The Evolving Role of Central Banks

9 Central Bank Independence in New Zealand

Patrick Downes, and Reza Vaez-Zadeh
Published Date:
June 1991
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Since the commencement of New Zealand’s new central banking legislation, on February 1, 1990, the Government that created it has been voted out of office, but not because of the legislation—although the prolonged drive toward lower inflation has undoubtedly been politically costly. The change of government is not likely to have a significant effect on the legislation itself because both main political parties supported its introduction—a very unusual circumstance deriving partly from the widely perceived misuse of the previous legislation by the so-called conservative National Government in the early 1980s.


The relevant part of the old legislation (Reserve Bank Act of 1964) provided for the Reserve Bank to provide advice to the government on monetary policy and to carry out the monetary policy of the government. There was also a mixed bag of objectives for monetary policy, which included the maintenance and promotion of social welfare; the promotion of trade, production, and full employment; and the maintenance of a stable internal price level. At times the relative importance of the objectives was changed according to political whim or current political pressures. Hence, the Bank had great difficulty in giving consistent advice to the government in terms of the legislation. Not only were there inherent conflicts between these objectives but also absolute power in decision making was in the hands of the minister of finance—a set of circumstances that led to a disastrous outcome for the New Zealand economy in the early 1980s.

New Zealand’s Economic Scene in 1982–84

Advice given by the Reserve Bank and the treasury on monetary policy was rejected by the Government. Large fiscal deficits arose—financed by a mix of Reserve Bank credit, compulsory government stock purchases by financial institutions, and foreign borrowing. After a prolonged period of high inflation, a price and wage freeze was imposed in an attempt to suppress inflation. Control of all interest rates and of the lending activity of institutions was widespread. No effective monetary policy was being applied; the fixed exchange rate was overvalued; large external deficits were present; external debt was growing; and, last, but not least, was a maze of controls on every aspect of the financial system.

Following my return to New Zealand in 1982, I was given the task of planning the eventual liberalization of the financial system. I became chairman of an informal high level committee of senior Reserve Bank and treasury officials. The committee examined the whole framework of the New Zealand financial system in detail and prepared a series of policy papers embodying proposals for eventual deregulation of the system.

A new (Labour) government was elected in July 1984 in the middle of a financial crisis. For a period of one month, the Reserve Bank faced the knowledge of an impending change of government and the promise of a significant devaluation of the currency. This expectation naturally placed enormous pressure on the foreign exchange market. We learned then just how ineffectual exchange controls can be: there was a massive outflow of foreign exchange in a very short period financed by large, short-term borrowings by the Reserve Bank of New Zealand and the New Zealand Treasury.

The new Government promptly took a number of new steps. The exchange rate was immediately devalued by 20 percent. Interest rate and other financial controls were quickly removed. The fiscal deficit was fully funded by the sale of government paper through the domestic capital market. Exchange controls were removed at the end of 1984, and the exchange rate was floated in March 1985. Orthodox monetary policy was restored, with low inflation the declared objective. The whole financial system was thus remodeled in a remarkably short time, perhaps illustrating that you do not have to have a crisis to bring about major economic reform, but it certainly helps.

The Reserve Bank Changes

The procedure for determining monetary policy and the Bank’s relationship with the government had been drastically changed in 1984, but with no change in the existing Reserve Bank Act. A new finance minister, Roger Douglas, came to the Reserve Bank in 1985 and suggested that the Bank explore ways for it to achieve more formal autonomy in the conduct of monetary policy. The main aim was to prevent a reversion to the kind of policy followed by former Finance Minister Muldoon and to protect the new framework by setting up procedures having transparency and clarity. Reserve Bank reform was also seen as a logical part of the general reform taking place within the New Zealand public sector. So a search for a new central bank statute began.

A range of central banking models was examined by Reserve Bank officials. The natural focus was on those with a high level of autonomy—Germany, the United States, and Switzerland. The eventual model chosen was probably more like that of Canada but with some unique features. The Reserve Bank staff team worked carefully through the technical issues, in close consultation with the treasury. Then it took another year for the legislative process to be completed before the new Act was passed in December 1989 and became effective from February 1, 1990.

The Framework

The framework of the Act was that price stability is the single basic objective of monetary policy, with some acknowledgement of the need for concern about the efficiency and soundness of the financial system. Public transparency was made a key feature; hence, there is provision for a Policy Targets Agreement to be signed by the minister of finance and the governor of the Reserve Bank. There is also provision for a six-monthly public statement by the Reserve Bank explaining the policy. The effect of the Act is to provide a trade-off between more policy autonomy for the bank and greater accountability—both in policy and financial terms—to the Government and the public.

There has been some argument about the single objective of price stability but generally support has been quite broad. It is interesting to note that manufacturers and farmers have taken different views of the new policy: farmers support it; manufacturers oppose it. The objective of inflation spelled out in the initial target agreement (0–2 percent by the end of 1992) has attracted much more criticism. The National Government elected on November 20, 1990 has proposed moving the target date to December 1993. The specific target arose primarily from a desire for clarity as to the meaning of price stability; some people would view it as being unduly precise.

There are four specific caveats within the target agreement allowing for the inflation target to be varied. These relate to a change in indirect taxes; a material change in the terms of trade (e.g., the current oil shock); a major domestic crisis; and a significant change in the consumer price index (CPI) arising from changes in house prices or mortgage interest rates. (This provision relates to Reserve Bank disagreement about the way the CPI is calculated.) The targets may be renegotiated if any one of these occurs.

