Appendix: Financial market impacts of a “sudden stop”

Interrupted funding markets

Under a worst case scenario, the rising cost of servicing offshore debt would further increase the level of borrowing required to meet the higher servicing cost. This could precipitate a dynamic of spiralling debt. In this situation, demand for New Zealand dollars could completely dry up, as investors sought to reduce exposure to New Zealand-denominated investments because of insolvency fears. This is a so called “sudden stop” on New Zealand international funding. National solvency risk would therefore first present as liquidity risk with banks not being able to roll over their New Zealand denominated/hedged offshore loans. In this instance, banks would have to rely heavily on the RBNZ to bridge the funding gap.[40]

Although New Zealand never fully reached this scenario, except but for a brief period at end of 2008, it was still necessary for Crown guarantees to be put in place to assist banks in raising offshore funds. However, bank recapitalisation was not required as banks remained solvent throughout the period.

A seriously damaged banking sector would severely restrain domestic credit availability, which would have long-term consequences for GDP levels. But also demand for credit would be low, as eventually individuals would face default as result of the financial crisis. This would further add to banks financial stresses.

Lower exchange rates

With international investors avoiding New Zealand currency assets together with considerable monetary stimulus, the currency would likely come under pressure. Current buying pressure would turn into selling pressure. The result would be offshore creditors taking currency losses. This is the very risk that international creditors would have been concerned about and trying to avoid. Therefore, paradoxically, in trying to avoid losses, first movers taking remedial actions to reduce New Zealand dollar exposure would be the cause of the losses that late movers are likely to incur. This is particularly relevant to New Zealand, as a significant portion of New Zealand's offshore funding remains short-term wholesale debt that has to be regularly rolled over.

A large fall in the currency would have little direct financial impact on New Zealand's banks because most foreign-currency debt is hedged. However, the fall could be quite disorderly at times, and require some intervention to maintain a functioning market.[41] The currency could fall well below the low recorded in 2000 of a TWI around 46; well below what is likely to be necessary for achieving external balance (New Zealand currently has a TWI around 70).

Very large exchange-rate movements, if sustained for any length of time, would have large redistributive effects across the economy. This would have substantial real economic costs weighted to the short term, as the domestic economy contracted in the transition to a lower equilibrium exchange rate level. This is because import prices would be pushed sharply higher to the detriment of consumption. But, a very low exchange rate would also provide a large income boost to exporters, which would encourage a switch to further tradables production, notwithstanding the natural time lags in growing further agricultural output.