Graeme Wheeler: The introduction of macro-prudential policy
Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to Otago
University, Dunedin, 20 August 2013.
* * *
New Zealand's economy is now one of the most rapidly growing among the advanced
economies. Growth is likely to remain strong and become more broadly based over the next
two years, particularly as construction activity in Christchurch, Auckland and elsewhere
gathers momentum and provides further stimulus to the manufacturing sector. Our forecasts
in the June 2013Monetary Policy Statement, which are currently being reviewed for the next
Statement in September, suggested that in 12 months' time the economy could be growing
at just over a 3 percent annual rate, with the unemployment rate declining towards 5 percent
and annual CPI inflation back within the 1 to 3 percent target range.
These summary indicators, however, disguise the nature and complexity of the adjustments
taking place in New Zealand. Included among them are the impact of the monetary and
liquidity policies of major central banks, domestic economic policy settings, the powerful
long-term global structural changes affecting our economy, and the effects of natural events
such as earthquakes and drought1. Just as firms and households develop strategies to adjust
to these forces, the Reserve Bank also needs to respond to them in meeting its goals of price
stability and financial stability. I will turn to two of the largest forces influencing our economy
- our over-valued exchange rate and the over-valued housing market.
1. The over-valued exchange rate
Our exchange rate is over-valued relative to what would be sustainable long-term in the
absence of sizeable increases in our terms of trade and productivity. Against many of the
world's major currencies, the New Zealand dollar is positioned in the top decile relative to its
historic experience. At these levels, the exchange rate is a considerable headwind for New
Zealand's exporters and those that compete with imports, although it has benefited
purchasers of imported goods and services and contributed significantly to the current low
level of inflation.
Our real exchange rate is about 16 percent above its 15 year average2. It is important to look
at both long-standing structural and more recent cyclical factors when considering the
reasons for New Zealand's high real exchange rate - although at any time the relative
strength of these factors can change.
Figure 1: New Zealand's real effective exchange rate
Source: Bank for International Settlements.
Note: BIS real effective exchange rate for New Zealand, narrow measure incorporating bilateral rates with
27 economies.
Some of the appreciation in the real exchange rate over the past decade is due to the
improvement in our terms of trade (or the ratio of export prices to import prices), which are
now 20 percent higher than the average for the 1990s. This reflects the rapid growth of the
East Asian economies, and especially China, and the rising global demand for protein.
Another factor exerting upward pressure on the real exchange rate is New Zealand's low
level of savings (relative to our business and residential investment needs) and our
consequent dependence on foreign savings to achieve these needs. Our low propensity to
save means that higher interest rates than elsewhere are needed to achieve similar inflation
outcomes and these higher real interest rates result in upward pressure on the real exchange
rate.
In recent years some important cyclical factors have also been important drivers. These
factors have made the returns on New Zealand financial assets more attractive when
compared to the returns available in many advanced countries experiencing lower growth
rates and adopting more stimulatory monetary policies.
Monetary policy in the advanced countries has been highly accommodating with countries
representing two thirds of global output having policy interest rates between zero and
1 percent3. In addition, the Federal Reserve, European Central Bank, Bank of England and
the Bank of Japan have cumulatively conducted around USD 6 trillion of additional monetary
stimulus through quantitative easing. These liquidity injections, often involving the purchase
of longer maturity government securities, have been designed to boost domestic asset
prices, stimulate spending and, in some instances, depreciate the exchange rate.
The combination of historically low policy rates and quantitative easing has lowered bond
yields globally and the increased investor demand for riskier and higher yielding assets has
compressed spreads. New Zealand government bonds, with their relatively high yields
compared to other advanced economies, remain attractive to foreign investors who own
68 percent of government bonds on issue.
The magnitude of the policy challenges that led central banks in the US, Europe, and Japan
to have policy rates at or close to the lower bound of zero, and to resort to large scale
quantitative easing, are much greater than those facing New Zealand.
For example, the US experienced a huge decline in household wealth. The Federal Reserve
reports that median real net household wealth fell 39 percent from 2007 to 2010 to levels
seen in 1992. In 2011, the median real level of US household income dropped to its lowest
level since 1995. Partly due to the Federal Reserve's highly accommodating monetary policy
that helped to stimulate employment and a recovery in the housing and equity markets, real
levels of wealth have now returned to their 2007 level, although not for the median and lower
income groups.
