Case Study: New Zealand Central Bank Intervention in Foreign Exchange Markets, June 2007

Background

On Thursday, June 7, 2007, the Central Bank of New Zealand (The Reserve Bank of New Zealand) announced that they were raising their key monetary policy interest rate (i.e., the Official Cash Rate) by 25 basis points to 8.00%. The rate was increased because of the central bank’s concern over domestic inflation and the fact that the Reserve Bank is mandated to achieve an inflation target of between 1 and 3%. However, the rate increase was generally not expected by financial markets.

In announcing the rate increase, the Governor of the Reserve Bank of New Zealand, Alan Bollard, provided the following information on the bank’s web site:

“Domestic demand has grown strongly since late 2006, particularly in the household sector. Housing market activity has been buoyant, consumer confidence has remained relatively robust and a range of business sector indicators, including employment and investment intentions, have been strong. As we have noted recently, government spending continues to increase, which is contributing to domestic demand.

“Following several years of strong growth, firms have indicated that capacity remains stretched and that finding both skilled and unskilled staff has become increasingly difficult. These pressures continue to underpin inflation.

“A sustained period of slower growth in domestic activity will be required to alleviate inflation pressures. Lending rates have risen significantly in recent months, partly due to previous increases in the OCR. Given the usual lags, we have not yet seen the effect of these increases on domestic demand and inflation pressures. There are some early indications from recent opinion surveys and other data that growth may be starting to soften, but these are by no means conclusive. Indeed, at present the risks to domestic activity appear to remain on the upside.

“A significant development in the past six months has been a marked increase in dairy prices. While there are uncertainties about the future path of these prices, the increases will assist in narrowing New Zealand’s trade deficit. The rise in dairy sector incomes will provide a substantial boost to economic activity over the next few years, but will also add to inflation pressures.

“Parts of the export sector outside the dairy industry will continue to face challenging conditions due partly to the New Zealand dollar. As we noted in April, the exchange rate is at levels that are both exceptionally high and unjustified on the basis of New Zealand’s medium-term fundamentals.

“Had we not increased the OCR this year, it is likely that the inflation outlook would now be looking uncomfortably high. This further increase in the OCR is to ensure that inflation outcomes remain consistent with achieving the target of 1 to 3 percent inflation on average over the medium term.”

The Strength of the New Zealand Dollar (the “Kiwi”) Up to the Intervention

In the year leading up to the June interest rate hike, the New Zealand dollar (also known as the “kiwi”) had been one of the strongest currencies in the developed world, increasing 26% against the US dollar and 32% against the Japanese yen. This strength reflected the large interest rate differential between New Zealand and the United States and Japan. The New Zealand key rate was 8.0% compared to a rate of 5.25% in the United States and 0.50% in Japan. With this interest rate differential, carry trade strategies (i.e., borrowing in low interest rate countries and investing in high interest rate countries) were causing the New Zealand dollar to strengthen. The chart below shows exchange rate from July 1, 2006 through July 7, 2007. In early July, 2006 the exchange rate was just over $0.60 (in American terms) and by early July 2007 it was around $.75

As would be expected, in response to the surprise interest rate hike, the New Zealand dollar continued to strengthen. The chart below shows the exchange rate from May 18, 2007 through July 8, 2007.

However, given the export dependency of the New Zealand economy, the growing fear was that the strong, and strengthening, kiwi would adversely affect New Zealand’s export sector. In fact just after the June 7 interest rate increase the Governor of the New Zealand Central Bank expressed his dissatisfaction with the exchange rate calling it “exceptional and unjustified in terms of economic fundamentals.”

New Zealand Central Bank Intervenes in the Foreign Exchange Market, June 11th

On Monday, June 11, the Reserve Bank of New Zealand confirmed that it had intervened in the foreign-exchange market by selling the New Zealand dollar in an attempt to weaken the currency. It is the first time the central bank intervened in the foreign-exchange market since the country's currency was floated in 1985. It was estimated that the Reserve Bank may have sold up to $120 million New Zealand dollars during its intervention. Another intervention took place on June 17th.

In response to the first intervention, the New Zealand dollar, tumbled on Monday, falling about 2% against the U.S. currency, 1.7% against the Australian dollar, and 1.9% against the yen. The chart below shows the exchange rate from May 18, 2007 through July 11, 2007 (note, the 9th and 10 was the weekend, and so the first trading day corresponding to the intervention was the 11th). On that day, the exchange rate fell below $0.75

Did Intervention Make Any Difference?

It appears from the chart below (which traces the exchange rate from June 1, 2007 through July 11, 2007, that the intervention had little effect on the overall move of the exchange rate. By July 11, 2007 the exchange rate was around $0.78. Clearly, high interest rates in New Zealand continued to dominate the foreign exchange market. This suggests that central bank intervention generally has very short term effects (in any) on these markets and that economic and financial fundamental are the determining variables.

History of Central Bank Intervention among Developed Countries

Although their intervention activities appear to be slowing, central banks within the developed world have a recent history of intervening in the foreign exchange markets in support of their currencies.

Historically, the Bank of Japan (BOJ) appears to be one of the world's largest players in currency intervention.

According to the Federal Reserve Bank of San Francisco, between April 1991 and December 2000, the BOJ bought $304 billion worth of U.S. dollars on 168 occasions and sold $38 billion on 33 occasions. The BOJ has not intervened in support of the yen since 2004.

The Reserve Bank of Australia intervened 1,054 times between July 1986 and November 1993. The European Central Bank intervened four times in late 2000, buying euros and selling dollars to halt the slide of the European currency.

The United States Central Bank has not intervened in support of the US dollar since 1998.

Even through, with the exception of the Reserve Bank of New Zealand, there has been a reduction in central bank intervention over the last decade or so, one should be aware that any central bank still has the discretion of intervening if it feels conditions warrant and while intervention may not affect the longer term fundamentals, it still may have some effects over the very short term. One should also be aware, the central banks in many parts of the developing world still engage in intervention.