Alan Bollard: Easy money - global liquidity and its impact on New Zealand
Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Wellington
Chamber of Commerce, Wellington, 15 March 2007.
* * *
1. What has been happening to global liquidity?
Globalisation has had major effects on the New Zealand economy over the last decade or two.
Monetary policy has certainly not been immune. Some of the impact has been very helpful to us in our
primary task of achieving price stability. We have enjoyed a useful disinflationary impact from the flood
of cheap manufactures available from China and other newly industrialising countries. We have
enjoyed the benefits of trading with a buoyant world that has been enjoying good stable growth rates
with stable prices. More recently however, we have had to focus on a related phenomenon which has
had some unanticipated effects: the growth of global liquidity.
Global liquidity has increased dramatically over recent years. In our part of the world, this reflects:
•
a surplus of savings relative to investment in the East Asian and oil-exporting countries;
•
new players, new products, new transactions and markets; and in particular
•
the impact of the "carry trade" fuelling investment flows into a range of markets.
A feature of the period of relatively strong growth in the world economy over the past several years
has been large and growing financial imbalances among the world's major economies. The US current
account deficit has increased significantly over this period, although it has stabilised over the past year
relative to the size of the US economy. Meanwhile, most East Asian countries have consistently run
current account surpluses since recovering from the 1997/98 financial crisis, when many experienced
deficits. More recently, the rise in oil prices has underpinned a substantial increase in the surpluses of
the oil exporting nations.
Figure 1: Current account balances
These relative current account positions broadly reflect the contrasting balances between saving and
investment in these countries. In the case of the deficit countries - such as the US, Australia and New
Zealand - investment has exceeded saving, with the excess savings of surplus countries financing the
shortfall. Excess savings relative to investment amongst the surplus countries has increased
substantially since the late 1990s, led by Asia, a range of developing countries and more recently the
oil exporters. This has given rise to a phenomenon that US Federal Reserve Chairman Ben Bernanke
has referred to as a "global savings glut".1
Figure 2: Gross saving and investment
Source: IMF World Economic Outlook, September 2006; Economics@ANZ
For many of these countries - particularly the developing economies - this represents a considerably
different set of circumstances to that existing prior to the late 1990s, when developing economies
(including many of those in Asia) were net recipients of capital. In the case of the developing
economies in Asia, the response to the 1997/98 financial crisis has been to focus on export-driven
growth and the associated accumulation of foreign exchange reserves - a strategy that most are
continuing to pursue almost a decade after the crisis. The strength of exports relative to domestic
demand has seen saving outstrip investment in most of these economies - even in the case of China,
where investment growth has been very strong. Accordingly, we have the ironic situation whereby a
range of developing countries are (in net terms) the providers of capital to some of the world's most
developed economies. This rapidly rising "savings glut" has been a principal source of increased
global liquidity.
Figure 3: Capital flows to developing economies
Source: IMF World Economic Outlook, September 2006; Economics@ANZ
2. How is this being recycled?
Along with financial deregulation and the general opening up of economies, the flow of increased
global liquidity through markets has provided the impetus for many changes. In a recent speech2,
Malcolm Knight, General Manager of the Bank for International Settlements, highlighted a number of
important new features:
•
the unbundling and re-pricing of risk through major advances in financial engineering,
resulting in improved ability to lever lending via new markets such as for credit transfer
products;
•
the emergence of new financial players such as hedge funds and private equity firms that
have not been traditional intermediaries;
•
more reliance of financial firms on markets to handle growing complexity;
•
a reliance on market liquidity even in stress situations; and
•
a surge in volume and value of transactions.
The search for means to generate a return on this liquidity has spurred massive growth in
securitisation of debt and the development of a vast array of derivatives. The propagation of these
instruments can itself be seen as a source of liquidity growth and, by some estimates, a substantial
one at that. From a monetary policy perspective, this implies a very big increase in the liquidity that is
not directly controlled by central banks.
