VII New Zealand
- Tomás Baliño, Charles Enoch, and William Alexander
- Published Date:
- July 1995
New Zealand’s experience with financial sector and monetary policy reform is of particular interest because of the breadth of the reforms, the speed with which they were implemented, and the absence of reversal. In a span of nine months, in 1984-85, New Zealand’s financial sector went from being one of the most heavily regulated among industrial economies to one of the least regulated.
Motivation for Reform
The motivation for economic and financial liberalization was the persistently poor performance of the New Zealand economy, relative to other industrial economies, and the recognition that institutional and regulatory rigidities hampered the economy’s ability to adjust to structural changes in the economic environment. The financial sector reforms were intended both to remove microeconomic inefficiencies and to achieve macroeconomic control—in particular, to bring about a more efficient allocation of credit through deregulation of the financial sector and to enhance monetary control via the development of open market operations.
A tentative process of deregulation had taken place in 1976, with the partial decontrol of interest rates. But it came to an end with the re-establishment of interest rate controls in 1981 and their extension in 1982 in conjunction with an anti-inflation program of comprehensive wage and price controls. In 1984, however, an extensive process of reform began, with the bulk of the financial liberalization measures being introduced in the period between July 1984 and March 1985. The financial sector reforms were accompanied by extensive reform of trade, the tax system, labor markets, and the financial management of government (including a review of the role and structure of the central bank), plus privatization and corporatization of state-owned enterprises, substantial reduction in assistance to industry, and industry deregulation.
Prior to 1984, financial sector regulations in New Zealand segmented the financial market. Segmentation comprised direct controls on the price of financial services and the portfolio composition of financial institutions, entry restrictions, and specific cost advantages for the regulated activities. Three broad categories of direct controls existed at the start of 1984: (1) ceilings on many of the deposit and lending interest rates of bank and nonbank financial intermediaries;7 (2) restrictions on the balance sheet composition of financial institutions—which included reserve asset ratios for trading banks and public sector security ratios for other financial institutions, credit growth guidelines, and priority lending guidelines—and restrictions on the types of activities different types of institutions could undertake; and (3) foreign exchange controls, which included restrictions on residents’ purchases of foreign exchange, overseas borrowing, and access to domestic financial markets of foreign-owned companies.
The heavy regulatory system had a number of adverse effects. It not only discouraged domestic savings but also channeled too large a share of those savings to investment projects of low or negative overall economic benefit. In addition, it reduced competition among financial institutions, reduced the scope of financial services, and was akin to a tax on regulated institutions and activities—which affected their relative competitiveness and shifted funds to the less regulated institutions and activities. Furthermore, it created a conflict between monetary control and the maintenance of low interest rates.
The ability of the Reserve Bank of New Zealand (RBNZ) to achieve monetary control and carry out an independent monetary policy was compromised by its commitment to buy or sell government debt at administratively set prices, so as to peg interest rates on government debt at below-market levels. This, in effect, compelled the RBNZ to monetize large fiscal deficits, a requirement that at times conflicted with the RBNZ’s commitment to buy and sell foreign exchange at a fixed exchange rate. Moreover, the reserve asset ratios and public sector security ratios were used as an instrument of monetary policy—to affect the flow of credit—and to keep interest rates on government securities artificially low by creating a “captive” demand for them. There was, therefore, little incentive for the government to foster the development of secondary markets in government securities.
Process of Reform
Financial Reforms Since 1984
A new government brought about major changes in the regulatory system and the conduct of monetary policy, beginning in July 1984. The situation called for both macroeconomic stabilization and a broad program of reforms. The conventional recommendation is to first bring about macroeconomic stabilization and subsequently to introduce capital market reforms. In New Zealand’s case, the sequence was reversed.8 At its inception, the reform program was greatly influenced by the prevailing economic situation, in particular, the foreign exchange crisis. In the four weeks leading up to the election, the RBNZ’s foreign exchange reserves had been depleted, despite extensive overseas borrowing, as widespread expectations of a devaluation in conjunction with frozen interest rates led to a run on the currency. The currency was devalued by 20 percent, and all interest rate controls were removed. Restrictions on foreign exchange transactions were removed in October–December 1984, and the New Zealand dollar was floated a few months later in March 1985.