Main Legislative Provisions

The key clauses of the new Act provide that the Bank formulate and implement monetary policy with the economic objective of achieving and maintaining stability in the general level of prices; that the minister, before appointing any person as governor, fix in agreement with that person policy targets for the Bank during that person’s term of office; that the Bank when formulating and implementing monetary policy have regard to the efficiency and soundness of the financial system and consult with and give advice to the government and others to achieve and maintain its economic objective; that the Government may direct the Bank to pursue an economic objective for monetary policy other than price stability for a period of not more than twelve months, with provision for extension; that the Bank publish statements at least every six months explaining its policies and objectives for the target period and reviewing its past performance; and that the governor be removed from office for, among other things, inadequate performance in relation to the policy targets. There is also provision for a five-year Funding Agreement to be signed by the minister and the governor, specifying the maximum allowable expenditure by the Bank over that period.1

Board of Directors

The principal role of the Board of Directors is to monitor the governor’s performance. The new Act provides for a maximum of ten directors, up to seven of whom will be outside directors. They have the power to recommend the governor’s dismissal (in extremis) but do not participate in policy formation; hence, they do not have advance access to market-sensitive information. The governor is chairman of the board (which will include two deputy governors in future—-one of whom will be deputy chairman of the board). Governors are appointed for five-year terms and other directors for three-year terms.

Functions of the Reserve Bank

Normal central bank functions will continue under the new Act. These include note and coin issue; foreign reserves management; bank licensing and supervision; and conduct of a stock registry (a commercial function for which a tax obligation will accrue). It is perhaps useful for me to comment on two specific functions: prudential supervision and bank licensing.

Prudential Supervision

Prudential supervision was first introduced in the 1986 Amendment Act operative from April 1987. The announced aim of the prudential supervision powers was to ensure the maintenance of public confidence in the financial system as a whole. It is important to note that there was no specific provision for either protection of depositors or the protection of individual financial institutions. This was made quite explicit.

As background, it is worth noting that there has been no history in New Zealand of deposit insurance or explicit depositor protection—one institution (Securitibank) was allowed to fail in 1977 and, more recently, the case of the Development Finance Corporation of New Zealand (DFC) in which the Government and the Reserve Bank played an important role in assisting a settlement with creditors involved use of the Bank’s statutory management powers under the Act.

The supervision initially covered licensed foreign exchange dealers, commercial banks (there were only four at the time), and any other nonbank financial institution specified by the Reserve Bank as being important enough to warrant supervision. The main practical aim was to provide a mechanism for collecting information on the main financial players and to maintain oversight of developments in the system.

The 1986 Act included extensive provisions for failure management, that is, preventing the failure of one institution from spilling over into a generalized loss of confidence in the financial system. There was a wish to avoid explicit regulatory controls; this was understandable in light of New Zealand’s previous negative experience with financial controls. Later, the capital adequacy proposals of the Basle Committee were adopted. Increasing attention was also given to specific supervisory matters, such as large exposure rules. The basic approach (i.e., financial system concern rather than depositor protection), nonetheless, remains in place. Coverage now extends to banks only, and banks are in future to be directly charged for 75 percent of the cost of supervision.

Bank Licensing

For many years the four major commercial banks in New Zealand (three overseas-owned, one government-owned) operated on comfortable margins with little real competition. The decision to open up the foreign exchange market was taken in 1983; some basic qualifying criteria were devised and the market was opened to new applicants. Soon there were about twenty players and foreign exchange margins were greatly reduced. In 1986, the banking market was opened, again with some basic qualifying criteria (e.g., minimum capital of $15 million) but with no specification by the authorities as to how many banks there should be. This was left for the market to determine. There was no headlong rush by new applicants. Initially, eight new banks (mainly overseas-owned) were licensed. Today, there are about twenty-two banks. One or two have come and gone, and there have been several mergers and takeovers. The banking system remains open and competitive. Some banks, notably the government-owned Bank of New Zealand, have had problems following the 1987 share-market crash, but there have been no serious concerns about the system as whole.

Appraisal of Progress

Inflation has come down to 5 percent (year to September 1990) after years of inflation at 10–20 percent. The 0–2 percent inflation target is still seen as achievable but will be very difficult. The new Government proposes to extend the target date to December 1993. The old built-in public inflation expectations of high inflation have made the job of getting inflation down difficult and have added to the social and economic cost of that process. Unemployment is now close to 8 percent and is much higher among the Maori population; Maoris comprise some 10–15 percent of the total population.

Political agreement is strained within both main parties; there are some outstanding dissentients (including former Finance Minister Muldoon) but they do not seem too important at this stage. The new finance minister, Ruth Richardson, is a tough and resolute inflation fighter. The framework of the Reserve Bank Act does not appear to be under any real threat.

The pre-election accord between the Government and the combined trade unions was an interesting exercise. The unions agreed to deliver a 2 percent wage round (plus some allowance for productivity) in return for government action on the fiscal deficit and the promise of a neutral monetary policy. The accord is clearly at risk with the new government in office.

Since February 1990, there has been some government criticism of Reserve Bank monetary policy actions in the financial markets. The imminence of the elections lay behind that criticism; it was a new experience that made everyone aware of the new world of central banking in New Zealand.

In summary, there have been some costs for the Reserve Bank in moving to the new legal framework, but there have also been considerable gains both for the policy role of the institution and, more important, for the future of monetary policy. The likelihood that New Zealand will maintain a stable financial environment in the future has probably been greatly enhanced.


The author is Deputy Governor of the Reserve Bank of New Zealand. This paper is a summary of the presentation given by Mr. Knight at the seminar.


See Clauses 8–10,12, 15, and 49 of the Reserve Bank Act of New Zealand of 1989.

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