therefore on New Zealand inflation, we have to assess also the impact which the New Zealand exchange rate is having on the situation. If, as is possible, the world economy slows further, and if, as also seems possible, this has a negative effect on the world price of New Zealand's export commodities, will our export industries, and those industries competing against imports, be protected from those cold winds by a low exchange rate? Make no mistake. As many of you are aware, the New Zealand dollar is not far above its lowest level ever against the United States dollar, and remains at a very low level also against the Japanese yen and sterling. It is not so low, to be sure, against the Australian dollar and the euro, two other currencies which have been weak in recent times, but weakness against the US dollar, the yen, and sterling is certainly providing strong benefits to many of the companies and individuals operating in export and import-competing industries. As a consequence, while the world prices of New Zealand's commodity exports have gone up by an already large increase in the 12 months to April (almost 14 per cent), the New Zealand dollar prices of those exports have risen by a very strong 36 per cent over the last year, and by almost 60 per cent over the two years to April. Initially, the volume of New Zealand's exports of good and services grew rather strongly in response to this stimulus (helped no doubt in part by the return to more normal climatic conditions down on the farm). More recently, export growth has slowed down quite sharply. We don't fully understand why this is so. Perhaps it just takes longer than we might have thought for businesses to gear up to increase exports. Perhaps businesses have been frightened by media stories about the slowing in the world economy. Perhaps businesses were so traumatised by the experience of a strong exchange rate in the mid-nineties that they will respond only cautiously to the apparent enticements offered by the now-low exchange rate. Perhaps other countries with which New Zealand exporters compete in, say, the US market have experienced similar levels of exchange rate depreciation against the US dollar, thus eroding much of the benefit to our exporters of the depreciation of the New Zealand dollar. Perhaps for many of our exporters the Australian market is still the major market, and here there has been little depreciation over the last few years. One of the difficult judgements we have had to make in deciding how to run monetary policy in recent months concerns what the low exchange rate means for future inflation pressures. If the economy ANZ New Zealand Commodity Price Index, 2 May 2001. responds to the low exchange rate as it has in the past, we would expect to see strong growth in net exports over the next year or two, with export and import-competing industries investing in new capacity, hiring more staff, and expanding production. The risk is that such a strong expansion in the export and import-competing industries would put pressure on available resources. That in turn would lead to increased inflation unless monetary policy were kept appropriately tight. If, on the other hand, the economy does not respond to the low exchange rate as it has in the past, as seems possible on the basis of very recent experience, it may be that export and import-competing industries will expand only moderately. In that situation, monetary policy would not need to be as tight in order to keep inflation under control. Like it or not, no central bank operating in an open economy can afford to ignore the exchange rate in setting monetary policy. The fact that we have not only not increased the Official Cash Rate despite our currently low exchange rate but have actually felt able to reduce it in recent months largely reflects our assessment of the global economy, and our assessment that, for reasons not yet fully understood, the exchange rate is not providing the stimulus to export and import-competing industries that has been true in the past. But, as will be obvious, if the economy does start responding to the low exchange rate as it has historically, there will be a need for interest rates to be quite a bit higher than currently, if resources are going to be able to move from domestic parts of the economy to the export and import-competing industries without causing inflation. This is true because, in aggregate, the economy is already operating at close to capacity, with some measures of capacity utilisation back at levels last seen in the boom of the mid-nineties and unemployment at a near 13 year low. As an aside, the data on employment and job advertisements released 10 days ago on balance support this assessment that there is little spare capacity in the labour market. While it is true that total employment did not increase over the March quarter, wage rates have begun to climb – by a little more than we and the market had been expecting; hours worked rose strongly during the quarter, and are now some 6 per cent above the level in the first quarter of last year; unemployment is at its lowest level since June 1988; and job advertisements, while down slightly for the month of April, remain well ahead of their level at this time last year. There are clearly strongly conflicting influences on the future path of inflation in New Zealand. It is entirely possible that we will need to ease monetary policy more than we have done to date. It is also entirely possible that we will need to increase interest rates from their present level. In such an environment, it is prudent to adjust policy cautiously as we watch the evolving balance of those influences. At this stage, we see inflation settling back near the middle of our target range with something close to current interest rate settings. But it is not difficult to imagine outcomes that are rather less benign – in either direction. At the end of the day, monetary policy depends on the outlook for inflation one to two years ahead. At the moment, that in turn depends primarily on how the economies of our trading partners evolve, on the extent to which any global slowdown affects demand for our exports, on how the New Zealand exchange rate behaves, and on how the New Zealand economy responds to the exchange rate. My plea to observers and commentators is to keep in mind that New Zealand's economy is not the Australian, or the American, or indeed any other economy. In the March Monetary Policy Statement, I mentioned that the New Zealand economy was "favourably out of sync" with the rest of the world. Actually, we are often out of sync with the rest of the world, either favourably or unfavourably. New Zealand's economic fortunes depend to a significant extent on a relatively narrow range of exported goods and services, and so we often face relatively sharp slow-downs and, on the flip-side, relatively fast accelerations. That is the nature of our economy. For the Reserve Bank, that inevitably means trying to steer a course through these short-term vicissitudes, a course appropriate to the inflationary pressures in the New Zealand economy, whatever the Federal Reserve and other central banks are doing.
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Address by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Conference for Commonwealth Central Banks on Corporate Governance for the Banking Sector, London, 6 June 2001.
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Donald T Brash: Promoting financial stability: the New Zealand approach Address by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Conference for Commonwealth Central Banks on Corporate Governance for the Banking Sector, London, 6 June 2001. * * * Introduction It is a great pleasure to have the opportunity to speak to you today. The theme of this conference – Corporate Governance in the Banking Sector – is a subject that has been an important element in the Commonwealth Secretariat's financial sector work in recent years. It has also been a notable feature of other international initiatives, including those of the International Monetary Fund and World Bank, in their efforts to address the causes of financial crises and to promote greater financial stability. Appropriately, improving corporate governance is seen as a significant way of encouraging banks to strengthen their capacity to manage risks. And it has rightly been viewed as an important element in the management of central banks. Today, I want to discuss the role that corporate governance plays in the New Zealand banking supervision framework and to relate this to the importance we attach to strengthening market discipline in the financial system. But before doing this, let me briefly recap the main points made in the report issued by the Commonwealth Secretariat last year on the causes of financial instability and the policies for promoting stable financial systems. This provides a useful context within which to discuss the New Zealand approach to financial sector regulation. Causes of financial instability As indicated in the Commonwealth Secretariat's paper Corporate Governance in the Financial Sector, financial instability is caused by a combination of factors. These include: · rapid financial sector liberalisation unsupported by measures to encourage prudent risk management in the financial sector; · unsustainable macroeconomic policies, such as loose monetary policy and excessive fiscal spending – such policies can contribute to asset price volatility and a subsequent erosion of asset quality in the financial system; · exchange rate arrangements that lack credibility, including unsustainable exchange rate pegs – this is particularly important where financial institutions and corporations have come to rely on an exchange rate peg, and fail to hedge their currency risk, only to sustain currency losses when the peg collapses; · protection against imports and other policies that impede the efficient allocation of resources in the economy; · poor banking supervision; · inadequate financial disclosure arrangements, including poor quality accounting and auditing standards; and · weak market disciplines in the banking and corporate sectors, reducing the incentives for high quality risk management by banks. Policies for promoting stable financial systems The broad range of factors that can contribute to financial crises suggests the need for an equally broad set of policy responses. Of course, the particular policies will vary from country to country, depending on a country's stage of development, the nature of its economy and the structure of its financial system. There is no single "right" policy prescription. Each country must develop policies that suit its own particular circumstances. However, at a general level, it can safely be said that the following types of policies will be needed in order to promote financial stability: · sound, sustainable and credible macroeconomic policies, including a monetary policy aimed at promoting price stability; · microeconomic policies that minimise distortions to relative prices and that encourage efficient allocation of resources; · exchange rate policy that is seen as credible by all market participants, that facilitates macroeconomic adjustment and that builds in incentives for financial institutions to hedge against currency risk; · an effective legal and judicial system, facilitating the enforcement of legal contracts; · policies to encourage banks to manage their risks prudently, including corporate governance and financial disclosure; · policies to encourage effective market disciplines in the financial sector, thereby strengthening the incentives for banks to manage their risks prudently; · policies to promote robust payment systems and minimise inter-bank contagion, such as netting arrangements, real time gross settlement and failure-to-settle structures within the payment system; and · effective and well-enforced banking supervision arrangements. It would be tempting to discuss each of these policy areas, given their importance to the promotion of sound and efficient financial systems. But we would need a great deal longer than one day to do justice to such a broad range of complicated policy issues. Instead, I want to focus on the main theme of this conference – corporate governance in the financial sector. Corporate governance in the financial sector As noted in the Commonwealth Secretariat's report, improving corporate governance is an important way to promote financial stability. The effectiveness of a bank's internal governance arrangements has a very substantial effect on the ability of a bank to identify, monitor and control its risks. Although banking crises are caused by many factors, some of which are beyond the control of bank management, almost every bank failure is at least partially the result of poor risk management within the bank itself. And poor risk management is ultimately a failure of internal governance. Although banking supervision and the regulation of banks' risk positions can go some way towards countering the effects of poor governance, supervision by some external official agency is not a substitute for sound corporate governance practices. Ultimately, banking system risks are most likely to be reduced to acceptable levels by fostering sound risk management practices within individual banks. Instilling sound corporate governance practices within banks is a crucial element of achieving this. As the Commonwealth Secretariat's report notes, there are a number of ways in which corporate governance in the financial sector can be strengthened. These include: · having a well designed and enforced company law; · having codes of principles developed by professional or industry associations, setting out desired attributes of corporate governance, and associated educational and consciousness-raising initiatives; · maintaining high quality disclosure requirements for banks and other companies, based on robust accounting and auditing standards; · adopting measures to strengthen market disciplines in the banking sector, including by promoting a contestable and competitive banking system and seeking to ensure that bank creditors are not fully insulated from loss in a bank failure; · effective banking supervision arrangements, with particular emphasis on policies that encourage sound governance and risk management practices; and · leadership by example, including the adoption of sound governance, accountability and transparency practices by central banks and regulatory agencies. New Zealand's approach to financial stability Against this background, let me briefly summarise the New Zealand approach to promoting financial stability. This has three main strands: · promoting self discipline by banks in the management of their risks; · fostering effective market discipline on the banking system; and · supervising banks for the purpose of promoting financial stability, but seeking to avoid supervisory practices that might erode market discipline and weaken the incentives for bank directors to take ultimate responsibility for the management of risks. Let me elaborate on each of these in turn. Banks' self discipline in managing risks Banking supervision in New Zealand places considerable emphasis on encouraging banks' self discipline in managing risks, primarily by reinforcing the role of bank directors in taking ultimate responsibility for the stewardship of their banks. Since the mid 1990s, when a new public disclosure framework was introduced for banks, a key mechanism for encouraging banks to manage risks prudently has been the need for banks to issue public disclosure statements each quarter. The disclosure statements are in two forms: a brief Key Information Summary, which is aimed at the ordinary depositor; and a more comprehensive General Disclosure Statement, which is aimed principally at the professional analyst. The Key Information Summary contains a short summary of information on the bank, including: · the bank's credit rating; · the bank's capital ratio, measured using the Basel framework; and · information on exposure concentration, exposures to connected parties, asset quality and profitability. The Key Information Summary must be displayed prominently in, and be available on demand from, every bank branch. The General Disclosure Statement contains wider-ranging and much more detailed information on the bank and its banking group, including: · comprehensive financial statements; · credit rating information; · detailed information on capital adequacy, asset quality and various risk exposures; and · information on the bank's exposure to market risk. One of the most important features of this disclosure framework is the role it accords bank directors. Each director is required to sign and make certain attestations in the disclosure statements, including: · whether the bank is complying with the prudential requirements imposed on it by the Reserve Bank; · whether the bank has systems in place to adequately monitor and control its banking risks and whether those systems are being properly applied; · whether the bank's exposure to connected parties is contrary to the interests of the bank; and · whether the disclosure statement contains all the required disclosures and is not false or misleading. Directors face potentially severe criminal penalties and civil liability where a disclosure statement is held to be false or misleading. Complementing the disclosure requirements, banks incorporated in New Zealand are required to have a minimum of two independent directors (who must also be independent of any parent company) and a non-executive chairman. These requirements are intended to increase the board's capacity to scrutinise the performance of the management team. In addition, independent directors provide some assurance that the bank's dealings with its parent or other related parties are not in conflict with the interests of the bank in New Zealand. The disclosure requirements have increased the accountability of bank directors and, indirectly, the accountability of various levels of management within the banks. As a result of the disclosure arrangements, we have seen directors taking greater care than might otherwise have been the case to ensure that they are adequately discharging their obligations. In so doing, directors have strong incentives to ensure that there are appropriate accountability mechanisms within the management hierarchy.
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Speech by Dr Roderick M Carr, Deputy Governor of the Reserve Bank of New Zealand, to the New Zealand Association of Economists, Christchurch, New Zealand, 27 June 2001.
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Roderick Carr: Banking on capital punishment Speech by Dr Roderick M Carr, Deputy Governor of the Reserve Bank of New Zealand, to the New Zealand Association of Economists, Christchurch, New Zealand, 27 June 2001. * * * Introduction It gives me great pleasure to address the annual gathering of the best and the brightest economists in the country. Today I am not going to talk to you about the state of the economy or its immediate prospects; these are matters on which you are well informed. Indeed the transparency which surrounds the conduct of monetary policy in this country leaves little private information in the hands of the central bank. Further, with both a single decision-maker structure and long serving incumbent Governor, there is little new information to reveal about how the Bank goes about managing monetary policy. In fact as the Bank has served as training ground for many commentators and market economists, not only are we transparent but reassuringly predictable. I want to take my time today to stimulate your minds with a different set of issues. At the heart of capitalism lies capital. Limited liability corporations have facilitated the accumulation and mobilisation of capital to rival church and state but as we will see the asymmetry of payoffs inherent in limited liability may induce excessive risk-taking. The provision of financial intermediation services, particularly banking, has given rise to an extensive theoretical and empirical literature in economics. By banking I mean the provision of two particular services, liquidity transformation and credit origination. The efficient provision of these services is essential to the growth and prosperity of market-based economies. Virtually all banking services are now provided through limited liability corporations and the question of how much capital should be held has become the subject of international debate. Of all the interesting topics we could discuss, today I want to focus on the issue of bank regulation in general and, in particular, bank capital. I want to update you on recent international initiatives concerning bank regulation and outline both the case for capital regulation and the risks we take when regulators go too far. I want to highlight why it is essential to the efficient allocation of resources that providers of bank capital and even bank creditors must stand ready to take their punishment when things go wrong and the unexpected happens. I want to highlight the distinction between economic capital, rating capital and regulatory capital. I want to promote an antidote to the moral hazard created by asymmetric payoffs, implicit or explicit deposit insurance and regulatory capture. Finally I want to summarise recent policy initiatives we have taken to enhance the value of disclosure and underpin market discipline. The New Zealand regime in brief Let me briefly remind you of New Zealand's approach to banking supervision. Our regime relies on self discipline, market discipline, and regulatory discipline. Any organisation wishing to call itself a bank while carrying on business in New Zealand must obtain a registration from the Reserve Bank. Our conditions of registration prescribe minimum levels of capital in line with international standards known as the Basel Accord. We also require mandatory levels of public disclosure. Directors are required to provide regular public attestations as to the soundness of the bank, the robustness of its systems and its exposure to risk. We monitor these disclosures and meet with all registered banks annually to discuss strategy and any emerging issues. We rely on external auditors to verify financial statements. By year-end, all registered banks will be required to have and publish a credit rating from an approved rating agency. Where we depart somewhat from traditional supervisory approaches is in our reluctance to validate what the directors of the bank are accountable for. We weigh more heavily than most the moral hazard arising from the regulator approving specific actions of the board and management of the bank. It is the role of the board and depositors to be satisfied as to the condition and conduct of the bank, not to rely on the supervisor's ability to constrain bank risk-taking. But let me be clear – New Zealand does not deny there is a case for bank regulation. But as they say – the devil's in the detail. Global trends in bank regulation The draft proposals for the regulation of bank capital recently released by the Basel Committee on Banking Supervision, often referred to as Basel 2, run to nearly 800 pages. These must be one of the most extensive, most prescriptive, transnational regulatory proposals ever conceived. Yet in a recent extensive review of the academic literature Joao Santos of New York University's Solomon Center concluded: "The justification for any regulation usually stems from a market failure such as externalities, market power or asymmetry of information between buyers and sellers. In the case of banking, there is still no consensus on whether banks need to be regulated and if so, how they should be regulated." While this conclusion would not go unchallenged, not least by the tens of thousands of people employed as bank regulators around the world, it serves to highlight the wide range of views which exist about the issue of bank regulation and the extent to which current problems are the result of past poor regulation. Let me explain. The 1988 Basel Accord and the new proposals In 1988, G10 countries reached a consensus on minimum capital standards for internationally active banks. The Accord can be summarised in a couple of pages. In essence, it states that for every $100 of loans, a bank should have at least $8 of capital, of which at least $4 must be permanent equity. Because loans secured over residential property were seen to be less risky than other loans, they only had to have 50% as much capital. Loans to banks from OECD countries were seen to be less risky still, so they only had to have 20% as much capital, and loans to governments denominated in their local currency 0%. There were several other categories and treatment for off-balance-sheet exposures. In my view, the 1988 Basel Accord arose mainly from a desire to promote competitive neutrality and to avoid arbitrage between differing national capital requirements for banks, as it did not seek to determine a socially optimal level of bank capital. In the 1980s, highly leveraged Japanese banks had been aggressive participants in the previously lucrative US municipal bond underwriting market. US banks responded to what they saw as unfair competition by pressing for an internationally agreed definition of capital standards for credit risk and a uniform methodology for the measurement of capital. While the 1988 agreement addressed the issue of minimum bank capital, it created a whole new industry in arbitraging between bank and non-bank capital requirements. Widespread securitisation of bank assets is perhaps the best example. Today the case is made that the 1988 Accord promotes regulatory arbitrage of this type, rewarding risk-shifting which may undermine the soundness of financial systems around the world. The solution, Basel 2, proposes to more closely align bank capital with the riskiness of the bank's assets and operations. Subject to signoff by bank regulators, banks may adopt their own models for determining how much capital to hold. In the absence of approval, a standardised, but more flexible than Basel 1, model is proposed. Market discipline is to be enlisted by requiring greater disclosure of risks facing a bank. While Basel 1 was a Capital Accord, Basel 2 is an accord having three pillars – capital requirements, regulatory validation and market discipline. The real question remains unanswered. Is the closer alignment of regulatory capital with economic capital good public policy? In validating a particular capital allocation model, do regulators let bank management, bank directors and bank creditors off the hook by, in essence, providing a warrant of fitness for the model and the bank? In order to evaluate the proposals, we should go back to first principles. The case for regulating bank capital Is there a case for a country to specify minimum levels of capital which banks should hold? No such requirements exist for pharmaceutical companies, software vendors or telecommunications providers, where failure might impose externalities which would actually be life threatening. The fact that banks are risky ventures that go bust from time to time does not alone justify that minimum capital standards should be imposed. The traditional case for regulating banks in order to reduce the probability that they might bust is that when depositors see a bank go bust they act in fear and ignorance as to the true condition of all other banks. They run to their own bank to be first in line to withdraw deposits and in so doing may force a perfectly sound bank to run out of liquid assets, sell sound assets at a discount and so become insolvent. The combination of asymmetric information about the credits created (depositors can not know the state of the bank's borrowers), the sequential service constraint (all on demand deposits can be withdrawn in full), and the liquidity transformation services provided by banks (short term deposits finance long term loans) makes banks inherently vulnerable to a loss of confidence. Further, banks often borrow from and lend to each other both in the short-term money markets and through the payment system. Thus, the failure of one bank may indeed pose a threat to the solvency of another, even absent a run by depositors. Banks will hold liquid assets and capital at levels high enough to meet some subjective assessment of the probability of runs and counterparty failures. An alternative argument used to justify bank regulation is that in a system where central banks are called on to provide lender of last resort facilities to solvent but illiquid banks, in order to distinguish solvent from insolvent banks the central bank should undertake on-site examinations to establish the state of each institution. The prospect of system-wide contagion, in which society is denied the liquidity transformation and credit origination services of the banking industry, provides the soundest basis for regulating banks and socialising the costs of individual bank failures. The objective in socialising losses is to preserve services for future savers, borrowers and transactors, but the consequence is to protect current depositors from facing losses and to allow bank shareholders to earn excess returns if the bank holds less than the socially-optimum level of capital. So the model of public policy for banking in many countries is something like this. Protect the depositors to stop the run. Stop the run to stop the contagion. Stop the contagion to ensure society continues to get banking services. However, once the probability of bank runs has been reduced, banks will hold less liquid assets and less capital than would otherwise be the case. Indeed capital ratios have been declining relentlessly during the past 150 years, from 35% in the 1860s to 4% by the mid 1980s. The banks became more ‘efficient’ intermediaries but, to the extent the risk of failure has increased because of lack of depositor discipline on the banks and risk has been moved elsewhere (to taxpayers or deposit insurance funds), efficiency gains are more apparent than real. The predisposition of governments to bail-out the creditors of failed banks makes all the difference to both the sign and magnitude of the impact of regulation on the efficiency of liquidity transformation and credit origination in the economy. Bailing out banks Perhaps the earliest recorded example of a government bail-out of bankers was the action by the Roman Emperor Tiberius Caesar who in 33 AD provided support to "reliable bankers" after fraud, defaults on foreign debt, liquidity draining government policies, sinking of uninsured cargoes, and a slave revolt precipitated a banking crisis. However, government safety nets were rare before the twentieth century. In the era of free banking, market forces prevailed. Bank failures in the nineteenth century were relatively frequent but smaller in scale, and self-correcting in comparison to the experience in the twentieth century. Banks today are playing a larger role in the economy than a century ago. Bank assets in New Zealand represent 180% of GDP. Payments made every day via the banking system amount to 35% of GDP. Virtually every adult member of society has a bank account, a credit card, and a debit card to facilitate non-cash payments. Many households rely on credit services to smooth consumption. Banks also provide working capital to small and medium size enterprises and facilitate payments both domestically and internationally. Arguably, the externalities associated with the failure of a single bank have increased in the last quarter century. In the last quarter of the 20th century around the world there have been over 100 separate incidents of banking systems facing a crisis. In some cases, losses have exceeded 40% of annual GDP (Thailand) and losses of 10-20% of GDP have been common. It has been very rare for bank creditors to bear losses and in some cases even shareholders have been saved with public money. So what is going on? Has the market failed or simply not been allowed to operate? The international consensus, not without dissenters, is that markets have failed or could be expected to fail, that oversight by regulators and prescribed minimum levels of capital are essential if banking systems are to be sound. Some countries have concluded that, because depositors rightly perceive that banks will still fail and therefore depositors might run from solvent banks, deposit insurance is necessary to prevent runs. However, given the focus of deposit insurance on small deposits, and the extent of wholesale (uninsured) deposits in many banks today, deposit insurance is now often justified on the grounds it makes it politically acceptable to fail banks which should be failed and to limit the extent of taxpayer liability to insured deposits only. The contemporary case for bank regulation runs something like this. Once the state is exposed to the underwriting risk and moral hazard of a deposit insurance scheme (implicit or explicit), it must monitor the banks to reduce the probability of failure. With an implicit guarantee or explicit deposit insurance scheme in place and the regulator deeply implicated with any bank failure, markets assess the probability of loss given default to be lower than otherwise, making them more willing to take risks with banks. This reduced risk aversion translates into holdings of lower levels of bank capital than would otherwise be required to underpin a portfolio of risky loans. In this, our current world, the privately optimal level of capital in banks could well diverge from the socially optimal level. I say "could" because we cannot rule out the possibility that at some very low probability of failure it may be efficient for society to underwrite banks rather than have them each carry the higher capital and liquidity levels necessary to withstand a once in a 500 year incident of general loss of confidence. While some regulators agree there is a role for market discipline, many believe the market may not know what information to ask for, or banks may be reluctant to supply it. Consequently even advocates of market discipline agree there is a role for the regulator in prescribing what information should be provided. Proponents of market discipline believe it is then more efficient for bank creditors, through their agents, to monitor the bank rather than to rely on the judgement of a bureaucrat. Determining the optimal level of bank capital Let us set aside the issues facing the solvent but illiquid bank by assuming a central bank has the capacity to act as lender of last resort. This presumes the central bank will be able to distinguish an illiquid but solvent bank from an illiquid and insolvent one. Let us focus on: · how banks might determine the privately optimal amount of capital to hold; · some factors which might cause the socially optimal amount of bank capital to diverge from the private optimum; and · strategies to cause convergence between the socially and the privately optimal level of capital. Because bank management might have misjudged the quality of its borrowers, because economic circumstances may cause once sound borrowers to fail and because depositors might withdraw funds earlier than expected, necessitating asset liquidations at discount rates above expected yield to maturity, bank management (wishing to preserve their jobs) and bank shareholders (wishing to preserve the franchise value of their business), will find it optimal to hold some capital. That is, to retain within the bank assets with an expected net present value in excess of the net present value of liabilities. But by how much? If too little capital is held, the probability of failure is too high; if too much capital is held, the rate of return on equity is less than it might be. Surely this is an equilibrating mechanism where depositors' interests are protected by shareholder and management incentives to preserve the bank? Those who advocate a return to free banking would argue so. And did not Modigliani and Miller show nearly 50 years ago that debt/equity ratios do not influence the value of the firm? Well at least in frictionless markets with complete information and no taxes. Let us set aside the traditional argument in favour of bank regulation – that banks are opaque, depositors need agents to monitor the bank on their behalf, and regulators can do this cost effectively. Let us set aside the strongest argument for regulation – the prospect of contagion. Let us assume complete markets and symmetric information and that depositors, shareholders and bank management seek to maximise the expected value of their interests. In this world, let us assume there is an unnatural person with full contractual capacity and limited liability. That is, payoffs are asymmetric. This unnatural person is a bank and I contend it will seek to hold less than the socially optimal level of capital. Depositors earn high rates of interest, shareholders earn high dividends and management takes high salaries in the good times when the net present value of claims owned by the bank exceeds the net present value of the obligations of the bank. In the bad times, depositors do not expect to face losses, shareholders liability is limited to the capital invested and management can withdraw and retire on prior period earnings or exit the industry. Of course, this is a highly simplified model. To ensure its investment in people, processes and proprietary information is protected and because of the costs of bank failure in terms of reputation and potential litigation, owners and managers will choose to hold some capital. The ability of the shareholders to put the bank to the bank's creditors arises from limited liability. The ability of the creditors to put the bank to the government (taxpayers) arises if the externalities associated with failing the bank are expected to exceed the cost of recapitalising the bank. This is most likely if the bank is assessed to be systemically or politically important. Each of the major banks operating in New Zealand has a significant share of system assets and hundreds of thousands of personal customers. They would seem to meet any reasonable threshold of systemic or political importance. While failing a bank might mean liquidation, it is almost certain to involve loss of credit origination capacity and disruption to the payment system. "Too big to fail" (not failing a bank because of its size) need not mean all bank creditors should escape without loss. I would be the first to concede that our large banks are too big to liquidate or to indefinitely suspend withdrawals, but it would be foolish for bank creditors, including depositors, to assume that they will necessarily be made whole. Of course, bank shareholders would have lost all their investment before creditors suffer any loss. Yes, this is another one of those occasions when the Reserve Bank takes the opportunity to state on the public record that neither the Bank, nor the government, guarantees any of the deposits of any registered bank. Nevertheless, limited liability, systemic impact, and political voice underpin expectations of asymmetric payoffs for shareholders and bank creditors, and together these suggest that the privately optimal level of bank capital to cover expected losses might lie below the socially optimal level of capital required to meet both expected and unexpected losses. Let us call the former "economic capital" and the latter "regulatory capital". Economic capital is optimal for shareholders; regulatory capital is optimal for taxpayers. There is also a level of capital necessary to sustain a given credit rating from an independent rating agent. Let us call "optimal rating capital" that level of capital optimal for depositors, given the premium over the risk-free rate paid by the bank to attract deposits allowing for the value of the option debt holders presume they have to put their deposits to the government. Bank management has an interesting role. On the one hand, they want the shareholders to assess their expected rate of return to be high so the bank can access additional capital at the lowest marginal cost. On the other hand, bank management, on behalf of shareholders, want to convince the rating agency that their risks are well controlled so that they may be able to access deposits at the lowest possible cost for a given level of capital. Bank management face an incentive to convince regulators that the level of capital consistent with that demanded by depositors to protect them (rating capital) is also the socially optimal level of capital. Enter the so-called hybrid or innovative capital instruments that the market prices as debt and regulators often count as capital. This device seeks to provide regulatory capital at levels above economic capital. What makes capital "capital" is something we will come to shortly. Let us return to consider the gap which, if it exists, should be of interest. That is, the gap between optimal economic (private) and optimal regulatory (social) capital. The draft Basel 2 Accord is based on the assumption that under the 1988 Accord there was such a gap and that it was material. The implication in the draft Pillar one of the Basel 2 Accord concerning bank capital is that the total amount of regulatory capital should remain unchanged and that economic capital was being eroded and should be augmented. More closely tying capital to the probability of default on loans and the expected loss given default, together with an explicit charge for operational risk and the retention of a charge for market risk on the trading book, are the essential elements of Pillar one of Basel 2, which seeks to better align economic and regulatory capital. The alignment of regulatory capital is seen as good and the complexity of the proposed calculation of regulatory capital is in part justified as a way of making regulatory capital mimic economic capital, which is presumed to be the level of capital the market would demand. Optimal economic capital may fall short of optimal social capital Asymmetric payoffs to shareholders and depositors mean the privately optimal level of capital lies below the socially optimal level of capital given the full distribution of returns to all stakeholders from the portfolio of risky loans originated by the bank's management but underwritten by shareholders, depositors and ultimately taxpayers in the case of systemically significant banks. In my view, alignment of economic and regulatory capital leads to an inherently undercapitalised privately owned banking system. In the absence of market discipline, it would be a mistake for the regulator to go along with whatever capital banks determine to be privately optimal. But recall it may still be efficient to socially insure, rather than capitalise the banks to absorb the most extreme unexpected losses. However, most safety nets have been slung to underwrite much more common events yet fail to ensure the preservation of the credit origination, liquidity transformation, and payment service capability of the institution. The analysis is made more complicated if the shareholders, depositors and taxpayers come from different nation states. Any idea of a utility maximising objective function to determine socially optimal bank capital needs to recognise the segmentation which occurs when the three sets of stakeholders cannot be presumed to be in a continuing relationship after a bank failure. But that is not the full extent of the gap. Economic capital is calculated on the basis of expected losses. To the extent minimum capital requirements are set consistent with economic capital, unexpected losses will not be borne by bank shareholders. Unexpected losses must be borne by bank creditors, a deposit insurance fund, an ex post levy on surviving banks or socialised via taxpayer support arising from implicit deposit insurance. Losses which are unexpected to an individual bank are not necessarily unexpected to a banking system. The question is to what extent should banks' shareholders put up capital to underpin not only each institution but also the banking system? Does not deposit insurance seek to do just that? Deposit insurance, moral hazard and undercapitalised banks The arguments against deposit insurance (whether explicit or implicit) are well rehearsed. Depositors and banks take more risk (incur moral hazard). Banks make more risky loans, which crowd out safe loans. Small scale and inefficient banks are protected. Regulatory capture and regulatory forbearance increase the loss given default. Credible deposit insurance may reduce the probability of bank runs as a cause of bank failure and increase the political acceptability of failing insolvent banks, but it does so at the risk of increasing the probability of failure, risks increasing losses given failure and appears to increase fragmentation and inefficiency in the intermediation process. Increased competition may be associated with more participants and industry profitability may be reduced. However, it is more likely that profits are reduced because costs are higher than because fees and margins are lower. A less profitable banking industry may simply reflect a less efficient one. To mitigate the moral hazard of insured depositors tolerating excessive risk-taking by bank management on behalf of shareholders, advocates of deposit insurance promote schemes with: (a) caps (only a small limited amount of deposits are insured for each depositor); (b) co-insurance (only pay a percentage of losses); and (c) deposit insurance premiums based on the riskiness of the bank. However, experience is that coverage provided by deposit insurance is extended over time and by circumstances. To the extent that deposit insurance makes credible the threat that some depositors may face some losses by making it clear that small retail depositors with political voice will be protected, but no others will be, the case is made that deposit insurance adds to market discipline. Of course, that presumes that the uninsured depositors will discipline the bank but what of the bank that raises only insured deposits, or of the systemically important bank with material externalities? There may be little market discipline on such banks and the deposit insurer or regulator must constrain the rationally excessive risk appetite of the bank. As the regulator becomes ever more prescriptive and fixed with knowledge (or blamed for the lack of it), so the chances of a bail-out increase, market discipline weakens further and regulators get drawn in further. In my opinion, public sector bureaucracies find risk management extremely difficult. Rarely are the payoffs for taking more risk commensurate with the incentives facing individual decision makers. Consequently bureaucrats are too risk averse most of the time and not risk averse enough when confronted with the high probability of a bad outcome becoming even worse. Is there a better model – one in which there is a realistic prospect that shareholders, having put up something close to the socially optimal amount of capital, are at risk, and depositors, facing a credible threat of loss, insist on that level of capital being sustained? Capital needs to stand ready to take its punishment for being associated with risky ventures that go bad, whether expected or not. For capital to be punished, it needs to be: · permanent; · available at the time of insolvency; · accessible in the jurisdiction of the obligations of the bank; and · under no obligations to its holders that rank ahead of any other obligations. To constitute bank capital, rights accorded to owners must be capable of being irrevocably, completely, unilaterally, and immediately cancelled in the event all other obligations are not expected to be settled in full. An antidote to moral hazard For bank creditors (all senior unsecured creditors) to have incentives to monitor the soundness of the bank, they must face the prospect of a loss of some or all of their investment. Such a loss must be: · reasonably expected even if extremely improbable; · politically acceptable; · quickly determined; and · promptly administered. A "haircut" is a process involving a reduction in the face value of an obligation of the bank. The amount of the reduction may reflect the negative equity of an insolvent bank which has been liquidated (a dead haircut), or the amount necessary to recapitalise a bank in order for it to continue in business. It is the latter case I wish to focus on. It is the case where bank creditors recapitalise the bank. The creditor recapitalisation option is far from a done deal but we continue to explore the feasibility of adding it to the options for managing a bank crisis. In the bank creditor recapitalisation case, creditors may recover some or all of their haircut from the subsequent sale of the bank. To the extent bank creditors have become the shareholders of the recapitalised bank, they might have all the rights of ordinary shareholders and indeed might sell their shares at a profit. Of course, by taking more of the creditors' money than is necessary to cover losses, creditors are being required to meet a social policy objective but they are the primary beneficiaries of that policy – gaining immediate access to a substantial proportion of their deposits, avoiding costly and drawn out liquidation proceedings and preserving access to the payment system. The alternative is most often the nationalisation of the bank at the expense of taxpayers. In most parts of the world, regulators faced with a failing bank with a large number of depositors are confronted with advising governments to nationalise or liquidate the bank. Confronted with this choice, liquidation is likely to be an unacceptable option for all but the smallest of banks. A credible regime to recapitalise the bank using depositors' and other creditors' money possibly offers a policy option that might be preferable to nationalisation. The key features of a bank creditor recapitalisation might include the rapid assessment of the rough order of magnitude of the negative equity, placing the bank into statutory management, freezing withdrawals for a short period, deduction of a proportion of all obligations of an immediate nature and recording deductions against the name of the obligatee in a memorandum account, guaranteeing the residual obligations of the institution, if not the entire institution, and reopening the institution. Over time, the application of partial equity conversions to other time obligations as they fall due and the conversion of creditor obligations into equity could take place. While avoiding the complexity, costs and moral hazard of deposit insurance, ex ante the prospect of bank creditor recapitalisations may provide creditors with an incentive to monitor their bank and insist on levels of capital closer to the socially optimal level. A credible creditor recapitalisation option may avoid the need for and inefficiency induced by a deposit insurance regime. It may avoid the need for intrusive regulatory oversight. It seeks to protect the taxpayers interest. It may significantly reduce the public subsidy to depositors and other bank creditors arising from the put option they have not paid for and reduce the excess returns to bank shareholders from running an undercapitalised bank. It would appear to impose few administrative costs on banks to counter what is perceived to be a very low probability event. Of course, it is possible to consider a world of deposit insurance for small depositors and haircuts for other bank creditors or for a bank creditor recapitalisation scheme that distinguished between small and large creditors. Of course, a deposit insurance scheme does not provide a solution to the question of how a systemically important bank should be recapitalised. What is envisaged is a regime that requires pre-positioning of creditor recapitalisation capability within registered banks, and thereby offers the prospect of preserving the credit origination, liquidity transformation, and payment facilitation services while avoiding the worst liquidity impacts of a bank failure. By ‘pre-positioning' I mean that as part of their Business Continuity Plans banks might be required to confirm they had the systems capability to implement a creditor recapitalisation within a specified number of business days and banks could confirm their ability to ‘reconnect' with a bank which had been recapitalised with bank creditors' funds. Politicians and regulators would no doubt wish to retain the flexibility to nationalise, recapitalise, or liquidate a failing bank. Crisis management and organisational form For creditor recapitalisation to be a viable alternative to nationalisation or liquidation, it is essential that a bank's assets can quickly be identified. That requires legal certainty as to the owner of the claim to future cash flows. Such legal certainty does not exist if there is doubt as to the jurisdiction in which assets are located. In the absence of a global insolvency regime, at the point of failure of a transnational bank the world is destined to have a rerun of the BCCI fiasco when national regulators laid claim to assets in their jurisdiction. Years passed in some cases before rightful ownership was determined. As the world moves to embrace first transnational and ultimately global retail banking, as banks seek efficiency from cross-border outsourcing, as competitive pressures drive aggregation and more countries play host to foreign banks which are systemically important, the more apparent it will become that not all depositors in a bank are equal. The location of assets is far from certain and outcomes on failure are unpredictable, arbitrary and potentially unfair. Predatory national regulatory practices, such as preferring home country depositors over foreign depositors within the same corporate entity or designing deposit insurance regimes as barriers to competition or as a device for unfair competition, may become a source of increasing friction. Both the USA and Australia have depositor preferences and the European Union is confronting potentially competitive national deposit insurance regimes given the flexibility allowed under the EU directive. New Zealand bank regulation and organisational form Some of you may be aware that starting about eighteen months ago the Reserve Bank began to focus on managing a bank failure in a system dominated by foreign owned banks. To date, we have been agnostic about the matter of organisational form. We were relatively indifferent to whether a foreign bank branched into New Zealand or operated via a locally incorporated entity. In a banking regime in which public disclosure and market discipline play a central role, along with the accountability of bank directors for the sound operation of the bank, we became concerned about some aspects of the unincorporated or branch form of organisation. Firstly, the notion of ‘branch capital' in a world where assets can be moved cross border quickly and at low cost, where the very notion of a ‘New Zealand' asset is losing definition and foreign depositors may be given priority in the event of liquidation, made the branch balance sheet increasingly meaningless as a guide to assets and liabilities which were likely to exist at a point of failure. In a regime based on disclosure, unexpected, unpredictable and arbitrary outcomes would not be seen as a ‘fair game'. Further, the more we looked at the issues the more we, the regulator, became fixed with knowledge as to the inadequacies of branch-based disclosure. Secondly, disclosure regimes differ markedly between countries. In some cases, the level of public disclosure by banks branching into New Zealand would be inadequate to found a presumption that depositors could be informed as to the condition of the bank. Indeed branch accounts built on the notion of branch capital can be inherently misleading. Thirdly, the lack of local directors mitigates against the incentive effects of the full force of legal sanctions. Finally, placing a branch into statutory management is inherently more complex, slower, and more uncertain than taking action against a locally incorporated entity. For these reasons, the Reserve Bank concluded that in certain cases it was likely to require that retail banking business above NZ$200 million of deposits should be conducted via a locally incorporated subsidiary. Where the bank is systemically important, or comes from a jurisdiction which prefers home country depositors or from a jurisdiction where the level of public disclosure is inadequate, local incorporation of retail deposit-taking may be required. We continue to discuss the implementation of the policy with the banks directly affected. It is worth noting that our concerns about organisational form were aroused well before our thinking on creditor recapitalisation as a means of resolving a failed bank had been developed. The case for local incorporation stands irrespective of whether a failed bank is nationalised, recapitalised, or liquidated. It is implausible to believe that New Zealand will never again face the prospect of a major bank in distress. Our banking system is presently one of the soundest in the world. On the basis of the weighted average credit rating of the banks operating in New Zealand today, Moody's Investor Services rates New Zealand as the third soundest banking system in the world. We also have one of the highest levels of foreign ownership and, among privately owned systems, one of the most concentrated. By their nature, banks are exposed to risks which they seek to manage. It is by absorbing and managing those risks that banks contribute to our economic growth and prosperity. They transform short-term liquid deposits into long term, difficult to monitor assets. Liquidity transformation and credit origination services have volatile expected future cash flows and changing discount rates. Bank capital is the buffer that enables a bank to meet its obligations to others even when its claims on others fail to materialise as expected. Bank management does not seek to break the bank but neither do motor vehicle drivers usually seek to have accidents. New Zealand's position in respect of banking supervision So where does that leave New Zealand in terms of banking supervision? There is a case for regulating banks given the prospect of contagion. However, bank regulation and supervision taken too far, by which I mean supervision which displaces the paramount role of directors and depositors in monitoring the bank, run major risks of weakening market discipline by reducing the incentives for sound risk management, including the holding of liquid assets and adequate capital. It is my belief that part of the reason why we have seen a fall in bank capital ratios over the last century has been because of a weakening of market discipline. While some reduction may have been a true gain in welfare to the community through more efficient risk transfer, carried too far, inadequate capital simply allows bank shareholders and depositors to earn excess rates of return at the expense of future taxpayers. So what? It is therefore important to take all reasonable steps to strengthen self discipline and market discipline on the banking sector, including by: · applying high standards of corporate governance; · ensuring high standards of public disclosure; · defining and applying accounting and auditing standards; · having a credible crisis management strategy; · avoiding deposit insurance if at all possible and in particular avoiding unlimited and inappropriately priced schemes; · minimising the extent to which depositors, perceiving banks to be too big to fail, conclude they are not at risk at all; and minimising the amount of private information regulators hold or are believed to hold so as to limit the extent to which regulators and taxpayers are implicated in practices which are found to be unsound leading to taxpayer bail-outs. Creditor recapitalisation is one possible mechanism for making credible a non-zero probability that bank creditors, even at the biggest banks, might not be made whole in the event of a bank failure. We are currently working on the bank creditor recapitalisation proposal and would encourage other supervisors to do so. However, we acknowledge there may be circumstances where creditor recapitalisation is not feasible and, even if feasible, may not be optimal. So our case is one for exploring alternatives to ever more intrusive and prescriptive regulation of the risk management process which lies at the heart of financial intermediation. The socially optimal level of capital in a national banking system will exceed the privately optimal level, being the aggregate of individual bank's assessed economic capital, if taxpayers in each national jurisdiction are expected to bear losses which, although unexpected to each bank, are ‘expected' across a portfolio of banks. This is because the expectation of the socialisation of losses changes the behaviour of banks ex ante. Whether taxpayers should in fact bear losses, given a failure, is a different issue. That is determined by the costs of the bail-out and future costs of moral hazard, including the cost to future taxpayers. These costs to future taxpayers include the dead-weight costs of the additional tax burden to finance future bail-outs. These expected costs must be weighed against the potential costs and losses taxpayers face from the loss of liquidity transformation and credit origination services that may accompany the loss of confidence associated with depositors taking losses. Conclusion By making credible the policy option that the bank creditors in the national jurisdiction will bear losses, the expectation of a bail-out is reduced and the privately optimal level of bank capital held in the jurisdiction converges toward the level of capital which is socially optimal. If banks operate in widely diverse international markets, if significant numbers of depositors are expected to bear losses and are treated pari passu, there is reason to hope that the privately optimal level of bank capital globally will converge to the socially optimal level. In such a world, shareholders bear expected losses while bank creditors bear unexpected losses. In such a world, the role of the regulator is to protect taxpayers, current and future, from being exploited by bank shareholders and depositors. This is a role not dissimilar to the role independent central banks have in protecting savers from unexpected losses arising from unexpected inflation. Time inconsistency, which explains politicians' predisposition to excessively easy monetary policy, also explains their readiness to bail-out failing financial institutions. Anchoring inflation expectations contributes greatly to the efficient allocation of resources, so does managing expectations about who bears the risks of associating with risky banking ventures. The Reserve Bank is continuing its policy research and consultation on bank crisis management. Our banking supervision regime is based on the three disciplines – self-discipline, market discipline, and regulatory discipline. The credibility of our regime hinges in no small part on having a credible range of options as to how we would deal with a banking crisis. We are reluctant to engage in forms of regulation and supervision that undermine incentives for banks and markets to deliver socially optimal outcomes. In summary, what we support is a regime in which banks face incentives to hold sufficient capital to ensure the probability of failure is reduced because bank management and shareholders are aware that imprudence by them will mean at-risk depositors might run. The capital willingly held by the bank should be sufficient to align incentives of shareholders with those of regulators by ensuring the put option depositors perceive they hold is a long way out of the money. The level of bank capital needs to go beyond that necessary merely to absorb expected losses. Bank capital needs to be sufficient to absorb all but the most improbable unexpected losses. In my view, incentive-compatible regulation does not mean setting regulatory capital equal to economic capital. Even when depositors and shareholders bear all the costs of a bank failure via riskbased premiums paid to a deposit insurance scheme, unless there is agreement on when it is optimal to socialise the cost of systemic failure, economic capital and regulatory capital will diverge. This is even more likely to be the case when shareholders and taxpayers are in different national communities. It is my contention that bank shareholders and bank creditors should bear a very large proportion of the systemic risk currently laid at the feet of future taxpayers. To shift this risk requires new instruments such as local incorporation and plans to recapitalise failing banks with creditors' money. It is necessary to ensure that capital is really available to absorb losses, and is of sufficient quality and held in sufficient quantity. Banks should face incentives to hold closer to the socially optimal level of capital.
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Address by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the 'Catching the Knowledge Wave' conference, Auckland, 2 August 2001.
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Donald T Brash: Faster growth? If we want it Address by Dr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the “Catching the Knowledge Wave” conference, Auckland, 2 August 2001. * * * Fundamentally, this conference is about economic growth, and how New Zealand can get more of it. Many New Zealanders do not see increasing growth as a high priority objective. What we want is to have access to better housing, better health-care, and better education. What we want is to protect the relatively egalitarian society of our past from increasing income disparities. What we want is more attention paid to preserving our natural environment. What we want is less stress and more leisure time. But the reality is that if we want better housing, better health-care and better education, we certainly need economic growth – we have difficulty funding our collective desire for health care and education now, and those costs look certain to rise in the years ahead. If we want to retain a relatively egalitarian society, we absolutely need economic growth – without it, too many of our highly skilled people will leave our shores, forcing up the relative incomes of the skilled people who choose to stay. Perhaps surprisingly, even if we want more attention paid to preserving our natural environment, we need growth – international experience suggests that it is the relatively affluent countries which can afford to spend resources on protecting the environment. So a conference on economic growth is not "just about money" but concerns many of the issues of vital relevance to all of us. It also concerns issues which go well beyond the statutory responsibilities of the Reserve Bank, and for this reason I must stress that my comments this morning reflect personal views, and not necessarily those of the Bank. Our growth performance: much improved How have we been doing in the economic growth stakes? Unfortunately, not too well if we judge from the last three decades. Over that period, our growth in GDP per capita has averaged 0.8 per cent per annum, compared with an average of 2.0 per cent per annum in the countries of the OECD. As a result, we have slid from 9th in the OECD "rankings" in 1970 to 20th in 1999 (comparisons made on a purchasing power parity basis, rather than at market exchange rates), and have also been well surpassed by some countries which are not OECD members at all (Singapore being the best example). As recently as 1990, New Zealand's GDP per capita was roughly on a par with Ireland's and Singapore's. By 1999, both countries had very considerably surpassed us. In 1990, Australia's GDP per capita was only some 5 per cent above New Zealand's; by 1999, it was nearly 40 per cent above New Zealand's. What should we make of these figures? The first thing to say is that for a whole range of reasons GDP per capita is not a very precise measure of human well-being. We New Zealanders have more cars per capita than people in all but a tiny handful of countries. We have substantially more EFT-POS terminals per capita than any other country in the world. We have easier access to uncrowded beaches and countryside than people in most other countries. We spend much less time commuting, even in Auckland, than people in many other countries. Our life expectancy at birth is the same as that in, say, Germany, the United Kingdom and the United States, and infant mortality is identical to the developed country average. As Paul Carpinter recently observed, quality of life measures often show Auckland in the top ten cities world-wide , something hardly consistent with New Zealand's being towards the bottom of the OECD "ladder". "Climbing the OECD ladder: what does New Zealand have to do?", a memo written by Grant Scobie and Peter Mawson to Alan Bollard, New Zealand Treasury, 4 April 2001. Ibid. Speech to the annual conference of the New Zealand Association of Economists, Christchurch, 28 June 2001. But having said that, there can be little doubt that there has been some relative decline in our living standards in recent decades. At first sight, our relatively slow growth seems surprising. We have many characteristics which make for rapid economic growth. For more than a decade, we have had macroeconomic stability, with a sound fiscal position and monetary policy delivering consistently low inflation. We have a competent and corruption-free judiciary implementing a legal system based on British common law. We have a civil service which is also competent and corruption-free. We have a stable political environment, with a substantial measure of consensus across political parties on the important aspects of macroeconomic policy. We are an English-speaking society, and one where people tend to be highly receptive to the adoption of new technology. On several indices, we are ranked among the freest economies in the world. And we've had an extensive period of economic reform, specifically designed to help us to grow more quickly. Doesn't our poor growth performance suggest that the reforms were seriously flawed? Not at all. I don't think there is much doubt that the reforms of the mid-eighties and early nineties have helped our growth potential a great deal. I have mentioned the decade of macroeconomic stability – which also delivered a huge reduction in the net public sector debt, from over 50 per cent of GDP in the early nineties to under 20 per cent at the present time. The reforms also delivered a very big improvement in the quality of service in areas such as banking, retailing, telecommunications, postal services, health-care, and airlines. Recent years have also seen very rapid growth in a whole host of relatively new industries – wine, mussels, software, furniture, specialised manufacturing, education services – to say nothing of a rapid increase in the sophistication of some of our traditional industries. Moreover, while GDP per capita grew at a rate of only 0.8 per cent per annum over the last three decades on average, it grew at almost 1.7 per cent during the nineties, virtually identical to the average OECD per capita growth over the same decade. So the reforms seem to have arrested our relative decline, but not, as yet, enabled us to begin the process of reducing the gap in per capita incomes which emerged over earlier decades. We are now keeping up, roughly, but not catching up. Why have we not done better still? Given that many of our reforms were, at the time, regarded as world-beating, why haven't we done better? I don't think anybody has a totally satisfactory answer to that question, but let me suggest a few factors which seem relevant. First, New Zealand is a very long way from all of its export markets, and there is a growing awareness that this imposes a considerable handicap on our performance. As The Treasury observed in its Briefing for the incoming Government in 1999, "Draw a circle with a radius of 2,200 kilometres centred on Wellington and you capture within it 3.8 million New Zealanders and rather a lot of seagulls. Draw a similar circle centred on Helsinki and you capture within it a population of over 300 million, from 39 countries." And for Helsinki, The Treasury could equally well have said Dublin or Singapore. Second, our natural resource endowment makes us extremely efficient at producing some things that we are effectively banned from selling to many of the consumers of the world. Thus for example, although we are one of the world's largest cheese exporters, and have developed a range of sophisticated cheeses in recent years, we are limited to a tiny quota of about 0.6 per cent of the US cheese market. If New Zealand producers want to sell butter to Japan, they find that Japan has limited total butter imports, from all sources, to less than 2,000 tonnes each year, with sales beyond that tiny quota facing a tariff of more than 500 per cent. Our distance from world markets and a resource endowment which favours the production of goods which face major obstacles in international markets are facts of life. To make matters worse, we have compounded matters by creating some of our own obstacles to economic growth. For example, as a country we squandered a large amount of capital investing in projects of very low or negative value in the late seventies and early eighties, most as a result of strong government encouragement – the Clyde dam, NZ Steel, and the synthetic petrol plant to name just three. Scobie and Mawson, op. cit. Towards Higher Living Standards for New Zealanders: Briefing to the Incoming Government 1999, The Treasury. Second, because of very high effective rates of protection in many parts of the manufacturing sector, we probably squandered even more capital over several decades by investing in industries where New Zealand had no prospect of ever being internationally competitive. (Many studies have suggested that economic growth tends to be fairly closely correlated with the degree of openness of the economy, and, while New Zealand is now a very open economy, that was not true until about a decade ago.) Third, we have paid a high price for years of encouraging investment in real estate while discouraging investment in plant and equipment – the result of the interaction between a period of high inflation and a tax system based on the assumption that prices are stable , plus perhaps the bitter memories of the 1987 share-market crash. Fourth, we have paid a high price for not encouraging the acquisition of education and skills – the result of decades of protection for industries requiring only a modest level of skill and, perhaps, a welfare policy providing benefits of unlimited duration. Fifth, we have paid a high price for tolerating an education system which produces too many people with inadequate literacy and numeracy skills, unable to fill the jobs available in a modern economy. And we have paid a price too for disdaining commercial success, with the consequence that too few of our youth aspire to make money growing a business and too many of our most able entrepreneurs have chosen to leave our shores. (It has to be a strange society which cheers somebody being paid millions of dollars for a few minutes of belting the daylights out of his opponent in the boxing ring, or somebody who wins millions in a highly regressive game of chance; but criticises somebody paid one million dollars for a year of running a complex company providing services to hundreds of thousands of customers, or somebody else paid $300,000 for running a large hospital with hundreds of staff and thousands of patients.) What about the future? Can we be optimistic about the future? There are clearly some factors adversely affecting our growth rate which we can never change. Most obviously, we will always be thousands of kilometres from our major markets, and it will take years before the high protection impeding our agricultural exports is eliminated. We can not avoid the fact that, as a country, we have squandered large amounts of capital on projects which have only a minimal benefit for future growth. But perhaps the significance of our distance from major markets is diminishing as transport and communications systems become ever cheaper and more efficient (I suspect that there are both costs and benefits for New Zealand in that development), and barriers to our exports continue to reduce, though painfully slowly. Moreover, within New Zealand we have eliminated the protection and the subsidies which caused so much misallocation of resources in the past. Inflation no longer interacts with the tax system to steer investment into real estate and out of investment in plant and equipment. And most of the other factors which have adversely affected our growth are ones which we ourselves can change, if only we have the will to do so. In recent times, many political leaders have suggested that as a country we should be aiming to return New Zealand's income levels to the top half of the OECD. As far back as 1990, the Trade Development Board, now Trade New Zealand, proposed that that goal be achieved by 2010. Would it now be feasible to raise New Zealand's per capita GDP to the median OECD level by 2010? What such a goal would imply in terms of growth rates over the next decade would clearly depend in part on how fast other OECD countries themselves grow over the decade, but plausible numbers – which assume that other OECD countries achieve the same per capita growth rates over the next 10 years as they did in the nineties – would require GDP per capita growth in New Zealand of about It is not hard to see why a tax system that allows the deductibility of nominal interest payments in full – even when much of the interest paid in a high inflation environment is, in reality, a compensation to the lender for erosion in the capital value of the loan – but does not tax the increase in the nominal value of the asset strongly encourages people to borrow heavily to invest in real estate in an inflationary environment. It is also the case that, in allowing deductions for depreciation based on historical cost and taxing profits on inventory on the basis of the historical cost of acquisition, the tax system, in an inflationary environment, over-taxes, and thus discourages, investment in other kinds of businesses. 3.6 per cent per annum, somewhat more than double the growth in per capita GDP achieved by New Zealand in the nineties. Can a doubling of our per capita growth rate, as compared with the average of the nineties, be achieved? I am sometimes surprised to hear people argue that such a goal should be easy to accomplish. Why, it is occasionally argued, some companies have grown by 10 per cent annually for years! Even whole regions sometimes grow at rates which are well above the growth rates suggested as being necessary to raise per capita income levels to the median of the OECD. But what is often overlooked in making such comments is that a company may grow at a high rate for years because it can absorb resources of people and capital from outside itself; regions can similarly grow rapidly by absorbing people and capital from other areas. New Zealand as a whole may increase its gross output more rapidly by bringing in lots of additional people and lots of additional capital, but that increase in gross output may produce only a modest increase in the per capita incomes of New Zealanders. No, doubling the growth in per capita incomes would be extremely difficult. But perhaps it would not be impossible. Some other small countries – Finland, Ireland, and Singapore are the most frequently cited examples – have achieved similar or even greater increases in per capita income, but it has been a very rare achievement, sometimes made possible in part by starting from a situation of economic collapse (Finland), and sometimes made possible in part by being able to bring very large numbers of unemployed people into the workforce (Finland and Ireland). Finland and Ireland also derived substantial benefits by being inside the European Union. We do not start from a position of economic collapse, and our unemployment rate is already low compared with that in many other OECD countries. We do not have large numbers of unemployed people with appropriate skills and attitudes waiting to leap into the workforce. We are not part of a very large market of 300 million people. To have any chance of doubling our per capita growth rate we will need to see quite radical changes in people's attitude and behaviour, and quite radical changes in public policy to encourage those changes in attitude and behaviour. Minor changes at the margin simply won't do the trick. Even major changes might not do the trick, since we seem to have some deeply-engrained cultural characteristics which are not conducive to rapid growth – surprisingly widespread disdain for commercial success, no strong passion for education, and a tendency to look for immediate gratification (as reflected in our very low savings rate and strong interest in leisure) – and it usually takes years, and perhaps generations, to change such cultural characteristics. Indeed, this attitudinal change is probably the most important single need if we are to radically increase our per capita growth rate. We need to want faster growth or, in personal terms, higher income. This may sound like a rather odd comment, but many of us know people who, having started a successful business, were happy to sell out of it for a few million dollars because that was more than sufficient to buy a nice house, a bach by the sea, a boat, and a decent car. And let's not criticise those who make that choice – after all, economic growth is a means to an end, and not an end in itself – but recall that retiring to enjoy the good life is not usually the attitude of entrepreneurs in the United States or other more successful economies. But let’s assume that most New Zealanders do in fact want to see faster economic growth, so that our more able children will not feel obliged to leave as soon as they can afford a one-way air-ticket to Sydney or London, so that we can keep and attract able people without creating Latin-American-style income disparities, and so that we can afford the health-care and quality of life which our Australian cousins will increasingly enjoy. What might be required? Increasing per capita GDP is about increasing the proportion of the population who are contributing to the production of goods and services in the market economy, and about increasing the productivity of those people. What scope is there for increasing the proportion of the population who are contributing to the production of goods and services in the market economy? Not very large. Certainly, not nearly as large as was the case in Ireland and Finland when they began their period of rapid growth, with very high levels of unemployment. Participation in the workforce by those between 15 and 64 is currently around 66 per cent in New Zealand, not far below participation rates in Singapore and Ireland (68 to Scobie and Mawson, op. cit. 70 per cent) currently, and unemployment, while higher than anybody feels comfortable with, is already approaching levels which are relatively low by OECD standards. Getting still more people into employment in the market economy may involve making some difficult social and political trade-offs. For example, does the present welfare system – with largely unrestricted access to benefits of indefinite duration, and with a very high effective marginal tax rate for those moving from dependence on such benefits into paid employment – provide appropriate incentives to acquire education and skills and to find employment? Nobody that I have ever met in New Zealand wants to deny those who are temporarily down on their luck sufficient income support to enable them to get back on their feet. In that respect, we are not willing to pay the price which Singapore paid to achieve very high growth, a society almost devoid of taxpayer-funded income support. But increasingly it is recognised that we will not achieve a radical improvement in our economic growth rate while we have to provide income support to more than 350,000 people of working age – 60,000 more than when unemployment reached its post-World-War-II peak in the early nineties – to say nothing of the 450,000 people who derive most of their income from New Zealand Superannuation. This is partly because of the huge fiscal costs of these transfer payments – amounting to an estimated $13 billion this financial year, or some 11 per cent of estimated GDP (both figures include the fiscal cost of New Zealand Superannuation). This cost substantially constrains the government from devoting more resources to education, law and order, research and development, and tax reduction. Indeed, it is probably fair to say that there is no other part of the government budget which can provide resources for these things. Certainly, it is hard to see scope for big reductions in the health or education budgets, the only other really major categories of government spending. But I mention these transfer payments and the very high effective tax rates faced by those trying to get off them at this point not simply to draw attention to the fiscal costs but mainly because these payments have an influence on the numbers of those contributing to the production of goods and services in the market economy. Are there ways in which we can change the incentives facing people now receiving such transfer payments? There are clearly a number of alternatives to the present way in which we provide income support short of adopting a cold-turkey Singaporean approach, and there is no single "right" way of doing it. Could we, for example, drop all benefits to the able-bodied and scrap the statutory minimum wage, so that pay rates could fall to the point where the labour market fully clears, but simultaneously introduce a form of negative income tax to sustain total incomes at a socially-acceptable level? Could we introduce some kind of life-time limit on the period during which an able-bodied individual could claim benefits from the state? Could we, perhaps, gradually raise the age at which people become eligible for New Zealand Superannuation, reflecting the gradual increase in life expectancy and improved health among the elderly? One of my colleagues has suggested the idea of abolishing the unemployment benefit but introducing some kind of "employer of last resort" system, perhaps run by local authorities with support from central government, under which every local authority would be required to offer daily employment to anybody and everybody who asked for it. Clearly, there would be huge benefits not just to economic growth but also to social cohesion if we were able to achieve a radical reduction in the number of those dependent on income transfers from the state. Increasing productivity But even more important than increasing the proportion of the population who produce goods and services in the market economy is increasing productivity. Ultimately, it is productivity – output per person – which mainly determines the standard of living, and it is clear that increasing GDP per capita by 3.6 per cent per annum means at least trebling the rate of productivity improvement which New Zealand has achieved in recent years (not much above 1 per cent). How might we move in this direction? Before attempting to answer that question, let me stress that, while the Reserve Bank makes a useful contribution to the economy's performance, it can never make the difference between 1.7 per cent per capita growth and 3.6 per cent per capita growth. The Reserve Bank can and does operate monetary policy to maintain stability in the general level of prices, and that is a necessary condition if New Zealand is to maximise its growth, but it won't produce a doubling of our growth rate. The Reserve Bank can and does promote the stability of the financial sector, and that too is a vital contribution to maximising New Zealand's growth, but it won't produce a doubling of our growth rate. No, most of what now needs to change if we want to double our growth rate involves policies and behaviour which fall well outside the Reserve Bank's areas of responsibility, as I have already noted. The second point I want to make is that it is important as we talk about all the opportunities afforded by the "knowledge economy" not to forget that for many years to come most New Zealanders will not be employed in software companies or biotechnology research firms. They will be employed in "the old economy". But that does not mean that they will be employed in industries which lack scope for improving productivity. On the contrary: it is useful to recall that over the last 15 years, with average productivity improving by little more than 1 per cent per annum, productivity in agriculture improved by almost 4 per cent per annum – a rate of productivity growth which, if achieved across the economy as a whole and sustained for a decade, would easily see our per capita incomes reach the OECD median within a decade. Improving productivity involves a whole host of things which can be loosely grouped under three headings – improving human capital, improving physical capital, and improving technology. Improving human capital To improve our human capital, we urgently (I almost said "desperately") need to improve the quality of our education system. And I say "improve the quality of our education system" rather than increase the resources devoted to our education system. We might need to increase the resources devoted to education, but we already spend a higher fraction of our national income on government support for education than the great majority of other developed countries. Despite this, international surveys of educational achievement suggest that we are not getting educational outcomes consistent with this high level of expenditure. It must be a source of grave concern that so many of the people coming out of our high schools have only the most rudimentary idea of how to write grammatical English; and that while Singapore, South Korea, Taiwan, and Hong Kong occupied the top four places for mathematics in the Third International Maths and Science Study, New Zealand ranked only 21st (out of the 38 countries in the study). It can not be good for our economic growth, or for the employment prospects of many of our young people, that, according to an OECD report released in April 1998, nearly half of the workforce in New Zealand can not read well enough to work effectively in the modern economy. It must be a matter for particular concern that 70 per cent of Maori New Zealanders, and about three-quarters of Pacific Island New Zealanders, are functioning "below the level of competence in literacy required to effectively meet the demands of everyday life". The University of Auckland is one of the two main hosts of this conference, so you would be surprised and disappointed if I did not stress the importance of doing more to improve the quality of tertiary education in New Zealand. And clearly, I believe that that is vitally important, though whether that means even more public sector resources going into the tertiary sector or other kinds of reform I am not in a good position to judge. But I strongly suspect that improvements in pre-school, primary, and secondary education are even more important for our long term growth, and for the long-term social cohesion of our society, than are improvements in tertiary education. Indeed, it may well be that improvements in these pre-tertiary areas are the fundamental prerequisites for improving the quality of tertiary education in New Zealand. But although there can be little doubt that improving our human capital by securing improved educational outcomes would contribute to New Zealand's long-term growth, the higher-growth dividend from improved educational outcomes would almost certainly accrue well into the future, not within the next few years, or possibly even within the next decade. Indeed, it is sobering to reflect that some of the countries which have had particularly good economic growth in recent years, such as Australia and the United States, have literacy levels not significantly higher than New Zealand's. It may well be that better educational outcomes would be more important in ensuring that more of our people have access to higher paid jobs, and thus in assisting social harmony, than in assisting economic growth directly. IEA Third International Mathematics and Science Study, 1998-1999. Human Capital Investment: an International Comparison, OECD, 1998. Adult Literacy in New Zealand, Ministry of Education, 1998. Improving physical capital One obvious way of increasing the output per person employed is to give people more physical capital to work with. (And by "physical capital" I mean not just plant and machinery but also roads and other infrastructure.) Of course, more physical capital is of no use whatsoever if it is the wrong sort of physical capital, and that points towards the huge importance of "getting the signals right" – by which I mean ensuring that investment takes place in areas which maximise the goods and services produced by that capital. As the Japanese have discovered in recent years, all the investment in the world will not encourage growth if the extra capital produces few of the goods and services which people actually want. Happily, as I have mentioned, we now have most of the signals right – businesses are no longer encouraged by high levels of protection to invest in industries where New Zealand will never be internationally competitive; the financial sector is free of the regulation (and the irrational exuberance which immediately followed the removal of that regulation) which used to distort the allocation of resources; and the misallocation caused by the interaction of inflation and the tax system is also now a thing of the past. Under these circumstances, what might we do to encourage investment in more physical capital? At very least, we need to seek and destroy those obstacles to investment which are within our own control. There is little doubt, for example, that businesses, especially small and medium-sized businesses, find the compliance costs of many public sector rules and regulations a significant obstacle to more investment. The recent report of the Ministerial Panel on Business Compliance Costs highlighted these issues, and noted that complying with a multiplicity of rules and regulations stifled the ability of businesses "to expand, innovate and compete". Businesses saw the biggest single problem as the way in which the Resource Management Act was being implemented, and described dealing with that legislation as being "cumbersome, costly and complex". It should not require two years to get all the approvals needed to set up an early child-care facility catering for only 30 children, or ministerial intervention to cut through the red-tape involved in setting up a boat-building yard. Most of us know similar horror stories. We may also need to look at whether there are deficiencies in our national infrastructure which are acting as a deterrent to investment. Do we, for example, need to improve the transport infrastructure in some parts of the country – perhaps in some of the areas where forests are reaching maturity by upgrading roading systems, perhaps in Auckland by completing the originally-planned motorway system and by introducing more appropriate congestion charges? Could we do more to encourage investment by expanding the size of the market? If the small size and isolation of the New Zealand market discourage investment in New Zealand, should we be doing more to encourage those with the skills and attitudes which can assist our growth to immigrate to New Zealand? Should we more vigorously seek economic integration into a much larger market? We have made a great deal of progress through our free trade arrangement with Australia, and the bilateral free trade arrangements with Singapore, and potentially Hong Kong and other countries in the region, are greatly to be welcomed. But if we really want to encourage investment in New Zealand for a much larger market, perhaps we should be devoting every effort to negotiating a free trade arrangement and greater economic integration with the United States also. There can be little doubt that one of the major reasons for the recent economic success of both Ireland and Finland is their membership of the European Union, as I have mentioned. A closer economic integration with the United States would not make New Zealand any closer physically to California, but it would carry potentially enormous economic benefits. It is in this context that the time may have arrived when we need to give serious consideration to the pros and cons of alternative currency arrangements. Far be it from me to advocate the abolition of the Reserve Bank of New Zealand and, as I have said on a previous occasion, any decision to abandon the New Zealand dollar in favour of some other currency is finally a political decision, not a decision for central bankers. And frankly, I do not know whether there would be net economic benefit in adopting some other currency arrangement, but if we are to have a no-holds-barred discussion on how to improve New Zealand's economic performance, one of the issues which should be looked at is this. Another matter relevant to how we might encourage more investment in physical capital is the tax regime. Do we need a substantial change in the tax structure to encourage investment in New Zealand by New Zealanders, by immigrants, and by foreign companies? And if so, what might that change look like? This isn't the place to go into detail, but it would probably involve a significant reduction in the corporate tax rate (it is disturbing that New Zealand's corporate tax rate is now the highest in the Asian region). The rate of company tax is rarely the only factor determining the location of a new investment, and indeed it is not often even the dominant factor. But it is a relevant factor, and is one of the issues to look at if we are serious about encouraging more investment in New Zealand. Improving technology And finally, how might we increase the growth rate of productivity, or of GDP per capita, by further increasing the rate at which we adopt new technology from abroad, and develop new technology of our own? Roger Ferguson, Vice Chairman of the Federal Reserve Board, cites research done by Fed economists which suggests that "the consolidated influences of information technology investments account for about two-thirds of the acceleration in (US) productivity since 1995". And there can be little doubt that a radical improvement in New Zealand's productivity growth rate will require a more rapid adoption of new technology than has been the case in recent years. To some extent, we would see more rapid adoption of new technology if we saw more investment in human and physical capital. The three things often go together. But there are some things we probably need to do to encourage this. To begin with, we should at least try to ensure that there are no obstacles to the development and adoption of new technology. In particular, we need to ensure that our regulatory framework does not close off developments in biotechnology, an area where we must surely have the potential to be world leaders. This does not, of course, mean that there should be no restrictions whatsoever on experiments in this area, but it does mean that we should remember that every restriction has a cost as well as a potential benefit, and sometimes the cost can be very substantial. Do we need to go further, by providing positive incentives to undertake research and development in New Zealand? Our unhappy experience with governments providing incentives to particular private activities inevitably and rightly makes us nervous about such a suggestion, but might the "externalities" associated with research and development – the economic benefits which the individual firm can not itself capture and retain – justify an exception in this case? Recent OECD data suggest that Australian businesses spend about double what New Zealand businesses spend, relative to GDP, on research and development, while those in Ireland spend about three times as much, those in Finland spend about six times as much, and those in Sweden spend about nine times as much. Even allowing for some over-statement arising from businesses having an incentive to re-classify expenditure as R & D where there are tax benefits from doing so, New Zealand businesses seem to be spending substantially less on R & D than do businesses in other successful economies. Do we need to take steps to encourage the adoption of new technology by encouraging a more entrepreneurial, a more risk-taking, culture? At a minimum we may need to try to make entrepreneurs feel more loved – if not our only national heroes at least among our national heroes! We also need to foster an understanding of financial matters, and an interest in business activities, in our schools, through programmes such as those run by the Enterprise New Zealand Trust. We need to consider whether the personal income tax structure provides appropriate encouragement to entrepreneurial New Zealanders to stay in New Zealand, and encouragement to entrepreneurial potential New Zealanders to come here. Our top rate of personal income tax is not particularly high by the standards of other developed countries, but it cuts in at a level of income below that in many countries and our tax system allows relatively few deductions. Compared with the rapidly growing economies of Hong Kong and Singapore, our top rate of personal income tax is very high. Perhaps we also need to think of some more innovative moves in the tax area. The United Kingdom attracts many entrepreneurial people from all over the world to live and work in that country by exempting from UK tax all income generated outside the UK for people not born in the UK. I understand that Switzerland effectively "negotiates" the tax to be paid by wealthy foreigners who want to live in Switzerland. It may be no accident that many entrepreneurial New Zealanders have moved to these countries in recent years. Another idea was suggested in the discussion paper issued by the McLeod Committee recently, namely establishing a maximum amount of income tax to be paid by any individual during the course "The productivity experience of the United States: past, present, and future", a speech at the US Embassy in The Hague, 14 June 2001. A new economy? The changing role of innovation and information technology in growth, OECD, 2000, page 29. of a year. The McLeod Committee suggested that that might be $1 million. Even a maximum of $500,000 per annum would be more than enough to cover 10 times over the cost of public services likely to be used by a person paying that much tax, but would be a level of tax which would seem very attractive to many expatriate New Zealanders and other entrepreneurial people in the US, Europe and Asia, from whom we are currently collecting no tax revenue at all. I strongly suspect that establishing such a maximum would actually generate significantly more tax revenue for the New Zealand government than the present tax structure does. Yes, it would offend our traditional New Zealand values to waive income tax once $500,000 had been paid, but what if very few current New Zealand residents pay more than $500,000 in tax each year? And if such a regime encouraged 1,000 entrepreneurs to come to New Zealand and the government were to gain, say, an extra $500 million a year in tax revenue to finance more early-childhood education and tax incentives for research and development, who amongst us would be worse off? Indeed, the likelihood is that such an injection of entrepreneurial drive might well play a major role in changing the rate at which New Zealand business adopted new technology, and so in improving the growth in New Zealand productivity. More savings? Before concluding, let me talk briefly about the role which increased national savings might play in helping us to increase New Zealand's economic growth rate. "Briefly" because I am not at all sure what role national savings play in economic growth in a world where capital is free to move from country to country. We know that Japan has one of the highest savings rates in the world, but has had one of the worst growth records in the developed world for more than a decade. We know that the United States and Australia have had rather low national savings rates in recent years, but both countries have grown strongly. We certainly know that savings which are channelled into investments which yield little or no growth are of no benefit. On the face of it, our own national savings performance has been poor over several decades, and that has been reflected in persistent balance of payments deficits over more than a quarter of a century – and very high private sector levels of indebtedness to foreign savers as a result. We know that, because of our heavy dependence on the savings of others, a significant fraction of the total output produced within New Zealand now accrues to those foreign savers. We know too that we probably all pay somewhat higher interest rates than would otherwise be the case because of the risk premium which foreign lenders charge as a result of our heavy dependence on the savings of others. But even if we were sure that improving our savings performance was a vitally important ingredient in improving our growth performance, or our standards of living more generally, nobody knows for sure how best to do that. In recent years, successive governments have sought to contribute to an improved national savings performance by running fiscal surpluses, though there is no certainty that that increases national savings in total – the possibility is that increased public sector savings may be offset by reduced private sector savings, perhaps because of enhanced public confidence that taxpayer-funded retirement income is assured. What about special tax incentives for retirement saving? Alas, there is little evidence that such incentives have any significant effect on national savings – to the (limited) extent that they increase private sector savings, they may well simply produce an offsetting reduction in public sector savings (because of the reduction in tax revenue required to provide the incentives). They also tend to be quite regressive, in that most of the benefit of the incentives goes to those on the highest incomes, who might well be savers even without the incentives. It is possible that some form of mandatory savings scheme might produce an increase in national savings. It is hard to avoid the conclusion that Singapore's breath-taking savings performance over several decades is related to the very high level of mandatory savings required by that country's Central Provident Fund. But on the other hand, it is not yet entirely clear that Australia's more modest mandatory savings scheme is having a marked effect on Australia's savings performance, although it is clearly having an effect on developing a pool of institutional savings. Tax Review: Issues Paper, June 2001. On balance, I would probably be a supporter of some kind of mandatory savings scheme as one contribution to improving our growth performance. But the case is not yet conclusively proven, and I would prefer to see more informed debate on the subject (as distinct from the substantially ill-informed debate of the kind we saw when this matter was last on the public agenda in 1997). One thing is clear however: we can not afford to lament the extent of foreign investment in New Zealand, and more generally the extent of our dependence on the thrift of foreign savers, unless we are also willing to save more ourselves. Our high level of dependence on foreign capital, year after year, is simply the other side of our lousy savings performance. Conclusion Mr Chairman, let me conclude by reminding you that we have some huge advantages in terms of economic growth – macroeconomic stability, a substantial measure of consensus on economic policy across the political spectrum, a competent and corruption-free judiciary and bureaucracy, an English-speaking population. After some decades of growing substantially more slowly than other developed countries, we have recently picked up our growth performance and during the nineties achieved per capita growth at a rate closely similar to average growth in other OECD countries. There are, therefore, plenty of reasons to be optimistic. Getting ourselves back to around the middle of the OECD pack in terms of GDP per capita within a decade – indeed, even within two decades – will still be a major challenge to all of us. Fortunately, our history suggests that we thrive on major challenges.
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Address by Mr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the managers of small and medium-sized businesses, Whangarei, 21 November 2001.
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Donald T Brash: Monetary policy in “Interesting Times” Address by Mr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the managers of small and medium-sized businesses, Whangarei, 21 November 2001. * * * Ladies and Gentlemen About seven or eight years ago, I was visited by a share-broker who told me what a great job the Reserve Bank had done in explaining its actions to the banks and the big corporates. I felt good, until he said “But frankly, you have done a lousy job communicating with the small and middle-sized businesses in New Zealand.” True, I protested, but I can’t even get a good mailing list to cover the tens of thousands of smaller businesses. “Fair enough”, he replied, “but every small business has a bank account. Put it on the banks to invite their small business clients to meetings which you host, and to which you speak.” And from that conversation grew the idea of this meeting. We had meetings of this kind for the first time in 1995. We repeated the idea again in 1998. And now we are doing it for the third time this year. In part, we want to use this meeting to tell you how we see the world. And in part, we want to learn, from your questions and comments when I have finished, how you see the world. We are acutely aware that the health and vitality of the New Zealand economy depends to a huge degree on the health and vitality of the small and middle-sized businesses represented in this room. We live in “interesting times” You will recall the ancient Chinese curse “May you live in interesting times”. Sadly, these are “interesting times” and we all know why. Just one week after the terrible events of 11 September, the Reserve Bank made an unscheduled and largely unexpected interest rate cut, from 5.75 per cent to 5.25 per cent. Within the Reserve Bank, we briefly debated whether I should hold a press conference to explain what we had done. We decided not to, in large part because there would have been very little I could usefully have said. Essentially, what I could have said at that time was “We don’t know yet what the economic consequences of these events will be, and we certainly don’t know what they mean for inflation in New Zealand. All we can say is that confidence has taken a huge knock; this is more likely to reduce prices than to increase them; and under these circumstances there is scope for lower interest rates.” That would not have made for a very productive press conference. Time has moved on, and there is more we can say now. Last week, we issued our latest assessment of the outlook for the economy and for inflation, and reduced the Official Cash Rate by a further 50 basis points to 4.75 per cent. Why did we do that? Interestingly, when we looked over our shoulder at the historical data available to us, it was hard to see a justification for any cut in interest rates. The latest comprehensive information we had on economic growth showed that, in the first half of this year, the economy grew by 2.3 per cent, equivalent to an annual growth rate of more than 4 per cent. The latest information we had also showed that unemployment was at its lowest level in 13 years. Job advertisements, as surveyed by the ANZ Bank, were running at a high level. Many businesses were reporting that they had little unused capacity to meet increased demand. In some parts of the country, there were reports of great difficulty finding skilled and even unskilled staff. The world prices for many of our commodity exports, while lower than a few months earlier, were holding up surprisingly well. And to top it all off the exchange rate was not far above its all-time record low, which meant that, in New Zealand dollar terms, our exporters and tourist operators were being substantially insulated from the slow-down in the world economy. To some extent, this was the same picture that we had painted in our August Monetary Policy Statement. There we had suggested that there might have been a case for an early increase in the Official Cash Rate were it not for the threatening clouds in the international economy. And that was weeks before we knew just how strongly the economy had grown during the first half of the year. But three months on, and notwithstanding the relatively robust historical data, we have cut the Official Cash Rate by a total of 1 per cent. We have done that because, despite the relatively strong position that the New Zealand economy is now in, we see the real prospect of the economy slowing down quite significantly over the next year or so. And if that slow-down occurs, interest rates can be lower than previously without jeopardising the price stability objective which the Reserve Bank is required to achieve. The basic cause of this rather abrupt change in the outlook for our own economy relates to a fairly substantial change in the outlook for the world economy. Back in early August, as our previous Statement went to press, the Consensus forecasts for the 14 countries which dominate our export trading suggested relatively slow growth this year but quite a marked pick-up in growth next year (figure 1). As we went to press with last week’s assessment, the general expectation was for growth to be significantly slower this year than previously expected, and growth next year to be even more markedly lower than previously expected (figure 2). And this deterioration in the world outlook seems to get somewhat worse with every passing week. Figure 1 Export partner GDP growth August 2001 Monetary Policy Statement (annual average percentage change) Source: RBNZ, Consensus. Figure 2 Export partner GDP growth November 2001 Monetary Policy Statement (annual average percentage change) Source: RBNZ, Consensus. Moreover, the deterioration is not confined to a single country. Most economists are now expecting a recession in the United States. Almost all economists are expecting a recession in Japan. Several of our biggest trading partners in Asia are clearly in recession already. Europe continues to slow down. Only Australia, among our main trading partners, seems to be enjoying reasonably robust growth for the moment. (Figure 3) Figure 3 Sum of 2001 and 2002 export partner GDP growth (annual average percentage change) Source: RBNZ, Consensus. And this slowdown in the world economy is bound to have an impact on the New Zealand economy, in particular by reducing the demand for our exports and reducing the prices of those exports. We are beginning to see that already, and as it occurs we expect to see both some reduction in growth in New Zealand and some downwards pressure on prices - including some reversal of the very strong increase in the price of things like meat and dairy products, which in recent months has done so much to push up the price of the average food-basket. So it seems reasonable to believe that inflation will be much less of a problem as we look forward 12 months than it has been over the last 12 months. Having explained our decision to reduce the Official Cash Rate last week, let me use this situation to make four points. Price stability means neither inflation nor deflation The first point I want to make is that the Reserve Bank is just as serious about keeping inflation above zero as it is about keeping it below 3 per cent. Dropping interest rates now is about preventing inflation falling too low. And if inflation threatened to go negative, you can be sure we would be very active indeed in stimulating the economy. It’s been said that any fool can keep inflation down, and that’s true, but our task is much more demanding than that. I know our rhetoric is mostly about the economic and social costs of inflation, rather than about the economic and social costs of deflation. That’s because, at least in New Zealand, inflation has been much the more common problem, certainly for the last 60 years. Also, because New Zealand went through a period of quite high inflation in the seventies and eighties, we have had to work hard to persuade people that we are serious about keeping inflation down, in order to bring down inflationary expectations. But make no mistake. Inflation going below zero would be just as much a breach of the Reserve Bank’s inflation target as having it go above 3 per cent. Deflation causes its own set of economic problems and distortions, doing social and economic damage. And our policy deliberations are always, without exception, mindful of both risks. We are always trying to find the policy setting - the interest rate - which will deliver an inflation outcome which is neither too hot nor too cold. Preventing deflation is also part of the law under which I operate. The Reserve Bank Act 1989 makes it clear that monetary policy must deliver “stability in the general level of prices”. And the Policy Targets Agreement which I have with the Minister of Finance, a requirement of the Reserve Bank Act, defines “stability in the general level of prices” as inflation measured by the Consumers Price Index of between zero and 3 per cent. Deflation is not “stability in the general level of prices”, any more than inflation is. This means that, once price stability has been achieved, and as a very rough rule of thumb, the Reserve Bank’s monetary policy will be seeking to restrain inflationary pressures by raising interest rates roughly half the time, and will be seeking to restrain disinflationary pressures by lowering interest rates roughly half the time - as we did in the second half of 1998 and as we have been doing through most of this year. New Zealand goes into this world slowdown in a strong position Secondly, although New Zealand will be affected by the world slowdown, we are not completely hostage to external events. It is important that we don’t talk ourselves into a gloomy frame of mind just because the slowdown in the world economy could be substantial, and could last well into next year. When the world slowdown began, many sectors of the New Zealand economy were in rude good health economically, as I have mentioned - and I haven’t even mentioned such other advantages as a strongly capitalised banking system and a government running fiscal surpluses. In other words, we start into the slowdown from a good position. Figure 4 Prices of New Zealand’s export commodities (denominated in US dollars) Source: ANZ. Yes, export prices look likely to fall, and indeed have already done so in a number of cases, but in US dollar terms they have, on average, been at relatively high levels for much of the last year or so (figure 4), and in New Zealand dollar terms they have been pushed up even further by the low level of the kiwi dollar (figures 5 and 6). This low exchange rate provides very useful insulation from the downturn in the world economy, by propping up returns to New Zealand exporters (and indeed returns to those competing with imports) despite weaker prices abroad. There has been a sharp decline in net confidence in the business sector in recent months, as measured by both the National Bank Business Outlook survey and by the quarterly survey undertaken by the Institute of Economic Research (figure 7). And businesses have become less confident not only about the economy in general, but also about the outlook for their own businesses. Figure 5 Prices of New Zealand’s export commodities (denominated in US and NZ dollars) Source: ANZ. Figure 6 NZD/USD exchange rate and the TWI Source: RBNZ. Figure 7 New Zealand business confidence Sources: National Bank of NZ, NZ Institute of Economic Research. But at least as of late last month, more businesses continued to expect an improvement in their own business over the year ahead than expected a deterioration. As you can see from the graph (figure 8), the National Bank survey for September, taken prior to the tragic events of 11 September, showed that only 6 per cent of businesses expected that their own business would deteriorate over the year ahead. By the October survey, that had increased to 16 per cent expecting a deterioration. In both surveys, roughly half of all respondents expected no change in their business over the period ahead. And despite the increased gloom, roughly twice as many businesses were expecting their business to improve as were expecting a deterioration, even in October. Figure 8 Expected business activity (September and October 2001 surveys) Source: National Bank Business Outlook. Interestingly, surveys conducted in September by both the Employers and Manufacturers Association in Auckland, and the Canterbury Manufacturers Association in Christchurch, showed a remarkably upbeat mood in both cities. And both surveys were conducted after the events of 11 September. A survey conducted by Bancorp in late October found respondents (134 in all) more optimistic about general business conditions, and more confident about increasing investment expenditure, than a similar survey four months earlier. A more limited survey of the top 20 listed companies undertaken by the New Zealand Business Times, also in late October, found that, with only a single exception, corporates had not changed budget allocations or staff hiring intentions since 11 September - and the exception was “a company that is subject to a particular restructuring in its business.” Moreover, if the slowdown in the global economy affects us more adversely than we currently expect, there is scope to stimulate additional demand without causing inflation to accelerate. Typically, monetary policy is these days the policy instrument of choice for providing temporary stimulus to the economy. We have now eased monetary policy by reducing the Official Cash Rate from 6.5 per cent early this year to 4.75 per cent currently. There is little doubt that that reduction will help to cushion the effects of the international slowdown. But if we need to reduce the Official Cash Rate further, there is clearly plenty of room to do so, and in that respect we are in a very much easier position than the one in which the Japanese central bank finds itself, with official interest rates already at zero, and with no further reductions possible. So there is good reason for businesses in New Zealand to be more optimistic about the future than is the case in many of our trading partners: New Zealand starts from a situation of relatively strong growth, and there is ample scope for monetary policy to stimulate the economy if that should be needed, without jeopardising price stability. New Zealand Business Times, 2 November 2001. But unfortunately policy is unable to provide complete protection But thirdly, having said that, it is unfortunately quite impossible for policy-makers, whether in the government or in the Reserve Bank, to protect your business from all the effects of the global slowdown. In part that is because policy - whether government fiscal policy or Reserve Bank monetary policy works with what in the trade we call a long lag, or delay. In other words, the time between when the Reserve Bank changes the Official Cash Rate and when that change impacts your business will almost certainly be many weeks and probably many months. I have heard that some businesses believe that a change in the Official Cash Rate can have an almost instantaneous impact in the market, because of the effect which such a change can have on confidence. But that is surely the exception rather than the rule. In most situations, the lag or delay between a change in monetary policy and the impact of that change on the economy is typically more than a year. To make life even more complicated, the lags are not only quite long but are also variable - they vary somewhat from situation to situation. This means that, if we had to offset the effect of, say, a world economic slowdown on the New Zealand economy by easing monetary policy, we would need perfect ability to see the future for more than a year ahead, perfect understanding of precisely where the economy is now, and perfect understanding of how the economy works. Well, we do our best, and I am fortunate to have some of the brightest economists in New Zealand on my staff, trying to discern the future. We study 6,000 data series. We look for relationships which look realistic in recent history. We talk to businesses up and down the country - about 50 or 60 before each quarterly Monetary Policy Statement. We use some sophisticated economic models, but stir in very large amounts of judgement. We are constantly looking to update our assessment of the real economy outside the Reserve Bank’s doors. We get a steady flow of data relevant to New Zealand from overseas economies. We believe we are as well-informed about the economy as any other organisation in New Zealand, and better informed than most. But we can still get it wrong. Let me illustrate. One of the most reliable relationships in recent economic history is that the world prices of the commodities New Zealand exports tend to rise when the economies of our trading partners are buoyant, and tend to fall when the economies of our trading partners are subdued. That sounds pretty much what one might expect on the basis of common sense, and that is consistent with the data (figure 9). Figure 9 NZ’s export partner growth and world commodity prices Sources: RBNZ, Consensus, ANZ. Figure 10 World export price index projections (previous Monetary Policy Statements) Source: RBNZ. November 2001 is central projection. So since at least the December 2000 Monetary Policy Statement, we have been expecting the prices of our commodity exports to decline (figure 10). And we projected the same thing to happen in March this year, even though in the intervening period prices had risen some more, despite a steady weakening in the world economy. And we projected prices to fall in our May Statement, even though they had risen some more, despite still more weakening in the world economy. And in our August Statement, we again projected world prices to fall, even though by August they had risen still further and the world economy was looking quite seedy! And in the Statement we issued last week, we still projected that the slowdown in the world economy would produce a fall in our export prices! Indeed, had we not expected our export prices to fall, the case for reducing the Official Cash Rate last week would have been non-existent. Should we have changed our expectation about export prices because over most of the last year the traditional relationship between export prices and the growth of our trading partners has broken down? Obviously we don’t think so, but the example is a good illustration of the difficulty of forecasting the economy even in “normal” times. And of course these are anything but normal times. No economic model, and no economic forecaster, could have foreseen the events of 11 September. By definition therefore, given the long and variable lags between a change in monetary policy and the impact of that change on the real economy, and the inability of even the most experienced central bankers to foresee the future, we will sometimes fail to adjust policy sufficiently quickly to protect your business from a sharp downswing - or for that matter, from a sharp upswing (though that may well cause fewer complaints!). There is another reason why monetary policy can not protect your business from all the adverse effects of world events. Even if we had super-human ability to see into the future, the reality is that world events have quite different effects on different industries and different regions. Monetary policy, with its single interest rate instrument, can only react to the balance of inflationary pressures in the economy as a whole, not to the pressures in individual industries. In other words, we can’t have a high interest rate to restrain the very buoyant conditions in the dairy industry but a low interest rate to support the software export sector, which has been adversely affected by the sharp deceleration of spending on information technology in the United States. We can only have an interest rate which seems appropriate to the economy as a whole - and must accept that that interest rate will seem far too high for some parts of the economy and will be arguably too low for other parts. We saw that situation rather clearly in the mid-nineties, when the building sector was experiencing quite strong inflationary pressures, but many export industries were experiencing quite strong disinflationary pressures. It would have been great to have been able to have a high interest rate applicable to the building sector but a low one applicable to export industries. But as long as we have a common currency throughout New Zealand, that is not an option. So the Reserve Bank can help your business by trying hard to anticipate developments in the New Zealand economy, and can adjust monetary policy quickly if it looks likely that inflationary or deflationary pressures will emerge. But we can’t provide complete protection, either for the economy as a whole or, even more clearly, for each industry and region. Monetary policy doesn’t determine the economy’s long-run growth rate Finally, it is important to be aware of what monetary policy can and can not do for the economy’s long-run growth rate. There is now virtually unanimous opinion among economists and policy-makers around the world that central banks can’t engender faster economic growth by being more tolerant of inflation. On the contrary, there is a virtually unanimous view that the best thing that monetary policy can do for economic growth is to keep inflation low and stable. It is a myth, though one clearly believed by some New Zealanders, that the United States economy has grown faster than the New Zealand economy over the last decade because the US central bank has a mandate to encourage growth and maintain price stability, whereas the New Zealand central bank has only a mandate to maintain price stability. The reality is that in both countries it is now fully recognised that the best thing which monetary policy can do to encourage growth is to keep inflation under control. In that respect, the Federal Reserve and the Reserve Bank of New Zealand think and operate in the same way. This is not the place for a comprehensive discussion on the determinants of trend growth in output. Essentially, economic growth depends on growth in inputs of labour and capital, and advances in the productivity with which that labour and capital are employed. And most of the things which impact on those factors are quite unrelated to monetary policy. Some studies have suggested that high levels of taxation discourage growth through their effect on incentives to work, save and innovate. Others have pointed to the importance of protecting private property rights if growth is to be dynamic. Still others note the importance of human capital, and highlight the role of education as a determinant of economic growth. And of course there are many other relevant factors, such as the rules and regulations which may make undertaking new investments a slow and cumbersome process. Getting policies in all of these areas right is crucial if trend growth is to be increased, and none of them are policies susceptible to central bank influence. Conclusion So in conclusion, in these “interesting times” • First, the Reserve Bank is as committed to avoiding deflation as to avoiding inflation, and that means that we will always be leaning against the wind to the best of our ability, tending to tighten policy if inflation looks likely to rise in the future, and tending to ease policy if inflation looks likely to fall below the bottom of our target. • Second, the New Zealand economy is well-placed to weather the international slowdown, with moderate growth, low unemployment, an exchange rate which is providing useful support for export and import-competing industries, and ample scope for further easing of monetary policy if that should prove necessary. • Third, even with the best will in the world, the best economists in the world, the most regular contact with companies up and down the land, monetary policy can never provide you with complete protection against the vagaries of life, whether these vagaries come in the form of international crises or in the form of some dramatic domestic development. • And fourth, monetary policy doesn’t determine the economy’s long-term growth rate - that is determined by a whole range of factors which have nothing directly to do with the Reserve Bank. Sometimes the Reserve Bank will need to leave monetary policy unchanged for months on end. Sometimes we will need to adjust interest rates in small incremental steps, as earlier in the year. And sometimes we will need to adjust rates more aggressively, as over the last couple of months. Different circumstances will require different responses. But what I can say is that, in “interesting times” as in normal times, the role of monetary policy is to help and not to hinder, and that is what we are committed to doing.
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Speech by Mr Donald T Brash, Governor of the Reserve Bank of New Zealand, at the American Economics Association conference, Atlanta, 5 January 2002.
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Donald T Brash: Inflation targeting 14 years on Speech by Mr Donald T Brash, Governor of the Reserve Bank of New Zealand, at the American Economics Association conference, Atlanta, 5 January 2002. * * * Mr Chairman, Ladies and Gentlemen It is a great honour to participate in this session on inflation targeting this morning, and to share the platform with such distinguished practitioners of that art. I was asked to speak first because my name comes first, by a rather narrow margin, when the four speakers are lined up alphabetically. It also happens that New Zealand was the first country in the world to adopt a formal inflation target, in the sense that we understand the term today, in the late eighties. Both of these facts give me some latitude about what to talk about, although when Jacob Frenkel invited me to participate in this panel discussion he stressed that I was not being invited to address the theory of inflation targeting so much as to talk about some of the lessons we have learnt from experience over almost 14 years. And that is what I propose to do. Bernanke et al have defined inflation targeting as "a framework for monetary policy characterised by the public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more time horizons, and by explicit acknowledgement that low, stable inflation is monetary policy's primary long-run goal. Among other important features of inflation targeting are vigorous efforts to communicate with the public about the plans and objectives of the monetary authorities, and, in many cases, mechanisms that strengthen the central bank's accountability for attaining those objectives." I am very comfortable with that definition. Has inflation targeting met its objectives in New Zealand? Countries usually adopt inflation targeting for one or more of the following reasons: • A desire to find some credible anchor for monetary policy, often after a period of high inflation and/or the loss of a previous anchor (perhaps an exchange rate target which proved impossible to maintain or a money aggregate target which proved both difficult to achieve and less closely connected to the inflation rate than hoped for). • A desire to give the central bank instrument independence, but to balance that with some clearer specification of what the central bank should seek to achieve with that instrument independence - in other words, to make it possible to balance independence with accountability. • A desire to reduce the social and economic costs of disinflation by reducing the inflation expectations of both financial markets and agents in the real economy. In New Zealand's experience, I have little doubt that the adoption of inflation targeting helped to provide an anchor for monetary policy. Certainly, there had been important progress in reducing inflation between the mid-eighties and the time a specific target was first discussed in April 1988, but in the year to March that year CPI inflation was still 9 per cent, and predictions by the Reserve Bank that inflation would fall below 4 per cent within two years were widely ridiculed. B.S. Bernanke et al., Inflation targeting: Lessons from the International Experience, Princeton University Press, 1999, p.4. By 1991, inflation was under 2 per cent, and inflation has averaged around 2 per cent over the last 10 years. Of course, lots of other countries have also achieved low rates of inflation over the last decade, so it is impossible to be dogmatic about the extent to which inflation targeting helped in the case of New Zealand. But in my own judgement the single focus which inflation targeting required of the central bank was a material factor in focusing the Bank on that objective. Beyond the first year or two, we did not spend a lot of time debating what the optimal inflation rate might be. In terms of making the decisions about monetary policy, that was irrelevant because the target had been agreed. The only debate was about what degree of monetary policy pressure was needed to achieve that objective. In the seventies and eighties, during most of which period New Zealand did not have an inflation target, New Zealand's inflation was not only markedly higher than it was in the nineties, it was also higher than inflation in other OECD countries. Inflation targeting helped us to achieve a substantial improvement in our inflation performance in absolute terms; it helped us to reduce inflation relative to inflation in other developed countries; it helped to reduce the volatility of inflation; and it helped us to maintain that improved performance. Interestingly, and perhaps contrary to some impressions both in New Zealand and abroad, achieving this marked improvement in inflation performance was not bought at the cost of an increase in output volatility. Yes, output volatility was higher in New Zealand during the nineties than in, say, Australia or the United States, but that is hardly surprising: one would expect to see rather more output volatility in a very small, commodity-dependent, economy than in a much larger and more diversified economy. But the nineties saw both a decline in inflation volatility and a decline in output volatility in New Zealand, as compared with the two previous decades. Inflation targeting has also come to be seen as an important aspect of the Reserve Bank's accountability. New Zealand had no tradition of central bank independence prior to the late eighties. Although more and more people could see the cynical way in which monetary policy could be manipulated by politicians who gave greater weight to their own re-election than to preserving the purchasing power of the currency, it was always going to be a challenge to get substantial political buy-in to full central bank independence. One of the things which made that political buy-in possible to the extent that both major political parties voted for the legislation giving the Reserve Bank instrument independence late in 1989 - was the fact that it was Parliament which mandated price stability as the Bank's objective, and what that meant was to be formally and publicly agreed in a Policy Targets Agreement (PTA) between the Governor and the Minister of Finance. In other words, there was to be full instrument independence but not full goal independence. The legislation was drafted in such a way that the PTA could have been based around exchange rate targeting, nominal income targeting, or conceivably even money aggregate targeting, but in the context of the time everybody understood that the PTA would be based around the inflation target which had been announced more than 18 months earlier. The Bank was to be accountable for delivering that agreed inflation target, and the legislation made it clear that the Governor could lose his job for "inadequate performance" in achieving that objective. There is no doubt that a desire to change inflation expectations was an important part of the motivation in the adoption of an inflation target in New Zealand. Then-Minister of Finance Roger Douglas was very concerned in March 1988 that, with inflation moving into single figures for almost the first time in 15 years (with the exception of a brief period during which all prices, wages, interest rates, dividends and rents were subject to tight administrative control), the public would expect the monetary authorities to ease up, and settle for inflation in the 5 to 7 per cent range. It was in that context that the Minister announced, during the course of a television interview on 1 April 1988, that he was thinking of genuine price stability, "around 0, or 0 to one per cent". It is less clear that the adoption of an inflation target was in fact successful in reducing the costs of disinflation by reducing the inflation expectations of financial markets and the public - and this despite the fact that my senior colleagues and I devoted an enormous amount of effort to convincing the public of the seriousness of our intent. Guy Debelle has done a study of the sacrifice ratio involved in reducing inflation in Canada, Australia and New Zealand. For New Zealand (which had a specific inflation target) and Australia (which did not, at least until after its disinflation had been completed), that study suggests that the sacrifice ratios were similar. I would not myself want to put too much store by that result. New Zealand's inflation performance had been rather worse than Australia's for some years by the late eighties, and one would therefore expect to find inflationary expectations more deeply entrenched in New Zealand. Moreover, just two years into the disinflation process in New Zealand the Government introduced a 10 per cent Goods and Services Tax, which increased the CPI by an estimated 8 per cent. Then, in mid-1989, that tax was increased from 10 per cent to 12.5 per cent. Both moves presumably had some effect in maintaining inflationary expectations at a relatively high level. Although I can not prove it, I believe that the inflation targeting regime did help to change expectations and behaviour at the margin. I well recall that, in late 1990, not many months after the Policy Targets Agreement had seen the 0 to 2 per cent inflation target formally agreed between Governor and Minister, the head of the New Zealand Council of Trade Unions, Ken Douglas, wrote an article which appeared in one of the major newspapers. The article argued that the Reserve Bank was focused on an undesirably narrow objective (namely, low inflation), but that, as long as that was the case, unions would need to moderate wage demands to avoid increases in unemployment. In the weeks which followed, he actively, and with very considerable courage, campaigned for moderate wage settlements as a way of reducing unemployment. I have little doubt that the inflation target played a part in encouraging "Output volatility in New Zealand", in Independent Review of the Operation of Monetary Policy: Reserve Bank and NonExecutive Directors' Submissions, Reserve Bank of New Zealand, October 2000. Guy Debelle, "The Ends of Three Small Inflations: Australia, New Zealand and Canada", Canadian Public Policy, March 1996. The Dominion, 31 October 1990. employers and unions to adjust their wage settlements to levels which were quite quickly consistent with the inflation target. There was also a very large reduction in the spread between the yield on New Zealand government New Zealand dollar long-term bonds and that on US Treasuries. In the mid-eighties, that spread had peaked at around 1000 basis points. By early 1990, that spread had reduced to around 400 basis points, and it has been well under 200 basis points for most of the last decade. Of course, most of that reduction in spreads was presumably simply the result of New Zealand's greatly improved inflation performance, but that improved performance was, as I have argued, in part attributable to the inflation targeting framework, while that framework probably also helped, at the margin, to convince markets that low inflation was likely to endure. An inflation target agreed by Governor and Minister In New Zealand's experience, the fact that the inflation target was, and still is, formally agreed between the Governor of the central bank and the Minister of Finance on behalf of the Government has been unambiguously positive. And I make this point because some observers have suggested that this need to agree the inflation target between central bank and executive/legislature is an undesirable restraint on central bank independence. There is no question that it is, in principle, a restraint. In our framework, the inflation target is formally agreed between Minister and Governor, and can be changed either by mutual agreement or by the Minister unilaterally (if the Governor does not agree to a change) by the use of the so-called override provision in the legislation. But, in a world of open capital markets, the fact that the legislation requires the Policy Targets Agreement, or any override of that Agreement, to be in the public domain means that no Minister can manipulate the target for cynical political ends. On the contrary, the Minister has every incentive to make it publicly clear that the inflation target he wants the central bank to deliver is consistent with price stability and a stable currency. Indeed, it is this obligation to be transparent about the objectives of policy, and about the modus operandi of policy, that is one of the most important aspects of the New Zealand inflation targeting framework, arguably as important as instrument independence itself. If a Minister were, say, to instruct the Bank to ignore the inflation rate and focus instead on increasing the growth rate - as he could do by invoking the override provision - markets would almost certainly deliver an immediate increase in interest rates across almost the entire yield curve (the Bank would still, of course, be able to anchor the overnight rate), together with a sharp fall in the exchange rate. The need to be transparent ties the hands of both government and central bank unless there are good and explainable reasons for change. The fact that the inflation target is a matter agreed between Minister and Governor has effectively protected the Bank from criticism by the government, and in the almost 14 years during which inflation targeting has been in place, the number of government ministers who have attacked the Bank can be counted on the fingers of one hand. Given that the Minister of Finance is involved in agreeing the inflation target, it is not easy for him or other ministers to attack the Bank for having policy too tight unless inflation is, or looks likely to be, below the target. Of course, we are not fully protected from criticism, even from the government: given the long lags with which monetary policy operates, and the inherent uncertainty, we may still be criticized for the timing or magnitude of policy moves, though in practice that has been a very unusual event in our experience. Moreover, agreeing the target between the Minister and the Governor has the important indirect effect of improving the consistency of monetary and fiscal policies while still leaving the central bank with instrument independence. By agreeing the inflation target with the Governor, the Minister of Finance is implicitly agreeing that if fiscal policy is changed, monetary policy may need to change also, potentially offsetting any stimulus (or restraint) emanating from fiscal policy. We saw this most dramatically in mid-1990 when the Minister announced an expansionary Budget just months before the general election scheduled for late that year. Markets were concerned about the loosening in fiscal policy, and became uneasy about the future direction of policy. This was reflected in a rise in long-term interest rates and a fall in the exchange rate, to which we responded by tightening monetary policy. Immediately, an editorial in New Zealand's largest daily paper noted that the Budget had "rekindled inflationary expectations. The (Reserve Bank) was bound to lift interest rates.... Electors are frequently bribed to their ultimate cost. This time the independence of responsible monetary control quickly exposes a fiscal fraud." The main Opposition party campaigned in the election on a commitment to get interest rates reduced, not by leaning on the central bank but by "giving monetary policy some mates" through tighter fiscal policy and deregulation of the labour market. Five years later, with several years of fiscal surplus behind it, the Government undertook to reduce income taxes subject to several conditions being met, one of which was that the Reserve Bank was satisfied that such tax cuts would not require a significant tightening of monetary policy. To me, these are good illustrations of the benefit of having the specification of the objective of monetary policy a matter for formal and public agreement between government and central bank. It forms a kind of pre-commitment strategy. The pre-conditions for inflation targeting There is another issue related to inflation targeting on which I would like to comment, and that relates to the pre-conditions which must be met before a country can sensibly embark upon it. It has sometimes been suggested that inflation targeting is such a complicated undertaking that only countries with lots of economists with PhDs from good American schools, several sophisticated econometric models, and a good understanding of how the monetary transmission mechanism works dare to undertake it. On the basis of New Zealand's experience, I would argue that this is quite incorrect. Of course, operating any monetary policy is easier, and more likely to be successful, if the central bank has access to competent people and has a good understanding of how the transmission mechanism works. But the core elements of inflation targeting are not particularly complex, or rather are no more complex than operating other approaches to monetary policy. When we embarked on inflation targeting, we had our fair share of competent staff, but we had no clear understanding of how the transmission mechanism worked and a rather inadequate economic model. Indeed, the economy had been subject to such dramatic change over the previous few years that no model based on past relationships would have been of much use to us. Notwithstanding those deficiencies, we have little doubt that inflation targeting has been successful in New Zealand. We certainly have no reason to believe that we would have been more successful if we had been trying to target nominal income or a money aggregate. Evolution has been significant Perhaps because we began inflation targeting at a time when the New Zealand economy was undergoing so much structural change, it was probably inevitable that our approach to the task would evolve quite significantly over the years after 1988. In the early years, we assumed from international experience that raising interest rates would tend to reduce inflationary pressures and that reducing interest rates would tend to increase inflationary pressures. But we had no reliable evidence, indeed no evidence at all, which might guide us on the extent to which an interest rate change in New Zealand would change the inflation rate. For this reason, and perhaps because some of us retained deeply monetarist sympathies, we began the process of reducing inflation by adopting a very "quantitative" approach to the task - we determined to hold the liquidity in the banking system stable, something made relatively easy by the clean float of the exchange rate (in place since March 1985) and by a government commitment to fund any fiscal deficit by the sale of bonds. Interest rates across the whole yield curve were completely driven by market pressures, and fluctuated considerably. In the late eighties, we realised that, while we did not know in any specific sense what effect a change in interest rates had on inflation, we did have a reasonable estimate of the effect of exchange rate movements on the inflation rate. We estimated that a 1 per cent movement in the exchange rate, as measured by a trade-weighted index, produced a change in the Consumers Price Index of about 0.4 per cent over the following year or so. And from this fact we developed an implementation regime which was for a time rather heavily oriented to the exchange rate. New Zealand Herald, 3 August 1990. At no time did we have an exchange rate target in the conventional sense. But we did derive a "conditional comfort zone" for the trade-weighted measure of the exchange rate which seemed to us, given all the other factors affecting the inflation rate, to be consistent with progress towards, or later maintenance of, the inflation target. In other words, the comfort zone was moved up (an appreciated New Zealand dollar) when domestic inflation was projected to rise towards the top of the inflation target, and down (a depreciated New Zealand dollar) when domestic inflation was projected to fall towards the bottom of the inflation target. We still set no interest rate, but rather made small adjustments to the target for the quantity of settlement cash in the banking system, with the aim of tightening or easing monetary conditions. And while we did not announce our comfort zone for the exchange rate, the financial markets usually had a very clear understanding of where that zone was, both because we were open about the exchange rate "pass-through coefficient" (0.4) which we were using in our inflation forecasts and because from time to time we would "clear our throat" to draw attention to the fact that monetary conditions were in danger of becoming inconsistent with the inflation target. We referred to our use of OMOs in the implementation of monetary policy - not so much "open market operations" as "open mouth operations". We discovered that occasional "open mouth operations" were actually all we needed to implement policy most of the time, and we left the target for settlement cash unchanged for years at a time. In other words, the mere fact that the financial markets understood that we could adjust the quantity of settlement cash in the banking system, thereby tightening or easing monetary conditions, was sufficient to produce a change in monetary conditions consistent with our objective of meeting the inflation target, without the need for any actual change in settlement cash. It was in one sense the ultimate "no hands central banking", where we set no interest rate and no exchange rate, and left the target for settlement cash unchanged for many months on end. In time, what moved monetary conditions was our quarterly, published, inflation forecasts, and the widespread knowledge that, if push came to shove, the central bank was able to inflict financial pain on banks if monetary conditions did not move in a way consistent with the inflation target. This system also imposed an absolutely miniscule "monetary policy tax" on the financial system, since the amount of settlement cash in the system (on which we paid a below-market interest rate to discourage banks from holding excess balances) was never more than 0.1 per cent of banking system deposits, and was normally well below that. As time went by, we moved away from a focus on the direct price effects of movements in the exchange rate. In part, that was because these price effects became progressively more muted, as several other inflation targeting countries also found in the nineties. In part too, it was because we developed a better understanding of the inflation process in New Zealand. We moved our forecasting horizon out somewhat, beyond the direct price effects of exchange rate movements to the more medium-term effects of the real exchange rate and real interest rates on inflation through their effect on the output gap. But we continued to implement policy through our ability to move the quantity of settlement cash in the banking system, and through making our views about the appropriateness of monetary conditions known through our quarterly inflation forecasts and occasional "open mouth operations ". This worked effectively as a system for keeping inflation under control, but it had disadvantages from a public relations point of view. Occasionally, monetary conditions would become a bit too easy to be consistent with our inflation target, and we would draw attention to the fact that conditions should be somewhat tighter. And conditions would tighten, usually through an increase in market interest rates and some appreciation in the exchange rate. But we had no quantitative way of informing the market about how far conditions should tighten, with the result that we often had to make a "that's about far enough" statement a week or 10 days later. The financial market understood this system, but to the general public it sometimes led to the perception that the Reserve Bank was having difficulty making up its mind whether conditions were too loose or too tight. We needed some kind of quantitative indicator. So in June 1997, we started expressing our views on the appropriateness of monetary conditions in terms of a Monetary Conditions Index. We announced that we would use an MCI based on a movement of 100 basis points in 90 day interest rates being equivalent to a movement of 2 per cent in the trade-weighted measure of the exchange rate, with the average conditions prevailing in the December quarter of 1996 being equal to 1000. Had this experience been a total success, I would have been happy to acknowledge our debt to the Bank of Canada for this experiment! The experience was not a total failure. In particular, it finally persuaded financial market participants, at home and abroad, that we had no exchange rate target in the conventional sense. Prior to that time, and related no doubt in part to the "conditional exchange rate comfort zones" which we had used in the late eighties and early nineties, there had been quite a widespread perception that we were in some sense "putting a floor" under the exchange rate, with the result that investing in New Zealand dollars was a "one way bet". I well recall a conversation with a fund manager in New York late in 1996, at a time when almost all observers felt that the New Zealand dollar was considerably over-valued. Referring to the action by the Swedish central bank to drive overnight interest rates to 500 per cent to defend the krona some years earlier, he asked me whether we would have "the courage" to do the same, to defend the New Zealand dollar. I assured him that there was absolutely no way that I would push New Zealand interest rates to 500 per cent to defend the New Zealand dollar. "Why not?" he asked. "Because we do not have an exchange rate target; we have an inflation target", I replied. "Clearly, if the New Zealand dollar falls sharply, this may have implications for the future inflation rate, and this might require us to push up interest rates somewhat, but the mere fact that the exchange rate declines does not require us to push rates to 500 per cent." He was appalled, and warned me that if my views became known on Wall Street, the New Zealand dollar "was done". I urged him to spread the message since, as indicated, the currency was almost certainly well over-valued by almost any measure at that time. Adopting the MCI in June 1997, and expressing our views about monetary conditions in terms of a "desired" level of the MCI, finally ended the view that the Bank had a covert exchange rate target. It also gave us, for the first time, a quantitative way of telling the market by how much we wanted conditions to tighten or loosen. But the MCI was quickly, and to some extent unfairly, discredited, partly because it was introduced at the very outset of the Asian crisis. That crisis hit demand for many of New Zealand's exports very hard, and it was appropriate that the New Zealand exchange rate declined to reflect that external shock. We recognised that, and gradually reduced our "desired" level of the MCI through the second half of 1997 and the first half of 1998. But we failed to recognise the extent to which the external shock had affected the appropriate exchange rate, with the result that we reduced the MCI too slowly through that period. Even though we were still not setting any interest rate directly, the result was a sharp increase in 90 day interest rates to "offset" the sharp decline in the exchange rate, and we have acknowledged elsewhere that that probably exacerbated the short and shallow recession which took place in the second part of 1997 and the first part of 1998. We relaxed the "bands" around the "desired MCI" in the second half of 1998, and in March 1999 finally moved to a conventional implementation regime, abandoning both the quantity target for settlement cash and, as a signaling device, the MCI, and adopting instead an Official Cash Rate, whereby the interest rate on overnight money in the system is kept within a range of plus or minus 25 basis points from the nominated rate. Our approach to the inflation target itself evolved somewhat over the 14 years. In 1988, the target was simply expressed as "0 to 2 per cent". When the first formal Policy Targets Agreement was signed early in 1990, the target was still 0 to 2 per cent, and there was explicit provision for renegotiating the target if the inflation rate was affected by what we referred to as "caveats" - large external shocks to the price level (such as a big change in the international oil price), changes to indirect tax rates, and similar. The second Policy Targets Agreement, signed shortly after the general election in late 1990, extended the date by which inflation of 0 to 2 per cent had to be achieved from the end of 1992 to the end of 1993, and removed the need for renegotiation of the Agreement if the inflation rate were affected by "caveatable" items. Instead, the Bank was to ensure that CPI inflation excluding such "caveatable" items was within the target. This led us to calculate and publish what we referred to as "underlying inflation", which was CPI inflation less "caveatable" items. But this had all sorts of problems associated with it, not least a perception problem, with the Bank calculating the underlying inflation rate on which the Governor's performance was to be judged. Now we have a target of keeping the CPI between 0 and 3 per cent (the target was widened after the general election of November 1996) and a need to have a good explanation if inflation diverges from that target. The Policy Targets Agreement makes it clear that external shocks, changes in indirect tax rates, and similar factors constitute valid reasons for the inflation rate to diverge from the target for a time. (The latest PTA, signed on 16 December 1999, is attached.) We characterise ourselves as "flexible inflation targeters" rather than "strict inflation targeters", in Lars Svensson's terminology. But there is debate even within the Reserve Bank itself whether we have always been flexible inflation targeters or whether perhaps we have evolved to greater flexibility than we had earlier in our inflation targeting history. There is little doubt that in the early years our rhetoric was rather "strict". We had the challenge of convincing a sceptical public, made cynical by years of broken political promises about keeping inflation under control, that this time there was going to be a serious commitment to keeping inflation under tight control. So we emphasised that monetary policy had been given only a single goal by statute, namely "stability in the general level of prices", and I as Governor was liable to be dismissed for failing to deliver that objective. And we repeated that message, again and again. We recognised that the more quickly we could convince both financial markets and the general public that we were absolutely committed to achieving the inflation target, whatever the cost in terms of unemployment and lost output, the smaller that cost in employment and output would be. Allowing people to think that we were "soft-hearted", and would back off the inflation target as soon as unemployment started to increase, seemed a certain way to increase unemployment. (Having said that, and as indicated earlier, it is not unambiguously clear that demonstrating a strong commitment to a particular inflation target was in fact successful in improving the inflation/unemployment trade-off during the period of disinflation, though my personal view is that it helped.) In those early years, it is probable that none of my colleagues themselves really believed that we would be able to get inflation within a 0 to 2 per cent target and keep it there. But in 1991, two years ahead of the deadline imposed by the Policy Targets Agreement, inflation fell within the target for the first time, to the considerable surprise of many people both inside and outside the central bank. And in 1992, inflation was again within the target. And in 1993. And in 1994. By this time, many people, again both inside the central bank and outside it, were coming to believe not only that inflation could be kept inside a 0 to 2 per cent target, but also that keeping inflation within the target was not such a difficult job after all. Economic growth was among the fastest in the OECD; inflation was within the target; New Zealand dollar 10 year bond rates were marginally lower than the yields on 10 year Treasuries (in the first part of 1994). It all seemed pretty easy. In the year to June 1995, underlying inflation increased to 2.2 per cent, outside the target for the first time since 1991. But that result was influenced in part by an adverse weather pattern in May 1995, which had sharply increased the price of fresh fruit and vegetables. We still thought that we would quickly return to within the inflation target. In the event, we were close to the top of the target, or marginally above it, from the June 1995 year to the December 1996 year. We had all learnt that keeping inflation within such a narrow range was a major challenge, and could probably be accomplished only at the cost of undesirably high volatility in the real economy. We began talking about the inflation target as something to which we would be constantly aiming, but not something which we could or should deliver at all times, and that is how we regard the target today. We recognise that there is a trade-off, not between growth and inflation, but rather between the volatility of growth and the volatility of inflation, and we are prepared to accept some degree of inflation volatility to avoid throwing the real economy around too violently. Of course, we have been immeasurably helped in doing this by the fact that inflation expectations have become more firmly anchored on the target. Were inflation expectations to become dislodged, we would be obliged to return to a stricter and more vigorous pursuit of the inflation target, even at the expense of some short-term output volatility. Single decision-maker or committee? In the New Zealand central bank, all important decisions are vested in the Governor, not in the Monetary Policy Committee or in the Board, even though we have both. We are by no means unique in this structure - laws in both Canada and Israel vest similar powers in the Governor. But the pattern is unusual internationally. There are clearly advantages and disadvantages in all decision-making structures. When Lars Svensson conducted a review of the New Zealand monetary policy framework for the New Zealand government last year, he recommended moving from the present structure to one where monetary policy decisions are made by an internal committee of five, chaired by the Governor. Interestingly, the I was sufficiently new in the central bank, and sufficiently naïve, to assume that it could be achieved, and did not hesitate to sign the Policy Targets Agreement. Underlying inflation peaked at 2.4 per cent in the year to December 1996. Lars Svensson, Independent Review of the Operation of Monetary Policy in New Zealand: Report to the Minister of Finance, February 2001. New Zealand Treasury, the non-executive directors of the Reserve Bank, and most of my colleagues argued against changing the structure in this regard. And the Government also decided not to change the decision-making structure, after consultation with other political parties in Parliament. The arguments in favour of having a single decision-maker related essentially to accountability and communications. The legislation under which the Bank currently operates was passed into law during the late eighties, when there was a heavy emphasis on improving the quality of public sector administration. Devolving more authority to public sector chief executives, and holding them responsible for their outputs, was central to that approach. So when I expressed surprise to the Minister who was responsible for the Reserve Bank legislation that the Bill envisaged the Policy Targets Agreement being between the Minister and the Governor, not between the Minister and the Bank, he explained nonchalantly that "We can't fire the whole Bank. Realistically, we can't even fire the whole Board. But we sure as hell can fire you!" So leaving the Governor in sole charge of monetary policy decisions makes it very clear who is to blame if inflation falls outside the agreed target. Having a single decision-maker also makes communicating the Bank's monetary policy message relatively easy also. Several of my colleagues take an active part in helping to take the Reserve Bank's message to the general public, but the message is the Governor's, not their own. And this consistency of message is, I believe, helpful. Having a single decision-maker is also helpful in the context of the way in which we publish our inflation forecasts. New Zealand is, to the best of my knowledge, the only country where the central bank publishes economic forecasts based on endogenous monetary conditions. In other words, our published forecasts attempt to answer the question: "What monetary conditions will be required to move the inflation rate back towards the middle of our 0 to 3 per cent target range over the one- to two-year horizon?" So the forecasts reveal not only where we think the Official Cash Rate is likely to be in the immediate future, but where, on the basis of present information and clearly specified assumptions about the exchange rate and other variables, it is likely to move over the next couple of years. There are pros and cons of this approach to forecasting - though we are convinced that there are more pros than cons - but I have been told by some of those who have served as members of monetary policy committees in other central banks that such an approach would be virtually impossible where decisions are made by committee. It is often hard enough to reach a decision on what the policy interest rate should be tomorrow without having to work out where it should be over the next year or two. There are, of course, risks in having monetary policy decisions vested in a single individual. In our case, we believe that these risks are substantially mitigated by the clear specification of the target for monetary policy in both legislation and the Policy Targets Agreement; by the high level of transparency required by the legislation; by the way in which the Governor is appointed (by the Minister of Finance, but only where the individual concerned has been recommended by the Board); by the longstanding tradition of open discussion and debate in the Bank; and by the fact that the Bank's Board is charged with the primary responsibility of monitoring the Governor's performance, with an obligation to recommend the Governor's dismissal if directors are not satisfied with his performance under the Policy Targets Agreement. Single mandate or dual mandate? Finally, let me briefly touch on the vexed subject of the central bank's mandate. We clearly have a single mandate: monetary policy was required, by the 1989 legislation, to "achieve and maintain stability in the general level of prices". Period. There is no reference to other objectives, and I am entirely comfortable with that mandate, notwithstanding my healthy regard for New Zealand's most famous economist, the late Bill Phillips. In other words, I am entirely comfortable with the proposition that there is no long-term trade-off between growth and inflation; and that the best contribution of monetary policy to economic growth is the maintenance of low inflation. But I do want to suggest that those who make a major distinction between central banks with a single price stability mandate and those with a dual mandate, such as the Federal Reserve System, exaggerate the difference. Yes, there will be differences in the policy reaction to some kinds of shock 9 I do not propose to get into a discussion at this point about whether bias-adjusted zero inflation is better or worse than some very small amount of positive inflation. for example, a central bank with a dual mandate might ease policy in response to a sharp increase in oil prices because of the adverse effects of such an event on real income, and therefore on demand, whereas a central bank with a single price stability mandate may well leave policy unchanged, or may even tighten somewhat, depending on circumstances. But the reality is that both kinds of central bank regard price stability as the best contribution that monetary policy can make to economic growth. And once price stability has been reached, the actions of a single-mandate central bank will often appear identical to those of a dual-mandate central bank. (Of course, the rhetoric will often be different.) This is because most central banks these days focus their monetary policy attention on some concept of core or underlying inflation, and ignore the transitory impact on prices of exchange rate movements, movements in international oil prices, changes in indirect taxes, and so on. And focusing on core or underlying inflation means to a very large extent trying to assess whether there are unused resources in the economy. In other words, keeping core inflation under control once price stability has been achieved is to a very large extent about keeping the estimated output gap as close to zero as possible. Is the central bank outputsmoothing, or focused exclusively on maintaining price stability? It may be very difficult to tell unless the central bank explains itself, and I would argue the two approaches are often very similar. Even where inflation has been pushed away from target, it will often be difficult to tell the difference between the actions of a central bank with a single mandate and the actions of a central bank with a dual mandate. Yes, in theory there may be a difference, but in practice that difference may be very small or irrelevant. We saw that in 1996, when inflation in New Zealand was slightly above the thentarget of 0 to 2 per cent. We chose to move back to the target over a number of quarters rather than more quickly, partly because we did in fact make the judgement that the economic costs of moving back to the target very quickly would have been unjustified, but also because we recognised that to have achieved a very early return to target would have required a drastic tightening of policy, with the severe risk that further down the track the inflation rate would have gone below the bottom of the target. Personally, I am very comfortable with our single mandate, especially in the New Zealand context where we have had a long history of believing that monetary policy can do a whole range of things which we now realise have very little to do with monetary policy. The end of history? Is inflation targeting "the end of history" from a monetary policy point of view? Certainly, I believe it has a huge amount to commend it, and the arguments against its adoption seem, in most situations, to be rather weak. But there remain a number of important unresolved issues, in inflation targeting as in other approaches to monetary policy. How best should central banks communicate the conditionality of their inflation forecasts, while still conveying useful information? Why do movements in the exchange rate now seem to be having such small effects on inflation - does this reflect something about the nature of inflation targeting, or perhaps just some peculiarity of the most recent economic cycle? To what extent can central banks make sufficiently reliable estimates of the output gap, and to what extent do changes in the output gap now affect the inflation rate? And perhaps the most troubling question for us all, inflation targeters and others: is there more to achieving monetary stability than calibrating the central bank's interest rate to keep the prices of goods and services purchased by the household sector stable? During the last decade or so, consumer price inflation has been exceptionally well behaved in most major economies. But at the same time, we have experienced episodes - indeed some severe episodes - of monetary instability in other guises, including asset price instability, financial system instability, and exchange rate crises. These experiences leave us with plenty of unanswered questions. What might Japan have done differently to avoid the bubble, and subsequent collapse, in asset prices - a collapse which has done so much damage to the Japanese monetary system and the Japanese economy more generally? And what might Japan do now, facing more generalised deflation? Are we entirely confident that, in 10 years The suggestion that monetary policy might have reached the "end of history" in the sense that Francis Fukuyama had in mind was first raised, and rejected, by Stephen Grenville, then Deputy Governor of the Reserve Bank of Australia, in an address to the 30th Anniversary Conference hosted by the Monetary Authority of Singapore on 20 July 2001. time, we will be looking back at the recent episode of asset price inflation and deflation in the US with complete satisfaction? We know that monetary policy can keep consumer price inflation under control, and we believe that inflation targeting has been an effective way of achieving that. But clearly there are plenty of challenging issues for our successors to deal with.
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Speech by Mr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers' Chamber of Commerce, Canterbury, 25 January 2002.
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Donald T Brash: An indebted people Speech by Mr Donald T Brash, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers' Chamber of Commerce, Canterbury, 25 January 2002. * * * Mr Chairman, ladies and gentlemen I am delighted to be here again for my ninth annual address to the Canterbury Employers' Chamber of Commerce. Last year I spoke to this audience about what goes on "behind the scenes" in formulating monetary policy at the Reserve Bank, and over the years I have addressed a wide range of topics. In 1998, I talked about New Zealand's balance of payments deficit and its relevance to policy-makers. The topic of that speech was "New Zealand's balance of payments deficit: does it matter?" I want to return to this topic today, from a slightly different tack. As part of our brief to watch out for things to do with financial stability, we in the Reserve Bank have been doing some thinking recently about New Zealand's dependence on foreign capital and some of the risks that that exposes us to. (As an aside, it seems fitting to be addressing this topic in Christchurch this year, as my own Masters thesis, submitted to the University of Canterbury forty years ago this year, was entitled "New Zealand's External Debt Servicing Capacity" - although I am bound to say my understanding of the issues has evolved considerably since that time!) Just how dependent are we on foreign capital? By international standards, and by our own historical standards, New Zealand is unusually dependent on foreign capital. Since the mid-1970s, New Zealand has consistently spent more on goods and services from abroad, including the income paid to the foreigners who have provided us with capital, than it has earned from exports. It has, in other words, consistently run a current account balance of payments deficit. Each of these deficits has had to be financed by capital inflows of one kind or another. Source: Statistics New Zealand Speech to Canterbury Employers' Chamber of Commerce, 30 January 1998. See, for example, the article "International capital flows, external debt, and New Zealand financial stability" in the December 2001 issue of the Reserve Bank's Bulletin. Four years ago when I talked about the current account, the deficit stood at 6.4 per cent of GDP, then one of the largest deficits in the world relative to GDP. In fact, the deficit deteriorated further, peaking at 7.0 per cent of GDP in the year to March 2000. The latest information we have is for the year to September 2001, when the current account deficit was 3.4 per cent of GDP. That is low by recent New Zealand standards. But what matters is not any particular year's current account deficit - whether the 14 per cent peak deficit in 1975, when the terms of trade collapsed, or the rather lower deficit of the last year, helped by good commodity prices and an unusually low exchange rate. What matters, when we think about financial stability, is the accumulation of deficits: the stock of debt and equity finance which foreign investors have provided to this economy over the years, and the relationship of that stock to our wealth and income. Capital inflows match (and fund) a current account deficit. Capital inflows can take the form of debt (foreigners lending to us) or equity (foreign investors buying property and shares in other productive assets in New Zealand). But each inflow adds to the stock of foreign debt and foreign ownership. The numbers involved are large. If we add together all the current account deficits since 1975, they total almost $80 billion, and of course there were substantial amounts of foreign debt and foreign ownership prior to that date. Source: Statistics New Zealand I have no doubt that foreign investment in New Zealand has been very beneficial to the New Zealand economy and to most New Zealanders, and that is especially true since we abolished the subsidies which we used to extend to some foreign investors through our protection of internationally uncompetitive industries. Of course, there is nothing inherently wrong with borrowing or debt either. I differ, for example, from a strict interpretation of the sentiment Mr Micawber expressed in Charles Dickens's "David Copperfield": "Annual income twenty pounds, annual expenditure nineteen pounds nineteen shillings and sixpence, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and sixpence, result misery." Taking on debt permits spending and investment earlier than would otherwise be possible. It can provide a buffer when income is temporarily low, and help finance profitable investment opportunities. This applies both to individuals and to nations. Much of the initial infrastructure of this country was financed by foreign borrowing from the United Kingdom in the nineteenth century. However, the more indebted a country is the more vulnerable it is to things going wrong. In many ways, the story is the same for a country as for a highly indebted individual - everything is fine as long "Foreign investment in New Zealand: Does it threaten our prosperity or our sovereignty?", speech to the Wellington Rotary Club, 20 November 1995. as there is the willingness and the ability to service the debt. But the higher the level of debt, the more exposed the individual is if, say, he or she is made redundant or faces unexpected expenses. I mentioned a moment ago that we have run current account deficits totalling around $80 billion since 1975. The best official measure of how reliant we are on foreign capital is Statistics New Zealand's International Investment Position data. That shows that our total net use of foreign capital - allowing for the best estimates of New Zealanders' holdings of foreign assets - is around $88 billion, or nearly 80 per cent of GDP. Moreover, the gross numbers matter too - the total amount of capital which foreigners have provided to New Zealand is around $170 billion. There is a mix of debt and equity: the distinction between the two isn't always clear cut, but in the official data approximately $120 billion of the total takes the form of debt. Source: IMF In isolation, these figures don't mean very much; and, after all, many of us have had mortgages well in excess of one year's income. International comparisons can help us gain a better perspective. Most mature and highly developed economies in Europe and North America are either net lenders to the rest of the world, or have financing from abroad equivalent to only 20-30 per cent of GDP. Even Australia, with its own history of persistent current account deficits, is only about half as dependent on foreign capital as we are. It is not easy to draw strong conclusions from international comparisons, as there are measurement difficulties in comparing data from different countries. However, it does seem that New Zealand is now much more dependent on foreign capital than any of the developed countries we like to compare ourselves with. One exception is the tiny - but much wealthier - country of Iceland, which is in about the same position. Looking back over history, the data are not as reliable, but it is not obvious that any developed country in the post-war era has been more dependent on foreign capital than we are now and certainly none since the general liberalisation of private capital flows over the last few decades. As I suggested earlier, a heavy dependence on foreign capital - whether of debt or of equity - need not be a problem. What matters is how that capital is used, and what is happening to the incomes and assets of those raising the finance. I have noted on many occasions that Singapore ran very large current account deficits, averaging around 11 per cent of GDP, for a long period in the 1970s. As any businessperson knows, borrowing or raising outside equity makes a lot of sense if there are profitable investment opportunities available. At a national level, an unusually high degree of dependence on foreign capital (especially debt) makes a lot of sense if there are opportunities that mean it is reasonable to expect the rate of economic growth to take a big step up, and to move ahead of the average. Tax considerations often encourage foreign parent companies to finance their local subsidiaries in the form of debt rather than equity, and some instruments are designed to be equity for some purposes and debt for tax purposes. Ireland may have been an exception in the late 1970s and early 1980s (the data do not allow a direct comparison). Singapore got that sort of pay-off. That country graduated from being a low-income developing country in the 1950s to the point where it now has per capita incomes higher than our own. Unfortunately, we haven't achieved a similarly dramatic transformation. Yes, our GDP growth performance has been better in the 1990s, but on most measures (eg growth in output per hour or per person employed) it has still not been as good as those of other, much less indebted, developed nations. Australia's picture looks better: although our trans-Tasman cousins have also run relatively large current account deficits, and are therefore also relatively quite heavily dependent on foreign capital, they achieved growth rates among the highest in the developed world during the 1990s. But even that does not get to the crux of the issue for New Zealand. Gross domestic product is a measure of the income generated within New Zealand, and New Zealand's growth in GDP was not too bad during the 1990s. But because we have become increasingly reliant on finance from foreign savers, an increasing share of the income this economy generates goes (in interest and dividends) to those who financed us. Gross national product is a measure of the income generated by New Zealanders' own resources. Unfortunately, GNP per capita in New Zealand barely increased at all during that time. In other words, because we have been such heavy users of capital from foreign savers - so reluctant to save enough to provide our own investment capital - much of the growth in the New Zealand economy in recent years has accrued to those foreign savers. This is not a speech about why our growth performance has been disappointing. I have spoken on that and related issues on other occasions, including to this audience two years ago. Instead, I want to devote the rest of this speech to looking briefly at how we came to be so dependent on foreign capital, and then turn to outlining some of the risks that that dependence may expose New Zealand to. How did we get into this situation? I don't think there are too many easy answers to the question of why we became so dependent on foreign capital. I think it is clear, however, that the current situation is more a reflection of private sector choices over a number of years than of government decisions, though of course to the extent that government policies have influenced private sector choices those government policies must share some of the responsibility. At the heart of the issue, countries run up obligations to foreign investors when, in total, they are spending (consuming or investing) more than they are earning. Let me stress that government borrowing is not the issue today. When we first ran large current account deficits in the 1970s, and through to 1984, government fiscal deficits accounted for much of the excess spending that gave rise to the current account deficits, and government borrowing abroad financed those deficits. As late as the early 1990s, New Zealand's total government debt was relatively high by international standards - though never anywhere nearly as high as the public debt of countries like Ireland, Belgium and Italy, or indeed Japan today. But a decade or more of prudent fiscal management means that our net public debt is now among the lowest in the developed world. Good comparative data are hard to come by, but it seems likely that the New Zealand government's overall net asset position is today at least as good as the average for developed countries. It is also worth noting that the New Zealand government now has no net foreign currency debt. The small amount of foreign currency government debt still outstanding is fully matched by foreign currency assets held by the Treasury and the Reserve Bank. The limited net amount of debt still owed by the government to foreigners is in the form of locally-issued New Zealand dollar bonds that foreign investors have bought on the local bond market. Nor is privatisation to blame. Many of the formerly government-owned assets that have been sold have ended up owned by foreign investors. But selling the assets didn't change the spending habits of New Zealanders. The deficits needed to be financed: selling assets (whether privately owned or publicly owned) has been one way of doing that, and if we hadn't sold such assets, we would have had to finance those deficits by going even further into debt. As I said a moment ago, current account deficits need to be financed, and that financing can take the form of either equity or debt. If not equity, then debt; if not debt, then equity. "The building blocks of economic growth", speech to the Canterbury Employers' Chamber of Commerce, 26 January 2000. See also "Faster growth? If we want it", a speech to the Catching the Knowledge Wave conference, 2 August 2001. Who then is behind the spending that has made us so reliant on foreign savings? The "culprit" has been the private sector - and New Zealand households in particular. The share of their incomes that New Zealand households are saving has fallen away very markedly. Household savings rates fell in a number of developed countries over the last ten years or so. But, while some caution is needed because of cross-country measurement difficulties, New Zealand's record looks particularly poor. Fifteen years ago, our household saving rate was not too bad by developed country standards. But by 2000, we had slipped down to the bottom of the OECD developed-country class. By that year, our households were, in aggregate, spending more than their income. The OECD average saving rate that year was 8.4 per cent. Source: Statistics New Zealand The sharp fall in the household savings rate has not been sufficiently offset by increased savings in other sectors of the economy, so that now our overall national savings rate also appears to be the lowest among the developed OECD countries. If we, as New Zealanders, are not saving very much, somebody else - somebody overseas - has to finance the ongoing investment the economy needs. Our level of investment is not unusually high, but our savings rate is unusually low. Why are we, on average, saving so little of our incomes? I have, from to time to time, suggested that we are poor savers because we have been effectively told by successive governments for more than half a century that we do not need to save for the things that people in many other countries save for. We have been reassured that government will care for us if we get sick; that government will pay for the primary, secondary, and tertiary education of our children; that government will care for us in old age. "You don't need to save" has been the message. And successive governments have also effectively told us, by their behaviour during the seventies and eighties at least, that if we nevertheless do save we would lose our savings through high inflation, and strongly negative after-tax real interest rates. But while there may be something in that explanation, it does not really explain either why our savings performance is so much inferior to that in, for example, most European countries (where the social welfare net is at least as generous as it is in New Zealand), or why our savings performance has actually deteriorated in recent years, as government's commitment in health, education, and retirement income has become a little less generous, as inflation has been largely eliminated and as real after-tax interest rates on savings have become positive. In principle, another possibility is that the savings rate (from current income) might be falling because households own assets that have risen in value, making people feel that there is less need to save from current income. This seems to have been the story in the United States - which has also become much more dependent on foreign savings in recent years. Ten years ago, US household saving rates were around 8 or 9 per cent, but by the end of the decade (at the end of the longest and strongest equity market expansion of the twentieth century), the US savings rate had dropped to just 1 per cent. One might question just how robust those high asset prices will prove - on most longer-term metrics, US share prices still look to me to be rather considerably overvalued. But, if people believe the wealth gains will last, it does make sense for them to increase spending and reduce savings in response. We, by contrast, have not seen soaring asset prices of that sort - indeed, the data suggest that real household wealth has been falling for several years. There are very real data difficulties in comparing wealth in different countries, but New Zealand stands out in the data we do have: we have a low ratio of wealth to income, indeed the lowest of the developed countries we've looked at. Our numbers are likely to be understated - in particular, farms are not included in the data, and farms make up a larger percentage of wealth here than in most other developed countries. But even if adjustments were made for these factors, it seems unlikely to change the overall picture materially. And our relative position in those league tables looks much worse than it did a decade ago. It is worth highlighting a few numbers. Financial assets and liabilities are easier than most to get a good fix on. New Zealand households' net financial wealth (deposits, shares, unit trusts, pension funds, etc less household debt) is estimated to be only around 70 per cent of our annual disposable income. In the bigger developed countries, that ratio averages around 270 per cent - even after the fall in international share prices last year. Even allowing for the inevitable problems in putting together such cross-country comparisons, and for the possibility that international share prices still have some further adjustment to do, that is a large - and sobering - difference. Put another way, the debt of the household sector in New Zealand is very much higher, relative to the sector's financial assets, than in many other developed countries. Household net financial wealth to income ratios 1990-2001 change 1995-2001 change US 261.8 304.7 333.0 71.2 28.3 Japan 260.3 283.8 356.9 96.6 73.1 Germany 130.8 140.4 150.0 19.2 9.6 France 130.6 184.7 264.4 133.8 79.7 UK 211.8 291.2 333.2 121.4 42.0 Italy 196.3 217.1 250.0 53.7 32.9 G6 198.6 237.0 281.3 82.7 44.3 Australia 253.0 218.4 266.0 13.0 47.6 New Zealand 102.7 108.6 70.4 – 32.3 – 38.1 Per cent Source: OECD, national sources, and UBS Warburg. 2001 data are forecast, except for NZ, which are 2000 actuals. Household debt to household financial assets ratios 1990-2001 change 1995-2001 change US 25.0 23.6 23.8 – 1.2 0.2 Japan 3.4 32.7 27.1 – 6.3 – 5.6 Germany 34.9 42.5 41.1 6.2 – 1.4 France 40.3 25.8 17.3 – 23.0 – 8.5 UK 35.6 24.9 24.4 – 11.2 – 0.5 Italy 12.9 12.9 12.9 0.0 0.4 G6 30.4 27.0 24.4 – 5.9 – 2.6 Australia 30.8 36.7 40.4 9.6 3.7 New Zealand 39.1 47.3 64.5 25.4 17.2 Per cent Source: OECD, national sources, and UBS Warburg. 2001 data are latest estimates based on monthly or quarterly figures, except for NZ, which are 2000 actuals. Unlike most developed countries, in New Zealand houses make up the overwhelming bulk of our relatively modest net wealth. Of course, we all have to live somewhere, but especially in a low inflation environment, houses do not offer a high investment return - either to most of us as owner-occupiers or to those holding investment properties (although I acknowledge the incentives created by the present tax regime). It is perhaps worth noting that New Zealand home ownership is no longer particularly high by developed world standards and, although getting consistent data over time is not easy, may even be slipping down the international rankings. I suspect this may surprise some people, as we tend to see ourselves as a nation of home-owners tending the quarter acre plot. It isn't obvious that we are building a disproportionate number of houses either, but perhaps - by default as much as by design we are rather too keen on having a house as the principal asset in our investment portfolios. What we haven't done is built up or maintained holdings of other income-earning assets. Later this year, the Retirement Commissioner will release a report based on a fairly comprehensive survey of New Zealand household wealth. While I have not seen the report of course, it will undoubtedly add a great deal to our understanding of household balance sheets. I suspect that underlying the aggregate figures - and by that I mean the household sector as a whole - some disturbing figures could emerge about just how low the wealth and savings of even the middle-aged middle income sections of our society are. What still isn't so clear is why we have cut our savings rate to such a low level. Part of it, of course, is simply that we could. In many developed countries following financial deregulation, households have run debt levels up quite substantially. Refinancing, and drawing down the equity in one's house, has become much easier - with revolving mortgage facilities, people can and do now "put the groceries on the mortgage". Banks have, at times, marketed this opportunity aggressively. I can recall one innovative television advertisement that encouraged home-owners to "put the boat on the house", and illustrated the message by depicting a boat balanced on the roof of the house. The wisdom of following their advice literally, or financially, was for the householder to determine! But whatever the wisdom, households went on a borrowing spree - we estimate that household borrowing increased by $45 billion during the 1990s alone, from 57 per cent of disposable income in 1990 to 110 per cent in 2000, and that despite loud complaints from some about the high real interest rates on such borrowing. Perhaps a little paradoxically, lower inflation also facilitated the increase in debt. When inflation was high, high nominal interest rates meant that bank limits on debt servicing as a share of income cut in very quickly. Given the way mortgages are structured, lower inflation, and the lower interest rates which come with it, have allowed individuals to borrow more than they could in high inflation periods. As we've highlighted in a number of our Monetary Policy Statements, household debt-to-income ratios now seem to be fairly similar to those in, say, the United States and the United Kingdom. But postderegulation adjustment to international norms isn't enough of an explanation. The difference between New Zealand and most other developed countries is that we do not have as many assets as householders in other developed countries do. Basically, we have borrowed to finance consumption or relatively unproductive investments. Source: OECD and Reserve Bank of New Zealand More work is needed in this area, but my own sense of what has gone on is relatively prosaic. Our incomes haven't been growing as rapidly as those in other comparable countries. But the range of goods and services available to us has increased dramatically, as we have liberalised and as other countries have grown - indeed, it is often commented just how good the services available in New Zealand now are. If our tastes (our demand for goods and services) are increasing faster than our income, savings inevitably fall. We were able to finance the difference between our low level of savings and our average level of investment expenditure by accessing the savings which foreigners made. Over the years, those differences have added up to large numbers. Average investment as a percentage of GDP 1988-1999 Residential Investment % Investment excluding residential % Finland 5.0 15.9 Netherlands 5.8 15.8 Denmark 3.9 15.2 US 4.0 14.6 Italy 5.0 14.5 New Zealand 4.9 14.3 UK 3.4 14.4 Australia 4.9 18.3 Canada 5.6 13.5 Average 4.7 15.2 Country Source: OECD Quarterly National Accounts What does it all mean? What should we make of all this? As I noted at the outset, the more indebted we are - as individuals and in aggregate - the less resilient to adverse economic shocks we are, and the higher the potential vulnerability. Without automatically presuming that there are problems, central bankers thinking about potential risks to financial stability should be prodding and probing when financing patterns in the economy look very different from international norms, or when structures and stocks change rapidly in a relatively short space of time. The changes in New Zealand debt levels over the last 15 years have been very marked and have taken us increasingly away from international norms. In recent years, and particularly following the Asian crisis, the Reserve Bank has been devoting more attention to thinking about potential risks, both economic and financial. Internationally, we have seen numerous financial crises over the last decade or so. Part of our work in this area has highlighted the encouraging features that differentiate New Zealand from the crisis countries, a point I will come back to in a moment. It is worth noting that, since capital account liberalisation 18 years ago, the country's increasingly large external financing requirement has been met remarkably smoothly through a variety of international crises and changing domestic economic and financial conditions. But the perennial question concerns what sort of shocks or emerging points of vulnerability should we be alert to. If things turned against us, where might the pressure points in the economy and the financial system be? In essence, there is one big New Zealand imbalance that manifests itself in two - connected - ways. First, our household sector balance sheets appear to be very out of line with the international norm. And second, we are very dependent on foreign capital, with a large share of that in the form of debt finance. Let's remind ourselves of the connection. Households do not, of course, typically borrow directly from overseas. Instead, they borrow from domestic banks. But that bank lending has to be financed somehow. Some of it is effectively financed by New Zealanders selling their holdings in New Zealand listed companies: we've seen a lot of that in the last 12-18 months as a low exchange rate has made many New Zealand companies appear very cheap to foreign buyers. But the household demand for credit has substantially exceeded the rise in the bank deposits of New Zealanders. As a result, much of the household borrowing has ultimately been financed by banks' borrowing from overseas. New Zealand banks now rely more heavily on overseas borrowing than banks in any other developed country - roughly a third of the total assets of the banking system are now funded by borrowing overseas, though not all of this funding is used to make loans to the household sector. Or measured another way, of the total increase in banks' balance sheets during the nineties, roughly a third has been financed from offshore. Of course, the average borrower isn't even aware of this (and need not be) - she goes to the bank on the corner and finances her house without realising from where the funds are sourced. Financial intermediaries do their job very well, bringing together domestic borrowers and often-foreign providers of funds. Interestingly, individual loan-to-valuation ratios appear to be relatively conservative (and bank balance sheets are in very good shape in New Zealand), but I wonder how sustainable existing property prices would be if households ever decided to try to adjust their savings patterns, bringing their holdings of assets more into line with the international mainstream - looking to buy more shares, or to invest more in small and medium-sized businesses, for example. Think, for example, of a large number of "baby boomers" realising that they really do not have enough income-generating assets to support a good lifestyle in retirement, and foregoing the next move up to a bigger house. In aggregate, the effects could be large. Think also of the impact on consumption spending, and the demand facing large parts of the business sector, if the household savings rate were to move back to 10 per cent of disposable income over a relatively short period of time. And of the possible implications then for the quality of bank loan books - built up at times when demand has been strong. We all hope that the imbalances resolve themselves gradually and without undue disruption. And there are some encouraging signs. Having run up debt over the 1990s (in particular), credit growth rates are now much lower than they were in the mid-1990s. And the lack of house price inflation in recent years is a salutary reminder of what life should be like in a low inflation environment. Perhaps households may be beginning to stand back and consider their overall balance sheets. This certainly seems to be the sector of the economy that needs to think about how well placed it would be to absorb a shock - a large drop in house prices, the loss of a job, and so on - and indeed the assets required to support a good quality of life in retirement. Nonetheless, we cannot be complacent. Lending to households continues to grow faster than incomes are rising. And the current account position itself, although improving in the last couple of years, is not overly encouraging given the strength of New Zealand's export prices recently and the fact that most commentators, ourselves included, believe that our exchange rate is substantially undervalued. Unless the current account deficit stays below around 4 per cent of GDP or we achieve a rather faster rate of economic growth than we have managed in recent decades, the ratio of net foreign capital to GDP will continue to increase from already unusually high levels. Resolving imbalances, even "naturally" if borrowers voluntary come to the conclusion that they are over-extended, can be painful, and it seems to be in the nature of life that adjustments of this sort don't always occur easily or smoothly. Often they seem to require some sort of external prompt or trigger. Browsing in a second-hand bookshop recently, one of my colleagues came across the following salutary observation from a New Zealand commentator writing in 1886: I fear it is of no use writing against excessive borrowing. The disease must run its course and no one will rejoice more than the writer if a certain cure is found for it. There are reckless lenders as well as reckless borrowers and the two must share the difficulties and troubles which may be in store for them in the future. One obvious area of risk is that those who are providing the finance from abroad may reassess their willingness to go on doing so. A sharply increased cost of overseas finance, for example, could dramatically alter the situation facing many New Zealand households. The external finance we now use takes a variety of forms: some short-term and some long-term; some debt and some equity; some in New Zealand dollars and some in foreign currency. The conventional wisdom is that the risk of financial instability tends to increase as the proportion of short-term liabilities increases, as the proportion of debt increases relative to equity, and the greater the proportion of liabilities denominated in foreign currency. Of course, these are simple rules of thumb not immutable laws of nature. They do not always hold. For example, it is clear that much of the apparently short-term debt owed by the New Zealand private sector is owed by foreign-owned subsidiaries to their overseas parents, and is quite unlikely to be called up at short notice. Sometimes, long-term debt can create less vulnerability than equity: an investor's equity stake could be short-term in nature, while long-term debt holdings might be part of an overall relationship between highly-integrated foreign parent companies and local subsidiaries. Even if the underlying equity investment itself is a long-term one - and it can often be difficult to off-load large or controlling interests quickly - equity holders may move to hedge themselves against currency risk if they fear that the exchange rate is vulnerable to a fall. That sort of selling could exacerbate any pressures on the exchange rate. Foreign currency borrowing is generally held to be much riskier than domestic currency borrowing, and most of the private sector's external debt is denominated in foreign currencies. But at the same time, the overwhelming majority of that foreign-currency debt is hedged back to New Zealand dollars (by contrast, most heavily indebted developing countries are unable to raise foreign funding in their own currencies). That meant that our banks and corporates got through the sharp fall in the exchange rate during the late 1990s - a fall which saw the New Zealand dollar fall against the US dollar by some 45 per cent from peak to trough - almost entirely unscathed. But the very fact that so much of the debt is hedged raises further questions. If New Zealand residents are not directly exposed to foreign currency exchange rate risk, who is taking the risk? If we can effectively borrow from abroad in New Zealand dollars, someone must be willing to lend in New Zealand dollars - someone, most likely, without a strong "natural" interest in holding New Zealand dollar assets. Unfortunately, we cannot be sure who these holders are, what drives them, or what might make them reconsider their willingness to be exposed to a relatively small peripheral currency. Financial systems and currencies can become illiquid quite quickly. Once investors begin to doubt the safety of the assets which they have tied up in a financial system or specific currency, they may want C.R. Carter, An Historical Sketch of New Zealand Loans and Other Matters Connected Therewith from 1853 to 1886, London, 1886 to liquidate them quickly - the more so when, as in New Zealand's case, we feature in few of the international "benchmarks" that shape where portfolio managers place the bulk of their funds. There are considerable advantages in maintaining an independent currency and free movement of private capital, but it does mean that stability relies to an important extent on maintaining the confidence of market participants in the currency and the financial system. An unusual feature of New Zealand's offshore financing is that such a large proportion of the financing now takes the form of hedged foreign currency financing undertaken by a relatively small number of banks. The ability of those banks to continue tapping the international markets, and to continue effectively hedging the foreign currency risks, is clearly a point of vulnerability. That is likely to be closely linked not only to their own financial health, but also to the financial health of the small number of overseas parents. Under some circumstances, all this could become much more difficult. For example, even shocks outside the control of the borrowing bank or its overseas parent, such as a slip in New Zealand's credit rating (or indeed, in Australia's rating, given the dominant role of Australian banks in New Zealand), could trigger a reappraisal of the risks inherent in dealing in the New Zealand market. Below certain ratings thresholds it can be impossible to tap financial markets. Concluding remarks Clearly there are risks in being as heavily dependent on foreign savers as the New Zealand private sector has become. Heavy reliance on foreign capital is something New Zealand shares with many of the countries that have experienced exchange rate or banking system crises in recent years. But fortunately New Zealand differs from these countries in many respects, and our points of vulnerability and it is no more than heightened vulnerability - appear to be rather specific to New Zealand. We have had a floating exchange rate for 17 years. That has made borrowers appropriately cautious in ensuring that their borrowings are well hedged, and can help the economy adjust to adverse economic shocks. Unusually among heavily indebted countries, we are readily able to tap international capital markets in our own local currency. We have a sound macroeconomic policy framework, a government committed to running fiscal surpluses, and a relatively low level of government debt. We do not have a large bubble in asset prices just waiting to burst. Our banks are well-capitalised and well managed, and have very low levels of non-performing loans by international standards. There is a good level of high-quality disclosure about the financial position of banks and the government. And yet the very fact that imbalances of the sort I have highlighted in this speech can emerge, even against the backdrop of what appears to be such a sound well-designed policy framework, is part of what makes our situation quite unusual - and hard to know just how things will work out from here. Other countries have not been this way before. Can I say unambiguously, however, that I am not predicting some sort of financial crisis for New Zealand. Yes, it appears that quite substantial adjustment in household balance sheets will be needed over time, and that will begin to reduce the levels of external indebtedness. We all hope that that adjustment will occur gradually, voluntarily, and against the background of favourable international circumstances. That seems by far the most likely outcome. But the message of this speech has been simply that when the ratios are as stretched as they have become in New Zealand, we are more vulnerable if things goi ng wrong - and that is something which firms, households, the government, and a central bank focused on financial stability need to be aware of. All that underscores the importance of a sound macroeconomic framework for fiscal and monetary policy, and of robust and well-managed banks. For us at the Reserve Bank, it also highlights the need for continual monitoring of the nature of the risks and the ways in which demand for finance, and the terms on which it is available, are changing. I have not devoted any time today to the question of what more public policy could or should do about this picture. Those are issues for another day.
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reserve bank of new zealand
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Rotary Club of Wellington, Wellington, 25 November 2002.
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Alan Bollard: The evolution of monetary policy Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Rotary Club of Wellington, Wellington, 25 November 2002. * * * As a new central bank governor, what I would like to do first is to give you an overall perspective on the role of the Reserve Bank in the New Zealand economy. I will then focus in on the role of monetary policy, and the implications of the new Policy Targets Agreement, and conclude by discussing how all this relates to achieving strong and sustained economic growth. Monetary policy formulation is a key function of the Reserve Bank, and it is often in the news. But the public attention obscures the other important tasks that the Reserve Bank undertakes. In the hubbub, the fact that monetary policy is part of a larger picture is often lost. The overall purpose of the Bank, as I see it, is to maintain the stability and efficiency of the New Zealand financial system. By the financial system, I mean the tools with which New Zealanders make transactions with each other and with the rest of the world. For very simple transactions, New Zealanders use notes and coins issued by the Reserve Bank. As you may know, nowadays our bank notes are made out of a polymer material that lasts much longer than in the days of paper money. This reduces the Reserve Bank’s costs. A side effect is that you’ll be seeing Dr Brash’s signature around the place for a while yet. Polymer notes are also very difficult to forge, because of their modern security features. That relates to our goal of an efficient financial system. A banknote that is easy to forge would make transactions difficult. Imagine having to check every twenty dollar note that came out of an EFTPOS machine. Of course, nowadays most significant payments are made using electronic means of transferring funds provided by the financial system. These are much cheaper, faster, and more secure than using large volumes of cash, particularly over long distances. The financial system also facilitates transactions that involve borrowing and lending. For example, individuals accumulate savings in our financial system, and invest those savings in assets like shares and term deposits. These funds then often find their way to New Zealand corporations and households, and are used to build New Zealand’s infrastructure. Typically, the individual investor receives a return on those investments, and is able later on to draw on the originally invested funds. We often take this system for granted, yet its smooth operation is essential to the wellbeing of the New Zealand economy. Banks play a key role in directing funds from individuals who wish to save to individuals who wish to borrow. The system works because people have confidence that funds deposited in banks will be available to them in the future, and that those funds will retain their buying power through time. The Reserve Bank has a central role in providing the regulatory framework for institutions that wish to describe themselves as “banks”. We register banks and we monitor their compliance with a comprehensive financial disclosure regime, required minimum capital adequacy ratios, and limits on the loans they can make to related parties. Our framework emphasises the role of bank directors in ensuring that banks effectively manage their risks, and on the role of the market in strengthening incentives for prudent management. This helps to promote a sound banking system. However, no banking system is without risk. Depositors still need to make their decisions carefully. Banks in New Zealand are not guaranteed by the Government or the Reserve Bank. There is no mandatory deposit insurance in New Zealand. I mentioned that an efficient financial system needs to have mechanisms by which money can be stored. This is so people can access their money when they need it, without their savings having eroded in value. Ensuring that money holds its value is the primary purpose of monetary policy. Indeed, by statute the Governor of the Reserve Bank is required to use monetary policy to keep the buying power of the New Zealand dollar broadly stable over time. Maintaining price stability does not mean keeping the price of each and every item the same. I am charged to maintain a stable overall level of prices, but individual prices are always changing. Some things, like computers, will probably continue to get cheaper, while some other things may continue to get more expensive, like Martinborough Pinot Noir. But the overall buying power of people’s savings is intended to remain broadly constant over time. In the current Policy Targets Agreement, I am specifically directed to attempt to achieve trend inflation outcomes between 1 and 3 percent. Why is this the primary objective of monetary policy? Both economic theory and hard experience suggests that money holding its value over time helps an economy achieving its potential. Stable money is not a silver bullet, and on its own it can achieve little. However, stable money is one of the building blocks of a successful economy. Yes, I could use monetary policy to engineer temporary economic growth. By lowering interest rates I could encourage people to borrow and spend for a period. As firms saw increased demand for their products, they would seek to expand output to meet that demand. They would invest in new capital and hire more workers, and this would create even more demand in the economy. At first this would look like a virtuous circle, one which could lead to an extended period of economic growth. The problem is that lowering interest rates for a period can not create out of thin air the resources needed for growth. Firms that tried to employ more labour and buy more capital goods would quickly run into shortages. That would lead to cost increases for them, and also lead them to put prices up themselves. Eventually, rising costs would make people realise that their increased activity was not profitable. Then the boom would turn into a bust, and firms would be forced to retrench. Moreover, during the boom period, inflation would rise beyond the price stability target, and the perverse incentives that inflation causes in investment and planning decisions would begin to weaken the economy. To be sure, if I allowed inflation to climb to just 4 or 5 per cent, the effect would be more subtle than the damage done when we had much higher inflation back in the 1970s and 1980s. But 4 to 5 per cent inflation would add nothing to New Zealand’s enduring growth rate and it might well trigger a larger inflation problem later on. So I have committed to deliver a trend rate of inflation consistent with the 1 to 3 percent range in the new Policy Targets Agreement. In other words, I plan to deliver a similar inflation rate to the one New Zealand has seen over the last decade. But it is also important to make clear that monetary policy in the 21st century involves more than just fighting inflation. I’ve described our over-arching goal as maintaining the stability and efficiency of the New Zealand financial system. Thus, the Reserve Bank cannot afford to be, in the words of Bank of England Governor Eddie George, “Inflation nutters”. We are not permitted to cure the patient by killing it. Let me explain how flexible monetary policy avoids such a result. By its nature, the New Zealand economy is often hit by economic disturbances - for example, changing conditions in the world economy, El Nino and La Nina periods in the weather and fluctuations in the number of people moving to and from New Zealand. All these things can have major impacts on the New Zealand business cycle. They frequently also have consequences for the inflation rate, which are sometimes temporary in nature. One example likely to have only a temporary effect is a drought, which in the short term typically pushes up the prices of agricultural products like fruit and vegetables, generating inflation. However, increases in the prices of things like fresh fruit and vegetables generally would not be seen by the public as the start of a general inflation problem. So it is unlikely that the inflationary consequences of this sort of disturbance would be long lasting. That is particularly true because overall spending in the economy would be reduced by a drought, because farm incomes would be down. So if monetary policy is excessively focused on price stability and we attempt to stop inflation caused by temporary climatic shocks, we could end up exacerbating a recession. By contrast, a policy which looks through short-term inflation fluctuations is much less disruptive to the real economy, and, of course, that’s what we do. In addition, the challenges that central banks face change over time. Look at other developed countries over the past decade or so. Having successfully eliminated the inflation problems of the 1970s and 1980s, central banks could be forgiven for expecting the late 1990s and this decade to be an easy ride. In reality, many central banks face arguably greater challenges. For example, in Japan, despite interest rates falling to very near zero, weakness in private sector demand has persisted for the best part of a decade. Monetary policy in Japan has been unable to prevent deflation - that is, persistent falls in the overall level of prices. In the United States, the challenge has been running monetary policy in a period where many people believed the economy was moving through a technological revolution that would lead to a prolonged inflation-free, economic boom. That belief translated into very high asset prices, which helped to underpin a long period of strong consumption and investment spending. A key question policy makers faced was whether the asset prices represented fair value, or were a bubble that reflected a collective over-optimism about the future. Finally, many central banks, including New Zealand, have struggled with the consequences of volatile nominal exchange rates. For example, both the Norwegian and British currencies have persisted at high levels which have been very tough for their exporters. There has been little scope for monetary policy in those countries to solve this problem without generating inflation that would be equally damaging to their exporters. In my view New Zealand is not about to undergo any of these scenarios. But the world that we face now has moved on from the world of 1989, when the Reserve Bank Act was passed into law. Maintaining price stability, as I am required to do, is different from firstly having to achieve it, as was required then. As you know, before becoming Governor, I signed a new Policy Targets Agreement with the Minister of Finance. This new agreement offers monetary policy a bit more scope to take evolving circumstances into account. In particular, the new agreement makes clearer that the Reserve Bank should maintain price stability in a flexible way that does not unnecessarily disrupt the real economy. The key change in the agreement is that the inflation target has been explicitly defined in terms of “future inflation ... on average over the medium term”. This implies that monetary policy should be forward-looking, and avoid getting distracted by transitory fluctuations in the inflation rate. In typical circumstances, we expect to give most attention to the outlook for CPI inflation over the next three or so years. If the outlook for trend inflation over that period is inconsistent with the target, we will adjust the Official Cash Rate. Our intention will be that projected inflation will be comfortably within the target range in the latter half of the three year period. This means we will set policy so that inflation will be within the target range in the medium term, unless we are hit by a major surprise event. If a major surprise does occur, we will explain what has caused inflation to be higher or lower than we wanted, and what steps we will take to ensure that it goes back comfortably within the band. I said the new Policy Targets Agreement offers us a little more flexibility, but it’s a flexibility that needs to be applied with care. The language of the new agreement makes clear that inflation should not be persistently outside either end of the band. This is because a sustained breach of the target could affect people’s perceptions of the trend inflation rate. That in itself could create a major inflationary problem. Thus, if one of the disturbances I mentioned earlier appeared to be strongly stimulating or weakening activity in New Zealand - suppose there was a sharp and persistent increase in tourist numbers for example - then the inflationary consequences might not be transitory. So, to keep inflation from rising and activity from going through a boom-bust cycle, monetary policy still needs to act to counteract the impact of these disturbances. And monetary policy still needs to respond particularly assertively when inflation is expected to be well outside the target range, or persistently outside it. But, at other times, if inflation is fairly stable and if we do not see pressures that have the potential to get out of control, then we have a mandate to be a little more flexible in our response. Is this increased flexibility justified? In other words, can we be a little more flexible than in the past without taking risks with price stability? I think we can, because keeping prices stable gets easier when prices have already been stable over an extended period. If inflation suddenly rises just after a period, like in the 1980s, when it was out of control, then there is a risk it will spark a self-fulfilling belief that it is out of control once again. In other words, if people believe that inflation is out of the bag, they may translate that into higher prices for the goods and services that they sell and higher demands for increased salaries and wages. By contrast, after inflation has been low and stable for a long time, people are much less likely to see price fluctuations as the start of something serious. Then a self-fulfilling prophecy is much less likely. Our freedom to be more flexible without compromising our price stability goal is thus a consequence of the hard-won achievement, during my predecessor’s tenure, of an environment where prices are expected to be broadly stable over time. In operating monetary policy, we will continue to carefully monitor people’s perceptions of the inflation outlook, to confirm that their confidence in price stability remains strong. What then of New Zealand’s current economic situation? As you know, the New Zealand economy has been going through a strong period, stimulated by international conditions favourable for us. We have had record tourist numbers, and excellent returns on dairy products and many other agricultural commodities. We’ve also had a very quick turnaround from a net outflow of migrants a year or so ago to a very strong net inflow, which has more than doubled New Zealand’s population growth. In combination, these factors have led to pressure on New Zealand’s resources. For example, many firms have seen strong demand for their products. This particularly applies to firms in sectors like retailing and construction that supply New Zealand households. When they’ve tried to expand to meet that demand, employers have reported difficulty finding additional staff. This tends to create pressure on prices, and indeed, at present, inflation is near our price stability ceiling. But we run policy looking forward, and it has not been clear how long the effects of that offshore stimulus will last. In the United States the long expansion has given way to recession, and the recovery from that recession appears to have faltered. The Australian economy is experiencing the effects of a drought and, like us, deteriorating trading conditions offshore. Moreover, the New Zealand dollar has been rising off the low levels seen a year or so ago. For these reasons, over the next couple of years we expect economic growth in New Zealand to slow from its present high rate. We expect that this will constrain much of the inflationary pressure that we see now in some sectors of the economy. At the same time, the rising dollar means that New Zealand dollar prices of imports have fallen. As a result, we expect New Zealand’s overall inflation rate to slow quite quickly over the next year. In terms of monetary policy, in this situation I see good grounds for waiting and seeing how things evolve. Interest rates are at a level in New Zealand where, in our view, they are not significantly stimulating or restraining the economy. If the world economy picks up and the New Zealand expansion continues, we will probably need more contractionary policy settings during 2003. On the other hand, further deterioration offshore and signs that it is catching up with New Zealand could require stimulatory monetary policy settings. So we are keeping our options open. Finally, let’s go back to the broader context for the Reserve Bank’s task. I have described how the Bank is focused on helping deliver a stable and efficient financial system to the New Zealand public, and how low and stable inflation is an important part of that. I have suggested that doing this contributes to sustainable and balanced economic development. I’ve also said that price stability is a contribution but not a solution to the economic challenge facing New Zealand. How do I see this challenge? Recall that New Zealand’s standard of living, as measured by GDP per capita, barely improved at all between 1975 and the early 1990s. It is only in the last decade or so that the New Zealand economy has managed to achieve a sustained lift in growth. The projections I released last week suggest that this growth will continue, but not at a pace sufficient to close the gap that has developed between our GDP per capita and the OECD average. To do that, over the next 20 years our rate of growth in GDP per capita would have to rise from 2.2 per cent over the last decade to almost 3 per cent over the following twenty years. That’s presuming the rest of the OECD grows at the same rate as in the last decade. Achieving this sort of productivity improvement is a worthy challenge. It is only by meeting that challenge that we will get more of the things we need: greater after tax income, improving standards of health care, education, and environmental protection, and faster and faster boats to keep defending the America’s Cup. I hope I have made clear today that the Reserve Bank will be working to achieve continued price stability without standing in the way of sustainable economic growth. Indeed, I think sound, flexible monetary policy contributes to the strong, balanced economic growth that, we all agree, New Zealand needs.
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Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers¿ Chamber of Commerce, Christchurch, 24 January 2003.
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Alan Bollard: Making sense of a rising exchange rate Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers’ Chamber of Commerce, Christchurch, 24 January 2003. * * * My subject today is “Making sense of a rising exchange rate”. The exchange rate has risen sharply over the last year or so, and has become the stuff of media headlines in ways not seen for some time, and the concern of exporters which I acknowledge. I’m going to sketch out our broad interpretation of what has been going on, and outline for you something of the way that the Reserve Bank thinks about the exchange rate in making monetary policy. For several years, of course, the New Zealand dollar fell quite sharply. It settled at levels that, against almost any yardstick, were too low to be sustained. That is so whether measured against the US dollar or in effective (trade-weighted) terms. Little more than two years ago, our dollar was trading at only 39 US cents - 30% below the average for the whole of the last 10 years. Even in trade-weighted terms, our exchange rate spent most of 2001 almost 15% below its 10 year average. When New Zealanders think about our exchange rate, we tend to think about what is going on here. In fact, that is only half (or less) of the story. The exchange rate is the price of our money in terms of other countries’ currencies, so what is happening in other countries, and what investors are thinking about opportunities elsewhere, matters greatly. In the long run - and, if you are a struggling exporter, that can be a very long time - exchange rates reflect long-term actual economic fundamentals: things to do with the underlying competitiveness of our economy and its firms. If our productivity performance outstrips that of other countries, our exchange rate will tend to rise. If our inflation rate is consistently higher than those of other countries, our nominal exchange rate will tend to fall. And so on. But that is for the long run. In the shorter-term it is largely a matter of making sense of fluctuations in the demand for funds and in the willingness of the world’s savers and investors to supply them. The demand for investors’ funds (loosely, the state of the current account of the balance of payments) does not tend to shift very quickly. Instead, changes in the attitudes and perceptions of financial market participants - changes in their willingness to supply funds - tend to be behind most exchange rate changes. To be concrete, in which country and in which sorts of assets do they think that returns will be greatest? Those perceptions and attitudes can be well-founded, or out of line with reality for a number of years. At times, they can shift quickly. In an ideal world, perhaps, the exchange rate would move simply to reflect actual economic fundamentals - both long-term factors such as structural changes in our relative productivity performance, and medium-term differences in economic cycles. The exchange rate would provide accurate signals to producers, and act as a buffer to temporary pressures. In fact, exchange rates are more volatile than this. Sometimes the moves prove to be well-grounded in economic fundamentals, but by no means always. And exchange rates (like share prices) fluctuate more than the underlying economic fundamentals. New Zealand’s exchange rate is a little more variable than most, partly because our economic fundamentals are more variable than those in larger and less commoditydependent countries. So when it comes to exchange rates we live in an imperfect world - less than ideal, but in my judgement (and we have done a lot of work in this area over the years) still better than the alternatives realistically on offer. Turning back to our own experience in recent years, the framework I outlined a moment ago does help make sense, broadly speaking, of the exchange rate movements in the last few years. For several years, investors globally were taking a gigantic punt on events in the United States, the leader of the “new economy”. They convinced themselves that the United States offered the best returns - the economy was growing rapidly, corporate profits were expected to get ever better, and share prices rose seemingly inexorably. The enthusiasm of international investors to hold US dollar assets outstripped the American economy’s need for those funds. Unsurprisingly, the US dollar rose sharply, to levels too high to be sustained for very long. And it rose against almost every other currency. Even with our OCR at 6.5% through much of 2000, investors just weren’t that interested in New Zealand - high tech equity markets were where the good returns were expected. Despite a stellar economic growth performance in the 1990s, markets were just as uninterested in Australia. Both our currency and Australia’s fell further than most. For us, the fall in the exchange rate was something of a mixed blessing. That is perhaps always the case. A falling exchange rate does tend to be good for producers - firms and farmers in Canterbury for example - but it is bad for consumers. It tends to feel better in the countryside than in the cities. It makes our wages look less attractive to prospective skilled migrants, but our beachside houses also appear cheaper to those wealthy foreigners looking for an Antipodean holiday home, and so on. From a macroeconomic perspective, how we feel about these departures from “equilibrium” (and our best assessment of that equilibrium level is somewhere in the range of 54-60 on the trade-weighted index) depends a lot on what else is going on. In this case, the low exchange rate happened to provide a timely buffer when the world economy slowed down sharply: for exporters of manufactured goods and services, in particular, it provided an offset to the impact of the sharp slowdown in world economic activity. But for a variety of reasons, our economic growth proved so robust that New Zealand was one of only a small number of countries that needed to raise interest rates quite a bit last year to help keep medium-term inflation pressures in check. The exchange rate had become too low for too long to really be helpful. And eventually, as these things do, the exchange rate began to correct - although no one could really reliably predict when this correction would get under way. In trade-weighted terms, our exchange rate has now risen by around 20% since the end of 2001; one of the largest twelve-monthly changes that we have seen in the 18 years since the exchange rate was floated. It is important to put this in context though: even after a striking 30% rise against the US dollar, that exchange rate is still only now around its average level for the last 10 years. On a trade-weighted basis, the exchange rate is now only a few per cent above its long-term average. As I noted earlier, changes in investors’ attitudes and expectations tend to be the main prompts for substantial exchange rate moves. How did those attitudes change last year? For investors, the US “miracle” has turned sour. Share prices have fallen for three consecutive years, and even US interest rates are unattractively low by international standards. America’s need to attract foreign capital - its huge current account deficit - remains as strong as ever. But when the US is no longer flavour of the decade, there was only one way for the US dollar to go. Down. That adjustment was both inevitable (eventually) and healthy. Pretty much every country in the developed world has seen its currency rise in value against the US dollar. But our currency has appreciated more than most in the last year. While on average, the currency has only returned to more normal levels, against the Australian dollar it has risen to levels that are not far off record highs. While many New Zealanders have been trying to make sense of our currency’s sharp rise, many commentators across the Tasman have been grappling with the question of why the Australian dollar has risen so little against other currencies so far. Indeed, in one recent global survey in which financial market commentators were asked which currency was likely to rise most this year, the Australian dollar was the overwhelming favourite. Two things seem to explain much of the New Zealand dollar’s sharp rise. First, our economy has performed very well indeed, surprisingly well in the last year or so. New Zealand is one of the few developed countries where economic forecasts were revised up last year. Amid a rather gloomy world outlook, investors have been attracted to favourable growth surprises. And second, it was a year when solid secure fixed income returns seemed to come back into focus among the investor community. Moody’s now rate New Zealand as AAA, and of course New Zealanders’ appetite for debt has meant we have long had interest rates that have been somewhat above those of most developed countries. Two of the other strongest currencies last year were the Norwegian krone and the South African rand, both economies with higher interest rates than those in New Zealand. At the margin, the fact that our current account deficit has been smaller than usual may also have contributed the world has been keen to put money here at just the time when we’ve needed a bit less than usual. The US, of course, scored poorly all round: it has had a high and widening current account deficit, low interest rates, and a continued disappointing growth outlook. But what of the rise against the Australian dollar? First, we’ve had higher interest rates than Australia (and the gap has increased somewhat) in a period when secure fixed income returns have been particularly attractive. Second, validly or otherwise, markets have taken the view that the New Zealand economy is growing more robustly than Australia’s at present (the drought, fires, and all that). And third, when both the New Zealand and Australian dollars are rising or falling, our currency has often gone a little further than theirs: perhaps something to do with our smaller size and less-liquid markets. It is not my main topic today but can I make just a few quick observations about interest rates. First, our interest rates are currently low by our historical standards (lower than they were when the exchange rate was falling, and only lower than this on three occasions in the last 20 years). Even after adjusting for inflation, interest rates are lower than they have been for most of that time. Second, while the Reserve Bank’s monetary policy has a big influence over the level of short-term interest rates over short periods of time, the average or normal level of interest rates over periods of years is mainly determined by New Zealanders’ willingness to save and appetite to borrow. For reasons that are not fully understood, over the years New Zealanders have continued to have a higher appetite for debt, at any particular level of interest rates, than do citizens of most other countries we typically compare ourselves with. Only when that changes will our interest rates settle, on average, around the level of those in other countries. I want to turn now to outline something of how we think about the exchange rate in setting monetary policy. In setting the Official Cash Rate, we are always very conscious of exchange rate changes, and how those developments will affect the outlook for growth and inflation a little down the track. Those effects have changed through time. For example, not just in New Zealand but internationally, prices seem to be less responsive to exchange rate movements than they were 15 years ago. Suppliers seem to be absorbing more of the impact of cyclical fluctuations in the exchange rate. And as an increasing proportion of our exports are moving up the value-chain, our firms are getting a little more pricing power themselves, and hence are less immediately exposed to the effects of exchange rate fluctuations. And, of course, access to sophisticated financial derivatives gives many firms some breathing space to adjust to changes in the exchange rate. But as a trading nation, exchange rate fluctuations will always be a big influence on the short-term economic outlook, and monetary policy. A rising exchange rate has a very real impact on exporting firms, and those supplying them - here in Christchurch and throughout the country. And it does so particularly when individual cross-rates move rather differently, for reasons that have nothing to do with events in New Zealand: for example, a firm which is sourcing inputs from Australia and exporting to the United States. What else is going on at the same time also matters critically. Sometimes an exchange rate change will helpfully offset some other development here or abroad, but by no mean always. Making these assessments is very far from being a mechanical or mechanistic exercise. Formal models and estimates of `equilibrium’ exchange rates help, and we use them extensively. But they only take us so far. A lot of wisdom, and experience, and informed judgement has to be brought to bear - and a willingness to acknowledge our mistakes and reassess at the next regular review. And, of course, we had a review of the OCR just yesterday, when we had to work through exactly those sorts of judgements, making sense of the unexpectedly strong rise in the exchange rate since the November Monetary Policy Statement. We put a great deal of effort into understanding both what might have driven the exchange rate, and into assessing what impact the rise might have. We concluded that the recent rise in the exchange rate, if sustained, will dampen economic activity looking ahead - at least as compared to what we were expecting in November. At the same time, we noted that domestic spending appears to have been more robust than we had anticipated - that means that the economy has still been growing strongly. Household spending appears to have remained high, and house sales and construction activity have been very buoyant. It is important to remember that the starting point has been one of quite intense pressure on resources - many of you, for example, are no doubt among the firms who report that they are finding it very hard to get good staff. For the moment, it is appropriate to leave the OCR unchanged, but the balance of risks has shifted. We will need to look closely at the data over the next few months, for evidence that points to reduced pressure on resources and medium-term inflation. If that evidence emerges, and if the exchange rate remains at around current levels, or even rises further, there may be scope for a cut in the OCR later in the year. Some prices are already falling as a direct result of the rising exchange rate. That, in itself, would not prompt us to adjust monetary policy - any more than the sharp rises in prices in 2000 and 2001 after the substantial exchange rate fall led us to adjust the OCR in response. We focus on the more sustained impact of exchange rate changes; the effects on economic activity and medium-term inflation pressures. Short-term changes in prices can affect people’s expectations about inflation, but it has usually been sensible for us to “look through” these effects. If we did not, we would typically be over-reacting, and pushing interest rates around more than medium-term considerations would warrant - and that might even exacerbate exchange rate fluctuations over time. Some, of course, would suggest that we should be more active and should adjust the OCR, not just to offset the dampening impact of the exchange rate, but to try actively to reverse, or slow, the rate of increase in the exchange rate. In this case, of course, it is important to remember that the exchange rate has simply recovered to more normal levels, pricing New Zealand assets and products more sensibly, albeit adjusting more quickly than is comfortable. And more generally, we need to be very cautious. We would be the first to acknowledge that monetary policy affects exchange rates, but modest changes in interest rates only rarely do so in a stable and predictable manner over periods that matter to people in the real economy. Understanding, after the event, what has driven the exchange rate is one thing, but reliably forecasting it, or using monetary policy to influence it, is quite another. What we constantly do, however, is to look behind developments in the exchange rate. We want to understand as well as we can what has been going on and why, and we continually test our reasoning and judgements to ensure that our monetary policy decisions are not unnecessarily exacerbating exchange rate changes. This prudent and sensible approach has in fact been written into our mandate - the Policy Targets Agreement with the Minister of Finance - since 1999. It keeps our focus on medium-term price stability, but requires us to ensure that in pursuing that medium-term goal we avoid unnecessary instability in output, interest and exchange rate. There are no simple answers as to how to apply these provisions to our policymaking; to know just what is “unnecessary”, not just right now, but over the medium-term. Sometimes, an OCR rise will exacerbate pressure on the exchange rate, but rises in both will be a necessary response to pressures on output and inflation. At other times, there will be scope for trade-offs, but there are rarely easy or reliable ones. For us, those choices might come more sharply into focus if we were to see another sharp rise in the exchange rate this year. You will note that I have not said much today about what I think might happen to the exchange rate in the coming year. And that is for a very good reason. However much we can understand, after the event, what has driven the exchange rate, neither economists and central bankers (nor anyone else) has a great track record forecasting exchange rates. And that is especially so when the exchange rate is no longer well away from sustainable long-term levels. Most observers do expect some further rise in our exchange rate, mainly because the US dollar is widely expected to fall further. But a year is a long time in financial markets, and much can change over that time in investors’ attitudes to likely returns both here and in other countries. I would emphasise in closing that the Reserve Bank will never be complacent about the sorts of exchange rate swings we have seen in recent years. We are limited in what we can do to prevent or moderate them, but we recognise the impact they have both on you as business people, and on consumers up and down the country. As I noted at the start of this address, if New Zealand can achieve a superior long-run economic performance that will lead to a trend increase in the exchange rate, but quite marked fluctuations around that trend will be an uncomfortable fact of life for us all. While keeping the goal of medium-term price stability constantly in view, the Reserve Bank will always be asking whether, and how, our decisions and comments can best avoid undue and unnecessary volatility in the economic environment we face - not just today, but over the full course of the economic cycle. The fact that some volatility is inevitable is no excuse for simply being oblivious to it. You cannot be, and we are not either.
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Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to The Annual Meeting of the Institute of Directors in New Zealand, Christchurch, 7 April 2003.
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Alan Bollard: Corporate governance in the financial sector Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to The Annual Meeting of the Institute of Directors in New Zealand, Christchurch, 7 April 2003. * * * Corporate governance is now a topic of considerable interest to a large and expanding cross-section of the community. It is obviously of fundamental importance to this audience, given that most of you are company directors. It is also of interest to the Reserve Bank, in its capacity as supervisor of the banking system. In this speech, I will discuss a number of themes relating to corporate governance, with particular emphasis on the important role it plays in promoting a sound financial system. Until fairly recently, corporate governance was not a topic that attracted much public attention. It was a topic reserved for discussion in the Board room or in academic environments. However, recent events, such as the Enron scandal and other corporate governance failures, have put corporate governance on the front pages of our main newspapers. Although none of us welcomes this kind of adverse publicity, it has nonetheless had beneficial effects. In particular, it has highlighted the important role that corporate governance plays in a modern economy and the consequences of getting it wrong. And it has strengthened the incentives for directors and policy-makers alike to reassess the structures needed to produce high quality corporate governance. In this address, I present a central banker's perspectives on a number of corporate governance issues. In particular, I will: • comment on the role that corporate governance plays in the financial system and wider economy, and why it is important for economic growth and financial stability; • highlight what I would regard as the key elements of sound corporate governance; and • discuss the role that corporate governance plays in the Reserve Bank's approach to banking supervision. Before traversing these subjects, I think it would be useful to begin by defining what I mean by corporate governance. In this address, I am deliberately using the term quite broadly to encompass the systems and structures that a corporate entity has in place to oversee its affairs. This involves a number of elements, including a clear understanding by directors of their company's strategic objectives, structures to ensure that the objectives are being met, systems to ensure the effective management of risks, and the mechanisms to ensure that the company's obligations are identified and discharged. Although corporate governance involves many systems and structures, the heart of it lies in the boardroom - a point I hardly need to stress with this audience. It is self evident that sound corporate governance is essential to the wellbeing of an individual company and its stakeholders, particularly its shareholders and creditors. We need only remind ourselves of the many companies, both at home and abroad, whose financial difficulties and, in some cases, ultimate demise have been substantially attributable to weak corporate governance. But sound corporate governance is not just a vital factor at the level of the individual corporation. It is also a critical ingredient in maintaining a sound financial system and a robust economy. And that is why governments have taken such an interest in recent examples of corporate governance failures. It is also why banking supervisors are placing greater emphasis on the role that corporate governance can play in promoting financial stability. In the financial system, corporate governance is one of the key factors that determine the health of the system and its ability to survive economic shocks. The health of the financial system much depends on the underlying soundness of its individual components and the connections between them - such as the banks, the non-bank financial institutions and the payment systems. In turn, their soundness largely depends on their capacity to identify, measure, monitor and control their risks. In New Zealand, the two core components of the financial system are the registered banks - which represent the vast bulk of financial system assets - and the payment system - which processes billions of dollars of transactions each day. Banks face a wide range of complex risks in their day-to-day business, including risks relating to credit, liquidity, exposure concentration, interest rates, exchange rates, settlement, and internal operations. The nature of banks' business - particularly the maturity mismatch between their assets and liabilities, their relatively high gearing and their reliance on creditor confidence - creates particular vulnerabilities. The consequences of mismanaging their risks can be severe indeed - not only for the individual bank, but also for the system as a whole. This reflects the fact that the failure of one bank can rapidly affect another through inter-institutional exposures and confidence effects. And any prolonged and significant disruption to the financial system can have potentially severe effects on the wider economy. The payment system is also a critical component of the financial system. It contains the pipelines that connect the banks and other financial intermediaries. And it provides the means by which vast numbers of transactions - personal and corporate, domestic and overseas - are made each day. The payment system involves many different components, including systems for settling large, inter-bank and inter-corporate payment transactions, and systems for handling myriads of smaller transactions, such as cheques, credit cards, direct debits and EFTPOS. Each system is managed by a payment operator. Some are private companies owned by the banks, while others are under the management of the Reserve Bank. Although these operators do not face risks of the nature that banks face - such as credit risk, for example - they do have major operational risks. In particular, they need to ensure that the systems for processing payments, the back-up arrangements, and the internal governance structures are robust. A major operational failure in the payment system has the potential to cause severe disruption to the financial system and wider economy. At its worst, a major payment system failure would bring countless commercial transactions to an abrupt halt, impede the operation of business in virtually all parts of the economy and fundamentally undermine investor and business confidence. The stakes are indeed high - hence the need for banks, other financial institutions and the payment system operators to maintain systems to enable them to identify, monitor and control their risks. And sound corporate governance is the foundation for effective risk management. Of course, corporate governance is not just an essential ingredient for financial stability. It is also a critical feature in the longer term performance of the economy. One could be forgiven for thinking otherwise, given the emphasis placed in the news media and elsewhere on the role of government in determining a country's economic performance. We frequently read and hear commentary suggesting that the key to better economic performance lies in better government policy - be it fiscal policy, monetary policy or structural reforms. To be sure, these are all important ingredients in shaping economic performance. But I believe one of the key drivers of how well or poorly our economy performs is where we invest our resources and how well we use them. By and large, the way we allocate and use our resources is not determined by policy-makers in Wellington. It is largely determined by the investment and management decisions of hundreds of companies. In turn, the quality of these investment and management decisions substantially depends on the quality of corporate governance in each company. Therefore, corporate governance is clearly of fundamental importance, both at the level of the individual company and for the financial system and economy as a whole. Unfortunately, to the detriment of both financial stability and economic growth, we have seen too many examples of corporate governance failures over the years, both in New Zealand and in many other countries. Indeed, it is not an exaggeration to assert that many of the financial crises seen in recent years, including in Asia, Russia and Latin America, can be attributed, in no small way, to fundamental weaknesses in corporate governance and risk management. In particular, we know that financial distress episodes in a number of emerging economies have been caused, in part, by excessive exposure concentration, directed lending, lending to connected parties, poor credit policy and inadequate management of foreign exchange risk. To a large extent, such basic risk management failures reflect a breakdown in corporate governance. They reflect poor management of conflicts of interest, inadequate understanding in the boardroom of key banking risks, and poor oversight by boards of the mechanisms for managing their banks, such as risk management systems and internal audit arrangements. In some cases, a lack of truly independent directors on the boards of banks was also a significant factor in weakening the effectiveness of boards. And we know that these problems were compounded by poor quality financial disclosures and ineffective external audit. In some cases, the rigour of the external audit process has been impaired by a lack of auditor independence, not least as a result of some audit firms performing a range of non-audit services for their clients. Of course, these kinds of corporate governance failures are by no means unique to the financial systems of emerging economies. We have seen similar examples of corporate governance and risk management failures contributing to financial system distress in a number of advanced economies, including much of Scandinavia in the 1980s and, of course, New Zealand and Australia in the late 1980s and early 1990s. And I hardly need to draw your attention to the much more recent high profile corporate governance failures in the United States, United Kingdom and elsewhere. In order to address these kinds of problems, and to reduce the risk of future corporate governance failures, much activity has been underway, globally and at the domestic level. The OECD has produced a set of corporate governance principles that have become the core template for assessing countries' corporate governance arrangements. Similarly, the Basel Committee on Banking Supervision - the international standard-setting body responsible for establishing international banking supervision principles - has distilled principles for corporate governance in banks. More recently, we have had the benefit of corporate governance reviews in the United Kingdom, and many are now reflecting on the implications of the recently enacted Sarbanes-Oxley legislation in the United States. Closer to home, in Australia, there has also been considerable interest in corporate governance issues, including the role of non-executive directors. And, of course, many countries have their own national codes of good corporate governance, either developed by government or by the private sector. New Zealand is no exception, with the Institute of Directors having issued a raft of very useful guidance material to directors. There are few absolute "rights" and "wrongs" in the field of corporate governance, but some key principles stand out. In particular, let me highlight a few basic principles to which we in the Reserve Bank attach considerable importance in a banking sector context. • First, I would particularly stress the importance of directors having a sound understanding of their company's business, the nature of its risks and its strategic direction. This provides the foundation for the sound management of any company. It is absolutely crucial in a bank. • Second, we firmly believe that the ultimate responsibility for ensuring that a company's risks are being properly identified, monitored and controlled lies in the boardroom. • Third, we place considerable emphasis on the importance of having an adequate representation of non-executive and independent directors on the board, and a clear separation of the position of board chairman and chief executive officer. • Fourth, it goes without saying - but I will say it anyway - that there is a fundamental need for directors to be scrupulous in ensuring that, individually and collectively, potential conflicts of interest are avoided or at least managed in ways that do not compromise the interests of the company. • We also stress the importance of rigorous internal and external audit arrangements - where the external auditor has a strong measure of independence and is not conflicted by having other significant financial interests in the company. • Finally, as the Governor of a central bank that has placed strong emphasis on disclosure by registered banks, and which sets high standards on its own financial disclosures, it will not surprise you to know that we stress the importance of regular, timely, comprehensive, meaningful and reliable financial disclosures of a company's affairs. These kinds of principles feature strongly in the Reserve Bank's approach to the supervision of banks in New Zealand. Before going on to explain our approach, and the central role that banks' corporate governance plays in our framework, it may be useful to set the scene by highlighting the key features of the New Zealand financial system. Some of them have particularly interesting implications for corporate governance. The New Zealand banking system is relatively unusual by international standards in a number of respects. First, unlike the financial systems of many countries, in New Zealand the banks form a very dominant part of the financial sector. Registered banks, of which there are currently 18, represent the lion's share of the total financial system, both in terms of total financial system assets and deposit liabilities. In terms of financial system stability, registered banks are by far the most important players in the financial system. And of the 18 registered banks, only about 5 banks could be regarded as systemically important, together holding more than 80% of total registered bank assets. The New Zealand banking system is also unusual in another way - the nature of its ownership. All but two of the registered banks are foreign owned, with the two New Zealand-owned banks being very small relative to the system as a whole. The foreign-owned banks operate either as subsidiaries or as branches of foreign banks, with most of the largest banks being wholly-owned subsidiaries of Australian and British banks. As I will note later in this speech, this raises particular complications for the nature of the corporate governance arrangements in these banks and raises interesting policy questions for the Reserve Bank as guardian of the financial system. As I have indicated, a fundamental component of New Zealand's approach to the promotion of financial stability is the emphasis it places on the importance of corporate governance as a means of encouraging banks to effectively identify, monitor and manage their business risks. This approach recognises the critical role which directors have in overseeing the stewardship of their bank. Indeed, it is worth noting that the New Zealand banking supervision framework, with its heavy emphasis on encouraging sound risk management through strong corporate governance arrangements, is somewhat unusual by international standards. In most countries, the standard approach to banking supervision involves reliance on prudential regulation of banks, where a bank's risk positions are substantially constrained by regulatory limits imposed by the supervisory authority. It also typically involves some form of on-site examination of banks by the supervisors. In contrast, the New Zealand supervisory framework quite deliberately avoids the use of prudential regulation - except in limited areas, such as minimum capital ratios and limits on lending to related parties. And the Reserve Bank does not conduct on-site examinations of banks. Our supervisory framework is deliberately light-handed in nature, in the sense that we minimise our intrusion into the management of banks' risks and the structure of their operations. Instead, we try to foster robust "self discipline" in banks through the corporate governance and disclosure frameworks we have established. That said, I should make it clear that, although the Reserve Bank does not conduct on-site examinations of banks' loans and risk management systems, we do meet annually with the senior management teams of the banks. These meetings provide an important opportunity to discuss recent developments in the respective banks, risk management, banking industry issues and other relevant matters. The meetings keep us well informed about each of the banks and the banking industry as a whole, but fall well short of the more intrusive bank examination process typical in other countries. We also differ from many other countries by not having deposit insurance or an explicit depositor protection objective. The statutory objectives of banking supervision in New Zealand are to promote a sound and efficient financial system and to avoid damage to the financial system resulting from a bank failure. We are not charged with protecting depositors or other bank creditors per se. We believe the New Zealand approach is an effective way of promoting a sound financial system. We also believe it reduces the moral hazard risks associated with conventional banking supervision, and strengthens the effectiveness of market discipline on banks. The fact that the New Zealand banking system is currently one of the healthiest in the world - with high asset quality, sound risk management practices and good capitalisation - bears testimony to this. However, we are certainly not complacent, and we remain ever-watchful to detect incipient signs of financial distress, and we stand ready to intervene if necessary. Moreover, we regularly review our supervisory framework to ensure that it continues to be an effective means of promoting a sound and efficient financial system. In that context, we are currently reviewing a number of our supervision policies, with a view to further improving the existing arrangements. Although some of you will already be au fait with the mechanisms that the Reserve Bank uses to promote strong corporate governance and risk management in banks, it is probably useful for me to briefly summarise the main features. These policies include comprehensive disclosure requirements for banks, a requirement for bank directors to attest to the veracity of their bank's disclosures and to make attestations on the management of risks, and requirements in relation to the composition of the board of directors. Let me elaborate briefly on these features: All banks in New Zealand are required to publish comprehensive financial and risk-related disclosures on a quarterly basis, including information on a bank's and banking group's: • capital position; • concentration of credit exposures to individual counterparties; • related party exposures; • asset quality and provisioning; and • interest rate, exchange rate and equity risks. Each disclosure statement is required to contain a number of attestations, signed by each director. These are intended to encourage directors to focus their attention on key risks within their bank and to be satisfied that these risks are being effectively managed. Directors of each registered bank are required to attest that the bank has systems in place to monitor and control adequately the banking group's material risks and whether those systems are being properly applied at all times. The directors are also required to attest that all prudential requirements applicable to the bank in question are being complied with, such as requirements relating to minimum capital adequacy and exposures to related parties. And the directors are required to confirm that exposures to related parties are in the best interests of the banking group. Each bank director is required to sign their bank's disclosure statement and to certify that disclosures made are not false or misleading. If a disclosure statement is found to be false or misleading, directors are subject to potentially severe legal penalties, including substantial fines and imprisonment. In addition, directors may face unlimited personal liability for creditors' losses where creditors relied on a bank's disclosure statement that was false or misleading. Banks incorporated in New Zealand are required to have a minimum of two independent directors, who must also be independent of any parent company or other related parties, and a non-executive chairperson. These requirements are intended to increase the board's capacity to exercise appropriate scrutiny over the performance of the management team. In addition, independent directors provide some assurance that the bank's dealings with its parent or other related parties are not in conflict with the interests of the bank in New Zealand. Complementing these requirements, New Zealand's approach to financial sector regulation seeks to create an environment conducive to robust market disciplines. This is achieved through a number of measures, including the promotion of a relatively open, contestable banking sector, a competitively neutral approach to regulation - enabling banks and non-banks to compete on largely equal terms and the absence of deposit insurance. In addition, the Reserve Bank's approach to responding to a bank failure stresses the importance of being able to manage a bank failure in ways that avoid the need for a government-funded bail-out, and seeks to ensure that shareholders, subordinated creditors and senior creditors, including depositors, bear their fair share of losses. All of these features are intended to strengthen the incentives for market scrutiny of banks and to further encourage the directors and managers of banks to ensure that their banks' risks - especially credit risk, market risks, exposure concentration, operational risk and liquidity - are being prudently managed. We are confident that these measures have been successful in contributing to a sound banking system. But we have recently sent a comprehensive questionnaire to the boards of all banks to develop a greater understanding of the means by which directors satisfy themselves that their banks' disclosures are not false or misleading and that their systems for controlling risks are robust. We will be very interested to see the results of that survey and then to assess whether the existing arrangements are sufficient for the purpose of promoting a sound financial system. We are also surveying auditors to enhance our understanding of the audit processes in relation to banks and to assess the adequacy of existing audit requirements for banks. In addition to our own assessments of these matters, we will also benefit from an external assessment of banking supervision arrangements and other elements of financial sector regulation later this year. That assessment will be conducted by a team of international experts led by the International Monetary Fund, as part of the joint IMF/World Bank Financial Sector Assessment Programme - FSAP for short. The FSAP was initiated in the aftermath of the Asian crisis, in 1999, and is designed to evaluate a country's financial system. It includes a comprehensive assessment of regulatory arrangements, including banking supervision and securities market regulation, using international standards and codes as benchmarks. It also involves stress testing the financial system to assess the system's capacity to withstand economic shocks. New Zealand will undergo an FSAP assessment later this year, and I am sure that the assessors will take a particular interest in the banking supervision framework and the emphasis we place on corporate governance and market disciplines. We await the results of the FSAP assessment with considerable interest. Although our policies are designed to strengthen the corporate governance of banks operating in New Zealand, the foreign ownership of most of our banks introduces complications as well as advantages. As I mentioned earlier, all but two of the registered banks in New Zealand are foreign owned, operating in New Zealand either as branches or subsidiaries of overseas banks. This raises interesting issues relating to corporate governance and risk management - issues to which the Bank is currently giving further thought. For example, in the case of banks operating as branches in New Zealand, how much reliance should we, as the supervisor of banks, or the public more generally, place on the directors of the bank in a foreign country for looking after the interests of creditors and other clients of the bank branch in New Zealand? Under existing policy, foreign banks are able to operate as branches in New Zealand unless they have substantial retail deposits or are deemed by the Reserve Bank to be systemically important. In such cases, they must operate as locally incorporated entities. Where they do operate as branches, we impose certain prudential requirements on them and require disclosure of the New Zealand branch operations, but we place considerable reliance on the directors of the foreign bank to ensure that the affairs of the bank as a whole are being prudently managed. We recognise of course, that this approach has its limitations. In particular, we know that the directors of a bank, and the corporate governance and risk management structures within a bank, do not generally draw distinctions between the foreign branch of the bank and the rest of its operations. We are also mindful that the foreign branch of a bank is legally indistinguishable from the rest of the bank, and that assets and liabilities can move quite readily, sometimes at the push of a button, between the branch and the rest of the bank. In fair weather, that is fine. But in times of crisis, the distinction between the branch and the rest of the bank, and the legal location of assets and liabilities, may well become very important indeed. You might think that the problem associated with branch banks could easily be solved by simply requiring banks to operate in New Zealand as locally incorporated subsidiaries. Many of the banks currently in New Zealand do just that. But even here there are corporate governance and related complications. Increasingly, both in New Zealand and elsewhere, international banks are managing their affairs as a global business, regardless of whether they operate in foreign jurisdictions as branches or subsidiaries. Core functionality, such as information technology, financial accounting and risk management, is being increasingly managed on a global level. In some cases, this is being done in a banking group's head office. In other cases, core functionality is being located in developing countries to take advantage of lower cost structures. In both cases, the legal boundaries between different parts of a banking group are becoming less relevant. And all of that is probably just fine when things are going well. But when things do not go well - such as in a bank failure situation - the legal divisions within a banking group and the location of core functionality become very important indeed. And it is precisely this issue that we in the Reserve Bank are considering at present. In a banking system where, increasingly, the core functions of banks are being run from outside of New Zealand, we as supervisor of the banking system need to be satisfied that there are mechanisms to ensure that the interests of New Zealanders are well served - in good times and, especially, in bad. We are therefore currently assessing the feasibility and efficacy of different options for ensuring that the New Zealand operations of foreign banks are structured in ways that meet the needs of the New Zealand financial system. Of course, this is not just an issue for the Reserve Bank. It is also an important issue for the directors of banks in New Zealand. The directors need to be satisfied that they are fulfilling their statutory responsibilities, and ensuring that sound corporate governance structures are in place, in the context of a bank whose core functions are, increasingly, being performed overseas. This involves a careful balancing act. On the one hand, directors need to ensure that the bank in New Zealand - as a separate legal entity - is meeting, and will continue to meet, its statutory and financial obligations, and is soundly managed and structured. On the other hand, they will inevitably and appropriately make those kinds of assessments in the context of the bank being part of a global banking group. The critical issue for the directors - and for the Reserve Bank - is just how much reliance should be properly placed on the parent bank and other components of the banking group when assessing the adequacy of the governance arrangements and prudential and operational soundness of the bank in New Zealand. For example, when the directors of the New Zealand subsidiary of a foreign bank form a view on the adequacy of that bank's risk profile and management systems, how much reliance should they place on the support of the parent entity? When assessing whether the bank is adequately capitalised, how much weight should be placed on parent support? When core functionality is being moved out of the bank to other parts of the group - including IT, financial accounting, and, importantly, intellectual capital - how far should local directors go in requiring arm's length service contracts for those services, and adequate back-up arrangements in the event of parent bank failure? When assessing the nature of the local bank's exposures to other parts of the group, how far should directors go in ensuring that the exposures are in the interests of the local bank? And, in all of these matters, and many more, what is the particular role of independent directors, how many should there be on the board, and how can one be assured that they are truly independent in their thinking and their approach to their job? These are issues that increasingly occupy our minds in the Reserve Bank. And we are considering the possible policy solutions to them. Increasingly, these kinds of questions will also be posed and answered by supervisors - and by bank directors themselves - in many countries, as banks become more global in nature. I expect that, within the next year or two, we will have made substantial progress in seeking to resolve some of these issues.
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Extract from an address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Property Council of New Zealand, 9 September 2003.
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Alan Bollard: The New Zealand housing market Extract from an address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Property Council of New Zealand, 9 September 2003. * * * I’d like now to consider in more detail the New Zealand housing market, it being one of the factors behind our strong domestic economy, at a time when many exporters have seen their incomes retreat in recent months. New Zealand’s housing sector has experienced a strong cyclical upswing over the past 18 months. It’s not just Auckland. Sales growth and rising house prices are prevalent in many parts of New Zealand. Building consents are at cyclically high levels. That’s both including and excluding apartments. Residential investment is expanding the nation’s housing stock rapidly, yet demand continues to outstrip supply. We see this in rising prices and a shortage of properties listed for sale. The median time it takes to sell a house currently sits at an unprecedented low of just 26 days. As a consequence, recently house prices have been rising rapidly. What’s driving this? The answer is demand exceeds supply. Demographics are part of the story. New Zealand has had rapid population growth in recent years, driven by net immigration. This includes not just people coming here but people here choosing not to leave. The longstanding drift of New Zealanders north and into town is also a factor. In addition, social changes are seeing the average number of persons per home reduce. Life-style changes are increasing demand for new kinds of accommodation, such as inner-city apartments and coastal and lakeside properties. Some of these factors have been at work for a long time. Even in the late 1990s, when population growth was relatively weak, there was substantial construction activity. However, more recently population growth has been marked. The natural increase in population currently is slower than a decade ago, but recent immigration has been very strong. In terms of permanent and long-term migration we had a net outflow of 10,000 persons per year in early 2001 and a net inflow of more than 40,000 per year in mid-2003. That too undersells the story. In addition we have short-term stays, such as students and those on work permits, and those who apply for residency once they are here. Total migration has been running at more than 60,000 persons per annum over the past two years. This is well in excess of the mid-1990s. Of course, more people means more demand for accommodation. Is there more to this story? Yes, we think so. In part the demand for housing reflects the fact that people with savings to invest have become disenchanted with the share market and other financial instruments. Savers still remember the 1987 share market crash and more recent tumbles in the US and Europe. As well, savers have seen global interest rates fall to historic lows and headlines of pension funds losing money. At the same time property markets have stayed uncharacteristically buoyant and so there’s been a flight to “bricks and mortar”. The proportion of the housing stock owned as rental property has been rising over recent years. Increasing numbers of people prefer to hold wealth in housing assets, as opposed to other investments. Property investment has been rising over the past year. Of course this isn’t all bad. If lifestyles are changing and housing needs are changing and if aggregate demand is up because more people live here, then we want more house construction. If supply meets demand without bottlenecks that’s good. There are, however, some initial signs that housing market activity and expectations of future activity are starting to exceed demand as indicated by demographic fundamentals. Credit demand has accelerated over the last year. Borrowing has begun to accelerate. Debt-to-income ratios, which began to level out in the late 1990s, are starting to rise again. People working in real estate and financial planning indicate a marked increase in the numbers of would-be investors. The newspapers are running advertisements for seminars offering to coach people on how to invest in property, often promising significant returns. Census and Household Expenditure Survey. I am concerned, as I said at the release of the Reserve Bank’s Monetary Policy Statement last week, that this could end in disappointment, especially for unsophisticated investors who are rushing to get on the housing-investment bandwagon. My worry is what if things reverse and supply exceeds demand? What if recent buyers, heavily in debt, find that rents have fallen, making outgoings more than incomings? What if they decide to exit property and then can’t sell at prices paid a few months earlier? How could supply exceed demand? We think that net immigration is likely to ease a little over the next two years. Partly that will reflect Government policy. Also the number of New Zealanders who want to begin their OE may go up again, as the economies of other advanced countries do better relative to ours. As other investments like equities regain their gloss the person who has bought a house to sell it to another buyer may find that the next prospective buyer has put his or her money elsewhere. When pension funds prosper again, that too will have the same effect. To those who say “Hold on, nothing is as safe as houses,” I would say separate nominal from real house prices. Real house prices are what matters. In our recent past there have been extended periods where real house prices have dropped, as illustrated. In the past price falls were often concealed by high inflation. Also, as the graph confirms, when property prices really skyrocket real property-price deflation often follows soon after. Rising house prices and, by inference, increasing rentals are by no means a certainty. As some New Zealanders found in the 1970s, the late 1980s and to a lesser degree in the late 1990s house prices can fall in real terms. Other countries, such as the UK, have experienced even more pronounced weakness in their housing markets at stages over the last 20 years. Prudent property investors need to ensure their ability to withstand falling prices and rents at some time in the future. People thinking of borrowing to buy a rental property should also factor monetary policy into their calculations. If inflation starts to gain momentum in New Zealand, interest rates, nominal and real, will have to be higher to keep that inflation in check. Prospective buyers should ask “Could my gearing face that - would I stay above water come higher interest rates?” To conclude, why as a central banker should I care about any of this? The narrow answer is that a stretched housing market contributes to inflation. However, the wider answer is that the stability of the New Zealand economy and the security of New Zealand households are linked in terms of risk concentration. For the wider economic interest and for New Zealand households, spreading risk needs to be a higher priority.
