Covid 19 coronavirus: Brian Fallow: How Reserve Bank is fighting the virus

Reserve Bank Governor Adrian Orr. Photo / File

In these days of fear and pestilence, the Reserve Bank's key function is to ensure both the Government and the banks have all the money they need to do the things they need to do.

So this week we saw the central bank announce it is prepared to spend up to $30 billion buying government bonds on the secondary market, a process novel in New Zealand but commonplace elsewhere called quantitative easing.

It has two objectives. One is to lower longer-term interest rates, as Government debt is normally seen as the risk-free benchmark rate for debt of longer maturities.

What prompted Monday's announcement was that bond yields were climbing as the market worried about who would be there to buy the rapidly growing pile of debt the Government would have to issue.

It worked. The announcement saw 10-year bond yields, which had jumped more than 60 basis points in a week, drop back below 1 per cent.

The other objective is to monetise the deficit, ensuring that the Government has the money it needs to meet its rapidly growing obligations.

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Only last week, Finance Minister Grant Robertson announced a $12b package intended to support employment and incomes. This week he added another $4b to the wage subsidy part of that package and committed to underwriting 80 per cent of a $6.25b business finance guarantee scheme for small and medium-sized enterprises which the banks will run.

In addition to such proactive measures, the Government's bottom line will be blown out by the "automatic stabilisers" as the recession sees tax revenue dry up and welfare payments soar.

How bad that gets will depend on the depth and duration of the recession.

"It's the deepest we will see in our lifetime," says John McDermott, executive director of the Wellington think tank Motu and until a year ago assistant governor and chief economist at the Reserve Bank.

• Covid19.govt.nz: The Government's official Covid-19 advisory website

As for the recession's duration, that will depend on the epidemic itself and the effectiveness of measures to contain it. "Right now the usual economic indicators are of little use, to be fair," McDermott says.

Instead, the crucial number for policymakers and forecasters to try to get a handle on is an unfamiliar one: the effective reproduction rate. That is the number of people that someone who catches the virus is, on average, likely to pass it on to.

The aim is to get it down from the base case of around 2.5 — which assumes no immunity and no measures to contain it, and which is a recipe for exponential growth in infections — to below 1.

And keep it there, which would see the epidemic start to fizzle out, barring fresh outbreaks from importation of the disease.

That is one key source of uncertainty. Another is whether New Zealand will continue to be able to import credit from the rest of the world on the scale to which we have become accustomed.

"The one fault line which is running through the global economy is the scale of leverage we start this event with," McDermott says. "That's why it matters that as it rumbles through the economy, the time horizon it lasts for has to be short."

Whether you look at the advanced economies or the G20 (which includes China) aggregate levels of debt, measured against the size of the economies, are much higher than they were in 2007 ahead of the global financial crisis.

By the end of this year all three components — government, corporate and household debt — are going to be a whole lot higher still.

The two traditional methods of mitigating the real burden of debt are to cut interest rates or to inflate it away. But central banks are up against the zero lower bound for interest rates, and if anything there is a deflationary rip running.

This global problem affects us in a couple of ways. One is that a majority of the current stock of Government bonds is held offshore. At a time when risk aversion is sky high and massive fiscal stimuli are being rolled out in countries a lot bigger and richer than New Zealand, it would be unsafe to assume that will continue.

The other and larger exposure is New Zealand banks' traditional reliance on tapping international wholesale markets for a lot of their funding.

At the start of 2020, what the statisticians quaintly call deposit-taking institutions had net foreign liabilities of $120b, equivalent to a quarter of their loan book.

Regulatory changes imposed in the wake of the GFC reduced their rollover risk — the risk that it will be impossible or prohibitively expensive to refinance those liabilities as they fall due — but they have not eliminated it.

And we had a taste of that last week when the FX swaps market froze and the spread between the official cash rate and 90-day bank bills widened markedly. The Reserve Bank had to step into the market to restore liquidity.

"To get us across this valley of disease, central governments have to step in with massive stimulus packages. Absolutely massive," McDermott says.

"But if everybody is doing it, the problem is you can't go around the world borrowing the money. If you try that interest rates will spike instead of fall. And that's what we saw [last] week."

In these circumstances the central bank has to step in so that the Government can do what it is trying to do, he says, with the understanding that it is a temporary expedient. "Once it has passed — and it will pass — you reverse that out."

Announcing the beginning of quantitative easing this week, governor Adrian Orr was clear the bank would be doing its bond-buying on the secondary market. The purchases of up to $30b would be spread over at least 12 months and across a range of maturities, in order to leave enough liquidity for the bond market to function effectively, he said.

That would give other would-be sellers of bonds a look-in and would not crowd out other purchasers when investors rediscover their enthusiasm for the safe haven of government debt.

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The Bank of New Zealand's head of research, Stephen Toplis, says rising risk premia will continue to butt up against the Reserve Bank's actions "but we believe the RBNZ will probably win the battle".

The other leg of the central bank's responsibility in these challenging times is to stand behind the banking system and the businesses and households on the other side of it, when they are creditworthy, so that the economy does not lose too much muscle mass while it is bed-ridden, so to speak.

So far, the Reserve Bank's moves have largely been as the banks' regulator.
It has deferred the planned increase in banks' capital requirements. It would be perverse to require them to set aside more capital for a rainy day when we are experiencing a deluge of Noah-esque proportions.

It has also reminded the banks that their existing capital requirements, which they exceed, includes a layer intended to be drawn down in tough cyclical times. These two measures should free up the equivalent of three years' normal lending.

Lastly, the Reserve Bank has revived a measure from the GFC playbook, opening the equivalent of a pawnbroker's window that cash-strapped banks can access. The term auction facility gives banks the ability to access term funding, using assets like mortgages as collateral, out to a term of 12 months.

It stresses that the banks are well capitalised but says opening this facility should give confidence that it stands ready to support the market if needed.

It is a reminder of the central bank's role as a lender of last resort.