2009 Annual Report
It is not until we experience a crisis that we know how fit our regulatory and economic institutions and practices really are. The global financial crisis and subsequent recession continually tested New Zealand’s fitness throughout 2008-09.
The crisis stemmed from a build-up of global imbalances and risky investments made from around the start of the millennium. A long period of economic growth and a rising savings pool in Asia and the oil exporting countries created significant demand for new financial assets and fuelled strong credit growth in many Western economies. New financial instruments proliferated, accompanied by new institutions and new financial markets. This process was supported by a period of unusually low interest rates and a general lack of concern for risk on the part of investors. Many countries, including the United States, Australia, the United Kingdom and New Zealand, took advantage of low interest rates to borrow heavily for assets like housing, leading to a sharp rise in asset prices.
In mid-2008, as interest rates reversed in the United States, the bubble burst. Low-income households there were unable to meet mortgage payments, mortgage foreclosures soared and lenders started to collapse. Stress in the US subprime housing market spilled into other derivative markets, then money markets, eventually leaching into capital and equity markets. Financial market stress hit housing in Anglo-countries, and then spread across the world into East Asian and European manufacturing economies. This global financial stress was quickly reflected in the cost and availability of overseas borrowing on which New Zealand is heavily reliant. However, in common with some other commodity producers, economic activity in New Zealand appears to have been less badly affected than in many other countries.
While the Reserve Bank and others had warned of the risks that were building up in recent years, no one foresaw the scale of the world collapse, which took markets by surprise. However, since we were not initially so directly hard hit, we had some time to assess events as they unfolded.
The Reserve Bank is a full-service central bank, and this has been hugely important, allowing us to gather information about the New Zealand economy from many sources. This includes our economic monitoring and business visits, our prudential monitoring of banks and other financial institutions, our financial market informants, our liquidity management operations, New Zealand’s payment and settlement systems, and the demand for our banknotes. In addition, we have been able to integrate our policy tools across monetary policy, financial stability and the financial system.
Around September/October 2008, events came to a head with advance warning of severe stress in the global funding markets which our banks access, as well as an unusually high domestic demand for cash.
At this time, we saw our central bank colleagues in advanced financial countries having to react swiftly with a range of orthodox and unorthodox tools, including liquidity facilities, artificial market support and capital injections.
We had the advantage of watching them move first, and the further advantage of being a single regulator in a less complex economy. Working across all our functions, we coordinated a range of measures to address the crisis.
We ensured we had sufficient cash in position to meet any unusual and urgent needs by the banks. Monetary policy was already responding. We swiftly reduced the OCR from 8.25 percent in early 2008 to only 2.5 percent by early 2009, the fastest and furthest fall on record.
With our responsibility for financial stability, we had been monitoring the financial system throughout the year, reporting our findings and concerns in our Financial Stability Report. As the credit crunch unfolded, we ensured banks could obtain longer-term funding by allowing them to borrow from us using a broader range of securities as collateral, including residential mortgage-backed securities.
We began the year with a large foreign exchange exposure, partly due to our intervention in 2007 when we signaled that the exchange rate was then over-valued. We have unwound some of this exposure over the past year.
All together, these liquidity and foreign exchange market measures have resulted in a much bigger balance sheet for the Bank, which in turn has required careful management by our Financial Markets Department.
For the last year or two, we had been strengthening our prudential oversight and preparing to regulate non-banks. This work allowed us to monitor bank balance sheet and lending positions much more closely. In October 2008, as other countries rushed to guarantee their bank deposits, we rapidly helped the Government design retail and wholesale deposit guarantee schemes. We assisted market acceptance with several overseas roadshows. And we encouraged banks to use the wholesale guarantee scheme, particularly in foreign term debt markets, to help bring funders and borrowers back together, to encourage markets to return towards normal.
Bearing in mind this has been a period of intense uncertainty, we now think we are through the worst. The banking system has held up reasonably well and the macro-economy has not sustained major damage.
But the experience has highlighted the imbalances and vulnerabilities in New Zealand that we had previously alerted to. Households have been consuming beyond their incomes, they have borrowed heavily for housing, funding their debt through mortgages. This situation is reflected in New Zealand’s very large current account deficit. Banks have funded much of this credit growth through relatively short-term foreign loans.
In the new world this current account position will need to improve significantly to stop our international debt position mounting further. To date, the exchange rate has not been supportive of a shift in production towards the export and import-competing industries of the economy that will be necessary to improve this situation. At some point the financial markets may become uncomfortable if New Zealand continues to run such large and persistent current account deficits.
We can take some important lessons from the experience of the last few years.
Our monetary policy has worked reasonably well, ensuring prices have been anchored despite a massive international commodities and asset boom. Unfortunately, this has at times been at the cost of export competitiveness, as relatively high interest rates in New Zealand supported our exchange rate at the same time that the US dollar weakened. We are a small open trading economy, and our own policies will be distorted if major economies run overly-loose monetary policy.
Prudential regulation of banks has worked reasonably well, seeing them weather historically difficult circumstances. In light of what we have observed, we are looking at increasing agricultural capital and bank liquidity requirements for the future – ensuring banks lengthen the average maturity of their funding base is a practical step we are taking to reduce the banks’ vulnerability to adverse developments in funding markets.
International regulators in the future are likely to require better tools to regulate financial systems over the economic cycle, potentially including dynamic provisioning and counter-cyclical capital instruments. We will assess these and other developments.
Some finance companies’ business models have not been sound and will need major repair. Non-bank deposit-taking institutions will be subject to a range of new prudential requirements over the coming year, aiming to bolster them for the future. We have also been preparing policies and resources to implement our prudential supervision responsibilities for the insurance sector.
Payments and settlements systems worked very well during a testing year, clearing record transactions without stress in the week after the Lehman Brothers collapse. Our finance and treasury staff have coped well with the huge increase in financial market transactions. Our information systems people have worked exceptionally hard to keep payments and settlements operating.
The New Zealand financial system as a whole has shown some vulnerability, but has pulled through without too much damage. The challenge will be to learn from and adapt the wave of international regulation now underway.
We have worked more closely than usual this year with the Minister of Finance and the Treasury to ensure the best outcome for New Zealanders. In such a stressed time we have relied even more than usual on the advice and foresight of senior management to stay ahead of events, on the dedication of Governors and staff to make things work through tough times, and on the guidance of the Chair and Board when dangers have loomed. They are what make the Bank. I thank them all.
17 August 2009