Types of foreign reserves and our balance sheet

How we fund and raise foreign reserves

In the past the foreign reserves have generally been funded through increases to the level of settlement cash and loans from NZ Debt Management. This means that the initial cost of funding the foreign reserves is around the level of the OCR. This cost is offset by the return generated on the investment of the foreign reserves into assets such as government bonds. When agreeing the level of foreign reserves, we have taken into account these costs, as well as the associated likely returns.

To purchase foreign reserves, we enter into market transactions to exchange NZD for foreign currency. This can be done in 2 main ways:

• buying foreign currency in the spot market (unhedged reserves)
• borrowing foreign currency in the cross-currency basis swap market (hedged reserves).

Unhedged reserves (spot market)

The unhedged reserves are raised by selling NZD in exchange for foreign currency in the spot foreign exchange market. This transaction results in us owning foreign currency, with the value of these assets fluctuating with increases or decreases in the relative exchange rate at which this foreign currency can be exchanged back to NZD. 

Unhedged reserves — we sell NZD to a counterparty in exchange for foreign currency.

Download the diagram showing how unhedged reserves work (88 KB)

Hedged reserves (cross currency basis swap market)

The hedged reserves are raised by lending NZD in exchange for foreign currency, generally in the cross currency basis swap market. We effectively borrow foreign currency under long term contracts and are not exposed to movements in the exchange rate, because all the foreign exchange rates are agreed at the start of the contract. Instead, we pay interest on the foreign currency — for example — USD that is borrowed, and receives interest on the NZD that are lent out in exchange. By borrowing foreign reserves on longer term contracts and ensuring that the maturities are spread out, we:

• manage any refinancing risks
• can make sure the level of foreign reserves is steady over time. 

This is important, as it means we are ready and able to intervene at any time, if necessary.

Hedged reserves — we lend NZD in exchange for borrowing USD. We pay interest on the USD we borrow and receive interest on the NZD we lend. At the end of the loan period we pay back the USD and receive NZD.

Download the diagram showing how hedged reserves work (94 KB)

Impact of foreign reserves on our balance sheet

Foreign reserves are an important asset on most central bank balance sheets. In New Zealand, the foreign reserves for intervention and foreign assets for domestic liquidity management have historically made up the majority of our assets.

The unhedged and hedged reserves have different impacts on the balance sheet. The unhedged reserves portfolio or ‘open foreign currency position’ exposes us to movements in the exchange rate, which can result in large but unrealised valuation effects on the balance sheet. These unrealised gains and losses can expose us to financial risks that need to be supported by capital or other forms of financial backing. 

Recently, the changes to our foreign asset holdings have largely been driven by the foreign assets held for domestic liquidity management purposes. Foreign assets related to domestic liquidity management are managed separately to the foreign reserves as they have different characteristics and serve different purposes. 

All else equal, as we increase the size of our foreign reserves both the size of the balance sheet and volatility from valuation effects are likely to increase.