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Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Auckland Club and the MBA Business Meeting,...
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Alan Bollard: Investing in a low inflation world Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Auckland Club and the MBA Business Meeting, Auckland, 14 October 2003. * * * The theme of my speech today is "investing in a world of low inflation". New Zealand has succeeded in achieving a low inflation rate and keeping it stable for more than a decade now. The average CPI inflation rate since 1992 has been just 2 per cent per annum, as against an average of 12 per cent per annum in the 1970s and 1980s. I have chosen my topic because I fear that, currently, too many New Zealanders are taking higher risks than they realise in their investment and borrowing strategies, because they don't understand that investing in a low inflation environment may be quite different from investing in the high inflation environment of earlier decades. Some of these risks arise due to the mix of assets New Zealanders are investing in. I suspect that too many households may be over-exposed to real estate investment, and that too many are becoming increasingly exposed to relatively high risk financial investments, without fully appreciating the risks involved. Also, there are some risks relating to the extent of borrowing being undertaken by households, which has left many households with very high levels of debt. Before getting into these issues, let me briefly say why I think this topic is important, and why the Reserve Bank takes a close interest in the issue of saving and investment. Households making well-informed saving and investment decisions not only make themselves better off, but also contribute to the stability of the financial system and growth across the economy. Of course, at any point in time, not all New Zealand households are in a position to save and invest, and not all savers can afford anything other than a house as their investment. Currently, about one third of households own their house mortgage-free, putting them in a good financial position to consider a range of investments. A further third live in a house they own, but with a mortgage, and for these households a strategy of reducing the mortgage as quickly as possible may make a lot of sense. The remaining third live in rented accommodation, and some of these households may have a strategy of saving to buy their own home. However, for households in any of these categories, if their financial position and scope to invest in a range of assets improves, important decisions about investment strategy arise. Those strategies often involve investing greater proportions of funds in financial investments, as opposed to housing, increasing the need to be well-informed about the risks involved. Clearly, unsound investment and borrowing decisions can have severe consequences for individuals and families. Households with high levels of debt and exposure to investments that are riskier than they appreciate could potentially face painful problems. Some may find that the rate of return on their investments is considerably less than they had thought it might be, or even that their investments make a severe loss. Some may find that the debt they have accumulated takes a lot longer to pay off than they had expected - and indeed considerably longer than it would have in the years of high inflation. Some households may find, as a combination of all these things, that they are not well placed to cope with the "rainy days" that occur from time to time, such as higher interest rates, a recession, or a loss of employment. Here, the data on household balance sheets in New Zealand tell an interesting, but not a comforting, story. Households have been borrowing heavily over the last 10 years or so - as nominal interest rates have halved and finance has become easier to obtain - and household debt compared to income is now at the highest levels on record. Debt now stands at about 130 per cent of income, as against just 65 per cent in 1990. As I noted already, about half of New Zealand's homeowners have fully paid off their mortgage and have little other debt. Mortgage debt is concentrated within the 25 to 45 age bracket, with some homeowners in this category carrying high levels of debt for a lengthy period of time. Such households now may be much less well placed to cope with the unexpected than others in their position once were. The high level of borrowing by New Zealand households is also reflected in data on household leverage - that is, the ratio of household debt to the value of the house. The leverage ratio has drifted upwards in the last 20 years or so, from 15 to 20 per cent in the mid 1980s to around 30 per cent today. Australia and the US have seen similar trends. Finally, as far as the numbers go, the debt servicing burden of households (including those owning rental property) has been broadly constant over the last 10 years at around 10 per cent of household income. However, this has been in an environment of falling nominal interest rates. Nominal interest rates are now at historically low levels. An important question to ponder, therefore, is how would households cope with an increase in interest rates, now that average debt-to-income levels have essentially doubled. Interest rates have been relatively stable in recent years, but there will inevitably be times when pressures on inflation will require interest rates to rise. Why is the Reserve Bank interested in this? Obviously, individuals and families may find themselves in difficulties as a result of poor investment and borrowing decisions. My concern is not only about that, but also about the wider economic implications of any such difficulties. The financial health of households is important for the stability of the New Zealand financial system and the New Zealand economy. Households that borrow do so almost entirely from banks, and lending to households makes up about 40 per cent of total bank lending. Therefore, the ability of households to service their debts is crucially important to the health and soundness of banks and the broader financial system. As well as influencing the banking system, household investing and borrowing behaviour affects financial stability in New Zealand through the country's external financing. Household borrowing that is not funded by domestic savings must be financed offshore. Partly as a result of strong household borrowing over many years, New Zealand has a very high ratio of net external financing relative to our GDP - indeed, one of the highest ratios of any advanced economy. Currently, New Zealand's net financing from offshore stands at about 90 per cent of GDP, compared with just 60 per cent for Australia, 25 per cent for the United States and 15 per cent for Canada. New Zealand's high dependence on external financing creates a risk that foreign lenders may at some time become more reluctant to increase their exposure to New Zealand. This would raise the premium we would have to pay in order to maintain access to offshore funding. Foreign lenders may even seek to withdraw their existing funds in New Zealand, especially if perceptions about the New Zealand economy, rightly or wrongly, take a turn for the worse. A sudden reduction in foreign lenders' willingness to continue to fund New Zealand borrowing would force the New Zealand economy through a sharp and painful adjustment - possibly including a drop in the exchange rate, a jump in interest rates and gyrations in economic activity. If too extreme, the strain of these adjustments could undermine the proper functioning of the financial system, which would worsen the economic disruption. I should say at this point that, as far as we can tell, the system remains well placed to weather most plausible scenarios. Asset quality, capitalisation, risk management capacity and the state of parent banks are all strong. New Zealand is comfortably servicing its external debt, supported by a healthy economic growth rate and a robust capacity to earn foreign exchange. Hedges are in place to reduce the impact of exchange rate movements on New Zealand's external obligations. But this healthy situation notwithstanding, we would of course be remiss if we did not continue to watch developments closely for signs of financial vulnerability. Lastly, we are interested in investment and borrowing behaviour because it affects economic growth. New Zealand's growth in the past has probably been lower than it could have been, partly reflecting poor savings and investment. The high and variable inflation environment prevailing in the 1970s and 1980s was no doubt one of the main factors hindering effective saving and investment, by making it difficult for investors to discern well-performing from poorly-performing investments. Low and stable inflation now obviously helps, but the fact remains that the quality of our investment decisions is crucial for our future economic growth. Wise investment increases productivity and the economy's real rate of return, producing better growth and higher standards of living. And wise investment, in turn, means individual investors exercising good judgement and effective scrutiny when making their personal investment decisions. So, with an eye on sparing households unnecessary grief, mitigating risk to the financial system, and maximising economic potential, how should we invest in a world of low inflation? Let us start with the simple idea that the objective of investment is to maximise the expected rate of return for a given level of risk, over a particular period of time. Risk is the potential variability of the investment's return, including, in the extreme, the possibility that the investment might lose some or all of its value. For example, the investment might go bust, it might be difficult to realise the value of the investment when needed or required, and economic factors such as exchange rate or interest rate movements might cause the value of the investment to fluctuate. It is a fact of life that investments with higher promised rates of return generally carry higher levels of risk. This rule applies right across the spectrum of different investments - from low-risk propositions such as bank deposits and government bonds, through to higher-risk ones such as corporate bonds, subordinated notes, real estate and equities. The second important idea is that, when looking at the return on an investment, one should distinguish between the nominal return and the real return. The nominal return is the return received in cash flow and in capital gain before taking into account general price inflation, while the real return is the nominal return less the general inflation rate over the life of the investment. For any given level of risk, the higher or lower the inflation rate, the higher or lower the promised nominal return, generally speaking. But it is the real return that investors need to focus on - for it is the real return that determines whether the investor has gained or lost in making the investment. In today's low inflation environment, investors need to remember that an investment's apparently low nominal return may represent in fact quite a worthwhile real return. The drivers of real returns vary depending on the type of investment, but ultimately come down to certain basic fundamentals, such as growth in the economy and in particular industries, market shares, and company productivity. And, of course, all of these factors also affect the risk attaching to the investment. How does low inflation fit into this? Take real estate. New Zealanders have a fondness for investing in housing, currently holding around half their assets in that form. Most of this is owner-occupied housing, but an increasing proportion is investment in rental housing. New Zealanders are investing in rental housing to a significantly greater extent than in earlier years, with the proportion of private rental housing having risen from less than a fifth of total private urban dwellings in 1991 to around a quarter in 2001. I suspect it has risen further since then. In the 1970s and 1980s, when inflation was well into the double digits, house prices generally increased at a brisk pace in nominal terms, though with considerable volatility. In real or inflationadjusted terms, however, house prices were even more volatile and there were significant periods when house prices fell in real terms, as in the middle of the 1970s and late 1980s. For much of the 1970s and 1980s, housing was not a particularly attractive investment, unless of course one bought and sold astutely, getting timing right, taking advantage of trends in particular locations, and reading demand and supply with good foresight. As a matter of arithmetic, not everyone can outperform all the time. For every buyer there is a seller, and had investors looked at the real return achieved on average across the whole market, they might have felt that their exposure to housing was excessive through the 1970s and 1980s. Since the early 1990s, house prices have generally outpaced the inflation rate - that is, they have risen in real terms. That is especially the case in the last year or two, during which we have seen a dramatic increase in real estate prices in many areas throughout the country - arguably too much so. And this reflects the inherent volatility of real estate prices, whether in housing, farm land, commercial property or industrial property. Investors need to be mindful that the laws of gravity apply not only to Newton's apple - they also apply to asset prices, including house prices. In real estate, the "laws of gravity" relate to things like population, income, household formation and the earning potential of the asset. And this is where the low inflation environment matters for those who borrow to invest in real estate. In the 1970s and 1980s, there were sharp falls in real terms in house prices and other property prices typically immediately following a period of dramatic increases - but it was comparatively rare for prices to fall in nominal terms. This meant that if someone were forced to sell in a downturn, the value of the house would probably still be above the value of the debt on the house. Inflation would have shielded the investor from insolvency, at least in that respect. In contrast, in a world of low inflation, fluctuations in house prices can result not only in falls in real terms, but also falls in nominal terms. The risk for investors who borrow almost all of a house's sale price is that the value of the house could fall below the debt they owe. That is probably fine, as long as the investor can continue to service his or her debt. But it could cause real problems in the event that the debt can no longer be serviced - such as when interest rates rise sharply, or incomes fall. In that situation, if the investor is not covered by mortgage protection insurance and is forced to sell the property during a downturn, his or her insolvency on paper might become very real indeed. In view of the increase in household debt in the last 10 years or so, the increasing tendency for people to own a house for investment purposes, and to enter that investment very highly geared, it is possible that some households are now quite vulnerable. That vulnerability is also related to the effect that low inflation has nowadays on the funding side of the household balance sheet. In the days of high inflation, most New Zealanders could rely on their nominal incomes also inflating quite rapidly. This meant that, even with the high nominal interest rates prevailing at the time, households that borrowed on debt-servicing terms at the limit of affordability would find their debt-servicing burdens becoming more comfortable, and the real value of their debts declining, fairly rapidly. This is not the case today. Low inflation means that nominal incomes are rising much more slowly than in earlier years. As a result, the burden of debt servicing lasts for longer, and the real value of debt is eroded less rapidly. The period of vulnerability associated with debt-servicing being just affordable now lasts considerably longer. Some home owners and investors are well aware of the compounding impact of high debt levels on adverse events such as loss of employment or income. They adjust their investment and borrowing behaviour accordingly. However, I think there remain many in this country - and indeed in other countries like ours - whose behaviour suggests that they might not understand the risks they are taking. Leaving real estate aside now, what other investments are available, and how does low inflation affect the equation? After bank deposits, probably the most commonly understood financial security is equities. History shows that equities can deliver a superior long-term rate of return, but also that equity returns over short periods of time can fluctuate quite a bit. New Zealand investors tend to know this, having suffered in the 1987 crash, and have been rather cautious ever since. This caution and the small size of the domestic market, which limits local options, have contributed to New Zealand households not building up financial assets to the same extent as has happened in the US. However, it has also meant that New Zealand household balance sheets did not take such a hit from the techwreck and post-9/11 downturns in the markets. Investors in equities should be in for the long haul, to allow time to smooth out the inevitable fluctuations in share prices that occur from year to year. Also, because you can never be sure about any particular company, industry or region, if you are buying shares you should spread your investments across a diversified range of equities. What about interest-bearing securities? One of the consequences of reducing inflation to low and stable levels is that nominal interest rates on all types of these instruments have fallen substantially. As an example, the average 90 day interest rate in the 1970s was just over 10 per cent, and in the 1980s was around 17 per cent. In the 1990s, the rate fell to 8 per cent, and today stands at a little over 5 per cent - the lowest in many years. Interest rates on other instruments have fallen similarly. In real terms, of course, interest rates have not fallen anywhere near as substantially over the years, and remain attractive for investors, particularly relative to the real interest rates available in many other countries. Indeed, the real interest rate on interest-bearing securities today is considerably higher than was typical during the high-inflation times in the late 1970s and early 1980s. Taking tax into account widens the gap even further, because tax rates are applied to nominal, rather than real, interest income. Investors in interest-bearing securities are thus better off now than they once were. But people who rely heavily on interest-bearing securities for their incomes have nevertheless seen a fall in their incomes, in nominal terms. I fear that this reduction in nominal income, coupled perhaps with "money illusion" - that is, thinking in nominal rather than real terms - may be encouraging some New Zealanders to invest in higher yielding securities, in order to reduce the short-term impact on their cash flow position. In this drive to achieve higher rates of return, some investors may be taking higher risks than they appreciate - especially if they think in terms of the nominal interest rates that they used to receive in earlier years. For example, just a dozen years ago, low-risk securities regularly offered double-digit interest rates. Today, an equivalent low-risk security might only yield 5 or 6 per cent, or even less. To invest in securities offering the same nominal yields as were once available, investors now have to accept considerably greater risk. Perhaps reflecting this behaviour, deposits outside of the banking sector are growing quite rapidly. There are also reports of growing retail investment in higher-risk types of securities such as subordinated notes, capital notes, asset-backed securities, and interests in apartment buildings. These and other kinds of more complex investment products typically offer high yields, but that usually reflects higher levels of risk. For example, it may be that the investment ranks behind other debt obligations of the borrower, exposing the investor to a greater risk of loss if the borrower defaults. In other cases, the yield being offered may be linked to the performance of particular underlying asset markets, which may themselves be quite volatile. There is, of course, nothing inherently wrong with investors taking greater risk. For their own protection, however, they should be fully aware of the risks they are taking, rather than simply thinking in terms of the nominal interest rate offered. Given all this, what should a wise investor do? First of all, seek advice! This applies especially if an investment product looks complicated. There are many sources of information to assist in making investment decisions, including material published by public agencies such as the Office of the Retirement Commissioner, and by reputable members of the savings and investment industry. There is also the advice of professional experts. Naturally, the quality of advice is only as good as the quality of the person giving it, so if an investor chooses to use an investment adviser, the investor would be wise to check the adviser's qualifications and accreditation, experience, track record and independence. Checking the provenance of investment products and firms is all the more important in New Zealand because regulation of financial investments here is not highly paternalistic. The general approach of the Reserve Bank Act for bank deposits, of the Securities Act for financial securities, and of legislation for other forms of investment is to promote the proper functioning of the financial system as a whole, and not the performance or soundness of particular institutions. Laws relating to the financial system set extensive and tough disclosure requirements, so that individual investors can judge for themselves the risks and returns they are facing and make decisions accordingly. As noted earlier, low and stable inflation supports their ability to do this. Investors not prepared to be intensively involved in the day-to-day management of their investments have the option of engaging a professional to manage directly their financial affairs. There are many professional investment management services available. Although some professional service arrangements are pitched at those with sizeable sums to invest, there are also management services for those making smaller investments. Finally, managed-fund products such as unit trusts offer the smaller investor a combination of reduced risk through diversification, and the portfolio-management services of an investment professional. Vigilant and open-eyed investment strategies benefit not only investors. Households making wellinformed investment and borrowing decisions are better able to cope with rainy days, and better prepared for their retirement years. Soundness in the household sector undergirds the stability of the financial system, and of the economy as a whole. Finally, intelligent scrutiny of investment proposals, including the creditworthiness of financial companies, crucially helps weed out poor performers and improve good performers, promoting effective resource allocation and growth across the economy. For all these reasons, it is important that investors take all the steps they can to better understand the nature of the risks attached to their investment and borrowing decisions. This includes thinking in terms of real rates of return, rather than nominal rates. If we - each of us - can learn to become smarter and better informed, we will all be better off, individually and as a nation.
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An excerpt of an address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Australasian Institute of ...
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Alan Bollard: After the National Bank acquisition - living with big Australian banks An excerpt of an address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Australasian Institute of Banking and Finance, Auckland, 6 November 2003. * * * Having a banking industry consisting mainly of banks with Australian parentage has many advantages for us. Despite our country’s small size, our banking system benefits from the presence of strong, innovative, internationally-connected players that are from a highly-respected country and understand our preferred ways of banking. Of course, from time to time one hears complaints about “branch office” treatment of New Zealand borrowers, but overall on a day-to-day basis banks’ customers in New Zealand do well out of the deal. Meantime, the Reserve Bank’s main concern remains to regulate for the promotion of a sound and efficient New Zealand financial system, regardless of the fact of its Australian parentage. The conditions we put on ANZ’s acquisition of the National Bank do not signal any radical new approach to banking regulation. However, they do represent ongoing enhancements that we are very serious about and have been working on for some time. These are aimed at ensuring that local boards have effective operational reach over core assets and people, and that lines of responsibility and accountability are clear. We have been able to effect these conditions due to the new powers put in place by the RBNZ Amendment Act in August, and they provide an indication of the direction of our generic policy thinking on these matters. The Reserve Bank’s conditions associated with the acquisition were in four main areas. First, any transfers or outsourcing of the National Bank’s core banking functionality, including by way of an operational merger, will require the Reserve Bank’s further consent. Core functionality includes all management, operational capacity and systems necessary to operate the bank on a standalone basis in the event of failure of an outsourcing provider, including a parent bank. The intent of this requirement is to ensure that any outsourcing does not undermine the legal authority and practical ability of the directors or statutory manager of the National Bank to run the bank on a standalone basis if the need should arise. This doesn’t necessarily mean that the core functionality must be in New Zealand - it means that legal and practical access to it in a crisis must be unimpeded. The second area where we imposed conditions of consent strengthens the first. We require that the National Bank chief executive’s employment contract be between that person and the board of the National Bank, and that any amendments to the National Bank’s constitution have our consent. The intent of these measures is to ensure that there is coherence in the National Bank’s local accountability arrangements and that the local board remains in a strong position to exercise independent and meaningful governance of the management of the National Bank, in the best interests of the National Bank, in good times and in bad. This requirement should be seen as a means of reinforcing our emphasis on the role of directors in overseeing a bank’s operations, and our ability to manage a crisis involving the failure of any large bank in New Zealand. Third, we require all prospective appointments of directors or senior executives to the ANZ or the National Bank to be advised to us and the appointments made only if we have no objection. This measure ensures that the appointment process is in line with our new obligation introduced by the RBNZ Amendment Act to have regard to the suitability for their positions of directors and senior managers of registered banks. Generally speaking we would be unlikely to object to an appointment unless there were strong reasons to believe the individual would be unsuitable for a position of responsibility over a registered bank. Finally, we require that each registered bank in the ANZ Group maintain a level of capital in line with our current policy on capital adequacy for consolidated banking groups. This tightens up the capital adequacy rules a little in this case, to account for the fact that the ANZ Group now contains two systemically important registered banks. We regard it as important that each of these banks maintain adequate capital on a solo basis. We took these steps in pursuit of our statutory obligations to promote the maintenance of a sound and efficient financial system in New Zealand, and to avoid significant damage to the financial system that could result from the failure of a registered bank. We don’t think the conditions will make a great difference to the current day-to-day running of the National Bank’s operations under normal circumstances. However, we do see them as important in bolstering our ability to deal with a crisis situation involving the bank or the ANZ group. We sought to impose the conditions in a manner consistent with our general approach to banking regulation, which is not to get into the business of managing banks, but to put the onus for effective bank management on the shoulders of those bestplaced to carry that task - the directors and senior executives of banks. In giving consent, we recognised that, under certain circumstances, all our large banks being Australian-owned could increase our system’s exposure to stress emanating from the Australian economy and financial system. We will be considering this further and have let it be known that we will take further measures to manage this risk if necessary. As noted before, the conditions imposed on the ANZ’s acquisition are a specific application of our current policy thinking around governance and crisis management, coloured by the additional considerations introduced by the RBNZ Amendment Act. This thinking is still developing, and relevant to all systemically important banks. Generic policies regarding these matters will be fleshed out as part of our broader financial stability work programme, and we will be consulting with banks on those generic policies in due course.
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Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers' Chamber of Commerce, Christchurch, 30 January 2004.
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Alan Bollard: Asset prices and monetary policy Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers’ Chamber of Commerce, Christchurch, 30 January 2004. * * * It has long been a tradition that Reserve Bank Governors begin their year with a speech to the Canterbury Employers’ Chamber of Commerce and because the economy of Christchurch is focussed on exporting the topics picked have often been of particular interest to the tradable sector. Given current concerns about the exchange rate, you may have expected a talk on that subject. However, I want to talk about something else - a topic which may seem more esoteric, but in particular circumstances can be very important. Indeed, it is a topic that has been of considerable relevance to New Zealand from time to time over the years. Among central bankers right now one of the key topics of debate is whether monetary policy should actively seek to encourage asset price stability. The sharp end of this is whether monetary policy should seek to prevent or at least reduce asset price bubbles? This is exemplified by questions such as whether Japan’s long-running recession and the US “tech wreck” could have been ameliorated by monetary policy constraining the events that preceded them. Before going further, I should define my terms a bit. By an asset price I mean the price of something that one buys to generate income or to sell for a profit later. Examples are physical assets - like housing, land, other buildings and collectables like paintings or exotic cars - and financial assets - like shares, bonds and other financial instruments. By consumer prices I means things one buys to consume, like milk, petrol, a visit to the doctor and ordinary cars. Remember also that asset prices often behave more erratically than consumer prices, being slower to react to changes in supply and demand. Prices of, for example, fruit and vegetables move constantly to match up buyers and sellers. Asset prices are seldom that appealing in terms of classic economics. Under the Reserve Bank’s Policy Targets Agreement (PTA) the Bank is required to ensure price stability, as measured by the Consumers Price Index (CPI), and, subject to this goal, to avoid unnecessary instability in output, interest rates and the exchange rate. Asset prices are not included in the CPI. Thus the question is should monetary policy sometimes look ahead of its normal time horizon and try to offset the potential damage down the track to consumer prices and economic stability that can occur when asset prices tumble? Monetary policy automatically takes asset price developments into account The first point I need to make is that day-to-day central banks pay attention to asset prices when setting monetary policy, even when, as in New Zealand, their formal focus is exclusively on consumption prices. This is primarily because asset price movements impact on CPI inflation and large movements in asset prices can have significant implications for CPI inflation. For starters, in the case of physical assets, if their prices are rising faster than general inflation, people try to build or create more. For example, if the price of paintings is going up artists get painting. To do that they have to buy more paints, brushes and canvas, putting pressure on prices of these materials. In addition to that direct impact, asset price movements - physical and financial - also feed into CPI inflation due to the so-called “wealth effect”. As asset prices rise, people tend to feel wealthier. Some people go shopping as a result, and in an economy already running at full steam this gives inflation a push. This can apply with any kind of asset, but in New Zealand we see this mostly through house prices, due to the high proportion of home ownership here, as well as the large proportion of household wealth associated with housing, as illustrated in graph 1. Graph 1 Household wealth: housing and net financial assets Asset prices also feed through into spending and hence inflation in other ways. For example, asset price increases improve balance sheets, increasing the borrowing power of firms and individuals. Increases in net worth tend to increase the willingness of lenders to lend and borrowers to borrow, facilitating a general expansion in spending as well as an expansion in spending on the construction of appreciating assets. In New Zealand, for example, house price inflation can lead to greater demand for houses, and price increases in construction-related goods and services. These goods and services are directly included in the CPI making up about 8½ per cent. Lately, “purchase and construction of new dwellings” has been notching up price increases approaching 7 per cent year-on-year. This is much higher than the CPI average of around 1½ per cent (see graph 2), and contributed materially to our recent nontradables inflation of around 4½ per cent. Graph 2 The link between house price inflation and the CPI (annual percentage change) Central banks also pay attention to asset prices because they contain information that’s very useful when setting monetary policy. Normally asset prices reflect perceptions of future income streams that the assets will earn. Therefore, asset prices tell us something about how people think the economy will perform in the months and years ahead. Accordingly, in the ordinary day-to-day operation of monetary policy asset prices matter. Also, day-to-day, when the Reserve Bank raises or lowers interest rates to keep CPI inflation where it should be, this also tends to partly constrain rising or falling asset prices in a desirable way. So most of the time asset and consumer prices roughly track together and asset prices present no particular problem for monetary policy or the economy. That’s most of the time. The building and bursting of big speculative bubbles There are however times when things get more difficult and asset prices move well out of line with underlying economic fundamentals. For example, in Japan real estate prices and the equity market shot up through the 1980s, with the Nikkei getting to extraordinary levels before the inevitable collapse which took 60 per cent off equities in 3 years and 70 percent off real estate prices over the following decade. Economic growth struggled, averaging only 2 per cent in the 1990s compared to 4 per cent in the 1980s. In Sweden real estate prices boomed in the second half of the 1980s, nearly doubling over that time. The boom ran out of steam in 1991, and the correction was severe enough to require the rescue of a good deal of the Swedish banking system. Over the first 3 years of the 1990s, Sweden’s economy shrank by nearly 10 per cent. And in the US the NASDAQ increased fivefold over 3 years in the late 1990s, before losing all of that ground by early last year. With the boom having helped the US economy grow at an exceptional pace during the 1990s, the collapse helped send that economy nearly into recession. These examples hopefully make clear that this goes far beyond just housing assets, and includes equities or shares, commercial property, rural property and a wide range of financial assets. In each of these cases, at least early on in the episode, asset prices were behaving “normally” and asset prices reflected reasonable expectations of the earnings prospects of those assets. A variety of things can cause expectations of future earnings prospects to be revised either up or down, and this will of course affect the prices of the assets. As farmers in the audience know, rural land and stock prices swing readily with peoples’ confidence about the future. The sharp rise in dairy land prices in following the GATT agreement in the early 1990s was an example of how expectations can influence asset prices. But expectations of the future can sometimes go beyond the well-founded and can turn out to be horribly wrong. Sometimes, asset prices can become disconnected from reasonable expectations of future earnings, resulting in speculative bubbles that cannot be justified by economic fundamentals. These are situations where markets fail in a big way to get prices even approximately right. Such mispricing can be exaggerated by rule-of-thumb, momentum, or herd behaviour, or irrational exuberance if you like. It happens sometimes that speculators convince themselves that someone else will pay still higher prices for an asset in the future, and in such a situation prices can start bearing less and less relation to any reasonable expectation of future income streams. Classic examples of speculative bubbles include the tulip mania that swept Holland in the seventeenth century, and the South Seas bubble which caused the first big stock market crash in England in 1720. The more recent three examples I have cited were mild by comparison with these earlier ones! Although bubbles may persist for quite some time, experience shows that asset prices eventually return to a level that is more consistent with “the fundamentals”. Bubbles do reveal themselves in the end - people are not fooled forever. Eventually mistakes in pricing become widely recognised, and markets correct. This makes bubbles inherently temporary, involving first expansion and then contraction. It is often only once the contraction has taken place that we see how big the bubble was, or just how much prices were misrepresenting economic fundamentals. But by then a lot of damage may have been done. Failures to get asset prices “right” won’t always be obvious until prices have corrected, but in principle if we can’t square rapid price increases for assets with any apparent fundamentals then we are probably looking at a bubble. In extreme cases, that inability to square developments with fundamentals may become obvious before the correction happens. Speculative bubbles can do damage in two ways. First, they distort resource allocation in the wider economy as people get fooled into investing in the wrong things. Resource misallocation can also be caused by the consumer price inflation that sometimes accompanies asset price bubbles, since inflation makes decision-making more difficult. Second, when the bubble bursts there is damage to consumer and investor confidence, economic activity and potentially the financial system. Several recent international studies1 of asset price booms and busts have documented substantial costs from asset price cycles. The role of the financial system can be crucial to the consequences of a bubble building and bursting. The economic consequences when bubbles burst depends on the extent to which individuals and companies have taken on debts that they cannot comfortably meet. Asset price changes typically involve borrowing and lending in financial markets, because it is future income that is being used to “fund” current expenditure. Generally, at least some of the income from an asset is used to repay financial obligations associated with the asset’s purchase. With speculative bubbles, future capital gains - rather than future income - are often the main source of expected profit. If the bubble bursts, and such capital gains aren’t forthcoming, people have to look elsewhere for the money to service and repay their debts. Debt financing is an extremely useful feature of the economy. It facilitates the reallocation of resources in the economy towards the most profitable activities. Nevertheless, heightened debt can seriously backfire when bubbles burst. In particularly severe cases, borrowers’ troubles carry over to lenders as well, so that in a bubble situation financing, credit and leverage may create financial fragility. Since the financial system is at the heart of all economic transactions, any disruption to it can have significant implications for economic activity. This fragility is sorely exposed when the bubble implodes. These issues are well-illustrated by the Japanese and Swedish cases referred to earlier. Prudent lending practices can help to insulate lenders from serious fallout associated with declines in asset prices, but even then a bubble can still result in serious macroeconomic fallout. The bursting of the US high-tech stock bubble in 2000, and the subsequent weakening in equity prices more generally, was not accompanied by major financial sector problems, but it has been followed by a sustained period of very weak economic growth. Stretched balanced sheets, characterised by excess leverage, damaged business confidence, over-investment in high-technology enterprises, and sharply increased costs of new equity raisings all combined to hold back new corporate investment to such an extent that economic growth stalled. This brings us to the crunch question of whether central banks should try to constrain asset price bubbles to avoid or at least reduce the disruption to the real economy that can come from a bubble bursting? Firstly, we need to recognise that this is difficult as it is very hard to tell in advance whether or not any particular market changes are justified. Forecasting the future is never easy. At each point in time, there tend to be many plausible explanations associated with any given price movement, and it is hard to separate temporary factors from more permanent ones until some time has passed. Secondly, pursuing a separate asset price objective could mean having to compromise on our normal inflation objective. Seeking to stabilise rising house prices or an overheated stock market might mean having to force inflation lower than otherwise would be required. It might also mean greater variability in the real economy, interest rates and, potentially, the exchange rate. That could raise questions about the PTA’s requirement to conduct monetary policy to maintain CPI price stability and avoid unnecessary volatility in those other variables. A further difficulty is that interest rates have limited power to affect the perceptions which move asset prices in the first place. To materially affect some asset prices, such as housing, interest rates might need to move quite a bit, and probably by much more than would be required just to keep CPI inflation comfortably within the target range. Since interest rate changes affect not just house prices, but also the prices of most other assets, goods and services, there would be secondary, unintended consequences, with potentially serious consequences for the economy as a whole. Helbling and Terrones (2003), IMF; Bordo and Jeanne (2002), IMF; Detken and Smets (2003), ECB. Timing also makes this difficult. Given the lag of 1 to 2 years that we think applies between an interest rate move and its effect on the real economy, the risk is high that policy moves would be mistimed and only make matters worse. If interest rates are high at the moment that a bubble bursts, those high interest rates will still impact on the economy two years on. This would make the landing harder. So, given both uncertainty over whether asset price increases have overshot, and doubts over whether monetary policy responses are helpful for known bubbles, one has to be cautious in leaning aggressively against an increase in asset prices. What about using other instruments besides the interest rate? There are not many appealing options for this. Some less developed financial systems use mandatory credit rationing, but this instrument is also very blunt, harming newcomers to the market, distorting resource allocation and potentially depriving the private sector of sound investment opportunities. Another possible option - at least in theory - is to make more use of prudential regulation. For example, could the capital ratio applied to banks be used counter-cyclically? Could the risk-weight on credit exposures secured by residential property be applied in ways that reduce swings in house prices? From time-to-time we consider these kinds of issues, but have so far always reached the same three negative conclusions. First, such tools are unlikely to be very effective in addressing asset price cycles. The implementation of policy changes would take time, after which there would be a potentially long and variable lag in the impact on asset prices. Second, although such tools are less blunt than the OCR in targeting particular asset categories, they are nonetheless still relatively blunt instruments, and would have impacts that go beyond those intended. Third, the use of such tools for macroeconomic purposes conflict with the objective for which such tools were originally designed - i.e. financial stability. Indeed, the use of prudential regulation to moderate asset price cycles might backfire in some circumstances, creating perverse incentives for banks to bias their lending into riskier ends of the lending spectrum, which in turn could reduce the stability of the financial system. These factors have led us to reject the use of prudential tools as instruments for responding to asset price cycles. So where does that leave us? As I have already explained, in the course of doing what we normally do we automatically lean against detrimental effects of asset price movements, since there is often a correlation between asset price inflation and consumer price inflation. The harder question is what to do when a speculative asset price bubble is not accompanied by current or near-term inflation. Responding to a bubble bursting is relatively obvious. The collapse of big speculative bubbles is often accompanied by recession and disinflation or even deflation. The Japanese case illustrates the point. A rapid monetary response, aggressively if need be, to a sudden collapse in asset prices would be consistent with the PTA, assuming there was also a substantial risk of consumer price disinflation. Responding to an emerging bubble is more challenging. I have presented reasons why it is sensible to prevent the emergence of large speculative asset price bubbles, if possible. And I have presented reasons why that would be difficult to achieve, and why it would be risky to try. Nonetheless, it seems to me that the scale of the fallout from the build-up and bursting of very large asset price bubbles warrants taking some risks in an attempt to moderate - and that’s all that one might hope for - the problem. And it seems to me that there are cases when the asset price misalignment is sufficiently obvious that one can be confident enough to take the risk. But I need to be clear that such situations are likely to be rare indeed. And the risks may be considerable. We are talking about circumstances where monetary policy may well have to be quite tight - tighter than would be the case if the sole objective was to keep consumer price inflation within the target range. In such circumstances, I expect many audiences would say that the Bank was unnecessarily squeezing growth from the economy. It would be a foolhardy central banker who would take such risks lightly. That said, as I interpret my mandate, it does permit me to take such risks in rare circumstances. As I explained in an earlier speech, the PTA clearly requires monetary policy to be forward-looking. Normally, we would think in terms of the next three years. But, as I indicated then, there will be exceptions. Given the potentially long-lived nature of asset price misalignments, it may occasionally be helpful to take a longer view of when risks might eventuate, how best to insure against them, and at what price. As a recent IMF study 2 has pointed out, in effect an asset price boom can change the trade-off between current and future macroeconomic objectives. A new element enters the picture, which involves trading off the risk of severe economic dislocation further down the track with the near-term cost of reducing that risk. Recent New Zealand house price developments in context The next and obvious question is whether or not the recent run up in house prices in New Zealand constitutes a bubble so severe that it warrants a one-off additional monetary policy response, as described. Such a response would drive overall inflation to near the bottom or even below the 1 to 3 per cent target range in the PTA, thereby letting the air out of the bubble to avoid a collapse later. The immediate answer is no, though of course, in terms of the day-to-day controlling of consumer price inflation, housing is still the biggest thing being faced at the moment. Over longer periods of time, real house prices are determined by the balance between underlying demand and supply conditions. There are nevertheless some important idiosyncrasies to housing markets that should be borne in mind. On the demand side, such factors include demographics, migration, growth in household disposable income, features of the tax system and the average level of mortgage interest rates. On the supply side, factors include improvements in the existing housing stock, the availability of suitable building sites, and construction costs. Although the demand for housing can shift quite dramatically in a short space of time, the housing stock is relatively inelastic. It takes time to build new houses and the capacity of the construction sector to provide them also takes time to adjust to variations in demand. Accordingly, housing prices are prone to quite significant short-term movements. Extra demand for housing due to migration, for example, can create supply constraints given the time taken to plan and construct new housing. In New Zealand, the correlation between net migration inflows and house price inflation is striking, as illustrated in graph 3. Graph 3 Migration and house prices The price signals given by the housing market thus have to be treated with caution. Compared to markets for financial assets, the housing market is relatively slow to adjust, with long and variable Bordo and Jeanne (2002). times to close sales, and with, beforehand, much uncertainty about final closing prices, if deals are even reached. Aggregated statistics on house price movements are “noisy” indicators of the future outlook for the housing sector. Past prices are not always a good indicator of future prices. Also, data on residential real estate prices are not always of a high quality. This can mean that the housing sector is susceptible to over- and under-shooting. Initial one-off increases in house prices may be misinterpreted as increases in a trend, leading to further moves in the same direction, giving an impression that a major trend shift is underway even if in fact it isn’t. Because of the noisiness of the price signals, it can take a long time for this sort of thing to correct. Eventually, as for other types of assets, house prices do correct, either by falling outright, or by prices treading water for years until fundamentals have caught up. Do recent developments, in light of this susceptibility to over-shooting, imply that the housing market is in such a speculative bubble that an unusual monetary policy response is warranted? In some periods of our history, house prices and rural land prices have both moved through large cycles, both up and down - with the downs more noticeable in real terms (see graph 4). These real declines were sometimes masked by high inflation, which may have fed the false perception in some quarters that house prices never go anywhere but up. In the current low inflation environment, real house price declines as in the past would show up as outright declines in dollar prices. Graph 4 Property prices (annual percentage change) There is no doubt that we have seen quite strong increases in house prices in New Zealand in the last year or so. Some of that is justified by fundamentals, some simply reflects the fact that, in a small economy, with a small housing stock, it does not take much increase in demand to have a big effect on house prices. But some of the recent increases may also reflect excessive exuberance among some investors. Thus some people today may be incorrectly convincing themselves that level shifts associated with lower mortgage interest rates are in fact shifts in the trend of prices, that house prices only rise, and that someone can always be found who will pay more for a property. For a time, this behaviour can be price reinforcing, but eventually some unhappy soul will be stuck holding the bag. There are elements of speculative bubble behaviour present in recent house price developments. While that bodes ill for some individuals, however, it does not seem at this stage to be large enough, or of a character, to generate significant fall-out for the overall economy when the correction happens as it will. In terms of potential risks to the economy and to financial stability, a bubble in residential housing is less of a concern than a bubble in commercial property or in the stock market. On average, banks’ residential mortgage portfolios are much more stable than other loan portfolios. The historical loan loss on residential lending is very low indeed. Furthermore, recently the Reserve Bank worked with the major retail banks in an exercise that involved simulating a variety of shocks, including, amongst others, large falls in house prices and incomes, a foot and mouth outbreak, large changes to interest rates, the exchange rate and so on. The results of these tests suggest that the New Zealand banking system is well placed to absorb some quite nasty shocks including a large fall in nominal house prices. The current-day New Zealand financial system has particularly prudent lending practices, strong capitalisation, sound asset quality and strong parentage. To be sure, there are legitimate reasons to be concerned that resources are being misallocated as a consequence of incorrect perceptions about the likely future course of house prices. But in terms of the ideas discussed earlier, the economy-wide scale of resource misallocation and the fall-out from a housing market correction do not appear sufficiently severe to warrant running monetary policy unusually tight above and beyond the requirement to ensure consumer price stability. The scale of recent house price developments is by no means comparable to the boom and bust in New Zealand equities in the 1980s. Graph 4, below, reminds us of the dramatic bubble in equity prices that was experienced in the second half of the 1980s, when equity prices doubled in one year and halved in the next. This period is a reminder of how substantial shifts away from fundamentals can be, especially with the benefit of hindsight! It defies belief that equity prices at all times during this period were accurate reflections of the true fundamentals-based value of traded New Zealand companies. The 1980s experience was typical of the bubble phenomenon, as asset prices drifted to levels where they didn’t appear to have much connection with the real world, and then eventually they corrected back. So should the Reserve Bank have tried to head off the share market boom of the mid 80s, so as to avoid the 87 share market crash? That’s a really hard call. Monetary policy was already very tight as the Reserve Bank valiantly brought inflation down from very high levels, price stability not being achieved until 1991. To have applied even more pressure probably would have been very difficult. But now, with price stability in place, if our stock market was starting to look like the left hand side of graph 5 then, yes, a Reserve Bank Governor might well say extraordinary measures were required. Graph 5 New Zealand equity prices Conclusions In this talk I have made the following points. I’ve noted that, to some extent, monetary policy aimed at keeping consumer price inflation under control automatically takes asset prices into account in terms of their effect on general price inflation. However, even so, sometimes asset price bubbles occur, causing economic damage. I’ve suggested there are some very limited circumstances where monetary policy should look beyond the immediate inflation outlook and respond more vigorously to asset price developments. I have also noted that this carries risks and is difficult to do. And I’ve recorded that the New Zealand housing market currently does not warrant such a severe intervention, so that, for example, yesterday’s interest rate increase was just part of the normal operation of monetary policy to ensure continuing consumer price stability. There’s an old adage that a popular central banker is seldom a good central banker. Those in my trade have also been likened to dismal souls that take away the punch bowl just when the party is getting boisterous. A central banker trying to constrain an asset bubble would certainly not be flavour of the month because everyone loves a bubble on the way up. Still, central bankers are required to think-long term and sometimes that means taking decisions that won’t be welcomed at the time but, in the longer-term, are in the public interest. (Assistance in the preparation of this text was provided by Nils Bjorksten, David Archer and other RBNZ staff.)
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Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Trans-Tasman Business Circle, Sydney, 11 August 2004.
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Alan Bollard: Supervising overseas-owned banks: New Zealand’s experience Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Trans-Tasman Business Circle, Sydney, 11 August 2004. * * * In many respects the Australian and New Zealand economies are similar. With banking, however, there is a big difference - the New Zealand banking system comprises banks owned overwhelmingly from abroad, whereas in Australia the banks are mainly Australian-owned. Of course, the main overseas-owned banks in New Zealand are Australian-owned banks and, in this sense, it might be said that banking is another thing we have in common. But that would be to overlook that banking authorities in countries with predominantly overseas-owned banks face some additional, and different, issues from those in which the banks are mainly locally-owned. These differences include different roles in the supervision of banks, depending on whether one is the supervisor of the “home” country parent bank, or, as is predominantly the role of the RBNZ, a “host” supervisor of overseas-owned banks. More broadly, and more importantly, for a country whose banking system comprises predominantly overseas-owned banks, there are different issues concerning the capacity of its banking system to weather a crisis. In this regard, overseas ownership can be both an undoubted strength, but also a potential risk. There are also issues concerning the depth and breadth of financial services that overseas-owned banks provide to the local economy. In New Zealand we are a very welcoming host of overseasowned banks, but we also look for our “guests” to be good guests, and to make a positive contribution to the New Zealand economy. A number of things have happened recently to raise interest in these issues. First, there has been the take-over by the ANZ of the National Bank of New Zealand, previously owned by the British bank, Lloyds TSB. This means that about 85 per cent of New Zealand’s banks, measured by total assets, are now Australian-owned. Australia and New Zealand also now share the same “big four” banks. The ANZ owns the merged ANZ National in New Zealand; NAB owns the BNZ; the Commonwealth owns ASB; and Westpac in New Zealand trades as a branch operation. Second, early this year the New Zealand Minister of Finance and the Australian Treasurer put trans-Tasman banking supervision on the initial agenda of issues for working towards a single trans-Tasman economic market. The other issues identified for consideration were accounting standards and competition policy. On banking supervision, Ministers commissioned New Zealand and Australian officials to report jointly on trans-Tasman mutual recognition and harmonisation possibilities. This process is now well advanced, with a report currently before Ministers. I expect that Ministers will be indicating soon the direction to be taken. Third, there have been issues in New Zealand in relation to the seemingly small amount of tax the banks have been paying. And this has all been happening at a time when the RBNZ has been seeking to reinvigorate the regulatory arrangements for New Zealand’s banking system, to give it more resilience in times of financial stress. This has been behind our policies to require systemically-important banks (and some others) in New Zealand to be incorporated in New Zealand, that better ensure effective banking sector corporate governance, and that place some constraints on banks out-sourcing key operations. I will say more on these policies, and on our approach to banking supervision in New Zealand more generally, in a moment, but before doing that I would like to provide some context. Banking supervision policy needs to be viewed against the backdrop of the importance of the role of the banking system in the economy. Why the banking system matters Banks play a key role in mobilising and allocating the economy’s resources - mobilising from those who, for the meantime, have surplus resources, and allocating to where resources can be put to best use. This role is particularly important for meeting the funding requirements of growing small- and medium-sized firms, given that these firms have limited abilities to access funding directly from the securities markets, or from abroad. With SMEs comprising a large share of the New Zealand economy, as is also the case in Australia, this makes the banking system important for the economy’s growth prospects. Equally as critical is the role banks play in the payments system. The overwhelmingly-used means of payment these days is the bank deposit, whether it be to pay for the groceries, to pay wages, to make settlement on a property transaction, or to settle dealings in the wholesale financial markets. And we use a number of bank-provided systems to make these payments. These include EFTPOS, cheques, telephone banking, and internet banking. If it were not for the fact that a small number of banks dominate the banking system, bank failures might not be so much of a problem. But to shut down a bank with a 20 per cent plus market share, and thus to shut down the ability of perhaps 20 percent of the economy to access working capital and to make payments, is quite another thing - to say nothing of the risk that one bank failure can precipitate others, and wider financial system collapse. Banks therefore play a critical role, but at the same time they are potentially fragile organisations. They are different from most other firms, because their ability to operate is so dependent on maintenance of market confidence in their financial soundness. If a manufacturing firm’s solvency is in doubt, the public generally does not suddenly stop buying the product. But if there is material doubt in the market-place about a bank’s ability to meet its financial obligations, without official intervention to restore public confidence, it can no longer operate. This fragility is inherent in what banks do. Their business is to take deposits and make loans, which means that, necessarily, they are very highly geared. No other industry operates with a capital ratio as low as 8 per cent. And for deposit liabilities to serve as a means of payment, they need to be liquid. Hence, banks generally have a balance sheet structure also characterised by borrowing short and lending long. With this financial structure, the margins for error are fine and, in an uncertain and competitive marketplace, there are always risks. Indeed, banks on occasion do get into trouble, and probably more often than is commonly thought. Recently in Australia, there have been some high profile incidents at the NAB. In the late 1980s and early 1990s, both Australia and New Zealand had much more serious incidents to deal with. There was the failure of state banks and the parlous condition of Westpac in Australia, and similar problems at the BNZ and DFC in New Zealand. Before that, in 1979, there was the problem at Bank of Adelaide, and both countries have experienced fringe financial institution failures. None of this makes Australia and New Zealand unique. It is easy to find other countries that have experienced banking system difficulties that were even more serious. Sweden, Finland and Norway all experienced systemic banking collapses in the early 1990s, which required fiscal support in the vicinity of 5-10 per cent of GDP. In the Asian financial crisis later in the 1990s, Indonesia, Korea and Thailand all needed to provide fiscal support to their banking systems in excess of 30 per cent of GDP. Other cases include Japan (8 per cent of GDP), Spain (16 per cent) and the United States saving and loan crisis (3.2 per cent).1 And these are just the fiscal costs. The cost of bank failures is not limited to the cost of rescuing banks or bailing out depositors. The real economy costs can be greater and longer term, including weakened investor and consumer confidence, higher borrowing costs, potentially protracted credit contractions and, in consequence, lower economic growth. Given this combination of critical importance and potential fragility, no country can afford to view its banking system with indifference. The banking system is something that is central to a nation’s economy. And that applies whether the banks are locally- or foreign-owned. Indeed, some countries, including Australia, appear to see banks - at least the large, systemically-important, ones - as being so central to their economy as to preclude them from being foreign-controlled. Source: Hoggarth G, and V Saporta, “Costs of banking system instability: some empirical evidence”, Bank of England Financial Stability Review, June 2001. By contrast, in New Zealand, as a matter of policy, we don’t restrict foreign ownership in banks, and all our systemically-important banks are foreign-owned. But, while we have seen no need to restrict foreign ownership, we do see a need for regulation of overseas-owned banks so as to provide reasonable assurance that the New Zealand banking system could weather a period of banking stress. Sometimes it is suggested that having banks that are owned by substantial foreign-owned banks is actually an advantage, because the foreign owners can be relied on to mount a bail out if the need arises. While this may often be true, I think it would be imprudent to rely on such an assumption. To be sure, experience indicates that, usually, parent banks do stand behind their overseas operations, since not to do so could seriously undermine market confidence in the parent’s own financial position, and would involve writing off the franchise value embedded in their overseas investment. But there will be occasions when an overseas owner is either unable, because of its own financial weakness, or because of home country regulatory constraints, to provide that support. These cross-border issues are something that many countries, particularly the growing number with a significant foreign bank presence, are having to come to grips with. Increasingly we are being confronted with the fact that shareholders, customers, and taxpayers, not only have different interests in the banking system, but increasingly reside in different jurisdictions. The international framework for supervision of multi-national banks The internationally-agreed framework for the supervision of multinational banks, as devised by the Basel Committee on Banking Supervision, is known as the Basel Concordat (not to be confused with the Basel Accord on capital standards for banks). The Concordat assigns clear, and deliberately overlapping, roles to the supervisors of multinational banks in those banks’ “home” and “host” countries. The home country supervisor is responsible for consolidated supervision of the global bank. It sets standards to be met on a group consolidated basis, for example, that group capital is sufficient to support the global business. (Some home country supervisors additionally set standards to be met by the bank in its home country alone - so-called “solo” standards.) Host supervisors, that is, the authorities in the other countries where the bank operates, are charged with supervising the bank in their individual jurisdictions. This framework recognises the reciprocal and over-lapping, though not identical, interests of the respective authorities, and the importance of sharing information. As mainly a host supervisor, the prime role of the RBNZ is to promote sound banking by the overseas-owned banks operating in “our patch”. We do this mainly for our own purposes, in recognition of the vital role of our banking system to the New Zealand economy, but there is also a significant element of contributing to the effective supervision of the multinational banking groups of which the overseas-owned New Zealand banks are a part. In return, we have a close, reciprocal interest in the parents of the overseas-owned banks in New Zealand, and in the supervision of those banks by the relevant overseas authorities. With New Zealand’s banks almost entirely foreign-owned, there is at least as large a probability that shocks to the New Zealand banking system will originate from abroad as from within New Zealand. RBNZ supervision for promoting banking soundness The Reserve Bank of New Zealand, as the New Zealand banking supervisor, conducts its supervision of New Zealand banks that are overseas-owned within this internationally-agreed framework. (In New Zealand, unlike in Australia, the central bank is also the bank supervisor.) The RBNZ’s responsibility to supervise banks in New Zealand is prescribed in the Reserve Bank of New Zealand Act. This Act requires us to use the powers it gives to the Bank to promote the soundness and efficiency of the New Zealand financial system, and to avoid significant damage to the financial system that could be caused by the failure of a registered bank. There are three central pillars to how we promote sound prudential management by banks, including by overseas-owned banks, in New Zealand. First, we look to the banks themselves for self-regulation. This is about policies and structures that promote effective governance by banks’ boards of directors, including effective oversight by local boards of the local banks’ managements. We expect high standards of corporate governance from the boards of New Zealand banks, and this expectation is reinforced by some quite severe penalties that could apply should a bank’s directors fail to properly discharge their responsibilities. In these regards, we have observed a trend for overseas-owned banks in New Zealand increasingly to adopt “matrix management” arrangements, under which the reporting and accountability lines of local managements to their local boards may be weakened by direct reporting lines to overseas head-office managements. Hence, we took the opportunity when approving the amalgamation of the ANZ and National banks, to reinforce that the board of the merged bank must carry prime responsibility for oversight of the bank in New Zealand. Consistent with this, we have required that the chief executive of the bank must be appointed by, and be primarily accountable to, the New Zealand board. We will be consulting with other systemically-important banks about the application of similar requirements to them. We are also reviewing more generally the governance arrangements in banks to ensure that bank boards are sufficiently empowered to oversee the management of their bank in New Zealand and that they bear the appropriate accountabilities in performing their responsibilities. A second pillar is market discipline. For many years, banks in New Zealand have been subject to obligations to make quite comprehensive quarterly financial and prudential disclosures to the marketplace. These disclosures, combined with a policy of not bailing out failed institutions, help to strengthen market scrutiny of banks, and the market disciplines that go with that. This is an area of policy where the RBNZ has played a leading role, although other countries’ banking authorities too are now seeing an important place for disclosure by banks as a means of reinforcing prudential discipline. Globally, banks are making much fuller disclosures to the market than used to be the case, and that trend will be reinforced by new international disclosure requirements being introduced as part of the new Basel 2 capital requirements, on which I will say a little more in a moment. Third, we have some regulatory and supervisory requirements. Although our regulatory framework is somewhat less intrusive than that of many countries, it nonetheless contains most of the standard features. The IMF in its Financial Sector Assessment Programme (FSAP) review of the New Zealand financial system last year confirmed that we have a good model for host country supervision. The centre-piece of the regulatory requirements is a requirement that banks in New Zealand be adequately capitalised. We apply the standard Basel I capital accord in much the same way as do other supervisors. In the case of overseas-owned banks, we require the bank in New Zealand to be sufficiently capitalised in its own right, with not less than 8 per cent capital. This serves two purposes. It reinforces the responsibilities of the local board and management, since they have a balance sheet for which they are clearly responsible. And it provides a financial buffer should the bank incur losses in New Zealand, or should the parent bank fail and its New Zealand subsidiary have to be “cut loose”. Banking supervision and failure management This brings me to the second element of our statutory responsibilities - to avoid significant damage to the financial system that could be caused by the failure of a registered bank. Absolutely critical in this situation would be that the New Zealand authorities have the ability to take control of the failed bank in New Zealand. Without that ability to take control, and to take control quickly, we could not manage the situation. And in the case of a systemically-important bank, just shutting the doors generally would not be an acceptable response. In most cases, our objective would be to maintain the provision of critical banking services, but without resorting to a bail-out; certainly not a bail-out of existing shareholders, and desirably not of depositors and creditors, who could expect to bear some of the losses. To achieve those outcomes, the New Zealand authorities would need to have access to the critical operating and information systems necessary to operate the bank, and more or less immediately on the failure occurring. I should hasten to add that none of this means that, in the event of a bank crisis involving an overseas-owned bank, the RBNZ’s first preference would be to act unilaterally. In most situations a co-ordinated response involving home and host country authorities would be much preferred - from both authorities’ points of view. But a co-ordinated response requires that both authorities have a capacity to manage the situation in their jurisdiction. It would also be unrealistic to assume that co-ordination would always be readily achievable, as there would be a risk that the interests of the different regulatory authorities would diverge. This could occur if, for example, an economic shock places stress on the financial system in one country, but not the other; or the respective regulators in the two jurisdictions have different priorities in terms of the future of the failed bank. This is why we focus on ensuring that we have an effective failure-management capacity in respect of banks operating in New Zealand, including those that are owned from abroad. That in turn requires those banks, at least those that are systemically-important, to have key systems and key management available, either on the ground, or at least within our jurisdictional reach. This is another issue we addressed with the ANZ in the context of the ANZ-National Bank amalgamation, and intend also to take up with the other systemically-important banks. Another key requirement, if local authorities are to be able to manage a bank failure, is that there is clarity about the local bank’s balance sheet, that is, clarity on what its financial obligations are, and on what assets it has to meet those obligations. That clarity is not readily achievable for a bank that is a branch of an overseas bank because, legally, the assets and liabilities of a branch are inseparable from those of the overseas parent or head office. This is the main reasoning behind most countries’ requirements that systemically-important banks be incorporated locally, a requirement that now also applies in New Zealand. All systemically-important banks in New Zealand currently comply with the requirement to be incorporated locally, except for Westpac. Westpac has always been a branch bank in New Zealand. It has been engaged in discussions with us on this issue for some time, and currently has before us a proposal under which it would “buttress” its present branch structure, in ways it believes would deliver the policy outcomes we are seeking. However, as the proposal is still under our consideration, it would be inappropriate for me to comment further on that alternative structure at this time. Are these RBNZ banking supervision requirements burdensome? Our requirements of overseas-owned banks in New Zealand are not onerous or costly for those banks. Let me explain why not. First, there is nothing in what we require that APRA would not require of an overseas-owned bank that was systemically important to Australia. I say “would not” because Australian policy to date has precluded systemically-important overseas-owned banks in Australia. Second, the Reserve Bank of New Zealand Act requires that we promote the efficiency as well as the soundness of the New Zealand financial system. This is a responsibility we take seriously, and it is reflected in what we do in a number of ways. Not least, we see retaining the openness of the New Zealand banking system to overseas ownership as important for promoting competition and innovation in the New Zealand banking market. Another feature of our approach to banking regulation, as it applies to all banks in New Zealand, not just overseas-owned banks, is that it is largely “principles” based, and relatively light on “black-letter” regulation. Our approach to banking supervision is sometimes described as “light-handed”. That is a description that may give the wrong impression, at least if it gives the impression that we are not serious about our role. We are serious about the principles we apply, and in seeing to it that they are applied. But we endeavour to supervise in a way that not only is effective, but also is cost-efficient, including for the banks. The way to achieve that, we think, is to get the basic structures and incentives right particularly the incentives for directors to monitor and to exercise effective oversight so as to avoid having to disclose bad news. Also, as already outlined, our supervision of overseas-owned banks is conducted very much within the internationally-agreed framework of “home-host” supervision. We seek to ensure that our requirements do not cut against home-country requirements and, consistent with meeting our own responsibilities, dovetail as much as possible with those requirements. My more general point here is that avoiding unnecessary compliance costs is something we attach importance to. On the whole, I think we have been quite successful in achieving that. And, as part of the effort to enhance trans-Tasman co-ordination, we will be reviewing our requirements to see where we could achieve better alignment. It also bears stating that our requirements do not deny the many overseas-owned banks operating in New Zealand the benefits of large overseas-bank parentage, nor overseas banks the benefits of a New Zealand presence. New Zealand banks with overseas parentage benefit a lot from that parentage. Parent banks generally are a source of capital, a source of rating strength, which helps to lower New Zealand bank funding costs, as well as a source of risk management and systems expertise. For overseas banks, New Zealand is an open and welcoming market, with a level playing field for local and overseas participants. And for the Australian-owned banks, New Zealand has provided a significant addition to their home market, and one that, in recent years, has been very profitable. With operations on both sides of the Tasman, the Australian banks are well placed to service trans-Tasman customers, and our banking supervision requirements place few, if any, impediments in the way of that. Next steps Having said all that, the recent report to Ministers that I mentioned in my opening remarks has usefully sharpened the focus on achieving increased coordination of trans-Tasman banking supervision. We already have a formal Memorandum of Understanding with APRA2 and we will be looking to work with APRA on how best the two organisations can coordinate, both in terms of day-to-day prudential supervision and crisis management. New Zealand certainly will be prepared to carry its share of the regulatory burden under such co-ordinated arrangements. At the same time, co-ordination need not mean that our requirements need always be identical to those of APRA. On some matters we may adopt different approaches. One that is starting to receive some publicity concerns the implementation of new Basel 2 capital adequacy standards for banks. Under Basel 2, national authorities will have a choice between adopting a more sophisticated, internal model-based, approach to calculating capital requirements, or a simpler methodology that is closer to the existing Basel 1 regime. APRA has indicated that it proposes to apply the internal model-based regime in its consolidated supervision of Australian banks’ global operations, which, of course, encompass their operations in New Zealand. In considering this issue, we will be looking to ensure that the adoption of Basel 2 does not result in a general weakening in the capital adequacy of New Zealand banks, and our general preference is for a simpler rather than more complex approach, in part to keep compliance costs down. But we are also aware that if our and APRA’s requirements are not reasonably well-aligned, that could increase compliance costs, and we will be seeking to avoid that. More generally, given the high degree of integration of the New Zealand banking system with the Australian banking system, there may well be an opportunity to develop arrangements for transTasman banking supervision into a world-class model of “home-host” supervision. One area where more coordination may be possible is banks’ disclosure requirements, where international developments in accounting and disclosure standards will have implications for both countries. Another area where more structured co-ordination obviously would be useful is in crisis management. Concluding remarks By way of conclusion let me recap on what I see as the main points. First, the banking system matters. For any country, the banking system is one of the most critical elements of its economic infrastructure. This is as true for a country whose banking system comprises mainly overseas-owned banks, as it is for one whose banks are predominantly locally-owned. In that sense, while almost all the banks in New Zealand are overseas-owned, the banking system as a whole must still meet New Zealand’s needs - in fair weather and foul. http://www.rbnz.govt.nz/banking/supervision/0137035.html. Second, it is essential that the New Zealand authorities can supervise the New Zealand banking system and can respond quickly, decisively and effectively to a banking crisis. All countries need to shoulder the responsibility for the sound functioning of their banking systems. This is why we require systemically-important banks in New Zealand to be incorporated locally. And it is why we require such banks to maintain the capacity to function on a stand-alone basis, if required. Without that capacity, there is a material risk of the banking system becoming dysfunctional in a banking crisis. Avoiding that risk we see as being fundamental to the soundness of the New Zealand financial system. The measures we are introducing to counter that risk recently have been affirmed by Standard and Poors, who have noted that they “could well enhance the strength of the New Zealand banking sector and its ability to withstand a period of financial stress”.3 Third, the Reserve Bank is concerned to ensure that its supervision is efficient as well as effective. This is reflected in our emphasis on principles, and structures that emphasise incentives and accountabilities, rather than detailed prescriptive, or “black-letter”, regulation. It is also reflected in the internationally-agreed framework for the supervision of international banking groups, within which we operate. This sets up a basis for co-ordination amongst home and host country authorities, and avoids unnecessary duplication. With regard to the supervision of trans-Tasman banks, we already have a formal arrangement with APRA which provides, mainly, for information sharing. In the period ahead we will be looking to build on that arrangement, in a way that ensures that our supervision of Australian-owned banks in New Zealand is both effective and cost-efficient. Indeed, with the New Zealand banking system now comprising predominantly Australian-owned banks, there exists an opportunity to develop arrangements for the supervision of trans-Tasman banks that would be a world-class model of crossborder banking supervision. Standard and Poors Ratings Direct, “Robust local operations and strong parents fortify credit quality of New Zealand banks, despite profit moderation”, 28 July 2004.
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Property Council of New Zealand, Rotorua, 2 September 2004.
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Alan Bollard: What’s happening in the property sector? Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Property Council of New Zealand, Rotorua, 2 September 2004. * * * Introduction The property sector, in the broadest terms, is something that fascinates most people. Most New Zealanders own or aspire to own some kind of property, and property forms a significant part of the wealth of many of New Zealand’s households. As a country with a substantial reliance on agriculture, both currently and historically, the buying and selling of rural properties also has a particular potency in our national imagination. The Reserve Bank, by contrast, has a technical interest in the property sector, though of course we too know how perceptions can be everything. The Reserve Bank is charged with two key tasks, aside from issuing currency. They are implementing monetary policy to achieve price stability, and maintaining the stability of the financial system. Changes in asset prices, for the most part property prices, can have consequences for both of these tasks. Most asset prices do not directly enter the Consumer Price Index; the prices of new houses and cars are included, but that’s about all. However, even changes in the prices of assets that are not included in the CPI can have an indirect effect on consumer prices. For example, a sharp lift in commercial property prices or rentals ultimately impacts on the “cost of doing business”. In turn, that has an impact on the prices faced by consumers. Changes in asset prices can also have consequences for financial stability. We know from the experience of the late 1980s that a large fall in commercial property prices can result in some large firms running into serious financial difficulties, with major consequences for financiers and banks. It is important that our financial system is robust enough to withstand such shocks. So, in short, the property sector is definitely on our radar screens. What I want to do, therefore, in this speech is give you an idea of how we view the sector and its various parts. Of course, one can start with the core economic idea of supply and demand. However, we also know that the property market behaves differently from the market for consumer goods. In the property market, supply tends to be relatively inelastic. Or rather, it tends to respond quite slowly to changes in demand. In fact, the demand for buildings can increase dramatically as output rises. Consider a single firm. The value of the building stock that a firm uses can be large relative to the annual output that the firm produces. Hence a rise in output can result in a change in demand for building stock that is even larger, in value terms, than the initial rise in output. We know that the amount of new building work that can be put in place in a short time period is limited. For one thing, new buildings, and even alterations, involve design time, and time to get through the planning process. Second, there is always a limit on the building industry’s ability to meet demand. Such bottlenecks have been in clear evidence over the past couple of years as the demand for new housing and apartments has accelerated. Because supply often lags demand in the property market, there is the potential for a mismatch between the supply and demand, and this can work in both directions. When demand for property cools, due to a slowing economy, it’s hard to switch off new supply in the pipeline. So a rapid rise in prices can be followed by quite significant declines later on. All property sectors tend to exhibit price cycles, with these cycles reflecting this mismatch between demand and supply. Demand for most kinds of properties over recent years seems to have outstripped increases in supply - prices and rentals across most property classes have generally been moving upwards and vacancy rates downwards. We can attribute much of that strength directly to developments in the broader economy. Whilst it hasn’t been all plain sailing, this year the New Zealand economy entered its fifth year of unbroken growth. Just as that expansion has drawn heavily on the economy’s surplus labour and productive capacity, so too has it fuelled the demand for property. When you consider some of the causes and consequences of that growth, it’s not hard to see why the property sector has fared pretty well over this period. Some of the following statistics may help to put some perspective around the demand for property. Since 1998/1999, when the business cycle caused by the Asian crisis and drought bottomed out: • the total output of the economy has expanded by about 20 per cent; • the volume of retail sales has expanded by about 25per cent; • export volumes have risen by nearly a third, driven heavily by the primary sector; • the annual operating surplus in the agricultural sector has risen, in real terms, by around 35 per cent; • the number of people employed, either full time or part time, has increased by around 220,000; • net immigration has added 67,000 new people to the normally resident population, and when increases in foreign students and those here on work permits are included, the figure is considerably larger still; • the annual number of tourists visiting New Zealand has risen by nearly 1 million; and • there are about 40,000 more business units now operating throughout the country across a variety of industries. Clearly all of that will have helped to fuel the demand for property in some way. But each segment of the property market is different and each has its own drivers. So let me move on and make some remarks about the major areas of property - rural, commercial and industrial and housing. Rural property Prices of various rural land types - dairy, fattening land, etc - have tended in the past to move in a similar fashion. This suggests that a similar set of factors is driving the demand in each sector. World growth, which in turn affects commodity prices, is probably one of these factors. Another reason why the prices of different land types tend to move together may be competition for land between different primary sub-sectors. For example, increased demand for dairy products will tend to increase the value of land used for dairying, but the effects are also likely to felt by other sub-sectors, lifting the price of land that is currently being used for other purposes. Figure 1 shows changes in rural property prices and changes in the CPI. The profiles of the two series are clearly different. Consumer inflation was very high in the mid 1980s, but then fell to 2 per cent in late 1991. It has generally stayed low since then. In contrast, rural property prices showed large rises in the late 1980s and early 1990s before levelling off. Rural property prices have shown further gains in recent years, and increased by 12.9 per cent in calendar year 2003. What caused the large rises in prices that began in the late 1980s and continued over the 1990s? The levelling off in prices in 1991 appears to have been the result of a sharp fall in world commodity prices in the second half of 1990 on the back of a weak world economy. Figure 1 Rural property prices and the CPI Annual percent change The first thing to note is that rural property prices fell through much of the 1985-89 period, following the abolition of subsidies. In real terms, this fall was severe. In figure 1, we can view the gap between the rural property prices and the CPI as being the change in real property prices. The fall in real prices in the 1980s was huge, since nominal property prices were falling at the same time as consumer inflation was high. Given this, a lot of the rise in property prices that occurred in the early 1990s could be viewed as “catch up” with real prices correcting back to a more normal level. However, other factors were also at work - the exchange rate eased in late 1988 which flowed through into export prices; interest rates fell sharply between 1990 and 1992; a new government was elected in late 1990 and began carrying out further reforms; confidence was returning to farmers after they realised that they could in fact operate profitably without subsidies; and growth in the economy overall began to rise in early 1993. Figure 2 Rural property prices, commodity prices and merchandise terms of trade Indexes with base 1989Q4 = 1000 What has driven the rise in rural property prices since 2000? The initial boost came from an extraordinary rise in export earnings which occurred in the 18 month period beginning in June 1999. During this period world prices for our exports rose strongly, while the exchange rate declined. Figure 2, which shows property prices in index form (i.e. in level terms rather than growth rates), illustrates the strong climb in commodity prices as expressed in New Zealand dollars. On top of this climb in export prices, export volumes also rose. Export earnings peaked in December 2000 and have declined a bit since then. Even so, they are still at a much higher level than they were in the early 1999. This is despite the current strength in our exchange rate (which, I might add, is due in part to the weakness of the US dollar). Fortunately our exchange rate appreciation has occurred at a time when world commodity prices have been high. Also, given the speed with which our currency has appreciated, some exporters still have significant foreign exchange cover in place. They had taken out much of this cover in the period when the exchange rate was low. This has partly offset the impact of the exchange rate rise on their earnings. Another factor that drove land prices in the early 2000s was the conversion of farms to dairying. Over the second half of the 1990s, dairy prices rose relative to those for alternative pastoral products like meat and wool, with the positive effects of the Uruguay GATT round becoming apparent. The formation of Fonterra may have also been a factor in the move to dairy. In the last two years, other forms of farming have come to the fore. The continuing fall in sheep numbers in the EU, and residual anxieties about BSE and CJD in Britain, have pushed lamb prices to new highs. At the same time, the BSE outbreak in the US, which was traced back to a Canadian herd, has resulted in North American beef being virtually shut out of the world market. With demand for beef from North Asia continuing to be strong, world beef prices have risen sharply. While the outlook for agriculture remains positive, it is too early to say that prices for the commodities that we produce have shifted up a level and will stay there. It can be argued, for example, that increasing demand for dairy products from China means that our dairy prices will move to a higher level. Even if this was the case, it would be unwise to think that commodity price cycles would disappear altogether - prices will continue to cycle, even if they cycle around a higher level. The National Bank, in its Rural Report of March 2004, suggested that even now rural land might be too expensive. The National Bank notes that the value of an asset in economic terms is the present value of future expected income discounted at the required rate of return. The National Bank estimates that for the future income stream to equal the current price of rural land a discount rate of around 4 per cent is required, which is very low. Provided that the future income stream is being estimated correctly, this suggests that rural land is currently overvalued. Analysis that we have undertaken at the Reserve Bank indicates that the ratio of rural land prices to agricultural operating surplus is now above its long run average value. However, the ratio is not yet out of line with the values that it reached in the mid 1990s. Whether there will be a downward adjustment in prices presumably depends on whether market participants also reach the conclusion that rural land is overvalued. Rural dwellers often remind us that non-economic factors - lifestyle considerations in particular - are also important reasons for wanting to hold rural land. Industrial and commercial property The prices of industrial and commercial buildings rose sharply in the mid 1980s during the growth surge that followed the first moves to deregulate the economy. By industrial buildings I mean factories, cool-stores, warehouses and the like. By commercial buildings, I mean offices, retail buildings, hotels, and other similar places of business. Looking back, we can see that we had a price bubble. (Bubbles are often difficult to identify when they are occurring, but are clearly obvious once they’ve burst.) In a bubble, asset prices become disconnected from reasonable expectations of the future earnings of those assets. Markets fail to get prices right. This mis-pricing gets reinforced and exaggerated by herd behaviour, or irrational exuberance. Investors convince themselves that someone else will pay even higher prices for the assets in future. In the case of commercial buildings in the 1980s, the pace of construction was frantic, as supply rose to meet the high demand which was manifesting itself in high prices. Anyone who was around at that time can remember the cranes that cluttered the skylines of our major cities. While prices for industrial properties also rose sharply in the 1980s, construction of new industrial buildings was actually fairly steady during this period. The bubble that occurred in the mid 1980s was not limited to business property. The SE40 share market index doubled in one year and then halved in the following year, after the crash. Nor was the bubble limited to New Zealand; it occurred in other countries too, notably in the US. Figure 3 Industrial property prices and the CPI Annual percent change The bubble burst in late 1987 when the US share market crashed. It suddenly became obvious that asset prices had been out of line with economic fundamentals. We had witnessed a sustained period of misplaced investment, with the returns from this investment proving to be low. Misdirecting resources in this manner can be very costly for the economy. The consequences for New Zealand were serious. Some companies went bankrupt and the economy went into a recession. It didn’t recover from this recession until 1992. In terms of the loss of output relative to potential output, this recession was probably New Zealand’s second worst of the twentieth century. When the recovery did arrive, it was strong. Manufacturing, much of which had been restructured and was running under new ownership and management, began to thrive. For a number of years we had double digit percentage growth in manufactured export volumes. Consequently, the demand for industrial property rose sharply. In the newly deregulated environment of the labour market, employment growth was strong, and unemployment began a steady decline. The growth in service sector employment increased the demand for commercial property. The Asian crisis and the drought of 1997 slowed demand for both industrial and commercial properties. But prices have lifted again in recent years, fuelled by the economic growth stemming from all the factors I mentioned earlier. In general, these recent rises do not appear to be cause for concern. As I see it, we have learnt from the lessons of the past, especially the lessons from the 1980s. An incremental approach to industrial and commercial building appears to have been adopted. Little speculative building is being done, and arrangements regarding the tenancy of new buildings are often finalised before building begins. Additions and alterations continue to be a major component of total building activity, with office space being refurbished in order to meet clients’ needs. The clients too have probably played their part, by moving to open plan arrangements and paring back their requirements for floor space. I hope these trends continue. I do see some future challenges for the commercial and industrial property sectors. Building consent data over the past 12 months have indicated an increase in new building intentions in the sector. High levels of activity in the housing and apartment sectors have deflected some resources and labour away from the commercial building sector. Those pressures are likely to remain in the near future. In addition, planned government investment in roading and other areas of infrastructure will continue to place heavy demand on civil engineering and related professions as well as the demand for labourers, many of whom might otherwise choose to work in the property construction field. In fact, there are currently pressures on factors of production across all sectors of the economy. For a number of years now, firms across all industries have been reporting that it is getting harder to recruit both skilled and unskilled labour. There appears to be an emerging view on the part of employers that, over the last 10 years or so, the country as a whole has not done enough training, particularly in the skilled trades area. Hence, delivering on commercial construction projects over the next few years will be a challenge requiring careful management. Figure 4 Commercial property prices and the CP Annual percent change Housing I’d now like to make some comments about New Zealand’s residential property market, which has experienced a strong cyclical upswing over the past three years. During that period, we have seen record numbers of house sales together with a significant lift in the construction of new dwellings, both houses and apartments. Unlike the residential upturn during the mid 1990s, which affected mainly the upper North Island, this one has been spread across the country, including many parts of the South Island. House prices have increased substantially and by significantly more than we’ve seen in other New Zealand property markets over the same period. Indeed, Quotable Value New Zealand data suggest that house prices measured across the country as a whole have increased by nearly 50 per cent over the past three years. In some regions, the increase has been much more dramatic than that. Most market observers, the Reserve Bank included, agree that the upswing has now peaked and that demand is gradually beginning to cool. House sales, which are a good barometer of demand and a good leading indicator of future building activity, have edged down over 2004. The number of new building consents issued, although fairly volatile, appears to be easing after rapid growth in both 2002 and 2003. We’re also now seeing some cooling in the rate of growth in credit extended for housing purposes. Figure 5 House prices and the CPI Annual percent change Figure 6 Indicators of housing activity Annual percent change Nevertheless, both house sales and new consents remain at high levels by historical standards and current residential construction activity is very high as the sector continues to work off a considerable backlog of demand built-up over the past couple of years. To some degree, the residential construction sector has been able to enhance its own capacity to supply. The Household Labour Force Survey shows that employment in the wider construction sector has risen by nearly 40,000 people since 2001. A number of building companies have gone to great lengths to overcome shortages of labour either by accelerated training or by tapping into labour markets abroad. Even so, the sector remains stretched, with clear shortages of particular skills. The frustration households seem to face in finding a builder, plumber or other tradesperson at reasonable notice these days has become part of the national folklore. In talking about the various property sectors, it’s fair to say that economic analysts in New Zealand, including analysts at the Reserve Bank, tend to focus more heavily on the housing market than other markets. One of the reasons for this is simply that this is where much of the action has been over recent years; activity and prices in the markets for most other types of property, other than perhaps rural property, have been relatively more subdued. Another reason is the role that residential construction plays in economic growth. Residential construction accounts for around 6 per cent of total GDP, which is about twice the amount accounted for by non-residential construction. (However, if “other construction”, which includes infrastructure spending, is added to non-residential construction, the amount gets closer to the residential construction total.) Another reason why analysts are interested in the housing market is the “wealth effect”. A rise in house prices increases the wealth of households. In fact, in recent times, house prices have tended to be the major driver of changes in household wealth. A rise in household wealth in turn results in a rise in household consumption; with households feeling richer, they tend to spend more on consumption items. Given that private consumption accounts for nearly 60 per cent of expenditure on GDP, it can be seen why we take such an interest in the “wealth effect”, and what house prices are doing. Over the past three years, these linkages have been of particular interest to monetary policy. The upsurge in housing activity and construction has added directly to domestic inflation pressures. Residential construction costs, as measured by the Consumers Price Index, have increased by nearly 20 per cent, contributing significantly to overall inflation. We’ve also witnessed very strong household spending over this period which appears to have been reinforced by the rapid increase in house prices. Whilst I would not want to overplay the significance of housing and construction in our policy decisions - stronger inflation pressures have been evident in many other parts of the domestic economy as well - we have clearly had to take the strong housing sector into account when determining policy settings. The recent period of strength in the residential property market is hardly unprecedented in New Zealand. The early 1970s, the early and late 1980s, and the mid 1990s were also periods marked by intense activity in the housing market and strong house price inflation. There were some unique features to each of those cycles, but also some common drivers. Each coincided with a substantial acceleration in population growth to levels well above normal, due mainly to a spurt of high net immigration - more arrivals and fewer departures. Each cycle was also reinforced by some other stimulus, such as a lift in export prices received from abroad, fuelling household incomes. A sharp lift in net immigration and the sharp improvement in export returns from about 2000 through to 2002 were also catalysts for the recent upturn, although there are now indications that the migration pressures on housing are easing. Figure 7 shows estimates of the annual demand for dwellings from migrants. These estimates, which are indicative only, were derived by assuming that the number of persons per household would be the same for migrants as for the rest of the population. As figure 7 shows, the demand from short term visitors has been negative over the last year, as the number of visitors leaving the country has outnumbered those arriving. This has largely reflected a very sharp fall in the number of short-term overseas students in the country over the past 18 months (i.e. those here for periods of less than a year). There have also been other factors acting to reinforce demand for new dwellings in recent years. These include the drift of New Zealanders to warmer regions and into the cities, as well as social changes that have seen the average number of persons per dwelling steadily decline. Life-style changes and preferences have increased the demand for inner-city apartments and more exotic alternatives to the traditional New Zealand family home - the one bathroom, three bedroom bungalow. Strong economic activity, which means more income and more jobs, gives households the capacity to accelerate these changes. But when the supply of such housing is inelastic - as it always is in the short-run - the result is upward pressure on house prices and construction costs. Another source of demand during the latest cycle, at least in its early stages, has been the significant demand for properties by non-residents particularly in coastal and lakeside regions. The relatively low New Zealand dollar up until about 2002 helped to make such properties particularly attractive to foreign buyers. Although we have no reliable way of telling how much of New Zealand’s housing stock is now owned by people living abroad, that proportion has almost certainly increased substantially over the past few years. Demand coming from people living abroad is likely to be less sensitive to monetary policy than demand coming from resident population. Figure 7 Estimated annual demand for dwellings from migrants Number of dwellings (calculated as net migrants/average persons per dwelling) The housing markets in some parts of the country where such activity was prevalent a year or two ago, such as Nelson, appear to have been cooling recently. The significant rise in house prices in these regions following a surge in demand, coupled with the stronger New Zealand dollar, has presumably dampened overseas investor enthusiasm to buy such properties. However, by all accounts, Australian investors are still active in purchasing New Zealand properties at the moment. All of the factors I have mentioned help to explain why housing demand has been strong, but they are not the full story. One of the more noteworthy aspects of the housing upturn has been that very similar cycles have been seen in a large number of other countries around the world. Along with New Zealand, many countries, including Australia, the United States, United Kingdom, Ireland, France, Italy, Spain, and some other OECD countries, have all experienced very strong housing markets with significant increases in house prices in recent years. In many cases their upturns started a little earlier than New Zealand’s and the subsequent cooling seems a little more advanced. An associated feature is that debt to income ratios have continued to lift sharply in many of these countries over recent years, including Australia, the United States and New Zealand, reflecting the enthusiasm for buying houses. However, the question to arise is what the common drivers, if any, might have been? The investment motive seems to be a common factor. Households in most of these countries appear to have viewed investment in housing as a preferred alternative to other forms of savings and investment. In many countries, there also appears to have been something of an aversion on the part of the household sector to other forms of investment, such as shares or superannuation funds. That aversion is likely to reflect the losses that some investors incurred at the beginning of the decade as the world economy slowed and the “tech-wreck” unfolded. In our own case, one only has to look at the low level of net inflows into managed funds over the past few years, to see how investors have behaved in the wake of poor returns received earlier in the decade. Relatively low interest rates in most countries in recent years have also undoubtedly made the debt financing of housing purchases relatively more attractive for many households. One might argue that interest rates in some countries were set at too low a level over this period, but it should be remembered that until quite recently central banks have had to contend with weakness in general activity in many of these countries, notwithstanding stronger housing markets. Those buying a house primarily driven by an investment motive may or may not choose to live in the house themselves. An increasing number of purchases appear to have been by those wishing to let the house on the rental market and expecting to make a capital gain. We lack comprehensive statistics on such activity in New Zealand, but our contacts in the banking sector confirm that a substantial part of the recent growth in housing credit has been for that purpose. Investor housing activity has, of course, been a key driver of the recent property boom in places such as Sydney and Melbourne, as the Reserve Bank of Australia has noted. Such activity often relies on a steady stream of rental income in order to meet the financing obligations on the property. Growth in housing rentals in New Zealand has been lagging rising house prices for some time now, and thus rental yields in many parts of the country appear to be declining. Consequently, the success of “housing as an investment” may largely depend on the prospect for sustained capital gain over the coming years. Last year I commented on the potential vulnerabilities that some investors could face when the housing market or the economy inevitably cools. Those vulnerabilities arise either from being disappointed in respect to capital gain or being unable to meet outgoings should interest rates rise further or the rental market weaken in the future. Looking at the balance sheet of New Zealand households one might well ask whether these vulnerabilities are overstated. The recent sharp rise in house prices has to date made New Zealand households considerably more wealthy, at least on paper. To illustrate that proposition, the Reserve Bank’s own estimate of the household sector’s net wealth (including the current market value of housing) stood at $345 billion (about 3 times annual GDP) at the end of 2003. That was up from $260 billion (or about 2.5 times annual GDP) in 2001. This improvement in net wealth was despite households taking on an extra $23 billion worth of debt over the same period. Surely, we would need a very large and unprecedented fall in house prices to reverse that improvement? Figure 8 Net wealth of households $billion as at December The answer, of course, is that the aggregate household balance sheet gives very limited perspective on the exposures of individual households or investors. For example, some households or investors are clearly considerably more highly geared than the average New Zealand household represented in the balance sheet figures I just quoted. Moreover, there is a composition issue here. New Zealanders hold a very large, and increasing, portion of their wealth in housing. That itself creates a potential vulnerability. Past experience shows that individual house prices can and do fall by significant amounts even if the national average house price appears comparatively resilient. Consequently the Reserve Bank has been giving a consistent message to households and investors over the last year. Prudent buyers and investors need to satisfy themselves that they could withstand a reasonably significant fall in house prices and rentals and/or a reasonably significant rise in interest rates. In housing, as with any other investment, it’s the investor who takes the risk, thus it’s the investor who needs to be careful. I should point out that the Reserve Bank is certainly not projecting a calamitous fall in house prices over the next few years. However, some of the fundamental drivers of the housing cycle that I mentioned before, such as rapid population growth, certainly appear to be easing, and the evidence does point to a cooling market. A reasonable view is that house prices are unlikely to rise much further over the next two years, and some falls are certainly possible, particularly in some regions. Financial system stability Although the possibility of falls in house prices at some point in the future is something investors in housing need to be wary about, the Reserve Bank is also interested in what the consequences of a widespread fall would be for the stability of the banking system. More generally, we are also interested in the potential stability implications of a significant change in values for other types of property such as commercial or rural properties, against which the banking system extends significant amounts of debt. Last year, New Zealand participated in the International Monetary Fund’s (IMF) Financial Stability Assessment Programme (FSAP). In preparation for the FSAP, the Reserve Bank, in conjunction with the major banks, examined the potential vulnerability of the banking system to a significant fall in house prices combined with a marked rise in unemployment. One aspect of this exercise was to look hypothetically at what might occur if house prices did fall substantially and if the unemployment rate increased sharply, given current lending exposures. The exercise assumed movements that were extreme, but by no means implausible, by international standards. I am pleased to say that the results of this stress test were favourable - the banking system itself appears well placed to withstand a marked fall in house prices and an associated deterioration in the labour market should these events ever occur. In part, this reflects measures banks have taken to effectively insure themselves against the risk of default on housing lending. Of course, on matters related to financial stability there’s never room for complacency. Moreover, this positive finding does not remove the onus on individual households and investors to be careful. While the result of the stress test does give us a measure of confidence in the likely resilience of the banking system to a marked fall in house prices, some individuals could nevertheless be hurt if such a scenario was to eventuate. As part of the same exercise, we also examined the possible effects of a sizeable fall in both commercial property prices and corporate earnings for the banking system. Once again, this exercise suggested the banking system is well placed to absorb such a shock. And again, this positive finding does not remove the onus on commercial property investors to exercise appropriate care as they go about their business. Conclusion Summing up, property market developments in New Zealand over the past few years can be explained largely in terms of the economic cycle. The relative strength of many segments of property - in terms of prices, rentals, vacancies, or new building activity - largely reflects growing levels of demand for property as the scale of the economy and the number of people in it expands. To that extent, these developments provide little reason for concern. However, like any other asset markets, property markets can get out of kilter with the underlying requirements of the economy and investor preferences can change independently of the economy at large. As I have said before, at the margin this may have been the case in parts of the housing market over the past two years, with some investors becoming unrealistic about prospective returns. There are, no doubt, examples of overzealous investors in the commercial and rural property markets too. Since property markets, and the economy that they serve, are inherently subject to cycles, market participants need to remain wary of the risks and structure their affairs accordingly.
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Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Federal Reserve Bank of Chicago Conference: Systemic Financial Crises - Resolving Large Bank Insolvencies, Chicago, 2 October 2004.
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Alan Bollard: Being a responsible host - supervising foreign-owned banks Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Federal Reserve Bank of Chicago Conference: Systemic Financial Crises - Resolving Large Bank Insolvencies, Chicago, 2 October 2004. * * * This speech addresses a theme that has received increasing attention internationally and at the Reserve Bank of New Zealand of late - the issue of how a host supervisory authority can most effectively maintain a sound banking system and respond to bank failures when the system is dominated by foreign-owned banks. For any country, the stability of the financial system is critical to a healthy economy - a point that becomes dramatically apparent when systemically important banks fail. This is equally true for a financial system dominated by foreign-owned banks as for one composed mainly of domesticallyowned banks. In either case, the supervisory authority and central bank - whether home or host - must ensure that they have the capacity to maintain a robust financial system and to respond quickly and effectively to any financial crisis - often within hours. This is a challenge for any supervisor, but it is all the more complicated when it is a foreign-owned bank that gets into difficulty, given different jurisdictions, potentially different statutory objectives between home and host authorities, and a greater degree of jurisdictional separation between taxpayers and depositors than is the case with domestically-owned banks. In a world of increasing global and regional integration, the difficulties faced by a host supervisory authority is an issue of growing importance for many countries throughout the world. My counterparts in Central and Eastern Europe, Scandinavia and Latin America will readily relate to this theme, given that they also face increasing foreign bank participation in their financial systems. The challenge, therefore, is to ensure that home and host authorities respond to these changes in ways that enhance the stability of both of their financial systems, while continuing to derive the benefits that cross-border banking can provide. New Zealand’s banking system is dominated by foreign banks The Reserve Bank of New Zealand - New Zealand’s banking supervision authority - is well practiced at being a host supervisory authority. Our banking system has been dominated by foreign-owned banks for over a decade now. Few, if any, countries have a banking system as foreign-dominated as ours. Let me quote some statistics to illustrate the point: • All but two of the 16 registered banks in New Zealand are foreign-owned. • All of the four systemically important banks in New Zealand are Australian owned - holding around 85 per cent of banking system assets. • The four large banks dominate the banking system, with individual market shares ranging from around 15 per cent to 35 per cent of banking system assets. Overall, the strong presence of foreign banks has brought many benefits to New Zealand, in terms of both soundness and efficiency. It has enhanced risk management capacity within the banking system, facilitated the entry of new banking products and services, and reduced the financial system’s vulnerability to domestic economic shocks. Against these benefits, of course, there are also risks associated with such strong dominance by foreign banks. The New Zealand financial system is exposed to contagion risk from the parent banking systems - all the more so given the strong industry concentration and the dominant position of banks from just one country. Extensive foreign bank participation in the banking system can also complicate the supervision of banks in the host financial system - particularly if core functionality is outsourced to parent banks. It also complicates the process for dealing with bank crises in ways that adequately meet the needs of the host financial system. In order to maintain a sound financial system when most of the banks are foreign owned, robust host supervision arrangements are essential; so too are structures for coordinating home and host supervision. But, as I will shortly explain, the coordination of home and host supervisory arrangements in ways that meet the needs of both countries is both complicated and challenging. Differences in the interests of home and host supervisors One of the important issues arising from a banking system dominated by foreign banks is the relationship between the home and host supervisory agencies and central banks. Home and host countries undertake their banking supervision roles and responsibilities within the framework of homehost supervision set out in the Basel Concordat - the internationally agreed framework for the supervision by national authorities of multinational banks. The Concordat emphasises the general responsibility of home country authorities to supervise banks’ worldwide consolidated activities, as well as the host country responsibility to supervise foreign bank establishments in their territories as individual institutions. The Concordat, and its subsequent elaborations, have a strong emphasis on the need for adequate exchange of information, but have not - to date - sought to establish an international framework for the cross-border co-ordination of interventions responding to bank distress. It will not be easy to establish such a framework. A host financial system derives benefit from the home supervision of the parent banks. This provides some assurance to the host supervisor that the parent bank’s and consolidated group’s soundness comes under regular scrutiny by the home authority, including in respect of capital adequacy, risk positions, risk management systems, governance arrangements, and parent oversight of foreign subsidiaries and branches. Equally, the home supervisor benefits from effective supervisory and bank governance arrangements in the host country - especially when the home country’s banks have substantial foreign operations. In New Zealand, we openly acknowledge the benefit that our financial system derives from the role played by the Australian and other regulatory authorities in this regard. However, this does not cause us to be complacent or to place excessive reliance on the home supervisory authorities. We are well aware that, although home and host supervisory authorities and central banks have broadly complementary interests, they can also have divergences - and even conflicts - of interests in some key respects. Indeed, the areas of potential divergence or conflict are likely to become most apparent when the stakes are at their highest - in a bank distress situation. The potential divergences and conflicts can arise in a number of ways. For example: Home and host authorities may have different statutory objectives to meet in the exercise of their supervisory responsibilities. In some countries, depositor protection is a primary goal of supervision. In other countries - such as New Zealand - the soundness and efficiency of the financial system is the primary goal. Such divergences can lead to significant differences in supervisory policies and in the strategy for responding to financial crises. There can also be conflicts of interest between the home and host authorities in the allocation of capital and risks across a multinational banking group. The home authorities have an interest in retaining as much capital within the home jurisdiction, and particularly within the parent bank, as possible. Conversely, the host authority would like to see a reasonable portion of the group’s capital vested in the local subsidiary. A similar dichotomy of interest applies in respect of the spread of risk across the banking group. In times of stress, the allocation of capital and risk within the group can be crucial. Tensions between home and host authorities can quickly become apparent in those circumstances. This is especially so when the bank subsidiary is under-capitalised and the host authorities are requesting the parent bank to inject more capital. The situation is even more complicated when the bank in distress is a branch of a foreign bank. The home and host authorities may also have different interests in deciding the response to a banking crisis. The home authorities’ primary interest and (generally) their primary statutory duty is the maintenance of stability in the home financial system. They have no responsibilities for the stability of the host financial system. To the extent that they are interested in the stability of the host financial system, it is likely to relate to the possible impact on the parent bank’s operations in that system and the likely flow-on effects to the home financial system. A host supervisor therefore cannot rely on the home supervisor to act in the interests of the host financial system. Similarly, host countries do not generally owe any formal duties to home countries or their supervisory authorities. The home and host countries can have very different views on the choice of techniques for responding to bank distress. Clearly, the authorities in each country will have a menu of choices available, ranging from institutional bail-outs to liquidation, with intermediate options available in some circumstances. These choices have to be made on the basis of an assessment of the costs and benefits of alternative approaches within each market, and there can be no assurance that different countries will - or should - necessarily come to the same conclusion. Moreover, home and host authorities may have quite different perceptions of when a crisis is systemic. The failure of a bank operating in the home and host countries may represent a major systemic crisis or a threat to the reputation of the financial system in the host country, while being of relatively minor significance in the home country - or vice versa. In the former case, the host authorities would therefore attach great importance to a quick and effective resolution of the crisis, while the home authorities may be less concerned. Again, this could impede the ability to implement a coordinated response to the crisis. These matters are not straightforward when there is a largely bilateral relationship between home and host countries, of the kind faced by New Zealand. Matters become even more complicated when a parent bank has many operations in different countries. In these circumstances, the prospect of a large number of supervisors being able to agree on co-ordinated action within a short time-frame is not good. The international record tends to show that supervisors have effectively been placed in a position where they have had to act on their own judgement, in the light of their own particular circumstances, when complex cross-border bank insolvencies have occurred. The need for robust host supervision arrangements For these reasons, and in the absence of any fair and formalised, operationally and legally robust, international framework, we at the Reserve Bank of New Zealand think it would be very imprudent for a host authority to rely on the home authority to protect the host financial system. This does not mean that we are not still considering the issues with an open mind. But at this point, we need to continue to place importance on our ability to supervise the New Zealand banking system and to respond to a banking crisis in ways that enable us to protect New Zealand’s interests without placing undue reliance on the actions of the home authorities. That said, we also recognise that the most effective response to a cross-border crisis would desirably involve close cooperation and coordination between the home and host authorities. We are therefore actively working towards the implementation of enhanced home/host supervisory and crisis response arrangements, while still retaining a strong capacity to independently manage a banking crisis. Our dual aims are to maintain the capacity to protect the New Zealand financial system on a stand-alone basis, while also building the framework for closer coordination between the host and home authorities. Let me highlight the key features of both aspects of this approach. Our supervisory tools are similar to those of a home supervisor. While we have adopted a somewhat less intrusive approach than some supervisors, we require all banks, whether foreign-owned or domestically-owned, to comply with the same basic requirements, including in respect of minimum capital adequacy, related party exposure limits, comprehensive public disclosure requirements, governance requirements, and so forth. We monitor all banks on a regular basis and consult with the senior management teams of each bank annually, again, regardless of whether they are foreignowned or domestically-owned. We also take a close interest in the parent banks of the systemically important banks in New Zealand, including monitoring their financial condition and meeting with their senior management teams. In all of these areas, we have sought to dovetail our supervisory arrangements with those of the home supervisors - particularly Australia - in order to keep banks’ compliance costs relatively low and to avoid excessive operational inefficiencies for banks. We are a welcoming, but responsible, host. This approach is reflected in a range of areas, including in the approach we have taken to the prudential requirements for banks and in the way we monitor and assess banks. Looking forward, we see scope for further dovetailing of this nature in the context of closer coordination between the New Zealand and Australian authorities. However, the dominance of foreign banks in the New Zealand banking system has resulted in some additional supervisory measures being taken to ensure that the interests of the New Zealand financial system can be protected. By and large, these policies are common to many countries, particularly countries with substantial foreign bank participation. In New Zealand, they form a key part of being a responsible host supervisor. I would like to highlight two of our most recent requirements: • that all systemically important banks be incorporated in New Zealand; and • that foreign-owned banks in New Zealand are not overly reliant on parent bank or other outsourced functionality. Like many supervisors, we require all systemically important banks to be incorporated in New Zealand, rather than operate as a branch of a foreign bank. Currently, all but one of the systemically important banks in New Zealand are locally incorporated. We are working with the other bank to determine how it can meet our requirements. The local incorporation policy has three main objectives. First, local incorporation is an important element of being able to respond to a financial crisis effectively, in New Zealand’s interests. It provides a significantly higher degree of certainty over the balance sheet of a bank in New Zealand, enabling a statutory manager to assume control of a failed or distressed bank with greater certainty over legal jurisdiction than would be the case with a branch. Second, local incorporation enhances the Reserve Bank’s ability to supervise the banks on an ongoing basis in the interests of the New Zealand financial system. It enables the imposition of minimum capital adequacy requirements and risk limits, and provides a degree of separation between the subsidiary and the parent, thereby reducing intra-group contagion risk. Not least, local incorporation makes it much more difficult, legally and practically, for assets to be removed from the local operation to the parent bank; any such transaction must be for good value. This is not the case for a branch. Third, local incorporation establishes a basis for sound bank governance in the host country, including a board of directors with a responsibility to act in the interests of the local bank. This is particularly important in New Zealand, given the strong emphasis we place on the role of corporate governance as the foundation for effective risk management. In our supervision framework, we stress the need for the local board of directors to take ultimate responsibility for overseeing the management of the bank, including its risk management capacity. Of course, we also recognise that, subject to complying with the laws and regulations of the country in question, the parent bank has the right to determine the strategic direction and overall management of its foreign operations - in New Zealand and elsewhere. But we wish to ensure that, within this overall constraint, the local board has much more than a rubberstamping role. Another important policy requirement that we are developing to protect the New Zealand financial system relates to the growing practice of outsourcing core bank functionality. Here, I am referring to the tendency for foreign-owned banks to move large parts of their functionality to the parent bank or to third parties - which are often in another country. In New Zealand, this has been occurring on a significant scale. And it has not just been confined to the obvious areas, such as IT systems, accounting functions and the like. Outsourcing to the parent banks has also included the movement of risk management capacity, some treasury functions and some senior and mid-level management and technical expertise. Outsourcing makes it more difficult to supervise a bank effectively on an ongoing basis. This is especially so where core risk management functionality has been migrated offshore. In these circumstances, there is a limit to what any supervisor can achieve in seeking to promote sound risk management structures within the local bank. It also has the potential to weaken the role of the local board, thereby compromising the ability to ensure that governance arrangements are adequate to protect the interests of the local bank. But when the storm clouds gather, the effect of outsourcing can be very serious for a host banking system. In a situation where a parent bank is in acute difficulty, it is likely that its foreign operations will also be in difficulty. If the parent bank is unable or unwilling to provide financial support to the subsidiary, and if the home authorities are unable or unwilling to extend official support to the foreign subsidiaries of the parent bank, then the host authority needs to have sufficient functionality in the bank in its jurisdiction to maintain systemically important functions. A bank that relies substantially on outsourced services to its parent, or on inadequately outsourced arrangements to unrelated third parties, will not have that capacity. It will be substantially dependent on the outsource provider in order to maintain even quite basic functions. In a situation where the outsource provider is in serious strife, there is no guarantee that the bank will be able to maintain essential functions. In this situation, the host authority has limited scope to manage the crisis in its own jurisdiction. For these reasons, and in accordance with our legislation, we have initiated an outsourcing policy for application to all systemically important banks and potentially to some of the other banks. In essence, the policy will require banks to maintain sufficient functionality within the jurisdictional reach of its board of directors - and of a statutory manager if the bank has failed - to enable the bank to maintain all essential functions if the parent bank, or any other service provider, fails. We have no difficulty with outsourcing, provided that it is done properly and prudently, and that it meets our required outcomes. We must have the capacity to manage a bank distress or failure in ways that minimise damage to the New Zealand financial system. Managing financial crises As with any supervisory authority and central bank, the Reserve Bank of New Zealand attaches great importance to the ongoing preparedness to respond to a financial crisis. We have a broad range of measures in place and under development to ensure that we have the capacity to resolve a banking crisis in ways that maintain a robust financial system, preserve market disciplines, and minimise moral hazard risks. In this regard, our statutory duty is to protect the soundness and efficiency of the New Zealand financial system, rather then seeking to protect particular institutions or depositors. The tools required by a host supervisor to respond effectively to a banking crisis are much the same as those required by a home supervisor. However, in the case of a host supervisor, two elements are worth emphasising: • First, there is a need for clear legal and operational capacity to assume control of, and to maintain operational capacity within, banks that are in acute distress or insolvent. • Second, there is a need for balance sheet certainty for banks operating in the host country. As I outlined earlier, our supervisory policies are intended to deliver these outcomes. I wish to make particular reference to one aspect of our crisis management work - the development of what we currently call “bank creditor recapitalisation”. This is a mechanism that would enable the Reserve Bank to respond to a bank failure - including the failure of a systemically important settlement bank - in a manner that avoids or minimises the cost to the taxpayer, while still maintaining systemic stability. It comprises a number of elements, including: • applying a “haircut” to depositors and other creditors of the failed bank at a level assessed to be sufficient to absorb likely losses; • giving depositors access to the non-haircut portion of their deposits within a very short period of the failure occurring, but providing a government guarantee of those deposits so as to encourage depositors to keep their funds at the bank; and • facilitating either the recapitalisation of the bank or some other resolution option that is consistent with maintaining a sound financial system. While we are still developing the concept, we see this failure management structure as an important potential option for meeting systemic stability objectives, while preserving - indeed enhancing - market disciplines. Enhanced cooperation and coordination between home and host authorities Although these measures are all essential, we are mindful that a banking crisis in a largely foreignowned banking system should preferably include coordination between the home and host supervisors and central banks. This is most likely to occur when there is a well-developed relationship of cooperation between the parent and host authorities - in good times and bad, in sickness and in health. We are therefore now developing our thinking, and building on the existing relationships we have with the supervisor and central bank in Australia, as to the arrangements required to ensure that there is effective coordination between home and host authorities, both in the day-to-day supervisory process and, especially, in periods of financial distress. We want to ensure that there is a clear understanding between the banking supervisors, the central banks and the finance ministries of both countries as to their respective roles and responsibilities. We want to explore the scope for more defined and potentially more formalised cooperation and coordination so that both sides are better placed to supervise their respective financial systems more efficiently and effectively. And we want to have welldesigned structures for responding swiftly and effectively to cross-border financial crises in ways that recognise the respective roles of the relevant government agencies in each country. What would be the key elements in these arrangements? Ideally, they would include a number of attributes, such as: • Closer cooperation between the home and host authorities in the design and implementation of supervision policy, possibly including areas of policy harmonisation and mutual recognition. The implementation of Basel II provides a good opportunity for this, as do a number of other supervisory policy areas. Indeed, the implementation of Basel II is perhaps the greatest ‘fair weather’ challenge for cooperation and coordination between home and host regulators for many years. Striking a balance between the consistent adoption of Basel II methodology, while retaining the ability to set capital requirements that reflect each country’s risks, is essential. This is not to mention the challenges arising from the more regulatory intensive nature of some elements of the Basel II requirements. • Improved coordination of on-site and off-site supervision in some areas, including the regular candid exchange of information on banks operating in each other’s jurisdictions. • Agreement on the allocation of responsibility for the provision of liquidity support between the home and host central banks in defined circumstances. • Formal understandings on the respective roles of the home and host supervisors, central banks and finance ministries in responding to a cross-border bank failure, including protocols for determining when and how a joint home/host bank resolution strategy could be used to resolve a cross-border crisis. • Facilitating coordination of public communication between the home and host authorities in responding to cross-border financial crisis, where appropriate. This framework for coordination and cooperation needs to be pre-determined in order to be reliable. Memoranda of Understanding between home and host authorities can be useful, but they might not prove to be sufficiently reliable in a crisis situation. Indeed, most Memoranda of Understanding between home and host authorities tend to take a soft-edged approach to the respective obligations of the parties, creating too much uncertainty for them to be useful in a crisis. Some form of formalised cooperation arrangement between the home and host authorities is therefore likely to be necessary. This needs to strike a balance between creating reasonable certainty of coordination in specified circumstances, while preserving the flexibility for each country’s authorities to take independent steps to protect their own interests. It also needs to be structured in ways that recognise that bank ownership - and hence home country supervision - can change. There is therefore a need to avoid being locked into arrangements that might later prove to be unworkable or no longer appropriate. And there is a need for home/host arrangements to maintain a degree of internal consistency in the supervisory frameworks of the respective countries, so as to maintain clarity and to avoid conferring any competitive advantages or disadvantages on particular categories of banks. Creating the right balance in all of this is no easy task. Even if formalised coordination frameworks can be developed, their utility ultimately depends on how effective they are in a crisis. Rather than wait for a financial crisis to occur to see if the coordination arrangements work, it would be better to periodically test their effectiveness. Although no form of testing can ever fully simulate a real crisis and the tensions that go with it, we think that periodic crisis simulation exercises involving home and host supervisors, central banks and finance ministries will become an important mechanism in testing coordination arrangements. They could also make a material contribution towards building closer and more cooperative relationships between home and host authorities and central banks. Conclusion Maintaining a sound and efficient financial system and being able to respond to a crisis effectively is a crucial prerequisite for a country’s economic and social welfare. This is true whether the financial system is largely composed of domestic banks or dominated by foreign banks. And it is critical in a small, open, indebted, economy, such as New Zealand’s, given the potential vulnerability to international sentiment and cross-border capital flows. In the absence of any fair and formalised, operationally and legally robust, trans-national regulatory framework, the financial stability buck stops at national laws and the supervisor’s and central bank’s duties under those laws. The financial stability stakes are too high to pass on such a responsibility lightly. In banking, while the home and host authorities have some complementary interests, they also have areas of potentially diverging and conflicting interests, as well as jurisdictional limits. The Reserve Bank of New Zealand is committed to doing all it can to maintain a sound and efficient financial system in New Zealand. We believe that it is essential to maintain the frameworks needed to fulfil our responsibilities. This includes a clear legal and practical basis to supervise the financial system and the capacity to respond to a financial crisis effectively on a stand-alone basis if necessary. Equally, we must have a clear legal basis for providing liquidity support when required, on the basis of bank balance sheets and capital positions that are as meaningful and clear as they can be in the circumstances. But, we also recognise the benefits of mutual recognition and harmonisation of regulatory policies where sensible, and the benefits of cooperation and coordination between the home and host supervisory authorities. The efficiency and effectiveness of our banking supervision will be greater, and the crisis management options wider, the closer the home and host authorities are. The Reserve Bank of New Zealand is committed to remaining a welcoming, albeit responsible, host. However, the regulatory risks and rewards have never been greater.
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Excerpt from an address by Mr Adrian Orr, Deputy Governor of the Reserve Bank of New Zealand, to the New Zealand Society of Actuaries, Napier, 17 November 2004.
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Adrian Orr: A prosperous but vulnerable nation Excerpt from an address by Mr Adrian Orr, Deputy Governor of the Reserve Bank of New Zealand, to the New Zealand Society of Actuaries, Napier, 17 November 2004. * * * Reserve Bank Deputy Governor Adrian Orr is warning that the rise in New Zealand’s external debt in recent years stresses the need for policies to promote the soundness of the financial sector. That’s come in a speech in Napier to the New Zealand Society of Actuaries entitled “A prosperous but vulnerable nation”. The following is an excerpt from that address. “When we talk about the risks of indebtedness, it is important to remember that New Zealand is a reasonably prosperous nation. We can take on a certain amount of debt with comfort, and in some cases it is sensible to do so. The growth in borrowing in the last decade has not, in itself, raised the odds of a major financial crisis. But if things do go wrong, the losses from such a crisis could be severe - and more so now than they would have been, say, ten years ago. “The Reserve Bank’s interest in this area stems mainly from two features of borrowing behaviour in New Zealand. First, New Zealand relies heavily on funds borrowed from offshore, and a large and increasing share of these funds is channelled through the banking system. This channel has become more industry and geographically concentrated: just four Australian banks now own 85 per cent of New Zealand’s banking system assets, and they also perform some of the key functions of their New Zealand operations. In a banking sector crisis, an interruption to these intermediation services would create disruptions across the whole economy. “Second, a great deal of the funds raised offshore end up as household debt. In normal times, households are quite capable of managing their own balance sheets, and their decisions about spending, saving and investment may well be rational. But there is always a risk, albeit small, of a major economic shock that could leave many households without any income to service their debts. “Ideally, households would have used the recent run of strong economic growth to build up a buffer against such an event; instead, they have tended to leverage up further and invest more heavily in a few domestic asset classes, especially housing. The result is that a major shock could result in more defaults and heavier losses for banks and other lenders. “For policymakers, the stakes are higher now than they have been in the past. In response, we have taken a fresh look at our approach to banking regulation and supervision. In particular, we are developing our capacity to respond to banking crises in ways that serve the interests of New Zealand. This includes policies that aim to ensure that foreign-owned systemically important banks can be run legally and operationally from New Zealand on a stand-alone basis if and when needed. We are also working to ensure that there is as much coordination and cooperation as is possible between regulatory authorities both here and abroad during times of financial stress. “We also have a brief to monitor the wider financial system for emerging signs of stress. The publication of our first regular Financial Stability Report (PDF 888KB) is another step in raising awareness and debate around financial stability issues. “Banking policy should be part of a safeguard against rare, but costly, financial crises. We can think of it as a form of insurance: if the potential loss from an unforeseen event rises, it is appropriate to add a little more insurance cover. We believe that recent policy developments provide this extra cover, in ways that are consistent with our duty to promote the soundness and efficiency of the financial system.”
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Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the New Zealand Canterbury Employers¿ Chamber of Commerce, Christchurch, 28 January 2005.
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Alan Bollard: New Zealand’s potential growth rate Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the New Zealand Canterbury Employers’ Chamber of Commerce, Christchurch, 28 January 2005. * 1. * * New Zealand’s growth performance has improved What a difference a decade makes. If we look at New Zealand’s economic growth over the last decade, and compare it with the previous decade, we see that there has been a large lift in the country’s growth rate. Average growth over the earlier decade, 1984-1994, was 1.5% per annum, while over the last decade it has averaged 3.4%. Clearly, there were difficulties in the 1980s as firms struggled to come to grips with the new economic environment: exports subsidies were gone, government trading entities were corporatised and some privatised, there was a move towards user pays for government services, and various markets were deregulated. Then there were the other factors. These included the sharemarket crash of 1987, which was to have large flow on effects, especially for some local property sector firms. Another factor was the international recession of the early 1990s. Neither has the last decade been all plain sailing. We had the Asian crisis of 1997-98, but fortunately this did not last long. The economy was also affected around this time by droughts. Then in late 2000 and early 2001 we saw the onset of a major slowdown in the US following a sharp fall in the value of high tech shares. Nevertheless, the New Zealand economy did more than simply survive these difficulties; over the decade it had a much improved growth performance. Two broad factors appear to have been influencing growth over the last ten years: • The economic reforms of the 1980s and early 1990s have resulted in a more competitive environment for the private sector. Also, since the early 1990s we have had a more decentralised approach to wage setting in the private sector, which has given firms more flexibility in how they operate. • Reforms in the government sector have resulted in more stable macroeconomic policies. The Reserve Bank Act was passed in 1989; price stability was achieved by 1992, and has been maintained since then. We have also seen fiscal stability since the early 1990s, reinforced by the passing of the Fiscal Responsibility Act. We have seen a more medium term approach to planning and undertaking government expenditure, without the volatility associated with attempts to “pump prime” the economy. Our growth performance over the last five years has been particularly strong, with growth averaging 3.8% per annum. This was higher than growth over the same period for Australia, the US, and for the OECD as a whole (see Table 1). Table 1 Economic growth over the last 20 years Average annual percent change Period New Zealand Australia United States OECD 1984-1994 1.5 3.3 3.2 2.9 1994-2004 3.4 3.9 3.3 2.6 1999-2004 3.8 3.3 2.8 2.3 There are particular reasons as to why we have done so well over this period: • In 2000 and 2001 we had a period where the exchange rate was low and commodity prices had blipped up. Climatic conditions were also good in this period, lifting the volume of agricultural exports. Consequently, many exporters got a major boost to their incomes. Many firms were able to pay off debt and improve their balance sheets. • Following September 11 2001 New Zealand suddenly looked like a more attractive place to Kiwis, to would-be migrants, and overseas students, as well as tourists. The resulting large gains from net migration had a positive impact on the level of economic activity. • World commodity prices have risen sharply over the last two years, reflecting both recovery in the US and continuing strong growth in China. There have also been particular factors affecting the prices of commodities that New Zealand trades in. These include: the outbreak of BSE in the US, which stopped the exporting of US beef to Japan; the continuing rundown of sheep numbers in the EU; and droughts in Australia, which have affected that country’s rural exports. • Growth in private consumption has been very strong, aided by higher employment levels, and also by increases in house prices, which made households feel wealthier. Consumer confidence has remained high. Not all industries have experienced strong growth over the last five years. But the benefits from the strong growth in the macroeconomy have been clear to see. Job growth has been strong, unemployment has fallen, household incomes have risen, company profits are strong, and the government has a substantial fiscal surplus. These benefits are reflected in the rise in GDP per capita. (GDP is taken here, and throughout what follows, as being real GDP, or the volume of value added, rather than nominal GDP.) Given that GDP per capita is a broad measure of general living standards, it is the rise in GDP per capita that really matters to us, rather than the rise in just GDP itself. However, as can be seen from Figure 1, variations in GDP per capita have tended to reflect changes in GDP. (The gap between GDP and GDP per capita in Figure 1 reflects population growth.) Growth in GDP per capita averaged 2.2% in the 1994-2004 period, compared to 0.7% in the previous decade. The rise in GDP growth over the past decade has also lifted our growth in GDP per capita relative to the growth rate for the OECD as a whole (Figure 2). However, our level of GDP per capita in 2002, in terms of purchasing power parity (PPP), was still 14% below that of the OECD. Figure 1 Real GDP and real GDP per capita Indexes, base 1980=100 Having enjoyed a return to strong growth, and a rise in GDP per capita, we naturally want this situation to continue. Some of the factors which have lifted our growth rate recently, especially the impacts from policy reforms, can be expected to persist, thus improving the economy’s productive capacity or potential output in the long run. However, there are signs that the level of economic activity is currently higher than the level of potential output, thus giving rise to inflation risks. The capacity utilisation measure from NZIER’s quarterly survey of business opinion is at a record high level. Clearly many firms are stretched, running at full capacity, or close to it. Furthermore, firms have been reporting for some time now - for over three years - that they are having increasing difficulty in finding both skilled and unskilled staff. Figure 2 Changes in real GDP per capita Average annual percent change over 10 year period Source: OECD. GDP per capita has been calculated in US dollars using price levels and PPPs of 2000. Data is currently available only to 2003. 2. Monetary policy aims to keep the level of activity in line with potential We know that when output exceeds potential over extended periods, as has been happening recently, inflation tends to rise. Hence, the overnight cash rate (OCR) was lifted from 5.00% to 6.5% over the course of last year, in order to slow the pace of growth. Our forecast is for economic activity to move closer to its potential level over the next year, reflecting not only the effects of higher interest rates on private consumption and residential investment but also an easing in commodity prices. Determining the current level of potential output is a key issue for monetary policy. Analysis shows us that when GDP is significantly above its potential level, inflation increases. In this situation, aggregate demand is higher than what can be comfortably produced, and the result is a rise in inflation. Similarly, when GDP is significantly below its potential level, inflation falls. The role of monetary policy therefore is to keep the economy running close to potential, otherwise inflation will either increase or decline. Note that we are using the word “potential” in a slightly different way to its normal use. When something achieves its potential, we usually mean that it achieves a maximum value. But in the way that we are using the word here, we can have the economy operating above its potential. However, potential output is a maximum value of a sort - it is the highest level of output that will not produce upward pressures on inflation. Potential output is not a variable that can be observed directly. It is often estimated as a smoothed track of GDP. The smoothing takes out the short-term fluctuations in GDP and it is assumed that the resulting smoothed series reflects changes in the productive capacity of the economy. In effect, it is assumed that the smoothed series reflects the underlying growth in such things as capital equipment and labour. Estimating potential GDP presents some challenges. For example, we are more confident of what potential GDP was say three years ago than of knowing what it is today. This is largely because smoothing methods don’t work as well at the end of data series as they do in the middle of the series. This is frustrating, given that it is the end value - the latest value - that we are most interested in. Because of this “end point” problem, potential GDP is often estimated using methods that incorporate information from other cyclical series as well as actual GDP. Figure 3 shows the percentage difference between actual output and potential output. Potential output is estimated using an MV (multi-variate) filter. The method has been well documented. This MV filter, which is a smoothing mechanism, uses not only GDP data but also data on capacity utilisation and the unemployment rate. The chart also shows inflation for non-traded goods or services, which can be generally viewed as domestic inflation. The chart shows a strong relationship between the two series. Figure 3 Domestic inflation v difference between actual and potential output Percent The difference between actual and potential output is by no means the only factor driving inflation. For example, the world price of imports, the exchange rate, and wage settlements also have an impact on inflation, and these factors are taken into account. In general terms though, when output has moved significantly above its potential level, and looks likely to stay there, a tightening in monetary policy is likely to follow. There appears to be widespread community acceptance of the need to keep inflation under control. But some people may still have doubts, saying that they would be happy to put up with higher inflation if we were getting higher growth. The problem is that as inflation rises, peoples’ expectations regarding future inflation also rise. This affects behaviour regarding the setting of prices and wages. Inflation therefore tends to get locked in at a higher level. We had ample evidence of this in the 1970s and 1980s. A tightening will affect economic growth in the short term, but does monetary policy also have an effect on long term growth? We have done some research on this at the Reserve Bank. A recent Bulletin article (Smith 2004) examined both theoretical and empirical studies on this issue. The theoretical studies suggest that transitory changes in interest rates are likely to have only a transitory impact on factor accumulation (e.g. capital investment) and hence should not permanently affect the growth of output. The empirical studies suggest that high inflation, or even moderately high inflation, is harmful to growth. Studies have also looked at whether macroeconomic volatility is harmful to trend growth. The general view appears to be that the costs of macroeconomic volatility - in variables such as the exchange rate and inflation - are likely to outweigh any benefits. The article notes that the maintenance of price stability appears to be the main contribution that monetary policy makes to growth. These overall findings or conclusions, the article suggests, are already embodied in the Policy Targets Agreement (PTA). The PTA charges the Reserve Bank with keeping inflation between 1% and 3% over the medium term while avoiding unnecessary instability in output, interest rates and the exchange rate. The conclusions that we draw from this study and others are that: • A one-off easing of monetary policy will have no impact on long run real output - it will only affect the long run price level. • Good monetary policy applied consistently over time is a necessary condition for achieving a high long term average growth rate. (Good monetary policy is defined here as achieving stable and low rates of inflation while minimising short term disturbances to output and other variables i.e. successfully implementing the PTA). • Good monetary policy will not by itself ensure that long run growth is as high as it could possibly be. But bad monetary policy, if sustained, will prevent the economy from reaching its maximum growth rate. In this context, ongoing bad monetary policy will reduce growth below its maximum rate over a period of many years, leading to a permanent loss of output. Clearly, bad monetary policy, or the inadequate implementation of policy within the current framework, is something we want to avoid. 3. Accounting for growth Determining what our potential level of output is, and what the growth in potential output is, are important issues in implementing good monetary policy. As we will see, potential GDP changes over time. We will look at what drives these changes. The level of a country’s potential output at any point in time is dependent on a number of factors, including: • natural resources, including land and soils, rivers, ocean areas and climate, • capital equipment (buildings, machinery, transport equipment), • the amount of labour employed, and the skills and education that this labour has, • infrastructure, • a well functioning and effective government and judicial system. These factors generally influence the productive capacity of the economy, that is, they affect the supply side of the economy. However, demand factors can also ultimately affect the level of potential output. For example, suppose we have a permanent upward shift in the terms of trade. That is, we have a permanent shift up in export prices relative to import prices. The end result of this would probably be a higher level of employment and an increase in the amount of capital equipment being used. In other words, there would have been a rise in the country’s productive capacity or potential output. In trying to determine what the level of potential output might be, economic analysts usually look at the relationship between output and the primary inputs of capital and labour. By capital, we mean here the capital stock, or the real value of existing capital equipment. However, in recent times there has been a growing interest in defining sustainable development in terms of the impact that development has on natural resources. However, we will focus here on the primary inputs, capital and labour. Another factor that has a major influence on productive capacity, and which is not listed above, is productivity. Productivity is a measure of the ability of inputs, like capital and labour, to produce output. In simple terms it is output divided by inputs. The ratio of output to labour input, usually measured in GDP per hour worked, gives us a measure of labour productivity. Another measure of productivity is multi-factor productivity (MFP). In general terms MFP is output divided by a weighted average of the capital stock and labour. Economists tend to see potential growth as depending on the capital stock, labour, and MFP. MFP is the “unexplained” part of economic growth - it is that part of growth which is not accounted for by the primary inputs of capital and labour. One factor that influences MFP is technological change. We will come back to this later. As mentioned earlier, GDP per capita is the important variable, the one that we want to see growing. We can decompose GDP per capita into two factors as follows: GDP/population = [GDP/hours worked] [hours worked/population] That is, GDP per capita equals labour productivity times labour utilisation. Hence we can lift GDP per capita by raising labour productivity or labour utilisation, or both. This simple decomposition is the basis of the saying “We can lift our standard of living by either working harder, or by working smarter”. That is, we can do it by working more hours, or by lifting labour productivity. Lifting the hours we work can be achieved by higher labour force participation, which is something that has been happening over recent times. Another way of lifting hours worked is simply for those of us who are already employed to work longer hours. I suspect that a large proportion of the workforce wouldn’t find this attractive, at least on a sustained basis. This underlines the importance of lifting productivity if we are to be better off. Figure 4 shows growth in GDP per capita, and the contributions to this growth coming from changes in labour utilisation and labour productivity. The recent rise in labour utilisation reflects higher participation rates and a decline in unemployment. Given that participation rates are currently higher than they have been for nearly 20 years, and the unemployment rate is at a historically low level, it seems that rises in labour utilisation are unlikely to be as high in future. This means that gains in GDP per capita are increasingly going to have to come from productivity gains. Labour productivity is currently increasing by around 1.5% per annum. Labour productivity growth has averaged 1.2% per annum over the last 10 years. In the previous decade, it averaged only 0.7%, despite the strong growth in labour productivity that occurred in the recession of the late 1980s and early 1990s. Figure 4 Contributions to changes in GDP per capita Percent contribution to annual change Note: The chart was derived using 3 year averages of GDP per capita, hours worked, and population in order to show the underlying trends in labour utilisation and labour productivity. The importance of labour productivity growth to the long run economic outlook becomes very clear when we look at demographic trends. Figure 5 shows labour force projections which are based on three population projections. All three projections assume medium fertility and medium mortality but each has a different assumption regarding migration. With zero net migration the size of the labour force begins to decline from 2018. Higher levels of migration push the track up, but even with an annual net gain of 10,000 from migration, the growth in the labour force slows, and the labour force eventually levels off. Net gains from permanent and long term migration have averaged 13,600 per annum over the last decade, compared with -4,700 per annum in the previous decade. Figure 5 Projected labour force People in the in labour force, millions These projections reflect the ageing of the population. Birthrates underwent a long term decline from the 1890s through to the 1970s, although the post war baby boom provided a temporary interruption. Around 2010, the number of people leaving the labour force - mainly baby boomers - is projected to rise sharply. Even if these people were to put off retirement for a while, growth in labour utilisation is still likely to slow. Any substantial growth in the labour force would have to come via high levels of migration. Taking one of our labour force projections - the one based on annual net migration of 10,000 - we can derive scenarios for future GDP per capita based on assumptions about labour productivity. Let’s assume that labour productivity grows at 1.5% per annum, which as we have seen, is similar to the present growth rate. For each year of the projection we add this growth to the projected growth in the labour force to get GDP growth. (In doing this, we are assuming that number employed will grow at the same rate as the labour force. That is, we are assuming that the unemployment rate will stay constant over the projection period.) For each year of the projection, we can then calculate GDP per capita, using the projected population figure. The result is shown in Figure 6, along with projections using alternative labour productivity assumptions. The lowest scenario assumes no growth in labour productivity, and hence annual changes in GDP simply reflect changes in the labour force. Under this scenario, GDP per capita begins to decline from 2014. In this year, the growth in the labour force, and hence the growth in GDP, falls below the growth in the population. Reassuringly, the chart shows that labour productivity growth of 1% per annum is enough to keep GDP per capita increasing. However the chart suggests that in order for GDP per capita to keep growing at a rate similar to which it has done over the last decade, labour productivity needs to grow at 2% per annum rather than 1.5 % per annum. We will come back to this issue. The chart certainly illustrates the importance of labour productivity growth to ongoing improvements in the standard of living. The chart also illustrates the power of compounding. A lift in labour productivity by 0.5% annum will, if sustained, produce large differences in GDP per capita over time. Figure 6 GDP per capita, projected 2004/05 dollars, thousands Perhaps the most direct and obvious way to go about lifting labour productivity is to raise the skills of workers. That is, we would improve the quality of the labour which is an input to production. But workers cannot be the total focus of lifting labour productivity. With a bit of algebra it can be shown that labour productivity can be expressed in terms of MFP, or multifactor productivity, and the capital stock to hours worked ratio, which is often referred to as the capital to labour ratio. In general, a rise in the economy’s capital/labour ratio can be expected to lift labour productivity since labour now has more equipment to support it. Figure 7 Changes in capital and labour Annual percent change A rise in MFP will also lift labour productivity. Unfortunately, measuring MFP is never easy. There are always issues regarding the accuracy of data on the capital stock, hours worked, and even GDP. And when we combine all these variables to calculate MFP - the “residual” factor which affects output - the measurement errors in the component series can make analysis difficult. Furthermore, we are more interested in the underlying trends in MFP, rather than short term changes. One way of deriving a trend series for MFP is to use trend series for capital, labour, and GDP in calculating MFP. In fact, the GDP series that is used in deriving MFP in the context of the Reserve Bank FPS model is potential output. This is the smoothed series of GDP produced by using the MV filter. The labour input series used in the calculation is a smoothed series of total employment. The capital stock series is “productive capital”; it does not include housing. This series changes gradually over time and hence needs no smoothing. Figure 7 shows changes in these two series. Since 1996 the capital stock has increased at a higher rate than the labour input. Hence since 1996 there has been a rise in the capital/labour ratio. This rise, together with a slight lift in MFP, explains the rise in labour productivity over this period. This rise in the capital stock reflects strong investment growth. Real business investment accounted for around 13% of real GDP in 1994; it now accounts for nearly19%. Figure 8 shows the estimated contributions to potential output coming from capital, labour and MFP. The chart also shows total contributions, which is the annual percent growth in potential output. As can be seen the growth in potential output, as estimated using the MV filter, is currently around 3.7% per annum. To some people this might seem surprisingly high. However, our estimates show that growth in potential GDP has generally been high over the last decade, with the lowest annual growth rate being just under 2.5% in late 1998. And as we saw earlier in Table 1, growth in actual GDP was also high over the last 10 years. Estimated annual growth in potential output over the decade to March 2004 averaged 3.3%, compared with average growth of 3.4% in actual GDP. Turning now to the contributions to potential output growth in Figure 8, perhaps the first thing we should note is that the contribution from capital is generally lower than the contribution from labour. This is despite capital increasing faster than labour since 1996. The reason for this is that in calculating these contributions to potential growth we give a lower weight to capital than labour. These weights are based on capital’s and labour’s share of income GDP. The weights we have used are 0.29 for capital and 0.71 for labour. Figure 8 Contributions to growth in potential output Contribution to annual percent change The contribution to potential growth from labour has been high in recent years, reflecting migration inflows, higher labour participation, and falling unemployment. However, the contribution from labour is now beginning to decline, as migration eases. The contribution from capital has generally increased over the period from 1993, although it eased slightly during the Asian crisis/drought period of 1998-99. The contribution from MFP surged in the mid 1990s, reflecting the recovery from the recession of the late 1980s and early 1990s. Since this surge ended in 1997 the contribution from MFP appears to have trended upwards, although the rise has been gradual. Overall, the higher growth in potential output over the last five years ties in with the factors that we identified back at the start as influencing growth. The boost to export earnings that began in 2000 and which has largely been sustained through recent rises in world commodity prices has flowed through into firms’ balance sheets and has boosted investment. Also, gains from migration have lifted potential growth through their impact on the supply of labour. Looking ahead, growth in potential output is expected to ease slightly during the coming year. The contribution from labour will continue to fall, reflecting lower net migration. However, this fall will be largely offset by continuing growth in the contribution from capital, as firms seek to alleviate current capacity constraints. 4. Factors that might influence future potential growth We can lift our potential growth rate by increasing capital, increasing labour, and by lifting MFP. We will look briefly at each of these factors. We’ll look first at capital. We have seen the capital/labour ratio rise over recent years, indicating capital deepening. Is there scope to go even further in this regard? We know from recent work done at Treasury (Black et al 2003) that the capital/labour ratio is still significantly lower than in Australia. However, we have to be careful about making international comparisons, particularly at the macro level. The difference between countries might simply reflect the different industry composition of each economy. We know for example that, compared to New Zealand, Australia has a large mining sector, which is capital intensive. In general, any comparison between countries regarding productivity measures needs to be done at the industry level, and even then, there are always difficulties in ensuring that the data is comparable across countries. Nevertheless, we expect the capital/labour ratio to rise in the longer term, as we use more capital to do our jobs. Turning to labour, a lot of attention is often given to lifting the quality of labour through education and training. The benefits of this would show up in higher MFP. Also, the quantity of the labour input can be raised by increasing average hours worked, lifting the participation rate, and increasing net migration. However, while higher migration would lift potential growth, the impact on GDP per capita is not so clear cut. To have a direct effect on lifting GDP per capita, migrants would need to be more productive on average than the resident population. Or they would need to have skills which, when used here, enable some proportion of the resident population to lift their average level of production. That is, these migrants would be needed to alleviate bottlenecks. Current migration policy is largely based on ensuring that these criteria are met. There may also be scale or agglomeration effects from migration; there is some evidence that larger population centres tend to have higher productivity growth and higher GDP per capita than smaller ones. What drives MFP? Two factors are likely to be most important. Technological change is one of the most important drivers. The measure of capital stock that we use in estimating MFP does include some adjustments to take account of changes in technology that are embedded in new equipment. But these adjustments are only partial. Hence many improvements in potential output arising from technological change would be accounted for by the growth in MFP. Research into why MFP has risen strongly in the US over the last decade, during the so called “productivity miracle”, often points to information and computer technology (ICT) as being a major factor. It is likely that ICT has played a role in the gradual rise in MFP that we have seen in New Zealand. And given that we tend to lag the US in implementing ICT, we may see larger MFP gains yet from ICT in the future. The other main factor influencing MFP is the ability to reorganise and redirect resources to more productive and innovative uses. In all industries, there are probably still many efficiency gains that could be made, if only we could find them. Government activities, such as the provision of infrastructure, commercial law legislation, and town planning procedures may also have consequences for productivity. Productivity, and how to improve it, are currently topics that are being extensively researched by Treasury (see McLellan 2004). Clearly, the issue is important. Productivity growth is a key issue in lifting potential output, and hence, in lifting our sustainable growth rate. It is an important issue at the firm level too. Most people in business would be aware of the links between productivity and price setting at the firm level. For example, a rise in a manufacturer’s productivity will produce a fall in average unit costs, enabling the firm to either increase profits or to pay higher wages without having to increase prices. This highlights the fundamental importance of productivity gains; not only do they lift real GDP per capita, they also inhibit inflation. 5. The decade ahead We can use our analysis to give us an indication of what growth in GDP and GDP per capita could be in the coming decade. This is not a forecast, but rather an illustration of two scenarios. Table 2 sets out two scenarios for the 2004-2014 period. We have seen these two scenarios before, in Figure 6. The first scenario assumes that labour productivity will grow at 1.5% per annum, which is similar to the growth rate that we have had over the past 5 years. The second scenario assumes that labour productivity will grow at 2.0% per annum. Given that both scenarios are based on the same demographic projections, the changes in population and labour utilisation are the same for each scenario. As Table 2 shows, the projected increase in labour utilisation over the next decade is much lower than the increase that we saw over the last decade. This reflects the participation rates in the official labour force projections that we have used, as well as our assumption that the unemployment rate remains constant. These projected increases in labour utilisation are indicative only. Nevertheless these low increases gel with what we know. With participation rates already very high, future rises are unlikely to be as large as they were over the last decade. Furthermore, from around 2010 many baby boomers will be retiring, putting downward pressure on the overall participation rate. Also, given that the unemployment rate is already low, we definitely won’t see the same falls in unemployment that occurred over the last 10 years. Table 2 Contributions to growth in GDP per capita Average annual percent changes 1984-1994 1994-2004 2004-2014 Scenario 1 2004-2014 Scenario 2 Labour utilisation 0.0 1.0 0.3 0.3 Labour productivity 0.7 1.2 1.5 2.0 GDP per capita 0.7 2.2 1.8 2.3 Population 0.8 1.2 1.0 1.0 GDP 1.5 3.4 2.8 3.3 Our projections suggest that if we want to see GDP per capita grow at the same rate over the next decade as it did in the previous 10 years, we will need to lift our labour productivity. If labour utilisation was to grow by 0.3% per annum - which doesn’t seem to be unrealistic - then we would need to lift our productivity growth from its current rate of around 1.5% per annum to nearly 2% per annum. 6. Conclusion What can we take out from this mass of data and evidence? • After a low growth decade economic growth has been high in New Zealand over ten years, and more importantly growth in GDP per capita has been encouragingly high relative to other members of the OECD. • Partly as a result of this experience, in recent years the Reserve Bank has raised its estimates of New Zealand’s potential growth rate. Despite this higher potential, we have been growing at unsustainably high levels over the last year or two. We can’t keep growing near 5%. • A significant amount of this growth improvement has come from increased labour utilisation, which is now high by international standards and unlikely to keep increasing at the same rate. • Labour productivity growth has shown more recent improvement, lifting in the late 1990s. This is important because strong economic growth will depend crucially on this improvement continuing. In fact we will probably need to raise labour productivity growth to around 2% per annum (comparable to Australia and the US) to continue to achieve continuing economic growth much over 3% per annum. • Lifting labour productivity growth to 2% per annum seems potentially achievable, given the improvements in labour productivity that have already occurred. But it will require continued strong investment, clever innovation, good quality decision-making, and skilled labour. Lifting labour productivity will be mainly the role of the private sector. • The Reserve Bank’s role is to help promote stability, including price stability, monetary policy stability, and financial stability, things that become even more important during periods of strong growth. References Black, Melleny, Melody Guy and Nathan McLellan (2003) Productivity in New Zealand 1988 to 2002, Working Paper 03/06, New Zealand Treasury. McLellan, Nathan (2004) New Zealand performance: context and challenges, a paper presented to Treasury’s productivity workshop in July 2004, New Zealand Treasury (go to www.treasury.govt.nz/productivity for this and other papers from the productivity workshop). Smith, Christie (2004) “The long run effects of monetary policy on output growth”, Bulletin Vol 67 no 3, September.
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Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Australasian Institute of Banking and Finance, Sydney, 23 March 2005.
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Alan Bollard: Bank regulation and supervision in New Zealand - recent and ongoing developments Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Australasian Institute of Banking and Finance, Sydney, 23 March 2005. * * * Vigilance and reinvigoration The New Zealand economy has experienced a very good period of growth over the last ten or so years, averaging 3.4 per cent GDP growth per annum. In the last five years, with growth averaging 3.8 per cent per annum, New Zealand has been one of the fastest growing economies in the OECD even ahead of Australia. New Zealand's unemployment rate is now at a multi year low of 3.6 per cent. The banking sector has played a significant role in this economic growth, being the main intermediator of peoples' savings into investment and gateway for foreign investment funds. At around 74 per cent, banks account for the lion's share of financial system assets in New Zealand. In comparison, banks account for about 50 per cent of financial system assets in Australia. Bank balance sheet growth has been exceptional for several years, dominated by lending to households. What is pleasing to date is that the soundness of the banking sector has also remained intact. Banks are experiencing a period of very low loan default and strong profitability. However, it should never be forgotten that despite our impressive growth, New Zealand remains a small, open, and indebted economy. We have also been benefiting from a strong terms of trade upswing, and a structural rise in households' debt appetite, neither of which will be sustained forever. The potential vulnerabilities of our economy are reflected in the banking sector. Over half of New Zealand's foreign borrowings are sitting on banks' balance sheets, with New Zealand's private sector relative indebtedness the highest in the OECD.1 What's more, our banking sector displays amongst the highest levels of foreign ownership in the world - foreign banks own 98 per cent of New Zealand banking system assets, with 85 per cent being Australian-owned. Despite the benefits that foreign ownership and capital bring, these features mean that any banking crisis New Zealand faces is as likely to be caused by external influences as it is internal. The New Zealand financial system is vulnerable to shocks within the banking system (such as the mismanagement of a local bank), outside of the banking system (such as a wider economic threat), as well as shocks in other countries, especially Australia, that may be transmitted through our banking system. The serious mismanagement of an Australian bank, or a major shock to the Australian economy, could have serious negative repercussions for the New Zealand banking sector and financial system. It is awareness of these potential vulnerabilities that motivates the RBNZ's vigilance, and that has led to a particular focus over the last couple of years in assessing and reinvigorating how we go about regulating and supervising banks, as well as driving trans-Tasman policy harmonisation. The RBNZ's responsibility to supervise banks in New Zealand is prescribed in the Reserve Bank of New Zealand Act. This Act requires us to use the powers it gives to the Bank to promote the soundness and efficiency of the New Zealand financial system, and to avoid significant damage to the financial system that could be caused by the failure of a registered bank. For some time now the RBNZ has taken a three pillars approach, based on a regulatory culture of self, market and regulatory discipline. This approach places risk management largely in the hands of those closest to it, and lays responsibility for outcomes with boards of directors, management, and creditors - that is, those who have the most to lose from a mismanaged bank. The first pillar is self-regulation. This is all about the policies and structures that promote effective governance by banks' boards of directors, including effective oversight by local boards of the local banks' managements. We expect high standards of corporate governance from the boards of New Zealand banks, and this expectation is reinforced by some quite severe penalties that could apply According to IIP data as at September 2004. should a bank's directors fail to properly discharge their responsibilities. In the wake of the Enron-type corporate governance scandals and subsequent numerous reviews, the importance of good self-regulation has gained a lot more recognition recently with the passing of such legislation as the Sarbanes Oxley Act. In its Basel II recommendations, the Basel committee has also put a lot more weight on the importance of good self-regulation for ensuring bank stability than it did previously. The second pillar is market discipline. For many years, banks in New Zealand have been subject to obligations to make quite comprehensive quarterly financial and prudential disclosures to the marketplace. These disclosures, combined with a policy of not bailing out failed institutions, help to strengthen market scrutiny of banks, and the market disciplines that go with that. The third pillar consists of our regulatory and supervisory requirements. Although our regulatory framework is somewhat less intrusive than that of many countries, it nonetheless contains most of the standard features, the centre-piece of which is the requirement that banks in New Zealand be adequately capitalised. In its Financial Sector Assessment Programme (FSAP) review of the New Zealand financial system last year, the IMF confirmed that we have a good model for host country supervision. Fulfilling the second element of our statutory responsibilities - to avoid significant damage to the financial system that could be caused by the failure of a registered bank - requires the Reserve Bank to have a crisis management strategy. That is, we must be ready with a range of tools and options that would enable us to step in should a bank get into serious difficulties. What has reinvigoration involved? The Bank has been reassessing and testing each of the pillars described above, and at the same time putting a lot of effort into developing its crisis management capabilities. Maintaining and encouraging soundness and efficiency We strengthened the first pillar of self discipline, in the middle of last year, by implementing a policy of "fit and proper" review of appointees to positions as senior managers or directors of registered banks. Recruitment into these positions is still the sole responsibility of the banks' respective boards. The `fit and proper' policy simply means that the Reserve Bank seeks a "negative assurance" when appointments to senior management or boards are made. In no way does this relieve boards of their responsibilities. Our outsourcing and local incorporation policies also reinforce that a bank's board must act in the interest of the New Zealand bank. The use of parent-bank systems, tools and techniques is of course permitted, but only with the full understanding and ownership of the local bank and board. The local bank board is responsible and accountable for all aspects of bank operations Some minor changes to the second pillar will take place at the end of March when several amendments to our disclosure requirements come into force. The amendments will facilitate banks' adoption of international financial reporting standards and make a number of other changes relating to earlier changes to banking supervision policy and the disclosure regime. Basel II capital requirements have led to us reassessing aspects of the third pillar. We have decided to increase our emphasis on harmonisation with APRA when implementing the capital requirements of Basel II. Banks operating in New Zealand, and meeting certain criteria, will have the option to use the Internal Ratings Based and Advanced Measurement Approaches to calculating regulatory capital. The Reserve Bank is also developing a framework that will help it understand in more detail how banks are fulfilling their regulatory and supervisory requirements. Section 95 of the RBNZ Act gives the Reserve Bank the power to require a bank to provide us with a report by a Reserve Bankapproved, independent person. These reviews, the cost of which will be met by the banks themselves, are likely to investigate such issues as risk management, operational systems, and the nature of outsourcing. We have already exercised our section 95 powers in relation to one bank's outsourcing arrangements. Crisis management It is very important that, when dealing with a troubled bank, the New Zealand authorities should have a range of options available that can prevent a wider systemic crisis. These can range from the power to give directions, through statutory management, through to liquidation or a full-blown rescue. To exercise any of these options, it is essential that the bank in question have the records, people and systems it needs to operate on a stand alone basis - that is, it must be a bank, not a shell of a bank. We are putting a considerable amount of effort into securing our ability to manage a crisis, both by developing the Reserve Bank's crisis management capabilities, and by ensuring that there exists the legal and practical ability to continue to operate a failed bank via our local incorporation and outsourcing policies. Simply stated, our local incorporation and outsourcing policies require that systemically-important banks in New Zealand be incorporated locally, and that they maintain the capacity to function on a stand-alone basis, if required. Without that capacity, there is a material risk of the banking system becoming dysfunctional in a banking crisis. The measures we are introducing to counter that risk have recently been affirmed by Standard and Poor's, who noted that they "could well enhance the strength of the New Zealand banking sector and its ability to withstand a period of financial stress".2 Outsourcing is a reality in today's world, where national borders are permeable and the business environment highly specialised. However, where systemically important banks are concerned, the Reserve Bank needs to be satisfied that any outsourcing undertaken does not compromise their legal, operational, or financial ability to meet their obligations. Although it has not been an issue to date, outsourcing could well become more of an issue for Australia over the next few years. In November last year we released a paper for consultation, setting out the RBNZ's proposed outsourcing policy. We had already established principles for our proposed outsourcing policy and applied those to ANZ National Bank upon approval of its merger. The consultation paper formalised these principles and set out a policy framework for application to all systemic banks and some other categories of banks. Submissions on the discussion paper closed at the end of February and bank staff are currently working their way through those submissions. The outsourcing policy is very much outcomes-focussed, so individual banks can tailor a solution that best suits their situation and needs, while meeting our requirements. In this way costs can be minimised and a level playing field maintained. We intend to work closely with banks as they go about implementing the policy. There is no doubt that banks will incur some operational costs due to the outsourcing policy. However, we think these costs will be small and manageable, especially relative to Australian banks' annual gross revenue, profits, and the potential costs of a bank failure, despite the claims in the media to the contrary. Much of the public debate around the outsourcing policy has focussed on direct operational costs and thus the relatively small loss in productive efficiency that may occur. However, there are other aspects to efficiency to consider also, including allocative and dynamic responses. For example, our outsourcing policy could lead to better capital allocation due to more local decision making capacity, as well as systems that are more flexible and responsive to local needs. These aspects are especially important for the growth of small to medium size enterprises that dominate the New Zealand business landscape. Such benefits could accrue to bank shareholders and customers, as well as the wider New Zealand economy. At the heart of the Reserve Bank's crisis management work is the development of a crisis management toolkit that will provide tools, policies and procedures to guide the high-stakes decisions supervisors would have to make under very tight time frames. Crisis management can be thought of as having two phases. Phase one is the very short period, perhaps a day or two, immediately following the discovery that a bank is in severe distress. It involves decisions around whether and how to get the bank solvent and operating again. Phase two is the potentially lengthy subsequent period, during which it must be decided what to do with the bank over Standard and Poor's Ratings Direct, "Robust local operations and strong parents fortify credit quality of New Zealand banks, despite profit moderation", 28 July 2004. the long term. It involves decisions around the bank's value and long term ownership. It is important to have options for the initial phase that avoid destroying future economic value or squandering tax-payer money, or that ultimately reduce the options in phase two. Perhaps the most original of the tools we have been exploring for phase one is Bank Creditor Recapitalisation or BCR, which could enable the Reserve Bank to respond to a bank failure in a way that avoided or minimised costs to the taxpayer, while still maintaining systemic stability. Essentially, it involves applying a "haircut" to depositors and other creditors to recapitalise the bank, and then quickly making available to depositors the non-haircut portion of their deposits. BCR addresses some of the same issues as deposit insurance, which is currently receiving attention in Australia, in that it quickly restores liquidity for depositors. However, with BCR the costs of imprudent risk management and monitoring are borne by depositors, management and shareholders, thus reinforcing the market and self-discipline that underpins our regulatory culture. Much has been done to advance this project, including pilot testing of some IT prepositioning at one of the major banks. We are confident that, from an IT technical perspective, a BCR approach is likely to be feasible. However, substantial work remains to be done and no decision has yet been taken to formally adopt it as a crisis management tool. Regarding the bank `work out' phase, we are developing our thinking on other failure management options, such as good bank/bad bank split, partial sale of failed banks' assets and liabilities, government bail-out, and industry support. Although these are well known, almost garden variety, options for dealing with a bank failure, putting in place the decision-making frameworks, policies and procedures that will facilitate effective, low cost management of a bank crisis is a big job. The trans-Tasman dimension As I made mention of at the beginning, New Zealand is very dependent on foreign capital, and the bulk of this foreign capital is intermediated through a predominantly Australian-owned banking sector. This industry and geographic concentration of foreign ownership in one country makes the New Zealand banking sector quite unique. As you will be aware, home and host countries undertake their banking supervision roles and responsibilities within the framework of home-host supervision set out in the Basel Concordat. The Concordat emphasises the general responsibility of home country authorities to supervise banks' worldwide consolidated activities, as well as the host country responsibility to supervise foreign bank establishments in their territories as individual institutions. Our emphasis on market and self discipline and our less prescriptive regulation has led to New Zealand's supervisory and regulatory activity neatly complementing that of APRA and the other home supervisors with whom we share banks. In fact, we feel that New Zealand leads the world in home/host dovetailing from the host viewpoint within the very general framework provided by the Basel concordat. When it is done well, both home and host supervisors can benefit in obvious ways from each other's supervision. In New Zealand, we openly acknowledge the benefit that our financial system derives from the role played by APRA, and the other home-country regulators. However, we are also keenly aware that the interests of home and host supervisors can and do diverge, and that these divergences lead to differences in the style and substance of supervision and regulation. Moreover, these differences are likely to manifest themselves most sharply in the very pressured circumstances that a distressed bank brings. Such differences include: • Different statutory objectives. For example some supervisors have depositor protection as their main objective, while others have soundness and stability. • How capital should be allocated. Each supervisory authority would like to see as much capital reside within its own jurisdiction as possible. • How risk should be allocated. Each supervisory authority would prefer that the risk resides outside its own system. • Each supervisory authority is only responsible for financial stability in its own system. The effects on the financial systems of other jurisdictions of any actions taken to manage a bank failure in one's own jurisdiction are likely to be considered second order. • Different views on appropriate techniques for responding to bank stress. • Different perceptions of when a crisis is systemic - a particular risk when the subsidiary plays a much larger role in the host system than the parent plays in the home system. • Each system may also be subject to different destabilising influences. These differences are not straightforward to resolve when there is a largely bilateral relationship between home and host countries, of the kind faced by New Zealand. For these reasons, and in the absence of any fair and formalised, operationally and legally robust, international framework, a host authority would not purely rely on the home authority to protect the host financial system. All supervisors' actions are ultimately bounded by the legislation under which they operate. And in the midst of a crisis situation there is no room to negotiate legal boundaries. That said, we also recognise that the most effective response to a cross-border crisis would desirably involve very close cooperation and coordination between the home and host authorities. To this end the RBNZ has been active in pursuing closer cooperation with APRA. We have had for some time Memoranda of Understanding with APRA and the Financial Services Authority in the UK that allow for the sharing of supervisory information. However, a number of other cooperative measures have been undertaken recently: • We have initiated a secondment strategy of senior staff members between APRA and the Bank. We believe that we can learn from one another. • We have established a terms of engagement with APRA so that we can dovetail our Basel II implementation initiatives. • We are assessing all of our requirements of banks under the Basel Core Principles (BCP) so as to best ensure we have a single set of regulatory `rules' where possible and sensible. • We have agreed to share visits to Australian-owned banks on either side of the Tasman with APRA staff. The RBNZ has agreed with APRA a Terms of Engagement for Basel II implementation. The Terms of Engagement sets out the RBNZ's and APRA's intent to implement Basel II in a such a way that each supervisor's right to set its own minimum levels of capital is maintained, while at the same time seeking to reduce compliance costs where possible. It also requires that the RBNZ and APRA will conduct supervisory reviews of banks operating in both jurisdictions in a way that makes use of each supervisor's comparative advantage. This will involve joint sharing of information on, and recognition of, supervisory tools used and reviews undertaken. In February, New Zealand's Minister of Finance and the Australian Treasurer announced the formation of a Trans-Tasman Council on Banking Supervision to consist of the respective Reserve Banks and Treasuries, and APRA. This council will be represented at the highest level within the member institutions. Its main role will be the monitoring and coordinating of trans-Tasman home-host regulatory issues. The council is not based on statute. Rather its role is that of monitoring and advice, with reporting duties to the relevant Ministers. A key goal for the Council is to promote the maximum coordination, cooperation and harmonisation of trans-Tasman bank regulation where sensible, so as to best minimise compliance costs. Preliminary work is underway at the moment for the first meeting of the council, which is scheduled to happen soon. The first key output of the Council is to report to Ministers in late May on any legislative changes that may be required to ensure APRA and RBNZ can support each other in the performance of their current regulatory responsibilities at least regulatory cost. There are other significant early gains that could be made for the Council over the coming year. For example, we anticipate good progress on the home-host coordinated implementation of Basel II that I outlined in the Terms of Engagement earlier. We also think good progress can be made on gaining a clearer understanding of trans-Tasman bank failure management strategies and coordination. We look forward to building the trans-Tasman regulatory community based on the principles of cooperation and harmonisation. But, we will also work diligently to continue developing the capacity to preserve New Zealand's systemic financial interests. Conclusion Overall, the strong presence of foreign banks has brought many benefits to New Zealand in terms of soundness and efficiency. It has enhanced risk management capacity within the banking system, facilitated the entry of new banking products and services, and reduced the financial system's vulnerability to domestic economic shocks. However, along with the many benefits it brings, having an open, foreign-owned banking system also increases the chances of our financial system being adversely impacted by off-shore developments. The Reserve Bank of New Zealand is developing and maintaining the ability to deal with troubled banks in a way that is fiscally responsible, and that causes minimal disruption to real activity. We are also actively engaging with our trans-Tasman counterparts, and are optimistic about the opportunities the trans-Tasman Council and further harmonisation might offer.
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Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Institute of Finance Professionals New Zealand, Auckland, 11 August 2005.
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Alan Bollard: New Zealand payment system Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Institute of Finance Professionals New Zealand, Auckland, 11 August 2005. * * * Introduction Today I'm going to talk about one of our key pieces of infrastructure - our payment system. I believe it is the first speech by an RBNZ Governor dedicated to that topic. I'm pleased to take it up, because it's an area where we have spent quite a bit of effort in recent years, and because it is of very significant importance to the functioning of the economy. It is also closely linked to one of the Reserve Bank's statutory objectives - "avoiding significant damage to the financial system that could result from the failure of a registered bank". I'm certainly hoping that I never have to deal with a bank failure in New Zealand, but we do need to be very well-prepared for such an event because of the need to act very quickly and confidently in order to minimise systemic impacts. Most of the time, the various elements of the payment system work very well and are very reliable and we often take this pretty much for granted. However, any kind of disruption can be at best very inconvenient for users - as any of you who have been in a supermarket queue when the EFTPOS system goes down will know well. Some events can quite quickly cause more serious disruption, and have an impact on economic activity. Some of you will have been affected by the recent Telecom outage, which prevented some entities from accessing payment systems for a period, and which disrupted both trading and settlement activities. There have been other incidents like this from time to time, sometimes affecting only one participant directly, sometimes affecting many. I will return later to the lessons we have learned from these experiences. The payment system The payment system consists of all the diverse arrangements that we use to transfer money, whether using currency, paper instruments such as cheques, or a variety of electronic channels. It is something we all use every day - whether to purchase a book from someone using cash, buying it on Lambton Quay with our EFTPOS card, buying it from Amazon using our credit card, or - for many of you - to settle trades in the equity, debt or foreign exchange markets, in a number of different ways. And these transactions add up to quite a lot - on average more than $35 billion per day in the "wholesale" systems last year, and about $6 billion per day in the "retail" systems. The numbers of transactions are also striking - only a little over 4,000 per day in the wholesale systems, but more than 4 million per day in the retail systems. I might note at the outset that those transactions I just mentioned are all actually quite different in their characteristics. The first one - buying something with cash - is very simple: it just involves handing over some currency. No bank or settlement system is involved, and no record of the transaction is necessarily kept. That makes it all very quick and convenient, but the anonymity can lead to some problems as well, in respect of money laundering for example. That is a topic for another day. Note too that the Reserve Bank is a key participant in cash transactions, in the sense that it is providing a medium of exchange of undoubted quality. Aside from forgeries, no-one has to think about whether the money is "good". The second transaction - buying a book on Lambton Quay - introduces some new elements. First, typically a couple of banks get involved in the process - the ones where the bookseller and ourselves have our accounts. There's a pipeline going from one account to the other which is not instantaneous, and the bank receiving the money will often not let the recipient draw on it until it is sure that it has itself received the money from the paying bank. Secondly, customers wishing to make or receive payments need to maintain a transaction account with a bank - and this does involve them in accepting some risk in the event that their bank gets into trouble. In this sense, money "in the bank" is not quite as safe as Reserve Bank money. Thirdly, a merchant is now involved, and merchants participate in things like card schemes on a different basis from cardholders - for example, merchants may bear some risks of losses when cards are used fraudulently; and banks may bear some risks when merchants do not deliver the goods paid for. The third example, buying the book from Amazon, adds another dimension, the cross-border element of the transaction - now a local and a foreign bank are involved in the "pipeline", and the payments may be governed by legal and contractual arrangements that differ from country to country. As an aside, the ease with which we can now conduct international transactions, and pay for things when we are traveling overseas, would have been the envy of previous generations. In the wholesale financial markets, a final consideration comes into play - typically a local "payment" is made in exchange for the "delivery" of a security, or of some foreign currency. Not so long ago, there were often quite extensive delays between payment and delivery, implying significant risks for purchasers if the counterparty responsible for delivery failed in the interim. As I'll discuss more later, we have now moved to the happy position where most of these transactions can now be conducted on a simultaneous delivery-versus-payment (DVP) basis. There are two main lessons to draw out of these examples. First, the payment system is not a single entity. It is, in fact, quite a complex collection of disparate arrangements, with different participants, different rules, and different processes in each place. While there are similarities in the way things work internationally, each country also has its own idiosyncratic elements, reflecting its legal and banking history. The arrangements overlap and intersect at various points, and I have more than once heard them described as spaghetti. Of course, there is nothing wrong with serving spaghetti as long as you know how to handle it. Secondly, some of the key features I have described - in particular, the existence of sometimes-long pipelines between customers and banks, and the dependence on banks and their infrastructure providers - create risks for all the participants in the system, and those risks need to be understood and managed appropriately. I'm now going to talk about some of the significant changes in the payment system in recent years, and then about the various different roles that the Reserve Bank plays in this area, and how we go about some of them. I'll talk a bit too about the very successful risk-reduction programme that we have been pursuing. On the way, I'll have a few things to say about unfinished business and future business. Recent innovations There have been some fairly dramatic changes to the payment system over the last 20 years. Prior to about 1984, the system was almost entirely based on "paper", with currency and cheques being the dominant forms of payment for both retail and wholesale transactions. The first credit cards were issued in 1979, but these were also paper-based initially. The electronic era began about 1984, when EFTPOS emerged in the market. New Zealanders were enthusiastic adopters of EFTPOS, and New Zealand was - and still is - a world leader in the penetration of this technology. More recently, the use of PC-banking and the internet to initiate transactions have been growing rapidly in popularity. Cheques are progressively disappearing, but - contrary to longstanding predictions of a "cashless society" - the use of currency has continued to grow. In the wholesale markets, the Kiwi Interbank Transfer System (KITS) began in 1987, to handle electronically some payments between the four big banks. It was replaced in 2000 by the Same-day Cleared Payment service (SCP), which can handle interbank payments and payments between bank customers on a real-time basis. In 1990, the Reserve Bank commenced to operate the Austraclear system under licence. This system, as you know, provides a depository for debt and equity securities, the facility to transfer these securities on a real-time delivery-versus- payment basis, the facility to make cash payments, and a platform for the automated provision of intra-day liquidity to the banking system. Settlements amongst the banks in respect of each day's transactions used to take place on the books of the Reserve Bank - everything was netted down to a single number that each bank either owed to the system, or was owed by the system, and the banks' accounts at the Reserve Bank were debited and credited accordingly. No doubt this procedure started with a ledger, a clerk and a quill pen, and it didn't change much until 1998 when the electronic Exchange Settlement Account System (ESAS) was introduced. This system enabled three main changes: • Large interbank transactions could now be settled on the Reserve Bank's books at any time during the day, without having to wait until the end of the day, and without having to be included in the end-of-day netting wash-up. This is called Real Time Gross Settlement (RTGS) • Austraclear transactions were now also settled using ESAS, giving the securities market delivery-versus-payment in central bank money (Austraclear had previously been DVP in commercial bank money). New Zealand was one of the earliest countries in the world to achieve this outcome. • Reserve Bank operations to provide intra-day liquidity to enable these real-time transactions were automated though an "autorepo" facility Finally, late last year, the New Zealand dollar entered the CLS system, which provides a payment versus payment service for settling foreign exchange transactions. This substantially reduced the largest remaining settlement risk for the New Zealand banking system, and the design also significantly economises on the liquidity required to make foreign exchange settlements. CLS is connected to ESAS in order to achieve this. CLS has been very successful in New Zealand, and has already achieved a higher penetration in the New Zealand market than in any other country, some of which joined CLS back in 2002. Overall, it would seem that New Zealanders and New Zealand businesses get pretty good payment services by international standards - they are efficient, up-to-date, reliable and accessible. Our small size may have actually be an advantage, in that it has been relatively easier to innovate when a small number of similar institutions are involved. In addition to improving customer services, some of the innovations I have talked about have been motivated by the need to reduce risks, and I will return to that topic. The Reserve Bank's roles The Reserve Bank has been part of the payment system from its inception, but for most of the period had little involvement in a policy or operational sense. The various entities involved in the clearing and settlement of payments were owned and operated by the private sector. Of course, in the days when we were the Government's banker, we looked rather like other banks, with tellers and ledgers and all that stuff, and we were heavily involved with cheque processing and so on. We also had some other significant clients, like the former Dairy Board. But those parts of the business largely left the Bank during the 1980s reforms. Currently, the Reserve Bank has a number of roles in the payment system, and I have mentioned some of them already: • Issuer of currency - coin and paper (or these days polymer) "money" • Provider of exchange settlement accounts - electronic "money" • Provider and operator of ESAS - the facility to use our accounts for real-time transactions • Provider and operator of Austraclear - securities trading and settlement • Provider of liquidity to the banking system • User of the system for FX and securities trading and settlement • Regulator of banks and overseer of the payment system We are very conscious that we are wearing all these different hats, and that they could involve somewhat different interests. We therefore manage each of these roles separately, although with close co-ordination, and in practice we find that they rarely come into any conflict. Almost all of the roles are core businesses for central banks. The only exception to this is the Austraclear operation, which is more commercial in nature, and may not be an essential component of the Reserve Bank. We picked up the Austraclear business in the first place because we were interested to ensure that the New Zealand market is as well-served as possible, in terms of the efficiency and integrity of the clearing and settlement systems, the quality of risk management, and the recognition of the interests of all stakeholders. Those outcomes remain our long-term goals. We are committed to maintaining the quality of the Austraclear service for so long as it has a role to play, and we have recently committed to a major upgrade of the Austraclear system. Risk reduction and dealing with settlement failures Our regulatory role started to develop around 1990, a few years after we had entered the field of formal bank supervision for the first time in 1987. That responsibility, together with an increased focus on the issues internationally, awakened our interest in the size and nature of payment system risks. We developed the view that the existing understandings about what would happen in the event of a bank failure were probably not very workable or satisfactory, and initiated a dialogue with the industry aimed at ensuring that payment system risks were identified, monitored and managed appropriately. We were also keen to ensure that the status of transactions, including those in the various "pipelines", was certain at all times, and that payment system arrangements, including failure-to-settle arrangements, were legally, financially and operationally robust. In other words, the arrangements have to work both in theory and in practice, and under acute time pressures. By financial robustness, I mean that any losses which do occur can be absorbed without strain by those bearing the losses. These remain our goals. Much has been achieved over the last 15 years. The moves to real-time gross settlement and the entry of the NZ dollar to CLS were both landmarks in stripping large risks out of the system. They have been supported by some legislative changes that have underpinned them, and which provide a high level of certainty. A New Zealand Bankers' Association project to review the failure-to-settle rules for retail transactions has led to significant improvements and greater clarity. I am grateful to everyone who has contributed to these developments - our payment system has become much more resilient as a result. In terms of our goals, we have now achieved a high degree of legal robustness, and much improved financial robustness. I think there is further scope to move some large payments which still go through the deferred settlement systems into the real-time systems, in order to further reduce financial risks for both banks and their customers, and this might require some changes to bank customer behaviour. A few other things may also need to be tidied up, but reasonably soon we ought to be able to reach a point where we can say that financial risks arising within the payment system itself are no longer of systemic significance. However, operational robustness remains a systemic issue, and it is probably going to be our main pre-occupation in future. Two main things are driving us here. First, we have all seen enough incidents where operational failures have disrupted the payment system to cause us concerns. Some of these have arisen in individual banks, both large and small, but have had the potential to spill-over and affect other participants, and/or require emergency liquidity support. Others have affected a whole system or network, including the recent Telecom outage and some brief disruptions to New Zealand's access to the SWIFT network. What these experiences have shown is that: • serious problems can arise without warning, • they can escalate quickly if not resolved promptly • there is sometimes inadequate appreciation of the impact on other participants • communications to affected parties are not always adequate • diagnosis and repairs take time • there are not many - or any - fallbacks when some kinds of disruption occur • business continuity arrangements do not always provide the answers in a sufficiently timely manner The incidents have also sometimes provided confirmation that Murphy is alive and well - problems with completely unrelated causes can pop-up simultaneously, with nasty consequences. Another area of operational risk is fraud, and we have all seen reports of new kinds of fraud emerging. The New Zealand financial system has not been a major fraud target to date, but no-one can afford to be complacent about the potential risks as our electronic dependence continues to grow. Sometimes there is a difficult balance to be struck between making things as easy as possible for genuine customers and as hard as possible for fraudulent customers. Banks and other payment system participants have plenty of incentives to protect the systems from fraud, and to detect it as quickly as possible when it happens, and the Reserve Bank may not have a great deal to add. The important thing from our perspective is that risks should be managed by those best placed to manage them, typically the banks themselves. We do not think that bank customers should be unduly exposed to risks that they are not reasonably able to identify or manage. Our second driver comes from our ongoing work on bank failure management, which some of you will be familiar with. While we are not expecting any banks to fail, we do want to be in a position to discharge our legal responsibilities if one does get into trouble. And one of the things we may well want to do is to continue to operate a bank in statutory management, and keep it as a full participant in the payment system. We also need to be able to act quickly in respect of transactions that are in the various pipelines at the point where a statutory management is declared. To do this, we potentially need fast access to New Zealand management, technological and payment system resources. I noted earlier the complexity of the payment system overall, and I don't think that some of these questions have particularly easy answers. We are addressing some of them through our outsourcing policy, but others are likely to require alternative approaches, and some further co-operation with the industry. The goals include ensuring that key systems are designed to be "high availability" ones; that robust back-up arrangements are in place wherever feasible; that business continuity plans are effective and mutually consistent; and that rapid decision-making and communication capability is readily available. For us, this is very much "work in progress" at this point. Legislative powers Finally, in talking about regulation, I should note that in 2003 the Reserve Bank was given some formal legal jurisdiction over the payment system for the first time, in a new Part 5B of the Reserve Bank Act. The powers basically give us the right to obtain and publish information, and thus to throw a spotlight on any issues of public interest. They do not give us the kind of authority to scrutinise and determine prices, for example, that the Payment System Board has in Australia: here, that kind of role is performed by my former colleagues in the Commerce Commission, and we are very comfortable with that division of labour. The Reserve Bank is an advocate for competition and suitably-open access rules in the payment system. In practice the new legislation provides a more formal basis for the kinds of things we have been doing, and does not signal any change in direction. We decided recently to publish the principles we would follow in our payment system oversight work, and these have been put on our website today. You will be able to read them there, so I won't go into them in detail. They do include a largelyunchanged restatement of the goals we set ourselves a decade ago: They state that a sound and efficient payment system is one: • that does not generate high levels of risk to participants or to users of financial services, and in which any risks that are generated are managed appropriately by system participants; • that can continue to operate without disruption in the event of the sudden financial or operational incapacity of a participant, or following other types of financial crises or natural disasters, etc; • that incorporates delivery-versus-payment arrangements where appropriate, and especially with respect to high-value transactions; • in which the status of payments is certain at all times, and, in particular, in which the attributes of "finality" and "irrevocability" are supported; • in which payment services are efficient and reliable, and are responsive and relevant to customer needs; and • that is open, flexible and competitive, with no unwarranted barriers to entry. We have noted in the document that these goals are not an exhaustive list and may evolve over time. They do reflect recent and currently significant payment system issues. They also overlap substantially with the main international standard in this area, the Core Principles for Systemically Important Payment Systems released by the Committee on Payment and Settlement Systems in 2001. Conclusion Our aims have been to achieve a payment system that is sound and efficient, and - in particular - that is legally, financially and operationally robust. We have made excellent progress in improving legal certainty, reducing financial risks, and improving some aspects of operational robustness. However, the system now involves increased interdependence amongst all the participants, and more stringent timing requirements, particularly since the entry into CLS. Moreover, the increased dependence on technology that we have seen develop implies that technological risks have increased commensurately, and probably now pose the greatest potential systemic threat to the payment system. It is clearly in all of our interests that we fully understand these issues and risks, and ensure that we all have the capacity to manage them properly, so that the payment system meets the needs of the financial system and the wider economy well, and is fully resilient to stresses and strains. I am grateful for the good co-operation with the industry which has enabled the progress we have made, and I look forward to that co-operation continuing.
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Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to New Zealand Credit and Finance, Rotorua, 14 October 2005.
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Alan Bollard: Imbalances in the New Zealand economy Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to New Zealand Credit and Finance, Rotorua, 14 October 2005. * 1. * * Introduction The New Zealand economy has grown strongly over the past four years. Initially concentrated in the export sector, this expansion gradually shifted toward the domestic economy. While a sustained expansion in economic activity is obviously pleasing, we have also seen some significant ‘excesses' develop in the economy. Productive resources have become severely stretched, which has led to an increase in inflation pressures. There has also been a widening in New Zealand's current account deficit -- the difference between what the country earns overseas from its exports and investments and what it pays for its imports and the investments foreigners have in New Zealand. These two developments largely share a common underlying driver -- very strong growth in spending, particularly by the household sector, much of which has been debt-financed. 2. Looking at the imbalances Figure 1 : Current account deficit reaches 8% of GDP Some of the drivers of the recent current account deficit are not necessarily a cause for major concern. New Zealand has been undergoing a strong business investment cycle which has necessarily meant high demand for imports of capital goods, which we can't or don't produce locally. Investment is obviously necessary for sustaining future growth in activity. The profits paid on foreign investment in New Zealand have also been growing, due to the relative strength of many parts of the economy. 1/7 Figure 2 : Businesses importing capital goods But while some components of the current account simply mirror cyclical strength in the economy and the efforts of businesses to increase their long-term productive capacity, the widening deficit has also reflected very strong spending on part of the household sector. At a time when government and the business sector have increased their savings (with growing fiscal surpluses and higher profits), household savings has continued to decline. During the past few years, we have seen very sharp rises in house prices in New Zealand, reflecting strong demand by New Zealanders and overseas investors alike. Associated with this buoyancy in the housing market has been a strong tendency among many households to ‘unlock' housing equity builtup through capital gains to fund consumption. This often involves borrowing more against the equity in the home. Rising house prices have boosted the perceived wealth of home-owners and, along with an increased access to debt, have underpinned very strong consumption spending. Strong consumption spending has in turn fuelled much of the demand for imports that has led to a widening of New Zealand's trade deficit. In effect, we have seen a continued decline in the New Zealand household savings rate -- the proportion of current income that households put aside to invest for future consumption. Statistics New Zealand figures suggest that on average households in New Zealand do not actually save anything out of current income but instead dis-save to the tune of around 12 per cent of income per annum. Of course, there is plenty of room to debate whether this is the most relevant or accurate saving statistic.1 But comparative figures show that, typically, households in most developed countries save at least some of their current income. It is clear that the New Zealand household sector stands out as having one of the lowest savings rates of any OECD country. For example, the blurred boundary between households and firms these days might suggest that total private savings, including by firms, is more relevant. Another issue is that saving is measured as the difference between income and consumption, making it prone to measurement error in either of those aggregates. 2/7 Figure 3 : Household credit growing faster than income It is possible that households' expectations of the capital gains from housing have been so strong that many households have seen scope to unlock recent capital gains, whilst still expecting to be able to build up their equity sufficiently over the long-run to meet their savings goals. If so, they would have seen little need to save anything out of current income. Obviously the success of this strategy will depend on the extent to which house prices do in fact continue to rise from here. The Reserve Bank has noted several times in the past few years that some households may have had unrealistic expectations in this regard; indeed a fall in house prices cannot be ruled out. In Australia house prices today are, if anything, lower than they were a year ago, certainly so in Sydney. We are also conscious that there may be subtle changes occurring around what households regard as an acceptable target level of wealth in retirement. This may be driving current consumption and savings decisions. Traditionally, the bequest motive has been a driver of many New Zealanders' savings strategies. Some baby-boomers may be opting to spend more of their accumulated wealth during their lifetime and not make a significant bequest. It is also possible (but hard to gauge) that some households have viewed the recent increase in government savings (i.e. fiscal surpluses) as a sign that they can afford to save less themselves. Figure 4 : Households consuming from debt 3/7 Recourse to debt-financing has been an important part of the process. Despite an Official Cash Rate that has been high by international standards, households appear to have been very willing to increase debt levels to fund their housing and consumption activity. Strong competition among home loan providers -- which has meant lower home loan rates than might otherwise be the case -- has certainly done little to discourage households in this regard. In some cases, interest rates for fixed-rate home loans appear to have been priced below the all-up cost of lending, as lenders have competed for market share. Lenders have clearly seen home loans as a relatively low risk activity and have priced loans accordingly. Figure 5 : Effective mortgage rate Household behaviour is not the only influence on the current account. The rise in the exchange rate over the past few years has reflected rising commodity prices, New Zealand's strong relative growth performance and our correspondingly higher interest rate structure relative to the rest of the world. The high exchange rate has reinforced the widening of the current account deficit, placing pressure on export sector revenues, whilst making imports relatively cheaper. Although the factors behind the appreciating exchange are easy to identify, what has been surprising has been the continued willingness of investors to continue investing in New Zealand dollars through the likes of Eurokiwi and Uridashi2 issues notwithstanding a growing consensus that the exchange rate has reached unsustainable levels. Over the past year alone, we have seen an additional $20 billion of such issues, and demand has continued to remain very strong in recent months. Flows into these two particular products were larger than was the case for any other currency. Zealand See Drage, D, A Munro and C Sleeman `An update on Eurokiwi and Uridashi bonds', Reserve Bank of New Bulletin, 68/3, September 2005. 4/7 Figure 6 : NZD since float New Zealand is not the only country to have experienced a widening of its current account deficit in recent years. A number of others, including the US and Australia have also experienced widening deficits. Strong household demand has likewise been an important driving factor behind the increases although, as in the case of New Zealand, not necessarily the only factor. However, New Zealand stands out in one important respect. Over time, current account deficits have to be financed either through equity investment by foreigners or by borrowing from overseas. New Zealand's foreign liabilities currently outweigh its foreign assets to the tune of $124 billion (81 per cent of GDP) a much higher net liability position than in virtually any other developed country. This reflects our long history of running current account deficits. Figure 7 : New Zealand's net international investment position 3. The adjustment process Currently standing at 8 per cent of GDP, New Zealand's current account deficit is at levels that cannot be sustained indefinitely. Doing so would imply a continued increase in New Zealand's indebtedness, 5/7 and debt servicing costs, relative to the income available to service that debt (i.e. its GDP). History tells us that at some point the deficit will ‘correct' back to lower levels. The process of current account correction is likely to involve some combination of an expenditure reduction through lower domestic demand and expenditure switching away from imported goods towards locally produced goods and services. It is also likely to involve an increase in exports. Such adjustments are likely to be prompted by a lower exchange rate and/or higher interest rates. The transition to a lower current account deficit effectively means reducing New Zealand's reliance on foreign savings and increasing the saving we do ourselves. For the household sector, which has been relying heavily on debt in order to finance spending, this adjustment process may not be painless. A correction in the housing market -- a slowing in house price inflation or even an outright fall in prices -is likely to be part of this process. A reduction in the exchange rate from its current high level is likely to be an integral part of the adjustment process. Significant parts of the export sector, such as manufacturing and services have been under pressure, while those supplying local markets have faced considerable competition from falling import prices. There also appears to be a growing sense among analysts and commentators that the exchange rate is materially overvalued and that a substantial fall is both desirable and inevitable at some stage in the next couple of years. No one can reliably predict when the exchange rate will decline nor what path it is likely to take. Factors outside our control -- including the path of the US dollar -- could have a significant bearing on developments. It should also be emphasised that even once the exchange rate begins to fall, an increase in exports and a reduction in imports will not occur instantaneously. Export markets take time to rebuild and consumer buying patterns take time to respond to changes in relative prices. Although projecting when the exchange rate may begin to head lower is a difficult task, the likely precursors for such an adjustment seem clear. As the current account deficit continues to increase, one would expect the foreign providers of capital to re-assess the relative exchange rate risk attached to their investments in New Zealand dollar assets, increasingly recognising that the exchange rate cannot be sustained at current levels. In addition, a slowing domestic economy is likely to see expectations of future returns on such investments being revised down. 4. Why is the Reserve Bank concerned about all of this? The Reserve Bank's interest in the current account deficit, and its associated macro-economic effects, stems from our key areas of responsibility: • Our role in helping to maintain macro-economic stability. The Bank is required to maintain price stability whilst avoiding unnecessary instability in interest rates, exchange rates and output; and • Our financial stability role. The Bank is obliged to make sure the financial system remains resilient in the face of imbalances (such as a large current account deficit and growing debt levels) and subsequent adjustments that might occur. We will say more about our financial stability role when we release our next Financial Stability Report in November. While we believe the New Zealand financial system is well placed to weather strains that may be borne by its customers, we will be monitoring the risks closely as we go forward. On the price stability front, we are required to maintain inflation within the 1 to 3 per cent target band ‘on average over the medium term'. That task has been particularly challenging of late due to several factors: • As noted, household demand has remained very strong over recent times, despite relatively firm monetary policy settings. Consequently, inflation pressures have remained strong in many parts of the domestic economy, including housing and construction. • The recent sharp rise in world oil prices is putting upward pressure on inflation as higher petrol prices ‘at the pump' and the effects of higher fuel prices risk becoming entrenched in inflation expectations. At the same time, we are expecting these increases to exert a dampening effect on household and business demand. Estimating the balance of these effects is difficult. 6/7 • The likelihood of a more expansionary fiscal policy over the coming period has the potential to add inflation pressure in what remains a rather stretched economy. A growing fiscal surplus has clearly made higher levels of government expenditure affordable in the longer term. However, in the short-term, a more expansionary fiscal stance also has the potential to aggravate the current account deficit as well as increasing the work monetary policy has to do in order to contain inflation. These pressures will need to be borne in mind as the incoming government considers its fiscal options. We are conscious that the eventual adjustment of the high current account deficit could make the job of maintaining price stability more difficult in these circumstances. In the short-term, an exchange rate adjustment has the potential to boost inflation via its direct effect on tradables prices. How problematic this might be for monetary policy would largely depend on the timing and magnitude of the exchange rate adjustment, which is something over which the Bank has little control. A falling exchange rate in the context of continued strength in domestic spending would tend to generate stronger inflation pressures. Conversely, the inflationary effects of an exchange rate decline that occurred following a cooling in domestic demand are likely to be more easily managed. As far as possible, the Bank will not stand in the way of an exchange rate adjustment, accepting that a short-term boost to tradables inflation may be an unavoidable consequence of adjustment. Clearly, a more orderly and gradual exchange rate adjustment would pose less of a challenge for monetary policy. However, whatever the adjustment path, our job will be to focus on medium-term inflation stability. The extent to which monetary policy will need to continue leaning against domestic inflation pressures will largely depend on the spending and savings behaviour of households. 5. Conclusion Strong household demand associated with a buoyant residential property market has contributed to an increase in inflation pressures and a widening of New Zealand's current account deficit. The Reserve Bank remains focussed on ensuring that the inflation outlook remains consistent with the medium term target whilst recognising the macro-economic adjustments that are likely to occur in the face of a large and unsustainable current account deficit. We are concerned to see that, as far as possible, such adjustments occur in as orderly a manner as possible. 7/7
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Speech notes by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, at an address to the Employers and Manufacturers Association (Northern) AGM, Wellington, 2 November 2005.
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Alan Bollard: Housing debt, inflation and the exchange rate Speech notes by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, at an address to the Employers and Manufacturers Association (Northern) AGM, Wellington, 2 November 2005. The graphs for this speech can be found on the Reserve Bank of New Zealand’s website www.rbnz.govt.nz * * * New Zealand has enjoyed very strong growth over the last decade. GDP growth has averaged 3.6 per cent over the last five years. But now it is starting to slow, causing some concern to businesses. We have enjoyed strong growth New Zealand is an open economy and over the cycle we rely on important contributions from the export sector. But at the moment we observe that despite reasonable terms of trade the impact of net exports is weak, while the domestic sector has continued to grow extremely strongly, driving imports strength. Driven by very strong domestic spending The inevitable upshot has been that the creditable positive trade balance we have enjoyed over the last decade and a half has now reversed. Based on last week's trade data, the trade balance has now fallen to a deficit of 2 per cent of GDP. This trade deficit has been a principal (but not the only) reason for the severe fall off in the current account balance (the balance of flows carried in the country and abroad.) Our current account deficit has now reached 8 per cent, the worst figure since 1986 and very marked by OECD standards. Contributing to negative external balances Another way of looking at this is to say that we are consuming and investing much more than we are saving. The Government has had a strong saving record over the last decade, and more recently the business sector has been saving too. But the household sector, which represents a large part of the economy, has been running down its savings in spectacular fashion. While we may contest the validity of some of the data, there is little doubt we are now dissaving at about 12 per cent, very low by OECD standards. And very weak household savings An important part of what is going on relates to housing. Over the last five years as capital has appeared cheaper and mortgages have become more accessible, the household sector has participated in a large housing boom, including: first time home buyers; others trading up; additions and alterations; second homes; investor houses; investor apartments; and rural property. The outcome has been unsustainably high house price rises, exacerbated by a very tight labour market and growing non-residential construction. Several other OECD countries are going through a similar housing boom, but none of them have such a tight domestic economy and a poor savings record. New Zealand households are also unusual in the dependence they have on property assets in their balance sheets. In fact many households hold essentially no other assets. The typical holding of financial assets and equities is very low by OECD standards. The danger of this is it means our love affair with housing leaves us very exposed to a property slump. The housing boom has driven a lot of extra expenditure that typically accompanies new houses: fixtures and fittings, appliances, even cars. In addition, seeing their house value rise over the last five 1/3 years, many people have felt richer and have spent more on unrelated items - entertainment, travel, etc. The very tight domestic economy largely reflects this. Strong house price inflation Such spending has been made easier by banks and other financial institutions lending freely on homes, encouraging people to put other debt on to their mortgage, and increasing mortgage levels to allow home-owners to consume part of the equity in their homes. This may be part of a longer term change in behaviour by baby boomers to consume more of their wealth during their lifetime. However, this is a difficult time for such adjustment in the business cycle. The housing boom has meant good profits for many New Zealand companies supplying materials and building services. But it implies home-owners would rather invest in their country's homes rather than its businesses. What has the Reserve Bank been doing about these growing imbalances and inflation pressures? We identified the issue several years ago and have increased the OCR eight times, the latest last week. Our intention has been to ensure mortgage rates rise so as to curb excess demand. In addition, we have spoken out frequently about the need for home-owners to show care in increasing their borrowings and to increase and diversify their savings. These past interest rate hikes have slowed housing price growth. But it is still growing at around 14 per cent, driving unsustainable levels of consumer spending. The impact of higher rates on spending levels has been slower than in other periods because the effective mortgage rate has increased more gradually than the OCR. Global interest rates have been unusually low, reflecting loose monetary policies in a large part of the OECD, and supply of savings out of East Asia. Low global interest rates have kept longer-term rates in New Zealand lower than usual and necessitated more tightening in the OCR. Mortgage rates on upward trend In addition, late last year the banks in New Zealand started cutting margins as part of a mortgage war. The Australian-owned banks have enjoyed strong profits in New Zealand for some years. They are now seeking to keep up the returns by capturing more business through active marketing of fixed rate loans. This has kept the housing market much more buoyant, unlike in their home country Australia where floating rates predominate and the housing boom is over. So far our focus has been on the overall effects on the New Zealand economy. But we also need to emphasise the position of certain households that are potentially at risk. About a third of households have mortgages, and one tenth of those are quite deeply in debt, already spending over half their disposable income on servicing their mortgage. These people are vulnerable to interest rates rising, property prices falling, or their employment positions becoming more fragile. Later in November we will be releasing our Financial Stability Report, which will comment on the housing sector in more detail. This presents us all with a challenge. Strong housing activity and other consumption in this tight economy is starting to drive inflation higher. In addition, pre-election fiscal promises and coalition undertakings could fuel the strong domestic economy further if they happen in the near future. And, the big oil price rise is already increasing headline CPI, while second-round effects could drive inflation further. Oil price shocks We are addressing these inflation pressures through higher interest rates. But at the same time this strong domestic demand is driving the current account deficit, which itself is partly exacerbated by the opportunities the relatively higher New Zealand interest rates offer overseas investors in the New Zealand dollar. How do we intend to manage these issues? Our primary concern is inflation. We are already seeing signs of domestic spending slowing. Last week we increased the OCR again and stated that we need to see more housing and consumer 2/3 spending moderation before we will be comfortable that inflation pressures are contained. We will be helped in this by the pressures to increase mortgage rates already in the pipeline, by the tightening international bond rates, and by the increasing sensitivity of indebted households to monetary policy. We will be watching closely for signs of further slowing over coming months. But we cannot reduce inflation and reduce external imbalances alone. There are other key players in this process, all with responsibilities. Banks need to focus on their long-term interests, not just their one-year profit growth or market share target. In New Zealand, the banking sector is also responsible for the bulk of credit allocation. This task is an important determinant of New Zealand's long-term economic growth and hence banks' future profits, and must be considered carefully. The larger banks' shareholder interests, which are intrinsically linked to the health of the New Zealand economy, will not be achieved if they promote loans to people who cannot afford them. Some of the comments that have come out of the property industry suggesting that activity can continue sustainably at this level have been self-serving and unhelpful to those that will be caught up and damaged by a property market correction. We look to the industry and the financial advisory profession to offer professional and realistic advice. The more government can work to reduce fiscal pressures on the economy, the easier our job becomes. History shows us that the exchange rate cycle is linked to the broad economic growth cycle. As tighter monetary policy eventually dampens domestic demand - the main source of strong growth in the New Zealand economy - the exchange rate will in time fall. A lower exchange rate is necessary to improve the current account balance by dampening consumption of imports and encouraging exports. The high exchange rate dampens export earnings As far as possible the Reserve Bank will not stand in the way of such exchange rate adjustment. Over the short-term, a fall in the exchange rate would push inflation temporarily higher through higher prices for imported goods. But monetary policy would be focusing on the medium-term inflation outlook. Future track of interest rates More generally, the correction of imbalances will be driven by the slowing in domestic demand, which will bring down inflation to the target zone by 2007. This, however, comes at the cost of slowing growth. But it is important to recognise that such an adjustment needs to happen - and the sooner it happens, the less costly it will be. Inflation peaks at 4% then reduces Finally, households need to remember that saving only through property is unwise, that house prices do not rise forever, and that they cannot rely on others to do their saving for them. If they do, then they can hardly complain when foreigners own a growing part of our capital stock and when they buy New Zealand dollars. We need to take responsibility for our own savings. The high interest rates needed to encourage New Zealanders to save have had one difficult sideeffect, and that is offering inducements to foreigners to buy New Zealand dollars to fund our consumption. This has been one reason why the New Zealand dollar has remained so high (although of course our high commodity prices are another reason). This is starting to cause considerable discomfort for some exporters. We now see the exchange rate as exceptionally high, and in some respects this is unjustifiable; in time it will fall. The decline in the New Zealand dollar exchange rate will either be gradual, as domestic spending pressures ease off, or it will be more abrupt as global investors reassess New Zealand as an investment destination. Either way, those investors who think that the New Zealand dollar only goes up will be set up for disappointment. The medium-term economic prospects for this country look good, but we have some short-term adjustment to go through first. 3/3
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Speech by Mr Adrian Orr, Deputy Governor of the Reserve Bank of New Zealand, presented to the Institution of Professional Engineers New Zealand, Wellington, 22 March 2006.
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Adrian Orr: Towards a framework for promoting financial stability in New Zealand Speech by Mr Adrian Orr, Deputy Governor of the Reserve Bank of New Zealand, presented to the Institution of Professional Engineers New Zealand, Wellington, 22 March 2006. This speech draws on an article by Hunter, Orr and White forthcoming in the Reserve Bank Bulletin March 2006. * * * Thank you for the opportunity to participate in this conference on New Zealand infrastructure. The topic I have been assigned is "What infrastructure do we need to develop in order to keep New Zealand growing?" When people refer to infrastructure, they probably have in mind physical infrastructure, like transport, energy, water and communication networks. Those are all critical to growing the economy, and certainly in New Zealand they have been attracting a fair amount of attention. However, I will focus on an aspect of economic infrastructure that is at the core of the Reserve Bank's role, that is, New Zealand's financial infrastructure. The financial system I will argue is at least as critical to the future growth of the New Zealand economy as the physical infrastructure, though probably is more taken for granted. In this speech I will outline the beginnings of a framework for assessing the promotion of financial stability, and outline why the Reserve Bank of New Zealand sees it as an important role. I will also highlight some of the areas the Bank is working on to promote financial stability. The critical role of the financial system The financial system is not infrastructure in perhaps the traditional sense of the word (e.g. wires, bricks and mortar, electricity, communication devices). The system is also made up of legal structures, agreed behaviours and practices, information and knowledge. Of course, if the power goes off or phones go down, the financial system will struggle to operate. We think of the system as comprised of three interconnected components: financial markets, institutions, and payments systems. Financial markets are where financial contracts are entered into or traded directly between buyers and sellers (or borrowers and lenders). Financial institutions intermediate between borrowers and lenders (including the central bank) and provide financial services. While payments systems allow financial transactions within markets and with institutions to be made. These components of the financial system act together to enable the vast majority of economic exchange, and play a pivotal role in the allocation of economic and financial resources. In markets this is done through the `price mechanism': buyers who most highly value a particular resource will bid a higher price, and under certain conditions markets can set prices so as to efficiently allocate resources to where they have the most value (at least as measured by ability to pay). In practice, financial institutions allocate resource depending on the level of risk that the institution wishes to be exposed to. Achieving efficiency in allocating resources is mostly about ensuring that the conditions required for optimal economic exchange are satisfied. These conditions include the existence of markets that can allocate all forms of financial risk, clear ownership rights of both financial risk and reward, and investors having adequate information with which to make their financial decisions. The efficiency of the financial system itself is mostly about satisfying the conditions required for competition, for example, low barriers to entry and an absence of monopoly powers. It is important to note that at the same time as the system prices and allocates resource, it is pricing and allocating risk. The price of risk is the additional yield (or premium) an investor would expect to receive for holding a risky asset over and above the `risk-free' interest rate. Hence, in a market, investors who can best manage the risk associated with an asset will be prepared to receive a lower risk premium in compensation for the risk exposure (or conversely pay a higher asset price). Efficient pricing of risk therefore will tend to result in risk being allocated to those who best understand the nature of the risk, and are most willing and well-positioned to manage it. In this sense, an efficient financial system is also a stable one. When is a financial system stable? It may come as a surprise to many of you in the audience, but the last few decades have been recognised internationally as amongst the most financially unstable in modern history. 1 Many regions during this period have experienced periods of financial instability. This includes New Zealand, Australia, and Scandinavia, in the late 1980s and early 1990s, Japan throughout much of the 1990s, East Asia in 1997/98, and the United States, first in the early 1990s (the Savings and Loan crisis) and again early this decade (the ‘tech wreck’). These experiences have resulted in financial stability issues coming to the fore of central banks' attention. Many central banks, including the Reserve Bank of New Zealand, now publish regular financial stability reports alongside their regular monetary policy and inflation reports. However, the framework for undertaking this surveillance and for linking financial system surveillance to its policy powers and purposes is less developed than for central banks' monetary policy function. Unlike inflation targeting, financial stability is not an easily quantified concept, and is also not clearly separable from other factors such as political stability, international financial stability, and wider economic and social stability. In general terms, a financial system is stable when it has the resilience to continue to efficiently provide financial services under a plausible range of adverse circumstances. A plausible range of financial losses should also be able to be absorbed without financial system disruption. By contrast, the financial system can be considered impaired when a material number of users incur significant losses from exposures to financial system risks that they could not have been expected to be aware of, or manage. 2 We thus define the preconditions for financial stability as existing when all financial system risks are adequately identified, allocated, priced and managed. All four of these preconditions may not be strictly necessary or relevant in every instance. In some cases the preconditions could be adequately met through non-price approaches to risk management. Or one might argue that in a perfect market with full information, adequately ‘priced’ risk would also imply adequately identified, allocated and managed risk (in which case adequate pricing alone would be the only relevant precondition). For generality, and because the market fails for various reasons, we see an adequate combination of identification, pricing, allocation and management of financial system risk as necessary for financial stability. This definition of financial stability is in terms of preconditions rather than outcomes, and hence it is not like the definition of price stability in the Reserve Bank's Policy Targets Agreement. Our definition of financial stability is also an ex ante (rather than ex post) definition. Its value thus lies in prompting questions for policymakers and financial system users in relation to whether an apparent imbalance or misalignment may be a source of financial instability. However, even if the preconditions for financial stability are in place, volatility and sharp adjustments in financial prices (and/or quantities) can still occur. These are often an important part of the adjustment See Aliber (2005) "The 35 most tumultuous years in monetary history: shocks, the transfer problem, and financial trauma" IMF Staff Papers, Vol 52. Special Issue From Draghi, Giavazzi, and Merton (2006): "To understand the breeding conditions for financial crises the prime source of concern is not risk per se, but the unintended, or unanticipated accumulation of risks..." process in a sound and stable system. Short-term price volatility is often caused by the ‘price discovery’ or ‘quantity adjustment’ process that occurs as economic circumstances change. Such volatility is, however, less likely to lead to financial instability or necessitate some form of crisis intervention if the preconditions for financial stability are in place. Furthermore, financial crises can and will still occur. Financial crises are caused by a combination of unlikely events where the correlations were not obvious ex ante. Hence financial crisis management capabilities are necessary. Financial system risks, instability and market failures Financial system risks exist in all components of the financial system. If any one component (markets, institutions, and payments systems) of the financial system is impaired, then it can become unstable and will not operate to allocate resources efficiently. The main types of financial system risk can be categorised as credit, market, liquidity, and operational risks. Credit risk relates to the risk that contracts represented as payable as a fixed sum of money in the future will not be paid in full on maturity. Market risk relates to the potential for the market value of an asset to fluctuate because of, for example, changed credit risk assessment, changed assessments of the future income flow from the asset, or a change in the rate of exchange between currencies. Liquidity risk is the risk that a loss might be incurred as the result of a forced sale. Operational risk relates to the risk of economic loss caused by a process breakdown, for example, computer failure, human error, or fraud. Financial instability can be triggered by a variety of causes and shocks. These causes generally arise from combinations of structural and behavioural factors. Structural market failures are attributable to factors such as information asymmetries, externalities, and moral hazard. Behavioural market failures refer to issues such as herd behaviour in investment decisions, and investment fads and fashions, or myopia in decision making around various components of the financial system. There is substantial overlap between these structural/behavioural categories; for example a structural problem such as information asymmetry will likely contribute to herd behaviour, by causing agents to rely more on observations of each other's trades for information regarding the appropriate market price. Structural failures An important determinant of structural failures in the financial system is information asymmetry. Sellers (or borrowers) typically know more about the risks embodied in the exchange than do buyers (lenders). Faced with such an asymmetry, buyers will be cautious, and will tend to over-estimate (price) risk. If risk is over-priced, this may drive out the less-risky activities, causing buyers (lenders) to become more cautious still. Such a process can result in less exchange than would otherwise be the case if the two sides to the exchange were more equally informed. Hence, an important purpose of financial regulation is to address this information gap. The regulation may include insisting on a greater level of disclosure, or imposing certain standards on sellers (borrowers). Financial regulation, like many other forms of regulation, thus generally entails a combination of disclosure requirements and standard setting. The existence of externalities and ‘free-rider’ opportunities in some instances also means that risks may not be borne by the owner of the asset, and hence not priced or managed adequately. A result can be that under-investment in some risk management tasks may occur, such as, for example, ensuring the ongoing operational capacity of critical payment systems in a systemically important financial institution. Structural factors can mean that identifying, pricing, allocating, and managing financial risks can be very difficult at times, if not impossible, thus necessitating various forms of prudential regulation, financial crisis management capabilities, and/or the public provision of certain financial services. For example, it is difficult to be able to identify all threats to financial stability ex ante. Hence, some forms of risk are best managed by ensuring adequate capital buffers are in place to absorb losses without disruption to the system. The Basel II process of allocating capital buffers to various forms of financial risks in banks is an example of such an intervention. Some forms of risk are also not adequately priced due to the lack of a market for the price discovery process to occur. Likewise, both free-rider and externality aspects of certain payment system networks may mean that risks are not allocated accordingly and may be mismanaged. This may necessitate the public provision of certain services (e.g. utility networks) or prepositioned loss allocation mechanisms in the case of a bank failure. Behavioural stresses The financial system can also be exposed to destabilising behaviours. These influences can be exacerbated by some of the structural weaknesses discussed already, especially for example, the phenomenon of contagious bank runs. Recent developments in the field of behavioural finance have extended our understanding of the potential sources of financial instability. Concepts such as myopic decision-making, cognitive dissonance (repression of contradictory evidence), and fallacy of composition, some of which come from psychology, are receiving wider recognition in relation to the study of financial stability. It is becoming increasingly recognised that individually "rational" people all making the same choices can lead to herd behaviour and momentum that can drive a market price far away from that consistent with underlying returns and risks. For example, Kindleberger (1996) 3 describes how `euphoria' can turn into mania, as speculation "leads from normal rational behaviour to what has been described as `mania' or a `bubble'." History gives us many examples of ‘mania', bank runs, asset bubbles and other financial crises, from as early as the Dutch tulip bulb bubble in 1636 to the present day. Aliber (2005) describes the effect of financial deregulation in enabling Japanese banks to rapidly increase their real estate loans - resulting in both property price increases, and real estate company increases, boosting the Tokyo stock exchange. At the same time, Aliber notes that when Nordic controls on foreign borrowing were lifted, there was an inflow of foreign (notably Japanese) funds which led to real estate and stock price bubbles in Finland, Sweden and Norway. The Mexican crisis of the 1990's had its roots in overoptimism regarding the success of macroeconomic reform. Excessive lending driven by high expectations of growth helped to create both the Asian crisis and the US stock market bubble in the latter years of the 1990s and early this decade. New Zealand had a similar experience in the second half of the 1980s, when economic reform and financial liberalisation resulted in a surge in credit expansion and correspondingly leveraged bubbles in commercial real estate and listed equity prices. When it became apparent that the market's assessment of risk had become substantially misaligned from the returns, a reassessment triggered by the sharemarket correction in the US in October 1987, caused the bubble to burst and widespread defaults occurred. This correction of previous misalignments caused material damage to the financial system, including the failure and hence closure of a number of financial institutions and a significant fall in equity market participation for several years following. A common element in most of these mentioned financial crises has been the rapid expansion in the supply of bank credit which, at least with the benefit of hindsight, was priced too cheaply (i.e., the risks were under-priced). Borio (2005) 4 emphasises credit supply by highlighting the role of `financial imbalances' in causing crises. That is, where lenders over-extend themselves by financing highly leveraged assets that turn out to be incapable of generating the cash flows required to service the debt. However, credit growth measures and asset market valuations alone are not necessarily good financial stability indicators. Rather, it is assessing "why" the indicators have moved that matters most, and hence the need for a framework to assess these developments. Kindleberger (1996) "Manias, Panics and Crashes: A history of financial crises" John Wiley and Sons, Inc. Third Edition. Borio (2005) "Monetary and financial stability: so close and yet so far?" National Institute Economic Review No 192 (April). Financial system assessment and regulatory balance Making assessments of financial stability risks, such as the sustainability of credit expansions and large asset price movements, is difficult. The extent to which central banks should attempt such assessments is also an area of considerable debate. Much of the debate concerns rather polar positions, that is, whether or not central banks should ‘target’ asset prices. The financial stability assessment framework outlined in this speech does not approach this question as an "either-or" issue, but instead aims to assist an assessment-based approach by providing a framework of questions. Furthermore, crafting the regulatory infrastructure to support the process of economic exchange is far from straightforward. For example, regulation that excessively constrains sellers, whether directly or through imposition of compliance costs, can cause them to withdraw from the market and lead to economic inefficiencies. Significant ‘moral hazard’ problems can also arise, where over-regulation can remove the actual financial risk from the owner of the asset, institution, market, or payment system. The public provision of certain financial services may also crowd out competition and innovation. It is also very important to recognise that markets can and do generate their own solutions to what otherwise would be information asymmetry market failures. Financial intermediaries themselves are a market response to this underlying economic problem. The role of a bank is to monitor and manage the risks embedded in risky loans that depositors would be unable to monitor themselves. Banks in effect facilitate the economic exchange between depositors and borrowers by playing a role that balances up the information asymmetry. However, there is always the question: who monitors the monitors? In the financial system, a number of mechanisms perform this role: shareholders, and those appointed by them (boards of directors and auditors), creditors, rating agencies, and regulators. Experience suggests that market-based solutions - sometimes with regulatory prompting and encouragement - can often result in a better performing financial system than over-relying on regulatory interventions. The Reserve Bank thus balances self and market discipline practices and requirements, with additional regulatory requirements. We are acutely aware of the importance of getting this balance right, and the risks of over-regulation. The general principles we aspire to in all that we do with our prudential regulation role thus include: • Keeping efficiency issues at the centre of our attention; • Utilising the synergies amongst our monetary policy, macro prudential, supervision and market operation roles; • Maintaining a system overview as well as knowing individual institutions well; • Seeking to utilise market forces as far as possible rather than oppose them; • Recognising that we have many common interests with supervised institutions; • Using incentive-based techniques as much as possible; and • Making sure that we maintain high analytical standards in our regulatory design. In summary, we approach financial system regulation from the stand point of its role in enabling economic activity - by supporting the processes by which people and firms can engage in welfare improving specialisation and trade. To regulate to enable might seem something of a contradiction. However, for any system to work there needs to be some rules, referees, and general confidence. Users of the system need to have a basis for being confident about their financial contracts, institutions, markets, and payments networks. Absent a basis for confidence, the scope for welfare enhancing economic and financial exchange is diminished. The Reserve Bank's activities in promoting financial stability The Reserve Bank promotes the stability of New Zealand's monetary and financial system comprising the monetary unit of account, and the markets, institutions, and systems that make monetary exchange possible - through various activities. These activities include: maintaining low and stable inflation (i.e., maintaining the purchasing power of our money liabilities); acting as banker to the banks (and the government); prudentially supervising registered banks and being prepared to manage a bank failure; overseeing the payments and settlement system; and maintaining a reserve of foreign currency for financial crisis management. The Bank's activities in promoting financial stability generally fall into the prevention, correction, and crisis management categories. These are outlined in Tables 1 and 2 below. Table 1. Framework overview Financial System Risks Identify Allocate Price and/or Powers & Actions Manage Purposes Financial stability exists when risks are adequately identified, allocated, priced and managed Identify Ensure risks are Form view of RB Act Prevention market allocated to those how well risk is Credit Correction failure / who are willing, priced; and/or RB capital Operational source of aware, and best how well risks and balance Crisis financial able to manage are being sheet Market Management risk. them. managed. Markets Liquidity Institutions Payment systems Table 2. Reserve Bank activities and the Reserve Bank Act Relevant sections and parts of the Reserve Bank of New Zealand Act (1989) are in brackets (see also sections 5, 7 and 39). Information and monitoring: Financial Stability Report; Monetary Policy Statement (s 15); Provide advice to the Minister of Finance (s 23, s 33); information and disclosure relating to payment systems (Part 5B) Banks: Prudential regulation (bank registration, capital requirements, connected lending limits, disclosure, outsourcing policy) (Part 5) Prevention Liquidity: Provide liquidity to the banking sector through the payment system, open market operations, Bond Lending Facility, issue of currency (s 8, s 25, s 39) Payment and settlement systems: provision of critical infrastructure eg NZ operator of ESAS/Austraclear (s 32, s 39); support for the CLS' adoption of NZD, designated payment systems (Part 5C). Holding portfolio of foreign reserves for intervention purposes (s 24) Intervening in the foreign exchange market for monetary policy purposes (s 16, s 17, s 18) Correction Primary function is maintaining price stability (s 8) Impose prudential requirements upon banks (Part 5); ability to alter conditions of registration on banks (s 74); powers to give bank directions (s 113) Acting as lender of last resort (s 31) Crisis Management Statutory management (s 117) powers to give bank directions (s 113) Foreign exchange intervention (s 16, s 17, s 18) Prevention Most of the Reserve Bank's activities are aimed at preventing financial crises and thus promoting financial stability. For example, in the prudential supervision of banks an important element is the registration process. This process is directed to ensuring that banks are established with appropriate governance arrangements and capability, as well as having adequate capital for the business to be undertaken soundly and so that plausible losses are able to be absorbed without disruption. The disclosures that registered banks in New Zealand make also have an important preventative role, by bringing to bear the scrutiny of the market place on how banks are identifying, allocating, pricing and managing their financial risks. The Reserve Bank also plays a direct role in the surveillance of the financial system, through its direct supervisory and banking relationships, participation in the financial markets (particularly in foreign exchange and government securities), and wider financial system and macroeconomic surveillance and analysis. Much of this work is reported on in the Bank's Financial Stability Report and Monetary Policy Statement. The Bank thus contributes generally to the provision of information and analysis to the market place. At the macroeconomic level, imbalances such as inflation pressures and large surpluses or deficits on the current account of the balance of payments, can make the financial system more susceptible to shocks that test the resilience of the financial system. To assess how risky these imbalances are requires a good understanding of the causes of the imbalance, and of the underlying financial drivers. Again, understanding the "why" matters more than knowing the "what". This assessment combines judgement, research, forecasting and economic models. However, no system of policies and procedures can ensure that the conditions for financial stability are met all of the time. From time to time there will be developments where the Bank will become less confident that risks are being adequately identified, priced, allocated, or managed, and where interventions to lessen the potential for emerging financial instability will be called for. Correction and crisis management The Reserve Bank's interventions aimed at correcting potential preconditions for financial instability may take a number of different forms, depending on the analysis (including taking account of any unintended consequences of our intervention). Such Bank interventions may range from Governors' speeches that draw attention to the issue, through to the Bank exercising powers (with the consent of the Minister of Finance) by which it can give directions to a registered bank or banks. The Bank may also use its own capital or balance sheet to intervene in financial markets, such as for example, intervening in the foreign exchange market or providing the markets access to the Bank's bond portfolio in order to bolster liquidity. There is also overlap between the Bank's monetary policy and financial stability roles. For example, asset price bubbles have the potential to overwhelm monetary policy responses and threaten financial stability. The Reserve Bank Governor recently acknowledged that in rare situations an (asset class) price misalignment may be sufficiently obvious that a monetary policy response in excess of that required for the usual price stability objective could be required; in these cases in particular, a longer term view of the risks to price stability would be appropriate. 5 The Bank also has a crisis management role. Some categories of extreme and very low probability risk are also inherently difficult for the financial system to price and manage - the so-called "uninsurable" risks. Most insurance policies, for example, excluded compensation for loss arising from the Y2K problem (a once in a millennium event!). Another example of the Reserve Bank's contingency planning for a low probability, but potentially very damaging event, is its preparation for a potential influenza pandemic. 6 While `lender of last resort', foreign exchange intervention, and bank statutory management are the crisis management activities that are usually associated with a central bank, a recent additional example is the Reserve Bank's outsourcing policy. 7 A primary motivation for that policy is to better ensure that should a (large) bank become insolvent, or should an important provider of outsourced services no longer be able to deliver, that bank could continue to be operated. Again, while such an event may be in the low probability category, it would have significant consequences for the financial system as a whole. In order to implement any policy action, the Bank must be satisfied that the action is necessary and beneficial. Figure 2 steps through, in a stylised manner, the typical stages and questions involved in the policy decision process. Bollard, A (2004) "Asset prices and monetary policy" An address to Canterbury Employers Chamber of Commerce, Christchurch, 30 January 2004 http://www.rbnz.govt.nz/speeches/0145812.html See http://www.rbnz.govt.nz/crisismgmt for details on the contingency planning that is being undertaken for this risk. See http://www.rbnz.govt.nz/finstab/banking/outsourcing/index.html. Figure 2. Stylised overview of the Bank's policy decision process 8 Yes No Yes No This flow chart is intended as a broad overview - it is not a precise statement of how policy decisions will necessarily be made. No Implement policy action Recent policy developments Over the past few years we have “re-invigorated” the Bank's own financial stability role. This has been reflected in a number of ways. In November 2004, we commenced publishing a twice-yearly Financial Stability Report, as a complement to our quarterly Monetary Policy Statements. We have also introduced a local incorporation and an out-sourcing policy for registered banks. The former requires large banks to be incorporated in New Zealand, rather than operate as a branch of a foreign bank (as has been the case with Westpac). The latter requires banks to manage out-sourcing of core banking functions in a way that does not compromise their ability to maintain a core operational capability should a service provider become unable or unwilling to provide those functions. The local incorporation and outsourcing policies have been introduced mainly to improve the resilience of the New Zealand banking system in a bank failure situation. That is a situation that we all hope falls into the "rare event" category, though we know from experience that bank failures can and do happen. And we know that there is a tendency for rare events to slip into the background, and in the case of those that could be very damaging, perhaps more than they should. One of the jobs of the Reserve Bank is to act as a counter to such tendencies. In parallel with progressing these issues, which affect mainly the large Australian-owned banks, steps have been taken to strengthen the harmonisation and co-ordination of trans-Tasman banking supervision. Last year, the Trans-Tasman Council on Banking Supervision was established, with a terms of reference which cover supervisory co-operation, preparedness for responding to crises that involve banks that are common to both countries, and whether legislative changes may be required to ensure APRA and the RBNZ support each other in their regulatory responsibilities, at least regulatory cost. The Council recommended some legislative changes, for enactment in both Australia and New Zealand. Dr Cullen and the Australian Treasurer announced following their annual meeting that both Governments will be promoting those legislative amendments. Currently we are also involved in the Government contingency planning for a possible influenza pandemic. Besides making contingency plans to maintain our own operations, we have been working with the banks to ensure that business continuity planning is in place, and that key payments systems and cash distribution arrangements could be adequately maintained in the unlikely event that an influenza pandemic would impact on staff availability. We have been consulting with banks on how they envisage handling disruptions in household and business ability to service debt during a pandemic period, and to ensure that they are adequately positioned to cope with potential disruptions to the wholesale international funding markets our banks rely on. We are also liaising with other infrastructure providers, in particular, telecommunications services. Banks will need to isolate staff, and would expect an upsurge in the use of internet services; and the ability to operate ‘remotely’ will be a key requirement for our own preparedness. Steps are also being taken to ensure continuation of core services such as the operation of monetary policy, and the provision of currency and liquidity. Even if no pandemic hits us in the next few years, such planning will stand us in good stead for the future. The payments system is a component of financial system infrastructure that has been reconfigured substantially during the past decade or so to strengthen its financial resilience. Without going into technical details, we are now in a position where the great bulk of "high value" payments - mostly those connected with wholesale financial market and inter-bank foreign exchange dealing, and which amount to more than $35 billion on an average day - are fully certain (in Reserve Bank funds) for the recipient at the point they are made. This has been achieved by the introduction of "real-time gross settlement" arrangements. In the case of most foreign exchange transactions, these arrangements have been taken a step further, with the payments across the accounts of the two separate central banks whose currencies are involved also now being synchronized. This has removed the time difference between, for example paying NZD's in New Zealand and receiving USD in New York, and the risk of loss arising from a default occurring during that time gap. And we are not overlooking the retail payments system. Work is in progress with the New Zealand banking industry on two major issues. First, to improve the legal and financial clarity and resilience of the arrangements for processing the several million retail payments made every day in New Zealand. Second, to review the access and governance arrangements in the retail payment system to ensure the system remains durable in the face of changes in the technical and commercial landscape. A key part of our regulatory strategy for promoting the resilience of the financial system is our capital adequacy framework for banks. Banks need to hold sufficient capital in order to be able financially to withstand major loss and be positioned for future growth, so that the financial system can continue to circulate liquidity and provide funding for economic activity in New Zealand in the face of stress. It is important to be clear here that we are not talking about banks dealing with the "expected" losses that occur as a normal part of banking business - that is the role of provisioning. Rather, the focus of capital adequacy is on unexpected loss, or the rare but potentially debilitating losses associated with, for example, severe downturns in the economy's performance or gyrations in the prices of key collateral assets such as housing. Under such abnormal circumstances, the diversification strategies rightfully adopted by banks to manage risk in normal times may fail, as borrowers' risks more closely correlate, leaving capital as the only remaining defence. A major priority for our policy work this year is to implement the updated international benchmark for bank capital adequacy, known as Basel II, with these objectives in mind. Two of the driving principles behind Basel II are to improve regulatory capital requirements to make them more sensitive to the risks of unexpected loss, and to sharpen the focus of engagements between supervisors and banks on ensuring that banks have adequately accounted for the risks of unexpected loss in their capital management. Finally, we are currently engaged in important work in progress on the regulation of the non-bank financial sector - covering finance companies, building societies, credit unions, insurance companies and managed funds. This work has progressed to the point that the Government has decided that non-bank deposit takers, insurers and superannuation funds should be subject to a higher level of prudential supervision than currently and that, in principle, the Reserve Bank should be that supervisor. The next step will be a discussion paper that puts some more details on these proposals, presently envisaged for release in mid-2006. These developments signify the important role seen for these categories of financial institution in New Zealand's financial infrastructure. Conclusion This speech presents a step towards a broad conceptual framework for promoting financial system stability and guiding the Bank's policy actions. We argue that the preconditions for financial stability exist when all financial system risks are being adequately identified, allocated, priced and managed. The financial system is made up of markets, institutions, and payments and settlement systems. Financial system risks broadly include credit, liquidity, market and operational risks. All of the preconditions are important to best ensuring that the financial system is resilient to a wide range of economic and financial shocks, and able to absorb financial crisis losses with least disruption. The preconditions for financial stability also best ensure that the financial system is efficient in its delivery of financial services, as well as allocating resources efficiently. In making assessments of financial stability, the Reserve Bank does not have a single, well-defined quantitative measure. Instead we draw on a variety of information, practices, and on-going research. The Bank conducts regular surveillance of financial risks and reports on its assessments in the twiceyearly Financial Stability Report.
