2011 Annual Report
As well as ensuring price stability, the Bank's focus, therefore, is in ensuring the New Zealand economy and financial system are resilient in the face of shocks and volatility. We are seeking to reduce the likelihood of their being hit by bad shocks, and minimise any damage that they can inflict if we are hit.
Internationally, the US, the world engine of growth for so long, has shown only very slow signs of recovery, leaving markets deeply unsettled. Concerns in Portugal, Ireland, Greece and Spain (the 'PIGS'), the UK, Japan, and more recently Italy, have added to market instability.
Offsetting this, China, East Asia and Australia have generally surpassed growth expectations, with very strong impacts on commodity prices and a very strong kiwi dollar.
At home, the Christchurch earthquake in February 2011 was a major shock, causing significant disruption, destruction and economic uncertainty, hurting some businesses and stressing the insurance sector. The rebuild will be huge, but could also be disruptive, with likely bottlenecks and cost pressures.
Meantime, fall-out in the finance company sector has continued, with the Government carrying a significant liability under the Deposit Guarantee Scheme.
A tax revamp, with increases in GST, the Emissions Trading Scheme and excise tax, has contributed to a hefty rise in headline inflation and some impact on future inflation expectations.
In part related to the above events, revisions to current and past economic data have added to the challenges of reading the current state of the New Zealand economy.
Our objective through these surprises has been to see the New Zealand economy gain confidence and momentum, while staying on top of inflationary pressures. Early in the financial year, we saw value in lifting interest rates off their historical lows, and increased the Official Cash Rate to 3 percent in July 2010.
However, when the February earthquake hit, we cut the OCR back to 2.5 percent in March to 'insure' against a sharp fall in confidence and activity. We have recently signalled that we feel the economy no longer needs this earthquake-related 'insurance' in place.
While the future track of interest rates can be expected to rise to contain underlying inflationary pressures, we have signalled that movements in the OCR are likely to be much more restrained than in previous cycles. This is due to changes in funding costs for banks, exceptionally low mortgage durations, risk premia, and general caution by households and businesses, including de-leveraging.
Over the year there has been ongoing international pressure on the kiwi dollar. While some exchange rate strength is to be expected and is appropriate when our terms of trade has peaked at its highest level in almost 40 years, its recent pressure has concerned us as a drag on the economy, though it does also lessen the need for future OCR increases.
As foreshadowed last year, we have done more preparatory work on a range of macro-prudential tools. Macro-prudential instruments may help bolster financial system resilience and possibly moderate credit cycles, but expectations need to be realistic about what can be achieved. None would provide the definitive answers in terms of moderating the credit cycle, but we believe that, used in tandem, a number could potentially contribute to greater stability through future cycles.
The crisis years have also taught us some things about bank regulation. In particular, we are tightening up on the models that determine capital requirements for lending on housing and agriculture. We have put in place liquidity requirements that have already been shown to work well.
Where relevant for New Zealand, we are moving forwards with the set of new international bank regulatory standards known as 'Basel III'. We have also done work on how to manage banks in stress conditions, learning from the Ireland/Iceland/UK experiences. The main new tool here is Open Bank Resolution, which, when in place, will make it easier to keep the system functioning if a big bank fails.
The Reserve Bank has taken on responsibility for insurance regulation this year. As we begin the significant operational challenge of licensing insurance companies, we are seeking to put in place minimum solvency requirements that will enable insurers to withstand extreme but plausible catastrophes.
Further building system resilience has been our designation of a new NZX central counterparty clearing house. This provides a modernised equity settlement platform, and offers better protection against contagion in exchange traded derivatives markets.
Industry changes to the retail payments system have provided an opportunity for the Bank to require features that should assist in better managing payments, should a participant experience distress.
We have had to manage our own balance sheet to take into account big moves in the kiwi and fragility in offshore sovereign markets, especially US Treasuries. Our foreign reserves management benchmarking project will help us to do this in the coming year.
As the New Zealand currency ages and security features mature, we can expect a higher rate of attempted counterfeiting. For this reason, we have started work on a multi-year banknote upgrade project to make New Zealand's banknotes even more robust for the next decade.
Following on from learnings from the Christchurch earthquake, we are better able to handle significant Wellington disruptions using our new Auckland office disaster recovery capability.
Internally, our processes and skills have looked resilient through the stress of recent years. We are seeking to build on this strong platform through work on new accounting systems and statistical systems, as well as focusing training on managerial competencies.
We can expect more disruption and fragility ahead, much of it originating from offshore. We cannot predict all of this, but we can plan to be resilient through it.
This resilience is the result of the foresight and hard work of many people at the Reserve Bank. I extend my thanks to staff, senior managers and the Board for their contributions to our work in laying stronger foundations for New Zealand's future.
15 September 2011