Victoria University Economist Geoff Bertram argues the RBNZ should force NZ's banks to reduce their foreign currency borrowing to reduce pressure on NZ$

By Bernard Hickey

Victoria University Economist Geoff Bertram has proposed the Reserve Bank force New Zealand's banks to reduce their foreign currency borrowings to reduce the pressure on New Zealand's dollar and its export sector.

Bertram delivered a paper detailing the recent history of New Zealand's monetary policy, foreign borrowing and the New Zealand dollar to a Fabians' Seminar "Fresh Ideas for a Productive Economy" in Wellington last week. A full version of the paper is here.

In it he argues that New Zealand's inflation-targeting regime, its free floating exchange rate, unregulated capital flows and a sharp increase in foreign currency borrowing by New Zealand's banks since 1993 have had the effect pushing up the currency.

This has helped the Reserve Bank use the currency to suppress tradeables inflation and offset relatively high non-tradeables inflation.

Since the mid-1980s non-tradeable inflation, which includes such things as government charges and electricity prices, had signficantly outpaced tradeables inflation, which includes prices of imports, Bertram said.

The chart below shows relative non-tradeable and tradeable prices.

This included much stronger growth in prices of former government owned monopoly prices, such as electricity, vs the prices of tradeable goods and services such as hotel nights and imported goods.

Conventional inflation targeting had delivered unbalanced relative prices and raised the need for regulation of non-tradeable prices such as electricity as a tool of monetary policy, he said.

The Reserve Bank targets overall Consumer Price Inflation at 1-3% over the medium term, but does not break down its target into tradeable and non-tradeable components.

Bertram described the inflows of foreign currency to fund asset sales and foreign borrowing as a distant relative of the 'Dutch Disease', where an influx of oil revenues pushed up the Dutch Guilder in the 1960s after a gas discovery in the North Sea and slammed manufacturing jobs.

There had been a sharp increase in New Zealand's net foreign debt since the late 1980s, with an acceleration since the early 1990s as the local arms of the Australian banks began borrowing heavily in foreign currencies.

This sucked in foreign currency and pushed up the New Zealand dollar. The biggest growth in foreign debt by the banks was through the mid 2000s, which coincided with the biggest strength in the New Zealand dollar.

It also created a mis-match between New Zealand dollar lending and foreign currency borrowing. This bank borrowing in foreign currency rose from nothing in 1993 to NZ$80 billion by 2008. (See the red bars in the chart below. The yellow line shows government debt in foreign currencies now at zero)

Bertram said this currency mismatch exposed the banks to two types of shocks: a sharp depreciation of the New Zealand dollar would reduce the value of the assets relative to their attached liabilities, and credit rationing on international markets.

The provision of the Government's Wholesale Deposit Guarantee allowed the banks to banks to borrow with government backing, effectively forcing the taxpayers to pick up a NZ$8 billion foreign currency liability and parking it off balance sheet, Bertram argued.

"Putting the interests of the banks' (mainly offshore) shareholders ahead of those of NZ taxpayers and exporters came so naturally to the NZ policy elite that the guarantee barely caused a ripple on  the political pond," Bertram said, adding that New Zealand's banks had been consistent supporters of a strong currency when lobbying the government.

He criticised the government's decision to leave this exposure to wholesale guaranteed bank debt off balance sheet, much of which has yet to roll off.

"That amounts to keeping its fingers crossed that no new financial crisis breaks out that might push the banks into triggering the guarantee," he said.

"But more basically, over and above the NZ$8 billion of bank foreign currency funding (red, yellow and blue bars in chart above) underwritten by taxpayers, there is still another NZ$68 billion (as at May 2011) of foreign currency funded NZ$ bank assets outstanding," he said.

"A high priority for the robustness of the NZ economy is to get at least part of these bank liabilities repatriated into NZ dollars. That would put downward pressure on the New Zealand dollar, probably implying some capital losses for the banks' shareholders."

Bertram said the Reserve Bank should take the extra step of regulating this currency mismatch, rather than just its maturity mismatch via the Core Funding Ratio.

"Rather than just imitating overseas central banks by regulating maturity mismatch in bank balance sheets via the Core Funding Ratio, the RBNZ could require the banks to progressively to eliminate this currency mismatch from their books," he said.

"If the banks want to raise new funds offshore they should do so by issuing NZ dollar denominated securities or they could raise funds locally, including from the RBNZ, and pay off overseas loans as they mature," he said.

"Just as the past 15 years of growing currency mismatch propped up the nominal exchange rate, so should an unwinding bring it down."

I spoke with Geoff Bertram in the interview above.