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The Reserve Bank is changing the way it manages its foreign currency reserves to make it easier to respond should the dollar ever go into free fall.
Its traditional practice, unusual for a central bank, has been to hedge its foreign exchange position - matching its holdings of
foreign currency assets with equivalent borrowings in the same currency.
This shields the bank's balance sheet from movements in the exchange rate and has reduced the interest cost of holding the reserves since overseas interest rates tend to be lower than New Zealand rates.
"However, if the bank needed to intervene, say, to halt a large, rapid fall in the NZ dollar it would need to sell foreign assets to buy NZ dollars. Under existing arrangements if the exchange rate fell and stayed low after the bank had intervened, we would be left with large losses on our foreign borrowings," the bank said.
It would be expensive to refinance these borrowings during a crisis as lenders would be likely to charge higher interest rates. "At the extreme, foreigners might not be willing to lend to us at all."
Instead, the bank intends to have an open or unhedged foreign reserves position, funded by kiwi dollar borrowings. It would rise and fall over the exchange rate cycle but the aim would be to return to a "benchmark" level, which has not been disclosed.
ASB Bank chief economist Nick Tuffley said that if the Reserve Bank wanted to reduce its foreign currency liabilities, some $5.4 billion at the end of May, by buying foreign currencies, now would be a good time to do it with the exchange rate so high.
But running an open or unhedged foreign reserves position would mean the bank's balance sheet would swing around in a way it had not done before as that position was marked to market.
The Reserve Bank stressed it was not changing the criteria for intervening in the foreign exchange market with the objective of directly influencing the level of the exchange rate.
It drew a distinction between intervention and transactions aimed simply at building up or running down foreign currency reserves or managing the normal foreign exchange transactions of the public sector, such as paying for imported military hardware.
"These latter transactions are performed in a manner consistent with achieving the best possible price, which usually implies having as little impact as possible on the exchange rate," it said.
The bank said that while overt intervention and "passively adjusting its reserves" were different, the latter would give it another means of signalling its views on the appropriateness of the exchange rate.
"Such transactions will allow the bank to give concrete signals regarding the extent to which the exchange rate is over- or under-valued," Governor Alan Bollard said.
"That may indirectly affect the exchange rate by discouraging speculators from pushing the currency to extreme levels."
BNZ research head Stephen Toplis said the announcement was a bit of damage control. He said if it had said on June 11, "We think the currency is unsustainably high. In due course, it will fall. We are going to build up foreign exchange reserves with a view to making money on the deal over the next 12 months", it would have received a less hostile reaction.
"But they got a bit cute and said to themselves 'let's see if we can knock the currency over at the same time'," Toplis said.
Position change
The Reserve Bank is to start running an open position in its foreign currency reserves as its Australian counterpart does.
That will make it easier, and cheaper, to prop up the dollar should it go into free fall.
And it will allow the bank to make money over time from foreign exchange dealings.