5.2 Policies to improve the current regime

Based on current information, there is not a compelling case for New Zealand to move away from a floating exchange rate regime based on current information. This paper now turns to discuss policies that could help to improve New Zealand's freely floating exchange rate regime. An in-depth analysis of policies that could help to dampen large exchange rate cycles was completed in 2006 and 2008 in the Supplementary Stabilisation Instruments (SSI) work completed by Treasury and the RBNZ and the subsequent Finance and Expenditure Committee (FEC) inquiry into monetary policy in New Zealand.[27] It is useful to examine whether the views remain the same several years on in light of recent economic developments. However, underlying all of the discussion below is the conclusion from the FEC inquiry and the SSI work by the RBNZ and Treasury: that the current monetary policy framework is the most suitable for New Zealand.

Housing market pressures were a big feature of the last economic boom. House prices were overvalued, and much of the discussion of policies to mitigate large exchange rate cycles focused on policies to reduce these pressures. The next boom may not contain such a presence of housing.

Many of the policies discussed below have been analysed in terms of their ability to dampen high exchange rate variability. It is worth noting that some of these policies may be worthwhile in their own right.

There is unlikely to be a silver bullet that would reduce exchange rate variability without cost. Some policies may have a big impact on exchange rate cycles, but may have other adverse effects. In fact, many of the policies discussed in this paper only have the potential to reduce the very extreme peaks and troughs of exchange rate cycles. This paper now turns to examining some proposed policies.

5.2.1  Policies that are worth pursing

The FEC inquiry concluded that fiscal policy and housing policy were deemed to be worth pursuing for exchange rate stabilisation purposes.

Fiscal policy has an impact on the exchange rate through two channels. The first is through adding or subtracting from demand in the economy, which has a direct impact on the rate of inflation a country faces. Monetary policy then responds to changes in the level of inflation by altering the level of interest rates. Interest rate differentials between countries are a key driver of the exchange rate. Second, government spending can absorb scare resources in an economy, potentially taking them away from more productive uses. This can take resources away from the tradable sector.

A more stabilising fiscal policy can thus play a role in helping to stabilise the exchange rate. The key is for fiscal policy to provide more support to monetary policy, so that interest rates do not have to be raised so high during economic upturns. In practice, however, political economy considerations often make it very difficult to run tight fiscal policy during boom years. That, together with the fact that it can be very difficult to distinguish between cyclical and structural revenues, often leads to pro-cyclical fiscal expansions during upturns.

The FEC inquiry proposed further exploration of a range of policies to help reduce pro-cyclical fiscal policy. These included: higher thresholds around discretionary policy changes, targeting structural balances, introducing expenditure targets and rules to allocate surpluses and stabilisation funds as options worth exploring. By constraining the growth in government spending during economic booms the degree of upward pressure on the exchange rate can be reduced. Recently the Government did consider adopting an expenditure limit, although this was intended more to help control the growth in government expenditure, rather than to dampen exchange rate variability. However, the Government has decided not to proceed with an expenditure limit (Minister of Finance, 2010). Further work is currently underway to explore alternative ways of reducing the pro-cyclicality of fiscal policy (Brook, 2011).

Fiscal policy (mainly high government spending) has also played a part in recent times in the sustained overvaluation of the NZ dollar (see pages 12 and 13). In the period from 2005 to 2008 the economy was operating above full capacity. Therefore, via high growth in spending, the government sector was adding directly to inflation and taking scarce resources away from other parts of the economy, particularly the tradable sector. This was despite the Government running fiscal surpluses. For these reasons fiscal policy could play a role in helping to reduce the average level of the exchange rate. If the Government's operating deficit was reduced faster than currently planned this would also assist in achieving a lower exchange rate in the short-term.

Improving the responsiveness of housing supply could help to alleviate price pressures in the housing sector. Improvements to the Building Act and Resource Management Act are underway, though it is unclear whether these changes will significantly increase the responsiveness of housing supply. In any case, it is not clear to what extent the housing market will be a driver of future cycles.

The Global Financial Crisis has highlighted the need for increased resilience and stability of the financial system. There is also increased international attention on whether prudential policies aimed at enhancing financial stability could also have potential side benefits for stabilising the economic cycle. For example, the Basel Committee on Banking Supervision recently released a consultative document outlining a proposal for a countercyclical capital buffer regime (Basel Committee, 2010). Prudential policies could help to reduce the credit cycle and in turn take pressure off monetary policy and the exchange rate. However, while a counter-cyclical capital buffer might help financial stability (by requiring banks to have built up a bigger capital buffer at the end of the upswing), it is unlikely to make a material difference to the cycles themselves. This is because accessing capital is unlikely to be a binding constraint in upswings and very large changes in capital requirements (beyond what is probably credible) would probably be needed to make much material impact.