Deleveraging in the euro area, especially in the financial sector, is proceeding more slowly
than in the US and the euro area economy has just emerged from an 18 month recession.
The unemployment rate for the euro area is around 12 percent, and 15 percent if Germany is
excluded. Several countries face major adjustments. For example, unemployment rates
exceed 25 percent in Spain and Greece, Italy's real per capita income is back at 1996 levels,
and annual labour productivity growth in France and Italy has lagged that of Germany by
1.5 and 2.1 percentage points respectively since 2000.
Japan has suffered bouts of stop/start growth and deflation for the past two decades. Its
general level of prices is now back at 1992 levels and general government net debt is around
145 percent of GDP. In April 2013, the Bank of Japan announced its intention to double
Japan's monetary base by the end of 2014 in an attempt to achieve an annual inflation goal
of 2 percent.
New Zealand is likely to continue to attract offshore portfolio flows, especially since the larger
advanced countries are unlikely to raise short-term policy rates for a considerable time.
Investors also seem to be differentiating more between Australia and New Zealand.
Australia's exchange rate has fallen by 13 percent on a trade weighted basis since April 2013
and market expectations are for a further easing in policy rates. This upward pressure on the
cross rate is of concern, as Australia is the destination for around a third of New Zealand's
manufactured exports and these are more labour intensive than exports of commodities and
dairy products.
2. The over-valued housing market
Housing plays a critical role in our economy. It represents almost three quarters of household
assets and mortgage credit accounts for over half of banking system lending. Consequently,
housing is a major source of value and of risk to the household sector and the banking
system.
The Reserve Bank focuses on the housing market for three main reasons. First, housing and
the construction sector can be a source of inflationary pressure if construction costs and
rents increase and the "wealth effects" of rising house prices feed through into additional
spending or borrowing to finance consumer goods. Second, the possibility of a significant fall
in house prices can have important implications for financial stability and on the ability and
willingness of banks to lend to support a recovery. Finally, declining house prices can have
significant impacts on output and employment, especially when the associated de-leveraging
of household and corporate balance sheets continues for several years.
At present, rising construction costs are not a major concern for monetary policy.
Construction costs in Christchurch are up 12 percent over the past year and they have
recently been rising in Auckland. Changes in relative prices are needed to attract additional
workers and resources into the construction sector, but the Reserve Bank will continue
assessing the risk of any spill-over of these prices into more generalised inflationary
pressures.
Our main concern is the rate at which house prices are increasing and the potential risks this
poses to the financial system and the broader economy. Rapidly increasing house prices
increase the likelihood and the potential impact of a significant fall in house prices at some
point in the future. This is particularly the case in a market that is already widely considered
to be over-valued.
The Reserve Bank is not alone in expressing these concerns. Over the past several months
the IMF, OECD, and the three major international rating agencies have pointed to the
economic and financial stability risks associated with New Zealand's inflated housing market.
In April this year, the IMF suggested that New Zealand house prices were over-valued by
around 25 percent, and the OECD has expressed similar views4.
Figure 2: House price to income across OECD countries
(deviations from historical average)
Source: OECD
House prices increased by 16 percent and 10 percent respectively in Auckland and
Christchurch over the past year (three-month moving average to July 2013 over the same
period in 2012). They increased by 4 percent over the rest of New Zealand overall, with
considerable variability among regions. House prices are high by international standards
when compared to household disposable income and rents. Household debt, at 145 percent
of household income, is also high and, despite dipping during the recession, the percentage
is rising again. Furthermore, the growth of house prices is occurring after only a small
correction following the house price boom of 2003-2007 that saw New Zealand's house
prices increase more rapidly than in any other OECD country.
Figure 3: House price inflation by region
Source: REINZ
Rising house prices in Auckland and Christchurch are mainly a result of supply shortages,
although demand-side pressures are also a factor due to pent up demand, the lowest
mortgage rates in 50 years, and aggressive competition among banks for new borrowers,
including borrowers with low deposits.
Auckland's Council suggests that Auckland's current housing shortage is
20,000-30,000 houses with 13,000 houses needing to be built each year to meet future
demand. Christchurch's shortfall is around 10,000 houses. Strikingly, for a city with
geographical boundaries equivalent in size to Greater London, and a population of 1.5 million
(a sixth of Greater London), Auckland has only produced an average of 4300 new houses
annually over the past three years.