Principles Guiding the Reform Program
Two principles guided the reform program: (1) the government should avoid interventions that discriminate for or against particular activities or institutions, and (2) activities should be as contestable as possible. These principles implied both policy neutrality with respect to various activities and free entry. Macroeconomic policy was to support the reform program’s overall objective of increased efficiency. In particular, monetary policy was to be directed firmly at the achievement of price stability, so as to prevent the distortion of market signals, while fiscal policy was to remove distortionary subsidies and incentives, so as to be as neutral as possible in its effect on production.
These principles were reflected in several reform measures:
- the abolition of reserve requirements;
- the payment of interest on settlement balances;
- the financing of fiscal deficits by the sale of medium-term government securities to the private sector, and the market determination of interest rates on government securities issued through auctions;
- the amendment to the Reserve Bank Act to make price stability the primary function of monetary policy and to give the RBNZ the necessary independence to achieve it; and
- the adoption of a policy of open entry into the banking system and the reform of banking supervision.
Monetary Policy Operating Procedures
The elimination of interest rate controls and compulsory asset ratios necessitated a change in monetary policy operating procedures. Before outlining these procedures, two institutional changes made in 1983 should be noted. These were the introduction of the tender scheme for government bonds and the issuing of foreign exchange dealerships to a wide range of financial institutions. These proved to be important building blocks for the new monetary policy regime: the first for the nonmonetary funding of fiscal deficits and open market operations, and the second for the transition to a floating exchange rate.
The change in monetary policy approach from operating through direct regulatory controls to operating through market-based instruments had the effect of encouraging further development and deepening of the main financial markets. For example, once controls on financial markets were lifted and the government moved to a policy of funding its deficit in the domestic markets without recourse to implicit central bank finance, secondary markets in government securities developed quickly. In general, the growth and development of financial markets was stimulated by several factors. One is that deregulation contributed to “reintermediation,” that is, a reversal of the previous trend of the main financial institutions losing a share of the overall financial market to less controlled intermediaries. A second factor involved a general freeing up of access to credit, which permitted both households and corporations to shift the structure of their balance sheets toward greater use of debt. A third factor was that financial reform encouraged innovation in financial markets, including the development of new financial products. Finally, the monetary reforms meant that all financial institutions had to be much more active in monitoring and predicting the effects of policy and other influences on interest and exchange rates. Thus, the amount of analytical resources applied in financial markets was increased substantially, which contributed to a more active involvement in the markets. In all of this, the RBNZ took a hands-off approach—following the principle that creating the right environment was the best way to stimulate economic activity and the development of markets.9
The new monetary policy framework aimed at influencing the excess demand for liquidity in the banking system. Operationally, this involved controlling the supply of “primary liquidity,” defined as settlement cash and government securities that can be discounted for settlement cash on demand.10 Effective control over primary liquidity required the RBNZ to engage in open market operations in nondiscountable government securities. It also required insulation of primary liquidity from fiscal influences, which was accomplished by financing fiscal deficits with medium-term nondiscountable securities.11 Finally, by allowing the New Zealand dollar to float, the level of primary liquidity was insulated from swings in net capital flows. Once controls were lifted and the government moved to a policy of funding its deficit in the domestic markets without recourse to central bank finance, secondary markets in government securities developed quickly.
The 1984—88 period was largely a transition period for monetary policy, as the RBNZ sought, first, to insulate primary liquidity from fiscal deficits, seasonal fluctuations in government expenditures and revenues, taxation reforms, and foreign capital flows, and, second, to assess the implications for primary liquidity of structural shifts in the financial sector. These developments required frequent adjustments in the targeted level of primary liquidity and its definition.