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Speech by Mr Adrian Orr, Deputy Governor of the Reserve Bank of New Zealand, to the Retail Financial Services Forum, Auckland, 10 April 2006.
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Adrian Orr: Bank capital, risk management and the economy Speech by Mr Adrian Orr, Deputy Governor of the Reserve Bank of New Zealand, to the Retail Financial Services Forum, Auckland, 10 April 2006. * * * Thank you for the opportunity to speak to you today. The bulk of my comments will be focused on one of the major banking regulation initiatives the Reserve Bank is currently undertaking - the implementation of the new Basel II capital adequacy framework for banks. But first, I'll explain some of the context to this initiative, to try to give a sense of why this work is a priority for us. As I'm sure this audience will know, the Reserve Bank has important duties and functions regarding financial stability in New Zealand. These include the issue of notes and coins, the prudential supervision of banks, the operation and oversight of payments systems, the provision of liquidity to the financial system, and the role of lender of last resort to the financial system. As well as being critical for the effective conduct of monetary policy - the Reserve Bank's primary function, and the one for which we are perhaps most often in the headlines - financial stability is also crucial for the transactions supporting economic activity to be efficiently facilitated, for savings to be channeled efficiently to the most productive investment destinations, and for risk to be transformed and borne by the parties best able to manage it. When all of these things happen, the financial system makes its maximum contribution to sustainable growth in the economy and to the welfare of New Zealanders. Financial stability exists when the financial system is resilient to a wide range of economic and financial shocks, and able to absorb financial crisis losses with least disruption. There are obviously a number of dimensions to this proposition, that I and other Reserve Bank staffers have talked about at length in recent speeches and articles. I don't intend to rehearse that material here, but commend it to you if you are interested. It's all on our website. Suffice it to say for now that the Reserve Bank focuses its energies in the financial stability space on risk. For most of us, risk is a bad thing. However, financial activity is as much about risk as return, and as everyone knows there is no such thing as a free lunch. Our job in a nutshell is to do the best we can, using the best balance of the means at our disposal, to ensure that lunch generally does not cost too much. If we are successful, then by implication risk will have been identified by all parties it affects, priced by those able freely to choose to bear it, allocated to those who are best placed to bear it, and managed by those parties in the most efficient manner. These are the preconditions for financial stability to which we at the Reserve Bank generally refer when assessing the performance of the financial system and our own performance in promoting financial stability. I know this is all, to this point, somewhat abstract. The financial system is, after all, more recognisable as a collection of financial institutions, financial markets, and payment and settlement systems. Financial institutions include banks, insurance companies, fund managers and so on. Financial markets are arrangements whereby shares, bonds and other types of securities are issued and traded. Payment and settlement systems - also called "plumbing", a term that is evocative if nothing else enable the transfer of funds and claims from one person to another. In New Zealand, the first element of the three, financial institutions, is the most familiar to the most people. Among the OECD countries, New Zealand is currently one of the more heavily "banked" countries, meaning that a relatively large proportion of financial activity involves banks, as opposed to, say, direct investment and trading in shares or debt securities. For the bulk of the population, banks provide a place to park savings, the primary means of making day-to-day payments, and the main source of loans for such things as home-buying and business investment. As a crude measure of the importance of banks, about three quarters of all financial assets held in New Zealand are held in banks. The comparable number for Australia, for example, is about half. Moreover, New Zealand has a heavy reliance on foreign funding, and banks are the primary conduit by which domestic borrowing needs are met by foreign lenders. Over half of New Zealand's foreign borrowings come in via banks' balance sheets, and the vast majority (98 percent) of bank lending is done by banks that are owned by, or part of, foreign banks. 85 percent of all bank lending is done by banks owned by Australian parent banks. The strong presence of banks that are parts of (much) larger international banking groups brings both benefits and risks to New Zealand. On the benefit side, it has enhanced risk-management capacity within the banking system, facilitated the entry of new banking products and services, and provided a source of financial strength to weather domestic economic shocks. Against these benefits are increased exposure to adverse events or mismanagement in the parent banking systems, which is accentuated by the high industry concentration and the dominant position of banks from a single foreign country. In light of these facts, it should probably be undoubted that the soundness and efficiency of banks matters a lot for financial stability. Banks play a central role in identifying, pricing, and managing risk, and are in the business of allocating risk among their various customers. Indeed, the strength and resilience of New Zealand's banks are crucial to the ability of the New Zealand economy to endure the range of adverse macroeconomic situations in which we now and then find ourselves due to our particular economic circumstances. These circumstances include being a small, open economy with strong dependence on the vagaries of international commodity markets, and one with a high level of foreign funding of New Zealand economic activity. We have spoken recently about growing household indebtedness and the vulnerabilities that creates in economic performance. Going along with these vulnerabilities are an increase in the risk of foreign lenders becoming unwilling to continue to provide funding, and a concern about how that unwillingness might play out in the New Zealand financial markets and in the exposures of banks in New Zealand. These factors are amplified in our consciousness when we reflect on the small size and fairly narrow diversification of bank assets in New Zealand, compared to most other developed countries. I should emphasise at this point that there is no doubt that the New Zealand banking system is currently in robust health. Bank balance sheets continue to grow and that growth has not, to date, seen any rise in asset impairment. Loan default rates remain very low and bank profitability strong. We would obviously be remiss, however, and probably in the wrong jobs, if we were simply to rest on our laurels and hope that the risks do not eventuate or that trouble does not happen. The Reserve Bank of New Zealand Act requires us to use our banking regulation and supervision powers to promote the soundness and efficiency of the New Zealand financial system, and to avoid significant damage to the financial system that could be caused by the failure of a registered bank. For some time now the Reserve Bank has pursued these objectives using a mix of policies that promote effective governance by banks' boards of directors, that strengthen market scrutiny of banks, and that set certain minimum standards of risk management by banks. We continue to believe that effective governance and market scrutiny will go a long way towards delivering our financial stability objectives. However, these approaches generally work best under normal economic circumstances, and in some cases weaken considerably under conditions of severe economic stress or shock. One purpose of minimum risk management standards is to fill that gap in anticipation of stress, and reduce the adverse consequences of those circumstances - including the possibility of bank failure and its wider and potentially severe costs in financial system stability and economic performance. The cornerstone of effective risk management by banks is capital. Consequently, capital adequacy is at the core of prudential regulation, not just for the Reserve Bank but banking supervisors worldwide. We, along with our peer supervisors, are currently engaged in the implementation in New Zealand of the new international framework for bank capital adequacy, otherwise known as Basel II. 1 Individual banks need to hold adequate levels of capital so that they can absorb unexpected losses, so that their shareholders have a sufficient stake in the business to care about its ongoing viability, and so that they have a sound platform for medium-term growth and innovation. From the point of view of the banking and financial system as a whole, adequate capital is essential for the system to be able to withstand the stresses that arise from the ups and downs of the economy, including extreme stresses - such as the failure of one or more financial institutions - that may be associated with large and widespread unexpected losses. Basel II brings together improvements in the regulation of bank capital distilled from many years of experience under Basel I, the first international Accord on capital adequacy agreed by the G10 The Basel II framework has been promoted internationally by the Basel Committee on Banking Supervision (BCBS), a committee of senior banking supervisors from the G10 countries. See "Basel II: A New Capital Framework", Reserve Bank of New Zealand Bulletin, September 2005, Vol 68 No 3, for an introduction to Basel II and the Reserve Bank's approach to implementing it. countries in 1988. Basel II also takes account of advances in the measurement of risk, and a widespread and lengthy development and public consultation process since 1998. Basel I set in place two basic principles about capital regulation that continue to be relevant today: that banks should hold capital of a certain quality and above certain levels at all times, and that those levels should take account of the risks banks face. The major innovations in Basel II are that a bank's minimum capital requirements should be better aligned to the risks that the bank is taking, and that supervisors should allow banks optionally to use their own internal statistical models and processes to calculate their minimum capital requirements - provided that the internal models and processes meet certain minimum quality requirements. Basel II explicitly does not seek to change settings for the minimum level of capital in the banking system overall - only to make the minimum level for an individual bank more sensitive to the risk of unexpected loss faced by that bank. At this stage, I know of no supervisor who thinks there should be large reductions in bank capital in their jurisdiction upon the introduction of Basel II. Indeed, concerns that Basel II might lead to stability-threatening reductions in bank capital have led supervisors worldwide to scrutinise very carefully the quantitative calibration of the Basel II, and to put in place arrangements for a cautious transition from Basel I to Basel II. In New Zealand, the question of whether our requirements for the overall minimum level and quality of bank capital should be higher or lower is an ongoing workstream for us, quite aside from Basel II and considerations of risk sensitivity. Regulatory capital requirements for banks incorporated in New Zealand will be calculated under Basel II from January 2008. In New Zealand, banks will not be required to use internal models approaches, and those that do not will use "standardised" approaches, which link minimum capital requirements to external measures of risk. Banks applying to be "accredited" to use internal models to calculate minimum capital requirements will need to submit their applications to the Reserve Bank by July this year. Information requirements for accreditation submissions have been disseminated. Among other things, the requirements ask banks to support their applications with reference to loss data relevant to New Zealand risk circumstances wherever possible, to support any case made that the internal models are appropriate for use in New Zealand. A key focus for the Reserve Bank in assessing accreditation applications will be on how a bank's proposed internal models approach addresses the bank's credit risk exposure to losses on housing loans. This focus reflects that housing loans make up the largest part of banks' exposures in New Zealand. New Zealand banks are, through the extension of housing loans, potentially vulnerable to fluctuations in household income, interest rates, and the level of household debt. With the economy's strong performance over recent years, there has not been stress due to these factors on the ability of households to service their mortgages, hence the experience of default on housing loans has been minimal. However, as noted earlier, the focus of capital adequacy is not on favourable or benign economic conditions, or on the "expected" losses that occur as a normal part of banking business those matters should be addressed through provisioning. Rather, the focus is on unexpected loss associated with severe downturns in the economy's performance. "Stress testing" for such scenarios is required under Basel II, and the scenarios need to account fully for the behaviour of systematic risk. For example, stress scenarios should address the risk of a downturn leading borrowers' risks to correlate more closely, undermining the diversification strategies rightfully adopted by banks to manage risk in normal times. Experience shows that downturns in the housing market do happen and can cause significant losses to banks and to the financial system as a whole when they do. The Reserve Bank will be working to ensure that any internal models used by an accredited bank produce capital estimates that are based on "through the cycle" loss experience - that is, after adjustment for the peaks and troughs in observed losses that occur over the business cycle in New Zealand. Notwithstanding this emphasis on through-the-cycle loss experience for the purposes of internal modelling, it will also be important to ensure that capital management processes in practice deliver fairly stable capital outcomes through the business cycle. For example, a failure to adjust fully for the business cycle when incorporating loss experience into modelling processes could lead to capital falling during upturns in the cycle and rising during downturns, which would exacerbate the cycle through promoting lending growth during upturns and lending contraction during downturns. Capital settings should be for the long haul, and need to be robust over many business cycles and through a range of economic circumstances. An important outcome we will be seeking from our Basel II implementation is that the capital management processes within banks (both those using internal models and those using standardised approaches) ensure that adequate "buffer" capital is always held in anticipation of any need to manage any residual "procyclicality" in the outputs of internal modelling processes. As well as making minimum capital requirements more risk-sensitive, Basel II also includes the principle of sharpening the focus of engagement between supervisors and banks on ensuring that a bank's capital management process adequately accounts for the risk of unexpected loss. The quality of this process and the manner in which the outputs from internal models are used within the bank's governance and risk management more generally will be a key part of the assessment for a bank wishing to be accredited to use the internal models approaches. The bank will need to satisfy the Reserve Bank both that its internal models and processes are of adequate quality, and that the use of internal models is incorporated into the bank's risk management framework with appropriate knowledge and oversight, to be accredited. Our programme of engagement with banks on Basel II is well underway, focusing in particular on the banks intending to apply to use the internal models approaches, because of all the reasons set out earlier. Such banks are themselves devoting a large amount of resources to their applications, and to planning for the use of the internal models approaches, should they be accredited to do so. These large resources devoted to Basel II implementation, as well as the significance of the banks applying to use the internal models approaches, both reflect and underscore the need to get it right. This should not be taken to mean that we are leaving aside those banks that expect to be on the standardised approaches. As well as working on the internal models approaches, we are also well underway with proposals for the implementation of the standardised approaches and will be enter into discussions with the industry on these also over this year and next. In this part of the work, a key outcome we will seek is the preservation of competitive neutrality between banks using internal models and those using standardised approaches. Because most banks in New Zealand are parts of international banking groups, we will be communicating and coordinating the New Zealand implementation closely with relevant foreign supervisors. Also, it is only natural that banks owned by foreign parent banks should seek to base any internal models for New Zealand capital on models developed within their parent banks. However, where this is the approach taken, the New Zealand banks will still need to satisfy the Reserve Bank that those models are appropriate for New Zealand circumstances. In our coordination with foreign supervisors, engagement with the Australian Prudential Regulation Authority (APRA) will clearly be particularly important, because of the significant place in New Zealand's banking system of banks (including the four major banks) owned by Australian parent banks. Already, we and APRA have put in place Terms of Engagement to ensure that communication flows well between us. For banks with operations in both New Zealand and Australia, under the Terms of Engagement we will work with APRA to ensure that in meeting our responsibilities to set capital requirements for the New Zealand subsidiaries, we will keep compliance costs to the minimum necessary, consistent with New Zealand capital requirements being tuned to New Zealand conditions. We will do this by making use of APRA's and the Reserve Bank's comparative advantages and knowledge bases, by seeking to optimise the use of overall supervisory resources, and by sharing any assessments and other information needed. What is the Reserve Bank trying to achieve with Basel II overall? Observance of the principles I noted earlier on, of greater risk-sensitivity in capital requirements and of the need for levels of bank capital to be held stably and sustainably at sufficient levels to account for unexpected loss, should I hope not be remarkable. What is more the focus of our implementation work at the next level down, particularly for the banks seeking to use the internal models approaches, is to ensure that the more intensive supervisory attention is paid to the accuracy with which those banks' internal models capture and appropriately account for the particular characteristics of the New Zealand economy and financial system. I do not want to leave you with the impression that Basel II is all we are doing on the front of improving financial regulation. To come back to the themes I introduced at the outset, although our Basel II implementation effort is a major one, we are in addition pursuing a range of other initiatives and completing work on earlier projects directed towards enhancing the soundness and efficiency of the New Zealand financial system. These projects include the implementation of the outsourcing and local incorporation policies for large banks, both of which were finalised recently. Also, the Reserve Bank is working with other agencies to advance the legislative changes proposed by the Trans-Tasman Council on Banking Supervision, which New Zealand Minister of Finance Michael Cullen and Australian Treasurer Peter Costello recently agreed to promote. We are actively working with other New Zealand regulatory agencies to develop reforms to the regulation and supervision of the nonbank financial sector, and with the industry to improve the resilience of the payment and settlement system. And we are working with the banking industry and others to establish an appropriate state of readiness in New Zealand for a pandemic. I hope this brief rundown of one important aspect of the Reserve Bank's regulatory activity as it affects banks gives you a flavour of the approach we are taking, and why. The Reserve Bank will work to ensure that the implementation of Basel II in New Zealand, among our other regulatory activities, fits well with and supports the Reserve Bank's primary function of maintaining price stability through monetary policy - and the benefits in economic stability that that provides. Financial stability and economic stability are strongly connected - and this is why we believe that our roles as prudential regulator and as central bank in New Zealand are strongly complementary.
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Excerpt from an address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Financial Services Institute of Australasia, Wellington, 23 May 2006.
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Alan Bollard: A financial system that works for New Zealand Excerpt from an address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Financial Services Institute of Australasia, Wellington, 23 May 2006. * * * "In our latest Financial Stability Report (FSR), issued on 19 May, we assess that, over recent months, the New Zealand and global financial systems have continued to perform soundly. However, signs of increased volatility have emerged in some markets (eg, commodities and foreign exchange) and some major challenges to financial stability persist. "The Reserve Bank's interest in financial stability and banking regulation is to ensure there is adequate identification, pricing, and allocation of risks to the New Zealand financial system. "Many of the current challenges to New Zealand financial system stability were identified in our November Report, and some have increased. For example, New Zealand banks have continued to raise their exposure to the housing market. A very large proportion of foreign capital being utilised in New Zealand is now intermediated through the banking sector via secured residential mortgage lending. A slower housing market will thus pose challenges to bank risk management and we will continue to monitor this closely, especially when implementing the new bank Basel II capital requirements regime. "In addition, some (but not all) finance companies raising funds from the public have accumulated large exposures to property and consumer finance. These institutions could be hardest hit by slowing spending; especially those that have recently experienced rapid growth and have limited experience in managing downturns. "New Zealand households have also been increasingly ready to purchase property for investment purposes. Household indebtedness has increased significantly, so that over time households have raised their financial vulnerability to interest rate changes, unemployment, and swings in rental incomes and property capital values. On balance, the data suggest that the New Zealand household sector has continued to increase its financial concentration and overall debt exposure. "A slower growing economy will bring challenges to some households, in particular lower and middle income households that have large debt-servicing needs. "Meanwhile, New Zealand's financial markets have remained sound. The decline in the New Zealand dollar over the March quarter, from its previous exceptionally high level, represents some reduction in risks. The depreciation was managed in the foreign exchange market with good liquidity and efficient pricing, and was principally a cyclical adjustment to better reflect the underlying fundamentals of the economy. "We have also been working with banks to ensure adequate access to liquidity for settlement purposes. Work on access and governance issues with regard to the payment system also continues, and we will continue to pursue more rapid progress in this area. "Ownership of banks in New Zealand is dominated by overseas investors. Foreign ownership has brought many benefits, including scale and scope, to our banking system. However, it also has resulted in a banking system with concentrated ownership that is tightly tied to Australian financial stability. The Reserve Bank, therefore, attaches a high degree of importance to monitoring developments in Australia and to our relationship with the Australian regulator, APRA, and our work within the Trans-Tasman Banking Council set up last year. "The two Governments have agreed to legislation to require the Reserve Bank and APRA to consider the effects of their own regulatory actions on financial system stability in the other country. A statutory manager or administrator would have to inform the local regulator if they felt that actions might be detrimental to financial system stability in the other country. Work is underway on these proposed trans-Tasman legal amendments. These changes should help Australian banks meet New Zealand outsourcing requirements. "There is more work to do. Next, the Council proposes to focus on crisis management preparation. This will build on existing arrangements to enhance the ability to respond to a trans-Tasman banking distress situation. "A foreign-owned bank will inevitably be focused on long-term returns to its (mainly foreign) shareholders. But New Zealand's liberal attitude to bank ownership should not be misconstrued as giving away our interest in the New Zealand financial system. Our focus is on regulation to ensure financial stability for New Zealanders."
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to Federated Farmers, Nelson, 18 July 2006.
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Alan Bollard: Agriculture, monetary policy and the economy Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to Federated Farmers, Nelson, 18 July 2006. * * * The experience of the last decade has been that agricultural prices and agricultural production remain as important as ever to the New Zealand economy. Ten years ago we expected to see an economy evolving with a gradually diminishing relative role for primary production, fewer tonnes of produce, more specialised value added, less growth in labour and more value added. Some of this has happened. But we have also seen growth in volume of exports and more labour participation. And we still see a direct relation between the health of primary production and the health of the New Zealand economy. We have been through huge technological changes signalled by the birth of the internet. But at the same time the renewed vigour of globalisation has brought some old-fashioned features - a big increase in emerging market economies' appetite for resources on the one hand; and fewer obstacles to getting their manufactured goods to first world markets, on the other. At a time when the future of the Doha Round looks so fragile, it is ironic to see the gains we are getting from past improvements in global connectedness. Related to this has been a strong supply of cheap capital into the world's financial markets. The New Zealand economy has been through a long period of expansion since 1999, probably the second longest period of continuing growth since World War II. Source: RBNZ. When we look for the causes of this we see two main factors. First, much of the world has also been through a strong period of growth (despite some emerging market economies' financial crises, the 9/11 crisis, and the fear of deflation). Second (and related), we have enjoyed strong commodity prices through this period, and they are closely correlated to export prices. There is some evidence that these improved prices might be expected to continue in the future. Source: ANZ National Bank, Statistics New Zealand. As ever, a small open primary-producing country like ours can be subject to considerable volatility, much of it beyond our control in the short-term. We know that climatic factors, especially drought, can be big enough to make a difference to the timing and magnitude of exports. However, tracking these through changes in milk production, dairy product storage, slaughter numbers, onshore and offshore inventory, can be surprisingly complex and lead to big statistical discrepancies at times (for example, the surprisingly low growth figures late last year). Looking back, some economic historians now believe that New Zealand's difficult reaction to the East Asian Crisis in the late-1990s was partly due to a drought shock. Now that droughts are also associated with electricity price hikes, the climatic effect on the economy can be magnified further. Shocks can also be benign. New Zealand has had its share of "good luck" through the early 2000s with the European Foot and Mouth outbreaks impacting on sheep prices, the North American BSE cow infections limiting Japanese consumption of US beef, and recurrent Australian droughts limiting supply from there. What we used to see as New Zealand's tyranny of distance has been helpful in limiting biological incursions and underlying our environmental image. The other major feature through this period has been some big changes in land use, especially the major expansion of dairying into the South Island, helped by good prices, warmer climates, irrigation technologies, and Fonterra's general confidence about the future. Of course not all of the buoyant international prices have been received by New Zealand farmers, because of the recently strong New Zealand dollar. Source: ANZ National Bank, RBNZ. Farmers have become more sophisticated in dealing with volatility. They have learned from the foreign exchange exposures of the 1980s and the debt build-ups in some sectors, to integrate financial advice with agronomic decisions. There have been very big exchange rate cycles in recent years, although to some extent these have tracked our terms of trade in the way economic theory predicts they might, and hence helped cushion the economy from big moves in prices. When our overseas prices are high, a strong dollar tells New Zealanders they are richer, and vice-versa. That is not to say that there is not scope by financial institutions and primary processors to develop new instruments to lessen exchange and interest rate risk, to offset capital risk, and to better incentivise farmers with longer term contracts. Despite this, we do still have a problem of imbalance ahead of us. As New Zealanders have enjoyed this strong period of growth, they have invested heavily in housing, with consequent increases in household prices. A central bank might prefer to "look through" a period of asset price inflation, rather than trying to address it with tighter monetary policy. That is an issue that is still argued about overseas. We did not feel we had the option of sitting back and waiting for the market to "burst", for two reasons - the housing market has been an indicator of very strong activity through the broader economy; in addition, strong house prices have made New Zealanders feel richer and in turn spend very freely, bidding up prices elsewhere. As we approached this problem, the Reserve Bank encountered an issue that has been around in lesser form before: we increased the Official Cash Rate at a time when G-3 economies, worried by deflation, were running the loosest monetary policies for 30 years. We could influence short-term rates, but took a longer time to see this coming through on effective mortgage rates, because banks were able to restructure mortgages to fixed term and fund at lower international rates. Source: RBNZ. This is not to say that monetary policy was impotent through this period; merely that its effects were slower to eventuate. This made it necessary to pre-signal to householders the pipeline impact. It also makes it harder to judge the timing of monetary policy moves around the business cycle with as much precision as we might like. Interestingly this is a problem that other central banks overseas are now also starting to worry about, though their economies are at an earlier stage in the cycle. The collateral problem this caused was that as we tightened monetary policy, the New Zealand dollar looked increasingly attractive to offshore investors. This was by no means the only driver of $NZ strength (which in the medium term has been more affected by our terms of trade), but for a while it was a significant one. In particular, during 2005 we saw a strong demand offshore for Uridashi and Eurokiwi bonds denominated in $NZ. Of course we might like to blame offshore investors for the resulting pressure on our trade weighted index, but the other side of the account has been New Zealanders' continuing demand for mortgage finance, and the banks' willingness to supply it. The impact of this boom on the household sector has been quite marked: as house values have risen, both households and banks have been keen to increase mortgages and leverage up financing. Householders feel richer (as indeed they may be if house prices stay high) and borrow and spend more off the back of that. And rather than diversify their wealth, they have been more inclined to invest further in housing - directly and indirectly. Household balance sheets have more assets and more debt, so are much bigger in gross terms. They, however, look much less balanced because such a dominant proportion of their assets are held in housing, with a relatively small proportion of wealth held in equities, bonds and other instruments. This is in contrast to other OECD countries. Source: OECD, RBNZ. This is worth focusing on because the same phenomenon is happening to a large extent in the farming sector. Farmers are unusual because statistically they constitute both households that consume and businesses that produce, thus complicating analysis of balance sheets. But when we look at farms as a business we see some trends that look rather like urban households. Source: Quotable Value Ltd. Farmers with strong pay cheques over the last five years have been responsible for some of the pressure on housing and on second homes around the countryside (one reason why this housing boom has been much more regionally diverse than the Auckland-dominated house boom of the mid1990s). Source: REINZ. In addition, agricultural land prices have been bid up significantly, a consequence partly of good commodity prices, partly of farm aggregation, partly due to productivity increases, partly due to Fonterra-supply effects, and partly due to the availability of cheap credit. We have seen a strong period of lending to the farming sector. These are largely rational reasons why farmers might be willing to pay higher prices. Source: RBNZ. However these values are changing the nature of some farm balance sheets: it has become increasingly hard to try to rationalise prices paid for land using estimates of the future flow of income from the land. Such estimates have always revealed a "rural lifestyle premium" for agricultural land, but this premium is now starting to look rather unrealistic. Higher prices for land have looked reasonable when compared to product prices in past years. Returns to farming were very good until 2003, as the unusual mix of high international commodity prices and a low New Zealand dollar combined to make farming more profitable than any time in the past 30 years. But do high land prices today reflect the future income stream available from the land, or past effects? Farmers are effectively saying they expect good export prices to continue into the future. But for land prices to continue to grow at these rates requires improbably high increases in export prices and productivity. There appears to be a gap opening up between land values and expectations of returns. Future investment decisions should not be based on the expectation of ongoing double-digit growth in land values. Source: Quotable Value Ltd, Statistics New Zealand, RBNZ. An important part of farming is the management of risks. At any time the sector needs to be able to withstand a combination of risks from poor weather, falling land prices, unhedged exchange rate pressures, trade restrictions, animal disease, and falling commodity prices, especially in an environment of rising operating costs. Agricultural lending, at about $28bn, now represents around a third of registered bank lending to the corporate sector in New Zealand. I should emphasise that when we examine rural sector balance sheets and bank lending exposures we do not see generic signs for financial sector concern. The Reserve Bank's Financial Stability Report suggests banks do not look over-committed in the agricultural sector and farmers are unlikely to renege on debt. What concerns us more is that we could be heading to a period of lower economic returns from over-investment in land. At the moment the New Zealand economy is moving into a rebalancing period. A strong domestic sector is weakening, while the export sector is gradually strengthening, helped along by a softer New Zealand dollar. With our current account deficit over 9 per cent, this is a rebalancing that has to take place. From an overall economic viewpoint, we are pleased to see it underway. The big question for us is: will this rebalancing take place during a period of continuing strong world growth and good commodity prices? This is of course a complex question, but there is some reason to be optimistic - there is evidence that we may be enjoying not just one-off factors, but a better enduring trend in prices for our production than has been the case for some time. It is not quite the story of the 1960s again, but medium-term prospects do look better than the turbulent 1980s and 1990s.
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Excerpt from an address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Association of Superannuation Funds of New Zealand, Auckland, 13 July 2006.
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Alan Bollard: Can New Zealand expect to carry out independent monetary policy? Excerpt from an address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Association of Superannuation Funds of New Zealand, Auckland, 13 July 2006. * * * Reserve Bank Governor Alan Bollard says New Zealand can still expect to carry out its own independent monetary policy effectively, even though it occasionally has had to work against strong global crosswinds that can delay its impact. In a speech today to the Association of Superannuation Funds of New Zealand, Dr Bollard said New Zealand had just been through such a period, but now monetary policies are more aligned globally, enhancing the effectiveness of New Zealand's policy. The following is an excerpt from that address. "Since 1999 New Zealand has been through a longer growth phase than any since the 1960s/1970s. It has been a stronger period of growth than in Australia, the US or the UK. This growth has partly been driven by strong commodity prices and population changes, but partly also by strong household spending, fuelled by growth in house prices, and a readiness to take on increasing amounts of debt. "The Reserve Bank did not feel it could just ignore this build-up in asset prices. To us it signalled growing pressures through the economy. New Zealanders, feeling wealthier from owning more valuable houses, were actively looking for ways to spend that wealth. "As far back as 2004 the Reserve Bank was forecasting growing inflation, correctly as it has turned out (though that was not always the view of market commentators). Consequently in January 2004 it started tightening policy, taking the first step in what proved to be nine tightenings. "This tightening cycle took place against an unusual international backdrop, and one that proved to be more than usually influential. "Back at the turn of the millennium, US interest rates were for a while very close to New Zealand's. Then came the 9/11 crisis, the end of the `tech boom' and also some unusual deflationary influences. "As the economies of China and other emerging market economies got more connected to the developed world, we saw a flow of very cheap manufactured goods that helped depress prices; a flow of labour into the services sector; and very cheap capital produced by East Asian saving. The crash in technology-based equities resulted in a collapse in investment in the US and Europe and opened up significant excess capacity. "For the first time for many years the central banks of the big developed countries were faced with a prospect of deflation and capital inflows. They reacted strongly by cutting interest rates radically. The US Federal Reserve, for example, slashed rates from 6.5 per cent (the New Zealand rate) in 2001 to only 1 per cent in 2003. (In New Zealand we were much more cautious, only cutting rates to 5 per cent.) "New Zealand has never in recent years had to run monetary policy in an environment where the G-3 economies - the US, Japan and Europe - were running such loose monetary policy of their own. "The problem was exacerbated because the New Zealand business cycle was running well ahead of those in the big economies: while they were still worried about deflation, we could see inflation pressures mounting. Demand was very strong in many domestic industries, capacity utilisation was reaching record high levels and skill shortages were becoming acute. "New Zealand started raising rates in January 2004, just ahead of the US Federal Reserve's long climb back towards neutral real rates. Initially as we put up the Official Cash Rate, New Zealand shortterm market rates rose as expected, but the long end remained stubbornly low, anchored to US rates expectations. "We were experiencing another outcome of financial globalisation: long-term rates in New Zealand have over the last decade started to become very closely correlated with US long rates. "In New Zealand the floating mortgage rate rose quickly. Households increasingly switched to cheaper fixed-rate mortgages. The banks could readily provide these due to the cheap New Zealand dollar funding offered by overseas investors through instruments such as Uridashis and Eurokiwis. In 2003, less than 60 per cent of all mortgages were fixed, by 2006 it was more than 80 per cent. Competition between the mortgage lenders also acted to keep fixed rates low as bank margins were reduced to historically low levels. "The Reserve Bank kept pushing up the Official Cash Rate to slow demand. The effective mortgage rate, the main transmission mechanism for monetary policy in New Zealand, rose, but to only half the extent of the Official Cash Rate increase. Monetary policy was working, but more slowly than the Reserve Bank would have liked. "We could see that the full effects would eventually flow through on to mortgages, but in the meantime homeowners seemed to be borrowing on the expectation that rates would stay low. In doing so, households were skewing their balance sheets further towards low-yielding housing assets. Holdings of financial assets now look very low compared to what we see in other countries. "Overall gearing was not substantially increased. Households were apparently not worried about their greater indebtedness, about low rental returns, or about saving all their eggs in one basket. "By 2005 New Zealand's normal short-term interest rates were looking high by OECD standards (though not, despite some media confusion, the highest). The difference in yields was attractive to some investors, and that is one of the factors that contributed to the persistently strong New Zealand dollar. (Another key reason, we should not forget, was the strong terms of trade.) "This was certainly a factor weighing on the Reserve Bank's mind over the last couple of years, and a reason why tightening took place gradually and moderately. (As an aside, although some export industries came under significant pressure as the exchange rate rose, the sector as a whole appears to have managed the strong Kiwi dollar better than in previous cycles.) "The beginning of 2006 marked something of a turning point. The Reserve Bank finished its tightening cycle. New Zealand's terms of trade started to soften. Other OECD monetary policies started to catch up. And the trade weighted index fell by around 18 per cent between December 2005 and June 2006. At the same time the `pipeline effects' of the Official Cash Rate on fixed mortgages are continuing to come through. "This marks a rebalancing of economic growth from domestic sector-driven to export-driven. In this stage of the cycle our monetary policy has become a more effective brake on domestic spending. "Even during the best of times, monetary policy affects activity and inflation with a significant lag. However, as we look back on 2004/05, we see a `spongier' monetary policy than would be the case normally. Applying the brake took longer to slow things down. This is similar to a two-year period in the mid-90s, when our domestic/international interest rate differential was quite marked. "Clearly, this could occur again at some stage in the future. It becomes more of a problem when New Zealand's business cycle is significantly out of step with the OECD's, or when the latter have focused their monetary policy on a quite different issue. Arguably, we have also had times at the opposite end of the cycle, when it has been harder than we might have wished to stimulate consumption. "The Reserve Bank and the Treasury now have a work programme focused on whether there are ways to reduce the likelihood of finding our economy out of sync again; or on handling it differently if we do. "What is clear is that in a globalised world most of the Government's economic policies, including fiscal, industry and immigration policies, are all constrained by other countries' policies and by international pressures on them. With financial markets so interconnected, any small country's domestic monetary policy also now needs to be seen in an international setting. "Nevertheless, there is no question that we can run an independent monetary policy. We have control of our ship. If global winds are not behind us or our economy is out of sync with influential economies, then our progress becomes more difficult, and things can get uncomfortable. We may have to modify our chosen course. "But with major economies now raising their interest rates, global conditions are becoming aligned to containing inflation. In these conditions, New Zealand monetary policy is increasingly effective. Indeed in some respects we are in a more comfortable position than some other countries, having already raised interest rates. "In the meantime, we are starting to see some other countries, especially small open commodity economies, realising this too as they start to face the same pressures. They have been following the New Zealand experience with interest."
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Talk by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to PricewaterhouseCoopers Annual Tax Conference, Auckland, 9 November 2006.
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Alan Bollard: Kiwis like buying houses more than buying businesses Talk by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to PricewaterhouseCoopers Annual Tax Conference, Auckland, 9 November 2006. * * * Introduction This talk looks at a very Kiwi phenomenon: householder investors who prefer to put their savings into houses rather than a broad range of financial investments, especially equities. Apart from having all their eggs in one basket, this also has implications for the level of gearing taken on by the household sector and the manner in which New Zealand’s debt is funded. It has also meant that not much local equity is available for New Zealand business. The gap has been filled by foreign equity, which brings many development advantages for large businesses, but which is less conducive to supporting startups and other small businesses. It has also left the economy more vulnerable. The Reserve Bank has the dual roles of promoting stability in prices and promoting stability in the financial system, to enhance economic performance. Both these concerns drive this talk. 1 The bigger picture around financial stability will be updated when we release our latest Financial Stability Report on 15 November 2006. Household balance sheets In comparison with other comparable OECD countries, New Zealand households hold a very large part of their assets in housing. The rates of owner-occupied housing are not particularly high in New Zealand. Rather what marks us out are a number of features: We hold relatively large holdings of second homes (and associated durables like cars and boats), usually under-utilised, and delivering low returns. In addition, over the last few years we have spent heavily on investor housing (houses and apartments), investments stimulated by expectations of exciting capital gains rather than exciting rental yields. This talk does not represent investment advice for the household sector. Householders’ needs and options differ and they should get professional advice for this. Declaration of interest: My wife Jenny Morel runs a venture capital business, No 8 Ventures Limited. Readers should note that there are limitations on the quality of data in this paper. The comparative statistics have been assembled from a range of sources and may be subject to inconsistencies. Reserve Bank estimates have been used where data have been unavailable from other sources. This exposure to housing is being financed by increased mortgage debt from the banking system. The average New Zealand household’s debt has risen from around 100 percent of disposable income to around 170 percent over the last five years. This imposes a heavier mortgage-servicing burden, which has been justified by the big increases in house values. The typical household now commits about 13 percent of its disposable income to service debt. This makes these households much more vulnerable than they used to be to adverse events, such as increases in unemployment and rising interest rates. These debt servicing rates are significantly higher than in other OECD countries. Despite this vulnerability, the increases in house values have stimulated a strong wealth effect. Households feel richer (and provided house values hold up, they are richer), and have been spending with confidence. Their confidence is such that they have been prepared to dissave at an unprecedented rate. The preoccupation with housing assets has been at the expense of other assets that one might normally expect to find in balanced household portfolios, namely financial assets, such as equities. This speech highlights the unusually small holdings of equities by New Zealanders and some of its financial and economic implications. Most of our housing stock is owner-occupied, and our behaviour here is not unusual by OECD standards. In this talk I focus on those households with sufficient resources to consider investments beyond their own occupied houses. Many New Zealand households are not sufficiently well off to consider much in the way of equity investment. For those that are, a financial advisor would look at a particular set of household circumstances and, depending on these, advise an appropriate balance of holdings split between: • Land and buildings in both residential and commercial sectors. • Cash and financial debt instruments that might vary by duration and risk. • Equity holdings, both direct and portfolio ownership, in private and public firms. These holdings would differ largely depending on variations in income, wealth, household size, composition, and age. The situation is further complicated by the ability to hold assets directly or via managed funds; by quite different tax treatments; by decisions to invest in New Zealand or overseas; by commitments in directly held family firms, farms and forests; and by decisions by the Government to hold certain assets jointly on behalf of New Zealanders. Sources of equity in New Zealand It appears that holdings of equity by New Zealand households are particularly low by OECD standards, with direct holdings of both domestic and foreign equities making up no more than about 4 percent of total assets. A frequent reason cited is the severity of the October 1987 stock market collapse, an event that passed by 20 years ago. In the US, despite similar pressures in 1987, troughs in the 1990s, the “dotcom bubble”, and the “tech wreck”, direct equity holdings are now around 17 percent of assets. New Zealanders’ indirect holdings of equities via superannuation funds, unit trusts and other long-term investment products managed professionally by large funds also appear to be low by international comparison. Data on our holdings of equity is not conclusive. As at December 2005, the household sector held around $14 billion of domestic equities and around $6 billion of overseas equities. Indirect holdings of domestic equities on behalf of households via superannuation schemes, managed funds and unit trusts accounted for another $8 billion. The overseas equity holdings of such funds are likely to account for perhaps another $15 billion given their overall exposure to international assets. How much equity do individual households typically own? The picture built up by the Reserve Bank of household balance sheets from various surveys confirms that equity holdings rise sharply with income, implying that the distribution of holdings is highly skewed. Based on the 2001 Household Savings Survey we estimate that the median value of direct equity holdings for those households that own shares is around $6,000. However, the same survey showed that a very significant proportion of households (around 70 percent) had no direct holdings of shares at all. The listed public company investment opportunities available through the NZX are limited, given the slow growth of large New Zealand corporates, and the advantages some have seen in listing offshore. Some of the better-known names have delivered poorly to shareholders, or disappeared off the exchange. Despite this, the index returns have not been poor over the medium-term, and over certain periods have even out-performed housing investment in pre-tax terms. New Zealanders invest about twice as much in equities directly compared with managed funds. This may reflect our DIY investment culture, also a disdain for advisers, fund managers and their fees. Many see equities as a shorter term, more speculative investment rather than a longer term hold. New Zealanders in general do not have a high level of financial literacy about such investments and how to manage them. Aversion to equity may also reflect some psychological traits, particularly the desire to hold and control a physical asset over a financial one, or one where the investor can contain costs by utilising their own skills in construction, house maintenance or tenant management. Tax treatment will often prove a deciding factor in decisions about housing versus equities, direct versus portfolio approaches, and onshore versus offshore investments. From this individual point of view, housing-heavy investors may look to be acting rationally. In particular, capital gains on housing assets are usually tax exempt, while those on financial assets are often not. In addition, households can negatively gear investment properties so a loss is created, which can be deducted from income for tax purposes. But it is not the purpose of this speech to examine the implications of tax policy for household decision-making. I focus here on the wider concerns - the implications of holding too many eggs in one basket, the exposures generated by gearing decisions, and the lack of ready access to local equity by New Zealand firms. There are specific difficulties interpreting the data on equities. In particular, New Zealand is a country of small firms and farms, almost all privately owned, most of them through families. An important form of debt is mortgage financing on the owners’ house(s). This raises the statistical complication that the household sector holds more equity than is initially apparent. An additional complication comes from the inconsistent treatment of family trusts, and the assets held by them. We estimate that about 15 percent of households now hold assets through family trusts. Furthermore, globalisation is complicating things considerably. Our official data on offshore equity holdings by New Zealanders probably under-estimates the real situation. Statistics New Zealand surveys New Zealand resident institutions as to their offshore holdings and bases their measure of direct holdings on IRD returns. As a result, offshore holdings of private equity and equity paying low dividends are unlikely to be fully captured. Migrants into New Zealand pose particular measurement challenges, especially when they retain ownership interests in offshore operations where they continue to have family or corporate ties. Of course the Government itself has significant holdings of equity and it would be rational for householders to take these into account in their savings decisions. Through various Crown Financial Institutions, and in particular the New Zealand Super Fund, the Government indirectly holds about $600 million of New Zealand equities onshore and about $1,800 million offshore. Through its State Owned Enterprises and holdings in Air New Zealand, it holds another $10 billion directly. Local Government also holds significant equity positions. There are three particular types of corporate in New Zealand that have been untouched by foreign ownership because their form and modus operandi prevents this. They include State Owned Enterprises, and other Government companies and holdings. In particular, there are some very big infrastructure players among the State Owned Enterprises, with each of the top four firms having total assets in excess of $2 billion. The second corporate form of interest is the iwi or trust-owned Maori corporation, often with fragmented ownership. These are estimated to total about $4 billion. Finally, there are some large and powerful producer co-ops (especially in primary production) and retail co-ops with member ownership. These now constitute a high proportion of the New Zealand-owned corporate sector. Equity for the corporate sector Let us turn attention to the corporate sector in New Zealand, their organisational forms, where they invest, how they are financed, and ultimately how they are owned. The corporate sector, in contrast to the household sector in New Zealand, has over recent years been saving strongly; savings that ultimately are reinvested, returned to shareholders, or used for equity investment in other operations. The very low levels of household savings need to be viewed against this stronger corporate savings performance. Where do New Zealand corporates get their financing from? As noted above, the family-owned firms, farms and forests turn to the household sector. New Zealand corporates raise most debt finance directly from banks, either from the New Zealand subsidiary or, if they are big enough, directly from the offshore parent bank. These debt markets appear to work well, although borrowing locally means paying rates that have traditionally been higher than in other OECD countries, even Australia. The New Zealand rates contain a premium that reflects exchange risk and the liquidity risk that is inherent in a small remote market such as New Zealand. Compared with other comparable countries, the corporate bond market is a very thin one in New Zealand. (There are, of course, a very large number of global bonds denominated in $NZ, but most of these are Eurokiwis or Uridashis, whereby foreigners effectively provide finance for lending into the New Zealand household market.) The corporate bond market is thin because it is effectively restricted to those corporates large enough to be recognised internationally. In addition, there is a significant compliance cost to issuing bonds/notes domestically, and direct bank debt often looks an easier option. (The lack of a corporate bond market in turn means a less mature yield curve and lower quality pricing information.) For most small to medium sized businesses, the banking system is a more cost effective conduit for accessing offshore investors funds. The effect of this is to limit the onshore funding options available, and to limit the onshore financial instruments New Zealanders can easily invest in. Turning to the stock market, it appears that domestic corporates and New Zealand individuals have an ownership stake in publicly listed companies of around 53 percent. The remainder (47 percent) of the stock market is owned mainly by interests from the US, Australia, and the UK. This differs slightly from the international investment position, which suggests foreign interests own only around 28 percent of New Zealand assets. The lower proportion suggested by the international investment statistics reflects the fact that ownership of non-listed and unincorporated businesses tends to be rather lower than in publicly listed companies. (Australia is the largest inward investor with around 30 percent of total foreign investment.) This is shown in the figure: due to small scale firms and private equity, the size of the stock market in New Zealand is very small, both absolutely and as a proportion of GDP. Of course some New Zealand firms list singly or jointly on the Australian exchange. Despite enjoying some good returns, the small size of this exchange limits options for both New Zealand firms and New Zealand investors. We are currently seeing a phenomenon where considerable private equity is roving the world looking for investment opportunities. Close to home, one source of this is the Australian pension schemes, which are filling limited investment opportunities onshore and are increasingly looking at markets like New Zealand. Some of this involves publicly listed New Zealand companies, while a less transparent part has been private offshore funds buying private New Zealand companies. Offshore some of these funds have helped develop more sophisticated segments of capital markets, such as venture capital. But in New Zealand the relatively small scale and low risk appetite of institutional funds means that this market has had to rely on a small number of high wealth individuals and has developed much less as a result. This limits high growth, high risk firms’ access to growth capital, particularly important in a market where home bias is strong due to the inevitable uncertainties in assessing start-up / growth firms. Some consequences of our equity short-fall What are the consequences of New Zealand’s households’ preference for investment in housing over investment in businesses? At the micro level it appears that small-medium firms have been less able to access New Zealandbased specialised capital market instruments, for example, in the area of private equity, and venture capital. It is hard to judge how much of a disadvantage this has been, but if it drives New Zealand corporates towards foreign financial markets and eventually towards foreign relocation, then that could be activity lost to New Zealand. New Zealanders’ unwillingness to provide equity capital has been an incentive for increased direct foreign ownership. In many cases this has been desirable, even inevitable, for expanding companies. One can see a natural progression whereby some New Zealand companies gradually outgrow the technical and market limitations of this country, and as they expand into bigger markets, take on more of the ownership attributes of international firms. But if that happens “prematurely”, there is an opportunity benefit foregone for New Zealand. New Zealand’s liberal attitude to foreign ownership has brought us many important advantages. We have enjoyed access to the world’s capital, to best practice international technologies, to specialised business skills, and to marketing networks. These have brought higher productivity, employment opportunities, and have contributed to our higher growth rates. This also has to do with the much discussed cultural tendency of some New Zealand entrepreneurs to grow their business to sales levels of some tens of millions, then exit for the “bach, boat and BMW” semi-retirement subculture, leaving overseas investors to expand the business further and develop its full value internationally. GDP is a measure of what is produced in New Zealand, while National Income (which used to be called GNP) measures the fruits of production that actually accrue to New Zealand residents. In 2005, National Income was around $10 billion lower than GDP, as a significant part of GDP accrued to the overseas owners of New Zealand-based companies. Ultimately, it is National Income that matters for the overall economic wellbeing of New Zealanders. The wedge between GDP and National Income has some quite complex welfare implications for government, which has to balance how much its policies aim to promote activity in New Zealand, or activity owned by New Zealanders, whoever or wherever they may be. One particular consequence is seen in our current account deficit, a measure of the external financing required by the country’s investment-savings imbalance. In recent years about half the deficit has been represented by the trade imbalance. The other half has mainly been the imbalance of income earned by foreigners in New Zealand compared with that earned by New Zealanders abroad. Measurement problems apart, this appears to have been growing as a result of recent investment trends. A further decline in the ownership share of New Zealand business will worsen this deficit and put the balance of payments under continued pressure. Interestingly, our net international investment position as a percentage of GDP has not worsened substantially in recent years. However it will be difficult for New Zealand to substantially improve the investment income component of the current account deficit in the short to medium-term because the stock of foreign ownership is already so large. If the $NZ were to weaken in the medium-term in line with many economists’ predictions, then we would expect to see a further pick-up in foreign investment attracted by cheaper New Zealand assets. Such a large debtor position, arising out of New Zealand’s poor savings performance, makes the country more vulnerable to adverse shocks. We are inevitably more exposed to changes in global interest rates or sudden shifts in the investment preferences of overseas investors. At times, this can make it more challenging to maintain price stability and avoid unwanted swings in economic activity. This pattern of household investment also impacts economic performance. If New Zealanders fail to identify and invest in higher yielding equity then we condemn ourselves and the country to lower returns, and economic growth will be lower.
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Background paper for an address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers¿ Chamber of Commerce1, Christchurch, 26 January 2007.
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Alan Bollard: Delivering sound and innovative financial services for New Zealand Background paper for an address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers’ Chamber of Commerce 1 , Christchurch, 26 January 2007. Alan Bollard, Adrian Orr, and David Drage wrote this paper. The authors would like to acknowledge the assistance of a range of Reserve Bank staff in putting this paper together. Any errors are the responsibility of the authors. * * * An important issue for the economic performance of New Zealand is whether New Zealand has the financial services on offer that will best enable the allocation of our resources to their most productive uses – both from the perspective of the investment product choice set an individual faces when saving and the options available to firms when raising capital. New Zealand’s rather unique financial market and institutional structure suggest that there is room for further development. This includes expanding the width and breadth of New Zealand’s capital market, enhancing the performance of the non-bank financial sector, and raising the total pool of financial savings and financial literacy. In doing so, New Zealand’s financial system will be more dynamic and sound, potentially raising our sustainable economic growth performance. This paper outlines the important influence the financial system has on economic growth, highlights some of the unique features of our system, and discusses how the potential gaps and vulnerabilities in New Zealand’s financial system could be addressed (including actions the Bank is undertaking). The important role of the financial system It is well known that New Zealand is, and has been for a long time, dependent on foreign savings for its investment capital. New Zealand finances around a third of its national investment spending through domestic savings, with the remaining two thirds financed from abroad. Given the many positive features of New Zealand’s economic and institutional structures, foreign savers have remained prepared to invest in New Zealand. In part we choose to access global savings because of the relatively small scale of New Zealand’s capital demands compared to the global pool. Both the price of capital and its means of delivery (or intermediation) are some of the most important determinants of the quantity and quality of investment in New Zealand. The financial system plays the central role in informing and facilitating these saving and investment decisions. It enables the vast majority of economic exchange to occur – both between people and across borders, and through time. As such, the financial system plays a pivotal role in the efficient allocation of economic resources and risk – thus influencing the long-run growth performance of an economy. Developed economies tend to have efficient and sophisticated financial systems. The financial system comprises three interconnected components: • financial markets in which financial contracts are entered into or traded directly between buyers and sellers (or borrowers and lenders). These includes debt (i.e., bond), foreign exchange, and equity (i.e., share) markets; • financial institutions which intermediate between borrowers and lenders and provide financial services. This sector includes banks (which dominate the institutional sector in New Zealand) and other non-bank financial institutions such as finance companies, credit unions and building societies; and • payments systems which allow financial transactions within markets and between institutions to be settled. Declarations of interest: Dr Bollard’s wife, Jenny Morel, runs a venture capital business, No 8 Ventures Limited; at the time of drafting this speech Adrian Orr had been appointed as Chief Executive of the Guardians of the New Zealand Superannuation Fund. This paper focuses primarily on the interaction between the financial markets and financial institutions. The efficiency of any financial system relates both to its role in allocating risk and resources throughout the economy (i.e., allocative efficiency), the economic costs of providing these services (i.e., productive efficiency), and the incentives for ongoing innovation (i.e., dynamic efficiency). When a financial system is operating efficiently, investors will receive the highest risk-adjusted returns on their investments, borrowers will minimise the cost of raising their capital, and the financial system will make its greatest contribution to economic growth. Countries with efficient financial systems also tend to be less prone to financial (e.g., banking or currency) crises, and tend to recover more quickly at less cost if such a crisis does occur. 2 A sound financial system is thus one that has the resilience to continue to efficiently provide financial services under a plausible range of economic circumstances. We define the conditions for financial system efficiency and stability as existing when all relevant financial system risks are adequately identified, priced, allocated, and managed. 3 Financial product offerings and New Zealand’s uniqueness In a developed economy firms, the government, and individuals will supply and demand a financial portfolio that includes debt (government and private sector), equity, and bank (i.e., loans and deposits) products. A range of financial services allow firms to raise capital in various forms and individuals to invest in a portfolio of these products so as to best meet their savings needs. Marvin Goodfriend provides an exposition on the reasoning for the creation of this financial product set in a developed economy, and the benefits it brings in terms of financial system soundness and efficiency. 4 Essentially firms, as they grow, have increasing demands for capital that cannot be supplied from within their firm alone (i.e., retained earnings), and as such they go in search of various forms of external finance. First and perhaps foremost, banks play an important role in the provision of external finance. However, the provision of external finance involves information-intensive processes such as credit evaluation, loan monitoring, and a premium for the risk of default, all of which add to the cost of borrowing. Bank lending thus comes at a price to the borrower over and above internal finance. However, as firms become more widely known they can afford to partially bypass bank lending (which is often relatively more expensive) and gain direct access to savings through capital markets. Firms with a sound public image (perhaps because of a good credit rating) may thus have a price incentive to directly issue their own debt securities. At some point it is also going to be the case that too much reliance on debt financing alone – no matter the form – will constrain a firms’ flexibility. Hence, many firms will inevitably rely on some combination of both external equity and debt for their financing. Naturally equity finance comes at an additional cost, which is essentially a share of future profits. This portfolio of capital raising products provides a firm the flexibility to choose its optimal gearing ratio, and mix of dividends and debt service. From a saver’s (or investor’s) perspective, a broad portfolio choice of debt and equity products is also desirable. An investor has the ability to combine these products – and their unique range of risk and return features – to best match their savings needs. The portfolio choice an individual makes generally comes down to issues such as their investment time horizon and income needs. Investor access to these capital raising products also provides an important market discipline on firms and financial institutions that promotes the dynamic and sound allocation of scarce resources. Mario I Blejer, Economic growth and the stability and efficiency of the financial sector, Journal of Banking and Finance 30 (2006). See Leni Hunter, Adrian Orr and Bruce White (2006), “Towards a framework for promoting financial stability in New Zealand” Reserve Bank of New Zealand Bulletin (Volume 69, Number 1). Marvin Goodfriend (2005) “Why a corporate bond market: growth and direct finance” remarks made at the BIS/PBC seminar on “Developing corporate bond markets in Asia” held in Kumming, China, 17-18 November 2005. New Zealand’s unique financial services It is thus instructive to assess the relative role that these financial products play in New Zealand. Doing so highlights just how unique – although not necessarily concerning – New Zealand’s financial intermediation is in some respects. While the profile looks similar to Australia, domestic credit 5 accounts for around 150 percent of GDP in NZ, compared to 180 percent in Australia, and our stock market capitalisation is less than half of theirs, relative to GDP. Relative to most developed economies, banks play a very dominant role in New Zealand’s intermediation process, with bank credit (especially mortgage credit) our preferred capital raising instrument. Domestic bank credit is comparatively large relative to the size of the economy and our capital (i.e., bond and equity) markets (see Figure 1). Figure 1: Channels of local currency funding Source: RBNZ, Bank for International Settlements In aggregate, banks own around 75 percent of New Zealand’s total financial assets, with around 90 percent of these owned by the largest four banks. By contrast, funds under management account for less than 20 percent of financial system assets, and the non-bank financial sector accounts for only 7 percent. The registered banks operating in New Zealand also have a relatively high reliance on foreign funding for their lending activities. The banking sector’s net foreign liabilities account for around 20 percent of New Zealand’s total liabilities, which is very high by international standards. Domestic credit consists of claims (lending) of M3 institutions on central government, and of M3 institutions and the Reserve Bank on the private sector. Figure 2: Offshore funding of banks Net banking sector non-resident liabilities / gross financial system liabilities Source: OECD. Bank Profitability – Financial statements of the Banks. RBNZ calculations New Zealand has a very high level of foreign ownership by developed country standards, with more than 90 percent of the banking sector owned by foreigners. Figure 3: Share of foreign bank assets in domestic banking systems Source: World Bank. Foreign banks are banks with more than 50 percent foreign shareholding. Similar to Australia, a relatively high proportion of lending is to households, with the bulk of this mortgage lending. Figure 4: Breakdown of lending by financial institutions Source: RBNZ for NZ and Australian credit figures (which include securitisation), National Central Banks In summary, the banking sector dominates the New Zealand financial system, with this sector highly country concentrated in its ownership, strongly reliant on (largely short-term) foreign funding, and focussed primarily on lending to the household sector for housing mortgages. Compared to other countries, New Zealand’s capital markets are relatively small. While the amount of New Zealand dollar corporate bonds (or securities) outstanding relative to the size of the economy is similar to that of Australia, very few of these are actually issued by local businesses. Instead, the vast majority of New Zealand dollar debt securities are issued by non-resident entities in offshore markets – mainly Eurokiwi and NZ dollar Uridashi bonds. In relative terms, New Zealand’s businesses are low users of the capital markets for fund raising. The Eurokiwi and Uridashi debt securities are issued into, for example, the Japanese retail financial sector on behalf of an international institution (such as the World Bank) wanting to raise capital. The Japanese investor gets access to New Zealand interest rates (and NZ/Yen currency fluctuations), while only facing World Bank credit risk. Meanwhile, the NZ Dollar denominated capital that has been raised by the World Bank is usually ‘swapped’ for US dollars with a local NZ bank, with the latter then on-lending this capital within New Zealand. From New Zealand’s perspective, this issuance provides a mechanism for hedging the interest rate and exchange rate risks associated with our offshore borrowing. Figure 5: Corporate bonds outstanding Source: Bank for International Settlements Government bonds are the dominant product in New Zealand’s debt market. However, the New Zealand government bond market has become less liquid over recent years, which is a reflection of the Government’s reduced funding requirement, having run fiscal surpluses for the past 10-15 years. The amount of government bonds outstanding has shrunk from more than 35 percent of GDP in the early 1990s, to around 20 percent currently. In addition, at present close to 70 percent of government bonds outstanding are held by offshore investors, many of whom are not active traders of their holdings. In line with this, turnover in the New Zealand government bond market is also lower than in other developed markets. Figure 6: New Zealand Government securities Source: RBNZ Figure 7: Government bond turnover ratio Source: Bank for International Settlements Equity market Unsurprisingly given the relative size of our economy and high level of foreign ownership, New Zealand’s stock market is small by global standards, with the total capitalisation of the market less than that of many individual corporations overseas. But it is also small relative to the size of our economy. As shown in the chart, the capitalisation of the stock market is very low as a proportion of GDP – something that limits options for New Zealand businesses and New Zealand investors. Whether as a symptom or consequence of this, the direct and indirect holdings of equity by New Zealand households appear to be relatively low by global standards. 6 “Why Kiwis like buying houses more than buying businesses” speech to Trans-Tasman Business Circle, October 2005. Figure 8: Equity market capitalisation as a % of GDP Source: IMF Is New Zealand well serviced by the financial product offering? New Zealand’s financial product range, and the way the products are used, raises some questions about its soundness and efficiency. In particular, the intermediation process in New Zealand is largely dominated by the banking sector which is primarily focussed on mortgage lending to households. Meanwhile, both the non-bank financial sector and capital markets are relatively small. Concerns have been raised by some commentators that the dominance of one intermediation channel may constrain financial market development. Whether or not banks have crowded out other market developments, the product range has implications for, amongst other things: • The operation of monetary policy, with regard to information regarding expectations gathered through financial market product prices; • Financial system efficiency and innovation, with regard to competition in product offerings and financial service completeness; and • Financial system soundness, with regard to alternative forms of financing or intermediation when this is dominated by only one or two channels (i.e., banks and derivatives markets) that have their own specific credit risks and operational drivers. Of course, a full range of desirable investment products will not necessarily evolve in any economy if there is no demand for them. That is, there is a potential ‘chicken and egg’ relationship between the size of the total pool of financial savings in a country and the range of financial product offerings available. Some have argued that the pool of capital created by a rise in household financial savings in other countries – notably Australia in recent years – has provided an important impetus for capital market development, via increased demand for investment products. Raising New Zealand financial savings is another important topic in itself. The concentration of bank lending New Zealand is well served by its banks, which are well capitalised and very profitable over the cycle. The sector is also relatively efficient by some standard measures. A common measure of bank efficiency – the ratio of non-interest expenses (cost) to revenues – indicates that New Zealand banks are comparatively efficient. Moreover, bank margins are around the average for developed economies. Figure 9: Bank efficiency: Cost / income rations Source: RBNZ (for New Zealand), Standard and Poors. Based on the largest banks in each country. Figure 10: Bank margins: Net interest margins Earnings from all interest bearing assets (including debt securities) minus the cost of all funding, as a ratio of average assets. Source: West LB Global Bank Chartbook However, the banking sector is very dominant in New Zealand’s financial intermediation process, and heavily industry and country concentrated in its ownership structure. This raises questions around overall financial system efficiency and soundness. For example, given that bank lending is dominated by residential mortgages, it may be the case that small to medium-sized firms will find it difficult to raise bank loans. In part this might explain the relatively high use of home mortgages for raising business capital, with around 10 percent of total mortgage lending estimated to be going into financing business. Banks’ dominant intermediation position appears to enable them to price standard loans and offer deposit rates very aggressively at times for short-term competitive reasons. This activity may potentially limit the room for the alternative forms of investment products to develop and create pro-cyclical lending behaviour, thus accentuating asset price and business cycles. Banks also play an important role in the development of new financial products. However, the relatively small role that capital markets and the non-bank lending sector play in New Zealand may reduce this impetus domestically. Recently, for example, Professor Dick Herring identified a number of potential financial developments that would help improve New Zealand’s financial stability, including longer-term mortgages and various investment products (including mortgage securitisation). 7 The role of domestic capital markets A well functioning capital market offers a number of advantages. A broad and deep corporate debt market will generate an observable benchmark for firms raising capital and for investors seeking a fixed interest investment with a corporate credit risk premium. The existence of longer-term financing options that capital markets provide is also useful for firms who have long-term growth prospects, as for example infrastructure businesses. A well functioning capital market also provides incentives for innovation in banking products, as discussed already. And, the more means by which savings can be transformed into capital investment in a prudent manner, then the more back up there is if any single channel fails. However, as highlighted by the statistics discussed earlier, New Zealand’s domestic corporate bond market has been relatively stagnant since the early 1990s, and remains small in relative and absolute size. This market also remains relatively illiquid, with private placements often preferred and low turnover in the secondary market. The situation could be summarised as too few willing institutional investors on one side of the market, and too few quality issuers on the other side. One constraint on investor demand for access to corporate debt has been the shape of New Zealand’s interest rate yield curve, with the highest returns to investors often being seen at the shorter-end of the lending spectrum. This in part reflects New Zealand’s low savings rate and favours short-term bank deposits as the preferred savings instrument. However, other more structural challenges to the development of a deep and liquid New Zealand corporate bond market include tax effects that favour both non-financial investments and bank offshore debt raising. One of the main competitors to the corporate bond market is New Zealand’s well developed derivatives market in both foreign exchange and interest rates. These markets have developed in response to a demand for risk mitigation from banks and corporates. These markets have enabled larger domestic companies to access offshore capital markets directly for their funds, and then manage the associated foreign currency and interest rate risks. 8 Such financing activities have proved reasonably efficient for the larger companies and banks. For example, the major New Zealand registered banks have quite legitimately set up offshore subsidiaries for the specific purpose of accessing offshore capital markets to fund their lending activities. These legal structures enable banks to avoid the 2 percent Approved Issuer Levy (AIL) that is levied on the interest paid to raise the capital, as the capital raised by the subsidiary is then loaned back to its parent. 9 Similarly many New Zealand corporates rationally choose to borrow directly in offshore Richard J. Herring (University of Pennsylvania) "Property Prices, Lending and Vulnerability to Financial Crises." speech to RBNZ workshop on Financial Sector Balance Sheets and Vulnerability to Financial Crises, September 25, 2006. Available at http://www.rbnz.govt.nz/research/workshops/25sep2006/2827569.html Tyler, Simon (2005) “The New Zealand corporate bond market” BIS Kunming conference. AIL was introduced in 1992 as a mechanism to make New Zealand fixed income more attractive for foreign investors, by enabling investment free of "non resident withholding tax". markets, often in a foreign currency that has a lower interest rate structure so as to minimise the cost of the AIL. While these activities make financial sense under current tax structures, they do constrain the amount of domestic capital raising activity and the access to high quality debt securities by domestic savers. A deep and liquid foreign currency and interest rate swap market is a strong virtue of the New Zealand financial system. However, it is by no means a perfect substitute for a deep and liquid bond market. In particular, interest rate swap trades are only as good as the credit risk associated with the institutions or parties (e.g., the local bank) involved in the swap. The swaps market is also subject to liquidity pressures at different points in the business cycle. It may not be as reliable in times of adverse economic conditions, when financial system robustness and a ‘spare tyre’ is most needed. Enhancing financial system efficiency and soundness To recap, there are several areas of interest with regard to possible constraints on the efficiency and soundness of the New Zealand financial system. These include: • The dominance of the banking intermediation channel and concentration of bank ownership to one country, Australia; • The dominance of the derivatives market (foreign exchange and interest rate swap markets) in intermediating between foreign savings and domestic borrowing; and • The relatively small size and role of domestic capital markets. The remainder of this paper highlights some possible actions that may better promote a sound and dynamic financial system. Some of these actions sit directly with the Bank and progress is being made. However, in doing so, we are acutely aware that just as markets can fail, so can regulatory interventions. Our experience suggests that market-based solutions – sometimes with regulatory prompting and encouragement – often result in a better performing financial system. So, with that caveat in place, let me highlight some near-term challenges. Banking A near-term issue for bank regulators (here and abroad) is whether bank regulatory rules accentuate the pro-cyclicality of bank lending. That is, credit booms and busts are positively correlated with the economic cycle and banks often face incentives to offer credit more generously in booms and less generously in busts. Regulators do not want their rules to magnify the cyclicality of bank lending, and hence the extent of economic cycles and any associated strains on the financial system. However, some aspects of the new Basel II capital framework have the potential to provide banks with additional incentives if not monitored closely. 10 Under Basel II, it is possible that overly optimistic assessments of risk at a good point in the economic cycle might feed through to the capital banks hold and encourage further pro-cyclical lending. For example, if banks were to underestimate the long-run risk of borrowers defaulting or overestimate the realisable value of collateral (e.g., a mortgage over a house) and that fed through to their capital requirement they might be encouraged to lend more. When implementing Basel II capital requirements in coming months, we will be working to ensure that the average level of capital a bank is required to hold for regulatory purposes is sufficient for all stages of the business cycle and any changes do not accentuate the lending cycle. On a different topic but still with banks, we are also looking at the role securitisation plays in the New Zealand financial system as part of our Basel II activity. In simple terms, securitisation is the parcelling up of a stock of assets (such as bank mortgages) and the on-selling of such parcels to interested investors. Basel II is a new set of bank capital adequacy requirements being implemented in many developed countries. For more details see: Yeh, A, J Twaddle and M Frith (2005), “Basel II: a new capital framework”, Reserve Bank of New Zealand Bulletin, 68 (3), 4 –15. Given the dominance of banks in New Zealand, and the concentration of their activity in mortgage lending, the securitisation of some of their mortgage books has the potential to reduce the concentration of mortgage loans on banks’ balance sheets and to distribute the credit risk associated with those loans more widely. In addition to spreading risk more widely, securitisation gives investors another product in which to invest their funds and provides banks with another way of sourcing funding and reducing maturity mismatches on their balance sheets arising from a preponderance of short-term funding and longer-term lending (e.g. fixed rate mortgages). It is unclear exactly why New Zealand banks have not been more active users of securitisation. Possible reasons include New Zealand banks’ current credit ratings and the pricing of bank debt and subordinated debt that make it more attractive for banks to keep mortgage loans on their own balance sheet. There are also up front costs to securitisations and banks may be looking for a more liberal treatment of securitisations with originator-provided credit enhancements for regulatory capital purposes. Our work on implementing Basel II capital adequacy rules is designed to more closely link the risk banks are taking with their regulatory capital requirement. For securitisation, the key element is determining the extent that a bank has passed on the risks associated with the mortgage loans to the investors in the securitisation and whether it retains exposure to the risk of the loans in form or substance. In carrying out our review of capital adequacy requirements relating to securitisations we will aim to ensure that banks are required to hold an appropriate level of capital to cover the risks they incur, without overlooking the extent to which the securitisation may result in risk reduction for the institution. Non-bank sector Meanwhile, non-bank financial institutions (such as building societies, credit unions, and finance companies) may also potentially fill gaps in the range of financial services offered in New Zealand. This tends to occur through specialising in the provision of services to particular sectors, groups, or regions. These institutions also increase competition, add to financial depth and liquidity, and provide a wider choice of product set for capital raising and investors. Hence, it is in New Zealand’s interest to have a sound and dynamic non-bank financial sector. At present the Bank is playing its role in the Government’s review of the regulation of many aspects of New Zealand’s financial system. 11 The main aim of this review is to ensure that the myriad of legislation in this area does not create unintended and undesirable distortions in the competitive environment, that unnecessary compliance costs remain are reduced, that the objectives of regulation are clear, and that investors are well informed in order to make good investment decisions. While final decisions related to the review are some months off yet, we are confident that the outcomes will include improved information flows to investors and some improved efficiencies for non-bank financial institutions. Capital markets There appears room for New Zealand’s capital markets to develop. One area to better understand is the drivers that have led to the development of two New Zealand dollar debt markets: one with resident issuers and one with non-resident issuers (e.g. Eurokiwis and Uridashi). Attracting domestic and offshore issuers and investors into New Zealand’s capital market would promote financial efficiency, allow larger domestic borrowers to reduce their reliance on the banking system, and continue New Zealand’s integration into the global economy. Evidence internationally and theoretically suggests one important component of a robust capital market is the existence of a reliable and liquid government bond benchmark yield curve. A challenge for New Zealand is to consider the overall net benefit of the government continuing to borrow (i.e., issue debt) even as it is starting to build a significant net asset position. This challenge is increasing as the New Zealand government debt market becomes increasingly illiquid. The government is undertaking a review of financial products and providers. The key objective for the review is to develop an effective and consistent framework for the regulation of non-bank financial institutions, intermediaries and products. The Australian government recently decided to continue issuing debt despite its persistent financial surpluses due to the perceived welfare enhancing features of a liquid government benchmark yield curve. The Australian experience also suggests that once broad based credit markets develop around the risk-free government yield curve, it is possible to scale back the government debt on offer. The New Zealand Treasury does not undertake its government bond funding with the primary objective of maintaining a benchmark yield curve. More recently, however, the Debt Management Office have shown a willingness to re-issue bonds that the market has expressed demand for and is working towards offering facilities that will help ensure that debt market participants can borrow parcels of government securities when they are unavailable on the open market. In addition, the Reserve Bank recently reduced the need for banks to hold government bonds as collateral in the interbank payment system, freeing up the supply of government bonds in the secondary market. We also introduced a ‘bond lending facility’ that improves the liquidity in the government bond market. Market participants have indicated a preference to see fewer but larger tranches of government bonds offered by the Treasury to consolidate liquidity in a few key sectors of the yield curve. Moreover, unlike Australia, where the supply of commonwealth government bonds is similarly tight, New Zealand has not developed a liquid government bond futures market to provide a substitute. Bond futures (as opposed to physical government bonds themselves) are the most actively traded instruments in well developed bond markets internationally and, as such, play an important role in allowing a wide range of market participants to manage and allocate interest rate risks. The advantage of bond futures is that their trading is not constrained to the total amount of government securities on issue, meaning that liquidity problems are less common once the futures market is developed. The futures market in New Zealand has struggled to develop because of a few factors. An important issue is the ‘chicken and egg’ syndrome again, where market participants have been reluctant to trade futures until liquidity has improved, but liquidity will not improve until more participants enter the market and trade. Another issue has been the historically dominant position of the Over-The-Counter inter-bank market for physical government bonds in New Zealand, which has tended to attract the trading activities of local banks who are the price-makers in that market. The recent reduction in local interbank government bond trading (reflecting a lack of availability of physical government bonds to trade) may mean local banks will have more of an appetite to trade and offer bond futures trading services in the future. Regarding the potential for rejuvenating the corporate bond market, there may be reason to reassess the efficacy of the Approved Issuer Levy placed on securities issued. In 1993 the New Zealand Treasury announced that they would pay the AIL on New Zealand government bonds, which led to the rapid expansion of the New Zealand government bond market. Subsequently, the AIL has remained an impediment to non-government securities issues and has driven many corporate to borrow in lower interest rate offshore capital markets purely to lower their AIL commitments. It is interesting to note that in Australia a "public offer test" was introduced to enable Australian companies to issue local currency bonds to foreign investors free of any non-resident withholding tax or levy. This enables Australian companies to issue local currency bonds that are treated equally by both domestic and foreign investors. Given the efforts New Zealand borrowers take to avoid the AIL, and given that it collects only marginal revenue, it may be appropriate to reassess it. We note that the government is currently seeking submissions on the appropriate calibration of taxation on Non Resident Withholding Tax and the AIL regimes. From a capital markets development perspective we see merit in changes that reduce the incentives for security issuers to issue outside of the domestic market. More generally, other crown initiatives will have an important bearing on the development of New Zealand’s capital markets. The investment activities of the New Zealand Superannuation Fund, along with the other government investment vehicles (including ACC and the Government Superannuation Fund), are a significant component of the demand for investment products. Their evolving requirements, particularly with regards to investment products that are currently outside the mainstream, will play a role in the development of our markets. Moreover, Kiwisaver has the potential to further boost demand for investment products. The ongoing review of the regulation around financial product provision may also lead to some improved cost-efficiencies for firms wanting to offer debt securities. This includes the potential for savings on offer documentation costs (with the potential combining of both investment statements and prospectuses), and revisiting the definition of ‘habitual investors’. In addition, a Treaty was recently signed between New Zealand and Australia for the mutual recognition of securities regulations. Across many aspects of New Zealand’s financial system, there is also a general push for improved investor information that enables the assessment of financial product features, including risk and return. These include ongoing improvements to bank disclosure statements, improved disclosure requirements for non-bank financial institutions, and more consistency and timeliness in investment prospectuses. The whole area of credit ratings and their use is also under review as part of the financial regulatory review. As part of the broader financial sector reforms under way, Government is placing greater emphasis on the role of investor education, to promote greater financial literacy and capacity for non-expert investors to make well-informed and well-considered risk/return decisions. A number of initiatives are planned or already under way in this area. Similarly, the move to strengthen the regulation of financial advisers and planners could be expected to produce longer term benefits in terms of potentially higher quality investment advice to investors. Overall, New Zealand’s financial system remains sound and dynamic. However, there is room for improvement across many aspects of it, in particular the non-bank financial sector and capital market development. These improvements can come about through more effective regulatory arrangements currently being considered, through a better understanding of the influence of the current tax environment, through the promotion of deeper and more liquid bond markets, and through improved financial literacy. However, some of these improvements may also occur as a natural consequence of financial innovation and the necessary recovery of private savings. As we have noted in the Bank’s Financial Stability Report and in speeches, while the government and corporate sectors have been net savers in recent years, the household sector has been a heavy net borrower, and this has been a driver of New Zealand’s external indebtedness. Aside from the potential financial stability or soundness concerns this raises, it may also have implications for product and service innovation, and ultimately the dynamism of our financial system. We asked at the beginning of this paper how well our financial services industry works for us. To conclude: banks deliver basic banking services in New Zealand reasonably efficiently. However our capital markets do not all look so sophisticated: there are some financial services that our businesses and our investors cannot easily access on-shore. Our financial system currently looks sound. The industry has adapted to our rather unique circumstances. Because of this, and in particular our lack of household savings, we probably remain more vulnerable to financial shocks than most developed countries.
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Wellington Chamber of Commerce, Wellington, 15 March 2007.
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Alan Bollard: Easy money – global liquidity and its impact on New Zealand Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Wellington Chamber of Commerce, Wellington, 15 March 2007. * 1. * * What has been happening to global liquidity? Globalisation has had major effects on the New Zealand economy over the last decade or two. Monetary policy has certainly not been immune. Some of the impact has been very helpful to us in our primary task of achieving price stability. We have enjoyed a useful disinflationary impact from the flood of cheap manufactures available from China and other newly industrialising countries. We have enjoyed the benefits of trading with a buoyant world that has been enjoying good stable growth rates with stable prices. More recently however, we have had to focus on a related phenomenon which has had some unanticipated effects: the growth of global liquidity. Global liquidity has increased dramatically over recent years. In our part of the world, this reflects: • a surplus of savings relative to investment in the East Asian and oil-exporting countries; • new players, new products, new transactions and markets; and in particular • the impact of the “carry trade” fuelling investment flows into a range of markets. A feature of the period of relatively strong growth in the world economy over the past several years has been large and growing financial imbalances among the world’s major economies. The US current account deficit has increased significantly over this period, although it has stabilised over the past year relative to the size of the US economy. Meanwhile, most East Asian countries have consistently run current account surpluses since recovering from the 1997/98 financial crisis, when many experienced deficits. More recently, the rise in oil prices has underpinned a substantial increase in the surpluses of the oil exporting nations. Figure 1: Current account balances Source: IMF World Economic Outlook, September 2006; RBNZ These relative current account positions broadly reflect the contrasting balances between saving and investment in these countries. In the case of the deficit countries – such as the US, Australia and New Zealand – investment has exceeded saving, with the excess savings of surplus countries financing the shortfall. Excess savings relative to investment amongst the surplus countries has increased substantially since the late 1990s, led by Asia, a range of developing countries and more recently the oil exporters. This has given rise to a phenomenon that US Federal Reserve Chairman Ben Bernanke has referred to as a “global savings glut”. 1 Figure 2: Gross saving and investment Source: IMF World Economic Outlook, September 2006; Economics@ANZ For many of these countries – particularly the developing economies – this represents a considerably different set of circumstances to that existing prior to the late 1990s, when developing economies (including many of those in Asia) were net recipients of capital. In the case of the developing economies in Asia, the response to the 1997/98 financial crisis has been to focus on export-driven growth and the associated accumulation of foreign exchange reserves – a strategy that most are continuing to pursue almost a decade after the crisis. The strength of exports relative to domestic demand has seen saving outstrip investment in most of these economies – even in the case of China, where investment growth has been very strong. Accordingly, we have the ironic situation whereby a range of developing countries are (in net terms) the providers of capital to some of the world’s most developed economies. This rapidly rising “savings glut” has been a principal source of increased global liquidity. “The Global Saving Glut and the US Current Account Deficit”, March 2005 Figure 3: Capital flows to developing economies Source: IMF World Economic Outlook, September 2006; Economics@ANZ 2. How is this being recycled? Along with financial deregulation and the general opening up of economies, the flow of increased global liquidity through markets has provided the impetus for many changes. In a recent speech 2 , Malcolm Knight, General Manager of the Bank for International Settlements, highlighted a number of important new features: • the unbundling and re-pricing of risk through major advances in financial engineering, resulting in improved ability to lever lending via new markets such as for credit transfer products; • the emergence of new financial players such as hedge funds and private equity firms that have not been traditional intermediaries; • more reliance of financial firms on markets to handle growing complexity; • a reliance on market liquidity even in stress situations; and • a surge in volume and value of transactions. The search for means to generate a return on this liquidity has spurred massive growth in securitisation of debt and the development of a vast array of derivatives. The propagation of these instruments can itself be seen as a source of liquidity growth and, by some estimates, a substantial one at that. From a monetary policy perspective, this implies a very big increase in the liquidity that is not directly controlled by central banks. “Now you see it, now you don’t: risk in the small and in the large”, February 2007 Figure 4: Estimates of global liquidity Source: Independent Strategy A particular development of interest to us has been the increasing integration of housing finance into these liquid international markets. A recent article in the Financial Times 3 reports on a significant slice of new mortgages in Hungary being issued in Swiss francs while households in Latvia and Romania are borrowing in yen. The article then goes on to focus on what they see as one of the biggest flows, the bonds denominated in NZ dollars by European and Asian issuers. 3. What are the global effects of this liquidity? The flows associated with the growth of global liquidity has played a role in helping to prolong the period of strong global growth seen in recent years. The associated search for yield has pushed down interest rates, bid up equity prices and generally put downward pressure on returns across a range of asset classes. Many of these effects have been clearly welfare-enhancing. But in contrast to how markets might have reacted a decade ago, it has also allowed less disciplined economic behaviour by some households and firms. It has allowed global imbalances, particularly those associated with the contrasting current account positions of the major economies, to build up and persist beyond what might have previously been considered sustainable. It has meant that when large economies operate with distortions in their own markets, those distortions can be felt halfway around the world. Risk appetites in global financial markets have generally been very strong in recent years. This perhaps reflects the extended period of relatively strong growth in the world economy underpinning investor confidence. This confidence has been bolstered by generally low market volatility, which has also lowered perceptions of risk. “Why the yen borrowing game could end in players taking a tumble”, 14 February 2007 Figure 5: Risk aversion and market volatility Source: Bloomberg; DataStream Perceptions of a relatively benign risk environment have provided the basis for investors to engage in a vast range of so-called “carry trades”. These involve borrowing to invest in an asset that is either yielding – or is expected to yield – a higher rate of return than the borrowing cost. In this regard, relatively low risk aversion and market volatility are important conditions for carry trades, so that traders are less fearful that sharp market moves could eliminate the expected yield differential. Currency carry trades, whereby investors borrow in low interest rate currencies to invest in higher interest rate currencies, have been some of the most popular. Relatively low interest rates in some economies, particularly Japan and Switzerland, have been used as the basis for a raft of leveraged investments and in so doing have further fuelled global liquidity. Figure 6: Global policy rates Source: DataStream The events of the past few weeks have provided a timely reminder of the importance of low risk aversion and market volatility for the carry trade. Fears sparked by a sharp retracement in China’s share market and growing concerns regarding the ramifications of problems in the US sub-prime mortgage market saw investors rush to reduce positions in a range of markets. Notably, this episode saw currency carry trades scaled back, with funding currencies strengthening and recipient currencies weakening – although the sell-off proved highly correlated across a wide range of asset classes. This period of turbulence has proved relatively contained to date, with risk appetites and markets recovering. But it does demonstrate the potential widespread impact of an increase in risk aversion and market volatility. Figure 7: Market developments since the beginning of the year Source: Bloomberg 4. How does it impact on the NZ economy? Given our relatively high interest rates, New Zealand has attracted a disproportionate share of global liquidity in recent years, putting upward pressure on the NZ dollar despite a relatively large current account deficit. These flows have come in many forms. One particular avenue has been the issuance of NZ dollar denominated bonds in offshore markets: Eurokiwi and Uridashi bonds. The derivative transactions associated with Eurokiwi and Uridashi issuance have provided a mechanism for the New Zealand banks to hedge the interest rate and currency risks associated with their offshore borrowings at cheaper rates than would otherwise have been the case. The upward pressure this has put on the New Zealand dollar and downward pressure on interest rates has exacerbated the current problematic imbalance between traded and non-traded sectors in New Zealand. Figure 8: Offshore NZ dollar denominated bond issuance (Eurokiwi & Uridashi bonds) Source: Reuters; Bloomberg; RBNZ But it is important to recognise that the attractiveness of the NZ dollar for offshore investors is not just a reflection of the current level of interest rate differentials, but also investors’ views regarding their sustainability. In this regard, it is interesting to note the relatively close correlation between house prices and the NZ dollar over the last 15 years. Without claiming a direct relationship between the two, this goes some way to illustrate the extent to which persist domestic inflation pressures have underpinned the outlook for interest rates, which in turn has maintained upward pressure on the NZ dollar. Accordingly, a sustained retracement in the NZ dollar from the highs seen in recent years could be contingent on our efforts to rein in domestic inflation pressures. Figure 9: House prices and the NZ dollar Trade Weighted Index (TWI) Source: Quotable Value; RBNZ Of course the inward capital flows that have kept pressure on the NZ dollar would not have happened without a strong domestic demand for borrowing. In this case it is New Zealand households’ desire to keep investing in housing, while at the same time consuming strongly, that fuels their demand for funds, and represents the other leg to these international transactions. 5. How does it affect monetary policy? No central banker today can ignore these effects on domestic monetary policy. A recent speech by Ben Bernanke 4 observed that financial market globalisation has made the Fed’s analysis much more complex. He notes that even for the US there is no such thing as total monetary independence. For example, correlations between long term interest rates in the US and other industrial countries have risen significantly. Having said that, he concludes that, despite Alan Greenspan’s term of “conundrum”, this has not significantly constrained their ability to influence domestic financial conditions. This is more problematic for a number of small open economies with higher interest rates – not only New Zealand, but also Iceland, Hungary, Australia and South Africa. The downward pressure created by abundant global liquidity on market interest rates has had implications for the operation of monetary policy. In general terms, the Reserve Bank has most impact on the shorter end of the yield curve, both by setting the OCR itself and influencing market expectations about the outlook for monetary policy. But further out the yield curve, other factors – including global interest rate developments and country risk premia – also influence interest rate levels. Figure 10: A stylised representation of the relative influences on the yield curve Source: RBNZ Low global interest rates have restrained the rise in longer-term interest rates relative to the upward pressure monetary policy has been able to exert on shorter-term interest rates during this tightening cycle. This has seen the yield curve progressively flatten and become negatively-sloped during the past few years. “Globalisation and Monetary Policy”, March 2007 Figure 11: The change in the yield curve since the beginning of the tightening cycle Source: Bloomberg Figure 12: New Zealand and US long term interest rates Source: Bloomberg A negatively-sloped yield curve has encouraged borrowers to take out term loans at relatively lower rates. Households in particular have favoured fixed rate mortgages, which now account for more than 80 percent of mortgage borrowing, and increasingly for longer terms. This has muted and delayed the impact of policy tightening in this cycle, although we have now seen the effective mortgage rate rise by around 110 basis points since its lows in late 2003. Figure 13: The OCR and the effective mortgage rate Source: RBNZ A further practical constraint for us has been that, although the TWI is influenced by a wide range of global events, in recent years we have not wished to add to upward pressure on the NZ dollar. We have also remained conscious of our obligation to avoid unnecessary instability in output, the exchange rate and interest rates, as required under section 4b of the Policy Targets Agreement. This has meant we have been more cautious in our OCR tightening path than might otherwise have been the case. 6. New Zealand policy in a global context The circumstances we face at present do not necessarily represent an enduring structural change in the environment in which policy operates. At some stage in the future when the large East Asian trading blocs are able to trade currencies and products with the world at more sustainable prices, a significant distortion to our own rate setting process will be removed. However, for that we must wait for G-7, Doha and other international forces to do their work. As for New Zealand, we need to see realisation amongst borrowing households and lending banks that this recent period of cheap international money has been unusual, and at some point will revert to more normal financial conditions. That means thinking about other eventualities ahead, and in some cases showing less exuberance. Monetary policy always impacts with long and variable lags. Those lags have been longer in this cycle, but as household debt grows the OCR becomes a more potent policy instrument. We are continuing to assess alternative measures that might support the OCR, working with the relevant government agencies. These include a tightening of tax rules applying to housing investment and changes to bank capital requirements to help moderate the amplifying effect of credit on the housing cycle. However, we will continue to rely on the OCR as the primary instrument of monetary policy.
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Waikato Grasshoppers, Hamilton, 12 June 2007.
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Alan Bollard: Commodities, dairy prices and the New Zealand economy Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Waikato Grasshoppers, Hamilton, 12 June 2007. The speech was prepared by Dr Bollard and Mike Jones. * * * For much of the 20th Century the fortunes of the New Zealand economy were linked to the world commodity markets. As these markets declined through the 1980s and 90s, so too did our competitiveness. Over the last year, the signs are that commodity prices are changing again. This is very good news for the New Zealand economy, offering better terms of trade, higher growth, and a reduced trade deficit. This speech looks at what this might mean for New Zealand, focusing on dairy prices and some consequences for monetary policy. World commodity prices have increased sharply in the last five years. The commodity price boom has coincided with a period of buoyant global growth. However, the sheer size and speed of this commodity price boom is somewhat unusual in a historical context, and, in fact, has seen commodity prices “decouple” from the global growth cycle (figure 1). Part of the explanation likely lies with China. The rapid pace of industrialisation of China, coupled with its relatively low per capita endowment of natural resources, has led to a sharp increase in world commodity demand. For example, according to the International Monetary Fund, China was responsible for 51 per cent of the growth in the world copper market from 2002-2005, 54 per cent of the increase in the steel market, 48 per cent of aluminum growth and 87 per cent for nickel.1 Figure 1: Global growth and growth in real commodity prices2 Quoted in Financial Times (2007) “Non-financial risks series: Mining groups encounter tough lessons” June 4. The CRB commodity price index measures movements in global commodities, both ‘hard’ and ‘soft’. It includes energy, grains, industrials, livestock, precious metals, and soft commodities. Initially, the increase in world commodity demand was most obvious in the oil price boom, followed by industrial commodities. More recently, many of the same factors that have driven the boom in global commodity prices have also driven a surge in world prices for some of New Zealand's commodity exports. Figure 2: World commodity prices and world prices for New Zealand’s commodity exports We appear to be going through an interesting (and only partly predicted) phase of world development. Emerging market economies in the 1960s and 70s significantly increased their per-capita consumption of food grains. In the 1980s and 90s we started to see protein increases which were mainly generated from animal feed grains. This decade has seen an intriguing new phenomenon: the conversion of acreage to biofuels production. Figure 3 gives a visual picture of just how big this consumption trend has been. The implication is that a country which can produce animal protein from pastoral production has a big competitive advantage. Figure 3: Consumption of food, feed and fuel What has been happening to world dairy prices? The most marked increases have been in dairy prices. Over the last year, dairy prices have increased by 73 percent. Milk powder prices have led the way, rising almost twice as fast as other dairy products. Figure 4: World dairy prices In large part, the recent gains in dairy prices can be traced back to a basic imbalance between global demand and supply. Global demand for protein has been on a structural uptrend for some time. Demand for protein is very income sensitive (figure 5) and rising income levels in emerging markets have led to improvements in diet, incorporating more meat, eggs and milk. In recent years, the strongest growth in consumption of dairy products has come from emerging Asian markets, particularly China. Figure 5: Asian incomes and consumption of agricultural products3 At the same time, dairy production from the major exporting regions, such as New Zealand, Australia and the European Union (EU), has been relatively lacklustre, hampering the ability of global dairy supply to meet the growth in demand. In the EU, exports of milk powder have now fallen significantly following the removal of export subsidies for milk powders. The elimination of milk powder subsidies has encouraged European dairy farmers to shift from exporting milk powder to supplying higher value added products (such as cheese) to their own domestic markets. Dairy stock levels in the EU have also been run down as a result which, combined with similarly low stocks in the US, has seen milk powder stocks globally hit very low levels. Australia is in the midst of one of the worst droughts on record. Despite the drought, dairy exports have held up remarkably well, sitting at around similar levels to last year.4 However, with production well down on last year, some easing in dairy exports seems likely going forward. Further, it is unlikely that production will ever fully recover to pre-drought levels. New Zealand dairy exports have recorded relatively modest growth over the past three years (around 3 percent p.a.). The recent boom in biofuel demand has further hindered global dairy supply. Strong demand for ethanol has seen corn prices, the primary source of livestock feed, advance over 50 percent in the past six months. Includes China, India, Indonesia, Korea, Malaysia, Philippines, Thailand, and Vietnam. Dairy Australia. Figure 6: Dairy and corn futures This has significantly increased the cost of dairy production for farmers overseas. Higher corn prices have also seen the ratio of milk prices to feed prices (for grain-fed cattle) worsen over the past year or so, meaning there is now less of an incentive for overseas farmers to increase dairy output (figure 7). And with more land in the US now being used for ethanol production there is less land available for any expansion in feed and/or dairy production. All of these factors may act to slow further expansion in the global dairy herd. Figure 7: Milk-feed price ratio Where will dairy prices go from here? Any discussion about the outlook has to be heavily qualified. Predictions of future dairy prices involve a range of uncertainties and we shouldn’t pretend that the outlook is clearer than it really is. The evolution of global demand and supply for dairy products depends on a wide range of factors including complex interactions with other commodity markets. Even if one can identify the predominant drivers of the dairy market, translating those into accurate predictions about prices is another matter. We shouldn’t forget that the marked run-up in dairy prices over the past six months is a development that largely took the industry by surprise even if it can be rationalised in hindsight. Moreover, even if dairy prices are moving to new structural levels, it is reasonable to think they will still be subject to cyclical fluctuations. That said, current spot market shortages do seem to suggest dairy prices are likely to remain at high levels in the short term. Looking further ahead, the future path of world dairy prices depends on the ability of global supply to respond to higher prices, as well as the ability and willingness of consumers to pay higher prices. There is certainly no compelling reason to suggest that strong global demand for dairy products will slow markedly soon. Supply responses in dairy are slow inevitably slow. And with the boom in biofuel demand sending production costs in many parts of the world soaring, the ability of supply to “catch-up” to demand will be constrained further. As a result, any increase in global dairy supply may well rest on the prospects for emerging exporters such as Argentina and the Ukraine, along with the ability of China to increase production to meet its own demand. It is certainly possible that we could be heading into a “new era” for dairy prices. Developments in other soft commodities Dairy prices look set to be the star performer amongst New Zealand’s export commodities over the next few years. But that is not to say the outlook for other commodities is bleak. In fact, the global backdrop seems likely to turn increasingly favourable for prices for meat and forestry, New Zealand’s second and third largest commodity exports respectively. Forestry prices have been increasing since 2005 on the back of strong Asian (particularly Chinese and Korean) demand for logs. Pulp prices have also joined the fray lately due to the increased bio-fuel demand already mentioned. And looking ahead, prices could press even higher. Russia is set to increase its tax on log exports in large incremental steps over the next three years, with the first increase starting in July. This should provide support for log prices given Russia’s strong presence in international log markets. Figure 8: Real commodity prices: total and ex-dairy Beef and lamb prices have come under pressure in recent months as drought conditions overseas have induced higher than normal rates of slaughter. Prices, particularly for lamb, have fallen as this “wall of meat” has hit world markets. But, of course, higher slaughter now means lower slaughter later. As meat producers in drought stricken regions rebuild their herds, global prices for both meat and beef should recover. There is also potential for prices to remain permanently higher if increased feed costs (bio-fuels again) prevent some of this herd re-stocking. All of this means that, even if dairy prices were to correct downwards, buoyant prices for some of our other key export commodities may well provide some offset, limiting the downside to our commodity export returns overall. Other effects internationally Surging prices for dairy products, as other well as for other soft commodities such as wheat, corn, and oats, have sparked international fears over food price inflation. There is growing concern within the food industry that the present upswing in prices is structural rather than temporary and, indeed, food companies overseas have already begun passing these price increases onto consumers. Development agencies providing protein supplements to vulnerable third world countries are being particularly affected. This partly explains the accelerating rates of food price inflation in other parts of the world. US food prices have risen by 6.7 percent since the beginning of the year while UK food price inflation recently reached 6 percent. In comparison, annual growth in New Zealand’s food price index has been more muted, around 4 percent in annual terms. However, with dairy and other food prices continuing to increase there may be additional upward pressure on New Zealand’s food prices in future. This has implications for monetary policy, which will be discussed later on. Impacts of higher payouts on NZ dairy industry Higher dairy prices will flow through into a higher payout for New Zealand’s dairy farmers. We estimate that Fonterra’s recent upward revision to its payout forecast for this season and next will add an extra $2 billion to dairy farmers’ incomes (at current production levels). Just what farmers do with this extra income remains to be seen. The cash windfall is likely to be spread across repaying debt, increasing savings, upgrading equipment, buying more cows, fertiliser and other farm inputs, purchasing/converting land, and, to some degree, cars and holidays. There are also the downstream, multiplier effects to consider, which could see a bigger boost to the rural economy than the $2 billion payout increase alone would suggest. But let’s not forget the cost side of the equation. Farmers often remind us that the cost of producing milk has increased substantially over the last few years. Significant cost increases could dampen the overall impact of higher payouts on the rural economy. Figure 11: Dairy payout and cost (per kilogram of milk solids) Higher payouts may also spur a fresh wave of dairy conversions, which was certainly the experience following the record 2001/2002 payout. Figure 12: Rural land use Before the recent dairy price increase, dairy farm prices were looking very top-heavy, and hard to justify on the basis of expected payouts. The rate of increase has been even higher than for house prices. The commodity price increases may have saved some farmers from difficult liquidity positions. Figure 13: Dairy land prices and house prices More conversions seem all the more likely considering the less favourable returns available from sheep and beef farming at present. The implications of a higher conversion rate would be another step-up in on-farm investment which would in turn lead to further increases in dairy sector debt levels. Figure 14: Dairy sector credit Changing land use would also bring fresh consideration of the environmental impacts arising from increasing milk production. Examples include water allocation for irrigation in Canterbury and the run- off implications of intensive nitrogen use. In a world where customers pay increasing attention to the environmental footprint of production, this is a serious issue. Other impacts on NZ activity There is some evidence to suggest that prices for agricultural commodities are becoming increasingly linked to prices for other commodities, particularly energy. Figure 15: Oil prices and world prices for New Zealand’s key export commodities Strong growth in demand for biofuels suggests greater convergence between agriculture commodities and energy commodities in future. Arbitrage from the oil market may support some agricultural commodity prices (in New Zealand’s case mostly dairy prices and, to a lesser extent, beef prices) at structurally higher levels, as long as high oil prices are sustained. But, if we are going to see dairy prices remain at high levels, there are some other “winners” and “losers” to bear in mind. We know that higher world commodity prices are typically associated with a higher exchange rate. And, while the recent appreciation in the exchange rate has dampened returns to dairy farmers to a degree, it has, at the same time, effectively distributed some of these income gains to consumers via lower import prices. However, as the increase in commodity prices has mostly been in dairy, the higher exchange rate has reduced New Zealand dollar returns for many other exporting industries, including some farm production. This phenomenon is known as “Dutch Disease”: very high prices for one export sector can crowd-out competitiveness in other export sectors. Monetary policy implications It bears repeating that we cannot be sure about the path of dairy prices over the next few years following their recent run-up. Assuming dairy prices do remain at elevated levels there are likely to be many benefits for New Zealand, including higher growth and a reduced trade deficit. However, from a monetary policy perspective, a terms of trade shock of this magnitude poses some challenges. It is likely that higher dairy prices will affect inflation in a number of ways. Firstly, as alluded to previously, increases in world dairy prices will lead to higher domestic dairy product prices. This has already begun to occur. Milk and milk based products are part of the CPI, increases in domestic dairy prices are likely to have a fairly prompt (though likely small) impact on CPI measured inflation. Secondly, and most importantly, higher dairy prices will provide a substantial boost to rural incomes. Of course, for many this is very good news. However, we are dealing with a stretched economy at present. Domestic demand is already strong. Capacity is tight. If this extra income is spent and/or invested by farmers it will add to this domestic demand pressure. It may be that a large portion of this extra income is saved or used to repay debt. But to the extent that some of it is spent, it may make it harder to achieve our medium-term inflation target. This effect could be compounded even further if these higher incomes become reflected in higher rural land prices. A reacceleration in land prices risks adding to domestic demand pressures through wealth effects and equity withdrawal. These two strong influences on inflation will be partly offset to some extent by the strong exchange rate. The high New Zealand dollar will dampen medium-term inflation pressures by suppressing activity in those exporting sectors not lucky enough to be receiving high commodity returns. We should not lose sight of the fundamental message: the trend we are seeing in commodity prices is very good news for the New Zealand economy. Assuming they are appropriately conservative in their spending, dairy farmers have a real chance to contribute to our growth.
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Opinion article by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, 27 June 2007.
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Grant Spencer: Recent intervention by the Reserve Bank of New Zealand in the foreign exchange market Opinion article by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, 27 June 2007. * * * On 11 June, the Reserve Bank confirmed that it had intervened in the foreign exchange market to sell New Zealand dollars. This was the first such intervention since the exchange rate was floated in March 1985. The Bank’s 11 June announcement has prompted a lot of discussion and commentary around the objectives and impact of FX intervention. It is useful to clarify a number of issues around this subject. Foreign exchange intervention is an ongoing process and the Bank will not be commenting publicly on its specific intervention activities. We will, however, continue to release our financial accounts, which show the accumulated impact of the Bank’s intervention activities. These accounts are posted on the Bank’s website at the end of each month, with a lag of one month. Under the Bank’s Policy Targets Agreement with the Minister of Finance, the Bank seeks to avoid unnecessary variability in interest rates, output and the exchange rate as it goes about maintaining low inflation. The Bank’s primary monetary policy instrument is the Official Cash Rate (OCR). The foreign exchange intervention framework provides an additional tool for the purpose of trying to moderate the extremes of the exchange rate cycle. Intervention operates at the margin, affecting the balance of demand and supply for the New Zealand dollar. It can have an immediate downward impact on the exchange rate as it did on 11 June. That can help to moderate the “peaks” in the exchange and the length of time we spend at peak levels. It does not attempt to defend a particular level of the exchange rate. Rather it sends a signal that, in the Bank’s view, the exchange rate is out of alignment with the economic fundamentals. Those speculating in the New Zealand dollar need to be aware that the exchange rate is not a one-way bet; they need to be cautious. The Bank’s policy is to intervene only when the exchange rate is at exceptional levels; when it is unjustified by medium term economic fundamentals; when intervention is seen as consistent with the Policy Targets Agreement; and when market conditions make intervention opportune. In recent times, the New Zealand dollar has been at levels that the Bank regards as both exceptionally high and unjustified by the economic fundamentals. Many businesses would agree. The high level of the exchange rate is creating challenging conditions for large parts of the tradables sector, particularly for those not directly benefiting from the recent rise in world commodity prices. With New Zealand’s current account deficit sitting around 9 percent of GDP, it is our view that the exchange rate cannot be sustained at current levels over the medium term. Does trying to lower the New Zealand dollar run counter to monetary policy and the Reserve Bank’s low inflation objective? We do not believe so. Intervention is about seeking to moderate the trend in the exchange rate and rebalancing monetary policy pressure. It does not fundamentally alter monetary policy and does not signal a future easing of conditions. The direct liquidity impact of FX interventions is always offset via the Bank’s money market operations. The mechanics of foreign exchange market intervention are quite simple. The Reserve Bank acquires foreign currency reserves by selling New Zealand dollars. This activity may be limited by the amount of foreign reserves we are prepared to accumulate; but is not limited by the Bank’s ability to supply NZ dollars. In this sense, intervention to lower the NZ dollar is less restricted than in the reverse situation where intervention is working to support the NZ dollar by running down reserves. Many countries around the world have policies which allow foreign reserves to be built up as the exchange rate rises and reduced when their currencies come under pressure. Unlike many commercial traders, the Reserve Bank has the scope to hold additional foreign reserves for an indefinite period. When the exchange rate eventually falls to a more sustainable level, the holding of foreign reserves should become profitable as their value will increase in New Zealand dollar terms. Claims by some observers that the Bank has somehow “thrown away” taxpayers’ money by intervening simply do not stack up. FX intervention is a supplementary monetary policy tool and is considerably less potent than the central OCR instrument which has an important influence on the trend of the exchange rate. As noted in the Bank’s June Monetary Policy Statement, the outlook for the OCR will depend on how inflation pressures evolve over the months ahead. Evidence that inflation pressures are abating will be an important step in seeing the exchange rate return to more sustainable levels.
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A background paper by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Dr Chris Hunt, Economics Department, for an address by Dr Alan Bollard to the Canterbury Employers¿ Chamber of Commerce, Christchurch, 25 January 2008.
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Alan Bollard: Coping with shocks – a New Zealand perspective A background paper by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Dr Chris Hunt, Economics Department, for an address by Dr Alan Bollard to the Canterbury Employers’ Chamber of Commerce, Christchurch, 25 January 2008. * 1. * * Introduction All economies face “shocks” – unexpected events provoking some sort of response. Shocks affect households and firms at the micro level, and the path of economic growth and inflation at the macro level. For a small and open economy like New Zealand, many of the shocks shaping economic activity have an international dimension, and this turbulence is part and parcel of the economic landscape. New Zealand’s economic institutions and policymaking frameworks recognise this volatility, and over time, they have responded in a manner which has improved the overall resilience of the New Zealand economy to most shocks. Indeed, the last ten years has been a period of relatively stable inflation outcomes both in New Zealand and globally, due in no small manner to the efforts of monetary policy in pursuing the mandate of price stability. Fig 1: Price stability (5-year moving average of annual CPI inflation). Source: Statistics NZ & IMF. However, the challenges confronting a central bank in maintaining price stability in the face of shocks should not be understated. Real-time policy decisions are made in the context of a great deal of uncertainty about shocks. Firstly, shocks, by definition, are not foreseen. Secondly, the likely magnitude and effects of emerging shocks on inflation are often unclear. Moreover, economies are complex and dynamic systems in which the transmission of shocks can change over time. This is particularly relevant to international shocks and their effects on the New Zealand economy. Over the past decade the rapid industrialisation of China and other emerging markets has radically changed the structure of the global economy, as well as global inflation and growth dynamics. China’s thirst for raw materials, for example, has underpinned higher prices for oil and a number of non-fuel commodities. Moreover, globalisation – the “annihilation” of geographic distance through increasing trade and financial integration – has affected both the speed and strength with which international shocks hit the New Zealand economy. Recent financial market instability emanating from the US sub-prime housing market and percolating through to a wider range of financial markets is testimony to how a shock in one economy can quickly feed through to the other parts of the global economy. To date, monetary policy in New Zealand has been able to manage the many shocks that have occurred reasonably well. Inflation over the past decade has averaged 2.2 percent. However, over the past three to four years, inflation has tended to track in the top half of the Reserve Bank’s target range of 1 to 3 percent. This result reflects accumulated demand pressures in the late stages of an economic expansion, and also a number of supply-side cost shocks. 1 This paper discusses a number of these important demand and cost-side price shocks that monetary policy has had to deal with over the past five years, or that will pose key policy challenges going forward: • the surge in oil prices; • the more generalised commodity price boom; • the synchronised global housing market boom; • the shock to personal consumption from the run-down in household savings across the advanced economies, and; • efforts to mitigate the risks of climate change. These shocks are large. They also share an important international dimension – they are either sourced from abroad, or are local shocks experienced by a range of key economies across the globe. Before looking at these shocks individually, we will take a step back and examine how the macroeconomic impact of shocks has changed over time. This provides a useful backdrop to our consideration of the current crop of shocks. 2. Some stylised facts about shocks and economic volatility So what exactly do we mean by “shocks”? For our purposes, in an important sense, “shocks” are the essence of economic activity – shocks define the course of prices and output. Shocks can increase or decrease price pressures; shocks can boost or depress economic growth. A shock is a change in the economic environment in which agents – firms, households and governments – make their decisions. Shocks continuously hit the economy. 2 Shocks operate at many different levels. Shocks can originate from the actions of other economic agents or from the physical environment (e.g a natural disaster, drought etc). Some shocks may only have a marginal impact on economic behaviour in aggregate, while others have more pervasive macroeconomic consequences. Shocks can be short, sharp disturbances to economic activity which may dissipate quickly, while other shocks could be more enduring or permanent. The frequency of shocks can range from things that affect Inflation would have been higher over the period, were it not for exchange rate appreciation which has helped ease inflation pressures by acting to lower imported inflation. This appreciation is itself partly a function of higher short term interest rates required to dampen domestic inflation pressures. Relatively high interest rates in New Zealand have attracted foreign capital and increased demand for the NZD. Note, that while the term ‘shock’ is a useful heuristic to discuss the multitude of influences on economic activity, it is often difficult to neatly demarcate cause and effect. Some shocks may be genuinely ‘out of the blue’, while others may be the result of a complex interaction of other shocks. decision making on a daily basis, to longer term shocks, such as those associated with technological change. One way of looking at the impact of shocks to prices and output is through the volatility of inflation and economic growth, and how this has changed over time. The volatility of both inflation and growth has declined significantly since the 1970s – we now live it seems, in a more stable economic environment. This has been labelled the “Great Moderation” by economists. There is however, a variety of explanations as to why we seem to be living in a more stable economic environment. It could be luck, in the sense that there may be fewer major shocks buffeting the global economy (Stock and Watson 2002). However, as the IMF (2007) has recently emphasised, the decline in volatility is likely to be a result of more flexible economic institutions and macroeconomic policy, which now tend to act effectively to mitigate the shocks to prices and output, rather than inadvertently accentuating these shocks as at times in the past. 3 The volatility of inflation: The average rate of inflation in the advanced economies has remained low and stable since the early 1990s at between 2 and 3 percent (IMF 2006 April, p. 98). This is a reflection of the recognition of the deleterious effects of high and unstable inflation in the 1970s and 1980s, and of subsequent efforts by central banks across the world to achieve and maintain price stability. Central banks now target inflation outcomes, either as a primary objective (in inflation-targeting regimes such as New Zealand’s), or alongside other objectives (as in the case of the US Federal Reserve). This approach has been successful in keeping inflation outcomes within a narrow target range, resulting in lower inflation volatility (figure 2). Other explanations for the current period of low and stable inflation, aside from monetary policy, include the role of China and other emerging market economies in exporting cheap manufactured goods, thereby lowering imported inflation; the associated heightened state of global competition which has helped to contain cost pressures; and institutional and technological changes leading to greater flexibility in labour and product markets. See in particular chapter 5 of the IMF’s 2007 October World Economic Outlook (WEO), “The changing dynamics of the global business cycle”, for a discussion of how the current global expansion compares with those in the past. Fig 2: The decline in inflation volatility (rolling 5-year standard deviation of annual inflation). Source: RBNZ Calculations. The volatility of output: In New Zealand and most other developed countries, the volatility of output has declined from the 1970s onwards. That is, economic growth is more stable today than during the oil price disruptions and stop-go macroeconomic policies of the 1970s. 4 Economies are also spending less time in recessions, while expansions are longer. Indeed, the current economic expansion is New Zealand’s longest in the post-WWII period (figure 3). Economic growth in immediate post-WWII period was very volatile associated with the boom-bust of the Korean war and the rapid post-war reconstruction of Europe and Japan. Economic growth was more stable in the 1960s, only for volatility to increase dramatically in the 1970s. Fig 3: New Zealand’s Post-War economic expansions. Source: RBNZ Calculations. Figure 4 shows that although growth in New Zealand has become more stable over time, output volatility remains higher in New Zealand than elsewhere, reflecting the small and open nature of our economy and the relative impact of shocks to economic activity. 5 The IMF (2007) highlights the important role that better monetary policy has played in stabilising economic growth since the 1970s. Other factors contributing to this more stable growth outcome include improved fiscal policy, lower terms of trade shocks, and structural changes associated with the shift to a service sector economy, just-in-time inventory management techniques and more flexible labour and product markets. Some of these factors were, as noted above, also influential in reducing the volatility of inflation. The decline in country-level output volatility shown in figure 4 has been greater than the decline in output volatility measured at the aggregate global level. This is because globalisation – greater trade and financial openness – has also increased the ease and speed with which shocks are typically transmitted between economies, increasing the co-movement of output across countries. In the 1960s, with growth outcomes less correlated across countries, output fluctuations of individual countries tended to offset one another at the aggregate level. Fig 4: The decline in output volatility (rolling 10-year standard deviation of real GDP growth). Source: RBNZ Calculations; Datastream. Why is this Great Moderation in both prices and output important? There is a well-developed body of literature arguing that low and stable rates of inflation are beneficial for economic growth since such an environment provides greater certainty for households and firms to make decisions. There are also reasons why lower volatility in output may have positive effects on the underlying trend rate of growth of an economy – however, the evidence here is somewhat more circumspect than in the literature on the linkages between inflation volatility and economic growth. The reduced volatility in both prices and output should not be taken for granted. New Zealand knows only too well what happens when the “golden weather” comes to an abrupt end, as it did in the early 1970s. Back then, a terms of trade driven economic boom came to a halt following the collapse of our export prices, and the inflation shock associated with higher oil prices in the wake of the Yom Kippur War in 1973 and the formation of the oilproducing cartel OPEC. As a consequence, New Zealand entered a prolonged period of high inflation and low growth, which eventually precipitated a painful, but necessary period of major economic restructuring. The abrupt end to the price stability of the late 1960s and early 1970s provides a cautionary tale of “what can happen if policies do not respond to risks and new challenges in the global economic system as they arise” (IMF 2007, p. 67). Policymakers have to be alert to the nature of emerging shocks to the economy, and how they might threaten price stability. One should note also at this point that policy itself can be a source of shocks, as was the case in the 1970s and early 1980s when an inappropriate approach to monetary policy exacerbated the effects of the supply-side oil shock and contributed to the high and volatile inflation of that period. The present challenges to monetary policy derive, in part, from structural changes in the world economy and the concomitant role of emerging market economies in shaping global price dynamics. Emerging markets are also implicated in what, at first glance, might be thought of as purely domestic shocks such as the rundown in household savings and the housing boom in New Zealand. These shocks can be linked to “global excess liquidity” – or the easy credit conditions the global economy has enjoyed for much of the last five years. Emerging markets have helped sustain this excess liquidity via central bank reserve asset accumulation. The purchase of USD assets by emerging economies has helped keep US and global interest rates lower than otherwise would be the case. Finally, large, rapidly industrialising emerging economies such as China’s and India’s will be the dominant contributors to increases in greenhouse gas emissions in the near future. It must be said, however, that much of the damage from climate change is likely to be due to the build up in emissions to date, primarily from the advanced economies. 3. The oil shock The price of crude oil recently hit $100 a barrel in intraday trading, some $80 higher than at the start of 2002. This is close to the highest level ever recorded in real terms measured in US dollars (figure 5). 6 Traditionally, oil price spikes of this magnitude have tended to augur economic downturns, if not recessions. Oil is a key input into the production process, while households spend a significant fraction of their disposable income on petrol. Uncertainty about the future price of oil prompts households to consider delaying consumption on a range of other goods and services and firms to delay investment in major projects. An oil price spike therefore can have significant implications for both prices and economic activity. Fig 5: Real Oil Prices (West Texas Intermediate). Source: RBNZ Calculations; Datastream. In US dollars for West Texas Intermediate (WTI) crude oil. The price of oil has eased back somewhat and is currently around $90 a barrel. As Keith Sill of the Federal Reserve Bank of Philadelphia notes, five of the last seven US recessions have been preceded by an increase in the price of oil. 7 However, he also notes the power of oil price shocks in explaining economic recessions diminishes dramatically from the mid-1980s onwards. And indeed the global economy has appeared relatively immune to the current run-up in oil prices. This is mainly attributed to the fact that the recent oil price rise originates in strong growth in the demand for oil, rather than in supply disruptions of the sort underlying previous oil price spikes in 1973 and 1979-82. 8 Moreover, the world has become more efficient in using energy. For example, primary energy consumption has fallen from 11.3 percent of GDP in 1980 to 8.3 percent in 2005 across the OECD, while the share of oil in primary energy consumption has fallen from 55 percent to 41 percent. 9 Nevertheless, while robust global economic conditions and the rapid industrialisation of China and other emerging markets, together with a weak supply response, might largely explain the run up in oil prices, for oil importing countries like New Zealand, the current oil spike still represents a cost shock to the economy. The challenge for monetary policy is how to respond to a cost shock of this nature. Cost shocks, unlike demand shocks, move output and inflation in opposite directions, thus posing somewhat of a dilemma for policy. For example, policymakers could respond to an increase in headline inflation arising from higher oil prices by tightening policy firmly to slow the economy and reduce inflation. However, this strategy would also exacerbate the negative output effects of the shock itself. Another approach – the one adopted by the Reserve Bank – is to look through the first-round direct impacts of oil prices on CPI inflation (via retail petrol prices), but to respond to the risk of more generalised inflation pressures arising from the shock, such as rising inflation expectations. 10 Expectations effects might be associated with higher wage claims from workers in compensation for reduced real disposable income, or with a tendency for firms to build a margin for generalised inflation into their own prices. It is not necessarily a straightforward exercise to forecast what the generalised inflation pressures from any given cost shock might be. Reserve Bank calculations suggest that the direct effect on inflation from the oil price spike has so far been to add around 0.3 percentage points per annum to annual CPI inflation since 2004, when New Zealand petrol prices started to rise steeply. Indirect effects, for example through higher taxi charges, account for another 0.2 percentage points per annum. Survey measures of inflation expectations have also increased over this period, suggesting there may be expectations dynamics at work, though it is difficult to identify the specific oil price effects as distinct from the effects of the other shocks discussed below. 4. The non-fuel commodities boom The robust global demand that has underpinned higher oil prices has also contributed to a more generalised boom in commodity prices. This has been starkly evident in metals prices, which have increased 200 percent in nominal terms since early 2002 (based on the IMF’s Primary Commodity Price Index up to December 2007). Other non-fuel commodity prices have also increased, but not to the extent of metals prices. Food commodity prices have Interestingly Sill notes that oil price shocks do not have strong effects on inflation, a reflection of the fact that past oil price spikes have tended to be fairly temporary in nature. However, geopolitical instability and associated disruptions, together with refining capacity pressures, have certainly added a layer of supply-side concerns to the current spike. These statistics are taken from data from the US Energy Information Administration (EIA) website [www.eia.doe.gov]. The latter approach is consistent with clause 4(b) of the PTA, which cautions the Reserve Bank against inducing “unnecessary instability in output, interest rates and inflation”. increased 86 percent, and prices of agricultural raw materials (including timber, cotton, wool, rubber and hides) have increased a more modest 36 percent. 11 In real terms, non-fuel commodity prices remain well below historical peaks. For the past five decades most non-fuel commodity prices have fallen relative to consumer prices by an average of 1.6 percent per annum, reflecting large productivity gains in the metals and agricultural sectors relative to other parts of the economy (IMF 2006, October, p. 141). The driver of the current surge in nominal prices of non-fuel commodities has been increased demand from emerging markets, and in particular China, together with idiosyncratic supply side factors in particular commodity markets. According to the IMF (2006), China contributed 78 percent of the total world growth in metals consumption between 2002 and 2005. This compares with a contribution of 35 percent between 1993 and 2002. 12 China’s contribution to growth in demand for agricultural commodities has been no less impressive. Between 2002 and 2005 China contributed 103 percent of the total increase in world consumption of beef; 90 percent of growth in demand for cotton; and 26 percent of growth in sugar consumption. China’s demand for agricultural products has proven a boon for New Zealand’s dairy farmers in particular. Dairy prices, as measured by the ANZ Commodity Price Index, have increased 290 percent since mid 2002 in world price terms, and 150 percent in New Zealand dollar terms. Higher dairy prices are also related to higher fuel costs, as the development of alternative energy sources such as biofuels has increased the demand for corn. Corn is a major food source for livestock in the Northern Hemisphere. Switching land use towards corn production has probably also driven up the prices of other food commodities. Higher export prices have outweighed any negative effect on New Zealand’s terms of trade from the run-up in oil prices. Since late 2002 New Zealand’s terms of trade have increased 20 percent and are at their highest level since 1974. However, the current level of the terms of trade pales by comparison to the commodity price boom of the early 1970s, and the wool boom induced by the Korean War (figure 6). Note the IMF Commodities Indices obscure the impact of the non-fuel commodities price boom on New Zealand’s export prices, because the IMF Indices use a weight for dairy in their indices lower than the share of dairy in New Zealand’s commodity exports. See chapter 4 of the IMF’s 2006 September WEO, “The boom in nonfuel commodity prices: can it last?” for a discussion on the impact of Chinese demand on world prices. Fig 6: New Zealand’s terms of trade. Source: Statistics NZ. Nevertheless, the higher terms of trade are a significant development which brings with it an improvement in New Zealand’s economic welfare. However, by boosting export incomes, they could have an inflationary downstream effect, depending on the spending impacts of this windfall. Monetary policy will take into account the pressures on food price inflation arising from the boom in agricultural commodities, together with inflation pressures from other imported commodities. 13 As with the oil price shock, the appropriate monetary policy response is generally to look through the first-round effects, but respond to the second-round expectations consequences. Reserve Bank calculations suggest that the recent run-up in dairy prices and food prices more generally will add about 0.4 percentage points directly to the CPI over the next year. The inflationary effects from higher incomes (in the absence of a policy response) are likely to be at least three times the direct effects. 5. The global housing boom Since the late 1990s housing markets around the world have gone from strength to strength in both advanced and developing economies (key exceptions among advanced economies being Japan, Germany and Switzerland). Over the past decade, real house prices have grown 5.3 percent per year on average for advanced economies (Fitch Ratings, 2007). In New Zealand average annual real house price growth since the start of 1997 has been 5.7 percent. 14 Since food constitutes a greater share of the CPI basket of goods in emerging market and developing countries, the 1st-round pressures on monetary policy are likely to be more acute in those countries. Based on the QV Ltd nominal house price index deflated by CPI inflation. The current increase in global house prices is unprecedented in terms of its strength, synchronicity and duration. The global boom in housing markets is largely explicable by fairly benign financial conditions with low interest rates worldwide, together with financial liberalisation and deregulation which have increased the access to credit for most households (IMF 2007 October). Overlaying these common global drivers are factors specific to individual economies. In New Zealand’s case an important driver of the housing boom was the surge in immigration following the terrorist attacks of September 11, which came on top of an already strengthening domestic economy. Since 2001, nominal house prices have more than doubled, while real house prices have increased 85 percent. Concomitant with the run-up in house prices since 2001, the ratio of house prices to disposable income has also increased sharply over this period. The 2001 immigration shock specific to New Zealand accentuated developments common to other countries that experienced housing booms, such as lower real interest rates associated with lower inflation from the early 1990s onwards, financial deregulation that eased credit constraints for households, and sustained household income growth. In the New Zealand context, the specific tax treatment of rental housing may be an additional idiosyncratic factor influencing the demand for house and hence house prices. Fig 7: Real house prices in New Zealand. Source: Quotable Value Ltd. However, the increases in both nominal and real house prices seen recently are not unprecedented in New Zealand’s history. House prices surged in both the early 1970s and early 1980s (figure 7). However, the current cycle does stand out in the context of broader price stability in the inflation targeting era. Moreover, a key feature of the current housing cycle has been the extent to which New Zealand households have leveraged up in order to purchase their major asset. Household debt as a percentage of disposable income climbed sharply from 2001 onwards and now stands at 160 percent. This increase in debt levels and run-down in household savings does raise questions about the sustainability of the current high level of house prices. The question of what central banks should do about asset prices in the event that a “bubble” develops is somewhat of a vexed issue. The standard approach is not to target asset price inflation per se, but to respond to the generalised inflation pressures from the wealth effects that are associated with revaluations in the asset. If the bubble should burst, the central bank should stand ready to clean up the mess, by easing monetary policy and thereby stimulating demand. House prices are not included in the New Zealand CPI regimen. Rather, it is construction costs of new dwellings that is directly measured in the CPI basket. Construction costs have increased 37% since 2003, adding an estimated 0.5 percentage points per annum since 2003 to annual CPI inflation. 15 In the current cycle it has been the indirect effects of increasing house prices which have also been an important driver of inflation. In effect, households have been able to withdraw the increase in the equity of their house to finance consumption, by banking the capital gains when selling a house, or refinancing their mortgage. It is difficult to quantify these indirect wealth effects given their diffuse nature. However, they are likely to have been very significant. While the Reserve Bank has been responding to housing related inflation pressures, among other things, with increases in the OCR, monetary policy appears to have worked with a longer lag than usual, reflecting the role of low global interest rates that have influenced mortgage interest rates here in New Zealand, as well as competition among mortgage lenders. This has prompted discussion of possible alternative tools specifically directed at the housing market as a means to dampen inflation pressure from that source, alleviating pressure on short-term interest rates and therefore the exchange rate. 16 The extent to which the current run-up in house prices in New Zealand reflects fundamental drivers, versus a degree of irrational exuberance and a misperception on the part of households and investors about future house prices, will influence any subsequent downturn in the housing sector and have flow-on implications for economic activity. This concern is not limited to New Zealand. Traditional valuation metrics such as the ratio of house prices to income and of house prices to rents are looking increasingly stretched across a number of countries, raising fears of a possible sharp correction in house prices. Correction in the US housing market has been well underway for over a year now, while a number of European housing markets currently appear vulnerable to correction. 6. The personal consumption boom New Zealand’s strong economic growth performance over the past decade has been driven by a boost in personal consumption, which has sustained domestic demand and generated underlying inflation pressures. This strong personal consumption growth can be attributed, in part, to the propensity of New Zealand households to consume more out of their income than in the past. Indeed, New Zealand households have been consuming more than their income for many years. The household saving rate has been negative since the early 1990s, and strongly negative since 2002. Why have New Zealand households been able to run down their saving rate to the point of substantial dissaving? The answers echo the reasons identified in the previous section: lower Note the weight of construction costs in the CPI basket was reduced from 9 percent to 4.7 percent in the 2006 CPI Review. See the Reserve Bank’s submission to the FEC inquiry into the Future Monetary Policy Framework. interest rates which have enabled households to service a higher level of debt; financial innovation which has eased credit constraints; and generally buoyant employment conditions. 17 In terms of household balance sheets however, net wealth (the difference between assets and liabilities) has increased, despite the negative saving rate. This is because the revaluation on the asset side (the gain in house prices) has outweighed the increased borrowing secured on housing (the increase in household liabilities). New Zealand households are not alone in consuming more than they earn. Both in Australia and the US household saving rates are negative (figure 8). Household savings rates in other advanced economies are also falling, but are not yet negative. However, at -14.6 percent, New Zealand is clearly an outlier. The decline in household saving also accounts for a large part of the decline in total national saving (household + corporate + government savings) across the advanced economies. 18 Fig 8: Household saving rates (percent of disposable income). Source: OECD; Statistics NZ. To what extent is this ability to consume more out of income and the associated decline in the national saving rate sustainable? In one sense lower national saving implies lower standards of living in the future. At the moment, our national saving is lower than current investment, and the shortfall is funded by borrowing from overseas. 19 This situation is unlikely to persist indefinitely as the budget constraints on households will at some point start Another factor that could be influencing New Zealand household’s savings decision is the fact that government savings is strongly positive – household’s may feel they do not have to save as much for their future if the government is doing it for them. Advanced economies in general are currently saving too little relative to their current levels of investment. The flip side of this macroeconomic imbalance is that emerging market and developing economies are saving too much relative to their current investment levels. China and other emerging markets are essentially funding the consumption of consumers in the advanced economies. This is manifest in New Zealand’s large current account at -8.3 percent of GDP. to become binding, or if the terms at which foreigners lend to New Zealand become prohibitive. Monetary policy has had to deal with the inflation consequences of debt-financed consumption spending over the last decade. Reserve Bank calculations suggest that the increase in personal consumption could have contributed about 0.5 to 1 percentage points per annum to annual inflation from 2003. This includes the indirect wealth effects from house price gains mentioned in the previous section and the increased consumer spending from the run-down in household savings specifically, together with the healthy conditions in the labour market which have underpinned income growth. Looking ahead, as household spending growth moderates, demand-driven inflation pressure will abate. However, if this adjustment occurs abruptly, precipitated by a sharp fall in house prices or a sharp increase in unemployment for example, there may be financial stability issues. In this case it will be the systemic stability remit of the Reserve Bank, rather than monetary policy which will come into focus. 7. Climate change and the carbon emissions trading scheme Climate change arguably poses one of the most important policy challenges in the years ahead. There is now an emerging consensus that man-made climate change is occurring although its magnitude and ramifications are much debated. The emission of greenhouse gases is a global (negative) externality, where the cost of climate change is not borne fully by those emitting the gas. Being global in scope, there are major coordination challenges in bringing together countries to combat climate change. In addition, the benefits of mitigation efforts directed towards climate change are likely to accrue far into the future, while the costs have to be borne by current generations. Moreover, much of the damage will occur from the already accumulated stock of greenhouse gas emissions (mainly from the advanced economies), while it is the emerging market and developing countries that will contribute most to emissions in the future (figure 7). Fig 7: Carbon Emissions (millions of tonnes of carbon per year). Source: IMF WEO October 2007 Dataset. There are two broad approaches to dealing with this profound shock – adaptation and mitigation. Adaptation involves changing behaviour to reduce the economic and social impacts of climate change (e.g building flood defences, or planting more weather resistant crops). Mitigation involves actively reducing greenhouse gas emissions. And to overcome the free-rider problem implied by this negative externality there are two key policy approaches – taxes on greenhouse gas emissions, and emissions trading schemes. New Zealand, as part of its obligations under the Kyoto Protocol, has elected an emissions trading scheme. The scheme is designed to reduce annual greenhouse gas emissions from various sectors of the economy to 1990 levels over the 2008-2012 reference period. From 2008 the scheme will be phased in gradually for different sectors. For any producer/sector which emits more than its greenhouse gas allocation, additional emission units will have to be purchased, either from other producers or from overseas. Much of the cost of purchasing additional units will initially be borne by government, with the amount of government support varying by sector. From 2013 the amount of government support will progressively decline with assistance to be completely phased out by 2025. The phased introduction of the scheme implies higher prices for liquid fuel (from 2009) and electricity (from 2010). The Reserve Bank estimates that both the direct and indirect effects of these higher energy prices will add 0.25 percentage points to inflation in 2009 and 0.35 percentage points in 2010. 20 In addition to these first-round effects, there may well be second-round inflation expectations effects of the scheme. As with other cost shocks the Reserve Bank stands ready to respond to the more generalised inflation pressures from the scheme. However, the implications for monetary policy are somewhat clouded by the This assumes an emissions price of NZD 21 per tonne. See Box C in the December 2007 Monetary Policy Statement for details. magnitude and speed of any second-round effects, the price of emission units and the effect on economic activity. 8. Conclusion Over the past half decade demand-side inflation pressures in New Zealand have been significantly influenced by the shock to personal consumption from the run-down in the household saving rate, and the related increase in household net wealth from the housing boom. This has helped reinforce the underlying strength of the economy and associated pressure on resources. More recently, the increase in global dairy prices has added to these demand side pressures by boosting incomes at the farm gate. Increases in commodity prices such as oil and other imported raw materials have also added to inflation pressure by increasing the cost structure of the production process. The New Zealand government’s decision to adopt an emissions trading scheme as part of its Kyoto Protocol obligations will add additional cost pressures onto the economy over the coming years. To date, New Zealand has weathered these shocks reasonably well. Inflation remains low by historical standards, and within the mandate to keep future inflation between 1 to 3 percent, on average, over the medium term. But this relative stability should not be taken for granted. Good policy today does not necessarily guarantee good policy tomorrow, particularly when there is considerable uncertainty when confronting new shocks. New shocks can often necessitate new ways of confronting a dynamic economic landscape. Many of these new challenges and associated price pressures can be linked to the growing role of China and other emerging market economies. Globalisation and the increased interconnectedness this entails also implies that shocks to inflation (and economic growth) can be more easily and rapidly transmitted from place to place. Indeed, the on-going financial market turbulence that began last August is a timely reminder of both the interconnected world we live in, and how quickly events can unfold. What began as difficulties in the US housing sector and the associated securitisation of mortgage-backed financial products, has developed into a re-pricing of risk more generally, increased global financial market volatility and tighter credit conditions. Since the December Monetary Policy Statement there has been ongoing turbulence in international financial markets and a deterioration in the outlook for the United States and European economies. We will be watching these developments closely, particularly their implications for the Asian and Australian economies and for world commodity prices. At a structural level, financial globalisation also highlights the possible limits to conducting monetary policy in a small open economy such as ours – particularly when our business cycle is out of synch with the rest of the world. Relatively low global interest rates over the past five years have impacted on the transmission mechanism of monetary policy, essentially acting to delay the effects of Reserve Bank policy changes on household and firm behaviour, and ultimately on inflation. Both current and longer-term factors act to test the limits of our monetary policy framework on a regular basis. Nevertheless, New Zealand’s policy framework remains well within the norms of international central banking practice. Although there are, as always, challenges facing the conduct of monetary policy as we move forward, we are well-placed to take them on. References Fitch Ratings (2007) “House prices and household Debt – Where are the risks?” Special Report, 29 July. IMF (2007) World Economic Outlook, October. IMF (2006) World Economic Outlook, October. IMF (2006) World Economic Outlook, April. RBNZ (2007) Finance and Expenditure Select Committee Inquiry into the Future Monetary Policy Framework – Submission by the Reserve Bank of New Zealand, July. RBNZ (2007) Monetary Policy Statement, December. Sill, K. (2007) “The Macroeconomics of Oil Shocks” Philadelphia Federal Reserve Business Review Q1, p. 21-31. Stock, J. and M. Watson (2002) “Has the business cycle changed and why”, NBER Working Paper 9127.
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Remarks by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, at the International Symposium on "Globalisation, Inflation and Monetary Policy", organised by the Bank of France, Paris, 7 March 2008.
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Alan Bollard: Financial stability challenges for small open economies Remarks by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, at the International Symposium on “Globalisation, Inflation and Monetary Policy”, organised by the Bank of France, Paris, 7 March 2008. * * * Two asset prices that are of particular interest for policymakers in most small open economies are house prices and the exchange rate. Over the past decade, the “global savings glut”, declining interest rates and a search for yield drove up exchange rates for many small open economies such as Australia and New Zealand and also helped fuel a sharp increase in house prices in many countries. Recent developments in global markets stand to have further impacts on housing markets and exchanges rates and create some new challenges on both the monetary policy and financial stability fronts. The experience of the past decade is now doubtlessly familiar. The decline in interest rates was reinforced by the “great moderation” in the apparent variability of most economies. Investors became more willing to accept risk, partly in order to maintain returns as risk free interest rates dropped, and partly because the risks seemed smaller. From a monetary policy perspective, the past decade highlighted some of the challenges that we face in trying to run an independent monetary policy in a connected world. In targeting inflation, as many small open economies do, we set a domestic policy interest rate, which has some bearing on domestic monetary conditions. But domestic monetary conditions also hinge on what is happening to interest rates across the rest of the world. Sometimes global interest rate developments are “in sync” with domestic monetary policy and support it. At other times, they are “out of sync” and can work against it, making monetary policy spongier, and perhaps less effective at the margin than would otherwise be the case. At times over the past decade, monetary policy in New Zealand and some other smaller open economies had to contend with global interest rates that were considerably lower than domestic economic conditions would warrant. Financial institutions in these countries were able to access cheaper funding than they could obtain domestically, exchange rates rose to uncomfortable levels on the back of the carry trade and some asset markets – such as housing – were able to surge on the back of lower effective interest rates than domestic policy settings might suggest. A strong element of the capital flow into New Zealand – and this is a financial innovation, though now a relatively old one – has been the issuing of fixed income NZ Dollar securities to international retail investors by very high quality international names such as the World Bank. The willingness of these investors to take NZ Dollar risk at elevated currency levels has helped keep the currency relatively high and short term interest rates a bit lower than would otherwise have been the case. This has been far from an ideal mix of monetary conditions at a time when most of the inflation pressures have been concentrated in interest rate sensitive sectors like the housing market. The possibility of collateral damage on the country’s tradable sector has to be taken seriously. In New Zealand, we have done significant work, documented in a number of studies on our website, on whether there might be additional regulatory measures or other policies that may have helped adjust the balance of monetary policy pressure to better match the underlying inflation pressure. It will not surprise anyone in this room to know we have not found a “silver bullet”, although analysis continues. Besides retail investors, we have also seen the presence of institutions such as hedge funds engaged in the “carry” of funds borrowed in low yielding markets to invest in markets like New Zealand. An unresolved debate is whether these hedge funds actually provide additional market liquidity for smaller economies or whether they effectively soak it up – particularly in troubled times. The role that these hedge funds can play at the stage where an over-valued exchange rate begins to adjust back to a more normal level is also unclear. Whether hedge funds assist the adjustment process or whether they make it more abrupt and costly, is debatable. Many countries have seen pronounced strength in property markets over the past decade. Strong residential property markets have often gone hand in hand with strong consumer spending. New Zealand has been a leading example. House prices have risen substantially as a ratio to income over the past five years. As longer term interest rates have risen recently in New Zealand, and housing turnover has slowed, the elevated level of house prices has looked increasingly unsustainable. One interpretation of recent housing cycles is that a “glut of capital” lowered interest rates and putting upward pressure on house prices, creating a persistent tail wind for some economies. As houses change hands and are more heavily borrowed against, equity is withdrawn by the seller, who may often choose to spend the money. This has helped to keep demand very robust in New Zealand for a number of years and seems to have supported consumer spending as well. With recent developments in global finance markets, we now seem to be moving into a new era and policymakers are facing some new challenges on both the monetary policy and financial stability fronts. We are only just beginning to understand what is prompting such a marked shift away from risk taking and the pursuit of yield to heightened risk aversion. A ready pool of investors and an appetite for risk appears to have encouraged substantial financial innovations and the creation of a new set of financial instruments, some of which ultimately proved to be a lot riskier than they initially seemed. Much of this activity was concentrated in the US. The creation of these instruments involved the following elements which I only mention here, but are likely to be worthy of further study and analysis in years to come: • Origination of credit on riskier terms. A clear example is the covenant-lite debt that private equity firms were able to obtain until 2007, and the increased flow of mortgage lending in the US that would previously not have occurred. • Contracting out of origination, and securitisation of the completed loan, both of which have at least the potential to create moral hazard. • Pooling of risk and assumptions about correlation which were based on historical data but did not always prove accurate ex post. • Credit guarantees, often from the so-called “Monoline” insurers. • The use of conduits by financial institutions to expand credit creation and asset holdings above and beyond the usual balance sheet constraints. • A relatively relaxed approach to liquidity risk, with an implicit assumption that wholesale funding was not at risk – as seen in the Northern Rock case, for example. These events are having important implications for smaller open economies, including New Zealand, Australia and the economies of Scandinavia and Eastern Europe which have a substantial reliance on the international capital markets. Most of these countries have not been very directly affected by the problems arising from the complex innovations described above. In New Zealand, for example, we have not really seen the development of any of the complex financial instruments at the heart of the US’s current financial problems. However, as a net borrower and a participant in international markets, New Zealand is certainly affected by the sharp changes in interest rates, credit spreads and exchange rates that have occurred as a result of recent developments. We are currently seeing increased funding costs in global markets for reasons that are largely not of our own making. We currently face something of a mixed bag at present in terms of global interest rates. At one level, a loosening in monetary policy in the US and some other countries is putting downward pressure on medium to longer-term interest rates. For those smaller economies like New Zealand and Australia which are facing relatively strong inflation pressures at present, that would ordinarily make the monetary policy challenge harder. On the other hand, higher credit spreads are actually increasing the effective cost of funds for many of our financial institutions and businesses accessing funds through the global capital markets. So we actually face some quite difficult judgements in assessing how policy settings and global conditions will affect domestic economic activity and inflation in the months ahead. Despite increased global risk aversion, it is not yet evident that the carry trade is dead. We have still seen a relatively strong issuance in the New Zealand dollar in recent months via Uridashi bonds for example. The New Zealand dollar remains at relatively high levels and has recently been at a post-float high against the US dollar, albeit largely reflecting the weakness in the US dollar itself. However, as one might well expect, exchange rate volatility has been high of late and there is perhaps more than the usual uncertainty around the likely path of the exchange rate over the months ahead. With banks’ funding costs on the rise, mortgage rates have been increasing in New Zealand and Australia and in some other small open economies recently. This occurs at a time when New Zealand’s housing market is already slowing due to the effects of past policy tightening. Whilst we are projecting the housing slowdown to be of the soft landing variety, there is obviously some risk of a more pronounced slowdown. History shows us that either scenario can happen. Clearly, the path of global interest rates from here on will have some bearing, given their influence on bank funding costs. Of course, monetary policy is not our only focus. Global market developments also have important ramifications for financial system stability in smaller open economies. The banks in many of these countries are net borrowers in global markets, New Zealand and Australia being two examples. Recent events have highlighted some risks and vulnerability that institutions and regulators need to ensure are properly managed. We always used to talk about these risks but they have come into sharper focus. Our institutions need to be able to cope with sharp changes in the cost of funds in the global market place. But as we saw in July last year, we also need to confront the possibility that global funds may not always be as readily available as we perhaps used to think. Financial market liquidity policies and the management of funding by financial institutions are two areas that are likely to receive considerable policy attention in many countries over the coming months. Specifically, I note a very timely and comprehensive analysis of liquidity issues was prepared in a Special Financial Stability Review by the Bank of France in February. In New Zealand, we have also been keenly aware of the liquidity risks that recent events have demonstrated. Banks have had an important role intermediating capital account flows into New Zealand (and Australia), and have accepted a significant amount of short term capital flows in order to minimise funding costs. We want to look at whether the vulnerabilities that this can create have been adequately priced and managed – noting that some of the costs of a liquidity event are probably externalities that would ultimately be borne by other New Zealand parties. Breakdown of short term lending markets is one specific challenge we would expect to confront if the financial stability situation deteriorates markedly further in one or more of the major advanced economies. There will doubtless be other flow-on effects as well. Like the transmission of subprime issues to monolines and seemingly unrelated markets, many of these flow-on effects could surprise us. However, the potential for a deterioration in financial stability to further intensify risk aversion seems significant. For countries like New Zealand with substantial borrowing from abroad this could clearly have an impact on our cost of funds and/or our access to funds in some global financial markets.
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, at a private function, Auckland, 30 July 2008.
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Alan Bollard: Flexibility and the limits to inflation targeting Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, at a private function, Auckland, 30 July 2008. * * * Introduction The New Zealand economy, like many others around the world, is going through a tough time. The cost of living is rising and there is a risk of persistent inflation emerging. However, there is also a broad and quite rapid slowing underway in retail spending and the housing market. The extraordinarily large and persistent rise in international oil prices has made New Zealand poorer – it now costs us more to produce and to consume, and the economy needs to adjust to that. This is a difficult combination of influences not seen since the oil shocks of the 1970s. On the positive side, food commodity prices are also generally going up and this has benefited our dairy sector in particular. There is some evidence that international meat prices are now on the move upwards also. To add complication, financial markets and banking systems around the world remain very unsettled. Credit markets worldwide began malfunctioning following the US subprime crisis, and have not yet returned to normal. Risk aversion remains widespread. Indeed, some people think the credit situation will get worse before it gets better. The New Zealand dollar exchange rate has fallen somewhat in response to these domestic and international pressures. On a trade-weighted basis, the exchange rate remains at high levels, but there are big differences in the level of the dollar against particular currencies. We are at historical highs against the US dollar and the Japanese yen, but well below average against the Australian dollar – and almost exactly historically “normal” against the euro and the British pound. These are strong influences, and they tug in many different directions. Through all this, the Reserve Bank’s task of maintaining price stability is a difficult one. Many other central banks are facing similar challenges. In New Zealand we are arguably starting from a relatively good position, in that interest rates have been at firm levels and restraining inflation pressure for some time, and have room to fall in response to the weakening economy and abatement of the inflation pressure. For some other countries, growth is set to weaken markedly while inflation concerns remain, but real interest rates are already low or negative. In this speech, I would like to put current circumstances in the context of the internationally accepted inflation-targeting framework for monetary policy, as applied in New Zealand. I want to ask the question: although the framework has stood the test of time – almost twenty years and counting – is it up to the challenges we face now? I will start by affirming that price stability is the best contribution monetary policy can make to economic growth and prosperity. Overall macroeconomic stability, however, also depends on a sound overall government policy framework that does not itself contribute to economic fluctuations. It also depends strongly on what is happening beyond our borders, with foreign demand and foreign interest rates. And, this is one of those times that shows that the New Zealand economy is subject to powerful external forces. Monetary policy can only do so much. The challenge for us is to be flexible in buffering these forces as they hit the economy, without undermining public confidence in our commitment to price stability. In some cases – such as the rise in oil prices – we need to make difficult judgements about how best to look through unavoidable nearterm inflation spikes, while ensuring that inflation returns to target over the medium term. All of this is consistent with and envisaged by the Policy Targets Agreement. I’m going to conclude that the framework does work relatively well, and is the best approach we and many others have yet found, among a limited number of viable alternatives. Of course, we continue to seek improvements to it. But overall, although current circumstances are indeed very difficult, the framework, and our interest rate decisions to date, position us well to take on the difficult challenges that we face in the years ahead. Back to basics: the role of price stability in macroeconomic policy It is now universally accepted that price stability is a cornerstone of modern, well-functioning economies. Inflation is costly in a social justice sense, because it arbitrarily redistributes wealth among different groups in society. Not only does inflation blunt the link between effort and reward, it typically hits hardest those who can least afford it. Inflation is also costly because it obscures the relative price signals that must come through clearly if the economy is to adapt to change and make the most of opportunities for growth. At present, high oil prices should be encouraging energy efficiency and alternative fuels development. High dairy prices should shift land use towards dairy production. An environment of stability in the general level of prices helps these signals come through so that the right consumption, investment and other business decisions are made. It is also generally accepted that maintaining price stability is the best contribution that monetary policy can make to help an economy realise its maximum sustainable growth rate. The maximum rate itself depends on the microeconomic decisions of individual households, businesses, savers and investors responding to myriad price signals and opportunities for technological improvement. Good monetary policy is about promoting, through price stability, a stable background for these decisions. Other elements of economic policy that also contribute to good decision making and stability include fiscal prudence, the rule of law, and a regulatory framework that does not introduce economic distortions. Wide-ranging evidence and research in New Zealand and abroad establishes three key lessons about the interaction of growth and inflation. First, that there are many determinants of the long-run level of economic growth. The level of inflation (let alone inflation targeting) is not the only thing that matters. Second, to try persistently to promote growth with loose monetary policy will in all likelihood simply generate a higher level of inflation, which will damage growth prospects in the long term. Third, a monetary policy that loses sight of the importance of price stability will probably contribute to large economic cycles, as inflation gets out of hand and then needs to be reined in with an economic crunch. Figures 1 and 2 show that New Zealand actually illustrates the second lesson most clearly, compared to many other countries. In our case, lower inflation has been associated with a higher level of GDP growth per capita. We should not forget that this decade we have enjoyed the longest stretch of continuous growth since comparable records began. The figures show the experience of a number of other OECD countries in reducing inflation from the high levels of the 1970s and 1980s to the low levels of the past couple of decades. All except the US and Japan have followed New Zealand in becoming inflation targeters. That the determinants of growth are complex is illustrated by Australia, the UK and Sweden lowering their levels of inflation without much difference in growth, and US and Canada having lower growth in the low inflation period. Japan had much lower growth in the low inflation period, but this reflects that Japan’s low inflation period was one where the Japanese central bank was persistently but unsuccessfully trying to stimulate the economy, rather than a deliberate effort to hold inflation very close to zero. Figure 1. Inflation and average GDP growth per capita, selected OECD countries Sources: Statistics NZ, DataStream, Statistics Sweden, Government of Japan Cabinet Office. Country key: AU Australia, CAN Canada, JAP Japan, NZ New Zealand, UK United Kingdom, US United States, SWE Sweden. As for growth volatility, in all cases except Sweden, lower inflation has been associated with less volatile per capita growth performance – though the difference is only slight in New Zealand’s case (Figure 2). Figure 2. Inflation and volatility of GDP growth per capita, selected OECD countries Sources: Statistics NZ, DataStream, Statistics Sweden, Government of Japan Cabinet Office. Country key: AU Australia, CAN Canada, JAP Japan, NZ New Zealand, UK United Kingdom, US United States, SWE Sweden. The international inflation-targeting framework, New Zealand style A target in terms of the rate of CPI inflation is now a mainstream way of expressing a commitment to price stability in terms of a measurable statistic. In fact, inflation targeting is one of New Zealand’s successful exports. Since New Zealand’s adoption of inflation targeting following the Reserve Bank of New Zealand Act 1989 (the Act), over 20 countries have followed. 1 Some of these are shown in Figure 3. Many of those who began inflation targeting relatively early are, like New Zealand, open economies with floating exchange rates. Quite a few of them are also, like us, small and strongly influenced by the prices of commodities on international markets. The list includes both developed economies and emerging economies, from the West and from the East. This long, growing and diverse list of economies suggests strongly that inflation targeting is a monetary policy strategy that can handle a wide range of circumstances and shocks. Figure 3. CPI inflation target ranges, selected countries with date of commencement of inflation targeting Sources: Roger and Stone (2005), ECB. The ECB’s target is specified as below, but close to, 2 percent. In our case, Parliament has defined in the Act the framework within which the Reserve Bank must target inflation. As is well known, the Act specifies that maintaining price stability is the Reserve Bank’s primary function (section 8). The Act also makes the Reserve Bank operationally independent, but accountable to Parliament and the general public for its operations in pursuit of price stability. Finally, the Act provides for the specific policy target to be negotiated between the Governor and the Minister of Finance (effectively on behalf of Cabinet). This, of course, is the familiar Policy Targets Agreement (PTA). The Board of the Reserve Bank and Parliament’s Finance and Expenditure Select Committee have the formal Roger and Stone (2005) provide a comprehensive review of the international experience of inflation targeting. responsibility for regularly monitoring and evaluating the Reserve Bank’s and Governor’s monetary policy performance. Of course, we are also informally evaluated by the financial markets, and by everyone else with an interest in monetary policy, on a continuous basis. Although inflation-targeting countries differ somewhat in their implementation details, the key elements of an inflation target plus independence plus accountability are widely accepted. Even non-inflation-targeting countries, such as the US and Japan, have independence and accountability arrangements that result in their central banks interacting with the public and financial markets in much the same way as in New Zealand. We all regularly review and document the economic outlook, adjust interest rates accordingly, and appear before our empowering legislatures to explain these interest rate decisions and how we intend to ensure that inflation evolves consistent with our targets. All of this activity reflects that inflation targeting in practice is not as simple as just a target number for CPI inflation, with interest rates going up when inflation goes up and down when inflation goes down. Considerable analysis is involved in deciding when and by how much to move interest rates in response to the forces influencing the economy. We make choices and judgements about the path of inflation we will aim for over the medium term, and what risks need to be taken into account. The judgements are complicated by the lags with which monetary policy acts on the economy, and the uncertainty involved in forecasting. All central banks are keenly aware of the interaction between monetary policy and output, interest rate and exchange rate volatility. Good monetary policy means being flexible about responding to price and demand pressures in that light. We place a lot of importance on explaining how we intend to use this flexibility, setting out our analysis and assumptions so that others may evaluate our performance. This is for two reasons. First, they are what a public agency should do in a democratic society. Second, and just as importantly, regular explanation and clear resolve about price stability help ensure that the public’s inflation expectations remain “anchored” – that is, consistent with ongoing price stability. Anchored expectations make the job of monetary policy easier, and create the room to be flexible in accepting fluctuations in the actual inflation rate. With anchored expectations, such fluctuations will not undermine public confidence that price stability will be maintained over the medium term. In our case, the numerical target itself, “future CPI inflation outcomes between 1 percent and 3 percent on average over the medium term”, incorporates flexibility. The “medium term” is not formally defined, but we normally aim to ensure inflation is within the range in the second half of a three-year forecast horizon. Other PTA clauses reinforce the flexible approach. Clause 2(a) requires the Reserve Bank to monitor a range of prices. This explicitly ensures that the reference to the CPI does not blinker our view of inflation pressure in the economy – we should “look at everything”. The use of the CPI reflects that it is readily accessible and understood, and calculated by an independent agency (Statistics New Zealand). Clause 3(a) recognises that specific prices, such as oil and food currently, will sometimes move a lot, causing CPI inflation to move temporarily away from the target. However, Clause 3(b) then says that these circumstances are not reasons to lose sight of the medium term inflation target. Finally, Clause 4(b) requires that in pursuing the target the Reserve Bank should avoid unnecessary volatility in output, interest rates and the exchange rate. Through these clauses, the PTA provides guidance both to the Reserve Bank and to the general public about what flexibility means. Among other things, it means that we should not be “trigger happy” in responding to new events, but should use the full width of the target range, in light of the particular shocks that arise. In the absence of a PTA we would take this approach anyway, because it is good monetary policy practice, but having the PTA express it explicitly is helpful from an expectations point of view. As Figure 3 shows, all inflation-targeting central banks in developed countries tend to cluster around a fairly narrow range of target numbers very similar to New Zealand’s (emerging economies tend to have slightly higher ranges). The lower bound of 1 percent is there because of the danger of deflation, while the upper bound reflects the evidence that sustained inflation above around 3 percent hurts growth. Alan Greenspan said that price stability exists when people do not factor inflation into their decisionmaking, and research evidence suggests that a numerical target below 3 percent accords well with this idea. The success in reducing inflation around the world (using inflation targets or otherwise) is probably not all due to better monetary policy, though the evidence suggests that monetary policy played no small part. Beneficial circumstances, including the long period of strong productivity growth in Asia and resulting falling prices of Asia’s exported manufactured goods, no doubt helped. Institutional features such as the exact specification of targets probably matter much less than the good conduct of monetary policy – that is, the appropriate use of flexibility. Dealing with large shocks: flexible inflation targeting in practice Flexibility requires difficult, but unavoidable, judgements about how best to respond to economic developments as they unfold, but without jeopardising medium-term price stability. Shocks can be big or small, and of a variety of types demanding different treatment. The structure and behaviour of the economy changes, and people learn, over time. Some types of behaviour, such as housing and asset price cycles, can be quite destabilising, in that they tend to generate boom-crash dynamics. As a result, interest rates move, sometimes by a lot. This is true not just in New Zealand but in other developed economies (inflation targeters and otherwise). Different economies face different pressures at different times, and targets are specified a little differently, but the swings in policy rates over time are similarly large across a diverse range of countries. For example, over this decade to date, the US policy rate fell 6½ percentage points between 2000 and 2004, then rose more than 4 percentage points between 2004 and 2007, and fell again by more than 3 percentage points through to this year. Unpredicted and temporary price shocks are relatively easy for monetary policy to deal with. By definition, they happen too quickly to respond to anyway, and their short duration lessens the risk that they will destabilise the economy. An example is a sharp rise in fresh vegetable prices due to bad weather, that everyone reasonably expects to be reversed when the weather improves. We look through such shocks, consistent with the PTA’s focus on the medium term. When a shock is persistent, or forecast to evolve over a long period of time (say years), it is much more difficult to judge the appropriate response. A very good current example is oil prices. Over the past four years or so, international oil prices in US dollar terms have quadrupled. Consensus forecasts have consistently failed over this time to give any hint this might happen, as can be seen in Figure 4. Though the rising New Zealand dollar over this period has offset the impact on local prices a bit, the impact of the oil price shock on CPI inflation over this time is clear, and it accounts for a large part of why CPI inflation is where it is today. Figure 4. International oil prices and Consensus projections Sources: Datastream, Consensus Economics Inc. Projections are as at June of the year indicated. In these circumstances, we have real choices about how to respond. We can either let any further anticipated direct inflation consequences of the shock come through, or try to offset them with tighter policy than otherwise. The PTA does not explicitly address long-lasting shocks, but as noted before, it does provide sufficient guidance and scope for the Reserve Bank to take a sensibly flexible approach. The basic approach of looking through the near-term, unexpected inflation impact is the same. However, the key judgement with this kind of persistent, high-profile shock is about the heightened risk that the period of elevated headline CPI inflation might lead the public to question the Reserve Bank’s commitment to the medium term inflation target, and plan and act on the basis of a higher expected inflation rate. Getting inflation expectations down again can be very costly, as shown by New Zealand’s own economic history – let alone the history of countries that have experienced hyperinflation such as the Weimar Republic in the 1920s, Argentina in the 1980s and Zimbabwe currently. Figure 5. CPI inflation and inflation expectations Sources: Statistics NZ, RBNZ. There is thus much less scope to be sanguine about long-lasting price shocks compared to sudden and ephemeral shocks, because the risk is greater that inflation expectations could drift away from the target range. Currently, inflation expectations appear to remain anchored at a level consistent with the target range, though there is a slight upward drift, apparently reflecting the sustained elevation of headline inflation (Figure 5). The key requirement in this sort of situation is that policy is kept tight enough to ensure that inflation expectations remain anchored. Sustained oil price inflation is just one stark example of a shock that might persist for some time. There are actually two other large and sustained shocks all at work on the New Zealand economy at the moment: a retrenching housing market after the biggest housing boom ever, and very strong dairy prices. Also, very large increases in other commodity prices such as steel and fertiliser, while having a smaller direct effect on CPI, have had a substantial impact on business costs in some sectors. The appropriate response to the housing market downturn is fairly straightforward, because it is a demand-driven shock. With weak domestic spending, loosening policy to bring demand closer to the economy’s supply capacity is also consistent with keeping future inflation on target. The dairy price shock is more difficult, as it combines a positive stimulus to demand (increased income for dairy farmers and associated industries) with a negative stimulus (the reduction in real household disposable income due to rising prices of dairy products). We need to judge the net effect on demand, and account for the upward risk to inflation expectations from the price increase itself. A complication is that the exchange rate will tend to move in response to the terms of trade effects of the dairy price movement, and spread its impact further around the economy. The oil price shock is of the most difficult type. For a net oil importer such as New Zealand, it reduces disposable incomes and demand (suggesting looser policy is appropriate), but also has a direct upward impact on inflation and presents upward inflation expectations risks (suggesting tighter policy is appropriate). The exchange rate will respond to the terms of trade movement in this case also. The overall impact of this mixture of large shocks of different types produces the complicated picture we have at present. Demand is weak, but the economy’s supply capacity is under pressure from higher oil and other input prices. On top of these movements in the supplydemand balance, prices are rising. The overall adverse movement in the terms of trade as oil prices have continued to rise, while dairy prices have at least paused, leaves New Zealand poorer. Adjustment to the relative price shock, which in this case is sourced from the fundamentals of supply and demand in international markets, has to occur through a combination of lower real wages and lower real profit margins. It does not make sense for the Reserve Bank to try to prevent this adjustment. Instead, the key policy requirement in this situation is to allow the initial externally driven relative price changes to occur, but keep monetary policy sufficiently firm to ensure that generalised second-round inflation effects do not take hold – in other words, to keep inflation expectations anchored. We are already starting from a position of high real interest rates in New Zealand, reflecting the need to restrain inflation pressure that has built up in recent years. Indeed, current headline inflation remains above the target range of 1 to 3 percent (though CPI excluding food and energy prices is rather lower). However, our judgement at this stage is that the contractionary effects of the housing downturn, high oil prices and the global credit crunch will substantially outweigh the stimulus from high export prices and projected expansionary fiscal policy. We have thus adopted an easing bias in our monetary policy stance. Our judgement is that the weakness in the economy will be sufficient to bring inflation, and inflation expectations, down over the medium term consistent with the target range. Our starting position is arguably more favourable than that of other economies, in the sense that there is plenty of room for our projected easing in interest rates as the economy and the existing inflation pressure weaken. Most developed economies are facing much the same, very uncomfortable, combination of slowing growth in the presence of rising inflation pressure, but some are still running very low or negative real interest rates. For the year to June, the US reported 5 percent inflation, Australia 4.5 percent, the euro zone 4 percent, and the UK 3.8 percent. The Governor of the Bank of England recently had to write to the UK Chancellor explaining a departure from the Bank of England’s target range, making very similar arguments to the ones we have been using for treatment of oil and food price shocks, and warning that worse is to come. To make things worse, for this group of countries and some other developed countries, growth over the next couple of years looks likely to run one or two percentage points below where it has been in the past few years (Figure 6). Figure 6. Inflation and growth outlook, selected developed countries Sources: Statistics NZ, DataStream, Statistics Sweden, Government of Japan Cabinet Office, Consensus Economics Inc. Country key: AU Australia, CAN Canada, JAP Japan, NZ New Zealand, UK United Kingdom, US United States, SWE Sweden. In some Asian countries, the situation is very difficult indeed, where food in particular forms a much larger proportion of the consumption basket. Singapore’s and China’s inflation rates are both above 7 percent, and their real interest rates are negative – but monetary tightening is constrained by exchange rate considerations. For the countries shown in Figure 7, the movement towards high inflation with low growth is quite marked. Figure 7. Inflation and growth outlook, selected Asian countries Sources: Datastream, Consensus Economics Inc. Country key: CH China, HK Hong Kong, KR Korea, MLY Malaysia, SNG Singapore. The challenges for inflation targeting Independence and accountability arrangements for central banking have an unattractive flipside in that they can lead to heightened expectations of what monetary policy is actually able to achieve. Inflation targeting is not an elixir for stabilisation. The current very large international forces remind us that small economies like New Zealand are especially dependent on developments offshore. This decade, the New Zealand dollar has been very strong, materially complicating monetary policy – due partly to the sizeable gaps that opened up at various times between our interest rates and those in some other countries, including Japan, the US and Switzerland. Rising commodity export prices have also played a role. There is little we can do about other countries’ interest rates or international commodity markets. To state the obvious, we run New Zealand’s monetary policy according to New Zealand economic conditions, and other central banks run their monetary policies according to their own economic conditions. The Australian dollar has also strengthened markedly in the past two or three years, largely reflecting similar factors. Dealing with asset price cycles and their consequences for price stability is another issue that central bankers across the world are grappling with. Housing market booms occurred this decade not only in New Zealand, but also the UK, Australia and the US. The aftermath of these booms is still playing out currently in New Zealand, the UK and the US at least. On the positive side, there are things that can be done to enhance the environment within which monetary policy operates. These include a wider government policy framework that at least does not contribute to the cyclicality of the economy, and to the tendency for inflation shocks to become entrenched. Even better are government policies that reduce cyclicality – such as the well-known “automatic stabiliser” features of well-designed fiscal policy frameworks. Although economic stabilisation is not the primary motivation for these other policy areas, we do work with other government agencies to try to enhance the stabilisation properties of government policy where possible, including reducing structural distortions that tend to generate economic cycles. These issues motivate us to continue to look for other instruments that might support the OCR as tools to promote macroeconomic stability. We also look forward to the findings of the Finance and Expenditure Select Committee’s Inquiry into the Future Monetary Policy Framework. In both the Supplementary Stabilisation Instruments work we did in 2006 and in our submission to the FEC’s Inquiry, we reported that there did not appear to be any magic bullets among the range of potential instruments considered. Having said that, we did find that certain adjustments to tax and other regulatory structures might reduce their contribution to the cyclicality of the economy. Analysis of the other instruments and approaches suggested they would be either ineffective in the long run, or would introduce large economic distortions. As noted earlier, the differences in central bank mandates, inflation targeting frameworks and monetary policy conduct across countries are not large enough to explain the differences in long-run growth performance we observe. Savings, investment and average interest rate patterns reflect the long-running fact that New Zealanders remain willing to borrow and spend at much higher interest rates than those prevailing in other countries. Conducive policy frameworks, including sound monetary policy, help maximise long run growth performance and prosperity – however, what is also needed is savings and investment behaviour geared towards growth. Despite spending time looking, we have found no clearly superior alternatives to the flexible inflation targeting approach to maintaining price stability. Such things as monetary targeting and fixed exchange rates have been tried before in New Zealand, as in other countries that are now inflation targeters. Both monetary and exchange rate targeting regimes tend to be very inflexible. They require the burden of many types of shocks to be forced through output, rather than absorbed by the policy instrument itself, and tend to be most suitable for situations where inflation expectations are poorly anchored and the commitment of the central bank to price stability is doubted by the public. Another alternative that could appear superficially attractive is to require monetary policy to target multiple objectives such as growth, employment, export and the balance of payments. This was the approach taken in New Zealand and many other countries in the post-war period up to the early 1980s. It inevitably had a short-term focus, and resulted in stop-go policies and high inflation. We now know that one instrument cannot succeed in achieving multiple objectives over the cycle. The move to inflation targeting, with its single, clear objective, resulted from the lessons learned in that period. We do not want to re-learn those lessons. Conclusions Monetary policy – day to day, month to month and year to year – is about balancing judgements in an uncertain world. It is not a precise tool. Times like the present are particularly challenging, when there are large and persistent shocks on both the demand and the supply sides of the economy. Nevertheless, we believe the inflation targeting framework provides us sufficient flexibility to deal with the short-term consequences of shocks, without losing sight of the essential medium-term inflation objective. The New Zealand framework and approach is very much like that used in other economies. The next few years will not be easy, but I believe that the framework is the best available, and that the Reserve Bank is up to the challenge of applying it flexibly. Overall, the framework has been relatively successful. Despite the current shocks we are going through, we expect inflation and inflation expectations over the medium term to be within the target band. The public expects us to meet our target, and this helps to keep expectations anchored. Very few of the countries who have adopted inflation targeting have given it up. Alternatives that dilute the focus on medium term inflation and price stability could seriously threaten the anchoring of inflation expectations and damage the credibility of the New Zealand macroeconomic policy framework, especially in the current environment of high rates of headline inflation and strong forces on the economy. References Roger, S and M Stone (2005) “On target? The international experience with achieving inflation targets”, IMF Working Paper WP/05/163.
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Wellington Chamber of Commerce, Wellington, 10 December 2008.
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Alan Bollard: Everyone needs to play their part – inflation and recession in the New Zealand economy Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Wellington Chamber of Commerce, Wellington, 10 December 2008. * * * The world economy faces some significant challenges. Finance markets have been going through turmoil, the pace of global expansion has slowed abruptly, and policymakers have focused on preventing a more pronounced slowdown. For some commentators, concerns over inflation appear to have taken a back seat, for now at least. As the global economy has weakened, commodity prices have fallen, substantially in some cases. Many commentators are of the view that lower commodity prices and weak economic activity will drive inflation significantly lower. It is worth remembering that for the moment, however, inflation rates in New Zealand (and many of our trading partners) remain very high. In the September 2008 year CPI inflation reached 5.1 percent, the highest rate since 1990. The higher rates of inflation are broadbased. These reflect some common drivers: • A strong run-up in world commodity prices, which have had a direct inflationary impact. Oil prices increased nearly tenfold in USD terms in the decade to July 2008, with global food prices also rising strongly. Prices of the milk, cheese and eggs category rose 18 percent over the last year. • The long-running expansion in domestic demand contributed to a build-up of pressures on capacity and high rates of domestically generated inflation. So far, weaker demand conditions have been slow to feed through into lower domestic inflation. In the building industry for example, rising prices for raw materials and strong wage inflation have continued to underpin high rates of construction cost inflation. • There have also been sizeable price increases in areas not directly exposed to a high degree of competition over the past few years. Increases in local authority rates have run well in advance of overall CPI inflation for a number of years. Cost increases in some utilities have also been notable, particularly electricity. • In the banking sector, the cost of international funding has risen significantly and become less assured. However, since July the Reserve Bank has cut the Official Cash Rate by 3.25 percent. Short term mortgage rates have been cut, but not by this much. Banks should not expect to be able to maintain high profit margins in the current environment. Table 1 Consumer price inflation over the 3 years to 2008Q3 CPI component Average annual rate for the 3 years to September 2008 quarter Annual percent change CPI contribution Food 4.0 1.0 Petrol 14.3 0.5 Construction 5.7 0.3 Household energy 6.6 0.2 Local authority rates 7.0 0.2 Total CPI 3.2 3.2 Source: Statistics New Zealand, RBNZ estimates. Figure 1 Some contributions to quarterly CPI inflation Source: Statistics New Zealand, RBNZ estimates. As the global economy has weakened, commodity prices have fallen again, substantially in some cases. Since July, global oil prices have declined by two-thirds and are back to mid2005 levels. Other commodity prices have also eased, including prices for our agriculturally based exports, with international dairy prices now around half of where they were a year ago. Sharply lower commodity prices are expected to flow through into lower consumer prices. However, the impact on short-term inflation will depend on a number of factors including the exchange rate, other costs, taxes, and firms’ margins. In the past, these factors have tended to mitigate the impact on retail prices. Although global oil prices more than doubled between mid-2005 and mid-2008, New Zealand retail petrol prices only increased by around 60 percent over the period. Retail petrol prices have been dropping recently, but we believe they should be dropping further to restore refinery margins. Similarly, retail dairy prices only increased around 25 percent from early 2007 to October this year, while global dairy prices more than doubled to their peak in late 2007. In addition, there was a lag of more than six months before higher global dairy prices flowed through to the retail level. However, now that global prices have crashed, there is plenty of room for retail price cuts. The exchange rate has tended to play a buffering role and has helped moderate the impact of large swings in global commodity prices in New Zealand dollar terms. Despite the substantial appreciation of the New Zealand dollar between 2002 and 2007, tradable CPI inflation has remained quite high. This may partly reflect trends in global import prices, but it is also likely to reflect some importers widening their margins when the NZD was going up and demand conditions were more favourable. While the lower NZD will eventually lead to higher inflation, this will be tempered by lower global import prices and a narrowing in firms’ margins to reflect the current demand climate. The prevalence of discounting and reports of high retail stocks suggest some temporary respite for retail prices from the lower dollar. As a result of all this, the Bank’s December Monetary Policy Statement projections are for annual CPI inflation to trough around 1½ percent in the September 2009 quarter, before lifting slightly above 2 percent thereafter. Headline CPI and inflation expectations (annual) Source: Statistics New Zealand, RBNZ estimates. We need to see inflationary pressures reducing significantly across the board, if we are to keep on easing monetary policy, thus helping the New Zealand economy to recover. That depends on all sectors of the economy responding to the reduced demand and not adding inflationary pressures to the system. Some examples: we would hope that the electricity industry does not take advantage of its market position and keep increasing rates, that local authorities realise they need to set rates increases below inflation for a change, that the construction materials industry respond to much weaker demand, that the food industry react to lower international commodity prices with price cuts, that petrol companies keep cutting forecourt prices, that the transport industry pass on fuel price cuts, and that the banks pass on interest rate cuts. Only then will all these firms be playing their proper role in New Zealand’s recovery.
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Address by Mr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers' Chamber of Commerce, Canterbury, 30 January 2009.
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Alan Bollard: Coping with global financial and economic stresses Address by Mr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers’ Chamber of Commerce, Canterbury, 30 January 2009. Paper by Mr Alan Bollard and Mr Tim Ng for the above-mentioned speech. The original speech, which all the figures and tables can be found on the Reserve Bank of New Zealand’s website. * 1. * * The great turbulence The period known as the Great Moderation has ended. That era, roughly dating from the mid-1980s to the mid-2000s, was characterised by strong growth, low and stable inflation, and internationalisation of trade and financial flows. By the end, it was also associated with very large imbalances of savings and investment, and a consequently very large increase in the stocks of credit outstanding. These imbalances and excessive credit stocks remain evident at the household, business and national levels. The process of correction to these imbalances has revealed vulnerabilities in the world’s major financial institutions and financial systems. The supply of credit is under severe contractionary pressure, putting immense pressure on economic activity everywhere. Central banks, financial regulators and governments around the world have taken, and are continuing to take, extraordinary action to limit the damage to the financial system and global economy. This speech looks at what the next few years may bring. I first review the story so far, in the international and domestic economies. I then look at how the correction process might play out over the coming year or so. New Zealand is better-placed than many of our trading partners to weather the crisis. This is for both structural reasons, and also because of the remedial policy actions we have already taken and are positioned to take if necessary. Finally, I discuss the road ahead. I look at how New Zealand households, firms and banks can be expected to cope with the stresses, and how we will use policy to smooth the ride where we can. 2. The story so far Since the onset of the crisis in 2007 there has been a rapid-fire succession of extraordinary events and policy interventions. Some of the higher-profile triggers of market volatility are shown in Figure 1, overlaid upon the spread between US short-term interbank interest rates and the market’s expectation of future official interest rates. Normally this spread is close to zero. The difference from zero is a measure of the level of financial market dysfunction. As Figure 1 shows, this measure of dysfunction waxed and waned considerably through the period, but was substantial throughout. Figure 1. Disruptive events and the US 3-month LIBOR-OIS spread Source: Bloomberg This is but a small fraction of everything that has been relevant, for obvious reasons of space. In the rest of this section I try to knit it together into a single story, probably risking oversimplification along the way. The narrative here is necessarily linear, but that obscures many important feedbacks and interactions. These feedbacks are a very real part of understanding and coping with the turmoil. It is no accident that the massive simultaneous surges in the prices of commodities, equities, housing and other real estate around the world since the mid-2000s until 2007 matches the surge in credit. In hindsight, this correlation can be explained fairly simply as the mutual reinforcement of a number of powerful factors. Emerging market countries, especially in Asia, ran high rates of national savings out of the earnings from strong export-led growth. As world oil prices surged, national savings in oil exporting countries also increased rapidly. Finally, the developed world ran fairly loose monetary policy as part of the recovery from the 2000-01 recession. In this environment, the premium charged for credit risk fell to low levels through the middle part of the decade (Figure 2). The growth in asset prices in the latter part of this period increased capacity for secured borrowing, adding further stimulus for credit growth. Figure 2. Spread between US 10-year sub-investment grade corporate bond yields and US government bond yields Source: Datastream Figure 3. Credit-to-GDP ratio Sources: IMF, Datastream. Together, these factors enabled the funding of an extraordinary rate and diversity of financial innovation and credit creation in the developed world, and very substantial increases in the ratios of credit to GDP in developed countries, particularly the UK (Figure 3). Also fuelling the credit growth through the period was a shift of the major US and European banks away from the traditional “originate to hold” banking model towards an “originate to distribute” model, which for a range of reasons was seen as more profitable. In “originate to hold”, mortgage and other credit originations typically stay on the originating bank’s balance sheet until maturity. In “originate to distribute”, the credit originations are securitised and sold, removing them from the originating bank’s balance sheet. A typical securitisation would involve, along the way, the creation and sale of derivatives based on the securitised exposures, further increasing the fee-earning potential of the underlying origination in an environment of voracious demand for risk. “Originate to distribute” enabled a greater amount of credit creation to be supported by the same amount of financial system capital. It also made it harder for the institutions involved in the process of credit supply and derivative creation to assess their credit risk exposure and price it, because of the greater number of independent institutions involved, and the complexity of the transactions and instruments. The institutions involved came to depend on credit rating agencies for the apparently simple risk summary contained in a credit rating. In the event, the rapid growth and diversity of financial institutions and products ran well ahead of the ability of financial institutions to understand their risk positions, of rating agencies to translate the new exposures that were created, and of regulators to ensure that financial institutions were managing risk prudently. Long-standing, well-conceived banking practices were abandoned as financial institutions focused on maximising short-term profitability. The mutually reinforcing strengths of real and financial demand showed up first in rising prices in the commodity and asset markets. As debt-funded consumption and investment in the developed world surged, generalised inflation pressure began rising. As suggested in Figure 1, the first obvious signs of credit over-extension appeared in mid2007, as credit impairment on US subprime mortgage exposures began to surface. Money market spreads rose quickly in the US and Europe as frictions emerged in the cash markets. Soon, the credit quality and liquidity of other types of asset-backed securities and derivative instruments became subject to doubt. The frictions spread further and markets in which risk is traded away became dysfunctional. Financial institutions became increasingly unwilling to deal with each other as uncertainty about who was exposed, and how badly, became more and more enlarged. As 2008 progressed, it became obvious that the financial dysfunction was taking a lot longer to clear than expected. Innovative products with strong credit ratings proved less than robust. Unanticipated concentrations and correlations of risk were suddenly revealed – including within the largest global banks and credit insurers. The substantial increase in the diversity and sophistication of financial products and institutions turned out not to have reduced systemic risk through diversification. The fragmentation of risk had not enabled individual institutions efficiently to isolate, hedge and transfer risk. Understanding of risk had become lost in translation as risk was traded across institutions and national borders. Measured regulatory capital that had seemed bountiful up until 2007, now looked thoroughly inadequate. When risks began to crystallise and losses emerge, the destabilising triggers of ratings downgrades, asset price declines and market illiquidity turned out to have more viciously compounding effects on credit availability than anticipated. The willingness of financial institutions to deal with each other broke down. The continued operation of the global financial system turned out to depend on a far larger number of individual markets and institutions than had been assumed. Liquidity bottlenecks in some arcane products and markets, such as monoline bond insurance, became suddenly obvious. US and European financial system conditions deteriorated significantly in the second half of 2008, especially following the failure of the major US investment bank, Lehman Brothers, in mid-September. Other sizeable financial institutions in the US and Europe – including AIG, the world’s largest insurance company at the time – failed or were restructured during this time. Confidence and the sense of rational discrimination by investors and depositors among Northern Hemisphere financial institutions evaporated. The feedback between increasingly restricted credit and the slowdown in the housing market and general economic conditions became much more significant. Drastically revised prospects for world growth produced a commodity price slump (Figure 4). By the end of the year, world equity markets had lost in the order of US$30 trillion – half their value (Figure 5). Real house prices in the US and the UK had fallen from their peaks by a third and a quarter respectively, with still no sign of deceleration in their rates of descent (Figure 6). Figure 4. The cycle in international commodity prices Sources: Bloomberg, Reuters Figure 5. Equity prices Source: Bloomberg. Figure 6. Real house prices Sources: National data sources, Datastream, RBNZ estimates. The synchronisation of equity market cycles across the world has been remarkable, not least because it has included parts of the world with financial systems less directly affected by the problems in the US and Europe, such as most of Asia. The degree of synchronisation in house prices, though, is even more historically unique. It has occurred mainly, but not entirely, in the major English-speaking countries (including New Zealand and Australia), where the increase in household leverage was particularly enthusiastic. Combining the plunges in value of these two major asset classes implies that households, businesses and sovereign wealth funds all lost massive amounts of wealth. The fall in US house prices alone suggests a typical loss of half the wealth of households in their prime earning years – more than US$50,000 for every US homeowner, or US$4 trillion in total. 1 The international policy response Through the turmoil, the authorities in the major Northern Hemisphere economies escalated their responses, as it became clear that successive interventions were at best only holding back the tide. The initial response to the deterioration in liquidity conditions in 2007 was an increase in central bank money market operations, designed to increase the volume and availability of cash in the banking system. Variously, central banks widened the range of collateral they would accept in return for cash, relaxed the conditions on which they would grant emergency lending, encouraged banks to use emergency lending facilities, and arranged swap lines with each other to ease foreign exchange shortages in offshore markets. Troubled financial institutions had to be rescued with the use of public funds, in cases where the institution’s failure was deemed to be a threat to the stability of the system. The UK government announced a blanket guarantee of all deposits of Northern Rock, the mortgage lender, in September 2007. Major US investment bank Bear Stearns was acquired by JP Morgan Chase with financial assistance from the US Federal Reserve in a deal announced in March 2008. Subsequently, as the problem widened and developed into widespread public concern about the fundamental solvency of some major financial institutions, governments in many countries moved to restore confidence with more sweeping measures. The coverage limits under deposit insurance schemes were extended or, in some countries, removed altogether. System-wide guarantees of other bank liabilities were introduced also. In the second half of 2008, central banks responded to the intensifying risks to the economic activity with rapid reductions in official interest rates, in some cases coordinated. Many governments announced large fiscal stimulus packages. The large-scale nationalisations of the financial system and acquisition of financial risk in the Northern Hemisphere have distorted incentives, and this will have to be addressed in the future. More immediately, the expansion in the public balance sheet, combined with the financing burden of the fiscal stimulus packages, have reduced fiscal resilience and constrained the scope for future fiscal action. The elevated risks to fiscal and external sustainability are already being priced and watched closely by sovereign credit rating agencies. The ratings of a number of Northern Hemisphere countries have already been downgraded. The New Zealand version The emergence of money market frictions in the US and Europe in the second half of 2007 spilled over onto New Zealand shores instantly. The spread between local short-term interbank interest rates and expectations of official rates rose, reflecting the increased premium on liquidity worldwide. However, although there was a degree of friction in trading conditions, money generally continued to flow. As a precaution, the Reserve Bank introduced a range of measures to expand the scope of our money market operations, along the lines of those taken by central banks elsewhere, in order to ease the liquidity pressures that had emerged in the local interbank market. As the Baker and Rosnick (2008). international turmoil continued into 2008 and deepened, we broadened our liquidity facilities further, primarily as a precaution to ensure that the banking system could handle any additional liquidity pressures were they to arise. The international financial turmoil arrived at a time when a number of local finance companies were already under pressure, largely due to credit weaknesses specific to that sector and to particular institutions. The failure rate in the non-bank deposit-taking sector increased as funding became more difficult to obtain. However, the solvency of the core New Zealand financial system was not in doubt, and still is not. We stepped up our usual prudential supervision activities with banks, both to increase the chances of detecting problems and to ensure that banks themselves were doing everything they could to mitigate their liquidity and other risks. Table 1 lists the major changes to Reserve Bank’s liquidity facilities and liquidity management processes to date. 2 Table 1. Changes to New Zealand liquidity management arrangements Announcement date Measure 23 Aug Eligibility of New Zealand bank bills for acceptance in the overnight reverse repurchase facility 7 May Eligibility of AAA-rated New Zealand residential mortgage-backed securities and New Zealand wider government sector debt for acceptance in Reserve Bank liquidity operations Extension of the maximum term of the overnight reverse repurchase facility from one day to 30 days 9 Oct Eligibility of residential mortgage-backed securities in Reserve Bank liquidity operations prior to the securities receiving formal ratings 29 Oct Establishment of reciprocal currency swap line with United States Federal Reserve 7 Nov Introduction of Term Auction Facility for injection of cash for terms up to 12 months Introduction of Reserve Bank bill tender 12 Dec Eligibility of highly rated New Zealand corporate securities and New Zealand dollar asset-backed securities in Reserve Bank liquidity operations The Australian and New Zealand Governments also introduced guarantees of bank liabilities around the time that they were introduced offshore. In the New Zealand case, it was seen as prudent to ensure that depositors remain confident in an environment of extreme global risk aversion and uncertainty. The guarantee of wholesale liabilities was a precaution to maximise the ability of local institutions to participate in international funding markets while they remained disrupted. See Nield (2008) for more explanation of the Reserve Bank’s recent changes to liquidity management arrangements. In our monetary policy operations, we monitored the weakening in the domestic economy for signs of pressure coming from the international credit turmoil. Domestically it was clear that the economy was weakening from the housing downturn, although there were offsetting factors from commodity prices remaining fairly high and the Asian and Australian economies remaining fairly robust, until quite late. The Reserve Bank began cutting the OCR in July 2008, in response to the weight of accumulated evidence pointing to reduced need for tight monetary policy. This was despite headline CPI inflation having reached 4 percent for the year to June 2008, mainly due to the influence of record high petrol prices. During the worst months of 2008, as the rate of deterioration in the outlook sharply increased, we cut the OCR in steps that are very large by the usual standards of monetary policy operation (Figure 7). The rapid abatement of medium-term inflation pressure in New Zealand was such that we saw, and still see, a period of monetary stimulus as now warranted to keep inflation consistent with the target. Figure 7. New Zealand Official Cash Rate Source: RBNZ. 3. The road ahead We are now in a period where financial, monetary and regulatory policymakers around the world are fully occupied in understanding the mess, and in making the transition back to more normal economic conditions as orderly as possible. At the same time, underlying the cyclical volatility and noise are longer-run structural shifts and trends that policy needs to allow to come through. Booms and busts The extraordinary surges then collapses in global credit, asset and commodity prices all now resemble, with the benefit of hindsight, overshoots followed by undershoots. The reversal in the price of credit and tightening in credit availability has been extremely abrupt. Most countries are not yet seeing slowing credit volume growth, due to the masking effect of drawdowns of existing credit lines. However, major international financial markets and banks are now much less willing, or completely unable, to provide new funding, even at very high spreads and with various forms of government support. Anomalous pricing and the breakdown of normal arbitrage between markets is widespread. These are not normal conditions, but an over-correction that should reverse over time as confidence and capacity to trade return. If history is a guide, housing and equity markets will also overshoot, or may have already. Housebuilding activity in the US has essentially ground to a halt, but the US population continues to grow and needs somewhere to live. Some overshoot of house prices on the downside is probably unavoidable to restart demand for housing and, eventually, new investment. The question is how to limit the downside’s extent. Similarly, while there is undoubtedly an overhang of investment at inflated asset prices to be worked off, equity price falls below fair value are how markets typically work to generate opportunities too attractive to pass up. Finally, the commodity price rise and fall is very large. Oil prices alone quadrupled between 2004 and 2007, before crashing back to the 2004 levels where they are currently. Explaining price movements, let alone gleaning the medium term trend in prices, is very difficult in liquid markets with limited short run supply elasticity. On balance, the underlying trend in real commodity prices over coming decades is probably still upward. Financial market hubris during the upswing, and its opposite in the downswing, probably played a significant role in amplifying the cycle. The fundamentals of supply and demand continue to argue compellingly for underlying strength in prices. For dairy products, for example, we still believe emerging market incomes will grow strongly over the medium term, underpinning growth in demand for protein and a more Westernised diet. For hard commodities, the physical and technological constraints on supply seem difficult to surmount. Whatever the case, large swings in commodity prices seem likely to remain with us in coming years, as supply and demand pressures lever more strongly on limited inventory buffers. Very noisy signals in credit, asset and commodity prices have resulted in what now look like material misallocations of resources in a range of industries over the past few years. Here in New Zealand, there has been a dairy land price boom, which has spurred large amounts of investment in dairy-related industries, in some cases highly leveraged. The house price boom does not seem to have left us (or Australia) with a significant oversupply of housing (unlike the US, for example). It has, though, produced a large increase in household and developer leverage. The global recession Comparisons of the present world recession to previous recessions, and even to the Great Depression of the 1930s, are rife. To be clear, the state of the global economy and the outlook are very serious, but we are nowhere near Depression-level economic conditions. That said, we can certainly learn from the Depression experience. 3 Then, as now, the global financial system became seriously incapacitated. Concerns about the state of the international economy came in waves. In the present case, markets would take heart from announcements of major official intervention, such as the bailout of the major investment bank Bear Stearns in the US, to be followed by new bouts of adverse news and further reversals of confidence, such as in response to the non-bailout of Lehman Brothers. See Reddell and Sleeman (2008) for an overview of economic conditions in New Zealand at the time of the Depression and other periods of major economic weakness. However, in macroeconomic terms the outlook is considerably better. In world growth terms we are somewhat below the early 1980s recession – that is, worse than the growth troughs in the early 1990s and early 2000s (see Figure 8). Unemployment rates will certainly continue to rise, but peak well short of the levels reached in the Depression. Then, unemployment rates rose well above 20 percent in many cases. Policy frameworks were much less well-equipped to handle the slump. In some cases, policy responses such as tightening of some fiscal settings and trade protectionism, and prevailing macroeconomic management frameworks such as maintenance of the gold standard, seriously exacerbated the initial problems. Figure 8. World GDP growth since 1970, and IMF forecasts for 2009-2010 Sources: IMF, Datastream. Compared to previous global recessions, the current one has some distinguishing features. It originated in the US financial system and quickly spread to the European one, eventually spreading across most regions of the world – but by different means. In the European case, the financial system vulnerabilities were both directly generated by US-originated credit exposures, as well as through a sharp reappraisal of the consequences of the credit boom and adverse relaxation of credit standards within Europe itself. Elsewhere, and especially in Asia, the transmission has been through more conventional trade and commodity price channels, as the East Asian financial systems, including the capacity of the official sector to withstand financial shocks, have remained fairly robust. To date, Asian and many other emerging market economies have been less affected than in previous episodes. This resilience so far is very different from the crises of the past two decades. However, the adverse impact of the developed world recession on Asian exports and investment is now showing quite strongly. It is not clear how severe the impact may ultimately be. What is needed for stability to return to the world financial system? Two fundamental conditions are needed for conditions in the global financial system to return to normal. First, housing markets in the US and UK need to stabilise. As suggested earlier, there is a natural limit to how far housing market activity can fall. Second, sufficient capital as a buffer against risk and as a base for growth needs to be restored to Northern Hemisphere financial institutions. The sufficiency of capital then needs to be transparently observed by all in the market in order for confidence to return and normal financial trading to resume. This latter process may well drag on beyond this year. So far, the running total of credit losses declared by US and European financial institutions since the crisis began still exceeds the amount of new capital raised (Figure 9). And, there remains uncertainty about the level of losses still to be crystallised, or still to be generated as a result of the recession. Financial institutions and authorities face the formidable challenge of establishing credible estimates of the losses still to be borne and the exposures still to be covered, and then finding the new capital to get the financial system back on its feet. Figure 9. Cumulative credit losses by region and total new capital raised Source: Bloomberg Meanwhile, the massive fall in household wealth since 2007, with largely unchanged household debt, means that the financial outlook for households across the developed world (especially those who “leveraged up” in the boom phase) is now much less healthy, especially in view of the increased threat of unemployment and the reduced fiscal strength of government. Households are likely to respond to this in two ways – first, by cutting back consumption and investment and increasing savings; second, by selling assets to pay off liabilities. Both processes will keep downward pressure on asset prices and drag on economic activity for many years, probably beyond the return of normal financial market conditions. Much more cheap credit than was sustainable was taken up over many years, not only by the Northern Hemisphere financial sector and household sector but also certain elements of the corporate sector (the US auto industry, for example). In the early part of the process, the impairment of the financial system will actually force the household and corporate sectors to reduce debt, as the opportunities for leveraged investment in housing and other assets will be much reduced. This increased propensity to save may blunt the impact one might otherwise expect from fiscal and monetary policy stimulus. Finally, external surplus-running emerging markets, especially in Asia, will have strategic consumption and investment choices to make. Their broad development strategy in the early to mid-2000s was to grow national income by exporting cheap consumer goods to developed, largely deficit-running, economies. This strategy will now be less viable given household and national financial retrenchment, and pressure on exchange rates to fall to assist in the reduction of imbalances, in the West. Asian governments will need to generate large increases in consumption and domestic investment demand, to replace the gap left by exports, if they are to continue growing at the high rates needed to meet their national and social development objectives. The net financial flow from East to West that characterised the middle part of this decade will as a consequence need to fall somewhat, even if it doesn’t reverse. As the large emerging markets such as China and India continue to develop amid these large shifts in global economic and financial currents, the reduced dependence of the world on consumption and investment in the West and consequent shift of political power will accelerate. New Zealand’s position New Zealand, like the rest of the Asia-Pacific, has thus far held up better than many developed economies. The global financial crisis hit the Northern Hemisphere first, and hardest. The transmission of the shock to us through Asia and Australia – which together account for half our trade in goods – has been slower than the transmission from the US to Europe. However, we haven’t escaped unscathed either financially or economically. New Zealand investors have lost money. Sectors of the New Zealand economy exposed to external demand have weakened sharply. A few factors count in New Zealand’s favour. The parts of the US and European capital markets that have been most damaged are investment banking, hedge funds, private equity, sovereign wealth funds, and stock, bond and derivatives markets. New Zealand’s direct exposure to these parts of the international capital markets, and to complex derivatives or structured credit products, is very light. Our banking system is well-capitalised, vanilla, and mortgage lending is generally on good credit quality. The large Australian banking groups, of which the major New Zealand banks are a part, are now among the largest and highestcredit-quality banks in the world. Also, our established track record for transparency in our regulatory institutions, sound management of the public accounts, and forward-looking monetary policy are well-regarded internationally. Through this episode, we have attracted relatively little adverse attention in financial markets. Finally, New Zealand’s freely floating exchange rate is an effective buffer against the current, internationally sourced, shock. The downturn in international commodity prices, as well as international investor risk aversion and the contraction of liquidity in the global financial system, have led the value of the New Zealand dollar to fall against all the major currencies (Figure 10). This has been especially the case against the Japanese yen – the currency of a country that typically runs a current account surplus, unlike the others in the New Zealand TWI. Not only does depreciation cushion the incomes of sectors exporting goods and services priced in foreign currency, it also acts powerfully and in the right direction to encourage the reduction of national debt and re-balancing of sectoral demand that is needed in New Zealand, as a deficit-running country. As a small, open economy with flexible product and labour markets, we should be better positioned than many others to re-orient production and income generation in response. Figure 10. New Zealand TWI 4 Source: RBNZ. However, there are also some negative features about New Zealand’s situation. Our exposure to the global commodities trade is particularly evident now, with the commodity price volatility currently. The overall impact on New Zealand depends on the balance between imported (oil) and exported (agricultural) commodity prices. Usually commodity price rises and falls see the New Zealand terms of trade rise and fall more or less in concert, because of the greater proportion of commodities on the export side than the import side. This is the pattern we are seeing currently, with the terms of trade having fallen about 10 percent so far since early 2008. With open capital borders, defensive monetary or financial system policy actions taken by bigger economies can cause collateral damage to smaller ones. Guarantees of financial institution liabilities, or provision of official credit facilities, inevitably have to have boundaries, to limit the risk of the sovereign granting the guarantee or credit. But in an environment where depositors and investors are panicky, and the appetite or capacity to take risk is limited, the boundary will inevitably generate a rush of funds to the safe side, putting pressure on governments, even in countries with safe financial systems, to “match” the actions taken abroad. We saw this illustrated clearly in October last year with the extension of government guarantees of bank liabilities overseas. The TWI shown in this Figure is a 50:50 trade-to-GDP weighted TWI calculated from 1990 onwards. It is the same as the official TWI after 1999, but differs from the official TWI before 1999 because simple bilateral trade weights were used in the official TWI at that time. The analytical measure is preferred to the official measure for analytical purposes, because it is calculated consistently over history. Finally, even though our banking system is vanilla in terms of credit risk, it has vulnerabilities resulting from the need to fund domestic lending activities by offshore borrowing. As is well known, New Zealand has been running a large external deficit for some time, mirrored by a severe household savings imbalance. This imbalance grew even larger during the credit and house price boom. The banks have been funding this shortfall of domestic savings mostly with short-term debt (“commercial paper”) issues, which need to be renewed every few months. The increase in New Zealand’s external vulnerability was the reason for Standard and Poor’s placing New Zealand’s foreign currency credit rating on “negative outlook”, increasing the focus on the economy’s adjustment to the imbalances and the role of fiscal policy in supporting it. The banks hedge most of the foreign exchange risk on their offshore liabilities, so we do not face the risk of dangerous escalation of the burden of foreign-currency liabilities if the exchange rate falls, as often happens in emerging market crises. However, the debt still does have to be renewed. Part of the price of that renewal, when offshore investors are both skittish and there is little cash around, is that the terms must become more attractive to the investors, through some combination of a lower exchange rate and higher premiums on credit to New Zealand. The New Zealand economy will be trading through a world economic and financial environment that will be extremely weak for most or all of this year, at least. The impact of the sudden worsening of international economic conditions and substantial monetary stimulus late last year will not become clear for some quarters. The large fiscal stimulus packages announced in our major trading partners do not take effect until later in the year, with lags from there until spending responds. In the near term, there will be considerable downward pressure on the domestic downturn already well underway, with weakness in household expenditure, the export sector and activity likely to persist through the year. Coping at the business and household level In light of this weakness and uncertainty about what the year holds, New Zealand businesses and households are understandably behaving cautiously. They are reducing expenses, increasing savings and otherwise shoring up balance sheets. The availability of governmentguaranteed savings vehicles at relatively attractive interest rates, certainly compared to those elsewhere, is probably encouraging this behaviour. However, the shutters on spending have not come down completely. Overall, we are seeing a broadly rational response to the difficulties we face. The massive financial downdrafts hitting the economy this year will force a mix of pricing and wage-setting restraint, moderated employment plans, and higher hurdles for new investment. Within this, the precise coping strategies taken will vary across the economy’s sectors, depending on the particular shape of domestic and external forces playing out in each. None of this will be easy. Business and labour will be challenged by the need to be realistic about the painful adjustment ahead, without undermining our collective ability to respond to the recovery in demand when it arrives. The more that the domestically-generated part of the economy’s cost structure can be kept under control, the less pressure there will be for the burden to show up in reduced employment and output. Banks also will need to play their part. Lending policies have turned conservative and cautious, which is normal banking behaviour in risky times. However, just as the banks have done very well in New Zealand in good times, so they have a key role to play in tough times. They are a critical part of the mechanism by which monetary policy stimulus gets through to the wider economy. While continuing to manage their risk prudently, the banks’ challenge will be to continue lending on sound business proposals, to keep working to develop stable sources of funding from depositors and the financial markets, and to keep passing on to lending rates the cuts in wholesale interest rates. What if things get worse? What if things get markedly worse? For the Reserve Bank at least, as for other New Zealand authorities and our colleagues abroad, the first priority for the coming year will be to remain ready to respond. Further adverse news is likely and further remedial interventions may well be necessary. Lest there be any doubt, the tool box is by no means empty. We have done a lot already and it will take some time for these actions to have their full effects, but we are entering the year well-positioned on the monetary policy, liquidity management and prudential policy fronts. If we need to, there is still room for us to cut the OCR further in response to adverse economic developments. The Policy Targets Agreement provides ample scope to respond consistent with our inflation target. Although there remain local financial market frictions, the conventional monetary transmission mechanism through interest rates is working adequately. We remain confident that we will be able to keep future inflation tracking satisfactorily, with inflation expectations anchored, and both well clear of the danger zone of deflation. This contrasts with the position of, say, the US and the UK, where official interest rates have been cut to levels close to zero, and where the capacity of banks to lend is seriously constrained. Japan, of course, has had several recent years of experience in this position. Japan still has very low inflation and the difficult challenge of stimulating the economy with little means of imparting conventional monetary stimulus. These authorities are now pursuing other means of reducing the cost of borrowing in the economy. It is possible we may learn from them new techniques to manage the range of effective short and longer-term interest rates. The depth and scalability of the Reserve Bank’s money market operations and liquidity facilities have served and positioned us well through the current episode. The expanded facilities – especially the acceptance of residential mortgage-backed securities as collateral and the Term Auction Facility – give us substantial capacity to scale up the volume of cash in the system if required. Prudential policy will continue to put priority on ensuring that banks adequately manage the risks associated with rolling over their debt funding. Consultation on a proposed new prudential regime for the management of liquidity risk by registered banks closed at the end of last year, and the Reserve Bank aims to finalise the new policy in this area by around March 2009. We expect the finalised policy to reinforce incentives for banks to lengthen the maturity of their funding, and hence reduce their future vulnerability to short-term funding risks. We will be further advancing our work programme with our Australian counterparts on improving regulation and supervision of banks with trans-Tasman operations. Finally, the Reserve Bank is not the only agency with a role to play in stabilising the economy. Fiscal policy is sharing some of the burden of the shock by stimulating spending, and New Zealand’s fiscal position is stronger than that in many other countries. Regulatory policy has the potential to address identifiable problems in a targeted way, though of course longer-term structural adjustments and re-allocations of resources need to be allowed to take place. 4. Conclusions Last year might have seemed like a blizzard of outlandish news, large-scale economic and financial policy interventions, and confusing messages. We are in the middle of a major international shock, currently developing from financial turbulence into economic recession. Our banking system remains well-capitalised. Widespread credit problems have not suddenly appeared. However, we have not escaped the impact of the massive tightening in credit conditions internationally. In our case, the tightening has exposed vulnerabilities associated with household and external indebtedness. The global recession is also now affecting us through trade channels and a slump in world commodity prices. The remedial efforts we have taken in New Zealand have probably been about as successful as might be expected. We eased monetary policy substantially and very rapidly. Inflation remains under control, following the largest international commodity and asset price surge for decades. We greatly expanded our liquidity facilities. Cash continues to circulate, in the face of enormous pressure to hoard it. We continue to develop our monetary policy, liquidity management and prudential policy tools and to consider how the mix of tools might best be applied. This includes working with other government agencies to promote overall stability. Sometimes our tools can be treated independently, sometimes they work together, and sometimes they work against each other, necessitating judgement about the right balance. Issues remain. This episode has shown that apparently isolated risks can suddenly correlate, threatening the stability of the system. Central bank liquidity operations and the impact of monetary policy will be blunted if credit markets do not work and financial institutions cannot lend. Scarce liquidity makes banks’ short-term funding vulnerabilities painfully evident. Debt loads that looked sustainable during good times are less sustainable under crisis conditions. In the medium term, prices and quantities will adjust to correct imbalances. However, that process can be very rocky for exposed players, with real economic costs. Perhaps the foremost lesson of the Depression experience is that a sequence of setbacks should be anticipated. In responding to the urgency of cyclical stabilisation, we need to recognise the underlying large structural adjustments underway. The debt build-up will take years to prune back down to sustainable and prudent levels. It is by no means clear how the international financial system will be organised in the future. The institutions and tools of financial regulation and supervision may well undergo farreaching change. We need to understand better how financial risks can reinforce each other and harm the macro-economy. Households, firms and banks will naturally be very cautious during this process. However, we should also be watchful for the opportunities, and mindful of the risks of defeatism. Within the Western world, New Zealand’s economy and financial system are relatively well-placed to weather the adjustment. Our challenge will be to remain well-positioned to take advantage of the economic recovery when it arrives – possibly suddenly and strongly, which has been New Zealand’s experience in the past. Households and firms should not pull down the shutters, and banks should continue to lend on sound business propositions. References Baker, D and Rosnick, D (2008) The impact of the housing crash on family wealth, July, Center for Economic and Policy Research. Downloaded at www.cepr.net Nield, I (2008) “Evolution of the Reserve Bank’s liquidity facilities”, Reserve Bank Bulletin, 71(4), pp. 5-17.
