Sunday, July 15, 2007

Reserve Bank announces changes to FX management

An interesting change announced by the Reserve Bank - in particular the obvious reference to "responding to crisis situations involving sharp falls in the NZ dollar."
One wonders whether this is mainly an announcement for effect, a real repositioning to give themselves more flexibility in the types of moves they have already tried, or an independent repositioning of their strategies.

Certainly it is obvious that the Bank has now realised that it will not be getting any help from the Government in terms of Labour curbing its inflationary policies - and that the Reserve Bank has realised that to continue hiking interest rates to counter this will irrevocably damage the export sector.

The Reserve Bank today announced changes to its financing and management

of New Zealand's foreign currency reserves.

The moves arise from a review of the Bank's balance sheet, announced in
its Statement of Intent in June 2006. The review was aimed at enabling
the Bank to manage its balance sheet to best meet monetary policy,
currency, liquidity management and foreign reserves requirements.

Reserve Bank Governor Alan Bollard said that for the last 20 years, the
Bank's foreign currency assets have been fully matched by foreign
currency liabilities.

"That was an unusual approach by international standards and we are now
moving in the direction of a more conventional approach," Dr Bollard

In the future we will hold some portion of our foreign reserves on an
unhedged basis - an "open FX" position. This means that part of the
foreign reserves portfolio will be funded in New Zealand dollars rather
than in foreign currencies."

Dr Bollard said that the main reason for this new approach to foreign
exchange (FX) management is to give the Bank a more effective means of
responding to crisis situations involving sharp falls in the NZ dollar.

"In crisis situations it is of paramount importance that the Bank
retains access to foreign currency reserves. With a portion of our
reserves no longer borrowed from abroad, but funded internally, we will
become less dependent on international capital markets in times of

"Also, the use of unhedged reserves in this situation will be less
costly and give rise to less additional risk than would be the case
using hedged reserves. Unhedged foreign reserves provide a more
effective form of insurance against a currency crisis."

The Bank's guidelines for operating in the foreign exchange market have
also been modified. Overt intervention intended to affect the exchange
rate directly may still occur. In addition, the Bank will be able to
more gradually accumulate or reduce its foreign exchange position when
the exchange rate is at extreme levels and unjustified by medium-term
economic fundamentals.

Dr Bollard said that the Bank's more passive FX transactions will not
necessarily be expected to directly affect the exchange rate.

"However, such transactions will allow the Bank to give concrete signals
regarding the extent to which the exchange rate is seen as over- or
under-valued. That may indirectly affect the exchange rate by
discouraging speculators from pushing the currency to extreme levels."

Because the interest rates on the Bank's New Zealand dollar borrowings
are higher than on foreign currency borrowing, the annual cost of
holding foreign reserves is expected to increase somewhat with the
change in approach.

The increased open FX position on the Bank's balance sheet is also
expected to result in greater variability in the Bank's net income, as a
result of foreign exchange gains and losses. However, the Bank's foreign
exchange positions could be expected to be profitable on average over
the medium term.

The Bank has been using and will continue to use its FX market
operations to lift the level of its unhedged reserves towards a new
long-run average level. The Bank publishes its open foreign exchange
position monthly on its website, with a lag of one month.

Background documents on this new policy are available on the Reserve
Bank and New Zealand Treasury's websites.