Annual Report 2010 – Governor’s Statement
When an economic recession coincides with a financial crisis, recovery is likely to be slow and fragile. This was the lesson from the 1930s Depression. Governments have learnt much from that terrible experience. This recovery is certainly proving brittle, uncertain, and full of surprises.
Compared to many other countries, New Zealand was hit less hard during the Global Financial Crisis. But any expectations we may have had of an easy recovery during this year have been dispelled. We have now emerged from a long recession, and have experienced some quarters of significant growth. This has been helped by growth in Asia and Australia. But Europe has disappointed with its frail fiscal picture, the US has suffered a very weak labour market, and Japan continues to struggle with deflation. The global financial markets, including our international funding markets, have also remained volatile.
New Zealanders have experienced the recession in various ways, and have changed their behaviours as a result. Households have been reducing mortgage debt where possible, and have been very cautious about re-entering the housing market - attitudes that have been reinforced by recent tax changes. Businesses have also been reducing debt and cautious about reinvestment.
This private sector restraint has meant a slower return to growth. But it has helped the rebalancing of the economy, which has been a growing challenge for a long time. The Government’s establishment of a Savings Working Group underlines the importance of domestic savings performance to address imbalances, and improve investment and economic growth. The global financial crisis demonstrated the fragility of a banking system that relies so heavily on short-term foreign debt funding. It also highlighted New Zealand’s external imbalances, demonstrated by our deficit in the balance of payments on goods and services, and our negative net investment income position. These deficits are now slowly improving.
Government spending, which was stimulative during the recession, is now more restrained.
That is appropriate in view of the financial markets’ renewed focus on the sustainability of sovereign debt issuance.
Monetary policy was also stimulative over the period of the crisis, and together with a number of special policies, this helped mitigate the worst of the effects. A temporary weakening of the New Zealand dollar also assisted recovery. Now, most of the crisis policies have been withdrawn or are time-limited, including most of the special liquidity facilities for banks and other institutions, the government’s retail deposit guarantee scheme, the wholesale deposit guarantee, and the Bank’s increased foreign reserves position.
This means we can manage a return to normality through the traditional monetary policy tool, the Official Cash Rate (OCR). We have already moved to increase the OCR somewhat, but it still remains at an historically low level. Over time, the OCR will move back to more neutral levels, but this process will likely be slow, and the OCR is unlikely to need to rise as far as in previous recoveries. This is due to a combination of circumstances: the cautious behaviour of households and businesses; the low levels of new lending; the high cost of funds; the move back to floating rate mortgages; a different yield curve; contained inflation expectations; and the very low interest rate paths expected in most major economies.
There have been a number of administered price increases, including a GST rise. So far, the pass-through to inflation appears muted, but any ongoing inflationary effect would present a challenge for monetary policy. It is critical that businesses and labour groups do not try to use the GST rise as a veil to increase margins and remuneration.
This means restraint by the electricity sector, other utilities, local government, and others who have a record of using strong market positions to push up prices.
A further focus this year, also based on learnings from the Global Financial Crisis, has been the development of new macro-financial and prudential policy options. The Reserve Bank of New Zealand has been at the forefront of this thinking amongst central banks. Experiences of the last few years point to the illiquidity of bank funding under certain conditions, and for that reason we have introduced a liquidity policy with funding matching criteria and a core funding ratio. This has led to a lengthening of funding maturities on bank books, and has already proved its worth during the unsettling days of the Greek sovereign debt crisis. We are now examining the potential for using the core funding ratio as a device to stabilise the financial cycle in New Zealand.
At the same time, there has been much international focus on new bank regulatory tools: tighter capital definitions, counter-cyclical capital, leverage ratios, bank taxes, and living wills. Some of these policies will become encapsulated as ‘Basel III’ requirements. New Zealand is not represented in the international committees that have developed this regulation, and some of it may prove to be an unnecessary impediment to the efficiency and effectiveness of our system.
The New Zealand finance company sector has been a major casualty of the crisis, with many failures and significant government support through the retail deposit guarantee scheme. The Reserve Bank of New Zealand is taking over regulation of the non-bank deposit takers. During the year, we have put in place requirements for credit ratings, capital, connected exposures, and the composition of boards. To make this work for New Zealanders, the trustees, who are the front¬line supervisors, will have to lift their game.
The government has also decided the Reserve Bank will regulate the insurance industry, and we are putting the building blocks in place for this.
This year, we completed development work to improve the robustness and efficiency of the Reserve Bank’s payment and settlement systems, to update inventory systems to manage our currency, and to fundamentally rebuild our financial and economic statistical systems. The crisis reinforced that accurate knowledge and robust controls are crucial for a central bank.
Financially, we have paid a dividend to government of $290 million for the 2010 year. This leaves the Bank with equity of $2,574 million, a strong base for the potential risks inherent in our activities and large balance sheet. This dividend follows a voluntary dividend payment in April 2010 of $45 million, which we determined was surplus to our capital requirements as we emerged from the financial crisis.
As this Annual Report shows (pp 40-49), we have maintained stable underlying income from interest earnings and stable operating costs. Nonetheless, we have recorded a loss of $111 million for the year ended 30 June 2010. This incorporates unrealised losses due to revaluations on our assets and liabilities.
Most of these losses occurred on our unhedged foreign exchange position, as exchange rate and interest rate movements partially reversed the large unrealised gains of the previous year. While our reserves are still showing a positive return based on purchase costs, we foreshadowed in the 2009 Annual Report the likelihood of volatility in accounting profit and loss.
The Bank’s operating costs are funded on a five-yearly basis, reflecting its operational independence in several key functions. In June 2010, the Minister of Finance and I entered into a Funding Agreement for the five years ended 30 June 2015. This was ratified by Parliament on 20 July.
The focus of the new Funding Agreement is on extending capacity in new regulatory and surveillance areas, commencing a programme of upgrading bank notes, and establishing a small office in Auckland to offer more security in the event of Wellington disruptions.
As we went to print, Canterbury was struck by a massive 7.1 magnitude earthquake and hundreds of aftershocks. While the economic impact was still being assessed, our sympathy goes to distressed residents and businesses. The fold-out shows how we can use our range of functions to assist.
The Reserve Bank of New Zealand is one of the few OECD central banks to retain all its functions in one organisation. It has been hugely useful during the crisis and recovery to be carrying out monetary policy, financial stability, foreign reserves management, bank regulation, payments and settlements, and currency management all under one roof. It also means we have benefited from the skills and experience of a wide range of employees who are working together for New Zealand’s recovery. During this difficult period, we have worked more closely than normal with the New Zealand Treasury and Minister of Finance, and thank them for this cooperation. I particularly acknowledge Deputy Governor, Grant Spencer, and my senior management group for their dedication, focus and advice through this period, and Chair, Dr Arthur Grimes, and Board members for their guidance and judgement. It is their contributions that make the Reserve Bank what it is today. I thank them all.
Reserve Bank of New Zealand
9 September 2010