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Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers' Chamber of Commerce, Christchurch, 29 January 2010.
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Alan Bollard: The crisis and monetary policy – what we learned and where we are going Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers’ Chamber of Commerce, Christchurch, 29 January 2010. * * * Background paper by Dr Alan Bollard, Governor, and Mr Felix Delbruck, Economics Department, Reserve Bank of New Zealand. 1. Introduction Inflation targeting is a monetary policy framework that was developed in response to the high inflation and macroeconomic instability of the 1970s and 1980s. Twenty years ago, New Zealand was the first country to formally adopt key elements of this approach – such as an explicit inflation target and various accountability and monitoring structures – in the Reserve Bank Act 1989. The framework has been durable, even as we’ve continued to learn how the economy works and continued to adapt and refine the way we do monetary policy. The past two decades have included one of the longest periods of growth that New Zealand has seen in decades, as well as droughts, migration shocks, terms of trade changes, an Asian crisis, a dot-com boom and bust, and, most recently, the worst global economic and financial crisis seen in generations. This speech looks back over those two decades of inflation targeting to see what lessons we can draw from these experiences, as well as outlining some of the challenges ahead. 2. Assessing two decades of learning The framework we put in place in 1989 and refined in the following two decades has now been adopted in its main features by over 20 countries. In looking back, I will focus on the New Zealand experience, but the main conclusions I draw are not unique to New Zealand. I will argue that inflation targeting has done well on the price stability front, and has given central banks a lot of flexibility in helping steer the economy through turbulent waters. However, in itself, it has not guaranteed balanced growth or macroeconomic stability. Other factors matter: neutral fiscal policies, monetary settings in the major global economies, and a stable financial system. It is in the interplay of the financial system and macroeconomic stability that most learning will need to be done in the coming years. Price stability has been broadly achieved In terms of what it was directly designed to achieve, namely price stability, inflation targeting has been a success. Consider the range of conditions under which inflation has been contained within a fairly narrow range. These include an early period of restructuring, a “benign” period of rising global integration and rapid growth in information technology, where energy prices were low and the costs of a wide range of manufactured goods were falling rapidly; a challenging period of sharply rising commodity and asset prices in the past few years; and the extreme ructions of the global financial crisis. This can be seen from figure 1, which shows New Zealand CPI inflation since 1980, as well as a survey measure of 2-year ahead inflation expectations. In particular, while inflation expectations crept up in the boom years, and fell back sharply in late 2008 as the financial crisis hit, they have remained well-anchored across that time period. Figure 1 New Zealand inflation and surveyed inflation expectations Source: Statistics NZ, RBNZ Inflation targeting has supported, but not guaranteed, macroeconomic stability In taming inflation expectations, the inflation targeting framework has removed a major source of economic volatility. It has also allowed for active macroeconomic stabilisation in a broader sense. Most notably, once the global financial crisis hit, we were able to respond with significant policy easing swiftly, cutting the OCR by more than 5 percentage points and providing banks with emergency liquidity at rates consistent with the OCR, at a time when the international wholesale funding markets were severely impaired. We were able to provide this degree of support because the inflation targeting framework allowed for a flexible response, and inflation expectations were well anchored. However, the extent of the financial crisis makes it clear that inflation targeting monetary policy has not been sufficient to guarantee comprehensive macroeconomic stability. Recall the decade or so from the second half of the 1990s to the late 2000s that many commentators called the “Great Moderation” or the “Goldilocks” economy, when many economies experienced an extraordinarily long stretch of unbroken strong growth. Even then, we continued to see large movements in commodity prices, house prices, interest rates, and exchange rates. There were also significant shifts in the composition of growth, from the traded to the non-traded sector, and big increases in household and external indebtedness. Some of these changes were structural, such as the rise in the global demand for agricultural and other commodities from the late 1990s onward, or the surge in migration to New Zealand in the early 2000s. Some of the price movements were beneficial in helping the New Zealand economy adjust to those changing conditions. But we also saw growing economic imbalances, and the commodity and asset price rises in the years leading up to the financial crisis were among the hardest challenges faced by central banks over the past 20 years. From 2004 to 2008, international oil prices quadrupled in US dollar terms. What was the best way to respond to this development? Should we continue to let the direct inflation consequences of the shock pass through (as we would do with a more temporary price shock), or should we try to offset them with higher policy rates? This was a very delicate balancing act, made more difficult by uncertainty around what level of oil prices was ultimately sustainable. In the event, we monitored a wide range of indicators, including “core” inflation measures and inflation expectations. Despite significant rises in short-term CPI forecasts, these underlying inflation trends remained relatively stable, so that we were largely able to “look through” the oil price spike and set policy appropriately for a changing growth outlook in 2008. The rise in house prices posed an even greater challenge. When any asset price rises sharply in the context of subdued overall inflation, monetary policy needs to decide whether to raise interest rates now – even though inflation pressures are subdued – to prevent potential asset bubbles that might have deleterious consequences later. In New Zealand, while we do not “target” house prices, we have been able to identify a clear link between the housing market and broader household spending, and have therefore always monitored the housing market as an important indicator for the inflation outlook. However, in an environment of low perceived risk, willing capital markets, and widespread expectations of capital gains, short-term interest rates turned out to have only limited leverage over housing activity. The difficulty was exacerbated by a tax system which favoured investment in housing, and by expansionary monetary and exchange rate policies in the major global economies which fuelled a global carry trade. Thus the NZ dollar appreciated while mortgage rates remained relatively low until quite late in the piece (figure 2). Figure 2 OCR and effective mortgage rate Source: RBNZ The grass is not always greener For all the difficulties we faced, as we look back, we can see that alternative monetary policy frameworks would not have provided the flexibility that we had to navigate these waters, and may in fact have made it harder to maintain price stability while avoiding unnecessary volatility in the wider economy. This is particularly clear if we think about policy approaches that target the exchange rate in one way or another. Consider an ANZAC dollar. The NZ dollar has fallen by over 10 percent against the AU dollar since 2006, a period in which Australia experienced an unprecedented minerals boom and very strong growth. If our currency had been pegged to the AU dollar, New Zealand’s exchange rate to the rest of the world would have been higher, interest rates would have risen three times already, and our recession would probably have been deeper. The argument is even stronger for other currencies, such as the US dollar. Australia and New Zealand are not the same, but we are far more similar to each other than to Europe or the US. If our currency had been pegged to the US dollar over the past decade, interest rates would have been lower for longer in 2003 and 2004, exacerbating the housing boom (figure 3). Some of the challenges of a currency union can now be seen in Euro area economies such as Ireland, Greece and Spain, where monetary policy settings have been unable to lean against unsustainable domestic booms, or against the deep recessions that followed. Figure 3 Policy interest rates in NZ, the US, and Australia Source: Bloomberg Figure 4 GDP growth in Euro area economies Source: DataStream Singapore’s monetary policy regime is sometimes pointed to as an alternative to inflation targeting that has maintained stability in the currency while achieving a track record of low and stable inflation. Over the past two years, of course, this has not been the case, with inflation approaching 8 percent in 2008 and prices falling in 2009. Over a longer period, it does appear that Singapore has generally managed to guide its exchange rate to keep inflation stable. But a range of special factors made this possible – Singapore’s extraordinarily high trade ratio, its large stock of domestic savings and foreign exchange reserves, and a range of supplementary stabilisation instruments and capital controls. In particular, in New Zealand, with its much larger non-traded sector, a Singaporean regime might potentially have required greater swings in the exchange rate than we actually saw to achieve similar inflation outcomes. Global policies, the tax system and financial stability also matter A lesson from this period is that while monetary policy can always achieve price stability, whether this occurs in the context of balanced growth also depends on other factors. As the housing boom has shown, these factors include global policy settings and the structure of the tax system. Looking back over two years of crisis, perhaps the key lesson is that financial stability cannot be ignored when thinking about macroeconomic stability and the conduct of monetary policy. We’ve been reminded that financial system developments have the potential to complicate monetary policy enormously, and that stable prices do not guarantee a sound and efficient financial system – well-functioning financial markets and soundly managed institutions which make decisions based on a long-term outlook for earnings. In some economies such as the US, financial system dysfunction during the crisis rendered the standard monetary policy tool partially or wholly ineffective as spreads blew out and policy rates hit the zero lower bound. We, too, have had to take into account movements in financial market spreads and credit rationing in our policy deliberations over the past year, to an extent we would not have envisaged a decade ago. And the crisis has shown what enormous macroeconomic damage can result if financial market participants do not adequately price and manage financial system risks. 3. Stabilising the economy in the future Inflation targeting has proven to be a monetary policy framework that combines the discipline of focus that is needed to ensure a stable level of prices, with an operational flexibility that enables the economy to better cope with a wide range of shocks. But as we have seen, it has not eliminated economic imbalances or liberated central banks from difficult tradeoffs. Can we do better, and can those tradeoffs be made easier in future? We know that the difficulty of our job ahead will in part depend on policy choices made by the major global players as they exit from current stimulatory policy settings. As the world emerges from recession, central bankers around the world are weighing the need to provide ongoing support for a very fragile recovery against the need to be ready for more normal conditions. This will be yet another delicate balancing act, made more complex in economies like the US by the need to unwind “quantitative easing”, and other unconventional policy support measures. At the same time, choices will need to be made about when to withdraw fiscal stimulus. Unlike the synchronised policy easing that we saw in late 2008, the removal of stimulus will occur at different times in different parts of the world, reflecting different recovery paths. Australia has already embarked on the exit road, the United States and Europe are still at the door. How deftly this process of normalisation is handled will be crucial to whether the global economy recovers in a balanced way, and how stable recovery is likely to be in New Zealand. If US monetary policy settings remain too easy for too long, and if exchange rates in China and the big surplus economies remain low even in the face of a dramatically improved economic outlook, we will risk facing conditions similar to those during the years leading up to the crisis: abundant global liquidity searching for returns in the wrong places, feeding unsustainable asset booms and growing economic imbalances. Against this is the risk of a slower, more fragile recovery. It will be some years before we can judge how appropriate this normalisation has been. The difficulty of our job will also depend on the wider domestic policy context. In particular, achieving both low inflation and balanced growth is considerably easier in an environment of fiscal discipline, and where the tax system is neutral with respect to households’ and firms’ investment decisions. In this respect, a failure to gradually remove the recent fiscal stimulus would put added pressure on monetary policy over the coming period. We are also hopeful that the recently released report of the Tax Working Group will lead to a more efficient and even-handed tax system. Tax policy is complex and needs to meet multiple objectives. Our concerns are to minimise tax-fuelled property investment and consumption that might detract from more balanced savings and growth. Another important part of the domestic policy context is our financial policy framework. A lot of work is being done in this space internationally. Central banks, financial regulatory bodies, the Basel Committee on Banking Supervision and the Financial Stability Board are working out ways to strengthen and improve the prudential supervision of financial institutions. This includes raising the quantity and quality of minimum capital buffers held by banks, and improving the resilience of banks to liquidity shocks. It includes measures to make banks easier to restructure and unwind should they become insolvent. Financial regulators are also working on designing a “macro-prudential” architecture for bank regulation. This essentially means taking into account the impact of individual banks on the riskiness of the financial system as a whole. For example, a large systemically important bank needs larger capital buffers than a smaller player. Similarly, larger buffers may need to be built up in boom times, when banks are more vulnerable to a systemic downturn. In New Zealand, the financial system is a lot simpler than in other parts of the OECD, and has not seen the same types of excesses. Nevertheless we have taken steps to make our banks more resilient to financial system shocks. In implementing the Basel II capital framework, we have ensured that banks’ assessment of risk is based on a “through-thecycle” approach rather than just on the period of recent growth. We have also put in place a new prudential liquidity policy for banks which is intended to make the system less vulnerable to a drying up of international funding markets, such as we saw in late 2008 and early 2009. Can prudential instruments such as minimum capital and liquidity requirements also help monetary policy? This depends on the link between those instruments and bank funding and lending, and also between bank lending and the behaviour of housing and other asset prices. In the case of housing, the link between mortgage lending and market prices is fairly clear. What is less clear is the extent to which the instruments themselves may constrain bank lending and housing demand in an emerging boom. At this stage, we believe that the new liquidity policy and in particular the Core Funding Ratio could usefully contribute to the monetary policy task by limiting the banks’ ability to fuel credit growth using cheap and plentiful short-term wholesale funding during boom periods, as was the case from 2003 to 2007. In this respect, the Core Funding Ratio could potentially act as an automatic stabiliser and reduce the required hikes in the OCR during economic upturns. The role for a macro-oriented minimum capital requirement in promoting macro-financial stability (as opposed to individual bank resilience), and also assisting monetary policy, is less clear. The relationship between capital requirements and loan pricing is highly uncertain, particularly as the large lenders in New Zealand (as elsewhere) target capital holdings well in excess of current regulatory minima. At best, these instruments could supplement the role of the OCR, but will not fundamentally alter it. Ideally, they would change the mix of monetary conditions and take some pressure off the exchange rate. Overall monetary conditions would still need to be set appropriately to keep inflation stable. We must also be realistic about the learning that still needs to be done in the macro-financial area. Central banks do not yet understand enough about the properties of prudential instruments to use them as an adjustable policy lever, and doing so could raise coordination issues between monetary policy and prudential policy decisions. More broadly, economists have a relatively good understanding of inflation and the real economy, but the unknowns are much greater when we try to model macro-financial variables. We still have much to learn about how price stability and financial stability outcomes move together, about the relationship of CPI and asset price inflation, and about the interplay of credit and economic activity. As a small, flexible and full-service central bank, the Reserve Bank is in a good position to be at the forefront of progress in integrated macro-financial policy design. We have joint price and financial stability objectives and joint powers to achieve these objectives. Our prudential supervision, financial market and payments system functions provide us with useful skills and information to draw on. But we need to be cautious about what we claim to understand and what we can influence. 4. Conclusions The inflation targeting framework has performed its primary task reasonably well over two decades, achieving price stability through both good and bad times. While it has been in place, inflation expectations have remained anchored, and it has proven flexible in responding to rapidly changing economic conditions. Major alternatives that dilute the focus on medium-term inflation and target other macroeconomic outcomes would risk reducing confidence in the future level of prices and would have led to worse overall outcomes at key points over the past 20 years. Nevertheless, price stability alone is not sufficient to ensure a stable and balanced economy. For that to work best, we need to maintain a flexible approach to monetary policy. But we also need a conducive global financial environment, and support from other domestic economic and financial policies that have a bearing on asset markets and financial leverage. We need to be realistic. The world is not ours to influence, and it is unlikely to offer us perfect conditions. But in New Zealand, we will be seeking less distortion from future tax policy, and an increased macro-orientation of prudential policy.
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, at the Local Government New Zealand, Dunedin, 6 May 2010.
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Alan Bollard: Handling our economic recovery Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, at the Local Government New Zealand, Dunedin, 6 May 2010. * 1. * * The global financial crisis caused major market damage We are now seeing the world pull gradually out of the Global Financial Crisis. It was an unexpected, deep and costly event, the world’s worst since the Great Depression. The recovery is mixed, fragile in some places and has a long way to go. Just as we were very uncertain about the depths of recession, so no one can be sure how robust and widespread the recovery will be. Already we have had many surprises. The purpose of this presentation is to analyse New Zealand’s recovery from the recession to date, and to indicate how it might proceed. The crisis struck across almost all countries and almost all sectors. Like a virulent virus it transmitted speedily from one market to another. Some of these markets produced their own antibodies very quickly, while others sustained prolonged damage. The figure gives an impression of when the virus hit and how it quickly passed through the world’s financial and economic systems. 2. Economic recoveries can be slow and fragile Recovery from a global economic recession that has been sparked by a financial crisis is particularly hard to predict. That is because established fundamental economic relationships have been put at risk and may need to be rebuilt over time. Research into historical world crises yields some interesting results. International financial crises yield particularly deep and prolonged recessions when they are linked with banking and currency crises. A similar trend can be seen for globally synchronized recessions (IMF, 2009). Economic contractions tend to last for around six quarters, with an output loss of around 3.5 per cent. Such periods are also associated with employment continuing to decline for substantially longer than GDP (Reinhart and Rogoff, 2008). On balance after a banking crisis, recoveries tend to be more gradual, and are associated with weak domestic demand, tight credit conditions, and continued contractions in residential and business investment. In addition, recovery is not even across countries and across sectors. Typically certain parts of the economy like equities and stocks recover early. Others like the labour market can lag significantly. The figure shows the paths of recession and recovery for US GDP during past recessions over the last 40 years. It can be seen that the recovery from this Global Financial Crisis is slow and still fragile, fraught with uncertainties. 3. New Zealand was assisted by significant stimulus Something that has marked out this global crisis as compared with the 1930’s Great Depression is that we have learned the importance of government policy stimulus being applied early, forcefully and consistently. While still too early to be definitive, economists generally see government stimulatory policies as having been quite successful in stemming the recession. Of course long-term outcomes cannot be judged until we see how successful countries are at exiting their stimulus without long-term costs. New Zealand like Australia has been fortunate in several respects: the crisis did not hit deep, the financial sector stayed broadly sound, and recovery is being helped by strong commodity markets. That has meant we did not have to stimulate the New Zealand economy by anything like the levels in Europe and the US. Nevertheless we have just been through the biggest co-ordinated stimulatory programme involving monetary policy, fiscal policy, liquidity assistance and government guarantees since World War II. These look to have been relatively effective in their timing and design, and are not expected to have left big public costs behind. The graph of GDP shows that the New Zealand economy went in to recession in Q1 2008, although this was initially triggered by an unusually-severe drought, rather than the Global Financial Crisis. The figure also summarises the main stimulus measures that were put in place, together with another important market insulator, the exchange rate reaction during the crisis. It shows that many of the measures were implemented fairly quickly. The economy contracted 3.4 per cent over the period, reaching a trough around March 2009, and back to fragile growth later in the year. By the time we received the last quarter 2009 GDP data we were in a position to say that recovery was firming and we would need to exit much of the stimulus. Most but not all of the special liquidity measures have now been terminated, leaving conventional monetary policy to guide the stages of recovery. Note: Fiscal policy stimulus defined as significant increase in fiscal impulse measured, New Zealand Treasury in Half-Year Economic and Fiscal Update, December 2009. Exchange rate depreciation is the major fall in the New Zealand TWI from March 2008 to March 2009. Very stimulative monetary policy refers to the major reduction in OCR from 8.25 per cent to 2.5 per cent followed by a conditional undertaking to hold the rate low. Retail deposit guarantee refers to the original scheme, terminating in December 2011. The extended scheme is likely to have much less impact. Wholesale funding guarantee has now expired. Term auction facility relates largely to the acceptance of residential-mortgagebacked securities. With the termination of these special programmes, the Reserve Bank does not feel it needs quite as much risk-based capital on its own balance sheet, and consequently has returned $45 million to the Crown. 4. The world is on two different recovery paths A feature of this recession is that we are seeing quite different troughs and recoveries in two regions of the world, as shown in the figure. In the “East”, defined as emerging market economies and commodity exporters, the cycle has been more shallow, and a very strong “V-shaped” recovery is underway. Of most relevance to us, China and Australia are both in this group, but also other Asian economies, and oil exporters and commodity exporters from Latin America, Southern Africa, South-East Asia and Australasia. In the “West”, an Icelandic-style cloud of despondency still settles over the old Northern economies with large financial sectors and high production costs. In the US, Eurozone, and particularly UK and Japan the cyclical trough was historically deep, and the recovery looks slow and fragile. The difference in these two zones shows up clearly in the figure. The Eastern region lost 2.5 per cent growth through the crisis, but is now back on to a pre-crisis growth trend, and has clearly passed pre-crisis income levels. The Western region lost a lot more income through the period – around 4.5 per cent and is struggling to resume its (much lower) precrisis growth trend, and has not yet made up for lost income. The economic recovery is involving some degree of global rebalancing. The huge current account deficits of the West and surpluses of the East have been partly reduced as a result of a rebalancing of consumption and savings. The broader economic and geopolitical implications of rebalancing are only now starting to be seen in the G20 and in bilateral negotiations. 5. Our own recovery is externally-driven New Zealand has been considerably helped during this recovery period by a strong China and emerging market growth in consumption, a strong minerals-driven Australia, and some other market and climatic factors. We saw a commodities boom in the pre-crisis year, but few people expected to see it repeated immediately post-crisis. Most would be aware that world dairy prices have recovered significantly over the past year. But in addition, beef, forestry and aluminium prices have also risen to very high levels. These high world prices have not completely benefitted New Zealand growers because of the relatively strong $NZ. (Of course these high commodity prices are themselves one of the drivers of the strong $NZ). Interestingly when we look at longer-term movements in New Zealand’s export and import prices, we can see the origins of our country’s post-war strength, followed by some very difficult decades of declining terms of trade through the 1970’s and 1980’s reflected in slower growth relative to the OECD. Now we might speculate whether we are on a gradually improving trend in the terms of trade, one that has shown itself very resilient to the global crisis. Overall, we are emerging from the crisis with some reconstruction of our external deficit as a result of strong exports, weaker import growth, suppressed domestic profits, and some consolidation of balance sheets. This too is a desirable trend, although it is still unclear how much will be an enduring development. 6. Domestically cautious rebalancing is underway While the export sector has strong drivers, the domestic sector is seeing much more fragile recovery. There are no strong drivers here. Businesses and households have been through a harsh experience and they are responding very cautiously, deleveraging their balance sheets. Balance sheet adjustment can take some time. We have not been through an adjustment quite like this before, so there is considerable uncertainty in the minds of households and business people, and also in how we interpret their behaviours. The business sector has emerged from the crisis bruised but not permanently scarred. In general, businesses went into the period with healthy balance sheets, in contrast to the 1990–92 recession. However they are now behaving very cautiously and as a generalisation, are still not looking to invest in plant and equipment or re-employ staff. Together with the deleveraging taking place, that means they are not undertaking new borrowing. Indeed the banking sector credit data continues to be extraordinarily restrained. This is probably an unusual combination of demand weakness and supply constraint. Whatever the explanation we certainly wish to see credit available for all sound business ventures. In the meantime business credit growth continues to contract by 8 per cent (as can be seen in the figure), a most unusual situation and one that contributes to our monetary aggregates showing no growth over the past year. The household sector looks correspondingly soft. House prices and activity contracted markedly through the recession, although they ended up a little more robust than we had feared. However, as we now record positive growth again, we have seen only a very soft pick-up in house prices, new building and sales, despite moderate demographic growth. Despite this, rather than building up housing assets, so far in this recovery, householders are concentrating on reducing their mortgage borrowing sharply, and hence building up housing equity. Another way to see this is as householders building up savings and reducing debt. This is happening through borrowers not taking on new mortgages as in the past, and using lower interest rates with constant repayments to reduce the size of outstanding loans. The net effect can be seen in the figure. 7. Our focus is how to reduce monetary stimulus With unconventional stimulus programmes now largely terminated, the stage is set for us to influence the pace of recovery through more conventional discretionary monetary policy. This should be more comfortable ground for us all. In our official cash rate review last week we noted: “As previously indicated, we expect to begin removing policy stimulus over the coming months, provided the economy continues to evolve as projected.” We used the words “begin removing stimulus” deliberately. With an official cash rate at an historically low level of 2.5 per cent we are clearly in a very stimulative position. Using a truck driver analogy, our foot is strongly on the accelerator. Over coming months we expect to reduce the pressure on this pedal, but in effect to keep some throttle going. Truck drivers know they must reduce acceleration long before the corner. We are not talking about tightening policy yet. We do not expect to have to touch the brake pedal for some time. Analysts differ in their views as to what level of the OCR implies moving the foot from accelerator to brake. Actually, given the behavioural changes that are in place due to financial market pressures, it is unclear exactly what the “neutral” official cash rate is, something that can only be established incrementally over time. Financial markets currently expect the Reserve Bank to begin raising the official cash rate around the middle of the year and continue to do this in small steps for some time. This is broadly in line with our current views as outlined at last week’s OCR Review. However, the timing and pace of returning the OCR to less stimulatory levels will ultimately depend on economic developments. Both markets and ourselves foresee that the official cash rate will not need to rise as far in this cycle as it did in the last one. There are a number of reasons for this, none of them individually definitive, but all pointing in the same direction: in brief the financial markets have already effectively tightened conditions as a result of more costly funding; the New Zealand private sector is reducing debt and cautious about new borrowing; most borrowers are on shorter duration mortgages and the steeper yield curve does not much encourage lengthening this; increasing policy rates in the shadow of Australia should be easier than being a world leader; and, finally, we believe there may be alternative ways of influencing over-exuberant bank lending through macrofinancial policies. Our economic recovery is out of its first stage of intense fragility, and into a new phase of rebalancing growth. But a final caution: recovery so far has been full of surprises. There will be more to come!
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Speech by Mr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Wellington Regional Chamber of Commerce, Wellington, 14 June 2010.
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Alan Bollard: New Zealand’s economic recovery, external vulnerabilities and the balancing act ahead Speech by Mr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Wellington Regional Chamber of Commerce, Wellington, 14 June 2010. * 1. * * How is our recovery going? We have been out of recession for a year now, and we can take stock of the recovery so far. We hit a trough in the New Zealand economy in the second quarter of 2009, marking a turning point after a year during which we contracted a total 2.2 percent. This was a long and deep recession by our standards, but compared with other OECD countries, we got through reasonably lightly. A period of fragile stimulus – assisted growth followed. We have now removed most of the temporary liquidity measures that we introduced during the crisis. We believe we are in a more robust growth situation, and that is why we have judged this to be the right time to start removing monetary policy stimulus and move towards more normal policy settings. The recovery has been assisted by strength in our Asian-Australian trading partners, and in our international commodity prices. We have been enjoying very strong export price growth by the standards of the last two decades. While it will take time to confirm this, there is evidence that we have moved to a stronger terms of trade track, and this is clearly good for our growth future. The domestic recovery has been much more muted. Both the business and household sectors have been through harsh times and this has changed their behaviours – they are reducing debt and reassessing their spending. Understanding how much these are temporary or enduring behaviours, is complicated by the tax and spending changes announced in the recent Budget. These will likely rebalance investment from property to other assets but it is too early to be clear about this. In addition, the indirect tax changes will offset the pattern of consumption. The overall effect is that we expect a gradual recovery in business investment, housing and general consumption, but off a low base, and less funded by debt than in the past. The Greek fiscal crisis, the subsequent European support package, and the resulting financial market concerns have not changed our central view about economic recovery, but they have certainly given us food for thought about the strength of European markets for our exports, about the robustness of the term funding markets for our banks, and about financial market tolerance for fiscal deficits. We will keep watching these developments closely. 2. Is our economy rebalancing? There has been a lot of discussion about the big global imbalances that had been allowed to develop over the last decade, and the extent to which they contributed to the Global Financial Crisis. More importantly we are all keen to see how much global rebalancing is now underway with the recovery. So far the answer is that some rebalancing has happened, but it is still quite unclear whether this will be lasting or sufficient. What about New Zealand? Here we are seeing strong improvements in export prices, but they are not yet translating into strong domestic consumption or strong investment. Instead households and businesses are using extra income to stabilise their balance sheets. In assessing the state of balance of the New Zealand economy, we might view it through four different lenses: funding imbalances for banks, fiscal imbalances on the government account, savings imbalances on the household account, and external imbalances. These are all inter-related, though in complex ways. Funding imbalances – Australasian banks have relied heavily on short term foreign funding, and that proved a vulnerability in the crisis. For that reason we have put in place a liquidity policy requiring banks to hold longer-term foreign funding plus retail deposits to meet an increasing core funding ratio. That has already contributed to longer duration funding. This recently proved its worth during the Greek crisis when there were renewed signs of fragility in international funding markets. Fiscal imbalances – The Greek crisis also focussed attention on to government funding deficits. The Global Financial Crisis led to many governments assuming the costs of rescue packages and the risks of the financial sector more generally, during the recession at a time when their tax revenues were falling and social expenditures rising. The result has been some very unattractive fiscal deficit positions and forward projections that will strain available funding. The markets have focussed on cases like Greece with no independent exchange rate or monetary policy. However as the Bank for International Settlements shows, the issue of fiscal sustainability goes much wider. They show rapid growth in public debt to GDP ratios for the next 30 years, even under an assumption of fiscal retrenchment, resulting in interest payment to GDP ratios that could go as high as 20 percent or more. Many OECD countries would need to run at least 2–3 percent budget surpluses consistently for several decades just to stabilise their public debt ratios at pre-crisis levels. The New Zealand fiscal accounts continue in deficit, but with a credible and improving track going forward. The recent budget confirmed this. The financial markets have seen this as very credible, and New Zealand is generally rated very positively for its fiscal approach. This is shown in the following international estimates of financial fragility by the UBS, an index that includes public sector debt and private credit. New Zealand is rated in the middle of the pack. Household balance sheet – The household sector has been the most obvious source of imbalance in New Zealand with balance sheets heavily skewed to housing, high debt ratios, and very low traditional savings via financial instruments. By comparison with other OECD countries New Zealand households are very low savers, on average consuming around 9 percent more than they earned over the past decade, according to Statistics New Zealand estimates. Figures like these may over-state Kiwi households’ vulnerability and there are other data that present a less worrying picture, but by any standards New Zealand household balance sheets do not look healthy. This was one reason why we have had such high levels of the OCR over the last decade. Based on our Monetary Policy Statement, we forecast New Zealand household savings to improve from a very poor position to one that has improved, but is still insignificant deficit. We believe that since the crisis, New Zealanders have decided they are over-exposed to property assets and to high debt, and they are prepared to constrain consumption to improve their savings. But we are unclear how much rebalancing they contemplate, and for how long. In addition much will depend on how these extra savings are invested, and whether this is domestically or internationally. Financial markets do not judge our savings balance directly, but rather through its funding implications and its contributions to the external balance. Balance of Trade – Strong export prices for much of our primary products (somewhat muffled by the strongish exchange rate) have been yielding improved export returns. At the same time consumers, farmers and businesses are all moderating their demand for imports. The result has been a quick and significant improvement in the direction of trade, recording positive balances once again. However we forecast that only part of this improvement is permanent, as import growth will revive. Were the New Zealand dollar to drop improving our competitiveness, export prices would improve in local currency, and there would also be a positive supply response in some products. Investment Income – While the trade component in our balance of payments has improved, the other major component is far more problematic: that is the investment income balance. This measures incoming earnings from the very limited amount of New Zealand investment abroad against outgoing earnings from the much larger stock of foreign investment in New Zealand. New Zealand runs a large investment income deficit of around 6–7 percent of GDP, which is showing little sign of enduring improvement. Indeed it will be difficult to improve this metric as that would require us to get our net external debt position on to a downward trend and that would require a significant change in historic patterns of inward and outward investment. These two components combine into the current account, which has been in significant deficit in New Zealand for 40 years. That is not problematic in itself, but if it is consistently funding consumption rather than investment, then that cannot continue. The deficit worsened during the housing boom years of 2005–2008, sitting near 9 percent, a very deep deficit by OECD standards. Interestingly, throughout the crisis we experienced little sign of financial market discomfort with that position. We are now experiencing a big improvement in the current account, reducing the deficit to 3 percent, but we believe it will deteriorate again as the recovery picks up. 3. Our overall external imbalance Years of running these external deficit flows means that we are now significantly in debt to foreigners: in plain terms, they have more than twice as much invested in NZ ($290 billion) as we have invested overseas ($125 billion). This means the country is running a sizeable net investment deficit of around 90 percent of GDP. Most of the debt inherent in this position is in the private sector, not the public sector. A significant proportion of this relates to the banking system which does most of the country’s offshore borrowing, effectively on behalf of households and businesses. Most of it is currency-hedged, so we do not suffer major currency risks from it. The graph shows how the position has grown over the last decade. Our forecasts see this external deficit continuing to grow. Financial markets and credit rating agencies use a range of indicators to form their assessment of a country’s viability or fragility. At the moment most of the focus is on sovereign debt and the fiscal accounts. However as the recent credit downgrade of the Government of Spain showed, overall external indebtedness can play a role in this. New Zealand is one of the very few developed counties with net external liabilities so high. The UBS country risk index mentioned above rates us rather higher in terms of external fragility (an index based on exports, current account, external debt, and foreign exchange cover). This external deficit cannot keep increasing with impunity. Ultimately the markets would penalise the large external liabilities and deficit position by requiring a larger premium for its continued funding, and the sheer size of servicing our obligations could become an intolerable burden to the country. Already we spend around 6–7 percent of GDP servicing debt and returning profits off-shore to owners of New Zealand domiciled businesses. As the recent IMF Report on New Zealand makes clear, there are a number of aspects of our external position that are unusual by world standards: We have relatively high foreign investment here, but we do not do much investment overseas. We have high levels of private debt, predominantly overseas funded, short-term, but fx hedged. Almost all of this debt is channelled through bank lending. We do not save much, with very limited financial savings and stocks and shares. Overwhelmingly our household assets are invested in housing and other property. 4. How to reduce our vulnerability If this growth in our external indebtedness cannot continue, then it will not. But rather than await the market descriptions noted above, are there proactive steps that can improve the situation? The diagram shows a highly simplified picture of how the actions of households, businesses, banks and government feed into our balance of payments, in a way that over time drives our net international position. While the actions of government and businesses can be significant, the real impact comes from household consumption and savings, and from the actions of banks. With this is mind, how can we see this external position best being controlled and improved? Reducing our external vulnerability is a long-term proposition that would mean running lower current account deficits than we have in the past and sustaining them over an extended period, not just one or two years. Our calculations suggest that reducing current account deficits to no more than about 5 percent of GDP on average is necessary to stabilise the Net Investment Position as a share of GDP, while reducing that share over time would require lower deficits to be run. There are many factors that can influence the size of our deficits, some of which are within New Zealand’s control and some that are not. Changes in national savings, the terms of trade, exchange rates, interest rates, and the fiscal balance can all affect New Zealand’s external vulnerability. Most would take some time to have an effect on the external balance sheet. From a policy perspective, there are no magic bullets for running better current account balances. However, there are a range of policy areas underway that can certainly make a positive difference: Continuing to move New Zealand’s tax system in favour of saving rather than consumption. Ensuring fiscal policy remains focused on achieving a conservative path for the public debt. Ensuring that our framework for financial regulation discourages excessive rates of credit expansion and excessive leverage. The core funding requirement for banks is already resulting in a lengthening maturity structure for their offshore borrowings which has helped them reduce their exposure to recent financial market volatility. Continuing to search for ways to help ensure that monetary policy adjustment is not borne excessively by the tradables-producing industries. However some of this will continue to be dependent on how other countries run their exchange rate policies. Ensuring that public policy facilitates investment activities that achieve sustainable real returns and does not inadvertently encourage activities that are of little lasting economic value. But this challenge is not primarily up to the Government. It mainly requires the changes that we are seeing in household behaviours to continue. Helping them are higher returns for bank deposits, revamped regulation of financial advisors, investment offers and finance companies, more attention to financial literacy, and a rising interest rate track which favours savers. More of these savings will be in asset areas other than property and some of them will be in overseas investments. Ultimately the onus is on households to continue the current trend of saving more and investing better.
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News release and speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Taranaki Chamber of Commerce, New Plymouth, 19 August 2010.
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Alan Bollard: Keeping inflation anchored during economic recovery Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand and Mark Blackmore, Special Adviser, Economics Department, to the Taranaki Chamber of Commerce, New Plymouth, 19 August 2010. * * * The main theme of my commentary today is inflation during the recovery, what we expect to happen with the forthcoming increase in GST and what it means for monetary policy. The New Zealand economy is into its second year of recovery with much of the ground lost during the recession already made up. The economy has been growing since the June quarter of 2009 and we are now in this September quarter in the sixth quarter of growth. Initially growth was very muted but it picked up a little momentum towards the end of last year. Compared with some past recoveries this is certainly not a fast or robust one. So far, it is comparable with the initial slow rebound from the 1991 recession. It lags behind the 1998/99 recovery from the East Asian crisis, which is probably freshest in most peoples’ minds. We should not really be surprised by the gradual nature of the recovery. The global shock that hit us was, something like a once-in-a-generation event. We also still have to work off some of the excesses of the past expansion, such as high levels of private indebtedness along with reducing the fiscal deficit. These will remain a drag on growth for some time yet, as they are in a number of OECD countries. As a result the recovery still has some fragility about it. We do, however, expect GDP growth to continue, with the emphasis on export growth as household and business spending remain subdued. This outlook and the associated policy implications will be reviewed over coming weeks as we prepare the September Monetary Policy Statement. What does this imply for inflation? Inflation has been well contained recently, with consumer prices increasing 1.8 percent in the 12 months to the June quarter this year. This marks five consecutive quarters where annual consumer price inflation has been at or close to the midpoint of the Reserve Bank’s 1 to 3 percent inflation target. It is worth noting that this contained inflation picture comes after a period of very strong growth in the prices of domestic assets and international commodities. Both played a major part in the strong inflation pressures New Zealand experienced in the mid-2000s. How does this inflation performance compare with other countries? Globally, consumer price inflation has reduced as a result of the financial crisis. It actually went negative in the US and Euro area for several quarters on the back of lower energy and food prices, but it has since rebounded a little. Measures of so-called “core” inflation in these countries have been trending down since the start of the crisis. The inflation record in Australia has been similar to New Zealand, except over the past few years as their economy avoided recession and some price pressures continued. In New Zealand there have already been several government policy developments that have affected prices: the amended Emissions Trading Scheme coming into effect on 1 July, changes to tobacco and excise taxes and ACC charges all have had significant effects on inflation. Despite this, consumer price inflation is likely to be close to 2 percent again in the September 2010 quarter. However, the most significant event is the increase in the rate of GST on 1 October. This will push headline inflation substantially higher. This mainly involves direct effects of GST on goods and services purchased. The figure shows the forecasts we published in the June Monetary Policy Statement, implying some price pressure this quarter and a 2 percent price shock next quarter. Since then our expectation of the peak in inflation has eased back to around 5 percent or just below. The figure shows that the spike in inflation is expected to be short-lived. The inflationary effects should be largely out of the system by later next year. Our industry intelligence to date suggests that the GST increase is not being treated as a big disruptive event by the retail industry. Pre-stocking does not appear major, nor does prepurchasing, and a last quarter sales fall-off is not expected. The spending effects of the GST increase are counter-balanced by the income tax reduction. As the economy grows, employment levels are expected to increase, and plant and equipment will be worked harder. As this occurs underlying inflationary pressures are likely to gradually increase, but consumer price inflation is forecast to remain comfortably inside the target band in the second half of our forecast horizon. Higher headline inflation would obviously pose a challenge for monetary policy. There have, of course, been periods in the past when inflation moved temporarily outside the Bank’s target band. The Policy Targets Agreement with the Government deliberately gives the Bank the ability to “look through” temporary inflation spikes. The Agreement defines the Bank’s price stability target in terms of the Consumers Price Index. However, it also instructs us to focus on the medium-term trend in inflation, and lists changes in indirect taxes and significant government policy that directly affect prices as specific reasons why inflation might vary around its medium-term trend. As such, monetary policy will not attempt to offset the immediate direct inflation impact of the coming policy changes. Given the staggered nature of the indirect tax increases and the progressive introduction of various sectors to the Emissions Trading Scheme, there is an additional risk that the coming spike in inflation causes consumers and businesses to reassess their expectation of medium-term inflation. The degree to which monetary policy can “look through” temporary inflation spikes depends crucially on the extent to which New Zealander’s inflation expectations are impacted by such spikes. Of late, inflation expectations have risen from the lows seen at the trough of the recession but they remain contained. Two-year-ahead inflation expectations initially lifted late last year, when there was some talk of the housing market gaining significant momentum again and the economy had clearly moved out of recession. Subsequent to that we saw excise taxes rise, the ETS-related charges become more definite and the announced rise in GST. All of these are likely to have played some part in inflation expectations staying up, even as the housing market has eased off and the pace of the recovery has remained moderate. However, the Reserve Bank does not expect the forthcoming price spike to have a lasting impact on inflation expectations. (In support of this, the just-released AON survey shows that longer-term inflation expectations have not moved as a result of the impending GST increase.) The GST increase in 1989 did not materially affect inflation expectations, and again we expect this to be the case in 2010. As in 1989, personal income taxes will be reduced on 1 October, offsetting the impact on disposable incomes coming from the GST increase. Other temporary spikes in inflation have also not generally fed into inflation expectations and the Reserve Bank has been able to “look through” the immediate impacts of the price change. This is one of the big pay-offs of keeping inflation well anchored. Nonetheless, the price and wage setting behaviour of firms and households will be monitored for evidence of indirect and second-round effects on inflation. For now, it is assumed that the coming policy changes will have only limited impact on perceptions of future inflation. The key to ensuring no significant effect on inflation expectations is for businesses, labour groups and households not to use the GST increase as a veil to increase margins and wages. Doing so would simply spread inflation and harm the recovery. The extent of indexation in the economy is much less than it was decades ago, but there are still some wage and price adjustments that are unavoidably linked to the consumers price index. The 1 October income tax reductions mean most people are already compensated for the effects of the GST increase. Given this, there is less argument for one-off CPI-indexed wage increases. A particular message of restraint is for those parts of the economy, both public and private, that have a record of increasing prices by more than the rate of economy-wide inflation. We expect to see relative prices change in a well functioning economy. In a competitive market they represent an important signal for resources to move around the economy in search of more profitable opportunities. A good example is the agricultural transformation that has occurred with the rise in dairy prices. There may also be public policy reasons why some prices move more than others. But there are also examples of persistent price increases in sectors that have not suffered persistent cost increases, and these have an inflationary effect. The diagram shows the impact of excise tax increases on alcohol and tobacco industries, and that the energy and local authority sectors have recorded persistently high price pressures. Given the fragility of the recovery it is important that firms base their pricing decisions on low underlying inflation, and not the forthcoming temporary spike. Monetary policy would need to respond if inflation expectations and prices were ratcheted up significantly. The result would be higher interest rates and a dampening of the economic recovery. We are hopeful this will not need to be the case, so that monetary policy can play as full a part as possible in supporting economic growth.
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Summary of remarks by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, at the Symposium on Financial Sector Governance, Auckland, 20 September 2010.
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Grant Spencer: The impact of the global financial crisis on financial policy Summary of remarks by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, at the Symposium on Financial Sector Governance, Auckland, 20 September 2010. * * * In this presentation, I would like to discuss New Zealand’s financial policy response to the Global Financial Crisis. My focus here will be on permanent changes to policy following the crisis rather than the initial short term “emergency” responses. I will cover financial policies overseen by the Reserve Bank, namely monetary policy, liquidity management and the prudential supervision of banks and non-banks. Monetary policy In New Zealand, monetary policy focuses on the maintenance of price stability. This alone provides no guarantee of economic stability or financial stability. However, the experience in New Zealand and overseas suggests that maintaining price stability over the medium term is the best and most worthwhile contribution monetary policy can make to achieving broader economic and financial stability. Our inflation targeting framework served us well during the financial crisis and helped guide sensible policy responses. Immediately prior to the crisis, monetary policy in New Zealand had been relatively restrictive with the Reserve Bank increasing the Official Cash Rate (OCR) between 2004 and 2007 in response to elevated inflation pressures associated with a booming housing market. As the global crisis emerged and deepened, we responded by reducing the OCR aggressively. The OCR was cut during 2008 and early 2009 from a high of 8.25 percent to just 2.5 percent. These reductions were appropriate, despite high headline rates of inflation at the time due to record high oil prices. The policy easing was consistent with an outlook for rapidly diminishing inflation pressures as the global and domestic economies turned sharply downwards. Going forward, medium term price stability will remain the primary objective of monetary policy. However, we expect that monetary policy will have more bite over the next few years than it has had for many years; for a number of reasons: First, following the crisis our banks now face a higher cost of funds. It is now more expensive for them to borrow offshore, which in turn has seen them compete more aggressively for funds raised in the domestic retail deposit market. We currently estimate that the spread of the banks’ average cost of funds over the OCR is some 150 basis points higher than prior to the crisis. This state of affairs is likely to persist for some time. It means that, for any given OCR, the rates the banks charge their customers for lending will be higher than before. Second, the evidence to date suggests that, following the global crisis, households and businesses are considerably less willing to take on new debt. Credit growth remains very subdued. We believe that this diminished appetite for debt will remain for some time as people and companies work to gradually strengthen their financial positions. Third, unlike the situation over much of the past twenty years, New Zealand is now facing an upward sloping yield curve – longer term interest rates are higher than short-term rates. This means that fixed rate mortgages are now more expensive than floating or very short-term fixed rate mortgages. This has seen many borrowers shift back to floating rates over the past two years. As a result, as we move the OCR higher it is likely to have more “bite” than it did previously. Liquidity management As the global financial crisis broke, a key policy response from the Reserve Bank was the expansion of liquidity facilities that we provide to banks and other financial institutions, including a broadening of acceptable collateral instruments. This expansion of facilities was needed to ensure that the financial system remained liquid and that institutions could continue to make payments as required without creating undue stress in the interbank market. In particular, as the banks’ access to global markets became very restricted in late 2008–early 2009, the Reserve Bank provided access to term funding secured over mortgage backed securities. The banks also increased their use of parent funding during this period. With the crisis behind us, we have been reconsidering the appropriate role and scope of the Reserve Bank’s liquidity facilities. The crisis has demonstrated the value of liquidity support for fundamentally sound institutions in the face of systemic market disruptions. While it is important that institutions provide for their own liquidity in the first instance, it is clear that central bank liquidity facilities are an essential backstop at times when shocks to confidence cause market liquidity to dry up. Key requirements for central bank facilities are that: their pricing encourages a return to normal market trading; they are targeted at system liquidity, not individual institutions; and they are fully collateralised. In light of the GFC experience and the Bank’s broader mandate to promote the efficiency of the financial system, we intend in the future to adopt a somewhat broader approach to liquidity management than was the case prior to the crisis. The range of securities that we accept as collateral will be wider than in the past in order to help support liquidity in a number of key financial markets. Such markets include: the NZ dollar, Bank bills, NZ Government securities, and local authority/SOE stock. In addition, access to the Bank’s overnight facility will be extended to major NZ dollar settlement systems. Prudential policy: banks Turning to prudential policy, the global financial crisis has prompted a major review of policy internationally. In New Zealand, the financial crisis highlighted shortcomings in the banks’ management of funding and liquidity rather than credit losses of the sort seen in the major economies. A heavy reliance on short-term foreign borrowing by the NZ banks meant they were vulnerable to the sort of liquidity shock experienced in late 2008–early 09. While the banks’ funding shortfall was met through parent funding and the Reserve Bank’s expanded liquidity facilities, the experience underlined the need for banks to lengthen the maturity of their liabilities relative to assets, in order to reduce their vulnerability to such shocks. To address these issues, the Reserve Bank introduced a new prudential liquidity policy for banks in April 2010. This policy requires that the banks hold sufficient eligible liquid assets to meet one-week and one-month liquidity mismatch ratio requirements. In addition, the banks must meet a Core Funding Ratio requirement of at least 65 percent. Core funding consists of customer deposits (weighted by size) and market funding of one year or greater to maturity. The Core Funding Ratio requirement will rise to 75 percent by mid 2012. The banks have already made good progress in lifting their Core Funding Ratios to be well in excess of the 65 percent minimum requirement. Internationally, the moves to strengthen banking regulation are being led by the Basel Committee on Banking Supervision (BCBS), made up of banking supervisors from the major economies and convened by the Bank for International Settlements (BIS). The BCBS has developed a number of proposals under the broad “Basel 3” label which are expected to be agreed at the upcoming G-20 meeting in November. The proposals are focussed on strengthening banks’ minimum capital and liquidity requirements. These include higher Tier 1 capital requirements, a greater emphasis on common equity in Tier 1 capital, and a leverage ratio to act as a backstop to the risk weighted capital regime. Other proposals include more explicit liquidity requirements (similar to those described above for New Zealand), arrangements for greater international coordination of supervision and revisions to international financial accounting standards. The crisis has shown that existing accounting standards are problematic for financial institutions in a number of areas such as mark-tomarket asset valuations and provisioning rules for loan losses. Another area to receive attention under Basel 3 is the possible use of macro-prudential policy adjustments to help counter pro-cyclical behaviour in financial systems. The BCBS has proposed that banks be required to build up additional capital buffers at times of rapid credit growth that could then be drawn down in times of stress. The intention of the instrument would be to lessen the impact on the economy when the boom turns to bust as well as possibly constraining excessive credit growth. A number of central banks, including the RBNZ, are also looking at other macro-prudential tools that could possibly be used to help limit the extremities of the credit cycle. The challenge here is to find instruments that will actually work without imposing major efficiency costs on the financial system. Prudential policy: non banks New Zealand’s non-bank deposit taking sector comprises a number of different institutional types. The savings institutions (building societies, credit unions and the PSIS) have generally weathered the crisis well. The finance company sector, on the other hand, has faced considerable upheaval over the period since 2006, with only about a third of the companies in early 2006 now remaining active. While the Global Financial Crisis added to the difficulties faced by the finance companies, the sector’s issues have been largely home-grown as a result of poor lending decisions, particularly with respect to property development lending, and inadequate capital support. While the Crown retail deposit guarantee scheme has provided some liquidity protection for the sector, allowing time for the sounder institutions to rebuild investor confidence, the companies that have been unable to recapitalise or restructure have ultimately been forced to exit the industry. An amendment to the Reserve Bank Act in late 2008 saw the Reserve Bank become the new prudential regulator of the non-bank deposit taking sector; with trustees remaining the front line supervisors. Since then the Reserve Bank has been developing a new regulatory framework and phasing in the new prudential requirements. Key elements include mandatory credit ratings, connected lending limits, an 8 percent minimum capital requirement, and fit and proper tests for senior managers and directors. While these reforms are clearly too late to avert the negative consequences of earlier finance company practices, the overall aim is to raise safety standards in the sector so that the remaining players are more resilient to future business cycles. Conclusion The Global Financial Crisis had major effects on the NZ financial system and economy. It prompted responses across the full range of Reserve Bank policies, including monetary policy, liquidity management and prudential policies. Many of these responses were short term in nature but there have also been important long term policy consequences. Indeed, in the prudential policy area, there is significant policy change still yet to come from the strengthening of international standards under the “Basel 3” initiative. Most of the permanent policy changes undertaken by the Reserve Bank have related to liquidity: requiring banks to better protect themselves against liquidity shocks; and recognising a somewhat broader role for the Reserve Bank in supporting financial system liquidity in times of stress. This should not be surprising given that the dominant transmission channel for the Global financial Crisis was an unprecedented reduction in global financial system liquidity.
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Speech by Mr Alan Bollard, Governor of the Reserve Bank of New Zealand, at the Deloitte Tax Conference, Auckland, 19 November 2010.
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Alan Bollard: The recovery, the aftershock and the economic future Speech by Mr Alan Bollard, Governor of the Reserve Bank of New Zealand, at the Deloitte Tax Conference, Auckland, 19 November 2010. * * * The crisis The Global Financial Crisis has been the major economic event of our time. As we continue through the recovery phase and encounter unexpected aftershocks it is timely to reconsider what this means for New Zealand. The Global Financial Crisis was not as harmful as the 1930s Depression, but from that event we learnt that recovery to economic normality can be a slow, fragile, uncertain process with temporary set-backs and aftershocks. The 2008 Global Financial Crisis has been different from the 1930s: it was widespread and internationally synchronised, it hit deep, but not long. It originated from the banking sector, spread virally across a number of sectors, hit the housing sector particularly hard, and was ultimately arrested by active government stimulus. The Global Financial Crisis finally troughed in mid-2009 in an internationally-synchronised way. There was general relief as the macroeconomic data became more reassuring, and the very large contractions in economic activity ceased. At that stage our focus turned to what the recovery would look like. The history of major financial crises shows a consistent pattern emerges: a long period of building up stresses (averaging a decade), a rapid unwinding, then an equally long period of gradual recovery 1 . Carmen M. Reinhart & Reinhart, Vincent R. (2010) “After the Fall”, Jackson Hole Symposium. Following regular post-war business downturns that were not associated with financial and banking crises, economies have traditionally recovered speedily and strongly. Not this time in the West. Instead we have seen businesses very cautious about reinvestment, with scarcely any credit growth. In the US, households have been traumatised by the twin fear of losing their jobs and their houses. We have observed two particular aftershocks to the crisis, neither of which was expected, as countries struggle to rebalance in two distinct ways. External rebalancing We are seeing an external “aftershock” playing out across the globe right at the moment with big movements in exchange rates to cross-rate extremes not seen for decades. The need to rebalance externally has been driven by the record build-up of international imbalances that created the pre-conditions for the Global Financial Crisis. In short-hand the East was building trade surpluses, savings and high reserves, while in the West the opposite was happening. In late 2009 we saw an initial rebalancing, driven mainly by negative forces: a reduction in spending by Western consumers, a reduction in Western imports, and a deleveraging of Western balance sheets, rather than a shift to an export-led growth recovery. However the forecasts suggest this rebalancing may not continue, and we have not yet reduced these international imbalances to sustainable levels. In the US these concerns have been manifested in weak labour and housing markets. Up to 30% of mortgagees face negative or near zero equity in their homes and long-term unemployment is stubbornly elevated, with intense political pressures on monetary policy to provide relief. This has led to further moves to inject liquidity in unorthodox ways, referred to by the financial markets as “QE2”. So far these policy measures have had a major effect on equity and bond prices, on capital flows and on exchange rates. They have depressed the $US, generated a new carry trade in $US, and resulted in significant new capital inflows to emerging markets. The US economy remains weak, with housing and labour markets mired as both households and businesses seek to rebuild impaired balance sheets. This requires a policy prescription of very easy monetary policy. But the growing currency tensions risk unleashing trade conflicts, a development that proved very costly in the 1930s. Many countries expected to have their recovery and external rebalancing aided by a softer currency, and when this did not happen they became very concerned. Chinese – US economic tensions have risen, as the US sees the RMB staying unnaturally low, a result of the tie to the $US, with much rhetoric but a political reluctance to revalue. The Chinese response has been to increase regional convertibility mechanisms, but only to allow minimal RMB appreciation. As this dispute escalates, there is a risk of Congressional intervention and anti-dumping actions. In the Eurozone, tensions between Germany and the peripheral PIIGS countries mirror the China-US relationship, with Germany running large current account surpluses via very strong exports, buoyant growth and the euro currency. Hurt most are the Swiss (who have been trying to intervene to depreciate the Swiss franc), and other peripheral European economies outside the EMS. Japan, with its own economic problems and a strengthening yen, took major unexpected unilateral action in mid-September: a massive (2 trillion yen) sell-off of the Japanese currency. This has had some short-term effects on the value of the yen, but it angered other G-7 economies whose currencies are themselves at risk. In addition it has implications for other East Asian currency regimes, where countries under exchange rate pressure such as Thailand, Taiwan, South Korea and Philippines, could be encouraged to intervene. Other countries such as Malaysia that have been trying to liberalise, may find themselves under pressure to re-impose capital controls. Internal rebalancing The second aftershock has been a sovereign debt crisis resulting from the need for countries to rebalance internally. Financial markets pressured overstretched Western fiscal balance sheets and the price of debt rose dramatically. Countries needed to rebalance internally: domestic demand needed to take over from public demand. Governments have spent hugely on fiscal stimulus, liquidity injections, and bank support through the crisis. There was a broad expectation that the private sector would take over from public sector stimulus to once again be the engine of growth: businesses would restock and reinvest, and the household sector would regain confidence. But, as local economies slowed, the costs of stimulus and rescues, low tax revenue and high demand for social spending hit government fiscal accounts hard. The resulting crisis first burst out in Ireland and the Southern European cluster of countries, collectively labelled the PIIGS, where there had been persistent over-stimulus and loose fiscal management. This profligacy meant that these countries were faced with a premium on their debt (see figure below) and the complex pan-European political and monetary institutions struggled to provide guarantees to bolster this situation, while also ensuring these countries took appropriately tough domestic fiscal actions. Spurred by these events, financial markets have now also focussed on some more major G-7 sovereign risks, in particular in the UK, US and Japan, where demographic ageing adds pressure to major government funding burdens. With the recession delivering lower tax revenue, higher social spending, and banking sector liabilities, projected government funding requirements in these countries now look very tight, severely limiting the room for future support to (increasingly unorthodox) monetary policy. Thus private demand in Western countries remains too weak to provide real impetus to the recovery. This reflects excesses prior to the crisis, the current outlook and the limited willingness and limited ability of fiscal policy to come to the rescue. Of course this has significant imbalances for the New Zealand outlook. Demand from Western countries is gradually improving, but still not very encouraging. The sad US housing story is bad for our wood exports, the UK fiscal retrenchment is hurting our UK tourist numbers and the fragile Japanese recovery restrains our food exports. Our own internal rebalancing is progressing, but very slowly. Substantial fiscal stimulus helped cushion the economy over the past few years. The fiscal deficit will need to be closed and private demand take over public sector support. Moreover, it appears that some of the fiscal deficit is structural and unwinding this support will subtract from growth for a number of years, with our housing market remaining weak, consumption impaired, balance sheets fragile and businesses remaining cautious. Private demand is still impaired. What is yet to come However at the same time the strong growth in East Asia and Australia emerging markets has been very beneficial. These markets were much less affected by the financial crisis, have themselves enjoyed strong export prices, and are now being buoyed by growing domestic demand. Russia, Brazil, energy exporters, South Africa and the Southern American countries are also in this group. They are developing a much stronger geopolitical voice for the G-20. The Chinese and India stories exemplify this – not by any means a simple picture, but here are two economies with continued strong export demand, government building of infrastructure, and evolving domestic demand. These economies have strong connections to regional growth that will benefit New Zealand indirectly over and above our direct trade exposure. Other medium term implications look particularly interesting for New Zealand. Post-war evidence shows that as emerging markets develop significant middle classes, there is a commensurate increase in demand for protein, increasingly animal-based. That has been the pattern across a number of countries with different cultures in different geographies. Many of these countries are limited in expanding their own food production, by lack of suitable land, lack of water, increasing climatic volatility, and high oil prices. A recent Nomura report 2 argues that real food prices will need to rise significantly. New Zealand is not a huge food producer (not being among the top half dozen producers of any of the world’s key food product groups). However our food exports (as a % of GDP) top the world, and we are the best placed in competitive terms in Nomura’s food vulnerability index. Food trade is volatile in the short term, but these trends are very positive for New Zealand’s terms of trade which have picked up significantly over the last decade. The other important positive pressure is from Australian growth. The Australian mineral boom is now well documented, and expected to continue, if not intensify. The drivers in China and elsewhere look reasonably sustainable and as a low cost producer, Australia appears better positioned than most to weather any reduction in Chinese prices. The strength of the mineral boom has meant a strong Australian recovery and a very strong AUD currency. Both of these outcomes are driving strong Australian demand for food and manufacturing exports from a more competitive New Zealand. We are a primary product supplier to Asia, but we need to see ourselves also as a post-primary supplier to Australia. So the medium-term outlook looks favourable. In the meantime we see New Zealand continuing its recovery. The aftershocks identified so far, and other aftershocks yet to come, mean that this recovery could yet be a prolonged process. “The coming surge in food prices”, Nomura, Sept 2010.
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers' Chamber of Commerce, Christchurch, 28 January 2011.
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Alan Bollard: Looking into the crystal ball – a forecast and some risks for the year ahead Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers’ Chamber of Commerce, Christchurch, 28 January 2011. * * * I would like to thank Kirdan Lees, Manager Issues and International, Economics Department, Reserve Bank of New Zealand, for his assistance in this speech. See slides at the end of the document. Introduction: For New Zealanders, Christmas and New Year are the times for family, relaxation and reflection on the year past. January is the month when we traditionally look ahead, and consider what the year may hold. This speech presents our economic view of 2011, and then poses a series of international and domestic risks to that forecast. Of course our forecasts will not turn out to be completely accurate. The risk analysis is a way to examine some of the complexities that may affect us. What we can and cannot forecast: There are limits to what we, the Reserve Bank, and indeed any economists, can forecast. Like meteorologists, economists have a reasonable understanding of what might happen in the near term, but over the longer term, perhaps beyond six quarters or so, uncertainty begins to increase. We generally find we can predict movements over the business cycle but struggle to adequately deal with big changes in structures or behaviours. Over the long term, we resort to analysing patterns and trends in the data in ways not dissimilar to how meteorologists look to la Nina and el Nino events to help understand the longer term picture. These patterns and trends do contain useful information but, like longterm weather forecasts, provide limited comfort if you want to know if it will rain on your wedding day in Christchurch in early summer. We regularly assess our forecast performance and look for ways to improve what we do. We find our activity forecasts a year ahead are reasonably accurate and likewise, we can forecast some price information, particularly for that part of the economy little affected by international trade. However, exchange rates and international prices are much harder to forecast. Of course forecasting has been particularly difficult as the world pulls out of the Global Financial Crisis. People’s behaviours and business’s behaviours have changed significantly and we have little from history to guide us about how enduring or deep these changes may go. In addition, the recovery has been rocky and fragile. In this speech we go further and look at some “what-ifs”, identifying some economic developments that could make a sizable difference to our forecast picture. We examine a number of international and domestic scenarios that could conceivably impact us. These scenarios contain both “good” and “bad” outcomes, and some have perverse or indeterminate collateral implications that make it hard to classify them. Moreover, these scenarios are not necessarily independent events. Interactions between shocks can be complex and important; and when it comes to the Global Financial Crisis, nothing is simple. For example, Howard Davies’ recent book documents 38 different things BIS central bankers’ speeches that went wrong during the Global Financial Crisis. 1 Many of these were inter-related, and those interrelations made the situation worse. But before we turn to the risks to our outlook, we will focus on what we think will happen over 2011, based on our view at the time of the latest Monetary Policy Statement, updated for data over the last month. What we think will happen over the next year: The Global Financial Crisis was a deep and damaging event. Even in New Zealand where we have been less affected, recovery has been slow and patchy. In fact, 2010 was a disappointing year: we initially saw recovery happening, but the second half went unexpectedly soft (as it did in many OECD countries). During 2011 we expect the recovery to pick up and gradually become more secure. The international outlook continues to be uneven. Growth in the Asian region has been strong but has brought its own difficulties with inflation and asset price bubbles building. The outlook for Western and developed economies is still spongy as these economies slowly recover from the aftershocks of repairing damaged bank balance sheets and ongoing government fiscal exposures. Commodity prices have reached very high levels, driven by emerging market demand. These high commodity prices generate stronger export revenue and provide a much-needed boost to incomes. However, farmers continue to use this income boost to repair balance sheets. Indeed the business sector, broadly speaking, continues to behave cautiously, opting to rebuild company balance sheets rather than take on new investment. We think that investment will start to pick up in the second half of this year as confidence returns, but it is by no means clear how persistent business caution will remain. The national construction market remains very soft. But the picture for the next few years is dominated by the significant impact of the Canterbury earthquake. Major damage has been done to homes, businesses and infrastructure, with a consequent significant loss of value. At the same time, there will be a big increase in economic activity as the repair work gets underway. There are many estimates, but we think that earthquake-related construction spending will add at least $5 billion to New Zealand’s nominal GDP. While essential infrastructure rebuilding will be frontloaded, our business contacts suggest much of the commercial rebuild may be a prolonged process lasting several years. All else being equal, this will add some pressure to prices and the exchange rate, but we think this is manageable. Housing turnover within the Canterbury region has been impaired, and nationally turnover remains at low levels, despite the floating mortgage market being well below historic norms. While firming over the past couple of months, we believe the current level of house sales is consistent with continued softness in house prices this year. As forecast, the December consumer price index jumped 4% as a result of the GST increases. Despite this, we think price inflation remains comfortably under control. This is the message that was communicated in the December Monetary Policy Statement and repeated in our January OCR Review this week. Consequently, it now seems prudent to keep the OCR low until the recovery becomes more robust and underlying inflation pressures show more obvious signs of increasing. See Howard Davies, “The Financial Crisis: who’s to blame”, Polity Press 2010. BIS central bankers’ speeches Four international risks: The forecasts for the year are crucially dependent on a number of international risks. A number of large economies have faced very unusual conditions as they emerge from the Global Financial Crisis, and this has resulted in high uncertainty. We highlight a number of these risks. 1. US economic gloom or boom: US recovery has been quite slow overall, but the labour and housing markets have been hit particularly badly. The US labour market remains just below double-digit rates of unemployment, with over 15 million men and women unemployed. The number of long-term unemployed is particularly worrying, with over 6 million unemployed for more than 6 months. As the effects of the crisis linger, it becomes particularly difficult for the unemployed to find work. With the US housing market moribund from low household income, confidence effects, falling prices and lengthy legal delays on the mortgage foreclosure process, workers have been either unwilling or simply unable to move to seek new employment. Moreover, in the US, both monetary policy and fiscal policy face constraints. While the Federal Reserve can pump more money into the system this risks losses on the securities they hold in return for this cash. In addition, quantitative easing no longer has the same surprise impact; reducing mortgage interest rates at the margin has little impact on households facing unemployment and unable to sell their own home. There is little room for further fiscal stimulus since Federal and State debt positions are extremely stretched. While US firms and households continued their deleverage at the end of 2010, the US Government is still increasing its debt position. If this US domestic gloom continues or worsens, it is difficult to see American consumers playing any part in driving world recovery. Further, it could impact equity markets, and start to focus financial markets on the size of US state and Federal debt. But just as possible, the US may surprise us with economic strength over 2011. Many US businesses hoarded cash over 2010. But now flow of funds data show non-financial firms started borrowing again in the third quarter of last year, though retaining cash from bond issuance rather than undertaking new investment. It would not be difficult for businesses to ramp up investment quickly, and then demand for labour could increase almost as rapidly as labour was shed going into the crisis. Under this scenario, US consumers would start to spend again, acting as an engine of growth for trans-Pacific trade. Incomes would rise, providing a much needed boost to the US housing market. Markets might even worry about a pick-up in inflation from the current extremely stimulatory settings, in which case the Federal Reserve would have to rapidly call in stimulus measures, increasing policy rates during 2011, with some consequent market disruption. In this scenario, the US dollar would presumably appreciate, taking some pressure off the New Zealand dollar and providing an improved opportunity to rebalance our economy towards export growth. 2. Sovereign debt reaches crisis point The Global Financial Crisis cruelly exposed some governments with extended public debt positions, high fiscal deficits, inappropriate regulatory environments and low productivity environments. Stimulus packages for the economy and rescue packages for certain banks have pushed some sovereign balance sheets into crisis. Financial markets have been merciless in the way they have signalled sovereign weakness, and indicate tough treatment ahead. This has most obviously occurred with the PIIGS group of countries in the Eurozone, pushing European authorities into the very uncomfortable positions of having to underwrite individual country balance sheets. BIS central bankers’ speeches There is a possibility that this situation could worsen in 2011. So far, the risk spreads on sovereign bonds have stayed stubbornly high. More European countries are feeling the heat. Managed sovereign defaults could still occur, and these could impact the banking systems of core European countries. Investors continue to re-evaluate the price of sovereign debt in the euro area. Moreover the countries that have implemented austerity plans could find the terrain rougher and the recovery harder than first thought. This would imply more spill-over to the wider euro area economy. Some eastern European economies on the periphery could suffer, and countries outside the euro area might not be immune. Renewed fragility in funding markets could have other effects. Slow growth and high debt in Japan, together with its skewed demographic profile, could worry volatile markets, and other Western countries would not be immune from this. A scenario of renewed capital market fragility would also make life much tougher for Australian and New Zealand banks, and that would be extremely damaging to our economic recovery. 3. Emerging markets out-perform and bubbles burst One feature of the post-crisis world has been the ability of emerging markets, characterized by the BRICs grouping of Brazil, Russia, India and China, to recover rapidly from the massive fall in global demand during the recession. This suggests that these countries now contain many of the institutional features, some put in place in the Asian region as a result of the Asian crisis, that will foster growth and provide more resilience to shocks that may hit the global economy across 2011 and beyond. This group of countries has managed to finally attain their place at the world table as the new G-20 order is hammered out. This change in the underlying geopolitik will be complex and not just occur over 2011, but during the next decade. But in the short-run strength in the BRICs is underpinning the global recovery and this could intensify further. If this happens, it will boost New Zealand’s trading prospects. At the same time there is a real risk of overheating. Much of the strong growth in China was driven by the extension of credit through the latter part of the crisis. This helped China to post double digit growth rates for most of the past year. But now there are general signs of over-heating through Asian economies, risking asset bubbles: Chinese asset prices, Hong Kong and Singaporean property, capital inflows into other East Asian economies, inflation in India, and house prices in Australia. A worse scenario for New Zealand would see the Asian banks, which until now largely have been insulated from the Global Financial Crisis, affected by deflating asset prices. Domestic demand could slow, Asian countries turn protectionist, and current account surpluses rise. A material slowing in Chinese growth appears a likely scenario. After recent extended efforts to moderate this economy, policymakers might need to apply the brakes in response to rising consumer prices. This could be very disruptive, risking loan defaults, poor bank balance sheets, capital controls, exchange rate tensions, import protection and a regional slowdown. One effect would be to hit industrial commodity prices. A disruption of this magnitude would have another undesirable effect: knocking Australia’s terms of trade, and exposing rising imbalances in that country. New Zealand would lose the advantage of the China/Australia growth locomotive that has helped drive our own export demand over the last twelve months. In such a situation, some of the shock would likely be offset by a lower New Zealand dollar, though this would have to be balanced against higher imported inflation. 4. The commodity boom intensifies One possibility for 2011 is that the commodity boom could intensify, surprising us with stronger export prices for primary exporters, continuing the theme in 2010. With a strong dollar hurting manufacturing exporters, so far the boom has been widespread across most commodities. This includes hard commodities, like the coal, copper and iron ore used to help BIS central bankers’ speeches fuel China’s growing economy, and also soft commodities like dairy, meat and fish, as food demand grows throughout the Asian region. Over the long term, the infrastructure construction in China is likely to sustain high prices for hard commodities, while rising demand by emerging middle classes in Asia suggests increased demand for protein and soft commodities. Moreover, as the global economy settles into a new post-crisis order, many long held structural supply chain relationships are changing, often exacerbated by weather-related shocks. In the last year we have seen the effects of Ukrainian drought, Russian log taxes, US oil spillages, Chilean earthquakes, and Brazilian and Queensland floods on primary production and prices. La Nina weather conditions could suggest more volatility ahead. New Zealand farmers are still recovering from the last commodity boom when some overcommitted, and are still looking to reduce the debt they built up. A more measured reaction this time is important. New Zealand stands well placed to benefit from some of these changes through 2011. As oil prices rise, Western governments encourage bio-fuel conversion which exacerbates the soft commodity price pressures. New Zealand Inc.’s import bill rises, but farmers and primary exporters do well. But as oil prices rise, this places pressure on inflation not just in New Zealand, but globally, risking a bursting of the commodity boom just like the 2007–08 event. Indeed if oil prices escalate beyond $100 for long, growth in much of the world will suffer again. As trade relationships change this creates opportunities for New Zealand exporters. For example, Australia supplying meat to Asia and Russia leaves a gap for New Zealand to export beef to the US market; while prices for New Zealand forestry have benefitted from regulatory controls implemented in the Russia Federation that have created a shortage of logs for Chinese markets, increasing the price of New Zealand logs. However, high commodity prices put upward pressure on food prices and any intensifying of the boom will generate potentially severe inflation in the Asian region in particular. Additionally, over the past two or three years many financial market participants have looked to build a position in commodities as a new asset class in its own right, alongside more traditional assets, such as stocks. The extent of these positions and how this might play out if the boom intensifies is yet to be determined but it constitutes a key risk for 2011. Four domestic risks: Of course, just as there are international drivers and risks to the outlook, there are several key risks and drivers to New Zealand’s growth path on the domestic front. One overarching theme for the domestic economy is the extent to which households, firms, and even the government want to keep reducing their respective debt position, and how much they are able to do so. 1. New Zealanders save but don’t spend One possibility we could confront during 2011 is that the cautious household reaction we saw over 2010 turns out to be a structural change in behaviours rather than a cyclical response to a marked recession. House prices could be forced to drop much further to reach true economic values. This would cast a pall of gloom over the market, with homeowners keeping houses off the market, not re-building, and trying to pay off mortgages faster, saving more, and spending less. The construction and retail sectors would suffer as a result. Under this scenario, the Reserve Bank might have to reconsider some further monetary policy stimulus. Such restrained spending would keep domestic demand in check for 2–3 years, constraining growth short-term but building a stronger base for long-term growth. The positive side of this risk is that it would accelerate New Zealand’s much discussed rebalancing, reducing the current account deficit, improving competitiveness, reducing BIS central bankers’ speeches exchange rate pressure, relieving pressure on funding markets, and reducing our external vulnerability generally. The negative side is that New Zealanders would have to reduce their consumption compared with pre-GFC years, and that could create an emigration exodus. 2. Financial market fragility Another negative scenario would be if financial markets, scarred by European debt, were to become more allergic to indebted small countries generally. In that situation local banks could find their funding markets increasingly fragile, and with an overly cautious eye on Basel III, and more interesting expansion opportunities elsewhere, the cost and availability of credit would tighten for New Zealand business. This would limit business re-investment and mean some businesses might hit capacity bottlenecks later in the year when demand starts to recover. In addition, funding market fragility would be bad news for our public debt. If participants in fragile sovereign funding markets were to form a view that New Zealand exposure is less attractive, credit rating agencies might re-assess New Zealand sovereign debt, meaning that debt servicing costs could rise. If the market were to form the view that the government deficit was increasingly structural and hard to correct, and if the New Zealand Government were forced to consolidate faster, this could generate a contractionary effect on consumption, which would be difficult to counter with monetary policy. And in such an environment, looser fiscal policy would not be a serious option. 3. Construction boom While we have outlined a number of negative risks to the business environment, one that could be more positive would be a large pick-up in construction this year. There are two obvious drivers. Firstly the Canterbury earthquake: our estimates suggest that the $5 billion rebuild added to nominal GDP comprises about $1 billion of damage to infrastructure and about $1 billion to commercial buildings, with the remaining $3 billion comprising residential claims. In itself this is very big by New Zealand standards, indicated by the fact that it will add one percentage point to growth each of the next two years. However, these estimates are uncertain and damages from ongoing aftershocks, suggest the extent of the ultimate rebuild could be significantly larger. In addition the relatively strong inward migration, the limited investment during the last few years, growing demand in the Auckland region, and leaky homes rectification means that the stock of housing could be falling behind demand. Rectifying these would put additional pressure on resources, increasing prices already lifted by GST and other taxes/charges. Households might start to ratchet up their expectations about future inflation and in such a case the Reserve Bank could be confronted with the need to increase policy rates to dampen the accelerating inflation outlook. 4. The rugby world cup One driver of growth over 2011 is, of course, the Rugby World Cup. We think the event will add about $700 million to the New Zealand economy over the six weeks of the event, contributing approximately a third of a percent to GDP. More optimistic assumptions about multiplier effects would suggest a stronger impact, during months which are normally a tourist down-time. Winning the World Cup would also boost general confidence. BIS central bankers’ speeches How likely is it that New Zealand will win? We have asked our expert team of forecasters to answer this question. They have pointed out several solid facts: we have always won the World Cup at home; we will have a Cantabrian leading the team and another directing the back-line. Our expert team of forecasters predict that on average, the All Blacks will beat Australia in the final at Eden Park, by 23.9 to 15.6. How to plan your business for whatever 2011 brings: Sorry, that’s your job! Good luck for the year! BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, with Messrs Bernard Hodgetts and Mike Hannah, at the Basel III Conference, Sydney, 25 March 2011.
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Alan Bollard: Where we are going with macro- and microprudential policies in New Zealand Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, with Messrs Bernard Hodgetts and Mike Hannah, at the Basel III Conference, Sydney, 25 March 2011. * * * Thanks to Mike Hannah and Bernard Hodgetts for assistance in preparing this speech and to Grant Spencer, Toby Fiennes, Michael Reddell, Yuong Ha and Anella Munro for useful comments. Introduction Following the Global Financial Crisis, there has been general acceptance of the need for central banks and financial regulators to adopt a greater “macro-prudential” orientation to their supervision of financial systems and institutions. While the objectives of prudential policy are usually systemic, the policies have focused on ensuring the balance sheets of individual institutions are robust to shocks. The crisis showed that this micro-prudential approach can sometimes miss important system-wide financial risks. So, policymakers are increasingly focussing on the resilience of the financial system as a whole, and in particular on the capacity for pro-cyclical lending behaviour to amplify the macroeconomic cycle in a destabilising manner. I will return to these concepts and issues later. There is currently considerable interest in macro-prudential instruments – policy tools that might be used to promote a more stable and resilient financial system and help smooth the credit cycle, reducing the risk of boom-and-bust cycles. These tools would take the form of specific prudential requirements placed on the balance sheets of banks or other financial institutions, such as capital requirements that vary over time, or restrictions on lending like loan-to-value caps. This is not to suggest that micro-prudential policy is unimportant or that existing tools cannot be enhanced. On the contrary, a strong micro-prudential framework is essential for a robust financial system and remains at the heart of our efforts to maintain stability in the financial system. The Basel Committee on Banking Supervision (the Basel Committee) is now close to completing a major strengthening of the micro-prudential framework, while keeping systemwide stability objectives firmly in mind. Micro-prudential policies/tools The Basel Committee has developed and released new global regulatory standards for bank capital adequacy and liquidity, as endorsed by G20 leaders at their November 2010 summit. While the frameworks are now broadly set, further work is being undertaken on some areas of detail, in particular with regard to the liquidity standards. In addition, work continues on related international financial reform issues such as measures for systemically important banks, and reviews of international accounting standards, the Basel Committee’s Core Principles for Effective Banking Supervision, and the international standards for financial market infrastructures. The Reserve Bank of New Zealand is not compelled to adopt the full package of new global standards. While we are very supportive of strengthening global standards for bank capital adequacy and liquidity, we are likely to adapt aspects of the standards to New Zealand conditions or take a different view on some matters (for instance in relation to the leverage ratio). BIS central bankers’ speeches We are currently in the process of assessing the potential impact of the new Basel 3 standards in the New Zealand context, but are yet to make final decisions about the measures we will adopt. We do not propose to “lead the world”, but just as most jurisdictions are likely to implement Basel 3 ahead of the Basel Committee’s timeline, we would expect to do likewise. We are also likely to continue to implement our new liquidity policy according to our existing timetable (which is some years ahead of the Basel 3 timeline). While our liquidity policy is different in form to Basel 3, the substance is similar, and we do not propose to modify the policy in the near term. There remains some uncertainty about how our liquidity policy will align with the global standards and with the Australian Prudential Regulation Authority’s liquidity requirements. We will be monitoring international developments and engaging closely with APRA as this process unfolds. With regard to the Basel 3 leverage ratio, it is not risk-based, so it can give a misleading picture of risk, and a single leverage ratio implies that one size fits all banks, which is not credible. However, we will explore practical issues with the ratio prior to making a final decision on this. More generally, the Reserve Bank remains committed to making improvements to its existing prudential policy framework, given the importance for both institutional and wider financial system stability. With our major banks accredited to use their own risk measurement models for Basel 2 capital calculations, we put particular emphasis on ensuring that those capital models are calibrated to plausible economic downturn scenarios, rather than the relatively benign credit loss conditions of the past decade. Macro-prudential/financial policies/tools Objectives We have always had system stability as our objective for prudential policies, and the institutional focus of those policies has worked well in practice. The conservative and through-the-cycle approach to capital adequacy, including Basel 2 implementation, is an example of how our micro-prudential stance has enabled our financial system to flourish and to be resilient through the recent crisis. We believe this approach and our micro settings are effective in doing the job almost all of the time. However, by its nature, micro-prudential supervision has not always paid sufficient regard to macro-financial interactions. The aim now is to design prudential policies with macro-effects firmly in mind. The challenge for researchers is to identify policy instruments that can actually be used in a real-world setting. This involves careful analysis of what individual tools might or might not be able to achieve, the channels through which they would be expected to work, and the potential costs associated with using them. The case for these new instruments rests mainly on their scope to build greater financial system resilience to the risks associated with the extremes of the credit cycle. In addition, some tools may have the ability to directly dampen the credit cycle. Some tools are potentially more effective in achieving the first of these objectives than the second. While a range of instruments is being viewed enthusiastically by some commentators, we must be careful about unintended consequences. The case for any particular instrument needs to be informed by a full analysis of its likely effectiveness in a real-world setting, along with the associated costs of deploying it. It is important here to be clear whether tools would be aimed at building resilience and/or dampening excessive credit growth. BIS central bankers’ speeches We also need to think about policies that address the cross-sectional dimension as well as the time dimension. In other words, the risk exposures and interconnections between institutions at any point in time (the “cross-section” dimension), as well as the tendency for financial institutions, households and businesses to become over-exposed during an upswing, and excessively cautious in the subsequent downturn (the “time dimension”). There are also numerous design issues. Would the instruments be set by rules or discretion? Would they be set once and left alone or varied over the course of the economic cycle? Or would they be deployed only in exceptional circumstances? What governance arrangements are needed? We need to be very conscious of the costs of using macro-prudential tools when considering whether to use them. Some tools have the potential to damage financial system efficiency. They could also result in disintermediation (that is, promote lending through channels other than those affected by the restrictions) or cause other unintended or undesirable consequences. During the period from the 1960s to the 1980s, New Zealand and other countries used a range of prudential measures to assist in the control of money and credit, some of which look rather similar to the macro-prudential instruments currently under consideration. Some of these tools, including the system of reserve asset ratios that applied to the trading banks in New Zealand, ultimately proved quite ineffective and led to the re-routing of financial activities outside of the banking system. So history reminds us of the need for caution. Above all, macro-prudential policy should not be viewed as a panacea for macro-economic imbalances. When seeking solutions to these imbalances, we also need to consider the role of the tax system and the broader regulatory environment. Where clear distortions in these areas exist, we need to correct them in lieu of adopting macro-prudential solutions. Tax distortions in the area of investor housing contributed to an overheated housing market in New Zealand during the last cycle, and the Reserve Bank was strongly supportive of tax changes made in this area last year. Potential macro-prudential instruments for New Zealand Over the past year, the Reserve Bank has been assessing a range of macro-prudential instruments that might have a role to play in contributing to broader financial stability in New Zealand.1 As in other countries, credit growth in New Zealand is currently weak, so we have not felt a pressing need to implement such tools. We want the credit process to be able to support economic growth. However, there have certainly been periods in our history where we have experienced unsustainably strong credit growth and asset price cycles, and we have seen the damaging effects of these, both on the economy and the financial system. We will certainly face similar developments in the future, so we want to develop our macro-prudential toolkit now to enhance our ability to deal with them when the time comes. Rapid credit and asset price growth have amplified the general economic cycle and have made monetary policy’s task of controlling inflation more difficult. We have seen the difficulties that can arise when interest rates alone are used. The collateral damage to the net export sector from the high New Zealand dollar exchange rate during the previous economic upswing prompted a search for potential tools to assist monetary policy. Now, in light of the broader and significant social and macroeconomic costs arising from financial system distress in the aftermath of the global financial crisis, there is greater will to consider additional tools. For further discussion on macro-prudential instruments see Ha and Hodgetts (2011). BIS central bankers’ speeches We believe several instruments may be useful from this perspective and could potentially form a useful part of the Bank’s macro-prudential toolkit in the future. The instruments we have been considering include credit-based measures and liquidity and capital buffers. We have been analysing these policy options in a New Zealand context, undertaking some simulations and other calculations to help establish their likely effectiveness. Our expectation is that we would use these tools infrequently. In this regard, the Basel Committee has suggested that some countries might only use the counter-cyclical capital buffer once every 10 to 20 years when faced with exceptionally strong credit growth. We think this is a useful perspective. Related to this we would have a preference for standards that can be set and to work through a cycle where possible, that is act as an automatic stabiliser rather than a discretionary stabiliser. This is an important learning from fiscal policy. While our work is ongoing, we would offer the following preliminary conclusions: Credit-based tools A range of credit-based tools has been used by the emerging economies, especially in Asia, for many years. They include a wide range of regulated caps, targets and limits. These tools are receiving increased attention by the advanced economies. Of these tools, we have looked specifically at loan-to-value restrictions. Loan-to-Value restrictions Loan-to-Value restrictions (or LVRs) have been used by a number of countries in response to excessive credit growth and overheated housing markets and, on balance, appear to have met with some success. Such a tool could be particularly useful in circumstances when funding and credit margins move counter-cyclically, and so reduce the effectiveness of liquidity and capital requirements in braking credit growth during a boom. Another advantage would be that an LVR restriction could be imposed and enforced relatively swiftly, given that banks would require longer operational lead times to meet higher liquidity and capital requirements. However, the use of non-price or administrative restrictions is subject to greater long-term enforcement and disintermediation risks. Moreover, we are not aware of any instances where LVR restrictions have been applied to sectors other than housing. Accounting-based tools Expected loss provisioning Expected loss provisioning is a return to the more forward-looking (and less pro-cyclical) standards of the 1990s, where general provisions may be based on the expected loss over the life of a portfolio of loans, rather than current loss experience. The two international accounting boards – the IASB and the FASB – have each published proposed models for expected loss accounting and the two boards have since been working to align these proposals. A return to a system of expected loss provisioning in due course can be expected to play its part in contributing to a less pro-cyclical financial system. Liquidity tools Core Funding Ratio The Core Funding Ratio is a tool that can help promote greater financial system resilience by requiring banks to fund credit using more stable sources than they might choose in the absence of the requirement. This discipline is particularly desirable during periods of rapid credit growth, when recourse to relatively cheap short-term wholesale funding rather than more stable longer term funding is more likely. BIS central bankers’ speeches As a tool to actively lean against excessive credit growth, our simulations suggest that the Core Funding Ratio could, in some circumstances, play a useful supplementary stabilising role by requiring banks to always maintain a proportion of core funding which is typically more expensive than shorter-term wholesale funding. Alternatively, the Core Funding Ratio could be used as a counter-cyclical policy tool. Although the Core Funding Ratio could be a less effective anchor on credit growth during a global boom (when funding spreads become compressed), it would still be effective in its primary role of ensuring that banks resort to more stable funding sources. Capital-based tools Countercyclical Capital Buffers A Countercyclical Capital Buffer is a further potential tool for building resilience in the face of excessive credit growth, which could be very beneficial during the subsequent downswing. It has also been suggested that these buffers might help to dampen the credit cycle directly. However, our calculations suggest it would have only a small dampening effect on the upswing of the credit cycle through its effect on the cost of funds (unless one makes extreme assumptions about the size of the counter cyclical buffer or the market cost of capital). Sectoral risk-weight adjustments Sectoral risk weights could be adjusted to boost capital requirements for lending to a particular sector, over and above that calculated under the existing Basel 2 framework. While sectoral capital buffers would offer scope to more closely target those sectors subject to rapid credit growth, we have found in simulations that the use of such buffers is likely to have only a modest effect on the pricing of credit for the affected sectors, unless dramatic adjustments are imposed. In principle, sectoral risk weights, generated by Basel II throughthe-cycle risk models, should already reflect the risks of lending to the sector, including the risk of a cyclical downturn. Accordingly, we must, in the first instance, focus carefully on the integrity of the risk models used to support Basel 2, before contemplating additional overlays. In recent years, we have sought improvements to the banks’ Basel II risk models in New Zealand in key areas such as housing and agriculture, when it has become clear that risk assessments have been overly optimistic. Moral suasion The potency of the tools we have considered as instruments to affect the credit cycle could be enhanced by a “moral suasion” effect, in addition to any direct impact via the cost of funds or credit constraints. This might mean that our simulations and calculations understate the effectiveness of the various tools to influence the credit cycle. The deployment of any tool would send an important signal to financial institutions, investors, rating agencies and the general public about the central bank’s unease about rapid credit growth, and/or the risks accumulating in the financial system. It could thus help to reinforce a change in lending and borrowing behaviour. That said, we are naturally cautious about the strength of the moral suasion effect, particularly in the context of a credit boom (where risk aversion may be low), and if the instruments themselves were not widely considered by institutions to have “bite”. Interplay of macro-financial and monetary objectives The recent focus on macro-prudential instruments has gone hand-in-hand with the debate about the role of monetary policy in leaning against asset price cycles and the accumulation of financial imbalances. We know that easy monetary policy, in the form of low interest rates, can interact with financial decisions by encouraging greater leverage. Whether monetary policy can moderate imbalances or lean against the dynamics of credit booms is a more BIS central bankers’ speeches complex question. Some economists have argued that monetary policy could be used to more actively address these imbalances than in the past. This would essentially see monetary policy take on a more active role in leaning against asset market and credit cycles rather than focussing solely on medium-term inflation. An alternative view is that macro-prudential policy instruments are the preferred means to deal with these imbalances. This has been the suggestion of Blanchard and others2 who state that the authorities now have potentially many more instruments at their disposal than they used before the crisis. They argue that the policy interest rate is a poor tool to deal with excess leverage, excessive risk taking, or deviations of asset prices from fundamentals. Whether macro-prudential tools are actually suitable for leaning against the credit cycle and managing various imbalances ultimately rests on an analysis of the individual tools and policy experience over time. Some tools may be useful, while others may well prove to be ineffective. Our analysis of recent credit cycles suggests that the timing and magnitude of previous credit and asset price cycles fuelled the general business cycle and made the monetary policy task more difficult. These credit cycles also resulted in growing macro imbalances and institutional resilience was weakened due to the heavy reliance on short-term wholesale funding. Though bank capital positions remained adequate throughout the past two decades, there were downside risks, given that sectoral lending looked stretched, particularly for housing and agricultural lending. To the extent that macro-prudential policy may have helped to dampen the credit cycle, there would have been less pressure on monetary policy and on the exchange rate. While none of the macro-prudential instruments we have considered would be a silver bullet in terms of moderating the credit cycle, we believe some could make a useful contribution. It may be the case that macro-prudential tools could be employed more effectively to influence the credit cycle by adopting a multi-pronged approach where several tools are employed in tandem. For example, faced with evidence of excessive credit growth, counter-cyclical capital requirements could be used alongside increases in the Core Funding Ratio, and this might represent a more even-handed approach than focussing on either one alone. This approach might even be supplemented by a more targeted instrument such as a Loan-to-Value restriction. Using multiple tools in this fashion would also tend to reinforce the signalling effect on lenders and borrowers. Our current policy stance In addition to strengthening banks’ liquidity positions, the new Core Funding Ratio might be expected to discourage periods of very strong credit expansion. In recent years, banks have tended to fund cheaply in the offshore money markets and then use derivatives to synthesise fixed-rate term New Zealand dollar funding at a relatively low cost. The Core Funding Ratio, which is part of the new prudential liquidity policy, will drive banks to either compete for more stable funding from non-financial customers, or borrow in wholesale markets for terms longer than one year. During periods of rapid credit expansion, banks will thus not have the same ability to borrow in the offshore money markets, and will need to put increased emphasis on customer deposits and longer-term funding markets. As a result, lending rates may automatically move higher without the Reserve Bank needing to move the official cash rate to the same extent. Through these channels, the policy has the potential to have a role in assisting monetary policy, although this effect is likely to operate “at the margin”. With shortterm wholesale market rates not likely to rise as much, the attractiveness of the New Zealand See Blanchard et al (2010). BIS central bankers’ speeches dollar as a destination for “carry trade” investors could also be reduced, which is of benefit to a small open economy such as ours in terms of reducing exchange rate volatility. Statutory powers and governance3 The prospect of new macro-prudential tools raises important governance issues. These include how decision-making about particular tools can be dovetailed with monetary policy decision-making and how policy changes should be implemented. In New Zealand, the Reserve Bank has dual responsibilities for price stability and promoting the soundness and efficiency of the financial system through its prudential powers under the Reserve Bank Act. The powers under the Act thus provide us with the scope to adopt additional macro-prudential instruments as long as they are used with the intent of better achieving financial system stability. On the other hand, using macro-prudential tools purely for macroeconomic stabilisation purposes would require changes to current legislative arrangements. We do not believe that such an approach would be sensible. In most instances we would expect a macro-prudential intervention aimed at moderating macro-financial imbalances to be consistent with the desired monetary policy stance. In the rare event of inconsistency with monetary policy, we would either need to hold back on macro-prudential intervention, or proceed with considerable caution. An example of this might be in a severe downturn where, on financial stability grounds, we might want to keep a capital or liquidity buffer in place for longer than usual, while also wishing to stimulate the economy. An important issue for consideration is thus how the Reserve Bank might choose to implement macro-prudential policy in the future. The process would begin by establishing that asset market imbalances had become exceptional and unsustainable − as reflected in asset prices and/or excessive credit. Then we would determine whether this was likely to contribute to macro imbalances in the future, which warranted policy action to bolster financial sector resilience and/or moderate the credit cycle. We are continuing to work on developing a set of indicators to help identify the build-up of financial imbalances, but, in practice, there will need to be a degree of judgment in assessing whether a macro-prudential overlay is warranted based on the Bank’s financial stability objective. Next, we would assess whether a macro-prudential overlay would support monetary policy, or at least not work against it. The nature of the imbalances would then guide the selection of the appropriate tool. Generalised credit growth and broadly-based accumulation of banking system risk would prompt consideration of tools that are broad-brush in effect, such as the Core Funding Ratio, or an aggregate Capital Buffer. Pressures emanating specifically from housing or other sectors could suggest more targeted tools such as Loan-to-Value restrictions or adjustments to risk weights for the implicated sectors. Turning to governance structures, there is no consensus in the literature whether monetary policy and prudential regulation and supervision should be combined in a central bank, or undertaken by separate institutions. A strong case can be made that central banks are best placed to be macro-prudential regulators and that centralising responsibilities within the central bank helps to avoid problems of coordination. Certainly, this appears to be the trend internationally following the crisis. Our own experience is that dealing with these policy overlaps is assisted by having a small “full-service” central bank managing monetary policy and prudential policy across all its dimensions. Nevertheless, the coordination of these functions can still pose challenges and good internal process is important. See Spencer, G (2010) for further discussion of the Reserve Bank’s macro-financial stability role. BIS central bankers’ speeches We established a Macro-Financial Committee in 2009 for the internal consideration of macrofinancial issues and policies. This complements the Reserve Bank’s Monetary Policy and Financial System Oversight Committees, which consider monetary policy and microprudential policies respectively. The Macro-Financial Committee currently reviews indicators of financial stability, oversees production of the Bank’s Financial Stability Reports, and analyses potential new macro-prudential policy tools. If and when new macro-prudential policies are implemented, these will be reviewed and recommended to the Governor by the Macro-Financial Committee. The implications of such recommendations for micro-prudential policy and for monetary policy will be considered by the Governor and potentially referred to the other policy committees. We also regularly consult with the Treasury and Minister of Finance to keep them abreast of prudential policy developments and to glean their views. The Financial Stability Report, which is a legal requirement under our Act, requires us to explain and justify the prudential policies we adopt. Conclusion Micro-prudential and macro-prudential policies are both important. Good micro-prudential regulation should contribute to financial system stability and we need to remain focused on improving the regulation of individual financial institutions. However, we have learned that this might not be enough to contain system-wide risks. Macro-prudential instruments that focus on system-wide imbalances can also bolster financial system resilience and possibly help to moderate credit cycles. We need to be realistic about what can be achieved. Even if credit cycles can be moderated, they will not be eliminated. Like other countries, New Zealand has already taken steps to promote a more resilient financial system with our liquidity policy helping to shift the banking system on to a more stable funding base. In terms of using macro-prudential instruments to better manage the credit cycle, there has not been a pressing need for the use of such tools given recent weakness in the credit cycle. However, we do need to keep preparing for how we might deal with credit and asset price booms when they recur in the future. Our work so far on macroprudential instruments suggests that we should keep our expectations modest, but we have identified several tools that we would contemplate using in the right circumstances. The world has little practical experience with some of the macro-prudential tools currently under consideration. There will be an important learning period ahead as countries start to use these instruments and develop their implementation frameworks. We can expect our understanding of this broad area to have evolved significantly in five or ten years’ time. References Blanchard, O, G Dell’Ariccia and P Mauro (2010), “Rethinking Macroeconomic Policy”, IMF Staff Position Note 10/03, IMF February. Ha, Y and B Hodgetts (2011), “Macro-prudential instruments for New Zealand: A preliminary assessment”, paper prepared for Reserve Bank workshop on macro-prudential policy, RBNZ, 21 March 2011, available at http://www.rbnz.govt.nz/research/workshops/March2011/4280799.html Spencer, G (2010), “The Reserve Bank and Macro-Financial Stability”, Reserve Bank Bulletin, 73(2), June, available at http://www.rbnz.govt.nz/research/bulletin/ RBNZ (2010), Financial Stability Report, November, available at http://www.rbnz.govt.nz/finstab/fsreport/ BIS central bankers’ speeches
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Mr Enzo Cassino, Acting Manager, Financial Markets Research, to the Sim Kee Boon Institute Conference on Financial Economics, Singapore, 5 May 2011.
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Alan Bollard: Economic surveillance after the crisis – reflections from a small full service central bank Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Mr Enzo Cassino, Acting Manager, Financial Markets Research, to the Sim Kee Boon Institute Conference on Financial Economics, Singapore, 5 May 2011. The speech was delivered by Dr John McDermott, Assistant Governor of the Reserve Bank of New Zealand. * * * Introduction Nearly four years after it began, the Global Financial Crisis continues to impact the changing behaviour and practices of the world’s central banks. In particular, it has affected the way central banks monitor and analyse economic conditions to formulate monetary and financial stability policies. We can describe this monitoring and analysis process as “economic surveillance”. Economic surveillance refers to all the various channels we use to obtain information about the financial system and the economy to support our decision-making. This monitoring covers both the global and domestic economies. It also covers a wide spectrum of sources and methods, including statistics, financial market data, the functioning of the payments and liquidity infrastructure, external commentaries, and intelligence gathered from contacts in the financial and business sectors. Collecting, analysing and interpreting this range of data requires a wide range of skills and expertise in central banks, including macroeconomics, financial modelling and market liaison. The financial crisis has led to some changes in the way we do economic surveillance and presents new challenges and opportunities for central banks. Our perspective on this task at the Reserve Bank of New Zealand comes from being a small “full service” central bank responsible for both monetary policy setting and supervising the financial system. Our view is also impacted by New Zealand being a small open economy. This makes us a price taker in the markets for many tradeable goods and also exposes us to the impact of economic and financial shocks in larger economies. It also makes it more difficult for us to set standards of regulatory compliance for our financial sector in isolation and independently of regulatory developments in larger economies. Surveillance before the crisis To better understand the impact of the crisis on central banks’ behaviour, it is useful to start by describing how monetary authorities behaved before the crisis. In the pre-crisis world, monetary policy setters were often able to inform their decisions using a number of reasonably reliable empirical correlations between real or financial variables that had been historically quite stable. While structural change and the breakdown of empirical relationships still commonly occurred at times, many empirical regularities appeared to be robust enough to be useful for forecasting and policy making. One example in the New Zealand context, and in many other countries, was the very tight relationship observed between changes in house prices and household consumption spending through the early-mid 2000s, which was of considerable benefit in forecasting domestic demand. There was also a relatively close correlation between house price growth and growth in credit provided to the household sector during this period. Another key feature of policy-making before the crisis was the clear separation between monetary policy formulation and financial stability policy in full service central banks. In addition, independence between monetary and fiscal policy decision making was a basic aspect of central banks’ institutional structure in many countries since the 1980s. As part of BIS central bankers’ speeches this separation, there was usually separate monitoring, with different data sources and analysis for monetary policy and financial stability policy formulation. Following the crisis, there have been several significant changes to this structure. First, some of the historically stable empirical relationships appear to have become weaker during the crisis compared to the mid 2000s. For example, in New Zealand, house prices fell more sharply than consumption during the crisis. Likewise, while house prices declined, household credit continued to grow during 2008–9, albeit at a slower pace.1 It is too early to confirm econometrically whether these divergences represent permanent structural breaks, or whether the historical correlations will be quickly re-established. However, these divergences have at times made it more difficult to interpret household behaviour and to forecast the economic outlook. While household credit has continued to grow, credit to the business sector has fallen at a historically unprecedented rate in New Zealand since the crisis. This has contributed to a sharp slowdown in business investment. BIS central bankers’ speeches Secondly, the separation of monitoring for monetary and financial stability policies highlighted a lack of coordination between these various roles for the identification of issues and risks. For example, in 2006 most financial stability reports still identified national financial systems as healthy.2 In addition, IMF commentaries identified current account imbalances in many countries, but did not link them to systemic risks in financial systems.3 The instability in the global financial crisis and its flow-on effect on the real economy has required much greater co-ordination and interaction between monetary and financial stability policy setting by central banks. As a result, the distinction between information flows gathered for monetary policy and financial stability purposes is now far less distinct. There is now a greater focus on financial system information and financial market data in monetary policy formulation, triggered by the breakdown in the forecasting performance of structural and statistical models. Likewise, more attention is paid to real economy imbalances and sectoral financial positions, by looking at household and business sector balance sheets, when assessing financial sector risks. As a result, there is a very active research agenda aiming to incorporate housing and financial sectors into the dynamic stochastic general equilibrium models used in many central banks.4 This broader outlook and greater overlap between monetary and financial stability policy is reflected in the RBNZ’s “Cobweb” diagram, which is H. Davies and D. Green (2010) Banking on the Future: The Fall and Rise of Central Banking. Independent Evaluation Office of the International Monetary Fund (2011) IMF Performance in the run-up to the Financial and Economic Crisis: IMF Surveillance in 2004–7. See W. White (2010) “Some Alternative Perspectives on Macroeconomic Theory and Some Policy Implications”, Globalisation and Monetary Policy Institute Working Paper 54, Federal Reserve Bank of Dallas. BIS central bankers’ speeches used to indicate financial stability risks across several different dimensions.5 In this framework, financial stability risks could be reflected in the global and domestic economies, and in financial market conditions. All of these areas are also routinely monitored for monetary policy formulation. Following the crisis, concerns about the sustainability of sovereign debt have risen in many countries, most notably in the peripheral euro zone economies. Consequently, central bankers have also needed to co-ordinate their policies more closely with fiscal policy decisions. As a result of these changes, policymakers now need a much wider spectrum of information to set policy, and central banks are now required to have broader concept of “economic surveillance” in mind to inform their decisions. The Global Financial Crisis showed economic surveillance is more important than ever and how we go about that has been permanently changed. During the rest of the discussion, we will consider how different aspects of surveillance have been altered. International financial surveillance This crisis was initially about financial institutions and markets and we have learned that it is necessary for central banks and regulators to know more about financial market flows, about non-traditional financial institutions and instruments, and about the inter-connectedness of institutions, especially in the presence of instruments that can go viral. Before the crisis, it A number of other institutions, including the IMF, have introduced similar frameworks or indices in recent years to measure financial stability. See P. Bedford and C. Bloor (2009) “A Cobweb Model of Financial Stability in New Zealand”, Discussion Paper DP 2009/11, Reserve Bank of New Zealand. BIS central bankers’ speeches was assumed that financial markets were efficient in transmitting changes in policy interest rates through conventional financial instruments via the traditional banking system and ultimately into the wider economy. Factors such as securitisation through leveraged derivatives, often carried out by “shadow” banking institutions, generally attracted little attention in policy discussions. In addition, financial spreads had been historically stable enough to accurately reflect the degree of risk on investments. Yet in the crisis environment of September 2008, financial prices failed to convey the collapse in confidence and paralysis across the international financial system, as policymakers and private financial institutions alike grappled to understand the extent of contagion of exposure to toxic assets through shadow banks and opaque derivative products. Therefore, central banks had to rely increasingly on alternative sources of information to guide policy in restabilising the system. At the Reserve Bank of New Zealand, international financial surveillance has always been important, with a particular focus on Australia, given the strong links between our four systemically important banks and their Australian parent institutions. However, despite an active surveillance programme and the advantage of some distance from northern hemisphere financial centres, like other institutions, we were wracked by surprises when the crisis began. Being a full service central bank helped. In September 2008 we were seeing the lead up and likely consequences of the Lehman’s crisis through our bank regulator reports, our traders’ views of funding markets and our domestic markets analysis of overnight bank trading. But information also came from some less typical sources, including our Payment and Settlement Systems monitoring of the size of and timing bank payments, which provided a useful perspective on the degree of nervousness in financial institutions. Our currency manager was also able to relay to us banks’ requests for special deliveries of high denomination bank notes, which warned us about a growing nervousness among some members of the public during the heat of the crisis. Using these new sources has expanded our surveillance toolkit in ways that may be useful in the future. However, many aspects of international financial surveillance remain unresolved. Some key issues include: What will be the future of high risk instruments similar to sub-prime and how will they be monitored? What will be the relationship between the traditional and shadow banking sectors and will there be accurate data transparently available? What will Basel III compliance require in terms of new surveillance and what new information will it offer? In this regard, the shift towards exchange-based trading of derivative products and away from “over-the-counter” markets may be a welcome move towards increased transparency, centralised data collection and better monitoring. Electronic trading and data will mean greater availability of a wide range of financial market data. These data will provide information about market pricing, volumes, liquidity and investors’ appetite for risk. However, just as important as information gathering is filtering, analysis, and transmission in forms suitable for economic interpretation and forecasting. Much more work will need to be done on developing suitable analytical methods to achieve this. International economic surveillance What had been thought to be a financial crisis turned into an economic one in late 2008 when fast-growing economies including Asian economies like Singapore (which had been the subject of a debate on international economic decoupling), were suddenly hit with a vicious reduction in trade flows, industrial production and growth. Before the crisis, models of the international transmission of economic shocks were based mainly on trade linkages. The BIS central bankers’ speeches crisis reminded us that financial market channels can cause contagion in ways that may not always be obvious. Although the possibility of contagion through financial channels has long been recognised, macroeconomic models and analysis have typically relied more heavily on trade linkages as the key transmission channel of shocks across countries. However, during the crisis, the explosion in risk premiums and a changed pattern of capital flows transmitted the shock much more quickly to many economies. As a result, there has been greater focus on financial market conditions and linkages to understand the impact of international shocks on real economies. More recently, the rapid development of commodities as an asset class has meant policy easing by major central banks can be transmitted through higher commodity prices to the rest of the world. As easier monetary conditions make funding cheaper and reduce returns on fixed income investments like government bonds, investors may look for higher returns on riskier assets, such as commodities. This could potentially cause a (temporary) divergence between commodity prices and market fundamentals, and has prompted concern about rising inflationary pressures in many countries during recent months. This has provided new challenges for understanding transmission channels between economies and for forecasting inflation.6 At the same time, however, the stronger relationship between commodity markets and investment flows could potentially allow us to use commodity prices as new indicators of financial conditions in global markets, although determining the precise nature of the For a discussion of the increasing difficulty in modelling and forecasting inflation, see “Issues in Inflation”, Global Macro Issues, Deutsche Bank, March 2011. BIS central bankers’ speeches relationship is still very difficult, given our current level of understanding of the market linkages. Looking ahead we need to realise that macroeconomics will remain inextricably linked to financial market conditions. Consequently our economic surveillance will need to focus on the macro-financial and macroeconomic interactions to a much greater extent than in the past. As the crisis demonstrated, sometimes these interactions can be quite complex. Domestic economic surveillance In the domestic macroeconomic arena we have learnt other lessons from the crisis. The crisis challenged traditional economic forecasting, especially model-based forecasts. For example, the lack of factors such as balance sheet positions, financing or credit constraints in many simple models of consumption based on a single representative agent has proved unsatisfactory in the post-crisis environment. As a result, we have had to learn about householders’ new attitudes to consumption and saving as they focus on “deleveraging” and rebuilding savings. In this new environment there has been much greater attention to modelling the behaviour of different types of consumers, with differing asset holdings, access to finance and risk attitudes. This has led to the development of new types of models which allow for this heterogeneity. An example of this has been the recent focus in the economics literature on “agent-based” computational modelling.7 It has also led to greater reliance on alternative data sources such as household balance sheets and more up-to-date indicators of spending such as that provided by electronic measures of payments. There has also been greater attention to micro-level survey datasets to obtain information about individuals’ consumption and saving behaviour. Of course, these more detailed data present new challenges in terms of identifying signals from noisier data. As a result, a range of new technical tools will be needed to filter and synthesise the data from these new sources.8 A further lesson for future economic surveillance, is the increased prominence that credit flows and asset prices may play in policy analysis. In contrast to the pre-crisis consensus view that it is difficult to identify an incipient asset bubble, let alone prick it, most central banks today are putting a lot of effort into monitoring the housing sector, household balance sheets and other assets in an attempt to do just that. Before the crisis, monetary policy setting was often characterised as being represented by some form of “Taylor rule” (or some inflation-targeting rule), under which policy rates changed only in response to deviations of inflation from target and to the output gap, with no direct reaction to asset price movements. As The Economist recently described it, “monetary policy took on... the trappings of a quasiscientific discipline: the judicious adjustment of the short-term interest rate could keep inflation low and thus iron out the bumps of the business cycle”.9 Financial markets also expressed a high level of confidence in central banks’ skills, with indicators of inflation expectations generally well anchored at central banks’ inflation objectives in most developed economies. This vote of confidence from markets was despite warnings from central banks that the era of the “Great Moderation” with steady growth, and low stable inflation may not last indefinitely. For example, Bank of England Governor Mervyn King, who frequently referred to the Great Moderation as the NICE era (Non-Inflationary Consistently Expansionary), warned in 2004 “...the combination of low and stable inflation For a discussion, see J.D. Farmer and D. Foley (2009) “The Economy needs Agent-Based Modelling”, Nature, 460, 6 August, pp.685–686. As an example of a recent model to filter information from volatile data, the RBNZ recently started using a regime-switching model to analyse exchange rate movements. See E. Cassino and Z. Wallis (2010) “The New Zealand Dollar through the Global Financial Crisis”, Bulletin, Vol 73 No.3, Reserve Bank of New Zealand. “A More Complicated Game”, The Economist, February 19 2011. BIS central bankers’ speeches and continuously falling unemployment must come to an end at some point, and may already have done so.”10 But since the crisis, there has been vigorous academic debate about the ability of central banks to identify asset price bubbles and their ability to “lean against the wind” in response.11 However, this requires a great deal of judgement, and better information from a wide range of sources. Identifying the equilibrium value of asset prices will be the new challenge for central banks, in the same way that identifying potential output or the NAIRU was the challenge in earlier decades. Identifying bubbles will require new empirical tools, such as the regression-based methods being developed by Peter Phillips,12 but as with assessing disequilibrium in the goods or labour markets, we will still probably need to rely on information from a wide range of qualitative and quantitative sources to help identify the presence of a bubble and understand the nature of it. How successful we will be remains an open question. The crisis has prompted a revival of interest in money and credit, which in recent decades central bankers, including ourselves at the RBNZ, have tended to put less weight on in the monetary policy formulation process. Several factors have contributed to this revival. First, the impairment of the flow of credit as a result of the financial crisis has led to fears of a creditless recovery, or at least a recovery held back by less plentiful credit. Second, there has been a significant change in money flows during the crisis (with depositors favouring the banks over the non-banks). Overall, there has also been a recognition that credit growth over the past decade was excessive and a potential risk to financial stability given the build-up in leverage and rising asset prices that accompanied it. We are continuing to build our understanding of money and credit at the RBNZ, and its inter-relationship with both sectoral financial decision making and potential risks for the banking sector. However, much still needs to be learned about the relationships, especially the nature of causality and how policy makers can utilise the relationships to achieve their goals. Inside regulatory institutions Within the area of prudential supervision, there has been more focus on the funding markets and balance sheets of the main banks, including their debt maturity and risk management policies. This follows the closure of international funding markets in late 2008 and the increased fragility of markets generally. At the RBNZ, our focus is particularly on the four systemically important banks in New Zealand, which are all subsidiaries of Australian owned parent banks. During the Global Financial Crisis we learned that much of the mandated disclosure of public information from the banks was available with too long a lag and was too general to be much use in predicting stress vulnerability. Consequently we have reduced the information we require to be made public but are requiring more real time private information about funding, bad debt, deposits, loans etc. These receive very close attention from the regulator. The need for timely information has required much greater use of financial market data, and detailed, up-to-the-minute institutional data in assessing the condition of financial institutions. As a result, there has been greater co-ordination between financial market monitoring and Speech at the Eden Project, Cornwall, 12 October 2004. For coverage of this debate, see S. Wadhwani (2008) “Should Monetary Policy Respond to Asset Price Bubbles? Revisiting the Debate”, National Institute Economic Review no. 206, NIESR and W. White “Should Monetary Policy “Lean or Clean”?”, Globalisation and Monetary Policy Institute Working Paper 34, Federal Reserve Bank of Dallas. See, for example, P. Phillips, Y. Wu and J. Yu (2011) “Explosive Behaviour in the 1990s NASDAQ: When did Exuberance Escalate Asset Values?”, International Economic Review, Vo. 52, No. 1. BIS central bankers’ speeches bank supervisors. This co-operation between supervisors and financial market monitoring is much easier in a full service central bank without institutional or legal impediments to information flows. The Financial Crisis has also inspired a large international push through the Basel Committee on Bank Supervision and the Financial Stability Board, including Basel III, new accounting standards and other forms of bank regulation. The broad aim of these changes has been to lead to a more resilient banking sector. However the new environment also requires more oversight of banks and more early warning systems. As a result, there has been a resurgence in interest in early warning indicators of financial sector crises, which first emerged in response to the Asian Financial Crisis in the late 1990s.13 More recent early warning techniques, such as Contingent Capital Analysis (CCA),14 which combine information from institutional balance sheets and financial market data, are being actively investigated by central banks, bank supervisors and other financial regulators. While the aim here is a worthy one, we do need to keep our expectations realistic about our ability to develop robust and reliable early warning indicators. More generally, within central banks and regulators the crisis means that more attention is being paid to the financial markets intelligence function. Information is now being swapped much more readily between central banks and regulators. There is much discussion about the relative interplay of microfinancial policies, macrofinancial policies and monetary policy. Relations with Treasuries and Ministers of Finance have also become closer as government funding has been required for deposit guarantee schemes and as central banks take into account the more fragile state of sovereign funding markets. At the RBNZ we have also strengthened our links with regulators in other countries. Well before the crisis we had strong formal links with our Australian counterparts at the Reserve Bank of Australia and the Australian Prudential Regulation Authority (APRA). These links have continued to develop in recent years, with good two-way information flows ensuring that both sides are more alert to emerging prudential issues. We are also building better ties with our Asian central bank partners in EMEAP (Executives’ Meeting of East Asia Pacific Central Banks). Conclusion In a recent article,15 Professor Robert Shiller argued that “the Depression of the 1930s was blamed on a lack of knowledge...one result was an improvement in our measurement systems”. Shiller notes that the development of national accounts data began as a reaction to the “information black spots” of the Depression. In the same way, the Global Financial Crisis has changed the nature of economic monitoring and surveillance required by central banks. Central banks now require information from a wider range of sources and much greater interaction between monitoring for monetary and financial stability. But economic surveillance is not just about capturing developments – it is about reading the risks and threats to the economy, and the mood of the markets, public and business sector, or, in other words, gauging the “atmospherics”. However, despite these innovations, central bankers will need to be realistic about their goals. Good surveillance usually will not stop nasty surprises, but it may buy some lead time and help policymakers to make better sense of surprises when they happen. As ECB President Trichet noted in a recent interview “central banks need formidable analytical capacities and skills. You need both state-of-the-art analytical work, as deep and robust as possible, and you need judgement, based on experience and solid See R. Caballero and P. Kurlat (2009) “The “Surprising” Origin and Nature of Financial Crises: A Macroeconomic Policy Proposal”, Financial Stability and Macroeconomic Policy, Jackson Hole Economic Symposium. D. Gray and S. Malone (2008) Macrofinancial Risk Analysis. R. Shiller (2011) “Needed: A Clearer Crystal Ball”, New York Times, April 30. BIS central bankers’ speeches capacity to synthesise all pertinent analyses. This is true in absolutely all circumstances, and particularly in times of crisis”.16 Ultimately, the aim of central bank policy and its main contribution to increasing social wellbeing remains, as before the crisis, to maintain macroeconomic stability. However, since the crisis it has been increasingly acknowledged that consumer price stability is not, on its own, a sufficient condition for overall macroeconomic stability, as was probably assumed during the Great Moderation. Traditional policy tools need to be augmented with macro-prudential instruments targeting financial stability goals. Going forward, the aim is to set monetary and financial policy instruments to take account of the inter-relationship between the financial sector and the real economy, which will require a broader framework for economic surveillance. But this new environment will present new challenges for central bankers and academics. New empirical tools will need to be developed to identify the signal from the noise in a vastly expanded range of data sources, to make the maximum contribution to policy decisions. The quality of the new data, from both official and un-official sources will vary widely, making it difficult for policy makers to interpret.17 In addition, understanding the relationship between traditional monetary policy tools and new macro-prudential tools is a key priority for the research agenda in order to co-ordinate them effectively. As Professor Shiller argues, “We should respond just as we did to the Depression, by starting the long process of redefining our measurements so we can better understand the risk of another financial shock. The past suggests that this project will take many years to complete. But it will be worth the effort”. Jean-Claude Trichet: Interview with Helsingin Sanomat http://www.ecb.europa.eu/press/key/date/2011/html/sp110426.en.html. The crisis has demonstrated that official data are not always entirely reliable, as illustrated by the significant revisions to the fiscal deficit in Greece. Initially the Greek government projected a deficit below 3% of GDP for 2009. This was eventually revised by Eurostat to 15.4% of GDP. BIS central bankers’ speeches and Kauppalehti, April 2011,
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Opinion piece by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, at the implications of the Canterbury earthquakes for the Reserve Bank, 13 May 2011.
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Alan Bollard: The implications of the Canterbury earthquakes for the Reserve Bank Opinion piece by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, at the implications of the Canterbury earthquakes for the Reserve Bank, 13 May 2011. * * * As Canterbury’s recovery from its devastating earthquakes progresses, it is timely to assess the economic damage in Canterbury and beyond, and consider what the Reserve Bank – and monetary policy – should do. Prior to the February earthquake, New Zealand’s economic activity had been weaker than expected through 2010. Households were already spending less, focusing on reducing debt, and this had slowed business investment. By late 2010, however, signs of recovery had begun to emerge, notably among exporting firms benefiting from improved overseas demand and commodity prices. The February earthquake disrupted this recovery. It resulted in significant loss and trauma, compounding the effects of the September 2010 earthquake and subsequent aftershocks. In addition to the considerable impact on peoples’ lives, there has been substantial damage to assets, as well as disruption to economic activity. The total cost of damage has been estimated at $15 billion – approximately 8 percent of annual nominal gross domestic product. That is a very large proportion of our economic activity, in relative terms twice as big as the impact of the recent Japanese earthquake. These estimates are very uncertain and could move around a lot. The vast bulk of the losses to residential and commercial property will be covered by insurance – via the Earthquake Commission (EQC) for residential property, and private insurance for both residential and commercial property. Unlike some other countries like Japan, there is a high level of reinsurance in New Zealand, meaning the majority of privately insured losses will be borne by global insurance companies rather than domestic insurance firms. The Government will bear the majority of the remaining losses, with an estimated $3 billion in damage to uninsured public infrastructure and government buildings, as well as the costs being met from the EQC reserves. Fiscal costs will also include the array of additional government support programmes – support to small businesses, clean up and recovery costs, and ACC payments. These costs are material and will place pressure on the Crown accounts at a time of fiscal consolidation. We see three distinct phases in economic activity following the earthquakes: disruption, stabilisation and reconstruction. Economic disruption is most pronounced in Canterbury, but flowing through to other regions. Consumer spending, tourism and residential investment can be expected to have deteriorated. Most businesses with operations in the centre of Christchurch have lost some production, generally from the impact on their workforce. The Canterbury Employers Chamber of Commerce estimates around 30 percent of businesses in Christchurch were materially impacted by the February quake. However, we may be seeing the first signs of a stabilisation phase, with business confidence surveys recovering strongly. BIS central bankers’ speeches The Official Cash Rate cut in March, along with government support programmes, looks like it has been helpful in stabilising confidence, and we would expect the deterioration in activity to be arrested by mid-2011. In Canterbury, activity can be expected to lift due to resumption of business activity, replacement spending and government support. But the Canterbury economy will remain subdued due to wealth losses, weakness in tourism and construction, and obstacles including damage to infrastructure and capital. Nonetheless, recovery in the Canterbury economy, combined with the boost from the Rugby World Cup, will result in a marked pick-up pace of overall GDP growth. The reconstruction phase is expected to begin in earnest in 2012, with residential and nonresidential investment lifting growth sharply. Spare capacity and labour will be absorbed rapidly, and inflation pressures will pick up from current low levels, prompting interest rates increases. The likely drivers of inflation from a reconstruction such as we will see in Christchurch are the demand and supply of labour, materials and equipment, and the availability of finance. How government policy affects regulatory standards and the rebuild is also clearly important. How will the Reserve Bank deal with this? We are guided by our Policy Targets Agreement (PTA) with Government that says, in the case of natural disasters, we should accommodate any initial inflation effects, such as higher rents or insurance premiums. However, we should respond to any medium-term generalised inflationary pressures that are likely to develop, as resources are devoted to reconstruction in Canterbury. This means assessing the extent to which wages, construction costs and other prices rise nationally, as resources are drawn into the Canterbury region. At the same time, monetary policy should also look to avoid any unnecessary instability in activity, the exchange rate and interest rates resulting from the earthquakes. This consideration was behind the decision to reduce the OCR in March so as to mitigate the near-term negative impact of the February earthquake. It is appropriate for monetary policy to remain supportive, given the continued downside risks to economic activity stemming from the Canterbury earthquakes and more broad fragility in the New Zealand economy. It is likely that the OCR remains on hold until these downside risks pass and the economy begins to recover. BIS central bankers’ speeches
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the New Zealand Shareholders Association Annual Meeting, Tauranga, 6 August 2011.
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Alan Bollard: The role of banks in the economy improving the performance of the New Zealand banking system after the global financial crisis Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the New Zealand Shareholders Association Annual Meeting, Tauranga, 6 August 2011. * * * This speech was written by Dr Alan Bollard, Chris Hunt and Bernard Hodgetts, with thanks to Don Abel, Toby Fiennes, Michael Reddell and Grant Spencer for useful comments. Introduction The New Zealand financial system has been significantly tested in recent years by the effects of the global financial crisis, volatile global commodity prices, the end of a domestic housing boom, and the resulting slowdown in domestic economic activity between 2007 and 2009. Over the past year, even with the economic recovery underway, the financial system has faced further challenges from the series of earthquakes in the Canterbury region and from ongoing fragility in the global financial markets due to sovereign debt concerns. Unlike the case in many countries, New Zealand’s banking system has remained relatively resilient over this period. Banks dominate the New Zealand financial system to an extent seen in few other economies, accounting for around 80 percent of the total assets of the financial system. Moreover, four banks – the Australian-owned subsidiaries and their branches domiciled in New Zealand – account for nearly 90 percent of the banking sector, or just over 70 percent of the financial system as a whole. It is these institutions that provide the lion’s share of financial services and products to the New Zealand economy, and therefore are of key systemic importance. What explains the New Zealand banking system experience relative to other jurisdictions where banks failed, or required government recapitalisation? Briefly, our banks stuck to their knitting over the boom, engaging in very profitable lending to households and the rural sector in the main, without recourse to the sort of exotic financial innovation witnessed elsewhere. As prudential supervisor of the banks we certainly witnessed some decline in lending standards over this time, and what we considered misplaced exuberance around lending to some sectors, particularly later in the cycle. However, New Zealand’s conservative application of the regulatory capital regime (under both the original Basel I and the new Basel II frameworks) helped to promote sound risk management and the banks appear to have steered clear of the dubious lending practices evident in parts of the non-bank sector. Nevertheless, one point needs to be made clearly. When the crisis did hit, the banks did require public sector support. The Government implemented both retail and wholesale funding guarantees to preserve confidence in the banking system, while the Reserve Bank expanded its liquidity facilities in order to ensure that banks remained liquid and well-funded. The financial crisis revealed a major limitation in the banks’ business model that lay behind the rapid expansion in credit during the lead-up to the financial crisis – a tendency to fuel much of that lending primarily through short-term wholesale funding from offshore. However, unlike banks in the Northern Hemisphere, the banks’ own capital buffers proved sufficient to absorb the rise in non-performing loans and accompanying decline in profitability that followed from the economic slowdown. Banks play an important role in supporting economic growth and it is worth reflecting on the lessons that have been learnt from the global financial crisis and the experience of the New Zealand financial system over recent years. Under the Reserve Bank Act, the Reserve Bank has a legislative mandate to promote the “soundness and efficiency” of the BIS central bankers’ speeches financial system. In thinking about ways to make the financial system safer and more resilient, consistent with the aims of global regulatory reforms, we need to take both these dimensions of financial system performance into account. More stringent regulations may well make the financial system safer but possibly at the expense of the efficiency and cost at which it provides services to businesses and consumers. What role do banks play in the economy? Any modern financial system contributes to economic development and the improvement in living standards by providing various services to the rest of the economy. These include clearing and settlement systems to facilitate trade, channelling financial resources between savers and borrowers, and various products to deal with risk and uncertainty. In principle, these various functions can be provided by banks or other financial institutions or directly through capital markets. Banks and other financial intermediaries exist because they are an efficient response to the fact that information is costly. Banks specialise in assessing the credit worthiness of borrowers and providing an ongoing monitoring function to ensure borrowers meet their obligations. They are rewarded for these services by the spread between the rates they offer to the accumulated pool of savers, and the rates they offer to potential borrowers. This process is known as “maturity transformation” and is at the heart of modern banking. Banks offer a repository for savings, and then transform them into longlived (illiquid) assets – housing loans and lending to businesses. In addition, banks play a role in providing payment and settlement services which are necessary for households, business and other financial institutions to settle day-to-day transactions. As a country becomes more developed, one typically sees the capital markets playing a greater role in supplying financial products and services relative to that supplied by the banks. In many advanced economies, for example, raising business debt through securities rivals or exceeds that provided though the banking system. Unusually, New Zealand has a large banking sector, while the role played by the capital markets and non-bank financial institutions is small. Table 1 compares New Zealand to five other economies whose banking systems also tend to dominate their financial systems, using data immediately prior to the financial crisis as compiled by the IMF.1 Table 2 compares the New Zealand and Australian financial systems. The following points emerge: Relative to the financial system as a whole, the New Zealand banking system is large in common with the other countries included in the table. New Zealand’s banking system is larger than Australia on this metric. In relation to the size of the economy however, the New Zealand and Australian banking systems are of roughly equal size, and much smaller than the other countries identified by the IMF. New Zealand’s financial system is much smaller than in the other economies included in Table 1. On the eve of the crisis Iceland’s financial system was 4 times as large as New Zealand’s. New Zealand’s financial system is also smaller than Australia’s largely reflecting Australia’s compulsory superannuation and the large funds management business. The New Zealand banking system is not as internationally active as the countries in the IMF sample as measured by gross foreign assets and liabilities. However, our banking system’s negative net foreign asset position in 2007 was similar to Ireland’s, IMF (2010), “Cross-cutting themes in economies with large banking systems”, Policy Paper, 16 April. BIS central bankers’ speeches but smaller than Iceland’s. (The rest of the world’s net claims on the New Zealand banking sector is also reflected in figure 1 below). New Zealand has a relatively highly concentrated banking system, even compared with those countries with large banking systems. The big four Australian-owned banks command a larger role in the New Zealand financial system, compared to their parents in Australia. Table 1: Bank-dominated financial systems before the crisis – a comparison Iceland Ireland Switzerland Hong Kong Singapore New Zealand Financial sector size and growth Financial sector assets (% of GDP, 2007) Financial sector assets (% of GDP, 2001) Financial sector structure Bank assets (% of total financial assets)* Banking sector concentration* (share of the largest 3 banks) Banking sector Bank loans (% of total bank assets)* Bank assets (% of GDP, 2007) Bank assets (% of GDP, 2001) Bank foreign assets (% of GDP, 2007) Bank foreign liabilities (% of GDP, 2007) Bank net foreign assets (% of GDP, 2007) –124 –44 –54 (*) average 2003–2007 Source: IMF, RBNZ. BIS central bankers’ speeches Table 2 Financial system structure – comparison with Australia (as at December 2010) New Zealand Australia Total financial system assets $474 bn AU$4.6 tr as a percent of GDP 244% 340% Foreign branches Locally incorporated $380 bn AU$2.7 tr as a percent of total financial system assets 80% 58% as a percent of GDP 195% 197% as a percent of total bank assets 89% 77% as a percent of total financial system assets 71% 43% 25% 180% Number of banks Domestically owned Total bank assets Big-4 banks’ assets Stock market capitalisation as a percent of GDP Sources: RBNZ, APRA, RBA, World Bank. The dominant role of banks within the New Zealand economy can also be examined by looking at financial claims between the different sectors of the economy – financial corporates, non-financial corporates, households, government and the rest of the world. As can be seen from figure 1, banks dominate the flows between the financial sector and the rest of the economy. Figure 1 Financial claims between registered banks and other sectors, December 2009 (percent of GDP) BIS central bankers’ speeches New Zealand has a very “plain vanilla” banking system with a large proportion of assets being loans to households and businesses. Relatively few of its assets are held in the form of trading securities. New Zealand’s banks largely fund themselves “on balance sheet” rather than through the securitisation channel common in some other countries. The banks have little in the way of funds under management, nor do we allow them to conduct much insurance business. Reflecting New Zealand’s history of current account deficits, the banking system has a reliance on foreign wholesale markets, particularly the short-term funding markets. Given these trends and our relatively underdeveloped capital markets, the question can be asked whether the structure of our financial system is optimal for the economic growth outcomes we would like to achieve. The answer is by no means clear. The failure of any one of our larger banks could have serious repercussions for the rest of the economy. Moreover, there may be efficiency concerns if the banks are perceived by their customers and investors to be “too-big-to-fail” and hence gain a competitive advantage over other banks and other non-bank financial institutions or financial markets. New Zealand firms could well benefit from greater capital market development to help them grow and reach the scale necessary to compete on the world stage – a point made by the Capital Markets Taskforce and more recently the Savings Working Group. Larger capital markets might help to stimulate greater competition in the financial system by providing a substitute for bank funding of both small and large businesses. However, it is not clear whether our underdeveloped capital markets are more a symptom of low national savings or a direct cause of relatively low growth outcomes over the past two decades. Finally it may well be that because of the large number of small businesses in New Zealand, relationship lending through a bank-based system is actually an optimal arrangement. Banks and financial (in)stability – making the system safer Transforming short term deposits into longer term lending – one of the most important functions that banks perform for the rest of the economy – is also what makes financial systems prone to fragility. This process exposes banks to illiquidity or possibly insolvency given the possibility of bank runs from depositors and creditors, or deterioration in lending quality. Banks’ own practices and financial regulation have an important bearing in reducing or amplifying this risk. For example, banks have choices around how much debt they use to fund their lending (leverage), while the quality of that lending is influenced by a number of governance-related factors. These include the control that creditors and shareholders exert over bank managers, as well as the internal risk management systems of the bank. Regulations also set boundaries on what banks are able to do. Given the interconnections between a bank and the rest of the economy, the effects of a bank in stress or failure can potentially spill over to the wider financial and economic system when financial savings cannot be accessed, the credit intermediation process is disrupted or the transactional role via the payments and settlement systems is undermined. The extent of such contagion will depend on the “systemic importance” of the bank, which will be roughly related to its size, the nature of its exposures, interlinkages with other banks and so forth. Governments are naturally reluctant to see such important institutions fail since economic crises that are accompanied by major banking crises are typically far worse than usual business cycle slowdowns. However, as we have seen from the experience of Ireland and Iceland, supporting stressed banks can create major fiscal problems, particularly if the banking system is very large relative to the size of the economy. A banking crisis can evolve into a sovereign debt crisis, which itself can have cross-border contagion effects. As mentioned at the outset, the New Zealand banking sector did not experience the sorts of problems that affected the US or European banking systems. Despite a tightening in lending conditions and standards, which had a significant effect on some businesses, our banking system was largely able to maintain the confidence of depositors and creditors. However, it BIS central bankers’ speeches did still require a backstop of government support. In the aftermath of the crisis we are aligning our prudential initiatives with global efforts focussed on redesigning the regulatory safety net. This improvement in the soundness of our banking system centres on the implementation of stronger microprudential standards; the development of a new macroprudential framework; and improved failure resolution management. (i) Microprudential standards Microprudential settings in New Zealand were largely appropriate heading into the crisis. Both before and after the implementation of Basel II, our capital requirements ensured locally incorporated banks held high quality (Tier 1) capital that excluded hybrid debt/equity instruments in order to absorb potential losses. The larger banks that were accredited to use their own internal models to calculate capital requirements under the Basel II guidelines were also strongly encouraged to use risk parameters that “looked through” the boom-bust cycle. Basel II largely appears to have served us quite well, although the banks’ initial modelling of capital requirements for both housing and rural lending was not sufficiently conservative, a point highlighted by the sharp fall in farm prices and earnings in 2008–09. In response, the Reserve Bank has initiated a number of adjustments, most recently a tightening in the area of capital requirements for farm lending. Over the course of the crisis the Reserve Bank introduced a Prudential Liquidity policy to ensure that bank lending is largely funded by stable (retail and long-term wholesale) funding and to ensure that banks have sufficient liquid assets to withstand short-term market disruptions. Banks are now also able to issue covered bonds to help diversify and lengthen their wholesale funding. Banks should now have more robust liquidity structures, reducing their need to call on emergency liquidity facilities with the Reserve Bank during periods of funding market volatility. The Reserve Bank will be reviewing its capital adequacy framework in view of guidelines from the Basel Committee now widely known as “Basel III”. In addition there may be minor developments to our liquidity policy. We are broadly supportive of Basel III, but will implement it in a manner that is appropriate for our financial system. We don’t believe our banking system requires the sort of radical overhaul that is being discussed as necessary in some other countries, given the relative resilience of our banks over the course of the crisis. The Reserve Bank’s supervisory approach for banks has also changed, with a shift from a high reliance on market disclosures, to one that uses more private reporting. This will enable the Reserve Bank to utilise more detailed and timely information from internal reports that banks themselves use to manage risk. (ii) Macroprudential framework Microprudential policies are typically aimed at building the resilience of individual institutions, while a macroprudential approach focuses on system-wide risks and vulnerabilities and a range of instruments or tools that might be used to build greater financial system resilience to the risks associated with the extremes of the credit cycle. Examples include countercyclical capital requirements, liquidity ratios or caps on loan-to-value ratios for housing lending. Some of these tools may also have the ability to directly dampen the credit cycle. We have been considering a number of potential instruments for these purposes including credit-based measures and capital and liquidity buffers. Our examination of the costs and benefits of these tools suggests we should keep our expectations modest in terms of the effectiveness of any one tool particularly as instruments to help control the flow of credit. However, we have concluded that our Core Funding Ratio – part of the Prudential Liquidity policy – could help to dampen periods of excessive credit growth in some circumstances by making the marginal cost of funding more expensive than it would be were it not in place. BIS central bankers’ speeches (iii) Failure resolution management One important lesson from the crisis was that few countries had an adequate framework for resolving the failure of a systemically important bank or financial institution in an orderly fashion. Moreover, the existing resolution tools did not address the cross-border complications that occur with globally active banks. Improving the resolution framework is an important component of efforts to address the systemic risks posed by the largest and most interconnected of the international banks. New Zealand’s largest banks are not of global systemic importance and nor are their Australian parents. However, distress in any one of our larger banks in New Zealand could have a potentially large negative effect on the New Zealand economy and could expose the government to large fiscal risks in the event of a bailout. The recently announced Open Bank Resolution (OBR) policy is a failure resolution option that aims to preserve the continuity of banking services to retail customers and businesses, while placing the cost of a bank failure primarily on the bank’s shareholders and creditors rather than the taxpayer. Under OBR, the creditors of a distressed bank, including its depositors, would face a “haircut” of their funds based on initial estimates of the shortfall in the bank’s capital position. Access to their remaining funds would be supported via a government guarantee. This would allow the affected bank to remain open for business while the longer-term options were worked through. We believe OBR would help address the “too-big-to-fail” problem posed by our largest banks. Currently we are not contemplating additional loss absorbency or capital surcharges for the largest New Zealand banks, measures that are currently being planned for the largest 30 or so global banks. Making the financial system more efficient – the role of banks The banks’ role as financial intermediaries has a major bearing on how efficiently the economy allocates its resources between competing uses. In considering efficiency, we are interested in whether lending activity helps resources flow to their “best use” or whether some sectors get too little or too much credit relative to what is needed for the economy to perform at its best. We are also interested in whether lending and other financial activities are provided in a cost effective manner from the point of view of consumers and the degree to which the banks improve and innovate their financial products and services over time. All else equal, a well-managed bank acting prudently and operating in a reasonably competitive market will be making credit available at an appropriate price to creditworthy borrowers. However, in concentrated banking systems dominated by a handful of large banks, competition may be lacking. Households and firms may end up paying more to access credit (and other bank services) than in a more competitive system. Financial sector efficiency can also be compromised by boom-bust cycles, which is why there has been a resurgence of interest in how we might avoid or reduce these. During booms, lending standards may fall significantly and lenders may underprice risk, with too much credit being allocated to any one sector (such as the rural sector or property development). In turn, when the boom turns to bust, the over-allocation of credit may be revealed when physical and human resources become underemployed. International evidence suggests what might be more important for competition and efficiency is how “contestable” the banking system (or individual banking product markets) is, rather than simply how many banks operate (i.e. market structure). Contestability is influenced by both the actions of incumbent banks, and by various formal and informal barriers to entry and exit. BIS central bankers’ speeches Cross country comparisons undertaken by the OECD suggest formal regulatory barriers to entry and exit to the New Zealand financial system are low by international standards.2. While banks seeking registration must meet minimum qualitative and quantitative criteria so that their entry to the market is consistent with the soundness and efficiency objective, the Reserve Bank does not impose quotas of any kind nor do we restrict foreign ownership. However, the costs associated with establishing a new retail branch network in New Zealand appear to be high given the small scale of the market. Notwithstanding the success of Kiwibank in the retail market, the fact remains that it is difficult for new players to enter the New Zealand market and assume a competitive position other than through direct acquisition of an existing bank or by specialising in a narrow market segment. In terms of informal barriers to entry, one such barrier may come about from the practical difficulties customers face switching between banks. Shifting one’s banking activities from bank A to bank B is usually a more involved process than shifting between cellphone providers or electricity companies. The customer inertia that this creates makes it difficult for new entrants to gain critical mass even if they price their offerings keenly. Encouragingly, some of these barriers may have eased recently through technical innovations at the payment systems level orchestrated by Payments New Zealand (PNZ). More switching implies greater incentives for banks to compete and innovate. Figure 2 Post tax return on equity – OECD comparison (average 2002–2007) Source: OECD, Australian Prudential Regulatory Authority, RBNZ calculations. OECD (2006), Competition and regulation in retail banking, Policy Roundtables. BIS central bankers’ speeches Although some of the smaller banks have succeeded in “nipping at the heels” of the larger banks and stimulating competition in some markets, overtaking the market share of the larger banks has proven a very tall order. It is likely that the “franchise” or brand value of the large New Zealand banks is an important factor that gives established banks an advantage. Customers do appear to place considerable weight on the “brand” of the financial institutions with which they bank and the larger banks have considerable investment built-up in their brands, both tangible and intangible. What does all this imply about the efficiency of the New Zealand banking system? Efficiency is very difficult to measure in absolute terms, but two commonly used indicators include the return on equity and operating costs as a share of income. Profitability is a gauge of the economic rents that banks are able to earn, while operating costs tell us something about the efficiency with which services are delivered. In the decade preceding the global financial crisis, the New Zealand banking system’s return on equity (RoE) appears to have been among the highest of the OECD group of countries coming second in a sample of 22 countries for the period 2002 to 2007. Rates of return in New Zealand were ahead of those in Australian banks, which were third highest in the comparison. Operating costs were second lowest in the sample while loan loss provisions were also towards the lower end. While we are acutely aware of the accounting issues that can make these comparisons misleading, taking the comparison at face value would suggest the New Zealand banks (and their Australian parents) were among the world’s most cost-efficient, and also among the most profitable. This was at least partly due to their relatively strong asset quality. From a financial stability perspective, the relative strength of the Australasian banks could be seen as a desirable feature. A leaner banking system would have had fewer financial buffers to draw on and therefore would be potentially more exposed to the sorts of risks that arose following the global financial crisis. However, the question can be asked why the banks’ rates of return were not at levels that on average were more typical of other countries. The result could be seen as evidence that competition and contestability in the banking sector were lacking enabling the banks to earn higher profits than would otherwise be the case. However, alternative explanations are also plausible. One relevant factor is that the sample period covers a major domestic credit boom. A comparison over a longer period would be likely to reveal rates of return more in line with the banks’ international counterparts. There have certainly been periods when New Zealand bank profits have been weaker most notably in the early 1990s following the commercial property downturn. Another potential explanation relates to the higher cost of capital facing New Zealand. Riskfree interest rates have been consistently higher in New Zealand than in most other countries, and this could account for part of the higher observed rate of return in New Zealand. Moreover, the degree of support that the major New Zealand banks receive from their Australian parents allows them to maintain lower capital levels than would otherwise be the case to maintain their credit ratings. Nevertheless, the capital ratios of New Zealand subsidiary banks are similar to those of the Australian parents, and it remains an open question why the Australasian banking system as a whole has been relatively profitable. Some work we have done comparing the margins that banks charge on some financial products like residential mortgages suggest that the New Zealand banks have not earned interest margins that are particularly high relative to other countries. This would support the view that strong profitability was due to low operating costs rather than undue market power being exercised over customers. However, a comparison across the full range of financial products is difficult due to a lack of comprehensive data and other country differences. BIS central bankers’ speeches Clearly, operating conditions for the banks have changed profoundly since the financial crisis. It is still too early to be definitive about how this will affect financial performance over the years ahead. In terms of bank shareholders, regulatory changes designed to create safer banks might be expected to lower required rates of return over time. However, a host of other structural changes will also have a bearing on returns. In the past three years, bank balance sheets have shown little growth, with households and businesses choosing to curtail debt and save more. If this trend endures, banks will have less opportunity to generate higher profits through balance sheet expansion. A combination of higher risk aversion, global regulatory changes and sovereign debt issues have led to a rise in the cost of debt funding for banks although where these costs are likely to settle in the longer run is uncertain. The higher funding costs have encouraged some large corporates to raise funds directly in the capital markets in lieu of the banks and it will be interesting to see whether this trend continues. The banks’ ability to recover higher funding costs from customers will depend partly on the strength of loan demand as well as competitive pressures from other parts of the financial sector. All things considered, it seems unlikely that the rates of return in banking enjoyed over the past decade can be sustained in the future. Conclusion The global financial crisis has focussed policymaker’s attention on making their banking and financial systems safer and more resilient to shocks. While New Zealand’s bank-dominated financial system stood up well during the crisis and does not require the extensive overhaul required in some countries, we have continued to develop our prudential policies with the aim of improving the resilience of individual institutions and the financial system as a whole. Ensuring that core banking services can continue if any one of our large banks comes under duress, and that the cost of bank failure falls squarely on the shoulders of shareholders and creditors, is another plank in our regulatory reform agenda. Notwithstanding the importance of financial system resilience, we also need to understand more about the efficiency of the financial system when assessing its performance and contribution to the economy. BIS central bankers’ speeches
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Mr Satish Ranchhod, to the Rotary Club of Wellington and Victoria University of Wellington one day conference "Organisational Effectiveness in Times of Seismic Risk", Wellington, 18 October 2011.
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Alan Bollard: Economic impacts of seismic risk – lessons for Wellington Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Mr Satish Ranchhod, to the Rotary Club of Wellington and Victoria University of Wellington one day conference “Organisational Effectiveness in Times of Seismic Risk”, Wellington, 18 October 2011. * * * With thanks to Don Abel, Stephanie Begley, Alan Boaden, Denys Bruce and Robert Cole for their contributions to this work. Introduction The earthquakes in Canterbury have had a profound human and economic impact that will continue to be felt for many years. The devastating nature of these events has highlighted the importance of risk management and the consequent organisational preparedness. This is particularly true for Wellington, a city that is built on hills, flood plains and reclaimed land, overlooking a harbour connected to Cook Strait, and dissected by a major active fault line at the intersection of the Indo-Australian and Pacific tectonic plates. It has been a little over a year since the first of the major earthquakes in Canterbury and we have seen these events produce highly complex and unforeseen outcomes. One of the least expected outcomes has been the long lasting nature of the earthquakes through their associated aftershocks. Planning in the face of such uncertainty is a great challenge, but it is vital to ensure that our society is able to continue to function effectively in times of considerable disruption. From the perspective of the Reserve Bank, organisational preparedness means both business continuity considerations for the Bank itself, as well as working to maintain economic stability. This paper focuses, firstly, on the impact of the Canterbury earthquakes on the economy and how the Bank has responded; secondly, the business continuity planning of the Bank itself; and thirdly, the lessons we can learn from Canterbury that we, as institutions, can apply in Wellington. It does not cover the important topics of seismology, engineering, and human issues. Economic effects of the Canterbury earthquakes The earthquakes in September 2010 and February 2011, as well as the associated aftershocks, significantly affected the economic environment. In addition to the considerable impact these events had on people’s lives, there was substantial damage to assets, as well as disruptions to economic activity. The affected areas are home to around 12 percent of the country’s population and damage to housing was extensive. Out of a total housing stock of approximately 220,000 homes, around 165,000 were impacted, including many that are now uninhabitable. There has also been substantial damage to commercial assets and infrastructure, particularly within Christchurch’s central business district. It has proved very difficult to calculate the cost of the damage. It is likely over $20 billion (most of this involving damage to housing, with significant damage also to commercial buildings and infrastructure). Of course estimates of damage, estimates of insurance claims, and estimates of reconstruction can all differ somewhat. Our working assumption is that there will be approximately $20 billion of rebuild. This is equivalent to around 10 percent of GDP, which represents a very large shock in relative terms. (As a comparison, the massive earthquake that struck Japan in March 2011 is estimated to have caused damage equivalent to around BIS central bankers’ speeches 3 to 4 percent of Japan’s annual GDP.) We recognise that there is considerable uncertainty around these numbers and that revisions to this estimate are likely to continue for some time. Indeed, we frequently note that our working assumption is to the nearest $5 billion. It is also important to note that this assumption relates to the current replacement value of damaged assets. The nominal cost of rebuilding these assets could be larger as construction costs and prices for materials may well increase over the coming years, and as reconstruction incorporates quality improvements. Indeed, the Reserve Bank’s Insurance Oversight Team estimates that total property insurance claims (including buildings and other assets) stemming from the earthquakes could be considerably higher than these numbers. In addition, some of the damage caused will not have been insured or will not be repaired. The response to these events The devastating impact of the Canterbury earthquake necessitated a large and coordinated response by central and local government, as well as private sector agencies. New Zealand was also fortunate enough to receive assistance from other nations during the disaster recovery period that followed the February earthquake. For the Reserve Bank, the earthquakes raised a number of broad concerns related to protecting the soundness of the financial system. We were also conscious of our aim of maintaining medium-term price stability. When determining the appropriate response to achieve these goals, we considered three distinct phases in economic activity following the earthquakes: disruption, stabilisation and reconstruction. Rather than representing specific time periods, each of these phases relates to the underlying state of the economic environment. In turn, each raised a different set of concerns. In the period of disruption that immediately followed the earthquakes, human life and safety were the dominant concerns, with recovery efforts led by Civil Defence. The Reserve Bank and other organisations were focused on ensuring that essential economic activity could continue. This involved the maintenance of payments systems, including the supply of additional cash. We also focused on ensuring that key financial institutions were able to continue operations. After immediate safety factors were addressed, concerns shifted to ensuring the stability of business and economic activity. During this period, we have been focused on the soundness of the financial system, including the financial health of key economic organisations. We have also focused on providing appropriate support for economic activity. Over time, CERA and other organisations’ response to these events will shift again as economic conditions in Canterbury and the economy more generally improve. As this occurs, the Reserve Bank’s focus will move away from the provision of emergency support, and towards ensuring that the degree of economic stimulus provided is appropriate for achieving our medium-term policy aims. Uncertainty about the state of the economy following the earthquakes has been very high. Over the past year, we have been engaged in a process of ongoing learning about the state of the economy following the earthquakes that has fed into our policy deliberations. This process will continue for an extended period, even as the economy continues to recover, although our focus will gradually shift. The earthquake and financial system soundness Cash handling and payments systems One of our most pressing concerns immediately following the earthquakes was the maintenance of payments systems. In the aftermath of events such as natural disasters, there is strong demand for food, water, petrol and other necessities. And with damage to BIS central bankers’ speeches power and telecommunications systems, access to cash is a key concern. Only two hours after the February earthquake the Reserve Bank started receiving orders from banks for more cash for delivery to Christchurch. Ensuring cash was available required us to work closely with banks and Cash in Transit companies to meet the spike in demand. This task was complicated by damage to roads that meant travel, where possible in Christchurch, was taking about three times as long as normal. The public also needed information about where cash was available. To ensure this, Bank staff used Google maps to provide a live feed of operational and accessible ATMs. Overall about $150 million of extra cash was sent to Christchurch in the week of the earthquake, representing about $350 per resident. There was a big drop in electronic payments and increased demand for cash, initially in the form of $20 and $50 notes through the surviving ATM machines. We learned a lot about ATM configuration to ensure operability, and the internet was very useful to provide up to date information on ATM availability. Banking An additional concern following the earthquakes was the stability of key financial institutions including banks and insurers. These institutions play an important role in shaping the ongoing conditions in Canterbury. Further, we were conscious that significant disruptions in one region could affect the functioning of these organisations at a national level. Most commercial banks do not have their core banking systems located in Christchurch, and those that do had effective back-up systems located outside the Christchurch region. Additionally, banks’ disaster recovery procedures proved to be quite effective, and certainly had become much better honed by the time of the February earthquake. Banks took a longterm view of their customer relationships through the provision of generous customer assistance packages, and generally adopted a helpful, constructive attitude to their customers’ difficulties. Banks came together as an industry throughout the disaster, sharing a lot of information and advice amongst each other, and have opened small business support centres. Some households and businesses came under financial stress as a result of the earthquakes and this had an impact on banks and other financial institutions. However, the banking industry has not been subject to significant financial risks from the earthquakes. Losses on residential mortgages are expected to be relatively light due to insurance coverage and the Government’s earthquake recovery packages. In addition, many smaller commercial businesses were not located in areas where major damage occurred. Bank provisioning for credit losses totalled nearly $100 million. Nevertheless, there remains a great deal of uncertainty in quantifying the effects of the earthquakes. Insurance The insurance sector has had a number of significant and complex concerns. A well funded and functioning insurance sector assists with the recovery from a significant destructive event. New Zealand is fortunate that insurance will fund the majority of the costs of the Canterbury earthquakes, and most of this funding comes from large offshore reinsurers. In other parts of the world, such as Japan, government, businesses and households bear a much greater share of disaster costs. Since the September earthquake, almost $4 billion of insurance claims have been paid out by the Earthquake Commission (EQC) and private insurers. There is still much more to be paid out by insurers, and this will occur over several years while Christchurch is rebuilt. The importance placed on the role that public and private insurers have in reducing the financial burdens of disasters can be seen from the EQC’s $11 billion of funds and reinsurance, which were built up over decades and are available to meet disaster claims. This is backed up by a Government guarantee if more funds are needed. The Government also decided in April to support AMI (the biggest residential insurer in the Christchurch BIS central bankers’ speeches region), in order that policyholders with earthquake claims could have certainty that their valid claims would be paid. The magnitude and ongoing nature of the earthquakes raise a number of challenges for the insurance sector, and potentially the economy more generally. A number of insurers have suffered significant hits to their balance sheets. On the other hand it appears that the international reinsurance market has worked as we would hope, bearing in mind that we have now suffered a series of insurance “events”. Following the Canterbury earthquakes there have been both temporary and longer term changes in the insurance market. While the ground is still moving, there is limited availability of new cover for earthquakes in the Christchurch area. For most businesses and households this means they are not free to change insurers at present, while for those currently without insurance cover the impact is more significant. Some earthquake-prone buildings and infrastructure can no longer get insurance cover in Canterbury or elsewhere in New Zealand. Other changes to date include higher nationwide premiums to fund increased reinsurance costs and bigger excesses. Property insurers that have had their reinsurance program renewing since February, have generally been able to maintain or increase their reinsurance cover. However, reinsurance premiums have more than doubled, and in many cases a higher retention (claims borne by the insurer before reinsurance starts to pay out) also applies. We are now seeing delays in payouts and some litigation around liabilities. This may look untidy, but it may also be inevitable in such a complex situation. The effects on economic activity The earthquakes have resulted in severe disruptions to short term economic activity, and a loss in balance sheet values, but will bring significant stimulus in the medium term. Disruption was mainly due to reduced household and business spending, as well as lost exports and production in Canterbury. Furthermore, following the earthquakes we saw sharp declines in consumer confidence and business sentiment economy-wide. Sectors most affected have been tourism, education and central business district retailing. Encouragingly, however, some of the significant contributors to Canterbury’s economy, particularly agriculture, manufacturing and professional services have been remarkably resilient after the first few weeks. Construction and related services have been through a frustrating period of disruption and prolonged wait. But next year they will enter an era of huge expansion, New Zealand’s largest ever construction project, big enough to drive the nation’s growth by an extra 1 to 2 percent, but with the potential to also cause bottlenecks, skill shortages, cost increases and planning problems. Already there has been some population loss to the region, but next year this may turn around. Monetary policy and the earthquakes The Reserve Bank’s immediate focus following the earthquakes was the soundness of the financial system. We remained conscious of our focus on the maintenance of medium-term price stability. In the aftermath of the February earthquake, we did observe some near-term prices increases (for instance, in commercial and residential rents). Consistent with the Policy Targets Agreement, monetary policy does not react to such short-term price changes. However, we were also conscious that the substantial reconstruction required in Canterbury would provide a large boost to economic growth over a period of five years or more. During this period, residential investment spending is likely to rise to a share of GDP similar to that seen during the mid-2000 construction boom. But in contrast to that earlier period, there will be a much higher concentration of work in one geographic area. Combined with increases in business investment spending, this will boost medium-term activity and inflationary pressures for an extended period. It would therefore be inappropriate, all else equal, for monetary policy to be stimulatory during the reconstruction period. BIS central bankers’ speeches This concern was balanced against the negative impact of the earthquakes on near-term activity. In the Canterbury region, activity certainly reduced. In addition, there were declines in nationwide consumer confidence, as well as investment and hiring intentions among businesses economy-wide. It was difficult to know how large or long lasting such impacts would be and there was a risk of a marked deterioration in economy-wide activity. Furthermore, although GDP growth was likely to be higher than it might otherwise have been during the reconstruction period, the destructive effects of the earthquakes meant that New Zealand would still be worse off. Given these risks, the Bank reduced the official cash rate by 50 basis points following the February earthquake. We described this as an insurance measure, one that aimed to avoid a significant and persistent deterioration in activity. We were conscious, however, that depending on wider economic conditions, this insurance would need to be removed as rebuilding, and a recovery in activity more generally, drew the economy’s resources into production. Since that time however, monetary policy has had to account for a number of significant developments. These include the continuing sovereign debt concerns in Europe and related developments in financial markets. Business confidence appears to have now recovered well nationwide, and to a large extent also in New Zealand. We believe the cuts in the OCR assisted this. Fiscal impact of the earthquakes The impact of the earthquake on the Government’s fiscal position has also been significant. Central and local government have faced significant cost increases as a result of the earthquakes. The largest of these has been the $11.7 billion EQC insurance cost. This has exceeded EQC’s reinsurance cover of $4.2 billion, with the shortfall exhausting the National Disaster Fund. The Government also faces significant expenses related to the purchase of residential properties in the red zone, support for AMI, and costs associated with damage to infrastructure. In addition to these costs, the government faced significant costs related to welfare and emergency responses (totaling around $363 million at end of June 2011). Following the earthquakes, the employment situation of many individuals was affected with around 40,000 employees and 9,000 sole traders seeking assistance. It was also necessary for the Government to increase spending related to healthcare, social services and public administration and safety services. Earthquake-related expenditure estimated at $13.6 billion contributed to a marked deterioration in the Government’s operating deficit over the 2010/2011 year, and further earthquake related expenditure will be required over the coming years. The resulting pressure on the Government’s debt position was highlighted by Standard and Poor’s when they downgraded New Zealand’s long-term sovereign rating to “AA” earlier this year. Fitch also noted some concerns about the impact of the earthquakes on the fiscal debt in their latest assessment. In response to the costs associated with the earthquakes, the Government’s June Budget incorporated an increased focus on fiscal consolidation with a reduction in new discretionary spending over the coming four years. In addition, the Government has recently announced an increase in the earthquake cover levy component of home insurance, to cover the costs faced by the EQC and to rebuild its Natural Disaster Fund. As part of our response we have also been researching how other countries have responded to similar earthquakes. Rapid recovery of communications infrastructure, speedy decisions on rebuild, and availability of finance, have led to rapid bounce-backs in industrial production, confidence and growth. Where the New Zealand situation looks most different is in the lingering seismic instability. BIS central bankers’ speeches The lessons for Wellington We have learned that an event like a major earthquake has many unpredictabilities and uncertainties about it, elements that are incident and location-specific, with characteristics that unfold in different ways. And these make it difficult to plan crisis responses in detail. We have learned the same thing about financial crisis, as in the semi-ironic title of the classic Reinhart & Rogoff book on international economic crises entitled “This Time Is Different”. This means institutions need to focus on general preparedness, competency, leadership, delegation powers and resilience, rather than on detailed plans for specific situations which may not repeat themselves. We have also learned that some earthquakes cannot be thought of as a short sharp event, but rather are a rolling set of shocks with a long period of continuing after-quakes. These can cause on-going damage, delay assessment, continue disruption, and slow reconstruction. The impact of ongoing seismic instability on insurance and construction can be very marked. We have seen how earthquake damage is hugely sensitive to magnitude, depth, location and timing of day and week. In 2009 the biggest earthquake in the Southern Hemisphere occurred in Fiordland, 7.8 on the Richter Scale. It caused no damage at all. The much smaller February 22 Christchurch aftershock was so disastrous, not just because of its vertical acceleration, but its location under Christchurch and its timing on a week-day lunchtime. The same sensitivity could apply to Wellington. We also know now that structural damage is only part of the story. The February Christchurch earthquake showed that soil liquefaction can also cause land damage that is highly problematic for buildings and underground infrastructure. Given that most private insurance does not cover this, it presents major problems for rebuild. This is further exacerbated by land-slips. Both liquefaction in valleys and reclaimed land, and slips on higher ground could cause major economic complications in Wellington. Christchurch has also taught us that some sectors are very sensitive to earthquake disruption. For Wellington we might assume that certain people-based industries (like tourism and education) would be vulnerable, although much office-based services would relocate as necessary once telecommunications and electricity could be resumed. Wellington might be expected to be more resilient in that many of the buildings have been built or altered with earthquakes in mind (e.g. wooden houses with corrugated iron roofs and reinforced chimneys), or in the case of older commercial buildings, reinforced to meet earthquake standards. These standards are now being reviewed in the light of Christchurch, and will likely be increased, requiring significant further upgrading in Wellington (and possibly driving a small commercial building boom as happened in the 1980s). The challenge here will be to avoid a costly regulatory over-reaction to a one-off event. Christchurch with its flat terrain and grid roading structure allowed easier repair of aboveground infrastructure and access to all suburbs. This cannot be assumed in Wellington where slips would close roads limiting access, and where the whole city could find its air, rail, sea, motorway and road links with the region cut completely for some time. Hill top communications and electricity transmissions are quite different in Wellington, gravity-flow underground piping is quite different, and the Cook Strait cable represents a particular vulnerability. A further concern is that earthquake insurance coverage could become much more limited, more expensive, and more restrictive in Wellington, following the Christchurch experience. Already we are seeing big increases in reinsurance premiums, tighter covenants, high excesses, and a move from full replacement to indemnity policies. Following the September and February earthquakes, there was immediate transmission of images world-wide with passers-by posting cell phone pictures live to television stations and on the internet. This engendered an immediate (but limited) market reaction, hitting the New Zealand dollar and stock prices. At the Reserve Bank, we spent time explaining the event to BIS central bankers’ speeches overseas financial institutions and that limited excessive financial market reactions. A bad Wellington earthquake with an epicentre in the nation’s capital, could engender a more extreme financial market reaction, and it would be the Reserve Bank’s role to intervene to ensure an orderly foreign exchange market if that proved necessary. If the country’s political leadership and key administrative infrastructure were caught up in an earthquake, this could drive a bigger financial reaction, and make government policy responses much harder. Reserve Bank planning for emergencies In the event of an emergency the Bank’s focus would remain on the maintenance of economic stability, as much as possible. With this in mind, the Bank has been proactive in developing its policies and procedures to ensure the resilience of our organisation and the economy in the event of significant disruptions. Central to our planning has been the establishment of business continuity plans focused on the needs that may follow a major event, and how the Bank’s ability to perform its operations may be impeded. To ensure plans can be implemented successfully, key people from each department are assigned to support the Bank and its critical business functions in the event of disruptive incident. These plans and the related systems are tested regularly. The Bank has also focused on ensuring that the necessary infrastructure is in place. In particular, a seismic assessment of the Reserve Bank’s main office was undertaken in September. The results from this assessment show the building should withstand an earthquake greater than the Christchurch earthquake experienced. But even though our building could be standing after an earthquake, there is a risk that damage to surrounding buildings could make the Wellington office inaccessible. To ensure that the Bank’s core functions can be maintained in such circumstances, an Auckland office has been set up that houses a dozen staff on a day-to-day basis. These staff are engaged in a number of business critical roles (including foreign reserves management, domestic liquidity, and payments and settlement systems) to ensure the economy of New Zealand would continue to function with some stability in the event of a major disaster. Furthermore, provisions in the Reserve Bank Act provide for the delegation of key aspects of the Governor’s role to the Auckland Office Manager, with appropriate safeguards. Conclusions The events in Canterbury are particularly salient for Wellington. We have long known that this region is at risk from seismic events, and clearly we must prepare for potential disruptive events of any sort. However, we must also consider what degree of preparedness is appropriate to ensure the survival of people, as well as organisational effectiveness. Several factors are relevant in this regard. Disaster preparedness is necessary and desirable, but not costless. Increases in safety standards (such as seismic strengthening) can result in significant costs for an economy that linger long after the risks they aim to address have occurred. They can also create a complicated regulatory environment that may result in significant impediments for activity. A related consideration is the frequency of events. While it is possible to prepare for very low-frequency high-impact events, doing so may be constraining in terms of activity and prohibitive in terms of costs. The assessment of such risks in New Zealand is currently very complex and there is a lot of work currently going on to assess this. BIS central bankers’ speeches We must also be conscious of New Zealand’s characteristics as a nation. In contrast to many other developed economies, we are geographically and economically isolated. If we face large challenges, we may do so with little external financial support. Determining the appropriate balance of such concerns in advance will always be a challenging task. For decision makers, it is important to ensure that key organisations will have the capacity to operate effectively in the event of a significant shock. Additionally, we must be conscious that our response to events could be a drawn out process, and one that needs to evolve over time. BIS central bankers’ speeches
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Mr Mike Hannah, Head of Communications Department and Board Secretary, to the Canterbury Employers' Chamber of Commerce, Christchurch, 27 January 2012.
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Alan Bollard: A tale of two crises Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Mr Mike Hannah, Head of Communications Department and Board Secretary, to the Canterbury Employers’ Chamber of Commerce, Christchurch, 27 January 2012. * * * Thanks to colleagues at the Reserve Bank of New Zealand. This paper does not represent financial advice. Introduction As New Zealanders get back to work they are looking back over the year as a guide to the challenges that will lie ahead. The year has been marked by two slow-burning but dramatic events that all are having to continue to adjust to: the European sovereign debt crisis and the Canterbury earthquake aftershocks. These crises were not predicted, and they have shocked the New Zealand economy in quite different ways, evoking different responses. We look at the economic effects and how New Zealand is responding. Part 1: The European sovereign debt crisis The European crisis to date A sovereign debt crisis starting among the peripheral euro-economies, and accelerated by the global financial crisis (GFC), has blown out with the threat of contagion to larger European economies, affecting funding markets for all countries, including New Zealand. The peripheral and central European economies are still threatened, with recession looming, despite a number of policy initiatives. The New Year has opened less bleakly than some feared, but credit downgrades and funding market nervousness in Europe also indicate clearly that it is too early to call an end to the uncertainty and volatility. The GFC and sovereign debt crises have both severely shaken global financial markets, and reduced wealth and economic activity. They are related crises to a large extent, but they are different crises, and their different natures mean different responses and resolutions. The GFC was essentially a credit and bank crisis, with interbank lending and liquidity freezing as banks lost trust in one another, nervous as to who would be left holding worthless subprime paper hidden in opaque derivatives. It was a crisis that taught us about tail-end risk and the fragility of market liquidity, despite the depth of the market. Funding markets (even highly liquid conventional ones) can freeze up under stress, despite the apparent availability of funds and credit-worthy borrowers. The European crisis has highlighted the crucial role of sovereign debt markets, where banks have managed to transfer unfunded liabilities to governments, and governments have issued debt to fund the transfers. The European sovereign debt crisis owed much of its origin to the GFC, but also to the imbalances that had built up in many economies, through large unsustainable fiscal deficits, persistent current account deficits, and demographic and other public liabilities. When governments in a poor fiscal state were required to issue more debt, either to bail out banks or fund ongoing fiscal programmes, the pressure on the sovereign balance sheets became intolerable to markets. New and even roll-over funding became difficult to access and much more expensive. BIS central bankers’ speeches Different crises bring different market responses. Whereas a banking debt crisis can flare up, the sovereign debt crisis has manifested itself in a “slow-burn”, and financial markets have reassessed their capacity to fund large and growing levels of government debt. Markets are now incorporating different levels of credit risk for member states, and assessing the differing degrees and credibility of government support – whereas, before the crisis, sovereign debt in the euro zone was viewed as being largely free of default risk. Policymakers are still struggling to come up with credible policy responses that will reduce these credit risk premiums without creating the moral hazard that would encourage continued indiscipline by some countries. 10-year government bond yields Source: Bloomberg With economic activity at stalling speed, short-term inflation risk is very low. In these conditions, inflation-targeting countries, including New Zealand, have seen scope for big cuts in interest rates during the GFC and persisting through the subsequent sovereign debt crisis. However, monetary policy in Europe, unlike in New Zealand, has had to operate a lot closer to the “zero bound”, where policy interest rates are near zero with no scope for further cuts. This has left quantitative easing (QE) and other unorthodox monetary policy as options still in Europe and the US, as their economies have failed to restart. These tools are worth considering at the zero-interest bound, but they can have unpredictable effects and may be hard to exit. Where QE has been employed, it is still too early to judge the overall impact. Moreover, monetary policies around the world have begun to take on some features that we tend to associate with fiscal policy, assisting the private sector directly. This casts central banks in a non-traditional role. Another lesson from the sovereign debt crisis has been the benefit that New Zealand derives from retaining a flexible exchange rate, especially where there are country-specific sources of economic stress. In Europe, while the depreciation in the euro generally makes European exports more competitive, the one-size-fits-all currency presents adjustment difficulties for the much weaker peripheral countries. The fact that New Zealand has its own flexible currency, on the other hand, means our economy has the ability to cushion some effect of adverse external shocks. BIS central bankers’ speeches We have also learned about the effectiveness of various exchange rate interventions, ranging from a variety of capital controls to (so far) apparently “successful” interventions like the Swiss, and “unsuccessful” ones like the Japanese. Fiscal policy can also provide useful stimulus if the recession is deep and/or long. But it needs to be swiftly identified and implemented, credibly sun-setted, and coordinated with monetary policy. The sovereign debt crisis has underlined the importance of maintaining a strong fiscal position and effective institutions leading into a crisis, which otherwise can contribute to longer-term structural and financing problems. A major crisis, however, can deliver a severe combination of reduced revenue, higher transfers, and ballooning government debt (potentially exacerbated by bailed-out bank debts being transferred on to a government’s balance sheet). That exposes other structural problems like population ageing and long-term savings and investment imbalances. As this crisis persists, it is evident that public borrowing capacity is being much more tightly constrained by credit ratings, fiscal projections and market discipline. This limits what governments can do to stimulate economies in the future, or bolster bank balance sheets, if there were to be a double dip. And governments also need to be aware of the risks of consolidating budgets too quickly and damaging growth. In Greece, worsening fiscal numbers led markets and credit rating agencies to demand more austerity measures, which in the short term at least led to further worsening in the fiscal numbers, as the economy weakened. It is difficult for them to get out of this vicious circle, and avoid the consequent broader impacts on their society. The sovereign funding markets have put a premium on public transparency, foresight, exchange rate flexibility, credible debt management, and good political economy. Governments are consequently becoming more focussed on achieving structural budget balance, or at least a credible timeframe for achieving these. The European sovereign crisis has demonstrated that banks must have adequate capital and long-term funding to ensure survival in tough times. Following the GFC, international regulators have agreed to bolster the minimum capital adequacy and liquidity requirements of banks, as set out under the “Basel III” proposals on prudential standards. The Reserve Bank expects these new standards to be broadly applied to the New Zealand system, with some tailoring for local circumstances. The sovereign debt crisis in part owes its origin to government assistance, sometimes specifically for institutions judged “too big to fail”, or more broadly in the form of guarantees to wholesale and retail investors. The former was not seen in New Zealand, but guarantees have left their mark. Relative to overseas experience, New Zealand got off lightly, but taxpayers still bore sizeable losses as guaranteed non-bank deposit takers collapsed for a variety of reasons. The issue of “too big to fail” needs to be addressed. For this reason, the Reserve Bank is focussing on alternative “failure resolution” options. For example, the Bank is requiring the large banks to pre-position for its “Open Bank Resolution” (OBR) policy. Fortunately, the New Zealand banking system was relatively well-positioned to handle the fallout from the European crisis as it moved from credit risk to funding risk. The major banks all have similar risk profiles; their predominant risk exposures are to the local housing market and to agriculture, two sectors that held up relatively well. We are alert to the possibility that the next crisis could impact these sectors in a more systematic way and have moved to enforce capital requirements (under the Basel II framework) that are relatively conservative by international standards. We should not over-state what bank regulators can do. Sophisticated international regulators were unable to predict and control the crisis. Financial innovation was, and will continue to be, an integral part of a growing banking sector. The next crisis will be different, but as in the BIS central bankers’ speeches past, will likely involve the less-regulated parts of the financial system. Regulators must be as innovative as the practitioners. There are technical economic solutions to Europe’s dilemma, but we cannot just assume that politicians can deliver them, given their differing governmental structures, complex coalition agreements, the role of officials, and public sentiment (e.g. broad-based Greek opposition to austerity, Washington gridlock on debt ceilings). It is worth noting that all the peripheral euroeconomies have changed governments since the beginning of the crisis. In the medium term, political stances will need to respond to market pressures, but meantime we are already seeing the enormous political challenges some countries are facing in moving towards sustainable fiscal policies. There is more public concern and engagement on economic and financial problems – take note of the “Occupy” movement. Social media are playing a new role in reflecting public concerns about crisis and debt. How the euro crisis may develop The euro area debt crisis has exposed flaws in the current structure of the European monetary union. In particular, unified monetary policy has not been supported by political union or a set of credible fiscal rules. The outlook for the euro zone remains very uncertain, partly because the outcome will in large part be determined by political considerations rather than purely economic ones. What may be economically optimal (e.g. risk sharing among euro zone countries, moves towards fiscal union) may not be politically optimal. Many of the proposed solutions would involve some surrender of national policy sovereignty, which would not be palatable for member states. Although governments in several countries are facing funding difficulties, the country most likely to default, or restructure its debt, is Greece. Progress with European banks Progress with European governments BIS central bankers’ speeches Avoiding default or managing an orderly default, with “fire breaks” in place to limit contagion, would provide an opportunity for the euro zone to reform its institutions. We saw the first step towards this with the “fiscal compact” agreed in principle by euro zone members and nine other EU states last December. However, a disorderly Greek default, with funding markets seizing up for other governments and banks, would have a major negative effect on the euro zone and the rest of the world economy. In a worst-case scenario this could lead to the break-up of the European Union. Despite the problems facing the Greek economy, and financial markets factoring in a rising risk of default, we believe the most likely outcome is that the euro zone will stay intact. A country choosing to leave the euro zone might also have to leave the European Union, depriving it of free access to export markets that would be needed to drive its recovery. Converting its public debt from euro into a less valuable new domestic currency would also cause significant damage to the domestic banking system and banking systems in the rest of the euro zone. So far, progress has been made in providing liquidity to banks and roll-over funding for governments. But this has not changed the fundamental picture about bank solvency and fiscal discipline. As long as uncertainty remains high, and funding conditions are difficult, growth in Europe is likely to remain weak, with several countries possibly entering a recession. Looking ahead, the current economic recovery is very slow and fragile and there will be more problems ahead; it may take some years for Europe to get back on to the previous growth track. Growth forecasts Source: Haver Analytics, RBNZ Implications for New Zealand The world’s recovery from the GFC and the European sovereign debt crisis has been disappointingly slow and fragile. Rogoff and Reinhardt’s review of global financial crises in their book “This Time it is Different”, suggests that, where banking crises are involved, it takes economies several years to recover (like in the 1930s Depression), whereas recoveries post-war have typically taken several quarters. As economies work off their debt overhang, they will continue to suffer through asset price adjustments. BIS central bankers’ speeches New Zealand’s geographical isolation is no protection from economic events abroad. If major world economies have a significant economic problem, then that is going to affect us too, as New Zealand has seen in our export commodity prices, currency, and funding our foreign debt. Experience shows that regions cannot “decouple” themselves from global financial events, though the timing and transmission of shocks can be quite different. For example, New Zealand’s increasing reliance on Asia as a trading partner reflects export market flexibility and has helped growth, but could not shield us from the slowdown in world demand, or the drying up of financing, even if it has meant a smaller drop in demand for our exports. Economies in the Asia-Pacific region (including Australia) account for around 60 percent of New Zealand’s merchandise exports by value, a significantly larger share than exports to the euro area (at just 7 percent). Europe accounts for a significant share of global economic activity, and is an important trading partner for many Asia-Pacific economies. Spillovers from a recession in Europe could spark a slowdown in Asia, pushing down commodity prices, and having a marked impact on Australia and New Zealand. When large economies take remedial measures such as the bailouts in the euro zone and quantitative easing in the United States, and the consequent fiscal austerity, it can have major distortionary effects on the global economy and New Zealand. Such measures affect financial market pricing, access to international credit and international capital flows. Funding may not be available to banks or to sovereigns. European banks have been deleveraging worldwide and, while this has not yet had much direct impact on New Zealand, they have been significantly involved in funding and trade in the Asia/Pacific region, so indirect effects are likely. International markets are an important source of funding for our domestic banks. Although New Zealand banks are currently well funded, bank funding costs are likely to increase to some degree over the coming year. This is likely to put some upward pressure on retail interest rates relative to the Official Cash Rate (OCR). Monetary policy will need to take account of such pressures. The Reserve Bank’s new prudential liquidity policy, introduced in 2010, has helped to reduce this vulnerability of the banks to liquidity shocks, by requiring banks to hold more “core funding” (i.e. retail deposits and long-term wholesale funding). However, the underlying vulnerability will remain until New Zealand achieves a sustained improvement in national savings. Part 2: The domestic earthquake crisis While the whole world is focused on the European crisis, New Zealand has been suffering from its own domestic dramatic events – the Canterbury earthquakes. The earthquake to date The earthquakes have been a debilitating, chronic event, with a profound human and economic impact that will continue to be felt for many years. It has been 16 months since the first of the major earthquakes. The location and timing of the quakes has been quite acute. There has been an unusual propensity to liquefaction. Significant aftershocks are still occurring – there have been more than 400 greater than Richter magnitude 4, including more than 40 greater than Richter magnitude 5 since September 2010 – and this has been a shock to everyone’s hopes for recovery and rebuilding. The scale of impacts and ongoing activity means the rebuild is unprecedented. The Reserve Bank is interested in the ongoing economic effects of this shock and how we expect rebuild to happen. BIS central bankers’ speeches I will focus on the economic effects and what we expect to happen, and the limitations surrounding what we are doing. To date, demolition has progressed and basic repairs have begun, and this will continue for some time. However, widespread reconstruction is on hold while aftershocks continue. When it does begin, major reconstruction is assumed to take more than five years, with housing and essential infrastructure first. Reconstruction of commercial structures could be even more protracted. The availability of insurance has been an important factor in the timing of the rebuild. There are some unique or unusual aspects (e.g., CBD closure, building code changes, land remediation, damage on damage) which mean that assessing the value of claims is complex and takes time. Additionally, with the risk of ongoing damage from aftershocks and still high levels of uncertainty, insurers are not currently increasing their overall exposure to Canterbury and some insurance holders are having difficulties getting cover for new risks or increased limits. We now know that damage to buildings is only part of the story. We generally understand structural remediation. But in addition, land has been damaged by subsidence, lateral spread, cliff collapse and by soil liquefaction, all of which present major technical, insurance and economic problems for rebuild. It has proved very difficult to calculate the complete cost of the damage resulting from the earthquakes, and we found that early cost estimates could be unreliable. The earthquakes resulted in significant damage to housing, as well as commercial buildings and infrastructure. Our working assumption before the December 2011 aftershocks was that around $20 billion (in current dollars) of damaged property would be rebuilt. This would be equivalent to around 10 percent of GDP – a very large shock indeed. (As a comparison, the massive earthquake that struck Japan in March 2011 is estimated to have caused damage equivalent to around 3 to 4 percent of Japan’s annual GDP.) The nominal cost of rebuilding could be higher as construction costs and prices for materials may well increase over the coming years, and as reconstruction incorporates quality improvements. Furthermore, we estimate that the total cost of claims stemming from the earthquakes could be much higher – around $30 billion – as this includes claim handling expenses, claims for business interruption, temporary accommodation, consequential loss and other non-rebuild related costs. Recent aftershocks are likely to have added to nominal insurance costs, but the costs of the rebuilding in real terms may not be significantly affected (i.e., you only rebuild a house once). As the main rebuild is yet to get underway, and various regulatory (e.g., building standards) and legal issues are still to be resolved, there remains considerable uncertainty around these numbers. Revisions are likely to continue for some time, and the final cost will be known only once all claims have been settled, which could be some years away. In addition, the longer the delays to rebuilding, the greater the human cost and the risk of leakage of businesses and residents from Christchurch to other centres. Delays could also mean the rebuild is done more quickly, albeit starting later, so exacerbating inflationary pressures. Central and local government have faced significant costs as a result of the earthquakes. The largest of these has been the $11.7 billion EQC insurance cost (and the more recent aftershocks are likely to increase EQC’s costs). The costs of the February 2011 quake have exceeded EQC’s reinsurance cover of $2.5 billion per event, and EQC and Government, as guarantor, bear the cost of any subsequent cost increase for that event. The total claims are expected to exhaust EQC’s available assets – that is, the National Disaster Fund. BIS central bankers’ speeches Earthquake-related building consents Source: Statistics New Zealand The Government also faces significant expenses related to the purchase of residential properties in the red zone, support for AMI, and costs associated with damage to infrastructure. In addition to these expenses, there are significant costs related to welfare and emergency responses (totaling around $363 million at end of June 2011). Following the earthquakes, the employment situation of many individuals was at risk with around 40,000 employees and 9,000 sole traders seeking assistance. It was also necessary for the Government to increase spending related to healthcare, social services and public administration and safety services. Earthquake-related public expenditure estimated at $13.6 billion contributed to a marked deterioration in the Government’s operating deficit over the 2010/2011 year, and further earthquake related expenditure will be required over the coming years. The resulting pressure on the Government’s debt position was highlighted by Standard and Poor’s when they downgraded New Zealand’s long-term sovereign rating to “AA” earlier this year. Fitch also noted some concerns about the impact of the earthquakes on the fiscal debt in their latest assessment. In response to the costs associated with the earthquakes, the Government’s June Budget incorporated an increased focus on fiscal consolidation with a reduction in new discretionary spending over the coming four years. In addition, the Government has recently announced an increase in the earthquake cover levy component of home insurance, to cover the costs faced by the EQC and to rebuild its Natural Disaster Fund. Banks and other financial institutions may have to absorb bad debts from some households and businesses as a result of the earthquakes. The impact on the New Zealand banking sector is expected to be manageable, based on banks’ bad debt provisioning estimates. Banks report that the Canterbury earthquakes have had a relatively small impact on aggregate asset quality. Three of the major banks commented on their earthquake provisioning in their results for the half-year to March 2011, and these banks have made additional provisions in the region of $125 million – well under 0.1 percent of their total lending. BIS central bankers’ speeches Overall, there still remains a great deal of uncertainty in quantifying the effects of the earthquakes. Provisioning estimates have been based on many unknowns, and these will be subject to change as the insurance climate and other uncertainties become clearer. As the regulator for insurers, the Reserve Bank is now responsible for overseeing the introduction of new prudential requirements for insurers, including new solvency standards, fit and proper requirements for directors and other senior officers, and a requirement that insurers have appropriate risk management programmes. All insurers wanting to continue insurance business in New Zealand must obtain a licence by March 2012. It is well known that one large insurer (AMI) has faced financial difficulties associated with meeting the large value of claims, while some small niche insurers have indicated they intend to selectively withdraw coverage nationally or from certain regions. Insurers remain cautious about writing new insurance in this environment. Balance sheets of other insurers have been significantly impacted, in some cases requiring more capital, and shareholders, including foreign owners, are providing this, as is appropriate. The Reserve Bank continues to monitor the effects on balance sheets in the insurance sector. Our focus is on the soundness of the sector, and so we are particularly interested in levels of existing and future catastrophe cover. We are starting to see higher global reinsurance costs being reflected in increased non-life insurance premiums for New Zealand customers. We are yet to see how the industry realigns itself as a result of these events. There is the prospect of some consolidation with the purchase of AMI by IAG (subject to regulatory approvals), and we are seeing changes to reinsurance capital requirements and availability of insurance. We can expect that there will be changes, and that the industry will adjust. New Zealand is well-placed in that insurance will fund the majority of the costs of the Canterbury earthquakes, and most of this funding comes from large offshore reinsurers. New Zealand is unusual in its degree of insurance and re-insurance. In other parts of the world, such as Japan, government, businesses and households have borne a much greater share of disaster costs. The wider impacts of the earthquakes Following the earthquakes, we saw sharp declines in consumer confidence and business sentiment throughout the economy. Short-term economic activity was severely disrupted, mainly due to reduced household and business spending, as well as lost exports and production in Canterbury. Sectors most affected have been tourism, education and central business district retailing. The domestic economy has proven relatively resilient to the challenges posed by the Canterbury earthquakes, encouragingly including some of the significant contributors to Canterbury’s economy, particularly agriculture, manufacturing and professional services. In Christchurch we are currently seeing residential investment and consumption picking up more than elsewhere in New Zealand. Business investment spending is also expected to increase over the coming years, as damaged assets are rebuilt and replaced, as well as a more general lift in investment spending as activity in Canterbury and other regions recovers. We have continuously updated our reviews of the Official Cash Rate to take into account the impact on economic activity and inflationary pressures. We cut the OCR in March 2011 as an “insurance cut” following the February 2011 aftershock. The deepening Euro crisis and ongoing aftershocks in Christchurch have led us to leave the OCR unchanged over seven successive reviews. BIS central bankers’ speeches Domestic trading activity Source: NZIER Quarterly Survey of Business Opinion Reconstruction, is projected to eventually provide a boost to demand similar to the mid2000s housing boom. Residential and non-residential investment will lift growth sharply. Spare capacity and labour will be absorbed rapidly, and inflation pressures will pick up from current low levels. We will need to keep monitoring this to judge whether the level of the OCR continues to be appropriate. The outlook for rebuilding in Canterbury remains subject to a high degree of uncertainty. In the January OCR Review, we took account of the latest aftershocks and pushed out our assumption of the rebuild by a few months, with a gradual lift in activity over 2012, consistent with demolition and repairs to housing and infrastructure getting underway, with reconstruction getting underway in earnest in 2013. Reconstruction spending Source: RBNZ BIS central bankers’ speeches One learning from other large earthquakes overseas (e.g. Kobe, San Francisco, Chile) has been that activity bounces back relatively quickly once major shocks have stopped. Additionally, even if activity is delayed, pressure on resources may not be avoided. Building regulations will play a key role in not only the rebuild in Christchurch but potentially in other earthquake-prone regions. In Christchurch businesses have proved adaptable and innovative in getting operations back up and running after the quakes and aftershocks. Their resilience and tenacity is reflected in how few have actually left the city and in visible fight-backs such as the new container shopping mall and the business “hub”. With 80 percent of Christchurch insured, capital could prove less of an issue than in other disaster-hit countries such as Japan or China, with much lower insurance rates. A further boost will come from a large temporary reconstruction workforce that will require accommodation and services. The earthquake reconstruction in Christchurch is very big in relation to the national economy. Along with strong commodity prices it represents the major driver of growth over the next few years. How well Christchurch manages that will reflect on all New Zealand. GDP growth (annual average) Source: Statistics New Zealand, RBNZ Conclusion 2011 saw two bad jolts hitting the New Zealand economy. These have already had their initial impacts, showing up in lower actual growth numbers. But the New Zealand financial system has so far stood up well, and the people of Canterbury have comprehensively insured their structures sufficiently. These preparations have meant we are weathering the shocks well. Both events have important economic implications and have created uncertainty, but we now have a clearer picture of the future. In the terms made famous by Donald Rumsfeld, we are moving from “unknown unknowns” to “known unknowns”. We cannot expect to have complete clarity for 2012. Unexpected things will continue to happen and there will be more BIS central bankers’ speeches aftershocks, both financial and seismic; the effects of both shocks could continue to rumble on for some time. The challenge for all of us, policy-makers and business people alike, in 2012 will be to deal with these “known unknowns”, to get on with economic activity, and to help Christchurch and New Zealand grow. BIS central bankers’ speeches
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Ms Rochelle Barrow, to the Trans-Tasman Business Circle, Auckland, 17 February 2012.
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Alan Bollard: Could we be better off than we think? Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Ms Rochelle Barrow, to the Trans-Tasman Business Circle, Auckland, 17 February 2012. * * * The authors are grateful for the helpful comments and suggestions received from Michael Reddell, Phil Briggs, Bernard Hodgetts, Yuong Ha and Tim Ng. Any remaining errors are the responsibility of the authors. Executive Summary Quality macroeconomic statistics help us understand developments in our economy, and especially about the way economic activity and related measures are changing over time. Time series data play a critical role for us in monetary policy. However, macroeconomic statistics also play another important role; they are used by analysts and the media to judge how well New Zealand is doing relative to other countries, and they also play a part in how positive we feel about ourselves. International comparisons of macroeconomic statistics can be fraught with difficulties. Differing definitions, measurement, currencies and price levels are just some of the factors that can cloud the picture. Our view is that in New Zealand, some conservative statistical interpretations and particular characteristics of our economy have resulted in the understatement of New Zealand’s economic performance. In international league tables New Zealand is in some ways better off than is often thought. Though better, more comparable statistics, do not make any individual New Zealanders any better off in an absolute sense, they do affect the interpretation of New Zealand’s relative economic performance over the decades and they impact individual decisions. In this paper we discuss some of these statistical issues and provide some rough estimates of their possible impact on GDP per capita – which is the most widely quoted, if not always the most useful, indicator of an economy’s performance. Our list is not exhaustive, but surprisingly all of the treatments covered result in an underestimation of New Zealand’s GDP. Could New Zealand’s GDP be higher relative to other OECD countries? Could it be around 10 percent higher relative to Australia? And what might that mean for thinking about the New Zealand economy and its changing fortunes? As this paper outlines, Statistics New Zealand, like other countries including Australia, regularly changes its measurements. A number of examples of change Statistics NZ has made and the difference to the resulting statistics is provided in my paper. Statistics New Zealand was given additional funding in last year's budget to undertake a major multi-year change programme. This enables it to accelerate its ability to change statistics to keep up with the evolving requirements. Why statistics matter At a central bank, macroeconomic data and statistics play a crucial role in policy deliberations. Our analysts consume a vast quantity of data looking for insights into the performance of New Zealand’s economy and financial sector. These analysts become familiar with data sources, their strengths and weaknesses, and the methodologies employed to produce statistics. Knowing how a statistic is compiled is an essential part of ensuring that it is interpreted correctly. Of particular interest to the Reserve Bank are macroeconomic statistics. They summarise a significant volume of detailed and sophisticated interactions that occur in an economy, often BIS central bankers’ speeches in one headline number like gross domestic product (GDP), the unemployment rate, and the consumers price index (CPI). In New Zealand, we have adequate, but certainly improvable, official and private macroeconomic statistics and indicators for the purposes of monetary policy formulation – where the focus is mostly on cyclical developments; the shorter-term swings in how economic activity is performing. However, statistics on economic performance also play a role in shaping national conversations about how our economy has performed over time, and especially relative to economic performance in other advanced economies. As far as possible, policymakers and private analysts need good comparable national and international data to enable those comparisons, and the consequent policy recommendations and debate to be as well-founded as possible. Even if there are weaknesses in the data, analysts and journalists will use whatever is available. Even when caveats are given that information may be overlooked. In recent decades, a large emphasis has been placed on developing internationally comparable statistics – not just so that the same things are measured the same way in different countries, but also to enable useful cross-country comparisons of levels of economic activity, in the face of things like big swings in market exchange rates. Organisations like the UN and IMF produce conceptual frameworks, like the system of national accounts (SNA), to aid statisticians when producing macroeconomic statistics. However, while these frameworks provide guidance, they are not completely formulaic. How a country implements framework recommendations depends on a number of factors, including the nature of their economy, what data sources are available, and the level of resource they have. Given how complex and large some of these frameworks are, and that they are often updated, countries may also be at different stages of adopting the latest version of the framework. There are many different ways of estimating statistics and the measurement decisions taken by statisticians make a difference. Different data and methods can deliver different results. We believe that some of the statistical methods used to measure the New Zealand economy currently result in an understatement of New Zealand’s economic performance when compared to other countries. This paper discusses some of these statistical methods and attempts to estimate the possible impact on New Zealand’s GDP. This paper is not intended as a criticism of Statistics NZ with its statistical challenges and limited resources. Its purpose is to raise awareness of these factors, increase the priority placed on improving the quality of New Zealand’s macroeconomic statistics and to make people aware of the issues regarding international comparisons. In some cases, plans are already in place to remedy statistical weaknesses. What is required for successful comparisons? Most people when assessing whether the New Zealand economy is performing well will ask, relative to what? One way of posing the question is to ask how the economy is performing relative to its own past history. For those sorts of comparisons, consistently compiled (or revised) data through time is important. Another important way of posing the question is to look at how New Zealand is doing relative to other advanced economies. In New Zealand we often compare ourselves with Australia, our nearest neighbour, and a labour market to which New Zealanders have quite ready access. BIS central bankers’ speeches However, comparing statistics can be fraught with difficulties unless certain conditions are met1: The definition is the same; conceptually are the statistics covering the same things. The measurement is the same or similar; are the methods used to estimate consistent. Appropriate adjustment is made for the influence of exchange rates, price levels and consumption tastes across countries. When these conditions are not met, those performing the comparison may attempt to “standardise” the data themselves. The nature of these adjustments and their levels of transparency can add further confusion to international comparisons2. For example, New Zealand does not currently produce all of the key macroeconomic statistics that most other advanced economies do3. As a result organisations such as the OECD sometimes attempt to estimate these in order to include New Zealand in international comparisons. 1. Definitions Over the last 30 years there has been a large push towards the development of integrated international conceptual frameworks for producing statistics to aid international comparisons. These frameworks help to ensure the quality and integrity of statistics by providing a theoretical background to what is being measured and definitions. For example the SNA mentioned earlier defines what is included and what is excluded from GDP. There is no entirely right or wrong answer as to what should be included in GDP – what really matters is consistent transparent treatment, including where possible consistency across countries. The frameworks are reviewed and updated periodically as the economy evolves. This can result in new definitions of concepts such as GDP, investment and consumption, often involving a significant amount of work in backdating data to ensure consistency through time. 2. Measurement Statistical frameworks are often accompanied by compilation guides, which guide statisticians in how best to measure the theoretical concepts. They often present a best practice method, and if data sources and resources are not available to implement that method, other less desirable measurement options are presented. The measurement decisions made by statisticians can have a significant impact on the end result. 3. Currency unit and price level Statistics must be expressed in a common unit for comparison. A simple way to achieve this is to convert individual currencies to a base currency using exchange rates. However, this type of conversion can distort comparisons because of the impact of such things as shortterm currency fluctuations on exchange rates. This is why a lot of international comparisons are now performed using purchasing power parity (PPP). PPP conversions are currency conversion rates that both convert to a common currency and equalise the purchasing power of different currencies. OECD (2006). While not stated as an explicit condition for international comparisons, the statistics themselves must have integrity in order to compare with other countries. The past statistical issues in Greece are a well documented example of statistics which lacked integrity and which made it difficult to draw meaningful comparisons with other countries. See Barrow (2010) and RBNZ (2007). BIS central bankers’ speeches The income gaps between countries are typically smaller on a PPP basis than they are if simply converted into a common currency as over time, prices of tradable goods tend to be much the same across countries, but the real cost of labour-intensive services tends to be much lower in poor countries than in rich ones. However, PPP adjustments have their limitations. Probably the most significant is the representativeness of the products used in the calculation. PPP comparisons are most accurate in comparing incomes or consumption in pairs of very similar countries, where similar products and consumption tastes exist. The more the differences between countries the more important it is to do the corrections, but the more approximate the comparisons are. Thoughtful observers typically caution against putting much weight on differences in PPP income measures of less than perhaps 5–10 percent, even if all the countries recorded their GDP data in exactly the same way. What is the impact of statistical treatments on our GDP? This next section explores in more detail some of the differences in measurement in New Zealand relative to the rest of the world, in particular Australia. We attempt to quantify the impact of these measurement differences on estimates of the level of New Zealand’s GDP. For the 2010 year, net national income per capita PPP league tables produced by the OECD currently have Australia 35 percent higher than New Zealand. Statisticians around the world use the SNA to guide measurement of their economies4. The SNA is a comprehensive and systematic set of accounts, similar to a business accounting framework, but for a nation. The framework captures a considerable amount of detail about how an economy works and how economic agents behave. As noted earlier, statisticians can chose to implement the SNA in a variety of ways, bearing in mind the constraints (both on data and resources) that they face. It is these constraints and decisions taken which need to be recognised and understood when comparing macroeconomic statistics across countries. 1. Measuring the unobserved economy In order to produce a comprehensive consistent estimate of GDP, all economic production (defined by the SNA production boundary) in an economy should be measured, whether that production is “observable” or not. The unobserved, or not directly measurable, economy includes some activities that are illegal, underground (cash jobs), or undertaken by households for their final use (growing their own vegetables). While the inclusion of estimates for illegal activities such as drug dealing are not common, almost all countries that prepare GDP statistics include estimates for some other unobserved activity. A 2008 UN report suggests that for most countries, tax-based measures of income, like those used in New Zealand, tend to understate actual levels of income. This tends to affect initial estimates of the income measure of GDP; and in most countries these are adjusted up. The SNA defines key macroeconomic statistics like GDP, saving, investment, consumption and wealth. It enables the analysis of incomes generated by production, and the redistribution of income within the economy (via tax and welfare payments). The system also identifies capital and financial flows, and provides information about the level of an economy’s productive assets and the wealth of its inhabitants. BIS central bankers’ speeches According to the report and a survey of country practices, of the 45 countries surveyed, New Zealand and Japan were the only countries that made no explicit estimates of unobserved activities in the estimation of GDP5. The importance of the unobserved economy is of course quite different across countries, so under reporting will vary for this reason. However, the issue for international comparison is that New Zealand does not currently include any estimate of this production in its GDP. Taking Australia as a benchmark, where explicit estimates are not made for illegal activity, but are made for the underground economy and household backyard production, we believe GDP in New Zealand could be underestimated by 2 percent6. Given it is the household sector which is mainly engaged in this activity, household income and therefore saving could also be underreported. Of course, it is worth noting that most estimates are that the underground economy in New Zealand is somewhat small. As with other countries, our comprehensive GST system reduces opportunities for tax avoidance, as does our relatively comprehensive broad-based income tax system. We encourage further research in this area. 2. Measuring the value of financial services Banks and other financial intermediaries earn income not only through explicit fees and charges but also on the margin between the interest they pay to depositors and the interest they charge borrowers. Because of the margin, the financial services that we consume do not necessarily have an explicit price, unlike most goods and services in an economy. For the purposes of the SNA the services provided, through the use of the margin, are known as Financial Intermediation Services Indirectly Measured or FISIM. Calculating the value of a service without a price is complex7. However, the SNA provides guidelines on how this can be achieved through the use of a relevant reference rate. In addition to how the value of FISIM is calculated, what is important for GDP estimates is how those financial services are allocated to their end users. Within the SNA framework, goods and services consumed by businesses in order to produce other goods and services, are treated as intermediate consumption (or an expense) and subtracted from GDP. However, the use of goods and services by household, government and the foreign sector are treated as final demand and these add to GDP. Most countries treat FISIM in a way that increases GDP by allocating the service to the sector that uses or consumes it8. In New Zealand all financial services are assumed to be used by businesses in the production of other goods and services. There is considerable international debate on the measurement of FISIM as a result of volatility during the Global Financial Crisis9. However, it is the allocation method which UN (2008). In Australia a 1.3 percent adjustment to GDP is made for the underground economy and a 2.0 percent adjustment is made to household income. For more information see IMF et al (2008). The method used in New Zealand is the SNA 1968 recommendation, which is presented as an option in SNA 1993, when data sources available do not allow the best practice alternative. The method is to allocate all of FISIM to a notional industry in the production measure of GDP (often referred to as the bank service charge). This ignores any consumption of services by households, government and foreigners. Best practice is to estimate each industry’s expenditure on financial services and subtract it from the value added of that industry (rather than simply off total GDP). Then household, government and foreign consumption of financial services is estimated and this is added to final consumption estimates. The impact of this allocation method is an increase in GDP, because less is subtracted from the production based measure of GDP and more is added to the expenditure based measure of GDP. BIS central bankers’ speeches impacts negatively on New Zealand in international comparisons. We estimate the impact of this at approximately 2 percent of GDP, although we acknowledge there are other estimates. The failure to allocate some of FISIM to the household sector has resulted in a growing understatement of income measures over the last 20 years, a period when the household sector has borrowed more, and hence consumed more financial services. Box – Case study – Household saving rate10 Measurement is difficult in times of change. In the early 2000s there was a rapid increase in the number of New Zealand households using trusts to manage household finances. The use of trusts impacted quite significantly on the data sources used to estimate New Zealand’s household saving rate. In the mid 2000s New Zealand’s household saving rate was considered an outlier relative to other countries. At the time, unlike other countries, New Zealand did not produce other sectoral saving estimates (other than government) that could be used to validate the household saving rate either. Due to the concerns raised about the quality of the estimates and the important policy decisions being made at the time, Statistics NZ reviewed the measurement of the household saving rate and in 2010 a number of methodological improvements were made. In 2005 the household saving rate was first estimated at –15 percent. The current estimate for 2005 is now –6 percent. There is a considerable amount of debate internationally regarding how value added is calculated for the Finance industry. At present measures do not adjust for the level of risk taken on by the industry. Some statisticians argue that value added should be risk adjusted and that this would significantly reduce the contribution of the finance industry to GDP in some countries. Given the nature of the financial sector in New Zealand, we do not believe risk adjusting value added estimates would result in significant change. Note that revisions made to the household saving rate did not result in corresponding major revisions to the national saving rate. At the time New Zealand did not produce a full set of sectoral income and outlay accounts, so the household sector rate could not be validated. Quality adjustment is also common practice in other countries. BIS central bankers’ speeches 3. Other Services The increasing importance of service industries could also be influencing our GDP estimates. In particular, government administration, health and education services are particularly difficult to measure. Of course these measurement difficulties are experienced by many countries. A number of different estimation techniques are used overseas. In the absence of good output measures in New Zealand, the output of some service industries, particularly in the government sector where prices may not exist, is assumed to be directly proportional to industry inputs. This measurement assumes no productivity growth in the industry, and will likely result in an understatement of GDP and productivity. This will have had a reducing impact on GDP levels, though we cannot estimate by exactly how much. 4. Measuring the value provided by residential buildings In an economy, residential buildings provide services to those who inhabit them and are included in the calculation of a country’s GDP. An imputed rental derived from occupying your home is included in the calculation so that GDP is not affected by home ownership rates over time, or across countries. The contribution of residential building, whether they are occupied by the owner or rented, to GDP is significant. In New Zealand and Australia different methods are used to estimate this contribution. The most significant difference for comparability is that in Australia the output of residential buildings is quality adjusted; that is the measurement method used allows for an increase in the quality of properties over time11. The types of quality improvement allowed for includes size and location. In New Zealand the measurement method assumes no quality improvement. Output purely reflects the number of properties. We note there are some complex issues around the use of constant or current prices here. The lack of quality adjustment leads to an understatement of GDP. If we assume a similar growth path to Australia for New Zealand, we estimate the approximate ballpark for GDP could be 1.5 percent higher. 5. New standards for measuring the economy Statistical frameworks, like the SNA, must be updated and revised to ensure that the statistics produced remain relevant and fit for use by policy and decision makers. However, with change comes a comparison issue, as countries progressively move to new standards. The international standard for SNA was revised in 2008 and a number of conceptual changes were introduced. One of these changes was the move to capitalise research and development, which had previously been treated as an expense. This change means that research and development activity now counts as investment and adds to GDP, rather than subtracts from it. Quality adjustment is also common practice in other countries. BIS central bankers’ speeches In 2009 Australia implemented a number of new standards and classifications into its production of macroeconomic statistics, including the 2008 version of SNA. In this, Australia made changes earlier than any other country did. These changes resulted in significant revisions to national accounts and balance of payments statistics. The table below quantifies the revisions made to nominal GDP estimates. In the year ended June 2008 GDP estimated using the new version of SNA (and making adjustments to employment income) was 4.4 percent, or $50b AUD higher, than the older version. BIS central bankers’ speeches The revision upwards of Australian GDP results in an even wider gap between New Zealand and Australia GDP per capita measures. However, New Zealand and Australia, while still producing GDP estimates, are now producing these statistics on a different conceptual basis. They are no longer directly comparable. Statistics NZ plan to introduce SNA 2008 in 2013–14. This is similar timing to other countries around the world. It is difficult to estimate the impact that new international standards will have on New Zealand’s national accounts and GDP. We estimate approximately a 3 percent increase in GDP. 6. Reconciling different measures of GDP A country’s GDP can be estimated three ways, using the production method, the income method, or the expenditure method. Conceptually the three measures provide equal results. However, in practice, due to differing data sources and imperfect methodologies, this is rarely the case. Statisticians use a process called supply and use balancing to make the three measures equal. This essentially forces all goods and services produced in an economy to be used by an economic agent. In New Zealand supply and use balancing is performed annually and only in nominal terms, or current prices. These estimates are released with approximately a two year lag. Many analysts are more interested in timelier, more frequent (quarterly) and price adjusted (real) GDP estimates. However, for this a trade-off is made. Timely, quarterly estimates of real GDP are derived using incomplete data sources and in New Zealand, the two measures of GDP produced – production and expenditure – are not forced to equal. Given that current price GDP estimates are balanced, the discrepancy in real GDP estimates is the result of an error in either estimating volume growth (real GDP) or prices. BIS central bankers’ speeches In recent years the quarterly measures of real GDP have presented quite different views and diverging on the New Zealand economy. The headline measure preferred by Statistics NZ is the production measure, primarily because it exhibits less volatility than the expenditure measure on a quarterly basis. This measure implies that the recession in New Zealand was deeper and more prolonged than the expenditure measure. However, since 2007 a relatively large gap between annual real GDP estimates has opened up. Production GDP estimates have undershot expenditure GDP estimates for five years running. When expressed in 1995/96 dollars the gap in the March 2011 year is $5.9b or 4.3 percent of GDP12. Given that the discrepancy will likely be revised away in future years, which is most reliable measure of New Zealand’s economic growth? Will production based estimates be revised upwards or expenditure based estimates be revised downwards? Will these revisions have implications for the level of New Zealand’s GDP? In Australia, all three GDP measures are available on a quarterly basis, and instead of elevating one measure over another, the quarterly GDP movement is calculated by averaging the movements of the three measures. This by nature decreases volatility in the headline GDP estimate. Using the average measure of Australian GDP, Australia avoided a technical recession, apparently the only OECD country to do so. However, based on the production measure of GDP, the headline measure in New Zealand, Australia experienced a technical recession in the March 2009 quarter. These discrepancies can be expected to decrease in size in June 2012 when Statistics NZ update annual constant price national accounts estimates. This process will result in significant revisions to New Zealand’s real GDP. However it is not known which measure will be revised and to what extent. BIS central bankers’ speeches Alternative national accounts series Much of this discussion has focused on GDP comparisons, since GDP is the most widelycited national accounts measure of aggregate economic performance. But there is a wide variety of other national accounts measures. For example, Gross National Income (GNI) adjusts the value of output in New Zealand for the income generated here that accrues to foreigners, and income generated abroad accruing to New Zealanders. For most advanced economies the difference is not large, but in New Zealand GNI is about 7 per cent lower than GDP. In addition, GDP measures the value-added in New Zealand. However, in drawing crosscountry comparisons it might not be the value-added here that matters, but the level of household consumption (whether of things purchased directly by households, or services provided to households directly by the government). In a similar vein, comparisons of income per head can usefully take account of how much depreciation takes place each year: GDP and GNI are gross measures, while Net DP and NNI adjust for depreciation, to give a sense of how much of the economy’s production is left available for consumption. The difference affects New Zealand and Australia comparisons quite materially: Australian GDP per capita is significantly higher than that in New Zealand, no matter what adjustments one does, but because the Australian resources sector is very capital intensive, much of the income is needed simply to cover the depreciation on the capital stock. In purchasing power parity terms, even with current national accounts measurement, actual individual consumption per capita is only about 20 percent higher in Australia than in New Zealand. This incidentally supports our view that New Zealand’s GDP is currently being understated. It is also worth noting that common living standard comparisons use GDP or GNI per head of population. Those comparisons are useful for some purposes, but they do not shed much light on the productivity performance of the economy. For example, although New Zealand’s GDP per capita lags much of the OECD, that performance is achieved only with relatively high working hours per capita. These differences do not matter very much from year to year but need to be borne in mind in assessing the overall performance of the economy and resources available for consumption, both now and in the future. Alternative measures of well being GDP per capita (and the other associated national accounts measures) has often been criticised as an incomplete statistic of economic well being. Over recent years a number of new indicators have been developed which usually supplement GDP estimates with other characteristics of an economy, such as the level of educational attainment or long term unemployment rate. The OECD better life indicator is an example, and New Zealand rates very highly on this comparison. (The UN’s Human Development Index, another attempt at a composite measure of living standards, also scores New Zealand consistently highly, although still a little lower than either Australia or the United States). Based on 11 topics the OECD has identified as essential, in the areas of material living conditions and quality of life, New Zealand ranks fourth in the OECD13. The graph below, sourced from The Economist, illustrates the point well. New Zealand appears as an outlier. The 11 topics are housing, income, jobs, community, education, environment, governance, health, life satisfaction, safety and work-life balance. BIS central bankers’ speeches What does this mean for international comparisons? International comparison of macroeconomic statistics is fraught with difficulties. Differing methodologies and data sources means that, in some cases, statistics are not directly comparable, despite data being labelled the same. Analysts and policymakers are wise not to make much of smallish differences – and short-term changes in differences in incomes across countries, which can be substantially affected by the different shocks each country faces in the short-term. This paper has given some insight into the impact measurement can have on macroeconomic statistics. We estimate that measurement of parts of the unobserved economy could add 2 percent to New Zealand’s GDP and the allocation of FISIM another 2 percent. Quality adjusting for residential buildings in New Zealand could add a further 1.5 percent. Improving the estimation of value-added by service industries could also improve New Zealand’s GDP. While more difficult to estimate due to its complex nature, the move to SNA2008 could add an additional 3 percent to GDP (and reduce the gap to Australia to that extent). It is almost certain that consistent measurement conventions used in New Zealand and Australia would narrow the reported income gap with Australia (differences would be smaller with some other OECD countries). We cannot be precise about this, but the (mainly Australian) conventions noted above could add something very approximately in the broad ball-park of 10 percent to New Zealand’s official GDP. These are not definitive, we accept there are counter-arguments to these numbers. BIS central bankers’ speeches But what does this mean for New Zealanders? Of course, revising GDP does not lift the actual incomes (wages and salaries) and purchasing power of individual New Zealanders, and does not raise the tax base for the government either. We cannot make ourselves better off directly just by measuring things differently. And the steady outflow of New Zealanders to live in Australia – one of the largest relative outflows of a country’s citizens seen anywhere in the OECD – will not principally be because of GDP statistics, but because of individuals’ actual and perceived sense of the opportunities for themselves and their families. But reducing measurement differences is important for many other reasons: Households may not make optimal decisions regarding employment, training, migration, saving and investment if they believe that our GDP per capita is significantly lower than it actually is, and that they might be better off elsewhere. Financial markets need accurate measures of New Zealand’s ability to borrow and repay debt. This impacts our financial institutions and our sovereign borrowing. Measuring New Zealand’s GDP properly is a key concern of credit rating agencies. We need well-focused informed economic and social policy. Clearly it is more difficult to know whether these are working if there are doubts about the level of GDP per capita, and whether our measure is truly comparable with that of other countries, including that of our large trans-Tasman neighbour. New Zealanders rightly worry about the extent to which New Zealand incomes have drifted below the world’s highest in the last 40 years, but how large is that drift, and how have the gaps changed in more recent times? For helping answer those questions, good and economically comparable data are vital. This paper does not answer the question “are we closing the trans-Tasman gap”? However it does argue that the gap is not as wide as most people think. BIS central bankers’ speeches At the 2012 annual leader’s meeting, the Prime Ministers of Australia and New Zealand agreed that, to promote further reform and economic integration, the Productivity Commissions of each country would conduct a joint study on the options for further reforms that would enhance increased economic integration and improve economic outcomes. Given this aim, a useful contribution could be to improve harmonisation of statistical measurement in Australia and New Zealand, where appropriate, to improve data comparability. While this has not been an exhaustive exploration of the issues we hope that the information presented here helps people to better understand some of the pitfalls of international comparisons and perhaps why New Zealand is often seen as an outlier. In the meantime we observe that where there is scope for technical interpretations to differ, Australia has tended to take the optimistic alternative and New Zealand the conservative one. Could this be a reflection on our national characters? As usual, the devil is in the detail. Compare with care. References Barrow, R (2010), “Current issues with New Zealand’s Macroeconomic Statistics – A user perspective”, paper to the Advisory Committee on Economic Statistics. RBNZ (2007), “Supporting Paper A10: Possible improvements to macroeconomic statistics”, submission to the Finance and Expenditure Select Committee Inquiry into the Future Monetary Policy Framework, http://www.rbnz.govt.nz/monpol/about/3074316.html. OECD (2006) “Eurostat-OECD Methodological Manual on Purchasing Power Parities”, http://www.oecd.org/dataoecd/59/10/37984252.pdf. IMF et al (1993), “System of National Accounts 1993”, http://www.imf.org/external/pubs/cat/ longres.cfm?sk=575.0. IMF et al (2008), “System of National Accounts 1993”, http://unstats.un.org/unsd/ nationalaccount/sna2008.asp. UN (2008), “Non-observed economy in national accounts – Survey of country practices”, http://www.unece.org/fileadmin/DAM/stats/publications/NOE2008.pdf. BIS central bankers’ speeches
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Presentation by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to the Financial Institutions of NZ 2012 Remuneration Forum, Auckland, 3 May 2012.