Initiatives such as the Auckland Accord, and measures to increase the availability of land
zoned for residential housing, and to raise productivity and lower costs in the building sector,
are important for increasing housing supply. However, it is likely to take considerable time for
the supply/demand imbalance in the housing market to correct through supply-side
measures alone. In the absence of demand measures, house prices might continue to rise
rapidly and pose an increasing risk to financial stability.
The conventional mechanism to help restrain housing demand while working on the supply
response would be to raise the Official Cash Rate (OCR), which would feed through directly
into higher mortgage rates. However, while higher policy rates may well be needed next year
as expanding domestic demand starts to generate overall inflation pressures, this is not the
case at present. Consumer Price Index (CPI) inflation currently remains below our 1 to
3 percent inflation target. Furthermore, with policy rates remaining very low in the major
economies, and falling in Australia, any OCR increases in the near term would risk causing
the New Zealand dollar to appreciate sharply, putting further pressure on New Zealand's
export and import competing industries.
In the current situation, where escalating house prices are presenting a threat to financial
stability but not yet to general inflation, macro-prudential policy offers the most appropriate
response.
3. The role of macro-prudential policies
One of the major insights from the Global Financial Crisis (GFC) was how rapidly macro
instability could develop even though an economy might be growing close to its potential,
and be experiencing sound fiscal policy and price stability. Economic and financial risks can
build up for several reasons, including over-investment in particular sectors such as housing,
a rapid increase in leverage in the banking and shadow banking sectors, and excessive
household indebtedness. The output losses and increased human distress from the massive
adjustments in the balance sheets of households, corporates, banks, and governments are
still being felt in many countries five years after the initial impact of the GFC.
The fallout from the GFC triggered a renewed interest in macro-prudential policy in several
countries. While micro-prudential policy settings (e.g., capital ratios and risk weights) are
fixed on a through-the-cycle basis, macro-prudential policy measures provide an overlay to
mitigate significant but transitory risks (such as credit and asset price cycles) that can
endanger the economy and the financial system.
a Memorandum of
In May 2013, the Minister of Finance and the Reserve Bank signed
Understanding outlining the purpose of macro-prudential policy, the range of policy
instruments, and governance arrangements relating to their possible deployment. The
macro-prudential policy framework seeks to build additional resilience in the domestic
financial system during periods of rapid credit growth, rising leverage, or abundant liquidity.
The instruments can also help to dampen growth in asset prices that pose risks to financial
stability.
The macro-prudential measures may require banks to hold additional capital buffers, have
higher proportions of stable funding, or limit the share of high loan-to-value ratio (LVR)
residential lending. Instruments such as the counter-cyclical capital buffer and sectoral
capital overlays require banks to hold additional capital against potential shocks in asset
markets or particular sectors. A temporary increase in the core funding ratio would make
banks more resilient to liquidity shocks and, like capital buffers, serve mainly to increase the
resilience of bank balance sheets rather than have a significant dampening effect on asset
cycles.
LVR restrictions have the added benefit of dampening asset prices more directly, by affecting
the supply and cost of high LVR lending as well as reducing the riskiness of bank loan
portfolios.
High LVR lending, as reflected in mortgage lending to borrowers with less than a 20 percent
deposit, has constituted around 30 percent of new mortgage lending in recent months - up
from 23 percent in late 2011. This high LVR lending is a significant factor behind the buoyant
housing demand in some regions.
Over recent months, the Reserve Bank has been consulting with the banks on the use of
macro-prudential instruments and on how LVR restrictions could be implemented in New
Zealand. Today we are announcing the introduction of speed limits on high LVR lending with
an implementation date of 1 October 2013. These are designed to help slow the rate of
housing-related credit growth and house price inflation, thereby reducing the risk of a
substantial downward correction in house prices that would damage the financial sector and
the broader economy.
Under the LVR "speed limit", banks will be required to restrict new residential mortgage
lending at LVRs of over 80 percent to no more than 10 percent of the dollar value of their
new housing lending flows. However, some loans will not count towards the banks' use of the
speed limit. These include Housing New Zealand's Welcome Home Loans, bridging loans,
refinancing of existing loans and high-LVR loans to existing borrowers who are moving
home but not increasing their loan amount. Allowing for these exemptions, we estimate that
the 10 percent speed limit will effectively limit the banks' high-LVR lending flows to about
15 percent of their new residential lending.
