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New Zealand learns from the sidelines of the crisis

New Zealand may have fared relatively well during the global financial crisis, but the difficult economic climate, combined with specific market failures, has served to raise some serious questions among policy-makers, banks and the Reserve Bank of New Zealand itself.
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New Zealand learns from the sidelines of the crisis

The past five years have been a turbulent and challenging time for central banks and financial regulators the world over. The Reserve Bank of New Zealand (RBNZ) is no different. Indeed, full-service central banks in small, open economies such as ours have faced their own particular breed of challenges, despite rarely hitting the world headlines.

New Zealand has been fortunate in that it survived the global financial crisis rollercoaster ride comparatively well, having benefited from good commodity prices, price stability and low government debt. A healthy – and relatively straightforward – banking sector, along with sturdy business balance sheets, also helped see the country through.

But, as is the case with other similar sized economies, it does not mean we escaped unscathed. In New Zealand’s case, mother nature dealt a further blow in the form of a devastating earthquake, which hit the Canterbury region in February 2011, taking a significant human and economic toll. The New Zealand economy continues to trudge ahead and we join our counterparts in dealing with the shadow of northern hemisphere economic malaise and an uncertain global recovery.

Aftershocks of the crisis

While both New Zealand and Australia escaped the worst of the crisis, it was not without the need to step outside normal policy approaches, such as employing emergency liquidity measures. However, Australasia’s more vanilla-flavoured banking sector meant New Zealand had little exposure to the complex instruments and opaque market interconnections that other countries were confronted with.

While we did not feel the impact of the global financial crisis directly, secondary blows were landed. Economies such as ours – without significant direct exposure to toxic assets – were still infected by the deterioration in financial and economic conditions that took place in late 2008 and early 2009, whipping the rug out from under business and consumer confidence. Inventories began to pile up, as the fall-out filtered through Asian export-focused economies such as our own. Access to bank funding markets became squeezed and currencies fell against the US dollar as investors sought liquid safe haven funds.

Fortunately, capital levels in our own banking system were not heavily eroded, making it easier to subsequently bolster capital and liquidity standards than it might be elsewhere. This is where vanilla-flavoured banking systems – more common in small, open economies such as ours – have a particular advantage: they are more flexible and it can be easier to adjust regulatory standards. In New Zealand’s case, the emphasis has been on strengthening liquidity standards ahead of capital ratios, in a bid to reduce the vulnerability of banks to external funding shocks.

The flexibility that can come with being small is also reflected in the impact of the floating exchange rate, which buffered some shocks, falling when commodity prices dived, thereby preserving incomes, but rising when prices came up again, buffering against higher oil price inflation.

Lessons learnt

A dramatic teacher, the global financial crisis has turned some central banking preconceptions on their head and sparked a rethink of what is known and where economic research should focus. Financial regulators and monetary and fiscal policy-makers are scrambling to better understand and repair the damage sustained to economies, financial systems and governments’ financial capacity.

A key learning was just how interconnected the world has become and exactly what that means for small, open economies. Shocks taking place on the other side of the world can cross the geographic divide at lightning speeds, rattling distant markets instantly. Indeed, world financial markets open first in New Zealand every morning, so headline price shocks, and less obvious confidence shocks, can be revealed in our corner of the globe first.

The increasingly complex web that is global financial and economic markets in the modern world meant the blows inflicted by the global financial crisis were felt by small economies too: particularly in bank funding markets. As funding markets closed up, smaller economies were often lost in the funding rush.

The downstream impact of policy decisions made by global economic heavyweights on small, open economies was another stark lesson from the crisis. Moves by G4 countries (India, Brazil, Japan and Germany) into unorthodox monetary policies in recent times, in particular quantitative easing, have caught others in their wake. Small, export-focused economies rely on exchange rates to reflect long-term relative competitiveness. But, in the short term, these can be distorted by unorthodox policies being unsheathed elsewhere. The downside of being small is that the means of fighting back can be limited, despite how distorted the impact may be.

Furthermore, it became apparent just how quickly contagion can spread, not just internationally, but domestically too. This is particularly so in the case of tail-end risk on bank balance sheets, with the crisis highlighting how this can rapidly spread to infect other banks. 

Counting costs

A stark lesson has been handed down in dealing with failing banks without damaging the government, a scenario some small, open economies have had to face. It has also become evident just how difficult it is to price the risk of a bank failure into a regulatory system.

Observing the misfortunes of other small economies – be it with their own currencies, such as in the case of Iceland – or the difficulties encountered in a currency union, as experienced by Ireland and Portugal, have been educational too. Lessons learned here revolve around the optimal size of a banking sector, private imbalances, government debt and the intolerance of financial markets when pushed too far. Indeed, debtor countries have been taught a vivid lesson on the consequences of being deemed to hold too much debt by world financial markets.

Meanwhile, high credit default swap spreads and bond margins in countries such as Portugal, Ireland, Italy, Greece and Spain indicate how the price of risk has now been recalculated by financial markets in this new world. A clearer lesson could not have been portrayed on the importance of sound government accounting and good bank behaviour.

As with many similar institutions around the world, the RBNZ has been turning its thinking inside out and holding it up to scrutiny in the post-global financial crisis light. It is not just risk that has been recalculated during the crisis: the price of money has changed too. Negative government bond rates, some long-dated, are now a matter of course. The unthinkable, negative policy rates are also now a reality in some parts of the world. For a central bank such as ours with a history of relative high interests rates (the official cash rate is currently sitting at a record low of 2.5%), this has caused some serious contemplation on levels.

Other developments are also being put under the microscope, such as why, despite some economies showing signs of capacity pressure developing, inflation continues to surprise on the soft side.

Generational shift?

The crisis experience has raised questions around whether we can still rely on orthodox monetary policy to work in the traditional way. In New Zealand’s case, we think so. We also believe the Basel III amendments to prudential policy will provide the level of protection we need to bolster banking sector robustness in this new world. In terms of fiscal policy, we think being able to present government accounts that are seen as credible and easily fundable is the optimal stance.

Meanwhile, we continue to examine the possibilities that macrofinancial policy might offer. While still largely untested, we think it can play a complementary role to monetary policy in a small, open economy such as New Zealand. But we are conscious of its limitations and that it will not be a silver bullet for correcting economic imbalance.

It is important to note at this point that it is not just policy-makers that have been doing some hard thinking, and adjusting their course as a result of the crisis. Banks have sustained some heavy blows and are deleveraging; businesses, while potentially cash-rich, continue to hold back on investment in these uncertain times; and households, also shaken by the events of the global financial crisis, are holding back on consumption.

These adjustments feed into our own assessments. Such behavioural changes could merely be a temporary reaction to the environment we face, or the crisis may have ushered in a new generation of thinking. We continue to watch and learn.

We do so in an environment in which policy-makers must continue to manage the general deleveraging currently under way, as well as the ongoing exposures to financial disruptions occurring offshore. All this is set against the threat of crises reoccurring. However, we like to think that small can be synonymous with agile.

Alan Bollard is the governor of the Reserve Bank of New Zealand.

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