The RBNZ changes its policy on reserves

The reserve bank's new mandate, which was confirmed in March, means that it needs to intervene to correct exceptional peaks or troughs in the kiwi dollar when these are deemed to be not justified by fundamentals. Intervention will be at the governor's discretion. The central bank retains existing powers to intervene should foreign exchange markets become "disorderly", (it is to receive an extra NZ$1.9 billion for this), but the new powers are distinct from this and signal a break from the central bank's history. It has not intervened since 1984.

The central bank is at pains to stress that it is not targetting a level of the exchange rate on a daily, quarterly or even yearly basis. The aim is not to influence the long-term rate or take the market on, but to "trim the extreme tops and bottoms of the New Zealand dollar exchange rate cycle" according to Adrian Orr, a deputy governor at the reserve bank. While the central bank attempted to spell out the intellectual reasoning behind this change, the amount of reserves earmarked for this purpose remains secret.

Although many observers say the central bank has bowed to political pressures, the published correspondence shows the governor, Alan Bollard, requesting the ability to intervene to affect the level of the exchange rate. Coincidentally, the finance minister, Michael Cullen, had sought advice from the central bank on the same subject around the same time and they appear to have come to the same conclusions.

The reserve bank takes the risk

Intervention is the bank's responsibility and it will bear the risks, meaning any profits or losses the central bank makes will impact directly on the bank's balance sheet. Since the reserve bank strictly follows New Zealand's tough corporate accounting standards - and thus marks to market its foreign exchange and derivatives portfolio - this may result in huge volatility in the central bank's profits and losses. An extra NZ$1 billion in capital is to be raised to help absorb any potential losses. In addition, the governor has sought cross-party support for the change to try and ensure that a new administration will not back out of the arrangement at the wrong moment.

The central bank still maintains that intervention is unlikely; the floating rate, "serves New Zealand well," according to Orr. Timing will be a key issue and, as Bollard dryly notes in a letter to the finance minister, determining when the exchange rate has departed from fundamentals is "unfortunately difficult". True, intervention can be successful, the bank said in a statement, but the impact is usually "small" and possibly "temporary". Intervention may also lead to large unrealised losses on open positions, which may persist during the exchange rate cycle. The central bank says these may prove profitable over the long term, but it will clearly be faced with possible loss of reputation from carrying these losses and having to explain why they were incurred.

The reserve bank faces a greater challenge in how it will juggle an expanding, and potentially conflicting, set of tasks. The reserve bank's "goal" is to achieve price stability; but it also stands "prepared" to deflate asset bubbles; and it now has an "objective" to reduce exchange rate variability at so-called extreme levels of the exchange rate - but must act consistently with the "goal".

From being the pioneer of focused inflation targetting, the central bank's aim seems much less clear now. It will not take long for the central bank to face calls to burst bubbles, use this new monetary policy tool, or justify non-intervention; a tiresome and thankless task.

What's really going on? The so-called exchange rate "cycle" has long been a concern to the reserve bank, but the recent success in reducing and stabilising inflation has meant that swings in the exchange rate have become much more noticeable. New Zealand's central bank candidly admits (as well it might) that cost-benefit analysis to justify this change is difficult to do. 'Success' - averting a crisis - would be at best limited, late in terms of returns and difficult to show. Conversely, some of the costs at least will be well known: the central bank calculates that to borrow and hold an additional NZ$1 billion of reserves costs the New Zealand taxpayer NZ$750,000 every year.

It is difficult to escape the conclusion that the real winner is the finance minister. He is now able to direct any complaints about the kiwi dollar's strength to the central bank's door, and will not carry the marked-to-market consequences of any intervention on the government's books. The central bank looks to be on the defensive. It is now tasked with deflating expectations of intervention, while justifying the expense of holding the extra reserves, dealing with resulting uncertainty in the markets, juggling multiple objectives and patching up possibly large new holes in its balance sheet.