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Grant Spencer: Prudential lessons from the Global Financial Crisis Presentation by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to the Financial Institutions of NZ 2012 Remuneration Forum, Auckland, 3 May 2012. * * * New Zealand has a small open economy and a financial system that is well integrated into the international financial system. So, not surprisingly, New Zealand was heavily affected by the Global Financial Crisis (GFC) and the global recession that followed. In the real economy, our export prices tumbled and GDP growth remained negative or flat through most of 2008 –2009. In the banking system, while we saw no failures, the banks were unable to access funding from the international markets for a number of months. This was alleviated through Reserve Bank liquidity support and government guarantees. In the non-bank sector of course, we saw a string of finance company failures. These were related more to the domestic property sector downturn and weak internal governance than international developments. However, increasing investor caution and competition for funding in the wake of the GFC did increase the funding pressures on finance companies. The GFC has taught us many lessons and it will continue to do so as we witness the follow-on effects of the original shock. Today I want to talk about three key lessons from the GFC that I regard as the most important for prudential policy in New Zealand. Indeed I believe they are very relevant for all countries with well developed banking systems. The three lessons are: 1. The contagion effects of a crisis can be heavily amplified by the contraction of liquidity in funding and asset markets. 2. The credit cycle is a major driver of risk in the financial system – the seeds of crises are often sewn in the credit booms that precede them. 3. Large bank failures can have devastating effects on both financial systems and government finances. Governments must find ways of protecting the financial system from bank failures without having to resort to bail-outs. I will look at these three lessons in turn, considering the broad international responses we have seen, and looking specifically at what we are doing here in New Zealand. The net result of all this is a raft of changes aimed at strengthening our existing prudential regime for banks, which we believe will enhance the soundness of New Zealand’s financial system going forward. 1. Heightened contagion and liquidity risk In the GFC, the first round of credit losses was seen in institutions holding US sub-prime mortgage investments. However, the uncertainty around who actually held such investments led to a sharp contraction of liquidity in a much wider range of markets. This loss of global liquidity had adverse consequences that were much greater than the initial sub-prime losses. Many financial institutions were simply unable to refinance maturing debt in markets that had frozen. In many cases, liquidity problems translated into solvency problems when banks had to revalue assets on the basis of very thin and distorted market trading. The consequent amplification of contagion effects was greater than expected by regulators and banks alike. The primary response to the heightened vulnerability of the international banking system has been a concerted strengthening of prudential capital and liquidity standards under the banner BIS central bankers’ speeches of “Basel III”. The new framework was released by the Basel Committee in late 2010 and is currently being implemented by banking authorities internationally. While some countries, such as Australia and New Zealand, are moving faster than others, the new Basel III capital standards are expected to be widely adopted over the coming few years. On the capital side, the emphasis has been on increasing the loss absorbency of bank balance sheets by raising the quality and quantity of capital (Figure 1) Figure 1 Basel III versus Basel II capital requirements (percent of risk weighted assets) Source: RBNZ The Basel III standards for increased liquidity buffers are being less uniformly adopted than the new capital standards. This is perhaps not surprising given this is the first attempt at cross border coordination of bank liquidity requirements. It also reflects significant country differences in the liquidity of sovereign debt markets – the liquid asset of choice by the Basel Committee – and in approaches to liquidity provision by Central Banks. In New Zealand, as in many other countries, the GFC revealed liquidity risks that were much greater than the Reserve Bank or the banks had expected. At the height of the crisis, in late 2008/early 2009, the liquidity shortfall was met through special liquidity facilities at the Reserve Bank and additional parent bank funding as well as Government guarantees on bank deposits and debt securities. In order to ensure greater bank self reliance going forward, the Reserve Bank introduced a prudential liquidity policy in April 2010. The policy includes minimum liquid asset requirements and, perhaps more importantly, a minimum core funding ratio (CFR) (Figure 2). This requires a minimum proportion of total lending to be funded by more stable “core funding” instruments, ie retail deposits and long term borrowing (over one year). BIS central bankers’ speeches The banks’ core funding ratios had reached very low levels in the period leading up to the GFC. After the crisis, banks realised they needed to strengthen their core funding and were also encouraged to do so by the rating agencies. The new CFR policy reinforces this trend and will ensure that strong funding buffers are maintained in the future, including through periods of greater risk appetite. The CFR is currently set at 70%. Last November, due to difficult international market conditions, the Reserve Bank deferred a planned further increase in the CFR to 75% which had been scheduled for June 2012. We are confirming today our intention to increase the CFR to 75% on 1 January 2013. Figure 2 Core funding ratio of NZ banks (percent of loans and advances) Source: RBNZ The heightened awareness of contagion and liquidity risks has led to a range of other policy responses in addition to the strengthening of capital and liquidity buffers. Such measures include extra safety requirements for large global “systemically important financial institutions” (SIFI’s), and changes to the “wiring” of the financial system in an attempt to reduce contagion risks. Examples of such measures include the “Volcker rule” in the US, which is aimed at isolating the risks from proprietary trading, and the Vickers recommendations in the UK, which propose to separate retail banking from investment banking. The challenge for such policies is to achieve a sustained reduction in financial system risk rather than simply distorting market behaviour. Some countries have also adopted measures intended to restrict executive remuneration in banking. This has occurred mainly in countries such as the UK and US where bail-outs resulted in the Government becoming a major bank shareholder. In Australia, APRA has not BIS central bankers’ speeches imposed direct controls, but has set down guiding principles for executive remuneration and incentive schemes. 2. Countering the credit cycle There is no doubt that the severity of the GFC was aggravated by the sustained boom in asset prices and credit that preceded it. An important contributing factor to the boom was the persistently easy global monetary condition over this period. A further contributing factor was the tendency for prudential policies to be pro-cyclical. For example, new provisioning rules brought in by IASB in the early 2000’s, prevented banks from taking a “through the cycle” approach to loss provisioning. Also, many banks had adopted capital models that tended to reduce the capital backing of loans when markets were strong and increase capital backing when markets were weak. In this sense, the existing prudential framework failed to take account of the growing systemic risk arising from the sustained boom in credit and asset prices that occurred between 2002 and 2007. The lesson was clear: prudential policy should take more account of macro-financial risks as well as the micro-financial risks specific to individual banks. In response to this lesson, macro-prudential policy has become an active new area of policy development internationally. In the Basel III regime, the important new macro-prudential element is the counter-cyclical capital buffer (CCB): an additional capital requirement that local supervisors may apply when credit is booming, and remove when the cycle is turning down (Figure 3). A range of other instruments are also being developed and applied in various countries under the general heading of “macro-prudential” policies. In broad terms macro-prudential policies are aimed at reducing financial system risk by introducing additional safeguards, such as capital and liquidity buffers or collateral requirements that vary with the macro-credit cycle. Such policies will also tend to have the effect of either: 1) dampening the credit cycle; or 2) dampening international capital flows and hence exchange rate pressures. For those reasons, macro-prudential policies might be expected to play a useful secondary role in helping to stabilise the macro-economy. BIS central bankers’ speeches Figure 3 Countercyclical capital buffer (Credit-to-GDP ratio, deviation from trend) Source: RBNZ At the Reserve Bank we have been doing a lot of thinking about potential macro-prudential policy instruments and how they might be used1. The four instruments we currently consider viable candidates are: The Counter Cyclical capital Buffer The Core Funding Ratio Adjustments to sectoral risk weights2 Limits on Loan to Value Ratios (LVR’s) The Reserve Bank already has powers under the Reserve Bank Act to modify prudential instruments with the objective of financial system stability and efficiency. However, this is a new approach to prudential policy and as such we are developing, along with Treasury, an explicit macro-prudential governance framework to be agreed with the Minister of Finance as a basis for policy decisions going forward. We expect that the Reserve Bank will take the lead role in implementing macro-prudential policy, subject to consultation with Government. See Reserve Bank Financial Stability Reports; Bollard (2011) “Where we are going with macro and microprudential policies in New Zealand”, Speech to the Basel III Conference, Sydney; Ha & Hodgetts “Macro-prudential instruments for New Zealand: A preliminary assessment”, Reserve Bank of New Zealand workshop on Macro-prudential policy; Spencer (2010),”The Reserve Bank and macro-financial stability”, Reserve Bank of New Zealand bulletin 73(2). As used to calculate Risk Weighted Assets under the Basel capital adequacy regime BIS central bankers’ speeches The natural question arises: how will macro-prudential policy interact with the Reserve Bank’s independent monetary policy mandate? The first point to make is that macro-prudential policy will have an important influence on monetary policy, in a similar way to fiscal policy, for example. Thus if macro-prudential policy is acting to dampen aggregate credit and demand, there should be less work for monetary policy to do (Figure 4). Because of this potential assistance from macro-prudential policy, there may well be situations where monetary policy seeks the support of macro-prudential policy, just as it may seek the support of fiscal policy (section 10 of RBNZ Act). But macro-prudential can only be used to assist monetary policy if it is also consistent with its primary financial stability objective. Figure 4 Essential monetary and macro-prudential policy interactions Source: RBNZ An important point to note here is that, like fiscal policy, macro-prudential policy is likely to be on a slower time schedule than monetary policy. Changes in the counter-cyclical capital buffer, for example, will require six to twelve months notice for the banks to comply. Thus, while we will try to ensure that macro-prudential policy is consistent with monetary policy objectives, these policy settings are less amenable to fine tuning. In that sense, macro-prudential policy is likely to be taken as a background “given” when it comes to making short term monetary policy decisions. The final point I must emphasise is that macro-prudential policy cannot replace monetary policy. While macro-prudential can hopefully assist monetary policy, it will never be as powerful or as flexible an instrument as the Official Cash Rate (OCR). Further experience will inform us better on the different impacts of the various macro-prudential instruments. However, the experience from other countries (for example in Asia) suggests that macro-prudential is unlikely to fundamentally alter the economic tradeoffs faced by monetary policy. That is to say: monetary policy will still face difficult choices! BIS central bankers’ speeches 3. Stronger failure resolution mechanisms During the GFC, many failing banks were bailed out by governments who feared the systemic consequences of large scale creditor losses. There were some exceptions: in cases such as Bear Stearns a private sector “white knight” was found3; in the case of some medium sized banks the FDIC resolution regime could be implemented (eg Washington Mutual); in the case of the Icelandic banks losses were imposed on both domestic and foreign creditors; and of course Lehman Brothers was allowed to fail under normal commercial process. While there were glimpses of what could be achieved through effective failure resolution mechanisms, the widespread fallout from the Lehman collapse tended to reinforce the “too big to fail” consensus. Probably the most costly case of bank bail-outs occurred in Ireland where the government is estimated to have spent close to 30% of GDP on bank recapitalisations between 2008 and 2010. The burden this placed on the Irish taxpayer contributed to the downfall of the Irish government and the need for an IMF-led rescue package. The lesson was clear: country authorities need better options for dealing with bank failures than having the binary choice of either a full taxpayer bailout or an unconstrained liquidation. Many countries have responded by introducing stronger powers for their banking authorities, new mechanisms for absorbing losses ahead of default and more systematic procedures for resolving actual failures. Canada, the UK and the US are good examples. A range of approaches have been taken. New tools such as “living wills” and “bail-in bonds” are being used to enhance the likelihood of an ailing bank’s survival. Statutory management powers are being strengthened and new resolution structures such as bridge banks are being established to facilitate the orderly resolution of failing banks without recourse to government funds. The key international forum on these matters, the Financial Stability Board (FSB) has set clear guidelines on how failure resolution regimes should be structured. In particular FSB recommends: “The resolution plan should facilitate the effective use of the resolution authority’s powers with the aim of making feasible the resolution of any firm without severe systemic disruption and without exposing taxpayers to loss while protecting systemically important functions. It should serve as a guide to the authorities for achieving an orderly resolution, in the event that recovery measures are not feasible or have proven ineffective.” (From FSB, Key Attributes of Effective Resolution Regimes for Financial Institutions, Annex III, October 2011) In New Zealand, while we already have quite strong failure management powers within the Reserve Bank Act. We know that the failure of any of our large systemic institutions would require close official involvement. Our main response to this third lesson from the GFC has been to enhance our existing failure management framework by including a resolution structure called “Open Bank Resolution” (OBR). The OBR framework requires banks to structure their systems so that, in the case of a failure where losses exceed a bank’s available capital reserves, the excess losses can quickly be allocated across depositors and other creditors. The intention here is to allow a bank failure to be resolved quickly, say over a weekend, with depositors having access to their diminished, but guaranteed balances on Monday morning. The bank (under statutory Albeit with the Federal Reserve taking a significant amount of risk. BIS central bankers’ speeches management) and its customers would be free to participate in the payments system from the re-opening, thus minimising any systemic impact of the failure. The Reserve Bank has been developing the OBR policy over a number of years; the GFC experience provided the final prompt to make it operational. The policy can be seen as a complement rather than a substitute for the various “recovery plan” tools such as living wills and loss-absorbing debt instruments. OBR is also fully consistent with the Reserve Bank’s local incorporation and outsourcing policies that were introduced in the early 2000s to help protect New Zealand’s largely foreign owned financial system from shocks to parent institutions. It must be emphasised however that OBR is just one tool in the resolution toolbox. The government may or may not implement OBR when dealing with a bank failure; the choice will depend on a number of factors. But it is important for government to have this option available. OBR gives the government a realistic alternative to the costly bail-out option should a large bank get into difficulties. The policy also serves as a reminder to investors that there are no guaranteed institutions, thus helping to limit moral hazard in the financial system. Conclusion The GFC continues to teach us many lessons. Today I have focussed on three key lessons for prudential regulation that I believe are relevant for New Zealand and indeed all countries with developed banking systems. The first is that financial institutions are more vulnerable than we previously thought to network contagion effects which can be heavily amplified by the evaporation of market liquidity. In response, we have “upped the game” on liquidity requirements for banks, and are doing the same with capital under the “Basel III” capital adequacy framework. Second, we need to be more active in offsetting the build up of macro-financial risks. We are developing macro-prudential policy tools for this purpose which will dovetail with our existing micro prudential framework. Such tools will not prevent credit cycles in the future, but should reduce the risk associated with them. The macro-prudential policy will be focused primarily on financial system stability. However, by its nature, is likely to lend support to monetary policy. In this regard, macro-prudential policy should also “keep an eye” on monetary policy objectives. Third, and finally, while we can reduce the likelihood of bank failures, we also need to be better prepared for the rare event of a large bank failure. The OBR option will help to protect both the financial system and the government accounts from a large bank failure. Learning these lessons and improving our prudential policy framework will make us better equipped to withstand the effects of future financial shocks. BIS central bankers’ speeches
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Comments by Mr John McDermott, Assistant Governor of the Reserve Bank of New Zealand, prepared for the BIS Research Workshop "Globalisation and inflation dynamics in Asia and the Pacific", hosted by the Bank for International Settlements, Hong Kong representative office, 19 June 2012.
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John McDermott: The future of inflation targeting? Comments by Mr John McDermott, Assistant Governor of the Reserve Bank of New Zealand, prepared for the BIS Research Workshop “Globalisation and inflation dynamics in Asia and the Pacific”, hosted by the Bank for International Settlements, Hong Kong representative office, 19 June 2012. * * * Introduction Inflation targeting as a monetary policy framework has been largely successful at keeping inflation in check in the many countries that have adopted it over the past 20 years or so. 1 Certainly the inflation performance in New Zealand has been far superior under the inflation targeting regime (figure 1). I expect inflation targeting is very familiar to most people here but let me briefly recap what that framework entails in the New Zealand context. Then I will use the most recent business cycle in New Zealand to illustrate how the framework coped with some very significant shocks to the New Zealand economy. Figure 1 Headline CPI inflation Source: Statistics New Zealand Roger, S (2009) “Inflation targeting at 20: achievements and challenges” IMF working paper, WP/09/236, October. BIS central bankers’ speeches What inflation targeting looks like in New Zealand Inflation targeting frameworks have a number of elements including an explicit numerical target to be met over a defined time horizon, as well as typically specifying a process for how the central bank is to be held accountable for its monetary policy actions and how it is expected to communicate its monetary policy decisions. In New Zealand, we aim to keep future consumer price inflation between 1 and 3 per cent on average over the medium term. 2 Like many other central banks we have a range of publications we can use to provide our view of inflationary pressure and explain our monetary policy actions. The most prominent is the quarterly Monetary Policy Statement. Although the principles of inflation targeting are the same across countries there are some differences in the details. For example, New Zealand has a different accountability structure in that we have a single decision maker rather than a committee for monetary policy decisions. We also differ to most central banks in that we publish an interest rate track that we think would be necessary to achieve our inflation target. These differences do not appear have made a difference in the ability to achieve the inflation target. How did the inflation targeting framework cope with the most recent business cycle in New Zealand? The most recent business cycle in New Zealand was one of the longest and largest in the past 60 years. 3 The Reserve Bank has been analysing this cycle to help assess its monetary policy. This analysis provides a useful case study on the use of inflation targeting in a small open economy, like New Zealand’s. An analysis of the drivers of the business cycle was published in the Bank’s March Bulletin while a discussion of monetary policy over the business cycle will be published in the Bank’s June Bulletin in a few weeks. In summary, that analysis notes that the New Zealand’s economy expanded from 1998 to 2007 and then had a six quarter recession in 2008–09. From 1998 to 2007 there were a number of significant shocks that determined the shape of the business cycle (figure 2). First, there was a strong and unexpected increase in population growth from net immigration in 2002/03. Second, there was a significant boost to the economy from a rising terms of trade from 2000, which accelerated late in the period. Third, oil prices roughly doubled from mid2007 to mid-2008. Fourth, government spending rose rapidly from 2005. This came at a time of pre-existing excess demand in the economy. In New Zealand, the inflation targeting framework is founded on the Reserve Bank Act 1989 (the Act) and the Policy Targets Agreement (PTA). The Act makes price stability the primary function of monetary policy and gives the Reserve Bank independence in operating monetary policy, subject to an agreement between the Minister of Finance and the Governor (the sole decision maker) specifying the functional target. The PTA defines price stability in the form of an inflation target, currently future annual CPI inflation “...between 1 per cent and 3 per cent on average over the medium term”. The PTA says that in pursuing price stability monetary policy should “seek to avoid unnecessary instability in output, interest rates and the exchange rate”. For details of the dating for New Zealand’s business cycles see Hall, V B and C J McDermott (2009) “The New Zealand business cycle” Econometric Theory, 25, 1050–1069. BIS central bankers’ speeches Figure 2 Net permanent and long-term migration Real Dubai oil prices (1998 prices) Source: Statistics New Zealand Source: Reuters, Haver Analytics, RBNZ calculation Terms of trade Government spending (consumption plus investment, percent of annual GDP) Source: Statistics New Zealand Source: Statistics New Zealand, RBNZ calculations In setting monetary policy we had to take a view both on how these shocks would unfold and how they might change the inflationary pressure in the economy, as summarised by our view of the output gap. As our forthcoming Bulletin article 4 notes, throughout the recent boom we expected the output gap to dissipate rapidly. However, as it turned out the output gap remained positive for an extended period (figure 3). Chetwin, W (2012) “Business cycle review, 1998–2011” Reserve Bank of New Zealand Bulletin 75(1), 14–27. And Chetwin, W and M Reddell (2012) “Monetary policy in the last business cycle: some perspectives” Reserve Bank of New Zealand Bulletin 75(2), forthcoming. BIS central bankers’ speeches Figure 3 Output gap estimates from June quarter Monetary Policy Statements (percent of potential output) Source: Statistics New Zealand, RBNZ calculations With an extended period of excess demand pressure, average inflation tracked in the upper half of our target zone. While the persistent component of inflation was higher than we would have ideally liked during the business cycle expansion, it did remain anchored within the target zone. That outcome was far superior to our experience of the 1970s when inflation was persistently at double-digit levels. The difficulty of anticipating how long an inflationary shock will last is central to the forecasting process required for monetary policy. In many models that are used for monetary policy analysis, the output gap often quickly returns close to zero following a simple aggregate demand shock, and it is natural to think in those terms. 5 However, the interaction of a persistent aggregate demand shock and inertia in the economy can considerably prolong the time for which the economy is in a state of excess demand pressure. Figure 4 illustrates this point by showing the response of an aggregate demand shock with a half-life of only two quarters in a stylised model of monetary policy with typical parameter settings. The point is that excess demand can remain material in the economy long after the underlying shock has gone. Here I am referring to the New Keynesian style models as described in, for example, Woodford, M. (2003). Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton University Press; and Benes, J, A Binning, M Fukac, K Lees, T Matheson (2009) K.I.T.T.: Kiwi Inflation Targeting Technology, Reserve Bank of New Zealand. BIS central bankers’ speeches Figure 4 Response of output gap and inflation to a persistent aggregate demand shock RBNZ calculations Of course, the shocks we face in the economy can be far more complicated than in this simple illustration. Three of the shocks shown in figure 2 delivered ongoing pressure to the economy. Even the relatively short-lived large inflow of migrants in 2002/03 had ongoing impacts. The housing stock cannot be increased as quickly as the changes in migrant flows. Consequently, house prices rose and, even after the boost to population subsided, continued to rise beyond all forecasters’ expectations. Higher house prices in turn stimulated a large construction boom which put further pressure on resources. Private sector credit started to expand well in excess of the nominal growth in the economy (figure 5). In line with conventional wisdom, we put relatively less weight on credit data than on interest rates. 6 Had we had a higher weighting on credit growth data, our view of the persistence of pressure on resources would likely have been stronger much earlier in the boom. The academic consensus on monetary policy used to be that there was no independent information for monetary formulation in money and credit numbers over and above that available in interest rates. See for example, Gali, J (2008) Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework, Princeton University Press, Princeton. While this view was never completely accepted at the Reserve Bank of New Zealand (Bollard, A (2005) “Housing debt, inflation and the exchange rate” Address to the Employers and Manufacturers Association (Northern) AGM)) money and credit aggregates were never very prominent in the formulation of monetary policy. One of the processes we changed following the global financial crisis was to formally present information on monetary and credit aggregates to the Monetary Policy Committee to assist with the production of the Bank’s forecasting in its Monetary Policy Statement. BIS central bankers’ speeches Figure 5 Excess of domestic credit growth over nominal GDP growth Source: Statistics New Zealand, RBNZ calculations Monetary policy in New Zealand is also complicated by exchange rate issues. In a small open economy the inflation target is a complement to a floating exchange rate regime. During the boom period expectations of tight monetary policy to offset the excess demand pressure probably contributed to the persistently high exchange rate throughout the period, causing considerable discomfort and worries about the sustainability of parts of New Zealand’s tradable sector. After the global finance crisis there are new challenges for monetary policy to deal with. The current recovery in the business cycle, both in New Zealand and in other advanced economies, is proving weaker than historical precedents. Our forecasting frameworks need to be expanded so we can examine possible sources of the disappointing recoveries, such as say the impact of the overhang of public and private debt on the economy. Inflation targeting works, and other lessons for the future Despite the challenges and the ongoing shocks to the economy, monetary policy did what it was supposed to do, keep inflation low. The framework maintained the Reserve Bank’s focus on the target and the frequent publication of forecasts forced us to constantly update our views of the economy and the inflation pressure within it. The Bank’s analysis on the recent business cycle underscores that the inflation targeting framework is an effective way to conduct monetary policy under a range of testing circumstances and that the framework is a useful tool for future inflation control. With low inflation and the credibility of inflation targeting came much lower volatility in the general level of prices. That is helpful for resource allocation, affecting longer term performance, and for macroeconomic stability over the medium term. This credibility was BIS central bankers’ speeches very helpful when the global financial crisis hit. To help offset the very large negative shock the Bank started lowering interest rates even while annual inflation was above its 1 to 3 percent target. Of course, that is not to say the framework cannot be improved in any way. Over the course of the past 20 years or so the framework has evolved to reflect lessons learned and is likely to evolve further in response to new developments. In particular, our monitoring of monetary and credit information has increased in the wake of the global financial crisis. The Reserve Bank has also been looking into the effectiveness of some macroprudential instruments that may limit build-ups of problems in future periods of rapid credit growth. 7 For details see Spencer (2012) “Prudential lessons from the Global Financial Crisis”, Presentation to Financial Institutions of New Zealand 2012 Remuneration Forum, May. BIS central bankers’ speeches
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Paper by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Mr Tim Ng, for the Sir Leslie Melville Lecture at the Australian National University, Canberra, 9 August.
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Alan Bollard: Learnings from the Global Financial Crisis Paper by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Mr Tim Ng, for the Sir Leslie Melville Lecture at the Australian National University, Canberra, 9 August. * 1. * * Introduction The global financial system went through major convulsions in 2008, putting great pressure on an already weakening global economy. A massive global economic recession followed, contributing to the emergence of a sovereign debt crisis in the euro area. European sovereign debt problems remain a dark cloud overhanging the world economy. These extreme events have provoked us to re-think what is known and where economic research should focus, in some cases fundamentally. We had long known that banks that appear individually sound can be vulnerable to problems affecting the whole banking system, and that such problems can amplify economic shocks. But the crisis sharply accelerated the study of financial fragility, contagion and instability nonetheless. The crisis has also challenged us as financial regulators and monetary and fiscal policymakers. We are all working to understand, contain and repair the damage to financial systems, to economies and to governments’ financial capacity. The policy choices in many areas involve difficult and uncertain tradeoffs. This paper discusses some lessons from the crisis experience to date, and some analytical and policy challenges. 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. We find it useful to structure the discussion in three parts: the episode of near-seizure in many advanced-country financial systems in 2007–08; the global recession of 2008–09; and the current situation of extreme fiscal weakness in many parts of Europe. (Of course, real events have not been as simple and linear as that structure might suggest – expectations and feedback loops have played a substantial role.) We conclude with some reflections about research and policy strategy in this new world. 2. Financial system disruption, 2007–08 Global financial markets sharply became unsettled in July and August 2007, when a number of large US and European financial institutions suspended redemptions in investment vehicles linked to US mortgage debt and their derivatives. Through the following year, concerns mounted about the extent and complexity of global bank exposures and vulnerabilities to growing economic weakness. These concerns soon embraced a very wide sweep of financial products in the US and elsewhere. Bear Stearns was effectively bailed out by the US taxpayer on the basis that it was too interconnected to be allowed to fail. But the shock bankruptcy of Lehman Brothers in September 2008 saw investors panic, as perceptions about the safety of financial institutions in general took a sudden turn for the worse. Each of these events saw funding spreads in interbank markets worldwide spike (Figure 1). Firms, investors and regulators generally failed to anticipate quite how financial system fragilities could interact. Prior to the crisis, they had viewed hedging markets and financial engineering as powerful means of detaching credit and liquidity risk from a wide range and large volume of circulating private-sector securities. The rapid growth and use of apparently low risk private-sector securities in funding markets was itself due to a number of interacting factors. These included a strong global demand for low-risk assets (mis-sold or mis-used on the basis of inaccurately high credit ratings), loose monetary policy, and credit-fuelled BIS central bankers’ speeches housing booms in a number of advanced economies, which encouraged financial innovation to meet the demand for low-risk assets. Figure 1 LIBOR-OIS spreads Source: Bloomberg. In many large advanced countries, an overall result leading up to the crisis was increased leverage and funding fragility in both the financial system and the “real” economy. Many could see that these growing imbalances were unsustainable and would need to correct, and that the correction might be very disruptive. But to anticipate fully the magnitude of the subsequent event would have required connecting many apparently disparate pressures and signals. Among the most important of these were two factors: first, the funding fragilities created by the shadow banking system; and second, the catastrophic collapse of liquidity caused by investors’ sudden doubts about the credit risk and marketability of previously “safe” assets, and about the standing of counterparties. The dumping of risky financial assets and indiscriminate cutting of funding caused asset return correlations to jump. The shock rapidly spread between global banks, partly reflecting high-frequency marking-to-market. The cost of credit default insurance for the large financials shot up (Figure 2). Bottlenecks in market or institutional hubs impeded or prevented risk shedding. The fire sales and chain reactions proved very difficult to halt. Faced with disappearing private-sector funding markets, central banks stepped in to supply funds in large quantity to solvent banks. To limit their own (and hence their governments’) financial exposure, the idea was to take good collateral at interest rates and haircuts high enough to recognise the lending risks. However, lending terms could not be so punitive as to discourage use of the facilities, which would defeat their purpose. This was easier said than done given the shrinking supply of good collateral. BIS central bankers’ speeches Figure 2 CDS spreads, selected global banks Source: Bloomberg. Banks that became insolvent despite central bank funding assistance presented their governments with tough choices about rescue. Financial support in the form of direct injections of equity or debt blew out government balance sheets in many cases (Figure 3), and guarantees of bank debt added sizeable contingent liabilities. Figure 3 Gross government outlays to support financial sector since crisis Source: IMF. BIS central bankers’ speeches In New Zealand and Australia, problems in the core banking system during the crisis were comparatively mild, reflecting our more vanilla-flavoured banking sector and relatively sound bank capital structures. There was little exposure to complex instruments and opaque interconnections in our markets. Nevertheless, during the period of extreme market nerves, like other authorities we had to act rapidly to support system liquidity and banks’ ability to fund themselves, including by issuing government guarantees of bank liabilities. Regulatory responses Regulators worldwide have responded to the financial crisis experience with a large and ongoing programme of reforms. Among the most important include strengthening requirements on banks’ capital and liquidity structures, and bolstering domestic and international financial supervision. Basel III is a key international process to facilitate the parts of these reforms focused on bank balance sheets. We do note, however, that not all the proposed reforms relate to problems in the Australasian banking system. Neither is it clear that all countries that experienced banking system problems will adopt all the reforms. In our simpler banking systems it is generally easier to recalibrate regulatory standards. Capital levels have not been heavily eroded by the crisis, so capital and liquidity standards can be strengthened quickly compared to those advanced economies struggling with weak or complex financial systems. In some economies there is a risk that banks will meet higher capital or liquidity ratio requirements by contracting lending, rather than by increasing capital. This has slowed the strengthening of bank balance sheets and crimped the availability of credit to firms for investment. With the current risk that global funding conditions could turn adverse very suddenly and our banking system’s dependence on offshore wholesale funding, in New Zealand we have placed priority on strengthening liquidity standards even before increasing capital ratios. 3. Global recession, 2009–10 The rapid deterioration in financial and economic conditions in late 2008 and early 2009 quickly caused a collapse in business and consumer confidence, exacerbating the interruption of economic activity across the world. Cross-border spillovers through regional supply chain structures and global customer markets were accelerated by short-term funding disruptions, such as in trade finance. Now economies without large direct financial exposures to “toxic” assets, such as Asian export-oriented economies, were sucked into the downdraft. The abrupt marking-down of the outlook for Western growth and consumption of high-value goods saw inventories pile up, especially in those countries positioned as manufacturing hubs or producers of capital goods. In six months or less, industrial production in Japan, Singapore and Korea, for example, fell 30, 25 and 19 percent respectively. The damage to bank balance sheets from suspect loans and marked-down asset valuations, as well as the sudden exit from the scene of many financial intermediaries, showed up in restricted lending capacity and greatly expanded funding spreads. Accordingly, those non-financial firms and households that still wanted or needed credit either had to pay elevated rates or to deleverage, further depressing activity. When central banks recognised the magnitude of the recessionary forces in train, they cut policy interest rates very quickly (Figure 4). In some Northern Hemisphere markets, the dysfunction in the financial system had loosened the link between official policy rates and lending rates to firms and households. As well as cutting official interest rates, the US Federal Reserve and the Bank of England stepped in directly to key credit markets to lower interest rates in those markets. BIS central bankers’ speeches Figure 4 Policy interest rates Source: Bloomberg. The relatively high level of interest rates before the recession meant that deep cuts were possible. The New Zealand and Australian Reserve Banks, for example, cut policy rates by 575 and 425 basis points respectively between July 2008 and April 2009. Crisis then brought opportunities. Monetary policy researchers had always wondered what might happen if price inflation and interest rates approached zero in several major countries, or even went negative. Now we would find out. The case of Japan no longer seemed so unique. As monetary policy interest rates approached zero in a number of advanced countries, some central banks began to try to influence general financial conditions through “unconventional” tools, meaning tools other than the official short term interest rate (the “cash rate” in this part of the world). One such tool is purchases of long-maturity financial securities in large volume on the open market, called “quantitative easing” or QE. These purchases have been most prominently carried out by the US Fed and the Bank of England, causing roughly a tripling and quadrupling, respectively, of their balance sheet sizes to date (Figure 5). One channel by which QE is believed to work is by increasing demand for the targeted securities, raising their prices and hence reducing interest rates on them, which should then flow through to longerterm interest rates in general. Other possible channels include exchange rate impacts and signalling of a central bank’s expectations to keep policy rates low. Unconventional policies can have unconventional side effects. We are currently observing spillovers from large economy QE impacting capital flows and exchange rate pressures in small open economies. Continuing exchange rate pressure is problematic for a country like New Zealand. BIS central bankers’ speeches Figure 5 Central bank asset holdings Source: Bloomberg. In the face of plummeting demand, many countries hurriedly enlisted discretionary fiscal policy also. With a fiscal and credit stimulus package of 4 trillion yuan (about 600 billion US dollars, or 14% of Chinese GDP), China carried out the biggest fiscal stimulus in post-war history. Fiscal stimulus packages were typically worth several percent of GDP, with the cumulative expansionary shift of the fiscal stance over the three years from 2007 to 2009 amounting to four percent of GDP in both advanced and emerging economies. These expansions are now being wound back (Figure 6). Figure 6 Shifts in fiscal stance Source: IMF. BIS central bankers’ speeches 4. Sovereign credit challenges, 2010– In many advanced countries, the recession-induced reductions of tax revenue and increased social spending were compounded by governments taking on debt to support the banking sector. These actions brought forward sovereign debt sustainability problems in some countries, particularly in Europe. By the second quarter of 2010, sharply rising concerns about the fiscal position of first Greece, and then other non-competitive indebted euro area countries, were quickly reflected in the interest rates they had to pay in sovereign funding markets. Markets made and continue to make sharply differentiated judgements about sovereign creditworthiness across the euro-area countries, placing considerable strain on euro-area political and economic institutions. The crisis also refocused public and market attention on the fiscal cost of aging populations. The projected sharply increasing cost of state-funded health care and income support for retirees, at the same time as a reducing working population, had been recognised for some time. But now, the problem has come forward in time, with the potential national incomes available to support future fiscal expenditure looking much lower. Some severe implications for wealth and transfers between generations are starkly apparent, and these will be politically and socially difficult to manage. While market fiscal sustainability concerns are especially focused on the euro area currently, governments elsewhere are also drawing lessons for the re-alignment of fiscal settings with reduced growth prospects. In some ways these are difficult lessons to accept, as well as to debate publicly. Where countries are under strain, fiscal austerity measures may be needed to signal the political commitment to achieving consolidation, even though this can also reduce growth, at least in the short term. The cost and availability of funding for many euro area countries remains very sensitive to fiscal sustainability projections, probably exacerbated by the inability of these countries to issue the currency of their debt. Figure 7 Government debt ratios and bond rates Sources: Haver Analytics, IMF. AU=Australia, AT=Austria, BE=Belgium, CA=Canada, CH=Switzerland, DE=Germany, ES=Spain, FI=Finland, FR=France, GB=United Kingdom, IE=Ireland, IT=Italy, JP=Japan, KR=Korea, NL=Netherlands, NZ=New Zealand, PT=Portugal, US=United States. BIS central bankers’ speeches Governments needing to finance deficits have had to pay considerable attention to market conditions and perceptions. In general, where discretionary fiscal measures were quickly implemented, and were seen to be extraordinary, targeted and sunsetted, markets have been more forgiving. To date, the US, Germany, Japan and the UK have retained the confidence of investors and their status as safe havens – despite government debt ratios that are high even by the standards of the troubled euro area countries. Australia and New Zealand have continued to benefit from relatively low public debt ratios (Figure 7). 5. A new world Five years after the first tremors in 2007, the world looks rather different. Interest rates are much lower. Risk pricing is much more sharply differentiated. The threat of deflation is now real for several countries, and inflation is very low for others. In most advanced countries since the crisis, real per capita GDP growth has been insipid at best. Although weak banks appear to be much less of a problem in Australasia, impaired bank balance sheets in the Northern Hemisphere are casting a long economic shadow. Some banking systems remain weighed down by non-performing loans, while markets for securitised loans are still largely moribund. Financial institutions and their funders appear to have recognised the importance of robust funding, loss-absorption capacity and clarity about bank balance sheet exposures. 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. 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. The new environment creates some structural and strategic challenges for the global financial industry. Much-reduced financial engineering and weaker financial institutions are likely to see some retrenchment of certain banking activities. Also, with very low yields, financial institutions subject to obligations or strong expectations to pay fixed returns (such as pension funds) face pressure to increase holdings of risky assets, so they can support these returns. A renewed search for yield for these reasons raises the risk of excessive investment or bubbles in such lower quality assets. 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. Household caution is understandable given the restrained growth outlook, and the continued need for external rebalancing. But it is also consistent with cyclically weak labour and housing markets. We have yet to see whether deleveraging will continue as the gradual recovery proceeds, or if households instead revert to pre-crisis behaviours. BIS central bankers’ speeches Currently, business sector balance sheets after the crisis are generally in better shape than following previous recessions. The labour market weakness probably means some shift in the share of national income in favour of capital. Furthermore, a reluctance to invest in the current environment of uncertainty (the Australian mining sector being a notable exception) means that many firms are actually quite cash-rich. Asia-Pacific impacts Increased saving and reduced investment in advanced economies, and the beginnings of a shift towards domestic expenditure and away from exports in emerging economies, are starting to reduce the global imbalances that had grown markedly pre-crisis. However, in the meantime, the reduced investment is also holding back global productivity and potential growth. This probably adds to the pressure for re-balancing of external and domestic growth drivers in emerging economies. While world growth has fallen overall, the share accounted for by emerging markets, particularly in Asia, has continued to grow. This shift, combined with the strong rebalancing forces, has produced an unusual constellation of economic conditions in Australia and New Zealand. 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. At the same time, in New Zealand we have our own post-crisis debt, resulting from pre-crisis debt-fuelled household expenditure, which is now proving to be a restraint on demand. And although our fiscal positions are favourable relative to many other advanced economies, the debt overhangs, dependence on offshore funding and its sensitivity to sustainability concerns suggest that the current tilt of fiscal policy towards consolidation may persist for a while. 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. Research and analysis The crisis has re-oriented 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. BIS central bankers’ speeches 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. But uncovering enduring and reliable inferences about behaviour from discontinuous and perhaps unique real-life observations is daunting. Non-linearities, contagion and large-scale failures are a far cry from familiar linear models with diversified exposures and rational expectations. The jury is still out on whether extreme behaviour is forecastable in a useful way at all, even if it can be modelled in the abstract. A good example is the sudden change of perceptions about current monetary and fiscal arrangements for euro area. From barely perceptible differences between euro area government bond rates since the euro began trading in 1999 until 2008, we now face divergences many times greater than those seen even during the convergence period before the euro’s creation (Figure 8). Figure 8 Euro area government bond rates Source: Bloomberg. Policymakers’ models are usually built around a well-defined economic equilibrium. In the current environment, knowing exactly where equilibrium is and whether it is unique seem like especially big asks. More than usual, the financial industry and policymakers alike appear to be groping to understand how things will look in the next decade. Modelling approaches based on chaotic dynamics and multiple equilibria are not new to the profession. But their utility has been limited due to their extreme sensitivity to assumptions, and the difficulty of extracting a simple story on which to base decisions. Yet at least they remind us of the limits to predictability and certainty. Policy strategy What does all this mean for macroeconomic and financial policy strategy in the years ahead? As a first goal, and one that is unchanged by the crisis, macroeconomic and financial policy should seek to provide a stable backdrop for economic activity. The familiar guideposts of price and financial stability remain relevant. As a second goal, policy might try to buffer and insulate the economy to some extent from disturbances. Third, while buffering to the degree BIS central bankers’ speeches possible given limited knowledge, policy should allow resource allocation signals to come through as undistorted as possible. Within this high-level policy framework, the stresses on fiscal and monetary policy in many economies have led to new policy challenges. Policy interest rates are very low and fiscal deficits very large in many countries. In New Zealand and Australia, policymakers must manage ongoing exposures to offshore financial disruptions as well as generalised deleveraging pressures at home and abroad. Finally, exchange rates and relative prices and wages are shifting due to commodity market developments. Financial regulation and supervision 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. With reduced credit demand, costly funding and stricter regulations, the banking sector is going to have to get used to more restrained returns. The financial system’s basic function is to make credit judgements across uncertain investment propositions, to monitor borrowers’ performance and creditworthiness, and to price credit accordingly. Restoring that function is the ultimate goal of financial reform. In doing so, we need to ensure that regulation does not overly increase the costs of banking, especially in more vanilla systems such as Australia’s and New Zealand’s. Our systems are already focussed on utility banking, rather than on the riskier types of investment banking. The sobering experience of the crisis underlines the difficulty of getting the right balance of light-handed versus heavy-handed supervision. Supervisors, financial institutions, credit rating agencies and everyone else inevitably see financial and economic developments imperfectly, both ex ante and ex post. It is therefore unrealistic to expect to be able to reduce the probability of a systemic crisis to zero. Part of the strengthening of the financial system overall must therefore include practical preparation for further crises. This includes regulation and supervision with an eye to ensuring that a crisis can be dealt with effectively, should it eventuate. In our integrated Australasian banking system we have learned the value of strong homehost cooperation in regulating trans-Tasman entities. We have also learned the value of having the capacity in each jurisdiction to deal with failed institutions expeditiously, whatever their size or parentage. In New Zealand, we have emphasised having mechanisms to allocate losses appropriately to creditors and shareholders and to release residual claims on the bank quickly, in the event of trouble at the banks. BIS central bankers’ speeches Macro-financial policy We learned in the crisis that a “micro-prudential” focus on the soundness of individual institutions does not ensure that the whole system will continue functioning under adverse conditions. Part of the international response is macro-financial policy, a new focus of policy development concerned with the stability of the financial system as a whole, and on financial behaviour and its interactions with the economy. Macro-financial policy acts on the structure of financial institution balance sheets and behaviours across the whole system. Such controls add to micro-prudential controls to ensure the soundness of individual institutions considered in isolation. 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. Fiscal policy The experience of sovereigns in less favourable fiscal positions demonstrates how quickly and catastrophically a sovereign can lose credibility for ongoing prudent fiscal and economic management, especially if the exchange rate is not available as an adjustment mechanism and internal cost structures are not flexible. That credibility is a vital resource. Although we have our own versions of the aging population problem, we went into the crisis from a fairly healthy government financial position. Australia’s position now appears still to be relatively favourable, while New Zealand is more in the middle of the pack of advanced countries. Yet, other features of our national balance sheets give some cause for concern should another global funding pressure event occur. It will take a long time for the structural causes of financial fragility in Europe to be addressed, and for the process of public and private balance sheet repair to run its course. In the meantime, crises may reoccur and cause either funding disruption to Australia and New Zealand, or even worse, a renewed global economic downturn. 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 BIS central bankers’ speeches 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. Monetary policy The events of the past five years have led monetary policy into unfamiliar territory. After responding largely successfully to the priority of reducing and stabilising inflation following the 1970s experience, monetary policy now faces a number of 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. Currently it appears that a large part of the Australasian currencies’ strength can be attributed to emerging market demand underpinning global markets for New Zealand and Australian commodity exports, at least on a mediumterm view. Shorter-term volatility seems to have increased with foreign exchange markets swinging between willingness to back economic outperformance of the region (so called “risk on”), and aversion to anything that looks “peripheral” (so called “risk off”). The growth of resource-hungry Asia (China especially) will gradually shift domestic labour and capital allocation. This shift is certainly not easy, and maybe beyond the realm of stabilisation policy to manage. Instead, the key factor in smoothing the transition is flexible capital and goods markets, and clear relative price signals. The challenge for all is to look through aggregate and shorter-term cyclical effects and read the longer-run signals from real exchange rate and relative price developments. In the current volatile environment, the zero lower bound on nominal interest rates is not very far away. Policy rates fell a lot further during the acute phase of the crisis. 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. BIS central bankers’ speeches Fortunately there is now experience at home and abroad with market-supporting liquidity interventions that can be activated at short notice, as well as some tentative lessons from the QE experience in the major advanced economies. Nevertheless, QE remains new ground for central banks in many ways. The early evidence suggests that it does work to some degree to stimulate the economy, although the precise mechanisms involved are still a matter of some debate. 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. 6. Conclusion The combination of G7 weakness and rapid growth of the resource-hungry and populous emerging world is unique in post-war economic history. Over the next few years, Australian and New Zealand firms will need to make strategic decisions about how to make the most of these opportunities. Their success or otherwise will depend on how well they can extract resource allocation signals from volatile data. We are living in a new economic world, albeit one that may be best enjoyed from hindsight. Until then we will keep on learning. BIS central bankers’ speeches
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reserve bank of new zealand
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Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Mr Michael Reddell, to the Employers and Manufacturers Association, Auckland, 6 August 2012..
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Alan Bollard: Dealing with debt Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Mr Michael Reddell, to the Employers and Manufacturers Association, Auckland, 6 August 2012. * * * Introduction Households, firms, and governments across much of the advanced world have taken on very large amounts of debt in the last couple of decades. In New Zealand, for example, the private sector owes three times what it did in 1998. People and governments are now living with the aftermath; dealing with the debt. Many individual lives will have been irreversibly changed. Even at an aggregate economy level, it looks as though we could be dealing with the aftermath for quite some time yet. This speech offers some perspectives on what the accumulation of debt means for people, and for our economies. Inevitably some of the material will have quite a provisional flavour: how things will play out remains uncertain, and is being intensely debated by academic researchers and policymakers alike. It matters to us all. Some context Debt is not new. In his recent book, Debt: The First 5000 Years, the American sociologist David Graeber demonstrates the central role that credit has played in economic and social life stretching back millennia. But some things are newer: for example, the scale and pervasiveness of the public and private debt, the scale of cross-border gross and net debt, and the central role that highly-leveraged financial institutions and wholesale financial markets play in making that debt possible. And what is particularly striking in the last few decades has been the rate at which debt has increased (relative to income). If debt is not new, neither is it a bad thing. Debt gives borrowers and savers alike additional options. The ability to lend and borrow is an important part of what enables us to enjoy the sort of life we do. To see the point, one has only to try to imagine a world without debt – a world in which entrepreneurs could not borrow to develop fast-growing firms, and where home ownership was restricted to the rich and the over-50s (who had saved the full price of a house). At a national level, the ability of one country’s citizens to borrow from those of another country means that regions that need a lot of new capital to develop (think of the United States or New Zealand in the late 19th century) can borrow from those with a lot of savings (think of the late 19th century United Kingdom). That has huge benefits. Public debt can serve important purposes too. Historically, many of the biggest increases in public debt occurred during wars; debt allowed the huge fiscal costs to be spread across time. Other big increases in public debt were used to fund the expansion of public infrastructure. More mundanely, the ability to borrow enables governments to buffer some of the macroeconomic effects of downturns. High debt and big swings in public and private debt have featured prominently in New Zealand’s modern economic history: BIS central bankers’ speeches • Central government debt was over 100 per cent of GDP for 70 years from the 1870s (and in excess of 200 per cent of GDP at peak). In 1972 net government debt was as low as 6 per cent of GDP, but was back to 50 per cent by 1992 (Figure 1). • Private debt data are not as readily available, but total mortgage debt – houses and farms – is estimated to have been around 140 per cent of GDP at the end of the 1920s. It is a little lower than that now, but as recently as 1990 the stock of mortgages was equal to only around 35 per cent of GDP (Figure 2). • Our net international investment position (the net amount of debt and equity raised from foreign lenders and investors) has gone through similarly wide fluctuations. We were very heavily dependent on international capital prior to World War II, but the net amount outstanding abroad dropped to perhaps as low as 5 per cent of GDP in the early 1970s. Over the 1970s and 1980s, the net reliance on foreign savings increased substantially, settling at levels that are high by international standards and seem uncomfortable (Figure 3). Over the last couple of decades the main New Zealand story has been about the substantial increase in private debt; taken on by farmers, non-farm businesses, and households alike. For most of the period, government debt was falling and our (net) reliance on international savings has not changed very much. Figure 1 Government debt* * From 1972, gross sovereign-issued debt and former core Crown net debt. Source: NZ Treasury, Statistics New Zealand BIS central bankers’ speeches Figure 2 Farm and housing mortgage debt Source: RBNZ, Statistics New Zealand Figure 3 Net international liabilities Source: Statistics New Zealand, Lane & Milesi-Ferretti (for pre-1989 NIIP data) Rapid growth in debt can foreshadow problems The phrase “all things in moderation” might well have been invented for debt. For individuals, circumstances differ hugely. Young people starting out in the housing market probably always will borrow a large proportion of the price of their first house, and a large amount relative to their current income. Such loans are risky for the individual borrower if BIS central bankers’ speeches something goes badly wrong. But for a well-managed bank (and for the economy as a whole) higher risk loans like those will typically be balanced with other loans which have gradually been being repaid for 20 or 30 years. For whole economies, “too much” debt can cause problems. But researchers are not really sure quite what is “too much” (among other things, measurement and institutional differences complicate things). Historically, a much better indicator to watch out for has been large increases in debt (relative to incomes) for several years in succession. As Reinhart and Rogoff have documented, financial crises are often followed by tough economic times. But even without a financial crisis, periods of rapid increases in debt tend to be followed by periods of economic stress – recessions that last longer and prove more troublesome than a “plain vanilla” recession, in which any lost output is recovered very quickly (New Zealand’s mild 1998 recession might have been an example of that sort of recession). There are good reasons why a large and rapid increase in debt (to GDP) seems to matter. Debt is not taken on in a vacuum. People are readier to take on debt when they are relatively more optimistic than usual about the future. Banks are keener than usual to lend when times feel good. And people make choices, re-organise their balance sheets and their spending patterns on the basis of that heightened optimism. Any number of factors, often at least a couple in combination, can result in a credit boom getting started. Countries’ experiences differ on that score, even in the most recent boom. But, typically, something causes spirits to lift, and with them spending and business activity. People become more willing to take the risk of buying a house or farm, of consuming more of their incomes than previously, or of expanding a business. Once credit is growing rapidly, the process tends, for a time at least, to be self-reinforcing. Easy credit tends to lift asset prices (strengthening expectations of further price increases), and people feel wealthier as a result. Experience tends to confirm people’s initial heightened sense of optimism. Expectations of future incomes are revised up and people make plans accordingly. In time, almost inevitably, people tend to be lulled into complacency about downside risks, and become over-optimistic about how long the good times will last. Towards the end, it is often the most optimistic borrowers and most optimistic lenders who are still readiest to borrow and lend. New Zealand’s credit boom was triggered by a number of factors among them the huge unexpected surge in immigration in 2002/03. Potential household borrowers found that jobs were easy to get, wages were rising quite rapidly, and business profits were good. Consumers felt more confident too, and were willing to spend. Population pressure and supply constraints meant that despite a high level of construction activity, house prices doubled. The boom in rural land (and growth in lending to farmers) was even bigger (Figure 4). When credit is growing rapidly, asset prices are rising, and turnover is high, businesses servicing the domestic economy find themselves doing well. They, in turn, invest to take advantage of what look then like sustainably better opportunities. Sustained booms also generate surprising amounts of tax revenue. In New Zealand’s case, as the boom went on, fiscal policy shifted to a substantially looser stance. That shift put more cash into the pockets of many, including families who might otherwise have found buying a house becoming just too expensive. BIS central bankers’ speeches Figure 4 Credit growth: the boom by sector (Dec 2001 = 100) Source: RBNZ But as booms go on, pressures build up on scarce resources, and policy interest rates tend to be raised to keep inflation in check. Optimistic borrowers shrug off rate rises for a while, but the burden of servicing the debt gradually, but inexorably, begins to mount. Marginal projects become harder to sell and prudent lenders get a little uneasy. Modern credit booms have also often tended to skew the economy, diverting resources away from the tradables sector towards the more domestically-oriented parts of the economy (construction, consumption and government spending). Productivity growth – the basis of sustained future income growth – tends to erode when that happens. The more leveraged a borrower is, the smaller the adverse change in circumstances that is needed for the loan to become a problem. Perhaps a firm’s sales growth slows or asset prices do not rise quite as much as had been expected, the risk of losing one’s job rises, it takes a little longer to fill vacancies in rental properties, or the servicing burden becomes just too heavy. By the peak of New Zealand’s boom, for example, many highly-leveraged owners of investment properties faced weekly outgoings (interest and other expenses) well in excess of rental income. Of course, the quality of the debt, and the purpose for which it is taken on, matter. New Zealand was probably fortunate that the small amount of very high risk lending was mostly undertaken by finance companies and other lenders who were outside our core banking system. But the nature of credit booms is that some of what initially looked to be good sound borrowing – whether to finance personal consumption or to undertake productive business investment – turns out not to be. That debt can then hang heavily: on the borrowers or (if borrowers fail to pay) the lenders. During credit and asset price booms, not everyone borrows. For every buyer of a higherpriced asset, there was a seller. And both probably felt good about the deal done in good times. Older people who managed to downsize and sell the family home or farm secured a larger retirement nest-egg. As a result, they can consume more for the rest of their lives. A downturn in house or farm prices does not directly affect them. But the people who optimistically paid a very high price for assets, and who borrowed to finance the purchase (or who perhaps drew down some of the apparent increase in equity in their existing home) are now stuck with the higher debt. Time cannot simply be turned backwards. Having belatedly BIS central bankers’ speeches realised that we had become over-optimistic, we cannot just go back to 2001. For better or worse, people have to live with, and work through, the consequences of past choices. That means many people have to reassess their plans, which typically means less spending and less investment. An atmosphere of caution takes hold, and affects everyone’s behaviour to some extent. For some it might just mean eating out less often, or cancelling an overseas holiday. Employers become more cautious about hiring, so those who lose their jobs face longer spells out of work. For some it might mean postponing retirement; for others delaying having (or cutting back the number of) children. On the other side, potential house buyers can now bide their time – no longer worrying about being priced out of the market if they wait a few more months or bid a little less aggressively. Lenders, quite rationally, become more cautious too: collateral values are not rising any longer, and many business borrowers find their cash-flows lagging behind what the banks had counted on. On the fiscal side, when times get tougher governments also have to revise their plans, reassessing the level of tax revenue they can count on, no longer putting substantially more new money into the economy each year. The flow of new programmes tails off; existing provisions are wound back and the private sector has to adjust to that change too. Adjusting after a credit boom During the last three years of the boom, private sector credit in New Zealand rose by around 14 per cent each year (Figure 5), when (nominal) GDP was rising at about 6 per cent. As we noted in our review of monetary policy, published recently in the Bulletin, we probably put less weight on this gap at the time than we should have, or than we would do today. And that last phase came after a decade or more when private debt as a share of GDP had already steadily and substantially increased: private sector credit was about 70 per cent of GDP in 1990 and was 160 per cent at peak in 2009. The end of the credit boom came rapidly: annual credit growth fell from 15 per cent to 2 per cent in only 18 months. Figure 5 Private sector credit* growth * Private sector credit to resident borrowers, excluding repos Source: RBNZ BIS central bankers’ speeches Figure 6 Public and private sector credit* *Private sector credit to residents, ex repos, and former core Crown net debt Source: RBNZ, Statistics New Zealand New Zealand’s credit growth was not so different from that in a variety of other countries. In one form or another, the United Kingdom, the United States, Australia, Spain, Denmark, Ireland and a swathe of other small OECD countries all saw historically large increases in private debt, and typically in asset prices too. The only major countries to avoid such booms were Japan and Germany. Japan, of course, was still adjusting to its own earlier private debt boom and bust. If we had been asked a decade ago about how New Zealand might have coped in the aftermath of a rapid build-up in debt and asset prices, we might have been relatively sanguine, especially if we had been told that the boom would end without a systemic banking crisis in either New Zealand or Australia. If asked, we would have talked in terms of a few years of relatively low actual growth, as the pressures on resources that had built up during the credit boom years dissipated. We would have looked towards a fall in the exchange rate, which would have raised both the cost of consumption and the returns to production. That, in turn, would have prompted productive resources to shift back towards the tradables sector. Consumer spending would no doubt have been expected to weaken but we would have expected materially stronger exports. That sort of view underpinned, and is reflected in, the economic projections we published in the years just before the global recession. In this, entirely conventional, textbook resource-switching story the economy would have emerged better-balanced. We would not have expected any material or sustained interruption in the incomes the economy could sustainably generate over time. If anything, the rate of potential GDP growth might have been expected to accelerate. In many ways, in fact, it was New Zealand’s story in the early 1990s, when we had had corporate and government debt excesses, and a financial crisis of our own, to work through. Then, markedly lower real interest rates and a lower exchange rate facilitated a step-up in economic growth, exports, and productivity. BIS central bankers’ speeches Over the longer term, the prosperity of a country and its people depends largely on the quality of the country’s institutions, and the product and market innovations which firms operating here can generate or draw on. The terms of trade – the value of what the world will pay for what we sell – also matters. Neither the quality of our institutions, nor the scope for generating or adopting innovative products and practices, should be materially adversely affected by an overhang of debt and somewhat overvalued house and farm prices. As just one stark example, the economic historian Alexander Field’s new book A Great Leap Forward demonstrates that, despite the grim American experience of the Great Depression, underlying total factor productivity growth remained strong through the 1930s, laying the foundations for renewed American prosperity in the post-war era. Sweden’s experience in the 1980s and 1990s is also widely cited. Household and corporate debt rose markedly in the boom years following liberalisation (though by less so than New Zealand and other countries experienced in the last decade). That culminated in a severe recession and banking crisis in the early 1990s. But a sharp fall in exchange rate in 1992, and a strong recovery in the rest of the world, underpinned a substantial rise in Swedish business investment and export incomes. A few years further on, the level of per capita GDP was right back at the trend level one might have expected to have seen if the crisis had never happened (Figure 7). In another example, Korea experienced a very large credit boom in the 1990s and then a severe financial and economic crisis in 1997/98. But per capita incomes were quite quickly back on the previous rapid growth path once the crisis passed (Figure 8). Figure 7 Sweden: per capita real GDP Source: Conference Board Total Economy Database BIS central bankers’ speeches Figure 8 Korea: per capita real GDP Source: Conference Board Total Economy Database Experience suggests that the aftermath of a debt and asset price boom need not materially hold back a country’s economic performance for long. But this time it looks as if the accumulated debt is, in fact, acting as quite a sustained drag, in New Zealand and other advanced economies. Figure 9 New Zealand: per capita real GDP Source: Statistics New Zealand, RBNZ BIS central bankers’ speeches In mid 2012, New Zealand’s GDP per capita is still around 3 per cent below its previous peak (reached back in December 2007). Even allowing for the froth at the peak of the boom (in the jargon, the output gap we think existed in 2007); if the growth rate of the previous decade or so been sustained, per capita GDP would now be substantially higher than it is (Figure 9). But there is nothing in our forecasts – or those of other agencies – to suggest we are likely to get back to previous trend any time soon. To do so by 2017, 10 years on from the peak of the last boom, New Zealand’s economy would have to grow by perhaps 5 per cent each and every year from here on. Perhaps it will happen, but it does not look very likely at this stage. Indeed, we recently revised down our view of New Zealand’s sustainable rate of growth. Looking at per capita GDP growth across countries since 2007, New Zealand’s growth appears to be around the middle of the pack: some advanced countries have done quite a lot better, and some considerably worse. Our experience on that count is not much different from that of the United States (and while we have done a little better on employment they have done better on productivity). In many countries, we have to deduce or infer an important role for debt, but in the United States, where much more detailed data are available, it is clear that the recent economic performance of states and counties where people took on relatively more debt has been worse than the economic performance in the rest of the country. There are, however, important differences. A crucial difference from, say, the American (or Spanish and Irish) experiences so far is that New Zealand house prices have not come down very much, or for very long. The Federal Reserve recently released data suggesting that median household wealth in the United States fell 40 per cent in the three years to 2010 – and was back to 1992 levels. Most of the drop in wealth resulted from a fall in house prices – and house prices in the United States had not risen as much those in New Zealand. Sharp falls in nominal house prices tend to be much more disruptive, especially to the financial system, than the same fall in real house prices that occurs gradually through a prolonged period of house price inflation running a little lower than general inflation. Another important difference is that the government’s debt as a share of GDP is still materially lower in New Zealand than in many advanced countries. Public debt here, and in most advanced countries, has increased substantially since 2008, but our starting point was so much lower than most. New Zealand avoided the sort of systemic financial crisis, and associated bank bailout costs, that has resulted in significant additional public debt being taken on in a growing number of countries. It is, however, widely accepted, here and abroad, that ongoing fiscal deficits are now mostly structural in nature. Authorities cannot just wait for time and normal economic recovery: only concrete policy choices will close the deficits, although of course there is lively debate as to just how rapidly that should be done. Factors that help explain the tepid recovery Why, then, are so many countries, even ones like New Zealand that avoided both a systemic financial crisis and the difficulties of a common currency area, still experiencing such a tepid recovery? We cannot be definitive but, in addition to the current idiosyncratic pressures in Europe, three factors seem to be at least part of the story: • First, the very widespread nature of the 2000s credit boom and the resulting overhang. Consider, by contrast, the experience after Japan’s credit and property boom in the 1980s. Many talk of Japan’s “lost decade” – but per capita GDP in Japan fell only slightly and briefly in the early 1990s, and its per capita growth and productivity (GDP per hour worked, or per person of working age) performance since the end of the boom far outstrips anything New Zealand or the United States (let alone the United Kingdom) have seen in the last few years (Figure 10). When Japan had to adjust, it was able to do so partly by exporting more. The world economy was performing strongly, and lots of borrowers in other countries were very ready to increase their own debts. When a single country experiences weak domestic demand, BIS central bankers’ speeches resources can switch relatively readily into sectors more reliant on external demand. But it is hard for that to happen in a large chunk of the advanced world all at the same time, especially when many of those countries cannot cut official interest rates further, given the effective near-zero bound on nominal interest rates. • Second, the sharp rise in New Zealand’s terms of trade in recent years appears to have complicated our adjustment. Such a lift in the terms of trade, if expected to last, would typically trigger an investment boom as firms in the tradable sector sought to take full advantage of the much-improved product prices and higher expected profits. The Australian investment boom of the last few years is an example. Nothing similar has happened here since the global recession. Whether that is because of the overhang of existing rural debt (and the illiquidity of the rural property market) or because the high terms of trade are not expected to last, or some other reason altogether, is not clear. But, for now, high export prices have tended to hold up the exchange rate, but private business investment, even in sectors benefiting directly from the high terms of trade, has remained subdued. • Third, there is the economic position of the advanced world as a whole relative to the emerging world as a whole. Once, fast-growing emerging countries ran balance of payments current account deficits and slower-growing advanced countries ran surpluses. That was as true of 19th century New Zealand and the United States as it was of 20th century Singapore and Korea. For the decade or more, the pattern has been the other way round. Many emerging economies, some globally significant, have been running large surpluses or even balanced current accounts, when one might reasonably have expected that they would be running deficits, and thus supporting demand in the rest of the world. That might have been tenable, and consistent with strong widespread global growth, while the West was in a position to run up public and private debt rapidly. But advanced economy debt already appears too high, especially against a backdrop of rapidly ageing populations. A more balanced pattern of global growth would be likely to provide medium-term benefits to all regions of the world. Figure 10 GDP per hour worked following credit booms* (1989 = 100 for Japan; 2007 = 100 for New Zealand and the United States) *Horizontal axis shows years before and after 1989 for Japan, and 2007 for New Zealand and the United States. In each case, GDP per hour worked is set equal to 100 in the base year. Source: Conference Board Total Economy Database, Statistics New Zealand BIS central bankers’ speeches Prospects for lower debt ratios Some of the big historical swings in domestic and external debt ratios New Zealand has experienced were highlighted earlier. There is nothing self-evidently permanent about the sorts of debt ratios we and other countries have seen in recent years. Indeed, there is good reason to think that over time debt to income ratios will fall back somewhat. But no one has a good sense of when or how much. History and theory offer no more than tentative pointers. For now, it is sobering that across whole economies, including New Zealand, debt to income ratios have still been edging up. In many countries, including New Zealand, private (business and household) debt to income ratios having fallen back a little – and that is typically what people have in mind when they talk about deleveraging. But the rising public debt has typically been at least offsetting any reduction in private debt ratios, and in New Zealand private debt itself is now growing at around the same rate that nominal GDP is increasing. (Of course, private and public debt are connected, although not tightly or mechanically. The private sector tends to respond to big government deficits by saving a little more than otherwise. In the same way, big government surpluses in the boom years probably led the private sector to save a bit less (and take on more debt) than it otherwise would have.) Debt to income ratios can fall, broadly, in three ways: bad debt write-offs; income growth; and by borrowers, in aggregate, making net repayments of their loans. In the United States, some of the (not insignificant) reduction in household debt to date has been in the form of bad debt write-offs. Those losses on housing lending have had obvious consequences for the financial sector. In New Zealand, there have been few significant losses on lending to households and, outside the finance company sector, total loan writeoffs have been relatively modest. Banks’ non-performing loans rose materially, but peaked at not much more than 2 per cent of total loans outstanding – well below the very substantial losses after 1987, in turn no doubt partly reflecting the much better quality of lending this time round. Most private lending is secured on property, so large loan losses tend to occur when there is both a substantial fall in property values and a high unemployment rate. In most areas, New Zealand property prices did not fall very much or for long. And painful as it is for those directly affected, New Zealand’s unemployment rate in the last few years has risen to only around the average for the last 25 years. Income growth is the most attractive path to lowering debt to income ratios. It has often been an important part of successful adjustments. But, so far, incomes are still well below previous expectations. Across the economy, most borrowers in the middle years of the last decade probably expected that incomes would keep rising reasonably fast – not to find that average real incomes have not grown at all since 2005. Faster sustained growth remains very attractive, if only we were able to achieve it. For New Zealand, it is difficult to envisage the sort of resource-switching that seems likely to be required occurring without a sustained fall in the (real) exchange rate. That, in turn, probably involves structural change in the real economy and some improvement in the international situation: it is certainly not something New Zealand monetary policy can bring about. What about prospects for net repayments of debt? Business credit rose rapidly during the boom, although in a more disciplined way than during the property and equity boom of the mid-late 1980s. The stock of this debt fell for a time after 2008, partly because during the recession a number of highly-indebted firms had no choice but to raise additional equity or sell assets to get their debt back to levels acceptable to their bankers. Looking ahead, if business savings (retained earnings) increased further, those savings might be devoted partly to repaying debt. But sustained growth is likely to require increased investment and that is more likely to require some additional external finance. As it is, non-property-related business lending once again appears to be rising at a reasonably healthy pace. A return to sustained fiscal surpluses will, over time, mean a fall in the level of net public debt. But as governments do not generate much of their own income, returning to surpluses, BIS central bankers’ speeches from the current position of significant structural deficits, involves some mix of discretionary spending cuts, or increased taxes. In the transition, either route will tend to reduce income in the hands of firms and households. And what about households? There is no simple single story. The very low level of activity in the housing market in recent years (Figure 11) has tended to dampen household debt slightly artificially. That happens because existing borrowers go on repaying their mortgages, but not much new debt is being taken on. But such low levels of turnover (and despite the recent rise, turnover is still very low by historical standards) and low house-building activity are not expected to continue. Sharply higher house prices were a significant channel through which household debt rose: young buyers had to take on a lot more debt to buy out older sellers who had taken on their debt when house prices were much lower. If house prices are not changing much now, the typical young new buyer will still be taking on more debt than the typical older sellers will have been repaying. But if real house prices were to fall over time, perhaps as the evident supply constraints were eased, that would be likely to lead to materially lower aggregate household debt to income ratios. Figure 11 House sales to population ratio (quarterly sales per thousand of population) Source: Real Estate Institute of New Zealand, Statistics New Zealand Higher household savings rates raise household wealth, but whether they alter gross household debt very much depends on who is doing the increased saving. For example, if people with large debts are now feeling overburdened then any increase in their savings will typically reduce the aggregate level of household debt. Many of the most indebted households are already quite cash-constrained. On the other hand, most households have little or no debt and if it is predominantly those people who are saving more, whether because the economic climate encourages greater caution or perhaps because lower interest rates (and lower expected asset returns more generally) makes building up adequate retirement savings a bigger challenge, household financial assets may rise, but with little observed change in household debt. Whatever the precise pattern, it seems likely that the experience of recent years will change the nature of conversations in New Zealand families. For decades, it has seemed attractive for households to borrow – first as a hedge against a couple of decades of high inflation, and BIS central bankers’ speeches more recently as real house prices rose more dramatically than at any time in our history. High inflation is a thing of the past. And a repeat of the house price boom not only seems unlikely but would be very damaging and risky if it were to occur. Few of us have the luxury of simply observing or waiting for history. Businesses and households face real spending and savings decisions each day and New Zealand’s economic performance in the next few years will depend in part on the way in which firms and household respond to the changing circumstances and risks, in a climate of considerable uncertainty. Implications for the Reserve Bank What does all this mean for us specifically as New Zealand’s central bank, charged with running monetary policy to maintain price stability and conducting prudential supervision to promote the soundness and efficiency of the financial system? When recessions happen, central banks typically cut policy interest rates quite a lot. In 2008/09 we cut the Official Cash Rate (OCR) by nearly six percentage points, more than almost any other central bank cut. But like most other central banks we have been surprised at the way policy rates have needed to, and been able to, remain so low for so long. We expected that most of the OCR cuts would be relatively short-lived, while the economy regained its footing. Financial market prices suggest that the private sector typically shared that sort of view. Two years ago, for example, we thought the OCR would be around 5.75 per cent by now (Figure 12). It is still 2.5 per cent, and financial markets have recently been toying with the idea that the OCR might yet need to go lower (albeit mainly because of global risks). Even our counterparts across the Tasman, dealing with Australia’s record terms of trade, have been cutting their policy rate back towards 2009 lows. It begins to look as though something is going on now that we have not seen before. It is still too early to know quite what the nature and scale of the change is, and how enduring it might be. Among the challenges policymakers face is getting a better understanding of why, given how weak GDP has been in many countries, there is not more excess capacity evident in our economies. Fortunately, few monetary policy decisions are set in stone: we get to review the OCR, in light of all the emerging data, murky as they often are, every six weeks or so. Figure 12 90-day interest rate projections Source: RBNZ estimates BIS central bankers’ speeches Wearing our other (financial stability) hat, we are conscious of the risks financial institutions (the lenders) face. On the one hand, our banks (and their Australian parents) are still heavily reliant on foreign wholesale funding (and, of course, more than half of New Zealand government bonds are also held by foreign lenders). Over the course of New Zealand’s history, dependence on foreign funding has repeatedly proved an Achilles heel. The position is less risky than it was in 2008, but the risks certainly have not disappeared. If anything, the climate for cross-border lending, and for wholesale funding of banking systems, is probably less favourable than it has been for decades. New Zealand banks are well-capitalised and credit risk is measured conservatively. The quality of New Zealand bank assets looks reasonably good, even in the face of some fairly demanding stress tests. But we will need to keep watching that situation closely, especially if incomes continue to lag behind what was expected when much of the debt was taken on. Our sense is that real house prices are still somewhat overvalued: they are certainly well above historical levels (Figure 13), and look expensive by international standards (relative to incomes or rents). If house prices were to fall, debt to asset ratios (the traditional measure of leverage) would worsen (as they have done in the United States), even if debt to income measures were still gradually falling. Figure 13 House price to rent ratio (1970=100) Source: OECD (to 2010Q3), QVNZ, Statistics New Zealand Farm debt grew very rapidly during the boom. Dairy farmers, for example, have taken on almost $20 billion of net new debt since 2003, and (real) farm prices are well above where they were. Banks have taken some significant losses on loans to the dairy sector over recent years: for some borrowers things did not turn out anywhere near as well as expected. In aggregate, the debt stock will probably be sustainable if commodity prices stay strong. But whatever the medium-term prospects, we know that commodity prices go through very big cycles. When product prices are very volatile, high leverage can be a recipe for a nerve- BIS central bankers’ speeches wracking ride for borrowers, lenders, and bank regulators alike. We have taken steps to require banks to hold more capital against rural loans than they were doing previously. Concluding comments Standing back from the details, five years on from the beginnings of the global crisis, the picture is still far from clear. Some things about dealing with debt have unfolded as expected: what cannot go on forever does not do so, and effortless adjustments after several years of rapid credit growth are rare. But other things have been less expected, not just here, but across the advanced economies. In particular, the persistently tepid recoveries remain a surprise. At present, none of the various hypotheses to explain what is going on seem fully adequate. The accumulation of debt within New Zealand itself, and the disappointed expectations of borrowers who paid very high prices for assets, is clearly playing some role in our low rates of growth of productivity and GDP. Quite how large that contribution is may be something economic historians still debate decades hence. But the global nature of the adjustment is clearly also an important part of the New Zealand story. Whatever the precise channels, as yet not much of the expected rebalancing of the New Zealand economy (particularly towards exports) seems to have happened. Perhaps this should not be too surprising in view of the persistently high real exchange rate, itself partly influenced by the adverse international climate. Looking ahead, we suspect that sustainable long-term ratios of household and farm debt, in particular, are likely to be below current levels. We also suspect that our net international investment position as a share of GDP (our net reliance on foreign debt and equity finance) will, in time, settle at a level lower than it has been for much of the last two decades (although a sustained improvement in our productivity prospects could, at least temporarily, mean a further increase in our use of foreign savings, to finance the investment needed to take advantage of the improved prospects). But it is also fair to note that we have suspected for a long time that New Zealand’s private and external debts were, in some sense, too high to be sustained. Towards the end of his term, the previous Governor Don Brash gave a thoughtful speech on debt issues in early 2002, in which he noted that New Zealand then looked as if it was dealing with the aftermath of a long accumulation of private and external debt and adjusting accordingly. The exchange rate, for example, had been quite low for a couple of years. But that period turned out to be just a pause before the latest and largest wave of borrowing and asset price growth. Some things make this time look different – in particular the wide range of countries undergoing similar experiences – but it pays to be cautious about drawing strong conclusions. Looking ahead, we will need to be open to revising our hypotheses as events unfold. History is littered with booms and busts, some of which seem to have gone on for a very long time. But these things pass. When New Zealanders today look at Australia’s prosperity, who remembers the searing financial and economic crisis Australia itself endured in the 1890s and early 1900s? Even severe overshoots in credit and asset prices, which can be costly and disruptive at the time, and which may permanently change the lives of some borrowers, are likely to throw our overall economic performance off course only temporarily. Our history, and the experience of other countries, attests to that. BIS central bankers’ speeches
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Speech by Mr Don Abel, Assistant Governor and Head of Operations of the Reserve Bank of New Zealand, and Mr Steve Gordon, Head of Risk Assessment and Assurance of the Reserve Bank of New Zealand, at the Oceania CACS 2012, Wellington, 10 September 2012.
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Don Abel: The economy, uncertainty and institutional response Speech by Mr Don Abel, Assistant Governor and Head of Operations of the Reserve Bank of New Zealand, and Mr Steve Gordon, Head of Risk Assessment and Assurance of the Reserve Bank of New Zealand, at the Oceania CACS 2012, Wellington, 10 September 2012. * * * The assistance of Bernard Hodgetts, Tim Ng and Mike Hannah in drafting this address is gratefully acknowledged. The events of the past decade have been extraordinary. Prior to the Global Financial Crisis (GFC) a western-based consensus, built around unfettered markets, in particular financial markets, allied with a commercial emphasis on the maximisation of shareholder value, dominated the evolution of developed economies. For many years this prescription seemed to work but some inherent flaws were revealed by the sudden collapse of financial markets in 2007–08 and the subsequent fall-out that we are continuing to experience today. To remind ourselves of what happened is to provide a basis on which lessons can be drawn to improve our collective futures. As risk managers you need to be aware of these lessons that may directly affect your institutions and which you can reference to calibrate your responses in these uncertain times. From the early 2000s there was a build-up in a number of troubling factors. First, from the early part of the decade onwards credit began expanding in numerous countries at double-digit annual rates. Much of the credit growth was to households and coincided with a rapid increase in house prices along with a significant increase in debt burdens within the household sector. At the same time, there was a significant deterioration in lending standards in many countries as financial institutions attempted to sustain the growth in credit. Second, financial risk management practices were adopted which, in hindsight, proved to be quite ill founded and based on a naive understanding of the underlying risks. The packaging of sub-prime loans into highly-rated residential mortgage backed securities in the United States, in an attempt to reduce risk through diversification, is the best example. When the United States housing market later weakened, investors holding these securities were exposed to risks they (and the agencies that had rated them) never thought existed. Third, underlying fiscal imbalances in many countries continued to worsen. Many governments ignored the reality of longer term fiscal pressures associated with ageing populations and growing income inequalities leading to increased health and social security spending. Later decisions to support economies and financial systems in the wake of the GFC would further stretch fiscal positions. Fourth, global imbalances were also continuing to worsen. While the causes of these imbalances are complex, the lack of fully flexible exchange rate regimes in some countries was undoubtedly an aggravating factor. Large and growing current account deficit countries in many western economies were mirrored by large and growing current account surpluses in other countries such as China. These surpluses then formed the basis for much of the financing of the debt-fuelled imbalances occurring in the western economies. Surprisingly many of these phenomena were largely ignored by policy makers, until it was too late to intervene. The financial institutions and rating agencies that were meant to monitor and price for risk proved to be more interested in short term profits and management bonuses. Governments were reluctant or unable to take the longer view in terms of their fiscal positions. The regulators in western developed economies displayed a notable BIS central bankers’ speeches reluctance to take action at an early point when it might have made a difference. In the end the inevitable financial crash occurred and governments around the World were left to pick up the pieces and the taxpayers the tab. What the financial collapse revealed was a world economy that was “seriously imbalanced”. On the one side stood the western developed economies whose societies had expanded debt, both private and public, to maintain and lift living standards. While, on the other, the newly emerging economies, benefiting from globalisation and the low cost production of manufactures, had recycled their earnings as savings to the western economies. For most of the 2000s this apparently mutual beneficial relationship persisted, but eventually it unravelled as a substantial part of the debt accumulated in the developed countries turned out to be unserviceable. The pressures of rapid growth in the developing countries were also becoming apparent. Oil prices started to rise rapidly from a low of around $20 a barrel in 2001 to a peak of $140 just prior to the GFC. Currently the price of oil is around $100 a barrel. This represents an ongoing weight on economic activity that did not exist at the opening of the 2000s, despite the fact that the World is in a period of low growth. There was also strong growth in non-oil commodity demand and prices. Hard commodities, like iron ore, coal and industrial metals were sucked into China and other East Asian economies to fuel industrial development and urbanisation. While soft commodities, like dairy products and meat, experienced substantial volume and price increases as the rapidly growing middle classes in the emerging countries, with rising incomes, shifted their eating preferences towards protein-based diets. The currencies of commodity producing nations became in-demand, appreciating in value as capital flowed into them, creating problems for import competing industries and, in some cases, exporters as well as the control of domestic monetary conditions. When the financial collapse occurred it was sudden, and sharp, and unprecedented in the post-Second World War era. Global financial institutions, big names, were wounded, some fatally, others less so. Some required bail-outs from governments. Financial markets were in turmoil, unable to distinguish between potentially “good” names and potentially “bad” names and, for a short period, the flow of money in the world economy practically stopped. Even small financial markets like in New Zealand were caught in this maelstrom. In concert with other governments around the World, we were forced to take action to safeguard our domestic-based financial institutions. The difference for New Zealand, though, was that the vast majority of the growth in financial assets was held on the balance sheets of the four large Australian owned banks. Rather than on-selling mortgages or transforming their risk through complex financial derivatives, New Zealand’s domestic banks had supplied plain-vanilla financial products and avoided an excessive leveraging of their capital. Furthermore, lending standards in New Zealand, at least within our banking system, had generally remained sound. But within parts of our non-bank deposit taking sector – most notably the finance companies – New Zealand experienced its own homegrown example of poor risk management, leading to considerable financial loss for many people. High risk loans made in areas like property development, financed from household deposits, proved to be an unsustainable combination when property markets turned down from around 2007 onwards. A lesson from the GFC for risk managers is that “innovative financial products” should be treated with a great deal of scepticism. Understanding where the true risks lie and how they could play out when economic fortunes change is paramount. Another lesson is that poorly managed risks may take years to be realised. The build up of risk on financial institutions’ balance sheets, which was uncovered by the GFC, was created over a number of preceding years. BIS central bankers’ speeches The current situation The New Zealand economy was not immune to the collapse in World financial markets. As credit growth and commodity prices tumbled, our GDP shrunk through 2008 and in the first half of 2009. But, by the second half of 2009, with commodity prices lifting again, modest growth resumed in the order of 2% per annum. Banks, which had relied heavily on short-term wholesale funding from offshore during the boom, found funding harder and more expensive to obtain. The situation was gradually alleviated following the introduction of a government guarantee for wholesale debt and as funding markets reopened in early 2010. The downturn associated with the GFC, nevertheless, had more long-lasting effects for our businesses and households as inflated property prices were punctured. As noted earlier, many non-bank financial institutions failed with depositors suffering great loss. And, with a high degree of uncertainty about the future, businesses and households preferred to be conservative, reducing debt and spending and avoiding future commitments. The government sector, on the other hand, faced a prospect of accumulating debt as tax revenues fell and spending demands increased. In the space of five years from 2008 the fiscal deficit as a percent of GDP moved from a positive 3% to a negative 4%. In comparison, the shift to increasing household saving can be traced in Figure 1 with the ratio of saving to disposable income changing from a substantially negative position in 2003 to a slightly positive one today. Figure 1 Household saving to disposable income ratio Source: Statistics NZ Into this mix another completely unanticipated event fell. The Canterbury earthquakes, centred on the second largest city in New Zealand – Christchurch – caused a catastrophic loss of life, property and infrastructure. BIS central bankers’ speeches To rebuild Christchurch will cost at the very least $20 billion. While the impetus to the regional economy of Canterbury will be very large, this spending represents a replacement of damaged buildings and infrastructure, not a net gain to national wealth. And, the extent to which the cost is not covered by insurance, it results in a further need for fiscal consolidation at the central government level and increased property rates at the local, Canterbury, body level. In addition, overseas reinsurers are now acutely aware of natural disasters and the cost of property insurance for all New Zealanders has risen across the country with Christchurch and Wellington being especially impacted. Medium term influences As the governments of developed countries in the western hemisphere struggled to deal with the consequences of the GFC, their spending and borrowing ballooned causing fiscal deficits to rise at pace. The central banks in these countries also had a role to play by reducing policy interest rates close to zero – “the lower bound” – and embarking on programmes that substantially expanded their monetary bases (quantitative easing) in an attempt to push up domestic demand while depreciating their currencies. Despite these unprecedented interventions economic recovery in Europe, the United Kingdom and the United States has remained stubbornly subdued. This can best be illustrated by comparing the current path of the recovery in the United States with previous recoveries in the post-war period (Figure 2). Figure 2 Path of real GDP since end of recession GDP Index GDP Index Unemployment in many of these countries has lifted sharply and, of particular concern is the high level being recorded amongst young people. In Greece and Spain, for example, the rate of unemployment for those under 25 years of age has risen to around 50%. To put this in perspective, the comparable number in New Zealand is 12% (Figure 3). BIS central bankers’ speeches Figure 3 Unemployment rate: Under 25 (SA, %) The social and political ramifications of these levels of unemployment in the Eurozone are considerable and weigh heavily on the economic policies that governments are able to pursue. CPI inflation in the western economies, on the other hand, is largely stable at around 2% and the far more pressing financial issue facing these countries has been the build-up in sovereign debt. As can be seen from Figure 4 a number of European nations, the United Kingdom and the United States all have levels of debt in excess of 50% of GDP. The sovereign debt crisis has become critical in the Eurozone as the southern, peripheral states of Greece, Portugal, Italy and Spain have struggled to implement domestic economic austerity and structural reform policies aimed to placate financial markets and reduce their debt and borrowing costs. Their individual ability to trade their way to stability and growth has been circumscribed by membership of the Eurozone and consequent adoption of the Euro currency. For at least the past year, the World has watched, in a combination of concern and fascination, as Eurozone governments and the IMF have moved from one crisis meeting to another in the hope of finding a solution that will maintain the integrity of the European bloc but also the economies of the constituent sovereign states. At this point it is not at all clear how the crisis will resolve. What is evident is that the Eurozone as a whole is falling into recession with the weaker southern states pulling the stronger northern states down. While countries within the European bloc undertake much of their trade with each other, lower growth overall is having a dampening effect on World output more generally. BIS central bankers’ speeches Figure 4 Sovereign debt Austerity measures are also being pursued in the United Kingdom and the United States. Tightened government spending in combination with restrained business sector investment and household consumption and investment – housing – has meant these economies respectively are not growing or growing only slowly. In the case of the United States the situation is complicated by the November presidential election which has the effect of postponing difficult decisions, in particular how to deal with the impending “fiscal cliff” of expiring tax cuts and increased spending cuts. Together these two policy measures if fully engaged would be likely to push the United States back into recession. New Zealand’s future, however, now resides firmly in the economies of Australia, China and East Asia. This grouping (excluding Japan) today accounts for 49% of our trade compared with 39% a decade ago. And it is this grouping that is experiencing growth rates of 5–6% per annum. Our problem is that Australia is dependent on China while China and East Asia have ties to the fortunes of the rest of the World. The question is to what extent will growth in the Asian economies be affected by developments in the West? China’s high rate of growth, averaging close to 10% per annum over the past decade, has been driven by exports and high levels of investment in infrastructure and housing. Neighbouring East Asian economies have benefited by supplying intermediate goods to Chinese manufacturers. There is no doubt that the low activity now being experienced by the western developed economies will slow expansion in China and East Asia but this seems more likely, perhaps optimistically, to be a relative deceleration rather than a plunge towards outright recession. There is still a lot of scope for China to increase efficiency and productivity as well as investment and its levels of urbanisation and consumption have the potential to expand considerably. What can be assumed reasonably is that the prospects for China over the next 4–5 years will be considerably better than for the Eurozone, United Kingdom and United States. Within New Zealand the path of recovery from the Canterbury earthquakes has been a matter fraught with great difficulties and much heartache. Nobody anticipated the frequency and severity of the aftershocks that accompanied the February 2011 event. The scale of the BIS central bankers’ speeches disaster has been enormous and only now as the aftershocks seemed to have dissipated does it appear that rebuilding can begin in earnest. The earlier forecasts of a relatively quick recovery can be seen to have been quite unrealistic as the detail of land use planning, sorting through insurance disputes, coordinating competing interests, providing logistical support and resources has taken over. The path for rebuilding, based on the most recent information available, suggests that activity will start to ramp up from the end of this year, accelerating through 2013 and 2014 before reaching a peak in 2015. Degrees of uncertainty Right now the uncertainties faced by decision-makers are unusually diverse and numerous. The World is in the process of transiting to a new order of economic reality, the dimensions of which are difficult to map with any certainty. What is clear, nevertheless, is that choices for policy makers, business leaders and householders can no longer be based on a simple assumption of brisk growth resuming as before and that the economies of the western hemisphere will be in a position to direct economic policy and growth ad infinitum. With the rapid development of the Asian bloc and India, combined with a lack of access to easily recoverable energy supplies as well as political instability in the Arab states, the World is having to adjust to an environment of high and on-going energy costs. A new easily exploitable resource might be discovered, with a consequent reduction in prices, but this remains an uncertain prospect and definitely not one on which to base business decisions. The western developed economies, in particular, face multiple challenges and the degree to which these will be overcome in the next five years is far from clear. The volatility seen in financial and equity markets is a symptom of this uncertainty currently most obvious in the responses to the Eurozone crisis. Structures, previously thought inviolable, such as the Euro currency, are now recognised to be vulnerable. In the banking and finance sectors regulators are tightening standards, imposing new capital requirements and introducing new macro-prudential tools to assist in maintaining the stability of financial systems and the control of credit creation. Fiscal policy is dominated by a desire to reduce sovereign debt by increasing government savings. On the one side financial markets need to be reassured that governments are able to act responsibly and implement sound, long term, economic policies to promote economic growth, while, on the other, the voting public have to be convinced that the lengthy period of restrained growth that typically accompanies structural reform and fiscal austerity is in their best long term interest. In these highly uncertain times households themselves act to restrain growth by increasing savings and reducing spending. Obtaining the right balance between these factors will largely determine the direction of the western economies with a positive outcome being sustained ultimately by the return of business and consumer confidence leading to investment and productivity growth. Similar forces can be seen at play in the New Zealand economy. The difference being that the imbalances and structural issues here are not nearly as deep-seated as in many of the western economies. Furthermore, New Zealand has been fortunate to be placed geographically in the eastern part of the Pacific primarily selling soft commodities that are now experiencing increasing demand from Asian trading partners who continue to experience relatively good growth. The Canterbury earthquakes have proved to be an additional test of resilience for the country and although insurance will cover the majority of the cost of recovery, the process of rebuilding will take much longer than originally thought and may well cost more than currently forecast. The impact of these events on the provision and cost of insurance is now becoming apparent and is reflective of a general review of the insurance cover for natural disasters world-wide. The frequency and intensity of these types of events seems to be on a rising trend creating further management challenges for private and public enterprises. BIS central bankers’ speeches Institutional response Institutional language is now coloured by words such as austerity, crisis, collapse, disaster response, instability, volatility, vulnerability and, above all, uncertainty. The GFC exposed the weaknesses of risk management to the World and especially the inadequacy of institutions that allowed their risk management practices to be subverted by the drive for short term profitability. Many of these institutions no longer exist and if they do, not in a form they would have recognised prior to the GFC. The irony is that despite its lack of strength in the decades building up to the GFC and its ultimate failure, risk management remains absolutely critical to the success of institutions. Furthermore, the incidence of risk means that the enterprise needs to take a long run view of its business not a myopic, short run, approach. Which is a good thing if it helps to make the business operating environment more stable. The issues outlined earlier in this paper reveal the complexities that private and public enterprises will need to navigate in the future. Possession of a metaphorical radar, capable of identifying obstacles both near and far, should be second-nature to those leading and managing the enterprise. In the current climate effective risk management aligns very closely to the theme of your conference: “Embracing uncertainty and delivering value in turbulent times”. As risk professionals you must systematically identify the key areas of risk for your institution and develop a built-in resilience and ability to respond to whatever happens. Anticipation and not the “ambulance at the bottom of the cliff” is required. In Table 1 some key risks are set out. Your challenge is to interpret these macro developments and translate them into tangible business meaning. Table 1 Areas of Focus Risk Themes Key Points and Area of Focus Global economic and political • • • • • • High and volatile energy costs Sovereign debt and austerity issues Fragility and interconnectedness of the financial system Eurozone developments Credit, funding and liquidity conditions Rising influence of Asia Domestic landscape • • • • • Growth Household and business spending Exchange rate developments Property prices Agriculture sector Environmental • • Natural disaster preparedness Business continuity planning Information technology • • Significant dependency on technology High impact risk area Operational risk • • Change and uncertainty increase operational risk Operational risk is pervasive and relates to many other risks that materialise BIS central bankers’ speeches The first group relate to global economic growth and relevant questions for decision-makers, who have the ultimate responsibility to mitigate risks, are what does this mean for product demand and prices, cost of production, transport and supply of goods and services? Actually these questions are fundamental to how institutions are run. What is being suggested here is that a bit more thought is given to how events might deviate from what is perceived to be “normal”; what steps should be taken in settled times to ensure the future of the enterprise and through doing so the wider role it plays in society. In our globalised and wired environment the speed at which information is transmitted would suggest that no one should be surprised at the consequences of a collapse of steel prices in China or a deep liquidity crisis in european funding markets. The point in question is to what extent have these types of events been imagined and planned for, sorting the “sheep from the goats”. Tools such as stress testing and scenario analysis, if rigorously deployed, can provide valuable insight into the uncertain future and assist in preparing the institution to deal with an existential crisis that may arise. In terms of the Bank, as you would expect, considerable effort is placed on monitoring and assessing all financial risks as these are of high relevance to monetary policy, our prudential and supervisory responsibilities as well as the management of our $27 billion balance sheet. The second area noted in Table 1, which is inextricably linked to the first, is the domestic landscape. Growth has been modest and confidence somewhat repressed and there are no imminent signs of a sudden or material positive change to this pattern. In this setting, where there are limitations as well as opportunities, businesses will need to be astute in reading the emerging trends and, in doing so, identifying the risks associated with fulfilling their particular business objectives. The next area of focus shown in Table 1 is described as environmental. The Canterbury earthquakes served as an unwanted illustration of the power to literally shift the ground on which institutions stood and planned their activities. The consequences are now playing out across many levels, including the fact that the insurance industry was poorly prepared to deal with such a cataclysmic event. Business continuity planning should be well within the frame for risk professionals. Possessing a clear understanding of critical business processes and having made the capital and human investment required to be able to continue operations in the event of a disaster is simply good management. In February 2011 the Bank established a small satellite office in Auckland so that the time critical aspects of our business, such as the support of financial market liquidity and payment systems, could continue if Wellington was shutdown in a regional disaster. Recently a small internal flood on the Wellington site meant the building had to be evacuated and operations were carried out successfully in Auckland for the best part of a day. Information technology risk is an area that, no doubt, many of you will be very familiar with. Reliance on technology is immense and consequently the risks inherent in the loss of integrity or availability of systems is severe for most enterprises. Consumers and businesses depend on these systems to operate effectively on a minute by minute, day by day, basis. The potential business loss and reputational risks in not being able to deliver services are considerable and it is surprising that some businesses continue to be parsimonious when it comes to providing sound back-up systems. Of course when it all falls apart they come to central government for help – which in my eyes is as good a measure of managerial recklessness as any other. The Bank acts as banker to the commercial banks, providing inter-bank settlement facilities and related payment services, so we are acutely aware of our responsibilities in the operation of the New Zealand financial system. Over the past decade we have invested $13m in upgrading and improving our payments infrastructure. As you would expect, across both the audit and corporate risk functions at the Bank, payment system assurance is given considerable focus and is subject to close monitoring. BIS central bankers’ speeches Operational risk is the final area over which a close watch should be maintained. This risk relates to failures by staff and break-downs in processes, facilities and equipment in daily activities. Operational risk is pervasive across all business processes and, in fact, can be the root cause of a wide range of incidents that disrupt or impede the meeting of objectives. With increasing change and complexity as well as uncertainty, operational risk inherently grows. Mistakes and errors are more likely and institutions need sound policies to reduce both the underlying likelihood and impact. Operational risk management is quite process oriented and is therefore one area within which businesses can focus on continuous improvement. Incident capture, causal analysis and applying lessons learned from an operational risk event can serve to strengthen the wider business environment. At the Bank we have a system called Proactive Problem Management to serve this purpose. It has been in place for over a decade and it is not about attributing blame but about improving how we do things. It entails line management reporting of incidents and, with the assistance of the central risk management function, finding ways to remediate the situation and, in some circumstances, identifying any wider systemic patterns that may be of relevance. Although the Bank’s Head of Risk reports directly to me, he has an indirect reporting line to the Governor and, with his team and me in attendance, meets with the Governor formally once a month. He also has an independent meeting with the Chairman of the Board Audit Committee at least once a year. He has ample opportunity to talk directly with the Governor or the Chairman of the Board Audit Committee if he feels that is required. Currently we are refreshing our risk model and have developed an embedded enterprise risk management lead community through all of our business units. These people work with the Heads of Departments to identify, assess and manage the business risks. The model is enterprise driven in that it aligns risks to departmental objectives in a context of the over-riding governing mandate for the Bank: the Reserve Bank Act. The model also includes major projects and smaller initiatives and actions that relate to specific risks. By doing so it provides an insight into active risk management mitigations that are underway giving a level of validation as to how resource is being directed towards certain risk areas. Conclusions The first half of this paper outlined the extraordinary events that have buffeted the World since the onset of the Global Financial Crisis. As noted earlier there was an inevitability about the financial crash. From a debt perspective western economies had become seriously bloated, and in the absence of any countering force, there was always going to be a day of reckoning as banks in many developed countries fed an insatiable appetite for credit in the pursuit of short term gain. Better regulation and policy interventions in the future may help to stabilise markets by aiming to reduce excessive and risk-laden decisions. But ultimately it is the people involved in the key roles of institutions that largely determine the future of their enterprises. Accountability, honesty, responsibility; these sorts of well founded values must be present in the culture of institutions if they are to survive in a rapidly evolving and highly uncertain environment. Risk experts are integral to this process and need to hold true to professional and personal values that instinctively drive judgement and consequent actions in the workplace. As skilled practitioners you should know the points at which proposed courses of action are misaligned to business goals in the broadest sense which include the enterprises’ responsibilities to the wider community. In good institutions there will be sound frameworks and governance protocols to address misalignments and the risk function has the important job of influencing and leading others to make the right decisions. BIS central bankers’ speeches Uncertainty is a part of life and, indeed, can make life exciting, if not overdone. But Reserve Bank governors generally prefer “boring” and our Governor has been no exception, saying so on a number of occasions. Unfortunately the past five years and the immediate future will certainly not meet that preference. By accepting uncertainty and looking for explanations of what is happening, you should be able to assist your institutions towards strategies that respond to the unusual pressures that we currently face. Delivering value in these turbulent times should be second-nature to risk managers. BIS central bankers’ speeches
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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Admirals' Breakfast Club, Auckland, 26 October 2012.
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Graeme Wheeler: Central banking in a post-crisis world Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Admirals’ Breakfast Club, Auckland, 26 October 2012. * (I) * * New Zealand’s vulnerability in international markets In “Les Miserables”, Victor Hugo wrote of the vulnerability of a little black cat. “We all know the habit of cats of hesitating in an open doorway – hovering uncertainly at the risk of being crushed by the closing of the door.” New Zealand shares this sense of vulnerability. We are a small economy – around four and a half million people in a world of seven billion, producing output roughly three-quarters of that of Queensland. Our vulnerability is increased by our habit of not saving enough for our investment needs, resulting in a large accumulation of foreign debt. Yet, we face the world with tremendous assets. The World Bank suggests that on a per capita basis, New Zealand is ranked eighth for natural capital (pastoral and crop land, forest resources and subsoil etc) with only oil producing countries ahead of it. We lead the world in renewable natural resource related capital. OECD comparisons of high school student attainment place us seventh among 71 countries. Transparency International considers New Zealand the least corrupt country in the world, and the World Economic Forum ranks New Zealand among the best for the quality of its institutions, and the efficiency of its product markets and its financial markets. With these assets we should be capable of stronger economic growth. Internationally, and particularly in smaller economies, economic growth is driven by the private sector and its ability to compete on global markets. We need to reverse the slowdown in multifactor productivity growth since 2005 and the decline in value added in our tradables sector. And we need to reverse the shift of resources into the public sector and other non-traded activities. Our economy is continually buffeted by external shocks. Some are natural events, like the catastrophic series of Christchurch earthquakes that represent the sixth largest global insurance payout ever. Others reflect tectonic shifts in the global economy. These include the rapidly growing importance of East and South Asia in international trade and investment, the rising global demand for commodities, and the changing global saving and investment patterns associated with the expanding middle class in developing economies and demographic aging in the western economies and Japan. The integration of financial markets, reduction in trade barriers, and global diffusion of skill enhancing technologies, and especially information technologies, mean that economic shocks are transmitted more rapidly across the globe and business cycles become more synchronised. Overlaying these structural shifts are enormous economic adjustments flowing from the global financial crisis. Household balance sheets, especially for the lower and middle income classes, have been severely damaged in the US and large parts of Western Europe. This process of deleveraging debt and rebuilding wealth is likely to take several more years. For example, the Federal Reserve reports that median real net household wealth in the U.S. fell 39 percent from 2007 to 2010 to levels last seen in 1992. In 2011, the median real level of US household income dropped to its lowest level since 1995. In many countries, the banking and commercial real estate sectors are still contracting, and the indebtedness of the banking sector in the Euro Area remains very high. Tensions remain around large current account imbalances, exchange rate pressures, slow growth, and high unemployment. Across much of the developed world, as in New Zealand, real incomes per capita have yet to recover to 2007 levels. BIS central bankers’ speeches The world is very different from the heady days of 2003 – 2007 when the global economy grew at its fastest rate in four decades and international fora debated whether the growth dynamics of the emerging economies were becoming decoupled from the industrialised world. No-one believed that the banking system could fail in a G7 economy – let alone a group of G7 economies. Nor did they contemplate how rapidly fiscal positions could be overwhelmed by lower tax revenues and pressures on governments to become investors and guarantors of last resort – in areas well beyond their traditional investor habitat and risk tolerance. We are in new territory for central banking. For the past three to four years policy rates in the U.S., the Euro Area and in many other countries have been at historic lows, some short-term government securities markets are returning negative yields, and the Bank of International Settlements reports that the volume of central bank assets in the advanced countries – itself largely a result of massive liquidity injections – expanded to 25% of GDP, double the ratio of 2007. Forward curves and forward guidance by the major central banks suggest that interest rates will remain at historic lows for at least another two to three years. These policy settings are unprecedented. The challenge will be to transition to more normal monetary conditions before high rates of inflation and widespread escalation in asset prices are generated. We have already seen bull markets in commodities, gold, and fixed income markets, and a rapid contraction in credit spreads in emerging markets and high yield debt as investors search for higher returns. With this international backdrop, and with internal debate over New Zealand’s economic prospects, there has been public commentary on the appropriate goals for the Reserve Bank. This includes suggestions that the Reserve Bank should tolerate higher inflation, give greater emphasis to economic growth and unemployment, target nominal income, or the exchange rate, or interest rates, and apply loan to value limits to contain the Auckland housing market. I will explore some of these issues. (II) The importance of price stability and an efficient and stable financial system Price stability and financial stability remain the Reserve Bank’s central objectives for monetary policy and prudential policy. These provide the best framework for achieving stronger growth in output and employment in the longer term. Price stability enables households, businesses, and governments to plan with greater certainty; it facilitates long term contracting; lowers the inflation risk premia embedded in interest rates; and enables producers, consumers, and investors to respond to opportunities created by changing relative prices rather than diverting resources to hedge against inflation. The recent Policy Targets Agreement (PTA) reinforces the importance of price stability and introduces the goal of keeping future average CPI inflation near the 2 percent target mid-point of the 1 percent to 3 percent range. Over time, attaining this outcome should help to anchor inflation expectations around the mid-point. Deep, efficient and well-regulated financial markets facilitate economic growth by helping to channel funds to their most productive uses and to allocate risk where it can best be borne. Where economic policies and regulatory structures are sound and conducive to competition, financial markets can enhance productivity and create opportunities for saving, accessing credit, and buffering people against difficult times. Over the past four years the world has again witnessed the destructive power of dysfunctional financial markets. Financial sector instability can arise from many sources, including unrealistic expectations as to the sustainability of future yields on financial assets, excessive risk taking by investors, poorly designed macro-economic and regulatory policies, and through regional or global contagion from failures in offshore financial systems. The importance of a stable and well-functioning financial system is also recognised in the PTA with its emphasis on the need to monitor asset prices and to have regard to the BIS central bankers’ speeches efficiency and soundness of the financial system. Prior to the global financial crisis the debate in central banking circles had been how hard should monetary policy lean against asset bubbles in order to diminish the spill-over of “wealth effects” into excessive demand growth and inflation. While these spill-overs will continue to be an important policy consideration during buoyant asset markets, central bankers and fiscal authorities are now much more conscious of the deflationary impact of collapsing asset prices and the deleveraging it triggers, particularly if the banking system is put at risk and governments are called on for bailouts. For these reasons the Reserve Bank has placed a high priority on strengthening New Zealand’s prudential regime, including introducing macro-prudential instruments and having an open bank resolution capability in place. Macro-prudential instruments are being developed in many countries and in our case we are focusing on instruments such as the core funding ratio, the counter-cyclical capital buffer, adjustments to sectoral risk weights, and housing loan-to-value ratio limits. These instruments are expected to reinforce the overall tougher approach to prudential regulation and supervision under the new Basel III regime. We need to ensure that we have well governed and well capitalised financial institutions, with strong funding and liquidity buffers, and sound risk management practices. Although macro-prudential instruments are likely to be used infrequently, they will provide additional buffers to the financial system that vary with the macro-credit cycle. Their purpose is to help maintain a sound and efficient financial system, but in most instances the instruments will also reinforce the stance of monetary policy. A Memorandum of Understanding between the Minister of Finance and the Governor of the Reserve Bank is currently being discussed with the Treasury. It will confirm the guidelines under which the Bank should operate macro-prudential instruments in “promoting the maintenance of a sound and efficient financial system”. It will also outline the consultation processes with the Minister and the Treasury if macro-prudential intervention is under consideration, and prior to any decision to deploy macro-prudential policy instruments. Maintaining financial stability requires mechanisms to manage financial distress. Open Bank Resolution (OBR) will enable a distressed bank to continue operating, while placing the cost of the bank’s failure on the bank’s shareholders and creditors, rather than taxpayers. Although bank failures in New Zealand are very rare, OBR will provide the Government with a real alternative to bailout. It will reduce the risks of moral hazard, and strengthen the incentives for banks to operate prudently and to pursue private sector solutions in the event of crisis. The Reserve Bank is working with banks to ensure that OBR is a live option by 30 June 2013. We are also reviewing other financial institutions as part of our prudential oversight responsibilities. This includes working with over 100 insurers in New Zealand to ensure that they meet the Reserve Bank’s new licensing standards by 7 September 2013. We are also working to establish a licensing framework for around 60 non-bank deposit takers that we currently regulate. (III) Quantitative easing, targeting growth and the exchange rate Pursuing price stability and using our prudential powers to promote financial system stability and efficiency, are the greatest contributions that the Reserve Bank can make to fostering New Zealand’s long term economic growth. We do not see any reason to adopt quantitative easing in New Zealand. Quantitative easing is being adopted by central banks that have little or no scope to lower interest rates in economies experiencing major deleveraging, and where deep concerns exist about generating and sustaining economic growth. It is a sign of desperate times for central banks, who in some instances are shouldering the burden of domestic policy paralysis over fiscal policy. Since the onset of the global financial crisis, the Federal Reserve has expanded its balance sheet by 13 percent of GDP, the European Central Bank by 16 percent of GDP, the Bank of Japan by 10 percent of GDP, and the Bank BIS central bankers’ speeches of England by around 20 percent of GDP. In all four cases the official cash rate is 0.75 percent or less. In all four cases there is little evidence of any appreciable impact on economic growth. New Zealand is in a very different situation. Our economy is growing at an annual rate of around 2 percent and the Reserve Bank has scope to lower interest rates if needed. While annual CPI inflation has fallen to 0.8 percent, we expect inflation to head back towards the mid-point of the target range. We will continue to monitor inflation indicators, such as pricing intention and inflation expectation data, closely over the coming months as stronger residential investment gets into full swing. We do not see scope for directing monetary policy to achieve target rates of economic growth. This lies beyond the capability of monetary policy. Trend rates of economic growth depend largely on the quantity and quality of human capital and the amount and productivity of the capital that labour has to work with. But, we do examine the state of the economy very closely when setting monetary policy. We study a range of economic indicators such as building and manufacturing activity, measures of capacity, conditions in the labour market, trends in competitiveness, and forward indicators of orders and investment intentions. Doing so enables us to get a better feel for the pressures on resources and to assess whether there is scope to support stronger growth in demand while achieving our inflation objectives. There is considerable public debate on the exchange rate. Several external commentators, such as the International Monetary Fund (IMF), suggest that the exchange rate is over-valued in terms of economic fundamentals. Some of the strength in our exchange rate is a reflection of the weakness of the US dollar. On a bilateral basis the New Zealand dollar is especially strong against the US dollar, Euro and Sterling. Against the Australian dollar, it has tracked slightly below average. Ultimately, it is the relative rates of return between New Zealand and the rest of the world that explains the strength of the New Zealand dollar. These returns reflect developments in the economy and international demand for our products and services. Over the longer haul the dollar is very strongly correlated with measures of the terms of trade or commodity prices, and much of the strength of the New Zealand dollar is due to our terms of trade being close to a 40 year high. Exchange rate movements can also reflect differences in growth rates between economies, differences in interest rates, perceptions of safe havens, and fluctuations in investor risk appetite. New Zealand is not alone in experiencing upward pressure on its exchange rate. Several commodity producing countries, and countries with stronger growth rates and positive interest rate differentials compared to the U.S. and Euro Area, have experienced substantial currency appreciation since the global financial crisis. The appreciation in our exchange rate has affected the tradables sector of the economy. Manufactured export volumes, although growing at around 3 percent a year since the global financial crisis, are lower than they would otherwise be; investment in industries such as tourism has declined; and the profitability and output of import competing industries is reduced. On the other hand, resources shifted to the more sheltered and less competitive non-tradables sector where producers find it easier to raise prices. The high exchange rate does however, generate some important benefits to the economy. Consumers and producers benefit from lower import prices, and interest rates are lower than would otherwise be the case. The Reserve Bank wishes to see a lower exchange rate provided it can be achieved without damaging price stability and financial stability. In the wake of the global financial crisis, institutions such as the IMF, are reviewing the scope for managing capital flows. Capital controls may be appropriate in some circumstances, perhaps to mitigate problems arising from temporary surges in capital inflows in economies with weak financial sectors. For a debtor country like New Zealand, an open capital account is essential. Introducing capital controls, instead of making the necessary adjustments, would damage the credibility and BIS central bankers’ speeches stability of New Zealand’s financial sector, and increase the real cost of capital for New Zealand. Reducing interest rates can at times reduce pressure on the exchange rate but analysis of past OCR cuts in New Zealand shows on average minimal or no intra-day impact on the exchange rate, and even less impact on a weekly basis. Analysis of “unexpected” OCR changes with Trade Weighted Index changes following a rate decision still does not show a strong relationship to subsequent movements in the exchange rate. This reinforces the idea that the exchange rate primarily reflects returns in the broader economy rather than simply returns in the money market. We set the OCR such that the inflation outlook remains consistent with the PTA and the financial markets understand this. If we reduced the OCR without sound reasons the exchange rate might drop initially but rise later when the inflationary implications of the rate cut became clear, especially if the belief was formed in the meantime that the central bank’s commitment to price stability was wavering. Foreign currency intervention is unlikely to have a sustained impact on the New Zealand dollar, but can have an impact in the short term if the Reserve Bank makes the right calls about the exchange rate departing from fundamentals. The Reserve Bank has four criteria to assess whether intervention should be undertaken. These are: whether the exchange rate is exceptional relative to history; is the exchange rate justified; would intervention be consistent with the PTA; and whether the market conditions exist to successfully shift the value of the currency. Even if the first three criteria are satisfied at a point in time, it makes little sense to risk incurring losses to taxpayers by intervening when currency flows supporting the New Zealand dollar are particularly strong. But we will remain vigilant on these criteria and will be prepared to intervene if all conditions are met. So there are clear limits to what monetary policy and exchange rate intervention can do to lower the New Zealand dollar. In order to achieve a sustained reduction in the New Zealand dollar it would be necessary to alter the overall level and pattern of saving and investment in the economy. In particular, it will be necessary to tackle our addiction of depending on foreign savings to finance our consumption and investment. This dependency means that we have persistently needed interest rates above those in most developed economies to maintain inflation at target levels similar to those being followed elsewhere. Policies that increase domestic savings, including reducing the government’s fiscal deficit, and to reduce the flow of resources into the public sector and other non-tradables sectors, would help to achieve a sustainable reduction in the exchange rate. (IV) Concluding comments Throughout the world, monetary policy is being conducted in a highly challenging environment. Years of close to zero interest rates and massive liquidity injections in the U.S., Japan and Euro Area are creating negative spill-overs for smaller economies such as New Zealand. Difficult adjustments lie ahead as the major central banks try to re-establish more normal monetary conditions and prevent inflation from moving beyond target levels. And, in New Zealand, we have never had to conduct monetary policy when a major part of the economy faces a concentrated construction programme in the order of 12 percent of GDP – and insurance payouts in excess of this. Various groups in our economy are under pressure from the high exchange rate, rising house prices, and those living off interest income worry about low yields. Monetary policy, by itself, cannot deliver quick fixes to achieve and sustain more rapid economic growth, lower unemployment, or maintain a lower exchange rate. Other policies are central for achieving these outcomes, but when they are applied, monetary policy can be supportive of them. In conducting monetary and prudential policy, the Reserve Bank will be consistent, open, and flexible in reflecting on new information and data. In doing so, our focus will remain on BIS central bankers’ speeches meeting the objectives in the PTA and maintaining New Zealand’s reputation for credible monetary policy outcomes and financial stability. This is the best contribution we can make to help bolster New Zealand’s rate of economic growth and serve New Zealanders. Graeme Wheeler BIS central bankers’ speeches
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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers' Chamber of Commerce, Christchurch, 1 February 2013.
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Graeme Wheeler: Improving New Zealand’s economic growth Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers’ Chamber of Commerce, Christchurch, 1 February 2013. * * * I’m conscious of George Bernard Shaw’s comment that “if all the economists were laid end to end, they would never reach a conclusion”. So I’ll try and be more of a one-handed economist in offering some thoughts on New Zealand’s economic performance, ways in which it might be improved, and our role in the Reserve Bank. New Zealand’s economic performance Like other small, commodity-producing economies, our economic prospects depend greatly on the growth in world trade and output. IMF data suggests that the global economy is expanding at an annual rate of around three and a quarter percent – or just below its average rate for the past three decades. But it doesn’t feel like business as usual. Over the past two decades, the global economy has changed dramatically. Asia is now the world’s largest economic region. Its GDP at market exchange rates is about 15 percent higher than that of North America and 60 percent more than the euro area. China and East Asia are the main growth poles in the global economy and emerging and developing countries accounted for 80 percent of global growth last year. Among the advanced economies, growth prospects in the US are improving (despite December quarter GDP) but the recovery is the slowest for 70 years. Japan is going through another weak patch, and the euro area is likely to be in a difficult recession until 2014, and then recover slowly. This, in spite of US$15 trillion of additional spending by the world’s governments in response to the global financial crisis and over US$5 trillion of quantitative easing by the major central banks. With official interest rates close to zero in the major advanced economies, investors continue to search for higher yields in countries with stronger growth rates, favourable commodity price outlooks, sound macroeconomic policies, and higher interest rates. As with Australia, Canada, Sweden, Norway and some Asian and Latin American countries, the ensuing exchange rate appreciation affects the growth of our import substitution and export sectors. I’ll return to this issue in greater depth when addressing the New Zealand Manufacturers and Exporters Association later this month. How have we fared relative to other advanced countries over the past two decades? Since 1990 we’ve outperformed many OECD countries on inflation and unemployment. Our inflation rate has been one and a quarter percent below the OECD median and our unemployment rate half a percent lower. But our per capita income has lagged behind and we’ve run large current account deficits. Real per capita GDP growth has been one and a quarter percent, about half a percent below the median and our current account deficit has averaged five percent of GDP – about the 6th largest relative to GDP in the OECD region. There are two main ways in which our prosperity can improve over the longer run. The first is if the world is willing to pay more for what we produce. The second is by raising our labour productivity – that is by increasing the level of output per working hour. In the short term, we can generate higher income if we increase labour force participation or work longer hours. But we already have a higher proportion of our population in the labour force than nearly all other OECD economies and we work longer hours than most people in the OECD. The good news is that there’s strong international demand for our commodity exports. Despite falling over the past 15 months, our terms of trade, or the ratio of export prices to import prices, remain 20 percent higher than the average for the 1990s. This improvement BIS central bankers’ speeches partly reflects the expansion of the global middle income class over the past two decades, led by China, and the rising demand for protein. Our labour productivity story is much less impressive. Since 1990, our labour productivity has grown at an annual rate of one percent, about one and three quarters percent below the seven largest OECD economies. This is the main reason why our real per capita GDP is now 25 percent below the OECD median. This is striking given the high international rankings for the quality of our institutions, control of corruption, ease of doing business, and according to the World Bank, the highest per capita endowment of renewable resources in the world. So why is our per capita income so far below the OECD median? Partly it’s due to our geographic location and small economic size. Distance and economic size matter a lot even in a more globalised world of trade, capital and knowledge flows, and increasing interdependence. This also partly explains why our export range is concentrated over relatively few products – with food and beverages accounting for almost half our exports. The OECD and IMF believe size and distance, which limit economies of scale and market opportunities, account for around three quarters of the gap in our per capita income compared to the OECD average. But this is not the whole story. Despite our high international rankings in key areas, the latest World Economic Forum’s Global Competitiveness Report ranks New Zealand’s overall competitiveness at 25th out of 142 countries. Besides market size, we perform poorly on our macroeconomic environment, and especially on our budget deficit and low national savings. But regulatory and performance-related factors also diminish our growth potential. Many of the remedies to substantially improve our ranking lie in our own hands, and groups such as the 2025 task force, the Savings Working Group, and the Productivity Commission, emphasised reforms that can raise our living standards. Three areas seem particularly important. The first, is to raise our level of saving and investment, and improve the quality and productivity of our investment. In 2007, the World Bank analysed the stylised characteristics of the 13 economies that had grown at an average rate of seven percent per annum or more for a 25 year period since the 1950s. Eight of the countries were in Asia.1 We share many of the characteristics of these countries in terms of openness of the economy, macroeconomic stability, and market based resource allocation. One key difference however, is that all these countries had savings and investment ratios in excess of 25 percent of GDP and often over 30 percent. Over the past three decades our net national savings rate averaged only three percent of GDP – almost five percentage points below the OECD median. For the past 25 years, our net household savings as a percentage of household disposable income averaged minus two and a quarter percent – the lowest in the OECD (where data are available), and 10 percentage points below the OECD median. Our desire for such high levels of consumption was met by borrowing the savings of foreigners. As a consequence, our net foreign liability position is 73 percent of GDP, one of the highest ratios in the OECD, and not much different from some countries that have been at the centre of the financial crisis in the euro area. The build-up in external debt increases our vulnerability to economic shocks and the high propensity of New Zealanders to borrow means that higher interest rates than elsewhere are required to achieve similar inflation outcomes. The Growth Report, Strategies for sustained growth and inclusive development. BIS central bankers’ speeches Although, our national savings ratio is low, our investment rate over the past three decades has been around the OECD average, and this is also true of business investment. But our capital to labour ratio, or the amount of capital that labour works with, is low by OECD standards. Second, much of our investment goes into housing rather than more productivitypromoting investment, and in 2011, 70 percent of households’ net wealth was in the form of net equity in housing. We need more investment, including foreign investment, that can bring benefits of job creation, technology transfer and market opening. Today, about 75 percent of global trade is undertaken by multinational corporations and about a third of trade is intra-firm trade. However, instead of welcoming foreign investment, we have one of the more restrictive frameworks among OECD countries. We should re-examine the factors, including tax and regulation, that diminish and distort the incentives to both save and invest. A second priority should be to return to fiscal surpluses and lower public sector indebtedness. This will strengthen the economy’s resilience and create more fiscal room for responding to future economic shocks. The expansion in government spending has historically been one of our main growth industries and our budget deficit relative to GDP, after adjusting for the impact of the economic cycle on spending and revenue, was one of the largest in the OECD in 2011. This is the main reason why the 2012 Global Competitiveness Report ranked us 112th for our budget deficit. Important steps are being taken to reduce government spending and this will be an on-going challenge as demographic change will greatly expand government outlays unless there’s significant policy change. For example, the ratio of the over 65 age group to those of working age is projected to change from 1:5 to almost half that in 25 years’ time. Increasing fiscal deficits mean that monetary policy has to be tighter and interest rates higher than otherwise, and this adds to the exchange rate pressures on the export and import substitution industries. This constrains output and employment in sectors facing international competition – sectors where productivity growth potential is usually higher. Instead, resources often find more attractive returns in the non-traded or sheltered sectors where, although measured productivity is lower, producers face less international competition and can raise prices more readily. This is one reason why it’s critical to cut back ineffective government spending, and ensure that our welfare spending is targeted better at those in need. Modern growth theory stresses the importance of the role of human capital, and the knowledge and skills of the population. The quality of education is critical in creating opportunities for growth and increasing real income. We need to improve the evenness of our education outcomes. Globalisation and technology have widened the distribution of income within most advanced economies, including New Zealand, over the past three decades. In the mid-2000s we had greater income inequality than most OECD economies, and this is unlikely to have changed. The bottom income deciles are populated by those with lesser skills, and those who experience prolonged and recurrent spells of unemployment. Addressing these groups would both promote productivity and reduce inequality. Our education system is well regarded internationally. We rank 7th among 65 countries in the OECD’s Programme for International Student Assessment that tests high schoolers’ performance across reading, mathematics, and science. But, we have the greatest difference in reading performance between students from different socio-economic backgrounds out of all OECD countries, and the PISA scores for Maori and Pacific Island students are much lower than the average for students of European descent. Over the past 15 years, unemployment rates for Maori and Pacific Islanders have been three times that for the European population. How can the Reserve Bank best contribute to New Zealand’s economic prospects? There are two main ways. BIS central bankers’ speeches The first is by delivering price stability and reducing the risk of inflation surprises. Price stability, and expectations that future inflation will be both low and stable, contribute to economic growth in several ways. They reduce uncertainty as to future inflation outcomes and assist planning and long term contracting. They enable producers and consumers to identify relative price shifts and allocate resources in response to shifts in demand. They avoid the distortions created by the interaction of high rates of inflation and the tax system that lead to higher effective rates of taxation. And they reduce the incentive for investors to acquire non-productive assets, such as investment properties, as hedges against inflation. Research by the IMF suggests that in industrialised countries the threshold level of inflation above which inflation significantly slows economic growth is estimated at 1–3 percent.2 In considering inflation pressures the Reserve Bank closely examines recent developments in the economy, and the outlook for competitiveness, demand, and output growth and employment. In setting the official cash rate we aim to avoid excessive volatility in output growth, interest rates and the exchange rate. We seek to respond to changing conditions but avoid rushing into decisions that might need to be quickly reversed and in doing so create uncertainty as to the Reserve Bank’s objectives. Four times a year we prepare two year ahead economic forecasts. But forecasting is far from an exact science. Instead, there are conditional probabilities around each element in the forecasts and our published numbers are our central expectations: that is, what we believe is the most likely path of these variables. There are always many uncertainties, an important one right now being the economic impact of reconstruction here in Christchurch. For example, how much investment will take place and how quickly, how will insurance pay-outs be used, how much employment is likely to be generated and where does it come from, and what cost pressures and bottlenecks are associated with reconstruction and how is the impact being reflected more broadly across the country? The second area where we contribute to New Zealand’s growth is by strengthening prudential regulation and supervision to help create a more stable and efficient financial system. A well-functioning financial system helps an economy grow by pooling and mobilising savings, allocating funds to investment, providing liquidity, and redistributing risk. The financial system needs regulation because in a limited liability framework the interests of banks and bankers can differ widely from those of society at large. Bankers face incentives to increase leverage and risk in the expectation of achieving higher returns. In doing so they tend to under-price tail risk and often seek to build competitive advantage through complex financial products and customised services. Their financial accounts can be opaque and shareholders and creditors often lack the means to monitor bank balance sheets, or the incentive to do so if they believe that the government will provide financial support to a failing institution. As the global financial crisis demonstrated, interconnections among financial institutions, and their sheer size, mean the failure of a financial institution can have massive destructive effects on the economy and the welfare of citizens. The Reserve Bank has several important initiatives underway to enhance the stability of our financial system. Last month we increased the capital requirements for our banks and are currently registering over 100 insurance companies and around 60 non-bank deposit takers. We’re working with banks to introduce an open bank resolution system by 30 June this year, which will enable a distressed bank to continue operating, while placing the cost of the bank’s failure on the bank’s shareholders and creditors, rather than taxpayers. And, later next month, we will consult with financial institutions on a framework for the potential use of macro-prudential instruments. These instruments, which include the counter cyclical capital buffer, sectoral capital requirements, the core funding ratio, and quantitative restrictions on high loan-to-value ratio lending, are designed to increase the resilience of the financial Threshold Effects in the Relationship Between Inflation and Growth. IMF staff papers, Vol 48, 2001. BIS central bankers’ speeches system to shocks, and dampen the financial cycle when concerns increase about systemic risk. Conclusion To a considerable extent our destiny largely lies in our own hands. We don’t have the luxury that many developing countries enjoy of relying on catch up technology to propel growth. We operate much closer to the technological frontier, and if we are to attract new capital, entrepreneurship and investment in innovation, our policies have to stand out internationally. There’s no simple generic formula for raising growth rates, but the more prosperous countries and the economies that are growing rapidly all built strong linkages with the global economy, and created an environment that fostered strong productivity growth, and high rates of investment from domestic and foreign sources. We’ve much to do in continuing to build our global linkages and addressing government spending and regulatory issues that diminish productivity and competitiveness. But addressing these will create valuable payoffs for our future given our major resource endowments, our impressive agricultural and primary production engine, and the potential in our education, tourism and other sectors. In most situations the comments made almost a century ago by William Bryan, the 41st US Secretary of State remain relevant: “Destiny is not a matter of chance; it is a matter of choice”. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Speech by Dr John McDermott, Assistant Governor and Head of Economics of the Reserve Bank of New Zealand, to FINSIA (Financial Services Institute of Australasia), Wellington, 15 March 2013.
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John McDermott: The role of forecasting in monetary policy Speech by Dr John McDermott, Assistant Governor and Head of Economics of the Reserve Bank of New Zealand, to FINSIA (Financial Services Institute of Australasia), Wellington, 15 March 2013. * 1. * * Introduction As is well known, the Reserve Bank Act requires the Bank to seek to maintain price stability, an objective similar in spirit to that of most modern advanced-country central banks. The Governor is legally responsible for monetary policy decisions and they are made independently from the government. Last week he explained in a speech how we make and communicate these and other important Reserve Bank decisions.1 Because the economy is never at rest, and monetary policy actions take time to affect inflation, forecasting economic conditions is an essential part of making these decisions. The forward-looking nature of monetary policy is reflected in the Policy Targets Agreement (PTA) between the Governor of the Bank and the Minister of Finance, which specifies the price stability target as “future CPI inflation outcomes between one percent and three percent on average over the medium term, with a focus on keeping future average inflation near the two percent target midpoint”. There are difficulties and uncertainties involved in assessing the current state of the economy and its likely future path. Modern central banks therefore put a huge amount of energy into forecasting. Events such as the global financial crisis and the Canterbury earthquakes showed how we must be prepared to pivot, at times very quickly. Reflecting this complex policymaking environment, the Bank’s Governing Committee is advised by a team of about 40 economists and financial market analysts, including two external monetary policy advisers drawn from the private sector. This speech explains how forecasting fits into the monetary policy process. I’ll address the limitations and trade-offs involved in forecasting and how we manage these in monetary policy decision-making, and illustrate by discussing important issues in the current forecast. 2. The forecasting process and economic framework Forecasting links the Bank’s policy rate decisions and strategy to the requirements set out in the PTA. The forecasting process follows a quarterly cycle with two OCR reviews, one of which is accompanied by the Monetary Policy Statement for the quarter. Through the quarter, we examine the incoming data, update forecast tracks and scenarios, and discuss policy risks. Inputs to the process are many and various. We draw on official data, surveys and other information covering output, sales, employment, consumption, investment, exports, imports, wages, prices and so on. We visit businesses and labour organisations representing all the country’s regions and economic sectors to gather up-to-date perspectives on economic developments “on the ground”. We analyse other agencies’ forecasts and stay in close touch with other central banks. Our market monitoring and prudential supervision activities provide financial and credit market intelligence. Finally, our external monetary policy advisers are a key source of private sector input to our deliberations. Wheeler, G (2013) “Decision making in the Reserve Bank of New Zealand”, speech delivered to the University of Auckland Business School, 7 March. BIS central bankers’ speeches We use all this to form a coherent picture of international and domestic conditions and a macroeconomic projection. The projection captures our view of the most likely future developments in inflation, output, employment, interest rates, the exchange rate and other key macroeconomic variables, based on the information to hand and our understanding of how the economy works. The economic framework Forming an assessment that can support policy decisions requires an economic framework to boil down the large and complex set of information into something more manageable. The framework includes some fundamental economic principles to anchor our analysis and dialogue. These include the big lesson from the 1970s experience, that you can’t sustainably get higher growth by tolerating a bit more inflation, and that to try to do so will eventually cause high and variable inflation, and damage the economy. Long-run growth is fundamentally determined by growth in the productive base of the economy – that is, labour, the capital stock and knowledge. The best contribution monetary policy can make to long-run growth is to keep aggregate inflation predictably low, so that it can form a useful benchmark for pricing behaviour. This involves counteracting, where possible, the inflation effects of emerging economic pressures (sometimes referred to as shocks). In understanding the macroeconomic consequences of shocks, the main effects to account for are as follows. Firstly, inflation tends to fall when demand is weak enough for there to be slack in the labour and goods markets (technically, a “negative output gap”), and rise when the opposite is true. This relationship is most obvious in the case of non-tradable inflation (see Figure 1). Secondly, investment and consumption demand tend to rise when interest rates fall. Thirdly, the exchange rate tends to be high when relative prospective returns available in New Zealand are above those offshore. Finally, short term interest rates, reflecting the price stability objective of monetary policy, tend to rise in response to increases in future inflation pressure. All of these key macroeconomic variables are therefore linked together by economic behavioural tendencies. We say “tendencies” because other things than those mentioned matter too, and may at times be substantial drivers of the patterns we see in the data. For example, a major source of exchange rate fluctuations in New Zealand is the outlook for the world prices of our commodity exports and the terms of trade. Housing investment moves quite substantially with the ebbs and flows of net migration. Government spending and other fiscal policy changes are a further source of demand shock. BIS central bankers’ speeches The role of models and the need for judgement The overall variation in the data can therefore be viewed as a combination of the sequence of shocks and the responses of the economy to those shocks. One major task of the economic analyst is to disentangle the two, at least conceptually. One tool we use to help with the task is a structural forecasting model, which continues our long tradition of using such models in forecasting and policy analysis. The model is calibrated to the “typical” economic behaviour observed over the past two decades of price stability in New Zealand, and embeds the fairly standard views of economic behaviour outlined above. Its key features include intuitive economic mechanisms, a relatively simple structure, and adaptability to accommodate a range of economic circumstances. Using a model provides a number of benefits. It enables us to link policy decisions to our objectives and to the economic outlook, to consider simultaneous shocks and interactions among economic variables systematically and consistently, and to ensure that there is some consistency in interpreting the flow of data between forecast updates and policy decisions. But even the most advanced models can only be very abstract representations of the economy, and our forecasting model is deliberately designed to be relatively simple and adaptable. Too much complexity would make it difficult to understand the transmission mechanisms and dynamics in the model, and would be unlikely to improve forecasting accuracy materially. Judgemental input to any model and adjustment to the model’s outputs are therefore a necessary part of building up the forecast – and indeed the process of adding judgement itself helps us form views about the outlook in a systematic manner. There are three main motivations for adding judgement currently. Firstly, responses to rare events such as the global financial crisis and the Canterbury earthquakes will, by design, not be picked up in the forecasts of a model that is calibrated to the “average” experience over the last 20 years. Secondly, like most macroeconomic models, our model does not explicitly model the financial sector, which is a key feature of modern economies. The modelling framework does include an interest rate spread between the floating mortgage rates and the 90-day bank bill rate, and this is the point where we typically add judgement to account for financial factors in the model. Finally, judgement is needed to account for how the economy responds at different points in the business cycle, since models generally only generate the average response seen across the cycle. Judgemental adjustment in the framework often is motivated by the qualitative information we receive from business visits, as well as from the knowledge of experienced forecasters gained over many business cycles. As noted, our forecasts are updated regularly. As new data comes in each quarter, we are able to learn from our errors, get a sense of which bits of the model to trust and which to keep adjusting, and revise our forecasts accordingly. 3. Monetary policy, risk management and trade-offs Monetary policy operates in a complex environment. In developing our central projection, we must consider multiple risks and trade-offs. Monetary policy and risk management The likelihoods of various economic outcomes affect markedly the costs and benefits of alternative policy actions. Forming a view on these likelihoods is, furthermore, subject to a range of uncertainties. Firstly, the information on the economy’s current state and direction and rate of movement can be difficult to read, conflicting and sometimes revised. Secondly, some important economic concepts cannot even be directly observed, including the “potential” level of output consistent with stable inflation, or the “neutral” rate of interest that BIS central bankers’ speeches has neither a stimulatory nor a contractionary effect on spending. Thirdly, our understanding of economic behaviour is imperfect, and behaviour itself can shift over time as the economy’s structure and opportunities available to firms and households change. Because of these uncertainties, monetary policy can often appear “cautious”, in the sense that, under normal circumstances, we tend to adjust interest rates quite smoothly to economic developments, at least compared to the observed volatility in the data. This reflects a desire not to jerk the economy around in response to bumps in the data that may turn out to be quite temporary. But now and then the economy is hit by a big and unusual shock quite outside the range of possibilities one might reasonably anticipate, for the purposes of monetary policy at least. The series of Canterbury earthquakes, or the events of the global financial crisis, are obvious examples. When such big events hit, the monetary response instead may be very rapid, reflecting that we can be sure that the outlook has markedly changed. These uncertainties explain the limited predictive power of economic forecasts. Our analysis generally suggests that our forecasting track record is somewhat better than the average of other forecasters.2 But what is also clear is that all forecasters face difficulties in predicting future economic outcomes beyond the next few quarters. Quite simply, much can happen over that timeframe. The central projection in our Monetary Policy Statement therefore represents just one path of the many possible. Monetary policy and trade-offs Even if we knew the future perfectly, we would face important choices about how quickly and strongly to react to economic pressures and to seek to restore future inflation to target. These choices have impacts on the economic volatility during the adjustment period. The PTA recognises this trade-off. It requires the Bank to seek to avoid unnecessary instability in interest rates, output and the exchange rate in its pursuit of the price stability target. This is known as flexible inflation targeting and all inflation-targeting countries take the same basic approach. The forecasting framework enables these trade-offs to be systematically addressed and balanced. There’s often concern, for example, that increases to the policy interest rate will adversely affect growth by causing exchange rate appreciation. But we do not hike the interest rate for no reason. While higher interest rates are normally associated with a higher exchange rate, this usually reflects strengthening of the economy due to other forces on spending, such as a pickup in foreign demand, rising terms of trade, or an increase in government spending. It therefore does not follow that keeping interest rates lower than otherwise in order to prevent exchange rate appreciation would necessarily be successful. Assuming the inflation target is credible, strength in the domestic economy will generally cause the exchange rate to appreciate even without immediate policy tightening, as people will anticipate eventual monetary tightening in order to limit rising inflation pressure. This kind of response is consistent with the principles of economic behaviour outlined above. The sustained economic expansion in New Zealand prior to the global financial crisis illustrates these trade-offs well. The OCR was steadily raised 200 basis points from 2003 to 2006 and the New Zealand dollar exchange rate moved from 55 US cents to 75 US cents. Even a tightening of monetary conditions of this magnitude was not sufficient to prevent CPI The latest assessment of our forecasting accuracy is Labbé and Pepper (2009). McCaw and Ranchhod is also useful for more detailed discussion of the reasons for the historical pattern of forecasting errors. BIS central bankers’ speeches inflation from reaching more than three percent by the end of 2006 (Figure 2). We could perhaps have leaned harder against this expansion at the time, but this would probably have exaggerated the exchange rate cycle on both the upswing and the downswing. We draw several lessons from this experience. One is that when there are strong forces on the New Zealand economy, policy settings may need to lean quite hard against them. A second is that financial cycles can be surprisingly large and long-lasting. A third is that such forces in a small open economy can cause large exchange rate swings. Difficult judgements must be made about the balance across the trade-offs. Issues in our current forecasts Our current forecasts also show the current challenges in predicting the balance of opposing economic forces, recognising the uncertainties, and accounting for trade-offs. The combination of the global financial crisis and the Canterbury earthquakes has left a legacy of tough economic issues to resolve. The persistently elevated exchange rate, high household debt overhang, and substantial fiscal consolidation will weigh on the economy, but acting in the opposite direction are rising house prices and the large construction spending surge from the Canterbury rebuild. Our central projection indicates low inflation in the near-term but strengthening over the medium-term. Mindful of our requirement to focus on future average inflation over the medium term, our policy strategy is to “smooth through” these near-term variations in inflation in a forward-looking manner. The “net” of all these effects and their timing are quite sensitive to assumptions. Our task with our quarterly forecast updates is to keep up to speed with the incoming evidence on whether our assumptions are accurate. Judgement is particularly important in respect of future movements in the exchange rate. The exchange rate can move sharply and suddenly, for reasons that cannot be foreseen even if in hindsight the connections seem quite obvious. Often, sudden and large downward movements (depreciations) result from large and sudden shocks from offshore, such as seen at the onset of the Asian crisis in mid-1997 or the sudden intensification of global financial disruptions in 2008 (Figure 3). BIS central bankers’ speeches At other times, an unexpectedly long period of strong or weak relative economic performance, or strong forces such as commodity price swings or domestic demand pressures, can generate substantial and prolonged departures of the exchange rate from its long-run average levels. A second key judgement in our forecasts is the extent to which household spending is constrained by high debt levels and the GFC experience, which has implications for the degree to which the strengthening housing market will feed into private consumption. Finally, the profile and wider spillover effects into construction costs of the Canterbury rebuild will depend upon how capacity pressures are resolved. Our current judgements are that the household debt position means consumption is likely to follow less of a pronounced upswing as a result of the housing market upturn than has historically been the case, and that the concentrated character of the rebuild means its spillover effects to housing markets in the rest of the country will be muted. However, since there is little recent experience against which to benchmark these events, we will have to monitor the evidence carefully to ensure that our judgements in this area remain reasonable. The current environment also confronts us with trade-offs across policy objectives. Near-term inflation is low and is forecast to gradually increase back to the midpoint of the target range. An interest rate cut might help inflation return to target sooner. But such a cut would also probably exacerbate the current strength in house prices, risking further increases in private debt levels, potentially raising financial stability issues. Indeed, the PTA specifies that, in setting monetary policy, we must monitor asset prices and have regard to the soundness and efficiency of the financial system.3 On the other hand, while an interest rate hike might limit housing market risks, it could also place further upward pressure on the exchange rate. In the near future, macro-prudential measures will be part of the toolkit for responding to financial stability risks. These measures will generally support and complement our efforts to stabilise inflation with monetary policy, as upswings in the macroeconomy often coincide with increasing asset prices and leverage. We’re currently engaged in consultation regarding the use of macro-prudential instruments and will say more about this in our upcoming Financial Stability Report. A box in the December 2012 Monetary Policy Statement explains the new PTA. BIS central bankers’ speeches 4. Forecasting supports accountability and communication activities Forecasts, risk assessment and management of trade-offs are a critical element of our communication of policy strategy and accountability for our actions. We aim to be as clear as possible in the Monetary Policy Statement about both the economic outlook and the strategy framing monetary policy decisions and plans.4 Shortly after the Statement is published, the Governor holds a press conference and the Statement is reviewed by Parliament’s Finance and Expenditure Select Committee. The Bank’s Board of Directors, who are appointed by the Minister of Finance, formally review each Statement and OCR decision as part of their duty to monitor constantly the Reserve Bank’s performance of its obligations under the Act. These various examinations and question and answer sessions are very thorough. In addition, senior Bank staff travel around New Zealand and give talks explaining the main considerations supporting the latest decision. By explaining the rationale for policy decisions, we enable our views to be discussed and challenged. The Statement thus acts as a record of our monetary policy deliberations. Some other central banks instead publish minutes of their monetary policy meetings, which amounts to much the same thing. Our communications activities are also intended to assist the economy by stabilising inflation expectations. Published forecasts help markets assess the economic environment and understand our policy strategy.5 We have published policy outlooks since 1997 in the form of a future path for short term interest rates. A number of other central banks, including those of Sweden and Norway, have subsequently followed this practice. The future interest rate track in any projection represents the Bank’s best view of the outlook for monetary policy settings given the information to hand at the time, and is not a commitment to the particular path shown. Our analysis shows that as long as the markets do not regard our published interest rate path as a commitment, there are benefits for the economy from the publication of the numbers.6 There are various ways of communicating the policy outlook. We present our projection as a single narrow line. Of course, around this line is a range of possibilities that widens markedly the further ahead one looks. We find that projecting a single central projection, though, simplifies the discussion considerably, and makes the forecast numbers easier to connect to the forecast story. There are obvious risks of oversimplification or inadvertently conveying unrealistic precision in such an approach. But on the other hand, showing an unhelpfully wide range can undermine the central message. Different central banks handle this issue in different ways. Some use “fan charts” showing distributions of possible outcomes, while others use explicit or implicit statements of policy “bias” rather than a projected path for interest rates. In our case we’ve placed emphasis on the clarity of the basis for our policy decisions and outlook, which we think large fans could obscure to the extent that they hide the relationships between the different macroeconomic variables in the forecast story. As another means to show these relationships and how they inform policy, we now and then make use of “alternative scenarios”, where we work through quantitatively the implications for the forecast numbers of different settings for the key assumptions, to show how outcomes might differ from our central projections. For example, the Monetary Policy Statement released yesterday features an alternative scenario and discussion of the (distinct) possibility Blinder et al. (2008) discuss these aspects of monetary policy communications in detail. Svensson (2006) and Woodford (2005) offer useful discussions of this principle. Bergstrom and Karagedikli (2013). BIS central bankers’ speeches that the exchange rate might follow a different path, higher or lower, to that in our current central projection. 5. Conclusion Forecasting is a difficult but essential part of modern monetary policy. This reflects that the economy is never in a state of rest, and that there are lags between changes in the OCR and their effects on the economy. Forecasting provides value by explaining the economic story and framing the risks underpinning the policy strategy. If done well, this process helps policymakers, firms and households to plan for and adapt to changing circumstances. As well as enforcing internal discipline and structure on policymakers’ deliberations, an explicit, coherent and transparent forecasting framework also facilitates external accountability. Forecasting, central bank independence and a strong accountability framework are now all part of the orthodox, “full” framework for inflation targeting adopted by more than 20 developed countries.7 The models and processes we use to support our forecasting are carefully designed. As in the design of any process there are trade-offs that must be managed. We want to capture complex economic relationships and phenomena, while preserving the flexibility to accommodate unusual circumstances and a grasp of the essentials. No one in the forecasting business is under any illusions that what they do is a perfect science. Moreover, the economy is not a collection of mechanical equations, but a growing, changing system of interacting human choices. With experience comes improvement. Currently, monetary policy faces some big forecasting issues. One is the treatment of the exchange rate and its likely future path, which will have substantial effects on the economy. Another is the reconstruction in Canterbury and the effects flowing from that. The outcomes in practice could, and probably will, turn out quite differently to our projections at any particular time. But the important thing is that we’ve done the best we can to anticipate the different possibilities and how we might have to react to them. In our quarterly forecast cycle we do our best to update, test, revise and communicate our views thoroughly. This enables us to keep the OCR as well-positioned as we can, and our policy strategy wellunderstood, so that our efforts to maintain stable inflation do not cause more economic volatility than necessary. References Bergstrom, K and O Karagedikli (2013) “The interest rate conditioning assumption: investigating the effects of central bank communication in New Zealand”, RBNZ Discussion Paper, forthcoming. Blinder, A, M Ehrmann, M Fratzscher, J De Haan & D Jansen (2008) “Central bank communication and monetary policy: a survey of theory and evidence”, Journal of Economic Literature 46(4), 910–945. Hampton, T, D Stephens and R Philip (2003) “Monetary policy communication and uncertainty”, RBNZ Bulletin 66(2), 29–34. Labbé, F and H Pepper (2009) “Assessing recent external forecasts”, RBNZ Bulletin 72(4), 19–25. Roger (2009) provides a review of the two decades of inflation targeting experience around the world, that began with New Zealand’s introduction of inflation targeting with the Reserve Bank Act of 1989 and subsequently spread. BIS central bankers’ speeches McCaw, S and S Ranchhod (2002) “The Reserve Bank’s forecasting performance”, RBNZ Bulletin 65(4), 5–23. Roger, S (2009) “Inflation targeting at 20: achievements and challenges”, IMF Working Paper WP/09/236. Svensson, L (2006) “Social value of public information: Morris and Shin (2002) is actually pro transparency, not con”, American Economic Review 96(1), 448–451. Woodford, M (2005) “Central bank communication and policy effectiveness”, NBER Working Paper 11898. BIS central bankers’ speeches
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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the University of Auckland Business School, Auckland, 7 March 2013.
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Graeme Wheeler: Decision making in the Reserve Bank of New Zealand Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the University of Auckland Business School, Auckland, 7 March 2013. * * * I’m sure that central banking was the furthest thing from his mind when the British mountaineer, Eric Langmuir aptly said: “A decision without the pressure of consequence is hardly a decision at all”. Central bankers are often criticised for avoiding decisions, although leaving policy settings unchanged is often a major decision in itself. Sometimes they are accused of communicating in a secret code with the real meaning known only to other central bankers. So how do we undertake important policy decisions in the Reserve Bank and how do we endeavour to communicate? i) Operational independence In 1990, the Reserve Bank became the first modern central bank to have a legislated structure in which the government took the lead in setting the objective, while the central bank had operational independence in, and formal accountability for, the execution of monetary policy. New Zealand also led the way with flexible inflation targeting, a framework now widely adopted by central banks across the OECD region. The 1989 Reserve Bank of New Zealand Act states that “the primary function of the Reserve Bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices”. The legislation created provision for a Policy Targets Agreement (PTA) between the Minister of Finance and the Governor of the Bank. In practice, the PTA defines the objectives of the Bank, specifies an inflation range representing price stability and outlines considerations that the Bank must give weight to in framing monetary policy decisions. The current PTA, signed on 20 September 2012, introduces the goal of keeping future average CPI inflation near the two percent target mid-point of the one percent to three percent range. Like its predecessor PTAs, it also requires the Bank to seek to avoid unnecessary instability in output, interest rates, and the exchange rate. The Governor’s responsibilities and obligations are conferred and imposed under the 1989 Reserve Bank of New Zealand Act, the 2009 AMLCFT Act, the 2010 Insurance (Prudential Supervision Act), to which is expected to be added the Non-Bank Deposit Takers legislation currently in the House. The Governor has the power to act for the Bank on all matters within the ambit of the Acts that are not required to be dealt with by the Board of the Reserve Bank (which relate to the appointment, remuneration and removal of the Deputy Governors). The Governor may delegate decision making authority to other officers of the Bank. ii) The bank’s span of responsibilities The Reserve Bank is a full service central bank and its responsibilities are broader than most other central banks. Not all central banks are responsible for prudential and regulatory oversight of the banking and payment systems, or have the authority to undertake exchange rate intervention. In addition, the Bank has an extensive programme of financial stabilityrelated initiatives underway that includes Open Bank Resolution, the introduction of macroprudential instruments, a review of the payments system, and implementation of Basel III capital requirements. The Bank has also taken on responsibilities for anti-money laundering and regulation of insurance companies and non-bank deposit takers. BIS central bankers’ speeches iii) Important checks and balances The checks and balances and accountability mechanisms relating to the Bank are considerable and include: • Publication of an annual report, at least two Monetary Policy Statements (we do four), and two semi-annual Financial Stability Reports. The Bank’s reports are reviewed by Parliament’s Finance and Expenditure Committee, the Board of Directors of the Reserve Bank, and the Bank provides press conferences around each Monetary Policy Statement and Financial Stability Report. • External auditing of the Bank’s financial reporting, oversight by the Audit Committee of the Reserve Bank Board, and a strong in-house internal auditing function that reports to the Governor and works closely with the Board’s Audit Committee. • Publication of regulatory impact assessments of any prudential policy that it adopts. • Monitoring and oversight by the Board of Directors of the Reserve Bank, which acts as agent to the Minister of Finance in reviewing how well the Bank meets its legislative responsibilities. The Board reviews the Bank’s performance under the PTA, and its efforts to promote the maintenance of a sound and efficient financial system. In considering the Bank’s monetary policy decisions, the Directors receive all of the papers discussed by the Bank’s Monetary Policy Committee, the written advice that the Governor receives from individual members of the Monetary Policy Committee, and webcasts of the Governor’s press conferences. The Board meets nine times a year (four times a year outside of Wellington where receptions are held with the business community) and provides advice to the Governor on various management issues. The Board assesses the Bank’s performance in meeting its obligations and responsibilities, discusses this with the Minister of Finance, and publishes its review in the Bank’s Annual Report. • The Minister of Finance’s powers under the Reserve Bank of New Zealand Act to direct the Bank to formulate and implement monetary policy for different economic objectives to those specified in Section 8, and to determine the basis for foreign exchange intervention by the Bank. The most coercive powers exercisable against registered banks may only be exercised by the Minister, or with his consent. These powers must be exercised transparently, and have not to date been used. iv) The policy decision making framework In order to assist with major policy decisions, we recently introduced a Governing Committee, comprising the Governor, the two Deputy Governors and the Assistant Governor, under the chairmanship of the Governor. The Governing Committee will discuss all major monetary and financial policy decisions falling under the Bank’s responsibilities, including decisions on monetary policy, foreign exchange intervention, liquidity management policy, prudential policy (both micro and macro) and other regulatory policies. To date, individual Governors have taken responsibility for particular areas of the Bank, such as operations, monetary policy and financial stability. Going forward Governors will have more individual and collective involvement in key decisions taken across all areas of the Bank. This is the same decision making framework adopted by the Bank of Canada, which also has a single decision maker model. As with the Bank of Canada, the Governor retains the right of veto on committee decisions. The Committee formalises and expands past practice. Several other central banks, including the central banks of Brazil, Mexico, and Sweden, make monetary policy through a central committee comprising the Governors, although sometimes other internal members are included. These committees benefit decision making by pooling the knowledge, wisdom, and expertise of individual Governors. Such committees BIS central bankers’ speeches bring strength, especially where considerable uncertainty is involved, and can mitigate extreme preferences of an individual. The Bank’s Governors team has extensive experience inside and outside the Reserve Bank. While the change represents a management rather than governance initiative, the Governing Committee will maximise the knowledge and experience of the Governors individually and as a collective, rigorously test ideas and build consensus around major policy decisions. Analytical and policy papers are discussed in several important committees including the Monetary Policy Committee, Macro-financial Committee, Financial System Oversight Committee, and the Assets and Liabilities Committee (which examines impacts of portfolio decisions and changing relative prices on the Bank’s balance sheet). These committees have clear terms of reference, mainly meet fortnightly, and are chaired by a Governor. Usually decisions are taken at the committee meeting, but major and complex policy decisions will often be referred to the Governing Committee. Management decisions are taken at weekly meetings of the Bank’s Senior Management Group and all communications issues and requests are discussed weekly at the Communications Committee. v) Communicating policy decisions We are expanding our on-the-record speaking by increasing the number of speeches, broadening the range of topics while remaining within the Reserve Bank’s framework, and increasing the number of speakers. At the same time, the Bank will continue its extensive off-the-record briefings to groups ranging in size from 15 to 400 people, but we will become more selective in the 80–100 briefings we provide each year. We are also expanding our communications through social media, in-house videos, webcasts and other online channels. We provide considerable background briefings to the media, but announce our policy decisions through our publications, speeches, and press conferences. We will also provide six-monthly briefings to the caucuses of the political parties, and are redesigning our website to expand its information content and increase its accessibility. To be effective, monetary policy requires transparency in terms of policy goals and how these are to be achieved. The former is contained in the Policy Targets Agreement; the latter through our Monetary Policy Statements, OCR announcements, speeches and press conferences. In commenting on monetary policy decisions and especially those relating to the official cash rate, we are conscious that traders pre-position themselves prior to policy announcements and that the exchange rate and interest rate spreads can alter depending on the policy decision and the language that accompanies it. Above all, we want policy statements to accurately reflect the economic conjuncture and outlook as we see it, and the range of considerations we are weighing in fulfilling our responsibilities. In the case of monetary policy, these include implementing monetary policy in a sustainable, consistent, and transparent manner, having regard to the efficiency and soundness of the financial system, and seeking to avoid unnecessary instability in output, interest rates, and the exchange rate. The 90-day interest rate projection contained in the Monetary Policy Statement is a form of forward guidance as to our expectations of movements in the Bank’s Official Cash Rate. It is intended to help businesses and households plan with greater confidence in managing their consumption patterns and saving and investment decisions, and to help shape expectations about the future path of inflation and interest rates. This also helps market participants to anticipate the Reserve Bank’s policy responses as new data becomes available. As with most conditional projections, the interest rate path is affected by the risks and uncertainties that usually increase with time. In practice, the balance of language around the projection is at least as important as the projection itself in shaping expectations of the outlook. When market expectations adjust smoothly and efficiently, it can diminish the need for larger policy adjustments by the central bank that could otherwise unsettle markets and have greater impacts on asset prices and spending decisions. BIS central bankers’ speeches Concluding comments Global financial markets are still dealing with the major regulatory changes and the massive adjustments taking place in government, corporate, financial sector and household balance sheets in economies that generate around two thirds of world output and over three quarters of cross border capital flows. The spill-overs from these adjustments and the fiscal and monetary responses to them can be especially challenging in small open economies with stronger growth prospects, and where there are high expectations of what central banks can achieve. The Reserve Bank endeavours to provide an accurate assessment of the implications and challenges of these adjustments for the New Zealand economy. In doing so, we seek to be clear on what we can and cannot influence, and how government policy instruments and private sector responses can increase our effectiveness. At the same time we’ve been extending our regulatory oversight, building the protections available to taxpayers in the event of bank failure, and increasing the range and scope of instruments to help deliver price stability and increase the efficiency and soundness of the domestic financial system. Within the Bank we are looking to the team of Governors to debate major policy matters leading to decisions, and increasing the frequency and scope of our on-the-record reporting. BIS central bankers’ speeches
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Speech by Mr Grant Spencer, Deputy Governor and Head of Financial Stability of the Reserve Bank of New Zealand, to Employers and Manufacturers Association, Auckland, 8 April 2013.
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Grant Spencer: Reserve Bank of New Zealand’s perspective on housing Speech by Mr Grant Spencer, Deputy Governor and Head of Financial Stability of the Reserve Bank of New Zealand, to Employers and Manufacturers Association, Auckland, 8 April 2013. * * * The housing market is once again highly topical. When house prices move we get interested, and for good reason: the home is usually the single largest asset that a family owns; and a mortgage is often the single largest financial transaction undertaken by a household. The housing market is also a major driver of the macro-economy and of the financial sector. As such, housing market developments are very relevant for the Reserve Bank’s two key policy objectives: price stability and financial stability. Today I will discuss current developments in the New Zealand housing market, the risks that are emerging, and the policy responses that may be appropriate to address these risks. The importance of housing How important is housing to the typical New Zealand household? And how important is housing to New Zealand’s economy and financial sector? Table 1: Household assets and liabilities for Australia and New Zealand (as at December 2012) Note: Consumer durables are excluded from household assets. For New Zealand, net worth deducts student loans. The share of housing assets is somewhat overstated because the data excludes assets such as equity in unincorporated and unlisted businesses. See Briggs (2012) for more details on these excluded assets. Source: RBA, RBNZ calculations/estimates. The most recent data on household balance sheets is shown in Table 1. Two observations are key: first, the value of housing is a large share of total household assets in New Zealand compared to Australia (and the United States) where financial assets play a much greater role in saving for retirement. Consequently, house price movements in New Zealand have a relatively large impact on household confidence and spending compared to many other developed countries where the state of the financial markets plays a larger role in driving consumer confidence and spending. Second, debt is not evenly distributed across households. On average, gearing of New Zealand households is relatively low, with housing debt equal to around 27 percent of the value of the housing stock. And overall mortgage interest payments only account for around http://www.rbnz.govt.nz/research/bulletin/2012_2016/2012Dec75_4briggs.pdf BIS central bankers’ speeches 9 percent of total household disposable income in New Zealand. However, some households have very high levels of debt, and interest payments consume a large portion of their income. A first-home buyer borrowing 90 percent of the value of a house could have debt servicing costs of 35 percent of disposable income, even at today’s low interest rates. Add to this the fact that mortgage credit is by far the biggest asset class of the New Zealand banking system, making up just over half of total banking system lending, and it becomes clear that housing is a significant source of risk to both the household sector itself, and the New Zealand banking system. Housing cycles in New Zealand can have important macroeconomic effects. Figure 1 shows long-term house price cycles against GDP growth and the exchange rate. Housing has often been associated with real activity cycles, and is even more correlated with financial cycles, as represented by changes in credit demand and the exchange rate. Figure 1: House price inflation, GDP growth and the exchange rate Source: Property IQ, Statistics New Zealand, RBNZ. Note: House price inflation and GDP growth are annual averages. In the housing boom of 2003–07, for example, housing had a significant impact on the growth of aggregate demand and GDP through a number of channels: wealth and confidence effects where people felt richer, making them willing to spend and borrow more; direct effects on investment as higher house prices improved the return to residential construction; and financial accelerator effects where increased collateral values supported increased spending through credit expansion. The latter channel has created a strong link between house prices and the financial cycle. During the boom that link was accentuated with the emergence of widespread housing investment activity, bringing with it rapid credit growth, a high volume of offshore borrowing and upward pressure on the NZD exchange rate. Consequently, housing can be highly relevant for the Reserve Bank’s Monetary and Financial Stability policies. Monetary policy responds to house price pressures when these are seen as a clear driver of inflationary pressure through stronger domestic demand. This can occur when wealth effects push consumption ahead of income growth and households borrow against housing capital gains. That process was prevalent in 2003–07 and a key reason why monetary policy leaned against the housing boom – with mortgage rates being pushed up to just under 11 percent by 2008. It is also why asset prices are explicitly mentioned in the new Policy Targets Agreement between the Governor and Minister of Finance, even though house prices do not enter the Consumer Price Index (CPI) directly. BIS central bankers’ speeches On the financial stability side of Reserve Bank policy, the dominance of residential property as the banking system’s single largest sectoral exposure underpins the Reserve Bank’s prudential focus on housing lending risk. We pay considerable attention to the housing risk models used to determine banks’ capital requirements and have generally adopted a conservative approach, with higher risk weights relative to international norms. Consistent with this approach, we are currently reviewing the scale of housing risk weights in relation to loan-to-value ratios. We are also focussing on the additional housing-related systemic risk that might arise from credit cycles in our new macro-prudential policy regime that is currently out for public consultation. While as yet untested in New Zealand, such policies are deployed in Canada, Switzerland, Sweden and Hong Kong, for example. Macro-prudential policies draw on existing prudential tools to limit financial system risk arising from excessive credit and asset price movements. Practically, this means that additional prudential requirements may be applied for a period during credit up-cycles and then removed during down-cycles. The tools operate directly to improve the resilience of bank balance sheets and indirectly to moderate the extremes of the credit cycle. Sources of pressure in today’s housing market We are again facing a strong housing market with median house prices having risen by 8 percent over the past year. So far, the nature of the current market is different to the boom of 2003–07. As seen in Figure 2, the current house price pressures are concentrated in Auckland and Christchurch. House price inflation in the rest of the country is less pronounced, around 4 percent over the past 12 months, although there is considerable variation among districts. Figure 2: House price inflation by region (annual percent change) Source: REINZ, RBNZ estimates. Supply constraints in Canterbury and Auckland and pent up demand from first-home buyers are important factors. There is an element of investor demand and of new foreign buyers entering the market in Auckland, but these factors – at least as yet – are not as influential as they were back in 2003–07. The relevance of housing supply constraints has been discussed in earlier Reserve Bank/Treasury reports and, most recently, in the Productivity Commission’s report on BIS central bankers’ speeches housing affordability.2 Contributing to the current national housing shortage has been the low level of residential construction activity in recent years. From 2007 to 2011, residential investment as a share of GDP fell by 2-and-a-half percentage points. In Christchurch, the general shortage of accommodation is reflected in median house prices up 12 percent, rents up 16 percent, and the cost of building up 10 percent over the year to December 2012. These pressures are likely to persist for some time despite the insurance industry’s plans to finance 10,000 new houses over the next three to four years. In Auckland the situation is more complex – and more uncertain. The Auckland Council puts the current shortfall at around 20,000 to 30,000 homes, with an additional 13,000 per year needed going forward. However, the current rate of building is hardly making a dent in that, with residential building consents for new dwellings in Auckland currently running at just 4900 per annum. The Ministry of Business Innovation and Employment estimates that land ready for subdivision in Auckland has the capacity for 14,500 new homes. But, while zoning and utilities infrastructure may be complete for those subdivisions, only 2000 sites are ready to build on – with utilities actually connected and consents approved. These numbers reinforce the complexity of supply constraints noted by the Productivity Commission. It is not just a zoning or Metropolitan Urban Limit issue. The cost and the duration of subdivision development and house construction are also major constraints, particularly for the supply of “affordable” homes to first-home buyers. On the demand side of the housing equation, the two key drivers historically have been migration flows and interest rates. Permanent and long-term migration inflows have not been exceptional in the post-global financial crisis (GFC) period, averaging 7000 per annum, compared to 18,000 per annum on average during the 2003–07 boom period (Figure 3). Internal migration to Auckland from Christchurch and other areas could be contributing to the Auckland housing shortage. However, while our data on internal migration flows is sketchy, this factor does not appear to be a strong driver of the current Auckland market. Figure 3: House prices, net migration, and mortgage rates Source: Property IQ, Statistics New Zealand, RBNZ. The role of mortgage interest rates in current market pressures is much clearer. Current “best in market” rates are around 4.8–5.0 percent. These are down half a percent over the past year due to lower funding costs on international markets. They are the lowest mortgage rates on offer since the 1960s. While there are good reasons for this – low CPI inflation and very low international interest rates – the cost of credit is now only slightly above average http://www.rbnz.govt.nz/monpol/about/2452274.pdfhttp://www.productivity.govt.nz/sites/default/files/Final percent20Housing percent20Affordability percent20Report_0_0.pdf BIS central bankers’ speeches rental yields of 4.5 percent per year. Added to this, credit has become easier to obtain, with banks competing aggressively to gain or protect their mortgage market shares. An increasing proportion of new mortgage lending is going out at high loan-to-value (LVR) ratios: now around 30 percent of new lending is at LVRs over 80 percent, compared to around 25 percent of lending in late 2011-early 2012. Annual growth in housing credit is just over 4 percent and has been running at higher rates over recent months. Easy credit conditions, combined with the upward trend in house prices, are strengthening the incentive for renters to become first-home buyers and for existing owner-occupiers to upgrade. With new construction still at a slow pace, this excess housing demand increases house price pressures. Movements in rents tend to support this interpretation. Compared to Christchurch, average rents in Auckland have been growing at a more moderate annual rate of 4 to 5 percent, although still somewhat stronger than for the rest of the country (Figure 4). This suggests that the physical housing shortage in Auckland is less acute than in Christchurch and that credit factors have been an important driver of escalating house prices in Auckland. Figure 4: Inflation in rents by region (annual average percent change) Source: Department of Building and Housing Reserve Bank policy perspective As mentioned earlier, the Reserve Bank views housing from a monetary policy perspective and from a financial stability perspective. Considering monetary policy first, the key question for us is whether the housing market buoyancy will lead to wider inflationary pressures. An important factor in this regard is whether we begin to see a reversal of the trend increase in the household savings rate that has occurred over recent years. This general deleveraging process, where many households have reduced debt and sold up investment properties, has moderated household demand in recent years and reduced the official interest rate settings needed to keep inflation pressures in check. Our projections in the March Monetary Policy Statement suggest that household spending will generally pick up in line with stronger incomes. We assume that the boost to spending arising from perceived increases in housing wealth will not be pronounced and that housing market activity does not encourage a rise in speculative investment that could extend house price pressures to the rest of the country. So while new home owners will continue to take on BIS central bankers’ speeches new debt, we assume that existing home owners will continue to conserve or increase the equity in their properties, rather than seeking to “gear up” existing housing assets. There is a risk of course that our assumptions turn out to be wrong: that the housing market continues to gather momentum and that households return to their pre-GFC ways of borrowing and spending in excess of incomes. The recent fourth quarter GDP numbers, which showed expenditure GDP growth of 1.4 percent and private consumption growth of 1.6 percent over the quarter, remind us that this alternative outlook for household behaviour is a real risk. Turning to financial policy, we have been encouraged by the general improving trend in household (and business) balance sheets since the GFC. However, the improvement in household debt ratios has been gradual relative to the rapid escalation of debt during the pre-GFC boom (Figure 5) Figure 5: Household debt to household disposable income Source: RBNZ. The chart shows a very recent uptick in household debt to household disposable income. If that uptick becomes a reversal of the recent downward trend, then household balance sheets will become increasingly stretched, making them vulnerable to future economic shocks, such as increases in interest rates or unemployment. The trend in the banking system since the GFC has also been one of deleveraging and general risk reduction. Problem loans are reduced and stronger capital and liquidity buffers are in place. This trend has been a key theme of our Financial Stability Reports in recent years. But if households become more stretched financially, then the banks’ balance sheets will also become more risky. That is the prospect we now face as a result of debt levels rising faster than incomes and the increased proportion of high LVR lending that has been evident since early 2012. We have concerns that the current escalation of house prices is increasing risk in the New Zealand financial system, by increasing both the probability and potential effect of a significant downward house price adjustment, that could result from a future economic or financial shock. Unlike many other countries, New Zealand did not experience a major house price correction during the GFC and the median house price is now 12 percent above its end-2007 level. This has left us with house prices that are already high relative to BIS central bankers’ speeches international norms. For example, in a recent international study of housing affordability, median New Zealand house prices (relative to disposable incomes) were the third highest amongst comparable countries.3 The more that house prices continue to overshoot their long-run sustainable levels, the greater the prospect of an eventual significant downward correction. We have seen in those countries most affected by the GFC the significant damage that can result from sharp declines in house prices, both in terms of financial system losses and the economic stresses placed on borrowers. The impact of such an adjustment could be worsened by existing economic headwinds in the form of an overvalued exchange rate, drought affected agriculture and the government’s significant fiscal consolidation. We are not the only ones concerned. This view of increasing housing risk in the New Zealand financial system is shared by the International Monetary Fund in their recent “Article IV” assessment4 and was voiced during the recent OECD mission to New Zealand. It is also shared by Moody’s and Standard and Poor’s in their most recent risk assessments of the New Zealand banking system. What can be done to reduce the imbalances? An important medium- to long-term policy response is to work on alleviating the housing supply constraints, particularly in Auckland. That means freeing up land for subdivisions and also reducing the time and cost barriers faced by developers. As recommended by the Productivity Commission, there is also a need to promote/facilitate productivity improvements in the building sector itself, in order to bring unit costs more into line with international norms. The Government is working on measures to address many of these supply constraints, but we know it could take many years to correct the supply/demand imbalances through supply measures alone.5 For example, recent Motu research on a regional housing model for New Zealand concludes: “The over-arching conclusion across all simulations is that housing markets are very slow to adjust to disequilibria, such that exogenous shocks have very long lasting effects on prices and the housing stock.” (Grimes et al, 2013)6 In the short-to medium-term, we want to ensure that the banking system is adequately capitalised for the risks associated with mortgage lending and also avoid demand pressures that could exacerbate a house price overshoot that is in no-one’s best interest. A continued escalation of house prices would frustrate first-home buyers; it would risk drawing more investors into the market which would reinforce the price overshoot; it would likely reverse the recent improvement of household debt relative to income; and it would add a further layer of risk to the banking system. From a Reserve Bank monetary policy perspective, if the house price and credit expansion begin to fuel excessive consumption spending and inflationary pressures, a monetary policy response would become more likely. The Reserve Bank’s flat interest rate outlook in our recent Monetary Policy Statement would need to be revisited. In the financial policy area we are currently consulting on a potential increase in bank capital requirements against high LVR lending. We also expect to soon have in place a macroprudential policy framework that could be used to increase resilience in the banking system against a future housing downturn while having a moderating influence on credit expansion http://www.demographia.com/dhi.pdf http://www.imf.org/external/np/ms/2013/031813b.htm http://www.treasury.govt.nz/publications/informationreleases/housing/pdfs/ha-202689.pdf http://motu-www.motu.org.nz/wpapers/13_02.pdf BIS central bankers’ speeches to the housing sector.7 Macro-prudential policy is primarily aimed at enhancing financial stability, but it may also contribute to achieving monetary policy objectives. It is not seen as a replacement for monetary policy and it is not expected to be as powerful a tool as monetary policy. Macro-prudential policy could nevertheless have a stabilising impact on credit supply decisions by the banks as well as credit demand decisions by households. Conclusion I have talked about the importance of housing to New Zealanders, certainly from an economic and financial perspective, and also from an emotional perspective. This often makes housing a major force behind economic and financial cycles, and a very relevant factor in the Reserve Bank’s monetary and financial policy considerations. Current housing market pressures are centred in Christchurch and Auckland where significant supply shortages are apparent, for quite different reasons. In Christchurch the imbalance is being addressed through a major four to six year rebuilding programme, funded largely by Government and the insurance sector. In Auckland the housing imbalance is more complex and uncertain. There are clearly supply constraints and high costs of development that need to be worked on over the medium- to long-term. However, there are also escalating demand pressures in the Auckland market, particularly arising from low interest rates and an easier supply of credit. It is important that these pressures moderate in order to avoid a destabilising overshooting of house prices while additional supply is gradually brought on stream. New Zealand needs to avoid another housing boom, which could potentially be more costly than the last, particularly at a time when the economy faces headwinds from an overvalued exchange rate, drought and a substantial programme of fiscal consolidation. http://www.rbnz.govt.nz/finstab/macro-prudential/5166933.pdf BIS central bankers’ speeches
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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Institute of Director, Auckland, 30 May 2013
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Graeme Wheeler: Forces affecting the New Zealand economy and policy challenges around the exchange rate and the housing market Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Institute of Director, Auckland, 30 May 2013. * * * Thank you for the invitation to meet with you today. I would like to discuss some of the key forces shaping our economy and the challenges they present for businesses and for the Reserve Bank. I will focus mainly on two highly topical areas: the exchange rate and the housing market, but first let me frame them in a broader context. i) Forces affecting the New Zealand economy Our economy is buffeted by a range of domestic and international factors. Some are driven by natural events, like the $40 billion rebuild activity in Canterbury, and the decline in agricultural production and spending associated with the drought. Some result from international conditions, like the 20 percent decline and subsequent recovery seen in our export commodity prices over the past 18 months, or the monetary and liquidity policies of major central banks that increase the upward pressure on our exchange rate. Other pressures, such as house price inflation, are driven by supply shortages, pent up demand, and the lowest mortgage rates in 50 years. And others, such as the government’s fiscal consolidation, represent major adjustments in domestic economic policy. At the same time, businesses also face challenges in adjusting to powerful long-term structural changes that are global in nature. These include: the growing importance of China and the East Asia Region as a major pole for global growth and international trade; the global transfer of skill enhancing technologies; the relative decline in the international price of information technologies and manufactured goods; and the rising international demand for highly skilled labour. Producers therefore have many global and domestic forces to respond to. The success with which they adjust to global structural changes is also influenced by current economic conditions. For example, the challenges faced by producers competing against foreign lowcost producers, or multinationals with global supply chains, increase when our exchange rate overshoots. On the other hand, the high exchange rate makes imports of capital goods cheaper and may encourage the take up of capital intensive technologies. The interaction of multiple forces can pose difficult policy challenges for the Reserve Bank, although taken in isolation, the direction of their short-term impact on output, employment, and inflation is reasonably clear. For example, the high exchange rate and fiscal consolidation generally exert downward pressure on demand, output growth, and inflation. In contrast, the massive programme of reconstruction in Canterbury, and the increase in house prices and residential construction in Auckland, are boosting demand and output, and tending to exert upward pressure on inflation. One of the more complex analytical challenges for example, is whether New Zealand can achieve the resource allocation needed for the rebuilding activity in Canterbury and Auckland without seriously damaging its tradables sector. This damage could occur if the relative price changes needed to induce the supply response spilled over into broad inflationary pressures, necessitating tighter monetary policy and creating further upward pressure on the exchange rate. This is one reason why reducing the Government’s demand for resources through fiscal consolidation is so important. I will now turn to the issue of exchange rate pressures and the housing market. BIS central bankers’ speeches ii) Exchange Rate Pressures The high exchange rate continues to be a significant headwind for the tradables sector, restricting export earnings and encouraging imports over domestic tradables production. Our real effective exchange rate is about 18 percent above its 15 year average1. There are several reasons for this exchange rate appreciation. Foreign investors are attracted by our higher growth, commodity linkages into Asia, and positive interest rate differentials in a low yield world. Our economy is growing more strongly than most advanced economies, our terms of trade are 17 percent higher than their average level during the 1990s, and central banks in countries representing around two thirds of world output currently have official interest rates between 0 and 1 percent. In addition, various types of quantitative easing have added USD5 trillion of assets to central bank balance sheets over the past four years. These policies, which seek to stimulate growth by ‘printing money’, have negative currency spillovers for attractive investment destinations such as New Zealand that experience foreign portfolio inflows and upward exchange rate pressure. Fluctuations in investor risk appetite are also an important factor influencing our exchange rate. The surge in global liquidity, and especially that associated with quantitative easing, has led to rising equity markets in several countries. We see this most recently in Japan and the US, where the Nikkei and S&P indexes have increased by 40 percent and 16 percent respectively since the end of 2012. A close relationship exists between the New Zealand dollar and international risk assets such as equities. A rise in the S&P 500 often reflects a broader ‘risk on’ trading environment that leads to higher exchange rates in the currencies of better performing advanced economies such as New Zealand, Australia, Norway, Sweden, and some emerging market economies. Among the developed market currencies, the Kiwi has been the third strongest performing currency against the US dollar (after the Mexican peso and Swedish krona) over the past 12 months. Figure 1: NZ dollar and global equities Source: RBNZ, Haver The real effective exchange rate provides a more accurate picture of competitiveness than the nominal effective exchange rate as it corrects for differences in relative inflation rates (or relative unit labour cost movements) between New Zealand and its major trading partners. BIS central bankers’ speeches On 11 April 2013, our exchange rate, on a trade weighted basis, reached a post float high of 79.7. Fortunately it has retreated a little in recent weeks as a result of a stronger US dollar. Investors, however, remain keen to hold New Zealand dollar assets even though, in our view, the exchange rate remains significantly over-valued. For the current exchange rate to be sustainable in the long term, sizeable increases in the terms of trade and/or productivity would be needed. In mid-2012 the IMF suggested that New Zealand’s exchange rate was over-valued by 10– 20 percent. The current account deficit is sizeable, and private sector external indebtedness is high. Foreigners already hold 69 percent of outstanding New Zealand government bonds. Investors also appear to downplay the liquidity risks inherent in a small market like New Zealand. Our past exchange rate cycles have exhibited substantial overshooting followed by a sharp and rapid exchange rate depreciation. Such rapid exchange rate corrections reflect the drain in market liquidity that can occur when a small market like New Zealand begins to turn down. Figure 2: NZ’s real effective exchange rate Source: Bank for International Settlements Note: BIS real effective exchange rate for New Zealand, broad measure incorporating bilateral rates with 61 economies. It is, nevertheless, possible that the exchange rate could remain strong for some time. Recent output, demand, and confidence indicators in New Zealand have been favourable whereas key economic indicators in the Eurozone remain grim and there is some uncertainty about the strength of growth in the US. A further surge in global liquidity is expected as Japan endeavours to double its base money supply within two years. And while the Federal Reserve could begin to cut back its bond purchase programme later in the year, quantitative easing could well increase in the UK and the euro area. In addition, central banks and sovereign wealth funds, which tend to be more long-term investors, have been increasing their presence in the New Zealand market. The Reserve Bank has been responding to the rising exchange rate through two avenues: in maintaining the Official Cash Rate (OCR) at an historically low level; and through a degree of currency intervention. The high exchange rate is reflected in the current low level of the OCR. The appreciating exchange rate exerts downwards pressure on inflation in the tradables sector by lowering the cost of imported goods and reducing activity and resource pressure in the tradables sector (tradables inflation has been negative since the second quarter of 2012). This means that the BIS central bankers’ speeches OCR can be set at a lower level than would be the case if the exchange rate had not appreciated as strongly. Figure 3: Tradables and non-tradables inflation Source: Statistics NZ In assessing whether to intervene in the exchange market, we apply four criteria. These are whether the exchange rate is at an exceptional level, whether its level is justifiable, whether intervention would be consistent with monetary policy, and whether market conditions are conducive to intervention having an impact. This last factor is especially important given the volume of trading in the Kiwi. (In the most recent survey – April 2010 – by the Bank for International Settlements, the Kiwi was the tenth most traded currency in the world with daily turnover of spot and forward exchange transactions totalling around USD $27 billion.) In recent months we have undertaken some foreign exchange transactions to try and dampen some of the spikes in the exchange rate. But we are also realistic in respect of potential outcomes given the strength of the foreign demand for the New Zealand dollar relative to the scale of our intervention capacity. We can only hope to smooth the peaks off the exchange rate and diminish investor perceptions that the New Zealand dollar is a oneway bet, rather than attempt to influence the trend level of the Kiwi. But we are prepared to scale up our foreign exchange activities if we see opportunities to have greater influence. iii) Housing pressures Housing has a particularly important role in the New Zealand economy. It comprises almost three quarters of household assets and mortgage credit accounts for over half of total banking system lending. Consequently, housing is a major source of value and of risk to both our household sector and banking system. In considering the sources of risk around housing, the Reserve Bank focuses on three broad dimensions. First, what are the inflation risks from rising construction costs, rents, and other housing-related expenditures, and the additional spending from ‘wealth effects’ associated with rising house prices and households’ willingness to borrow against housing capital gains? Second, how well are the banks capitalised in order to protect their balance sheets against a significant fall in house prices, and how serious might the risk be for individual banks and the domestic financial system as a whole? And third, what is the possible impact of a significant fall in house prices on the New Zealand economy? While these three risks relate to both our price stability and financial stability mandates, it is the financial stability risk that concerns us most in the current situation. BIS central bankers’ speeches The IMF consider New Zealand house prices to be over-valued by around 25 percent2. House prices, relative to disposable incomes and rents, are high by international standards, and unlike in some other economies, our house prices did not decline significantly in the aftermath of the global financial crisis. Our median house price is 12 percent above the end 2007 level even though New Zealand experienced the biggest house price boom in its history over the 2003 to 2007 period (and the most rapid house price inflation in the OECD). We are now into our second major house price cycle over the past decade and house prices, as measured by the Real Estate Institute of New Zealand, rose by 8 percent over the past year (March quarter 2013 over March quarter 2012), and 13 percent in Auckland and 10 percent in Christchurch. Outside these areas, prices rose by an average of around 4 percent, although there is considerable variation among districts. House price increases are being driven by a combination of supply shortages (especially in Auckland and Christchurch), pent up demand, and the lowest mortgage rates since the mid1960s. The rise in house prices in Auckland in particular has strong momentum. Easy credit conditions mean that the cost of credit is now only slightly above average rental yields of 4.5 percent and this, combined with the rise in house prices, increases the incentive for renters to become first home buyers and for existing house owners to upgrade. Banks are competing aggressively to meet the demand for mortgage lending. Consequently, the share of mortgage lending to clients with deposits less than 20 percent of the value of the house now comprises around 30 percent of new lending across the five major banks – up from around 23 percent in October 2011. Households remain highly levered with household debt around 145 percent of household disposable income. The correction in the debt ratio after the global financial crisis was gradual relative to the build up over the 15 years prior to the global financial crisis, and the ratio has recently picked up. Figure 4: Household debt as a percent of disposable income Source: RBNZ Despite being over-valued, house prices could continue rising for some time. In this respect, the recently agreed Auckland Accord reflects the growing need to improve the responsiveness of housing supply. Other measures can help. The adoption of the full range of supply side measures in the Productivity Commission’s recent report would lower costs, and the demand for housing could also be moderated by changing the tax treatment of housing to reduce its attractiveness as an investment relative to other assets. But the current IMF, April 2013, “New Zealand – Staff report for the 2013 Article IV Consultations”. BIS central bankers’ speeches supply/demand imbalance in Auckland is very large and it could take several years to address this through supply measures alone. Adding to the challenge is the decline in capacity in the construction industry in the last five years. According to the latest Business Demographic Statistics, in February 2012 there were 5,000 fewer firms and 14,000 fewer employees in the construction sector than there were in February 2008. Despite this overall decline, construction sector employment in Canterbury had increased by 15 percent. Although the construction sector is a relatively fluid industry and attracts workers from other sectors, the level and pace of construction activity outside Canterbury will no doubt be constrained by the pull of resources into the Canterbury rebuild. A strong run-up in housing markets can be a risk to future financial stability because it can increase both the risk of a sharp correction and the consequent financial sector disruption. The Reserve Bank is concerned that the current escalation of house prices is increasing the probability and potential effect of a significant downward house price adjustment that could result from a future economic or financial shock. These concerns are shared by the OECD and by the IMF in its recent review of the New Zealand economy, and housing risks have been noted recently by all three of the major international credit rating agencies. We are responding to the financial stability risks around the housing market in several ways: by raising banks’ capital requirements for housing lending; conveying our concerns about risks to financial stability; and putting in place a framework for macro-prudential policy to address those risks and increase the financial system’s resilience. Earlier this month, following a review of the major banks’ housing risk models, we raised the risk weights applying to all current and new high loan-to-value ratio (LVR) housing loans for the four major banks that use their own models to calculate minimum capital requirements. This represents a 12 percent average increase in housing capital (an increase of around $125 million on average) and it should further strengthen the capacity of banks to withstand a housing downturn and encourage banks to review the riskiness of the loans they are writing. We have been expressing concerns about the financial stability risks associated with the scale of housing lending, and especially high LVR lending, in our published research and speeches, and in our conversations with bank boards, audit committees, chief executives, and risk management teams. We recently completed a round of public consultation on a macro-prudential policy framework that is aimed at building additional resilience in the financial system during periods of rapid credit growth and rising leverage or abundant liquidity. The instruments can also help to dampen growth in credit and asset prices that might pose risks to financial stability. These measures would require banks to hold additional capital buffers, have higher proportions of stable sources of funding, or limit the share of high LVR lending. Instruments such as counter cyclical capital buffers and overlays on sectoral risk weights are aimed more at increasing banks’ capital adequacy rather than increasing the cost of lending for borrowers. Quantitative restrictions on the share of high LVR lending are designed to more directly affect the supply and cost of this type of lending. Two weeks ago the Minister of Finance and I signed a Memorandum of Understanding confirming the elements of the policy, including the range of policy instruments, and governance arrangements relating to their possible deployment. We are currently working on the operational details for each of the instruments and will soon be consulting with banks on these features. Macro-prudential instruments directed at the financial sector risks arising from the housing sector have been deployed in several countries (eg., Canada, Israel, Korea, Norway, and Sweden), with weight often put on restrictions around the level of high LVR lending. While there are important design issues to address in devising such measures, the empirical evidence to date suggests that during episodes of quickly rising real estate prices, LVR limits BIS central bankers’ speeches can help reduce the incidence of credit booms and decrease the probability of financial distress and sub-par growth following the boom3. One should be cautious in predicting the size of the impact of such measures when house prices are increasing rapidly, but we believe that macro-prudential instruments could have played a useful role in building up capital buffers and reducing credit demand and asset price pressures in the housing price boom of 2003–2007. iv) The exchange rate and the housing market The exchange rate and the housing market present difficult challenges for monetary policy when both the currency and asset prices appear to be overvalued and investor demand is expected to remain strong. Generally, housing demand can be constrained by raising official interest rates and letting them feed through into higher mortgage costs. However, while this would help constrain the demand for mortgage finance, increasing the OCR would carry significant risks in New Zealand in the current environment. It would increase the interest rate differential between New Zealand and most of the advanced countries, and could lead to a further strengthening in the exchange rate and further downward pressure on tradable goods prices. This would, in turn, be expected to push CPI inflation further below the 1 to 3 percent target range. The exchange rate impact could be pronounced if investors believed that the increase in the OCR was a precursor to further increases and saw New Zealand as leading other countries in the monetary policy tightening phase. Viewing the issue from another perspective, if our exchange rate continues to strengthen on a trade weighted basis, in the absence of a corresponding improvement in New Zealand’s economic outlook, inflation pressures would diminish and a reduction in the OCR might be warranted. However, with mortgage interest rates at a 50-year low, large housing shortages in Auckland and Christchurch, and surveys indicating that home buyers expect price rises to continue, a lower OCR would quickly feed into higher house prices and further increase the risks to financial stability. This is where macro-prudential policies can play a useful role. Capital and liquidity overlays can help build up buffers in the banking system while adding to the cost of bank funding. And loan-to-value restrictions may help to reduce the actual supply of mortgage lending. While these measures are aimed at financial stability objectives, their effects might also have the benefits of increasing the degrees of freedom available to the Reserve Bank in conducting monetary policy. For example, if house price pressures abate, all other things unchanged, it would increase the possibility that the OCR could remain at its current level for longer than through this year, which is the time profile built into the forward projections contained in the March 2013 Monetary Policy Statement. Similarly, if housing pressures are much less of a concern and the exchange rate continues to appreciate and the inflation risk looks low, it may create opportunities to lower the OCR. Macro-prudential measures can be useful in helping to restrain housing pressures, but they are no panacea. This reinforces the importance of progressing measures to enhance productivity in the construction sector, free up land supply, and examine related tax issues. If the house price and credit expansion begin to fuel excessive consumption spending and inflationary pressures, a monetary policy response would become more likely. Blanchard, Olivier, Giovanni Dell’ Ariccia, and Paolo Mauro, April 2013, “Rethinking Macro Policy II; Getting Granular”, IMF Staff Discussions Note. BIS central bankers’ speeches v) Concluding comments As a small open economy, New Zealand can expect to be buffeted by an array of domestic and financial shocks that are sometimes temporary in nature or linked to longer-term global structural change. But these are extraordinary times. Not only does the economy need to absorb the impact of a significant drought, a major programme of fiscal reduction, and the resource allocation associated with rebuilding our second largest city, we also have to adjust to heavy portfolio inflows that cause our exchange rate to appreciate and reduce the profitability and competitiveness of our tradables sector. And we need to do so at a time when house price inflation is increasing risk in the New Zealand financial system. Many of these challenges will be with us for some time. The Government’s fiscal adjustment is expected to be spread over three years, the Canterbury rebuild is likely to take a decade or longer, and the housing supply/demand imbalance in Auckland could take three to five years to close if left to supply measures alone. On the external side, New Zealand is likely to be an attractive investment destination for the foreseeable future and interest rate rises in the major economies may be two or more years away. The Reserve Bank needs to achieve its price and financial stability objectives in this environment. Doing so will require us to draw on the full array of policy instruments, including macro-prudential instruments, as appropriate. BIS central bankers’ speeches
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Speech by Mr Grant Spencer, Deputy Governor and Head of Financial Stability of the Reserve Bank of New Zealand, to the Business NZ Council, Wellington, 27 June 2013.
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Grant Spencer: Macro-prudential policy and the New Zealand housing market Speech by Mr Grant Spencer, Deputy Governor and Head of Financial Stability of the Reserve Bank of New Zealand, to the Business NZ Council, Wellington, 27 June 2013. * * * There has been much discussion around the increasing pace of house price inflation in New Zealand. We at the Reserve Bank have been highlighting the risks for financial stability and potentially also for broader price stability if house prices continue to accelerate. The strong housing market is starting to underpin household demand but, with some slack still in the economy, this cannot yet be described as a threat to overall inflation. Our most recent projections show CPI inflation trending gradually back towards the mid-point of our target band. We are also well aware that any Official Cash Rate (OCR) increases at this time would likely put unwanted pressure on the exchange rate. For these reasons, higher interest rates are not the right policy response at this time. This brings me to my topic today: macro-prudential policy. You will be aware that the Reserve Bank has recently been developing a number of macro-prudential policy tools. Today I would like to review the structure and intent of these instruments and focus particularly on the loan to value ratio (LVR). This tool is more complex than the others we are considering, yet it also offers the greatest potential for moderating the current excesses in the housing market. First I will recap on why we see the housing market as a real threat to financial stability. Housing market a threat to financial stability Figure 1: House price inflation and effective mortgage rate Source: Property IQ, RBNZ. The current housing market pressures in Auckland and Christchurch are due to a combination of factors. The pressures in Christchurch are a direct consequence of the significant damage to the housing stock from the earthquakes and the demands of the BIS central bankers’ speeches re-build. In Auckland, housing imbalances are the result of limited supply over a number of years and strong demand, supported by historically very low mortgage interest rates and easy credit terms, including a willingness by banks to accept relatively low deposits (figure 1). More recently it looks as though net inward migration is picking up and this could add further pressure to housing demand. While demand has been strengthening, supply remains limited. Low rates of housing construction since the global financial crisis (GFC) have left a shortage in Auckland, assessed by the Auckland Council at 20,000 to 30,000 homes. The recent accord between the Government and Council targets the construction of 39,000 new houses over the next three years and we fully support their efforts to improve the responsiveness of housing supply to the growing demand. But with a myriad of planning and resourcing issues to deal with, it could take many years to clear the shortage. In Christchurch, the supply response has a similar range of obstacles to overcome, with the added complexity of insurance issues. It could take several years to complete the more than 10,000 homes needed. In our view the strength of housing and credit demand is not fully reflected in the aggregate credit data. Total outstanding mortgage credit growth is increasing but still at lower rates – of around 5 to 6 percent per annum – than in the previous boom. However these growth rates are net of debt repayments which have been significantly higher in the years since the GFC. New mortgage approvals and loans have been growing at a faster rate and are now comparable with the pre-GFC peak levels. The value of house sales is now also near the 2006–07 peak levels (figure 2). Figure 2: House sales and changes in mortgage credit (monthly) Source: REINZ, RBNZ. If house prices and debt were rising from depressed levels, then these trends would not be of real concern. However the current house price and debt trends are on top of already high base levels – both by historical and international standards. For example, figure 3 shows New Zealand having the fifth highest house price overvaluation, relative to incomes, in the OECD. The further house prices are stretched, the more likely it is we will see a disruptive downward correction at some point in the future. While the banks’ balance sheets are currently in good BIS central bankers’ speeches shape with strong capital and liquidity buffers, such a correction could be very damaging if combined with a serious economic or financial shock to New Zealand. The Reserve Bank is not alone in its belief that the housing market is posing a growing risk to financial stability in New Zealand. This view was also expressed by the International Monetary Fund (IMF) and OECD in their recent reports on New Zealand and also by the three major rating agencies. Figure 3: House price to income across OECD countries (deviations from historical average) Source: OECD While the Reserve Bank’s mandate is to promote financial stability, not social equity, there are clear implications here for housing affordability. As house prices and debt levels trend increasingly upwards, so too housing becomes less affordable, particularly for first home buyers. While macro-prudential policy measures might make credit less accessible for a period, they should help to make house prices more affordable in the longer term. Such measures should also reduce the risk of a sharp housing downturn and the loss of equity that would result, particularly for highly indebted home owners. New macro-prudential framework The aim of macro-prudential policy is to manage risk in the financial system arising from transient but pervasive macro-financial developments, such as credit and asset price cycles or major international financial shocks. While micro-prudential policy settings (e.g. capital ratios and risk weights) are fixed on a through-the-cycle basis, macro-prudential policy measures are introduced as an overlay when needed in order to mitigate significant but transitory risks affecting the whole financial system. Macro-prudential policies can achieve this in two ways: first, by increasing the resilience of bank balance sheets to a potential shock (which also gives them a greater capacity to keep lending in the downturn); and second by seeking to dampen a credit and asset price cycle on the upswing in order to reduce the severity of the eventual downturn. Macro-prudential policies have become more prevalent since the GFC because that experience highlighted the massive financial and economic damage that can result from macro-financial shocks. BIS central bankers’ speeches A macro-prudential framework for New Zealand has been developed over the past year or so. The Reserve Bank has communicated the framework through a range of speeches, consultation documents and reports (see for example Spencer (2012), RBNZ (2013a), RBNZ (2013b)). A Memorandum of Understanding has been signed between the Reserve Bank and the Minister of Finance which sets out the key objectives, instruments and responsibilities under the new framework. The Reserve Bank has decision-making responsibility for macroprudential policy implementation but must consult with the Minister and Treasury prior to the deployment of any instrument. The Reserve Bank has also undertaken to keep the public informed on macro-prudential policy through speeches and publications, with the main accountability document being our six monthly Financial Stability Report. Four potential instruments have been put forward and these are summarised in Table 1. The four instruments work in quite different ways to reduce financial system risk. The countercyclical buffer and sectoral capital overlay work by requiring banks to hold additional capital buffers against potential shocks in asset markets or particular economic sectors. The additional capital requirement may give rise to some increase in lending rates as a result of higher overall funding costs and may also reduce the supply of credit to housing at the margin, but is unlikely to have a major impact on the overall growth in housing credit. Table 1: Macro-prudential Instruments Counter-cyclical capital The CCB is part of the Basel III framework. It requires an additional capital buffer (CCB) overlay to be applied, normally of up to 2.5 per cent of risk weighted assets. Higher capital holdings would increase the resilience of bank balance sheets to credit shocks. The CCB might also moderate the credit cycle via upward pressure on bank funding costs. Banks would be given up to 12 months to raise the extra capital. Adjustments to the minimum core funding ratio (CFR) Adjustments to the CFR would vary the proportion of stable funding (retail deposits and long term market funding) required relative to a bank’s total lending. A CFR tightening would increase the resilience of banks to liquidity shocks. It could also lean against the credit cycle by increasing bank funding costs. Banks would be given up to six months’ notice in which to meet an increase in the CFR. Sectoral capital requirements (SCR) Sectoral capital requirements are akin to the CCB and would require banks to hold extra capital against lending to a particular sector. An SCR would provide an additional cushion against credit shocks in the relevant sector and could reduce the relative attractiveness of lending to that sector. Banks would be given up to three months’ notice in which to raise the extra capital. Restrictions on high loan-to-value ratio (LVR) residential mortgage lending. Restrictions would take the form of caps or “speed limits”, the latter restricting the share of new bank lending that has a high LVR. Such restrictions, if binding, would reduce the incremental risk in bank mortgage portfolios and would also have a direct effect on the supply of new bank credit, thus potentially moderating housing market pressures. Banks would be given at least two weeks’ notice of any LVR restriction. Similarly, a temporary increase in the core funding ratio would make banks more resilient to liquidity shocks but would likely have only a limited effect on credit growth through somewhat higher lending rates. This is to say, the instruments based on capital and liquidity overlays mainly reduce risk in the system by increasing the resilience of bank balance sheets rather than by having a significant dampening effect on asset cycles. LVR restrictions, on the other hand, have the potential to reduce risk more directly: both by reducing the riskiness of loan portfolios; and also by dampening asset prices through a reduced supply of credit. BIS central bankers’ speeches International precedents for use of the first three instruments are limited. The CCB is part of the new Basel III regime which is live from January 2014 for New Zealand and somewhat later for many other countries. The deployment of a SCR has been recently announced by the Swiss and will come into effect in September. They are applying a capital overlay of 1 percent against all residential mortgages. The CFR is an existing micro-prudential tool, similar to the Net Stable Funding Ratio (NSFR) under the Basel III regime. As a macroprudential tool, the CFR is unique to New Zealand, although the possibility of using the NSFR as a macro-prudential tool has been under consideration in the United Kingdom. There are considerably more precedents for the use of LVR restrictions and I will elaborate on these shortly The point I want to make here is that, of the four macro-prudential instruments, the LVR instrument is the one with the best scope to dampen the current strong demand for housing, as well as reducing the riskiness of bank balance sheets. For this reason the Reserve Bank is looking closely at the use of LVR restrictions to address the growing housing market threat to financial stability. While all four of the macro-prudential instruments remain valid options, I will use the rest of my time to focus on LVR restrictions and how they would work. Loan-to-value restrictions As I mentioned, LVR restrictions have the most potential to reduce risk both by making bank balance sheets less risky and by dampening housing market pressures through reduced credit supply. Borrowers with high LVR loans are often stretching their financial resources, paying a deposit of less than 20 percent and often also having high debt service ratios (DSRs). Such borrowers are more vulnerable to an economic or financial shock such as a recession or an increase in interest rates. A high LVR loan is more likely to be underwater in the event of a default and is therefore a riskier proposition for the lender. A restriction on the volume of high LVR loans should reduce the inherent risk in banks’ mortgage portfolios as well as reducing the overall supply of credit to the housing market. The international evidence suggests that a prevalence of high LVR lending can accentuate loan losses and worsen economic disruption when inflated house prices correct abruptly. Two examples are the United States and Ireland. While lending practices in these countries were far more extreme than we have seen in New Zealand, their experiences are instructive. In both countries, house price appreciation was fuelled by competition between lenders, and falling lending standards. By 2006, 20 percent of new mortgage lending in the United States was sub-prime, often with minimal credit checks and very high LVRs. Similarly in Ireland, lending was often occurring at LVRs over 100 percent. Annualised house price growth peaked at 16 per cent and 15 per cent in the US and Ireland in the lead up to the GFC before falling sharply. The subsequent sharp downturns gave rise to considerable financial distress in both countries, with high LVR borrowers particularly hard hit. At the bottom of the US housing market in 2010/11, around 25 percent of the 50 million or so mortgage holders had loans larger than the value of their houses. In New Zealand, losses from housing loans in the wake of the GFC were well contained compared to many countries, although there was an increase in defaults. The Reserve Bank recently analysed data on banks’ loss rates, by LVR category, over the period from 2008 to 2012. The increase in loss rates followed a fall in nominal house prices of around 10 percent from their peak in 2007. While there was some variation across banks, the data shows that loss rates on high-LVR loans generally increased more (and in several cases substantially more) than loss rates on lower LVR loans. This evidence of high and correlated loss rates supports the proposition that higher LVR loans have more systemic risk than lower LVR loans. It is on this basis that the Reserve Bank recently took the (micro-prudential) measure of increasing high LVR risk weights on the housing exposures of the major banks (RBNZ, 2013c). BIS central bankers’ speeches A number of countries have applied LVR restrictions over the past few years, including Canada, Sweden, Norway, Israel, Korea and Hong Kong SAR. In the case of Sweden and Norway, the LVR restrictions are in the form of guidelines rather than hard regulatory limits. The LVR restrictions often work in concert with regulatory debt servicing limits (e.g. Korea), while insured mortgages in a number of economies are exempted from the restrictions (e.g. Canada and Hong Kong SAR). The available evidence suggests that LVR caps can slow credit and asset price cycles. In addition, the IMF has studied house price corrections in OECD economies since 1980 and concluded that the fall in prices was significantly more severe for economies with higher maximum LVR ratios (IMF, 2011a). With regard to slowing down credit growth and house price appreciation, the IMF (2011b) has found, using a cross-country analysis since 2000, that credit growth and house price inflation slowed following the implementation of LVR caps in more than half of cases where the tool was used. A more sophisticated estimation approach found that the introduction of LVR caps reduced the pro-cyclicality of credit growth. Studies estimating the effects of LVR caps in Hong Kong (Craig and Hua (2011), Wong et al (2011)), Korea (Igan and Kang (2011)), and most recently in Canada (IMF (2012)), have found that reductions in maximum LVRs had a significant impact on housing transactions, house prices, house price expectations and/or housing credit growth. We are currently consulting with the banks on how LVR restrictions could be implemented in New Zealand (Refer Consultation on framework for restrictions on high-LVR residential mortgage lending). The consultation is concerned with a range of mainly technical implementation issues such as: how is a loan defined, what is a valid valuation, how will LVRs be measured and reported to the Reserve Bank, and what loans will be exempted. I will not go into all the details, but I will mention some key features of our preferred approach. First, an LVR restriction would apply to new lending by banks, not the banks’ existing loan portfolios. The banks can control the LVR of loans at origination, but they cannot control the effect of house price movements on LVRs of existing loans. Second, we favour speed limits over outright restrictions. We do not want to ban high LVR lending; we would prefer to restrict it as a share of banks’ total new lending. With a speed limit approach, we expect banks would need to build in their own internal buffers to give themselves a margin of error. Such buffers could reduce as banks become better at controlling their proportion of high LVR lending. Within the speed limit, each bank would make their own assessment of which customers received high LVR loans, based on their own criteria including other risk measures, such as debt servicing capacity, and the potential long-term value of those customers to the bank. Exemptions A number of submissions to the recent consultation have proposed targeting particular borrower segments. Our preference is to keep the policy simple and effective by not having major exemptions and by minimising the possibilities for avoidance. If for example there was a carve-out for small businesses, the potential for avoidance would increase markedly as individual borrowers set up companies for borrowing purposes. Categories where there is a clear case to exempt include Housing New Zealand mortgageinsured loans, bridging loans, refinancing loans and high-LVR loans to borrowers who are moving home (but not increasing their LVR or loan amount). Unintended consequences While we believe that LVR restrictions could have significant benefits in terms of reducing systemic risk in the housing market, they are not a panacea. We recognise there would be costs and unintended consequences. Most obviously there would be implementation costs. Banks will need to change systems and policies, and train staff to implement LVR BIS central bankers’ speeches restrictions. More substantially, there will be system-wide efficiency costs arising from borrowers and lenders seeking to avoid LVR restrictions. The most obvious channel for avoidance is family loans, which could become more prevalent as a means of reducing the amount of bank finance utilised by first-home buyers. That is a family’s prerogative and there is nothing the Reserve Bank could or should do about it. Alternative channels could include unsecured top-up loans or high LVR mortgages from non-bank housing lenders. Such disintermediation will tend to be greater, the longer that any restrictions remain in place. If it becomes widespread, then efficiency costs could become significant at the same time as the effectiveness of the policy is reduced. If avoidance activity is so prevalent as to undermine the effect of the LVR policy then either the LVR restriction could be removed or the LVR policy could be applied more broadly and/or more rigorously. For example, following the introduction of LVR restrictions in 2002, the Korean authorities expanded the regulatory perimeter in 2006 beyond banks to include nonbank financial institutions. One factor that will constrain these alternative channels is the cost of funding. Unsecured lending is considerably more expensive than mortgage lending, and non-bank funding is more expensive than bank funding. In Sweden, for example, it is quite common for households to borrow a portion of house purchase costs via an unsecured topup loan, and that activity increased when LVR restrictions were applied in 2010. But the borrowers who do that need to consider the higher interest rate on unsecured funds as well as the more rapid repayment of their top-up funds relative to their main mortgage. In this way there can be significant deterrent effects built into avoidance channels. The cooperation of the banks in implementing any LVR restrictions would be crucial for their success. We would expect bank management and directors to follow the spirit, not just the letter of the restrictions. In particular, they would need to ensure that the policy was not abused or undermined through innovative lending practices. Certainly we would be maintaining a close dialogue with the banks. Removal of restrictions When would an LVR restriction be removed? This would need to be assessed in light of the assessed impact of the restrictions on housing lending, house price pressures and the riskiness of bank balance sheets. Once the housing market returned to a better balance of supply and demand, the restrictions would be removed. Alternatively, we would look to remove the restrictions if they were judged not to be achieving their purpose of reducing systemic risk and/or if they were causing material distortions. If we saw a sharp correction in house prices, there would be a clear case for promptly removing any LVR restrictions. In that situation there would be little risk that removal of the restrictions would result in a resurgence of risk appetite. For example, the correction in house prices after 2007 resulted in a sharp decline in both the demand and supply of high LVR lending, suggesting that an LVR restriction would not have been necessary during this period. A preferred outcome would be a “soft landing” in the housing market, where house price growth moderates without resulting in a sharp correction. In that situation, the Reserve Bank would need to carefully weigh the efficiency benefits of removing any LVR restrictions against the risk that this might stimulate a renewed build-up of systemic risk. A persistent moderation in household credit growth would argue in favour of removal. Conclusion We at the Reserve Bank see the current overheated housing market as a real threat to future financial stability. While limited housing supply is at the heart of the problem, strong demand supported by easy credit is underpinning the rapid escalation of house prices. The demand for mortgages is now close to pre-GFC peak levels. If this momentum persists, the housing market pressures could also become a threat to general price stability. BIS central bankers’ speeches The new macro-prudential policy framework has been developed to address just this kind of macro-financial imbalance. The Reserve Bank is therefore seriously considering the use of macro-prudential policy. While the LVR restriction is more complex and difficult to implement relative to the other macro-prudential instruments, we believe this is the best tool, apart from interest rates, that could moderate the current strength in housing demand. In the current low inflation environment, interest rate increases are not seen as an appropriate response. Although they would have benefits for financial stability, LVR restrictions would bring with them efficiency costs. In order to keep these to a minimum, we believe any restrictions should be set as speed limits, and have relatively few exemptions. It is also important to keep the bigger picture in mind when assessing potential efficiency costs. These need to be compared against the significant economic and financial damage that could result from a housing boom that ends in a severe housing downturn. In the pre-GFC housing boom, with hindsight and with this macro-prudential framework, we would most likely have applied macro-prudential instruments with the aim of reducing systemic risk. In the current situation, with house prices and household debt ratios starting from much higher levels, and with interest rates at historically low levels, the risks to financial stability may well be greater. References Craig and Hua (2011), “Determinants of Property Prices in Hong Kong SAR: Implications for Policy”, IMF Working Paper, 11/277. IMF (2011a) “Evidence on House Prices, Credit, and Housing Finance Characteristics in Advanced Economies”, Annex 3.2 in Chapter 3, Global Financial Stability Report, April. IMF (2011b) “Macro-prudential Policy: What Instruments and How to Use Them?”, IMF Working Paper, 11/238. IMF (2012) “Recent experience with macro-prudential tools in Canada: Effectiveness and options going forward”, Chapter 3 in 2012 Article IV. Igan, D and H Kang (2011) “Do Loan-to-Value and Debt-to-Income Limits Work? Evidence from Korea”, IMF Working Paper, 11/297. Reserve Bank of New Zealand (2013a) “A new macro-prudential policy framework for New Zealand – final policy position” available online at http://www.rbnz.govt.nz/financial_stability/ macro-prudential_policy/5270425.pdf Reserve Bank of New Zealand (2013b) “Framework for restrictions on high-LVR residential mortgage lending” available online at http://www.rbnz.govt.nz/regulation_and_supervision/ banks/policy/5302259.pdf Reserve Bank of New Zealand (2013c) “Response to submissions received on review of bank capital adequacy requirements for housing loans (stage one)” available online at http://www.rbnz.govt.nz/regulation_and_supervision/banks/policy/5253295.pdf Spencer, G (2012), “Prudential lessons from the Global Financial Crisis”, speech delivered to Financial Institutions of NZ 2012 Remuneration Forum in Auckland, 3 May 2012, available at http://www.rbnz.govt.nz/research_and_publications/speeches/2012/4770342.html Wong, E, T Fong, K Li and H Choi (2011) “Loan-to-Value Ratio as a Macroprudential Tool – Hong Kong’s Experience and Cross-Country Evidence”, HKMA Working Paper, 01/2011. 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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to Otago University, Dunedin, 20 August 2013.