The securities discountable at the RBNZ, and hence the definition of primary liquidity, underwent a number of changes. Before December 1984, all government securities were discountable. From December 1984 until December 1985, only securities with less than six months to maturity were discountable, while from April 1986 eligibility was further restricted to securities with less than one month to maturity. Since December 1988, only RBNZ bills with 28 or fewer days to maturity have been discountable. These changes, and especially the switch from treasury bills and government bonds to the RBNZ bill as the sole discountable security, were made to avoid the effect on primary liquidity of marked seasonal variations in government financial flows.
Domestic liquidity was significantly affected by capital flows in 1984–85. Following the 20 percent devaluation in July 1984 and the removal of interest rate controls, a large inflow of foreign exchange led to a rapid buildup of liquidity. To absorb the excess liquidity, the government adopted an active program of public debt sales. To help absorb the liquidity inflow, tender sales now had to be supplemented by RBNZ sales from its stock of treasury bills. The situation was reversed in early 1985. Negative sentiment regarding the short-term prospects for the New Zealand dollar resulted in large capital outflows and a sharp contraction in domestic liquidity. (In early March, in the days following the floating of the exchange rate, overnight rates reached several hundred percent, while 90-day rates reached 35 percent.) This led the government to cancel its March tender sale, while the RBNZ injected cash into the system. The decision to float the exchange rate in March 1985 was taken partly so that the authorities would be able to exercise greater control over domestic liquidity conditions.
Other transitional problems arose from shifts in the linkage between policy instruments and policy goals. Deregulation of the financial sector and the real side of the economy altered historical relationships between, on the one hand, primary liquidity and interest rates, the exchange rate, and monetary and credit aggregates, and, on the other hand, between these last variables and real activity and prices. This led the RBNZ to adjust the base level of primary liquidity and other policy instruments on the basis of a range of indicators. The Reserve Bank Act of 1989, which took effect on February 1, 1990, formally made price stability the overriding objective of monetary policy and gave independence to the RBNZ to facilitate achievement of this goal.
The institutional and regulatory framework adopted in the reform of the financial sector has two main features: the promotion of effective competition—by removing restrictions and privileges that resulted in artificial market segmentation and engendering contestability—and the strengthening of prudential supervision. With respect to the first feature, the most notable reform was the removal in 1986 of entry barriers to the banking sector. Entry is now unlimited in the sense that there are no quantitative limits on bank registrations, and any institution (including foreign institutions) can register as a bank.12 The number of banking groups rose from 4 in 1987 to 21 in 1990 but has since declined to 15.
Two other important reforms were the opening of the payments system to competition by allowing any institution to open a settlement account at the RBNZ and the reform of community-owned banks, which removed all restrictions on their operations and phased out the government guarantee of their deposits. The latter reform was part of a supervisory policy that explicitly rejected government-mandated deposit insurance. The objective of prudential supervision in New Zealand is confined to preserving confidence in the financial system as a whole; it is not aimed at protecting depositors’ funds or preventing the failure of individual institutions. The role of the central bank is to maintain the liquidity of the financial system and to monitor the financial condition of institutions from the perspective of preventing systemwide problems. To this end, the RBNZ was granted wider powers of inspection and information collection and powers to facilitate the orderly exit or reconstruction of failing institutions.13
New Zealand was able to go, in the span of a few years and without backtracking, from a highly regulated financial system to a very liberal environment in which the central bank conducts monetary policy solely through indirect instruments. Several factors contributed to the speed with which the reforms were implemented: a high degree of political commitment to the implementation of the necessary reforms; sophisticated capital and short-term money markets; a sound banking system; and a well-functioning payments system. In addition, the transition was eased by a technically sophisticated central bank staff, supported by a well-developed statistical reporting system.
The successful transition to indirect instruments was supported by the following factors: the curtailment of the government’s direct access to central bank financing; the liberalization of the foreign exchange market; a monetary policy firmly oriented to price stability, backed by legislation ensuring the independence of the central bank; a new competition policy, contributing to the desegmentation of the financial sector; and new prudential measures and a strengthening of bank supervision. In addition, the transition was supported by intensive research at the central bank on monetary control and a flexible approach to liquidity management.