The Core Funding Ratio (CFR) recently introduced by the RBNZ may have some small stabilising attributes and, at the margin, reduce exchange rate variability. The CFR requires banks to hold a minimum ratio of retail and longer-term (greater than one year) wholesale funding. In the previous economic upswing, much of the increase in credit growth was funded by banks borrowing overseas in short-term wholesale markets, which provided a cheap and readily available source of funding. The CFR will reduce the ability of banks to use short-term offshore funding to expand credit, which may potentially dampen credit growth. The CFR has also increased the margin between retail and wholesale interest rates, which reduces the extent to which the OCR needs to increase to maintain low inflation. The increased wedge between retail and wholesale interest rates may dampen the carry trade because it may result in less attractive interest rates for foreign investors (Spencer, 2010).[28]

Further work is needed on these issues, although at this stage it is likely that any potential counter-cyclical effects of macro-prudential policies are likely to be small. They may still be worth having, but they are unlikely to remove the primacy of traditional macro stabilisation instruments like monetary policy and fiscal policy.

5.2.2  Policies that are not worth pursing based on current assessments

The SSI and FEC inquiries in 2006 and 2008 respectively examined other potential policies and subsequently deemed them not worth pursuing. Moreover, because the last cycle was dominated by the housing market, many policies focused on ways to reduce these housing pressures. Many of the policies that involved housing and lending were considered problematic, in that they were complicated or would create significant distortions. These included a mortgage interest levy, discretionary limits on loan to value ratios, stamp duties, migration policy and loss ring-fencing (for more detail on these policies see the FEC inquiry or SSI reports). However, some of the policies considered not worth pursuing for New Zealand have since been discussed or implemented offshore in the wake of the Global Financial Crisis, in particular, a Tobin tax and variable indirect taxes.

A Tobin tax is a tax on financial transactions, aimed at limiting short-term currency speculation, and has been often proposed as a way of limiting large exchange rate cycles. Such a tax is a tax on gross transactions; that is, the tax is paid twice, once when foreign exchange is acquired, and again when it is sold. Double taxation at a fixed rate has the crucial consequence of discriminating automatically against short-term capital (Federal Reserve Bank of San Francisco, 1999). Alternatively, it is possible to have a financial transactions tax that only taxes withdrawals. This is the case in some Australian States (though they exclude wholesale transactions). A tax on financial transactions has been recently proposed by the French as part of G20 discussions (The Financial Times, 2011b). Overall, the assessment of the FEC report was that a Tobin tax is not feasible at a national level; it would need to be part of a global effort to be effective.

There are serious obstacles to implementing an enduring and efficient system of controls on capital movement. Even if the controls could be enforced, long-term effects on the costs of capital for businesses and households could be negative (RBNZ submission to the FEC inquiry, 2008). International evidence also suggests that capital controls have little effect on the exchange rate, although for emerging market economies they may be justified on prudential grounds in some circumstances (Ostry et al., 2010). Overall, there is scepticism as to the effectiveness of capital controls. In a developed economy with sophisticated capital markets it is likely that market players will find a way around the controls. New Zealand is very dependent on the free flow of international capital, and there is a tension between raising the cost of capital and reducing exchange rate variability.

Capital controls have been employed by many countries in the past two years in an attempt to control or restrain the upside of the exchange rate cycle. In October 2009 the Brazilian authorities imposed a 2% tax on foreign purchases of domestic bonds and equities. The IMF noted in August 2010 that this tax had some impact on slowing capital inflows. But the Brazilian real continued to appreciate and in October 2010 this tax was doubled to 4%, and then again raised to 6% two weeks later. The Brazilian real has appreciated by 38% against the US dollar over the past two years (to 1 January 2011) (The Economist, 2011). Ultimately, it is difficult to isolate the direct impacts of capital controls on the exchange rate because the counterfactual is unknown.

Having a variable rate of GST has been suggested as a supplement to the OCR. The idea is that in periods of significant pressure on resources it could be raised to dampen this pressure, and in times where inflationary pressures were weak it could be lowered to increase demand. New Zealand's recent increase in GST may provide further insights into the potential impact of a change in GST. However, while a variable GST could have an impact on exchange rate cycles, the large administration and compliance costs, together with constitutional and governance issues would likely make it unworkable.

5.2.3  Conclusions on policy options to improve the current regime

There is no silver bullet available to help to moderate the high exchange rate variability seen in New Zealand. Fiscal policy, housing policy and perhaps prudential policy are all worth pursuing in their own rights, and all may have some small impact on the peaks and troughs of exchange rate cycles. More targeted policies could have an impact on exchange rate variability, but they come at a heavy cost.