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Graeme Wheeler: The introduction of macro-prudential policy Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to Otago University, Dunedin, 20 August 2013. * * * New Zealand’s economy is now one of the most rapidly growing among the advanced economies. Growth is likely to remain strong and become more broadly based over the next two years, particularly as construction activity in Christchurch, Auckland and elsewhere gathers momentum and provides further stimulus to the manufacturing sector. Our forecasts in the June 2013Monetary Policy Statement, which are currently being reviewed for the next Statement in September, suggested that in 12 months’ time the economy could be growing at just over a 3 percent annual rate, with the unemployment rate declining towards 5 percent and annual CPI inflation back within the 1 to 3 percent target range. These summary indicators, however, disguise the nature and complexity of the adjustments taking place in New Zealand. Included among them are the impact of the monetary and liquidity policies of major central banks, domestic economic policy settings, the powerful long-term global structural changes affecting our economy, and the effects of natural events such as earthquakes and drought1. Just as firms and households develop strategies to adjust to these forces, the Reserve Bank also needs to respond to them in meeting its goals of price stability and financial stability. I will turn to two of the largest forces influencing our economy – our over-valued exchange rate and the over-valued housing market. 1. The over-valued exchange rate Our exchange rate is over-valued relative to what would be sustainable long-term in the absence of sizeable increases in our terms of trade and productivity. Against many of the world’s major currencies, the New Zealand dollar is positioned in the top decile relative to its historic experience. At these levels, the exchange rate is a considerable headwind for New Zealand’s exporters and those that compete with imports, although it has benefited purchasers of imported goods and services and contributed significantly to the current low level of inflation. Our real exchange rate is about 16 percent above its 15 year average2. It is important to look at both long-standing structural and more recent cyclical factors when considering the reasons for New Zealand’s high real exchange rate – although at any time the relative strength of these factors can change. These were referred to in a recent address delivered to the Institute of Directors in Auckland on 30 May 2013: Forces Affecting the New Zealand Economy and Policy Challenges Around the Exchange Rate and the Housing Market. The real effective exchange rate provides a more accurate picture of competitiveness than the nominal effective exchange rate as it corrects for differences in relative inflation rates (or relative unit labour costs movements) between New Zealand and its major trading partners. BIS central bankers’ speeches Figure 1: New Zealand’s real effective exchange rate Source: Bank for International Settlements. Note: BIS real effective exchange rate for New Zealand, narrow measure incorporating bilateral rates with 27 economies. Some of the appreciation in the real exchange rate over the past decade is due to the improvement in our terms of trade (or the ratio of export prices to import prices), which are now 20 percent higher than the average for the 1990s. This reflects the rapid growth of the East Asian economies, and especially China, and the rising global demand for protein. Another factor exerting upward pressure on the real exchange rate is New Zealand’s low level of savings (relative to our business and residential investment needs) and our consequent dependence on foreign savings to achieve these needs. Our low propensity to save means that higher interest rates than elsewhere are needed to achieve similar inflation outcomes and these higher real interest rates result in upward pressure on the real exchange rate. In recent years some important cyclical factors have also been important drivers. These factors have made the returns on New Zealand financial assets more attractive when compared to the returns available in many advanced countries experiencing lower growth rates and adopting more stimulatory monetary policies. Monetary policy in the advanced countries has been highly accommodating with countries representing two thirds of global output having policy interest rates between zero and 1 percent3. In addition, the Federal Reserve, European Central Bank, Bank of England and the Bank of Japan have cumulatively conducted around USD 6 trillion of additional monetary stimulus through quantitative easing. These liquidity injections, often involving the purchase of longer maturity government securities, have been designed to boost domestic asset prices, stimulate spending and, in some instances, depreciate the exchange rate. The combination of historically low policy rates and quantitative easing has lowered bond yields globally and the increased investor demand for riskier and higher yielding assets has compressed spreads. New Zealand government bonds, with their relatively high yields compared to other advanced economies, remain attractive to foreign investors who own 68 percent of government bonds on issue. These countries comprise the United States, Japan, UK, Canada, the 17 Euro zone countries, Sweden and Switzerland. BIS central bankers’ speeches The magnitude of the policy challenges that led central banks in the US, Europe, and Japan to have policy rates at or close to the lower bound of zero, and to resort to large scale quantitative easing, are much greater than those facing New Zealand. For example, the US experienced a huge decline in household wealth. The Federal Reserve reports that median real net household wealth fell 39 percent from 2007 to 2010 to levels seen in 1992. In 2011, the median real level of US household income dropped to its lowest level since 1995. Partly due to the Federal Reserve’s highly accommodating monetary policy that helped to stimulate employment and a recovery in the housing and equity markets, real levels of wealth have now returned to their 2007 level, although not for the median and lower income groups. Deleveraging in the euro area, especially in the financial sector, is proceeding more slowly than in the US and the euro area economy has just emerged from an 18 month recession. The unemployment rate for the euro area is around 12 percent, and 15 percent if Germany is excluded. Several countries face major adjustments. For example, unemployment rates exceed 25 percent in Spain and Greece, Italy’s real per capita income is back at 1996 levels, and annual labour productivity growth in France and Italy has lagged that of Germany by 1.5 and 2.1 percentage points respectively since 2000. Japan has suffered bouts of stop/start growth and deflation for the past two decades. Its general level of prices is now back at 1992 levels and general government net debt is around 145 percent of GDP. In April 2013, the Bank of Japan announced its intention to double Japan’s monetary base by the end of 2014 in an attempt to achieve an annual inflation goal of 2 percent. New Zealand is likely to continue to attract offshore portfolio flows, especially since the larger advanced countries are unlikely to raise short-term policy rates for a considerable time. Investors also seem to be differentiating more between Australia and New Zealand. Australia’s exchange rate has fallen by 13 percent on a trade weighted basis since April 2013 and market expectations are for a further easing in policy rates. This upward pressure on the cross rate is of concern, as Australia is the destination for around a third of New Zealand’s manufactured exports and these are more labour intensive than exports of commodities and dairy products. 2. The over-valued housing market Housing plays a critical role in our economy. It represents almost three quarters of household assets and mortgage credit accounts for over half of banking system lending. Consequently, housing is a major source of value and of risk to the household sector and the banking system. The Reserve Bank focuses on the housing market for three main reasons. First, housing and the construction sector can be a source of inflationary pressure if construction costs and rents increase and the “wealth effects” of rising house prices feed through into additional spending or borrowing to finance consumer goods. Second, the possibility of a significant fall in house prices can have important implications for financial stability and on the ability and willingness of banks to lend to support a recovery. Finally, declining house prices can have significant impacts on output and employment, especially when the associated de-leveraging of household and corporate balance sheets continues for several years. At present, rising construction costs are not a major concern for monetary policy. Construction costs in Christchurch are up 12 percent over the past year and they have recently been rising in Auckland. Changes in relative prices are needed to attract additional workers and resources into the construction sector, but the Reserve Bank will continue assessing the risk of any spill-over of these prices into more generalised inflationary pressures. BIS central bankers’ speeches Our main concern is the rate at which house prices are increasing and the potential risks this poses to the financial system and the broader economy. Rapidly increasing house prices increase the likelihood and the potential impact of a significant fall in house prices at some point in the future. This is particularly the case in a market that is already widely considered to be over-valued. The Reserve Bank is not alone in expressing these concerns. Over the past several months the IMF, OECD, and the three major international rating agencies have pointed to the economic and financial stability risks associated with New Zealand’s inflated housing market. In April this year, the IMF suggested that New Zealand house prices were over-valued by around 25 percent, and the OECD has expressed similar views4. Figure 2: House price to income across OECD countries (deviations from historical average) Source: OECD House prices increased by 16 percent and 10 percent respectively in Auckland and Christchurch over the past year (three-month moving average to July 2013 over the same period in 2012). They increased by 4 percent over the rest of New Zealand overall, with considerable variability among regions. House prices are high by international standards when compared to household disposable income and rents. Household debt, at 145 percent of household income, is also high and, despite dipping during the recession, the percentage is rising again. Furthermore, the growth of house prices is occurring after only a small correction following the house price boom of 2003–2007 that saw New Zealand’s house prices increase more rapidly than in any other OECD country. IMF, (2013),”New Zealand – Staff Report for the 2013 Article IV Consultations”, April. OECD, (2013), “OECD Economic Outlook”, May. BIS central bankers’ speeches Figure 3: House price inflation by region Source: REINZ Rising house prices in Auckland and Christchurch are mainly a result of supply shortages, although demand-side pressures are also a factor due to pent up demand, the lowest mortgage rates in 50 years, and aggressive competition among banks for new borrowers, including borrowers with low deposits. Auckland’s Council suggests that Auckland’s current housing shortage is 20,000–30,000 houses with 13,000 houses needing to be built each year to meet future demand. Christchurch’s shortfall is around 10,000 houses. Strikingly, for a city with geographical boundaries equivalent in size to Greater London, and a population of 1.5 million (a sixth of Greater London), Auckland has only produced an average of 4300 new houses annually over the past three years. Initiatives such as the Auckland Accord, and measures to increase the availability of land zoned for residential housing, and to raise productivity and lower costs in the building sector, are important for increasing housing supply. However, it is likely to take considerable time for the supply/demand imbalance in the housing market to correct through supply-side measures alone. In the absence of demand measures, house prices might continue to rise rapidly and pose an increasing risk to financial stability. The conventional mechanism to help restrain housing demand while working on the supply response would be to raise the Official Cash Rate (OCR), which would feed through directly into higher mortgage rates. However, while higher policy rates may well be needed next year as expanding domestic demand starts to generate overall inflation pressures, this is not the case at present. Consumer Price Index (CPI) inflation currently remains below our 1 to 3 percent inflation target. Furthermore, with policy rates remaining very low in the major economies, and falling in Australia, any OCR increases in the near term would risk causing the New Zealand dollar to appreciate sharply, putting further pressure on New Zealand’s export and import competing industries. In the current situation, where escalating house prices are presenting a threat to financial stability but not yet to general inflation, macro-prudential policy offers the most appropriate response. BIS central bankers’ speeches 3. The role of macro-prudential policies One of the major insights from the Global Financial Crisis (GFC) was how rapidly macro instability could develop even though an economy might be growing close to its potential, and be experiencing sound fiscal policy and price stability. Economic and financial risks can build up for several reasons, including over-investment in particular sectors such as housing, a rapid increase in leverage in the banking and shadow banking sectors, and excessive household indebtedness. The output losses and increased human distress from the massive adjustments in the balance sheets of households, corporates, banks, and governments are still being felt in many countries five years after the initial impact of the GFC. The fallout from the GFC triggered a renewed interest in macro-prudential policy in several countries. While micro-prudential policy settings (e.g., capital ratios and risk weights) are fixed on a through-the-cycle basis, macro-prudential policy measures provide an overlay to mitigate significant but transitory risks (such as credit and asset price cycles) that can endanger the economy and the financial system. In May 2013, the Minister of Finance and the Reserve Bank signed a Memorandum of Understanding outlining the purpose of macro-prudential policy, the range of policy instruments, and governance arrangements relating to their possible deployment. The macro-prudential policy framework seeks to build additional resilience in the domestic financial system during periods of rapid credit growth, rising leverage, or abundant liquidity. The instruments can also help to dampen growth in asset prices that pose risks to financial stability. The macro-prudential measures may require banks to hold additional capital buffers, have higher proportions of stable funding, or limit the share of high loan-to-value ratio (LVR) residential lending. Instruments such as the counter-cyclical capital buffer and sectoral capital overlays require banks to hold additional capital against potential shocks in asset markets or particular sectors. A temporary increase in the core funding ratio would make banks more resilient to liquidity shocks and, like capital buffers, serve mainly to increase the resilience of bank balance sheets rather than have a significant dampening effect on asset cycles. LVR restrictions have the added benefit of dampening asset prices more directly, by affecting the supply and cost of high LVR lending as well as reducing the riskiness of bank loan portfolios. High LVR lending, as reflected in mortgage lending to borrowers with less than a 20 percent deposit, has constituted around 30 percent of new mortgage lending in recent months – up from 23 percent in late 2011. This high LVR lending is a significant factor behind the buoyant housing demand in some regions. Over recent months, the Reserve Bank has been consulting with the banks on the use of macro-prudential instruments and on how LVR restrictions could be implemented in New Zealand. Today we are announcing the introduction of speed limits on high LVR lending with an implementation date of 1 October 2013. These are designed to help slow the rate of housing-related credit growth and house price inflation, thereby reducing the risk of a substantial downward correction in house prices that would damage the financial sector and the broader economy. Under the LVR “speed limit”, banks will be required to restrict new residential mortgage lending at LVRs of over 80 percent to no more than 10 percent of the dollar value of their new housing lending flows. However, some loans will not count towards the banks’ use of the speed limit. These include Housing New Zealand’s Welcome Home Loans, bridging loans, refinancing of existing loans and high–LVR loans to existing borrowers who are moving home but not increasing their loan amount. Allowing for these exemptions, we estimate that the 10 percent speed limit will effectively limit the banks’ high-LVR lending flows to about 15 percent of their new residential lending. BIS central bankers’ speeches Banks commonly issue mortgage borrowers with pre-approvals, which represent a firm commitment to provide housing finance and may be valid for up to six months. Banks raised the issue of these pipeline approvals in responding to the Reserve Bank’s consultative document so, as an initial transitory step, we are allowing banks to meet the 10 percent speed limit on high LVR lending measured as an average rate over a six month period. Thereafter, the speed limit for banks with lending in excess of $100 million per month will apply to the average rate over rolling three-month windows, as originally proposed. However, we would expect the banks to modify their approach to issuing pre-approvals, in order to ensure that they fall within the 10 percent “speed limit” on an ongoing basis. Banks with mortgage lending below $100 million per month will be required to meet the speed limit on the basis of high-LVR lending rates over rolling six-month windows, to reflect the greater volatility seen in the high-LVR lending of the smaller banks. When LVR measures have been introduced overseas they often represent a strict moratorium on high LVR lending5. The speed limits we have set will enable some growth in high LVR lending and should have the effect of slowing the rate of growth in house prices. In this way, LVR restrictions will support monetary policy. While the primary purpose of the restrictions is financial stability, they will also provide the Reserve Bank with more degrees of freedom in conducting monetary policy. In particular, they will provide the Bank with greater flexibility in considering the timing and magnitude of any future increases in the OCR. This flexibility around the need for interest rate adjustments is especially useful in light of the overvalued New Zealand dollar and the international monetary conditions currently facing New Zealand. Like any other form of regulation, speed limits on high LVR lending will create incentives for lenders to introduce lending products designed to circumvent the regulation. We are concerned to ensure that specially designed lending products are not developed with the purpose of avoiding or undermining the LVR restrictions. This is why our framework for implementation will state that banks should not enter into any arrangements to avoid the LVR restrictions, and we are providing guidance as to the types of measures that the Reserve Bank would be concerned about if used to circumvent the LVR restrictions. The Reserve Bank expects bank senior management and bank boards to respect the spirit and intent of the LVR restrictions and to closely monitor the level of high LVR lending. An important issue is how long LVR restrictions might be imposed. This largely depends on the effectiveness of the measures in restraining the growth in housing lending and house price inflation. The measures will be removed if there is evidence of a better balance in the housing market and we are confident that their removal would not lead to a resurgence of housing credit and demand. We will monitor closely the impact of the restrictions, and report on that in our Financial Stability Reports. If the measures are not considered to be effective (and cannot be made effective through altering the details of the policy) they will be removed, but in this case their removal might necessitate higher interest rates than otherwise, or the imposition of alternative macro-prudential requirements. Concluding comments The outlook for the New Zealand economy over the next two years is for GDP growth to increase and the recovery to become more broadly based. Investment in Canterbury reconstruction is not expected to peak until 2015 and 2016. By this time the residential For example, Israel currently limits loans to first home buyers to a maximum LVR of 75 percent with LVRs for refinancing and investors limited to 70 percent and 50 percent respectively. In Hong Kong, LVRs are capped at 70 percent for most borrowers with even tighter restrictions targeted at certain parts of the residential market. BIS central bankers’ speeches building programme in Auckland should be well advanced, and the additional supply in Auckland and Christchurch should bring greater balance to the housing market. But many of the challenges discussed today will be with us for a considerable time, particularly as New Zealand is likely to continue to be one of the most rapidly growing advanced economies over the next two years. The challenges we face with an over-valued exchange rate and over-valued housing market are not likely to dissipate quickly given the extent of the supply/demand imbalance in the housing market and the likely continued attractiveness of New Zealand assets to foreign investors. It is critical that priority be given to implementing the measures needed to alleviate the shortage of housing and land supply, which is the dominant cause of the increase in house prices in Auckland and Christchurch. But the LVR restrictions announced today have a useful role to play alongside the supply measures. Both can help reduce the risk of a house price boom ending in a severe housing downturn that causes substantial damage to the financial sector and the economy. Provided loan-to-value restrictions help to dampen house price inflation, they will also assist monetary policy. As such, they increase the flexibility available to the Reserve Bank in determining the timing and magnitude of future adjustments to interest rates. This is not the primary reason for the policy, but could be valuable given the ongoing highly accommodating monetary conditions in international financial markets. BIS central bankers’ speeches
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Speech by Dr John McDermott, Assistant Governor and Head of Economics of the Reserve Bank of New Zealand, to the New Zealand Institute of Chartered Accountants CFO and Financial Controllers Special Interest Group, Auckland, 2 October 2013.
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John McDermott: Shifting gear – why have neutral interest rates fallen? Speech by Dr John McDermott, Assistant Governor and Head of Economics of the Reserve Bank of New Zealand, to the New Zealand Institute of Chartered Accountants CFO and Financial Controllers Special Interest Group, Auckland, 2 October 2013. * * * “....most usefully thought of as a concept rather than as a number, as a way of thinking about monetary policy rather than as the basis for a mechanical rule” (Blinder, 1998).1 1. Introduction I want to thank NZICA for providing me with this occasion to speak about neutral interest rates, why they appear to have “shifted gear” in the last few years, and what that might mean. Neutral interest rates are important to the way the Reserve Bank thinks about monetary policy – especially how stimulatory or contractionary interest rates are – and I want to share some insights from research my colleagues have been undertaking on this topic. First, let me recap the reasons behind our most recent monetary policy decision when we left the Official Cash Rate (OCR) unchanged at 2.5 percent. Looking ahead, we expect demand in the economy will be boosted by further reconstruction in Canterbury, high export commodity prices, momentum in the housing market and low interest rates. This pick-up in demand will be partly offset by fiscal consolidation and continued strength in the New Zealand dollar, and the starting point is one of very low core inflation. Reflecting the balance of these forces, the Reserve Bank believes that interest rate settings should remain stimulatory for some time yet and we noted in our September Monetary Policy Statement that we expect to keep the OCR unchanged in 2013. Interest rates, whether we look at the policy rate that the Reserve Bank sets or at the interest rates that households and businesses face, have been very low for the last four years, and it seems difficult to imagine that rates can stay at such low levels. We believe 90-day rates have been stimulatory since early 2009, when the OCR was first lowered to 2.5 percent in the wake of the global financial crisis (GFC). Indeed, we noted in the September Monetary Policy Statement that while we expect to keep the OCR unchanged in 2013, we do expect to increase the OCR next year. What average might we expect interest rates to head towards when we do eventually start to increase the OCR, and when would we expect to reach that level? Part of answering that question requires taking a position on just how much stimulus current interest rate settings are adding to the economy. If our economy were growing at a rate with no under- or over-utilised resources in aggregate (often referred to as a zero output gap) and inflation were close to the midpoint of our 1 to 3 percent target band, then interest rates that neither stimulated nor restricted the economy would be appropriate. Such a level of interest rates can be termed the neutral interest rate. Interest rates set below this “neutral” level tend to boost the pace of activity and inflation in a sluggish economy where inflation would otherwise be falling, and interest rates above this “neutral” level tend to slow the pace of activity and inflation where inflation would otherwise be rising during economic upswings. Our latest forecasts project the output gap to be near zero and inflation to be close to the 2 percent midpoint in March 2016 (figure 1). Consequently, the appropriate monetary policy setting at that time should be very close to neutral. Our projections suggest the level of the See Blinder, A (1998) Central banking in theory and practice (MIT Press). BIS central bankers’ speeches nominal 90-day interest rate that achieves this is about 4½ percent.2 This is very close to my best estimate of the neutral nominal 90-day rate at present, though any point estimate of neutral comes from a fairly wide confidence interval – perhaps 100 basis points or more.3 At this point I think it is useful to review the economic factors that determine neutral and explain how the Reserve Bank estimates it. Figure 1 A stylised view of monetary policy settings Source: RBNZ 2. What is a neutral interest rate? To set the scene, it is worth reflecting on exactly what interest rates are. Interest rates reflect the price of shifting resources from one period to the next. Over long spans of history, changes in neutral interest rates have been a significant part of the variation in actual interest rates (figure 2). For example, the change we can see in real mortgage rates over the past 90 years or so is greater than can be accounted for by business cycle fluctuations and monetary policy. The uncertainty in estimating neutral can be gauged from past work at the Bank which has produced error bands of between 1 and 2 ½ percentage points. These error bands are based in some cases on formal confidence intervals. In others they are based on the range of results produced by a collection of different estimation methods. For the rest of the talk I’ll only refer to the point estimate, but it should be taken as understood that there is always a band of uncertainty around our estimate of neutral. Here I am talking about neutral nominal interest rates. However, for the rest of the discussion when I talk about the concept of neutral interest rates I will mean real neutral interest rates. Therefore, if we were to assume inflation expectations are anchored at 2 percent, then the corresponding neutral real 90-day interest rate would be 2½ percent. BIS central bankers’ speeches Figure 2 Real floating mortgage interest rates over a long horizon* Source: RBNZ * Nominal interest rates deflated by CPI inflation Economic theory tells us that changes in neutral interest rates reflect changes in real economic factors such as population growth, productivity growth, preferences for savings and also world conditions.4 So it’s private preferences and opportunities that determine neutral – the neutral rate balances the choices of all participants in the market, on average over time. How can savings and investment decisions of New Zealanders affect neutral interest rates? As a starting point, the interest rate can be thought of as the mechanism which reconciles the demand for funds (consumption and investment) with the supply of funds (savings). What we see is, in general, people put somewhat more value on consuming today than deferring consumption until tomorrow. This means a positive interest rate is required to encourage people to save today. In that context, the fact that New Zealand interest rates normally tend to be higher than in some other advanced countries reflects New Zealanders’ tendency to invest more than we save.5 As I have mentioned, interest rates can change over time. If there is a change in preferences so that people now have a greater desire to save today and consume tomorrow, a lower interest rate will be required to equate savings and investment. And if at the same time underlying preferences for investment remain unchanged, then we would generally expect the neutral interest rate to be lower. When the Reserve Bank sets the OCR, this affects other interest rates in the economy. We set the policy rate away from neutral when inflationary pressure is rising or falling, to slow or In classic models, such as Ramsey or Solow models, the neutral interest rate is associated with the long-run equilibrium interest rate. This is determined by factors such as productivity growth and household rate of time preference (i.e. the strength with which households prefer to consume more now). In New Keynesian models, the neutral real interest rate is determined by domestic productivity growth, the household rate of time preference, and expected growth in the global economy. See Galí, J (2008) Monetary policy, inflation and the business cycle (Princeton). In an open economy the neutral interest rate in New Zealand is related to global neutral interest rates but need not be the same. BIS central bankers’ speeches accelerate demand growth and so alter inflationary pressure. Interest rates above neutral, for example, will generally discourage people from investing and consuming and encourage more saving, leading inflation to slow. So if the policy interest rate is at its neutral level, monetary policy will be neither expansionary nor contractionary. For our purposes, then, the neutral interest rate is the rate consistent with inflation being steady at, or close to, the midpoint of the inflation target band and a zero output gap.6 In the Reserve Bank’s framework we have a view of neutral levels for both the policy interest rate, represented by the neutral 90-day rate, to which I referred earlier, and the interest rates that households and businesses pay, which we typically proxy by the neutral floating mortgage rate. 3. What might have affected neutral interest rates in New Zealand? As I have noted, when I think about whether neutral interest rates might have changed, the typical factors I look at are world conditions, domestic productivity growth, population growth, and preferences for savings and investment. While our research indicates that the main reason for the apparent fall in neutral interest rates currently looks to be weaker productivity growth, I will go through each of those factors to illustrate how they matter, and why I think the others have been less important for the recent change. a) World conditions Although there was a fall in gross domestic product (GDP) growth around the world at the onset of the GFC (figure 3), I do not see the world outlook as having more than a marginal effect on neutral interest rates in New Zealand. The fall in GDP growth following the crisis is certainly consistent with the drop in actual long-term interest rates seen throughout the world, but GDP growth in our major trading partners is expected to return to around its pre-crisis trend. However, we remain wary about the future growth prospects of our trading partners. The global economy has seen many adverse shocks in the past few years and many downside risks remain. Figure 3 GDP growth in selected trading partner economies Source: Haver Analytics This assumes that no new economic “shocks”, such as changes in global tastes for our exports, or financial crises, or changes in government spending here and abroad, push the economy away from that state. BIS central bankers’ speeches Figure 4 Real 10-year government bond rates* Source: Haver Analytics, Federal Reserve Bank of St Louis FRED database, Bank of England, RBNZ * Real rates are nominal rates deflated by one-year-ahead inflation expectations. b) Productivity growth As noted, weaker productivity growth looks likely to be the main explanation for a fall in New Zealand’s neutral rates. In the past few years, productivity growth has fallen in New Zealand when compared to the two business cycles before the crisis. And this story is not unique to New Zealand (figure 5). Why does a fall in productivity growth suggest neutral interest rates have fallen? A sustained fall in the pace of productivity growth will lower returns to investment, making it less desirable to invest. If the desire to invest falls and the desire to save remains unchanged, a lower neutral interest rate will be required reconcile savings and investment plans. Figure 5 Multifactor productivity growth Source: OECD BIS central bankers’ speeches c) Population growth World population growth has been trending downwards since the 1960s. However, New Zealand population growth has only fallen more recently, and does not appear to be an important explanation for lower neutral rates in New Zealand (figure 6). Lower population growth decreases the number of people in the labour force, meaning less investment is needed to provide the necessary capital stock to employ the average labour force. As investment falls, a lower neutral interest rate – the one that equalises the supply of and demand for funds – will be required. Population growth in New Zealand over the last couple of cycles has tended to fluctuate in a way that does not match the apparent movements in neutral rates, and the recent fall in population growth is small by the standards of past movements. At the same time, the longer-lasting downtrend in world population growth raises interesting questions about the implications for neutral rates abroad. Figure 6 Population growth (5 year moving average) Source: World Bank d) Preferences for savings As I have mentioned, if people decide to save more and consume less a lower interest rate would be required to boost the pace of activity and inflation and reconcile saving and investment plans. But while savings rates have changed since the crisis in New Zealand, this appears to be more for cyclical reasons than because of a change in underlying behaviour. For that reason I would not expect it to explain much if any of the fall in neutral interest rates. After the crisis hit, businesses and households became more cautious leading to a rise in the household savings rates (figure 7), with the household sector trying to reduce debt and exposure to financial risk.7 Higher national savings also reflects higher corporate savings but this might well be more because of the corporate sector responding cautiously to falls in domestic and global demand than because of a change in underlying preferences. BIS central bankers’ speeches Figure 7 New Zealand savings rate by sector (share of Gross National Income) Source: Statistics NZ During the aftermath of the crisis, the Reserve Bank recognised that it was difficult to assess how long-lasting household caution would be, with the possibility that behaviour could either be simply a typical cyclical response to a period of economic weakness, or the early stages of a more structural change in New Zealander’s attitude to debt. As such, we were restrained in how we changed our view of neutral interest rates (see section 4). Household savings rates have continued to rise. But national savings has flattened more recently, driven by the sharp fall in the government savings rate (figure 8). Given that national savings are what matters in identifying whether neutral interest rates have fallen, preferences for savings can be only a small part of any recent change in neutral interest rates. Figure 8 Government OBEGAL (operating balance before gains and losses) Source: New Zealand Treasury, Budget and Fiscal Update 2013 BIS central bankers’ speeches To re-cap, of the four factors I have considered today the most likely to explain a fall in neutral interest rates in New Zealand is the fall in productivity growth. World conditions, domestic population growth and changes in preferences for savings have probably not changed enough to influence New Zealand neutral interest rates materially even if they have generally moved in the right direction. That said, these other drivers do have the potential to affect neutral rates in the future if recent movements are in fact the beginning of longerlasting structural changes. These factors have certainly been evident in the general downward drift of neutral interest rates internationally. 4. How has the Reserve Bank changed its view of neutral interest rates? Figure 1 showed how we at the Reserve Bank stepped down our view of the neutral 90-day rate over 2008 to 2010. Although we altered our neutral policy rate assumption, we made no change to our assumption about the neutral interest rate faced by households and businesses. We assumed that the increase in the spread between retail rates, such as the floating mortgage rate, and the policy rate was a result of the premium banks have had to pay on longer-term funding, with institutional savers being more wary about the risk of term investments than they were previously. Consequently, borrowing costs are higher for households and firms, relative to the 90-day interest rate, than in the previous business cycle (figure 9). Figure 9 Spreads between nominal floating mortgage rates and 90-day rates Source: Haver Analytics, RBNZ But as I have discussed, we now have more information on the underlying trends that determine neutral interest rates for households and businesses both in New Zealand and overseas. The evidence is pointing more and more to lower neutral interest rates. As a result we have now adjusted our view of the neutral rate for households and businesses, as proxied by floating mortgage rates, downwards. This view was fully factored into the September Monetary Policy Statement. Of course, because spreads remain higher than before the crisis, we have reduced the neutral floating mortgage rate by less than we adjusted the neutral 90-day rate down. BIS central bankers’ speeches 5. Measurement of neutral interest rates We have seen these changes in the real economy, but how in practice do we estimate the level of the neutral interest rate? Neutral interest rates are not observable in the way that the 90-day rate or retail interest rates are. Instead, neutral has to be inferred from the economic information that we have available. Neutral can also change over time, and it may not always be clear whether the change is caused by cyclical movements or an underlying trend in real economic conditions. One way to estimate neutral interest rates is to use time series econometrics to extract trends in interest rates over time, and to look at these in the context of behaviour of the drivers of neutral rates discussed above. The Reserve Bank’s estimates of trends in real long-term interest rates do suggest the neutral real 90-day interest rate has fallen since the GFC, both in New Zealand and in other countries (figure 10).8 And estimates based on equations that describe how monetary policy has responded to inflation and demand pressure in the past also suggest the neutral 90-day rate might be lower since the crisis.9 As I have discussed, adjustments in the Reserve Bank’s forecasting framework between 2008 and 2010 incorporated much of this fall. During this time, the neutral 90-day rate assumption in our models was lowered by 150 basis points. Because of the rise in spreads of floating mortgage rates over the 90-day rate we have not reduced our assumption of neutral interest rates for households and businesses by as much. Figure 10 Trend in New Zealand real 10-year government bond rates* Source: RBNZ * The real rate is a nominal 10-year rate deflated by one-year-ahead CPI inflation expectations. Econometric techniques will always involve some estimation error. To give an idea about the wide confidence intervals around neutral estimates, between 2000 and 2008 the Reserve See Chetwin, W and A Wood (forthcoming, 2013) “Neutral interest rates in the post crisis period”, Reserve Bank of New Zealand Analytical Note. Kendall, R and T Ng (2013) “Estimated Taylor rules updated for the post-crisis periods”, Reserve Bank of New Zealand Analytical Note AN2013/04. BIS central bankers’ speeches Bank’s published research has offered estimates of between 3 and 6 percent for neutral real 90-day interest rates since the early 1990s (Chetwin and Wood, 2013, forthcoming, reviews these estimates). However, we have processes for assessing and forecasting economic conditions that manage this uncertainty. As I talked about earlier this year, we draw on a wide range of information such as official data, surveys, visits to businesses and labour organisations, external agencies and external monetary policy advisors to form a coherent picture of international and domestic conditions and a macroeconomic projection.10 This information captures our view of the most likely future developments in inflation, output, employment, interest rates, the exchange rate and other key macroeconomic variables. We also forecast often – every 6 weeks – which ensures we update and correct our view of real economic conditions regularly. Despite all the sophisticated work my colleagues have done to estimate neutral, uncertainty can never be removed and there remains the chance that neutral may have fallen even further than we currently assume. This could be consistent with the weaker than expected inflation seen over the past year or so.11 But this low inflation could also be due to one-off factors such as telecommunication prices or driven by the high New Zealand dollar. This is why the Reserve Bank continues to watch developments very carefully. Indeed, there is some clear evidence that current interest rates are quite stimulatory to some types of activity – look at the Auckland housing market. There are many other factors that complicate the measurement of neutral interest rates in addition to future developments in the real economy. These include the needs to derive real rates from nominal rates and account for risk premiums. In practice, the Reserve Bank needs an estimate of the real neutral interest rate. To do this we require estimates of inflation expectations which are also unobservable and so must be proxied by surveys or different measures of trends in actual inflation. We have also seen changes in risk behaviour since the GFC, which has affected risk premia. Although changes in financial market sentiment need to be considered when making monetary policy decisions, the high frequency of changes in sentiment in financial markets offers little insight into whether neutral has changed or not. 6. Conclusion Having a view on the neutral interest rate helps the Reserve Bank in reaching a view about where actual interest rates need to be set. We constantly use a wide range of tools – economic theory, data and econometric methods – to examine whether neutral might be changing so we have the most up-to-date view on the economy possible. Nevertheless, because neutral is unobservable and estimates are uncertain, this process cannot be made into a simple mechanical exercise. Judgement will always be needed – indeed the same kind of judgement as is needed when making any economic forecast – when forming a view of the neutral interest rate. What I have talked about today highlights that over time, there can be changes in the level at which interest rates switch between being stimulatory and contractionary. Lower neutral interest rates are not necessarily a good or bad thing; it depends on the reasons for the fall. For example, if interest rates fall because of falls in productivity growth, that generally would not be seen as desirable. See “The role of forecasting in monetary policy”, Reserve Bank of New Zealand speech, delivered to FINSIA, Wellington, 2013. See Kergozou, N and S Ranchhod (2013) “Why has inflation been low?”, Reserve Bank of New Zealand Bulletin, 76 (3), September. BIS central bankers’ speeches The evidence and research we have accumulated does point to neutral interest rates being lower than in previous cycles. The neutral level of nominal 90-day rates looks to have fallen to around 4½ percent, though there is a confidence band around that figure. Based on the uncertainty we’ve typically found in the past, the band might be in the order of ½ percentage point each side of the central estimate. We have lowered the view of neutral 90-day rates in our forecasting framework in line with that (figure 1). That estimate compares with figures in 2003 of somewhere between 5½ and 6¼ percent. At the same time, we have reduced our view on the neutral lending rate for households and businesses by less only about 1 percentage point. That is less than the drop in neutral 90-day rates because of the significant increase in the spread between the two since the GFC. An implication of a lower neutral interest rate is that households and businesses will face lower interest rates “on average”, but this should not be read as a promise of lower interest rates all the time. Interest rates will need to be adjusted in response to the state of the economy. For times when demand in the economy is expanding more rapidly than the economy’s ability to meet that demand interest rates will need to be above neutral. Moreover, there is no reason to suppose how far interest rates move from trough to peak will be any different in the next business cycle than they moved in previous cycles. BIS central bankers’ speeches
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Speech by Mr Grant Spencer, Deputy Governor and Head of Financial Stability of the Reserve Bank of New Zealand, to the Property Council of New Zealand, Auckland, 15 October 2013.
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Grant Spencer: Trends in the New Zealand housing market Speech by Mr Grant Spencer, Deputy Governor and Head of Financial Stability of the Reserve Bank of New Zealand, to the Property Council of New Zealand, Auckland, 15 October 2013. * * * It is a pleasure to be here today at the Property Council of New Zealand to participate in your residential summit. Your speakers will have various perspectives on the New Zealand housing market. The Reserve Bank’s perspective is a macro one. We see the housing market as an important driving force in the overall New Zealand economy. It is not just of relevance for the building industry and for people buying and selling houses. The housing market is also relevant for upstream manufacturers of building products, for the net worth of all existing home owners, for banks seeking to fund home purchases, and for exporters facing pressures on the exchange rate. As a central bank mandated with price stability and financial stability objectives, the housing market is a key factor influencing our policy decisions. Most recently, we introduced restrictions on mortgage lending with a high loan-tovalue ratio (LVR), starting from the first of October. The main purpose of the LVR restrictions is to reduce risk in the financial system by moderating the current excess demand pressures on house prices, which are particularly evident in Auckland. We agree with most commentators that the key underlying issue here is a chronic housing supply shortage, and I will come back to this topic. But the period of rapid price increases over the past two years has coincided with very low interest rates and easier bank credit. Banks have competed aggressively for mortgage business and this has contributed to a ramp up in housing demand, which has far exceeded the available supply. If the growth in demand continues to exceed the growth in housing supply, house prices will become increasingly vulnerable to a sharp correction, which could be prompted, say, by a global financial shock. As seen in many developed countries in the global financial crisis (GFC), such a correction can come with significant financial and economic costs. Further, growing momentum in house price inflation would risk a return to the “borrow and spend”mentality of the last housing boom. The consequent growth in consumption would add to general inflation pressures and ultimately prompt stronger interest rate increases than would otherwise be necessary. In this way, a housing expansion can easily start to crowd out other economic activity including, in particular, export production through upward pressure on the New Zealand dollar exchange rate. In my talk today I want to look specifically at the current supply and demand pressures in the New Zealand housing market, at how the imbalance might be alleviated in coming years, and the impact that the LVR restrictions are expected to have. Housing market pressures are growing Between 2000 and 2007 house prices in New Zealand more than doubled, and household indebtedness increased from 100 to 150 percent of household disposable income. When the cycle turned in 2007, house prices fell 10 percent – a relatively benign fall compared with some countries, such as the United States, Spain and Ireland, where house prices fell by 30 to 40 percent. This is a key reason why the New Zealand economy has performed relatively well amongst OECD countries through the post-GFC period. But while New Zealand households’ balance sheets fared relatively well in the downturn, the vulnerabilities built up during the 2000s housing boom have not unwound: house prices and household debt both remain elevated relative to international and historical norms. These imbalances leave New Zealand vulnerable to a fall in house prices at some point in the future. Such a fall, potentially triggered by an external financial shock, could cause real BIS central bankers’ speeches damage to New Zealand’s financial system and broader economy. Figure 1 shows that house prices are high relative to household disposable incomes and rents, even though they have eased from their 2007 peak. On these sorts of measures, the OECD estimates that New Zealand house prices are 25 percent above their long-term averages. Figure 1: House prices relative to income and rents Source: Quotable Value Ltd., RBNZ, Statistics New Zealand, Ministry of Business, Innovation and Employment. From this high starting level, New Zealand house prices are now rising rapidly once more. Over the year to the September quarter, New Zealand house prices increased 9 percent. According to REINZ, house prices have increased particularly strongly in Auckland and Christchurch, with annual rates of 17 and 8 percent respectively (figure 2). House price inflation in the rest of New Zealand is running at around 3 percent. Some of the stronger regions include Nelson, New Plymouth and Queenstown. As a consequence of these rises, national house prices are now 11 percent higher than at the peak of the boom. Auckland prices are 26 percent above their previous peak. Figure 2: House price inflation by region, three-month moving average Source: REINZ. BIS central bankers’ speeches While we are currently satisfied with the soundness of the financial system and the stability of general prices, the increasing stretch in house prices presents a risk to future financial stability and future general price stability. The stretch is being driven by supply constraints, combined with an expansion in credit-based demand. The housing supply shortage In Christchurch, the supply of habitable homes was significantly reduced as a result of the Canterbury earthquakes in 2010/11. Both house prices and rents increased substantially as permanent residents sought to re-establish themselves and temporary residents moved in to work on the rebuild. In Auckland, the picture is different. The housing shortage has emerged over a longer period, and is more evident in homes for sale than in rental properties, with house prices moving up well in excess of rents. This pattern is consistent with an increasing trend of existing renters seeking to become first home buyers. In the last June quarter, available listings of houses for sale in Auckland reached the lowest level ever recorded. Looking back, the building of new homes in Auckland has been weak for many years. A significant number of new homes were built in Auckland between 2002 and 2005 when overseas immigration into New Zealand was strong. However, the rate of new building slowed dramatically in 2005, as immigration flows moderated, and has remained low since. In the rest of the country, construction of new dwellings remained elevated from 2002 right through until the 2008/09 recession, with many houses built outside of the main urban centres in regions such as Waikato and the Bay of Plenty (figure 3). Figure 3: New dwelling consents in selected regions (annual average) Source: Statistics New Zealand. While many dwellings were built in Auckland between 1991 and 2005, research suggests that, relative to population growth, districts in Auckland have the lowest supply responsiveness in the country. 1 If we exclude apartments from the picture, the construction of new dwellings has been weak or declining since 2004 (figure 4). See Grimes & Aitken (2006). BIS central bankers’ speeches Figure 4: New building consents in Auckland (quarterly) Source: Statistics New Zealand. Low rates of building have led to a gradually increasing shortage of homes in Auckland. This is reflected in a consistent upward trend in population-per-dwelling in Auckland since 2005. 2 Auckland Council estimates that there is a shortage of 20,000 to 30,000 homes in the region currently, and that 13,000 new dwellings will be needed each year to meet projected population growth over the next 30 years. A significant limitation on new home building in Auckland appears to be a scarcity of available land. This has been an increasing problem as the Metropolitan Urban Limit (MUL) has become more binding. As the availability of land within the MUL has decreased, land prices have been bid up, which, in turn, has probably curbed housing supply. The Productivity Commission (2013) estimates that, in 2010, land just inside the MUL was worth nine times the value of land just outside the boundary – up from six times in 1998. This is a key reason why land costs now comprise 60 percent of the cost of building a new dwelling in Auckland, compared with 40 percent in the rest of the country. In its report on housing affordability, the Productivity Commission (2012) identified restrictive urban planning, and the time and costs associated with land development and construction, as additional factors constraining the building of new houses. To help alleviate supply constraints, the Government, in agreement with the Auckland Council, has passed legislation to implement the Auckland Housing Accord. The accord seeks to free up enough land for 39,000 new homes in the next three years. To do this, the resource consent process will be sped up for housing developments within specified areas, consistent with the rules outlined in Auckland’s Unitary Plan. 3 Auckland Accord targets aim to make enough land available for 9000 new dwellings over the year to March 2014 – well above the current rate of 5600 new dwellings consented over the year to August. So far, the council has announced the release of enough land for 6000 homes under the accord. The accord targets are ambitious and it will take time for land Many thanks to Westpac for providing regional population-per-dwelling data. The Unitary Plan is regulatory document developed under the Resource Management Act, in accordance with the Council’s vision for housing development in Auckland over the next 30 years. BIS central bankers’ speeches to be developed and houses built. Nonetheless, the accord is an important step forward in helping to alleviate the Auckland housing shortage. Pressures on construction As more new homes are built in Auckland, this will create construction jobs and contribute to economic growth. However, this new building will occur at the same time as the Canterbury rebuild is taking place, creating significant resource pressures in the national construction industry. Figure 5 shows the amount of new dwellings that might be built over the coming three years if accord targets were fully met and 12,000 new homes were built in Canterbury over the same period. To achieve this, new dwelling construction would need to be 9 percent higher than at the height of the recent housing boom, even assuming no growth in home building through the rest of the country. At the same time, a significant amount of repair work, infrastructure and commercial construction will be taking place in Canterbury. In reality, we expect the targeted house building in Auckland and Christchurch to occur over a longer period than three years. How much longer will depend on the extent of improvements in approval processes and on the ability of the construction industry to expand its current capacity. Figure 5: New dwellings consented in an unconstrained building scenario Source: Statistics New Zealand, RBNZ calculations. Note: This scenario assumes that Auckland Accord targets are met, 12,000 homes are built in Canterbury over the next three years, and that building through the rest of New Zealand continues at its current rate. While phasing of this major home building programme will help to limit resource pressures, some wage and price pressures will inevitably result. The upward pressure on construction costs that we are currently seeing in Canterbury may well extend more broadly across the industry. On a moderate scale, this would help to attract resources into the construction industry and hence facilitate the building expansion. On an excessive scale, this would risk spilling over into general inflation and put upward pressure on interest rates and the exchange rate. To avoid the potential problems associated with excessive house price and construction cost inflation, we will need a more responsive supply side that includes: BIS central bankers’ speeches • A responsive and innovative building sector; • An adequate supply of labour, some of which will need to be imported; and • A responsive planning and consenting process. We will also need the demand side to be kept in check while the supply response takes place. The demand side and credit Clearly, the supply of houses is an important determinant of house prices– but it is only one side of the story. We have seen the shortage of homes in Auckland emerge due to low construction rates over many years. But house price inflation has accelerated only over the past two years, over the same period that credit conditions became easier and population growth picked up with stronger net inward migration. It is relevant that house price inflation in Auckland has not been matched by rental inflation, which is less affected by credit conditions. Looking more closely at credit conditions, interest rates are currently very low by historical standards. Indeed, the sub-5 percent mortgage rates on offer earlier in the year were the lowest since the 1960s. Low interest rates increase the incentive for households to own rather than rent. Over the past 18 months, as housing demand picked up, housing credit has also been easier to obtain than previously, with banks competing aggressively to write mortgages. As a consequence, credit growth has risen, with outstanding housing credit rising 6 percent through the year to August. Lending to borrowers with high LVRs has grown twice as fast, causing the share of high LVR lending to rise (figure 6). Figure 6: High-LVR loans as a share of new lending Source: RBNZ. Households who borrow at high LVRs tend to be the most vulnerable to a fall in house prices. In the event that house prices fall, these borrowers are more likely to see the value of their house fall below the amount of debt they have outstanding – particularly if they have entered the market recently. This can lead to financial hardship, mortgage defaults and, potentially, stress across the broader financial system. Apart from easy credit conditions, housing demand over the past year has been boosted by a growing net inflow of immigrants (figure 7). Net immigration to New Zealand has risen substantially over 2013 due to fewer departures of New Zealand citizens to Australia at the same time as inflows of returning citizens and non-New Zealand citizens from Europe, the BIS central bankers’ speeches United Kingdom and Asia have continued to increase. Over the year to August 2013, a net 13,000 people moved to New Zealand with the intent of staying a year or longer – the highest annual inflow since early 2010. As more people enter the country, this increases the demand for housing, tending to put upward pressure on rents and house prices – particularly in Auckland, where immigration flows have been strongest. Figure 7: Permanent and long-term immigration to New Zealand (quarterly) Source: Statistics New Zealand. The role of high-LVR lending restrictions The LVR lending restrictions in operation from 1 October 2013 are primarily intended to reduce systemic risk by slowing house price inflation. They seek to reduce the risk that a subsequent price correction in an increasingly overvalued housing market could pose for the financial sector and broader economy. Given the relatively slow response of housing supply, it does not make sense to let credit-based housing demand get too far out in front. Further, to the extent that the LVR restrictions dampen overall demand in the economy, they could also reduce the extent of interest rate increases, and hence exchange rate pressure, that may be needed over the coming cycle. At this point, we estimate that the LVR restrictions are worth approximately 30bp of OCR adjustment. The LVR restrictions are also expected to reduce risk in the banks’ balance sheets. Estimating the impact of the LVR restrictions is complicated by the fact that this is a new tool and New Zealand appears to be unique in using a speed limit approach. Quantitative estimates of impact are necessarily approximate, with key uncertainties including the extent to which low-deposit borrowers find other sources of funds, and the extent to which lower credit growth feeds through to house sales and prices. We estimate 4 that: • Mortgage credit growth will be 1–3 percentage points lower over the first year. • Home sales will be 3–8 percent lower over the first year • House price inflation will be 1–4 percentage points lower over the first year. See Bloor & McDonald (2013). BIS central bankers’ speeches Beyond the first year, these effects will be reduced. Also, the impact of LVR restrictions will not be uniform across the country. Market segments with a higher proportion of high-LVR borrowers are likely to see larger effects, as will areas where house prices and borrower incomes exceed the criteria for Welcome Home Loans, which are exempt. An important point to make here is that while house price inflation should be reduced by the LVR restrictions, New Zealand house price levels will remain high on most metrics, for example, relative to incomes and rents. In this sense it is hard to see how these restrictions will materially reduce the existing incentives to develop new residential property. Provided the “red tape” costs and delays are reduced, there will remain a strong price incentive to expand the housing stock, particularly in Auckland and Christchurch. In due course, we expect housing supply to catch up with demand, and for demand to be further moderated as interest rates return to more normal levels over the next couple of years. As the imbalance between demand and supply is reduced, we will look to lift the LVR restrictions. The indicators we will assess in this regard include house price inflation, mortgage approvals, credit growth and house sales. We will be looking for clear signs that excess demand pressures have substantially reduced and that a removal of the restrictions will not result in a return of such pressures. Conclusion The underlying issue in the New Zealand housing market is a shortage of supply. In Christchurch there is a specific housing shortage as a result of the earthquake-damaged housing stock. In Auckland, the shortage has been growing over a much longer period, with weak or declining rates of house building since 2005. While the trend in people-per-dwelling in Auckland has been moving steadily upwards since 2005, demand for home-ownership has accelerated in more recent times due to the ready availability of cheap credit and a growing trend amongst renters to become first home buyers. The recent growth in net immigration is also adding to the excess demand situation. Plans to increase the housing supply are well underway. Residential building consents are trending upwards in Christchurch and Auckland, and indeed in the rest of the country. The residential consent process has improved in Christchurch and efforts are being made to streamline planning and consents in Auckland via the Government/council accord and the Unitary Plan. However, meeting the combined three year targets of Christchurch and Auckland would require a major mobilisation of national construction resources. In all likelihood, the build will be stretched over a longer period. Expanding housing demand through easy credit will do nothing to speed up the housing supply response. It simply adds to housing demand, pushes up house prices and makes housing less affordable. The Reserve Bank has introduced LVR restrictions on bank mortgage lending aimed at moderating house price inflation by reducing the effective demand for housing. This is intended to reduce the build-up of systematic risk in the New Zealand financial system. It will also potentially reduce the extent of interest rate increases, and hence exchange rate pressure, that may be needed in the coming cycle. References Bloor, C and C McDonald (2013) “Estimating the impacts of restrictions on high LVR lending” Reserve Bank of New Zealand Analytical Note, 2013/05 Grimes, A and A Aitken (2006) “Regional Housing Markets in New Zealand: House Price, Sales and Supply Responses”, Centre for Housing Research Aotearoa New Zealand, Department of Building and Housing, and Housing New Zealand Corporation, Wellington. New Zealand Productivity Commission (2012), “New Zealand Productivity Commission Inquiry into Housing Affordability”, Final Report, April 2012. New Zealand Productivity Commission (2013) “The effect of Auckland’s Metropolitan Urban Limit on land prices”, Research Note, March 2013. BIS central bankers’ speeches
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Speech by Dr John McDermott, Assistant Governor and Head of Economics of the Reserve Bank of New Zealand, to Federated Farmers, Wellington, 22 November 2013.
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John McDermott: Understanding the New Zealand exchange rate Speech by Dr John McDermott, Assistant Governor and Head of Economics of the Reserve Bank of New Zealand, to Federated Farmers, Wellington, 22 November 2013. * * * Whenever presenting on the economy, the first question I get almost always relates to the elevated level of the New Zealand dollar. People are often concerned that that the exchange rate is too high or too volatile and believe that these problems could be addressed by running monetary policy differently. Concern about the exchange rate is understandable. Movements in, and the level of, the exchange rate can have substantial impacts on the performance and structure of the New Zealand economy and on people’s livelihoods. The exchange rate is important and the Reserve Bank devotes a great deal of resources to understanding it. Today I want to summarise the Bank’s thinking on the types of questions we get about the exchange rate. Given time constraints, it will be necessary for me to skip over many of the complications and nuances behind these questions. For those who would like to know more, I invite you to visit the Reserve Bank’s website. It has a large volume of analysis on the exchange rate – presented both in lay terms and in as technical a form as you could ever wish.1 Before I begin though, it is worth noting, what I think everyone now accepts, that the solution to a high and variable exchange rate is not higher inflation. International and historical experience has shown that if a central bank runs monetary policy looser than is required it will generate inflation. Such future inflationary problems would be very costly to resolve in terms of growth and employment. Is the exchange rate high? An initial question is whether the exchange rate is high. The answer, currently, is most certainly yes: the nominal exchange rate is at historically high levels against nearly all of our trading partners2. Here it is important to introduce the concept of the real exchange rate. The real exchange rate, as well as being influenced by the nominal exchange rate, also takes account of relative inflation rates so is a better measure of overall competitiveness. An exporter’s competitiveness is determined not just by the nominal exchange rate, but also by their cost of doing business relative to their foreign competitors. Unfortunately for New Zealand’s tradable sector, just like the nominal exchange rate, the real exchange rate is also high. Figure 1 shows the real exchange rate over the past 50 years, and the current rate is well above its historical average since 1964. When the New Zealand dollar is either high or low, it tends to remain high or low for longer than the exchange rates of other countries. So in the current situation, not only is it clear that the real exchange rate is high, it is also likely that this elevation will persist for some time. A relatively accessible example of the Bank’s research on the exchange rate was a conference we held (jointly with Treasury) earlier in the year. Copies of all the papers from this conference are available at http://www.rbnz.govt.nz/research_and_publications/seminars_and_workshops/Mar2013/programme.html. On a trade weighted basis and against the major currencies involved in New Zealand dollar transactions (other than the Australian dollar), our exchange rate is currently in the top decile relative to historic experience. BIS central bankers’ speeches What are the drivers of the real exchange rate? We can think about what drivers the exchange rate in a couple of ways. One is the cyclical dimension of the exchange rate and the other is the long term level. The Reserve Bank has models that are able to explain a good proportion of cyclical fluctuations in the exchange rate.3 These models typically highlight the correlation between the exchange rate and a few key variables, such as the terms of trade, interest rate differentials, relative house price inflation, and measures of risk. Of course, one should never confuse these correlations as causal explanations of the exchange rate. Figure 2 illustrates how the cyclical movements in the three most important variables used in one of these models can explain a large proportion of exchange rate fluctuations.4 Even though we can explain the cyclical movements in the exchange rate these movements may not be welcome by the tradables sector because, among other things, it adds uncertainty to decision making. That said, short term exchange rate volatility can be effectively countered through the use of forward exchange rate contracts, but it remains true that longer term exchange rate cycles are more difficult to handle for many exporting firms. For examples see McDonald, C (2012) “Kiwi drivers – the New Zealand dollar experience” AN 2012/02 and Cassino E and Z Wallis (2010) “The New Zealand dollar through the global financial crisis” RBNZ Bulletin September 2010. For specific details see McDonald, C (2012) “Kiwi drivers – the New Zealand dollar experience” AN 2012/02. BIS central bankers’ speeches More important issues relate to the long term drivers of the exchange rate and the implications of the exchange rate being overvalued. When the Reserve Bank talks about an overvalued exchange rate we usually mean that the exchange rate is too high to achieve desired economic outcomes such as an appropriate allocation of resources. In this sense the exchange rate can be overvalued even if its strength can be explained by factors such the terms of trade.5 An important issue when it comes to determining the exchange rate in New Zealand has been the persistent gap between savings and investment. Over the past 40 years New Zealand has demanded more capital for investment in housing, infrastructure and other assets than its domestic saving rate could finance. This has meant an on-going reliance on foreign saving and capital inflows. This saving shortfall has also put upward pressure on interest rates and the exchange rate. The resulting higher exchange rate has surely affected the tradable sector’s profitability and its decisions about investment, employment, and market strategy. These decisions may well have led to a misallocation of resources resulting in a tradables sector that is smaller than is desirable. International experience certainly suggests that countries that sustain fast growth tend to do so with a strongly growing tradables sector, tapping the potential of a global market and the productivity prospects that creates. Could the high real exchange rate be addressed by running monetary policy differently? A range of suggestions aimed at solving the overvaluation problem have been provided by a number of commentators, such as: Sometimes people use overvalued to mean a value of the exchange rate higher than indicated by economic fundamentals. This is not the meaning being used here but rather it means the effects of the exchange rate are undesirable from an economic perspective. BIS central bankers’ speeches • Keeping interest rates low; • Currency intervention; • Quantitative easing; • Capping the exchange rate; • Targeting growth and employment, and • Changing the focus of monetary policy. As much as we would like it otherwise, many of these suggestions are either unlikely to have a significant lasting effect, or have unpalatable trade-offs such as much higher inflation, or are simply not feasible. The limitations and problems associated with these suggestions have been well covered in Governor Wheeler’s speech Manufacturing decline not just a dollar story so I will not repeat them here.6 There are some things the Reserve Bank has been doing that, at the margin, may avoid the exchange rate being higher than is currently the case. The Bank does intervene in the foreign exchange market from time-to-time. But evidence from the past, here and elsewhere, suggests foreign currency intervention is unlikely to have a sustained impact in lowering the exchange rate.7 This is because daily foreign currency transactions in New Zealand dollars swamp any practical intervention capacity, averaging around $100 billion per day with more than 80 percent of the transactions taking place offshore. At best the Reserve Bank can attempt to smooth the peaks and troughs of the exchange rate. Of course, reasonable people can differ on what is the appropriate scale of intervention used to smooth some of the volatility. But the old economic saying that there is no free lunch still applies: the greater the scale of intervention, the greater the financial risk carried by the tax payer. More active macro-prudential policy has been undertaken recently to help reduce the buildup in systemic risk in the banking sector resulting from imbalances in the housing sector. The current low interest rates, although appropriate for the current inflationary environment, are contributing to those financial stability risks. In such circumstances one might consider using monetary policy more aggressively to lean against house prices.8 While this would mean inflation would take longer to rise to the mid-point of the target band it would reduce the risk of a future crash in the housing market. However, using monetary policy to reduce the financial stability risks of a booming housing market would put additional upward pressure on the exchange rate. Instead, we have used macro-prudential policy, in particular the loan-to-value ratio limits, to help moderate the risks in the housing market. This addresses the financial stability issue more directly and reduces the need for monetary policy to put pressure on interest rates and the exchange rate. What, other than monetary policy, will remedy the real exchange rate? Saying there is little monetary policy can do about the exchange rate, is not the same as saying there is little that can be done. The Reserve Bank undertakes a great deal of research and analysis on the exchange rate. One example of this research was an Exchange Rate Forum jointly hosted by the Reserve Bank of New Zealand and the Treasury earlier in the See http://www.rbnz.govt.nz/research_and_publications/speeches/2013/5150125.html. Chetwin, W and A Munro (2013) “Contemporary exchange rate regimes: floating, fixed and hybrid” paper presented to Exchange Rate Policy Forum. Borio C and P Lowe (2002) “Asset prices, financial and monetary stability: exploring the nexus” BIS working papers No. 114. BIS central bankers’ speeches year. One of the objectives of the forum was to generate ideas for reducing the harm caused by the exchange rate. The harmful effects of exchange rate cycles can potentially be addressed partly through improved microeconomic policies, especially those that promote greater competition. Such policies need to be structured to make the economy more flexible, thereby reducing the need for the exchange rate to carry the burden of absorbing economic shocks. An example here could be increasing the responsiveness of the building industry to housing demand. Likewise, reducing the magnitude of domestic demand cycles would reduce the pressures that monetary policy needs to lean against. Avoiding pro-cyclical changes in fiscal policy such as tax cuts or increasing public spending when resources are already stretched. Similarly, banks could avoid excessively relaxing credit standards when demand for financing is strong. Such actions would ease cyclical exchange rate pressures. Since the savings and investment gap plays a prominent role in New Zealand’s exchange rate story, it seems reasonable to suggest that it will be necessary to tackle our reliance on foreign savings to finance our consumption and investment. The dependency on foreign savings means that we have persistently needed interest rates above those in most developed economies. Addressing the residential investment needs of a growing population and increasing the incentives for private sector savings, such as the tax treatment of investment income and issues around the long-term design of public and private pension systems, are the sorts of issues that need to be debated to see what would work best in New Zealand. Conclusion The exchange rate plays an important role in a small open economy like New Zealand and generates many questions and concerns. The persistently high exchange rate is out of line with what looks to be necessary if New Zealand is to achieve its economic aspirations of catching up with the rest of the OECD’s income levels. The Reserve Bank spends a great deal of time on this issue because it is important. In so doing we have developed a number of models that can explain the exchange rate. But explaining the exchange rate is not the same as saying it is fairly valued. The New Zealand dollar is overvalued from the standpoint of its effects on the economy and we would like to see a lower exchange rate. A key conclusion of our work is that this overvaluation stems, at least in part, from the persistent savings and investment imbalance. Therefore to address New Zealand’s overvalued exchange rate the underlying imbalances themselves must be addressed. Raising domestic savings relative to our investment needs appears the best way to sustainably lower New Zealand’s real interest rates and take the pressure off the real exchange rate. BIS central bankers’ speeches
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Speech by Mr Geoff Bascand, Deputy Governor and Head of Operations of the Reserve Bank of New Zealand, to the Admirals Breakfast Club, Auckland, 6 December 2013.
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Geoff Bascand: Communication, understanding, and credibility Speech by Mr Geoff Bascand, Deputy Governor and Head of Operations of the Reserve Bank of New Zealand, to the Admirals Breakfast Club, Auckland, 6 December 2013. * * * I’m just a soul whose intentions are good Oh Lord, please don’t let me be misunderstood The Animals Central bank communication is again a renewed topic of interest. Internationally, the expanded use of and debate about the efficacy of “forward guidance” – i.e. words that foreshadow the future timing of monetary policy actions – has attracted much attention. Locally, the introduction of restrictions on low equity housing loans and the prospect of rising interest rates have been widely featured. Central banks’ communication strategies and their ability to communicate effectively have been challenged enormously by the events and consequences of the Global Financial Crisis and by the emergence of new technology and social media. Complexity increased, audiences expanded, and the immediacy and saturation of news coverage has turned the volume control on full. But as any parent of growing children knows, greater volume doesn’t always mean greater clarity! While arcane in some respects (some will recall United States Federal Reserve Governor Alan Greenspan terming his communication approach as “constructive ambiguity”1), central bank communication is not an abstract topic. Central bank pronouncements, their absence, and their tone, have economic and social impact. The Reserve Bank is extending its communication with the various groups that our activities impact. “Communicating on a broader front” is one of our strategic priorities2 – both in imparting our messages and engaging with and listening to our many stakeholders. This is because communication is critical to the Reserve Bank’s success, with its actions and its communications symbiotic. In my speech today I will outline why clear communication of our policy thinking is so important, and the forces that shape the way we communicate. I will also discuss how our approach to communication has evolved, and the tools we use to reach our audiences. And finally, I will proffer some thoughts on where to from here. Why, when and how should the Reserve Bank communicate? Broadly speaking, the Reserve Bank seeks to achieve price and financial stability and protect the value of your money. Our communications are ultimately geared to this purpose. These are important and sensitive matters, so understanding of, and confidence in our actions and messages – and indeed in the institution itself – is essential. This requires that our communication is seen as objective and credible. Greenspan’s communication was also often termed “Fedspeak” and “Greenspeak” in which ambiguous statements were made to purposefully obscure the statement. See Statement of Intent 2013-2016, p14. BIS central bankers’ speeches The why of monetary policy communication Much of the literature regarding central bank communication pertains to the operation of monetary policy. Three principal rationales exist for the transparency of monetary policy communication. First, is the need for accountability, with accountability supported by transparency? With central banks often having significant autonomy or independence in how they pursue their objectives, Parliament, its agents (e.g. the Minister of Finance and the board of the central bank) and the public must be able to assess whether they are fulfilling their responsibilities. The public debate sometimes appears to confuse independence of objectives with independence of operation. In New Zealand, the overriding objectives are set by the legislature; the autonomy extends only to the operational decision-making necessary to achieve the democratically set objective. There are multiple accountability mechanisms, including Reserve Bank Board monitoring of the Bank’s and Governor’s performance, public reporting via quarterly Monetary Policy Statements, six-monthly Financial Stability Reports and the Annual Report, appearances before the Finance and Expenditure Select Committee, media, financial market, and public scrutiny. A recent study by Dincer and Eichengreen (2013) reported the RBNZ as the second most transparent central bank in the world, just behind Sweden. The second rationale is promoting understanding. The credibility and effectiveness of economic policy is enhanced by public and financial market understanding of how an economy is performing, and how the central bank’s operations and policy settings are likely to affect it. All economic decisions, such as investment, spending, savings, employment, and price-setting decisions are affected by uncertainty and expectations of the path ahead. The Bank does not claim more accurate foresight than other analysts, but it can educate, inform, and explain its own decision-making approach, and thereby minimise one potential source of uncertainty. It can help make more predictable what would otherwise be less so. Doing so also provides important benefits for the Bank. Widespread understanding of the goal and operation of monetary policy makes it easier for the Bank to achieve its objective of price stability3, by better anchoring low inflation expectations. This means that wage and price setters are more confident that the focus of the Bank will be on achieving and maintaining low and stable rates of inflation. This, in turn, means that the Bank is able to respond to economic shocks by adjusting interest rates less than would otherwise be the case. Several studies find benefits from transparency in terms of reduced volatility of interest rates and smaller movements in market rates for a given change in central bank actions (e.g. see Blinder, 2008). Along similar lines, Drew and Karagedikli (2008) demonstrated that New Zealand’s short-term interest rates move more predictably and long-term interest rates and inflation expectations are more stable in association with greater transparency. Thornton (2002) argues this is the most critical reason for, and form of, transparency. BIS central bankers’ speeches 2014 marks 25 years since our inflation targeting regime was introduced – and over 20 years since low inflation was accomplished. Pretty much a whole generation of New Zealanders has not had to experience the distortions and inequities of high inflation that characterised the 1970s and 1980s. When seeking to build understanding of monetary policy goals and its operation, we also need to communicate the costs and benefits of proposals to change the framework around monetary policy. An example is the debate around the exchange rate and its relationship to monetary policy. The Bank has conducted research, published analysis and, together with the Treasury, convened a conference towards understanding of monetary policy and the exchange rate. Assistant Governor John McDermott recently gave a speech summarising the findings of this work (McDermott, 2013). The third and most potent rationale for transparency is to use communication as a fundamental tool for signalling a monetary policy action. In this context, statements and analysis by the Bank are designed to inform and shape expectations about future monetary policy settings. Indeed, when used in this instrumental manner, the words of the central bank are themselves monetary policy actions (see Holmes, 2009). Achieving this impact requires considerable central bank credibility. The institution needs to be perceived as a responsible and credible manager of its designated policy goals in order to successfully influence economic behaviour. As Janet Yellen, President Obama’s nominee as next Chair of the US Federal Reserve Board of Governors said: if the Fed’s communication is “to have its maximum effect, it must be understood and believed” (Yellen, 2012, p.7; my emphasis). One test in this respect is whether our statements yield the market responses we seek. The potency of words is also their danger. Market sensitivity to language is acute, and it is important to avoid misinterpretation4. Prior to the final sign-off of the Monetary Policy Historically, it was recognition of this sensitivity that led central bankers to limit their communication. Before Greenspan, Montague Norman (Governor of the Bank of England from 1921 to 1944) reputedly took as his personal motto: “Never explain, never excuse”. (http://www.federalreserve.gov/newsevents/speech/bernanke20071114a.htm). BIS central bankers’ speeches Statement or Official Cash Rate (OCR) statement, the draft communication is assessed by the Financial Markets Department of the Bank for expected market impact, and we subsequently monitor and evaluate its “success” in achieving the desired response. Reaching one audience effectively does not guarantee we have reached another. A recent foray into the “public audience” via an opinion article explaining the LVR policy, that repeated our monetary policy expectations, appeared to reveal substantial public surprise about our interest rate projections. While unintentional, it therefore possibly enhanced the projection’s impact. Achieving both accessibility and credibility, while simultaneously communicating with both the general public and financial markets, can sometimes create tensions5. The why of financial stability communication The arguments around transparency of central bank operations with respect to financial stability are less well traversed in the literature, although studies are increasing. Accountability is again a key reason for transparency about the regulator’s conduct, along with economic benefits from reducing asymmetry of information, improving the operation of financial markets, and helping people to understand financial risk (e.g. Born et al, 2012)6. The primary communication instrument for accountability and transparency around the Bank’s financial soundness responsibilities is the Financial Stability Report. Published every six months, this report sets out our assessment of trends in system risks, lending growth and standards, and policy changes. The report enables the Reserve Bank Board, Parliament and other commentators to evaluate our system-wide responsibilities and policy approach to financial soundness. Transparency around financial stability is achieved both by the central bank’s own reporting and perhaps more importantly by the disclosure requirements it imposes on financial market participants, enabling investors and depositors to assess lending risks. A number of authors have argued that the Asian banking crisis of the late 1990s was exacerbated “by the lack of transparency and disclosure in the banking system, making it difficult to gauge the severity of the situation or propose timely solutions” (Rosengren, 1998, p2). Since then there have been moves by central banks to impose greater disclosure on commercial banks and to ensure standardisation and definitional clarity around disclosed information. The Reserve Bank has required all banks to publish quarterly disclosure statements since 1 January 1996. Markets function better with transparency of information (e.g. Mehran and Mollineux, 2012), causing the cost of funds to financial institutions to better reflect their underlying financial strength. Transparency is especially important when financial stability risks may be building, as “communications can serve to align agents’ incentives, to coordinate their expectations, and to steer their behaviour in a way that helps to prevent crises” (Born et al (2012, p252). There may be occasions where complete transparency may work against the interests of financial stability, for example if a problem at a bank precipitated a run before the bank and the authorities had a chance to correct or at least clarify the problem. There are strong grounds, therefore, for seeing financial stability communication in normal times as different from that applying during times of crisis. In the event of an institutional failure or rescue, our decisions can of course be reviewed after the event. No rescue See Jackman (2002). Blinder (2008 p941) observes that studying central bank communications with the general public – in contrast to financial markets − is so far largely unexplored territory. However, perhaps reflecting the newness of this literature and of FSRs, Oosterloo et al (2007, p94) states that there is little evidence of the impact of financial stability reports on financial sector soundness. BIS central bankers’ speeches operation would be undertaken without wider public sector involvement, since taxpayer funds are at stake. Normal public sector accountability mechanisms (annual or ex-post reporting, audit, select committee examination, etc) operate in such a case. Transparency of the Bank’s financial stability activity is also limited by the requirement on us as a supervisor to maintain confidentiality of information that institutions provide to us7. This means that, generally speaking, we cannot reveal the nature of discussions or correspondence with a supervised entity, both to protect commercial confidentiality and to ensure entities feel safe in talking with us. The financial stability policy development process is more open and consultative than the operational, supervisory process. Public engagement in prudential policy development is a cornerstone of our approach – we consult regularly with the public and financial sector on major policy innovations before finalising our intended policy approach, which we publish. For example, we have consulted in recent years on the prudential liquidity framework, Basel III, the macro-prudential policy framework, insurance solvency standards and payments oversight proposals. Our Act requires us to consult with the banks before we impose Conditions of Registration, and also requires us to publish Regulatory Impact Assessments of proposed (financial) policy changes. The Act identifies these as accountability statements. The public (and financial sector) are engaged in decisions about our policy framework before they are made, and we can and do modify our approach in response to feedback. How do we compare? The Bank puts considerable communication effort into promoting understanding, and accepting the ensuing challenge and debate. This year we have given 17 on-the-record speeches (including this one), up from eight last year; 90 off-the-record addresses (c.f. 93 in 2012); on top of many other forms of communication, from our formal quarterly Monetary Policy Statements and six-weekly Official Cash Rate (OCR) announcements to research reports, webcasts, videos, newspaper articles, parliamentary committees, academic engagement, business talks and regional presentations. We make analysis and research accessible to wider audiences through such vehicles as the Reserve Bank Bulletin, and publish specific analytical pieces of work underpinning our decision-making via analytical notes. Quarterly monetary policy statements set out our analysis and understanding of the economy and its expected future path, as well as the risks of variation from that path. Other commentators may make different judgements and come to different views about likely economic behaviours, but we would be disappointed if they were not able to understand the reasoning behind our own monetary policy decisions. We have been communicating with increasingly wide audiences via expanding channels; yet demand for more engagement continues to grow. The news media and political appetite are extensive8. However, we require substantial disclosure of information by the institutions themselves. While we have no long-term time series for comparison, media references to the Reserve Bank have been running at over 1000 per month during the introduction of LVRs, compared with 500–700 earlier in the year when the Open Bank Resolution initiative was being discussed. BIS central bankers’ speeches Table 1 compares New Zealand against a number of other countries on a range of measures of (monetary policy) information disclosure. There is much similarity in practice, with a few notable differences. New Zealand, along with Sweden and Norway, is in the small minority of central banks that publishes an interest rate projection. Many other central bank economic forecasts are reported under unchanged monetary policy settings, on the assumption that if achievement of the policy target demanded a change in settings within the forecast horizon it would have been declared. Reflecting our institutional regime, which is essentially the same as Canada’s, there is no voting result or publication of policy committee minutes9. Minutes are also withheld by the ECB, Switzerland, Norway and Singapore. The ECB has been very explicit that it would regard their release as reducing the effectiveness of monetary policy by potentially reducing consensus decision-making and placing pressure on voting members to be seen to reflect the interests of their own country interests. It would be akin to having individual Cabinet members’ votes identified in a Cabinet minute. The UK and the USA both publish minutes and votes and are notable – especially the USA recently – for multiple individual expressions of view about the appropriateness of monetary policy, notwithstanding considerable arguments against the noise this generates. Australia publishes anonymised and summary minutes that they point out are not verbatim or transcript but rather a record of decision and the key contributing factors (Stevens, 2007). There the minutes largely serve the purpose of explaining the rationale for the monthly interest rate decision. Worldwide, financial stability reporting has increased considerably over the past 15 years or so. According to Oosterloo (2007, p94), 40 countries produced an FSR in 2005, up from only one country in 1996. New Zealand commenced its FSR in 2004. While less complete than IMF reporting recommendations, New Zealand’s FSR is in the top half of countries’ measured by comprehensiveness of indicators. The banking prudential regime, including its review processes and its transparency, was assessed by Treasury in 2010 as very good practice against OECD best practice guidelines10. What has changed? The arguments for open communication are now well-established. What is new, one might ask? I would point to four factors. i. Unconventional monetary policies affect New Zealand First, post-GFC, we are operating in a world where many advanced economies have deployed unconventional monetary policy. With policy interest rates near zero, quantitative easing and forward guidance have become instruments of choice. These policies and their communication lessons have important spillovers for New Zealand. Minutes and papers of the Reserve Bank Board reviewing the Governor’s prior Monetary Policy Statements and OCR decisions are commonly released under the Official Information Act, although sensitive material may be withheld. http://www.treasury.govt.nz/economy/regulation/bestpractice/bpregmodel-jul12.pdf. BIS central bankers’ speeches Forward guidance seeks to create greater certainty for households and firms in respect of future policy actions by the central bank. It does this by more explicitly linking future policy changes to either (or both) economic conditions (state contingent policy) or a specific time period (time contingent policy)11. In both the USA and the United Kingdom, central banks have foreshadowed policy interest rates remaining extremely low through 2015. Determining and communicating New Zealand’s monetary policy conditions requires us also to understand and communicate the impact of international economic and policy settings. With New Zealand further advanced in the economic and financial cycle, our short-term interest rate differentials are likely to widen. In coming months, the future path of the exchange rate will also be influenced by the Federal Reserve’s decisions on tapering of their quantitative monetary expansion. The Reserve Bank Act of 1989 required us to provide (a type of) forward guidance by publishing policy statements that set out how the Bank intends to achieve its explicit policy target. Since June 1997, we have published interest rate projections that are conditional on various assumptions e.g. about the paths for output, employment and prices. The communication challenge with forward guidance – which equally applies to publishing interest rate projections – is how to reduce uncertainty about the likely path of policy while at the same time conveying its conditionality and the possibility of change in policy settings. Achieving this depends crucially on the private sector believing the Bank’s unwavering commitment to the inflation target. E.g. The Federal Reserve Open Market Committee (FOMC) adopted the most recent („threshold“ or state contingent) incarnation of its forward guidance policy in September 2012 (with the Bank of England following suit in August 2013). See http://www.newyorkfed.org/research/staff_reports/sr652.pdf, http://www.bankofengland.co.uk/monetarypolicy/Pages/forwardguidanceexplained.aspx, http://www.bankofengland.co.uk/publications/Documents/inflationreport/2013/ir13augforwardguidance.pdf. BIS central bankers’ speeches Forward guidance, therefore, has not transformed the fundamental requirements of effective communication. Recent experience has demonstrated this vividly. Having established an expectation of tapering in September 2013, the Federal Open Market Committee then confounded expectations by not doing so. Interest rate volatility, particularly in longer-term bonds, was exaggerated, along with spillover in exchange rate movements for a number of countries. In the words of Michael Woodford (2013, p 5), “The use of forward guidance is not some kind of magical tool where the mere fact that the central bank says something means that people will then think exactly that. A central bank needs to give people a reason to think something new or different about what it is going to do”. Words can lose potency and indeed result in confusion if overwhelmed by their own frequency and noise (see Buiter, 2013). Clarity is crucial. We have to take particular care to avoid any financial market confusion caused by muddled or partial communications. Speaking with a single voice is essential. We take considerable care to ensure the Bank’s policy communications are consistent, are what the Bank wishes to say, and avoid any sense of the Bank saying different things through different channels or personnel. ii. The introduction of macro prudential policies Secondly, many central banks have adopted new macro-prudential policies in response to lessons from the financial cycles preceding and succeeding the GFC. We have recently introduced new capital requirements against high loan-to-value ratio (LVR) lending and also limits on the share of new high LVR lending. These new moves required a fresh understanding and enhanced communication12. New policy frameworks pose special challenges to build understanding of their efficacy, conditionality, and operation. Faced with rising house price inflation on top of seemingly already over-valued house prices, the Bank moved quickly to institute new policy measures. We set the scene for these measures in a number of on-the-record speeches in advance, as well as remarks at press conferences, and in Monetary Policy Statements and OCR statements about our concerns with easier lending standards and house price inflation. We published analyses of their potential impact, as well as comparisons with regimes in other countries. Following their introduction, we have carried out sustained communications about their operation, rationale and objectives in further speeches, media interviews, and the November Financial Stability Report. The introduction of LVR restrictions has attracted significant commentary from many different quarters. Some analysts feel there has been a blurring of financial stability and monetary policy objectives. Others have questioned the Bank’s operational policy design, its distributional impacts, and the legitimacy or autonomy of its decision-making. Some have credited the Bank with policy innovation and the willingness to act before a crisis eventuates. We have reiterated that LVRs are targeted at the primary objective of financial stability, but that there is also a potential benefit for monetary policy if they reduce the spillover of house price inflation into stronger consumer demand and higher price inflation for goods and services. Explaining important inter-dependencies with other policies – our own or wider government ones – is vital. It is well-known that monetary policy “needs friends”, as the saying goes, Born et al (2012, p249) state that macro-prudential policy is resulting in financial stability communications moving closer to the approach taken for monetary policy communications. He comments on the communications of LVRs in Israel, which triggered very similar debates to those in New Zealand. BIS central bankers’ speeches particularly supportive fiscal policies. Macro-financial (or macro-prudential) policies can also benefit from supportive micro-economic policies (e.g. productivity, housing, tax, regulation, etc) whereby these reduce risks and enhance the economy’s growth capacity and performance. In these circumstances, we endeavoured to support policies that promoted housing supply, as a goal, without commenting on specific policy proposals (Spencer, 2013). iii. The expansion in regulatory responsibilities Thirdly, we have acquired new, expanded regulatory responsibilities, in particular regulating nonbank financial deposit takers (NBDTs) and licensing and supervising insurance companies13. The Bank’s stakeholder engagement has changed significantly, whilst expectations upon it and its public persona as a guardian of financial soundness and efficiency have been magnified considerably. In terms of expanded regulatory responsibilities, the communication challenges to date have been more stakeholder management related (understanding the regimes’ operation and building trust in our regulatory relationship) rather than widespread public discourse. Taking on additional regulatory responsibility for insurers and non-bank-deposit takers means we are dealing with everyone from bank chief executives to building societies to small mutual insurers. These regulatory responsibilities were assigned to the Bank out of a concern to avoid financial failings, such as we saw with finance companies and in the insurance sector. The challenge here is that public expectations may well be at odds with regulatory and supervisory responsibilities and realities. We have communicated that we do not operate a no-failure regime (see Fiennes 2013), as well as explaining our responsibilities vis a vis the Minister of Finance and other institutions such as the Financial Markets Authority. I suspect we have many communication challenges ahead to reach public understanding that the Reserve Bank’s regulatory and supervisory oversight does not represent a “no failure” regime, and that there are no guarantees that insolvencies and other forms of business failure will not occur. This extension in regulatory and supervisory responsibilities will demand new channels, new audiences and new messages. iv. Taking advantage of new technologies Fourthly, generational change, media technology and the scale and immediacy of communication require new approaches too. Living in a hyper-connected world, with increasing access to computers, smartphones and tablets means that anyone around the world can learn what we do, connect with us, ask questions, challenge us or offer critique. Mobile users make up about 10 percent of all visitors to our website. We’ve developed a responsively designed site so it functions on any device, no matter how small, and where users are. The 24-hour news cycle means there is increasing demand for new and easily accessible information at all hours of the day. Additional regulatory responsibilities have also been assumed for anti-money laundering. BIS central bankers’ speeches Where to from here? We are implementing changes to our communication strategy. We are lifting our speaking engagements and our business connections14. Our speeches convey our messages, while we have a strong focus on listening to the business community. For example, the Reserve Bank Board will meet outside Wellington five times this coming year in Auckland, Christchurch, Dunedin, Rotorua and Palmerston North, holding business functions in each of the five centres and conducting question/answer sessions. We are continuing our regular business visits where we meet with about 50–70 businesses each quarter to understand current business dynamics. Our supervisory staff have extensive interactions with banks and insurers. We are developing a broader business engagement programme to liaise better with business people and leaders. We have expanded the number of on-the-record speeches, and are extending the 80–100 annual off-the-record briefings to achieve greater geographic representation and diversity of audience. We maintain a strong programme of engagement with the economics community through academic and public policy links. For example, the biennial monetary policy conference will be held in Wellington in two weeks with Professor Barry Eichengreen the distinguished visitor. Perhaps where we have most to do is in respect of the public audience. Here we are seeking to deploy new media channels, with greater use of videos (e.g. on our website and via YouTube) explaining what we do and why, and telling stories in pictures (e.g. infographics). We use Twitter as a messaging system but have not adopted the new Bank of England experiment of interactive discussion. We developed with Young Enterprise Trust a board game (“Skint to Mint”), which we rolled out across secondary schools in New Zealand to educate the next generation about sensible financial planning, and we sponsor other financial literacy initiatives through Young Enterprise Trust. Addressing the public directly requires us to use plain English more effectively in our communications. Generally the Bank has relied on business journalists to convey messages to their audiences from the Bank’s business sector speeches, and the press conferences following the Monetary Policy Statement and Financial Stability Report and the subsequent discussions in the Finance and Expenditure Committee of Parliament. However, we are also using the opportunities posed by media interviews. Generally, the interview channel has been used sparingly when sensitive policies have been under development. One of the key steps in our communications strategy will be the introduction of a regular stakeholder survey. The Swedish central bank (Riksbank) has a long history of conducting a two-yearly stakeholder survey and we can benefit from following their practice. The survey will help us understand whether we are sufficiently clear in our communications, and the level of credibility attached to them. It will also help us assess whether we prioritise the right communication channels. A key benefit will be the constructive broadening of our audiences, as stakeholder analysis will require us to gear our communications to a multiplicity of stakeholders. Conclusion Our communications approach is informed by theory, experience and best practice around the world. There is much that works well, but we are continually seeking ways to improve. This is not a new approach, but an extended one. As far back as 2001, Professor Lars Svensson commended the Bank’s extensive efforts to interface and communicate with the business sector. BIS central bankers’ speeches The refresh of our communications strategy recognises significant questions confronting the Bank, in terms of policy settings, policy objectives, tools, and governance. We are expanding our regulatory reach into insurance and the wider finance sector, and have introduced a new macro-prudential policy regime. With these changes afoot, our communication strategy is more than old wine in new wineskins. Longstanding policy frameworks are being scrutinised more closely by political and economic commentators. The policy landscape is changing and so is the communications domain. We will maintain our credibility and interaction with the academic and policy communities, continue to lift our business sector engagement, and become more engaged with general public audiences, using a range of channels. The Reserve Bank is deeply committed to transparency – of policy objectives, policy proposals, economic reasoning, and of our understanding of the economy, and of course of our policy actions and intent. Clear communication and strong public understanding make our policy actions more effective. We are working to enhance the openness and effectiveness of our communications. I hope that this contribution will be seen in that spirit. References Bernanke, B. S. “Federal Reserve Communications”, address at Cato Institute 25th Annual Monetary Conference, Washington, D.C., 2007. Bernanke, B.S. “Communication and Monetary Policy”, address at Herbert Stein Memorial Lecture, Washington, D.C., 2013. Blinder, A., M. Ehrmann, M. Fratzscher, J. de Haan and D. Jansen, 2008. “Central Bank Communication and Monetary Policy: A Survey of Theory and Evidence,”Journal of Economic Literature, Vol. XLVI, 4: pp 910–945. Born, B. M. Erhmann, M. Fratzscher, 2012, “How Should Central Banks Deal with a Financial Stability Objective? The Evolving Role of Communication as a Policy Instrument”, pp 244–267, in Handbook of Central Banking, Financial Regulation and Supervision: After the Financial Crisis, (eds, S. Eijffinger and D. Masciandaro), Edward Elgar Publishing. Buiter, W. 2013, “Forward Guidance: More than Old Wine in New Bottles and Cheap Talk?”, Global Economics View, 25 September, Citi Research. Dincer, N. N. and B. Eichengreen, 2013, “Central Bank Transparency and Independence: Updates and New Measures”, Bank of Korea Working Paper, No. 2013–21, (2013–09). Drew, A. and O. Karagedikli, 2008, “Some Benefits of Monetary Policy Transparency in New Zealand”, Reserve Bank of New Zealand Discussion Paper Series: DP 2008/01. Femia, K. S. Friedmand and B. Sack, 2013 “The Effects of Policy Guidance on Perceptions of the Fed’s Reaction Function”, Federal Reserve Bank of New York Staff Reports, No. 652, November. Fiennes, T. 2013, “NZ Regulatory Regime Well-adapted to Financial Landscape”, address at Law and Economics Association of NZ, June. Holmes, D. R. 2009, “Economy of Words”, Cultural Anthropology, Vol. 24, issue 3, pp. 381–419 Jackson, P. 2002, “The Reserve Bank’s External Communications”, Reserve Bank of New Zealand: Bulletin Vol. 65 No. 1, pp. 28–33. McDermott, J. 2013, “Understanding the New Zealand Exchange Rate”, Address to Federated Farmers Meat and Fibre Council, Wellington, November. BIS central bankers’ speeches Mehran, H. and L. Mollineux, 2012, “Corporate Governance of Financial Institutions”, Federal Reserve Bank of New York Staff Reports, No. 539, February. Oosterloo, S., de Haan, J. & Jong-A-Pin, R., 2007, “Financial Stability Reviews: A first empirical analysis,” Journal of Financial Stability, Elsevier, vol. 2(4), pages 337–355, March. Reserve Bank of NZ, 2013, Statement of Intent. Rosengren, W. 1998, “Will Greater Disclosure and Transparency Prevent the Next Banking Crisis?” Federal Reserve Bank of Boston. Spencer, G. 2013, “Housing Market Needs Supply Boost and Demand Restraint”, address at the Property Council, Auckland, October. Stevens, G. 2007, “Central Bank Communication”, Address to The Sydney Institute, December. Svensson, L. 2001, “Independent Review of the Operation of Monetary Policy in New Zealand”, Report to the Minister of Finance, February. Thornton, D.L. 2002, “Monetary Policy Transparency: Transparent About What?”, Federal Reserve Bank of St Louis, Working Paper 2002–028B. The Treasury, 2012, “The Best Practice Regulation Model – Principles and Assessments”, July. Woodford, M. 2013, “Interview with Michael Woodford”, Top of Mind, Issue 18, Goldman Sachs Economics, Commodities and Strategy Research, October. Yellen, J.L. 2012, “Revolution and Evolution in Central Bank Communications”, address at Hass School of Business, University of California, Berkely, November. BIS central bankers’ speeches
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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers' Chamber of Commerce, Christchurch, 31 January 2014.
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Graeme Wheeler: The building blocks of the economic expansion Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers’ Chamber of Commerce, Christchurch, 31 January 2014. * * * Introduction Small open advanced economies like New Zealand tend to have economic cycles that are heavily influenced by developments in the global economy. We saw this when our growth rate slowed during the Asian financial crisis in the late 1990s and the collapse of the dot-com bubble in the United States three years later, and, most recently, during the global financial crisis (GFC). Over the past two years our economy has outperformed most of the advanced economies. Our growth rate has averaged 2.7 percent, or twice the average of the group of 35 advanced economies in the IMF classification. Most of our economic indicators are positive with the terms of trade at a 40-year high, business confidence is the strongest since 1993, and consumer confidence is at a seven-year peak. This afternoon, I would like to offer some thoughts on the reasons for our stronger economic performance, and discuss the nature of the expansion and the challenges facing the Reserve Bank in helping to ensure that the expansion can be sustained. 2008 – 2011: Four difficult years Although New Zealand experienced a shallower recession than most of the advanced economies during the GFC, the economy has faced many difficult adjustments in recent years. These include: the liquidation of over 60 finance companies beginning in 2006 and 2007; the collapse of global trade in 2008 and 2009; droughts in 2008 and 2012; and the devastating Canterbury earthquakes in 2010 and 2011. The earthquakes, in particular, had a profound human and economic impact that will continue to be felt for many years. On a global scale, the Canterbury earthquakes are among the 10 costliest natural disasters in recent history. Relative to the size of the economy, the earthquakes are the most severe natural disaster faced by an advanced economy in recent times (table 1).1 Natural disasters in developing countries have in several cases been more deadly and had a larger cost relative to GDP than disasters in the advanced economies, even if insured losses have been low. For example, the 2010 earthquake in Haiti is estimated to have a death toll of over 220,000 and an economic cost of over 100 percent of Haiti’s GDP. BIS central bankers’ speeches In Canterbury, businesses closed, residents moved away, and foreign students and tourists stopped coming. Businesses that exported or competed against imported goods and services also faced the twin burdens of the high New Zealand exchange rate and more aggressive pricing by foreign competitors as global trade volumes slowed. In order to facilitate recovery in the economy, while maintaining the Reserve Bank’s obligations for price stability, we lowered the official cash rate to 2.5 percent, and helped to generate the lowest retail interest rates in 60 years. The forces behind New Zealand’s economic recovery Several factors beyond monetary accommodation contributed to New Zealand’s economic recovery. These include: the recently improved economic climate in advanced countries; high export prices for our major commodities; the strength of construction investment, particularly in Canterbury; and the range of other factors driving the increase in private consumption. (i) The international economy The global economy is recovering after many years of fragility and uncertainty. Output growth has increased in recent months in several advanced and emerging countries. World trade volumes are increasing and the global economy is now growing at about its average rate over the past three decades – albeit with exceptional monetary stimulus from central banks in the major economies. Business conditions have improved in the United States especially, and in Japan and in the United Kingdom. The euro area has emerged from recession but the recovery is slow and uneven. China, the world’s second largest economy, is growing at around 7.5 percent. (ii) The high terms of trade New Zealand’s terms of trade are at their highest level since 1973 (figure 1). BIS central bankers’ speeches Our farmers, especially, are enjoying very favourable export commodity prices and an excellent season of grass growth. Considerable focus is on the extremely high international dairy prices, but aside from aluminium, all of the sub-categories of the ANZ Commodity Price Index are at or near record highs. Strength in the New Zealand dollar is distributing some of these gains to the broader spending public, but, even accounting for this, export prices in New Zealand dollar terms are well ahead of those received in the 2008 commodity price boom. New Zealand is benefiting considerably from its export linkages with the rapidly growing economies of East Asia, especially China, and with Australia. Over the past decade China’s share of our exports has increased from 3 percent to 21 percent. China is now our largest export market for all our agricultural commodities except beef, where it is second only to the United States (figure 2). (iii) The strength of construction investment Over the past two years, construction investment has increased by 40 percent, largely due to the Canterbury re-build. The cost of the Canterbury re-build is forecast to be around NZ$40 billion in current prices, or around 20 percent of annual GDP. This massive reconstruction is a unique feature of the New Zealand outlook. It will have a major impact on the local and national economy for a number of years to come. Although there is considerable uncertainty as to the magnitude and phasing of the re-build, annual construction investment associated with the re-build is projected to peak in 2016 and 2017 at around $4 billion. In terms of its contribution to New Zealand’s GDP growth, reconstruction-related investment is expected to peak in 2014, with investment doubling relative to 2013 (figure 3). BIS central bankers’ speeches Construction activity is also increasing in Auckland. Residential consent issuance is running at 6000 per year – double the rate of mid 2011 (figure 4). The Auckland Accord set a target of 39,000 new housing consents over a three-year period and the Government, together with the Auckland Council, recently designated special housing areas for fast-track resource and building consent with capacity for 15,500 new homes. BIS central bankers’ speeches If these targets for Auckland are met over the next three years, and if 12,000 new homes are constructed in Christchurch, as predicted, then construction volumes would need to be 10 percent higher than in 2004, which represented the peak of the last building boom. This estimate, however, assumes no growth in home building in the rest of the country. Pressures on the construction industry will also increase with New Zealand’s infrastructure needs and repairs on the remaining 42,000 leaky buildings nationwide. (iv) Growth in private consumption Real private consumption has been growing at an annual rate of around 3.5 percent in 2013 as a result of many factors: the high terms of trade, the 40,000 person increase in employment, the 20,000 person increase in permanent and long-term immigration, the 9.5 percent increase in house prices, strong consumer confidence and low real interest rates. Private sector consumption and investment have driven the recovery and accounted for much of New Zealand’s economic growth over the past two years. Can the economic expansion be sustained? In small advanced open economies, expansions usually come to an end for one or more of the following reasons: growth in the global economy slows; the nation’s terms of trade decline significantly; a major policy correction is needed to address a deteriorating fiscal or current account deficit; or interest rates rise significantly in order to moderate rising inflation pressures associated with growing supply and demand imbalances. The economic slowdown is intensified if the adjustment is accompanied by a sizeable decline in house prices. Are any of these factors likely to end New Zealand’s current expansion? A further slowdown in global growth remains possible given the vulnerabilities in several major advanced economies due to low productivity growth and high levels of public and private sector debt. The areas of greatest risk lie in a potential faltering of momentum in the euro area, and the rapid build-up in debt levels in China, part of which originated in the shadow banking sector. However, international financial institutions such as the IMF and World Bank have recently increased their central forecasts for global growth and the sentiment at the World Economic Forum in Davos earlier in the month was generally more upbeat, despite market jitters around some emerging market economies. Some reduction in the terms of trade might be expected in light of their high level and the projected increase in world dairy supply. But any decline in export prices is likely to be moderated by the improving outlook for global growth and world trade. The current account deficit is expected to deteriorate with increased imports, but not to provoke a severe adjustment. Nor are major changes in fiscal policy envisaged. The Treasury’s forecasts suggest that the fiscal outlook is for a small surplus in the 2014/15 financial year and surpluses of around 2 percent of GDP in 2017/18. An important risk to the expansion lies in the increase in inflation pressures, and the rise in interest rates necessary to contain them. Annual consumer price inflation is currently 1.6 percent. As shown in figure 5, inflation in the tradables sector has been negative for the past 21 months, mainly due to the high exchange rate, and intensive international competition associated with the global oversupply of manufactured goods. Non-tradables inflation is currently increasing at an annual rate of 2.9 percent and is expected to rise towards 4 percent as the labour market tightens and capacity bottlenecks increase, especially in the construction sector. BIS central bankers’ speeches Some increase in inflation pressure is inevitable as the economy is growing more rapidly than potential output.2 Potential output growth slowed in the recession of 2008/9 and has not regained its pre-recessionary rate. We estimate that over the last two years potential output has grown by a little over 2 percent annually, compared with average GDP growth of 2.7 percent. This gap between the actual growth rate and the potential growth rate increases pricing pressures in the economy. Some factors are constraining the recovery in potential output growth. While New Zealand’s labour force participation is close to its pre-recession peak and the unemployment rate is falling, data suggests that skilled labour is becoming more difficult to find. The share of investment in GDP fell sharply in the recession and is now only back to its pre-recession level. Labour productivity only surpassed the pre-recession level in 2011 and OECD data suggests that multifactor productivity fell during the recession and has been slow to recover. Price pressures are particularly apparent in the construction sector as resources are reallocated to Canterbury and Auckland from other regions and activities, and spare capacity in the economy is being absorbed at a rapid rate. Such cost pressures could spill over into broader consumer price inflation, particularly if the construction sector reaches capacity constraints (employment in the sector is currently 9 percent below its 2006 peak). Household debt is rising again and households are forecast to spend more than they earn in 2014. Stronger inflation pressures and the increase in interest rates that would accompany them could put pressure on New Zealand’s real effective exchange rate and reduce the competitiveness of our export and import-competing industries.3 Potential output is the rate of growth that the economy can sustain at full employment without generating inflationary pressures. The real effective exchange rate provides a more accurate picture of competitiveness than the nominal effective exchange rate as it corrects for differences in relative inflation rates (or relative unit labour cost movements) between New Zealand and its major trading partners. BIS central bankers’ speeches Increases in the price of construction services in Canterbury are needed to attract resources to the re-build, but a key issue is whether they are spilling over into other sectors and regions. There are signs that this is starting to happen. Annual construction cost inflation in Auckland and the rest of the country has risen steadily over the past 12 months and is currently running at 5 percent (figure 6). Inflation pressures may also intensify if there is a rapid fall in the exchange rate. Exchange rate corrections can never be ruled out, especially when the exchange rate remains close to historic highs on a TWI basis and in the top decile of historic experience against the major currencies, including the Australian dollar. The New Zealand exchange rate has experienced rapid and prolonged falls on several occasions over the past 30 years (figure 7). The monetary policy response to a sudden correction in the exchange rate would depend largely on what triggered it. An interest rate response might be warranted if it were driven, for example, by portfolio investors reducing their exposure to New Zealand with few real economic factors underpinning it. It may not be needed if the decline in the exchange rate was driven by a sharp fall in the terms of trade. A further risk to the expansion is the level of house prices. By historic and international comparisons, New Zealand house prices are overvalued. A recent OECD study indicated that house prices in relation to income are 25 percent above their long-term averages, while rents are 60 percent above.4 The situation is exacerbated by household debt levels of around 150 percent of household disposable income that are again on a rising trajectory. OECD Economic Outlook, Volume 1, May 2013. BIS central bankers’ speeches While a substantial fall in New Zealand house prices is unlikely, such a fall could happen if there was a marked deterioration in the household sector’s ability to service its mortgage debt due to a sharp rise in unemployment, falling incomes, or very high domestic interest rates. A sharp correction of the type seen in several advanced economies in recent years would likely be accompanied by a domestic recession. The housing market poses risks to financial stability and the broader economy, and is a major reason why the Reserve Bank introduced speed limits on high loan-to-value ratios for residential mortgages in October 2013. At present, we have limited data relating to the post-LVR period. The information to date suggests that housing turnover and the rate of house price inflation may be easing, but this could be due either to LVR restrictions or other factors such as house affordability. It will be some time before we can gauge the overall effect of the measures. Monetary policy going forward The Reserve Bank’s goal under the policy targets agreement is to keep future average inflation near the 2 percent target midpoint. Achieving this will help to ensure that economic activity is kept more in line with the potential growth of the economy, thereby promoting a more sustainable growth path. Further, price stability itself has benefits for long-term economic growth. It enables households, businesses, and governments to plan with greater certainty; it facilitates longterm contracting; lowers the inflation risk premia embedded in interest rates; and enables producers, consumers, and investors to respond to opportunities created by changing relative prices rather than diverting resources to hedge against inflation. These benefits are eroded when inflation and inflation expectations become excessive. If actual inflation and expectations of future inflation were to rise significantly, competitiveness and real income growth would decline. The Bank’s subsequent efforts to maintain price stability by raising nominal and real short term interest rates would be more disruptive, the further inflation was allowed to deviate from target. Assessing the timing and magnitude of increases in the OCR involves difficult judgements because changes in interest rates tend to affect the rate of growth of output and inflation with a 12 to 18 month time lag, although it can be more rapid if the main transmission effects BIS central bankers’ speeches operate through the exchange rate. This means that interest rate judgements need to assess the degree of inflationary pressure in the economy throughout the forecast period and how inflation expectations and pricing behaviour might change in response to different levels of the OCR. These are judgements we face all the time. The complexity of them is increased in current circumstances by the fact that New Zealand’s terms of trade are at a 40-year high; our exchange rate remains close to historic highs on a TWI basis; the economy is reallocating resources to meet construction needs in Christchurch and Auckland; rising house price inflation is adding to consumer demand; net migration is increasing rapidly; and the United States is cutting back the scale of its quantitative easing. The Reserve Bank’s approach in assessing interest rate responses is driven by a combination of models, data, and judgement. We assess new economic information and whether it is different from the assumptions built into our published economic forecasts and interest rate projections. In the past six weeks for example, indicators on New Zealand’s economic growth and inflation have been stronger than those built into our December projections, but the exchange rate has also been stronger and initial indications are that house price inflation may be starting to moderate, although it is too soon to draw firm conclusions. The exchange rate remains a considerable headwind for the economy, and the Bank does not believe its current level is sustainable in the long run. We will undertake a comprehensive assessment of the outlook in the next Monetary Policy Statement in March when further information will be available. The Reserve Bank’s projected path of interest rate rises contained in the December Monetary Policy Statement suggests that the OCR will need to rise by around 2 percentage points over the next two years. Yesterday we kept the OCR unchanged at 2.5 percent, but signalled that inflation pressures are rising and that interest rates will need to return to more normal levels in order to keep future average inflation near the 2 percent target mid-point. We also indicated that the scale and speed of the rise in the OCR will depend on future economic indicators. Conclusion This afternoon, I have outlined the factors behind New Zealand’s strong economic growth, and the challenges facing the Reserve Bank in helping to ensure that the expansion can be sustained. We have supported the recovery through low policy rates. We recognise that the economy has been growing faster than potential growth for some time. Although headline inflation has been moderate, inflationary pressures are building and are expected to increase over the next two years. In such an environment, there is a need to return interest rates to morenormal levels and the Bank expects to begin this adjustment soon. Achieving this will help to ensure economic activity is kept more in line with the potential growth of the economy, thereby promoting a more sustainable expansion. BIS central bankers’ speeches
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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, at the Asia Pacific high level meeting on banking supervision, Auckland, 27 February 2014.
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Graeme Wheeler: Address to the 10th Asia Pacific high level meeting on banking supervision Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, at the Asia Pacific high level meeting on banking supervision, Auckland, 27 February 2014. * * * Good morning, and a warm welcome to Auckland. This morning I’d like to offer a few thoughts on a small country perspective on global financial sector regulatory reform. But, before doing so, I’ll comment briefly on the relationships within the regulatory community. Relationships 150 years ago, during the American Civil War, Abraham Lincoln said “the best thing about the future is that it comes only one day at a time”. Many of us here felt similarly in September 2008 as the Global Financial Crisis entered a deeper and more perilous phase. For central banks and banking regulators versed in stress testing, the GFC was an extreme tail risk event. None of us expected the elements forming the Basel II pillars, including market discipline, to fail in a G7 economy. Nor did we foresee a crisis that would re-price every asset across the globe, and damage financial stability in all our economies. Naturally, attention quickly focussed on the need to strengthen the capital and liquidity frameworks and broad regulatory architecture across the global banking system. This was necessary in order to help contain the externalities that were very evident in the GFC and build resilience against future crises. That’s why co-operation between central banks and regulators is especially important in all its forms. We place high value on our relationship with the BIS, EMEAP and with central banks and fellow regulators in the Asia/Pacific Region. Throughout the region, we have deep trade, cultural and political ties, and the region accounts for 60 percent of our trade and capital flows. EMEAP and its working groups are important channels for building relationships, discussing developments in member countries, and exchanging experiences and ideas on financial stability and regulation. The constructive two-way engagement and information sharing that the forum provides has given us a better understanding of other Asian central banks’ perspectives – including on where we differ, where we have common ground, and where we can learn from others. Small country perspective I’ll turn now to some small country perspectives on global financial sector regulatory reform and illustrate them briefly with New Zealand’s approach to prudential supervision. My main point is that: while it’s critical that the global regulatory response addresses regulatory arbitrage, it’s important also that small and large countries alike understand each other’s needs. These needs include meeting national sovereignty objectives and adapting BIS central bankers’ speeches the regulatory response to local conditions, while also meeting the spirit and desired outcomes of the Basel III standards. Small open economies differ from their larger counterparts in several respects: • Their economies are often less diversified and are more vulnerable to external shocks; • A large portion of their banking system may be foreign owned and regulated by home and host supervisors. Their shadow banking sector is usually smaller and less developed than in the larger economies; • They tend to have less sophisticated financial market infrastructures, with limited or no opportunities for local central clearing; • Credit risk is often concentrated in just a few sectors; • Bank balance sheets are less complex, with a predominance of vanilla banking rather than investment banking; and • There can be a shortage of highly-rated liquid assets, especially when governments run budget surpluses or small deficits, and where equity and corporate bond markets are small and lack liquidity. These differences can affect the way small countries choose to implement global standards. When there’s symmetry between financial market practices, small country regulators usually seek to align practices to global standards, so as to minimise the cost for banking groups operating across jurisdictions. When symmetries aren’t apparent, regulators in small economies seek to use the flexibility in global standards to adapt to local conditions. For some small countries, parts of the global standards have limited relevance or relate to low areas of risk, so their adoption may not be a priority. For New Zealand, shadow banking comes into this area – it’s a small sector, which we assess to be low risk. In other cases the alignment of global standards is influenced more by home regulator rules or market imperatives. For instance, requirements for central clearing and trade reporting of OTC derivatives may be imposed by the home regulator, or by counterparties, independent of any host supervisor requirement. Before concluding, let me make a few brief comments about New Zealand’s approach. As a financial regulator, the Reserve Bank of New Zealand generally seeks to align with international standards, but uses national discretion to adjust for local conditions as needed. Where we make adjustments we seek to achieve regulatory consistency, mindful also that our approach is: • to foster market discipline by stressing self discipline by banks in managing risks, and • to avoid supervisory practices that might erode market discipline or weaken the incentives for a bank to take ultimate responsibility for the management of risks. I’ll give three brief examples where we’ve used the flexibility in global standards to adapt to local conditions. • First, farm lending, and especially dairy farming, accounts for a large share of risks faced by New Zealand banks. We’ve adapted the Basel capital framework to account for the high correlation in bank farm lending losses, and the vulnerability of the New Zealand farm sector to shifts in a narrow subset of global commodity prices. BIS central bankers’ speeches • Second, our banks have historically relied on short-term funding from offshore counterparties. We developed our bank liquidity requirements ahead of the Basel III requirements, but they achieve very similar outcomes. Our mismatch ratios are very similar to the Liquidity Coverage Ratio, and our core funding ratio is similar to the Net Stable Funding Ratio. Grant Spencer, our Deputy Governor and Head of Financial Stability, will be talking about our liquidity policy during tomorrow’s panel discussion. • and third, the leverage ratio we feel is an unnecessary addition to the risk-based Basel II capital regime. Our banking system is relatively vanilla and we closely monitor risk weights on key assets. Actual leverage is well ahead of the proposed regulatory backstop. Concluding comments Small countries are not represented in the main Basel regulatory committees, the Financial Stability Board, or the membership of the G20. Nor do they have global banks. But they do follow the Basel debates carefully through their relationships in the regulatory community. They know the issues are complex – be they related to cross-border resolution and too-big-to-fail; assessing bank capital adequacy and acceptable tolerances for leverage; or addressing issues around complexity, compliance, and adjustment paths. And they understand the responsibilities all countries carry to close the regulatory net and avoid the regulatory arbitrage opportunities that would otherwise exist. On the regulatory front, large countries associate with many of the smaller countries as home supervisors, regulators of international infrastructures, and participants in peer reviews and other assessments. In these roles, it’s helpful if larger countries recognise small country differences, as well as the mandate of small country regulators to protect their national interests. Large countries should support the approaches taken by smaller countries to implement reforms – when they support the intended outcomes of global standards, but in ways that may deviate from large country norms in order to meet local country conditions. BIS central bankers’ speeches
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Remarks by Mr Grant Spencer, Deputy Governor and Head of Financial Stability of the Reserve Bank of New Zealand, at the tenth Asia-Pacific High-Level Meeting on Banking Supervision, Auckland, 27 February 2014.
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Grant Spencer: Comments on the Basel liquidity standards and central bank operations Remarks by Mr Grant Spencer, Deputy Governor and Head of Financial Stability of the Reserve Bank of New Zealand, at the tenth Asia-Pacific High-Level Meeting on Banking Supervision, Auckland, 27 February 2014. * * * Introduction While sourced in sub-prime credit losses, the Global Financial Crisis (GFC) was felt by most countries, including Asia Pacific countries, as a massive liquidity shock. This was felt in banking systems as a loss of market liquidity (ability to sell assets) and as a loss of funding liquidity (ability to issue securities). The immediate policy response was for central banks to provide large doses of liquidity to the banks and for governments to provide guarantees on bank debt securities. Most of these measures were subsequently pulled back as market and funding liquidity was restored in 2009. The longer term policy response to the unprecedented liquidity shock of the GFC has been two-fold: central banks have strengthened and broadened their capability as system liquidity providers, and prudential regulators have begun to strengthen liquidity requirements for banks. Central banks have become better prepared to respond to systemic liquidity shocks in their various forms, and at the same time new prudential standards are requiring banks to be better prepared to withstand liquidity shocks on their own account. The topic I wish to discuss here is the extent to which the new Basel liquidity requirements may have implications for central banks’ policy operations, and vice versa. I will discuss the extent of alignment between the two policy arms as well as some potential implications of the Basel III standards for central banks’ policy operations. Basel III liquidity standards The maintenance of prudential liquidity standards is fully consistent with the central bank’s public policy function of system liquidity support. Banks left to their own devices may hold liquidity buffers that are less than socially optimal, due to: 1. banks not allowing for systemic externalities that can result from liquidity shortages; and 2. banks potentially relying on the central bank to offset systemic liquidity shocks, thereby creating moral hazard effects. New Basel III standards will start to be introduced from January 20151 with the Liquidity Coverage Ratio (LCR), to be followed in January 2018 by the Net Stable Funding Ratio (NSFR). These standards are intended to strengthen banks’ ability to independently withstand liquidity shocks, by holding sufficient liquid assets to withstand a 30-day name The LCR will be phased in from 2015. For January 2015, banks will be required to have an LCR greater than 60 per cent. The minimum requirement will increase by 10 percentage points each year until fully implemented by January 2019. BIS central bankers’ speeches crisis (the LCR) and to reduce the inherent maturity mismatch in banks’ balance sheets (NSFR)2 In specifying the LCR, the Basel Committee on Banking Supervision (BCBS) has focussed on the need for banks to hold high quality liquid assets (HQLAs) that will remain liquid in private markets, even in a crisis situation. This essentially means that the bulk of LCR assets must be public sector securities that are “traded in large, deep and active repo or cash markets.” The aim clearly is to base the standard on the best available liquid assets and to achieve cross-border consistency for internationally active banks. However, for many countries, this model does not fit. In Australia, South Africa and Norway, for example, government securities are relatively limited in supply, and they are often locked away in long-term investment portfolios, thus further limiting the liquidity of secondary markets. The BCBS has considered situations where the market for HQLA might not be large enough to support LCR requirements and has developed alternative liquidity arrangements (ALAs). Permissible ALAs include: 3. the use of a contractual committed liquidity facility (CLF) provided by the relevant central bank for a fee. So far, Australia and South Africa have adopted this option; 4. the use of foreign currency HQLA to cover domestic liquidity needs, with haircuts to cater for currency risk. It appears Hong Kong and Singapore may adopt this option. 5. the additional use of Level 2A assets, such as high quality corporate debt and covered bonds, i.e. going above the 40 percent cap for Level 2 assets, but with higher haircuts. The BCBS state that the use of ALAs is only available where a jurisdiction can demonstrate and justify that an issue of insufficiency in HQLA genuinely exists. Additionally, the jurisdiction implementing the ALAs faces ongoing obligations relating to supervisory monitoring and reviews. New Zealand liquidity standards The Reserve Bank of New Zealand (RBNZ) introduced very similar, but non-Basel conforming, liquidity requirements in August 2010. The high dependence of the New Zealand banks on short term wholesale funding (mostly from offshore) was shown in the GFC to be a significant vulnerability of the banking system and we were keen to reduce this risk as soon as possible. Our aim was to be in line with Basel thinking but we wanted to move promptly and did not wait for final decisions on the Basel standards. It was also evident early on that the Basel emphasis on HQLAs was going to be an issue in New Zealand where some two thirds of government securities are held offshore, contributing to a general lack of liquidity in debt markets. The RBNZ’s Liquidity mismatch ratio3 is very similar in concept to the LCR. We have a oneweek ratio which requires banks to hold sufficient primary liquid assets4 to meet net outflows under a one week name crisis. There is also a one month mismatch ratio requirement where primary and secondary liquid asset holdings must be sufficient to meet potential outflows under a 30-day crisis. There is a close alignment between the eligibility of assets to meet the RBNZ liquidity standards and the eligibility of those assets as collateral in RBNZ operations. The NSFR is designed to ensure that banks maintain a stable funding profile in relation to the characteristics of their on- and off-balance sheet activities. In particular, the NSFR limits over-reliance on short-term wholesale funding, encourages better assessment of funding risk, and promotes funding stability. BIS “Basel III: The Net Stable Funding Ratio” January 2014. See Appendix 2 for definitions. BIS central bankers’ speeches This acknowledges the role of central bank eligibility in underpinning private market liquidity as well as the central bank’s ultimate role as lender of last resort to the banking system. Restrictions are placed on holdings of the lower quality “secondary” liquid assets in order to ensure that banks hold a majority of primary rather than secondary liquid assets. More importantly, from an overall funding risk perspective, RBNZ introduced a Core Funding Ratio4 (CFR) similar to the proposed NSFR. The current minimum requirement of 75 percent was phased in over a three year period. The CFR requirement has promoted a significant improvement in the stability of the New Zealand banks’ funding base, with short term wholesale funding falling from 35 percent of total funding in 2008 to 15 percent in 2013. While the CFR was introduced as a micro-prudential requirement, the RBNZ has more recently nominated the CFR as a potential macro-prudential instrument. This means that the CFR could be adjusted through the financial cycle with a view to increasing funding resilience and average funding costs in the upturn, and taking pressure off funding costs in the downturn. I will come back to this a bit later in the context of the interaction between liquidity standards and monetary policy. Central bank liquidity facilities Cecchetti and Disyatat (2009)5 differentiate between three kinds of potential liquidity shortage, relating to central bank cash, the funding of institutions, and the liquidity of key markets. In normal times, the central bank targets a supply of settlement cash consistent with maintaining short term market rates in line with the official policy rate. During the crisis, this approach was insufficient to restore stability. It was also necessary to introduce new funding facilities, and to broaden existing facilities in terms of the counterparties dealt with and the range of assets accepted as collateral. While most of the special funding facilities have been curtailed since the GFC, some countries have found it necessary to maintain direct funding facilities, for example the BOE’s funding for lending scheme. Further, it is probably fair to say that many of the special facilities used during the GFC effectively remain on standby, i.e. they could easily be reactivated in a new crisis situation. Many central banks have also retained the broader scope of their mainstream liquidity facilities. Examples here include BOE, BOJ, RBA, and RBNZ. These more permanent changes reflect lessons learned in the GFC about the different dimensions of financial system liquidity. Many central banks appear to have broadened their perspective on the “Lender of Last Resort” function and what this implies for central bank policies in normal times as well as during a crisis. One aspect of this broader approach is seen in central banks being more explicit about the key markets they will support6. This might involve a prior commitment to directly support particular markets in a crisis, (eg. the FX market, the interbank market, the short term repo market). It might also involve an ongoing commitment to accept certain securities as eligible collateral. During the GFC, the market liquidity of debt securities became critically dependent on their collateral eligibility at the central bank. Central banks adjusted their credit standards See Appendix 2 for definition. Cecchetti, Stephen G. and Disyatat, Piti, Central Bank Tools and Liquidity Shortages (February 1, 2009). Economic Policy Review, Vol. 16, No. 1, p. 29, August 2010. Available at SSRN: http://ssrn.com/abstract=1678162 orhttp://dx.doi.org/10.2139/ssrn.1678162. “Lessons from the Use of Extraordinary Central Bank Liquidity Facilities” Stéphane Lavoie, Alex Sebastian and Virginie Traclet Bank of Canada Review, Spring 2011. “Central Bank Liquidity Provision and Core Funding Markets” Grahame Johnson and Eric Santor paper presented at Reserve Bank of Australia 2013 Conference – Liquidity and Funding Markets. BIS central bankers’ speeches in order to accommodate the broader range of collateral instruments, albeit with larger haircuts to mitigate the risk. By maintaining broader ranges of eligible collateral, central banks are effectively continuing to support the liquidity of a range of debt markets. So in the post-GFC environment, central banks are generally now better prepared and more willing to support financial system liquidity in its various forms, through existing facilities, through dormant special funding facilities that can be reactivated as necessary, and through ongoing commitments to support liquidity in key financial markets, including by accepting a broader range of collateral instruments. Alignment of Basel standards and central bank liquidity policies The first point I would make here is that an increased preparedness by central banks to support system liquidity is totally consistent with a more rigorous approach to prudential liquidity standards. Externalities associated with liquidity shocks were clearly evident in the GFC, highlighting the need for banks to be prepared for both local and systemic liquidity shocks. Further, more active central bank liquidity support may accentuate the moral hazard problem by reducing incentives on banks to self-insure against liquidity shocks. There is thus a clear case for stronger prudential liquidity standards to ensure banks are better able to withstand liquidity pressures, notwithstanding the role of the central bank as underwriter of system-wide liquidity. However, it is difficult to say that the new Basel III liquidity standards have been aligned with the developments in central bank liquidity policies. First, the Basel III initiative is attempting to promote a convergence across countries towards a single international liquidity standard, whereas central bank liquidity policies have if anything become more diverse since the crisis. Second, the Basel III standards have focussed on safe haven liquid assets that are expected to retain their value and liquidity in a crisis, irrespective of central bank liquidity policies. While this approach may work in the major developed economies, it does not recognise the crucial role that central bank liquidity policies can play in smaller economies, particularly where there is no deep government security market. Of course, during the consultation process, the Basel III standards have been modified to accommodate certain local conditions through the alternative liquidity arrangement (ALA) provisions. In particular, the Committed Liquidity Facility (CLF) variation has been designed to accommodate countries where there is a shortage of Government stock (such as Australia and South Africa). This is a positive move in that it recognises the essential role of the central bank in liquidity provision during a crisis. However, the other variations under ALA, while allowing a wider range of LCR-eligible assets, do not link these to local central bank liquidity policies. For example, while there is an expectation that level 2A assets should be eligible central bank collateral instruments, there is no such expectation for level 2B assets. In the broader scheme, this issue comes down to a trade-off between international crossborder consistency and regulatory efficiency on a country-by-country basis. For the home countries of internationally active banks, the former is clearly important to avoid regulatory arbitrage. But for countries hosting predominantly domestic banking businesses, the need for international consistency is probably less important than the local characteristics of domestic markets when it comes to designing efficient liquidity standards. Basel III impact on central bank operations As I mentioned earlier, minimum prudential liquidity standards, including the Basel III standards, are essentially complementary to central bank liquidity policies. The more prepared banks are to meet liquidity shocks, the less work will need to be done by central banks. However, there may be implications for central bank liquidity operations in two respects. BIS central bankers’ speeches First, with banks required to hold their best quality liquid assets to meet the LCR requirement, they may offer lower quality liquid assets to the central bank in its regular market operations. This would result in central banks having to manage their credit risk more carefully, including paying closer attention to haircuts and securities pricing. This effect would likely persist in a crisis even though supervisors would be able to “release” the LCR requirement. Banks will tend to hoard high quality assets in a crisis, even though the LCR requirement may be reduced. A variation of this effect is for central banks, in the face of a high quality collateral shortage, to move away from sole reliance on reverse repos for injecting system liquidity. An obvious alternative instrument for this purpose, and one which we use extensively in New Zealand, is FX swaps. Second, for countries adopting the CLF as an alternative to HQLA, there is a question about how this will affect central bank liquidity operations in a stress situation. Typically, under existing arrangements, the central bank can closely control the quantum of system liquidity injections, given that standing (on-demand) facilities have a penalty margin attached. In the case of the CLF however, banks will be free to fully access funds to the extent of the committed credit lines. This could potentially make it more difficult for the central bank to manage the quantity and price of short term funds in a crisis situation. Interaction between prudential liquidity standards and monetary policy Another area where the Basel liquidity standards might affect central bank policies is the transmission of monetary policy. This interaction arises in the context of the NSFR or, in New Zealand, the Core Funding Ratio (CFR). These requirements are being introduced as microprudential measures, intended to improve banks’ resilience to liquidity shocks by reducing the maturity mismatch between assets and liabilities. The main impact of this policy, as observed with the CFR in New Zealand, will be for the banks to increase the average term of their funding, incurring some increase in average funding costs as a result of the term premium. My point here is that if the stable funding requirement is treated as a“set and forget” prudential standard, it could have pro-cyclical characteristics7 that influence the transmission of monetary policy. The particular situation of concern is in a cyclical downturn when a fixed NSFR will require banks to continue to roll over term debt at a time when term premiums are increasing, rather than allowing the banks to moderate the cyclical impact on their funding costs by shortening the average term of their borrowing. This could cause a weakening of the monetary policy transmission mechanism in that bank cost of funds might not reduce to the same extent as usual following a monetary policy easing in a cyclical downturn. If this pro-cyclical effect is significant then monetary policy adjustments to official interest rates may need to be more vigorous, potentially in both the upturn and the downturn, to achieve the same effect on bank cost of funds, and thereby bank lending rates. An obvious way to avoid this pro-cyclical effect of the NSFR would be to adjust the NSFR through the cycle, which would effectively make it a macro-prudential tool. This is indeed the approach that RBNZ is intending to take by including the Core Funding Ratio in its macroprudential“toolkit”8. However, no countercyclical adjustments have yet been made to the CFR. See for example “The macroeconomic effects of a stable funding requirement”, A. Munro, C. Bloor and R. Craigie, Reserve Bank of New Zealand Discussion Paper 2012. The MoU between the Minister of Finance and the Governor of the RBNZ is available at http://www.rbnz.govt.nz/financial_stability/macro-prudential_policy/5266657.html. BIS central bankers’ speeches Conclusion The GFC has rightly led to: 1) A new emphasis on liquidity standards for banks; and 2) A more comprehensive approach to the management of banking system liquidity by central banks. These two policy arms are complementary. However, while the Basel III liquidity regime has been created with the aim of achieving common liquidity standards for internationally active banks, the post-GFC evolution of central bank liquidity policies has been diverse and very local in character, making it difficult to achieve alignment between the two policy arms. Alignment has not been assisted in my view by the approach that has been taken to allowable variations in the Basel III standards. While the alternative CLF arrangement brings the central bank explicitly into the scope of the LCR for countries adopting that variant, the important role of central bank policies is not recognised more broadly. Regarding the implications of the Basel III liquidity standards for central bank operations, the main impact is likely to be on the quality of assets that central banks may need to accept in reverse repo operations. Banks are more likely to hoard their higher quality liquid assets to meet LCR requirements, including in a crisis situation. This will reinforce the need for central banks to improve their credit assessment capabilities, including closer attention to pricing and haircut requirements. A more substantive implication of the Basel III liquidity standards relates to the potential for the NSFR to have a pro-cyclical impact on banks’ cost of funds. Such effects could arise if banks are prevented from modifying the term structure of their debt in response to large changes in the interest rate term premium. In this regard, the prudential and monetary authorities may find that the NSFR cannot be treated as a “set and forget” policy ratio. Appendix 1: Alternative liquidity approaches under the LCR The following describes how some countries are implementing Alternative Liquidity Approaches under Basel III. Australia – the RBA and APRA have introduced a “Committed Liquidity Facility” (CLF) that provides an insurance overlay to otherwise “low quality” liquid assets, at a cost of 15 basis points per annum. The CLF will be sufficient in size to cover the shortfall between a bank’s holdings of HQLA and its LCR needs. Qualifying collateral for the facility will comprise all assets eligible for repurchase transactions with the RBA under normal market operations and other assets the RBA deems appropriate (including self-securitisations). Banks will be required to demonstrate that they have taken all reasonable steps towards meeting their LCR requirements through their own balance sheet management, before relying on the CLF. APRA will be reviewing each ADI’s liquidity risk management framework and management practices as the basis for approving the CLF for LCR purposes. South Africa – The South African Reserve Bank has approved the provision of a CLF and the utilisation of statutory cash reserves as part of HQLA for liquidity regulation purposes. South Africa has a limited availability of Level 1 HQLA and virtually no Level 2 assets that satisfy the Basel III criteria. The CLF will be provided for an amount up to 40 per cent of any particular bank’s liquidity requirements. The commitment fee is scaled so that the fees charged increase as the reliance on the CLF increases. There is also a drawdown rate of 100 basis points and drawdowns will be for a period of 30 days. Norway – Norwegian authorities acknowledge that the LCR requirements will pose a challenge to Norwegian banks due to lack of Government bonds, but also due to strict cashflow run-off assumptions imposed by the Basel III requirements. Net cash outflows in a crisis forms the denominator of the LCR equation. Where the strict rules around the run-off of cash-flows do not align with the characteristics of the underlying assets and liabilities, the required net cash outflow assumptions may be overstated and the required HQLA will BIS central bankers’ speeches consequently be higher. At this point Norwegian authorities have not stated their final policy position. Malaysia – also have issues with the Basel III approach to the proposed cash flow assumptions, particularly as they relate to institutional savings schemes. In Malaysia, these schemes are dominated by pension funds, which predominantly manage household savings. However, the LCR cash outflow assumptions for investments from institutional funds are more severe than for investments for retail funds, even though the underlying savings are from households in both cases. As a result, HQLA requirements for banks are higher than might be expected. Hong Kong SAR – Given the limited supply of HQLA denominated in Hong Kong dollars, the HKMA expects Hong Kong to be a jurisdiction which needs to adopt alternative arrangements for LCR purposes. HKMA have stated that they are likely to use option 2 for alternative arrangements, which allows the use of Level 1 foreign currency HQLA to cover local currency liquidity needs. Appendix 2: Basel III Liquidity Coverage Ratio (LCR) Definition of HQLA There are two categories of assets that can be included in the stock of High Quality Liquid Assets. “Level 1” assets can be included without limit, while “Level 2” assets can only comprise up to 40% of the stock. Supervisors may also choose to include within Level 2 an additional class of assets (Level 2B assets). If included, they will be within the 40 percent limit on Level 2 assets and comprise no more than 15 percent of the total stock of HQLA. Level 1 assets are limited to: 1. coins and banknotes; 2. central bank reserves (including required reserves); 3. marketable securities representing claims on or guaranteed by sovereigns, central banks, PSEs, the Bank for International Settlements, the International Monetary Fund, the European Central Bank and European Community, or multilateral development banks, and satisfying certain conditions such as being assigned a 0 percent risk-weight under the Basel II Standardised Approach and traded in large, deep and active repo or cash markets characterised by a low level of concentration; 4. where the sovereign has a non-0 percent risk weight, sovereign or central bank debt securities issued in domestic currencies by the sovereign or central bank in the country in which the liquidity risk is being taken or in the bank’s home country; and 5. where the sovereign has a non-0 percent risk weight, domestic sovereign or central bank debt securities issued in foreign currencies are eligible up to the amount of the bank’s stressed net cash outflows in that specific foreign currency stemming from the bank’s operations in the jurisdiction where the bank’s liquidity risk is being taken. Level 2A assets are limited to the following: (a) Marketable securities representing claims on or guaranteed by sovereigns, central banks, PSEs or multilateral development banks that satisfying certain conditions such as 20 percent risk weight under the Basel II Standardised Approach, traded in large, deep and active repo or cash markets characterised by a low level of concentration; BIS central bankers’ speeches (b) Corporate (non-financial) debt securities (including commercial paper) and covered bonds that satisfy certain conditions around a satisfactory credit rating and traded in large, deep and active repo or cash markets characterised by a low level of concentration; Level 2B assets are limited to the following: Residential mortgage backed securities (RMBS) that satisfy certain conditions. 2. Corporate (non-financial) debt securities (including commercial paper) that satisfy certain conditions including a minimum credit rating 3. Common (non-financial) equity shares that satisfy certain conditions such as being exchange traded and centrally cleared, denominated in domestic currency and traded in deep markets. Reserve Bank of New Zealand mismatch ratio The Reserve Bank’s mismatch ratio is akin to the LCR, although it is not compliant with Basel III requirements. All New Zealand incorporated registered banks are subject to minimum oneweek and one-month mismatch ratios. The aim of the mismatch ratios is to reduce the risk that an individual bank is brought down by a short-term loss of confidence. One-week mismatch ratio One-month mismatch ratio Primary liquid assets contain the following classes of assets: 1. ESAS balances with the RBNZ 2. NZD currency demand balances with other NZ banks 3. Foreign currency notes and coins held by the bank, and foreign currency demand balances held with overseas banks, subject to a haircut; 4. NZ government securities denominated in NZD 5. Other securities with haircuts: 1. High rated local authority securities 2. High rated State owned Enterprise securities. 3. High rated Kauris, 4. High rated two-name and single-name RMBS Secondary liquid assets have larger haircuts and contain the following classes of assets: 1. Local and Foreign government guaranteed securities 2. Lower rated local authority securities 3. Lower rated corporate securities 4. Asset back securities 5. Registered bank securities BIS central bankers’ speeches Reserve Bank of New Zealand core funding ratio The Reserve Bank’s mismatch ratio is akin to the NSFR. The basic notion underlying the CFR is a comparison between an estimate of the funding of the bank that is stable and can be assumed to stay in place for at least one year (‘core funding’), and the core lending business of the bank that needs to be funded on a continuing basis. The CFR is currently applied to locally incorporated banks. A bank must maintain its one-year core funding ratio at not less than the minimum specified in its conditions of registration, at the end of each business day. For most banks this is currently set at 75 percent. One-year core funding ratio = Where the one year core funding dollar amount = • all funding with residual maturity longer than one year, including subordinated debt and related party funding • plus 50 percent of any tradable debt securities issued by the bank with original maturity of two years or more and with residual maturity at the reporting date of more than six months and not more than one year • plus non-market funding that is withdrawable at sight or with residual maturity less than or equal to one year • plus Tier 1 capital BIS central bankers’ speeches
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Remarks by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Official Statistics User Forum, Wellington, 26 March 2014.
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Graeme Wheeler: Meeting demand for statistics in a fast moving world Remarks by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Official Statistics User Forum, Wellington, 26 March 2014. * * * Introduction It’s a pleasure to be here today and talk about the Reserve Bank’s experience as a user of official statistics. Like many central banks, we’re a major user and producer of statistics. We’re a big user of economic statistics so I’ll start by talking about some of our needs in this area. I’ll then go on to discuss our role in collecting, using and disseminating statistics on the financial system and some of the changes we’re facing. And I’ll offer a central banker’s view of some of the challenges that statisticians face in meeting the growing demands from users of these statistics. At the Reserve Bank, we rely heavily on a broad range of economic data. Statistics New Zealand produces many of the statistics we use but we also rely on data from other domestic and offshore sources. Once every quarter, we undertake an in-depth forecast to arrive at our best projection of where the economy and inflation are headed in the future. This in turn helps guide our policy decisions. We use a range of economic models, all of which rely heavily on data, and apply lots of judgment. Our assessment of the economy is very comprehensive. When we look at the external economy, we consider the economies of our major trading partners, the terms of trade, the exchange rate and the current account. When we look at the domestic economy we consider household and business spending, savings, credit trends and confidence. When we assess inflation pressures, we consider the economy’s growth potential alongside its actual growth rate and take into account the labour market, import prices and other factors that influence prices. Let me give you an idea of just how reliant we are on economic statistics. Our system for processing, storing and managing time series data is known as the Financial Sector Information System (FSIS). We developed it about six years ago and it provides us with a robust database for nearly all the data we produce or use. Today, FSIS holds around 36,000 time series. Around 20,000 of these are macro-economic time series relating to New Zealand and the global economy. Statistics New Zealand would produce the lion’s share of those 20,000 series. You’ll be relieved to hear that I’m not going to talk about all 20,000 statistics but let me make a few comments about what matters to us as a large scale user. Timeliness and reliability are obviously important when we’re trying to assess the economy in real time. So too is good quality guidance on how the statistics are compiled or what the statisticians call “metadata”. When we encounter puzzles in the data, it is essential to be able to have open and honest conversations with Statistics New Zealand about what might be causing them. Revisions need to be handled carefully. Most data are revised from time to time, but if revisions are large enough to re-write history, the original data would have had the potential to mislead policymakers. The earlier we can learn about upcoming revisions and what is driving them the better. Another thing that matters for us and for all users of Official Statistics is harmonisation. The economic data Statistics New Zealand produces should ideally be consistent with the financial data the Reserve Bank produces. There is real value in working off a common business register when we are putting together institutional statistics. That has real benefits for all users. BIS central bankers’ speeches What would be our top four ‘wants’ from Statistics New Zealand? We’d like sector balance sheets that would tell us who owes what to whom across the economy and with the rest of the world. We’d like a quarterly income-based measure of GDP, which would provide a useful alternative perspective on output to the existing production and expenditure-based measures. We’d like GDP to be rebased at the very least every 10 years to capture structural change in the economy. And we would love a monthly CPI to enable more timely analysis and forecasting of inflation. We recognise that there are many statistical needs and resources are limited. But nor should we lose sight of their value. New Zealand’s annual GDP is more than $220 billion so better quality or more timely decisions that result in a very slight improvement in economic performance could easily be worth millions of dollars per annum. We greatly value having a voice in Statistics New Zealand’s data development process and the opportunity to engage at a point in the process where our views can be taken into account. By all accounts, our relationship with Statistics New Zealand is in a good shape but both parties need to work hard and keep improving it. The Reserve Bank’s financial statistics Turning now to financial statistics, the Bank is a major user of data on the financial system, most of which we produce in-house, drawing on the powers under the Reserve Bank Act (1989) to collect data from financial institutions. These data account for most of the other 16,000 time series in our FSIS database and include institutional data collected for prudential purposes, data on the financial markets, data on notes and coins, and published financial system statistics. Our survey respondents include banks and other financial institutions and this “micro-data” is used in our role as a prudential regulator and supervisor. Commercial confidentiality means that this data isn’t generally published, but we use it to compile broader financial system statistics. We’ve a well-established practice of constructing and publishing these statistics. An example would be the Standard Statistical Return for the banking system, which provides comprehensive information on the banking system’s balance sheet. Some of our statistics act as inputs in the production of Statistics New Zealand’s own statistics, including the national accounts. Table 1 Some key Reserve Bank Financial Sector Statistics Collection Coverage Standard Statistical Return (SSR) Banks and Non-bank lending institutions Credit card survey Credit card issuers Liquidity survey Banks LVR new commitments Banks with residential mortgage lending Trade weighted indexes Major trading partner currencies Planned/Under Development Insurance data collection Licensed insurers Managed funds survey Investment and superannuation funds managed by NZ fund managers Income statement survey Banks Bank balance sheet survey Banks NZ Securities database Securities issued in the New Zealand market BIS central bankers’ speeches Financial statistics since the global financial crisis Our financial data collections have grown substantially in recent years for three reasons. First, the intensity of our prudential oversight has increased since the Global Financial Crisis of 2008/09. We’ve sought to strengthen our prudential regime for banks for example. As elsewhere, the GFC showed that risks around bank liquidity and funding in a period of financial turmoil were potentially much greater than anyone had expected. In 2010, we introduced new standards for banks requiring new minimum liquid asset requirements and a minimum core funding ratio. Introducing these new standards meant that we needed new liquidity and funding data to monitor compliance with the new standards at both an individual bank and financial system level. Another example of stronger prudential standards has been the introduction of temporary speed limits on the banks’ high-loan-to-value (LVR) lending reflecting our concern at the growing risks in the housing sector. This, in turn, required us to collect additional data on banks’ housing lending broken down by LVR. A second driver expanding our need for statistics has been the expansion of our regulatory responsibilities in recent years. Since 2008, the Reserve Bank has been given responsibility for the prudential regulation of the Non-Bank Deposit Taking Sector (NBDT). New standards for capital, liquidity and related party exposures inevitably require more data to be collected from the industry and may prompt a further upgrading of the sector’s statistics in the future. In 2010, we became the prudential regulator and supervisor of the Insurance sector, which up until that time had been relatively loosely regulated in New Zealand. This meant that there is currently little in the way of formal statistics on the insurance sector. Consequently we’re currently planning a data collection from the industry designed to meet our prudential and broader statistical needs. This is a major job as there are around 100 newly licensed insurers, and there are a wide range of potential risks to cover. The third driver behind the expansion in our financial collections has been growing demand from the general public, international agencies, media and financial analysts in the years following the financial crisis. There’s a growing appetite for more granularity and detail in financial statistics and for coverage of new areas. For example, there’s demand for more detail on the financial products and services offered by banks, expanded data on financial prices, and the ability to drill down into financial sub-sectors to a rather greater extent than before. And there’s much greater interest in understanding the capital markets – an area that to date hasn’t been well captured in statistics in New Zealand. Meeting demand for statistics in a fast moving world What statistics to produce and when poses important challenges for us as the main producer of New Zealand’s financial statistics. We need to respond to the increasing demands for data and data transparency but we also need to manage the cost, size and complexity of our statistical function and keep respondent burden to an acceptable level. Decisions to proceed with new collections must be based on a clear business case. In many respects the decision to begin a new financial data collection has the hallmarks of an investment decision to purchase a long-lived asset. We engage extensively with users in trying to identify clearly the benefits of the new data for financial analysis and policymaking in the future. Some of the benefits associated with new statistics accrue several years down the track once a good time series is developed. Choices made now about what (or) not to collect and how to collect it can have implications for the quality of financial analysis (or policymaking) for years into the future. BIS central bankers’ speeches In assessing the costs of the new collection we also focus on the costs that our respondents might incur in undertaking significant internal system changes and enhancements in order to provide the information. We have an obligation to ensure that the costs that they incur are “worth it”. Keeping up with structural change is always a challenge. The absence of financial statistics on a particular part of the financial sector can sometimes mask structural changes completely, because financial analysts have no way of seeing them. More often, we may be aware of shifting patterns but lack the statistics that can properly capture them. This can occur when new types of financial institution develop or when existing financial activities migrate from one type of institution to another that isn’t well represented by our statistics. Structural changes can be very difficult to detect when they involve new financial products, unregulated institutions or the provision of financial services from offshore. Structural change can also arise due to shifts in trading patterns between New Zealand and the rest of the world. Since the 1970s, the Bank has published weighted average measures of the New Zealand dollar relative to the currencies of our major trading partners. We report a variety of real and nominal measures of these trade weighted exchange rates (TWIs) on our website. Our flagship TWI was developed 15 years ago following the introduction of the euro and is based on five currencies (the US dollar, Australian dollar, yen, euro and British pound). Since then, trading patterns have changed dramatically. In particular, China is now the largest single destination for New Zealand’s merchandise exports and its exchange rate has become more flexible. Some years ago we developed a broader 14 currency trade weighted index, which included the Chinese currency and this is published daily on our website alongside the five currency index. However, we are currently undertaking a full review of all the exchange rate measures that we publish, which we hope to complete before the end of the year. Even with good statistical practices, and extensive liaison with users, many statistical collections ultimately become obsolete and need overhauling. Our standard statistical return for the banking system has served us well over the past 15 years but we’re now redeveloping it. That reflects changes in the banking sector over the period and a better understanding of what to monitor in the sector. For example, the existing return provides little if any data on the banks’ incomes and expenses and other performance metrics. Our hope is that a new collection methodology will serve us well for the next 15 years. During the rapid changes associated with the GFC, it became clear that the traditional time lags in the availability of some of our financial sector data became too long for fully informed analysis. Increasingly we drew on data from banks’ internal management systems that could be provided closer to real time. We’ve used this experience to try and shorten the time lag in the availability of some of our financial data. We’ve done this in areas such as bank credit, liquidity, solvency and debt issuance. Timeliness is essential for good policy making but timing also needs to be weighed alongside other parameters such as data quality, respondent burden and the costs of processing the data more quickly. Financial systems are complex, and users – especially uninformed users– often have difficulty interpreting the data. Our challenge is to provide the external users of our statistics with metadata and guidance around the use of our statistics without overloading them with too much information. As we seek to re-develop many of our statistics over the next few years and develop new ones, we will need to give equal attention to the support we provide to the users of the new statistics. Let me conclude briefly by saying There is no magic to good policy making. Good decisions depend on good quality statistics and information. Official statistics play a crucial role in informing the decisions that we take. BIS central bankers’ speeches They also provide accountability for those decisions. As a user of official statistics we would like to see a number of improvements to the suite of data we consume. We want faster, higher frequency, more comprehensive and higher quality statistics. New Zealand’s financial sector statistics, most of which are collected by the Reserve Bank, are in the midst of substantial change. The insights and changes prompted by the global financial crisis have provided us with a unique opportunity to assess the quality and fitness of purpose of our financial statistics and given some urgency to introduce some new data collections, redevelop existing collections, and explore new avenues for data supply. Whilst we’re the biggest user of our own statistics, we are taking into account the needs of a broad range of stakeholders in meeting this challenge. I wish you a fruitful two days. Thank you. BIS central bankers’ speeches
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Speech by Mr Grant Spencer, Deputy Governor and Head of Financial Stability of the Reserve Bank of New Zealand, at the Credit Suisse Asian Investment Conference, Hong Kong, 27 March 2014.
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Grant Spencer: Coordination of monetary policy and macro-prudential policy Speech by Mr Grant Spencer, Deputy Governor and Head of Financial Stability of the Reserve Bank of New Zealand, at the Credit Suisse Asian Investment Conference, Hong Kong, 27 March 2014. * * * Accompanying tables and figures can be found at the end of the speech. 1. Introduction The Reserve Bank expects to tighten monetary policy substantially over the next two years in response to emerging inflation risks. At the same time, speed limits on high loan-to-value ratio (LVR) lending have been in place since 1 October 2013, in order to reduce systemic risk associated with highly leveraged households and rising house prices. The natural question arises: how do LVR speed limits interact with monetary policy? And to what extent should they be coordinated? These questions relate to the current business cycle but also raise a broader question – what are the general principles that should apply in managing macroprudential policy and monetary policy going forward? These are important questions that do not have simple answers. They are being explored in the economic policy literature and the Reserve Bank is currently undertaking research to help clarify the issues in the New Zealand context. Today I would like to discuss the Bank’s current thinking on the interaction of monetary and macro-prudential policies, and point to areas for further analysis. The Bank sees it as important to communicate its thinking on policy coordination, to maintain the transparency it has built up over many years on monetary policy. To summarise the Bank’s current position, we believe it is essential to retain clear primary objectives for both monetary and macro-prudential policy. These primary objectives are price stability and financial system stability respectively. However, there is an appropriate role for policy coordination in certain circumstances and with certain policy tools. The key in this respect, is to ensure that the primary aims of the two policy arms are not undermined by too heavily diverting the attention of those policies to secondary objectives. Conceptually, there is a case for coordinating the use of monetary policy and a macroprudential policy instrument provided they both affect outcomes relevant to the achievement of both policy objectives. In general this condition is likely to be met, but in widely varying degrees. Most of the time monetary policy and macro-prudential policy should be able to operate largely independently, or have complementary effects on each other that are relatively easy to manage (Table 1). Relative independence will be possible when one or both of the policies are in ‘neutral’, and therefore imparting little influence on the other’s objective. The greatest degree of complementarity will occur when the real and financial cycles are in sync – either rising or falling together as depicted in the SW and NE corners of Table 1. In these situations, coordination should be relatively simple, requiring each policy setting to allow for the complementary effects of the other. Conversely, the two policies will be in greatest potential conflict when the real and financial cycles are out of sync, as depicted in the NW and SE corners of the Table. These are the situations where coordination is difficult but also important. This is where the primary objectives of the two policies need to be carefully balanced. (Table 1) To explore the policy coordination options more closely, I will first examine what macroprudential can do for price stability, and then turn the tables and ask what monetary policy can do for financial stability. BIS central bankers’ speeches 2. What can macro-prudential policy do for price stability? The basic motivation for using a macro-prudential instrument to assist monetary policy is to help support the price stability objective of the central bank. The monetary authority will in most cases welcome assistance from a range of other policies, such as supportive fiscal policy or structural reforms that increase competitive pressures and enhance productivity. Assistance will be particularly welcome from macro-prudential policy if it targets a ‘hot spot’ such as an overheated housing market. (Figure 1) Macro-prudential instruments can reduce systemic risk in two ways: 1) by dampening credit and asset price cycles; and 2) by increasing the resilience of balance sheets in the downward phase of the cycle. When thinking about policy coordination, we are mainly interested in tools that work through the first channel, such as LVR restrictions. Our work to date suggests that LVR restrictions have material impacts on the supply of credit (RBNZ (2013)) and hence on the inflation objective. Other macro-prudential tools, such as the Counter Cyclical Capital Buffer (CCB), operate more through the second (resilience increasing) channel, and are less relevant for coordination with monetary policy1. Assistance from macro-prudential tools is likely to be most appropriate when monetary policy faces constraints and difficult trade-offs in dampening inflation pressures. For a small open economy like New Zealand, these constraints often emerge as a result of spill-over effects from the global financial markets and, in particular, exchange rate pressures. A good example is the experience with monetary policy during the last housing boom from 2003– 2007. During that time, monetary policy lost a degree of traction as relatively high policy rates and market returns attracted strong capital inflows, resulting in a high exchange rate and downward pressure on long-term interest rates. Borrowers responded by locking in longer term financing at relatively low rates, thereby reducing the impact of official cash rate (OCR) increases. This meant that larger increases in the OCR were required to control inflation, putting additional upward pressure on the New Zealand dollar exchange rate. There were loud calls at the time for the use of alternative policy instruments to assist monetary policy. Possible candidates included macro-prudential policy and tax measures, such as a capital gains tax or a mortgage interest levy (Treasury and RBNZ (2006)). With hindsight, the use of another policy instrument would have been helpful during this period, to assist in slowing domestic demand and inflation pressure, with less of the work having to be done by the OCR and the exchange rate. LVR restrictions may have been able to assist, given the rapid rates of credit and house price growth at the time which presented risks for financial stability as well as price stability. Macro-prudential tools may also have been a useful complement to monetary policy in the economic downturn from 2008. If banks had entered the recession with more stable sources of funding and larger capital buffers, then the tightening in credit conditions that ensued after the GFC may have been ameliorated, potentially reducing the need to ease monetary policy as significantly. In this way, the use of macro-prudential adjustments in downturn situations can lower the risk of running up against the zero lower bound on interest rates. But there can also be significant costs if macro-prudential policy instruments are used too aggressively in support of monetary policy. All macro-prudential instruments create incentives for financial disintermediation– credit flows that avoid the regulation by moving outside of the regulatory perimeter. Over-use of macro-prudential tools in an attempt to These other macro-prudential tools work by forcing banks to temporarily increase capital or funding buffers during periods of rising asset prices and leverage. Because the cost of capital and/or core funding is likely to be compressed during such periods, any cycle-dampening effects from these instruments are likely to be more limited. However, these tools can have significant effects by improving the scope for banks to continue to lend in the downward phase of the cycle. BIS central bankers’ speeches manage the credit cycle would likely see disintermediation increase, thus reducing the effectiveness of the policy tools. Moreover, by pushing financial intermediation towards secondary ‘shadow banking’ channels, excessive use of macro-prudential policy could weaken financial system efficiency and ultimately reduce the soundness of the financial system. We have seen examples of such behaviour in New Zealand’s history and in many other countries. With all these considerations in mind, there may be scope for macro-prudential policy to assist monetary policy, to a limited extent, both in the up and down cycle, provided its primary objective of promoting financial stability is kept firmly in mind. 3. What can monetary policy do for financial stability? We regard financial stability as a necessary – but not sufficient– condition for macroeconomic stability. The GFC-induced recession is evidence enough of the potential for financial instability to generate macroeconomic instability. Further, monetary policy can influence asset price and credit cycles through its impact on bank lending rates. Thus, there is a potential case for monetary policy to assist in promoting financial stability or, at a minimum, not to undermine it.2 (Figure 2) The emerging literature identifies a number of channels through which monetary policy can influence risk-taking behaviour and the build-up of systemic risk (Borio and Zhu (2010)). In particular, an extended period of low interest rates can contribute to financial stability risks by increasing risk-taking, leading to a ‘search for yield’ and compression of credit spreads. In a similar way, an extended period of low interest rates can also lead to an excessive easing of bank lending standards. Looking at the issue from another angle, a tightening of monetary policy to rein in inflation pressure has often brought an end to credit booms (Drehmann and Juselius (2012)). In other words, sharp movements in interest rates, as well as sustained low levels of interest rates, can lead to financial system stress. However, a key lesson from the literature and from our own experience is that the transmission of monetary policy to financial stability is far less clear than its transmission to inflation. In particular, the effect of monetary policy on financial stability will depend critically on the state of the financial sector at the time. For example, the impact of an OCR tightening cycle may be very different depending on the starting levels of household and corporate debt and debt servicing capacity. When are monetary policy adjustments likely to be helpful from a financial stability perspective? This is likely to be in situations where asset and credit markets are buoyant and prudential policies alone are insufficient to constrain a build-up of financial system stress. For example, by themselves, macro-prudential policies such as LVR restrictions may have limited effects on asset price inflation and the credit cycle. Macro-prudential policies must remain consistent with micro prudential principles and are therefore not generally scalable in the way that interest rates are. Further, the impact of macro-prudential policies can be eroded if there is disintermediation outside the regulatory perimeter, something which becomes more likely if interest rates are set at stimulatory levels. Thus, in a situation where inflation is near the target, but asset markets are rising sharply, assistance from monetary policy can be an important means of meeting financial stability objectives. Many countries are currently actively considering how to manage the potential effects of an extended period of loose monetary policy on financial stability. For example, the Bank of England has recently included a financial stability knock-out in its forward guidance on monetary policy (Kohn (2013). BIS central bankers’ speeches As noted by Federal Reserve Governor, Jeremy Stein (2012), monetary policy“gets in all the cracks” of the financial system. It affects the cost of credit for all borrowers, including those that may be avoiding macro-prudential regulations as a result of disintermediation. Other policy initiatives that seek to alleviate supply-demand imbalances in asset markets can also be helpful. In the case of housing markets for example, this might involve regulatory reform around zoning and other planning restrictions, or changes in taxation that reduce the incentive for speculative investment. Should monetary policy respond to a request from the prudential authorities for tighter policy? The key test is whether this is consistent with the primary monetary policy objective of price stability. If monetary policy is diverted too far or too long from its primary objective of price stability there is a risk that the transparency and credibility of monetary policy will be damaged, thus reducing the long-run effectiveness of monetary policy in achieving its prime objective. This potential problem has been emphasised for example by Svensson (2011). Policymakers and academics around the world have debated the appropriateness of tightening monetary policy on financial stability grounds during credit or asset booms. Broadly speaking, there are two opposing views in the ‘lean versus clean’ debate: • The “clean” view was dominant prior to the GFC. This view proposes that monetary policy should not respond to asset or credit booms, except to the extent that they influence inflation pressures. It assumes that monetary policy can ‘clean up’ the impact on the real economy if the financial cycle crashes, and that the tightening in monetary policy required to lean against a credit or asset price boom would create unacceptable costs for the wider economy. This view implicitly assumes that microand macro-prudential instruments can effectively limit the extent of financial system damage in the downturn. • The ‘lean’ view has become more prominent since the GFC for two reasons. First, policy makers were surprised how large asset bubbles could emerge under conditions of sustained price stability, prudent fiscal policies, and small output gaps. Second, the output and employment losses and other social and economic costs associated with the aftermath of the GFC proved to be much greater and more deep-set than policy makers expected. The‘lean’ view proposes that monetary policy should actively lean against credit booms for financial stability purposes. It is assumed that: (i) monetary policy that leans against credit booms is consistent with long-run price stability; and (ii) increased interest rates can be effective in limiting a credit boom with limited costs for the wider economy. This view implicitly assumes that there can be circumstances where prudential policies – both micro and macro – are insufficient to contain financial system risks on their own. (Table 2) Research is continuing in this area. Although the ‘lean’ view has become more dominant, in particular reflecting research from the BIS (Borio and Lowe (2003)), there is no consensus that monetary policy should always respond to emerging financial stresses. Rather, there is an emerging consensus that financial stability is a valid secondary objective and that monetary policy may respond to financial stability concerns when such actions are also consistent with the primary price stability objective (Smets (2013)). 4. The New Zealand framework: conditional policy coordination New Zealand’s policy framework might be described as one of conditional policy coordination. That is to say, the two policies retain distinct primary objectives, but are free to lend a hand to the other policy objective, provided their primary objectives are not compromised. In New Zealand, such coordination is facilitated by decisions on macroprudential and monetary policies being undertaken by the Reserve Bank’s Governing Committee, but with clearly distinct mandates for the two policies. BIS central bankers’ speeches The Reserve Bank of New Zealand has long had a mandate to use its (micro-) prudential policies to promote a sound and efficient financial system. We do not have a mandate to protect the soundness of individual institutions. The macro-prudential policy framework established in 2013 also focuses on promoting a sound and efficient financial system using a set of instruments that may be varied through the financial cycle. A Memorandum of Understanding on macro-prudential policy was signed with the Minister of Finance in 2013 that sets out the objectives, instruments and responsibilities for macro-prudential policy (Rogers (2013)). The new macro-prudential framework draws lessons from the monetary policy framework. It incorporates a commitment to achieving the objective that it is best suited to financial stability – combined with decision-making at arm’s-length from political pressures. However, a key difference is that macro-prudential policy decisions involve a greater degree of consultation with government and the public. The New Zealand policy framework recognises the interactions between monetary and macro-prudential policies and the logic of conditional policy coordination. In pursuing its primary objective of price stability, the Policy Targets Agreement (PTA) states that monetary policy must have regard to financial stability. And in pursuing its primary financial stability objective, macro-prudential policy is required under the MoU to consider any implications for monetary policy. 5. LVR speed limits and interactions with monetary policy New Zealand has experienced live issues at the interface of macro-prudential and monetary policies. During 2003–2007, New Zealand experienced one of the highest house price appreciations among the OECD economies. A period of sustained low interest rates since 2009, combined with easing lending conditions and a housing supply shortage has contributed to a resurging housing market with house prices at end 2013 almost 15 percent above the 2007 peak. The Bank responded with the introduction of an LVR ‘speed limit’, commencing 1 October 2013 (RBNZ (2013)). The purpose of this LVR restriction is to reduce the build-up of financial system risk by: 1) dampening the rapid growth in house prices; and 2) strengthening households’ and the banks’ balance sheets. The policy does not ban high LVR lending, but allows banks to write no more than 10 percent of their mortgage commitments at LVRs over 80 percent, and has led to a significant reduction in high-LVR lending. (Figure 3) Initially, we estimated that the LVR restrictions would dampen annual growth in house prices by 1–4 percentage points; house sales by 3–8 percent, and credit growth by 1–3 percentage points over the first year that the policy was in place. The evidence to date suggests that the dampening effect of the LVR restrictions on house prices has been broadly in line with these expectations. House sales have fallen by 13 percent since September, and there are early signs that this is beginning to translate into weaker house prices and credit growth.3 (Table 3) While LVRs have a financial stability purpose, they have been an important consideration in our monetary policy assessment. The dampening effect of LVRs on house price inflation and credit is expected to reduce wealth and credit effects on consumption that might have otherwise increased due to a rapid expansion in house prices. This, in turn, is estimated to have reduced CPI inflation pressures by an amount similar to a 25–50 basis point increase in the OCR. Reserve Bank simulations of the counter-factual – what would have happened to house price inflation in the absence of LVR speed limits – suggests house price inflation would have been about 2.5 percent higher than its current level. We are continuing to monitor the effects of LVR restrictions and will publish new estimates of their impact in the Reserve Bank’s May Financial Stability Report. BIS central bankers’ speeches Earlier this month, in response to broadening inflation pressures, the Reserve Bank began an OCR tightening cycle after three years of no change in the policy rate. Given that the LVR restrictions began to moderate the housing cycle from October 2013, the monetary policy tightening cycle might have needed to be more accentuated in their absence. While the main benefit of the LVRs has been to redress the impact of the easier lending conditions, they may also have helped to take some pressure off the New Zealand dollar exchange rate. What if the policies had not been “conditionally coordinated”? While purely hypothetical, if these policy decisions were being made on a strictly independent basis, we may have seen macro-prudential policy‘wait’ for the coming monetary policy tightening cycle to slow the housing market. An absence of any macro-prudential measures may in turn have prompted the monetary policy tightening to have started somewhat earlier. To be clear, the monetary policy tightening cycle that is now underway is motivated by the need to ensure that CPI inflation remains in the vicinity of 2 percent over the medium term. The boost to financial system resilience provided by the LVR restrictions, as well as a decision to increase risk weights for high-LVR housing lending4, has meant that monetary policy has not needed to consider a tightening for financial stability purposes. However, while not motivated by the financial stability objective, the monetary policy tightening is expected to help in dampening further house price inflation. In this regard, as interest rates move back to more normal levels, we will expect to have greater scope to ease or remove the LVR restrictions. The Reserve Bank stated from the outset that the LVR restrictions are not intended to be permanent. They will be removed once housing market pressures have moderated and when we are confident there will not be a resurgence in house price inflation (Wheeler (2013)). But how should the exit be coordinated with the expected OCR tightening cycle? The factors to consider include: – The degree of moderation achieved in rates of house price inflation and credit expansion; – Factors that might affect the potential for a resurgence in house price inflation following the removal of the LVRs, such as the dampening effect of increased housing supply and mortgage rates, and the stimulatory effect of higher net immigration flows; – Any distortions or inefficiencies that become apparent as a result of the policy. A decision to ease or remove LVR restrictions will ultimately take into account both the financial stability and price stability implications of doing so. We will be alert to the risk that the removal of LVR restrictions could produce a resurgence in house price inflation, which would potentially undermine both financial and price stability. 6. Conclusion While monetary policy and macro-prudential policy need to retain their separate primary objectives of price stability and financial stability, the significant spill-over effects between the two policies make a clear case for their co-ordination. However, such coordination must be conditional on each policy arm continuing to focus on its primary objective. Changing to joint objectives for both policies would: 1) complicate policy decisions; 2) undermine transparency; and 3) potentially be damaging to the credibility of monetary policy and macro- prudential policy. Increased risk weights for high-LVR mortgages applied to the large Internal Ratings Based (IRB) banks from September 2013. BIS central bankers’ speeches The policy framework in New Zealand is consistent with this conditional coordination approach. In the monetary policy targets agreement we have financial stability as a secondary objective. This means that the monetary authorities need to think hard if an OCR decision might have adverse effects for financial stability. Similarly, in the macro-prudential MoU it is required that macro-prudential initiatives have regard to their potential impact on monetary policy. There remain many aspects of policy co-ordinations where we need to deepen our understanding. These include: • The quantitative effects of macro-prudential policy on macro-economic outcomes and their implications for monetary policy. • The scale and timing of spill-over effects between the OCR and our four macroprudential tools. • How best to coordinate OCR and macro-prudential policy decisions at different points of the economic and financial cycles, particularly when the two cycles are out of sync and the policies are not complementary. This is an active area of the academic literature and a priority area for our own research. I look forward to the insights that this work will give us for our future monetary and macroprudential policy decisions. References Beau, D, L Clerc and B Mojon (2012) “Macro-prudential policy and the conduct of monetary policy”, Banque De France Working Paper, 390. Borio, C and P Lowe (2003), “Borio, C. and P. Lowe (2002), “Asset prices, financial and monetary stability: Exploring the nexus”, BIS Working Paper, 114. Borio, C and H Zhu (2008) “Capital regulation, risk-taking and monetary policy: A missing link in the transmission mechanism?” BIS Working Paper, 268. Drehmann, M and Juselius M (2012), “Do debt service costs affect macro-economic and financial stability?”, BIS Quarterly Review,September 2012. Kohn (2013), “The interactions of macro-prudential and monetary policies: a view from the Bank of England’s Financial Policy Committee,Speech given to the Oxford Institute for Economic Policy, http://www.bankofengland.co.uk/publications/Documents/speeches/2013/speech692.pdf. Reserve Bank of New Zealand (2013), “Regulatory impact assessment: Restrictions on highLVR residential mortgage lending”, http://rbnz.govt.nz/financial_stability/macro-prudential_policy/5407434.pdf Rogers, L (2013), “A new approach to macro-prudential policy for New Zealand”, Reserve Bank of New Zealand Bulletin, 76:3. Treasury and RBNZ (2006), “Supplementary Stabilisation Instruments: Initial report”, http://www.rbnz.govt.nz/monetary_policy/about_monetary_policy/2452274.pdf. Smets (2013), “Financial stability and monetary policy: How closely interlinked?”, Riksbank Quarterly Economic Review, 2013:3. Stein (2012), “Lean, clean and in-between”, Speech presented to the NBER research conference: Lessons from the financial crisis for monetary policy, http://www.federalreserve.gov/newsevents/speech/stein20131018a.htm BIS central bankers’ speeches Svensson, L (2011), “Monetary Policy after the Crisis”,Speech given at the Federal Reserve Bank of San Fransisco, http://larseosvensson.se/files/papers/LS111129e.pdf Wheeler (2013), “The Introduction of Macro-prudential Policy”, Speech delivered to Otago University, http://rbnz.govt.nz/research_and_publications/speeches/2013/5407267.html. Table 1. Possible scenarios for macro-prudential and monetary policies Source: Adapted from Beau et al (2012). Figure 1. Monetary and Macro-prudential policy interactions BIS central bankers’ speeches Figure 2. Monetary and Macro-prudential policy interactions Table 2. Different views of the role of monetary policy in achieving financial stability Source: Adapted from Smets (2013). BIS central bankers’ speeches Figure 3. Share of high-LVR lending Table 3 Housing and credit developments since the introduction of LVR speed limits * Due to the slow-moving nature of housing credit, this figure is calculated as an annualised three-month percent change. BIS central bankers’ speeches
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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to DairyNZ, Hamilton, 7 May 2014.
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Graeme Wheeler: The significance of dairy to the New Zealand economy Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to DairyNZ, Hamilton, 7 May 2014. * * * When Charles Wilson, the CEO of General Motors, was being reviewed by the US Senate in 1953 for the position of Secretary of Defence in President Eisenhower’s Administration he commented: “For years I thought what was good for our country was good for General Motors and viceversa”. At the time, General Motors accounted for around 2 percent of US GDP. Many might express a similar sentiment about our dairy industry. Dairy farmers have experienced some of the greatest prosperity, and also most difficult adjustments, that our economy has seen. Prosperous periods, like the introduction of refrigerated shipping, the post WWII commodity boom, and the current flourishing trade with China. And difficult times, when the sector had to adjust to Britain’s accession into the EEC, the constant restructuring of co-operatives, the removal of subsidies in the mid-1980s, and periods of exchange rate pressure that were not necessarily accompanied by strong underlying commodity prices. Today, I would like to discuss the critical economic contribution that the sector makes to the New Zealand economy, and comment on three issues: • the impact of commodity prices on New Zealand’s exchange rate; • the importance of our dairy export trade with China; and • the level of dairy farmer debt I will begin by talking about the sector’s export performance. Dairy export revenue has risen dramatically over the past two decades (figure 1). At $15.5 billion, dairy exports make up almost a third of New Zealand’s annual merchandise exports. Figure 1: NZ Dairy exports (annual, New Zealand dollar terms) Source: Statistics New Zealand. BIS central bankers’ speeches Growing export receipts have been driven by higher prices and increasing animal numbers. Over the past eight years, dairy prices in NZ dollars were, on average, 65 percent higher than in the previous two decades and dairy cattle numbers increased by 30 percent. Productivity growth has also been impressive. During those eight years, improved stock management and supplement use helped generate farm productivity growth (measured by production per hectare) of 1.9 percent per annum. Productivity beyond the farm gate (as measured by the volume of exports per kilogram of milk solids produced) increased by a third as dairy processors became more efficient, reduced wastage, and shifted towards more lucrative products (figure 2). Figure 2: Volume of exports per kilogram of milk produced Source: Statistics New Zealand, DCANZ, RBNZ estimates. Strong growth in dairy receipts creates benefits for others, such as rural communities, rural service providers, machinery retailers, and financial institutions. There are also significant indirect effects on the broader economy through additional spending and upward pressure on the exchange rate. i) New Zealand’s exchange rate An important factor behind the rise in New Zealand’s exchange rate has been the strength of the terms of trade (which measures the ratio of export prices to import prices, both in NZ dollar terms). Our terms of trade are at their highest level since 1973 and are 20 percent above the average level of the 1990s. Dairy prices account for just under half of the ANZ commodity price index (though a smaller share of goods and services exports) so changes in global dairy prices have a major effect on the terms of trade and, in turn, the NZ dollar exchange rate. Figure 3 shows the close relationship between movements in the terms of trade and the exchange rate. Other factors also affect the value of our currency. An important structural factor affecting the long term level of the exchange rate has been the persistent gap between national savings and investment. Over the past 40 years New Zealand has demanded more capital for investment in housing, infrastructure, and other assets than its national savings could finance. This has meant an ongoing reliance on foreign saving via inward capital flows, placing upward pressure on interest rates and the exchange rate. BIS central bankers’ speeches Our current high exchange rate also reflects the relative strength of New Zealand’s economic performance and the consequent upward pressure on our interest rates relative to those in other advanced economies. Figure 3: TWI and Terms of Trade Source: Statistics New Zealand, RBNZ. A key issue is whether the strong increase in global dairy prices represents a permanent shift, or whether it reflects cyclical elements. We believe both factors are present. Structurally, the demand for protein is rising rapidly in middle income countries as per capita incomes and urbanisation increase. China’s 50 percent increase in dairy imports in 2013 reflects this structural change, as well as sluggish growth in Chinese milk production as small, inefficient producers leave the sector as part of the Government’s efforts to raise the quality of raw milk production. But cyclical or temporary factors are also in play. These include the 2013 drought in New Zealand, severe climatic conditions in Asia, and an outbreak of foot and mouth disease in China. The strong supply response from the US, Europe and New Zealand, as a result of the high global dairy prices, is expected to exert downward pressure on international dairy prices over the next two to three years. The high exchange rate has three major effects. First, it reduces income gains to New Zealand commodity exporters, but even allowing for this, commodity export prices are well ahead of those received in the 2008 commodity price boom (figure 4). BIS central bankers’ speeches Figure 4: ANZ commodity price index Source: ANZ banking group. Second, part of the benefit of increased dairy prices accrues indirectly to all New Zealand households, rather than specifically to dairy farmers. Appreciation in the New Zealand dollar lowers import prices, and significantly boosts the real disposable incomes of many consumers. Third, currency appreciation adversely affects the tradable sector, and especially export and import-competing firms that are not exposed to the dairy industry or other sectors enjoying high international prices. The Reserve Bank considers that the exchange rate is overvalued and does not believe its current level is sustainable. Many analysts consider that the positive news on the economy and the forecast tightening in interest rates is fully priced in and believe that there is considerable downside risk for the currency. Our exchange rate could be expected to weaken if one or more of the following occurs: the US economy continues to improve; global dairy prices continue to come off their recent highs; China’s growth slows; financial market volatility begins to rise; or if there is a global “risk off” event such as a correction in global equity prices. If, however, the exchange rate does remain strong, it is likely to be reflected in continued low or negative tradables inflation. In such circumstances, the high exchange rate, along with new economic data, will be a factor in our assessment of the extent and speed with which the Official Cash Rate (OCR) needs to be raised. Further, if the currency remains high in the face of worsening fundamentals, such as a continued weakening in export prices, it would become more opportune for the Reserve Bank to intervene in the currency market to sell NZ dollars. ii) New Zealand’s dairy export trade with China China’s economic growth over the past 35 years is unparalleled in modern times. China achieved average annual growth of 10 percent in the three decades to 2010, and although growth has slowed, the Government’s target is for annual growth of 7-and-a-half percent over the medium term. China’s growth has been driven by several factors: high domestic investment and savings ratios, sizable foreign direct investment, the impact of catch up technologies, the massive shift of labour from subsistence agriculture to higher productivity roles in urban industrial BIS central bankers’ speeches production, and on-going market based reforms including, importantly, those associated with its membership of the World Trade Organisation since 2001. China is the world’s second largest economy, and the largest trading nation. It is the second largest trading partner for the United States and the European Community, and the largest trading partner for the 11 countries of ASEAN, as well as Australia and New Zealand. China takes 21 percent of our merchandise exports – up dramatically from 4 percent a decade ago (figure 5). Figure 5: Export market shares (average annual percentage for given year) Source: Statistics New Zealand. China is our largest export market for every agricultural commodity except beef (where it is our second largest market behind the United States). It purchases a third of New Zealand’s dairy exports (figure 6). Figure 6: Share of primary exports to China (annual total) Source: Statistics New Zealand. BIS central bankers’ speeches Provided China’s economy continues to expand at around current rates, growing demand for protein-based commodities looks assured. China’s current rate of urbanisation, which is around 50 percent and well below the more industrialised Asian economies, could trend higher for another two or three decades (figure 7). Higher incomes, and greater access to refrigerated products, mean that urban dwellers’ per capita consumption of dairy products in China is about three times higher than that of rural dwellers. Figure 7: Urbanisation rates in industrialised Asian countries Source: World Bank. An important issue is whether China can maintain a 7–8 percent growth rate over the long term. Such growth rates would continue to make China an outlier compared with the development of other middle income economies. China has achieved outstanding economic growth for over 30 years, but it faces several difficult challenges in the years ahead. These include: a declining labour force and aging population; rebalancing the economy towards stronger consumption and higher value added exports; meeting infrastructure demands; addressing income inequalities in the central and western regions; tackling corruption and environmental issues; implementing the ambitious set of reforms announced in the third Plenum; and managing the very rapid build-up in local government and corporate debt over the past five years. So while the long term future dairy trade with China seems assured, there are risks of temporary disruption along the way. Two particular issues are firstly, whether we have diversified our dairy export markets sufficiently, and secondly, could we find that our market leadership in respect of exports of whole milk powder is challenged? There are grounds for optimism on the diversification front. Fifty years ago, nearly 90 percent of our dairy exports went to the United Kingdom, today it’s 0.3 percent. Currently, Fonterra operates in more than 100 countries, several emerging market economies are growing rapidly, and new trading opportunities are being opened up through international trade agreements, and possibly through a trans-pacific partnership if negotiations are successful. India, rather than China, is forecast by the Australian Bureau of Agricultural and Resource Economics and Sciences to be the major new market opportunity for dairy exports in the future. The Bureau projects global demand for dairy products to increase from USD7 billion BIS central bankers’ speeches in 2007 to USD85 billion in 2050 (in 2007 USD) 1. By 2050, India’s import demand for dairy products is projected to be USD48 billion – more than three times China’s USD15 billion, given the projected growth in China’s domestic production. World Bank projections suggest that China and India could be the world’s largest and third largest economies at that time. Figure 8: Projected global demand for dairy imports Source: ABARES. A second risk is that a strong competitor enters the Chinese market and threatens our market share. New Zealand supplied over 70 percent of China’s dairy imports in 2013 (figure 9). Figure 9: Chinese imports of dairy products Source: UN comtrade. Linehan v, Thorpes, Andrews N, Kim Y, Beaini F, March 2012 Food demand to 2050. Opportunities for Australian agricultural research by the Australian Bureau of Agricultural and Resource Economics and Sciences. Conference paper 12.4. BIS central bankers’ speeches This high market share reflects the high quality of our product, in terms of nutritional value and safety, and the marketing skills in achieving major inroads into a market that others have found difficult. But other countries also produce clean milk and these producers have seen the high returns and market share that New Zealand enjoys in China. Some, like the US producers, are investing in whole milk powder driers. While New Zealand is likely to continue dominating global milk powder export production for many years, we should expect competitors to more aggressively target the Chinese market. This reinforces the need for further diversification in export products and markets, including positioning for the opportunities that are expected to open up in the Indian market. iii) Dairy farmer indebtedness Dairy debt almost trebled over the past decade, and currently stands at $32 billion. It is concentrated among a small proportion of highly leveraged farms with around half of the dairy debt being held by only 10 percent of dairy farmers. Strong export earnings saw the sector’s debt to income ratio improve between 2010 and 2012, although for the decade as a whole this ratio tracked steadily upward (figure 10). Figure 10: Dairy debt (June years) Source: Statistics New Zealand, RBNZ. The elevated debt level means that some farmers are potentially highly exposed if there are substantial declines in the milk price pay-out, or if land prices fall. With dairy production techniques becoming more intensive and with a higher cost structure, the implied ‘breakeven’ pay-out for individual farm profitability has increased over time. A significant decline in the milk pay-out, for example, could place some highly indebted farmers under financial strain, particularly with the market for farmland being more illiquid in times of stress. Higher debt levels mean that farmers are also exposed to rising interest rates, especially with close to 70 percent of dairy debt comprising floating rate mortgages. Many dairy farmers however, are being cautious in the current cycle and are using their higher net incomes to acquire additional property and undertake farm improvements without taking on new debt – and in many cases are repaying debt. Farm building consents have BIS central bankers’ speeches been rising steadily and dairy conversions are increasing, while dairy farm prices remain well below 2008 levels and farm credit growth remains moderate (figure 11). Dairy farmers are therefore generally taking a cautious approach in the knowledge that the current high prices can turn around quickly. This is encouraging to see given the vulnerability of the sector and its already high debt load. Figure 11: Value of farm sales and credit growth Source : REINZ, RBNZ. Conclusion I began with a quote from Charles Wilson about what’s good for General Motors. He could not have imagined 56 years later that the US government would have a 60 percent ownership stake in the company. But it does illustrate how even the most dynamic enterprises can lose competitiveness and suffer major losses in market share. The New Zealand dairy industry is experiencing prosperous times, continuing the strong growth in export earnings of the past eight years. Animal numbers and prices have increased and on and off farm productivity growth has been impressive. And the future looks bright. There seem to be important structural reasons behind the rise in dairy prices that should continue into the medium term. But cyclical elements were also present and it would not be surprising to see a continuation of the correction in auction prices that we have seen in recent months. Looking ahead there are important challenges to manage. On the external front these include the oscillations in global dairy prices, the competition that dairy farmers will increasingly face from other international suppliers, and the need to continue diversifying our export markets and position ourselves for the enormous longer term opportunities that are expected to emerge in the Indian market. On the domestic front, dairy farmers should be conscious that high dairy prices can turn around quickly, and will need to continue managing their cash flows and borrowings in a prudent manner. BIS central bankers’ speeches
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Speech by Mr Grant Spencer, Deputy Governor and Head of Financial Stability of the Reserve Bank of New Zealand, to Admirals Breakfast Club, Auckland, 9 May 2014.
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Grant Spencer: Update on the New Zealand housing market Speech by Mr Grant Spencer, Deputy Governor and Head of Financial Stability of the Reserve Bank of New Zealand, to Admirals’ Breakfast Club, Auckland, 9 May 2014. * * * Accompanying charts and a table can be found at the end of the speech. 1. Introduction Housing is a key sector of the New Zealand economy, and an important factor influencing the Reserve Bank’s monetary and financial policies. And of course housing is never far from the front pages. Since 2012 we have seen rapid rates of house price inflation, reflecting a demand – supply imbalance. There has been a physical shortage of houses, particularly in Christchurch and Auckland. On the demand side there has been strengthening economic growth and inward migration as well as easy credit conditions, in terms of both the price and availability of mortgage finance. His combination of supply and demand factors has contributed to the price pressures we have seen. The Reserve Bank introduced Loan to Value Ratio restrictions (LVRs) in October with the aim of reducing the systemic risk arising from increasingly overvalued house prices. More recently, the Official Cash Rate (OCR) has been increased from 2.5 percent to 3 percent with the aim of forestalling general inflation pressures in the broader economy. Housing supply conditions have also started to improve with a recovery in residential construction, centred in Christchurch and Auckland. These factors are all working to reduce the housing market imbalance. The one factor that is not helping at present is the strong inward migration flow. Our overall view is that housing market pressures are easing gradually. Today I will review the progress being made towards a better balance in the housing market and discuss the potential implications for Reserve Bank policies. 2. Housing market activity is weakening After gathering momentum from mid-2012, the housing market looks to have slowed in the six months since LVR restrictions were introduced. The volume of nationwide house sales has dropped considerably (figure 2.1), with the number of sales in March 11 percent lower than in September last year. The decline in sales volumes has been reasonably widespread across the country, with the exception of Canterbury where sales were down only 1 percent over the same period. The recent uptrend in Auckland’s share of national house sales appears to be flattening out. Comparing market segments, we are seeing a smaller proportion of sales below $400,000. Some of this represents the reduced presence of first home buyers. BNZ-REINZ survey data (Figure 2.2) indicate that first home buyers accounted for 16 percent of sales in Q1 2014, compared to 24 percent a year earlier. The share of existing owner-occupiers has gone up by a similar amount, while the share of sales to investors has remained stable at 19 percent. The overall slowdown in housing market activity has also been reflected in house prices. After increasing steadily over 2012 and 2013, house price inflation has slowed since the introduction of LVR restrictions, despite the large increase in inward migration (figure 2.3). According to REINZ data, New Zealand house prices increased at an annual rate of 8.4 percent in the three months to March 2014, down from a peak of 9.8 percent in the three BIS central bankers’ speeches months to November 20131. The slowing in national house price inflation is largely due to easing house price inflation in Auckland, although this remains at a high annual rate of 15 percent (figure 2.3). Annual house price inflation is at 9 percent for Canterbury, and around 4 percent for the rest of New Zealand. House price inflation is not confined to Auckland and Christchurch. Outside the main centres, some of the stronger regions include Waikato/Bay of Plenty, Nelson/Marlborough and Otago. 3. Slower credit has contributed to the easing Data indicates that all banks have complied with the requirement to keep high LVR lending at no more than 10 percent of total lending over the six month period from October. For the system overall, the share of high LVR lending over the six months was 5.6 percent. This compares with a 30 percent high LVR share in early 2013. There has been some compensating increase in sub-80 percent LVR lending over the six months as the banks have intensified competition in this segment. However, the overall effect has been a reduction in the rate of growth in new mortgages. (figure 3.1). 4. LVR impact has been close to expectations The moderation in housing market indicators is broadly in line with the expected impact of the LVR restrictions. Table 4.1 shows actual reductions in national sales, price inflation and credit relative to our initial expectations. On a counterfactual basis, modelling work undertaken by the Bank suggests that, had banks continued to maintain 30 percent of their lending at high LVRs, annual house price inflation might be running some 2.5 percent higher than at present. We are comfortable that the restrictions are so far meeting their objective of helping to restrain the demand for housing while supply gradually catches up. In so doing, we believe the restrictions are mitigating the systemic risk of a housing market downturn that becomes more likely as house prices and debt levels become more stretched. We also believe that the LVR restrictions have helped to make banks’ balance sheets more resilient to any adverse housing market shock. I will come back to the LVRs shortly. 5. The supply gap remains large Demand is only one side of the story. Supply conditions are a very important influence on housing market outcomes. In its report on housing affordability, the Productivity Commission (2012) identified a number of supply factors –including restrictive urban planning, and the time and costs associated with development and construction – as factors constraining new housing supply in New Zealand. An important constraining factor has been the availability of land, particularly in Auckland. Section prices more than doubled in Auckland between 2000 and 2012 and, for sections within 25 kilometres of inner city Auckland, land prices tripled.2 As a consequence, land costs now comprise 60 percent of the cost of building a new dwelling in Auckland, compared with 40 percent in the rest of the country. Low rates of building in Auckland since 2005, combined with ongoing population growth, have led to a physical shortage of houses. Population-per-dwelling is estimated to have risen considerably in Auckland over the past few years (figure 5.1). While the size of the current housing shortage is uncertain, based on data from the 2013 Census of Population and The house price data from Property IQ gives a more lagged picture, but has slowed down even more than the REINZ data, suggesting the change in sales composition may have caused the REINZ index to somewhat understate the slowing in house prices. Ministry of Business, Innovation and Employment (2013), “Residential land available in Auckland”. BIS central bankers’ speeches Dwellings, it is now estimated to be between 5000 and 10,000 dwellings. This is lower than earlier estimates, but still material. In Christchurch, a significant shortage of accommodation also exists following the Canterbury earthquakes. Around 10,000 homes need to be completely rebuilt and a further 12,000 require major repairs (greater than $100,000 in value).3 The physical shortage of housing in Christchurch has been exacerbated by the extra demand for accommodation by construction workers. This has resulted in annual rent inflation of about 11 percent in Christchurch, compared to 3.5 percent in the rest of New Zealand. 6. The Auckland Accord is helping Auckland’s population is expected to grow markedly over the next 30 years. The Auckland Council estimates that 10,000 new dwellings will be required per year to meet future population increases. This expected future demand for accommodation means it will likely take some time to eliminate the current supply shortage. However, the Housing Accord being implemented by the Government and the Auckland Council is an important step towards achieving a better balance. Under the Accord, consent processes are fast tracked for housing developments within defined Special Housing Areas, consistent with the rules outlined in Auckland’s Unitary Plan. The Unitary Plan, developed under the Resource Management Act, sets out the Council’s vision for housing development over the next 30 years, but does not come into effect until 2016. The Accord is essentially an interim measure designed to accelerate development ahead of the Unitary Plan coming in to effect. The Accord aims for 39,000 new building and section consents to be issued over the three years to September 2016, with actual building likely to occur over a somewhat longer period. So far, 63 Special Housing Areas in a mixture of urban and rural locations have been created, with an estimated capacity for 33,500 new dwellings. Over the past year, “greenfield”land in the pipeline for housing development (i.e. zoned and with utilities connected) has increased to a level sufficient for about 25,000 dwellings, up 10,000 on a year ago.4 This is good progress, but acceleration in development activity is needed to meet the Accord and longer-term supply targets. 7. Construction is up but further boost required New building in Auckland has increased over the past year, with 6500 new dwelling consents issued in the year to March 2014, compared to 4900 in the previous year. New building activity still remains relatively low and a substantial further ramp up will be required to eliminate the supply shortage while accommodating future population growth. In Canterbury, residential reconstruction work is now picking up – after a very slow start. To date, most of the earthquake-related residential reconstruction work has related to The Earthquake Commission (EQC) repair program, with around 53,000 residential repairs completed as of April.5 The required 22,000 larger scale residential repairs and rebuilds (mostly managed by insurers) are now underway but only a small portion has been completed. Dwelling consents in Canterbury reached 6200 in the year to March and we expect to see significant further growth over the coming year. Most of the outstanding shortage should be eliminated over the next three years. With our two largest cities both seeking to boost housing construction over the next three years, there will be significant pressures placed on building resources nationally. We expect CERA (2014), “Greater Christchurch Recovery Update – Issue 30”. Ministry of Business, innovation and employment (2014), “Auckland Housing Accord monitoring report #1”. Fletcher EQR: http://www.eqr.co.nz/repairs/completed-repairs. BIS central bankers’ speeches total residential construction to increase by 30 percent over the next three years, well surpassing the historical peak of 2004. 8. Key risks going forward There are clearly many moving parts to the overall supply shortage equation– and many risks around the prospects for reducing the imbalance. Probably the major risk at present is the outlook for immigration. After increasing substantially over the past 18 months, net immigration rose to 32,000 in the year to March, in part due to fewer departures of New Zealand citizens. The Reserve Bank forecasts this pattern to reduce gradually as economic conditions improve in Australia, which is the main destination for New Zealanders shifting offshore. However, cyclical turning points are hard to predict and there is a risk that the net migration inflow remains greater for longer, which would underpin the demand for housing. On the other side of the equation, there is the risk of a continuing slow supply response due to bureaucratic and/or logistical constraints in Auckland and Christchurch. In Auckland more land is being made available but developments need to be approved and implemented, and construction needs to be consented and undertaken in scale. In Christchurch it is apparent that the consenting process has been improved, but risks remain around the slow pace of insurance settlements, particularly in the areas where land damage has been sustained. A third risk arises from the increasing pressure that will come to bear on construction resources, potentially resulting in further price and wage pressures in the construction sector. As seen in figure 8.1, construction cost inflation in Canterbury is running at around 8 percent per annum and, at a national level, reached 5 percent in the March 2014 quarter. Annual construction cost inflation in Auckland, which was running at below 2 percent a year ago, has accelerated to 6 percent. Rising construction cost inflation is a threat to housing affordability as well as to the overall rate of CPI inflation. 9. Monetary policy perspective From a monetary policy perspective, the Bank has two concerns: first that construction cost pressures could feed into generalised price inflation; and second that house price increases could cause households to increase their spending, reducing savings and putting additional pressure on overall domestic demand. The OCR increases that commenced in March are aimed at countering emerging inflation pressures in general, but their success, or otherwise, in moderating housing related pressures will be key. Based on current market interest rate expectations, adjusted for an average mortgage interest margin, floating mortgage rates could be 7 to 8 percent in two years’ time, up from current levels of around 5 to 6 percent. While this would be a significant move, figure 9.1 indicates that it would take mortgage rates back to their average of the past 20 years. That is, the outlook is towards a normalisation of mortgage rates which are currently near to 50 year lows. We should not expect to see historically low interest rates at a time when the New Zealand economy is growing strongly. Having said that, the timing and extent of interest rate increases required over the coming period will depend on a number of uncertain variables. A big uncertainty is the future path of the exchange rate, which has a major bearing on traded goods prices and overall economic activity. The more downward pressure that the exchange rate exerts on prices and activity, the less pressure will need to be exerted by interest rates. The other big area of uncertainty is around housing. Will inward migration continue to underpin housing demand? Will the dampening impact of the LVR restrictions be long lasting? Will the supply response soon start to have a moderating effect on house prices? Will home owners increase their spending out of capital gains? And how will rising mortgage rates affect spending by borrowers? BIS central bankers’ speeches With regard to this last question, we expect that interest sensitivity will be greater now than during the last tightening phase in 2003–2007. First, most New Zealand mortgages are currently on either floating or relatively short-term fixed rates whereas in 2003–2007 the bulk of mortgage borrowers were on 2-to-4 year fixed rates. This means that OCR increases will be felt more immediately by existing as well as new mortgage borrowers. Second, a higher starting level of mortgage debt relative to incomes means that any given interest rate increase will have a larger impact on monthly debt service payments, relative to incomes, than in the previous cycle. This latter point is shown in Figure 9.2 where the debt service ratio for a typical new borrower (with a 20 percent deposit) is projected to rise more sharply, relative to the interest rate track, than in the previous cycle. 10. Financial policy perspective The Reserve Bank’s concerns expressed through last year, and motivating the LVR restrictions introduced in October, related to financial stability risks arising from highly geared house purchases at potentially unsustainable prices. The high LVR lending through that period was increasing the likelihood of a house price correction by pushing house prices higher, and also increasing the vulnerability of banks to such a correction. As discussed earlier, the LVR restrictions have had a moderating effect on the housing market as well as reducing the proportion of high LVR loans in bank balance sheets. We believe that the LVR policy is achieving its purpose of improving the safety of the financial system. The market overall is less vulnerable to the effects of an adverse shock – from international financial markets for example. And banks are now less exposed to potential credit losses as the interest rate cycle turns upwards. Nevertheless, there remain a significant volume of high LVR loans on bank balance sheets – in the order of 20 percent – and, as seen in figure 9.2, debt service ratios are likely to increase substantially over the coming two years. This could put some stress on highlyleveraged borrowers and their lending institutions. We have stated clearly that the LVRs are temporary restrictions and will be eased or removed when housing market pressures have abated and when we are confident that a resurgence of high LVR lending will not occur following removal. The LVRs are supporting monetary policy but they will have a reduced effect over time. Also, the efficiency costs of such restrictions will tend to increase the longer they are kept in place. Before removing the LVRs, however, we will want to be confident that the housing market is responding to interest rate increases; and that immigration pressures are not causing a resurgence of house price pressures. It will take some time to gain this assurance. At this stage we consider the earliest date for beginning to remove LVRs is likely to be late in the year. 11. Conclusion Housing market and credit cycles are part of the economic landscape and, although they can be moderated through sound policy, they cannot be eliminated. When pressures become excessive the cycle can be damaging for the financial system and for the broader economy. This is why we monitor housing closely and why housing is a key factor influencing our monetary and financial policies. House price pressures in New Zealand since late 2012 have been driven by supply shortages and by strong demand supported by easy credit. On the supply side, progress is being made with national dwelling consents now up to an annual rate of 22,000. In Auckland, progress is being made in freeing up the supply of buildable land and improving the consenting process. And in Canterbury, the replacement of severely damaged homes is well in train after a slow start. However, the shortage remains large – with around 50,000 new homes targeted in Christchurch and Auckland over the next BIS central bankers’ speeches three years. This is a task that is likely to take considerably longer than three years to complete. On the demand side, pressure has been moderated by the LVR restrictions and will be further restrained as monetary policy brings interest rates back to a level more consistent with a strongly growing economy. Interest rate increases are expected to have a greater effect than in the previous cycle due to the high levels of existing debt and a high proportion of floating rate mortgages. However, many uncertainties remain around the housing market outlook, particularly regarding the future impact of the increasing net migration inflow. Over their first six months, the LVR restrictions have had a dampening effect on housing that is broadly in line with expectations. The easing or removal of the LVR restrictions will depend importantly on the restraining impact of interest rate increases and any renewed pressure arising from the net immigration. Achieving greater stability in the housing market will contribute greatly to maintaining financial and price stability, and to achieving sustainable economic growth. References Canterbury Earthquake Recovery Authority (CERA) (2014)”Greater Christchurch Recovery Update – Issue 30”, March, cera.govt.nz/sites/cera.govt.nz/files/common/greaterchristchurch-recovery-update-issue-30-march-2014.pdf, accessed 28 April 2014. Fletcher Earthquake Recovery (EQR), “Completed www.eqr.co.nz/repairs/completed-repairs, accessed 28 April 2014. repairs”, Ministry of Business, Innovation and Employment (2013)”Residential land available in Auckland”, Research Report, March, www.dbh.govt.nz/UserFiles/File/Publications/Sector/pdf/residential-land-available-inauckland-report.pdf, accessed 14 April 2014. Ministry of Business, Innovation and Employment (2014) “Auckland Housing Accord, Monitoring Report #1”, March, www.beehive.govt.nz/sites/all/files/Auckland_Housing_Accord_Monitoring_Report_1.pdf, accessed 14 April 2014. Productivity Commission (2012), “The housing affordability enquiry”, New Zealand Productivity Commission Final Report, March 2012. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Address by Mr Geoff Bascand, Deputy Governor and Head of Operations of the Reserve Bank of New Zealand, and Mr Steve Gordon, Head of Risk Assessment and Assurance of the Reserve Bank of New Zealand, to the New Zealand Institute of Chartered Accountants, Wellington, 24 June 2014.