Figure 4: Estimates of global liquidity
Source: Independent Strategy
A particular development of interest to us has been the increasing integration of housing finance into
these liquid international markets. A recent article in the Financial Times3 reports on a significant slice
of new mortgages in Hungary being issued in Swiss francs while households in Latvia and Romania
are borrowing in yen. The article then goes on to focus on what they see as one of the biggest flows,
the bonds denominated in NZ dollars by European and Asian issuers.
3. What are the global effects of this liquidity?
The flows associated with the growth of global liquidity has played a role in helping to prolong the
period of strong global growth seen in recent years. The associated search for yield has pushed down
interest rates, bid up equity prices and generally put downward pressure on returns across a range of
asset classes.
Many of these effects have been clearly welfare-enhancing. But in contrast to how markets might have
reacted a decade ago, it has also allowed less disciplined economic behaviour by some households
and firms. It has allowed global imbalances, particularly those associated with the contrasting current
account positions of the major economies, to build up and persist beyond what might have previously
been considered sustainable. It has meant that when large economies operate with distortions in their
own markets, those distortions can be felt halfway around the world.
Risk appetites in global financial markets have generally been very strong in recent years. This
perhaps reflects the extended period of relatively strong growth in the world economy underpinning
investor confidence. This confidence has been bolstered by generally low market volatility, which has
also lowered perceptions of risk.
Figure 5: Risk aversion and market volatility
Source: Bloomberg; DataStream
Perceptions of a relatively benign risk environment have provided the basis for investors to engage in
a vast range of so-called "carry trades". These involve borrowing to invest in an asset that is either
yielding - or is expected to yield - a higher rate of return than the borrowing cost. In this regard,
relatively low risk aversion and market volatility are important conditions for carry trades, so that
traders are less fearful that sharp market moves could eliminate the expected yield differential.
Currency carry trades, whereby investors borrow in low interest rate currencies to invest in higher
interest rate currencies, have been some of the most popular. Relatively low interest rates in some
economies, particularly Japan and Switzerland, have been used as the basis for a raft of leveraged
investments and in so doing have further fuelled global liquidity.
Figure 6: Global policy rates
The events of the past few weeks have provided a timely reminder of the importance of low risk
aversion and market volatility for the carry trade. Fears sparked by a sharp retracement in China's
share market and growing concerns regarding the ramifications of problems in the US sub-prime
mortgage market saw investors rush to reduce positions in a range of markets. Notably, this episode
saw currency carry trades scaled back, with funding currencies strengthening and recipient currencies
weakening - although the sell-off proved highly correlated across a wide range of asset classes. This
period of turbulence has proved relatively contained to date, with risk appetites and markets
recovering. But it does demonstrate the potential widespread impact of an increase in risk aversion
and market volatility.
Figure 7: Market developments since the beginning of the year
Source: Bloomberg
4. How does it impact on the NZ economy?
Given our relatively high interest rates, New Zealand has attracted a disproportionate share of global
liquidity in recent years, putting upward pressure on the NZ dollar despite a relatively large current
account deficit. These flows have come in many forms. One particular avenue has been the issuance
of NZ dollar denominated bonds in offshore markets: Eurokiwi and Uridashi bonds. The derivative
transactions associated with Eurokiwi and Uridashi issuance have provided a mechanism for the New
Zealand banks to hedge the interest rate and currency risks associated with their offshore borrowings
at cheaper rates than would otherwise have been the case. The upward pressure this has put on the
New Zealand dollar and downward pressure on interest rates has exacerbated the current problematic
imbalance between traded and non-traded sectors in New Zealand.
Figure 8: Offshore NZ dollar denominated bond issuance (Eurokiwi & Uridashi bonds)
Source: Reuters; Bloomberg; RBNZ
But it is important to recognise that the attractiveness of the NZ dollar for offshore investors is not just
a reflection of the current level of interest rate differentials, but also investors' views regarding their
sustainability. In this regard, it is interesting to note the relatively close correlation between house
prices and the NZ dollar over the last 15 years. Without claiming a direct relationship between the two,
this goes some way to illustrate the extent to which persist domestic inflation pressures have
underpinned the outlook for interest rates, which in turn has maintained upward pressure on the NZ
dollar. Accordingly, a sustained retracement in the NZ dollar from the highs seen in recent years could
be contingent on our efforts to rein in domestic inflation pressures.
