Ramp up the Core Funding Ratio, even if banks are squeezed, says Geoff Simmons, economist at Gareth Morgan Investments.

Economic data is reading a little bit like the zombie apocalypse at the moment: the dollar hit an all-time high this week while inflation is the highest it has been in 21 years.

Commentators are haunted by reminders of past crises, such as the Dutch Disease, so named when North Sea oil returns choked manufacturers in the Netherlands. There are hints of the stagflation (high inflation and stalled GDP) we last saw in the 70s. Even commodity prices seem to be losing their former gloss.

Well, desperate times call for desperate measures - that is why the next Monetary Policy Committee meeting on Thursday is the right time for the Reserve Bank to start pulling its new lever, the Core Funding Ratio.


The Core Funding Ratio was introduced with great fanfare in April last year, with the promise that it would help secure our banking sector against future crises. The basic idea is that the Core Funding Ratio requires banks to source a certain chunk of their funding from "stable" sources - like domestic customer deposits or long term funding.

The upshot of this is that unless banks can source enough of this kind of funding, they won't be able to make any more loans.

So far this Core Funding Ratio has been introduced gradually by the Reserve Bank, so that banks have had time to adjust. Term deposit rates did rise a little as a result. However, when the tool was launched the Reserve Bank hinted at the possibility that this ratio could move up and down according to economic cycles.

In the good years, private banks would be required to build up a war chest of stable funding that they can rely on when times turn tough. Conversely when the bottom falls out of the property market and bad debts pile up, the restrictions can be reduced.

The economy faces record inflation and exchange rates. If the Reserve Bank responds to inflation threats by using its traditional tool - interest rate hikes - the economy faces the prospect of even higher exchange rates.

This is exactly what happened in the boom of the mid-2000s: the Reserve Bank pushed up short-term interest rates, which attracted lots of foreign capital looking for short term gains. This succeeded in pushing the exchange rate up, which hurt exporters, and didn't really quell the boom.

The other possibility is to do nothing, which also carries risk.

The low interest rates we have at the moment only seem to be helping the Auckland housing market, not the places that need it like Christchurch. And if inflation gets embedded in the economy, then it becomes much harder to get rid of. Looking at the demands of 8.9 per cent wage increases from firefighters, and the price gouging that the service sector is engaging in during the lead up to the Rugby World Cup, this is a real possibility. So the Reserve Bank is between a rock and a hard place.


That is why the time is nigh to use this new tool as an alternative to traditional interest rate rises. If the Reserve Bank signalled a higher Core Funding Ratio, it would force banks to rely more on domestic customer deposits - so deposit rates should rise, and loan rates should rise to match them. As a result more of our borrowing would be financed by domestic savings rather than international borrowing. This would remove the incentive for foreign lenders to flood the country with their "hot money", which normally happens when interest rates rise.

Less foreign money coming into the country would in turn reduce the pressure on the exchange rate, which is good for exporters. This move would also be good news for domestic bank deposit holders, and in the ideal world it might even encourage a few more Kiwis to save.

Of course you won't hear bank economists calling for this change, and with good reason. Kiwis are notoriously poor savers, so our banks are reliant on overseas money for their loan books. Incredibly the most notable example of this foreign borrowing lately has been state-owned Kiwibank. A higher Core Funding Ratio would mean banks have to pay more for deposits to encourage Kiwis to save, or make fewer loans, or both. All of this means lower profits, so a higher Core Funding Ratio will ultimately put a squeeze on banks. Which might be a good thing, depending on whether you think our penchant for credit-soaked expansions remains unrealistic.

Given all the risks in the world economy at the moment, a bit more prudence can hardly hurt. Greece may have been saved from toppling for now, but there is no guarantee that the whole European house of cards won't come down, triggering another round of bank bailouts.

And of course the United States economy is like watching a slow motion car crash. This change alone would probably not be enough to curb our soaring exchange rate and save our non-commodity industries, but it would be a good start.

Of course, don't expect such bold moves from the Reserve Bank this Thursday. After all it is only charged with controlling inflation. Ultimately a soaring exchange rate makes its job easier.