Cullen Michael: Motions — Reserve Bank Funding Agreement—Ratification 
Cullen Michael: Motions — Reserve Bank Funding Agreement—Ratification 
[Volume:616;Page:12398] 
The amendment to the funding agreement is part of a package of measures to better equip the Reserve Bank to intervene in the foreign exchange market. The main change to the funding agreement is that any market losses sustained by the bank as a result of intervening in the foreign exchange market will not be treated as expenditure for the purpose of the funding agreement and will not cause the bank to breach the maximum allowable expenditure under the agreement. This is consistent with the intent of the funding agreement arrangements in the Reserve Bank of New Zealand Act which focus on the amount of income the bank is permitted to retain to meet its operational expenses. Market losses on currency positions are not part of the bank’s operational expenses but arise in exchange rate and interest rate movements which are generally not controllable by the bank. It is therefore appropriate that these expenses are not included in the funding agreement. However the bank will still be required to report any market losses in its statement of financial performance in accordance with New Zealand accounting practice and will still be accountable for all aspects of its financial performance in risk management.  
The other changes that have been agreed by the Government which support the bank’s ability to intervene in the foreign exchange market are the increase in the bank’s equity and the increase in its holdings of foreign currency reserves. Taken together these measures will strengthen the bank’s capacity to intervene in the foreign exchange market for two purposes. The first is to stabilise the market in periods of market dysfunction such as when the market is very liquid. This has been the bank’s intervention policy objective for many years. The Government has agreed to substantially increase the bank’s reserves for that purpose giving the bank access to around $7 billion in reserves for market stability purposes.  
The second is to reduce exchange rate variability by intervening in the market where the exchange rate is either severely over or undervalued relative to economic fundamentals. This is a new policy for the bank. Why has the bank proposed to adopt this new intervention policy and why has the Government supported its adoption? To answer that let me step back in time to the adoption of the currency exchange rate regime in 1985. New Zealand dollars floated in March 1985 after many years of unsatisfactory attempts to manage a fixed but adjustable exchange rate system. Since then New Zealand has maintained a clean float. The Reserve Bank has not intervened in the foreign exchange market in that period to influence the level of the exchange rate. In general the floating exchange rate has served New Zealand well. It has allowed monetary policy to be directed at domestic price stability with obvious success.  
 It has avoided the serious risks of prolonged exchange rate misalignment associated with fixed exchange rates. It has avoided the fiscal costs so frequently associated with maintaining a fixed exchange rate. The floating exchange rate has also provided a flexible mechanism to enable the economy to adjust to changing economic circumstances at lower costs than would otherwise have been the case. It has reduced the risk of serious financial crises often associated with pegged exchange rates. 
But as in other countries with floating exchange rates New Zealand’s currency is subject to major cycles which can be destabilising to individual businesses and to the economy at large. Hedging by companies against currency risk can only moderate not eliminate this impact. For the most part such exchange rate cycles are a fact of life that we will not be able to do anything about. However the Reserve Bank has advised that a well-timed intervention in the foreign exchange market when the exchange rate is markedly over or under valued relative to economic fundamentals can help to reduce the peaks and troughs in the exchange rate cycle. 
The bank is not expecting to intervene often and is not promising that intervention will always succeed but it considers there will be opportunities to make a small but valuable difference where that is consistent with the bank’s price stability target. Indeed it advises that to fail to take advantage of such opportunities would be to abrogate the bank’s responsibilities in the policy targets agreement to avoid unnecessary instability in the exchange rate. 
The Government weighed four issues before agreeing to provide the Reserve Bank with additional capacity to undertake foreign exchange market intervention. One obviously was the cost to the taxpayer for a mistimed or misjudged intervention. There are numerous so-called “war stories” about foreign exchange market interventions going wrong—George Soros and the Bank of England springs to mind as does our own experience in 1984. But these are examples of Governments defending an exchange rate that was not sustainable and indeed was fixed. They were trying to prevent an adjustment in the normal range of the exchange rate rather than trying to influence the extreme peaks and troughs around that normal range. The Reserve Bank will not be doing that. However as the bank has itself made clear any intervention carries some element of financial risk—but of course in economists’ language risk is both up and down both positive and negative. 
The bank will almost inevitably carry market losses on its books from time to time but these will generally be of an unrealised and non-permanent nature. They are likely to reverse as the exchange rate cycle progresses—that has been the experience in Australia. 
The second risk would be if monetary policies’ prime focus on maintaining price stability were subverted. That is why having the Reserve Bank conduct intervention under section 16 of the Reserve Bank of New Zealand Act consistent with the policy targets agreement is such an important part of the arrangement that the bank is proposing and it is vital to keep politics out of this exercise. The bank must have the capacity to make the decision not to intervene where that would be inconsistent with the bank’s statutory mandate of achieving price stability with the bank’s obligations under the policy targets agreement or when the bank does not think there is much scope to influence the exchange rate. 
The third risk is that currency speculators could be attracted to New Zealand. That is not to say that we do not see currency speculators attracted to New Zealand in any case—some indeed are attracted back to New Zealand. This is a real risk where a central bank defends or targets a particular exchange rate but the risk is much much less when the central bank merely seeks to trim the peaks and troughs in the exchange rate cycle as it is not seeking to keep the exchange rate within a target band. No target band has been set for this exercise. 
Finally there is the risk that businesses are fooled into thinking that they need no longer manage their own exchange rate risks—that the Reserve Bank will do that for them. Given the fact that exchange rate cycles are here to stay—a fact that will not be changed by the Reserve Bank’s foreign exchange market intervention—the risk of businesses being fooled into thinking they need no longer manage their currency risks is very low indeed. In fact they need to understand that they continue to have full responsibility for managing their currency risks and the Reserve Bank will doubtless be reminding them of this at every opportunity. 
All in all the change to the Reserve Bank’s exchange rate intervention arrangements is not particularly big but one that is likely to have a big effect. But any small moderation of the excessively variable exchange rate cycle would be welcome. The costs and risks are relatively small well understood and well catered for in the proposed arrangement. I therefore ask for the House’s support. I thank both New Zealand First and the Greens for their indications that that support is forthcoming and I note with some gratitude that the National Party’s position is that it will oppose it but if it should become the Government it will not change it.