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Geoff Bascand: Innovation and risk management – insights from Executive Management at Statistics New Zealand and the Reserve Bank of New Zealand Address by Mr Geoff Bascand, Deputy Governor and Head of Operations of the Reserve Bank of New Zealand, and Mr Steve Gordon, Head of Risk Assessment and Assurance of the Reserve Bank of New Zealand, to the New Zealand Institute of Chartered Accountants, Wellington, 24 June 2014. * * * “A ship in harbor is safe, but that is not what ships are built for” (John A. Shedd, Salt from My Attic (1928)). Introduction and rationale for risk management Effective risk management provides an environment for calculated risk taking and innovation. Good risk management contributes to institutional success. To be effective it requires strong leadership and organisation-wide ownership. Talking about risks and communicating plans to mitigate them is a leadership responsibility and an important part of a successful risk management framework. In this address, we will share our insights and experiences from Statistics New Zealand and the Reserve Bank of New Zealand to facilitate discussion about effective approaches to risk management while enabling innovation and institutional progress. In 2003–2005, Statistics New Zealand set about modernising the collection of Household Labour Force Survey (HLFS) interview data through computer assisted (face-to-face and telephone) interviewing. It was not a success. A review of the project by John Smyrk in 2005 stated:1 • “threats to the project were not identified”; • programs of pre-emptive and contingency actions were not assembled; • “things kept going wrong” for which there was no allowance in the plan. As a result, statistical outputs were hard to interpret and the statistical series and the organisation suffered reputational damage. Operating costs rose rather than declined as expected. They say one learns better from mistakes than victories. As the euphemism goes: there were lots of learnings about risk (and project) management from the project! The HLFS estimates employment and unemployment and is one of Statistics New Zealand’s highest priority economic data series. It is a costly collection, both in financial terms and in the burden imposed upon survey participants. Like other household surveys, it had been collected in the same manner for over 20 years. The incentives for change were considerable. A much expanded social survey programme was being introduced and there was a strong desire to modernise survey collection methods to reduce costs, speed processing, and introduce innovation. Rewards were in prospect but risks were not adequately anticipated or managed. J. Smyrk, “Enhancing business projects in Statistics New Zealand: learning from the HLFS-CAI initiative, A Report on a Review of HLFS-CAI”, September 2005. BIS central bankers’ speeches Innovation is critical to strong business performance as organisations seek to enhance product and service offerings, lift efficiency, upgrade technologies and increase their resilience and adaptability. Without innovation, organisations wither and customers and business owners suffer. Becoming ideas constrained is fatal, but there are risks in innovating. As Machiavelli said centuries ago, “Never was anything great achieved without danger.” Risk and reward are inextricably intertwined. Leaving the boat safe in its harbour will not yield progress. Good risk management is imperative for managing successful change. It involves anticipating and diminishing threats; protecting sources of value; and enabling value-creating risks to be taken in a calculated way, with reduced likelihood of failure or loss.2 Done well, it enables an organisation to seize opportunities to create and protect value for all its stakeholders. Good risk management enables an organisation to move forward, because the downside risks of change are contained, and risk management provides a forward-looking orientation. It allows organisations to focus their competencies on value creating activity. Done well, it informs strategy, investment prioritisation and business decision-making. It drives organisational direction and positioning. A second key benefit is that it reduces the likelihood and costs of adverse events that may damage organisational reputation, financial or business viability, and distract the organisation from achieving its goals. Novopay, and ACC’s privacy breaches, are familiar examples where the organisational and societal costs of risk management failures have been considerable. Good risk management fosters both adaptability and resilience, two crucial aspects of enduring organisational performance. Types of risk Generally, three categories of risks are identified: strategic, operational and project risks. 1. Strategic risks describe the impact on the business of possible changes in the wider environment, such as political, international, demographic, social, etc., and the dangers of business strategies not being adequately aligned to their operating environment. They also entail risks to the accomplishment of key business goals through loss of focus, inappropriate investment or resourcing, and reputational and communication risks. Mitigations of strategic risks tend to be strategic choices and business model approaches; investment prioritisation decisions during planning processes, often resulting in project initiations; and communications and stakeholder management. Strategic risks are often perennial, yet may be volatile due to changes in the external environment. For example, in the Reserve Bank’s case, the risk of monetary policy settings not achieving the inflation goals and the ensuing reputational damage is ever-present, but these risks are accentuated by swings in exogenous factors such as commodity prices, fiscal policy, immigration, or exchange rate movements. Financial stability goals are similarly vulnerable. Threats to financial stability are always present but are usually quiescent until something goes wrong. The global financial crisis (GFC) was an extraordinary escalation of a Risks can be positive or negative. Almost exclusively in this paper, we focus on negative risks, reducing loss. Often there is an intent of managing possible eventualities to a more neutral position where upside and downside risks are “balanced” and we shall address this approach. Positive risks are commonly treated as windfall gains. More sophisticated approaches are applied in some business circumstances, e.g. financial markets, which we largely ignore for the purposes of this general exposition. BIS central bankers’ speeches tail-risk, yet smaller threats may occur intermittently, each of them posing a challenge to the Bank’s reputation for managing a sound and dynamic financial system. In Statistics New Zealand’s case, an enduring strategic risk is the loss of confidence in the organisation by failing to deliver timely and accurate statistics. Errors in GDP or the CPI, or substantial unexplained volatility, as has occurred with the HLFS at various times, if persistent, can undermine confidence in the statistics themselves and the organisation more broadly. Consequently, a major component of risk management is the quality assurance framework and associated processes, along with strong project management adapted for “business as usual” scheduling and delivery. Other strategic risks may be more contemporary, and related to changes in the business’s operating environment. In Statistics New Zealand’s case, delivery of a major transformation programme (Statistics 2020 Te Kapehu Whetu) and realisation of the benefits from the investment is critical particularly in the window from financial injection (2011) to major systems and capability change (2017 say). Highly developed programme management and extensive external review processes seek to ensure that benefits are achieved and milestones accomplished. For the Reserve Bank, the recent introduction of a new macro-prudential policy regime presented significant challenges for the organisation. The adoption of macro-prudential policy in New Zealand drew on international policy insights from the financial cycles that preceded and succeeded the GFC. Governments became more concerned about the financial stability risks associated with credit and asset price cycles and introduced new counter-cyclical ”macro-prudential” policy measures to lean against emerging risks. A macro-prudential policy framework was agreed between the Reserve Bank and the Minister of Finance in May 2013. New policy frameworks present policy challenges in building understanding of their objectives and operation. Faced with accelerating house price inflation on top of already over-valued house prices, the Bank moved quickly to introduce new policy measures, including new capital requirements against high loan-to-value ratio (LVR) lending and limits on the share of new high LVR lending that banks could undertake. The challenge confronting the Bank was the risk of not achieving its financial stability outcome goals if it failed to act (with potentially very severe consequences) vis-a-vis the risks to the Bank’s reputation and confidence in its policy-making. There were risks and uncertainties to manage in introducing an important policy innovation that was new for households and banks. A classic risk-reward trade-off – one that required significant evaluation and preparation by senior management. Several steps were taken to ameliorate possible downside risks. We set the scene for these measures in a number of on-the-record speeches and in remarks at press conferences, and in Monetary Policy Statements and Official Cash Rate statements expressing our concerns with easier lending standards and house price inflation. We consulted with banks and published analyses of the potential impact of the measures, as well as comparisons with regimes in other countries. Following their introduction, we provided assessments of the impact, rationale and objectives in further speeches, media interviews, and in the November 2013 and May 2014 Financial Stability Reports. The introduction of LVR restrictions has attracted commentary from different quarters. In some commentators’ eyes, there has been a blurring of financial stability and monetary policy objectives, with some analytical debate about the merits of the policy. Others have questioned the Bank’s operational policy design and its distributional impacts. Some have credited the Bank with policy innovation and the willingness to act before a crisis eventuates. To date, the impacts have been broadly in line with the Bank’s expectations. House price inflation is moderating, along with the risks to financial stability (FSR, May 2014). 2. Operational risks relate to the achievement of business plans and “business as usual” results. They entail risks of failure to business operating systems, quality or BIS central bankers’ speeches service failures, integrity and conduct risks, security, operator error, incident or business continuity threats, etc. Operational risks are managed and mitigated through measures such as process design, process controls, policies and discretion limits, back-up and redundancy measures, quality assurance processes and review/feedback cycles, alignment of skills and resources with requirements, and investment in research and development and capital equipment. Mitigations operate on both likelihood and impact. For example, payroll authorities and process controls are often designed so as to minimise the possibility of error or fraud, and limit the financial impact if such an eventuality occurs. Many business continuity measures are focused on reducing impact (for example back-up procedures for disaster recovery, as they have no influence on event probability), whereas others, such as electing higher standards, may reduce vulnerabilities. Among their enormous social and economic impacts, the Christchurch earthquakes were a tragic wake-up call in respect of disaster recovery/business continuity planning (BCP) for many organisations. Statistics New Zealand was hit very hard in business terms by the three major quakes. The February quake severely damaged the main Christchurch office building and the separate census building. The quake of February 22, 2011 occurred 14 days before census day. After 48 hours assessing whether we could continue the five-yearly population and dwelling census, or usefully run it excluding Christchurch, we decided it was infeasible and I recommended that the government cancel it. $72 million spent, 7500 people employed and then let go (and paid out). As a result of cancelling the census, a number of other national post-censal social surveys also needed to be abandoned, specifically the Maori Social survey and the Disability Survey. Other economic and population statistical releases were delayed, and business was severely disrupted for subsequent weeks. In the week following the February quake, IT staff retrieved back-up tapes of data processed in January and February from the server room, which had been scheduled for transfer to Auckland. We operated tape back-up in Christchurch, after having rejected proposals for network (WAN-based) back-up from that site3 due to cost and budget restrictions and an assessed lower-risk profile in Christchurch. The back-up data was important for timely release of GDP data on March 23. Notwithstanding very extensive risk planning and control in the census programme, the organisation was unable to continue the census programme at that time. Some unforeseen risks eventuate. Their impact can sometimes be mitigated by management actions but sometimes organisations just have to trust their resilience. About four weeks after the February quake, Statistics New Zealand’s IT Group introduced remote access computing for staff. Initially, access was enabled through webmail that provided limited access to non-secure corporate tools. Subsequently, fully access to secure internal databases and statistical software was introduced. When the severe after-shock struck in June, all 240 Christchurch staff had such a facility and “normal” work resumed quickly. Remote computing had been considered in Statistics New Zealand for many years but had been assigned as low priority due to security concerns and limited demand given our officebased working norms. When the imperative arose, it was a quick and successful initiative. Sometimes innovation flows from risks that have already materialised. Reinforcing this point, when the census was re-run in March 2013, Statistics New Zealand sought to avail itself with the benefits of cloud computing, using Infrastructure as a Service for database management. The potential security and loss of control risks from third-party It was operating between Wellington and Auckland, but not between Christchurch and Auckland. BIS central bankers’ speeches storage with cloud computing were a concern, but from a full systems-perspective, the marginal risks and costs were assessed to be lower than those entailed in Statistics NZ replicating the security environment and having to provide its own disaster recovery arrangements. Risk perceptions and the ability to manage them were definitely influenced by the experiences of 2011. The Reserve Bank sets very high standards for business continuity, and has strengthened these further in recent years, reflecting the importance of the 24/7 hours availability of the payments system and the need to maintain domestic liquidity and foreign exchange dealing operations. We have experienced several incidents that spurred further risk assessment and mitigation measures. On the evening of 24 April 2012, several banks experienced difficulties in processing retail payments (i.e. exchanging and settling payments between banks’ retail customers such as merchants, government departments etc.). Some payments missed being included in the end-of-day processing and banks had to post them late, in some cases as late as the afternoon of the April 25. As a result, some bank customers who accessed their accounts on the morning of ANZAC day found that expected transactions had not been completed. The issue was triggered by a technical problem with the international financial communications network (SWIFT) and affected participants in the new Settlement Before Interchange (SBI) arrangements that had recently been implemented. These allow banks and other parties to exchange files of payment instructions and send settlement instructions to the Reserve Bank’s Exchange Settlement Account System (ESAS). ESAS operated normally, but because of the fault in the messaging system payments instructions were delayed or failed. The incident was the most significant disruption to the processing of retail payments for many years and the effects were felt by bank customers nationwide. This incident was complex due to the multiplicity of parties involved, some unclear (at the time) responsibilities, and communication between parties proving problematic. New, untested contingency arrangements were used reluctantly by banks. In the end those arrangements proved crucial, allowing the SWIFT system to be by-passed, and payments to be completed through NZClear. Since that event, the industry has accepted greater accountability for the collective responsibility to address issues and communicate effectively between the parties. As a result, subsequent incidents have been resolved more effectively. The Bank’s own payments system disaster recovery operations have been strengthened in recent years. In February 2011, the Bank established an office in Auckland as a full back-up to its payments and financial markets operations. There is fail-over capability to Auckland should Wellington’s operations be disrupted, and vice versa. Hardware, database and software back-ups exist for the most critical systems. The Bank’s BCP programme is extensive and regularly tested. The Reserve Bank, whilst perhaps better known for its monetary policy responsibilities, is a bank. It operates financial, lending and investment functions that are similar in a number of respects to those of commercial banks. And it holds and disburses cash, lots of it, albeit almost entirely to intermediaries rather than the public directly. Some $9 billion of payments flow through the interbank settlement and payments systems (ESAS/NZClear) each day. Security risks are a very serious matter for the Bank. Recently, we extensively upgraded the security arrangements around our cash processing and storage functions. IT security is an ongoing challenge. IT security risks arise through malware (viruses etc); cyber attacks (hacking and denial of service attacks) targeting external-facing publicly available services or exploiting vulnerabilities in our infrastructure; loss of data through mobile devices; insider breaches of privileges or authorities; and staff introducing vulnerabilities through exploitable physical or social media. BIS central bankers’ speeches The Bank has a dedicated security function and the IT security framework (that is currently being updated) provides an integrated, organisation-wide program for managing information security risks. Extensive control measures are in place, including technology-based mitigations and non-technical mitigations revolving around IT security policies, training, and incident management procedures. Systematic external and internal security monitoring and testing arrangements are in place. They reveal extraordinary numbers of potential threats. Suspicious events triggering alerts number around 500 million per month. These comprise a mix of non-standard but permissible events and adverse events. The security and network control task is to distinguish these and exclude the adverse anomalies, while enabling the acceptable abnormal. Operational risks, be they security, business continuity or service delivery, are most effectively managed through a risk management approach that is integrated into the business and culture of the organisation. Total quality management (TQM) is well recognised as everyone’s job, and the same is true of other operational risk management practices. 3. Project risks are sometimes treated as a subset of operational risks and are linked to the achievement of project outcomes. They relate to benefits not being achieved, perhaps because of delivery failure, key assumptions not being met, scope being poorly defined, delays in project completion, cost escalation, disruption from extraneous events etc. Typical risk controls for projects include: the establishment of a project risk register with risks identified, evaluated and controls determined, project planning, resourcing, and monitoring mechanisms, and governance arrangements. Risks often eventuate during change processes because existing processes were not fully understood and the number of unknowns is allowed to be greater than it should through inadequate planning, trialling and risk management. The Bank recently upgraded its treasury system (Findur) that captures financial trading activity, and produces financial performance reports among other functions. What was expected to be a relatively simple and quick upgrade process took around 11 months and incurred substantial frustration and cost – directly in terms of additional resources and indirectly through deferment of other scheduled developments. Risks unfolded that were not anticipated. With the benefit of hindsight, initial project planning, testing work and collaboration with the vendor were inadequate, and risk mitigations were not well enough established in advance. The project has now been completed with very satisfactory business outcomes, but better risk management and planning could have yielded better outcomes at lower cost. It need not be like this. The (population and dwellings) census is arguably New Zealand’s biggest project in any one year, involving over 7000 employees, every New Zealander, and a budget of approximately $100 million. Notwithstanding the cancellation in 2011 due to the Christchurch earthquake, the census – which is four years in the planning and involves six weeks of collection and analysis for around a year – has been conducted successfully, on schedule, within (or close to) budget, and achieved its objectives, for over 100 years. The Bank is introducing new banknotes in 2015, as foreshadowed in the Statement of Intent. While it is early days in the development of the notes, extensive risk planning has been undertaken. The project has been broken into multiple phases, with an actively managed risk register updated regularly, and aligned with the phasing of the project. The first two project phases have been concluded and the risks managed successfully. BIS central bankers’ speeches Components of risk management There are a number of core components in any risk management regime. We identify the key elements as follows: • Risk identification – risk awareness is a valuable trait that is sharpened with practice, but various disciplines are valuable to ensure risks are anticipated effectively. Risk identification is something every employee should do. The risks identified will be influenced by role and perspective. Senior management must focus on identifying strategic risks, while applying their assessment to operational and project risks identified by others. • Risk assessment – evaluation of likelihood and potential impact. Risks are pervasive but not all risks matter. It is critical to evaluate the significance of risks for the business and for a specific time horizon. Even if unimportant now, they may be significant later. Likelihood can change, as may impact. Risk severity shapes the nature and extent of management action. • Risk tolerance – what residual risk would be acceptable? Generally, risk cannot be eliminated but can be reduced. Management must decide what level of risk reduction is required and what adverse outcomes might be accepted. Sometimes risk appetite statements may be developed. • Risk planning and mitigation actions are identified and established to achieve the desired residual risk level. Preventative and remedial actions should be considered. Risks may be prevented or rendered unlikely through various control measures, and impacts alleviated through appropriate plans and actions. • Risk management is assigned – risks and their management require ownership within the business. When accountability is unclear, risks are less likely to be managed and more likely to materialise. Ownership should be assigned to the role or person who is best placed to manage the risk, acknowledging that impacts may be widespread. Even if the consequence for the organisation would be severe, it is best to allocate and manage the risk in the business area that has greatest scope for risk control. • Monitoring and review of risks regular risk review is required, to evaluate any changes in the risk or control environment. Likelihood and impact vary as political, social and technological factors evolve, and in response to changes in the business and the mitigations put in place. Incidents occur and provide insight into risk assessment. The monitoring-feedback loop is a critical part of keeping risk management in focus. • Reporting and escalation procedures – as risk severity changes, incidents occur, and risks materialise into issues, it is important that reporting and escalation processes exist. These enable broader perspectives and judgement to be applied in the evaluation and management of risks. Project governance processes are standard mechanisms for project risks. Supervisory oversight provides a reporting channel for operational risks and the senior leadership group should dedicate time to reviewing strategic risks, but more structured risk reporting processes for material changes in risk should be considered. A risk management committee may be established as one way of reinforcing the review processes. Enterprise risk management at the Reserve Bank The Reserve Bank has reviewed its enterprise risk management framework (ERM), and some key insights can be gained from this experience. BIS central bankers’ speeches The institution has one of the broadest sets of functions amongst its global central bank peers. Amongst others, its activities include responsibility for monetary policy, regulation and supervision of the financial system, currency (cash management) operations, and operations of the payment systems infrastructure. There are considerable risks associated with each of these functions. At the Reserve Bank we openly acknowledge risk and recognise that an effective enterprise risk management capability is an integral part of successfully running our business. Our ERM model was developed in-house, following an extensive review of the relevant international standards and research into how other institutions were approaching risk management. It was tailored to meet two critical criteria. Firstly, it had to be the right “fit” relative to the look and feel of the institution. Businesses have unique cultures and values, ways of doing things, and accepted working protocols and ERM solutions need to blend in; otherwise they may not be embraced or effectively used. Secondly, the ERM model had to be capable of covering all broad policy and operational functions within the Bank, and factor in the related external New Zealand level risks. These matters were considered essential to winning the hearts and the minds of stakeholders and embedding the ERM model in the dayto-day operation of the business. While these criteria may sound fundamental, ERM initiatives do fail due to these considerations being underplayed or bypassed. Some ERM models are abstract and are captured by a risk-by-list mentality that ultimately diminishes their relevance. Others don’t take the helicopter view across the broad spectrum of risks and therefore don’t pass muster at Board level as truly reflecting an institution’s risk profile. Stakeholder engagement is a major part of our ERM framework at the Bank and spans the Board, Governors, leadership team, and the wider staff population. There has been strong support and tone at the top at the level of the Governors and the Board. Awareness, education, and reporting of results have been important in promoting the importance, power and value of sound enterprise risk management. At the senior management team level we now pass an important litmus test in that every member, whilst often focusing on their own specialist departmental level activities, can articulate in detail the current enterprise risk profile across the institution and the main issues associated with each major project initiative that is linked to a strategic priority. Effective engagement requires ERM to connect to the day-to-day activities occurring across an institution. This provides the spark that gives substance to risk discussions, and promotes two-way conversation around how risks are being seen, managed, and where necessary treated. This means that risk managers need to have a solid understanding of all parts of the business in the context of strategic, operational and project risks. Aligned to engagement, the development of capability across the institution is also a major component of the Bank’s ERM model. At the outset of our review, we established an ERM Lead community that consists of selected senior staff whom collectively represent every function across the Bank. This community meets regularly and provides a point of contact into every department for the purposes of building up and regularly refreshing the collective risk profile. ERM Leads reach out across their respective departments to discuss risk and this provides ownership, comprehensive coverage, and capability across the entire Bank. Over time, as new and updated ERM initiatives develop, the ERM Lead community are a key engagement point to disseminate information across the Bank. As a mature and collegial community there are also healthy cross-departmental ERM forums, and these provide a further layer of enterprise level risk focus and robustness. To summarise, getting the “people” aspect right is critical for successful enterprise risk management. Engage, communicate, teach, explain, and then do it again, and again. There is of course also a need for sound methodology that allows for effective, repeatable, and consistent assessment and reporting of all risks. This needs to be deployed in the same BIS central bankers’ speeches manner across all functions to provide an enterprise wide “apples and apples” view of respective risks. At the heart of our methodology at the Reserve Bank we have a risk taxonomy, and associated risk likelihood and impact scaling system to classify and measure risk. This serves as a common language and is used to define and assess risks across the Bank’s activities. For example, the Bank’s leadership team can meaningfully discuss and compare a physical banknote risk alongside a monetary policy risk. Standardised reporting provides a department-level risk profile snapshot and an aggregated whole-of-Bank view. At the whole-of-Bank level a risk trend and treatment summary is compiled and this specifies how every reported risk is being managed. This provides the helicopter view in terms of where resources, spending and focus is being applied to manage specific risks. Importantly, this provides a level of comfort that we are knowledgeable about our risks and can consider opportunities and areas for innovation for the future. As part of our ERM model, we have given considerable thought to automation and data integration. This has resulted in an ERM data model that incorporates granular risk profiling that is integrated with internal audit issue log information and the Bank’s incident reporting records. In practice, any incident or audit issue arising is mapped to an enterprise risk, and over time a comprehensive view can be formed on how certain risks are manifesting themselves and being managed. Enterprise risks, audit issues, and incidents all use the same risk taxonomy and risk rating system and therefore data can be analysed consistently across these information capture systems. Automation extends to data visualisation of these relationships and this assists in identifying emerging trends and matters for further investigation. Incident management is a key part of our ERM framework. We call it Proactive Problem Management or PPM in its short form, and see it as a continuous improvement mechanism. While the initial focus is on escalating and risk managing the incident, considerable value is derived from the phase that immediately follows; this being to understand root cause and insights from them. This typically drives various action plans to further strengthen processes and frameworks. Monthly PPM summary reporting is produced for the Bank’s leadership team and discussions between the risk executive and Governors. This promotes discussions at the broader institutional level around matters such as opportunity to innovate and change the way we do things, risk culture and awareness, general robustness of process, and any trends or hot spots for follow-up. Staff are expected, encouraged and thanked for raising incidents in an open and transparent manner. The final element of the Reserve Bank’s ERM framework that brings all of this together is business integration. To obtain this integration, we limit risk profiling to a relatively small set of important risks that align to our objectives and initiatives as outlined in the Bank’s Statement of Intent. These risks factor in strategic considerations and related project activity underway across the Bank. The Bank’s leadership team regularly review the risk profile, and the Board receive a formal report twice yearly for discussion. In addition, the Bank’s senior risk management executive meets weekly with the Governor of the Bank to discuss the risk profile and related matters of significance. In essence, enterprise risk management is highly visible and can be seen in action day-inday-out across the business. ERM is transparent and inclusive and allows the organisation to make informed decisions. Perhaps most importantly, it has helped instil an organisation-wide risk management culture. We are very satisfied with the recent refresh of our ERM model. But we know that there will always be more to do to deliver a tailored best practice risk management solution to the institution. With this in mind our current focus is on further refining the articulation of risk appetite and exploring our risk culture as it relates to leadership behaviours and overall staff engagement. BIS central bankers’ speeches More generally, there is a strong sense that ERM is a powerful tool that can continue to identify opportunity and drive innovation across the Bank. There is a strong sense that by connecting to stakeholders and the business even more we will reap greater rewards in the future. Insights and reflections on risk management from executive management With over twenty years of senior executive management experience between us, the authors have witnessed successful and not so successful risk management endeavours. This section summarises our thoughts on the value and critical success factors in organisational risk management. We are unashamed advocates of risk management: done well, it pays-off. As the Performance Improvement Framework (PIF) “Getting to Great” document4 attests from its study of public sector agencies (and we see no reason to think it is different for the private sector) “The best performing agencies manage risk, while others tend to avoid it.” In summary: 1. Risks are more likely to eventuate when preparedness is inadequate. This is the story of the HLFS-Computer-Assisted Interviewing development and the Findur upgrade. All too often, we are over-optimistic that things will go well. 2. The adverse consequences when risks eventuate are generally worse when risk management is limited. For example, disaster recovery is a lot easier if measures are in place – even if they prove partial. The census data back-up was not perfect but it was much better than nothing. Reputational damage is lessened if measures exist yet are inadequate compared with the situation where the risks were unidentified and uncontrolled, i.e. mitigations were absent. For example, The ACC privacy breaches were accentuated by a lack of privacy management. The payments failure – while it still occurred – would have been much worse without contingency measures in place. 3. Being risk aware and risk prepared (risk smart for short) supports innovation, rather than impeding it, as many fear. In many cases, opportunity and risk are shadows of one another. Both elements must be kept be in focus. When someone identifies an opportunity, we ask what risks exist, so that the gains will not be lost. When risks are raised, we ask what opportunity is there to move forward. 4. Risk management is a whole of organisation task or responsibility. It needs to be demanded and modelled by executive management, owned and applied by business managers, and supported and monitored by a specialist risk management function. Accountability for risks should be assigned but everyone is responsible for risk management. Leadership is crucial in setting the risk/innovation tone and leading the organisational dialogue. An enterprise risk management framework helps instil widespread organisational ownership and builds a risk management culture. 5. Risk management tends to atrophy if one is not careful. Successful risk management tends to undermine its own apparent value. A higher risk appetite can be sustained and greater risks may be taken, or complacency can set in because risks have been successfully, but almost unknowingly, averted. It is important to develop the culture, disciplines, processes, and learning mechanisms that keep risk management fresh, e.g. quasi-incidents can be useful reminders perhaps via BCP SSC, “Core Guide 3: Getting to Great; Lead Reviewer insights from the Performance Improvement Framework”, April 2013. BIS central bankers’ speeches exercises, security penetration testing, and external review etc. Risk management committees have a place in maintaining the focus. 6. Engagement and conversations are vital. Risks need to be talked about. This builds awareness and action. Developing a culture in which risks and risk-taking can be discussed, managed and accepted is a key leadership challenge. While we are not wedded to explicit, whole of organisation, risk appetite statements, the conversations about risk tolerance for particular risks are crucial. It is important to send clear messages to an organisation about whether, why and which risks should be reduced or relaxed a little. Some are below the waterline and must be averted. Others may be above it and permit greater risk taking. Strong, consistent senior leadership is vital. Often staff or lay observers contend that risk management will tie an organisation up with process and overhead, slowing it and its innovative capacity down. This need not be the case. Motor racing and sail boat racing enthusiasts recognise the finely balanced science and art of incurring increased risk to increase speed, and then set about optimising the tradeoff. Recall Sir Peter Blake’s famous dictum that the black magic campaign was about doing everything to make “the boat go faster”, without making it unstable. Organisations need to incur risk in order to prosper. We are not there to tie down all the hatches and keep the sails furled. Our goal is not risk avoidance but risk awareness, risk management and, indeed, calculated risk-taking. BIS central bankers’ speeches
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Speech by Dr John McDermott, Assistant Governor and Head of Economics of the Reserve Bank of New Zealand, to the Wellington Chamber of Commerce, Wellington, 9 July 2014.
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John McDermott: Realising our potential – potential output and the monetary policy framework Speech by Dr John McDermott, Assistant Governor and Head of Economics of the Reserve Bank of New Zealand, to the Wellington Chamber of Commerce, Wellington, 9 July 2014. * * * Introduction It has long been recognised that the best contribution that monetary policy can make to strong and sustainable long-run growth is low and stable inflation. This proposition is at the heart of New Zealand’s flexible inflation-targeting framework to maintain price stability while not causing excess volatility to output, interest rates or the exchange rate. When explaining our monetary policy actions we frequently speak about the performance of the economy relative to its potential. Colloquially, the growth in potential output is how fast the economy can expand without generating inflation. Today I want to speak to you about the concept of potential output itself, rather than the more usual topic of economic growth relative to its potential. Because New Zealand’s growth in potential output is not a universal constant, but is subject to frequent changes, it makes sense for the Bank to devote a significant amount of resources to estimating potential output and explaining our thinking behind those estimates. Our estimates of potential output are regularly reviewed at every release of our Monetary Policy Statement. Our estimates can change for many reasons: data revisions can result in short term changes; capital purchases or labour market participation can result in changes over the medium term; and institutional developments can result in long-run changes. Indeed, the Reserve Bank’s estimate of potential output growth has been revised up over the past six months to a peak of 2.8 percent in 2015, from 2.5 percent previously. Today I will elaborate more on the short and medium term developments affecting potential output and, while not of immediate relevance for New Zealand monetary policy, I will touch on some longer-run issues. What is potential output? As noted earlier, potential output is typically considered to be the level of output achievable in an economy given the available factors of production – labour, capital and productivity – that is not associated with accelerating inflationary pressure on consumer prices. Any definition of potential output refers to an unobservable concept.1 Potential output could in theory be highly variable. It is undoubtedly highly uncertain and difficult to measure. Because of the difficulty in measuring potential output, we typically assume potential output evolves slowly and relatively smoothly. This assumption allows us to estimate potential output by using averages or trends of GDP data. The average rate of output growth over longer periods of time can provide us with a rough gauge of the growth capacity of an economy. Figure 1 shows that observed average growth in New Zealand has varied over the past five decades, ranging from a low of 2.1 percent in the 1980s to almost 4 percent in the 1960s. Over this period there have been significant changes in New Zealand’s economic environment through societal change, government policy, and external conditions. For monetary policy purposes the most satisfactory concept of potential output is the level of output that would occur if all prices and wages were completely flexible so that all resources were allocated to maximum benefit. BIS central bankers’ speeches Figure 1: Average output growth in New Zealand Source: Statistics New Zealand, RBNZ calculations. The Reserve Bank focuses on demand pressures and inflation Potential output is a useful concept in framing monetary policy in an inflation-targeting system. The so-called output gap, or, how actual output fluctuates around the path of potential output over the business cycle, describes a key component of inflationary pressures and motivates a monetary policy response. Higher growth in potential output is desirable, but whatever the state of potential output, identifying the fluctuations of actual output around the path of potential output is the focus of monetary policy. Monetary policy settings are mostly about the cyclical fluctuations in the economy. Figure 2: Stylised view of the output gap and inflation pressures Source: RBNZ. If we consider actual and potential output in terms of growth rather than levels, all else equal, inflationary pressure tends to rise when demand in the economy is growing faster than BIS central bankers’ speeches potential output, and tends to moderate when demand is growing slower than potential output. The Reserve Bank will typically respond by increasing interest rates in order to moderate demand pressures in the first case, and by reducing rates to stimulate demand in the second. While this may sound straightforward, policy formulation requires difficult judgements to be made in the face of considerable uncertainties, including judgements as to the size of the output gap and the path of potential output. Figure 3: Growth in actual and potential output in New Zealand Source: Statistics New Zealand, RBNZ estimates. The notion may be straightforward; measurement is not The notion of potential output is straightforward enough. But potential output is unobservable and has to be inferred from the other economic information we have available. Ultimately estimating potential output requires making a judgement about the extent to which particular fluctuations in observed output are cyclical and the extent to which they are changes in the path of potential output. The Reserve Bank expresses growth in potential output as the sum of contributions from estimates of trend growth in capital inputs, labour inputs, and productivity. Estimating potential output in real time is challenging. Growth in potential output is not constant – its path does not in reality follow a straight line as shown in our stylised figure. Views on the level or growth in potential output, both at present and over history, can and do change. Views can differ from analyst to analyst or model to model, even based on the same data. The Reserve Bank’s assessment of potential output has changed The Reserve Bank has recently revised its estimates of potential output growth. The Bank expects growth in potential output in New Zealand to increase over the forecast horizon as labour and capital resources available in the economy increase. Annual growth in potential output is estimated to peak at around 2.8 percent in 2015. This demonstrates a marked improvement in growth prospects from an estimated trough in potential growth of 1.2 percent following the 2008/09 recession. BIS central bankers’ speeches Figure 4: Components of potential output growth Source: RBNZ estimates. Our estimate of potential growth has increased since December, from a peak of 2.5 percent in 2015 to 2.8 percent. The increase in our estimate of potential growth is because: • Data revisions now reveal that there has been more investment in productive capital than previously thought; • Strong business confidence suggests that future investment could be stronger than previously thought; and • The supply of labour is expected to be stronger than previously anticipated, due in part to increased net immigration. Growth in actual output is expected to have peaked at around 4 percent in the year to June, driven by strong construction spending, increasing net immigration, high export prices, and low interest rates. With the economy growing at a faster rate than potential output, inflationary pressures are expected to increase. In this environment, it is important that inflation expectations remain contained and that interest rates return to a more neutral level. Structural changes and the economic cycle cause potential growth to fluctuate Growth in potential output fluctuates over the medium term as the availability of factors of production is influenced by the state of the economy. Let me explain this further using the example of one of the labour supply components of potential output – the labour force participation rate. Labour force participation captures the share of the total working age population (i.e. the population aged over 15) that are working or are available for work. Labour force participation has increased over time in New Zealand as female participation in the workforce has increased, and, more recently, as older age cohorts remain in the labour force for longer. Increasing participation increases the supply of labour and increases potential output. Assumed trends amongst labour market cohorts, combined with demographic projections, suggest that a structural upward trend in the participation rate will continue in New Zealand through the remainder of this decade. Labour force participation is also influenced by the state of the economy. Upswings in activity encourage more people to actively seek work, increasing the participation rate. Conversely, during recessions participation tends to weaken, as people leave the labour force, discouraged by lack of employment opportunities. BIS central bankers’ speeches Figure 5: Labour force participation rate and estimated trend (% of working age population) Source: Statistics New Zealand, RBNZ estimates. Similarly, growth in capital inputs can be influenced by structural factors in the economy such as population growth or changing technology, but can also move somewhat cyclically with business sentiment, access to finance, and investment intentions. In an ideal world, we would take full account of these short to medium term influences on potential, but it is difficult to measure and interpret these movements in real time. The Reserve Bank’s use of trends in estimating potential output means these estimates capture the large permanent or persistent changes in input components, such as lasting shifts in participation, but does not capture higher-frequency movements. “Fundamental” factors ultimately affect “long term” prospects There are a range of more fundamental determinants of growth that matter hugely for economic outcomes over the very long term, but their effect over shorter time horizons is difficult to detect. Typically these factors are more important for explaining differences in growth across countries rather than over time. For these reasons they are less relevant considerations for monetary policy and central banks tend to talk about them much less. To acknowledge their role in the overall growth story, let me briefly offer a couple of examples of these determinants: geography and institutions. Economic geography can have a significant effect on long term prospects.2 Proximity and connectedness to regional or global markets exposes domestic businesses to greater competition, aids in the transfer of technology and knowledge, and generates greater efficiencies of scale and scope. New Zealand’s small population and distance from major markets can make it difficult to capture these benefits. Our geographical location may be fixed, but the challenge posed by our isolation can change over time based on patterns of globalisation, political relationships, and technological change. Our own history evidences the massive impact that innovation and technological advance can play in overcoming geographic isolation. The sailing of the ship Dunedin is one such Boulhol, H, A de Serres and M Molnar (2008). See also, De Serres, Yashiro and Boulhol (2014). BIS central bankers’ speeches example. The Dunedin transported the first refrigerated shipment of frozen sheep carcasses from New Zealand to England in 1882, vastly expanding the market for New Zealand’s meat products. In the modern era, further improvements in transport infrastructure and advances in information and communications technology, used effectively, have the ability to dramatically reduce distance to markets. There is a vast literature on how the quality of institutions in an economy can contribute to growth prospects.3 For example, for businesses to innovate they must be confident in their ability to generate an adequate return on their investment, and that these returns will not be expropriated. A strong education system supports the formation of ideas and fosters the capability to absorb new technology into business practices to increase productivity performance. A well-functioning legal system that enforces a clear set of property rights provides businesses the ability to capture the returns from their investment for a time. Scaling up production of successful innovations requires access to capital markets. New Zealand has a relatively strong institutional framework by international comparison. Inflation targeting monetary policy constitutes a key piece of this institutional framework for supporting sustainable growth. Low and stable inflation aids in preserving property rights and keeps incentives clear for savers and investors. The Reserve Bank’s financial stability mandate is also important for supporting the sound and efficient functioning of financial markets. An example of this is the introduction of loan-to-value restrictions on residential mortgages in October 2013, in an effort to stabilise the housing market. What impact can monetary policy have on potential output? Recognising these various influences on potential output growth, one might ask what effect monetary policy can have on long term growth. The best contribution that monetary policy can make to sustainable long term growth is low and stable inflation. There is a short term trade-off between growth and inflation. Unduly easy monetary policy settings can boost economic prosperity for a time, but such a boost is unlikely to be long lasting. Economic consensus, reflecting in part the experience of the 1970s, is that the tradeoff between growth and inflation is unsustainable. Over time inflation expectations and nominal wages adjust to monetary expansion such that long-run unemployment and output are largely unchanged, but the rate of inflation is higher. Indeed, it can be counterproductive to use monetary policy to target higher inflation in pursuit of better output growth over the longer-term. Such attempts risk unanchoring inflation expectations resulting in higher and more variable inflation. High and variable inflation can harm long term growth.4 High and variable inflation generates considerable uncertainty for individuals and businesses, hindering their willingness and ability to plan and contract over the long term. Businesses have differing abilities to change their prices in response to inflationary shocks. As some businesses change prices and others do not, it becomes difficult to distinguish a generalised increase in prices from a shift in relative prices when the inflation rate itself is variable. Unexpected inflation acts as a hidden tax on financial investment for savers, yet reduces the real interest burden of debt for borrowers. This can distort saving and investment incentives and increase the inflation-risk premium embedded in interest rates. Eventually a reaction sets in against high inflation. Past experiences suggest that reducing inflation materially usually involves a greater slowing in activity than the boost to growth Acemoglu, Johnson and Robinson (2004). See, for example, Barro (1995), Bruno and Easterly (1998), OECD (2003). BIS central bankers’ speeches enjoyed as inflation increased. There is evidence to suggest that for advanced economies, the threshold at which inflation becomes negative for long term growth may be as low as 3 percent.5 The gains from operating monetary policy to achieve low and stable inflation are difficult to observe and may appear small. Gains from macroprudential policy in moderating credit cycles may be similarly difficult to observe. But, poor policy in either case can cause material damage to long term growth prospects as unsustainable booms unwind. Conclusion There is a range of factors that can cause potential output to fluctuate over the short, medium and long terms. Potential output is determined by the economy’s productive base – that is the supply of labour and capital and the efficiency with which these factors are utilised. The quantity and quality of these productive inputs are largely determined by the preferences and choices made by individuals and businesses – how much to work, how much to save, and how much to invest. These preferences can be influenced – for good or for ill – by the policies of central government. Monetary policy cannot persistently affect these preferences. It can however provide a stable backdrop against which individuals and businesses can make decisions about the most efficient allocation of their resources. References Acemoglu, D, S Johnson, J Robinson (2004) “Institutions as the fundamental cause of longrun growth”, NBER Working Paper 10481. Barro, R (1995) “Inflation and economic growth”, NBER Working Paper 5326. Boulhol, H, A de Serres and M Molnar (2008) “The contribution of economic geography to GDP per capita” OECD Economics Department Working Paper 2008/10. Bruno, R and W Easterly (1998) “Inflation crises and long-run growth”, Journal of Monetary Economics 41, 3–26. De Serres, A, N Yashiro and H Boulhol (2014) “An international perspective on the New Zealand productivity paradox”, New Zealand Productivity Commission Working Paper 2014/01. Graham, J and C Smith (2012) “A brief history of monetary policy objectives and independence in New Zealand”, RBNZ Bulletin 75(1), 28–37. Khan, M S and A S Senhadji (2001) “Threshold effects in the relationship between inflation and growth” IMF Staff Papers 48(1). Smith, C (2004) “The long-run effects of monetary policy on output growth”, RBNZ Bulletin 67(3), 6–18. Khan and Senhadji (2001). A caveat to these results is that this and other such empirical work uses a relatively short period of modern experience in attempting to identify effects on long term growth. BIS central bankers’ speeches
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Speech by Mr Grant Spencer, Deputy Governor of the the Reserve Bank of New Zealand, to the New Zealand Banker's Association, Auckland 22 July 2014.
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Grant Spencer: Taking stock of financial sector regulation Speech by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to the New Zealand Banker’s Association, Auckland 22 July 2014. * * * Introduction Thank you for the opportunity to meet with you this afternoon. I want to talk today about an important initiative at the Reserve Bank– to undertake a stocktake of our regulatory framework for banks and non-bank deposit takers. There has been a considerable amount of financial sector regulation in recent years, both globally and locally in New Zealand. In large part this has been a response to the major financial and economic costs of the global financial crisis. While the New Zealand banking system fared relatively well in the GFC, the unprecedented severity and scope of the financial shocks made it clear that the prudential regulatory regime needed to be strengthened, and that this should be coordinated on a global front. Five years on from the GFC, with most of the Basel III regime in place, we now have a considerably stronger prudential regime which we are broadly happy with. But it is also more complex and it has expanded at a rapid pace. We feel it is now opportune to take a step back and review where we have got to. We want to make sure that the reforms meet their intended objectives, are efficient and do not create misplaced incentives or impose large compliance costs that could outweigh the broader benefits of the reforms to society. Our aim here is not to fundamentally change or roll back the regulatory framework. We want to shape and thin the stock of regulation, not undertake a major reformulation of the system. I will set out the context and motivation for the review and then discuss how we will go about it. But first we should remind ourselves why we have financial sector regulation. The role of financial sector regulation The Reserve Bank’s prudential framework plays an important role in New Zealand’s economy. Its objective is to promote the maintenance of a sound and efficient financial system. In the case of the insurance regime, the objective is a sound and efficient insurance sector. Prudential regulation is necessary to achieve these objectives because of the existence of significant externalities in the financial system. The externalities are costs to the broader economy and society that are not taken into account in the commercial decisions of financial institutions. The interests of banks and NBDTs can differ from those of society at large. For example, they may face incentives to increase leverage and risks in the expectation of achieving higher returns, without bearing all the costs if things turn out badly. Banks in particular sit at the heart of the payment system so a bank failure can quickly spread and affect people and businesses who are not direct customers of the failed bank. These externalities can be significant– we estimate the potential cost of a serious financial crisis to be between 10 and 20 percent of GDP. 1 Reserve Bank of New Zealand (2012) “Regulatory impact assessment of Basel III capital requirements in New Zealand” available online at: http://www.rbnz.govt.nz/regulation_and_supervision/banks/policy/4932427.pdf. BIS central bankers’ speeches The international expansion of regulation The concerted effort of the major economies to bolster the global banking regulatory regime post-GFC has been coordinated within the G20 and associated bodies – specifically the Basel Committee on banking supervision (BCBS) and the Financial Stability Board (FSB). The emphasis of the reforms has been focussed on the large internationally active banks based in the G-20 economies. However, the reforms have been broadly implemented across most domestic banking systems. The growth in Basel Committee publications since the GFC is shown in Chart 1. New regulation under the broad banner of Basel III has generally been prescriptive in order to maximise international consistency and minimise the scope for regulatory arbitrage. This has contributed to an increasing complexity in financial regulation as new regulations have attempted to accommodate differences between the major banking systems. For example, Basel I (the first international capital standard in 1987) was 30 pages in length, the Basel II standard 347 pages, and the new Basel III standard 616 pages. 2 Further complicating the international regulatory environment have been the extensive “domestic” reforms of the US and EU 3 which have major extra-territorial implications for international banks based in the US/EU and, importantly, for banks dealing with US/EU banks. New Zealand’s approach to the evolving international framework New Zealand is not a member of the Basel Committee or the FSB/G20 and as such is not obliged to follow the Basel rule book. However, we agree with the underlying rationale of the international reforms. New Zealand banks did not suffer a serious credit shock in the GFC but we saw how quickly bank capital could be eroded in global financial institutions. And our banks experienced real difficulties in funding and liquidity management that required official Andrew G Haldane,“The Dog and the Frisbee” available at: http://www.bis.org/review/r120905a.pdf. See for example, the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 (the Dodd-Frank Act) at: http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf, and the EU reforms outlined at: http://ec.europa.eu/internal_market/bank/index_en.htm. BIS central bankers’ speeches support. We have therefore acknowledged the need to increase the safety of the financial system by enhancing the prudential regulatory regime. Given that Australia is a member of the G20 and BCBS, the parents of our major banks are required to comply with Basel Committee standards. Further, New Zealand is a debtor country that has relied on the major banks to fund its current account deficits over many years. The access of the banks to the international capital markets could be hindered if they were seen to be non-compliant with the key Basel and FSB standards. In short, as a small debtor country hosting foreign banks and reliant on international capital markets, we cannot afford to be too far removed from the Basel tent. I note that the current Australian Financial System Inquiry has recently reaffirmed this same position for Australia 4. Over the past five years we have reviewed the emerging Basel III reforms and shaped our financial regulations to suit New Zealand circumstances. This has been something of a balancing act. We have not adopted all the Basel reforms (for example we have not adopted the leverage ratio) and we have introduced some policies that differ from the Basel standards (for example the Reserve Bank’s liquidity standard, BS13), in order to better reflect New Zealand conditions. In doing this, our general approach to prudential standards has been relatively conservative, and we have tended to be early rather than late adopters of the new standards. A conservative approach to standard setting is consistent with our governance based approach to supervision. Under the New Zealand model, the responsibility for implementing the standards is very much sheeted home to the directors and executives of the regulated institutions. The Reserve Bank’s supervisory engagement with the banks is focussed on governance, strategic direction and risk management. It is not based on in-house reviews to check compliance with the standards. Non-bank regulatory frameworks Outside of the banking sector, the Reserve Bank’s role as prudential supervisor has expanded into new areas, largely due to domestic rather than international considerations. New Zealand suffered a major series of failures in the finance company sector, with 45 finance companies entering into liquidation, receivership or moratorium between 2006 and 2011. Legislation providing for the prudential regulation of non-bank deposit takers (NBDTs) was first passed in 2008, and substantially came into effect in 2010. More recently, additional legislation was passed last year providing for the licensing of NBDTs by the Reserve Bank. Our broad approach to NBDT regulation is based upon a version of the regime for registered banks, with generally less demanding standards that are tailored to the circumstances of the NBDT sector. Trustees are responsible for the day-to-day supervision of NBDTs, while the Reserve Bank regulates the sector, and sets and enforces prudential requirements. New Zealand’s insurance sector was also very lightly regulated until legislation was passed in 2010. The goal of the new regulatory framework was to reduce the potential impacts on policyholders of an insurer failing, and diminish the broader impact on the economy in the event of more widespread problems in the insurance sector. We have since licensed 100 insurers, and are developing a framework for the day to day supervision of licensed insurers. Our regulatory approach is based upon the three pillars of Financial System Inquiry: Interim Report, July 2014, available at: http://fsi.gov.au/files/2014/07/FSI_Report_ Final_Reduced20140715.pdf. BIS central bankers’ speeches self, market and regulatory discipline, and seeks to combine international standards and the particular characteristics of the New Zealand insurance sector. While the NBDT regime is in the scope of the regulatory stocktake, we feel the insurance regime is too recent to be included. We are however, reviewing insurance solvency standards as a separate exercise. Motivation for the stocktake In light of the international trends and the approach we have taken in New Zealand to financial sector reform, why do we need to undertake a review? First, it is sound practice to review a regulatory regime from time to time, particularly where it has been subject to rapid change. We need to review whether the regulation and the processes we follow are as rigorous, transparent and fair as they should be. Second, the burst of post-GFC regulation, particularly around capital adequacy, has produced a layering of requirements on top of the Basel II reforms that were finalised in 2008. A fresh look at the body of regulation in each key area should offer scope for simplifying the framework, including the removal of redundant regulations. Third, we need to step back and look at the consistency and coherence of the whole regulatory regime. For example, do the changes to capital and liquidity requirements have implications for the prudential policies in other areas such as disclosure or governance? Is our alignment with international standards appropriate? Do we have a consistent approach between banks and non-banks? Improving the efficiency, clarity and consistency of prudential standards In reviewing the specific prudential requirements applying to banks and NBDTs, our objective is to improve the efficiency, clarity and consistency of these requirements. Efficiently designed regulatory requirements should achieve their objectives while minimising compliance costs as far as possible. Some of the questions we will be asking about the efficiency of existing requirements include: • Are all of the prudential requirements necessary to maintain a sound and efficient financial system? • Do the requirements serve their original purpose? Should they be cut back, removed, or replaced? • Does alignment with international standards or the requirements of other jurisdictions help to improve efficiency by avoiding the need for banks with foreign parents to comply with multiple sets of rules? We also want to make sure that the prudential requirements applying to banks and NBDTs are as clearly presented as possible. In particular, the Banking Supervision Handbook has evolved organically over time and this has inevitably resulted in some aspects of the Handbook not being presented as logically and coherently as we would like. The scope of the review Included in the scope of the review will be the regulatory documents, regulations and legislative provisions containing the prudential requirements for banks and NBDTs. For banks, this means all of the standard conditions of registration, guidance and Orders in Council that make up the Banking Supervision Handbook, and that contain requirements relating to everything from capital to OBR pre-positioning. BIS central bankers’ speeches For NBDTs, it means the regulations and legislative provisions that establish their specific prudential requirements. The project will not be looking at changes to the Reserve Bank Act itself, or the recently enacted Non-bank Deposit Takers Act 2013 5. As such, it will not be looking at the supervisory approach adopted in the two sectors, or the matters that were considered as part of the review of the prudential regime for NBDTs that we undertook last year, such as the role of trustees in NBDT supervision. The key planks of the prudential framework will not be revisited, including the need for banks and non-banks to: hold sufficient capital; maintain sufficient liquidity; implement robust risk management systems and policies; and have strong governance regimes. A full list of the key planks is included in the terms of reference for the project that were published on the Reserve Bank’s website this afternoon. As noted earlier, the stocktake will also exclude the insurance regime, although a separate review of the insurance solvency standards is currently underway and will consider many of the same themes around efficiency, clarity and consistency. The broader insurance regime is too young to include in the review. The process for developing prudential regulations The second part of the stocktake will review the processes we use for developing prudential regulations. This will extend to how we identify potential threats to financial stability, how we assess actual versus intended effects of policies, and our approach to communications. I know that many of you will have views on these matters. Consultation periods are another matter that we will be looking at closely. Over the last three years we have carried out approximately 25 consultations relating to the banking sector, with the average consultation period being four to six weeks (although the shortest consultation period was three weeks and the longest six months). We want our general approach to the length and nature of industry consultation to be consistent and transparent, although there may still be occasional instances where the need to move quickly may force us to shorten the timeline. Co-ordination of policies with other government departments and agencies with an interest in the banking or NBDT sectors is clearly important. Many of you here will be aware that the Reserve Bank is a member of the Council of Financial Regulators (along with Treasury, MBIE and the FMA) that meets quarterly to discuss work programs and emerging issues. The Council has recently established a subcommittee, called the banking forum, which is intended to help ensure that government agencies see the big picture of regulatory initiatives affecting the banking sector at any given time. The exchange of information at the forum will help agencies to sequence regulatory reforms and consultations so that pressures from bunching are avoided. Process for carrying out the stocktake We are enthusiastic about the stocktake project, and believe it can lead to positive outcomes for the public, the Reserve Bank, banks and NBDTs, and other stakeholders. With the possible exception of those parts of the Act that contain specific prudential obligations such as those relating to governance and risk management. BIS central bankers’ speeches We anticipate that the project will take about 12 months, and involve several stages as set out in the indicative timetable below: Indicative timetable Stage 1 Initial Scoping Industry workshop / discussions with industry bodies/ Establishment of Late July 2014 – Early August expert panel Stage 2 Formulation of draft proposals RBNZ and expert panel analyse bank and NBDT prudential requirements August 2014 – February 2015 Industry workshop / discussions with industry bodies October 2014 Industry workshop / discussions with industry bodies February 2015 Stage 3 Public Consultation and Conclusion Discussion document prepared March 2015 – April 2015 Discussion document out for comment May-June 2015 Industry workshop / discussion with industry bodies May 2015 Analysis of submissions and formulation of draft proposals July 2015 – August 2015 Industry workshop / discussions with industry bodies Late August 2015 Conclusions finalised, Summary of submissions and report on conclusions published September 2015 The first stage will scope ideas that should be considered as part of the stocktake. As part of this process, we will shortly be holding a workshop with industry participants. The second stage will be the detailed formulation of draft proposals. This will last from August through to March next year. As part of this stage of the project, we are proposing to hold two further workshops with industry around October and February. We will also be assembling a small panel of financial regulation experts (from outside the banks themselves) to help formulate draft proposals. The third stage of the project will involve a public consultation on the proposals. It will seek input from all stakeholders, after which specific changes will be agreed upon. We expect to hold workshops with industry during this stage. Ahead of the workshops, one thing I would like industry to think carefully about is how they assess regulatory costs. Different banks and people within banks give us different perspectives. For some the impact on directors work programmes is the main issue; for others it is the cost of capital; for others it is the resources tied up in consulting on and implementing regulatory change. Keeping in mind that the fundamental building blocks of conservative capital, liquidity, risk management and governance are taken as given, we would be interested in industry views on what one or two big things would really increase the efficiency and effectiveness of the regulatory regime. Conclusion To sum up, the Reserve Bank is committed to delivering a world-class regulatory framework. That means one that fully supports the soundness and efficiency of the New Zealand financial system, and is lean, easy to use and as cost-effective as possible. BIS central bankers’ speeches The non-bank sector had serious issues earlier on which led to a strengthening of regulation in that sector. However, the banking sector came through the Global Financial Crisis in very good shape by international standards, which is a testament to the industry and to the regulatory environment. It is important though that we work to continuously improve the regulatory framework. We look forward to working with you all towards that end. Thank you. BIS central bankers’ speeches
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Statement by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, Wellington, 25 September 2014.
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Graeme Wheeler: New Zealand’s exchange rate – why the Reserve Bank believes its level is unjustified and unsustainable Statement by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, Wellington, 25 September 2014. * * * Introduction In its September Monetary Policy Statement (MPS) the Reserve Bank commented that: “The exchange rate has yet to adjust materially to the lower commodity prices. Its current level remains unjustified and unsustainable. We expect a further significant depreciation, which should be reinforced as monetary policy in the US begins to normalise”. Similar sentiments about the level of the exchange rate being “unjustified and unsustainable” were expressed in the 24 July OCR review. The September MPS noted that the economy appears to be responding to the policy measures taken by the Bank over the past year and that it would be prudent to undertake a period of monitoring and assessment before considering further policy adjustment. Nevertheless, it is expected that some further policy tightening will be needed to ensure that the objectives under the Policy Targets Agreement are met. This article discusses why the exchange rate has been strong, why the Reserve Bank believes the level of the exchange rate is “unjustified and unsustainable”, and the impact of the high exchange rate on the broader economy1. It also looks at episodes of exchange rate correction in New Zealand, and draws possible implications for future exchange rate adjustment. What is driving the current strength in the exchange rate? The New Zealand dollar exchange rate is at exceptional levels compared with its history. The Trade Weighted Index (TWI) is above its 90th percentile calculated from historical data. Relative to the US dollar, Japanese yen and the euro the exchange rate is above the 90th percentile. It is close to the 90th percentile against sterling and the Australian dollar. There are sound reasons why the New Zealand dollar should have strengthened in recent years. Three factors have been particularly important in stimulating demand for New Zealand dollar denominated assets. First, rising export commodity prices lifted New Zealand’s terms of trade late last year to their highest level since 1973, and about 40 percent above the average level of the 1990s. China’s expanding urbanisation and growing demand for protein drove much of this. China is now New Zealand’s main export destination, having increased its share of New Zealand’s exports from 5 percent to 21 percent over the past decade. Second, investors have also been attracted by the broad strength of the economy and our higher interest rates. Over the past three years New Zealand’s annual GDP growth has been 1.3 percentage points higher than the average of the advanced economies2. The differential between New Zealand’s OCR and policy rates in other advanced economies, which had been of the order of 1½ – 2 percent since 2009, began to widen in late 2013 as markets The concept of “unjustified” is part of the Reserve Bank’s exchange rate intervention assessment. For further detail on the Reserve Bank of New Zealand’s intervention framework see Eckhold, K and Hunt, C (2005)“The Reserve Bank’s new foreign exchange intervention policy” RBNZ Bulletin March 2005. Based on the IMF’s 36 country classification in its World Economic Outlook database. BIS central bankers’ speeches factored in the prospect of OCR increases. Countries that cumulatively produce around twothirds of global output have policy rates between zero and 1 percent, with most having rates close to zero. Meanwhile, the Reserve Bank increased the OCR by 1 percentage point over the period from March to July 2014. Third, and related to the previous point, the weak and uneven recovery in the advanced economies has seen many central banks adopt unconventional monetary policy as the lower bound on short-term policy rates was reached. Central banks in large advanced economies have kept policy interest rates close to zero and injected over USD 6 trillion of liquidity into global financial markets. This inflated prices of financial and real assets, depressed yields and compressed spreads on risk assets. Yields on 10 year sovereign bonds in Germany were recently at an all-time low, France and Spain reached 250 year lows and the Bank of England’s policy rate is at its lowest level since the Bank’s inception in 1694. The subsequent “search for yield” by investors, coupled with excess liquidity and low levels of financial market volatility, generated substantial portfolio inflows into New Zealand and put upward pressure on the exchange rate. An additional factor exerting upward pressure on the exchange rate over many years has been the persistent gap between savings and investment. Over the past forty years New Zealand has demanded more investment in housing, infrastructure and other assets than its domestic savings could finance. New Zealanders’ relatively high propensity to spend means that interest rates need to be higher than elsewhere to achieve similar inflation outcomes. The higher interest rates are also needed to fill the domestic savings gap by attracting the savings of foreigners. This has the effect of putting further upward pressure on the exchange rate. Unjustified and unsustainable When assessing the implications of current strength or weakness in the New Zealand dollar, the Bank focuses on two broad concepts – whether the exchange rate is unjustified and whether it is unsustainable. The Bank examines the real effective (or trade weighted) exchange rate when making this assessment. This corrects the nominal effective exchange rate for differences in relative prices (or relative unit labour costs) between New Zealand and its major trading partners. It is a better measure of overall competitiveness than the nominal exchange rate. An exporter’s competitiveness is determined not just by the nominal exchange rate, but also by their cost of doing business relative to their foreign competitors. Figure 1 shows the movement in New Zealand’s real effective exchange rate since 1964. The current level of the real effective exchange rate is well above its 50 year historical average. The level of the real effective exchange rate is considered unsustainable when it is clearly deviating from its long-run equilibrium. That is, from where the exchange rate would be expected to settle when business cycle factors have fully dissipated. The long run equilibrium exchange rate will be consistent with external balance over the long term, given certain assumptions regarding the terms of trade, domestic and world growth rates, interest rates, and external debt levels etc. Persistent deviations from equilibrium are likely to result in external debt ratios that eventually become unmanageable and misallocations of resources that inhibit the country’s long term growth potential. The Bank considers that the real effective exchange rate is unjustified when the level of the real exchange rate is inconsistent with the economic factors that typically explain its movement during the business cycle. BIS central bankers’ speeches The Bank uses a range of short term economic models to assess whether the real effective exchange rate is unjustified. These models can normally explain much of the cyclical fluctuation in the real exchange rate. For example, economic variables such as commodity prices, house prices and relative interest rates can account for much of the movement in the deviation of the real effective exchange rate from its long term average level. It is important to note that these cyclical variables are not necessarily the underlying cause of the movement in the real exchange rate. They can be proxies for broader considerations such as the strength of the economy and the expected returns from investing in New Zealand that investors compare against other international investment alternatives. Even allowing for New Zealand’s economic outperformance relative to most advanced economies, New Zealand’s real effective exchange rate is above the level that can be justified. In particular, the real exchange rate has not adjusted materially to the recent downward movement in commodity prices – the factor that normally best explains movements in the real exchange rate. Since July, the Bank estimates the real effective exchange rate has depreciated by around 3 percent. Since 11 July 2014, the nominal cross rate against the USD has depreciated by around 7.5 percent. Global dairy prices have fallen by 45 percent since February 2014 and Fonterra has cut its milk price from $8.40 per Kg of milk solids in the 2013/14 season to a forecast $5.30 per Kg of milk solids in the current season. Dairy farm incomes this season are expected to be about $5 billion lower – equivalent to a 2.2 percent decline in national income3. Despite this, in August, New Zealand’s real effective exchange rate was 1 percent higher than its February 2014 level. Dairy exports account for almost a third of New Zealand’s annual merchandise exports. BIS central bankers’ speeches The Bank’s analysis indicates that the real exchange rate is well above its sustainable level and also above levels justified by short term business cycle factors. Other institutions also consider New Zealand’s real exchange rate to be unsustainable. In May 2014 the IMF suggested that New Zealand’s real effective exchange rate was 5–15 percent above the level consistent with medium-term fundamentals4. The Peterson Institute in Washington DC assessed the effective real exchange rate to be 15 percent above its sustainable level, the highest of 34 currencies reviewed5. Unjustified and unsustainable are important considerations in assessing whether exchange rate intervention is feasible. Another consideration is whether conditions in the foreign exchange markets are conducive to having an impact on the exchange rate. The economic impact of the high exchange rate The elevated exchange rate affects the economy in many ways. The appreciation of the New Zealand dollar has helped to lower inflation in the tradables sector. Annual tradables inflation has been negative for much of the past two years as a result of the global oversupply of manufactured goods, falling capital goods prices and the high exchange rate. This has boosted the real disposable income of consumers. The high exchange rate has also made it cheaper for some firms to obtain capital goods and access new technologies, and provided an incentive to improve productivity. Through these channels the high exchange rate has helped to spread the benefits of elevated commodity prices. However, the high exchange rate continues to be a significant and unhelpful headwind for the non-agricultural traded goods sector by restricting export earnings and encouraging imports over domestic tradables production. It imposes high costs on firms that are forced to exit and re-enter markets due to large movements in competitiveness. Its impact has been hardest on export firms that are not experiencing high international prices for their products, and on manufacturers and other businesses that compete with foreign imports. An unsustainable real exchange rate diminishes the tradable sector’s profitability and affects its investment and employment decisions. It can also result in a smaller than desirable tradables sector. International experience indicates that countries enjoying sustained rapid rates of economic growth have generally had significant growth contributions from competitive tradables sectors and strong international trade linkages. New Zealand’s past experience with elevated exchange rates Since the float of the New Zealand dollar, New Zealand has experienced four major exchange rate cycles, including the current cycle. Each previous cycle has been notable for an unjustified and unsustainable real effective exchange rate followed by an initial depreciation and then a rapid correction (table 1). On average, once the exchange rate has reached a peak, the peak-to-trough decline has occurred over 13 quarters. The average total decline has been 28%, while the average decline over the first year has been 11%. IMF Staff Report for the 2014 Article IV Consultation on New Zealand. Petersen Institute for International Economics, Policy Brief 14/16. BIS central bankers’ speeches Several factors led to the depreciation of the real exchange rate in the late eighties. The share market crash of 1987 initiated a period of deleveraging in the New Zealand economy and this was compounded by the strong rise in oil prices in 1990 and a downturn in the global economy in 1991. The Asian crisis was a key driver of the exchange rate depreciation from 1997. The downward pressure on the currency was exacerbated by a series of droughts from 1997–1999 and the financial shocks of the Russian debt default and the collapse of Longterm Capital Management. The New Zealand dollar declined significantly from 2007, during the global financial crisis. The failure of Lehman Brothers, and the subsequent crisis in the US and in global financial markets drove a significant downturn in demand for New Zealand’s exports and damaged business and consumer confidence. Conclusion Our modelling work indicates that the real effective exchange rate is above the level that can be justified by cyclical economic variables and that its current level is unsustainable over the longer term. The nominal TWI is currently 4 percent below the historical high reached in July 2014. This decline in the TWI is small in relation to the 45 percent fall in global dairy prices since February 2014. We expect a significant further depreciation of the exchange rate as a result of the weakening in price of our dairy and log exports. Past experience suggests that when the New Zealand dollar begins depreciating from an unjustified and unsustainable level, the ultimate adjustment can be large. Some of this reflects the limited overall liquidity in the New Zealand dollar markets, and the potential for pricing discontinuities when overall investor sentiment changes markedly and investors cut or exit their positions in volume. Several factors could cause such a change in financial market sentiment. These include a deterioration in global risk appetite as the result of an adverse economic or geo-political shock, further declines in New Zealand’s commodity export prices, a slowing in New Zealand’s or China’s economic growth, and stronger indicators of economic growth in the US. Under the current US outlook, the Federal Reserve is expected to start raising interest rates in the second or third quarters of next year. A stronger outlook for the US economy would likely trigger greater investor flows into the US dollar on the expectation that the Federal Reserve would begin to tighten sooner. BIS central bankers’ speeches In the Reserve Bank’s view, the combination of these factors makes the New Zealand dollar susceptible to a significant downward adjustment over the coming six to nine months. Such an adjustment would be welcomed by the Bank as a move towards a more sustainable exchange rate level. BIS central bankers’ speeches
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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Bank for International Settlement (BIS) Conference on Cross-border Financial Linkages, Wellington, 23 October 2014.
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Graeme Wheeler: Cross-border financial linkages – challenges for monetary policy and financial stability Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Bank for International Settlement (BIS) Conference on Cross-border Financial Linkages, Wellington, 23 October 2014. * * * On behalf of my Reserve Bank colleagues, I bid you a warm welcome to Wellington. I especially want to thank the conference organisers, and the participants and presenters who have travelled far to join us. It is a great pleasure to co-host a conference with the BIS on Cross-Border Financial Linkages, as we think about these linkages a great deal. As the BIS triennial data indicates, the New Zealand dollar is the tenth most traded currency in the world with daily turnover of around USD105 billion. This is magnitudes beyond New Zealand’s economic weight by any metric – and about 250 times our daily external trade flows. In contrast with most other regions, the Asia-Pacific region has seen rapid growth in financial flows since the GFC. Asia-Pacific currencies are currently represented on 40 percent of global trades, up from 30 percent in 2007. However, cross-border financial integration is much more 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. Cross-border flows can, however, present challenges for monetary policy and financial stability and it’s to these issues that I turn. Cross-border financial linkages and monetary policy 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. 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. 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 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 BIS central bankers’ speeches 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. Domestic monetary policy and changes in exchange rate regimes can do little 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. 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. Commentators, including the IMF, sometimes suggest that 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. 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 preconditions 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). Although much is known about the factors that influence exchange rates in theory, empirical links between exchange rates and their driving factors have been difficult to pin down. Exchange rates are closely linked to interest rates in theory through uncovered interest arbitrage but, empirically, the connection is weak. Internationally, we see markets adopting risk-on and risk-off strategies that are often linked to expectations of the timing of monetary policy decisions by the Federal Reserve. And sometimes capital flows seem to matter: we see flights to quality and to more liquid markets accompanied by large exchange rate movements when risk and uncertainty increase. In our own economy, several factors appear to play a role in foreign exchange markets: actual and expected movements in commodity prices, information relating to expected future movements in policy rates and appetite for New Zealand dollar risk. But, without a strong empirical understanding of what determines the exchange rate there is considerable uncertainty regarding the efficiency of the exchange rate transmission channel. Cross-border financial linkages and financial stability Cross-border financial linkages can have important implications for financial stability when large institutions react in a similar manner and herding behaviour causes financing flows to amplify financial market shocks. We have seen this desperate search for yield across borders many times before with investors taking on more and more risk and in doing so significantly lowering risk premia. Rather than requiring higher risk premia from increasingly leveraged borrowers, investors continue to provide financing at declining spreads, fearful of missing out on the returns of those who preceded them. BIS central bankers’ speeches I would like to focus a little on the role that macro-prudential policy and liquidity management can play in reducing systemic risk in financial markets and will illustrate with reference to the New Zealand market. Residential property prices have been rising rapidly in several Asia-Pacific countries in recent years. In New Zealand, these pressures have been accentuated by housing supply shortages, historically low mortgage rates, tax preferences that favour investment in housing, and offshore investor interest. Strong housing demand can add to financial stability risks, especially when accompanied by high household indebtedness. Housing market exuberance can be particularly problematic when interest rate responses are not warranted because economic growth is well below potential, and inflation in factor and product markets is benign. Macro-prudential policies can be helpful in addressing financial stability concerns in such circumstances. But the introduction of macro-prudential policy requires policy makers to be clear about its goals, the duration of the measures, and how such measures might interact with monetary policy. The Reserve Bank introduced macro-prudential policy in the form of speed limits on loan-tovalue ratios (LVRs) in the residential housing market, on 1 October 2013. House prices – which were already significantly overvalued based on historical and international indicators – were accelerating rapidly in our two largest cities (that account for around half of the national market). In addition, household debt was at high levels, and banks were competing aggressively for mortgage lending to borrowers with small deposits. At the time, annual consumer price inflation was running at 0.7 percent, the exchange rate was strong, and the economy had a negative output gap. It was not appropriate to raise interest rates, but the potential for further rapid house price inflation was considerable as sizeable supply-demand imbalances seemed likely to continue for several years. We introduced a requirement that banks reduce their high LVR lending (defined as LVRs over 80 percent) to an average of no more than 10 percent of their mortgage commitments, and made this a condition of bank registration. The measure 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 percent to 5 percent currently, despite high levels of net immigration. We established clear and separate primary objectives for monetary policy and macroprudential policy. These primary objectives are price stability and financial system stability respectively. There is an appropriate role for coordinating the use of monetary policy and a macroprudential policy instruments provided they both affect outcomes relevant to the achievement of both policy objectives. This condition is likely to be met when the real and financial cycles are in sync and each policy can allow for the complementary effects of the other. The two policies will be in greatest potential conflict when the real and financial cycles are in opposite phases. 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. 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 BIS central bankers’ speeches house price inflation. We will be reviewing these criteria and their implications for LVR restrictions in next month’s Financial Stability Report. My final comment is on liquidity risk Liquidity risk and rollover risk are often the two major financial shocks that hit economies, and especially smaller economies, during episodes of financial market contagion. Unsurprisingly, given current yield curves, debt issuance almost everywhere has shifted towards longer-term funding. We still have much to learn around liquidity risk and the emergence of “black holes” in funding and asset markets. Liquidity risk is a key concern for countries with large external borrowing needs, especially if investors become skittish, trading volumes begin to thin and some price gapping occurs. Left unabated, liquidity problems can mutate into solvency problems. The Reserve Bank introduced a prudential liquidity policy in April 2010. This policy includes minimum liquid asset requirements, and a minimum core funding ratio. Like the Basel III net stable funding requirement scheduled for 2018, the policy requires a minimum proportion of total lending to be funded by more stable “core funding” instruments such as retail deposits and long term borrowing (beyond one year). In New Zealand, the commercial banks’ core funding ratios fell to around 60 percent prior to the GFC. Today the banks’ core funding ratios stand at around 85 percent (against a minimum of 75 percent) and the vulnerability of New Zealand banks to developments in offshore wholesale funding markets has been substantially diminished. Concluding comments One of the eight lucky signs of Buddhist philosophy, drami or the “endless knot”, illustrates how individuals and institutions across the world and over time are connected in a web of mutual interdependence. Another valuable insight from Asia is that of the four friends (the elephant, the monkey, the rabbit, and the bird). By standing on each other’s shoulders the bird is able to reach the fruit for all of them. Preventing future global financial crises requires us to understand the web of mutual interdependence characterised by the endless knot, and the wisdom of the four friends. Despite the invaluable data gathering and research by the BIS, our understanding of the drivers and impact of cross-border financial linkages remains limited in many areas. Our theoretical benchmark for much policy analysis continues to be based on capital-free arbitrage that assumes efficient and smooth changes in asset prices, with no material effect for capital flows. We have excellent speakers and papers over the next two days and an opportunity to explore many of these and other important issues. I wish you productive discussions and deliberations. Certainly, my Reserve Bank colleagues and I will take a great deal of interest in the conference sessions. BIS central bankers’ speeches
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Speech by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to the Payments New Zealand Conference, Auckland, 11 November 2014.
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Grant Spencer: Reserve Bank perspective on payments Speech by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to the Payments New Zealand Conference, Auckland, 11 November 2014. * * * Thanks to Payments New Zealand (PNZ) for the invitation to speak this morning. I would like to congratulate PNZ for again bringing together such a wide group of people with interest and expertise in payments matters. The ability to make payments conveniently and safely is vital to the functioning of the financial system and broader economy. The Reserve Bank therefore has a natural interest in the evolution and safety of the New Zealand payment system. The Bank plays three roles with respect to payment systems: • As a Central Bank, we are a payment system user. Like any other financial institution, we use various payment systems to settle a range of transactions. • The Reserve Bank is also a provider of payment and settlement services. Our role as the supplier of currency is widely known and notes and coins are still used to make a significant proportion of retail payments. We are also the operators of the Exchange Settlement Account System (ESAS) and the securities depository and settlement system, NZClear. We are currently undertaking a strategic review of these two systems and will be releasing a progress report this week. But this is not my topic today. • The Bank’s third role, undertaken jointly with the Financial Markets Authority (FMA), is the regulatory oversight of payment and settlement systems. In our broader capacity as financial system regulator we are conscious of the crucial role that the payment system plays in promoting a sound and efficient financial system. Today I will focus on this regulatory role, which I have responsibility for within the Bank. I will discuss recent changes in the payments landscape, some of the opportunities and risks that those changes present, and how the industry is responding to those risks. I will also talk about the role that I see for the Reserve Bank in influencing payment system developments. The fast-changing world of payments In retail payments, we are seeing rapid innovation, increasing technological complexity, and a breakdown of traditional boundaries between banking, telecommunications and IT functions. It was just 30 years ago that payments were overwhelmingly made using cash and cheques. While these instruments continue to play an important role, most payments these days are made using electronic debit, credit and payment cards. Figure 1. highlights the steady growth in cards transactions that has continued unabated over the past 10 years. BIS central bankers’ speeches Figure 1 Retail transactions in New Zealand (monthly) Source: Statistics New Zealand. Looking forward, the new growth areas in retail payments are contactless payments, mobile phone based applications and on-line payments. These innovations reflect technological advances in IT and telecommunications and ever-rising customer expectations. Payers and payees are demanding payment services that are convenient, reliable and secure. Increasingly, people also want the funds cleared from their transactions quickly, preferably in real time. As significant change is occurring in how we make retail payments, we are also seeing a number of new players, including telecommunications companies and the likes of Apple, Google and Paypal – a trend that is likely to continue. Banks, the traditional providers of an end-to-end payment service, are now facing competition from, and needing to co-operate with, other entities. What role will banks play in the future? Will they continue to do what they have always done? Or will their role be limited to providing the trusted store of value while other technology providers capture the transaction service? These trends imply new sources of risk in payment systems and a potential need for refinements to the regulatory regime. The move towards increased digitisation and electronic payment methods opens up the prospect of digital currencies such as Bitcoin becoming more important. As the currency issuer, the Reserve Bank does not feel threatened by Bitcoin which seems to behave more like a commodity than a currency. However, I do not doubt that future digital currencies will become more realistic substitutes for cash. Turning to wholesale payment systems, here too we are seeing innovation and growth. Wholesale payments are in large part related to the settlement of financial market transactions, including foreign exchange, equities, debt securities and financial derivatives. Innovations in products and trading strategies, some driven by new technologies, have contributed to ongoing growth in the turnover of these markets, with hardly a pause for the Global Financial Crisis (GFC) (Figure 2.) The amounts involved are very large globally. The foreign exchange market alone now accounts for over US$5 trillion per day. BIS central bankers’ speeches While New Zealand debt and equity securities transactions are generally settled on local systems (NZClear and NZCDC), the foreign exchange and derivative markets, being dominated by cross-border flows, have seen the development of sophisticated cross-border payment systems such as CLS for foreign exchange and the London Clearing House (LCH) for financial derivatives. Figure 2 Global wholesale market turnover Source: Bank for International Settlements. More so than in the retail space, a key driver of innovation in the wholesale space has been the post-GFC regulatory pressure from the G-20 and major country regulators to reduce risk in large payment and settlement systems, widely known as “Financial Market Infrastructures” (FMIs). The international regulators have become more concerned because of the growth in complexity and volume of payments, and the systemic risks that were made evident in the GFC. Increasing risk in payment systems Increasing risk in payment systems is apparent at both the retail and wholesale levels. And there is greater awareness now of some existing systemic risks that had not previously been fully appreciated. At the retail end, our reliance on electronic payments will continue to grow as we make more payments online and use mobile phones for more transactions. This greater use of technology is making our lives easier but also brings increased operational risk. Uppermost are concerns about the vulnerability of payment systems to cyber-attacks and risks associated with the involvement of new non-traditional players. A recent example of cyber-attack was at JP Morgan, America’s largest bank, in August of this year, where it is reported that 76 million household files were compromised by Russian hackers. Perhaps more concerning was the report that the attack was through a third-party website and that it took two months to discover the problem. BIS central bankers’ speeches Such incidents highlight the reliance that we now have on technology and what can happen when that technology fails. With customers becoming more accustomed to high levels of convenience and rapid settlement, operational lapses have, if anything, become more visible to the end-users. From the regulator’s perspective, a short-term disruption to customer service is not of major concern if its impact is contained locally. That is for the provider to sort out with its customers. However, operational lapses in large and/or highly connected payment systems can disrupt the wider financial system and economy. The regulator has a much stronger interest in the safety and efficiency of such systemic FMIs. We experienced this in New Zealand on ANZAC day 2012, when the exchange of retail payments between banks via SWIFT 1 was disrupted. ESAS continued to function and banks were able to invoke contingency arrangements. Nevertheless, there were significant delays to the exchange of payments and to the posting of transactions to customer accounts. There could easily have been a more widespread disruption of retail payments and commerce if there had not been a public holiday that day. The recent system outage at the Bank of England that disrupted the operation of the UK’s large value payment system, CHAPS, provides a further example of how widely a payment system disruption can be felt. The unavailability of CHAPS for nine hours meant that high value sterling payments, including the settlement of house purchases, could not proceed, causing a gridlock of house settlements. More seriously, the settlement of foreign exchange transactions around the world was disrupted because the functioning of the CLS system depends on the ability to make and receive payments in all currencies in CLS, including sterling. The greatest potential for systemic damage from payment systems arises in the event of a failure of one or more major counterparties to financial transactions, particularly derivative transactions. In physical foreign exchange and securities transactions, the use of Delivery versus Payment (DVP) removes credit risk from the payments process. But financial derivatives involve (sometimes long-dated) future commitments to exchange cash flows that vary with market prices. The posting of collateral is used to reduce credit exposures as derivative contracts go in and out of the money over time but this is an imperfect process, particularly in times of market turbulence. The failure of Lehman Brothers and AIG in 2008–09 focused the spotlight on the huge extent, and also the opacity, of credit exposures arising from over-the-counter (OTC) derivatives 2. The US authorities were ultimately able to untangle the Lehmans derivative book without further major contagion. In the case of AIG, a bailout was organised by the US Treasury in order to avoid the further financial fallout that would have ensued if AIG had been unable to meet its obligations on its large volume of derivative contracts. An additional area where we face growing risk management challenges is the increasingly global nature of the infrastructures that provide many wholesale payment services. In New Zealand we already rely on a number of offshore FMIs. These large global financial infrastructures provide advantages in terms of economies of scale but also pose legal and resolution risks for local counterparties in the case of an FMI failure. The outcome for a domestic bank would be determined by the legal and regulatory framework in the FMI’s home jurisdiction, over which New Zealand authorities would have little influence. SWIFT is the principal global messaging system used in payments systems. Derivatives bought and sold through banks, rather than exchanges. BIS central bankers’ speeches Responses to increased risk What are the appropriate responses to these increased payment system risks on the part of both industry participants and regulators? The providers of retail payments services need to closely manage the new operational risks arising from the increasing reliance on complex technologies and the internet. This is not just about ensuring that business continuity arrangements are in place for the day that a component of the system fails. It is also about cybersecurity and protecting systems from malicious attack. Systems that rely on the Internet are especially vulnerable and appropriate safeguards need to be in place. There are natural commercial incentives for payment system providers to ensure the resilience of their systems to such threats. If one provider’s system is corrupted, customers will quickly move to competing providers. While local operational risks can at times have broader systemic consequences, the regulatory response in this area has typically been of a low key nature -requiring payments providers to have robust governance, risk management and BCP structures in place. The international regulatory response has been more substantive in the area of systemic counterparty risk. The Lehmans and AIG episodes demonstrated that network contagion effects can generate damaging externalities, i.e. potential systemic costs of counterparty failure, that are not taken into account in bilateral derivative contracts. In the 1990s similar concerns about foreign exchange settlement risk led to the creation of CLS. In the post-GFC period, serious concerns about systemic risk in OTC derivatives markets led to a G20-mandated restructuring of derivatives clearing and settlement. In particular, G20 banks are required to report OTC derivative contracts to trade repositories and to clear those derivatives through central counterparties 3. More generally, regulators have recognised the need to ensure that large wholesale payment systems and other financial market infrastructures giving rise to systemic risk are as robust as possible. Much of the work on regulatory frameworks has been done by the Committee on Payments and Market Infrastructures (CPMI) 4 and the International Organisation of Securities Commissions (IOSCO). In 2012, these groups published updated international standards for financial market infrastructures in the form of Principles for financial market infrastructures (PFMI) 5. These principles represent international best practice guidance for addressing risk and efficiency in FMIs, and many countries have adopted the principles as the basis for their oversight regimes. Many national regulators have recently strengthened their regimes for the regulation and oversight of FMIs. Amongst the multitude of provisions in the US Dodd-Frank Act are requirements for the Federal Reserve to create uniform risk management standards for systemically important “financial market utilities” and to monitor the compliance of those systems. The European equivalent to Dodd-Frank is the European Market Infrastructure Regulation (EMIR), which sets rules for central counterparties and trade repositories. Other countries that introduced or plan to introduce strengthened regimes include the UK, Canada and Hong Kong. A common feature of these regulatory regimes is their risk-based approach. Regulators focus their oversight activity on the largest systemic risks to financial stability. Typically this involves classifying certain FMIs as systemically important and paying particular attention to those systems. So far these requirements only apply to OTC interest rate derivatives. Formerly the Committee on Payment and settlement systems (CPSS). http://www.bis.org/cpmi/publ/d101.htm. BIS central bankers’ speeches The Reserve Bank’s oversight role In the international context, the Reserve Bank’s regulatory framework in the payments area is at the non-intrusive end of the spectrum. The Bank and FMA have a relatively low level of regulatory authority in this area. Under the Bank-FMA designation regime 6, FMIs seeking designation must have their rules approved by the Bank and FMA. However, this regime is voluntary and, for FMIs not choosing to be designated, the Bank must rely on suasion and industry engagement to promote its stability and efficiency objectives. In promoting the soundness and efficiency of the financial system, and consistent with the internationally agreed principles for FMIs, the Bank has four core objectives that FMIs are encouraged to follow as responsible “NZ Inc. payments citizens”: • The first is good governance. It is important that FMIs are well managed by appropriately skilled people. Governance arrangements should ensure that the views of all relevant stakeholders are considered. • The second is a sound risk management framework, covering legal, credit, liquidity, operational and other risks. • The third is continuity of service. Given their role at the heart of the financial system, it is important that FMIs operate continuously. This means that a system should be able to cope with potential disruptions like technical problems and the failure of a participant. • The fourth is fair and open access. FMIs should have risk-based and publicly disclosed criteria for participation that promote fair and open access with no unwarranted barriers to entry. Fair and open access should encourage competition between participants and innovation. The Bank promotes these objectives through consultation with the industry and we especially value the relationship with Payments NZ in helping to achieve good results. We are confident that the requirements for designated FMIs will ensure that they meet the four core objectives. However, we would like to see these requirements extended to all systemic FMIs. In this regard we believe there is a case for some strengthening of the current regulatory framework. Our concern relates to situations where our objectives for the safety and efficiency of systemic FMIs cannot be achieved through suasion alone. Another area where we believe there is a need for change is crisis management. When there is a crisis, particularly in a systemic FMI, there is a need for prompt and deliberate action to restore normal operations and mitigate the flow-on effects of the disruption. In past systemic events, for example the ANZAC day disruption, the industry has looked to the Reserve Bank for leadership. We are happy to play such a role but would like to formalise crisis management roles and responsibilities. The Bank is currently looking to establish an enhanced oversight regime based around systemically important FMIs with attention given to crisis management powers. Our approach will be aligned with international principles and, while remaining near the non-intrusive end of the international spectrum, will focus on the core objectives for a sound and efficient payment system. The Bank does not seek to prescribe the shape of the payment system or the direction of innovation. Other national regulators take a range of approaches on such strategic issues. Across the Tasman for example, the RBA and Payments System Board can take quite strong positions on industry shape and direction. In our own case, we often express views on Once a payment system is designated, all payments through that system are final and irrevocable. BIS central bankers’ speeches industry direction, particularly if there are implications for systemic risk, but we prefer to see market-based solutions. An example of this is the current discussion about the future of domestic debit, where the Bank has not taken a position. We acknowledge the arguments in favour of preserving a domestic debit product so that competing payment instruments are available. However, we also note the popularity of scheme debit cards given their ability to facilitate on-line and overseas payments. It may be that the cost of re-investing in the domestic product to provide comparable functionality is too high. In recent times, the most significant change to the payments landscape has been the Settlement Before Interchange (SBI) arrangements for retail payments, introduced in 2012. These arrangements have helped to address long-standing concerns about settlement risk arising from a retail payments participant failing to settle. SBI has resulted in more frequent intra-day settlements and a significant shortening of the lag between retail transactions and the final clearing of funds. The Bank still has concerns about the length of time taken to settle retail transactions and the frequency of interchange. We are working with the industry to address this issue and good progress is being made. For example, the proportion of transactions settled after 9pm has reduced by about 30 percent in the past twelve months. Our expectation is that, by the end of 2016, SBI participants will interchange retail payments at least hourly. Another area where the Bank has taken an active interest is the establishment of Payments New Zealand (PNZ) and the opening up of the system to new players. Payments is a business in which the right balance has to be found between competition, co-operation and safety. Innovation is usually spurred by competition but for a payment vehicle to be successful it needs to be widely accepted, and that requires co-operation. New players often promote competition but there must be risk-based criteria for their participation. A positive feature of the New Zealand payment system over the years has been the extent to which participants have collaborated in establishing payment networks. The development of the domestic EFTPOS system, with a shared service provider switching transactions for a number of banks, is a good example of this. The success of the shared utility model in the past probably reflects the earlier industry structure, which was dominated by a small number of major banks. With more players entering the market and the increasing pace of innovation, collaboration may become less prevalent. The recent partial acceptance of a shared Trusted Services Manager for mobile payments reflects this trend. But, competition notwithstanding, at the highest industry level it is important that the views of all stakeholders are taken into account when decisions are made about the future architecture of the payment system. The establishment of Payments NZ improved governance of the payment system and paved the way for a more open and competitive payments industry. This outcome was welcomed by the Bank and we are watching closely the recent moves by PNZ to further open up its membership via a multi-tiered structure. We will continue to monitor the extent to which the interests of all stakeholders are accommodated in the committee structure. An example will be the progress being made towards an account numbering system that accommodates banks who wish to move from agency arrangements to direct participation in the retail payments system. The challenge for PNZ is to promote efficiency and innovation by allowing wider participation in the system, while at the same time continuing to manage system risks. On the wholesale front, recent international regulatory developments have been impacting New Zealand players, irrespective of our own regulatory framework. For example, while not a member of the G20, New Zealand financial institutions are affected by the G20 requirements relating to OTC derivatives. Many of the derivative counterparties of New Zealand banks are required to centrally clear and so New Zealand banks are ensuring that they have the same capability. The NZ banks are also being captured by new reporting requirements being applied to their parents. We continue to monitor developments in this area and so far have BIS central bankers’ speeches not mandated central clearing/reporting. This is a difficult issue for a small country where the relevant FMIs sit in offshore jurisdictions. It underlines the increasingly global nature of payments, and the need for our payments oversight function to be seen in the global context. Conclusion The payments industry landscape is more fast-changing than ever, with customer preferences and technology advances driving innovation in the retail space and international regulatory developments adding further impetus for change in wholesale FMIs. Increasing complexity and use of the internet are adding to risk in retail systems which must be managed carefully by system participants. Most major countries have moved since the GFC to strengthen their regulatory oversight of payment systems, with an emphasis on large systemic infrastructures. Internationally developed principles for FMIs have been widely adopted, including by New Zealand. The Bank is looking to strengthen its oversight regime in order to fully apply the principles to systemic FMIs. At the same time, New Zealand’s oversight regime will remain at the low intensity end of the international spectrum. The Reserve Bank’s approach to payment system oversight is not to be prescriptive in terms of future payments system architecture. Nor does the Bank want to force cooperative “utility” solutions on the industry which could inhibit innovation and competition. However, it is important that the industry has a high level governance structure that facilitates competition and innovation by allowing access to new participants, and gives all participants an input into the strategic direction of the industry. Payments New Zealand is the key governance body in this regard and its challenge is to find the right balance between openness and competition on the one hand, and the integrity of the system and its participants on the other. We will continue to follow governance developments with close interest. Thank you. BIS central bankers’ speeches
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Speech by Mr Geoff Bascand, Deputy Governor and Head of Operations of the Reserve Bank of New Zealand, at the launch of Brighter Money, Wellington, 20 November 2014.
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Geoff Bascand: Brighter money – enhancing innovation and embracing heritage Speech by Mr Geoff Bascand, Deputy Governor and Head of Operations of the Reserve Bank of New Zealand, at the launch of Brighter Money, Wellington, 20 November 2014. * * * Seeing people’s initial reactions to the new banknote designs is a heartening reminder of what an important role currency plays in our lives, and what a sense of pride and heritage our notes evoke. Three years ago, when we launched the project to upgrade New Zealand’s banknotes, we decided to retain representation of well-known New Zealanders and flora and fauna on our notes. Our research showed that New Zealanders were satisfied with the themes of the existing notes and the denominations available. Looking at the designs in print, we’re very proud of the way New Zealand’s rich cultural diversity, world-class achievements and unique heritage have been brought to life as part of the new designs. From our world famous mountaineer and explorer Sir Edmund Hillary, through to our Nobel Prize winning scientist Lord Rutherford, the stories that we’ve celebrated as New Zealanders will continue to live on through future generations. Some new ones may even emerge as the sharper and more colourful pictures on the notes bring flora, fauna, landscapes and history alive. But our Brighter Money doesn’t just celebrate innovation and the pioneering New Zealand spirit through the images depicted on the banknotes – the notes themselves are at the forefront of banknote technology. It’s been 15 years since the current New Zealand banknotes were last upgraded, and printing and design techniques have advanced significantly. In 1999, New Zealand was one of the few countries to be printing banknotes on polymer – now, it’s increasingly common as central banks around the world work to produce durable, secure currency. Security features have also advanced considerably in the last 15 years, and our new notes contain more sophisticated security elements that greatly enhance the overall design. The transparent windows are larger, and striking holographic features will help to make the notes very easy to verify, but hard to counterfeit. More details about these features will be made available closer to the time the notes are released. New Zealand is very fortunate, in that we have low rates of counterfeiting by international standards. But since the last banknote upgrade in 1999, there have been significant advances in copying, scanning, and printing technologies and the cost of this technology has reduced. As a result, the economics of counterfeiting have changed substantially and the risk of counterfeiting has increased. So we need to stay ahead of the game, as a counterfeit attack could potentially be very costly, and erode the high levels of trust New Zealanders have in the currency. Delivering New Zealand’s new banknotes is a key priority for the Reserve Bank, as we gear up for the pending release of the new banknotes and the subsequent growth in operational activity. Over the last year we’ve made sure that our Wellington facilities are now well equipped to handle the roll out of new banknotes, and we have the processing capability in place to handle the higher activity associated with the changeover of banknote series. After a multi-stage international tender, we chose Canadian Banknote Company (CBN) to design and print our new banknotes. CBN has a very strong reputation for technologically- BIS central bankers’ speeches advanced printing and has produced New Zealand’s passports since 2009. It also prints the Bank of Canada’s banknotes. In recent months we’ve had a team up at CBN’s facility in Ottawa making sure the designs you see here are being translated accurately and smoothly into printed banknotes. It’s a particularly detailed process, requiring fastidious checking and cross referencing of source material. We are still completing detailed work on the security features, which will help people to authenticate the new notes. So, the actual banknotes will look slightly different to the ones you see here today. We’ve still got a lot of work to do together with the team at CBN before the new Brighter Money comes rolling off the presses, but it will result in a product we all can be proud of. Closer to home, there’s been a lot of work going on behind the scenes to make these banknotes much more user-friendly for people with visual impairments. Most importantly, the new notes will continue to be the same sizes as the current ones – meaning visually impaired people can continue to use size to differentiate the denominations. In addition, the note value is shown in larger print and there is greater colour contrast between notes. New Zealand’s Māori culture is also better represented on our new notes. In particular, they incorporate more te reo Māori – notably Aotearoa, the Māori name for New Zealand, and Te Pūtea Matua, the Māori name for the Reserve Bank. As with the current notes, the names of the native birds on the reverse of the notes (hoiho, whio, kārearea, kōkako and mohua) continue to be written in Māori. Tukutuku panels also feature more prominently, weaving important cultural and symbolic meaning into the banknote designs. Designing, developing, printing and rolling out new banknotes involves many partnerships and moving parts. We’ve been working with the New Zealand Police to ensure the designs are counterfeit resilient, and a panel of experts from the national museum, Museum of New Zealand Te Papa Tongarewa, to ensure that the note designs are culturally and scientifically accurate. On a personal note – I have learnt first-hand the importance of design accuracy. Despite having a father as a botanist and a mother as an artist and printmaker, and growing up surrounded by drawings of ferns, I’ve been amazed at just how scientifically accurate the drawing of the silver fern needs to be before the team will let it near our banknotes! As well as the contracts for design and print with CBN, we have signed seven other contracts or supply agreements with six other vendors or component suppliers. To give you an idea of the scope of the changeover exercise – more than 40,000 pieces of cash-handling equipment will need to be calibrated for the new notes. We’ve been consulting with industry on the calibration and testing programme, and at this stage we’re confident the industry will be ready to handle the new notes later next year. We’ll continue to work closely with the industry to ensure the transition is as smooth as possible. Release approach We’re targeting October 2015 for the release of $5 and $10 notes, followed by the $20, $50 and $100s in April 2016. Issuing the new notes and collecting up the old notes is a major logistical exercise for the Reserve Bank. Our note circulation and distribution strategy has been designed in consultation with industry, and it represents a “business-as-usual” approach which should minimise the additional costs of introducing new notes. Such an approach means that the Reserve Bank will issue new banknotes as banks demand them, and we will take back old, surplus or worn banknotes as required. Some of these old series notes will be held in reserve in case we ever need to call on them, but most will be shredded and recycled. BIS central bankers’ speeches The Reserve Bank will withdraw the old series notes from circulation naturally as the banks return them to us. It may take 12–18 months for the new notes to be widely in circulation, but both sets of notes will remain legal tender so people can continue to use them with confidence. Of the approximately 148 million notes in circulation ($4.7 billion) we receive, process and reissue over 140 million banknotes each year. We expect it will cost an extra $7–8 million per annum for the next five years to issue and distribute the new notes, and replace our reserve stocks. In preparation for the changeover, we will be running a public awareness campaign to ensure that New Zealanders can easily identify the new notes and use the new security features. Today we’ve launched a Brightermoney.co.nz website that contains basic information about the notes and the wider upgrade project. We will progressively update it over time, and it will eventually become a one-stop-shop for industry players, retailers and the public to up-skill themselves about the new notes. Upgrading New Zealand’s banknotes is a big project, and it is one we have to get right – especially as demand for cash continues to increase. New Zealand is experiencing consistent growth of notes in circulation of 4.6 percent per year (in terms of note value; 2.5 percent per annum in terms of number of notes). This growth is being mirrored in many other countries too. The Reserve Bank’s project to upgrade New Zealand’s banknotes is about celebrating and honouring our country’s unique heritage and culture. It also involves embracing modern and innovative technologies. We expect Brighter Money to be something all New Zealanders can be proud of. While we’ve still got more work to do on the upgrade project, we’re confident we’ll continue to supply currency that New Zealanders can continue to identify with and trust. BIS central bankers’ speeches
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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to a Reserve Bank of New Zealand and International Journal of Central Banking conference, Wellington, 1 December 2014.
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Graeme Wheeler: Reflections on 25 years of inflation targeting Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to a Reserve Bank of New Zealand and International Journal of Central Banking conference, Wellington, 1 December 2014. * * * It is now 25 years since the Reserve Bank of New Zealand Act came into force. The Act established the operational independence of the Reserve Bank (Bank) in respect of monetary policy, and specified price stability as the single monetary policy objective. A month later, the Minister of Finance and the Governor signed the first Policy Targets Agreement, which specified an annual inflation target of 0 to 2 percent. Through this reform New Zealand became the first country to formally adopt inflation targeting as its monetary policy regime – that is, setting the Reserve Bank the explicit goal of maintaining inflation in a range consistent with overall price stability, giving the Bank the independence to pursue that goal, and holding it – through its Governor in New Zealand’s case – accountable for reaching the price stability objective. In the lead up to this reform there was extensive debate within the Bank over the goals and transmission of monetary policy. Consistent with emerging international thinking, the concept of a long-run Philips Curve trade-off was rejected, as were policy rules around monetary aggregates, and targeting nominal GDP. The literature on policy credibility and time consistency was explored in depth, along with insights from writings on corporate governance. On the design front, considerable effort went into defining price stability, agreeing a target range for inflation (as price level targeting was ruled out), and establishing caveats whereby it might be acceptable for inflation to be outside the target range for short periods1. At the time, these developments were highly controversial. The reforms were viewed by many here and overseas, as ambitious yet desirable. They were in line with efforts being pursued in many countries to rein in high inflation, and were consistent with domestic reforms under way to strengthen public sector performance by holding public agencies accountable for reaching clear contractual objectives. But others questioned whether it was appropriate, or even feasible, to have the Bank pursue price stability as its primary responsibility, and to hold the Governor accountable for an outcome not directly under the Bank’s control. Twenty-five years on, a new generation has grown up with low and stable inflation as the norm. Much the same has occurred elsewhere in the world, with all of the major central banks viewing low inflation as their main objective. But, beginning in the US in 2007, and spreading globally during 2008, we saw the worst financial meltdown since the Great Depression. The Global Financial Crisis (GFC) presented major challenges to policy makers and raised important questions about the conduct and focus of monetary and financial policies. This then is an appropriate time to take stock of our experience with inflation targeting: how have monetary and financial policies moved forward over the last 25 years, including in the aftermath of the GFC; and what issues and challenges lie ahead? I will offer some insights from the past 25 years. For a full discussion of these issues see Grimes, A September 2013 “Inflation Targeting: 25 years’ Experience for the Pioneer”. NZ-UK Link Visiting Professorship Lectures at the Bank of England. BIS central bankers’ speeches i) Inflation targeting has delivered price stability without reducing our long term growth rate The Bank continues to hold firmly to the view that the most important contribution monetary policy can make to promoting efficiency and the long-run growth of incomes, output, and employment is the pursuit of price stability. Price stability preserves the purchasing power of the currency and enables producers and consumers to plan with greater certainty for longer periods, including by responding to relative price changes that would otherwise be obscured during times of high inflation. Price stability also reduces the inflation risk premium in interest rates, facilitates long-term borrowing, lending and contracting, and reduces the need for speculative investments designed to protect against inflation risks. It is uncertainty around the long run price level that generates the costs associated with inflation. Inflation, particularly unexpected inflation, is a hidden tax, affecting most severely those with fixed incomes and holders of cash rather than inflation-protected assets. Price stability cannot by itself resolve concerns about inequality, but it does reduce the insidious toll that inflation exacts on the more vulnerable and less financially sophisticated. Unwinding deeply engrained inflation expectations and transitioning to the target band for inflation involved difficult adjustment costs. This adjustment contributed to the depth of the 1991 recession, which was also due to a marked slowdown in global growth. New Zealand’s annual inflation rate fell from 7.4 percent at the start of 1990 to 2 percent two years later. Real GDP declined by 1.6 percent in 1991 and the unemployment rate increased from just over 7 percent in 1990 to 11 percent at the start of 1992. Nevertheless, New Zealand’s macroeconomic record before and after the Reserve Bank Act came into effect indicates that its price stability objective has been met without any diminution in our economy’s long term growth rate. In the 20 years before the Act, annual real GDP growth averaged 2.2 percent while annual inflation was volatile around an average of 11.4 percent. Since 1990, annual inflation and real GDP growth have averaged 2.3 and 2.6 percent respectively and there has been a marked decline in inflation variability. Figure 1 Inflation and GDP growth (annual) BIS central bankers’ speeches International experience points in the same direction. We see this, for example, in the number of countries that now place the maintenance of low inflation at the core of their overall policy framework2. Even in countries where central banks face multiple statutory objectives, the importance of the price stability goal as a precondition for reaching broader objectives is well accepted. ii) Low and stable inflation expectations increase monetary policy’s effectiveness Like other central banks, the Reserve Bank pursues flexible inflation targeting. This approach has been reflected more explicitly through time in the Policy Targets Agreements – notably by emphasising that, in pursuing its price stability objective, the Bank “should seek to avoid unnecessary instability in output, interest rates and the exchange rate” (included as of the 1999 PTA), and in specifying the inflation target as one to be met “on average over the medium term”(included as of the 2002 PTA.) The effectiveness of monetary policy measures in influencing the short-term path of variables in the real economy is linked closely to policy credibility, which is reflected in the Central Bank’s record in achieving inflation goals and shaping expectations as to future inflation outcomes. Stabilising and anchoring inflation expectations close to the price stability objective provides the Central Bank with greater freedom in addressing inflation shocks and scope to take policy actions that influence output and employment growth in the short term. This means that if economic shocks or a monetary policy action result in inflation moving outside its target range, wage and price setters will expect it to return to its target band within an acceptable period. Without this credibility, such shocks and policy actions would lead mainly to variations in the rate of inflation – as we tended to see in New Zealand in the past. This flexible, medium-term approach to policy was drawn on at the onset of the GFC, when the Bank lowered the Official Cash Rate (OCR) by 575 points in 2008–2009, even though headline inflation was initially well above the target band. By focusing on the medium-term inflation outlook, the policy stance was able to cushion the impact of the crisis. In a similar vein, the Bank “looked through” the October 2010 increase in the Goods and Services Tax rate (from 12.5% to 15%) because it believed it would have limited impact on medium-term inflation expectations. iii) The long term path of the real exchange rate is unaffected by the monetary policy and exchange rate regimes Monetary policy affects consumer and investor behaviour through many channels including: the cost of borrowing; the tolerance for risk taking (which affects asset prices and borrowing capacity); expectations about future inflation; and movements in the exchange rate. In a small open economy like New Zealand, the exchange rate is a particularly important monetary policy transmission mechanism – albeit one that is often stronger and less predictable than we would wish. In recent years, New Zealand and many other economies have experienced an appreciation in their real effective exchange rate, driven in part by spillovers from the stimulative monetary policies pursued by the major central banks3. Despite a recent decline in the nominal rate, the high level of New Zealand’s real effective exchange rate remains unjustified and unsustainable. Jahan states that in 2010, 28 countries were inflation targeting, using the consumer price index as their monetary policy goal. He reports that several other central banks have adopted the main elements of inflation targeting, and many others are moving towards it. Jahan, S.2012 “Inflation Targeting: Holding the Line,” Finance and Development. The real effective (or trade weighted) exchange rate is a better measure of overall competitiveness than the nominal exchange rate. It corrects the nominal effective exchange rate for differences in relative prices (or relative unit labour costs) between New Zealand and its major trading partners. BIS central bankers’ speeches Real exchange rate appreciations produce mixed results. They benefit consumers by lowering inflation in the tradables sector; make it cheaper for firms to import capital goods and new technologies; and can thereby support growth in innovation and productivity. But real appreciation can make life difficult for exporting and import-competing firms, especially if they have little ability to adjust their prices to compensate for exchange rate changes. And exchange rate fluctuations impose significant uncertainties and costs on firms when they are forced to exit and re-enter markets due to changes in their competitiveness. Since the float of the New Zealand dollar in 1985, New Zealand has experienced four major exchange rate cycles, including the current cycle. Each cycle has been characterised by a significantly over-valued exchange rate, followed by an initial correction, then a rapid depreciation. Figure 2 New Zealand’s real effective exchange rate While we recognise the pressures associated with exchange rate overshooting, there is little the Bank can do to sustainably alleviate an overvalued real exchange rate, whether through monetary policy actions or the choice of exchange rate regime. New Zealand has tried various exchange rate regimes over the past 40 years, including a fixed rate, crawling peg, and now a floating rate. We have found, however, that the choice of regime has had little impact on the medium-term level of the real effective exchange rate. Past policy attempts to give the exchange rate more weight in monetary policy decisions tended to generate more interest rate volatility, with little lasting effect on the real exchange rate. Instead, the appropriate policy response often lies elsewhere – for example, through measures to improve domestic saving, boost competiveness, and raise the growth rate of potential output. I will take up these points next. iv) There are limits to what monetary policy can do: supportive structural and fiscal policies are also needed Monetary policy can complement but not substitute for other policies that influence long-term economic performance, including growth, employment, and the real exchange rate. Longterm growth is primarily a function of the economy’s structural characteristics and policies, including the quality and quantity of labour and capital inputs available to the economy, coupled with the productivity and innovation associated with their deployment. Similarly, the BIS central bankers’ speeches level of employment over the long run reflects the characteristics of the labour market, including skill levels, productivity, and institutional practices. Monetary policy cannot substitute for structural adjustment policies, nor can it deliver “desired” long term social equity, or distributional outcomes. Such policy considerations often arise in respect of the housing market. By influencing mortgage rates and the demand for credit, monetary policy can affect the demand for housing and thereby help ease imbalances in the market while housing supply is increased. But monetary policy cannot free up more land constrained by zoning regulations, address procedural and pricing issues around planning consents, or raise productivity in the construction sector. Fiscal policy also plays an important role in the economy’s long-term performance. For example, a constrained fiscal stance can help increase private saving, take pressure off interest rates and the exchange rate; and provide the economy with a buffer against shocks by restraining the build-up of public debt. The stance of fiscal policy also affects inflation expectations and investor judgements as to the degree of coordination among policy makers over macroeconomic policy. New Zealand’s varied economic experiences over the last 40 years illustrate how policy choices interact to either hold back or support long-term growth. The prolonged period of weak growth that the economy experienced in the 1970s and 1980s was partly triggered by terms of trade shocks, and especially the rapid rise in international oil prices in the early 1970s and the decline in commodity export prices. But the inflexibility of the New Zealand economy, including its wage and price setting practices and external trade constraints, hindered its capacity to counter these external pressures. In these circumstances, fiscal and monetary policies were relatively ineffective in preventing the slowdown. Instead, the main macroeconomic legacy was a substantial rise in public debt and double-digit inflation for most of the period from the mid-1970s to late 1980s4. In contrast, reforms pursued since the mid-1980s – directed in particular at macroeconomic stabilisation and wide-ranging market deregulation– increased the capacity of the economy to adjust and grow in response to changing external and domestic conditions. For example, the economy has responded well to the growing importance of East and South Asia in international trade and investment, and in recent years has withstood shocks such as the GFC, the Christchurch earthquakes, drought, and the shifting global demand for our dairy products and other commodities. v) Monetary policy independence requires a high level of accountability and transparency The widespread move towards inflation targeting around the world has been accompanied by reforms to increase central bank independence. To counterbalance their greater independence, central banks faced stronger demands for transparency and accountability – to government, markets, and the public in general – over their policy performance. Transparency has two main dimensions. It enables governments and the public to assess whether the Bank has met its objectives and to hold it to account. Transparency also increases the efficiency and effectiveness of monetary policy by boosting its predictability. Transparency is enhanced through regular publications such as the Monetary Policy Statement and Financial Stability Report, publication of research and policy pieces, and Over 1974–84, gross public debt increased from 40 to close to 60 percent of GDP, and net debt rose from 4½ to 30 percent of GDP. BIS central bankers’ speeches through extensive communications outreach. A recent international survey ranked New Zealand second among 120 central banks for transparency5. Multiple checks and balances are in place to monitor the performance of the Bank and hold the Governor accountable. The Reserve Bank Board meets 9 times a year to monitor and provide oversight on the Bank’s operations and policy decisions, and the Bank’s Governors appear before the Finance and Expenditure Committee 7 times a year. There are numerous other accountability measures: for example, the Board can recommend that the Minister of Finance remove the Governor due to inadequate performance; the Bank must have regard to any policy direction issued by the Minister in relation to government policies; the Bank places considerable weight on communications; and, as part of these, publishes full economic projections, and since 1997, indicates an endogenous interest rate path. The Bank has a broader set of responsibilities than most central banks, and although it has a single decision maker model, a Governing Committee was established in 2013 to make major policy decisions. The committee comprises the four governors, and it reviews all major monetary and financial policy matters falling under the Bank’s responsibilities, including decisions on monetary policy, foreign exchange intervention, liquidity management policy, prudential policy (both micro and macro) and other regulatory policies. The Governor retains a casting vote and, to date, formally retains sole decision making power. Several policy committees, each chaired by a governor, provide advice to the Governing Committee. The decision to establish a Governing Committee follows similar moves by the Bank of Canada, which also has a single decision maker model for monetary policy under its legislation. There is no evidence of the performance of the RBNZ, or other central banks where the Governor is formally accountable for policy decisions, being any weaker or more volatile than that of central banks where accountability rests with a committee. However, the Governing Committee functions very effectively and the case for decision making by committee rather than individuals is premised on the relative strengths afforded by groups and the possible risk-reducing attributes of group decision making. vi) Monetary policy needs to be supported by sound prudential policies With the onset of the GFC the world again witnessed the destructive power of dysfunctional financial markets. Financial sector instability can arise from many sources, including unrealistic expectations as to the sustainability of future yields on financial assets, excessive risk taking by investors, poorly designed macro-economic and regulatory policies, and through regional or global contagion associated with failures in offshore financial systems. The GFC showed how negative externalities can arise when financial institutions take on excessive leverage and do not bear the full cost of their activities. These externalities can have huge economic and policy consequences. For example, more than 6 years after the onset of the GFC most of the advanced economies have policy rates close to zero and the major central banks have undertaken around USD7 trillion of quantitative easing. Although the Federal Reserve has discontinued its bond purchase programme, global quantitative easing in 2015 is expected to be greater than at any time since 2011. Bank bail-outs during the GFC have imposed enormous costs on taxpayers (close to 30% of GDP in the case of Ireland) and at home we saw the large fiscal costs associated with the support for South Canterbury Finance. Sound prudential policies relating to capital adequacy, liquidity management, core funding, disclosure requirements, and stress testing of balance sheets cannot always prevent financial crises and the need for unconventional monetary policy, but they can lower the risk of systemic failure. Dincer N, and B Eichengreen 2014 “Central Bank Transparency and Independence: Updates and New Measures” International Journal of Central Banking. BIS central bankers’ speeches vii) The emergence of macro-prudential policy One of the insights from the GFC was how rapidly instability could develop even though an economy might be growing close to its potential, and be experiencing sound fiscal policy and price stability. An environment of low interest rates, rising leverage, aggressive competition among lending institutions, and a widespread search for yield by investors usually translates quickly into rising asset prices – especially when the global economy is growing at a rapid rate, as was the case during 2003–07. When financial crises occur, asset valuations decline and the lower asset prices may be unable to support the debt that financed their acquisition. We are currently seeing considerable appreciation in asset prices (including fixed income securities, equities, and real estate) in many countries as a result of extensive monetary accommodation and investors aggressively searching for yield. Many central banks and regulatory agencies have turned to macro-prudential policies in an attempt to reduce risks to financial stability, including those associated with an overheated housing market. In view of these concerns, the Reserve Bank introduced macro-prudential policy in the form of speed limits on high loan-to-value ratio (LVR) lending for existing residential property on 1 October 2013. House prices were already significantly overvalued based on historical and international indicators and were accelerating rapidly in Auckland and Christchurch (which account for around half of the national market) and gaining considerable momentum in several other regions. In addition, the ratio of household debt to household disposable income at 156 percent was high, and banks were competing aggressively to provide mortgages to borrowers with small deposits. Macro-prudential policy requires policy makers to be clear about its goals, the duration of the measures, and how such measures might interact with monetary policy. These measures often complement monetary policy when the real and financial cycles are in sync (i.e. with a strong outlook for inflationary pressures and the asset and credit cycle, or the opposite)6. Although LVR speed limits were introduced for financial stability purposes, 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” have reduced consumer price inflation pressures by an amount similar to a 25–50 basis point increase in the OCR. The introduction of LVR restrictions moderated excesses in the housing market, thereby enabling the Bank to delay tightening interest rates, and reducing the incentive for further capital inflows into the New Zealand dollar in search of higher returns. The impact of LVRs will weaken over time and they will be eased when housing pressures moderate and the Bank is confident that there will not be a resurgence in house price inflation. But the Bank cannot prevent or control housing cycles. It can only hope to influence the demand for mortgage lending and the availability of credit, and buy time for the housing supply to increase. In the end, the challenge of rising house prices needs to be met through increases in housing supply. But, this often requires other issues to be addressed such as the approval procedures around land use decisions and building consents, and other matters such as the tax treatment of savings, the taxation of investment in real estate, and ways to increase productivity and reduce costs in the building sector7. See Spencer G, March 2014. ‘Coordination of Monetary Policy and Macro prudential Policy’. Speech delivered to Credit Suisse Asian Investment Conference in Hong Kong. Because investor’s mortgage interest payments are tax deductible and those of an owner occupier are not, investors face a lower cost of capital than owner occupiers. BIS central bankers’ speeches viii) Future challenges Considerable progress has been made in reducing inflation and lowering inflation expectations since the introduction of the RBNZ Act. However, the implementation of monetary policy continues to pose many challenges. These relate to the difficulties in fully understanding economic linkages and assessing the need for and scale of policy change. These policy judgements are particularly sensitive in light of the significance of cross-border financial flows, and their impact on exchange rates and long term interest rates. As with many other central banks, the Reserve Bank developed a quantitative structural model (a dynamic stochastic equilibrium model) for forecasting purposes. However, irrespective of the complexity of their models, all central bank models are at best rudimentary in their capacity to model the financial sector and integrate it into the real economy. Policy judgements involve assessments of the rate of growth of potential output and the output gap, and the extent to which the current policy rate differs from the neutral rate (or the policy rate that is neither stimulatory nor contractionary). Although the “rate of potential output growth’ and “the neutral interest rate” are critical for evaluating the need for policy adjustment, they are model-based concepts and neither are observable. This means that policy makers often need to “feel their way” through an interest rate tightening phase, especially given uncertainties around the lags before policy adjustments affect inflation and output. Global forces can have an enormous influence on inflation and other relative prices such as exchange rates and interest rates. Inflation pressures have been moderated by structural changes in the global economy such as: the absorption of low cost producers into the global trading system; the dramatic reductions in the costs of processing, storing and transmitting information; falling capital goods prices; new forms of competition (e.g. associated with online selling); and cost reductions associated with global supply chains. Productivity growth tends also to be higher among producers serving regional or global markets rather than domestic consumers only. With integrated global capital markets, currency volatility and movements in long-term interest rates can be heavily influenced by cross-border transaction flows around capital movements, trade financing, remittances and price arbitrage, and risk transfer instruments. Empirical studies show changes in long-term interest rates are highly correlated across countries. This means that central banks operating in floating exchange rate regimes, particularly in smaller countries, are significantly constrained in their ability to run independent monetary policies. They can influence short-term rates but cannot set their own long-term rates. Instead, international investor activity has a greater influence over long-term rates.8 We see this at present. The Reserve Bank raised short-term rates during the period March to July 2014 but longer-term mortgage rates have fallen as a result of the decline in long rates in the major economies. This means that macro-prudential policies may need to be called on to help prevent asset price booms and complement monetary policy. But there is still much to be explored around the nature of the interaction of monetary and macro-prudential policies, the costs and benefits of such interventions, and the circumstances where such policy initiatives are likely to be successful. Particularly important in this regard will be considerations as to how best to coordinate monetary policy and macro-prudential policy decisions when economic and financial cycles are out of sync and the policies are not complementary. For excellent discussions on this see Rey H. 2014 “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence”, and Turner P. 2014“The macroeconomics of macro prudential policies” presentation at the Conference on “Effective Macro-prudential Instruments”, The University of Nottingham Centre for Finance, Credit and Macroeconomics. BIS central bankers’ speeches Concluding comments Monetary policy’s focus on price stability has played a vital role in the more stable and responsive economic climate that has emerged in New Zealand over the last 25 years. Under this climate, the economy has been able to take advantage of new trading opportunities in Asia and elsewhere; there has been strong growth in new sectors of activity – including in the information technology area; and the economy has been resilient in the face of severe external and domestic shocks, notably from the GFC and the Christchurch earthquakes. Moreover, the ability of monetary policy to help offset short-term shocks to output and employment has grown as inflation expectations have stabilised at a low level and as policy credibility and transparency have increased. New Zealand is not alone in these experiences: all major central banks now see price stability as their main objective and the most important contribution they can make to stronger long-term economic performance. While much has been achieved in these first 25 years of the Reserve Bank Act, important issues and challenges remain. The global economic environment remains difficult, we have experienced rapid increases in house prices, and we face the longer-term need to improve domestic productivity and savings and rein in the economy’s external imbalances. These global and domestic challenges serve as a reminder of what can and cannot be achieved through monetary policy to counter the sorts of pressures the economy may face in the years ahead. For example, monetary policy is relatively powerless to offset the spillovers that global economic and policy developments can impose on our exchange rate and commodity export prices. But, monetary policy can complement structural and fiscal policies in supporting the economy’s flexibility and adaptability, and help counter short-term economic fluctuations. Moreover, recent financial sector reforms, including the new macro-prudential policy framework, have given the Bank additional tools for containing systemic risks and promoting macroeconomic stability. There is still much to learn in this area, including in the interactions between prudential and monetary policies, but the Reserve Bank is now much better equipped to help build a stronger and more resilient economy than we were prior to 1991. BIS central bankers’ speeches
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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers' Chamber of Commerce, Christchurch, 4 February 2015.
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Graeme Wheeler: The outlook for the New Zealand economy Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers’ Chamber of Commerce, Christchurch, 4 February 2015. * * * Good morning and thank you for the invitation to meet with you. It’s become an annual tradition to begin the New Year’s speaking engagements with the Canterbury Employers’ Chamber of Commerce. The Reserve Bank has been speaking regularly at this event for 22 years, and it’s my great pleasure to join you again. We have often discussed how the Reserve Bank is viewing the state of the economy. As we enter 2015 my colleagues have several questions on their mind. What might we expect from the global economy and how could it affect us, what are the prospects for our economy and the main areas of risk, and how might monetary policy unfold in the future? In essence, the New Zealand economy is performing well in many respects and the prospects are good for continued steady growth, falling unemployment and low inflation. But the risks and uncertainties around the global economy are becoming more complex, and this presents considerable challenges for New Zealand enterprises, including the Reserve Bank. I will discuss the main issues that we are currently focusing on in the Reserve Bank – especially in relation to dairy prices, oil prices, house prices, and the exchange rate, and their implications for monetary policy. Let me turn first to the global outlook. A more risky and uncertain global economy We expect economic growth in New Zealand’s trading partners of around 3 ¾ percent this year – a little higher than last year and slightly above the average growth rate over the past 30 years. Growth in trading partner economies (Annual percentage change) Source: Haver Analytics, RBNZ estimates. BIS central bankers’ speeches While this might sound like business as usual, it’s also a more risky and uncertain environment. Why is this? • First, the divergence in growth between countries has become more marked. This has taken place on two levels: the diminishing contribution of the advanced economies to global growth, and the wide disparities in growth within this group of countries. During 1995 – 2007 the advanced contributed around 60 percent of global growth. Since 2008, this has reversed with the emerging economies accounting for about 70 percent of global growth. Advanced economies are experiencing their weakest recovery in 70 years. The good news is that the US economy finally has momentum and has been expanding at an annualised rate of 4 percent since April 2014, despite the weaker fourth quarter. By contrast, Japan and the 19 economies that form the Euro-area (which, when combined, are similar in size to the US economy), have grown about a third as fast as the US economy over the past 5 years. The disparities in economic performance are particularly great within the euro-area. For example, the unemployment rate in Spain and Greece, at around 25 percent, is at a post war high. On the other hand, Germany’s unemployment rate, at 4.9 percent, is at a post-reunification low. Real per capita GDP remains below 2007 levels in several European economies and in Italy it is back to 1997 levels. • Second, even though the Federal Reserve completed its quantitative easing in October, the expected scale of quantitative easing by the Bank of Japan and the European Central Bank means that total central bank asset purchases in 2015 are likely to be the highest since 2011. Estimated annual change in major central bank balance sheets USD trillion Source: Bloomberg, RBNZ estimates. (Note: estimated increase in balance sheets of the Bank of England, Bank of Japan, ECB and Federal Reserve.) Extensive monetary easing by central banks has stimulated asset prices globally, reduced risk spreads, and until recently, generated extremely low levels of market volatility. For example, the S&P 500 Index ended the year at historic highs and the BIS central bankers’ speeches Nikkei 225 Index increased by 68 percent during the past 2 years. Yields on Japanese and German 10 year government bonds fell to historic lows of 0.20 percent and 0.35 percent respectively (German yields are negative for maturities up to six years). Yields on 10 year sovereign bonds are also at historic lows in France and Spain, most European two-year rates are now negative, and the policy rate at the Bank of England is at its lowest level since the Bank was established in 1694. 10-year sovereign bond yields Source: Reuters. • Third, consumer price inflation is very low and below the monetary policy target bands in several advanced economies. Consumer price inflation has been falling steadily in many advanced economies over the past four years due to the high levels of excess capacity, the global oversupply of capital goods and manufactured products, and falling prices of information technology. But the 58 percent decline in oil prices in US dollars and the 26 percent decline in a wide range of commodity prices since the end of June mean several countries will experience negative headline inflation over the coming year 1. The Bloomberg Commodity Index recently hit its lowest level since August 2002. BIS central bankers’ speeches World oil price (Brent crude) Source: Haver Analytics. • And fourth, financial markets have been surprised by several developments in recent weeks. Although quantitative easing by the ECB had long been anticipated, the planned scale of asset purchases is at the upper end of market expectations. In the last three weeks we have seen the Swiss National Bank abandon its exchange rate cap, interest rate cuts by the Danish Central Bank, the Bank of Canada, and the Reserve Bank of Australia, (and twelve other central banks), a victory by the Syriza Party in Greece, and marked differences in view among commentators around the timing of interest rate increases by the FOMC. What might this mean for financial markets? Almost seven years after the onset of the Global Financial Crisis, central banks are increasingly operating in uncharted waters. Many continue to search intensively for mechanisms to help inflate their economies and return inflation expectations to their desired ranges. And they are doing so at a time when they, like financial markets, are unsure to what extent the weakness in commodity prices and particularly oil prices, reflects the possibility of weaker global growth. Market volatility, as reflected in exchange rate movements, interest rate spreads, and equity returns has increased in recent weeks, and we expect the rise in volatility to be sustained through 2015. There are two main reasons for this. • Yields on long term bonds in many countries are now so low that the primary transmission mechanism for expanded quantitative easing is likely to be through exchange rate adjustment. Exchange rate tensions among countries will increase if market shares are materially affected by countries seeking lower exchange rates. • US dollar liquidity has tightened since the Federal Reserve completed its asset purchases and will continue to do so as US interest rates start to increase. A rerating of credit and liquidity risk is underway and lending spreads are likely to widen for countries and businesses with large international funding needs. In addition, regulatory changes in recent years have reduced the ability of banks to underwrite or intermediate risk. Let me now offer some thoughts on the prospects for our economy. BIS central bankers’ speeches Outlook for the New Zealand economy In many respects, our economy is performing very well. The Bank’s current forecast is for real GDP growth of around 3 percent in 2015, falling unemployment, and continued low inflation. One concern is the balance between the traded and non- traded sectors of the economy, a subject I will return to in commenting on the exchange rate. Over the past three years the economy’s productive capacity has been increasing, primarily through increases in labour force growth and business investment 2. • The labour force has increased by 4.6 percent, labour force participation is around historic highs, and the annual increase in net permanent and long-term migration, currently running at 50,000, is also at an historic high. • The investment share of real GDP has been rising, having increased from 21 percent in 2011 to 24 percent in 2014. Investment has been increasing steadily, particularly commercial and residential construction in Auckland and Christchurch, but also as businesses take advantage of declining capital goods prices and expanding demand. SNA total construction expenditure (Seasonally adjusted, percent of potential output) Source: Statistics New Zealand, RBNZ estimates. Domestic demand growth has maintained its momentum despite the [52] percent decline in whole milk powder prices since February. Prices for meat and wool have provided some offset and farmers continue to show an extraordinary capacity to absorb shocks. Private consumption and construction spending have remained strong, and interest rates remain low by historic standards. Two other factors will affect demand growth. The fall in oil prices should provide an income boost to the economy in the order of 1 percent of GDP, and fiscal consolidation, equivalent to around 0.2 percent of GDP, is expected to take place during the 2015/16 financial year 3. Total factor productivity and labour productivity have been fairly flat over 2012–2014. BIS central bankers’ speeches Risks and uncertainties As with any economic forecasts, there are several risks and uncertainties, but I will comment only on the main ones we think about. These relate to the Chinese economy, and four key prices – dairy prices, oil prices, house prices and the exchange rate. • A significant slowdown in growth in China. China is pivotal in the global trading system as it’s the world’s largest trading nation and the number one or two trading partner for over 100 countries. Australia and China are our main trading partners and account for around 38 percent of our merchandise exports. We are particularly vulnerable to any major downturn in China as China is also Australia’s main trading partner (absorbing 37 percent of Australia’s merchandise exports). There are question marks around developments in China such as: the effects of the current slowdown in demand growth and declining property prices across major cities; the exposure of the shadow banking system to the construction sector; the decline in the working age population; the implications of population aging and stricter environmental standards for future public spending; the impact of the anticorruption campaign; the declining return on capital; and the commitment to the extensive economy-wide reforms that emerged from the Third Plenum. But China is, unquestionably, the greatest global economic success story over the past 35 years – with real GDP growth averaging 10 percent in the 30 years to 2010 and then transitioning to a trend rate of growth of around 7 to 7.5 percent. China’s growth will almost certainly slow to a more moderate trend rate: the issue is when and how successfully it can make this transition. As an increasingly higher wage economy it needs to produce higher value added products in its export mix, become more dependent on internal sources of demand for its economic growth, and balance the expectations of its vast populous for prosperity and other goals. Although this transition will inevitably be accompanied by a range of economic shocks, there are grounds for confidence. China’s 54 percent urbanisation rate is still a long way below the 75–90 percent urbanisation rate seen in most advanced economies. China also has enormous scope for exploiting catch-up technology given its very low ranking in international surveys, it has foreign exchange reserves of almost USD 4 trillion, and it has had 35 years of successful and pragmatic policy making. • Continuation of low dairy prices Dairy exports account for about a third of our merchandise exports. We are the world’s largest exporter of whole milk powder (WMP), China is the largest importer of dairy products, and about 90 percent of China’s WMP imports are from New Zealand. The international auction price for WMP has fallen sharply from a peak of USD 5,200 per metric tonne in October 2013 to USD 2,400 per metric tonne now. Based on Treasury’s December 2014 Economic and Fiscal Update. BIS central bankers’ speeches Dairy sector payout and international auction prices (USD/metric tonne) Source: Global Dairy Trade, Fonterra, USDA, RBNZ estimates (Note: Payout figures in chart include dividends) The drop in global prices is expected to lower dairy farmers’ incomes by NZD 6 billion compared with the 2013/14 season. However, the effect on farmers’ spending in 2015 is likely to be much smaller than that: farmers normally smooth spending through swings in income, and there are signs that last season’s record pay-out was used by many to bolster farm balance sheets. If prices do not recover as expected, there is a risk that spending will slow more sharply in 2016 as additional pressure comes on balance sheets and land prices. Dairy farm debt has trebled since 2003, and around half of the debt is held by 10 percent of the farmers. Agricultural lending by sector BIS central bankers’ speeches Estimates of the medium-term market clearing price for WMP tend to range around USD$3200 – 3800 a metric tonne. How long prices take to recover will depend on how quickly current demand/supply imbalances work through global markets. The imbalances reflect a number of factors. In 2013, global –especially Chinese – dairy inventories rose sharply following the perfect storm of a drought in New Zealand, global production shortages, and in China the rationalisation of small dairy producers and an episode of foot and mouth disease. In 2014, with inventories already high, global supply rebounded strongly in response to good weather and the high prices of the previous year. Adding to downward pressure on prices has been the diversion of trade from the Russian market after the imposition of trade sanctions. With household demand in China remaining solid, global dairy analysts expect Chinese import demand to recover from mid-2015 as inventories are run down, supporting a recovery in prices. A further risk to farm incomes stems from dry weather in several of New Zealand’s dairy regions recently. The recent dry weather has caused Fonterra to reduce its milk volume forecast for the 2014/15 season to 3.3 percent below that collected last season. • Oil Prices A key uncertainty is whether we have moved into a new era in the global oil market. Oil prices have fallen by 58 percent since the end of June 2014 and 35 percent since the end of November 2014. While both demand and supply factors help explain the fall in oil prices since mid-2014, commentators disagree about the exact balance and several influences are commonly cited. We put most weight on supply side explanations. A ramp up in global supply due to increased US oil production, lower than expected supply disruptions in the Middle-East, and, importantly, the OPEC decision to not change supply quotas have all played a role in pushing prices lower. Lower energy demand has also contributed, reflecting in part a weaker growth outlook in emerging Asia and Europe, and also changing demand patterns due to aging populations and ongoing increases in energy efficiency. Lower oil prices should bring several benefits to our economy. If supply-side factors are the major cause and oil prices remain around USD 50 per barrel, the cost of New Zealand’s annual petroleum imports would fall by about NZD 2.3 billion or 1 percent of nominal GDP compared with the price in mid-2014. It would represent a significant boost to household disposable income of around $600 per annum per household. If the main driver is weakening global demand, this would point to ongoing weakness in New Zealand’s export incomes. Lower oil prices pass directly and quickly into New Zealand prices for petrol. For example, in the December quarter petrol prices detracted 0.3 percentage points from headline CPI inflation, and we expect a larger effect in the March quarter. Over following quarters, lower petrol prices pass into lower input costs and lower prices for other firms – e.g. through lower freight costs. An important issue is how significant these indirect impacts of lower fuel prices might be, and to what extent they reduce households’ expectations of future inflation. We will analyse this in the March Monetary Policy Statement. Oil inventory levels are increasing, and supply remains high, so oil prices are unlikely to recover in the near term. BIS central bankers’ speeches • Housing We will be talking more about the housing market over the next few months. Our concern about house price inflation is based on the risk it poses to financial stability and the broader economy. Although it has not been a major factor in recent years, high rates of house price inflation can spill over into stronger spending and pressure on consumer price inflation. And the more that house prices get out of line with historic relativities, the greater the risk of a sharp correction, leading to financial instability. Analysis by the IMF in 2013 indicated that New Zealand, along with Norway, had the greatest deviation in house price to income ratios from its historic trends among several advanced economies. International house price-to-income ratios (deviation from historical average, 2013) Source: IMF Our focus is mainly on the Auckland and Christchurch markets as they represent around half of the national real estate market: they are where the housing shortages are greatest and where market pressures are the most intense. Auckland and Christchurch house prices are 39 and 27 percent respectively above their 2007 levels. House price inflation slowed as the Loan-to-Value ratio restrictions and the rise in mortgage interest rates helped to constrain demand, but appears to be increasing again in Auckland due to rising household incomes, falling interest rates on fixedrate mortgages, strong migration inflows and continued market tightness 4. Annual house price inflation measured on a three-month moving average basis is currently 10.9 and 7.4 percent in Auckland and Christchurch respectively, and 1.1 percent in the rest of New Zealand. We will have a clearer assessment when the February/March REINZ data is available. Data on inventories, days-to-sell and sales all point to continued price pressures. BIS central bankers’ speeches House price inflation (annual, 3-month moving average) Source: REINZ, RBNZ estimates. Resolving the housing shortages is key. In Christchurch this issue is expected to be resolved, albeit with longer delays than originally anticipated. In Auckland, much more needs to be done, especially in creating opportunities for residential construction in Auckland central. Auckland’s housing shortage is estimated to have increased over the past year to between 15,000 and 20,000 dwellings, and the Auckland Council estimates that 10,000 houses a year will be required for the next 3 decades. Residential building permits are currently running at an annual rate of 7,700 – a 70 percent increase over 2012 and twice the 2011 level, but well short of the increase that needs to be sustained over a long period. We will continue to monitor housing developments carefully, and the role that the banking system may be playing in contributing to pricing pressures in the housing market. • Exchange rate The New Zealand dollar exchange rate is at exceptional levels compared with its history. The Trade Weighted Index (TWI) is above its 90th percentile calculated from historical data. Relative to the yen and Euro the exchange rate is above the 90th percentile. It is close to the 90th percentile against the Australian dollar. The upward pressure on the TWI reflects several influences but primarily investors have been attracted by the broad strength of the economy and our higher interest rates. The strong exchange rate has boosted the real disposable income of consumers but been a significant headwind for export firms that are not experiencing high international prices for their products, and for manufacturers and other businesses that compete with foreign imports. Within the overall TWI some important adjustments have occurred. We welcome the 11 percent depreciation of the New Zealand dollar against the US dollar over the BIS central bankers’ speeches past year 5. However, the New Zealand dollar has appreciated by 7 percent and 4 percent respectively against the euro and the yen during this time. This reflects the impact of considerable policy easing by the ECB and Bank of Japan, which has further widened long term interest rate differentials with New Zealand. While the New Zealand dollar has eased recently on a TWI basis, the exchange rate remains unjustified in terms of current economic conditions, particularly export prices, and unsustainable in terms of New Zealand’s long-term economic fundamentals. We believe that, over time, New Zealand’s growth differentials will narrow vis a vis the advanced economies, making the New Zealand dollar more likely to undergo a significant downward adjustment. Reflections on monetary policy So what might this mean for monetary policy going forward? Annual consumer price inflation is currently running at 0.8 percent. The low rate of headline inflation is driven by the high exchange rate, low global inflation, and falling oil prices. Inflation in the tradables sector has been negative for much of the past 2½ years and remains very weak. Our pricing models point to further declines in headline inflation over the coming year as a direct result of this weakness in traded goods prices. Non tradables inflation – the more persistent component of inflation that is driven by domestic demand pressure and government charges – has been running at around 2½ percent. This inflation has come from varied sources including construction, household utilities and property maintenance, and taxes on tobacco and alcohol. CPI inflation and components (annual) Source: Statistics New Zealand, RBNZ estimates. We are currently undertaking analysis for the March MPS, but annual CPI inflation is expected to be below the band and could become negative for a period during 2015 as the The US dollar has appreciated by 15 percent on a TWI basis since June 2014. The New Zealand dollar has depreciated by 16 percent against the US dollar since June 2014. BIS central bankers’ speeches direct and indirect impacts of falling oil prices feed through the economy. We regard the fall in the oil price as a positive supply shock that will temporarily lower headline inflation. We then expect inflation to increase and move back towards the middle of the 1 percent to 3 percent target band, albeit more gradually than previously anticipated. We increased the OCR by 100 basis points in the period March 2014 to July 2014 because consumer price inflation was increasing as the output gap became positive and was expected to increase further. Since July, the OCR has been on hold while we assessed the impact of the policy tightening and the reasons for the lower-than-expected domestic inflation outcomes. The inflation outlook suggests that the OCR could remain at its current level for some time. How long will largely depend on the development of inflation pressures in both the traded and non-traded sector. The former is affected by inflation in our trading partners and movements in our exchange rate; the latter by capacity pressures in the economy and how expectations of future inflation develop in the private sector and affect price and wage setting. In our OCR statement last Thursday we indicated that in the current circumstances we expect to keep the OCR on hold for some time, and that future interest rate adjustments, either up or down, will depend on the emerging flow of economic data. Some commentators have suggested that a cut in interest rates would be appropriate at this stage. With a sizeable positive supply side shock, such as a major fall in the price of oil, a cut in interest rates can be appropriate if there is sufficient capacity to accommodate additional demand. Monetary policy settings could also warrant easing if domestic demand deteriorated and domestic price pressures abated further, perhaps in response to drought or a worsening in external economic circumstances. However, in our current situation there are important considerations why a period of OCR stability is the most prudent option. Commodity price declines reduce headline inflation for a period but do not deliver a sustained decline in inflation. Weak or even negative headline inflation that could be observed in 2015 is not reflective of underlying cost pressure in the non-tradables sector of the economy, and our medium term forecasts and measures of core inflation are well within the target band. New Zealand is the only country among the advanced economies that has had a positive output gap in the past two years, our unemployment rate is low and falling, net inward migration and labour force participation is at record levels, and business and consumer confidence surveys remain strong. In addition, we have already seen some effective easing of credit conditions with declines in fixed-rate mortgages, at a time when we have financial stability concerns about accelerating house prices in Auckland. Similarly, before any decision to raise interest rates, we would need to be confident that capacity utilisation and labour market pressures were generating, or about to generate, a substantial increase in inflation. Concluding comment New Zealand’s economy is in a strong position with continued steady growth, falling unemployment, and inflation at low levels. The drivers of growth look sustainable, particularly in light of the increase in productive capacity that has occurred in recent years. Monetary policy remains in a strong position to continue supporting ongoing low inflationary growth in the New Zealand economy. BIS central bankers’ speeches
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Speech by Mr Geoff Bascand, Deputy Governor and Head of Operations of the Reserve Bank of New Zealand, to the National Asset-Liability Management Europe Conference, London, 12 March 2015.
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Geoff Bascand: Central bank performance, financial management and institutional design Speech by Mr Geoff Bascand, Deputy Governor and Head of Operations of the Reserve Bank of New Zealand, to the National Asset-Liability Management Europe Conference, London, 12 March 2015. * * * Accompanying figures can be found at the end of the speech. Introduction A central bank’s performance needs to be assessed on how well it meets its statutory policy mandate. But policy outcomes are only one measure of performance and institutional credibility. Central banks incur substantial financial risk and are an important part of overall public sector finances. Maintaining the privilege of operational independence requires a record of successful policy outcomes and sound and prudent financial management. Therefore, financial arrangements and performance expectations are important components of overall central bank institutional design. These issues are even more important today. In the Global Financial Crisis (GFC) many governments became guarantors of last resort, and undertook investments that were well beyond their traditional risk habitat. Central banks were asked to do much more – either through pursuing multiple targets, directing credit flows, or by adopting unconventional monetary policies. Some central banks’ balance sheets have expanded enormously (see Figure 1). Central bank capital has been more at risk from some of these activities, and we have seen reinvestment by governments to build capital levels in some central banks. This paper sets out some broad financial and institutional design considerations and illustrates these with reference to the Reserve Bank of New Zealand’s (RBNZ’s) financial arrangements, balance sheet structure, and risk management. It explains their rationale and discusses some avenues we are exploring for future enhancements. Diversity of responsibilities and financial arrangements Monetary policy responsibilities are common to all central banks, albeit with widely varying operational approaches and performance targets. A mandate for financial stability is common, but the form and extent of these responsibilities can vary significantly. Lender-oflast-resort responsibility (emergency liquidity to the banking system) is inherent, but the responsibilities of central banks vis a vis finance ministries, regarding the resolution of institutions in financial difficulties or the provision of broader support to the financial system, vary widely. Prudential policy and oversight may or may not be a function of the central bank. Some central banks manage the country’s foreign reserves and others do not (see Figure 2). The diverse nature of these responsibilities flows through into a wide variety of financial arrangements. Financial risks and results are sensitive to the operational and policy responsibilities of the central bank. Historically, central banks have been considered profitable through their responsibility for money issuance. However, even here there are differing degrees of financial control or independence over seigniorage revenues. Seigniorage revenues have become both more predictable and constrained as a result of price stability goals. At the same time, increased BIS central bankers’ speeches policy mandates and portfolio exposures taken on by central banks can overwhelm these revenue streams through valuation changes1. Does financial performance matter? Generally speaking, the performance of central banks is judged by the public and government in terms of its policy mandate. Financial performance tends to be in the background when the impact and performance of the central bank is debated. But they are not completely separable. Occasional and moderate financial loss is unlikely to seriously impair a central bank’s operations. But sustained loss and diminution of equity, or a very large, even if exceptional, negative income (P&L) impact on public finances is likely to erode the institution’s credibility and policy freedom. Governments are beneficial owners2 of central banks, and conceptually the central bank’s cash flows and the equity investment in the central bank can be consolidated into broader whole-of-government finances. This is the case in New Zealand. Conceptually, a central bank’s net asset position is part of the public sector’s balance sheet, irrespective of whether a consolidated balance sheet is prepared. For example, policy decisions that influence the size of the central bank’s balance sheet (e.g. through accumulation of assets, or commitments in the nature of contingent obligations, such as guarantees to a distressed institution) expose the central bank’s equity to risk, and therefore the value of the government’s ownership interest in the central bank. Sound management of the central bank’s balance sheet is also important to maintain the central bank’s standing and credibility as a regulator and supervisor (if it has these responsibilities). The financial risks of central banks should be managed in a business-like way similar to our expectations of commercial banks. Failure to do so may result in a central bank’s operational discretion being fettered by institutional rules, removal of decision-making authority, or in extreme circumstances by intervention in the management of the central bank. At the same time, there needs to be recognition by all stakeholders of the significant financial risks that central banks take. They manage what are often among the largest foreign asset portfolios in the economy, and can have extensive credit exposure to individual financial intermediaries. I turn now to how the RBNZ seeks to manage these risks. New Zealand’s institutional arrangements are designed to limit the very large financial risk that the central bank could incur from its foreign exchange operations, and also to avoid the bank acquiring substantial contingent liabilities on behalf of the government (“the Crown”) through its liquidity and lender-of-last-resort operations. Nevertheless, there is still material financial risk inherent in the bank’s operation that is managed through the bank’s capital holdings, reserves/asset management, and best-practice risk management. The following sections describe how these arrangements and practices are managed at the RBNZ. RBNZ institutional and financial arrangements The New Zealand institutional framework is designed to balance policy and operational independence with accountability for policy and financial performance. Financial accountability and other expectations (e.g. reporting to Parliament) were strengthened in 1989 when the RBNZ was given greater policy independence. A 2 percentage point rise in the US interest rate on excess reserves would eliminate the Federal Reserve’s profit and equity capital within a year. (using BIS term p7) BIS central bankers’ speeches The Reserve Bank of New Zealand Act 1989 established the central bank as a body corporate whose primary function is to formulate and implement monetary policy for the purposes of achieving and maintaining price stability. The RBNZ (which I will also refer to as “the Bank”) is also mandated to promote the soundness and efficiency of the financial system. The Bank is owned by the Crown and capital is provided by the government, to whom dividends are returned. The Act grants the Bank the right to deal in foreign exchange, issue currency, and act as lender of last resort if it deems it necessary3. These arrangements and powers underpin the Bank’s financial strength and its risk exposure. Income is assured through the authority to invest proceeds from the sale of currency and bank capital, and may be earned (or lost) through trading or investment in debt securities, money market instruments, derivatives, and foreign exchange. New Zealand has a floating exchange rate, and prescribed limits on foreign reserve holdings contain the Crown’s risk exposure. By law, the Minister of Finance sets limits (a range) on the foreign reserve holdings of the Bank, and the Bank then manages them to achieve policy, liquidity and risk-return objectives. A Memorandum of Understanding with the Minister provides further guidance to the Bank on foreign exchange operations4. Even though with a pure floating rate currency, foreign exchange reserves conceptually may not be required, foreign reserves are held in the event that the Bank may be required to intervene in foreign exchange markets, for example where there is disorder in the currency markets or the currency is materially out of line with fair value. Foreign exchange intervention has been infrequent. Liquidity provision to troubled banks and lender of last resort functions are at the discretion of the Bank, including the terms and cost of borrowing. In the GFC, liquidity was provided by the RBNZ at the cost of the Official Cash Rate (OCR) and with interest rates falling, the Bank made positive returns from its lending. Ostensibly, the Bank incurs credit risk in these circumstances, mitigated through collateralisation. However, the major cost of financial stability support does not fall upon the Bank, but instead upon the fiscal authority (the Treasury). Whilst the Bank has responsibility as prudential supervisor to recommend the appropriate action if a financial institution fails, critical decisions on statutory management, capital injections or guarantee schemes are ultimately for the Minister of Finance to make, and would be expected to take the form of fiscal measures. Accountability is accomplished through public and parliamentary reporting requirements and monitoring via the Bank’s Board as agent of the Minister of Finance and on financial matters by the Treasury. The Bank must publish a Statement of Intent on its strategic and performance objectives for the coming three years, and publish an audited Annual Report for the previous year that includes information on policy, operational and financial performance. The SOI and the Annual Report are both tabled in Parliament and subject to the scrutiny of Parliament’s Finance and Expenditure Select Committee. The Bank observes the accounting standards imposed by the External Reporting Board (a statutory body). From this financial year, the Bank is required to apply New Zealand Equivalents to International Public Sector Accounting Standards (NZ-IPSAS) rather than International Financial Reporting Standards (IFRS). The change in financial reporting framework will not have a significant impact on the Bank’s financial reporting, although NZIPSAS and IFRS could diverge over time. The Bank also has responsibilities for the operation of payments and settlements systems that earn income and incur mostly operational risks, with financial risks defrayed in various ways. The MoU establishes that the primary purpose of reserves management and intervention activity is: Extreme disorder in foreign exchange markets – to ensure continued functioning of foreign exchange markets, in rare crisis circumstances. The secondary purpose is: Exchange rate overshooting – to lean against (on a modest scale) extreme cyclical peaks and troughs in the exchange rate that are judged inconsistent with economic fundamentals. BIS central bankers’ speeches The final piece of the RBNZ’s operating framework is the funding agreement. The RBNZ Act requires the Minister of Finance and the Governor to enter into a five-year funding agreement that specifies the amount of the Bank’s income that may be applied in any year towards meeting the operating expenses incurred by the Bank in carrying out its functions. The Funding Agreement must be ratified by Parliament, prior to the commencement of its funding period. The five-year funding agreement is a key mechanism that reinforces operational independence. The Bank does not have to seek an annual funding allocation from Parliament in the same way that government departments do, and its operating budget is not subject to annual variation in net income. On the other hand, the process of negotiating a five-year agreement is intensive in terms of establishing value for money, agreeing on strategic priorities for the Bank, and forecasting future demands on the Bank. Variations to the funding agreement within the five-year window are feasible, for example if the Bank acquires new functions, as it did in the last funding period for supervision of insurance and anti-money laundering. The RBNZ’s capital expenditure is within the discretion of the Bank’s management, but is controlled in part through the moderating impact on depreciation expense from the limit on total operating expenses in the funding agreement. Higher depreciation resulting from higher fixed investment would, therefore, imply lower expenditure on other items, such as personnel. Capital expenditure is also constrained by the Bank’s equity and dividend requirements, which are explained below. Large, unwarranted (and low yielding) capital expenditure could infringe upon these principles. By way of illustration, with the Bank introducing new banknotes in 2015, significant capital expenditure was required that could be financed within the balance sheet from cash and working capital. However, the operating expense incurred from issuing new notes and the obsolescence of the existing series was projected to be greater than could be accommodated within the funding agreement, requiring the Bank to seek the Minister of Finance’s approval for additional expenditure. In practice, the expenses span two different funding agreements, requiring more complex negotiations than normal. New Zealand’s institutional arrangements are now 25 years old and have proven robust to a number of tests, including significant volatility in exchange rates with material foreign exchange gains and losses, negative P&L results, expansion of functions, and changes in government administration. They work well because they are transparent and the Bank works closely with the Treasury to share analysis and information; because they have evolved in response to new mandates (e.g. through MOUs on foreign reserves and foreign exchange intervention, most recently in 2007, and on the level of Crown equity in the Bank, most recently adjusted in 2013); and because of strong performance standards (e.g. benchmarking the Bank’s reporting and capital adequacy against best international practice). How do we assess financial performance? Our financial strategy is primarily guided by our need to fulfil our functions, rather than financial results. This doesn’t mean we are indifferent to expected return or actual financial outcomes, but rather that we generally take a conservative approach to risk to ensure we have the capacity to carry out our statutory functions. Our financial strategy entails considered decisions on asset allocation and investment strategy, with greater weight on risk diversification and liquidity than on return; maintaining adequate capital for the risks we face; and measuring our investment performance against relevant benchmarks. Excluding exceptional circumstances, our objectives for reserves and liquidity management are to manage our financial performance as efficiently as possible, out-perform what other similar portfolios would achieve, and deliver a positive return on equity. BIS central bankers’ speeches Risk management and capital adequacy From the balance sheet perspective, financial risks arise from the Bank’s key investment portfolios of domestic (NZD) securities that support monetary policy operations and foreign reserve assets that can be used to finance market intervention, with the latter much greater in size and variability. Figure 3 depicts a stylised picture of the RBNZ balance sheet. While central bank balance sheets and financial performance can be very volatile, in constructing our balance sheet, we have taken strategic decisions that impose some limits on the potential volatility in reported financial performance. The balance sheet is partially immunised from major foreign exchange risk, and we have taken a conservative approach to credit and interest rate risk in foreign reserve activities. We also manage operational risk closely and are alert to the potential cost of operational errors. Asset holdings and the scale of the RBNZ’s balance sheet are primarily determined by: the amount of foreign reserves RBNZ holds to maintain its foreign exchange (FX) intervention capacity; trading banks demand for liquid assets, primarily to facilitate daily interbank payments; Treasury’s management of the Crown Settlement (cash) Account with the RBNZ; and the public’s demand for notes and coins. Financial risks arise from: • The RBNZ’s open FX position and associated foreign exchange risk, which is mitigated by limits on the position and holdings of a diversified basket of reserve currencies; • Interest rate risk arising from domestic market operations and from foreign reserves management, mitigated through duration and risk limits; • Credit risk arising from foreign currency assets, which is mitigated by investing in high grade debt instruments; and • Credit risk arising from derivative transactions, which is mitigated by holding high quality collateral. Investment policies control market and credit risk exposure through hedging policies, liquidity and investment ratings requirements, and counterparty credit limits. Perhaps the most significant of these is the restriction on unhedged foreign reserves. By agreement with the Minister of Finance, the open FX position is limited to a specified range, a subset of the total foreign reserves limit, with the remaining foreign reserve assets hedged from an FX perspective. New Zealand differs from many countries in this respect. The majority of foreign currency assets are funded through long-term foreign exchange swaps, and therefore hedged from foreign exchange risks or through long-term foreign currency borrowings (which have been originated by the Treasury and on-lent to RBNZ). Reserves and portfolio management is expanded upon below. Credit risk is mitigated by investing foreign assets in high-quality sovereigns, nearsovereigns, and international agencies. In terms of domestic lending, credit risk is mitigated by lending on a collateralised basis with banks providing RBNZ high-quality collateral, and the Bank applying discounts, with daily monitoring of collateral values and collateral calls to ensure the value of collateral is appropriate for the amount lent. The Bank has several sources of interest rate risk that are mostly controlled through risk caps and duration limits. On hedged foreign reserves, some interest rate risk arises through mis-match of duration of assets and liabilities. Reported earnings are subject to volatility from mark-to-market value of long-term liabilities. Another source of interest rate risk is due to changes in New Zealand’s short-term interest rates. Essentially, through FX swaps, RBNZ is investing at short-term interest rates, and variations in these rates from forecast levels impact earnings. The interest rate risk on unhedged foreign reserves is managed through strategic decisions and periodic review of asset allocation (i.e. our duration target for foreign currency BIS central bankers’ speeches reserve portfolios is managed strategically through the business cycle). The RBNZ also incurs interest rate risk from its holdings of government bonds, but in this case there is a corresponding impact within the Treasury, and this has no net impact on the Crown’s overall balance. Capital adequacy Notwithstanding a conservative financial strategy and investment policies that limit financial risk, the Bank’s income and balance sheet remain subject to some volatility. In order to manage this variation in annual financial performance and avoid the credibility risks associated with low levels of equity, the Bank has adopted a policy for holding a prudent level of capital and developed a framework for determining the appropriate level of capital. The RBNZ chooses to hold capital in line with both normal commercial practice and standard public sector arrangements in New Zealand. The Bank is not subject to regulatory capital requirements and thus determines its capital adequacy in agreement with its owner (the government), reflecting its balance sheet and business risks. Having capital is explicit recognition by the government that income from the Bank’s business will be volatile, and a buffer is required to absorb that volatility. It also supports the credibility of the central bank as regulator and supervisor of financial institutions. Assessment of the potential financial consequences of the risks facing the Bank determines the appropriate amount of capital the Bank should hold. Also relevant is the dividend policy. The Act requires the Bank to recommend an annual dividend to be paid in line with the principles set out in the Bank’s annual SOI, and the Minister of Finance decides upon the final dividend figure. The dividend principles state that the Bank should maintain sufficient equity for the financial risks it faces, and that excess equity should be returned to the Crown. They are also tempered by the requirement that unrealised gains on investments should be retained until they are realised in New Zealand dollars. Thus surplus capital is returned as dividends, while the onus is on the Bank to determine the appropriate amount to be held to maintain sound capital adequacy. The Bank consults closely with the Treasury on these matters, with the intention of coming to an agreed recommendation that is submitted to the Minister for decision. If ultimately the Bank disagrees with the Minister’s determination of the appropriate dividend, the Bank is required to publish its recommendation. In 2014, the Bank introduced a new Note to its financial accounts setting out the Bank’s approach to determining required capital, its dividend recommendation, and the basis of calculating the recommended dividend. The Bank’s capital adequacy framework5 evaluates credit, market and operational risks associated with the Bank’s balance sheet, investment policy, and operations. It considers possible correlations between these risks, and establishes the necessary capital to meet the possible loss associated with each of these risks, given its risk likelihood (see Figure 4). As noted, we aim to run capital modelling methods that align with best practice, and can choose models that address our balance sheet risks. As a result we are focused on evolving our modelling of market, credit and operational risk, and are less concerned about liquidity elements (as we invest heavily in high-quality liquid assets). Market risk is the possible loss of value of an asset or liability due to variation in exchange rates, interest rates, credit spreads or basis spreads. Market risk capital is the largest component of the Bank’s required capital. The Bank uses value-at-risk (VaR and stressed This section draws on Fraser (2013) “The Reserve Bank’s capital adequacy framework”. BIS central bankers’ speeches VaR) models to assess market risk capital, and has set the target probability of (total) loss at 1 in 10006. Our models currently capture October 2008 to April 2013 as the stressed period. The second component of required capital is for coverage of credit risk. The Bank evaluates credit risk using the Basel II credit VaR approach, drawing on historical data including consideration of sovereign and bank default probabilities during various periods of stress. Updating to various Basel III credit risk modelling techniques is a future development objective. As noted earlier, if a deep financial crisis arises, the Bank may incur credit risk through its lender-of-last-resort responsibilities, albeit lending is not expected to be contemplated without appropriate collateral arrangements. This risk is not incorporated in our economic capital modelling. The final, minor, element of our capital adequacy requirement is the buffer held for potential operational risks such as misconduct, property loss, systems failures, contractual disputes, etc. Perhaps the largest operational risks arise from the Bank’s responsibilities as the operator of New Zealand’s interbank payment and settlement system, and as the current owner and operator of the securities settlement system. The Bank has a number of controls to minimise the likelihood and impact of operational risks, including a highly developed enterprise risk management framework, formal operational investment policies and limits, an active (internal and external) audit programme, and a proactive problem management (incident reporting) regime. Portfolio management The Bank manages its foreign reserves in two separate pools, an un-hedged pool (exposed to changes in interest rates and FX rates) and a hedged pool. The primary purpose for both pools of reserves is to maintain crisis intervention capability. The un-hedged pool of reserves serves a secondary purpose of allowing the Bank to lean against (on a modest scale) extreme cyclical peaks and troughs in the exchange rate that are judged inconsistent with economic fundamentals. In contrast to most central banks, a large portion (currently 75 percent) of the Bank’s foreign reserves is in the hedged pool (100 percent prior to 2007) which helps to keep the return on foreign reserves relatively stable across time. For foreign reserves to be effective in meeting their purpose they need to be allocated across a diversified set of instruments that will maintain deep liquidity in both normal times and times of crisis or stress. The allocation of hedged and un-hedged reserves is collectively described as the Strategic Asset Allocation (SAA) and is set by the Bank’s Assets and Liabilities Committee. The SAA has a large influence on the Bank’s financial risk profile, given foreign reserves comprise a large part of the Bank’s balance sheet. I will now describe the characteristics of each pool of reserves in more detail and the SAA as it applies to hedged and un-hedged reserves. The first pool of reserves, hedged reserves, is what distinguishes the Bank’s approach to reserves management from most other central banks. The Bank borrows foreign currency (through long-dated cross currency basis swaps and also foreign currency loans from the New Zealand Treasury) to fund investments primarily in US, European, and Japanese sovereign debt markets. Borrowing in foreign currency reduces currency risk, but it generates refinancing risk. The Bank manages this refinancing risk by borrowing for long maturities (up to 15 years) and ensuring that maturities are staggered as much as possible. The duration of borrowing is matched to the duration of investments to reduce interest rate risk (i.e. if borrowing is on a three-month floating basis, investments are matched to mature in three Or more precisely, the confidence level on the potential loss calculations is 99.9 percent. BIS central bankers’ speeches months). This structure allows the Bank to maintain a stable return and low risk profile on its hedged reserves through time, whilst maintaining effective intervention capability. This stable return and low risk profile is in contrast to un-hedged reserves, which I will describe shortly. The SAA for hedged reserves is presented in Figure 5. Allocation weights are defined such that reserve managers can adjust the allocation dynamically (using FX swaps and cross currency basis swaps) to take advantage of favourable (funding) spreads across time. Performance is carefully measured, but it is not compared to a benchmark (given the complexity of benchmarking long-dated borrowing that is transacted on an irregular basis). The second pool, un-hedged reserves, is invested in sovereign debt markets with deep liquidity and across currencies with high FX turnover. These reserves are funded by the Bank’s New Zealand dollar liabilities so are exposed to changes in New Zealand dollar FX rates against each of the six currencies. The position has a high carry cost (due to the high cost of New Zealand dollar funding relative to the return on reserve investments) and returns are volatile given exposure to FX rates (and interest rates to a lesser extent). These reserves are expected to perform well in times of crisis or stress, both in terms of return and providing the most effective intervention capability. Within the limits set by the Minister of Finance, unhedged reserves can be increased or decreased in size allowing the Bank to lean against extreme cyclical peaks and troughs in the exchange rate that are judged inconsistent with economic fundamentals. The SAA for un-hedged reserves is presented in Figure 6. In determining the SAA we first specify the most appropriate reserve markets (country allocations) for unhedged reserves, given that allocations are applied to sovereign debt. Currently, the SAA is limited to six highly traded currencies – a more diversified position than was the case in 2008 (Figure 7). Then we specify the duration target for each of those markets individually. At this time we have constrained the instruments to be 2-year government bonds, the shortest duration assets that meet our liquidity criteria. The process of determining the SAA for un-hedged reserves is about selecting a portfolio that balances diversification and liquidity requirements against return or yield under “normal” market conditions. To ensure that un-hedged reserves are effective in meeting their purpose we constrain the investment universe and the potential allocation outcomes by strict diversification, liquidity and credit minima and maxima. Our allocation minimums and maximums force 70 percent of our allocation, before we optimise the remaining unconstrained 30 percent using a Markowitz model. For example, the Australian dollar allocation is capped due to the correlation of New Zealand and Australian currencies and our inter-related banking sector. While a greater unhedged allocation to Australian assets would provide good yield enhancement, it may not provide a source of effective reserves assets in a crisis due to high and positive correlation aspects. With the aim of keeping our reserves managers active in foreign reserve markets, the Bank allows reserve managers to deviate from the SAA in terms of FX and interest rate position (within limits). We measure their performance in doing so against a custom (un-hedged reserves) benchmark that is set to our SAA. Performance measurement comes in the form of risk-adjusted return measures, namely Information Ratios (reported for trailing two and five year periods) and the Sharpe Ratio. In addition to the hedged and un-hedged reserves described, the Bank has foreign currency investments in BIS Investment Pool funds (ABF and CNY). The CNY investment was entered into in 2014 to diversify the Bank’s foreign reserves and the ABF investments in 2003 and 2005 to promote development of bond markets in the Asia region. We also have US dollar investments (often in USD denominated European quasi government paper) as part of our domestic markets operations. These investments are classified as foreign reserves (according to IMF Official Reserve Asset measurement) but they do not contribute to the Bank’s intervention capability as they are funded by short-dated FX swaps. BIS central bankers’ speeches Despite the potential for improved returns, the Bank has resisted investing in equities or gold, as some central banks do. Our investment policy anticipates a periodic review of the SAA and risk-return decisions may be re-assessed in future. Future developments The Bank is continually seeking ways to enhance its financial management. In recent years, we have improved our economic capital modelling, reviewed and simplified our portfolio management and strategic asset allocation, increased transparency, and strengthened our performance reporting. There is scope to improve further. In particular, with enhancements to our risk modelling and pricing, we can potentially be more dynamic in our allocation decisions and improve expected financial returns without incurring significant additional risk. We are currently assessing our technology base with aspirations to better manage risks and pricing issues related to OTC derivatives (including bringing risk adjusted pricing and risk adjusted performance on to reserve managers desktop on a pre-trade basis). Together, these initiatives should help improve our performance and risk management culture. Maintaining our conservative liquidity profile (driven by intervention capacity) has an opportunity cost, and so we must be at least as good as other market participants at motivating and focusing our portfolio managers – by aligning incentives and trading activity to draw out these fractional returns (versus our benchmark). Concluding thoughts There is a strong link between the financial performance of a central bank and its ongoing ability to fulfil its objectives. The credibility of the institution and its operational freedom are contingent upon prudent financial management. Sound financial management can never ensure the success of a central bank; that will depend on its policy actions and outcomes. But poor financial management can certainly lead to failure. Central banking cannot be expected to produce smooth income growth. Constraints on asset allocation that arise from central bank’s responsibilities and the volatility inherent in foreign exchange and interest rate markets prevent that. Developing a shared understanding with the finance ministry of the financial risks that the central bank and public sector ultimately faces is vital. Central banks must build an open and cooperative relationship with the finance ministry and legislature, seeking clarity around responsibility for quasi-fiscal activities and returns. The RBNZ’s institutional and financial design is driven by our overall purpose of maintaining price stability and promoting the stability and efficiency of the financial system, and is enabled by an operating mandate set out in our empowering legislation. The legislation sets the parameters for what we do, while institutional arrangements with the finance minister prescribe limits within which the Bank manages foreign reserves, thereby limiting the Crown’s fiscal exposure. The Bank has established investment policies and operating frameworks that manage financial risks. Our approach to reserve management, with the bulk of reserves hedged against foreign exchange risk, is a key strategic risk management decision. Thereafter, our SAA modelling and diversification are geared towards balancing risk and return. The Bank’s equity position and dividend policy provide a buffer against adverse events, while also providing performance incentives through their disclosure, external scrutiny and the expectation of maintaining a consistent level of equity over time. There is a strong link between the level of capital invested by the government in the Bank and the level of risk taken. The RBNZ and the government have an open dialogue on these linkages, in terms of risk management, pre-positioning capital and determining dividend recommendations. The Bank believes that with application of industry best practice in risk BIS central bankers’ speeches and position optimisation, it can enhance financial performance while maintaining credibility and reputation through prudent capital and risk management. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Speech by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to the Chamber of Commerce, Rotorua, 15 April 2015.
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Grant Spencer: Action needed to reduce housing imbalances Speech by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to the Chamber of Commerce, Rotorua, 15 April 2015. * 1. * * Introduction The housing market is a key driver of economic and financial developments in New Zealand. It is watched closely by the Reserve Bank as a barometer of domestic demand and an indicator of financial stability. Over the past 12–18 months, Reserve Bank policy has helped to moderate pressures in the housing market. Increases in the OCR totalling 1 percent between March and July 2014 were intended to reduce the degree of monetary policy stimulus to domestic demand while the loan-to-value ratio restrictions (LVRs), introduced in October 2013, were aimed at reducing risk in the financial system. These policies were mutually supportive of each other and slowed the rate of growth of house prices during the first half of 2014, despite strong net inward migration and the ongoing shortage of housing. Since late 2014, housing market imbalances have become more accentuated, particularly in Auckland where the supply shortage is greatest. This is of concern to the Reserve Bank as it poses a threat to financial and economic stability. House prices as multiples of income and rents are already near record levels and further increases will accentuate the risk of a sharp price correction once demand and supply come in to closer balance. Today I will discuss these housing market imbalances: their causes and the risks they present. I will also touch on policies that could assist in reducing the current imbalances. But first, let’s recap housing market developments over the past year. 2. Housing pressures moderated in 2014 House price inflation nationwide accelerated from mid-2012 and peaked in the third quarter of 2013, supported by rapid growth in high-LVR lending by the banks and record low mortgage interest rates. The Reserve Bank became concerned that strong house price inflation and rapid growth in high-risk lending was increasing the risk of a sharp housing market correction at the same time that bank balance sheets were becoming more vulnerable. In response, the Reserve Bank imposed a limit on high-LVR lending effective from 1 October 2013. These restrictions, the subsequent tightening of monetary policy and election uncertainty helped to slow housing demand and ease house price inflation through to September 2014. House sales slowed markedly in the immediate aftermath of LVR restrictions, with all regions trending down except Christchurch. The slowing was evident for all buyer types, although there were shifts in the composition of sales. There was generally a larger fall in sales to firsthome buyers and existing owner occupiers. Sales to investors remained relatively stable while “new to market” and “returning to market” sales increased – reflecting purchases by new migrants and returning New Zealanders. BIS central bankers’ speeches Figure 2.1: Monthly house sales by buyer type Source: Corelogic NZ, REINZ, RBNZ estimates. House price inflation slowed from an annual rate of 9.3 percent in September 2013 to 4.9 percent in September 2014. The slowing in house price inflation was most evident in Auckland, with a more muted effect elsewhere. Reserve Bank research suggests that, nationally, house price inflation would have been 3–5 percent higher without the LVR policy. Figure 2.2: Annual house price inflation (three-month moving average) Source: REINZ, RBNZ estimates. BIS central bankers’ speeches Actual and anticipated increases in the OCR from March to July 2014 increased the cost of mortgage credit and contributed to a slowing in mortgage commitments from $4.5b per month at their peak to $4.2b in September 2014. 1 The share of lending at high LVRs fell from over 30 percent in mid-2013, to a low point of 3.6 percent in March 2014. From late 2014, however, there has been a pick-up in new mortgage lending with around half of new mortgage commitments at LVRs between 70–80 percent. The increase in new lending has not led to significant growth in bank balance sheets, due to many households taking advantage of low interest rates to accelerate their repayment of principal. Figure 2.4: New housing loan approvals, new commitments and credit growth Source: RBNZ. 3. New housing market pressures emerging Since September, coincident with the upturn in new mortgage lending, housing market turnover has increased sharply (figure 3.1). Some of this reflects the normal spring pick-up, and possibly a bounce back from pre-election uncertainty. Nonetheless, the data point to a strong resurgence in housing demand, particularly in Auckland. Seasonally adjusted, and measured on a three-month moving average basis. BIS central bankers’ speeches Figure 3.1: Monthly house sales (Seasonally adjusted) Source: REINZ, RBNZ estimates. New listings onto the market have not kept pace with the increase in house sales, causing inventory levels to decline from already low levels and adding to house price pressures. This is true for most regions, but is most pronounced in Auckland where current inventory would be exhausted in only 12 weeks at the current level of sales. Consistent with this, annual house price inflation in Auckland has been increasing, reaching nearly 17 percent in March. House price inflation has remained more moderate elsewhere, although price levels remain stretched in most regions. What has caused this resurgence in the housing market? The answer is not straightforward. Several demand and supply factors are at play. Population growth over the past year has contributed to increased demand for housing. Net permanent and long-term (PLT) migration inflows reached a record rate of over 55,000 in the year to February 2015– boosting the population by over 1 percent. While strong growth in migrant arrivals has pushed up the net immigration numbers, there has also been a significant slowdown in the number of New Zealanders leaving the country, currently at its lowest level for over a decade. It is estimated that over half of the net migrant inflow have settled in Auckland. This is providing a major boost to Auckland’s population, which grew by nearly 34,000 people in the year to June 2014 (figure 3.2). Although consent issuance of new dwellings in Auckland has continued to increase, reaching 7,700 in the year to February 2015, this has been insufficient to match the surge in population, let alone cut into Auckland’s housing shortage. BIS central bankers’ speeches Figure 3.2: Auckland annual net population change (rolling quarterly totals) Source: Statistics New Zealand, RBNZ estimates. People-per-dwelling is a useful metric for looking at the physical balance between housing supply and demand. Over time, people-per-dwelling should slowly trend down as the population ages, families shrink and people become wealthier. This means that the number of dwellings required will tend to increase at a faster rate than the population. If residential building is insufficient to keep up with population growth, then the number of people-perdwelling will trend up rather than down. In Auckland, people-per-dwelling has been increasing since 2008 while it has continued to trend down elsewhere in New Zealand (figure 3.3). The sharp rise in people-per-dwelling in Auckland in 2014 highlights that home building remains well below the level required to accommodate the rising population. We estimate the shortage of houses in Auckland has increased over the past year to between 15,000 and 20,000 houses. 2 This is based on an assumed trend of 2.9 people-per-dwelling. If the assumed trend for people-per-dwelling in Auckland was downward sloping, as we have seen in the rest of New Zealand, then the estimated shortfall of houses would be larger. BIS central bankers’ speeches Figure 3.3 People per dwelling Source: Statistics New Zealand, RBNZ estimates. An increase in investor demand in Auckland can be inferred from various indicators: we have seen a continued decline in the rate of home ownership, which reached a record low of 61.5 percent in 2013; there has been an increase in the share of house sales going to investors since October 2013 – from 33.8 percent in September 2013 to 37.4 percent in February 2015; and rental inflation has remained considerably below house price inflation. Average rental yields in Auckland have fallen from 4.6 percent in 2010 to 3.7 percent in 2014. Residential investors have continued to expand their interest in housing as rental returns have declined. This points to an excess demand for home ownership over and above the simple excess demand for accommodation. 4. New housing supply in Auckland is falling short of expectations Turning to the other side of the equation, it is clear that housing supply constraints are persisting. National residential construction activity has been increasing steadily for the past few years and, in constant prices, is now in line with the previous peak of 2004. Much of the increase has been due to earthquake repairs and rebuilds in Canterbury, which are now beginning to ease the accommodation shortage that has existed since the earthquakes. We have seen a substantial easing in Christchurch rental inflation over the past year. About 10,000 rebuilds or major repairs are yet to be completed 3 and residential building in Canterbury is expected to remain around its current high levels for the next couple of years. After that, however, we are likely to see a gradual tailing off of residential construction in Canterbury. Based on data from the Insurance Council of New Zealand. BIS central bankers’ speeches Figure 4.1: Annual new dwelling consent issuance by region Source: Statistics New Zealand. Auckland’s outlook is very different. Residential construction will need to continue at a high pace for many years. At current rates of building, it appears the shortage of housing is getting worse, not better. Auckland Council estimate that over 10,000 new homes each year will be needed to satisfy future population growth. 4 In essence, it could take many years to work off the current housing shortage. The Auckland Accord is a step in the right direction, and improves the outlook for further growth in housing supply. However, while the target for the first year (9,000 dwelling and section consents) was comfortably met, targets are more challenging in the next two years. The target for the final year to September 2016 is an ambitious 17,000 new dwelling and section consents. 5 To help facilitate faster growth in home building, 80 Special Housing Areas (SHAs) have been established. These include brownfield and greenfield areas with an estimated capacity for 43,000 dwellings over a period of 10 years. So far, SHAs have yielded few completed dwellings or “shovel-ready” sections. However, 11,000 new dwelling or section consents in SHAs are expected by September 2016. While the Accord is helping, significant factors continue to hold back new housing supply in Auckland. These include a limited supply of land for housing, a restrictive urban planning regime, public concerns over densification, uncertainty around future infrastructure development, and a fragmented and inefficient residential building industry. These factors were discussed in the Productivity Commission’s 2012 inquiry into housing affordability. Although many of the constraints apply nationally, they are more binding in Auckland due to the stronger pressures from population growth. An improved supply of useable land is essential. The land component of housing costs in New Zealand has grown considerably over the past 20 years with land now accounting for more than 60 percent of the total cost of a new dwelling in Auckland, and around 50 percent Auckland Council (2013). The split between the dwelling and section consents is expected to be around 10,000 new dwelling consents and 7,000 new section consents. BIS central bankers’ speeches in the rest of the country. 6 The Auckland Plan establishes a Rural Urban Boundary that provides scope for urban growth outside of the old Municipal Urban Limit. However, land blocks with disparate ownership and speculative investment in “land-banking” continue to tie up large areas of buildable land. Urban planning rules are complex and often restrictive. Planning must take account of the Resource Management Act, Local Government Act and Land Transport Act. Planning requirements can add significantly to the cost of a new dwelling and/or restrict the volume of new supply. A recent study 7 estimates the cost of planning regulatory requirements to be between $32,500 and $60,000 per dwelling in a subdivision and between $65,000 and $110,000 for an apartment. The relatively high cost impost for apartments is due to a raft of height, area and other planning restrictions that appear to have contributed to the relatively low number of apartment consents in Auckland over recent years (fig.4.2). Auckland also has a relatively low proportion of apartments compared to Sydney: 25 percent versus 39 percent of total dwellings. While apartment construction has picked up recently, the evidence suggests that more active encouragement of apartment development could be an effective means of easing the housing supply constraint in Auckland. Figure 4.2: Annual consent issuance in Auckland Source: Statistics New Zealand. Providing the infrastructure for new developments is a slow and complex process, in part due to multiple service providers with often conflicting incentives and funding arrangements. 8 Better collaboration and incentives across infrastructure providers is required for more efficient infrastructure planning and a better delivery of services. Productivity Commission (2014). Grimes and Mitchell (2015). In Auckland for example, the Auckland City Council, Watercare, Vector, NZTA and developers themselves are all involved in the provision of basic infrastructure. BIS central bankers’ speeches Overall delays and uncertainties throughout the development process can have significant implications for the total cost of development and ultimately whether proposed developments proceed. The planning approval process to convert designated SHA land to “shovel-ready” sections requires multiple approvals 9 and is estimated by the Council to typically take over two years to complete in greenfield situations. For existing residential zoned (brownfield) areas, the time to achieve all approvals for multi-unit dwellings is in excess of a year. 10 Further, capacity constraints in the construction sector could constrain further increases in housing construction in Auckland over the next couple of years. The needed pick-up in Auckland housing supply comes on top of the significant ongoing demands of the Canterbury rebuild, which are not expected to ease for at least two years. Also, employment in the construction sector now accounts for 6 percent of the working age population, similar to that seen in the mid-2000s property boom. Over the past year, vacancies in the construction industry have increased and construction firms have been finding it increasingly difficult to find skilled labour. Construction cost inflation in Auckland increased to 7 percent in the year to December 2014 (figure 4.3), highlighting the increasing resource pressure. Figure 4.3: Annual construction cost inflation by region Source: Statistics New Zealand. 5. Housing pressures are a threat to stability Rising house price inflation, particularly in Auckland, represents a risk to financial and economic stability. Irrespective of the mix of demand and supply-based factors, the longer excess demand persists, the further prices will depart from their underlying fundamental determinants and the greater the potential for a disruptive correction. New Zealand’s house prices, when compared to incomes or rents, are high on an international basis and very high when compared to New Zealand’s historic trend. Figure 5.1 shows that New Zealand’s house price-to-income ratio in 2013 was 30 percent above its historical average. Only Norway had a higher historical deviation. Including resource consent for a development master plan, applications for plan variations, engineering approvals for civil works and associated resource consents, survey plan approvals, and the approval of individual land titles. Auckland Council (2014). BIS central bankers’ speeches Figure 5.1: International house price-to-income ratios (Deviation from historical average, 2013) Source: OECD Auckland house prices are particularly stretched, having increased by three times since the start of 2002. This stretch is emphasised by the recent Demographia affordability survey that shows Auckland to be the ninth least affordable city out of 86 major metropolitan areas (population over 1 million) 11. In September 2014, the median Auckland house sale price was 8.2 times the median household income, compared to a survey median ratio of 3.8. Nationally, New Zealand’s median house price-to-income ratio is about 5.0. New Zealand is one of the few advanced economies that has not had a major house price correction in the past 45 years. During this period, most of the advanced economies have had at least one significant house price correction that has created difficult challenges for financial and economic stability. Several countries saw 20 percent plus house price declines in the GFC, including the US, Ireland, Spain, Greece and the Netherlands. A correction in house prices in New Zealand could be prompted by a range of potential shocks to the economy or financial system. Global interest rates are at record low levels and large mortgages have been “affordable” at these rates. As global interest rates return to more normal levels, many mortgage borrowers could come under pressure as they are required to refinance at higher rates. Alternatively, a downturn in the global economy and financial markets could lead to a drop in national income and rising unemployment, at the same time as foreign creditors are requiring an increase in the interest rate premium charged to New Zealand borrowers. In such circumstances, we could see the cost of credit rising at the same time that incomes and employment were under pressure. Such stresses would be expected to cause housing demand to ease. If this occurred when new supply was coming through in volume, then prices would begin to fall. A withdrawal of speculative interest in residential property or decline in migration inflows would accentuate any such fall. 11th Annual Demographia International Housing Affordability Survey, Jan 2015. BIS central bankers’ speeches With 60 percent of its lending in residential mortgages, the New Zealand banking system could be put under severe pressure in such scenarios. The resulting contraction in credit would amplify the impact of an adverse external shock to the domestic economy and financial system, making it more difficult to avoid a severe downturn. 6. What can policy do? Given the large physical shortage of housing in Auckland, and the prospect that population growth will outstrip new supply for some time yet, a primary issue to address is the slow supply response in Auckland. While progress has been made expanding the supply of land available for residential development and improving the resource consent process via the Auckland Accord, considerable scope exists to streamline the multiple approval processes required to complete a residential development. This could include: introducing greater flexibility and efficiency into urban planning processes; a requirement for transparent costbenefit analyses of urban planning regulations; and a more integrated approach to the planning and funding of infrastructure development. The Government’s review of the Resource Management Act (RMA) has the potential to substantially improve the planning and resource consenting processes. Also, the Productivity Commission is currently exploring ways to improve the policies, strategies and processes that underpin New Zealand’s housing development capacity, including the provision and funding of infrastructure. 12 Other measures to facilitate residential development might include a review of taxes and other incentives affecting land banking. Measures to increase productivity in the construction sector would also help facilitate larger-scale and more affordable housing development. While the housing supply constraint must be the main policy priority, it is clear that, under any scenario, it will take a number of years to eliminate the housing shortage. In the meantime, it is important that population-based demand pressures are not exacerbated by expanding investor and credit-based demand that simply amplifies the price effects of the physical shortage. Increases in house prices above their already high levels are unlikely to bring forth further supply; rather they make houses even less affordable and add to financial system risk. An important policy question on the demand side is whether measures could be taken to stem the high net inflow of migrants. However, there are real risks in trying to manage the migration cycle. Any measures taken will have long lags and therefore run the risk of reducing inflows just when the cycle is already turning down. Further, any such measures can only operate on gross inflows of non-residents. Policy cannot influence the volume of gross outflows or returning New Zealanders. The tax treatment of housing is a major factor with potential to influence the demand/supply imbalance in the housing market. As reflected in our submission to the Productivity Commission’s inquiry on housing affordability, housing is the most tax-preferred form of investment, particularly when it is highly leveraged. Investors are often setting the marginal market prices that are then applied to the full housing stock within a regional market. Indicators point to an increasing presence of investors in the Auckland market and this trend is no doubt being reinforced by the expectation of high rates of return based on untaxed capital gains. While there are difficult issues and trade-offs to consider in this area, the Reserve Bank would like to see fresh consideration of possible policy measures to address the tax-preferred status of housing, especially investor related housing. The inquiry is also looking into ways to improve governance, transparency and accountability of the planning system, and the involvement and engagement with the community. A draft report is due in June 2015. BIS central bankers’ speeches Mortgage credit growth is facilitating the renewed expansion in housing demand. While net growth in mortgage credit remains moderate, the flow of new mortgage lending has increased sharply since October 2014. Banks are competing aggressively by reducing margins on fixed mortgages and new mortgage commitments are growing at a 20 percent annual rate. We estimate that at least half of this new credit is going to the Auckland market. The Bank considers using macro-prudential policy in the housing area on two potential grounds: 1) to counter new credit-based demand and price pressures that are increasing financial system risks; and/or 2) to increase the resilience of the banking system to a potential housing downturn. The existing LVR restrictions on mortgage lending helped to moderate the market for a year and they continue to constrain risk in the banks’ balance sheets. With the current overheated housing market in Auckland, it would not make sense to remove these restrictions in the near term. To do so would invite a further surge in credit-based demand for housing. When conditions warrant, however, it will be appropriate to ease or modify the incidence of the LVR policy. The Bank is currently consulting on a new asset class for residential investment mortgages that will attract a higher risk weighting than owner-occupier mortgages. This is consistent with the international evidence showing larger loan losses for investor loans than for loans to owner occupiers during periods of housing market stress. A new asset class will see a greater consistency of treatment for investor mortgages across the banks and ensure that investor loans have capital backing consistent with their higher risk. A well-defined asset class would also facilitate the introduction of macro-prudential policy and the Bank is currently reviewing some options. Of course the Reserve Bank’s most powerful policy tool is the OCR. However, while the pressures in the housing market would suggest a tightening of interest rates, the primary objective of monetary policy, CPI inflation, is projected to remain below its target range for some time. Thus it would be inappropriate for monetary policy to lend assistance to the Bank’s financial stability objective at this time. This presents something of a policy conundrum, resulting from the current very unusual international environment. Persistently low global inflation and recent declines in commodity prices are acting to soften CPI inflation in New Zealand. At the same time, the low global inflation is causing central banks around the world to hold interest rates at historically low levels and, in the case of Europe and Japan, to adopt large quantitative easing programmes. The easy monetary policies are in turn contributing to upward pressure on global asset prices, including real estate, and increasing risks to financial stability. 7. Conclusion After moderating in the period following the introduction of the LVR restrictions, housing market pressures re-emerged in the fourth quarter of 2014. The market imbalance is considerably greater in Auckland than in other parts of the country, with house price inflation now at 17 percent per annum and median price-to-income multiples over 7. The increasing degree of stretch in prices means that an eventual market correction is increasingly likely to be disruptive to financial stability and the economy. The causes of the housing market imbalance are primarily linked to the rapidly expanding migrant population and a relatively slow housing supply response. The latter has been a longer-term issue and is due to a complex range of factors including: a scarcity of suitable land; restrictive planning regulations; a lack of coordination in infrastructure planning; and a fragmented and inefficient building industry. There have also been bottlenecks in the construction sector with both Christchurch and Auckland competing for resources. An BIS central bankers’ speeches acceleration in new credit commitments since September has facilitated the growth of house sales and prices over this period. Supply-side policy solutions are unlikely to yield quick results. The proposed RMA reforms could significantly improve the planning process but could take years to be felt in new supply. Greenfield developments will inherently be slow to deliver new stock. A release of resources from the Christchurch rebuild is likely to be a couple of years away. The best prospect for substantially increasing the supply of dwellings over the next one to two years appears to be in apartment development. The Government and the Auckland Council might therefore consider focussing their efforts on streamlining the approvals process and increasing the designated areas for high-density residential development. On the demand side, we consider that greater attention needs to be given to issues relating to the tax treatment of investor housing. There are practical difficulties in using migration policies to influence the housing cycle. Monetary policy, which in past cycles has been supportive of financial stability objectives, cannot be used currently to dampen housing demand. This cycle is unusual in that CPI inflation is staying very low – requiring interest rates to also stay low – even though rising asset prices are raising financial stability concerns. Macro-prudential policy is a potential instrument to help restrain credit-based demand pressures and/or improve the resilience of bank balance sheets in the face of a potential housing downturn. The LVR restrictions had a significant moderating effect in 2014 and are still acting to improve the resilience of bank balance sheets. They will be removed or modified as market conditions allow. Other macro-prudential options are being assessed, including in relation to investor lending. However, such tools are not a panacea –their impact is inevitably smaller than the main drivers of the current housing market imbalance. References Auckland Council (2013) ‘Shaping a business friendly city. The Proposed Auckland Unitary Plan’ December 2013. Auckland Council (2014) ‘Housing Delivery Cycle’ prepared by the Housing Project Office, December 2014. Grimes, A and I Mitchell (2015) ‘Impacts of Planning Rules, Regulations, Uncertainty and Delay on Residential Property Development’ Motu Working Paper 15–02, Motu Economic and Public Policy Research, Wellington. Ministry of Business, Innovation and Employment (2014) ‘Auckland Housing Accord, Monitoring Report #4’ http://www.mbie.govt.nz/what-we-do/housing/pdf-document-library/Auckland-HousingAccord-Monitoring-report-4.pdf, accessed 19 January 2015. Ministry of Business, Innovation and Employment (2015) ‘Auckland Housing Accord, Monitoring Report #5’ http://www.mbie.govt.nz/what-we-do/housing/pdf-document-library/auckland-housing-accordmonitoring-report-5.pdf, accessed 10 March 2015. Productivity Commission (2012), ‘The housing affordability inquiry’ New Zealand Productivity Commission Final Report, March 2012. Productivity Commission (2014), ‘Using land for housing’ New Zealand Productivity Commission Issues paper, November 2014. Watson, E (2013) ‘A closer look at some of the supply and demand factors influencing residential property markets’ Reserve Bank of New Zealand Analytical Note, 2013/11. BIS central bankers’ speeches
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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to ExportNZ, Tauranga, 29 July 2015.
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Graeme Wheeler: Some thoughts on the inflation outlook and monetary policy Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to ExportNZ, Tauranga, 29 July 2015. * * * Introduction I would like to discuss New Zealand’s recent inflation outcomes, the main factors accounting for them, and the outlook for monetary policy in ensuring that future average inflation over the medium term is near the 2 percent midpoint of the target band. Since the former issues have been covered extensively in our recent Monetary Policy Statements, speeches and analytical papers, the main focus will be on our current policy thinking. 1 New Zealand is far from alone in experiencing low inflation. Across the 30 or so economies (mainly advanced economies) whose central banks pursue inflation targeting, headline and underlying inflation have commonly been below specified goals. There are several reasons for this: the level of excess capacity in product and factor markets in several economies remains high; wage outcomes have been subdued, even in countries with low unemployment; measures of inflation expectations have declined; and many commodity prices are appreciably lower than a year ago. In most advanced economies, policy interest rates are at historic lows. In four advanced economies, they are negative 2. Recent inflation performance Over the past two years annual CPI inflation in New Zealand has been in the lower half of the 1 to 3 percent target band, except for the period since the December quarter 2014, when the fall in oil prices brought CPI inflation to very low levels. Low headline inflation during this period has been primarily due to negative inflation in the tradables sector (figure 1), which accounts for around half of the CPI regime. Figure 1: Contribution to headline CPI inflation (annual, deviation from 1992q1 to 2015q2 average) Source: Statistics New Zealand, RBNZ estimates See, for example, McDermott (2015), ‘The dragon slain? Near-zero inflation in New Zealand’, speech on 23 April 2015, and Richardson (2015), ‘Can global economic conditions explain low New Zealand inflation?’, Analytical Note 2015/3. This treats the euro area as one economy. If each economy were treated individually, 22 economies would have negative policy rates. BIS central bankers’ speeches Annual CPI inflation is currently 1.7 percentage points below the mid-point of the target range and 2.1 percentage points below its long-term average. Of the latter, 1.6 percentage points are accounted for by below-average tradables inflation, with the remaining 0.5 percentage points due to weaker non-tradables inflation. Tradables inflation has been low for several reasons. The global oversupply of commodities and manufactured goods, and the high level of excess capacity in the advanced economies, have kept cost and price pressures among our trading partners contained. 3 The steady appreciation in New Zealand’s real effective exchange rate since 2011 (until recently) has been a major factor behind periods of negative tradables inflation over the past three years. And, more recently, the 52 percent decline in oil prices since June 2014 (figure 2) resulted in negative quarterly inflation in the December 2014 and March 2015 quarters. Figure 2: Oil and the domestic petrol price Source: Reuters, Ministry of Business, Innovation, and Employment Non-tradables inflation has been relatively low and stable, averaging around 2.5 percent since the beginning of 2012. Low non-tradables inflation largely reflects the impact of strong factor accumulation that has expanded capacity, and enabled strong demand growth to be met without increased inflation pressures. This is particularly the case in the labour market, where record levels of net immigration and historically high labour force participation, along with natural increase, have expanded the labour supply by around 3 percent over the past year (figure 3), and enabled a strong rate of employment growth to be absorbed without any acceleration in wage inflation. The continuous commodity index is currently about 40 percent below its 2011 peak, and represents the second largest commodity bear market in 50 years (only in the immediate aftermath of the global financial crisis was there a larger decline). BIS central bankers’ speeches Figure 3: Annual labour force growth Source: Statistics New Zealand Non-tradables inflation has been about ½ of a percentage point weaker on an annual basis than the Bank’s modelling estimates would suggest is normal for this phase of the economic cycle, even allowing for the stronger growth in economic capacity. 4 This underestimate of inflation has also occurred in other countries and could be due to several factors. For example, inflation expectations may be weaker than survey data suggests, the tradables component of non-tradable products and services may be higher than previously thought, or online commerce may be increasing competition and squeezing margins in non-traded sectors, such as retail. Under the Bank’s flexible inflation targeting framework, the Policy Targets Agreement (PTA) specifically recognises that annual CPI inflation will fluctuate around the medium-term trend due to factors such as exceptional movements in commodity prices – like those experienced since mid-2014. Measures of core inflation have recently been higher than headline inflation. One of our preferred measures, from the sectoral factor model, was 1.3 percent in 2015 Q2 – within the Bank’s target range – and has averaged 1.4 percent on an annual basis since the beginning of 2012. 5 Outlook for inflation The Bank expects annual CPI inflation to be close to the midpoint of the 1 to 3 percent target range by the first half of 2016. The rise in headline inflation is expected to mainly come through higher tradables inflation, due to the 14 percent decline in the trade-weighted exchange rate since mid-April and as the decline in oil prices drops out of the annual figure. There are, however, several risks and uncertainties around the inflation outlook. These include the future path of the exchange rate, which will be influenced by future commodity The core measure of non tradables inflation is about 0.5 percent weaker in annual terms than suggested by its past relationship with the output gap and inflation expectations. The average absolute error of the model is 0.3 percentage points. The Bank uses several measures to estimate core inflation but puts greatest weight on a sectoral factor model. This model weights those components of the CPI that most closely reflect the general trend in CPI inflation and down-weights those that do not. The weightings evolve over time as the volatility of each component changes. BIS central bankers’ speeches prices, and the speed with which the recent depreciation feeds through to higher inflation. Our modelling suggests that a 1 percent exchange rate depreciation boosts annual CPI inflation, albeit with a considerable lag, by around 0.1 percentage points. The speed and magnitude of this adjustment over the coming quarters, and its impact on competitiveness, will depend on the currency hedging practices of exporters and the pricing power of businesses to pass on higher import costs. Net migration continues to be strong and, although this exacerbates housing pressures in some regions, it also acts to moderate wage outcomes. The size of the output gap will also influence the path of non-tradables inflation, as will the extent to which subdued price setting behaviour has some structural elements to it, and continues to persist. Economic and policy backdrop Central bankers have found the post Global Financial Crisis (GFC) years to be a very challenging time for conducting monetary policy. High expectations have been placed upon central banks at a time when the economic, financial and political interlinkages in the global economy seem more complex, and where monetary policy has become the fall-back policy to promote a strong global recovery. Globally, the corporate and household deleveraging process has been more difficult and prolonged than expected – especially in the euro area. In many economies, deleveraging (or simply reluctance to extend already high debt levels) has been reflected in slow growth in household demand, weaker-than-forecast business investment, and persistent levels of excess capacity. Our economy has generated better growth and employment outcomes than many other advanced economies in the post-GFC period. There are several reasons for this. Our banking sector was far less adversely affected by the GFC than those in the United States and Europe, Canterbury reconstruction generated strong investment and boosted manufacturing production, and, only 18 months ago, New Zealand’s terms of trade were at a 40-year high. Like other forecasters, we have been surprised by the strength of net immigration and its positive impact on productive capacity. There have also been question marks over the robustness of past empirical relationships, and the effectiveness of traditional monetary policy instruments, in an environment of unprecedented monetary accommodation in the global economy. Central bankers have learned how hard it is to increase inflation expectations when inflation expectations are embedded at low levels and household debt levels are high. They have seen the short-term relationship between inflation and aggregate demand become more uncertain, and their ability to influence long-term interest rates, which has always been limited, has weakened. In addition, in a world of extraordinary global liquidity and asset price inflation, it is more difficult to assess the size of output gaps and the level of the neutral interest rate. One aspect that appears not to have changed much is that monetary policy affects inflation and inflation expectations with a variable and potentially long lag. Monetary policy can take around 12–18 months to have its peak effect on inflation. Policy outlook 1. Recent policy developments In June 2014, the Bank started to scale back the extent of its expected OCR increases (figure 4), and by early February 2015 our expectation was that the OCR was likely to be on BIS central bankers’ speeches hold for some time. Also, by this time the Bank was discussing circumstances where the OCR might be reduced. 6 Figure 4: The Bank’s 90-day interest rate projections Source: RBNZ estimates. This perspective was reinforced as dairy prices began to fall sharply in March while the exchange rate remained close to its peak. Furthermore, the negative income effects from falling export prices were accentuated by a bounce in landed oil prices and an increase in refinery margins. The latter meant that the expected income gain of around $400 per household from the initial oil price decline had halved. Several considerations underlay the Bank’s decision to cut the OCR in June 2015. Statistical data revisions and the recent slowing in demand suggested that the output gap was likely to be smaller than forecast, non-tradables inflation looked to be low and stable, and the exchange rate had not adjusted sufficiently to the decline in the terms of trade. The decision to reduce interest rates was aimed at buffering the decline in the terms of trade associated with falling dairy and other commodity prices, and ensuring that the exchange rate contributed to moving inflation back towards the target mid-point. 2. The exchange rate The exchange rate has declined by 14 percent on a TWI basis and 15 percent against the US dollar since mid-April 2015. Other factors, in addition to policy signalling by the Bank, have put downward pressure on the currency. These include falling dairy prices, various domestic economic indicators suggesting some moderation in demand growth, and the strengthening in the US dollar and sterling. We signalled for some time that we believed the high exchange rate was unjustified and unsustainable. In the June MPS we described it as overvalued and suggested that a significant downward adjustment was justified and necessary to put New Zealand’s net external position on a more sustainable path. Since the June MPS, the exchange rate has Wheeler (2015), ‘The outlook for the New Zealand economy’, speech on 4 February 2015. BIS central bankers’ speeches declined by 5 percent on a TWI basis and global dairy prices have fallen by 16 percent (figure 5). In the July OCR review we noted that the exchange rate had declined significantly since April 2015 and, along with lower interest rates, had led to an easing in monetary conditions. We indicated that further depreciation is necessary given the weakness in export commodity prices. Our models suggest that the real exchange rate is currently in the vicinity of its long-run equilibrium value – if growth, inflation, and the terms of trade were at their long-run trends. However, the exchange rate remains above the level consistent with current economic conditions and, in particular, the current low level of export prices. Reflecting this, our economic forecasts, based on recent levels of the exchange rate and terms of trade, show the current account deficit becoming larger over the next two years. At current levels of export prices, a more substantial exchange rate depreciation is therefore required to stabilise the net external liabilities position relative to GDP. Figure 5: NZD exchange rate and export prices Source GDT, Reuters In this context, we believe that the exchange rate needs to weaken further. In addition, the high stockpiles of whole milk powder in China, the increase in global milk supply, and the trade diversion issues involving Russia make for a very uncertain future, with the potential for further downward pressure on global dairy prices. Also, over coming months, we are likely to see the Federal Reserve and the Bank of England begin the process of normalising their interest rates, and this may assist the currency lower. 3. Interest rates Turning to the interest rate outlook, our conditional projections in the June MPS built in a 50 basis point cut in interest rates over the forecast period. We cut the OCR by 25 basis points in June and indicated that, while further easing may be appropriate, our future policy course would depend on the flow of emerging data. In the July OCR review we reduced the OCR by a further 25 basis points, and indicated that, at this point, some further easing seems likely. The current level of interest rates remains below New Zealand’s neutral rate, as was the case when we raised rates during the period March to July 2014. We view the neutral interest rate as the policy rate consistent with the economy growing at its potential in the BIS central bankers’ speeches medium term and having inflation expectations matching the price stability objective. The Bank’s analysis suggests that the neutral 90-day rate currently sits in the 4 to 5 percent range. The Bank is continuing to reflect on this issue as the very low level of global rates could mean that the effective neutral rate may be at the bottom end of, or below, this range. We view the current monetary policy settings as providing stimulus to the economy at a time when output looks to be growing around 2.5 percent, slightly below potential 7, and core inflation remains a bit below the mid-point. At the same time, the moderation in wage and pricing behaviour and survey data suggests that inflation expectations have fallen and appear to be closer to the mid-point of the PTA target range than has been the case for several years (figure 6). Figure 6: Inflation expectations (annual, years ahead) Source: ANZ Bank, Aon Consulting, Consensus Economics, RBNZ The future path of the OCR will be driven by the flow of incoming data, our assessment of the economic outlook, and judgements as to what level of interest rates is needed to achieve the Bank’s price stability goal. Several factors will continue to be important in this regard including: whether wage and price-setting outcomes are consistent with the price stability objective; whether the range of inflation expectations data suggests expectations have stabilised at an appropriate level; future movements in commodity prices –especially global dairy prices; and the degree of exchange rate adjustment that occurs and how quickly it passes through into inflation. Some local commentators have predicted large declines in interest rates over coming months that could only be consistent with the economy moving into recession. We will review our growth forecasts in the September MPSbut, at this point, we believe that while demand and output growth may be a little below trend, several factors are supporting economic growth. These include the easing in monetary conditions, continued high levels of migration The growth rate of potential output is considered to be around 2.6 percent. BIS central bankers’ speeches and labour force participation, ongoing growth in construction and continued strength in the services sector. A relevant issue is how rapidly the Bank should seek to return inflation to the mid-point of the target band. There are important trade-offs here that can come at the expense of unnecessary volatility in output, interest rates, and the exchange rate – outcomes that, under the PTA, the Bank is required to seek to avoid. Attempting to return inflation to the midpoint quickly could create the risk of overshooting the inflation goal, un-anchoring inflation expectations, and increasing the volatility of interest rates and the exchange rate, as monetary policy is significantly eased and subsequently tightened. On the other hand, while moving interest rates only gradually might have the benefit of inducing less volatility in output and key relative prices, it would increase the risk that the Bank consistently undershoots its inflation target, and that inflation expectations get anchored at too low a level. Our judgement in the current circumstances is that aiming to return inflation to around its medium-term target level in about nine to 12 months’ time is an appropriate speed of adjustment. This may not always be the appropriate speed of adjustment. Nor does it mean that the Bank will necessarily deliver a precise outcome as the economy is constantly experiencing shocks and disturbances that policy may need to counter or accommodate. Having the scope to amend policy settings, however, is a key strength of the monetary policy regime. In response to these developments, the Bank will review and, if necessary, revise its policy settings to meet its price stability objectives. The time path of inflation may change as monetary policy is recalibrated, but the overall goal of meeting the specifications of the PTA will remain the central focus of policy. 4. The housing market We are conscious of the impact that low interest rates can have on housing demand and its potential to feed into higher house price inflation. Lower interest rates risk exacerbating the already extensive housing pressures in Auckland by stimulating housing demand, although, outside of Auckland, nationwide house price inflation is currently running at an annual rate of around 2 percent. Raising interest rates can be a useful policy response in leaning against asset price pressures when they are widely based and wealth effects are spilling over into demand and triggering broader inflationary pressures. There is currently little evidence of this and, in the present situation, raising interest rates would be inappropriate as it would put upward pressure on the exchange rate and further dampen inflation. Monetary policy and macro-prudential policy can each affect the housing market. While they have different primary objectives of price stability and financial system stability respectively, there can be important spillover effects between the two policies. In the Policy Targets Agreementfinancial stability is a secondary objective; in the macro-prudentialMemorandum of Understanding, macro-prudential initiatives need to have regard to their potential impact on monetary policy. We continue to be concerned about the financial stability risks and risks to the broader economy that would be associated with a major correction in Auckland house prices. In the current circumstances, macro prudential policy can be helpful in reducing some of the pressures arising from the Auckland housing market. The proposed LVR measures and the Government’s policy initiatives that it announced in the 2015 Budget should begin to ease the impact of investor activity. While a strong supply response over several years is needed to address Auckland’s housing imbalance, macro-prudential policy can help to lower the financial and economic risks while important regulatory and infrastructure issues are addressed and additional investment in new housing takes place. BIS central bankers’ speeches Conclusion In mid-2014, New Zealand’s terms of trade were at a 40-year high, but over the past 15 months the economy has experienced several shocks. Export prices for whole milk powder have fallen 63 percent since February 2014, and oil prices are currently more than 50 percent below their June 2014 level. Net immigration and labour force participation are at historic highs and the real exchange rate has declined steadily since April 2015. We think the economy is currently growing at an annual rate of around 2½ percent. To maintain growth around potential and return CPI inflation to its medium-term target level, some further monetary policy easing is likely to be required. We also believe that further exchange rate depreciation is necessary given the weakness in export commodity prices and the projected deterioration in the country’s net external liabilities over the next two years. The Bank will review and, if needed, revise its policy settings in response to emerging economic developments in order to meet the price stability objectives specified in the PTA. BIS central bankers’ speeches
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Speech by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to The Northern Club, Auckland, 24 August 2015.
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Grant Spencer: Investors adding to Auckland housing market risk policy Speech by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to The Northern Club, Auckland, 24 August 2015. * * * Accompanying figures can be found at the end of the speech. I am told that the Auckland housing market continues to be the hot topic of dinner conversation in Auckland. Auckland house prices have gone up by 24 percent over the past year. For prospective buyers, and especially first home buyers, this is not good news. Getting on the housing ladder has become a lot harder. Existing home owners on the other hand have seen their equity rise by 24 percent of the house value. For the Reserve Bank, we added this to the “What keeps you awake at night?” category some time ago. There are good reasons to think that the Auckland market poses an increasing threat to financial stability. Today I want to tell you why we are concerned. A natural place to start is to ask what demand factors are driving Auckland house prices, and then to think about the supply response to those pressures. I will provide some new information on the composition of sales and, after describing the landscape, I will explain why we are concerned from a financial stability perspective. When something keeps you awake at night, it is good to do something about it. I will discuss the multi-faceted initiatives needed to address this problem, and the role that the Reserve Bank is playing. I will finish by updating you on where we are at with the investor LVR restrictions that we announced in May, including the recent public consultation on the policy and how the new policy will be implemented. Strong demand is driving up prices The main underlying cause of the housing shortage in Auckland is the continuing record net inflow of migrants, against a background of very low residential construction activity over many years. As seen in figure 1, the outflow of Kiwis has slowed over the past three years at the same time as the inflow of foreigners and returning Kiwis has accelerated. This has reflected the strength of the New Zealand economy as well as weakness in Australia and the broader global economy. While Auckland accounts for a third of the New Zealand economy, about half of the net inflow is coming in to Auckland. In the year to June 2015, almost 50,000 permanent and long-term migrants arrived in Auckland, including New Zealand citizens returning from abroad. If these new residents have similar rates of home ownership and household sizes to existing residents, we estimate they could account for around one-third of the 30,000 Auckland house sales in the past year 1. Interest rates are also an important factor influencing the demand for and pricing of housing, particularly long-term rates. Interest rates determine the cost of mortgage credit and therefore the amount of debt that can be sustained on any given level of household income. Figure 2 shows how low interest rates since the GFC have facilitated a significant increase in debt to income (DTI) ratios. Interest rates also drive the discount rate used (implicitly or explicitly) by house purchasers in valuing the future stream of housing services. As seen in many countries around the world, low global interest rates post GFC have contributed to strong asset price growth, particularly in financial assets and in housing markets. This influence on house prices in New Zealand is reflected in the downward trend in rental yields (figure 3). While the sharper yield decline in This estimate is based on the assumption of around 3 people per dwelling and a home ownership rate of around 60 percent. BIS central bankers’ speeches Auckland points to additional factors at play in the Auckland market, interest rates have been a key driver of demand, particularly investor demand. It is useful to distinguish investor demand from owner occupier demand. While increased occupier demand, say due to population growth, adds to any underlying physical shortage of housing, higher investor demand affects the composition of rentals versus owner occupiers. However, investor demand can contribute significantly to house price pressures. If investors wish to expand their housing portfolios at a greater rate than the growth in demand for rental accommodation, this can push up prices even though the underlying housing shortage remains unchanged. Investor demand has become a growing factor in the Auckland market over the past year, and this has exacerbated price pressures arising from the underlying physical shortage. Evidence of an increasing investor presence in the Auckland market is clear. Based on CoreLogic data, investors accounted for 41 percent of all Auckland market sales in June 2015, up 8 percentage points since late 2013. While some of this growth was at the expense of first-home buyers in early 2014, the more recent increase from late 2014 has been at the expense of “movers”. A similar pattern is seen in net investor purchases 2 (figure 4), which has also increased significantly, suggesting further declines in the Auckland home ownership rate. Consistent with the increased share of investor sales, there has been a disproportionate expansion in mortgage credit to residential investors. The dollar value of new mortgage lending for all borrowers grew by 28 percent nationally, in the year to June 2015, reflecting increased house sales as well as higher average prices. Over the same period, new lending to investors increased nationally at a much greater rate of 40 percent. While some new lending represents “churn” as borrowers refinance existing loans and/or switch between banks, the sharp lift in new investor lending is consistent with greater investor participation in the housing market. What do we know about these residential investors who have been expanding their presence in Auckland over the past year? First, their rising market share has primarily been driven by increasing purchases by small investors, with two to four properties, as opposed to investors with larger property portfolios. We have also seen a reduction in the share of investor cash sales in Auckland from over 25 percent in late 2013 to around 20 percent currently. This sort of profile – i.e. smaller investors who are reliant on credit – suggests that the new LVR restrictions on Auckland residential investors are likely to have an impact on overall demand. This is particularly so when we consider that over half of investor lending is currently being written at high LVRs – that is LVRs of over 70 percent. Much has been said recently regarding the contribution of foreign investor purchases to price pressures in Auckland. Given that we do not have data on purchases by non-residents, it is not possible to make an accurate assessment of the extent to which such flows are adding to price pressures and also financing new housing construction. The role of non-resident investors in the Auckland market will become more apparent once the new requirements for purchasers to provide tax numbers are introduced in October. The supply response Currently, new dwellings are being built at a rate of around 8,300 per annum in Auckland. With roughly half of New Zealand’s net migration going to Auckland, this rate of construction may not be sufficient to prevent the existing shortage from rising beyond its current level of Net investor purchases are total purchases by investors less total sales by investors. BIS central bankers’ speeches around 15 to 20 thousand dwellings. 3 An increased rate of construction is needed. One positive change is that resources are increasingly being freed up in Canterbury as the residential rebuild tapers off. This should facilitate an increase in Auckland house building over the next couple of years. Our current forecasts, which are consistent with the Accord being met, suggest an annual construction rate of 8,700 in 2015, increasing to 11,000 by 2017. High-rise apartment construction and other high-density options will be a crucial part of increasing construction and reducing the supply shortage. The need for increased densification has been recognised by the Auckland Council in recently proposed changes to the unitary plan, which will be finalised in mid-2016. It is also encouraging that the share of apartment consents in Auckland is rising, and is expected to increase further with several apartment projects currently in the planning stages. However, at 18 percent in the year to June, the apartment share of consents remains well below levels seen in the mid-2000s and significantly below what we see in other major centres. For example, apartments represent 39 percent of the total stock of dwellings in Sydney, compared to only 25 percent in Auckland. Supply-side constraints remain a hindrance to faster rates of building. The key issues remain: a limited supply of land ready for building; restrictive planning processes, and a lack of coordinated planning in infrastructure development. Since the Housing Accords and Special Housing Areas Act 2013, there have been some encouraging developments, such as the proposed relaxation of density rules and initiatives to develop Crown land. However, more needs to be done and Special Housing Area building activity has remained very slow to date, with around 800 dwellings consented and 860 sections created in the 86 SHAs. The recent draft report by the Productivity Commission points to some far-reaching changes needed to create a more responsive supply side. The Reserve Bank supports the draft findings of the inquiry and believes that the recommendations should be considered carefully. Recommendations that have the potential to improve the responsiveness of housing supply include the promotion of less restrictive planning rules and streamlined planning processes. For example, reviewing and relaxing rules in district plans, clarifying the RMA to include land use for housing as a priority, and ongoing RMA reform to streamline plan development. The Bank also supports measures that encourage the timely and coordinated provision of infrastructure to support new housing developments, and policies that reduce incentives for land banking. Why are accelerating Auckland house prices a concern for stability? House price inflation slowed significantly following the implementation of restrictions on high loan-to-value ratio (LVR) lending in October 2013. More recently, average national house price inflation has picked up, due almost entirely to significant renewed pressures in the Auckland market. The latest REINZ figures for July show Auckland house prices up 25 percent over the past year, compared to 3 percent for the rest of the country (figure 5). As a summary measure of excess demand, this points to the Auckland housing shortage getting worse, not better. In addition, the volume of house sales is picking up in other areas such as Waikato, Bay of Plenty and Northland, and this could translate into growing price pressures in those markets. Looking at key house price ratios suggests an increasing degree of stretch in Auckland prices relative to sustainable levels. House price-to-income ratios have increased from around 6 to almost 9 in Auckland since 2012, a level seen in some of the world’s most expensive cities – cities such as London, San Francisco and Sydney. For the rest of New These estimates are broadly in line with estimates produced by the Auckland Council and Productivity Commission. BIS central bankers’ speeches Zealand, the average price-to-income ratio is about half Auckland’s level (figure 6). Similarly, rental yields have fallen materially in Auckland, and are currently at historic lows of below 3 percent. While low interest rates explain much of this downward trend, rental yields in the rest of New Zealand have remained well above Auckland yields (figure 3). Auckland is increasingly being seen as a regional (Asia-Pacific) centre, and this no doubt accounts for a part of the stretch in price-to-income ratios. However, good long-run fundamentals do not make Auckland immune to a correction. International evidence shows that the further house price-to-income ratios deviate from historical norms, the greater the potential for a sharp and damaging correction. 4 In Auckland’s case such a correction could be triggered by a range of domestic and external factors. The demand for housing would be reduced by a slowdown in the economy, which could result, for example, from continued weakness in export prices; or a drop off in the net inflow of migrants. Externally, if the current slowdown in China persists or accelerates then the flow of funds from that source could diminish. Or we could see an increase in the risk premium in New Zealand interest rates – either due to a global financial shock or due to a perceived increase in New Zealand specific risk. Indeed recently we saw an indication of this with Standard and Poor’s reducing the stand-alone rating of the New Zealand banking system, citing heightened risk in Auckland housing as their primary concern. 5 Interest rates internationally are at historic lows and well below rates seen in recent decades prior to the GFC. This reflects modest global growth, extraordinary monetary accommodation and weak inflationary pressures. It is not realistic to expect such low rates to remain the norm in the medium term, and the US Federal Reserve is likely to be raising rates in the coming months. Future interest rate increases, either because of a stronger domestic economy and higher CPI inflation, or because international long-term rates are higher, could have a marked impact on credit-based demand. New Zealand has high levels of household debt. On average, household debt is running at around 155 percent of household income and 30 percent of new borrowers are taking on mortgages at greater than 6 times income. At these ratios, it would not take much of an increase in interest rates to substantially erode mortgage affordability. All of these factors could reduce housing demand and take pressure off house prices. The greater the investor component of demand, the greater the scope for the reduced demand to be amplified through weaker house prices as investors exit the market. Further, if at the same time an increased volume of new houses and apartments was starting to come on stream, then an excess supply situation could develop, causing prices to come back more sharply. We have seen this happen in regional housing markets in New Zealand. For example, house prices in Thames-Coromandel and Queenstown-Lakes saw relatively large falls in the wake of the 2008/09 recession, after experiencing relatively strong building activity during the 2000s. In other countries, excess housing supply has seriously exacerbated housing market downturns – as seen in Spain and Ireland during the GFC. If such a correction happened in the Auckland market, it would pose a significant threat to financial stability, something the Reserve Bank is mandated to preserve. For example, following rapid increases to well above historical norms, Finland, Norway, and Sweden all experienced falls in house price-to-income ratios in excess of 30 percent in the late 1980s/early 1990s. Housing markets that were most over-valued prior to the global financial crisis on the basis of house price-toincome ratios also typically experienced larger than average house price falls. While the stand-alone ratings of the 4 largest New Zealand banks were lowered, their full issuer ratings were unaffected due to ratings uplifts from assumed parental support. Issuer ratings were lowered on seven nonbank institutions. BIS central bankers’ speeches What can we do about it? In light of the financial stability risks inherent in the booming Auckland housing market – and the many contributing factors – the Reserve Bank has continued to promote a broad-based policy response, including both demand and supply-side policies. On the demand side, we regard tax policy as an essential part of the solution, given the historical tax advantaged status of investor housing and the significant role being played by investors in the current Auckland market. The low level of Auckland rental yields (figure 3) suggests that expectations of capital gains and/or tax relief have been an important factor in investors’ purchase decisions. We fully support measures announced as part of the Budget to reduce the tax-advantaged status of investor housing. The establishment of a two-year bright-line test for assessing trading gains from investment properties will bolster the effectiveness of the existing tax in this area. The requirement to provide tax identification details, and a proposed withholding tax on house sales by non-residents, will also aid enforceability. I have talked about the important role of interest rates in the demand for and pricing of housing. Should the Bank therefore be using monetary policy to moderate the Auckland housing market? Our view, and that of the major central banks is: not if this requires monetary policy to deviate from its primary goal of achieving stability in the general level of prices. The Reserve Bank Act and the Policy Targets Agreement (PTA) state that monetary policy shall have regard to the efficiency and soundness of the financial system. However, in the current situation, with underlying inflation below target, falling export prices and weakening growth, it would not be appropriate to raise interest rates to dampen the Auckland housing market. Right now, that would push up the exchange rate, dampen growth and inflation and cause more problems than it solves. We should also keep in mind that the long-term trend in real interest rates is ultimately determined by economic behaviour, such as saving and investment preferences, not central banks. This trend has clearly been downwards in recent years, both in New Zealand and globally. The current nexus of low CPI inflation, low interest rates and strong asset prices is reflective of the global economic environment. Many other countries are facing the same issues in housing markets and are looking to policies other than monetary policy, such as macro-prudential policy, to address the consequent risks around financial stability. Macro-prudential policy Macro-prudential policy is about using bank regulatory tools to address systemic risks that have the potential to damage the financial system, as well as having serious consequences for the domestic economy. A macro-prudential overlay will usually be applied on a temporary basis, for example during an upward asset price cycle, and be applied to all banks. The main aim of such policies is to help bolster the balance sheets of the banks so they can better withstand the impact of a potential credit or liquidity shock and continue to extend credit in support of economic activity. Macro-prudential policies can also help to reduce the strength of the financial cycle by slowing credit growth, e.g. by restricting the amount of credit being extended to the booming sector. We will always be subject to economic and financial cycles. That is the historical reality. However, we can and should avoid the severe financial cycles that can cause major damage to the real economy – as we have seen internationally in the aftermath of the GFC. Our aim therefore is to reduce the amplifying effects seen in severe financial contractions by ensuring we have a very resilient banking system and also by directly moderating the credit cycle itself. Our on-going prudential requirements, together with macro-prudential overlays, aim to achieve that. There is a point to clarify here around the stress testing that the Reserve Bank conducts on the banking system as part of our prudential oversight function. Sometimes commentators BIS central bankers’ speeches incorrectly interpret the aim of macro-prudential policy as preventing bank insolvency. From a macro-prudential perspective, we may wish to bolster bank balance sheets beyond the point of avoiding insolvency. Stress tests help to inform our assessment of the adequacy of capital and liquidity buffers held by the banks. However, they are only one of the tools contributing to that assessment. In a downturn, banks will typically become risk averse and start to slow credit expansion in order to reduce the risk of breaching capital and liquidity ratios. In a severe downturn, faced with a rise in impaired loans and provisions, banks may start to contract credit which can quickly exacerbate the economic downturn. In this way, a financial downturn can have severe consequences for macro-financial stability well before the solvency of banks becomes threatened. In 2014, the four largest New Zealand banks completed a stress testing exercise that featured a 40 percent decline in house prices in conjunction with a severe recession and rising unemployment. While this test suggested that banks would maintain capital ratios above minimum requirements, banks reported that they would need to cut credit exposures by around 10 percent (the equivalent of around $30 billion) in order to restore capital buffers. Deleveraging of that nature would accentuate macroeconomic weakness, leading to greater declines in asset markets and larger loan losses for the banks. Such second round effects are not reflected in the stress test results. A key goal of macro-prudential policy is to ensure that the banking system has sufficient resilience to avoid such contractionary behaviour in a downturn. The macro-prudential policy approach we have adopted has been centred on Loan to Value Ratios (LVRs). In October 2013, the Bank introduced a requirement that no more than 10 percent of any bank’s new mortgage lending could be at LVRs over 80 percent. At the time, over 30 percent of new mortgages were being written at LVRs over 80 percent. Restricting the extent of high LVR lending has seen average LVRs in bank mortgage books gradually decline, with the proportion of high LVR mortgage loans on bank balance sheets falling from 21 percent to 14 percent. This has made bank balance sheets more resilient to a potential housing downturn (figure 7). At the same time, the reduction in high LVR lending helped to dampen credit growth and house price inflation over the following year. Subsequently, from around September 2014, the Auckland market started to accelerate while house prices in the rest of the country continued to moderate. As mentioned earlier, we have identified credit-financed investor activity as an important contributor to the Auckland resurgence. This raises concerns from a systemic risk perspective. Evidence from severe housing market downturns internationally show that loans to investors default more frequently at any given LVR during periods of market stress. Partly this is likely to reflect the fact that investors tend to take on more debt relative to income, so have less ability to absorb income shocks. The Reserve Bank has recently started collecting data on the debt to income (DTI) ratios of new borrowers (figure 8). Provisional data suggests that a much greater share of investors have high DTIs and that investor DTIs have been growing over the past year. International evidence also suggests that investors play a strong role in amplifying property cycles. Investor participation tends to rise towards the peak of the property cycle and investors are more likely to sell properties when prices start to fall. Thus, property cycles are accentuated when there is a large investor presence in the market. Our view is that banks need additional balance sheet buffers against residential investor lending, and that particular caution is required on investor lending in Auckland. The new LVR policy that we announced in May will require mortgages on Auckland 6 investment properties to have LVRs of 70 percent or less. The aim of the policy is to strengthen the resilience of Auckland is defined as the area of the Super City, extending from Rodney to Franklin. BIS central bankers’ speeches banks against an Auckland housing downturn, and to moderate the cyclical role of the large residential investor segment of the market. While the speed limit on owner-occupied properties in Auckland will stay at 10 percent, the speed limit on high LVR mortgages outside Auckland will be relaxed from 10 percent to 15 percent. That easing reflects the low and steady rates of house price inflation in most other parts of the country, and our stated intention to begin removing LVR restrictions when they are no longer warranted. In recent months, there have been some signs of housing demand spilling out of Auckland, with house price growth starting to increase in Hamilton and Tauranga. If this strength persists, full removal of LVR restrictions outside of Auckland could be delayed. The Bank will continue to monitor housing market developments and modify its macro-prudential policies accordingly. Implementing the new measures The Reserve Bank undertook a public consultation on the proposed changes to LVR restrictions in June. As a result of the feedback received, some changes are being made to facilitate the implementation of the policy, but the substance of the policy remains intact. The details of the final policy are now available on the Bank’s website. www.rbnz.govt.nz/regulation_and_supervision/banks/consultations/Response-tosubmissions-21-august.pdf. We announced our proposals for changes to the LVR policy in the MayFinancial Stability Report and began public consultation on 3 June. In response to the feedback received, we are making three main changes. First, a number of banks indicated they would not be able to formally meet the new restrictions by 1 October, given the need to make system changes. In response, the Reserve Bank is delaying implementation of the policy by one month to 1 November and providing all banks with an initial six month measurement period for meeting the restrictions. In making this change we are encouraged by the banks reporting that they are already curtailing lending to high-LVR Auckland investors ahead of the formal commencement of the policy. Second, banks noted that the proposed 2 percent speed limit for high LVR investor lending was insufficient to accommodate special circumstances such as extra lending required to provide assistance to borrowers in hardship. In response we are adopting a higher speed limit of 5 percent on high LVR investor lending. This will provide banks with more scope to manage the existing pipeline of pre-approved lending. Based on our experience with the existing LVR speed limit, it is expected that the actual flow of high LVR lending to Auckland investors will settle well below 5 percent as banks adopt a buffer to ensure compliance. Third, in light of feedback from the consultation, we have decided to introduce a new exemption category for lending for significant remedial construction work, such as for houses with weather tightness issues or requiring seismic strengthening. It would be undesirable to prevent banks from providing this lending, from both a financial stability and a broader efficiency perspective. To date, high LVR lending for such remedial work has counted against the existing speed limit. In conjunction with the new LVR restrictions, and consistent with Basel guidelines, the banks will be required to establish a new asset class for all loans to residential property investors. Loans in this asset class will attract a higher risk weighting than owner occupied mortgages, requiring banks to hold more capital against them. For banks following the standardised approach to capital adequacy, the average risk weight for investor loans will increase by about 6 percentage points. For the larger banks, that will be developing new internal risk models, our expectation is that average risk weights on investor mortgages will increase by a similar amount. BIS central bankers’ speeches Conclusion The resurgence in Auckland house prices over the past year has made the Reserve Bank increasingly concerned about the risks to financial stability. It is certainly on our “what keeps us awake at night” list. Auckland prices have risen a further 24 percent over the past year, stretching the price-toincome ratio for the region to 9. This is double the ratio for the rest of New Zealand and places Auckland among the world’s most expensive cities. New housing supply has been growing but nowhere near fast enough to make a dent in the existing housing shortage. In the meantime, net migration is at record levels and investors continue to expand their influence in the Auckland market. The increasing investor presence, now accounting for 41 percent of Auckland house purchases, has been supported by rapid growth in new lending, with half of the new credit at LVR’s of over 70 percent. This trend is increasing the risk inherent in the Auckland market. The increasing investor presence is likely to amplify the housing cycle and worsen the potential damage from a downturn, both to the financial system and the broader economy. We recognise that low interest rates are contributing to housing demand pressures and this is a factor we take into consideration when setting monetary policy. However, the current weakness in export prices, economic activity and CPI inflation means that interest rate increases are likely to be off the table for some time. Tax policy is also an important driver and we welcome the changes announced in the 2015 Budget, including the two year bright-line test, the proposed non-resident withholding tax and the requirement for tax numbers to be provided for investor house purchases. Macro prudential policy can help to moderate the risks to the financial sector and broader economy associated with Auckland’s housing market. Modifications to the Reserve Bank’s LVR policy, announced in May, are targeted specifically at Auckland residential investors. The speed limit has been eased for the rest of the country where housing markets are not subject to the same pressures. Our expectation is that investor LVRs will reduce financial system risk arising from this sector and assist in moderating the Auckland housing market cycle. However, macro-prudential policy is one of many factors aimed at reducing the imbalances in the Auckland housing market. Much more rapid progress in producing new housing is needed in order to get on top of this issue. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Institute of Finance Professionals NZ, Auckland, 14 October 2015.
