Academic journal article The Reserve Bank of New Zealand Bulletin

Foreign Currency Reserves: Why We Hold Them Influences How We Fund Them

Academic journal article The Reserve Bank of New Zealand Bulletin

Foreign Currency Reserves: Why We Hold Them Influences How We Fund Them

Article excerpt

Introduction

Almost all countries hold foreign currency reserves. Doing so provides options-a self-insurance of sorts that would not exist so readily in the absence of reserves. What options a country wishes to provide for will in turn depend on a number of other choices.

For a country with a fixed exchange rate and free cross-border capital flows, a large stock of reserves may be required to maintain the desired exchange rate. In that case, reserves help limit foreign exchange rate risk as well as ensuring the availability of foreign currency to facilitate cross-border transactions.

For an advanced country with a floating exchange rate, a much smaller stock of reserves is typically required. Intervention in the exchange markets is infrequent in these economies, and the primary reasons for holding reserves may relate to the risk that extreme market disorder could compromise the functioning of the foreign exchange markets in ways that create difficulties for the real economy of the financial system. Not all advanced floating exchange rate economies have a modest level of reserves, but most do. New Zealand is one of those countries.

The intended uses of foreign currency reserves, in turn, have influenced the approach New Zealand has taken to funding those resources. Different funding approaches have different characteristics, particularly in terms of rollover risk, influence on the foreign exchange market, and cost.

This article outlines the statutory framework for holding reserves in New Zealand, and how that has translated into the relatively unusual approach taken in New Zealand to financing the foreign reserves held as foreign exchange intervention capacity.

1 Foreign currency reserves: insurance against what?

The monetary policy framework and exchange rate regime: a brief history

The so-called monetary policy "trilemma" (figure 1, overleaf) is one lens through which we can understand the role of foreign currency reserves. The monetary policy trilemma (2) states that it is impossible to have all three of the following at the same time:

* a fixed nominal exchange rate;

* an independent monetary policy; and

* free capital movement.

For decades prior to 1985, New Zealand's economy was quite highly regulated and the New Zealand dollar exchange rate was fixed (but adjustable from time to time). Foreign reserves were held by the Reserve Bank and the Treasury, and were used routinely to maintain and manage the fixed exchange rate. For most of the period, and until just three months prior to the float, private capital flows were tightly restricted, and short-term private capital inflows were largely prohibited.

[FIGURE 1 OMITTED]

In principle, this combination of capital controls and a fixed nominal exchange rate implied a good degree of control over both inflation and the exchange rate. In practice, that control was exercised in a way that meant that inflation was high throughout the 1970s and early 1980s, and even during the fixed exchange rate period, the real exchange rate tended to be quite variable (Figure 2) as a result of devaluations, occasional revaluations and differences between domestic and foreign inflation.

[FIGURE 2 OMITTED]

New Zealand's current approach to foreign reserves was formed in the late 1980s, in the context of far-reaching public sector management and financial reforms, including the 1985 move to a freely floating exchange rate. The move to a floating exchange rate was an integral part of securing domestic monetary control and ending New Zealand's protracted period of high inflation. By the late 1980s, the choices New Zealand had made in terms of the trilemma were fairly clear: the nominal exchange rate had been freed to float; capital flows had been liberalised; the 1989 Reserve Bank of New Zealand Act established domestic price stability as the objective of monetary policy (figure 1). …

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