Reserve Bank takes out big foreign exchange insurance policy

Adrian Orr is at the helm at the RBNZ, which is committed to only intervening in the currency market in rare circumstances. Photo / Mark Mitchell

The Reserve Bank’s (RBNZ) decision to give itself more muscle to intervene in the currency market in the event of a crisis is being met with some scepticism.

The central bank is acquiring foreign currency assets to strengthen its ability to step in if the market isn‘t functioning properly, liquidity is limited, or the exchange rate is at an extreme or unjustified level relative to economic fundamentals.

The RBNZ is both borrowing and buying (using newly-created money) the assets, increasing its foreign currency intervention capacity by more than a third between June and September to $17.7 billion.

It is effectively taking out more insurance to insulate the economy from a big shock.

Nonetheless, experts are divided on whether the costs and risks associated with doing so are worth it.

Former Westpac treasurer turned consultant, Jim Reardon, was unconvinced the RBNZ had the resource and expertise to outperform the market, which he believed usually corrected itself anyway if an extreme move was not justified by economic fundamentals.

For example, the RBNZ would have to trade a lot of New Zealand dollars to become a big enough player in the market to influence the currency’s value.

Even if it managed to convince the market it had enough firepower to be influential, Reardon questioned whether it would be able to execute an effective intervention.

The RBNZ assured it wouldn’t go meddling in the currency market willy-nilly.

Its moves need to align with a framework it agreed to with the Finance Minister in December.

RBNZ assistant governor Karen Silk said, in a speech delivered on Tuesday, that the framework doesn’t fundamentally change the RBNZ’s approach towards foreign exchange interventions.

“Periods of intervention are still expected to be rare, and we remain committed to maintaining a free-floating exchange rate,” Silk said.

Westpac chief economist Kelly Eckhold, who used to specialise in foreign exchange policy at the RBNZ and IMF, supported the RBNZ’s approach.

“The intervention criteria applied are very conservative and really reserve intervention for those rare occasions where central bank purchases have some chance of a liquidity impact,” Eckhold said.

He said managing foreign exchange risk was a core part of a central bank’s job, particularly in the case of a small trading nation like New Zealand.

In fact, Eckhold believed the RBNZ’s actions could make New Zealand a safer bet in the eyes of foreign investors.

Silk recognised the RBNZ acquiring more foreign currency assets increased the size of its balance sheet and its exposure to “market, credit, liquidity and counterplay risks”.

The RBNZ is well acquainted with such risks. It’s currently drawing down on an indemnity the Government gave it when it launched its Covid-era “money printing” programme, because the bonds it bought via the programme are plummeting in value.

The Government has provided the RBNZ with additional indemnities and $1.8b of extra capital to account for the risk it’s taking on by acquiring more foreign reserves.

Silk said it was hard to pinpoint what the optimal level of reserves was, noting the RBNZ would consider New Zealand’s import values, debt levels, FX turnover, and other central banks’ positions, among other factors.

The RBNZ wouldn’t comment on the level of reserves it was targeting, due to commercial sensitivity, but said it would build its reserves over a number of years.

Eckhold accepted that if the RBNZ said too much about how it would go about building its war chest of foreign reserves, traders would bet against it.

Jenée Tibshraeny is the Herald’s Wellington business editor, based in the Parliamentary press gallery. She specialises in government and Reserve Bank policymaking, economics and banking.