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Graeme Wheeler: Some reflections on the world of central banking Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Institute of Finance Professionals NZ, Auckland, 14 October 2015. * 1. * * Introduction I recently read Andrew Graham-Dixon’s excellent biography on Caravaggio, the early 17th century Italian painter whose bold realism, deep sense of humanity and stunning use of light, transformed the art world. As now deceased Australian art critic Robert Hughes said, “there was art before him and art after him, and they were not the same.” Caravaggio lived a dramatic and tumultuous life. Graham Dixon described it as “the darkest and most dangerous life of any of the great painters”. While we could debate the desired temperament of central bankers, the world in which they have operated monetary policy over the past 8 years has also been dramatic and turbulent. Today, I will describe a little of that world – particularly that faced by central bankers in small open economies. It’s a world of complex global economic and financial linkages and interdependencies, and many unknowns: a world that requires constant reflection on new information, and where judgement in managing and balancing risks under considerable uncertainty plays a critical role. It’s also a world where people have strong views on monetary policy. That’s understandable because monetary policy affects peoples’ lives. It can affect the level of activity and distribution of income in the economy in the short term, the returns to savers and investors, the inflation expectations of wage and price setters, the price of real and financial assets, and the degree of financial risk taking. That’s why central banks endeavour to be explicit about their frameworks and judgements in their monetary policy statements and on-the-record presentations. In discussing the world that central banker’s face in small open economies, I will offer some thoughts on: the international economy; the constraints and uncertainties around monetary policy judgements; and the recent application of monetary policy in New Zealand. 2. The global economy This year the global economy has hit another weak patch. Concerns have intensified in recent months following weaker production and trade data for China, Latin America and East Asia, and greater financial volatility – including sizeable equity market adjustments in some financial centres, and large portfolio outflows from emerging markets. The global economy appears to be growing at around 3 percent – slower than its average over the past three decades and the weakest growth since 2009. This weakness comes despite several supportive factors including: the unprecedented monetary stimulus; the positive effect of low commodity prices on spending power; and cheaper and more sophisticated information technology. For example: • the world has never seen cheaper financing. Policy rates are close to zero in advanced economies that collectively generate 2/3rds of world output, and BIS central bankers’ speeches quantitative easing by major central banks in advanced economies has totaled around USD7 trillion in recent years. 1 • due mainly to the weakening in Chinese demand (but also to strong supply in many markets), prices of a wide range of commodities have been falling since early-2014. 2 While this slows growth in the developing world (which is the main global source of commodities) falling commodity prices are generally positive for growth in developed countries. • the decline in the cost of information technology over the past three decades possibly represents the largest continuous set of factor cost reductions the world has experienced. Not only is the marginal cost of storing, processing and transmitting information essentially zero, the creative destruction of information technology has generated new products and consumer markets, and enabled further efficiencies to be squeezed out of global supply chains. Despite these factors, and the ease with which capital can flow across borders, economic growth rates even in the advanced commodity importing countries remain below potential growth rates eight years after the onset of the Global Financial Crisis (GFC). Many reasons have been advanced for the disappointing global recovery. Some observers emphasise the depth of the GFC and its impact in repricing every asset across the globe, the scale of the household and corporate deleveraging that was unleashed and its prolonged impact on economic risk taking. Others link the weak recovery to the slowdown in global trade, which has been a major catalyst for global growth in recent decades, and to the impact of protectionism and the maturing of global supply chains. There are also debates about future economic prospects, including whether these might look increasingly like the recent past or even worse. Some consider that the global economy may be in danger of entering a period of secular stagnation characterised by excess desired global savings relative to investment and weak global demand. 3 Others question whether rates of innovation and technological progress are slowing and whether productivity gains from the ICT revolution have been largely realised. 4 The inflation picture also, is complicated. In the vast majority of the 30 or so economies (mainly advanced economies) whose central banks pursue inflation targeting, headline and underlying inflation have averaged below specified goals over the past few years. There are several reasons for this: levels of excess capacity in factor and product markets remain high in many economies; wage outcomes have been subdued, even in countries with low unemployment; surveys show that inflation expectations have declined; commodity prices have fallen substantially over the past 18 months; and the internet and other technologies may be changing the tradables content of traditional non-tradable goods and services. Turning to some regional perspectives, the greatest concern at this point lies around the growth outlook for China. Over the past 35 years, China has been the world’s most successful economy, increasing its share of world output from below 3 percent to 15 percent currently. Although China’s economy is just over 60 percent of that of the United States (at current exchange rates) it has a much greater impact on commodity markets and global trade volumes. This includes the 19 euro-area economies, USA, Japan, UK, Canada, Switzerland, Sweden, Demark and Norway. In 13 European countries 2 year sovereign bond rates are still negative. The continuous commodity index is currently about 28 percent below its peak in April 2014. Larry Summers blog: On Secular Stagnation: A response to Bernanke, April 1, 2015. Robert Gordon: Is US Economic Growth over? Fostering Innovation Confronts the Six Headwinds, NBER working paper no.18315, August 2012. BIS central bankers’ speeches China is now the number 1 or 2 trading partner for over 100 countries and its imports of nonoil commodities are around 2 ½ times higher than those of the US. Recent indicators suggest that challenges in China’s construction and manufacturing sectors continue to be a concern, particularly as much of the investment has been financed through extensive borrowing, much of it in the rapidly expanding shadow banking sector. China’s debt burden has increased at an unprecedented rate – from 130 percent of GDP in 2008 to around 200 percent currently. But financial markets have also been unsettled by other factors, including the types of policy measures introduced as the Shanghai index began declining, the magnitude of recent capital outflows, and the questions raised by the decision to allow the RMB to depreciate by 3.5% over two days in August. Although the Chinese Authorities have indicated they want a stable RMB, private capital outflows continue to be large. Any substantial depreciation in the RMB would have serious implications for the world economy: it would risk triggering exchange rate adjustment among competitor economies – particularly in Asia, and would spread deflationary forces across the globe. Although its recovery has been slower than previous economic expansions, the US is the main bright spot in the global economy. But even here there are significant puzzles around the labour market and investment climate. Why, for example, has recent US labour productivity growth been so slow, and what explains the substantial wage moderation and weakness in business investment at this stage of recovery? On the policy side, there is uncertainty as to when and how fast the process of raising interest rates might take place, and its possible impact on international growth and asset prices – especially at a time when the Bank of Japan and European Central Bank are considering expanding their quantitative easing programs. These are some of the considerations that shape the world of central bankers. It’s a world of complex linkages, of instantaneous information, massive daily cross-border portfolio flows, unprecedented monetary accommodation and, in some instances, sharp swings in market liquidity and asset prices. It’s also a world in which high expectations have been placed on central banks to use all of the scope within their mandate to stimulate growth in demand and counter the risk of inflation remaining below desired goals for extended periods. In seeking to do so, central bankers have often had to work without the support of fiscal policy, or the structural adjustment reforms needed to raise potential output growth. 3. Monetary policy in a small open economy Central bankers also operate in a world where there is widespread overestimation and misunderstanding of what monetary policy can deliver. I will elaborate on three areas that may contribute to this. These concern the scope of monetary policy; the dynamics – notably in terms of transaction volumes, driving forces and time horizons – of financial markets and their interaction with monetary policy; and the degree of precision of the links between policy actions and outcomes. i) Scope of influence Flexible inflation targeting here and overseas has been successful over the last 25 years in reducing inflation to low and stable levels – the best contribution monetary policy can make to an economy’s long-run growth. Over the shorter term, monetary policy stabilises inflation by countering fluctuations in demand growth and employment away from their longer-run trends. 5 With inflation expectations stabilised at low levels, and the associated gain in policy credibility, G Wheeler, Reflections on 25 years of Inflation Targeting, International Journal of Central Banking, September 2015. BIS central bankers’ speeches the ability of monetary policy to help counter short-run fluctuations in output and employment has increased. Monetary policy is, however, relatively powerless to influence the decisions that determine long-run economic performance and distributional outcomes. For example, over the long run, monetary policy can do little to generate higher spending by households and firms. Even in the shorter term, monetary policy’s influence may be low in an environment where debt levels are high and where there is considerable uncertainty about economic prospects. Monetary policy can influence risk-taking in asset markets, but this does not necessarily translate into risk taking in long term real assets – requiring the investment and entrepreneurial decisions that underpin productivity growth and hence long-run improvements in living standards. Monetary policy also can’t prevent international developments from affecting our economy, including through commodity prices and the exchange rate. In this regard, there is little that monetary policy can do to persistently lower an exchange rate, whether through the choice of exchange rate regime or direct policy actions. 6 Similarly, the Reserve Bank is unable to influence long term real interest rates. These are affected by a range of factors, including global savings and investment flows, risk premia and expectations for economic growth and inflation. Monetary policy can only influence short term interest rates and, over the medium term, actual and expected rates of inflation. ii) Market and policy dynamics: volumes and time horizons Working over a medium-term horizon, monetary policy operates on the basis of limited and sometimes imprecise information around the economic outlook, and uses a relatively narrow platform of policy instruments. Monetary policy generally affects inflation outcomes with a 12 to 18 month lag, reflecting the pace at which changes in interest rates and the exchange rate typically spread to risk-taking and spending in the economy. This means that central banks are constantly trying to interpret the outlook for inflationary pressures, growth and financial stability 12 – 18 months ahead. 7 Financial markets, which respond almost instantly to policy signals and expectations about risk and returns across the world, operate with a more immediate focus. Moreover, the magnitude of their transaction flows can swamp the balance sheet strength of any central bank. For example, the BIS reported that the NZ dollar was the 10th most traded currency in 2013 with daily foreign exchange turnover of USD 105 billion, equivalent to over 55 percent of GDP. 8, 9 The Reserve Bank’s foreign exchange reserves are approximately USD 6.5 billion. Investors compete aggressively against benchmarks that trigger financial rewards. Dominant institutional investors often place similar bets, and share similar benchmarks and pricing and risk management platforms. At times, they exhibit herd-like behaviour that can lead to amplification of cycles and mispricing of risk – especially in a low interest environment. Rather than requiring higher risk premia from increasingly risky borrowers , investors often continue McDermott, J (2013) “Understanding the New Zealand exchange rate”. Speech to Federated Farmers, Wellington. The full effect of monetary policy may not be felt for 18 to 24 months. BIS Triennial Central Bank Survey: Foreign Exchange Turnover in April 2013 (September 2013). BIS 2014–2015 Annual Report, page 85 reports that daily global financial exchange turnover totalled USD5.3 trillion in 2013, equivalent on an annual basis to 25 times global GDP. Total central bank foreign exchange reserves are currently around USD11.6 trillion. BIS central bankers’ speeches financing at declining spreads, fearful of missing out on the returns captured by those who preceded them. 10 The combination of massive financial assets under management (totalling USD75 trillion in 2013), extraordinary advances in computing power, instantaneous information and reduced capital controls mean that financial markets have become deeply integrated around the globe. This has led to an increasingly rapid global transmission of economic and financial shocks and policy actions, and to increased global synchronisation of business cycles. 11 iii) Precision Monetary policy involves many challenges and judgements. Mechanistic approaches to setting monetary policy don’t work, and since monetary policy affects inflation with a 12–18 month lag, by the time one is certain as to the correct policy adjustment, it may already be too late to be effective. At a technical level, setting monetary policy involves estimating output levels and forecasting how they might evolve relative to the level of potential output. This “output gap”, together with inflation expectations, are seen as the main drivers of inflation pressure in the economy. The degree of monetary policy stimulus is assessed by comparing the current and projected policy interest rate (in our case the OCR) against the neutral interest rate. 12 A major challenge is that potential output, the output gap and the level of neutral interest rates are not observable; all have to be estimated through economic modelling. Fortunately, economic management has come a long way since Paish described it in the 1960s as like driving a car with a brake and accelerator and only being able to look through the back window. The new-Keynesian based models and applied general equilibrium models used in central banks today are a significant advance and capable of producing complex economic simulations within minutes as to how the economy, and the path of inflation in particular, might respond to domestic and foreign-sourced disturbances, including changes to monetary policy. Despite their impressive structure, however, such models are inevitably a highly stylised and simplified representation of an economy, and the complex linkages between the financial sector and the real economy are often not well represented. In essence, no economic model can capture the full complexity of economic behaviour or fully reflect key relationships, interdependencies, and driving forces in the economy. While adding judgement to the model and adjusting the model outputs can help, the simulations or scenarios produced by such models are still highly conditional on the model properties and a range of “exogenous assumptions”. In many respects, their value lies more in raising questions rather than delivering clear-cut answers. 13 Central bankers try to acknowledge these uncertainties and the associated imprecision of policy through the nuances and conditional language that characterise their forward guidance and other policy statements. In publishing economic forecasts they make it clear – including We have seen this many times. For example: in the lead up to the Argentinian debt default of 2002 Argentina came to represent nearly one-quarter of the Emerging Market Bond Index. Rather than requiring higher risk premiums from an increasingly leveraged borrower, investors benchmarked to the Emerging Market Bond Index felt obliged to buy at the going price. Graham J (2014)“N Sync: How do countries’ economies move together? RBNZ Analytical Note 2014/04. Potential output refers to the sustainable long term growth path of the economy when resources are fully employed and price stability is achieved. The output gap reflects the difference between the level of output in the economy and potential output and, as such, indicates the degree of excess capacity or capacity constraints in the economy and the implications for inflationary pressures. We regard the neutral interest rate as the policy rate consistent with the economy growing at its potential in the medium term and having inflation expectations matching the price stability objective. McDermott, J (2013) “the role of forecasting in monetary policy”. Speech to FINSIA, Wellington, 15 March. BIS central bankers’ speeches through devices such as alternative scenarios, forecast ranges, and fan charts – that various economic outcomes are possible around a central projection. 4. Reflections on recent monetary policy in New Zealand Two important changes were introduced into the September 2012 Policy Targets Agreement (PTA). Firstly, the PTA requires the Bank to focus on keeping future average CPI inflation near the 2 percent midpoint of the target range. Secondly, it includes a stronger focus on financial stability, by requiring the Bank to monitor asset prices and have regard to the soundness and efficiency of the financial system in setting monetary policy. Including the reference to the midpoint in a medium-term context was aimed at lowering and stabilising inflation expectations close to 2 percent. This was important because for much of the period since 2000, annual CPI inflation has been in the top half of the 1–3 percent band, and measures of inflation expectations tended to average around 2.5 percent or higher. Recent data are positive on this front. As discussed in our September Monetary Policy Statement, survey measures of inflation expectations have fallen and are now consistent with inflation settling at 2 percent in the medium term. The PTA’s stronger focus on financial stability and the monitoring of asset prices requires the Bank to have regard to the potential impact of its monetary policy decisions on financial imbalances in the economy. We have used macro-prudential policy instruments and some prudential management interventions to help reduce the risks to the financial system and broader economy associated with a potential correction in Auckland house prices. Although financial stability considerations are secondary to the price stability objective in the PTA, housing market considerations do influence our thinking on the OCR. Our economy has been affected by several major shocks and adjustments in recent years. These include: the Canterbury earthquakes and subsequent rebuild activity; the 2013 drought; the terms of trade hitting a 40 year high and the subsequent 70 percent decline in dairy prices and early signs of a recovery in recent weeks; the 60 percent decline in oil prices; the related large swings in the real exchange rate; net migration and labour force participation reaching historically high levels; and annual house price inflation in Auckland reaching 25 percent, with house price to income ratios that are double those in the rest of New Zealand. All this has taken place in the context of unprecedented global monetary accommodation and, more recently, a significant slowdown in China and other emerging market economies. The PTA explicitly recognises (as has been the case), that annual headline inflation may fall outside the target band because of exceptional movements in commodity prices. The mediumterm focus of policy means that the Bank does not try to immediately correct deviations of inflation from its target range, but aims to do so steadily over time. Strong net migration flows have contributed to higher house price inflation, especially in Auckland, which attracts over half of the net migrant flow. Net migration however has had a smaller impact on broader inflationary pressures than in past cycles. One reason is the boost it provides to the labour force. In the two years to June 2015, the labour force expanded by 6.1 percent, enabling strong employment growth of 6.7 percent to be absorbed with only a moderate increase in wage costs. Moderate wage inflation, spare capacity and the decline in inflation expectations towards 2 percent have been important factors behind the subdued rate of non-tradables inflation. Structural elements linked to falling technology costs and the impact of on-line retailing may also have played a role. As new economic information became available we began scaling back our interest rate projections in the June 2014 MPS and in subsequent MPS’s. We commented more extensively on the level of the exchange rate, and cut the OCR three times in the period from June to September 2015. BIS central bankers’ speeches Recent economic indicators have been more encouraging. Some further easing in the OCR seems likely but this will continue to depend on the emerging flow of economic data. At the same time however, we remain conscious of the impact that low interest rates can have on housing demand and its potential to feed into higher price inflation. It is important also to consider whether borrowing costs are constraining investment, and the need to have sufficient capacity to cut interest rates if the global economy slows significantly. 5. Concluding comment Salle 77 in the Louvre is dominated by Thѐodore Gѐricault’s Raft of the Medusa, painted in 1819. Gѐricault drew inspiration from Caravaggio. It is a brilliant painting of the forlorn and exhausted sailors of the French Frigate, Mѐduse, desperately clinging to life on a makeshift raft in stormy seas. 14 Without wishing to draw any comparison between the occupants and central bankers, the wild seas are symptomatic of the world central bankers are trying to navigate. Central bankers’ goal of trying to smooth output gaps around the path of potential output hasn’t changed. But they are tasked with doing so while the global economy is in a difficult configuration with growth slowing in the developing world, unprecedented monetary accommodation, and prospects of tighter monetary conditions in the US and further easings in the euro-area and Japan. Little wonder that central bankers closely dissect new data and information, and cautiously feel their way with their policy responses. The French Royal Naval frigate, Mѐduse, sank off the coast of Senegal in 1816. Of the original 150 people on the raft, only 15 survived. BIS central bankers’ speeches
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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers' Chamber of Commerce, Christchurch, 3 February 2016.
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Graeme Wheeler: The global economy, New Zealand’s economic outlook and the Policy Targets Agreement Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the Canterbury Employers’ Chamber of Commerce, Christchurch, 3 February 2016. * * * Good morning and thank you for the opportunity to meet with you again, it’s a great pleasure to be here. I believe this is the 23rd year in which the Reserve Bank has been invited to meet with the Canterbury Employers’ Chamber of Commerce and offer some thoughts on the state of the economy. If it is helpful I’ll start with a few comments on the global economy, before turning to the domestic economy, the Policy Targets Agreement and the outlook for monetary policy. 1. The global economy Last year the global economy hit a soft patch and financial markets have had a rocky start to the current year. Global growth, at 3.1 percent, was the slowest since 2009 despite unprecedented monetary stimulus and falling oil prices. This wasn’t the first slowdown since the Global Financial Crisis (GFC), although previous episodes have largely occurred in the advanced economies, such as in the EU area in 2012. Indeed, the emerging and developing countries, led by China, have delivered a strong growth performance in recent years, accounting for about 80 percent of global growth since 2010 (measured in purchasing power parity terms) 1. This pattern began to change in mid-2014 with weaker trade volumes and slower growth in emerging markets – and especially in China, Russia, Brazil and South Africa. During 2015, foreign net capital outflows from emerging markets totalled USD 735 billion, the majority of which was out of China – the largest amount since 2008 2. Growth picked up in the advanced economies – particularly in the US and European Union. The slowdown in global growth hasn’t been for lack of monetary stimulus by central banks. In the history of the world as we know it, monetary conditions in recent years have never been easier. 3 A particular concern during 2015 was the slow growth (2 percent) in the volume of merchandise trade. Since the mid-1960s there have only been five occasions of weaker trade growth – each was associated with a major slowdown in global GDP growth (OPEC1, OPEC2, Asia Crisis and US high tech bubble, and the GFC) 4. The current weakness in trade volumes reflects the sluggish recovery in investment in advanced economies, slower growth in emerging markets, high inventories of commodities, and reduced import intensity in China. The Baltic Dry Index, which measures the cost of shipping raw materials such as minerals M Obstfeld, “The Global Economy in 2016”, IMF Survey Magazine, January 2016. Financial Times, “Capital Flight from China worse than thought”, January 20, 2016. Several developments illustrate this: policy rates are close to zero in most advanced economies, and negative in some; quantitative easing by the ECB and BoJ last year was the highest since 2011; sovereign bond yields in several countries – mainly in Europe – are currently negative for 2 year maturities and in some cases 5 year maturities; the policy rate at the Bank of England is the lowest since its inception in 1694; prices of financial assets and real estate surged to record levels in many countries; Switzerland sold 10 year bonds at a negative yield, and Mexico twice issued 100 year foreign-currency bonds that were heavily oversubscribed. OECD Economic Outlook; November 2015, page 19. BIS central bankers’ speeches and grains, has fallen nearly 70 percent since the end of July 2015 and is at its lowest level since the index was established 30 years ago. Figure 1: World trade volumes and GDP growth Source OECD. Forecasts of global GDP growth in 2016 look a bit more promising with the IMF, World Bank, BIS, and OECD forecasting growth of between 2.9 and 3.4 percent. However, if world trade remains depressed and market volatility continues, we are likely to see downward revisions to these forecasts. These institutional projections show improving growth in most advanced and emerging market countries (although with slower growth in China) and a pickup in world trade. All institutions see the balance of risks lying on the downside, with the main risks being: • Monetary policy in the three largest central banks is on a divergent path with the Federal Reserve having begun to raise the Fed Funds rate, while further monetary easing is possible in the euro-area and Japan. This policy divergence could lead to greater financial market volatility and uncertainty. • The weakness in commodity prices could be greater than projected and further reduce growth in commodity producers such as Brazil, Chile, Mexico, Russia, SaudiArabia and South Africa. • A further slowdown in China could feed through into lower demand and production in China’s many trading partners. For example, 10 percent of the European Union’s exports and 18 percent of Japan’s exports go to China. • The rapid build-up in non-financial corporate debt and falling corporate profitability in emerging markets pose risks to banking systems and to broader stability in these economies. Non-financial corporate debt in emerging market countries has increased from 60 percent of GDP to 90 percent of GDP since early 2009. At the same time, average emerging market profitability fell sharply in 2015 and is at its lowest level in a decade. 5 P Turner, The Financing of Emerging Markets Non-Financial Companies, BIS note to G20 Finance and Central Bank Deputies Meeting, 14 December 2015. BIS central bankers’ speeches Figure 2: Non-Financial Corporate Debt Note: The advanced economies group contains Australia, Canada, the euro area, Japan, Sweden, Switzerland, the United Kingdom and the United States. The emerging economies group contains Argentina, Brazil, China, India, Indonesia, Korea, Mexico, Poland, Russia, Saudi Arabia, South Africa and Turkey. Sources: IMF, Bank for International Settlements. At the country level, China represents the greatest risk to global growth given its impact on global trade volumes and commodity prices, the rapid build-up in corporate indebtedness and the difficult switching strategy (away from investment and manufacturing towards stronger private consumption and services) that is underway. China accounted for 40 percent of global growth in 2014. Although its output is 60 percent of that of the US (at market exchange rates), imports of non-oil commodities are around 2½ times those of the US. Market forecasts suggest that China’s economic growth is currently in the 5 to 7 percent range and supported by strong services sector production, whereas growth in activity in the manufacturing and construction sectors has slowed substantially. An area to watch closely is the rapid rise in China’s corporate indebtedness. At around 220 percent of GDP, China’s debt burden is not the highest among the largest economies, but the extent of its debt accumulation (over 70 percent of GDP in 6 years) is unprecedented. Most of the increase represents SOE debt, mainly in the areas of real estate, construction, mining and utilities. Many of China’s 155,000 SOEs are losing money, leverage has soared, and the average return on assets is low and falling. A key challenge will be how to begin the necessary de-leveraging process without causing a major slowdown in growth. Simulations by the OECD suggest that a reduction of 2 percentage points in Chinese domestic demand growth over the next two years, if accompanied by the types of financial market impacts on equity prices and uncertainly and risk premia that we observed in August last year and again more recently, would lower global growth by ¾ – 1 percentage point on average in 2016–2017 6. Its impact would be greater if this were accompanied by a sizeable and prolonged depreciation in the RMB that exports deflation to the rest of the world. “OECD Economic Outlook”, November 2015, pages 27–28. BIS central bankers’ speeches 2. Outlook for the New Zealand economy Our economy has faced a wide range of shocks since the GFC, some positive for growth, some negative. A partial list includes: the tightening in global liquidity in the immediate aftermath of the GFC; the Canterbury earthquakes; 2012/13 drought; terms of trade that reached a 40 year high; the 70 percent peak to trough movement in dairy prices; the 75 percent fall in oil prices; record net migration and labour force participation; sizeable movements in the real exchange rate and annual house price inflation in Auckland that reached 27 percent. Overall, the economy appears to have done reasonably well despite the headwinds created by some of these developments. The economy is in its 7th year of expansion. Annual GDP growth slowed to around 2½ percent in the first half of 2015, primarily due to the sharp decline in dairy prices, but the economy is projected to grow at around 3 percent over the next couple of years. At this stage there is nothing to suggest that the expansion will stop. However, more so than in recent years, there are greater uncertainties around the outlook, and, as with the global economy, the balance of risks lies on the downside. Foremost among these are the possibility of slower growth in China, weaker than projected dairy prices, and the implications of a serious El Nino event (although it appears that this threat has eased due to higher rainfall in recent weeks). The main upside risk is around the possibility of continuing strong migration inflows. i) Slower growth in China A marked slowdown in the Chinese economy would have important implications for New Zealand, especially if accompanied by a sharp decline in China’s household consumption. This would reduce the volume and price of our commodity exports to China, and likely affect our services trade, including exports of education services and tourism. Its overall impact on our economy would be magnified through other trade channels as China is the largest trading partner for over 100 countries – including our main trading partners. ii) El Nino New Zealand is experiencing El Nino weather conditions. Its impact on the economy will depend on whether it leads to drought conditions and, if so, where the drought hits and how long it lasts. A prolonged drought would lower agricultural production and reduce farm incomes. New Zealand’s last major El Nino occurred in 1997, and like the 2013 drought, reduced GDP by around ¾ percent. Farming patterns however, have changed considerably since the 1997 El Nino event. Since 1996, the dairy herd has increased by 61 percent, while sheep and beef numbers have fallen by 37 percent and 24 percent respectively. Dairy numbers have expanded in Canterbury, Southland, Waikato and Otago with much of the growth in Canterbury facilitated by extensive investment in irrigation. The severity of the 2012/13 drought reflected its impact in Northland, Waikato and the Manawatu – areas with heavy concentrations of dairying, but limited irrigation. 7 D Ford, A Wood, ‘El Niño and its impact on the New Zealand Economy’, RBNZ Analytical notes AN2015/07, December 2015. BIS central bankers’ speeches Figure 3: Irrigation by region (share of total hectares farmed) Source: Statistics New Zealand Agricultural Census. iii) Dairy prices Most dairy farmers have experienced two consecutive years of negative cash flows and cut back their spending. Our December 2015 MPS projections assumed that the price of wholesale milk power would rise gradually and reach USD 3300/metric tonne by mid-2018. The current auction price of USD 2188/metric tonne remains well below this level. Farm gate prices are falling in the US and Europe causing milk production to slow, while Fonterra expects production in New Zealand to decline by around 6 percent in the current season. Last week, Fonterra reduced its pay-out estimate for this season by 10 percent. iv) Net migration Over the past 3 years net permanent long-term migration has totaled 133,000. The December MPS projections assumed that we are about half way through the current migration cycle, which would make it the strongest net migration surge for several decades. However, there is considerable uncertainty around the magnitude of future flows given the difficulty in forecasting arrivals. A stronger or more persistent net migration inflow would create demand pressures, but also raise the economy’s supply potential. The impact on consumer price inflation would depend on how quickly the supply response (eg from the growth in labour force) offsets the additional demand generated by the net migration. However, property prices in the Auckland market and elsewhere would be pushed further upwards. 3. Policy Targets Agreement While the Policy Targets Agreement (PTA) for monetary policy is a relatively simple document, we continue to be surprised at the wide range of interpretations that we see in the media and in commentaries. I would like to take this opportunity to discuss: what the PTA says; the thinking behind the changes introduced in 2012; and how the Reserve Bank interprets the PTA – particularly in relation to recent data on inflation outcomes, and in relation to monetary policy going forward. BIS central bankers’ speeches i) What the 2012 PTA says The PTA has several important features, including: • A well-defined policy target to keep future CPI inflation outcomes between 1 percent and 3 percent on average over the medium term, with a focus on keeping future average inflation near the 2 percent target mid-point. • Recognition that inflation might deviate from its trend for several reasons such as international commodity price movements, natural disasters and government tax and other policy measures that affect prices. • A requirement that the Bank monitor asset prices, have regard to the efficiency and soundness of the financial system and seek to avoid unnecessary instability in output, interest rates and the exchange rate. ii) Considerations underpinning the 2012 PTA The 2012 PTA, which was signed by the Minister of Finance and myself in September 2012, recognises the flexible approach needed in making monetary policy decisions. Several considerations were important in this regard. • The 1 to 3 percent target range remains the central focus of the Bank’s flexible inflation targeting framework, as has been the case since 2002. The range was deliberately framed in a medium term context, with an “on average” connotation and recognized that inflation might move outside this band due to global developments in commodity markets, natural disasters, and/or government fiscal and regulatory decisions. • The concept of a mid-point objective was introduced with the objective of helping to lower and stabilise inflation expectations close to 2 percent. This was important because CPI inflation had averaged 2.3 percent since 2000 and measures of inflation expectations were averaging 2.5 percent or higher. The language deliberately emphasised the medium-term context of the mid-point objective. This was because attempting to move rapidly to a mid-point target could create damaging volatility in output and key relative prices, including asset prices, that could, in turn, threaten financial stability and undermine longer-term growth prospects. • The requirement that the Bank monitor asset prices was inserted for two related reasons. First, because of concerns at the rapid house price inflation and spillover into spending that New Zealand experienced in the mid-2000s (which was a key consideration behind the steady increase in the OCR during the mid-2000s that peaked at 8.25 percent in July 2007). Second, was the desire to avoid the serious economic and social damage caused by sharp falls in house prices that many economies experienced during the GFC. • In a similar vein, the addition of the phrase requiring the Bank to “have regard to the efficiency and soundness of the financial system”, recognised that interest rates affect the demand for credit, and therefore the balance sheets of households and financial intermediaries. The language requires the Bank to consider whether its monetary policy choices could undermine the efficiency and stability of the domestic financial system. iii) Recent Inflation data • Annual headline CPI inflation is currently 0.1 percent. Headline inflation is falling nearly everywhere across the globe, and is below the target range in nearly all of the 30 or so economies whose central banks pursue flexible inflation targeting. BIS central bankers’ speeches • Headline inflation in New Zealand is below the 1 to 3 percent band primarily because of negative tradables inflation caused by the slow global economic recovery and the 75 percent decline in oil prices that has taken them to a 13 year low. Domestic petrol prices at the end of 2015 were 8 percent lower than a year ago, reducing CPI inflation by 0.4 percentage points. In addition, the Government’s decision to reduce motor vehicle levies has taken 0.3 percentage points off the CPI. • Annual core inflation, at 1.6 percent, is consistent with the target range. 8 This is a useful measure of underlying inflation because it excludes one-off or highly volatile price movements that do not reflect fundamental sources of underlying inflation pressures. • Survey measures of inflation expectations have fallen and are now consistent with inflation settling at 2 percent in the medium term. Figure 4: Inflation expectations surveys and fitted curve Source: ANZ Bank, Aon Consulting, Consensus Economics, RBNZ estimates. • Non-tradables inflation is running at an annual rate of around 1.8 percent, but has been a little lower than forecast in recent years. This has also been the case in other advanced economies. Part of the reason is because the Phillip’s curve, which shows the relationship between unemployment gaps and annual CPI inflation, has flattened since the 1990s. G Price “Some Revisions to the sectorial factor model of Core Inflation”, RBNZ Analytical Notes, AN 2013/06, October 2013. BIS central bankers’ speeches Figure 5: Annual CPI inflation and unemployment gap Source: Statistics New Zealand, RBNZ estimates. The flatness of the relationship, in contrast with the clear negative relationship during the 1970s and 1980s, means that the economic recovery has translated into less inflation than historically might have been the case. There are several possible explanations for the flatness of the relationship. These include: inflation expectations embodied in wage and price setting behavior have fallen and become more stable; globalisation and increased competition from offshore is limiting the ability of businesses to raise prices; and greater labour mobility, high levels of net immigration, and concerns about job security may mean that workers do not press as much for higher wages when domestic demand increases. Over the past three years, higher than expected immigration appears to have been an important factor in moderating labour market pressures and wage outcomes. 4. Monetary policy going forward In balancing risks and making judgements about monetary policy we view the PTA flexibly, rather than taking a mechanistic approach. This is necessary in view of the numerous factors the Bank is required to consider – such as asset prices, financial stability and efficiency, volatility in output, interest rates and the exchange rate. All of these factors have bands of uncertainty attached to them. There are also considerable uncertainties associated with economic forecasting, and uncertainties as to which transmission channels monetary policy will operate through and the lags involved in achieving desired outcomes. The Bank’s main influence over inflation comes through its scope to influence the economy’s output gap and the degree of non-tradable inflation (which accounts for around half of the regimen that makes up the consumers price index). Monetary policy can also at times have a significant effect on inflation through its influence on the exchange rate and tradables prices. There are major structural forces acting to reduce inflation that domestic monetary policy cannot influence. These forces, arising typically from trends in globalisation, information technology and demography, have exerted substantial downward pressure on global inflation in recent years. BIS central bankers’ speeches Monetary policy also needs to work alongside other policies that can affect output growth and activity in markets, such as the housing market. For example, the Government’s fiscal policy has been contractionary in recent years and the regulatory framework around the housing market affects the supply and demand dynamics within that sector. Annual headline inflation is currently 0.1 percent. This is primarily because of the negative inflation in the tradables sector, and the decline in oil prices in particular. Low oil prices are recognised in the PTA as a factor that can legitimately cause inflation to be outside the target band. It would be inappropriate to attempt to offset the low oil price effect through the OCR, which tends to influence inflation outcomes over an 18 month to 2 year horizon. Our goal is to anchor inflation expectations close to the mid-point of the price stability target range, while retaining discretion to respond to inflation and output shocks in a flexible manner. In this regard, some recent inflation indicators are encouraging. Annual core CPI inflation, at 1.6 percent is well within the target range, and the Bank’s combined measures of annual inflation expectations are averaging 2 percent. We would not wish to see inflation expectations become unstable and decline significantly. Monetary policy is highly accommodative and the OCR is back to historic lows. Since the beginning of 2016, the New Zealand dollar has depreciated by around 4 percent on a tradeweighted basis and market interest rates have declined. Some further exchange rate depreciation is desirable given the ongoing weakness in export prices. We believe that imbalances in the Auckland property market pose a financial stability risk. Record low interest rates, along with record net migration inflows, strong bank lending, heightened investor activity, and insufficient housing supply have led to strong house price inflation in Auckland and an average house price to income ratio over 9.5 that is 70 percent higher than in the rest of the country. In addition, house price inflation has been accelerating in Waikato/Bay of Plenty, Northland and in Central Otago. Recent indicators suggest that housing activity in Auckland may be beginning to slow as a result of the Government’s measures introduced on 1 October 2015 and the macroprudential policy measures applying to investor-related lending. We will have a better feel for this when we see the February and March 2016 housing data. Nevertheless, the Bank’s macro-prudential policies have played an important role in reducing the risks associated with the growth in bank lending. Across the banking sector the share of high LVR lending (LVRs of 80 percent or higher) has fallen from 21 percent of overall housing lending before the introduction of LVRs, to 13 percent currently. Looking ahead, monetary policy will continue to be accommodative. With the ongoing weakness in commodity prices, and particularly oil, it will take longer for headline inflation to reach the target range. On the other hand, the data on core inflation and inflation expectations are more encouraging in terms of consistency with the PTA. However, most of the risks facing the economy are downside ones. Important amongst them is a rising concern about the strength of the global economy and increased financial market volatility. This reflects several factors, including the importance of growth in China and other emerging markets, tensions in oil and other commodity markets, and the prospect of increasing divergence between monetary policies in the major economies. In addition to the powerful structural forces that are reducing global inflation, our economy has been hit by several important supply-side shocks. These include falling oil and dairy prices, strong net migration flows and rising labour force participation. Some, such as the changes in oil prices, net migration and participation, are positive for growth, but all of the supply shocks are exerting downward pressure on inflation in New Zealand. These issues and the requirements in the PTA in respect of asset prices, financial stability and efficiency and volatility in output, interest rates and the exchange rate, mean that there is much to consider in determining monetary policy that extends well beyond the current level of headline inflation. If concerns deepen around the prospects for the global economy and its BIS central bankers’ speeches impact on New Zealand, some further policy easing may be needed over the coming year to ensure future average inflation settles near the middle of the target range. We will continue to monitor closely the emerging economic and financial data. Concluding comment The outlook for the New Zealand economy looks positive, with growth forecast to increase to an annual rate of 3 percent and inflation projected to move back within the target band. However, there are greater uncertainties around the economic outlook than normal, and the balance of risks lies on the downside. Foremost among these risks are the difficult external environment, weak commodity prices, and unusually strong net migration flows. In managing economic risks and assessing monetary policy we will continue to draw on the flexibility contained in the PTA and avoid taking a mechanistic approach to interpreting the PTA. A mechanistic approach could lead to an inappropriate fixation on headline inflation. It would cut across the flexibility deliberately built into the PTA framework and risk creating serious distortions in the financial system, housing market and broader economy. BIS central bankers’ speeches
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Speech by Dr John McDermott, Assistant Governor and Chief Economist of the Reserve Bank of New Zealand, to the Goldman Sachs Annual Global Macro Conference 2016, Sydney, 4 February 2016.
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John McDermott: Forward guidance in New Zealand Speech by Dr John McDermott, Assistant Governor and Chief Economist of the Reserve Bank of New Zealand, to the Goldman Sachs Annual Global Macro Conference 2016, Sydney, 4 February 2016. * * * Accompanying figures can be found at the end of the speech. Introduction I would like to thank Goldman Sachs for the invitation to speak here in Sydney today. It is a pleasure to take the trip across the Tasman to be part of your annual Macro Economic Conference. The focus of my comments today will be the Reserve Bank of New Zealand’s approach to forward guidance, and in particular, the publication of an endogenous outlook for the 90-day interest rate. I’ll touch on the benefits of this approach and how we aim to minimise the potential costs. I’ll highlight the importance of understanding the conditional nature of our forecasts. And I’ll finish by providing an illustration of the Bank’s conditional forward guidance in practice. Over the past few decades, transparency has become much more valued in the conduct of monetary policy. Transparency can improve the effectiveness of monetary policy, and increases the accountability of the central bank. Transparency is a value held in high regard at the Reserve Bank of New Zealand, which is seen as one of the most transparent central banks in the world.1 This value is applied to the way we conduct forward guidance, where the Bank is very open about its monetary policy outlook.2 In New Zealand, this includes the publication of a forward projection for the 90-day interest rate, comments on the outlook for policy, discussion of risks in our Monetary Policy Statement and the presentation of alternative scenarios. The Bank is one of only a handful of central banks that publish forecasts for the short-term interest rate.3 This is a practice we have maintained since 1997. The publication of the 90-day interest rate projection can improve the effectiveness of monetary policy in a number of ways. First of all, informing the public on our thinking about the transmission of monetary policy and a possible path of for interest rates can help individuals and businesses make more informed decisions.4 There are times when the Bank will know more about the economic situation and outlook than does the public or financial market participants. Every so often this will relate to Dincer and Eichengreen (2014), “Central bank transparency and independence: updates and new measures”, International Journal of Central Banking, Vol. 10, No. 1, pp 189–253, March 2014. For a discussion of the New Zealand experience see Bascand (2013), “Communication, understanding and credibility”, comments from Reserve Bank of New Zealand Deputy Governor Bascand, December 2013. The practice and definition of forward guidance can vary between both central banks and academics. Forward guidance can range from brief qualitative statements on the policy outlook in central bank communication, time or state dependent policy outlooks like those adopted by the United States Federal Reserve and the Bank of England post crisis, or the full publication of an endogenous interest rate forecast like at the Reserve Bank of New Zealand. These central banks include New Zealand, Czech Republic, Israel, Norway and Sweden. See Rudebusch and Williams (2008), “Revealing the Secrets of the Temple: The value of publishing central bank interest rate projections”, Asset Prices and Monetary Policy, University of Chicago Press. BIS central bankers’ speeches some research or insight we hold, but more typically this extra knowledge relates to knowing what the Bank itself plans to do. Second, the entire yield curve, rather than just the current level of the 90-day interest rate, has an influence on economic behaviour. Publishing the Bank’s projection for the 90-day interest rate can help shift the entire yield curve towards levels consistent with medium-term price stability, improving the effectiveness of monetary policy.5 Third, the publication of the 90-day interest rate projection helps accountability. Under the Policy Targets Agreement (PTA), the Bank is required to keep future average inflation close to the mid-point of the 1 to 3 percent target range, whilst avoiding unnecessary instability in output, interest rates and the exchange rate, and having regard for financial stability. This multitude of considerations influences the Bank’s judgement about how monetary policy should be adjusted to help move inflation towards its medium-term target.6 The publication of a 90-day interest rate projection, together with an inflation projection, conveys the Bank’s view of what it considers appropriate when making these considerations, and how this changes when new information becomes available. The Bank uses a range of modelling techniques and expert judgement to prepare a forecast for the 90-day interest rate. Our structural model, NZSIM7, is used to summarise all the new information provided by recent data, financial market developments, indicator models and our discussions with New Zealand businesses. Judgement is then added to this framework after the deliberation of our Monetary Policy Committee and Governing Committee. The 90-day interest rate projection, based on a range of assumptions, provides a guide of what monetary policy settings may be needed to return or keep inflation at target. We feel that this is a more informative approach than assuming a constant or market path for interest rates – which may present an interest rate path that is inconsistent with the Bank’s price stability mandate. Forward guidance – avoiding potential pitfalls This transparent approach comes with potential costs. First, research highlights that increased transparency, in some cases, can be detrimental to the economy. This is particularly the case if the public takes the Bank’s information as definitive, despite it being noisy or imperfect.8 We aim to minimise such instances by offering a full discussion of the assumptions and risks that underpin our projections, to clearly highlight the limitations in our knowledge. Second, some research claims that when a central bank provides an endogenous interest rate projection, fears of credibility loss may lead it to stick to a previously published policy path, even when faced with new economic developments.9 I can say, from my experience, that this has never been a problem at the Bank. For further discussion, see Woodford (1999), “Optimal Monetary Policy Inertia”, The Manchester School Supplement, Vol.67, Issue S1, pp 1–35. See Ford, Kendall and Richardson (2015), “Evaluating Monetary Policy”, Reserve Bank of New Zealand Bulletin, November 2015. See Kamber, McDonald, Sander and Theodoridis (2015), “A structural model for policy analysis and forecasting: NZSIM”, Reserve Bank of New Zealand Discussion Paper, DP2015/05. These points are expanded on in: Morris and Shin (2002), “Social value of public information”, The American Economic Review, Vol. 92, No. 5, pp1521–1534; Dale, Orphanides and Osterholm (2011), “Imperfect central bank communication: information versus distraction”, International Journal of Central Banking, Vol.7, No. 2, pp 3–39, June 2011. This issue is discussed in: Mishkin (2004), “Can central bank transparency go too far?”, NBER Working Paper 10829; Goodhart (2009), “The interest rate conditioning assumption”, International Journal of Central banking, Vol. 5, No.2, pp 85–108, June 2009. BIS central bankers’ speeches Third, some have argued that it may be difficult for a central bank to reach consensus on an entire path for interest rates.10 Practically, this has not been a problem at the Bank. Committee practices are efficient enough for the Governing Committee to reach an agreement on a qualified projection for the 90-day interest rate.11 More broadly, it is important that financial market participants and the public understand the 90-day interest rate is a conditional projection. It is not a commitment from the Bank to a specific set of actions. The effectiveness of monetary policy can be hampered if the public and financial market participants take the forecast as a commitment.12 The 90-day interest rate projection shows how interest rates may need to evolve to achieve price stability if the economy evolves in line with the Bank’s forecasts. Of course, the uncertainties faced in forecasting mean that the economy will almost always evolve differently to what the Bank expects. Cyclical factors like the strength of the international economy, movements in oil and other commodity prices, and the exchange rate can develop in unexpected ways. For example, at the current juncture, the economy is faced with a number of unique supply-side developments which add additional uncertainty to the outlook. These include reconstruction activity in Canterbury, the recent sharp fall in oil prices, a rapid rise in inward migration and the potential impacts of El-Nino. In addition to these business cycle developments, structural aspects that may be linked to factors such as globalisation, technology and demography can also have major impacts on economic growth and inflation. In normal times these structural aspects move relatively slowly. However they are important in determining how interest rates might affect inflation and the cycle in output and can move sharply in a crisis. All of these factors can affect the neutral interest rate, potential output and inflation expectations.13 If financial market participants understand the conditional nature of our forecasts, the 90-day interest rate projection can help participants understand how we are likely to respond to changes in the economic outlook. Every three months we provide a new projection for the 90-day interest rate. The changes in this projection, and the analysis in the Monetary Policy Statement (MPS) on the state of the economy, illustrate how unforeseen events have shaped the Bank’s outlook for policy. Over time, this should help financial market participants understand the Bank’s “reaction function” – that is, how economic events affect the outlook for inflation and the implications we draw for monetary policy. If financial market participants have a good understanding of our reaction function, and share similar views on the economy, interest rates should adjust to levels For example, see Goodhart (2009). Approaches to aggregating committee views are discussed further in: Svensson (2003), “The inflation forecast and the loss function”, Central Banking, Monetary Theory and Practice: Essays in Honour of Charles Goodhart, Vol. 1, pp 135–152. Bergstrom and Karagedikli (2013), “The Interest Rate Conditioning Assumption: Investigating the Effects of Central Bank Communication in New Zealand”, Reserve Bank of New Zealand, mimeo, find that if the public interpret interest rate forecasts as conditional, the forecasting performance of private agents for short-term interest rates is improved at short horizons. If the communication is interpreted as the central bank deviating from its interest rate rule, the forecasting performance of the public for short-term interest rates is again improved, but the forecasting performance for macroeconomic variables is worsened. The Bank has recently published a range of research on these factors. For more information see: Lienert and Gillmore (2015), “The Reserve Bank’s method of estimating ‘potential output’“, Reserve Bank of New Zealand Analytical Note, AN2015/01; Richardson and Williams (2015), “Estimating New Zealand’s neutral interest rate”, Reserve Bank of New Zealand Analytical Note, AN2015/05; Armstrong (2015), “The Reserve Bank of New Zealand’s output gap indicator suite and its real time properties”, Reserve Bank of New Zealand Analytical Note, AN2015/08; Lewis (2016, forthcoming) “Inflation expectations curve: a tool for monitoring inflation expectations”, Reserve Bank of New Zealand. BIS central bankers’ speeches consistent with medium-term price stability without the need for constant comment and intervention from the Bank. We try to facilitate this understanding by presenting a description of key judgements and alternative scenarios in our Monetary Policy Statements. These help illustrate how monetary policy would likely need to respond if judgements were to prove incorrect or if risks to the outlook were to crystallise. Financial market participants seem to have had a good understanding of the conditional nature of our projections. Figure 1 illustrates the point for the period since 2004. The red line in the chart shows how the market implied 1-year-ahead 90-day interest rate moves from the day after a Statement to the day before the next Statement. This change represents how market participants have interpreted the incoming economic data and events and how they think the Bank will respond. The blue line shows how the Bank revised its 1-year ahead 90-day interest rate projection from one Statement to another. The blue line gives an indication of how the Bank interpreted new economic events and the subsequent monetary policy response. Generally, market participants change their outlook for interest rates in a similar way to the Bank as new economic and financial information becomes available. The majority of the move in interest rates occurs before we have provided financial market participants with our interpretation of new events. This suggests market participants have a good understanding about how new information changes the Bank’s own outlook, the conditionality of the Bank’s projections and the Bank’s reaction function. Conditional commitment in action – changes in the policy outlook since 2014 The changes in the Bank’s policy stance since the beginning of 2014 provide a good illustration of the conditional nature of forward guidance in practice. At the March 2014 Statement, the 90day interest rate had averaged 2.85 percent in Q1 2014, and the Bank was projecting it to rise to 5.5 percent by Q3 2017. However, a number of factors led to a moderation in the outlook for inflationary pressure over the quarters that followed. Both cyclical and structural aspects of the New Zealand economy evolved in unforeseen ways. These events included significant falls in the prices of oil and New Zealand’s commodity exports, a stronger-than-expected exchange rate, weaker-thanexpected capacity pressures (and stronger potential growth), and weaker non-tradables inflation. Despite these developments, by the December 2015 Statement the Bank was projecting even stronger economic growth than had been expected in March 2014 (figure 2). This is not because the fundamental outlook had improved, but because this new information led the Bank to change its outlook for monetary policy and provide more stimulus to the economy. Indeed, the December 2015 Statement projected that the 90-day interest rate would be 2.6 percent in Q3 2017, almost 300 basis points lower than was forecast in March 2014 (figure 3). Given the weaker starting point for inflation, stronger growth was needed to bring inflation back to target. However, as discussed, this projection for stronger growth is conditional on a set of certain assumptions, and the Bank may need to change its activity and policy outlook if new events were to unfold. The changes in the 90-day interest rate projection over this time illustrate how flexible inflation targeting operates in practice. The forecasts evolved to ensure that medium-term price stability would be maintained. Therefore, despite inflation being weaker than expected and the revision to the 90-day interest rate outlook, the credibility of the monetary policy framework has been maintained. Medium-term inflation expectations have fallen over the past six months, but are currently near the 2 percent target midpoint (figure 4). External forecasters also expect inflation to return to target over the medium term. BIS central bankers’ speeches Crucially, the Bank is – and perceived to be – committed to its inflation target, which helps anchor inflation expectations. When formulating monetary policy, the PTA directs the Bank to have a forward-looking focus, irrespective of past inflation outcomes. The projection, at any time, seeks to ensure that price stability can be achieved while avoiding unnecessary instability in output, interest rates and the exchange rate. The Bank will continue to adjust monetary policy as conditions evolve to ensure that price stability is achieved over the medium term. Conclusion When it comes to communication, central banks use a diverse range of practices, and best practices differ from country to country. For New Zealand, we find it beneficial to publish a projection for the 90-day interest rate. It supports transparency, and its evolution over time contributes to market participants’ understanding of how the Bank responds to unexpected economic events. The projections are conditional in nature, reflecting the many challenges faced in forecasting the New Zealand economy. It is important financial market participants understand that these forecasts are not a commitment to a certain path of policy. Indeed, financial market participants generally have a very good understanding of the conditional nature of our forecasts. The experience since the beginning of 2014 highlights the conditional nature of our interest rate forecasts. Unforeseen economic events led to weaker-than-expected inflationary pressure in the economy. As a result, we significantly revised down the outlook for short-term interest rates. The Bank will continue to adjust monetary policy as conditions evolve to ensure that price stability is achieved over the medium term. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Speech by Mr Geoff Bascand, Deputy Governor and Head of Operations of the Reserve Bank of New Zealand, to Otago University, Dunedin, 7 April 2016.
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Geoff Bascand: Inflation pressures through the lens of the labour market Speech by Mr Geoff Bascand, Deputy Governor and Head of Operations of the Reserve Bank of New Zealand, to Otago University, Dunedin, 7 April 2016. * * * I wish to thank my colleagues at the Reserve Bank whose research on the labour market I have drawn upon in preparing these remarks, and in particular Miles Parker and Evelyn Truong. References can be found in the footnotes. Introduction Thank you for inviting me to speak today. It was a pleasure speaking as part of the Visiting Executives Programme last year, and even more so to have been invited back. Today I want to consider inflation pressures through the lens of the labour market. We have seen some extraordinary developments in the New Zealand labour market over the past three years and these pose challenges to our modelling of inflation pressures. Employment in New Zealand has increased by 180,000 or 8.3 percent over the past three years. In previous periods of very strong employment growth, such as the mid-2000s and the mid-1990s, wage growth accelerated. In the current cycle it has remained moderate. Even in Canterbury, with the demand pressures from rebuilding Christchurch and unemployment falling to around 3 percent last year, wage growth has been modest. Over the same period, we have experienced the largest recorded surge in immigration in more than 100 years, but without the generalised inflation pressures that accompanied the previous migration wave. The proportion of the population participating in the labour force reached record levels in 2015 and labour force growth has averaged about 2 percent per year since 2012, well above expectation (Figure 1). The Reserve Bank has undertaken considerable research over the past year on the impact of migration, labour market slack, and wage bargaining by New Zealand businesses. I will discuss what we have learned and the implications for monetary policy. BIS central bankers’ speeches To cut to the chase, recent low consumer price inflation can be mostly explained by falls in commodity prices and the high New Zealand dollar. However, the higher productive capacity of the economy from rapid growth in the labour force, much of which was unexpected three years ago, explains some of the remaining weakness in inflation.1 Strong labour force growth has had a moderating influence on wage inflation, and the migration cycle, in particular, has had lower inflationary impact than expected. I’ll begin by discussing how developments in the labour market affect inflation and monetary policy. Labour supply, demand and monetary policy Monetary policy works to meet our inflation target by setting interest rates to keep current economic activity close to its long run, sustainable level (i.e. potential output).2 When the level of output exceeds potential – that is to say there is a positive output gap – inflation tends to accelerate. Similarly, inflation tends to fall when the level of output is below potential. There are a number of measures of the output gap, but the balance of labour demand and supply is a central feature in most of them. It determines the cyclical impact on unemployment, wages and consumer prices (this relationship, known as the Phillips curve, was originally specified between wages and unemployment but is now often modelled between consumer price inflation and output).3 There is always some unemployment since it takes time to find a new position and the skills of job seekers may not match up with current vacancies.4 For example, many part-time workers in hospitality and retail were made redundant following the Canterbury earthquakes, whereas the vacancies arising from the rebuild are typically full-time construction jobs.5 When the level of unemployment deviates from its long-run “natural rate” it puts pressure on wages, in a similar fashion to the output gap and prices. When unemployment is below its natural rate, additional workers are relatively scarce and businesses will have to increase wages to entice people to seek work (from non-participation) or to move from other businesses. These higher wages increase business costs and put upward pressure on output prices. Indeed, labour costs are the factor most likely to cause price changes See McDermott, J (2015), “The dragon slain? Near-zero inflation in New Zealand”, Assistant Governor and Chief Economist, Reserve Bank of New Zealand, speech delivered to the Waikato Chamber of Commerce and Industry and Waikato branch of the Institute of Directors, Hamilton, 23 April. Potential output and monetary policy in New Zealand is discussed at length in McDermott, J (2014), “Realising our potential: Potential output and the monetary policy framework”, Speech by John McDermott, Assistant Governor and Chief Economist, Reserve Bank of New Zealand, 9 July. McDermott (2015), op cit. These frictions are modelled in more detail for New Zealand in Albertini, J, Kamber, G and Kirker, M (2012), “An estimated small open economy model with frictional unemployment”, Pacific Economic Review, 17(2): 326–353. Furlanetto, F and Groshenny, N (2012), “Matching efficiency and business cycle fluctuations”, Reserve Bank of New Zealand Discussion Paper, 2012/06, study the impact of changes in matching efficiency on US business cycles, finding that the impact can vary depending on the type of hiring costs faced by firms. Craigie, R, Gillmore, D and Groshenny, N (2012), “Matching workers with jobs: how well is the New Zealand labour market doing?”, Reserve Bank of New Zealand Bulletin, 75 (4, December): 3–12, discuss the New Zealand situation, highlighting the increased matching inefficiency in Canterbury following the major earthquakes there in 2010 and 2011. BIS central bankers’ speeches according to a recent survey of New Zealand businesses.6 Conversely, high unemployment puts downward pressure on wages and prices. With that framework in mind, we can look more closely at the factors driving the market and the consequences for inflationary pressure. Labour supply The labour that is available to be employed (labour supply) is determined by three main factors.7 First, is the working age population, itself a function of demographics and migration. Second, is the share of the working age population that participate in the labour force, either by working or by actively seeking work (the participation rate). Third, is the amount of time (number of hours) that people in the labour force are willing to work. Average hours worked per person have changed little recently. The main drivers of the rapid growth in labour supply are participation and population increase (figure 2). Many of the underlying demographic trends affecting the labour force are slow moving, and do not tend to affect monetary policy decisions from quarter to quarter. They do, however, have bearing on the conduct of policy, affecting long-run supply capacity, potential growth and neutral interest rates, so generally it is appropriate to consider both structural and cyclical forces. Not so long ago, the then Government Statistician8 projected the coming decades would exhibit much slower growth in the labour force and painted a picture of rising labour See Parker, M. (2014), “Price setting behaviour in New Zealand”, Reserve Bank of New Zealand Discussion Paper, 2014/04. Abstracting from considerations about skill levels or the quality of labour input. Given increasing educational attainment, labour’s contribution to growth has been stronger than aggregate hours. See Statistics NZ, (2008),” Accounting for changes in labour composition in the measurement of labour productivity”. See G. Bascand (2012), “Planning for the future: Structural change in New Zealand’s population, labour force, and productivity”, Government Statistician, Statistics New Zealand, Paper presented at Affording Our Future Conference, Wellington, NZ, December 2012. BIS central bankers’ speeches shortages – albeit over a fifty year horizon. In contrast, labour supply has been growing very rapidly, with cyclical forces dominating the longer-term lower trend. Participation The share of the population participating in the labour force, either by working or actively seeking work, has trended higher over the past 15 years, reaching around 69 percent in 2015. The main influences on this trend have been the ageing population, increased participation of older workers, and increased participation of women (figure 3). Figure 3: Contributions to change in labour force participation since 20019 As in many advanced economies, our population is ageing. Because older cohorts, and particularly those past retirement age, have a lower participation rate than the rest of the working-age population, an increase in the proportion of older cohorts, all else equal, decreases the aggregate participation rate. We’ve also experienced a significant increase in the participation of older workers, due to improved health and changes to retirement policies that encourage people to remain in the workforce for longer. The participation rate of the over-60s has increased from 14 percent in 2001, to 35 percent currently. This greater participation of older workers has exceeded the negative impact of the ageing population. Over the past 15 years, the participation rate of females has trended upwards, as social and cultural factors are seeing more women enter the workforce across all age groups. By contrast, the participation rate of men has been broadly stable. Participation can be cyclical because strong employment and wage growth encourage people to seek work, who otherwise would not choose to participate. Similarly, during downturns when unemployment rises and people spend longer time out of work, some are The chart shows the percentage point change in the participation rate since the March 2001 quarter attributable to each of the factors. The contribution from demographic change is calculated by holding the average participation rate of each age cohort fixed, and varying the relative size of each cohort. The contribution from youth participation is calculated by multiplying the change in the participation rate of male 15–19 year olds by the share of both sexes in that age cohort in the working age population in 2001. The contribution from the change in prime-aged (20–59) and older (60+) workers is calculated equivalently. The contribution from female participation is calculated by multiplying the increase in female participation beyond the change in the male participation rate by the share of females in the working age population. BIS central bankers’ speeches discouraged from seeking work and no longer participate in the workforce. A recent example of cyclical impact is Canterbury, where the strong rebuild activity encouraged additional workers to join the labour force. Participation in Canterbury rose from 67 percent at end-2011 to around 72 percent at the end of 2015, 4 percentage points above the rest of the country.10 Research underway at the Bank has identified there are large flows of people from outside the labour force directly into employment. This flow from non-participation into employment is much higher than that witnessed in other countries.11 Around two thirds of the newly employed – those who are employed in the current quarter but who were not employed in the previous quarter – come from non-participation, while only a third of the newly employed were unemployed in the previous quarter. One implication is that participation is potentially more sensitive to cyclical variation than previously thought. Another is that the unemployment rate is a weaker indicator of labour market slack and inflationary pressure than previously assumed. I will return to the measurement of slack later. Population In recent years, the main driver of population growth has been immigration, which is running at its highest rate for a century (figure 4). Net immigration has added about 130,000 people (3.5 percent) to the working age population in the past three years, and is projected to add a further 120,000 by 2018. Given its importance, I want to explain how migration affects the economy. The Canterbury rebuild is discussed in more detail in Wood, A, Noy, I and Parker, M (2016) “The Canterbury rebuild five years on from the Christchurch earthquake”, Reserve Bank of New Zealand Bulletin, 79 (3, February). See, for example, Elsby, M, Bart Hobijn, B and Sahin, A (2013), “On the importance of the participation margin for market fluctuations”, Federal Reserve Bank of San Francisco Working Paper Series, 2013–05 and Gomes, P (2009), “Labour market flows: facts from the United Kingdom, Bank of England Working Paper, 367. BIS central bankers’ speeches Migration increases aggregate demand in the economy. New arrivals require goods and services, and their household spending puts upward pressure on inflation. With housing supply fixed in the near-term, higher demand for housing increases rents and house prices and eventually encourages residential investment. The boost to demand from migrant spending and increasing activity generates additional demand for labour. However, recent work at the Reserve Bank12 suggests that the current migrant inflow may be having a smaller impact on demand and inflation than in previous cycles, partly due to the higher share of young migrants (figure 5). The study finds that younger migrants (17 to 29) have a smaller impact on inflation and real house prices than older migrants. This is probably because younger migrants arrive with fewer financial assets, spend less, and are less likely to purchase a house. Migration also boosts labour supply. In this cycle, fewer families and more work visas are likely to have boosted migrant participation. While students usually have lower participation, the recent relaxation of rules allowing migrants on student visas to work up to 20 hours per week may have boosted participation. Since migrants boost both supply and demand in the economy, the net effect on inflationary pressure can be ambiguous. Our historical experience has been that migration increases inflationary pressures in product and housing markets. In the current cycle, however, the migration drivers have been very different and recent research13 suggests that these differences matter for labour market outcomes. In particular, when migration is caused by weakness in the Australian economy (or the rest of the world), it increases labour supply at a time when our businesses are facing lower demand, and hence need less labour. This results in higher unemployment and lower inflationary pressure. Vehbi, T, “The macroeconomic impact of the age composition of migration”, Reserve Bank of New Zealand Analytical Note 2016/03. Armstrong, J and McDonald, C, “Why the drivers of migration matter for the labour market”, Reserve Bank of New Zealand Analytical Note 2016/02. BIS central bankers’ speeches Much of the current surge in net immigration is explained by weakness in the Australian labour market that has made New Zealand a relatively more attractive place to live. Fewer New Zealanders are departing for Australia, more are returning home, and foreign migrants who may have considered migrating to Australia are coming to New Zealand. The flow of net emigration to Australia has reversed over the past 12 months, and is the largest net inflow for 25 years.14 The differences in the composition and drivers of migration in the current cycle help explain why inflationary pressures have been more muted than expected. Labour demand and employment Following the 2007–08 global financial crisis, employment fell by over 55,000 in 2009. Since then, labour demand has recovered strongly (figure 6) and employment increased by over 8 percent in the past three years, well in excess of historical average growth rates. Higher household consumption arising from strong population and tourism growth and the Canterbury rebuild were major drivers of the employment growth, with jobs in construction accounting for more than a quarter of total jobs growth over the past three years. Labour market slack, wages, and inflation Having discussed the underlying causes of the recent strong growth in the labour force, I would like to conclude by discussing the implications for monetary policy. The labour market most directly influences consumer price inflation through wage outcomes. This is particularly true of non-tradables goods and services, where labour represents a higher share of the total cost of production.15 Broadly speaking, wage outcomes are Over the last 35 years, New Zealand has lost, on average, 16.5 thousand people per year through net emigration to Australia, In the past 12 months New Zealand gained 1600 people from Australia. Dunstan, A, Matheson, T and Pepper, H (2009), “Analysing wage and price dynamics in New Zealand”, Reserve Bank of New Zealand Discussion Paper, 2009/06. BIS central bankers’ speeches determined by three factors: labour productivity, inflation expectations and the balance between the demand and supply for labour. In the long run, growth in real wages – that is, wage growth beyond the change in consumer prices – should reflect labour productivity. Labour productivity in New Zealand has averaged only 0.8 percent per year since the global financial crisis, thereby limiting the increase in wages due to this factor. Wages affect consumer prices, but the relationship is complex and flows in both directions. Current and expected rates of consumer price inflation are factored into wage-setting. Recent research by the Bank highlights this relationship, with the majority of businesses, weighted by employees, reporting a direct or indirect link between inflation and wages.16 Other work has found that wage inflation expectations bear a closer relationship to past inflation outcomes than previously thought.17 In the March 2016 MPS, we expressed concern that recent declines in indicators of inflation expectations could become embedded in low wage settlements, thereby subduing inflation outcomes. Over the business cycle, a key driver of wage growth is the balance of supply and demand, or labour market “slack”. However, the unemployment rate is an inadequate indicator of labour market slack, particularly when the participation rate fluctuates. Researchers at the Bank have recently constructed a labour utilisation composite index, or LUCI, to help address this problem. Such indices combine the information in a large number of labour market variables into a single series of labour market tightness, and are used internationally to help gauge labour market pressures.18 The New Zealand index uses official statistics such as the HLFS and survey measures of the difficulty of finding labour, such as the QSBO.19 By construction, the LUCI has an average value of zero. A LUCI value above zero indicates greater labour market tightness than usual – a value below zero indicates greater labour market slack than usual. Our research shows that, historically, a higher LUCI has been associated with stronger wage growth. The LUCI suggests there was a large degree of slack in the labour market at the trough of the 2008–09 recession. The LUCI then gradually returned to zero, and has been around that level since early 2014 (figure 7). This movement is consistent with the range of the Bank’s suite of output gap indicators.20 With labour market conditions broadly in balance since 2014, there has been little additional upward pressure on wages recently. Nominal wage growth is currently around 1.6 percent per annum, noticeably below the rates witnessed in the mid-2000s (figure 8). Current wage growth is consistent with our models See Armstrong, J and Parker, M (2016), “How wages are set: evidence from a large survey of firms”, Reserve Bank of New Zealand Discussion Paper, 2016/03. Lewis, M., McDermott, J., and Richardson, A., (2016), “Inflation expectations and the conduct of monetary policy in New Zealand”, Reserve Bank of New Zealand Bulletin, 79 (4, March). See Yellen, J (2014) “Labour market dynamics and monetary policy”, Chair, Board of Governors of the Federal Reserve System, Speech given at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, for the use of an LUCI in the context of monetary policy discussions in the United States. The construction of the US LUCI is detailed in Hakkio, C and Willis, J (2013), “Assessing labor market conditions: the level of activity and the speed of improvement”, Federal Reserve Bank of Kansas City, The Macro Bulletin, July 18. See Armstrong, J, Kamber, G and Karagedikli, O (2016), “Developing a labour utilisation composite index for New Zealand”, Reserve Bank of New Zealand Analytical Note, 2016/04. Preliminary analysis of Statistics NZ’s new experimental monthly filled job series suggests it improves the LUCI and provides an earlier indication of changes in labour market slack. See Armstrong, J (2015), “The Reserve Bank of New Zealand’s output gap indicator suite and its real-time properties”, Reserve Bank of New Zealand Analytical Note, 2015/08. BIS central bankers’ speeches and the outturns we have experienced for productivity, inflation expectations and labour market slack. That current wage growth is lower than we expected two years ago reflects a slower than anticipated reduction in slack due to the unexpected increase in the labour force from migration, weak productivity growth and lower than expected headline inflation, particularly from oil and other tradable prices. Despite the lower nominal wage growth, real wage growth has been historically high. Given the sluggish performance of labour productivity, this high real wage growth likely reflects the downward surprises to headline inflation. In the absence of higher labour productivity growth, these recent increases in real wages are unsustainable in the long run. BIS central bankers’ speeches Concluding remarks In the past four years, New Zealand’s population has grown by a quarter of a million people, with over half that number coming from overseas. The migration surge has contributed to housing and consumer demand but had less impact on inflation than in previous migration cycles. The New Zealand economy has expanded steadily since 2011, with strong employment growth. Notwithstanding the 180,000 extra jobs, the unemployment rate has declined only modestly. The surge in net migration, together with higher labour force participation from women and older workers, has led to rapid labour force growth and an increased supply capacity of the economy. A new measure of labour market slack (the LUCI) suggests that labour supply and demand are broadly in balance. Unexpectedly strong growth in labour supply, along with the characteristics of the migration cycle, substantially explains why wage and non-tradables inflation pressures have been weaker than expected. Stronger than expected labour supply, and greater than expected slack, has been a factor in in our assessment that it has been appropriate to keep monetary policy accommodative. In view of the close relationship between labour market dynamics and inflation pressures, we will continue to monitor a broad range of labour market indicators to help inform our monetary policy decisions. BIS central bankers’ speeches
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Speech by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to the New Zealand Institute of Valuers, Wellington, 7 July 2016.
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Grant Spencer: Housing risks require a broad policy response Speech by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to the New Zealand Institute of Valuers, Wellington, 7 July 2016. * 1. * * Introduction New Zealand is experiencing a housing market boom. House prices are increasing at 13 percent per annum nationally, and at 15–20 percent in Auckland and close-by regions. Evidence from housing cycles in several advanced economies suggests that the longer this continues, the more likely there will be a severe correction. The Reserve Bank is mandated to promote the soundness and efficiency of the financial system. Our concern is that a severe housing correction would pose real risks for financial system stability and the broader economy. The banks are heavily exposed to housing with mortgages making up around 55 percent of total assets. Household debt, at 163 percent of household income, is at a record level. Many domestic and international factors are contributing to the strength of the market. The current record low interest rates are a world-wide phenomenon linked to post-GFC caution and very low inflation in the global economy. Also driving local housing demand has been an unprecedented net migration inflow over recent years reflecting New Zealand’s stronger economic performance relative to many other advanced economies. While strong demand has been underpinned by low interest rates, rising credit growth and population increases, the housing supply response has been constrained by planning and consenting processes, community preferences in respect of housing density, inefficiencies in the building industry, and infrastructure development constraints. The resulting housing market imbalance has been exacerbated by New Zealanders’ on-going preference for investment in bricks and mortar over financial investments, due in part to the ready availability of credit and a tax system that favours debt funded capital gains. Given the complexity of factors underlying the housing situation, there is no simple policy solution. We need to tackle housing on many fronts. The key challenge in the long run is to expand housing supply to meet the growing demand. The Reserve Bank has no direct influence over supply, but can influence housing demand through the credit channel. The Bank’s interest rate policy is targeted primarily at keeping future CPI inflation between 1-and-3 percent on average over the medium term, although it must also have regard to the soundness and efficiency of the financial system. The Bank’s other relevant instrument is macro-prudential policy. This can improve the resilience of banks’ balance sheets on a lasting basis and help restrain credit and housing demand, at least for a period. Today I will describe recent developments in the housing market and the imbalances that appear to be widening across the country. I will touch on the range of policies that could help to address these imbalances and focus on Reserve Bank policies that might assist. Specifically, I will review the macro-prudential policy options that the Bank is considering, with a view to possible implementation over the months ahead. 2. Initial loan-to-value (LVR) restrictions The Reserve Bank first introduced a broad 80 percent LVR restriction in October 2013, in response to growing housing market pressures and an increasing proportion of high LVR lending from 2011. Then, in November 2015, a resurgence of pressures in Auckland led the Reserve Bank to tighten the LVR restriction to 70 percent for Auckland investors. The LVR restriction was eased somewhat outside of Auckland as housing risks in the regions had not increased significantly since the implementation of the initial LVR policy. BIS central bankers’ speeches The Reserve Bank also established a new residential property investor class for banks. Loans in that class now attract a higher risk weight than for owner-occupier mortgages, requiring banks to fund such loans with a higher proportion of equity. The LVR restrictions have strengthened bank balance sheets against housing market shocks. The share of banks’ exposures to riskier mortgages has fallen across a variety of borrower types. Nationally, new investor lending at LVRs above 70 percent has fallen by around one third following the 2015 policy changes. It is now largely impossible to borrow more than 70 percent against an Auckland rental property. More broadly, the share of high LVR (+80 percent) mortgages on bank balance sheets has continued to trend downwards. High LVR loans now account for 12 percent of banks’ residential mortgage exposures, compared to around 21 percent just prior to the initial introduction of LVR restrictions in 2013 (Figure 2.1). This amounts to a reduction in high LVR (+80 percent) lending of around $20bn. Over time, these balance sheet trends will help to reduce banks’ losses on riskier loans in the event of a downturn in the New Zealand housing market. In so doing, it would facilitate a continued flow of credit through a downturn. Figure 2.1 Stock of high-LVR mortgages (% of total bank mortgage lending) The LVR restrictions were expected to have a temporary impact on house price inflation, house sales and housing credit. Auckland house price inflation and house sales fell more than expected in the months immediately following the introduction of the new restrictions in November 2015. However, the housing-related government tax changes, together with reduced offshore interest due to new requirements for IRD numbers, probably also restrained housing demand over this period. Our assessment is that the 2015 LVR policy changes brought about a 2–4 percentage point reduction in Auckland house price inflation over a six month period. This price impact is similar to that assessed for the initial LVR restrictions in 2013. 3. Recent worsening of housing imbalances New Zealand house price inflation began to accelerate again from around March 2016 as demand pressures intensified in Auckland. In the meantime, other regions were contributing to higher national house price inflation from mid-2015, particularly those areas adjacent to BIS central bankers’ speeches Auckland. Most regional centres are now experiencing annual house price inflation in excess of 8 percent (Figures 3.1, 3.2). Similarly, sales activity increased across the country in the first half of 2016. Reflecting the underlying housing shortage, new listings have remained flat. Listings as a proportion of sales are now 40 percent below the previous low seen at the height of the pre-GFC boom in 2007. Figure 3.1 Annual house price inflation (3 month moving average, s.a.) Auckland house price inflation in excess of income growth has seen the median house price to income ratio grow to 9.7 times in the most recent Demographia survey 1, making Auckland the fourth most expensive city relative to income out of 367 cities worldwide. This ratio is at an historical peak, having doubled since the early 2000s. Outside Auckland, house price to income ratios in most centres are around 4 to 6 (Figure 3.2). However, if house prices in the regions continue to grow at current rates, those ratios will worsen. Overall, New Zealand house prices relative to incomes are 32 percent above their long run average, and the second highest in the OECD 2. The IMF estimates that New Zealand house prices are around 20–40 percent overvalued based on long run affordability metrics 3. Cox and Pavletich (2016). http://www.oecd.org/eco/outlook/focusonhouseprices.htm. Mohommad, Nyberg, and Pitt (2016). BIS central bankers’ speeches Figure 3.2 House price inflation and price-to income ratios by urban area Increased housing demand has been driven by record net immigration, low mortgage interest rates and increasing investor participation. Net migration flows continue to hit new records, with annual net PLT migration now approaching 70,000 persons. Migration flows are also becoming more dispersed, with non-Auckland numbers recently rivalling the flow into Auckland. Mortgage rates declined over 2015 as the Reserve Bank eased interest rates in light of on-going low CPI inflation. One and two year rates are now in the low 4 percent range, which New Zealand has not seen since the 1950s. A dominant feature of the housing market resurgence has been an increase in investor activity (Figure 3.3). In recent months, investors have accounted for around 43 percent of sales in Auckland and 38 percent in other regions. Investor borrowing has maintained much of its momentum even though it is taking place at somewhat lower average LVRs. The prospect of capital gains appears to remain a key driver for investors in the face of declining rental yields. Figure 3.3 New Zealand house sales by buyer type (number of dwellings, s.a.) BIS central bankers’ speeches The declining affordability of New Zealand housing and increasing investor presence have seen a downward trend in the share of households owning their own home. This ratio has fallen steadily since the early 1990s, reaching 64.8 percent at the 2013 Census. The recent increase in investor housing activity suggests that the home-ownership rate may have declined further since 2013. The Reserve Bank considers that rising investor participation tends to increase the financial stability risks relating to the household sector in severe downturn conditions. Evidence from the UK and Ireland shows mortgage default rates significantly higher for investors (at any given LVR). There are likely to be a variety of reasons for this, but an important one is that owner-occupier households need to move out of their own home if they default, giving a powerful incentive to continue servicing their mortgages if at all possible. Investors do not face the same incentive for their rental properties and are also more likely to face income shocks (like rental vacancy) at the same time that house prices fall. Our view on the riskiness of investor lending is shared by other banking regulators. In recent years concern about investor lending has led the Australian Prudential Regulation Authority to limit growth in Australian bank lending to residential investors, the Basel Committee on banking supervision has recently recommended significant increases in the amount of capital held against investor mortgage lending, and the Bank of England has proposed rules that effectively tighten lending criteria for investor mortgages. Despite high rates of debt repayment, housing credit increased by 8 percent in the year to March 2016, its highest growth rate since 2008. New mortgage commitments are also elevated, running at an annual rate of 35 percent of outstanding housing debt. With high rates of churn in mortgage books, recent increases in interest-only lending and high debt-toincome lending could rapidly affect the quality of banks’ overall mortgage portfolios, tending to dilute the improvement generated by the LVR restrictions. Interest-only and high debt-toincome (DTI) lending to housing investors has increased considerably more than for owner occupiers. Persistent housing credit growth in excess of income growth has caused the household debtto-income ratio to grow steadily since 2012. At 163 percent this ratio now exceeds the previous peak reached during the GFC. There is a clear risk that on-going high house price inflation could lead to a further deterioration in the household debt-to-income ratio. While low interest rates have helped to contain debt-servicing ratios (DSRs) for New Zealand as a whole, high and rising debt levels leave households very vulnerable to any future increases in interest rates or deterioration in economic conditions. While a large increase in mortgage rates is unlikely in the current global environment, at today’s high debt-to-income ratios, a relatively small increase in interest rates could put significant pressure on some borrowers. This is particularly the case in Auckland, where DSRs for new buyers are close to 50 percent (Figure 3.4). A 1 percentage point rise in interest rates for these new buyers would boost the proportion of income devoted to mortgage servicing by around 5 percentage points. BIS central bankers’ speeches Figure 3.4 Representative Buyer DSRs (annual, % of average gross household income) On the other side of the housing market is the inability of new supply to meet the growing demand, particularly in Auckland. Although Auckland annual housing consents recently reached an 11 year high and are some 20 percent above last year in value, the number of residential building consents per capita in Auckland is currently around 40 percent of the peak level achieved in the mid-2000s. We estimate the shortage of houses in Auckland has increased over the past year and may now be in the order of 20,000–30,000 houses. Furthermore, the overall housing shortfall is expected to increase further as supply is growing more slowly than demand. More encouraging is the higher-intensity building development that is now contributing a greater share of new dwelling consents. Apartments, townhouses and other attached dwelling types accounted for 42 percent of new residential building consents in Auckland over the past two years, compared to 28 percent nationally. Figure 3.5 New Zealand housing demand and supply (annual) Note: this is based on an assumed average of 2.6 persons per household across New Zealand. BIS central bankers’ speeches Outside Auckland, housing supply has been more responsive to population growth. Consent issuance has been relatively strong in regions that have experienced the fastest rates of population growth. Supply in the Bay of Plenty has been particularly responsive, with an elasticity of consents to population growth that is twice the size of Auckland’s (Figure 3.6). International evidence from the GFC suggests that elastic housing supply responses can dampen house price cycles by reducing the degree of housing scarcity, and price growth, in the up phase of a housing cycle. Figure 3.6 Regional building consent elasticities4 4. A broad policy response is needed On-going supply-side constraints combined with rapid growth in the demand for housing continue to create significant imbalances in the housing market, particularly in Auckland. In order to relieve those imbalances, a range of initiatives is needed to increase the long-term housing supply response and moderate housing demand. The relevant policy areas extend well beyond financial policy and the responsibilities of the Reserve Bank. In this regard, we see the Reserve Bank as part of a team effort. The Productivity Commission’s Report, Using land for housing, released in October 2015, notes that an insufficient supply of land ready for new housing remains at the heart of the rise in house prices seen in Auckland and other high growth areas of the country. Costly and restrictive planning rules and regulations, insufficient provision of infrastructure required to make land ready for development, and a planning system unable to respond adequately to changing demand patterns were among the factors the Commission cited as contributing to the shortfall in housing-ready land. The Commission proposed a range of measures for the Government and local councils. The proposals include setting expectations for councils about the availability of land for For clarity, the estimate of Christchurch’s elasticity (ratio = 2) has been omitted from the chart as the estimate is affected by the post-earthquake spike in building activity. BIS central bankers’ speeches development, creating a system to measure development capacity, providing options to intervene when development capacity falls short of what is required and improvements around the financing and provision of infrastructure. In respect of the latter, the recent Government initiative to establish a Housing infrastructure Fund will help to relieve an important constraint. The Government has also recently released its proposed National Policy Statement (NPS) on urban development capacity which requires councils to ensure sufficient land supply to meet projected housing and business development needs. Councils will be required to monitor developments around housing affordability, building and resource consents and the value of land on urban boundaries. They will be required to ensure price competition, coordinate infrastructure development and streamline consenting processes. The NPS appears consistent with recommendations made by the Productivity Commission and should facilitate a greater supply of housing-ready land over time. A major supply-side milestone will be the outcome of the Auckland Unitary Plan (AUP) Independent Hearings Panel, which is expected to make final recommendations to the Auckland Council by 22 July. The Panel’s recommendations and the Auckland Council’s response to those recommendations will be crucial in setting the future path towards reducing the housing market imbalance. As a means of gaining further traction on the supply side, the Reserve Bank supports the idea of a framework for establishing Urban Development Authorities (UDAs). These would be Crown or local body entities, with powers to assemble and acquire land, accelerate planning and consent processes and oversee coordination of all the parties involved in housing development. Such entities could also potentially undertake the funding and development of infrastructure. UDAs have been used in various forms in a number of countries including Australia, the UK and the US to facilitate major housing developments in designated areas. However, by their nature, the role and powers of UDAs would be contentious and their creation would have to be carefully managed. While boosting the capacity for development and housing supply is paramount, it is also important to explore policies that will keep the demand for housing more in line with supply capacity. Two areas for on-going consideration include tax and migration policy. On the tax front, the implementation of the bright line test for housing investors introduced in October last year has helped curb short-term speculative activity in the housing market. Consideration might be given to further reducing the tax advantage of investing in residential housing. Like taxation of investor-owned housing, migration policy is a complex and controversial issue. However, we cannot ignore that the 160,000 net inflow of permanent and long-term migrants over the last 3 years has generated an unprecedented increase in the population and a significant boost to housing demand. Given the strong influence of departing and returning New Zealanders in the total numbers, it will never be possible to fine-tune the overall level of migration or smooth out the migration cycle. However, there may be merit in reviewing whether migration policy is securing the number and composition of skills intended. While any adjustments would operate at the margin, they could over time help to moderate the housing market imbalance. 5. What role can the Reserve Bank play? Low domestic interest rates have contributed to the increasing housing demand. Under the Policy Targets Agreement (PTA), the 1–3 percent inflation target range is the central focus of the monetary policy framework. However, the Bank must consider whether its monetary policy choices could undermine the efficiency and stability of the domestic financial system. In current circumstances, the PTA rules out actively leaning against the housing cycle using monetary policy. Doing so would risk driving CPI inflation below the target range over the medium term. Conversely, further reductions in the OCR could pose a risk to financial stability through their effect on credit growth and house prices. While the outlook for CPI BIS central bankers’ speeches inflation will ultimately determine the future path of monetary policy, the trade-off against financial stability risk needs to be carefully considered. The Reserve Bank’s primary policy instrument for promoting financial stability is prudential policy. The Reserve Bank’s baseline prudential policies require banks to hold permanent capital and liquidity buffers against adverse shocks that might occur in a severe business cycle downturn. We also have macro-prudential policies that impose additional safety requirements in periods when there is heightened risk of an extreme housing cycle. Such policies are relevant for the New Zealand banking system where residential mortgages make up around 55 percent of banking system assets and where a large share of total housing credit is to residential investors who have a relatively high risk profile. The main macro-prudential tools include loan to value ratios (LVRs); debt-to-income ratios (DTIs) and higher capital requirements for housing loans (capital overlays). These three instruments tackle housing cycle risk from different perspectives and can be seen as complements. The LVRs, which are already in place, help to reduce the impact of mortgage defaults on bank earnings by increasing the security coverage on housing loans. LVRs also tighten up banks’ lending conditions, potentially leading to a slow-down in credit growth and house price inflation for a period. Debt-to-income ratios have been used internationally but not yet in New Zealand. DTIs aim to improve the safety of borrowers’ balance sheets, thereby reducing the likelihood of mortgage defaults in a downturn. In particular, debt-to-income limits are intended to better equip borrowers to continue servicing mortgages in the face of income losses and/or increases in interest rates. DTIs, like LVRs, tighten credit conditions, resulting in some brake on credit and house price inflation. Capital overlays, like LVRs, improve the capacity of banks to absorb losses from mortgage defaults in a downturn. Additional capital requirements might also slow credit growth as banks adjust to higher equity funding. How might these macro-prudential instruments assist in the context of the current housing market imbalances? The original 2013 LVR restrictions (requiring a maximum 80 percent LVR for most mortgage borrowers) and the Auckland investor LVRs brought in last year (reducing Auckland investor LVRs to a maximum of 70 percent), have had the intended effect of making bank balance sheets more resilient to a potential housing downturn. Together with the Government’s October 2015 tax measures, the Auckland investor LVRs also helped to reduce Auckland house price inflation from its peak of 27 percent pa in September 2015 to 12 percent in May 2016. As discussed earlier, we have recently seen spill-over effects in the regions close to Auckland and a more general resurgence in housing market pressures across the country. The proportion of sales to investors nationally has grown from 34 percent in January, to 39 percent in May this year. LVRs on new investor lending have reduced significantly, but new credit commitments to investors have recently been growing about twice as fast as for the overall market. Investors have effectively used equity generated by increased valuations on their existing portfolios to raise the larger deposits needed for new acquisitions. The Reserve Bank has a range of policy options available. One is tighter LVRs to counter the growing influence of investor demand in Auckland and other regions, and to further bolster bank balance sheets against a housing market downturn. Given the growing housing market pressures across the country, one approach would be to adopt a single national LVR limit for investors. Given that the banks have much of the relevant systems work in place, we expect that such a measure could potentially be introduced by the end of the year. Another option is a new debt-to-income (DTI) speed limit to complement the LVR requirements by improving the resilience of household balance sheets to income or interest rate shocks. A DTI limit would make defaults less likely in a downturn. Furthermore, a DTI BIS central bankers’ speeches and LVR in combination would constrain credit growth and house price pressures on a more sustainable basis than would LVRs alone. A DTI would be a new instrument that would need to be agreed with the Minister of Finance under the Memorandum of Understanding on Macro-prudential Policy. Adoption would require more analysis and systems preparation than an extended LVR. We intend to consult with the banks on the viability of a DTI policy and data issues before making a decision on implementation. A third option is a housing capital overlay. The Reserve Bank has already indicated that it will be conducting a full review of bank capital requirements over the coming year. We will consider whether macro-prudential overlays have a role to play as part of that process. 6. Conclusion In conclusion, the Reserve Bank is concerned about the risks to financial and economic stability inherent in the growing housing market imbalances. Auckland pressures are reemerging following an easing in the market from late 2015, and house price inflation has accelerated in a number of regions. The causes of the imbalances are complex with a number of important drivers on both the demand and supply side. Addressing these imbalances will require policy action by a variety of agencies on a number of fronts. The underlying housing shortage needs to be urgently addressed, particularly in Auckland where population growth continues to outstrip housing construction. A step up in supply is required and finalisation of the Auckland Unitary Plan will be a key opportunity to facilitate such a step. On the demand side, the key drivers are population growth and easy credit. The low cost of credit is making higher debt levels affordable, particularly for investors who can deduct interest costs from taxable income. Residential investors are accounting for an increasing share of house sales and new mortgage credit. The Bank’s interest rate policy must have regard to financial stability concerns, but the global environment is likely to keep interest rates low for some time yet. Macro-prudential policy can assist in containing the growing risk to financial stability as the current housing market reaches new extremes. In light of the growing risk, the Reserve Bank is closely considering measures that could be progressed in the coming months. References Cox, W and Pavletich, H. ‘12th Annual Demographia International Housing Affordability Survey. Rating Middle-Income Housing Affordability’ Demographia International Housing Affordability Survey (2016 Edition: Data from 3rd Quarter 2015). Mohommad, A., Nyberg, D., and Pitt, A. ‘New Zealand: selected issues’. IMF Country Report 16/40, February 2016. Andrews, D., Sanchez, A.C. and Johansson, A. ‘Housing Markets and Structural Policies in OECD Countries’. OECD Economics Department Working Paper No. 836 January 2011. Spencer, G. ‘Action needed to reduce housing imbalances’. Speech delivered to the Chamber of Commerce in Rotorua, 15 April 2015. BIS central bankers’ speeches
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Speech by Dr John McDermott, Assistant Governor and Chief Economist of the Reserve Bank of New Zealand, to the Manawatu Chamber of Commerce, Palmerston North, 13 July 2016.
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John McDermott: How the Bank formulates and assesses its monetary policy decisions Speech by Dr John McDermott, Assistant Governor and Chief Economist of the Reserve Bank of New Zealand, to the Manawatu Chamber of Commerce, Palmerston North, 13 July 2016. * * * Introduction Thank you for the opportunity to meet with you this afternoon. My comments today will focus on the process of making a monetary policy decision. I do not intend to send any particular messages about upcoming monetary policy announcements. Seven times a year, the Bank announces a decision to set the Official Cash Rate (OCR). Four of these announcements are accompanied by a Monetary Policy Statement. Each OCR decision and Statement publication is a complex process involving many staff from across the Bank. The significant amount of background work reflects the uncertainty we face when setting monetary policy to achieve the objectives of the Policy Targets Agreement (PTA). As one example of this uncertainty, major economic data are often released with a significant lag, and remain subject to revision for some time. This makes interpreting even the current economic environment difficult. Inflation-targeting central banks have adopted some common features in their decision making to deal with uncertainty. These include policy discussions within a committee environment, consideration of a wide set of information, a focus on transparency and clear communication to stakeholders, and generally modest moves in policy settings with the chance for regular review. Today I want to focus on the Bank’s approach to two of these elements – committee decision making and reviewing our forecasts. My comments summarise some recent and upcoming Bulletin articles. 1 Making a monetary policy decision The Bank has used committees in its monetary policy decision making process for many years. Historically, their use has been most prevalent in policy discussion and advice. 2 In 2013, the Bank maintained the advisory role of its committees, and strengthened the role of committees in making a monetary policy decision. 3 These changes mean the Bank now relies less on the single decision maker model. The Governing Committee was formed, with this committee responsible for reaching a decision See: Lees (2016), ‘Assessing forecast performance’, Reserve Bank of New Zealand Bulletin, Vol. 79. No. 10. June 2016; Reid (forthcoming), ‘Evaluating the Reserve Bank’s forecasting performance’, Reserve Bank of New Zealand Bulletin; and Richardson (2016), ‘Behind the scenes of an OCR decision in New Zealand’ Reserve Bank of New Zealand Bulletin, Vol. 79. No. 11. July 2016. For a description of previous approaches to decision making at the Bank see: Brash (2001), ‘Making monetary policy: a look behind the curtains’, remarks by Donald Brash, Governor of the Reserve Bank of New Zealand, 1 March 2001; RBNZ (2007), ‘Submission to the Finance and Expenditure Committee inquiry into the future monetary policy framework’. See Wheeler (2013), ‘Decision making in the Reserve Bank of New Zealand’, remarks by Graeme Wheeler, Governor of the Reserve Bank of New Zealand, 7 March 2013. BIS central bankers’ speeches on the appropriate setting for monetary policy. The Governing Committee consists of the Governor, the Deputy Governors and the Assistant Governor. The Governor retains statutory responsibility for policy decisions. The Governor’s decision making responsibility is similar to the arrangement at the Bank of Canada, which has a single decision maker model in its legislation, but makes policy decisions within a committee framework. Making a decision by committee allows the consideration of a greater range of viewpoints. A group of individuals with a diverse and differing set of useful information should make generally more informed decisions than an individual. 4 The Bank’s Monetary Policy Committee (MPC) acts as an advisor to the Governing Committee on monetary policy issues. The MPC is made up of several senior staff (including the Governors) and two external advisors. After extensive background analysis, members of the Bank’s staff, the MPC and the Governing Committee work together over a 9-day period towards making a monetary policy decision and publishing a Statement (figure 1). In the first three days of this process, the Governing Committee has discussed with the staff and MPC: current economic and market developments; an initial set of economic projections; key risks and judgements that make up the projections; and a number of alternative scenarios and policy options. This is supplemented by a range of additional information relevant to the policy outlook, including information on trends in household and business credit and unobservable variables like the output gap, inflation expectations and the neutral interest rate. Particular effort has been made over these three days to ensure a diverse range of views and opinions have been heard. 5 The set of meetings conclude with a final set of conditional projections for the economy over the next 2–3 years and a conditional projection for the 90-day bank bill rate. Figure 1 The monetary policy decision making process in New Zealand After consideration of this information, the Governing committee meet on day five of this process to reach a broad range of decisions on monetary policy. The meeting has a number of goals. One aspect of the decision-making process is to reach a decision on the OCR. This decision is often the one that gains the most public focus. For a discussion of theory and evidence, see Blinder (2004), ‘The Quiet Revolution: Central Banking Goes Modern’, Yale University Press. For a full description of this process see Richardson (2016). BIS central bankers’ speeches However it is not just today’s OCR, but the full outlook for interest rates, which is important for influencing today’s consumer and business behaviour and ultimately inflation. As a result, the Governing Committee also puts significant focus in its deliberations on reaching a consensus on the outlook for interest rates consistent with the objectives of the PTA. The Governing Committee also works towards a consensus on what key messages to include in the Statement. The meeting begins with the Governor summarising the written advice of the MPC (including members of the Governing Committee). The Governors then discuss the MPC advice, their own views, and points of difference. If there are competing viewpoints within the Governing Committee, the members have an opportunity to reconsider their positions. Once the Governing Committee has reached a consensus on the range of policy considerations the Governor then formalises the decision The Governing Committee is a collegial committee, in that it aims to reach consensus on appropriate policy settings through debate. The collegial approach is advantageous in that is helps the Bank to sharpen the communication of a policy decision. If the Governing Committee is unable to reach a consensus view on the range of policy considerations, it will go with the majority view if one exists. If the views are balanced, the Governor will have final say on the policy outcome. Once a decision has been finalised, each member of the committee adopts the outcome as their own position when speaking in public, ensuring a consistent message and unified voice. Reviewing our performance Making a decision in a committee setting is one way the Bank deals with the uncertainty faced in setting policy. Another way to deal with this uncertainty is to regularly review our policy decisions and framework. This helps the Bank improve its state of knowledge of the economy and learn from any past errors. A number of reviews have been conducted on the elements of the Bank’s monetary policy framework. These include formal reviews, like in 2001 and 2007. 6 In addition, the Bank often invites other central bank and academic economists to observe the decision-making process and provide comments on potential areas of improvement. 7 A recent study by the BIS indicated that the Bank has self-commissioned more reviews than any other central bank. 8 One further avenue of review is to assess our own forecasting performance. 9 Reviews of forecast performance help to update our understanding of economic relationships, evaluate risks to the current outlook and identify areas where we could improve our accuracy. The Bank will always make forecast errors, reflecting the uncertainties in assessing the current state of the economy and its outlook. For example, the vast majority of forecasters were unlikely to have been able to accurately predict the sharp decline in oil and export commodity prices that occurred over 2014 and 2015 – one factor that has led to current low See: RBNZ (2001). ‘The monetary policy decision-making process’, Independent review of the operation of monetary policy supporting paper; RBNZ (2007) above. These visitors will often present a paper containing views on the decision making process and recommendations to improve the process. BIS (2016), ‘Self-initiated reviews of the central bank’s policy performance’, background note for the February 2016 meeting of the Central Bank Governance Group. Past forecast performance reviews include: McCaw S and Ranchhod S (2002), ‘The Reserve Bank’s forecasting performance’, Reserve Bank of New Zealand Bulletin, Vol.65, No.4; Turner J (2006), ‘An assessment of recent Reserve Bank forecasts’, Reserve Bank of New Zealand Bulletin, Vol.69, No.3; Labbe F and Pepper H (2009), ‘Assessing recent external forecasts’, Reserve Bank of New Zealand Bulletin, Vol.72, No.4. BIS central bankers’ speeches inflation. To further illustrate the point, figure 2 shows the Bank’s central outlook for annual GDP growth and the error bands around this estimate implied by our past forecast errors. Figure 2 June Statement annual GDP growth forecast and error bands Note: The error bands displayed above reflect the direction and magnitude of the Bank’s past annual GDP growth forecast errors at different forecast horizons, calculated over the period 2010q1-2016q1. To set the range of the error bands, the Bank’s forecast (in blue) is adjusted for bias using the Bank’s mean forecast error at each relevant horizon. The error bands are then set symmetrically relative to this bias adjusted forecast, using the standard deviation of the Bank’s past forecast errors at each relevant horizon. The dark shaded areas cover +/- one standard deviation. The light shaded areas cover an additional +/- one standard deviation. To say the potential for forecast errors is large is an understatement. So why do we even forecast at all? There are two important reasons. First, monetary policy influences activity, including wage- and price-setting behaviour, with a lag. Second, it is the outlook for the economy that matters for the economic behaviour of firms and households today. Therefore, we need an understanding of the likely direction of the economy over the next few years, to guide our monetary policy strategy to achieve price stability. We do a number of things to deal specifically with the uncertainty of our forecasts. First of all, we use a range of additional information to supplement our projections and guide our policy decisions, rather than relying solely on model driven forecasts. This includes market intelligence from our business liaison programme and the 120 or so presentations we make around the country to business and other groups each year. Second, we aim to highlight the conditional nature of our forecasts, and how we would respond if conditions developed differently. That way, financial market participants can anticipate our likely response when the economy evolves in an unexpected way. This helps to shift the yield curve towards levels consistent with medium-term price stability without the BIS central bankers’ speeches constant need for comment from the Bank. The Bank’s approach to forward guidance is something I talked about in a speech earlier in the year. 10 Third, we regularly investigate what we can learn from our past judgements. Table 1 presents the Bank’s forecast errors on key macroeconomic variables since the first quarter of 2010. The Bank’s projections have been inaccurate in two specific respects over this period. CPI inflation has been consistently weaker than forecast, while the New Zealand dollar has been stronger than forecast. Table 1 Mean forecast error (Monetary Policy Statement forecasts) Note: This table presents the mean errors of the forecasts from the Bank’s Statement made over the period 2010q1 to 2016q1. CPI inflation, 90-day rate and GDP errors are in percentage points and the TWI errors are index points. A positive number implies the outturns were lower than the Bank had forecast. One way to assess what we can learn from forecast errors is to benchmark our performance against other forecasts. Lees (2016) and Reid (2016) benchmark the Bank’s forecasting performance against other forecasters and the Bank’s own statistical models respectively. If the Bank’s forecasts are significantly less accurate than other forecasters or our own statistical models, then we can likely gain insights from these sources to improve our own modelling and forecasting framework. Generally, the Bank’s recent forecasts have performed well relative to these benchmarks. Looking at the period since the financial crisis, the Bank has been one of the better forecasters of New Zealand macroeconomic variables. In addition, the Bank’s forecasts are of a similar quality to those produced by our suite of statistical models. Overall, the Bank, other forecasters and the Bank’s statistical models did not foresee the persistent weakness in inflation or the persistent strength in the New Zealand dollar. This is a reflection of the inherent uncertainty that analysts and policy makers have to deal with when forecasting the New Zealand economy. Despite this, the persistent period of weaker-than-expected inflation remains a focus for the Bank. Low inflation has been a common experience in most advanced and many emerging economies. The Bank has shifted its resources in recent years towards more fully understanding this low inflation environment, and this is a strategic priority in the Bank’s 2016 Statement of Intent. The Bank has completed a range of research topics that have shed some light on the drivers of low inflation. This includes an assessment of international influences (including the exchange rate), 11 a review of our frameworks for estimating key unobservable variables, 12 McDermott (2016), ‘Forward guidance in New Zealand’, remarks by John McDermott, Assistant Governor of the Reserve Bank of New Zealand, 4 February 2016. Richardson (2015), ‘Can global economic conditions explain low inflation in New Zealand’, Reserve Bank of New Zealand Analytical Note AN2015/03. BIS central bankers’ speeches assessing the inflationary consequences of different migration drivers and strong labour supply growth, 13 and highlighting the potential impact of adaptive inflation expectations on current inflation. 14 The Bank will continue to update the public on the drivers of low inflation in speeches, research articles and the Statement. Conclusion Each OCR decision and Statement publication involves a lot of work from a number of staff around the Bank. This staff involvement reflects the inherent uncertainty the Bank is faced with when making a monetary policy decision. We have set up processes to help deal with this uncertainty and improve the quality of our monetary policy decisions. For much of the Bank’s history, advisory committees have been a key element of this process. Since 2013, the Bank has given a greater role to committees in monetary policy decision making. The Governing Committee works together to reach a decision on the appropriate setting of the OCR and the key contents of the Statement. A further important element of the Bank’s decision-making process is the opportunity for constant review. Since the financial crisis, inflation has persistently been weaker than forecast, and the Bank has continually reviewed its forecast performance over this period. Recent research has shown that the Bank’s forecast performance has been reasonable when compared to a number of benchmarks. This suggests that there were no obvious major sources of new information that the Bank could have used from these benchmarks in its decision making. Even so, the persistent period of weaker-than-expected inflation remains a focus for the Bank, and the Bank’s research program is shedding light on the drivers of low inflation. Increasing our understanding of low inflation is a strategic priority for the Bank. See: Richardson and Williams (2015), ‘Estimating New Zealand’s neutral interest rate’, Reserve Bank of New Zealand Analytical Note AN2015/05; Armstrong (2015), ‘The Reserve Bank of New Zealand’s output gap indicator suite and its real-time properties’, Reserve Bank of New Zealand Analytical Note AN2015/08; Lewis, McDermott and Richardson (2016), ‘Inflation expectations and the conduct of monetary policy in New Zealand’, Reserve Bank of New Zealand Bulletin, Vol. 79. No. 4. March 2016. See: Armstrong and McDonald (2016), ‘Why the drivers of migration matter for the labour market’, Reserve Bank of New Zealand Analytical Note AN2016/02; Vehbi (2016), ‘The macroeconomic impact of the age composition of migration’, Reserve Bank of New Zealand Analytical Note AN2016/03. See Karagedikli and McDermott (2016), ‘Inflation expectations and low inflation in New Zealand’, Reserve Bank of Discussion Paper Series 2016/09. BIS central bankers’ speeches
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Speech written by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, and delivered by Mr John McDermott, Assistant Governor of the Reserve Bank of New Zealand, for the Otago Chamber of Commerce, Dunedin, 23 August 2016.
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Graeme Wheeler: Monetary policy challenges in turbulent times Speech written by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, and delivered by Mr John McDermott, Assistant Governor of the Reserve Bank of New Zealand, for the Otago Chamber of Commerce, Dunedin, 23 August 2016. * * * I will discuss some of the main challenges confronting central banks in conducting monetary policy, particularly in small open advanced economies. The scope and influence of monetary policy in these economies is heavily constrained by economic and financial developments outside their borders. As a result, expectations of what monetary policy can achieve often run ahead of reality. I will then discuss some of the alternate views around an appropriate strategy for managing monetary policy in New Zealand under current circumstances. I will conclude by discussing the Reserve Bank’s current policy strategy. In doing so, I will draw heavily on and emphasise the messaging contained in the recently released August Monetary Policy Statement. I) Challenges faced by central banks in implementing monetary policy Nearly ten years on from the start of the Global Financial Crisis (GFC), growth remains disappointingly weak in many regions. The IMF’s latest World Economic Outlook is appropriately titled “Too Slow for Too Long”. It includes further downgrades in 2016–2017 growth projections for all the major economies, and for many emerging and developing economies. Tangible downside risks were identified, and the projections were shaded down further in July revisions. A similar picture emerges in the OECD’s latest Economic Outlook, which highlights the “self-fulfilling low growth trap” that has enveloped the global economy. Central banks face a difficult global economic and financial environment: • global economic growth remains significantly below its long-term average despite unprecedented monetary accommodation. 1 The rate of potential output growth across the advanced economies has slowed due to lower growth in total factor productivity and weak growth in the capital stock. 2 Output growth in the emerging markets has also slowed; • The volume of global merchandise trade (which is a strong catalyst for global economic growth) has drifted lower since the start of 2015. In an environment of weak economic growth and reduced trade volumes, trade restrictions in G20 countries have Global GDP growth has averaged 3.8 percent per annum since 1961. The decline in output from the pre-GFC trend path of GDP has been 15 percent or more in several countries. Global growth in 2015 was 3 percent, the weakest since 2009, and below trend growth of 3.8 percent. Potential output growth per capita in the OECD area has declined from around 2 percent in the late-1990s to around 1 percent at present. Analysis cited by the OECD indicates that about half of this slowdown is due to weak capital stock growth – reflecting both lower investment since before the GFC, and higher rates of depreciation arising from the growing share of ICT and intangibles in total investment. The other half of the slowdown is attributed to lower growth in total factor productivity (TFP), reflecting weaknesses in the spread of innovation through the economy, in business dynamism, and in product market reform. Potential output has also been held back by weak labour market performance, including deteriorating skills of the long-term unemployed, and by the impact of weak global trade in holding down the benefits to growth arising from competitive pressures, technological spill overs, and innovation. BIS central bankers’ speeches been rising steadily 3 and many governments are concerned about the strength of their exchange rates; • headline and core inflation and short-term inflation expectations in the advanced economies are very low, and the level of neutral interest rates has fallen; • interest rates are at historic lows and countries with negative policy rates now account for 25 percent of global output. 4 The volume of quantitative easing by central banks is expected to reach record levels in 2016. Around US$13.4 trillion of bonds carry a negative yield; and • high asset valuations are presenting risks to financial stability in many economies and the level of household debt remains high (and has been rising rapidly in several large emerging market countries). The conduct of monetary policy has become more complicated as global financial integration has continued to increase, and as the financial policy spillovers arising from the extraordinary monetary policy measures of the major central banks have increasingly been felt in the smaller and peripheral markets. 5, 6 Many of these issues are likely to be long lasting. They have complex structural elements to them and are unlikely to fully self-correct as global growth recovers. For example: • low inflation in some countries is linked to demographic change, especially in countries with a declining workforce and rapidly ageing population. Low inflation is also due to technological change around information flows and energy production, and to the global over-supply of commodities and manufactured goods; and • the decline in neutral real interest rates may be linked to the slowdown in productivity growth, and the growth in global savings linked to post-GFC deleveraging and aging populations. In responding to this economic setting, monetary policies are being stretched well beyond the normal parameters and stresses envisaged when policy frameworks were designed and inflation goals were first specified. II) Questions that central banks are grappling with In a world of unconventional monetary policy and unprecedented monetary accommodation, several questions are on central bankers’ minds; questions such as: • what are the risks that global growth will be revised lower? What is the outlook for commodity prices, and especially oil prices? How can the advanced economies The last five years of merchandise trade growth has been the weakest period since the 1980s. Between midOctober 2015 and mid-May 2016 G20 economies introduced new trade measures at the fastest pace seen since 2008. (WTO Director General’s Mid-Term Report on Trade Developments issues on 25 July 2016). Countries with policy rates at or below 0.5 percent now account for around 65 percent of global GDP. Around USD13.4 trillion of bonds carry a negative yield. Global foreign exchange market turnover reached an estimated $US5.3 trillion a day in 2013, up from $US3.8 trillion in 2007 and $US1.5 trillion in 1998. Global trading in OTC interest rate derivatives – mainly swaps and forward rate agreements – increased almost ten-fold between 1998 and 2013 (from $US265 billion in 1998 to $US2.3 trillion in 2013). The notional amounts outstanding in OTC derivatives markets (mainly interest rate contracts) reached almost $US700 trillion in 2013, compared with $US500 trillion in 2007 and under $US100 trillion in 1998. Chen, J, Mancini – Griffoli, T, and Sahay, R (2014) “Spillovers from United States Monetary Policy on Emerging Markets: Different this Time?”, IMF Working paper WP/14/240. BIS central bankers’ speeches achieve the growth rate needed to generate the “escape velocity” to ensure a durable recovery and moderate inflationary pressure?; • how long are the major central banks likely to run a divergent monetary policy stance (although they have become more similar as the Federal Reserve has pushed back expectations of interest rate rises)? When might the Federal Reserve next raise the Fed Funds rate?; • has monetary policy reached the limits of its effectiveness in central banks with negative policy rates and large programmes of quantitative easing? How much scope is there for additional monetary accommodation and will this be deployed – especially by large central banks, such as the European Central Bank and Bank of Japan?; • how serious are the distortions created by negative interest rates, and by quantitative easing and the associated rapid expansion of central bank balance sheets? How can these balance sheets be deleveraged over time and excess bank reserves absorbed, and what does this imply for monetary policy, asset prices and global long term interest rates?; • what are the risks that inflation expectations will fall further? How can inflation expectations best be raised when policy rates are already low, household indebtedness is high and households and firms are reluctant to borrow more?; • how reliable are the central bank’s estimates of the output gap? How flat has the Phillips Curve become and how much has the neutral interest rate fallen?; and • how should fiscal policy support monetary policy? Monetary policy decisions are influenced by assessments of such questions based on research, modelling and scenario analysis. The complexity of the discussions that underlie policy decisions within a central bank belies the apparent simplicity of what is often a single interest rate instrument and a single inflation target. III) Policy Choices in New Zealand New Zealand’s economy is in its eighth year of expansion. In many respects the economy is performing well: economic growth is above trend; employment growth has been strong; labour force participation is high; and the unemployment rate continues to decline. Furthermore, real wage growth has been quite strong; until recently, the household savings rate has been rising; and increasing economic growth has not been accompanied by the sharp deterioration in the current account that has accompanied previous recoveries. Not least, the cost of living, as measured by the consumers price index, has been rising slowly. As with every economy, there are also some negative aspects: domestic economic growth has been weaker on a per capita basis; slow global growth and rising protectionism creates risks for our export sector; the global dairy market has serious oversupply problems that depress our dairy returns (although the last two dairy auctions have been encouraging); excessive house price inflation is creating financial stability risks; our exchange rate is too high and affecting the competitiveness of our export and import substitution industries; and headline inflation (but not underlying inflation) lies below the target band in the Policy Targets Agreement. In addition, the strongest migration cycle in several decades is creating stresses as well as positives for the economy. 7 Monetary policy decisions attract considerable comment in most advanced economies, and New Zealand is no exception. That’s because monetary policy can have important effects on High net immigration raises potential output growth, increases aggregate demand, moderates wage pressure and increases house price inflation. BIS central bankers’ speeches peoples’ lives. It can affect the level of activity in the economy in the short-term, the cost of living for individuals and their expectations about wage and price outcomes, asset valuations, the cost of borrowing and the returns to savers and investors, and the incentives for risk taking. But several factors constrain the influence of central banks, particularly in small open economies. Long term interest rates are set by global saving and investment flows, country risk premia and expectations for economic growth and inflation. Central banks only have limited control over tradables inflation. For example, they have no influence on the global oversupply of commodities, manufactured goods and capital goods, or on overseas inflation rates. This did not matter so much when the annual increase in New Zealand’s import costs in the run up to the GFC was averaging 2 percent, but does when they have averaged minus 1.9 percent in recent years. 8 Central banks generally have limited control over the exchange rate. For example, the Reserve Bank has lowered the OCR six times since June 2015 and the TWI remains some 2½ percent higher than it was at the commencement of cutting. Central banks cannot persistently achieve a lower nominal exchange rate unless monetary policy is fully dedicated to that goal (and even then cannot permanently achieve a lower real exchange rate). They might influence financial risk taking through short term interest rates, but other factors, such as regulation and taxation, will determine whether this flows through into investments that enhance productivity and real income growth. In addition, the scope that central banks have to influence short-run activity and wage and price setting behaviour diminishes as interest rates approach zero, and the limits for quantitative easing are reached. Reflecting these constraints, central banks must make finely-balanced judgements when setting monetary policy. We attempt to base those judgements on evidence, research and scenario analysis and continue to review our policy record and international experience to see what we can learn from them. We also encounter a range of views about what monetary policy can achieve and how it should be operated. I will touch on three policy views that have recently been expressed in the New Zealand context. 1. The view that flexible inflation targeting is not an appropriate framework for conducting monetary policy The Bank’s position is that flexible inflation targeting remains the most appropriate monetary policy framework for conducting monetary policy in New Zealand. 9 Provided that sufficient flexibility is allowed to accommodate the frequent and often severe impact of external shocks, the most important contribution monetary policy can make to promoting efficiency and the longrun growth of incomes, output and employment is the pursuit of price stability. This also remains the view of the 30 or so central banks that describe themselves as inflation targeters, and includes most central banks in the advanced economies and several emerging market economies. I am not aware of any central bank that has moved away from an inflation targeting framework since the GFC. For example, no country has adopted price level targeting or targeted nominal income given the practical difficulties and theoretical challenges to those frameworks. However, several central banks, like the RBNZ, have expressed concerns that the unprecedented monetary accommodation in the aftermath of the GFC has led to excessively inflated asset prices. Many countries have introduced macro-prudential policies to help alleviate the risks this poses to domestic financial stability. The average annual percentage change (in NZ dollar terms) in goods and services import prices was 2 percent in the period 2005–2007 and –1.9 percent in the period 2012 – 2016 Q1. Several RBNZ speeches discuss the merits of flexible inflation targeting. For example, McDermott J (2012) “The Future of Inflation Targeting” (2015) “The Dragon Slain? Near-Zero Inflation in New Zealand”, Wheeler G “Reflections on 25 Years of Inflation Targeting” (2015) “Some Thoughts on the Inflation Outlook and Monetary Policy”. BIS central bankers’ speeches There have been assertions that inflation targeting is broken because inflation is low. These assertions do not stack up. Inflation has primarily been low because of unforeseen and unforeseeable global events. Monetary policy in New Zealand remains effective and able to influence domestic demand, and thus, non-tradable inflation. While there is some academic debate about the merits of different inflation targets, few, if any, central banks have modified their inflation targets in the last few years. Although there is nothing sacrosanct about what particular inflation band or target should be adopted as a measure of price stability, central banks have been reluctant to change targets. This is usually because the prospect of “making it easier when times become tougher” reduces the incentives on central banks to achieve earlier agreed goals and, in doing so, could damage the central bank’s credibility (particularly if a perception develops that the central bank will continually seek to respecify goals). New Zealand’s inflation target specification is not out of line with that set by the major central banks. For example, the Federal Reserve, Bank of Japan, Bank of England and the Bank of Canada have adopted inflation goals framed around 2 percent annual inflation (the European Central Bank expresses the goal as “achieving annual inflation rates of below, but close to, 2 percent over the medium term”.) 2. The view that the Reserve Bank should not lower interest rates Proponents of this view argue that the economy is growing strongly and interest rate reductions are unwarranted and undesirable. They suggest that borrowing costs are not constraining business investment, and worry that lower rates will accentuate already excessive house price inflation and sow the seeds for a major housing market correction that will slow growth and likely lead to a recession. They also argue that monetary policy is in danger of focussing too much on borrowers and ignoring the effect that lowering interest rates could have on those reliant on interest incomes. This view acknowledges that inflation could remain at low levels for many years and that we should accept that outcome. There are two inter-related risks with this approach that are linked to the exchange rate and inflation expectations, and which may lead to even lower inflation. According to the last BIS triannual survey, the New Zealand dollar is the 10th most traded currency in the world with the 2013 data showing average daily turnover of USD105 billion, roughly equivalent to 65 percent of New Zealand’s GDP. 10 If financial markets believe that the Bank has abandoned its inflation objectives and is seeking to maintain policy rates at a level consistent with below-target inflation, they will conclude that the easing process is over and proceed to bid the exchange rate up, perhaps substantially so. The TWI exchange rate is already at a high level based on the Bank’s models. A sizeable appreciation would further squeeze incomes in the tradables sector, and drive tradables inflation lower for longer, thereby lowering overall headline inflation. A significantly higher exchange rate that is not matched by a rise in commodity prices would likely slow economic growth. But it also carries another important risk. Low headline inflation increases the risk that inflation expectations might fall and become embedded in wage and price setting outcomes that become self-perpetuating and drive headline inflation lower. The outcome might be an economy with less house price inflation, but with a higher exchange rate, slower growth, and lower inflation. BIS “Triennial Central Bank Survey, Foreign Exchange turnover in April 2013: Preliminary Global Results”. BIS central bankers’ speeches If inflation expectations fall too far, it can be very difficult to raise them back up. In such a situation, further cuts in interest rates would be needed to stimulate economic activity and increase inflationary pressures. 3. The Reserve Bank should rapidly lower interest rates This view advocates bringing inflation quickly back to the mid-point of the inflation band by rapidly cutting the OCR. Driving interest rates down quickly would lower the exchange rate, contributing to increased traded goods inflation and stronger traded goods sector activity. The ensuing increase in house price inflation is not seen as a consideration for monetary policy, even though there would be an increased risk of a large correction in the housing market and associated deterioration in economic growth. There would be considerable risks in this strategy. An aggressive monetary policy that is seen as exacerbating imbalances in the economy would not be regarded as sustainable and would not generate the exchange rate relief being sought. With the economy currently growing at around 2½ – 3 percent and with annual growth projected to increase to around 3½ percent, rapid and ongoing decreases in interest rates would likely result in an unsustainable surge in growth, capacity bottlenecks, and further inflame an already seriously overheating property market. It would use up much of the Bank’s capacity to respond to the likely boom/bust situation that would follow and would place the Reserve Bank in a situation similar to many other central banks of having limited room to respond to future economic or financial shocks. Such consequences suggest that a strategy of rapid policy easing to extremely low rates would be counter to the provisions in the PTA that require the Bank to “seek to avoid unnecessary instability in output, interest rates and the exchange rate” and to “have regard to the soundness of the financial system”. IV) The Reserve Bank’s current approach I will outline the thinking that underpins our August Monetary Policy Statement. The Bank recognises the considerable flexibility that has deliberately been built into the PTA. This includes provisions that: • deliberately frame the inflation objective in terms of an inflation band with an “on average over the medium term” connotation; • recognise that commodity price movements, such as oil prices, and government tax and pricing decisions may move measured inflation outside the band; • require the Bank to monitor asset prices and have regard to financial stability risks; and • avoid unnecessary instability in output, interest rates and the exchange rate. 11 The forecasts contained in the August Monetary Policy Statement have the economy’s output gap currently at zero and rising to around 1.2 percent of GDP in 2018. We assess core inflation to currently be within the lower half of the target band and headline inflation is forecast to reach the lower end of the target band in December 2016. The output and inflation projections assume 35 basis points of further OCR cuts from the current level of 2.00%. For an explanation of how the Bank interprets the PTA and the considerations that lay behind the changes introduced at the last review see Wheeler G (2016) “The Global Economy, New Zealand’s Economic Outlook and the Policy Targets Agreement”. BIS central bankers’ speeches The key rationale for cutting the OCR by 25 basis points in August was to lower the risk of a further decline in short-term inflation expectations. In terms of the monetary policy transmission mechanism, we see the primary influence working through the demand and risk taking channels that raise annual non-tradable inflation to just under 3.5 percent over the projection period. We also anticipate that as our interest rate differentials narrow against other advanced economies, the exchange rate will weaken and, along with an increase in commodity prices and gradual rise in world inflation, will help traded goods inflation to move into positive territory. Our decision to further lower the OCR does increase the potential risk of further fuelling increases in asset prices, including within the housing market. This is one of the difficult tradeoffs that we have had to confront. The risks here are partly balanced by our macro-prudential policy moves that will further boost the resilience of the banking system. It may sound trivial for central banks to note that they will closely monitor the emerging economic data, but that is the reality of the situation in a world where there are major uncertainties and every indicator of growth and inflation is carefully scrutinised. The Bank’s output and inflation projections, and the associated interest rate track, are based on a series of assumptions and judgements that are continually tested in the light of new information and analysis. It is this emerging economic data that will determine whether the assumed 35 basis points of further easing is realistic or whether more or less monetary stimulus will be required. V) Concluding comments Central banks do not have special powers of market foresight or a franchise on wisdom. But they do have significant research and analytical capacity that can deliver valuable insights, and this is being applied to challenges associated with the current global economic and financial developments. It means that central banks are in a position to modify their perspectives and policies as new analysis and data becomes available. In the end, judgement is inevitably involved in balancing a range of risks and uncertainties. Some of these lie beyond the influence of the central bank, while others can be addressed or moderated through monetary policy. Policy decisions inevitably involve reflection and pragmatism in managing different trade-offs. We remain committed to the inflation goals in the Policy Targets Agreement. Our present judgement is that the current interest rate track, involving an expected 35 basis points of further interest rate cuts, balances a number of risks weighing on the economy while generating an increase in CPI inflation back towards the midpoint of the 1 to 3% target range. We do not believe that the outlook and balance of risks warrants a position of no policy change, nor a position of rapid easings. If the emerging information and risks unfold in a manner that warrants a change in our judgements, we will modify our policy settings and BIS central bankers’ speeches
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Speech by Dr John McDermott, Assistant Governor and Chief Economist of the Reserve Bank of New Zealand, to the Bay of Plenty Employers and Manufacturers Association (EMA), Rotorua, 11 October 2016.
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Understanding Low Inflation in New Zealand A speech delivered to the Bay of Plenty Employers and Manufacturers Association (EMA) in Rotorua On 11 October 2016 By Dr John McDermott, Assistant Governor and Head of Economics 2 The Terrace, PO Box 2498, Wellington 6140, New Zealand Telephone 64 4 472 2029 Online at www.rbnz.govt.nz Low inflation in New Zealand It is a pleasure to be here today to address the Bay of Plenty EMA. My job is all about trying to take the pulse of the economy, but you are some of the people that actually make it beat. In recent years, inflation has been low – and below the rate targeted – in many advanced countries around the world. The possible reasons for this are a focus of discussion for central bankers, financial market participants, politicians, academics and journalists, both here and abroad. Low inflation in New Zealand is what I want to talk to you about today. The consumer price index (CPI) for the September quarter will be released next Tuesday, and it is widely expected to reveal continued low inflation. The Bank’s goal is to keep future annual CPI inflation outcomes between 1 percent and 3 percent on average over the medium term, with a focus on keeping future average inflation near the 2 percent target midpoint. As described in the September Official Cash Rate (OCR) review, monetary policy will continue to be accommodative. Interest rates are at multi-decade lows, and our current projections and assumptions indicate that further policy easing will be required to ensure that future inflation settles near the middle of the target range. The Reserve Bank’s forecast in the August Monetary Policy Statement was for annual headline CPI inflation to be 0.2 percent in the September quarter. More recent information, including movements in petrol and food prices, remains consistent with this low number. Our typical margin of error in forecasting near-term annual CPI inflation is about 0.2 percentage points. So, while we have no prior knowledge, next week’s outturn could be between zero and half a percent. Actual inflation has been low, despite robust growth in the New Zealand economy. Looking at individual items in the CPI basket, low annual inflation in the September quarter is expected to result from: falling prices for petrol; further reductions in ACC vehicle levies (resulting in cheaper car licensing fees); cheaper and better quality audio-visual and computing equipment; and reductions in domestic and international airfares. These lower prices are expected to be only partially offset by increases in the prices of housing-related goods and services – things like construction costs, rents, property maintenance, and local authority rates – and increases in cigarette and tobacco prices. In annual terms, these large negative and positive factors have been at play for at least the past year (figure 1). Figure 1: Contributions to annual CPI inflation over the past year Ppts 1.5 Other Cigarettes & tobacco 1.0 Housing & household-related goods & services 0.5 Audio-visual & computing equipment Communications 0.0 Air transport -0.5 Other transport services (includes ACC vehicle levy) -1.0 Petrol Total annual CPI -1.5 Sep 2015 Dec 2015 Mar 2016 Jun 2016 Source: Statistics New Zealand, RBNZ estimates. Annual inflation is expected to return to the lower end of the target band in the December 2016 quarter, as previous petrol price declines drop out of the annual calculations and housing-related goods and services prices continue to increase strongly. Stability in the cost of living maintains the purchasing power of New Zealanders’ incomes. Inflation that is too high or too low has economic costs, and is of concern to the Reserve Bank. High inflation distorts the signals being sent from relative price movements, which results in resources in the economy being misallocated. On the other side, low inflation becomes a concern if it leads to the possibility of deflation. Although we do not see any significant risk of deflation in New Zealand, deflation carries important costs. Deflation would likely lead to consumers and businesses significantly delaying purchases or investment, in the expectation that these will become cheaper in the future. By delaying purchases and investment on a large scale, demand in the economy as a whole is reduced. This then leads to even lower prices. Deflation is particularly concerning as monetary policy eventually reaches a point where it cannot go any lower in order to stimulate the economy (known as the effective lower bound). A buffer above zero inflation is also needed to account for any measurement error in the price index. Across inflation-targeting central banks around the world, inflation of about 2 percent per annum is generally viewed as an appropriate medium-term goal. Although headline CPI inflation is expected to remain low in the near term, lowering interest rates now would do little to change these outturns. Monetary policy operates with long and variable lags. Accordingly, monetary policy in New Zealand is focused on the medium-term outlook for inflation, as directed by the Policy Targets Agreement (PTA) between the Governor of the Reserve Bank and the Minister of Finance. Focusing on inflation a year or two ahead avoids unnecessary instability in output, interest rates and the exchange rate, again consistent with the PTA. The Reserve Bank must also have regard to the efficiency and soundness of the financial system. The Bank responds to low inflation outcomes if these outcomes are expected to have an effect on medium-term inflation. If households and businesses respond to low inflation outcomes by reducing their expectations for future inflation, and wages and prices are set accordingly, then these lower inflation expectations would weigh on future actual inflation over the horizon relevant for monetary policy. We carefully monitor developments in inflation expectations, at various horizons. Looking back over recent years, annual CPI inflation in New Zealand has been lower than expected by the Bank and other forecasters. Understanding why this has been the case – and what the effects on inflation expectations have been – is important in order to set policy going forward. Annual CPI inflation has been below the 2 percent target mid-point since it was formalised in 2012, and below the bottom of the target band since the final quarter of 2014. Low inflation has been accounted for by an unusually long period of falling prices in the tradables sector (those exposed to international competition), as well as a decline in average non-tradables inflation (figure 2). Various measures of core inflation have also been low, although appear to have trended higher since the start of 2015 (figure 3). Figure 2: Headline CPI inflation and components (annual) % Non-tradable contribution Tradable contribution Headline -1 -2 Source: Statistics New Zealand. Figure 3: Core inflation measures (annual) Source: Statistics New Zealand, RBNZ estimates. At a high level, low inflation could be due to two factors: • Developments in the cyclical drivers of inflation; or • Structural changes in the way in which the New Zealand economy generates inflation. A key factor that has led to low inflation has been the underlying weakness in the global economy (figure 4). Although GDP growth in New Zealand’s trading partners has been near average levels, this moderate growth has required a significant degree of monetary stimulus abroad in the major economies. Quantitative easing and negative interest rates have become regular features of the global economy. Figure 4: Trading partner growth (annual) % Current forecast period Mar 14 Mar 15 Dec 15 Mar 16 Aug 16 Source: Haver Analytics, RBNZ estimates. A weak world economy has been a key factor underpinning the New Zealand dollar, with New Zealand’s performance relative to other advanced economies supporting demand for New Zealand dollar assets. The New Zealand dollar exchange rate has been higher than the Bank had assumed for much of the period (figure 5). The New Zealand dollar has remained elevated despite periods of increased risk aversion and steep declines in New Zealand’s export prices. The strength of the New Zealand dollar has dampened the prices of New Zealand’s imports, and contributed significantly to the current low inflation, particularly in the tradables sector. Figure 5: Nominal New Zealand dollar trade weighted index and the evolution of RBNZ estimates (actual shown in bold) Index Source: RBNZ estimates. The prices of the goods and services that New Zealand imports have also been lower than expected – even once the effects of high exchange rate have been taken into account. Again, a weak global economy has been the contributing factor, with significant spare capacity across the globe dampening the world prices for New Zealand’s imports. In addition to this impulse, there was a sharp decline in the price of oil over 2014 and 2015, reflecting a combination of increased global supply and a moderation in growth in emerging economies. This drop in oil prices has contributed further to low inflation in New Zealand. It is possible that structural changes may have also contributed to negative tradables inflation in New Zealand. This could include developments such as a change in exchange rate pass-through, or a permanent shift in distributor or retailer margins. However, Bank research suggests that such structural developments do not appear to account for weakness in internationally-driven inflation in New Zealand. That is, although movements in the drivers of low tradables inflation – the exchange rate, oil prices and global prices for our imports – have led to negative tradables inflation, it does not appear that there has been a material or permanent change in the ways that these drivers transmit through to domestic inflation. 1 Domestic inflation in recent years has been dampened by some sector-specific factors. Communications prices have been falling since 2011 (figure 6). The lower measured prices reflect an increase in quality: an increase in the size of broadband packages offered (at similar monthly charges); increased data and call minutes for mobile services; and the more-recent introduction of ultra-fast broadband. The net reduction in vehicle relicensing fees (reflecting a change in the way ACC calculates levies for light vehicles) has also held inflation lower since the September 2015 quarter (figure 7). Figure 6: Telecommunication services (contribution to annual CPI inflation) Ppts Ppts 0.2 0.2 0.1 0.1 0.0 0.0 -0.1 -0.1 -0.2 -0.2 -0.3 -0.3 -0.4 -0.4 Source: Statistics New Zealand. 1 Richardson, Adam (2015) “Can global economic conditions explain low inflation in New Zealand?”, RBNZ Analytical Note, AN2015/03. Figure 7: Other transport services (includes vehicle relicensing fees; contribution to annual CPI inflation) Ppts Ppts 0.2 0.2 0.1 0.1 0.0 0.0 -0.1 -0.1 -0.2 -0.2 -0.3 -0.3 -0.4 -0.4 Source: Statistics New Zealand, RBNZ estimates. Other cyclical developments have also contributed to weakness in non-tradables inflation. New Zealand experienced a sharp decline in the prices of its exports over 2014, following a boom in commodity prices that had seen New Zealand’s terms of trade reach a 40-year high. The key driver of the fall was a substantial decline in the global price of dairy products (figure 8). Figure 8: New Zealand’s export commodity prices (USD, by sector) Index Dairy Meat, pelts, and wool Forestry Aggregate Source: ANZ Bank. A number of developments contributed to the fall in dairy prices over 2014. A broad range of commodity prices declined over that period in line with the sharp decline in the price of oil, likely reflecting a combination of weaker global demand and the pass-through of lower energy costs. More specifically in the international dairy market, supply increased substantially – particularly in Europe following the relaxation and subsequent removal of production quotas that had been in place for nearly 30 years. This drop in New Zealand’s commodity prices acted as a headwind to the domestic economy, reducing on-farm investment and rural spending. The flow through to demand in the economy more generally ultimately contributed to weaker domestic inflation. A key structural development that has led to persistent weakness in inflation has been the stronger growth in New Zealand’s potential output (figure 9). This has enabled the New Zealand economy to grow at a robust pace without generating significant inflation, and is likely to continue to do so over the medium term. Figure 9: RBNZ potential output growth estimates through history (annual growth, August 2016 estimate shown in bold) % 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 Source: RBNZ estimates. Over recent years, most of the increased growth in potential GDP has been due to an increase in labour supply – through greater participation in the labour force and high net immigration. Employers, like yourselves, have been able to absorb this additional labour supply over recent years. More people entering the New Zealand workforce acts to dampen labour costs, and general inflation as a result. 2 The ability of New Zealand businesses to find a productive use for the remarkable increase in the supply of labour is one of the most positive aspects of the current economic expansion. 2 A recent Reserve Bank speech (Bascand, 2016) discusses labour market developments and their influence on inflation in New Zealand. More people increase both demand in the economy and growth in potential output. In previous cycles, the increase in demand has often outweighed the contribution to the supply capacity of the economy. Migration in previous cycles was therefore usually associated with an increase in overall capacity pressures and inflation, as well as a strong pick up in house price inflation. The consequences of the recent migration inflows on consumer price inflation have been much more modest in this cycle. Two key factors can account for this more muted response. First, the composition of migration matters a great deal for inflationary pressures. Younger migrants (17-29 years old) tend to have a positive but more muted impact on domestic demand compared to older cohorts (30-49 years old). 3 Second, the source of the migration impulse also matters – higher inward migration to New Zealand that is driven by a weaker Australian economy tends to result in a higher unemployment rate – all else equal – while inward migration to New Zealand driven by other factors has the opposite effect. 4 That is, people who move to New Zealand because their job prospects in Australia have deteriorated are likely to spend less once here. In recent years, we have seen a larger share of younger migrants than in previous cycles (figure 10), and weakness in the Australian labour market has been a driver of trans-Tasman flows. Vehbi, Tugrul (2016), “The macroeconomic impact of the age composition of migration”, RBNZ Analytical Note, AN2016/03. 4 Armstrong, Jed and Chris McDonald (2016)., “Why the drivers of migration matter for the labour market”, RBNZ Analytical Note, AN2016/02. Figure 10: Composition of net immigration by selected age groups (annual total) 15 to 29 000s 30 to 49 Other -10 -20 Source: Statistics New Zealand, RBNZ estimates. There also appears to have been a structural change in how households and businesses form their expectations of prices. Inflation expectations now seem to respond more to past inflation outcomes than they did prior to the global financial crisis (GFC). 5 This would mean any direct shocks to headline inflation (even if the shocks themselves are expected to be short-lived) now appear to have more persistent effects on inflationary pressures than they did in the past, via the expectations channel. This suggests that weak tradables inflation may have had a greater dampening impulse on non-tradables inflation through inflation expectations than would have occurred in previous periods. Two key factors that businesses and households take into account when setting prices are the degree of capacity pressure and inflation expectations. The Bank has reviewed its frameworks for estimating capacity pressure (also known as the ‘output 5 Karagedikli, Özer and John McDermott (2016), “Inflation expectations and low inflation in New Zealand”, RBNZ Discussion Paper, DP2016/09. gap’ – the difference between actual and potential GDP) and inflation expectations in New Zealand. Reserve Bank research re-emphasised the challenge in accurately estimating the output gap in real time. 6 When assessed against a vast range of possible capacity indicators, the Bank’s estimate of the output gap in 2015 was around the middle of this range of estimates. The Bank also developed a methodology to better incorporate and monitor the vast amount of information on inflation expectations into the Bank’s policy making. 7 The analysis shows that low inflation outcomes have lowered expectations of inflation at shorter horizons, which may dampen near-term price- and wage-setting. However, analysis points to longer-term inflation expectations remaining well anchored close to the mid-point of the bank’s inflation target (figure 11). Figure 11: Inflation expectations curve (annual, by number of years ahead) Source: ANZ Bank, Aon Hewitt, Consensus Economics, RBNZ estimates. 6 Armstrong, Jed (2015), “The Reserve Bank of New Zealand’s output gap indicator suite and its real- time properties”, RBNZ Analytical Note, AN2015/08. 7 Lewis, Michelle (2016), “Inflation expectations curve: a tool for monitoring inflation expectations”, RBNZ Analytical Note, AN2016/01. In view of low inflation outturns since 2014, the Bank undertook a review of its forecasting performance. Reviews of forecast performance help to update our understanding of economic relationships and identify any areas were we could improve our accuracy. 8 Generally, the Bank’s recent forecasts have performed better than external benchmarks. 9 Looking at the period since the GFC, the Bank has generally been better than others at forecasting inflation, and its forecasts have been of a similar quality to those produced by a suite of statistical models. 10 This forecast review suggests that there were no obvious sources of new information that the Bank could reasonably have been expected to incorporate when preparing its forecasts. Conclusion Annual CPI inflation for the September quarter is going to be low, as incorporated into the Bank’s most recent projections. However, it is expected to rise in the December quarter and be at the bottom of the target range as the transitory effects of earlier declines in oil prices dissipate. As described in the September OCR Review, monetary policy will continue to be accommodative. Our current projections and assumptions indicate that further policy easing will be required to ensure that future inflation settles near the middle of the target range. Actual inflation has been low, and lower than forecast, for several years – both here and abroad. The potential reasons for this are a topic of discussion around the world. In New Zealand, much of this weakness can be attributed to global developments that have presented themselves via the high New Zealand dollar and low inflation in our import prices. Strong net immigration and increased labour market participation have also boosted the supply potential of the economy, meaning that New Zealand has been able to grow at a robust pace without generating significant inflation. There also appear to have been changes in how inflation is generated in New Zealand: the drivers and composition of net immigration influence the degree of I recently delivered a speech that discussed this forecast review in more detail: “How the Bank formulates and assesses its monetary policy decisions” 9 Lees, Kirdan (2016). “Assessing forecast performance”, RBNZ Bulletin, 79(10). 10 Reid, Geordie (2016), “Evaluating the Reserve Bank’s forecasting performance”, RBNZ Bulletin, 79(13). associated inflationary pressure for any given migration flow, and inflation expectations appear to now place more weight on past inflation outcomes than they did prior to the GFC. The Bank will continue to closely monitor developments in the drivers of inflation and investigate any persistent changes in how inflation is generated. Our goal will be to achieve future inflation outcomes within the target range on average over the medium term, with a focus on keeping future average inflation near the target mid-point.
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Speech by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to the Payments NZ conference, Auckland, 8 November 2016.
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Grant Spencer: Innovation with resilience – a central banker's perspective Speech by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to the Payments NZ conference, Auckland, 8 November 2016. * * * Thanks to Payments NZ for inviting me to speak again at your impressive conference. This is a great forum for all involved in the New Zealand payments sector. I will give you a central banker’s perspective. My theme is innovation with resilience. We are seeing a huge amount of innovation in the payments industry. Since the last conference in 2014, the rapid pace of change has continued, driven by factors such as customer demands, changing technology, new players, and also regulatory changes. A challenge is to ensure that our systems remain resilient through this change. The Reserve Bank is a system operator and the regulator. We want to be responsive on both fronts. As operator we are upgrading the Exchange Settlement Account System (ESAS) and NZClear systems to ensure they remain fit for purpose. As regulator we are developing an enhanced framework for oversight of New Zealand’s financial market infrastructures (FMIs). Today, I will talk about some of the drivers of change, the many risks we face and the proposed new oversight framework. Drivers of change The payments landscape is changing dramatically as it experiences ‘digital disruption’1. Customers are now seeking to make and receive payments in real time, from any location, on any device, and at any time. These customers expect payment services to be faster, more personalised, easy to use, inexpensive and fully secure. The rise in customer expectations is being met and expanded by new providers attracted to the payments industry. We have seen the telecommunications and computing industries merging with the financial industry to provide innovative financial services, including payments services. Much of the innovation in the sector is building on existing technology platforms that are getting faster and smarter. For example, the IBM “Deep Blue” supercomputer that you may recall beat Gary Kasparov back in 1997, is less powerful than the iPhone that we carry in our pocket. Many of the new developments are taking place in the retail payments space — banks are introducing new services such as mobile and contactless payments, and engaging with new market players such as Apple Pay, Amazon and Alipay. For example, ANZ’s recent partnership with Apple Pay. Banks are having to make crucial decisions about how best to respond in the new payments environment. We are also seeing the development of important new technologies, such as Distributed Ledger Technology (or Blockchain) that could have major impacts on payment systems and financial market infrastructures down the track. Major technology upgrades are underway in over 15 countries that have or are in the process of deploying real time payment systems. One close to home is the New Payments Platform in Australia, which will give immediate clearing and settlement, and is scheduled to be implemented next year. Local banks are also speeding up their payments using existing technology. The payments pipeline project aims to address settlement risk within Settlement Before Interchange (SBI) by minimising the delays between the issuance and settlement of payment instructions. After two 1/5 BIS central bankers' speeches years of work, interbank retail payments should soon be settling within an hour. This will meet the consumer demand for faster clearing of funds and reduce settlement risk within SBI. Payments NZ recognises the rapidly changing landscape and has initiated the Payments Direction project, which involves environmental scanning and collaboration with key industry players. This work, including various white papers and initiatives such as today’s conference, are positive for the future of the industry. Higher level of risks Alongside the rapid pace of innovation and technological change, there are some serious risks. For example, a couple of months ago, Yahoo confirmed that 500 millions user accounts had been stolen — one of the largest cybersecurity data breaches ever. In the payments world, similar risks exist around the handling and storing of customer data. And, with customers increasingly demanding 24–7 access, payments disruptions for only short periods can cause major inconvenience. A particular source of risk is the concentration of outsourcing to third-party infrastructure suppliers. A major EFTPOS outage, for example, would mean many people and businesses cannot transact, even though they are connecting through a range of banks. For example, severe weather in Sydney a few months ago affected Amazon Web Services and led to widespread ATM and EFTPOS outages. This highlighted the issue of banks’ reliance on third party providers and not always having backup for their servers at alternative sites. Another key risk is the growth in payments fraud. While consumers expect secure, fast and reliable service, the opportunities for fraud are widespread and perpetrators are more innovative. We saw this with the cyber-heist at the central bank of Bangladesh earlier this year. Nearly USD$80 million is still unaccounted for as a result of that breach. And the hackers came close to getting away with USD$1 billion. New Zealand has been less exposed to cyber-heists than many other countries, ranking 18th of 19 in the list of most attacked countries in the Asia Pacific Region (Australia is 16th and Pakistan 1st)2. But with the landscape evolving so rapidly, it is important that the industry remain ahead of the game on cyber-security and be cautious when adopting new technologies and payment solutions. Network effects are inherent in payment systems and other FMIs, and result in a high degree of systemic risk. If FMIs are not well managed, they can become a conduit for the contagion of shocks across the financial system. This challenge concerns central banks and other payments regulators. How can we make FMIs more robust under stress, and how can we mitigate the potential contagion effects resulting from an FMI failure? International policy response International policy makers are responding to these growing risks in the FMI sector. Financial regulation since the global financial crisis has been strengthened, and this is also true for FMIs, particularly where systems are deemed to be systemic. Many new prudential standards now apply to FMIs, including the Principles for Financial Market Infrastructures (PFMIs)3 developed by the Committee on Payments and Market Infrastructures (CPMI) and the International Organisation of Securities Commissions (IOSCO); the OTC derivatives reforms agreed by the G20 and the Key Attributes of Effective Resolution Regimes from the Financial Stability Board (FSB)4. This year has seen the first internationally agreed guidance on cyber security from the BIS: Guidance on Cyber Resilience for FMIs5. Many jurisdictions, particularly within the G20, are implementing these reforms. 2/5 BIS central bankers' speeches The Reserve Bank’s response This leads me to the new oversight framework that the Reserve Bank and Financial Markets Authority (the FMA) have been developing for FMIs in New Zealand. The case we make for oversight is driven by potential market failures inherent in many FMIs, in particular negative network externalities where operators or participants might not fully consider the wider social costs of their actions, particularly in stress situations. While the Reserve Bank has had responsibility for overseeing the payments system for over a decade, we believe the current legislation is no longer fit for purpose. The lack of crisis management powers and our limited ability to induce system improvements mean we are not able to fully meet our mandate of promoting a sound and efficient payments system. Many of you provided input to our review of the FMI oversight regime over the last couple of years, and I thank you for that. We have taken our time in developing the framework so that it will be fit for purpose and reflect a risk-based approach to regulation. The new oversight framework, yet to be enacted, has several key features: The Reserve Bank and FMA would have information gathering powers in order to better identify emerging risks An FMI that is assessed as being systemically important would be required to be designated under a revised Designation Regime The Reserve Bank and FMA would have enhanced oversight of designated FMIs, including powers to: set requirements on governance and BCP standards; influence FMI operating rules, and play a key role in crisis management Currently designated FMIs would continue to be able to seek legal protection for netting and settlement under the revised regime. Other new non-systemic systems would also be able to opt-in to the new regime. To assess whether an FMI is systemically important, we are using international standard criteria: the size and concentration of financial risks within the FMI; the role and the nature of the transactions it processes; the extent to which there are alternative services available; and the FMI’s interdependencies with other FMIs. Our initial assessment identified nine FMIs that are either systemically important or potentially of systemic importance. Four of them are already designated systems: ESAS, NZClear, CLS and NZCDC. Two of the Payments NZ systems – SBI and HVCS – are also likely to be designated under the new framework. There are another three offshore based FMIs that are on this list too, including LCH, ASX Clear (Futures) and Singapore’s DTCC (trade repository). A key feature of the proposed new framework is crisis management. We are proposing that the Reserve Bank and FMA would have a tools to respond if a systemically important FMI fails or is about to fail. In such a situation, we want to facilitate an orderly recovery or resolution so as to minimise potential disruptions to the financial system. While the focus will be on systemically important FMIs, the proposed framework will help us monitor emerging risks in the broader industry. This would not be an “all-or-nothing” oversight regime. Rather, it would give the Bank and the FMA flexibility to tailor the oversight regime in light of the risks identified. The oversight regime would continue to be less intrusive than in most other jurisdictions. As in our recent engagement with the industry on the potential impact of a point-of-sale switch outage, we will seek to identify relevant action points for the Reserve Bank and industry. But, consistent with our broader regulatory philosophy, we will avoid prescriptive solutions if possible. Industry cooperation and rigorous self-assessment in the context of international standards is 3/5 BIS central bankers' speeches preferable to regulatory intervention. The proposals are still subject to Cabinet approval. The next step in the process would be to prepare new legislation. The Reserve Bank would issue an exposure draft for consultation around the end of Q1 or early Q2 next year. Apart from the new regulatory framework for FMIs, the Ministry of Business, Innovation and Employment (MBIE) has recently released an issues paper on retail payment systems, their focus being on merchant service and interchange fees. This is an important efficiency and competition issue that many countries are grappling with. The Reserve Bank and the Government share the common objective of a sound and efficient payments system and which facilitates innovation and open access. The Government’s issues paper looks at features of the retail payments system that may also have broader social efficiency implications, for example arising from the allocation of costs associated with new payment services. I encourage you to consider and make submissions on the issues paper. Replacement technology for ESAS and NZClear The Reserve Bank operates two important parts of the New Zealand payments infrastructure: ESAS and NZClear. These systems, both of which are designated, need to remain reliable, efficient and fit for purpose. We also need to be responsive to changing customer demands and new technologies. The current ESAS and NZClear systems, introduced in 1998 and 1990, have served us well, but both now require upgrades. The replacement project underway aims to implement systems that meet modern standards of reliability and security while having sufficient capacity and agility to meet customers’ performance expectations. At this point, these upgrades are expected to be completed by the end of 2018. Closing In conclusion, I want to reinforce what I have said about the proposed new FMI oversight regime. We have sought your input to the regime over recent years and we believe we have listened. We do not envisage that the new framework will significantly change how the payments industry operates or how we engage with each other. We already have a very collaborative relationship with the industry, including Payments NZ. While some current processes will be formalised over time, the nature of our open engagement means there should not be surprises. We want to continue our open dialogue with the industry, allowing mutual goals to be achieved in a low key and non-prescriptive manner. The rapidly changing payments landscape provides challenges and opportunities. Competition in payments is important but collaboration is also needed between financial institutions, new entrants and policy-makers. This is necessary to create the right environment for modernising the payments system and sensibly managing the risks that arise. Effective innovation is often best achieved through collaboration and we encourage the industry to move in this direction. For the Bank, the main focus is on preserving financial stability while also facilitating innovation and improved efficiency. To do this, we need to keep abreast of the changing technology environment and continue to assess the level of preparedness of the system to handle adverse shocks. The challenge for the Reserve Bank, and for all of us, is to understand the evolving financial services landscape, including its opportunities and vulnerabilities. As we move forward in this rapidly changing environment, it serves all our interests to first ensure the safety of the system. This is the foundation for achieving innovation and growth in the industry. 1 Watson, A (2016), “ Disruption or distraction? How digitisation is changing New Zealand banks and core banking systems’, RBNZ Bulletin,78(8). 2 Based on Microsoft’s Malware Infection Index 2016. 4/5 BIS central bankers' speeches 3 Bank for International Settlements (BIS) - Principles for Financial Market Infrastructures (PFMI). 4 Financial Stability Board (FSB) - Key Attributes of Effective Resolution Regimes for Financial Institutions. 5 Bank for International Settlements (BIS) - CPMI-IOSCO release guidance on cyber resilience for financial market infrastructures. 5/5 BIS central bankers' speeches
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Text of the Sir Leslie Melville Lecture by Mr Geoff Bascand, Deputy Governor and Head of Operations of the Reserve Bank of New Zealand, at the Australia National University, Canberra, 22 November 2016.
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Changing Dynamics in Household Behaviour: What do they mean for inflationary pressures? Sir Leslie Melville Lecture: A speech delivered to Australia National University in Canberra, Australia On 22 November 2016 By Geoff Bascand*, Deputy Governor 2 The Terrace, PO Box 2498, Wellington 6140, New Zealand Telephone 64 4 472 2029 Online at www.rbnz.govt.nz Introduction Thank you for the opportunity to speak to you all today. It’s wonderful to be back at the Australia National University (ANU) and an honour to give this lecture that promotes discussion between academics and policy practitioners. Today, I would like to explore how changes in household behaviour– in particular saving 1 and debt dynamics – are influencing inflationary pressures. Nearly ten years on from the start of the global financial crisis (GFC), some advanced economies are still struggling to reach the “escape velocity” needed to ensure that the economy grows above trend and generates a path of inflation that is consistent with central bank inflation targets. Despite extraordinary monetary accommodation in these advanced economies, economic growth remains disappointingly weak. Something seems to be different on the demand side of the economy since the GFC, and is challenging inflation modelling and inflation targeting frameworks. Estimates of the real neutral interest rate – that is the real interest rate consistent with the economy growing at full employment and achieving price stability over the medium term – have declined materially. 2 Some commentators suggest that nominal interest rates will remain low for years to come. Views vary as to the nature of the changing dynamics of aggregate demand. Some economists posit that we are now in an era of “secular stagnation”, with a persistent deficiency in aggregate demand. 3 Others point to an overhang from earlier excessive debt accumulation and suggest that demand is being depressed by a lengthy period of deleveraging. 4 Irrespective of the reasons for the weak demand, several supply-side arguments point to lower rates of growth in the labour force, innovation, and productivity, and consequently investment and output growth. In my address, however, I will focus solely on the demand side of the economy. While there are many common features to the international picture, there are also notable differences. In advanced economies, investment has generally been weak at a time when the household sector’s consumption-saving balance has not materially altered. A different picture, however, emerges in Australasia. As in other advanced economies, private debt levels rose rapidly in the early part of the twenty-first century, due to strong household credit growth. But, since the GFC, private debt levels have tended to stabilise and the household saving rate has increased. This is despite a large increase in wealth associated with rising house and equity prices. The path of consumption and the relationship between consumption and wealth is crucial to the Reserve Bank of Australia’s (RBA) and the Reserve Bank of New Zealand’s (RBNZ) assessment of business cycle dynamics and inflation prospects. Indeed, weaker spending out of wealth than expected is part of the reason why inflation has been lower than forecast in New Zealand. To what extent heightened saving preferences represent a permanent shift or a prolonged deleveraging adjustment is uncertain, though some indicators provide tentative support to the view that it represents a prolonged cyclical correction. In this address, I will briefly review international demand dynamics, before drawing a New Zealand and Australian perspective. I will then examine the changes in New Zealand’s saving behaviour and debt dynamics since the GFC, before turning to the implications for the RBNZ’s inflation modelling and forecasting. Increased saving or lower investment? Since 2008, OECD economies have grown more slowly relative to previous expansions (figure 1). Over the past seven years, growth has averaged 1.2 percent compared to 2.6 percent in the decade preceding the GFC. A similar picture emerges when comparing relative rates of consumption growth. Lower economic growth has been associated with lower neutral interest rates. The extent to which this reflects lower growth in aggregate demand or higher saving is unclear, as is the extent to whether it is a prolonged cyclical phenomenon or a permanent shift in growth rates. 5 Summers (2016) believes that long-term secular forces are at play that raise desired saving and reduce the propensity to invest, thereby driving down long-run equilibrium interest rates. Figure 1: Expansions in real GDP (OECD aggregate) 6 Index 1982-1990 2009-2016 1975-1981 2001-2008 1991-2001 16 19 22 25 28 Quarters from trough Source: OECD. An increased propensity to save could reflect many factors. For example, stronger precautionary motives in light of the severe global recession (due to upgraded assessments of financial and employment risk); demographic shifts towards higher saving households; greater saving related to population ageing and longer lives; more-binding credit constraints associated with higher debt levels; rising income inequality; and potentially a downgrading of future prospects for investment returns and growth. A lower propensity to invest might reflect lower rates of innovation and productivity growth, lower expected investment returns, 7 less capital-intensive technologies, and structural change towards less capital-intensive service industries. An alternative explanation proffered by Rogoff (amongst others) is that our economies are experiencing a prolonged period of deleveraging (in the public and private sectors), aimed at winding back excessive debt accumulation from the period preceding the GFC. In this scenario, national saving would be higher and growth in investment lower (or at least creditfinanced investment) for many years. What does the evidence suggest? 8 For advanced economies as a whole, national saving has not altered significantly over the last 25 years and, if anything, have declined slightly (figure 2). The savings-glut hypothesis proposed by Bernanke and others was associated with the large build-up of savings from China in the mid-2000s, much of which ended up financing higher United States (US) spending. However, more recently, China’s national saving rate has moderated, while in advanced economies saving rates have recovered towards pre-GFC levels. Figure 2: Gross national saving (share of GDP) % of GDP % of GDP China (RHS) Germany Japan US Advanced Economies Source: IMF. The US personal saving data illustrates these developments. Between 1991 and the onset of the GFC in 2008, the personal saving rate as a share of household disposable income fell by 5.4 percentage points. 9 This trend decline coincided with a large rise in house prices and build-up in household debt. Debt ratios deteriorated due to increased access to new financial products, the baby-boom generation transitioning towards middle age, and educational attainment for the population was rising (Dynan and Kohn, 2007). Following the GFC, the large decline in house prices led to a reassessment of household balance sheets and an associated cutback in consumption. 10 While national saving in the advanced economies has broadly recovered since the crisis, the weakness in investment has been striking. After being relatively stable as a share of GDP through the 1990s and early 2000s, the investment ratio tumbled in the GFC and has risen only marginally since (figure 3). The US investment ratio has recovered only modestly despite low financing costs, and as at 2016 remains 1.4 percentage points lower than its precrisis average level between 1990 and 2005. On the face of this data, the reduced propensity to invest appears to have more power than heightened saving behaviour in explaining the weak aggregate demand story, at least for the advanced economies grouping. Figure 3: Total investment (share of GDP) Index (1990=100) China Index (1990=100) Germany Japan US Advanced Economies Source: IMF. Household and government sector debt has risen significantly as a share of GDP since 1990. A reasonably sharp deleveraging in household debt has been observed in the US since the GFC, followed by modest deleveraging in the UK and Germany, but this appears to be an exception to the general pattern observed for advanced economies where debt-toGDP has been broadly flat (figure 4). These trends are broadly consistent with slow credit growth, in part due to tighter financial regulation and the diminished appetite for debt in the private sector. Bank credit in the private non-financial sector for advanced economies has barely expanded since 2008, while it grew at an annual rate of 8 percent in the eight years preceding the crisis. 11 Elevated debt levels may have inhibited credit, investment and consumption growth, but significant deleveraging is not yet apparent in the aggregate data (Buttliglione, Lane, Reichin and Reinhart, 2014). Figure 4: Household debt (share of GDP) 12 Index (2008=100) Index (2008=100) Advanced Economies Canada Germany UK US Euro area Japan Source: Bank of International Settlements. Australasian trends In contrast to some other advanced economies, New Zealand and Australia have experienced fairly stable investment-to-GDP ratios and uplift in saving, especially by the household sector. Relative to international trends, the Australasian investment story has been stronger with investment ratios now close to their pre-crisis average (figure 5). Both countries benefitted from large commodity price gains, and Australia experienced an extraordinary mining investment boom. New Zealand also experienced a surge in residential investment following the Canterbury earthquake and in response to the acute shortage of housing in Auckland. 13 But even beyond these sectoral shocks there are no obvious signs that the propensity to invest has weakened. Figure 5: Percentage point deviation in investment and saving from pre-crisis averages (share of GDP) 14 Investment % point National saving 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 -3.5 Australia New Zealand Other advanced economies Euro area G7 Source: IMF. In Australia and New Zealand, weaker-than-expected demand has come via lower-thanexpected consumption growth relative to income and, in particular, relative to wealth. Notwithstanding a smaller financial crisis than experienced in many advanced economies, Australasian households appear to have adopted a new-found prudence. One indicator of this is the net foreign liability position, which for New Zealand has fallen from a peak of 84 percent of GDP in March 2009 to around 65 percent of GDP in the 2016 June quarter. This reflects a narrowing current account deficit over the period resulting from higher national saving. In addition, there was a sharp narrowing in the investment income deficit (from 6.3 percent to 3.7 percent of GDP) as interest on foreign debt declined. In Australia, national saving began rising in 2004 and eventually peaked at 24.8 percent of GDP in 2011, contributing to a narrowing in the current account deficit since the mid-2000s. National saving has eased slightly in recent years, but the current account deficit and net foreign liability position have remained broadly stable. Turning more directly to the household sector, Australia’s household saving rate increased from around zero in 2003 to an average of about 7 percent of disposable income thereafter (figure 6). New Zealand also saw a recovery in the household saving rate from a trough of -6.8 percent in 2003 to 2.4 percent in 2012. Over a longer-term context it is striking that the 1990s and early 2000s were an exceptional period of low or negative saving. For example, in Australia, the personal saving rate has averaged about 10 percent since 1960 and was as high as 19 percent in 1973. In New Zealand, household saving averaged 4 percent of household disposable income from 1987 to 1994, and was then negative for most years until 2010. Figure 6: Household net saving rate (percent of disposable income) % % New Zealand Australia -5 -5 -10 -10 Source: Statistics New Zealand, Australian Bureau of Statistics. Decomposing changes in household saving Why has household saving increased? A number of explanations are plausible as I highlighted earlier. It is not my intention to examine these hypotheses comprehensively today. But I will point to some promising lines of inquiry by reviewing how different household groups have behaved before and after the GFC. The RBA recently examined the rise in the Australian household saving ratio between 200304 and 2009-10 by examining saving behaviour for different household groupings (Finlay and Price, 2014). They found that the propensity to save rose most for households reliant on less secure sources of income, or who are more vulnerable to asset price shocks, indicating a greater degree of risk aversion and thus heightened precautionary motives. University educated households also increased their propensity to save relative to high school educated households, which the authors suggested could reflect a downward reassessment of future income prospects by higher-educated households. Wealthy households and those with high debt levels displayed an increased propensity to save, reflecting a desire to rebuild wealth following the asset price shock during the crisis, and a more prudent attitude towards debt. We have recently undertaken similar analysis for New Zealand using Household Economic Survey (HES) data that compares consumption and saving across households at the peak of the last cycle (2007) and some five years after the recession (2013). 15 Whilst the HES provides a flawed estimate of aggregate household saving relative to national accounts data, 16 it is reasonably consistent in its methodology over time, affording a useful decomposition of changes in saving patterns. The HES data shows a smaller increase in the median saving ratio relative to the rise in the overall level of saving (or the aggregate saving ratio). This appears to be explained by much lower dissaving among individuals below the median as opposed to higher saving among those above the median. The saving ratios at the top end of the saving distribution are largely unchanged (figure 7). Figure 7: Distribution of the saving ratio (percent of disposable income) % % -100 -100 -200 -200 -300 -300 -400 -400 -500 -500 Percentiles of the saving ratio Source: Statistics New Zealand Household Economic Survey. Similar to Australia, saving rose much more sharply for higher educated households (those holding a degree), suggesting a downward assessment of future income prospects, such that much of the income growth over the period was saved. 17 Another parallel with the Australian study is the significant reduction in dissaving amongst those with the highest debtto-income (DTI) ratio (figure 8), supporting the notion of a debt overhang and a desire amongst such households to lower their debt ratios, or a reduced supply of lending to such households. These studies suggest there is tentative evidence of a recent shift in saving behaviour in Australasia owing to pessimism around income growth and the negative shock to wealth emanating from the GFC. The former would suggest a more enduring change, while the latter is more consistent with a prolonged cyclical adjustment. In both countries, there is no obvious sign that ageing demographics (i.e. an increasing concentration of middle-aged households with higher saving rates) had a strong influence over the change in saving behaviour during the period. When adjusted for changes in the age composition of households, the aggregate saving ratio in 2013 was only marginally lower than the unadjusted rate, implying that most of the (large increase) was due to economic factors. 18 Correspondingly, the increase in the saving rate was smaller amongst the 50-64 year old age cohort than it was for the 30-49 cohort or the 65+ group. Figure 8: Saving ratio by DTI quartile (percent of disposable income) 19 % -5 -10 -15 No debt Quartile 1 Quartile 2 Quartile 3 Source: Statistics New Zealand Household Economic Survey. Quartile 4 Consumption and wealth In absolute terms, real consumption growth has not been noticeably weak since the crisis, with annual real consumption growth in both countries similar to its long-term average of around 2.5 percent. However, population growth has been rapid and thus real consumption per capita has grown by only 1.2 percent and 0.8 percent per annum on average since 2008 in New Zealand and Australia respectively (figure 9), well below its long-term average. Moreover, this modest per capita consumption growth has occurred when wealth, namely housing wealth, has been rising rapidly. Figure 9: Consumption per capita (annual growth, percent) 20 APC % APC % -2 -2 -4 -4 -6 New Zealand Australia New Zealand (average) Australia (average) -6 Source: Statistics New Zealand, Haver Analytics. In the early 2000s, rapid increases in housing wealth were associated with strong growth in credit and consumption. A number of analyses focused on the mechanism of “housing equity withdrawal” whereby households either borrowed against rising housing wealth or sold down to realise the gains and potentially to finance general consumption. 21 Equity withdrawal represents one mechanism for dissaving and, for New Zealand, this dynamic can be observed in figure 10. It is clear that net equity withdrawal from housing wealth has so far been confined to the early to mid-2000s, which coincided with strong household consumption growth and a fall in the household saving rate. Although there has been a large rise in housing wealth in New Zealand and associated credit expansion since 2013, equity withdrawal has not eventuated according to our measure. The introduction of loan-to-value restrictions for housing loans since 2013 has likely played a part in offsetting credit growth related to the resurgence in housing market activity. Likewise in Australia, housing equity withdrawal was only a phenomenon that occurred in the early to mid-2000s (Kent, 2015). Figure 10: Housing equity withdrawal (percent of disposable income) 22 % (inverted) % -20 -10 Injection Withdrawal Housing investment (RHS) Housing equity withdrawal Change in mortgage debt plus capital grants -10 -20 Source: RBNZ, Statistics New Zealand, Housing New Zealand, REINZ. The reduced tendency to take on debt secured against the rise in the value of housing wealth has meant that we have not witnessed a rise in household indebtedness to quite the same extent that occurred prior to the crisis – at least not until very recently. New Zealand household debt rose from 60 percent of household disposable income in 1990 to 100 percent in 2000 and 160 percent in 2008 (figure 11). Post GFC, it then declined modestly in relation to income but has risen again recently, reaching 165 percent of household income in June 2016. Australia has exhibited a similar but slightly higher household debt track. In both countries, the ratios to income have been affected by commodity price movements, initially favourably and then negatively by lowering entrepreneurial incomes. The ratios to wealth are less affected. Figure 11: Household debt and wealth % of disposable income ratio 0.26 New Zealand household debt Australia household debt New Zealand debt-to-wealth ratio (RHS) Australia debt-to-wealth ratio (RHS) 0.24 0.22 0.20 0.18 0.16 0.14 0.12 Source: RBNZ, Haver Analytics. What might we infer from this broad stabilisation in debt levels for consumption and aggregate demand relative to the period leading up to the GFC? On its own, it doesn’t portend a significant tendency towards deleveraging. On the other hand, given the very large house price and wealth movements observed, the increase in household debt appears more modest relative to the previous cycle. This is consistent with the observed increase in saving, in part indicating greater caution on the behalf of households. Even when compared with financial wealth alone, household debt declined after the GFC, only increasing very recently. Undoubtedly, financial liberalisation and persistently lower nominal interest rates have supported greater debt accumulation, and this appears a marked phenomenon of the 1990s-2000s. The trend in debt levels appears to have plateaued, although the very recent observations make this less clear (household credit growth ran at 8.5 percent annually in the three months to August 2016). Nevertheless, the concern from a financial stability viewpoint is a high concentration of debt in the housing market, particularly when house prices are significantly over-stretched against conventional metrics, such as income. High and rising debt levels amongst households leave them increasingly vulnerable to a deterioration in economic conditions or normalisation of currently-low mortgage rates. To assess more rigorously whether the household sector has exhibited lower consumption out of wealth than it did during the “excessive” 2000s, we have undertaken some updated econometric modelling. 23 The new work includes improved measures of household wealth and data since the GFC. We estimate the long-run per-capita relationship between the level of consumption and the levels of housing and financial wealth and income from 1986 to 2016, and then examine the estimates for stability (or structural change). 24 The relationship is estimated using a split sample before and after 2005 where the housing market and housing equity withdrawal was near its peak. The parameter on income and housing fell by 32 percent and 50 percent respectively since 2005, while the parameter on financial wealth increased 25. This implies that for any given increase in income or housing wealth, consumption increases by less, indicating more cautious consumer behaviour since the mid-2000s. 26 The change in behaviour may reflect a reassessment of expected future capital gains from different forms of wealth following the crisis, particularly given heightened uncertainty in the housing market, and greater precaution about the stability or durability of income growth. How has the increase in saving affected inflation and monetary policy? In the standard New Keynesian model, monetary policy responds to shocks that affect inflation by setting interest rates to influence the gap between actual economic activity and its long run, sustainable level. When the level of output is below potential and inflation is falling, as it is currently for most advanced economies, 27 a reduction in interest rates accelerates investment and consumption, bringing forward spending from future periods to raise output. This orthodoxy assumes that current demand conditions and real interest rates are low for temporary reasons rather than reflecting any long-term structural shift in demand or productivity growth that would deter consumers and investors from responding to lower policy-induced interest rates. Strong forms of the secular stagnation hypothesis would argue that an interest rate adjustment is ineffective in inducing an inter-temporal shift in demand when consumers and investors anticipate, let alone experience, near-zero long-run interest rates. A weaker form would acknowledge that the neutral real interest rate has fallen transitorily, requiring a lower policy rate than previously - a complication for economies close to or at the zero lower bound. In New Zealand, there are a couple of reasons why the secular stagnation hypothesis appears unsupported. Potential output growth has substantially recovered from cyclical lows and has not inhibited actual GDP growth to the extent that it has in many other advanced economies. In saying that, potential output growth has still been slower in the current cycle relative to the previous two (figure 12), consistent with some reduction in the neutral interest rate. This is largely due to a much weaker contribution from total factor productivity and growth in the capital stock relative to the past two cycles. Much of the improvement in potential GDP in the current cycle is accounted for by the growth in labour supply owing to greater labour force participation and high net immigration. New Zealand is not currently exhibiting signs of a demographic slowdown that is besetting many advanced economies (population growth in the year to June 2016 was 2.1 percent). Figure 12: Contribution to annual potential GDP growth in recent business cycles % % 4.5 4.5 4.0 Current cycle 1998-07 cycle 1991-97 cycle 4.0 3.5 3.5 3.0 3.0 Total factor productivity 2.5 2.5 2.0 2.0 1.5 Labour 1.0 1.0 Capital 0.5 0.0 1.5 0.5 0.0 Source: RBNZ. Secondly, there is no strong evidence to suggest that aggregate demand growth is less responsive to interest rate adjustments. 28 The stimulus from low interest rates appears to be supporting house prices and construction sector activity via residential investment in line with previous cycles (even after accounting for the Canterbury earthquake reconstruction). 29 Construction sector activity continues to have a strong influence on the output gap. Although consumption growth per capita has been weaker than projected since 2013, this is partly explained by exaggerated expectations rooted in the housing cycle of the early 2000s. We have observed a lower propensity to consume out of housing wealth and an increase in household saving to more moderate levels since the GFC. With hindsight, it appears over-optmistic to have extrapolated the experience of the 1990s and early 2000s when debt accumulation and consumption out of wealth was exorbitant. As we have explained elsewhere (McDermott, 2016), New Zealand’s very low inflation has reflected negative traded goods inflation over the past 5 years. Non-tradables inflation has been slightly lower than expected, largely due to more rapid growth in supply capacity (and especially labour supply) than projected. That said, projections of demand arising from historical estimates of consumption from wealth have been over-optimistic, contributing to downward revisions to forecasts of the output gap. Weaker spending than expected out of wealth is part of the reason why inflation has been lower than forecast. We have been gradually incorporating the weaker relationship between consumption and housing wealth in our projections in recent Monetary Policy Statements, as our understanding of household behaviour has improved. Conclusion A number of hypotheses are available to help explain the persistently low economic growth in the advanced economies since the GFC. Secular stagnation in aggregate demand associated with excess saving and a long-term decline in the real neutral rate of interest is favoured by some. Prolonged – but nonetheless temporary – adjustment to debt overhang is an alternative proposition. In my speech today, I’ve contrasted Australian and New Zealand debt and household dynamics with those observed in other advanced economies. Since the GFC, Australasia has witnessed a moderation in debt accumulation, a return to historical (pre-2000) saving behaviour, and steady output growth. Saving appears to have risen more sharply amongst the most heavily-indebted households. While house price inflation has been strong and housing credit growth robust, this appears to reflect portfolio adjustment – an asset price response to low interest rates – and rapid population growth. This cycle has not seen the pattern of equity withdrawal that characterised the excessive growth in leverage of the early 2000s. Modelling suggests that the elasticity of household spending in response to housing wealth has moderated since 2005. Overall, the developments in Australia and New Zealand are more consistent with a debt overhang hypothesis, a la Rogoff, than secular stagnation, a la Summers. Moreover, rather than indicating a new low-growth paradigm, they tend to imply that extrapolations of high growth expectations from the 2000s were misplaced. High investment and consumption growth rooted in low world interest rates generated by increased savings primarily from Asian countries, and especially China, temporarily boosted growth and asset markets. In Australasia, the current outlook looks a lot like that which prevailed before the 2000s. In other advanced economies, weak investment growth coupled with a disappointing expansion in the supply side of the economy points to a world more consistent with lower long-term growth expectations. We have been taking into account the change in household behaviour in our modelling of inflation and our policy settings. Allowing for the increase we have seen, the links between interest rates, output and inflation appear stable. Nonetheless we will be attentive that such developments are not foreshadowing any greater or longer term change in household preferences. Currently, we are projecting per-capita consumption growth to improve and provide an impetus to output growth. The acceleration is modest compared to the previous cycle as household saving is expected to remain positive over the forecast horizon. Despite robust domestic growth, slow growth in many other advanced economies suggests that global disinflationary pressures will continue to act as a headwind as we endeavour to deliver domestic inflationary outcomes consistent with the midpoint of our target band. * I am very grateful to Martin Wong for his considerable help in the preparation of this address. I also wish to acknowledge Hayden Skilling for his research assistance on the household saving decomposition, and other colleagues for their comments on earlier drafts. 1 ‘Saving’ in this speech refers to the national accounts definition of income less expenditure. 2 Holston, Laubach and Williams 3 Summers (2013; 2016) 4 Reinhart and Rogoff (2010); Lo and Rogoff 5 Estimates for potential growth in advanced economies for the period 2016-2021 have fallen by 0.4 percentage points over the past two years, reflecting both lower factor growth and lower total factor productivity growth (IMF, 2016). 6 The expansions correspond to periods following global recessions, as identified by IMF (2009), while also including the dot-com crash of 2001 that coincided with mild recessions in many advanced economies. 7 Investment profitability appears to have declined since the crisis and the spread between equity and sovereign bond returns has widened, implying rising risk premia (IMF, 2014). 8 Rachel and Smith (2015) provide a comprehensive exposition of the multiple hypotheses for the decline in the global long-run real interest rate through shifts in the saving and investment schedules, generally treating the changes as enduring. They evaluate the estimated 450 basis point fall in the long-run real rate of interest since the 1980s with 100 basis points due to lower trend growth, 140 basis points through reduced investment demand and 160 basis points through shifts towards higher saving. They observe that in advanced economies lower investment demand appears to play a larger role, while in emerging market economies the shift upwards in saving preferences is larger. 9 Source: OECD. 10 Kaplan, Mitman and Violante (2016) estimates that a 30 percent decline in house prices was reflected in a 3.1 percent decline in nondurables consumption from 2007 to 2011. Kaplan et al. (2016) find no effect of initial debt levels on consumption. 11 Source: Bank of International Settlements. 12 We focus on changes in the household debt-to-GDP ratio rather than the level given measurement and institutional differences as discussed in Hunt (2014). 13 The share of construction investment relative to potential output in New Zealand has increased by 3 percentage points since the crisis. 14 Other advanced economies include: Australia, Czech Republic, Denmark, Hong Kong (SAR), Iceland, Israel, Korea, New Zealand, Norway, Singapore, San Marino, Sweden, Switzerland, Taiwan (Province of China). The pre-crisis period is 1990 to 2005. 15 Access to the data used in this study was provided by Statistics New Zealand under conditions designed to give effect to the security and confidentiality provisions of the Statistics Act 1975. The results presented in this study are the work of the author, not Statistics New Zealand. 16 For example the aggregate household saving rate in the HES was 14 percent in 2007 and 26 percent in 2013, compared with national accounts estimates of -4 percent and 2 percent. 17 The analysis did not identify education-related debt. It is unclear whether this is a factor in this result. 18 A New Zealand study by Vink (2016) found that the rise in the proportion of the population in prime-saving age groups contributed only one quarter to the overall trend increase in the aggregate HES saving rate between 1984 and 2010. The remaining three quarters of the aggregate trend increase is attributable to the rise in average saving rates of successive cohorts born since 1930. 19 DTI is based on mortgage debt held against owner-occupied property. Quartiles are based on those with positive debt levels. 20 Average is calculated over the full sample from 1990. 21 Schwartz, Hampton, Lewis, and Norman (2006); Smith 22 We follow the methodology in Smith (2006) where housing equity withdrawal is defined as the change in mortgage lending plus capital grants minus housing investment. Housing investment includes residential investment in dwellings, household transfer costs, transfers of dwellings to the household sector, and net transfers of land to the household sector. Capital grants include Kiwisaver first home withdrawals and Home Start grants since their introduction in 2011. Estimated residential investment and residential insurance pay-outs relating to the Canterbury rebuild have been excluded, as the related fluctuations in equity may not represent changes in household behaviour. 23 Wong (forthcoming) 24 For details of the cointegration estimation framework, see De Veirman & Dunstan (2008). The full-period analysis suggests that a 1 percent increase in real per-capita housing wealth is associated with a 0.20 percent increase in real per-capita consumption on average, while the long-run income elasticity is 0.47 percent. The marginal propensity to consume out of housing wealth is almost twice that of financial wealth (0.12 percent), although this difference in magnitude was much lower than that found in De Veirman & Dunstan (2008). 25 The increase in the coefficient on financial wealth is difficult to interpret as it was not well defined (statistically significant) in the pre-2005 sample. In other results, excluding farm income that is highly variable, the parameter on financial wealth is more stable and statistically significant across the split samples. 26 Given potential instability in the long-run relationship, which may undermine the cointegration approach, the wealth effects are also estimated using an alternative approach developed by Carroll, Otsuka, and Slacalek (2011). The result is similar to the baseline in that the marginal propensity to consume out of housing wealth has fallen in the split sample post-2005, while it increased for financial wealth. 27 The IMF (2016) estimated an output gap of -0.8 percent (as a percentage of potential GDP) for advanced economies in 2016, improving from a trough of -3.8 percent in 2009. 28 Modelling work in the RBNZ has found the response of the output gap to an interest rate shock since the GFC is not statistically different from the pre-GFC period. 29 Similar results for Australia were reported by Kent (2015). References Buttiglione, L., Lane, P., Reichlin, L., & Reinhart, V. (2014). “The 16th Geneva Report on the world economy: Deleveraging, what deleveraging?” International Center for Monetary and Banking Studies/Center for Economic Policy Research. Carroll, C. D., Otsuka, M., & Slacalek, J. (2011). “How large are housing and financial wealth effects? A new approach.” Journal of Money, Credit and Banking, 43(1), 55-79. De Veirman, E., & Dunstan, A. (2008). “How do housing wealth, financial wealth and consumption interact? Evidence from New Zealand.” RBNZ Discussion Paper, DP2008/05. Dynan, K. E., & Kohn, D. L. (2007). “The rise in US household indebtedness: Causes and consequences.” Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. Finlay, R., & Price, F. (2014). “Household saving in Australia.” RBA Research Discussion Paper, RDP 2014-03. Holston, K., Laubach, T., & Williams, J. (2016). “NBER International Seminar on Macroeconomics July 2016: Measuring the natural rate of interest: International trends and determinants.” Journal of International Economics (Elsevier). Hunt, K. (2014). “Household debt: a cross-country perspective.” RBNZ Bulletin, 77 IMF (2009). “Crisis and Recovery.” World Economic Outlook (Apr 2009). IMF (2014). “Recovery Strengthens, Remains Uneven.” World Economic Outlook (Apr 2014). IMF (2016). “Subdued Demand, Symptoms and Remedies.” World Economic Outlook (Oct 2016). Kaplan, G., Mitman, K., & Violante, G. L. (2016). “Non-durable Consumption and Housing Net Worth in the Great Recession: Evidence from Easily Accessible Data.” National Bureau of Economic Research, No. w22232. Kent, C. (2015). “Monetary Policy Transmission – What’s Known and What’s Changed.” RBA speech delivered on 15 Jun 2015. Lo, S. H., & Rogoff, K. (2015). “Secular stagnation, debt overhang and other rationales for sluggish growth, six years on.” BIS Working Papers, No. 482. McDermott, J. (2016). “Understanding low inflation in New Zealand.” RBNZ Speech delivered on 11 Oct 2016. Rachel, L., & Smith, T. (2015). “Secular drivers of the global real interest rate.” Bank of England staff working paper, No. 571. Reinhart, C. M., & Rogoff, K. S. (2010). “Growth in a time of debt (digest summary).” American Economic Review, 100(2), 573-578. Schwartz, C., Hampton, T., Lewis, C., & Norman, D. (2006). “A Survey of Housing Equity Withdrawal and Injection in Australia.” RBA Research Discussion Paper, RDP2006-08. Smith, M. (2006). “What do we know about equity withdrawal in New Zealand.” RBNZ Workshop (14 Nov 2006): Housing, Savings, and the Household Balance Sheet, Wellington. Summers, L. H. (2013). “Why stagnation might prove to be the new normal.” Financial Times, 15. Summers, L. H. (2016). “Age of Secular Stagnation: What It Is and What to Do about It.” The Foreign Affairs, 95, 2. Vink, M. (2016). “Intergenerational developments in household saving behaviour.” New Zealand Economic Papers, 50(1), 3-28. Wong, M. (forthcoming). “An assessment of the consumption-wealth effect in New Zealand.” RBNZ Analytical Note.
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Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to Development West Coast, Greymouth, 8 December 2016.
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Some thoughts on New Zealand’s Economic Expansion A speech delivered to Development West Coast in Greymouth On 8 December 2016 By Graeme Wheeler, Governor 2 The Terrace, PO Box 2498, Wellington 6140, New Zealand Telephone 64 4 472 2029 Online at www.rbnz.govt.nz Some thoughts on New Zealand’s Economic Expansion 1. Introduction Thank you for inviting me to meet with you again. It’s always a pleasure to be here and exchange views on how the economy is performing. In many respects the economy is performing well. Relative to the trends over the past two decades, we are experiencing stronger economic growth, lower inflation, and a lower unemployment rate - even with record levels of labour force participation. And the Achilles heel of many New Zealand expansions – a large current account deficit – has not eventuated (figure 1). Figure 1: Summary Macro-economic Indicators relative to trend Source: Statistics New Zealand Economists are well known for their two-handed assessments, and it won’t surprise you if I mention that not everything is as positive. The overall expansion, now entering its eighth year, is weaker than other post-WWII expansions. GDP growth on a per capita basis has been slow and labour productivity growth has been disappointing. House price inflation is much higher than desirable and poses concerns for financial stability, and the exchange rate is higher than the economic fundamentals would suggest is appropriate. New Zealand is not alone in encountering these challenges. Most of the advanced economies and several emerging market economies are experiencing weaker than normal expansions and slow labour productivity growth. Several are experiencing high house price inflation. In a world of weak trade growth and rising protectionism, many would prefer to have a more competitive exchange rate. I will return to some of these issues in discussing: • some of the characteristics of the current expansion, • the prospects for continued expansion and the key economic risks we face, and • 2. the role that monetary policy can play going forward. Characteristics of New Zealand’s Current Economic Expansion i) The expansion has taken place in a difficult global economic climate Global economic growth in 2015 and 2016 is around 3 percent – the weakest since 2009 and below its long-term average of 3¾ percent, despite unprecedented global monetary stimulus and a major decline in oil prices. Global trade, normally a catalyst for the global economy, remains weak. Merchandise trade growth over the past five years has been the slowest since the early 1980s, and protectionist measures in G20 countries and elsewhere are on the rise. Economies are grappling with the spillovers from unconventional monetary policies and heightened political uncertainty has also been making households and businesses more cautious. ii) The current expansion is longer, but also weaker than previous expansions At 28 quarters, the current economic expansion is the second longest in the past 40 years. Annual real GDP growth has averaged 2½ percent during the expansion, making it the weakest expansion during that time. Over the past year however, annualised GDP growth has accelerated to a little over 3½ percent (figure 2). Figure 2: Real GDP growth over New Zealand business cycles Index Recession GDP (log levels, indexed Mar2010=100) 39 quarters at 0.91% quarterly growth 18 quarters at 0.74% quarterly growth 28 quarters (to date) at 0.62% quarterly growth 24 quarters at 0.99% quarterly growth 18 quarters at 0.71% quarterly growth Source: Statistics New Zealand, RBNZ. Recessions are defined as two or more consecutive quarters of negative quarterly growth. iii) The drivers of the expansion have changed Initially the expansion was driven by improving terms of trade (which improved steadily from September 2009 and reached a 40-year high in June 2014), growing trade with China under the Free Trade Agreement, and the stimulus from the 575 basis point decline in the official cash rate (OCR) between mid-2008 and mid-2009. Increased construction investment, initially linked to Canterbury earthquake reconstruction, and the strong surge in migration and tourism have offset the effects of the 8 percent fall in the terms of trade since mid-2014 and contractionary fiscal policy since 2012. Monetary policy continues to be accommodative with the OCR remaining well below the estimated neutral interest rate, which is currently just below 4 percent. These factors continue to be the main drivers of the expansion, although Canterbury reconstruction is no longer a contributing factor. iv) Record migration, record tourism, and historically high labour force participation In annual terms, net immigration has been the strongest since 1860. Net permanent and long-term migration of 172,000 working age people has increased the labour supply by 5 percent since 2012. Annual potential GDP growth has more than doubled to around 2.9 percent from its 2010 trough of 1.2 percent, primarily because of this labour force expansion. Private consumption is being boosted by the strong growth in migration, record tourist inflows and the 11¼ percent increase in employment over the past 3 years. At 70.1 percent, the labour force participation rate is at an alltime high and the second highest among the advanced economies after Iceland. v) Labour productivity growth has been particularly weak New Zealand’s trend rate of labour productivity growth is in the bottom third of OECD countries. There are many reasons for this including: distance from markets; size of the domestic market; small size of most New Zealand firms; limited participation in global value chains; and lower volumes of capital per worker. But, as with most of the advanced economies, labour productivity growth has been below its historical trend in the current expansion. In the advanced economies, the decline in labour productivity growth is due to a slowdown in the growth of investment per hour worked (reduced capital deepening) and lower total factor productivity growth (TFP). 1 In New Zealand, the slowdown in labour productivity growth is mainly due to the reduced contribution from TFP – the average contribution of TFP to potential output growth in the current cycle has been less than half that of the previous two cycles (figure 3 – TFP is a measure of how efficiently and intensively other factors of production are being utilised). Figure 3: Contribution to annual potential GDP growth in recent business cycles 4.5 % % 1991-97 cycle 1998-07 cycle 4.5 Current cycle 4.0 4.0 3.5 3.5 3.0 3.0 Total factor productivity 2.5 2.5 2.0 2.0 1.5 Labour 1.0 1.0 Capital 0.5 0.0 1.5 0.5 0.0 Source: RBNZ estimates vi) The economic impact of high migration has been different from earlier cycles Migration inflows affect aggregate demand and supply in the economy. In earlier cycles the short-term demand impacts (in terms of spending and inflationary pressures) tended to dominate the effect of increased labour supply in raising potential output in the economy. Earlier periods of sizeable migration inflows, such as 2001–3, were quite quickly reflected in capacity and price pressures, and a strong pick-up in house price inflation. House price inflation has been accentuated by the strong migration inflows in the current cycle, but the impact on consumer price inflation has been weaker than anticipated. This more muted impact on spending is likely due to the higher proportion of younger cohorts in the migrant flows, and the fact that many migrants are returning from a weaker labour market in Australia and may be more cautious in their spending. 2 3 vii) The impact of wealth effects on private consumption has been weaker in the current cycle Growth in real consumption per capita has averaged 1.6 percent pa in the current economic cycle – about ½ percentage point below the post1993 average growth rate of 2.1 percent, despite the rapid increase in housing wealth. Although there are recent indications that per capita consumption is increasing, the lower propensity to consume out of household wealth and the increase in household saving have contributed to weaker than expected inflation. This more cautious consumer behaviour may reflect a reassessment of the ‘permanency’ of capital gains from household assets, and greater caution about the level and durability of future income growth. 4 viii) New Zealand’s terms of trade and the real exchange rate have been higher in this cycle Global commodity prices were on a downward trend from early 2012 and fell sharply after mid-2014. They began to pick up early this year. New Zealand’s terms of trade began falling in the second half of 2014, but the real effective exchange rate has generally remained high reflecting New Zealand’s higher economic growth and interest rates and the positive investment climate here compared to many other advanced economies. Figure 4 shows the average real effective exchange rate and average terms of trade during the past three domestic expansions. Figure 4: New Zealand’s Terms of Trade and Real Exchange Rate Index Index Real TWI Terms of trade (RHS) Source: Statistics New Zealand, RBNZ estimates. The real effective exchange rate is a measure of competitiveness that adjusts the nominal effective exchange rate by correcting for differences in relative inflation rates (or relative unit labour costs) between New Zealand and its major trading partners. ix) The recovery in household savings is reflected in an improved current account position and lower external debt ratios New Zealand’s household net savings rate improved by 8 percentage points in the period 2008 to 2013 (from minus 6 percent to positive 2 percent of household disposable income (figure 5)). Over this period, New Zealand’s overall savings rate (ie including savings by the business and public sectors) increased by around 5 percentage points, and this has been an important factor behind the improvement in New Zealand’s ongoing current account deficit and the decline in net external liabilities as a share of GDP (this ratio has declined from 84 percent of GDP in 2009 to around 63 percent of GDP currently). Figure 5: Household net saving rate (percent of disposable income) % % -2 -2 -4 -4 -6 -6 -8 -8 Source: Statistics New Zealand x) The period of negative tradables inflation has been very long Over the past five years, annual CPI inflation has averaged 1.1 percent. During this period, inflation in the tradables sector (those industries exposed to international competition) has been negative – averaging minus 0.8 percent annually, compared to positive 1.2 percent in the prior two decades. This means that pricing outcomes in the tradables sector have been a drag on inflation, lowering annual CPI inflation, on average, by around 0.4 percent (figure 6). While relative prices continuously adjust to market forces, New Zealand is unlikely to have experienced such a prolonged period of falling tradables inflation since the Great Depression. Declining tradables prices reflect the combined impact of the global over-supply of manufactured and capital goods, falling technology costs, weak commodity prices, and the appreciation in the New Zealand dollar exchange rate. Figure 6: Traded goods inflation has been negative for five years CPI Inflation and components (annual) % % Projection Non-tradables Headline -2 -4 -2 Tradables -4 Source: Statistics New Zealand, RBNZ xi) Long-run inflation expectations have remained anchored at 2 percent A positive feature of the current expansion is how longer-term inflation expectations have remained well-anchored at the mid-point of the Reserve Bank’s target range (figure 7). This is despite low headline inflation that has pulled down short-term inflation expectations, and some evidence that inflation expectations respond to past inflation outcomes more than before the GFC (ie, they have become more adaptive and less forward-looking). 5 Figure 7: Inflation Expectations Curve (annual, by number of years) 6 % % Source: RBNZ 3. Prospects for Continued Economic Expansion In the absence of major unanticipated shocks, prospects look good for continued strong growth over the next 18 months, driven by construction spending, continued migration, tourist flows, and accommodative monetary policy. Our November 2016 MPS forecasts show annual real GDP growth of around 3¾ percent over the next 18 months, with inflation approaching the mid-point of the target band, the unemployment rate continuing to decline, and the current account deficit remaining within manageable levels. Historically, expansions in small open advanced economies come to an end due to one or more factors: • global economic growth weakens or slows in major trading partners and affects the terms of trade and export growth; • a major domestic policy correction is needed to address a deteriorating fiscal or current account deficit; • long-term interest rates rise significantly in response to offshore movements triggered by higher inflation expectations and/or increased risk premia in major economies. Alternatively, domestic short-term rates may need to rise sharply to moderate inflation pressures associated with growing supply and demand imbalances. The main risks to the current expansion lie with future developments in the global economy, and a deterioration in the imbalances in the domestic housing market. i) Global risks On the downside, the main risks are: • the Euro-area economy remains subdued or deteriorates, with consumer and business confidence affected by developments relating to Brexit, migration and anti-globalisation sentiment; • the incoming US Administration follows through on pre-election rhetoric relating to trade barriers, and abandons or renegotiates existing trade agreements; • economic growth in China slows following a period of financial disruption linked to the very rapid build-up in corporate (mainly SOE) debt over the past 7 years, and a rising level of bad debts in the formal and shadow banking sectors. The main upside risk is that the US economy in 2017 grows more rapidly than the 2 2¼ percent growth currently projected by the IMF, OECD and BIS, due to substantial personal and corporate tax cuts and a large increase in infrastructure spending (with no major moves to raise trade barriers). ii) Risks in the domestic housing market Numerous measures indicate that New Zealand house prices are significantly inflated relative to usual valuation indicators. IMF data show that New Zealand had the third highest real increase in house prices among 64 countries in the year to June 2016. 7 New Zealand also had the greatest deterioration in the median house price to median income ratio of 31 advanced countries in the period 2010 to mid-2016. 8 OECD data indicates that, relative to their long-term averages, New Zealand has the highest house-price-to-rent ratio, and the second highest house-price-to-income ratio among the OECD economies. 9 Several cross-country studies have assessed the economic implications of housing market downturns. This research tends to show that almost half of the housing booms end in a bust, with downturns lasting around four to six years 10. In addition, soft landings in the residential investment cycle are rare, with most collapses leading to protracted falls in private consumption and investment, especially construction investment. 11 Even though it is too early to be sure, there are some indications that house price inflation in Auckland and other regions may be moderating. This may be a result of the increase in loan-to-value restrictions, higher funding costs being experienced by banks, and tighter credit criteria being applied by banks in connection with financing apartment development and house purchases by offshore residents. 4. Monetary Policy Considerations We enter 2017 with considerable political and economic uncertainties. These include: the policies of the incoming US Administration – particularly in regard to fiscal policy and trade policy; the UK Government’s strategy in triggering Article 50 and how the European Community will respond; the build-up of corporate debt and rising bad debts in the Chinese banking system; the nature of the future political and economic relationships between the US, China, Japan and Russia; and the possible outcome of important upcoming elections in Western Europe. Central banks monitor these developments carefully, and their impact on business and consumer sentiment and asset prices. New Zealand’s economy has been growing faster than potential output for five years, and the Bank’s forecasts suggest that we now have a small positive output gap. Long-term inflation expectations remain well-anchored at around 2 percent and shortterm inflation expectations have been rising slowly. The low point for CPI inflation has probably passed and, supported by the improvement in global commodity prices in recent months, we expect the December quarter 2016 CPI data to confirm that annual CPI inflation is moving back within the 1 to 3 percent target band. The central interest rate projections contained in the November Monetary Policy Statement (MPS) indicated that the OCR is likely to remain at its current level for some time. These projections are highly conditional and based on a range of key assumptions that relate to: trading partner GDP growth and inflation; developments in oil and dairy prices; exchange rate adjustment; migration and house price inflation; and judgements as to how the latter two factors might affect spending and CPI inflation. Different outcomes from those assumed in the MPS could imply a different policy path. In the MPS we assessed the overall balance of risks to be on the downside. Since the US election there have been important global and domestic developments. Ten-year bond yields in the US have risen by 50 basis points and the US real effective exchange rate has appreciated by almost 5 percent and reached a 14-year high as financial markets assess the implications of a possible large fiscal stimulus for economic growth, inflation and the level of outstanding US government debt. Ten-year government bond yields have increased by 40 basis points in New Zealand (figure 8). Figure 8: 10 Year Government bond yields 4.5 % Differential (RHS) NZ US 4.0 3.5 Bps 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Jan-15 May-15 Sep-15 Jan-16 May-16 Sep-16 Source: Bloomberg, RBNZ The factors behind the rise in US rates have increased market expectations that the Federal Reserve will raise policy rates at its meeting on 13-14 December 2016, and tighten more rapidly in 2017. Prospects of stronger growth in the US and the resulting spillovers through trade, commodity prices and relative exchange rate movements should be positive for New Zealand and a welcome development from a monetary policy perspective. However, while the 5 percent appreciation in the US dollar in recent weeks is helpful for New Zealand exporters, the TWI currently lies above its level in June 2015, despite the terms of trade being 6 percent lower and seven reductions in the OCR. As has been the case in several other countries, monetary policy has been made more challenging in New Zealand by low global inflation and zero or negative policy rates in several major economies. This has put downward pressure on our interest rate structure and contributed to asset price inflation and upward pressure on the New Zealand dollar. This trend may finally be turning. Another major change is the 7.8 strength Kaikoura earthquake. Early indicators are that reconstruction work, including by government, could be in the order of $3 – $8 billion, or around 1-3 percent of GDP. This is much smaller than the $40 billion associated with Canterbury reconstruction, and would occur at a time when the domestic economy is at or near full capacity. The supply disruptions are unlikely to have a major impact on overall economic growth. Some increase in construction cost inflation is likely as this is already running at 7.9 percent in Auckland and 6.3 percent nationally due to capacity bottlenecks within the sector. Increases in freight costs are also expected. At this stage these developments do not cause us to change our view on the direction of monetary policy as outlined in the November MPS. We expect monetary policy to continue to be accommodative, and that the projected policy settings will help generate sufficient growth to have inflation settle near the middle of the target range. 5. Conclusion Expansions in small open advanced economies often come to an end because of developments in the global economy that are transmitted through the terms of trade, long-term interest rates and the exchange rate. At this stage, the prospects for a continuation of New Zealand’s economic expansion with above-trend growth, strong employment and rising inflationary pressures look promising. The main domestic risk (and one that could be triggered by developments offshore) is a significant correction in the housing market. At this stage, however, the greatest threat to the expansion lies in possible international political and economic developments and their implications for the global trading environment. Furman, J (2015) ‘Productivity Growth in the Advanced Economies: The Past, the Present, and Lessons for the Future’. Remarks delivered to the Peterson Institute of International Economies, July 9, 2015. Vehbi, T (2016) ‘The macroeconomic impact of the age composition of migration’, RBNZ analytical note, AN2016/03. Armstrong, J and McDonald, C (2016) ‘Why the drivers of migration matter for the labour market’. RBNZ analytical note AN2016/02. Bascand, G (2016) ‘Changing Dynamics in Household Behaviour: What do they mean for Inflationary Pressures?’ Sir Leslie Melville Lecture: A speech delivered to Australian National University in Canberra, Australia, 22 November, 2016 Karagediki, O and McDermott J (2016) Inflation expectations and low inflation in New Zealand’, RBNZ discussion paper, DP 2016/09. Lewis, M (2016) ‘Inflation Expectations Curve: a tool for monitoring inflation expectations’, RBNZ analytical note, AN2016/01. IMF, November 2016 ‘Global Housing Watch’. IMF, November 2016 ‘Global Housing Watch’. OECD, 2016 ‘Focus on House Prices’, and Global Economic Outlook, June 2016. Bordo, M and Jeanne, O (2002) ‘Monetary Policy and Asset Prices : Does Benign Neglect make Sense’, IMF working paper WP/02/223, IMF World Economic Outlook 2003. Reinhart, C and Rogoff, K (2008) ‘This Time is Different – Eight Centuries of Financial Folly’ (Princeton University Press). IMF World Economic Outlook 2003.
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