Banks commonly issue mortgage borrowers with pre-approvals, which represent a firm
commitment to provide housing finance and may be valid for up to six months. Banks raised
the issue of these pipeline approvals in responding to the Reserve Bank's consultative
document so, as an initial transitory step, we are allowing banks to meet the 10 percent
speed limit on high LVR lending measured as an average rate over a six month period.
Thereafter, the speed limit for banks with lending in excess of $100 million per month will
apply to the average rate over rolling three-month windows, as originally proposed. However,
we would expect the banks to modify their approach to issuing pre-approvals, in order to
ensure that they fall within the 10 percent "speed limit" on an ongoing basis.
Banks with mortgage lending below $100 million per month will be required to meet the
speed limit on the basis of high-LVR lending rates over rolling six-month windows, to reflect
the greater volatility seen in the high-LVR lending of the smaller banks.
When LVR measures have been introduced overseas they often represent a strict
moratorium on high LVR lending5. The speed limits we have set will enable some growth in
high LVR lending and should have the effect of slowing the rate of growth in house prices.
In this way, LVR restrictions will support monetary policy. While the primary purpose of the
restrictions is financial stability, they will also provide the Reserve Bank with more degrees of
freedom in conducting monetary policy. In particular, they will provide the Bank with greater
flexibility in considering the timing and magnitude of any future increases in the OCR. This
flexibility around the need for interest rate adjustments is especially useful in light of the
overvalued New Zealand dollar and the international monetary conditions currently facing New
Zealand.
Like any other form of regulation, speed limits on high LVR lending will create incentives for
lenders to introduce lending products designed to circumvent the regulation. We are
concerned to ensure that specially designed lending products are not developed with the
purpose of avoiding or undermining the LVR restrictions. This is why our framework for
implementation will state that banks should not enter into any arrangements to avoid the LVR
restrictions, and we are providing guidance as to the types of measures that the Reserve
Bank would be concerned about if used to circumvent the LVR restrictions.
The Reserve Bank expects bank senior management and bank boards to respect the spirit
and intent of the LVR restrictions and to closely monitor the level of high LVR lending.
An important issue is how long LVR restrictions might be imposed. This largely depends on
the effectiveness of the measures in restraining the growth in housing lending and house
price inflation. The measures will be removed if there is evidence of a better balance in the
housing market and we are confident that their removal would not lead to a resurgence of
housing credit and demand. We will monitor closely the impact of the restrictions, and report
on that in our Financial Stability Reports. If the measures are not considered to be effective
(and cannot be made effective through altering the details of the policy) they will be removed,
but in this case their removal might necessitate higher interest rates than otherwise, or the
imposition of alternative macro-prudential requirements.
Concluding comments
The outlook for the New Zealand economy over the next two years is for GDP growth to
increase and the recovery to become more broadly based. Investment in Canterbury
reconstruction is not expected to peak until 2015 and 2016. By this time the residential
building programme in Auckland should be well advanced, and the additional supply in
Auckland and Christchurch should bring greater balance to the housing market.
But many of the challenges discussed today will be with us for a considerable time,
particularly as New Zealand is likely to continue to be one of the most rapidly growing
advanced economies over the next two years. The challenges we face with an over-valued
exchange rate and over-valued housing market are not likely to dissipate quickly given the
extent of the supply/demand imbalance in the housing market and the likely continued
attractiveness of New Zealand assets to foreign investors.
It is critical that priority be given to implementing the measures needed to alleviate the
shortage of housing and land supply, which is the dominant cause of the increase in house
prices in Auckland and Christchurch.
But the LVR restrictions announced today have a useful role to play alongside the supply
measures. Both can help reduce the risk of a house price boom ending in a severe housing
downturn that causes substantial damage to the financial sector and the economy.
Provided loan-to-value restrictions help to dampen house price inflation, they will also assist
monetary policy. As such, they increase the flexibility available to the Reserve Bank in
determining the timing and magnitude of future adjustments to interest rates. This is not the
primary reason for the policy, but could be valuable given the ongoing highly accommodating
monetary conditions in international financial markets.