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Thursday, March 23, 2006

RBNZ: Liquidity, exchange rate and inflation

The NZ dollar has fallen. NZH:
"The kiwi dipped to a low of 61.80USc in afternoon trade, a level not seen since May 2004, then closed at 5pm at 61.90USc.

"The market is negative towards the economy and the belief is the currency should be pushed lower," said Derek Rankin, director of Bancorp Treasury Services. "It sounds trite to say it, but there are more sellers than buyers - and there are no buyers." "

The Reserve Bank has not intervened in the forex market to date, but will if it becomes "sticky". I don't think we've got anywhere near that level just yet, esp. because the dollar has been falling steadily over the last month. We are very vulnerable to this risk however.

Today the RBNZ is due to release these key stats: Credit card stats for Feb Quarter, Current account balance: exports and imports and NZ overseas debt. If it is as bad as they sense it will be the dollar will continue down it's present path.

-----------------------UPDATE 11:45PM------------------------
NZH report:

New Zealand's current account deficit - the country's financial dealings with the outside world - was a monster $13.7 billion in calendar 2005, Statistics New Zealand said today.

The deficit equates to 8.9 per cent of Gross Domestic Product (GDP), the worst ratio since 1986 when it was also 8.9 per cent. The worst-ever deficit was 13.4 per cent in 1975 when the effects of the oil shock were felt. The 2005 figure was a record deficit in monetary terms. [...]

The annual deficit has widened for each of the last 11 quarters and is now $9 billion larger than the $4.7 billion deficit in the March 2003 year.

During 2005, New Zealand had a net inflow of capital of $12.2 billion to fund the deficit. This came from a $4.3 billion withdrawal of New Zealand investment from abroad and net flow of $8 billion of investment into New Zealand - mainly bond issues. New Zealand's net foreign debt rose $10.5 billion over the year to $136.5 billion. [...]


We will be paying prices based on our previously high dollar for a while yet, but as those exchange rate advantages work their way out of the system (ie. the increasing cost of our imports) we will see a spike in current a/c deficit and inflation. Business confidence will also take a hit.

With the US, the Eurozone and possibly Japan moving to increase their central bank's interest rates the currency traders that have pushed us into being the twelfth most traded currency in the world market will have far better bets than Kiwiland. As I have said on mentioned previously the key to any major down-selling of the Kiwi will be a reduction in our credit rating. It may even be on an automatic basis with some funds if we lose our top Sovereign debt rating - this will effect capital flowing into the country and borrowing as the so-called "risk premium" increases the costs of our borrowing off foreigners.

There is a lot of NZ denominated debt issued by the Aussie banks to Europeans and Japanese out there. Too much. When it expires and the punters want their money paid back they will not want it in more NZ$ they will want it in their currencies - that massive sell-off will inevitably affect our exchange rate. Even with the highest interest rates in the developed world our dollar is sliding rapidly - that should be a sign that all is not well.

Over the past year I have noted that Cullen has stashed parts of the government surplus into the Reserve Bank's coffers and the RBNZ recently raised the amount of liquidity available. Why? Why is the bank reviewing it's liquidity practices? Are they related?

Sadly they are related. The RBNZ has encouraged a forex market that has grown to a stupendous and dangerous level by the issuance of too much NZ currency overseas. I have previously said the situation is akin to "exporting inflation" ie. low domestic inflation rate being the prime concern of the RBNZ means they have interest rates left as a tool - and that in turn is a major function of the exchange rate.

The Aussie banks have used the RBNZ to give them money so they can issue it overseas - as this credit creation does not affect (directly) our domestic inflation - which is what larger currencies operate esp. the US$. As our dollar yields higher interest it becomes valuable to foreigners in low interest currencies who buy it predicated on our top-ranked credit rating (ie. expression of confidence that in the future we will hold our value ie. have a strong and ever expanding economy) - now while this lasts everything is tickety-boo (for the foreigners especially): our imports cost less, therefore our consumption is high, capital goods to expand and grow the economy are low, and with petrol being imported and (relatively) cheap our inflation rate is suppressed (without mentioning the disincentives to business of our high interest rates). Unfortunately the Kiwis at home buy over-inflated property, spurred by high immigration (which also is a cheap and brainless way of keeping the economy up) and that also keeps inflation low (savings directed into productive enterprises and infrastructure would of course be much better for all concerned).

So things are fine for the RBNZ because they keep inflation at 1-3% (now running at 3.4%) which is their mandate. Consumers like the low cost of their Chinese-made plasma screens. Property owners like their rising house valuations. But exporters are being priced off the international market and struggling first home buyers have to pay over the odds. And lurking in the background of the positives: steady growth, increased population and low unemployment is this rising spectre of inflation and (as I argue now what could be a Reserve Bank inspired credit crunch due to over-lending).

I've looked at the RBNZ's consultation paper "Review of the Reserve Bank of New Zealand’s Liquidity Management Operations:" and note the uneasiness, or to use their word, "stress" in the banking system at the moment - as over the last year or so traditional instruments used to settle accounts amongst the banks have been largely replaced by forex swaps (whatever the hell they are - it doesn't sound as sound as the normal types of securities and I suspect is part of the credit inflation created by the RBNZ's policies towards the banks and a misguided policy of creating a globally traded currency).

From the report:
"The Bank’s use of FX swaps has expanded significantly. From being an instrument used only exceptionally, to complement the use of reverse repurchase of government securities, FX swaps have become the predominant liquidity management tool. [...] the use of reverse repurchase has declined as government collateral has become more difficult to obtain."

The banks have been using the RBNZ's easy credit, and to put it bluntly, it's maxed out. "Most of these changes have been driven by the emergence of symptoms of stress," the report says.

"Having a financial exposure to the domestic banks becomes a potential conflict of interest for the Bank, as a prudential regulator, during times of financial stress; " - Well maybe it is already in a conflict of interest by lending money in the first place?

"Maintaining the status quo" is not an option for the banking system:
"Continuing with the status quo implies making marginal changes to the existing system by increasing the supply of acceptable securities available to banks when raising liquidity from the Reserve Bank. This could be achieved by one or more of the following means:
• increasing the supply of government securities;
• loosening the Bank’s credit tolerances; and
• widening the definition of acceptable securities (domestic and foreign)."

The notes under those bullet points are heavily against them - especially as increasing govt. securities would mean: "the supply of government securities would be large relative to the existing Crown debt programme causing debt management problems and an expansion of the Crown balance sheet."

"we have concluded that the Bank’s preferred way forward is to move to a fully cashed up liquidity management regime....The Bank’s work indicates that a level of around $7 billion may be appropriate."

I think they have realised that the practices of the banks aren't working out appropriately in a liquidity sense; but I don't think their lending practices to foreigners have been either and have caused our dollar to be far too high for far too long. Jordan Carter's blog has seen some discussion of the currency issue under the heading "Tipping point". That economic crunch (inflation spike, import cost increase), I think, may be heightened by a liquidity tightening, translating into a credit restriction as the RBNZ clamps down on that in the same tardy way it has dealt with inflation. It will be interesting to see what our banks (mainly Australian) have to say about that.


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