5 Policy options for reducing exchange rate variability

This section considers policy options for dampening high exchange rate variability under two categories: policies that would require a change from New Zealand's current, free-floating exchange rate regime, and policies that could potentially improve New Zealand's current regime.

5.1  Changing the regime

Figure 7 shows a spectrum of possible exchange rate regimes. New Zealand's exchange rate regime lies near the far right of the diagram, despite some foreign exchange intervention in limited circumstances.

Figure 7: Spectrum of exchange rate regimes

Source: Hunt (2005)

There are a number of possible alternative exchange rate regimes. This section focuses on the most often cited alternative regimes for New Zealand and explores their possible economic implications. The smallest change of regime is discussed first, which would be to engage in more active foreign exchange intervention. Some recent examples of foreign exchange intervention both in New Zealand and abroad are explored.

Singapore's intermediate regime and Hong Kong's currency board are then discussed. Finally, this section looks at the options at the fixed end of the spectrum: a currency union with Australia and fixing the New Zealand dollar to the US dollar.

5.1.1  Recent examples of foreign exchange rate intervention

Divergent global economic performance is currently causing a rapidly changing exchange rate policy environment. Due to the complexity and rapid pace of global developments, this paper does not attempt to address the current situation in detail, nor explore all recent examples of foreign exchange intervention. What this paper does do is cite some recent examples of intervention policies that can shed some light on New Zealand's situation and the usefulness or otherwise of employing these policies in New Zealand.

Many countries have engaged in foreign exchange intervention to influence their exchange rates in the previous few years.[16] New Zealand undertook foreign exchange intervention in 2007 for the first time since the dollar was floated in 1985. The RBNZ undertook currency intervention because they had judged that the level of the exchange rate was exceptional and unjustified and that intervention would be consistent with the RBNZ's monetary policy objectives as set out in the Policy Targets Agreement (Eckhold, 2010).

The first round of intervention had an impact on the exchange rate over several days. It helped to create doubt in the market about the future direction of the exchange rate and sent a signal to the market that the RBNZ was concerned about the high value of the New Zealand dollar (Spencer, 2007).[17]

A more recent example of exchange rate intervention is by the Swiss National Bank (SNB) in 2010 to slow the appreciation of the Swiss franc against the euro. The Swiss franc was seen as a safe haven currency when the Euro Area begun to face financial troubles. The SNB increased its holdings of foreign exchange reserves by SFr77.8 billion (16% of GDP) in May 2010, which took the total acquired to SFr138.5 billion (28% of GDP) since January 2010 (The Financial Times, 2010). The SNB also engaged in foreign exchange intervention from September 2008 until approximately June 2009. Swiss interest rates are near zero, reducing the cost of building up such large foreign exchange reserves. This is in stark contrast to New Zealand, which faces much higher domestic funding costs, significantly increasing the cost of intervention.

It is difficult to assess the impact of intervention because the counterfactual is unknown. The Swiss franc continued to appreciate against the euro after the SNB periodically intervened in the foreign exchange market from January 2010 until approximately May 2010 (figure 8).[18] This Swiss intervention came at a heavy cost given the exchange rate continued to appreciate. However, this loss may be reversed in the coming months and years if the Swiss franc depreciates, increasing the value of the SNB's existing holdings of foreign reserves (as was the case for the RBNZ in 2007).

Figure 8: The appreciation of the nominal Swiss franc against the euro

Source: Bank of England, Swiss National Bank, author's calculations.

Chile and Israel have also recently engaged in or announced foreign exchange intervention to slow the appreciation of their currencies. Chile announced in January 2011 that it would buy US$12 billion of foreign reserves in 2011 (The Economist, 2011). Israel ran a pre-programmed intervention policy during 2008 and 2009 to slow the appreciation of its currency in the face of a relatively strong economy compared to many other economies coinciding with an influx of capital.

In the past there has been a tendency among some commentators to view exchange rate regimes in terms of corner solutions, where countries either fully fix or float their exchange rates due to the difficulty of defending a particular level of the currency. The experience of countries like Switzerland suggests a need to monitor and identify how successful active management of the exchange rate can be. Country-specific factors are important to the various outcomes of foreign exchange intervention (e.g. large balance sheet and low average real interest rate in the case of Switzerland), which New Zealand does not possess in most cases.