Figure 9: House prices and the NZ dollar Trade Weighted Index (TWI)
Of course the inward capital flows that have kept pressure on the NZ dollar would not have happened
without a strong domestic demand for borrowing. In this case it is New Zealand households' desire to
keep investing in housing, while at the same time consuming strongly, that fuels their demand for
funds, and represents the other leg to these international transactions.
5. How does it affect monetary policy?
No central banker today can ignore these effects on domestic monetary policy. A recent speech by
Ben Bernanke4 observed that financial market globalisation has made the Fed's analysis much more
complex. He notes that even for the US there is no such thing as total monetary independence. For
example, correlations between long term interest rates in the US and other industrial countries have
risen significantly. Having said that, he concludes that, despite Alan Greenspan's term of "conundrum",
this has not significantly constrained their ability to influence domestic financial conditions.
This is more problematic for a number of small open economies with higher interest rates - not only
New Zealand, but also Iceland, Hungary, Australia and South Africa. The downward pressure created
by abundant global liquidity on market interest rates has had implications for the operation of monetary
policy. In general terms, the Reserve Bank has most impact on the shorter end of the yield curve, both
by setting the OCR itself and influencing market expectations about the outlook for monetary policy.
But further out the yield curve, other factors - including global interest rate developments and country
risk premia - also influence interest rate levels.
Figure 10: A stylised representation of the relative influences on the yield curve
Source: RBNZ
Low global interest rates have restrained the rise in longer-term interest rates relative to the upward
pressure monetary policy has been able to exert on shorter-term interest rates during this tightening
cycle. This has seen the yield curve progressively flatten and become negatively-sloped during the
past few years.
Figure 11: The change in the yield curve since the beginning of the tightening cycle
Source: Bloomberg
Figure 12: New Zealand and US long term interest rates
Source: Bloomberg
A negatively-sloped yield curve has encouraged borrowers to take out term loans at relatively lower
rates. Households in particular have favoured fixed rate mortgages, which now account for more than
80 percent of mortgage borrowing, and increasingly for longer terms. This has muted and delayed the
impact of policy tightening in this cycle, although we have now seen the effective mortgage rate rise by
around 110 basis points since its lows in late 2003.
Figure 13: The OCR and the effective mortgage rate
Source: RBNZ
A further practical constraint for us has been that, although the TWI is influenced by a wide range of
global events, in recent years we have not wished to add to upward pressure on the NZ dollar. We
have also remained conscious of our obligation to avoid unnecessary instability in output, the
exchange rate and interest rates, as required under section 4b of the Policy Targets Agreement. This
has meant we have been more cautious in our OCR tightening path than might otherwise have been
the case.
6. New Zealand policy in a global context
The circumstances we face at present do not necessarily represent an enduring structural change in
the environment in which policy operates. At some stage in the future when the large East Asian
trading blocs are able to trade currencies and products with the world at more sustainable prices, a
significant distortion to our own rate setting process will be removed. However, for that we must wait
for G-7, Doha and other international forces to do their work.
As for New Zealand, we need to see realisation amongst borrowing households and lending banks
that this recent period of cheap international money has been unusual, and at some point will revert to
more normal financial conditions. That means thinking about other eventualities ahead, and in some
cases showing less exuberance.
Monetary policy always impacts with long and variable lags. Those lags have been longer in this cycle,
but as household debt grows the OCR becomes a more potent policy instrument. We are continuing to
assess alternative measures that might support the OCR, working with the relevant government
agencies. These include a tightening of tax rules applying to housing investment and changes to bank
capital requirements to help moderate the amplifying effect of credit on the housing cycle. However,
we will continue to rely on the OCR as the primary instrument of monetary policy.