alan bollard : financial stability challenges for small open economies remarks by dr alan bollard, governor of the reserve bank of new zealand, at the international symposium on “ globalisation, inflation and monetary policy ”, organised by the bank of france, paris, 7 march 2008. * * * two asset prices that are of particular interest for policymakers in most small open economies are house prices and the exchange rate. over the past decade, the “ global savings glut ”, declining interest rates and a search for yield drove up exchange rates for many small open economies such as australia and new zealand and also helped fuel a sharp increase in house prices in many countries. recent developments in global markets stand to have further impacts on housing markets and exchanges rates and create some new challenges on both the monetary policy and financial stability fronts. the experience of the past decade is now doubtlessly familiar. the decline in interest rates was reinforced by the “ great moderation ” in the apparent variability of most economies. investors became more willing to accept risk, partly in order to maintain returns as risk free interest rates dropped, and partly because the risks seemed smaller. from a monetary policy perspective, the past decade highlighted some of the challenges that we face in trying to run an independent monetary policy in a connected world. in targeting inflation, as many small open economies do, we set a domestic policy interest rate, which has some bearing on domestic monetary conditions. but domestic monetary conditions also hinge on what is happening to interest rates across the rest of the world. sometimes global interest rate developments are “ in sync ” with domestic monetary policy and support it. at other times, they are “ out of sync ” and can work against it, making monetary policy spongier, and perhaps less effective at the margin than would otherwise be the case. at times over the past decade, monetary policy in new zealand and some other smaller open economies had to contend with global interest rates that were considerably lower than domestic economic conditions would warrant. financial institutions in these countries were able to access cheaper funding than they could obtain domestically, exchange rates rose to uncomfortable levels on the back of the carry trade and some asset markets – such as housing – were able to surge on the back of lower effective interest rates than domestic policy settings might suggest. a strong element of the capital flow into new zealand – and this is a financial innovation, though now a relatively old one – has been the issuing of fixed income nz dollar securities to international retail investors by very high

quality international names such as the world bank. the willingness of these investors to take nz dollar risk at elevated currency levels has helped keep the currency relatively high and short term interest rates a bit lower than would otherwise have been the case. this has been far from an ideal mix of monetary conditions at a time when most of the inflation pressures have been concentrated in interest rate sensitive sectors like the housing market. the possibility of collateral damage on the country ’ s tradable sector has to be taken seriously. in new zealand, we have done significant work, documented in a number of studies on our website, on whether there might be additional regulatory measures or other policies that may have helped adjust the balance of monetary policy pressure to better match the underlying inflation pressure. it will not surprise anyone in this room to know we have not found a “ silver bullet ”, although analysis continues. besides retail investors, we have also seen the presence of institutions such as hedge funds engaged in the “ carry ” of funds borrowed in low yielding markets to invest in markets like new zealand. an unresolved debate is whether these hedge funds actually provide additional market liquidity for smaller economies or whether they effectively soak it up – particularly in troubled times. the role that these hedge funds can play at the stage where an over - valued exchange rate begins to adjust back to a more normal level is also unclear. whether hedge funds assist the adjustment process or whether they make it more abrupt and costly, is debatable. many countries have seen pronounced strength in property markets over the past decade. strong residential property markets have often gone hand in hand with strong consumer spending. new zealand has been a leading example. house prices have risen substantially as a ratio to income over the past five years. as longer term interest rates have risen recently in new zealand, and housing turnover has slowed, the elevated level of house prices has looked increasingly unsustainable. one interpretation of recent housing cycles is that a “ glut of capital ” lowered interest rates and putting upward pressure on house prices, creating a persistent tail wind for some economies. as houses change hands and are more heavily borrowed against, equity is withdrawn by the seller, who may often choose to spend the money. this has helped to keep demand very robust in new zealand for a number of years and seems to have supported consumer spending as well. with recent developments in global finance markets, we now seem to be moving into a new era and policymakers are facing some new challenges on both the monetary