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Briefing to the Incoming Minister 2005

Reserve Bank of New Zealand

Introduction and executive summary

As New Zealand’s central bank, the Reserve Bank performs a number of functions, each of which contributes to the goal of promoting and maintaining a stable macroeconomic environment and a sound and efficient financial system. Doing so helps enable New Zealanders to conduct their business using a currency that largely holds its purchasing power through time, in an environment where avoidable swings in the macroeconomic environment are kept to a minimum, and using payment instruments and a financial system that are sound, efficient, and well regulated. Each of these interrelated dimensions of what the Bank does contributes to the overall environment that enables New Zealanders to make the most of our economic growth potential. The Reserve Bank has a considerable degree of operational autonomy in many of its areas of responsibility, balanced by clear and well-thought-out accountability mechanisms, and with important decision-making roles reserved for the Minister of Finance in a number of key areas.

By statute, the primary function of the Reserve Bank is to conduct monetary policy to maintain a stable general level of prices. Doing that in a way that avoids unnecessary fluctuations elsewhere in the economy, lays solid foundations that help firms and households to make good quality spending and saving decisions. The broad framework within which monetary policy is conducted is now well established. Under that framework, the Minister and Governor jointly agree an operational target for monetary policy (currently 1 to 3 per cent inflation on average over the medium term), and the Bank is then required to use the instruments of monetary policy to achieve such outcomes.

We are facing some particularly difficult monetary policy challenges right now. After several years of strong growth, accumulated pressures on resources have been quite intense, carrying core measures of inflation up to around 3 per cent. Although the pace of economic activity is now slowing, it is difficult yet to be confident that inflationary pressures will ease in the near term. The situation has been complicated by the sharp rise in world oil prices this year.

The persistent strength of domestic demand has been reflected in a variety of growing macroeconomic imbalances. Core inflation has risen and remains high. The balance of payments current account deficit has widened substantially. House prices are reaching levels that appear to be inconsistent with longer-term fundamentals. And the exchange rate, in trade-weighted terms, is sitting only a little below record highs.

Against this background, a further slowing in the pace at which domestic demand is growing is a priority. Reflecting this assessment, the Bank has indicated that further increases in the Official Cash Rate (OCR) cannot be ruled out. Fiscal policy also has a role to play. While the Crown’s own accounts are in a very healthy state at present, and could accommodate some further fiscal easing at some point, the economic imbalances outlined above mean that we would urge caution in considering any further easing of fiscal policy now.

The Reserve Bank’s financial stability responsibilities range widely and have a number of interacting dimensions. The analysis that underpins our monetary policy also informs our financial stability activities, while the regular and intensive interactions with banks and financial institutions undertaken as part of the financial stability role benefit monetary policy as well. The Reserve Bank is responsible for the registration and supervision of banks, including preparing for the possible management of a bank failure or a financial crisis. For a small, highly indebted, relatively undiversified economy, in which most of the banks are owned by parents based in a single foreign country, crisis preparedness is of particular importance.

At present, the Bank faces several significant longer-term issues in the broad area of our financial stability responsibilities.

Earlier this year, consistent with the Government’s commitment to a Single Economic Market with Australia, the Minister of Finance and the Australian Treasurer agreed to establish a Trans-Tasman Council on Banking Supervision. The initial work of the Council has focused on identifying possible measures that could ensure that the Australian regulatory agency (APRA) and the Reserve Bank can support each other in the performance of their regulatory responsibilities wherever possible. A report on this issue was provided to respective ministers in August 2005 and recommends some legislative changes in both countries designed to help ensure that, wherever possible, actions are not taken by an agency in one country that would be detrimental to financial stability in the other.

The Reserve Bank has placed considerable emphasis in recent years on ensuring that the New Zealand operations of large foreign-owned banks would be able to be maintained and managed effectively in the event of a bank failure. Our policy of requiring large banks, and some smaller banks that take retail deposits in New Zealand, to incorporate locally was a first step in that direction. More recently, considerable emphasis has been placed on ensuring that appropriate contractual and operational arrangements are in place so that any outsourced business functionality (including that outsourced to overseas parent banks) is able to be effectively maintained and operated, including in the case of a bank failure. The more critical the functionality, the more robust those arrangements need to be. The Bank is in the process of finalising its policy, after extensive consultation with the industry. The policy will be implemented on a case-by-case basis, with transitional arrangements to be agreed with banks where the policy requires amendments to existing outsourcing arrangements.

The Reserve Bank is currently participating in a series of officials working groups that have been established to review the regulation of the non-bank financial sector and the allocation of roles amongst the financial sector regulatory agencies. The Reserve Bank has indicated that it believes there is a case for extending prudential supervision to some types of non-bank financial institutions and that we would be willing to take on additional responsibilities in this regard. These various streams of work are expected to reach conclusions and make recommendations to Ministers over the coming year.

The Reserve Bank has the sole right to issue bank notes and coins in New Zealand. We aim to ensure that the issuance of currency is conducted efficiently and robustly, effectively meeting the currency needs of the wider community. As part of maintaining a cost-effective currency issue, major changes are afoot in respect of ‘silver’ coins. During 2006 the five cent piece will be withdrawn from circulation and the metallic content of the 10, 20, and 50 cent coins will be altered and these coins will be reduced in size. The Bank has consulted widely on these initiatives, and will be working closely with affected parties, and through an extensive public awareness campaign, to ensure that the changeover is as smooth as possible.