Balance Sheet Review Q and A
1. Why are you making this change?
The Bank announced a review of its balance sheet in its Statement of Intent in June 2006, aimed at enabling the Bank to manage its balance sheet to best meet monetary policy, currency, bank liquidity and foreign reserve requirements.
Open forex positions are a common practice among central banks. New Zealand’s existing reserves management practice is unusual.
These changes give the Bank a more effective intervention capability in a crisis situation, reducing its dependence on international capital markets and reducing the Bank’s exposure to risk when the NZ dollar may be under pressure.
2. Why are unhedged reserves better? What are the benefits?
Under the existing hedged regime, the Bank has matched foreign currency assets against foreign borrowings, thus hedging the assets against exchange rate movements.
However, if the bank needed to intervene, say, to halt a large rapid fall in the New Zealand dollar, it would need to sell foreign assets to buy New Zealand dollars. Under existing arrangements, if the exchange rate fell and stayed low after the Bank had intervened we would be left with large losses on our foreign borrowings.
At the same time, it would be expensive or difficult to refinance these foreign borrowings during a crisis, as lenders would likely charge higher interest rates. At the extreme, foreigners might not be willing to lend to us at all.
With a substantial portion of reserves unhedged, a run-down in foreign assets during a crisis would not expose the Bank to significant exchange rate losses and risk. This safer position would likely mean that the Bank’s crisis intervention actions would be more credible.
Indeed, if the foreign assets were purchased at a cyclical high in the exchange rate, the sale of assets during a crisis would provide exchange rate gains. However, the point of the changes is not to make money, but to have a reserves policy fit-for-purpose – in other words a policy that provides effective insurance in a crisis situation.
3. Will the RBNZ still intervene?
The Bank is empowered to intervene in event of “extreme market disorder”, or to help trim the peaks and troughs of the exchange rate cycle. The later supports the Bank’s monetary policy objective of achieving price stability while minimising unnecessary volatility in output, interest rates and the exchange rate. The Bank will continue to operate this intervention policy.
4. What is the difference between intervention and growing reserves?
Foreign exchange intervention by the Reserve Bank is the purchase or sale of New Zealand dollars in exchange for foreign currencies in the foreign exchange market with the objective of directly influencing the level of the exchange rate. This is distinct from FX transactions aimed simply at growing reserves or managing the normal foreign exchange requirements of the public sector. These latter transactions are performed in a manner consistent with achieving the best possible price, which usually implies having as little impact as possible on the exchange rate.
5. Now that the Reserve Bank has an open FX position does this mean that the Bank is more likely to intervene?
The Bank’s powers to intervene and the criteria for intervention do not change under the new policy. The Bank is empowered to intervene in event of “extreme market disorder”, or to help trim the peaks and troughs of the exchange rate cycle in support of monetary policy. The Bank will continue to operate this intervention policy.
The criteria for monetary policy intervention remain the same, ie:
- the exchange rate must be exceptionally high or low;
- the exchange rate must be unjustified by economic fundamentals;
- intervention must be consistent with the PTA; and
- conditions in markets must be opportune and allow intervention a reasonable chance of success.
6. How will the new policy affect monetary policy?
There will be a benefit for monetary policy. Under the current exchange rate intervention criteria, the threshold for taking overt action is quite high. The Bank’s new ability to purchase and sell foreign exchange more passively through the exchange rate cycle will provide greater flexibility for the Bank to signal its views in support of monetary policy on the appropriateness of the exchange rate. This should help at the margin to moderate the extreme peaks and troughs of the exchange rate cycle.
7. What is the cost of holding forex unhedged?
The cost of holding foreign assets will be higher under the new regime because they are being held against New Zealand liabilities, and New Zealand interest rates are generally higher than interest rates earned on our foreign reserve assets. The net cost will vary at different times as interest rates move. But this cost will be substantially reduced if the reserves are purchased when the New Zealand dollar is at a cyclically high level.
8. How will we know when the Bank has intervened or has built-up/run-down reserves?
Regardless of whether the Bank has overtly intervened or passively adjusted its reserves position, the Bank’s actions will be apparent after the fact. Each month the Bank and the Crown publish data on the status of the Bank’s balance sheet and the foreign exchange transactions the Bank has undertaken with the market. This information will indicate when the Bank has transacted in markets, with a lag of one month. The Bank’s data is published on its website (See Statistics, Table F5).
9. Has the Reserve Bank made losses on the recent intervention? Will we know whether the Bank has made gains or losses in the future?
The bank reports gains or losses on its trading of assets and liabilities, whether realised or unrealised, in line with standard accounting practice, in our Annual Report. It is not envisaged that we will publish the trading results on particular assets or liabilities.
10. What does Australia do?
Australia has used a very similar approach to managing its foreign currency reserves for the last 20 years.
11. What does it mean for the relationship of the New Zealand dollar to other currencies?
If successful, the new framework offers the Bank tools that might help moderate the cyclical extremes in the New Zealand dollar, although we do not expect the basic nature of the exchange rate cycle to be affected by this new policy.
12. Will the Bank’s FX transactions have an impact on financial system liquidity?
No. The Bank will neutralise the liquidity impact of its FX transactions through its domestic market operations. Transactions to sell (buy) the New Zealand dollar, all else equal, result in an increase (decrease) in the level of settlement cash balances held by the commercial banks at the Reserve Bank. This liquidity impact is fully offset (or “sterilised”) by the Bank adjusting its regular liquidity management transactions in the domestic money markets which it uses to maintain a steady level of liquidity in the system.
13. How will the new policy affect the Bank’s P&L and dividend to Government?
All FX gains and losses on foreign reserves will be recorded in the Bank’s Profit and Loss account. The Bank’s equity of approximately $1400 million provides a buffer against such movements. While FX gains and losses will not impact normal dividends to government, dividends will be impacted by an expected reduction in average net interest income, reflecting the higher cost of NZ dollar funding. It is intended that any realised gains on FX positions over time will be reflected in increased dividends to the Government over the medium to long term.
