This is worth a read:
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DEC 10

Interesting Query


I am interested in your proposals to help New Zealand achieve more stable exchange rates and would like to better understand them.

You have proposed a “balanced suite of changes” one of which is in respect of monetary policy in which you call for a ‘managed exchange rate’ and suggest that lower interest rates could be achieved by ‘loan to value ratios, robust core funding ratios and capital inflow controls’.

What do you mean by the phrase ‘loan to value ratios’ ? Are you saying that there should be set controls on the percentage of the asset value that a bank lends to borrowers, i.e. a max of say 70% of the value of a house?

What is a ‘robust core funding ratio’? Is it the same as a ‘reserve asset ratio’ which was the way we used to control the level of bank created credit supplied to the economy via bank lending.

What are you proposing by way of controls on ‘capital inflows’? and what sort of capital inflows are you proposing be controlled?

You also propose the introduction of capital gains taxes, which for a large part are not a real increase in capital but an inflation of asset prices. Have you proposed this to make it less attractive for people to borrow money to invest in say rental housing? And if so is this to reduce the demand for credit in order to reduce interest rates and thereby hopefully reduce the amount of capital inflows taking advantage of higher interest rates and thus hopefully helping to keep the exchange rate down?

Can you also point to what asset types would be subject to the CGT and what would be exempted?

Alasdair Thompson
Chief Executive
Employers' & Manufacturers' Association (Northern) Inc."



At outset any approach to remove volatility from the exchange rate is the realisation that it really matters to the future of our tradeable economy. The notion that exchange rate fluctuations are either beneficial or harmless is warped and unhelpful to the point of being terminal for the traded sector. Whilst that notion persists the tradable sector will struggle in an environment where returns cannot be predicted. In such a world productive investment in unlikely and we will see past trends continue as the tradeable sector contracts.

The problem is that the existing RBNZ behaviour does not control inflation in the non-traded sector, it encourages debt expansion associated with asset inflation, and headline inflation remains within band only as a result of deflation in the tradeable sector. Our call for a "suite of changes” indicates that we think there is no one policy change that can cure this problem. A number of things need to be done.

I use the term “managed exchange rate” as a contrast to our current policy framework that simply ignores the exchange rate. The collateral damage, or more correctly the target of the interest rate lever is the importation of loose monetary policy from elsewhere absent any compensating control on that capital flow. In the absence of regulation the banking system seeks to lower its borrowing costs and source cheap offshore funds to lend in New Zealand, supplying the borrowing needs of the New Zealand debt consumer, if assets are perceived as less risky, if assets have clear and obvious tax advantages then the debt pull sucks in the foreign sourced debt supply via the banks.

Of course that creates a major interest in the banks to see the exchange rate overvalued further lowering the cost of their offshore liabilities.

So choosing to use only the interest rate lever the RBNZ encourages the inflow of offshore funds, lifts the exchange rate, kills the tradeable sector and supports asset bubbles (aided and abetted by favourable tax status) to the loss of long term New Zealand sovereignty – the tradeable sector contracts and there is an asset spiral party for a while, but ultimately the tradeable sector will have lost the capacity to rebalance the economy.

More and more players in the traded economy have recognised this policy framework issue. The discussion has moved from what the exchange rate might be today to a conversation of what is it in the policy framework that delivers an unpredictable exchange rate. Most importantly what has to change to encourage exchange rate stability (a rate we can earn on a sustainable basis, not one borrowed in the short term) and investment in the tradeable sector.

Capital controls are the regulatory measures applied to the banking sector, source control via robust (the balance of retail and wholesale borrowing on the numerator) core funding ratio, debt growth controls via the capital reserve ratio, charges against currency mismatches and charges on short term money flows (see my Twitter feed today) – these all sit under the (macro) prudential banner and serve to shift banking incentives away from an overvalued and volatile currency environment.

On the demand side using loan to value ratios varied by asset class can restrain debt growth by limiting demand and thereby asset price inflation, it might also encourage banks to lend into the tradeable sector. The demand for debt can be further curtailed by the removal of tax harbours on capital gains via land taxes and capital gains tax. You saw all this discussed in detail by the Tax Working Group.

So balanced, low and broad taxation; lower interest rates; effective prudential measures; effective control of non-traded inflation; and focus on asset bubbles serve to help rebalance the economy.

Additionally we should deal with the issue of the level playing field: when other jurisdictions support their tradeable activity (R&D tax credits, equipment and patent right offs, productive investment incentives and much more) we place our tradeable sector at a disadvantage if we do not, but that said, exchange rate stability is the key issue.

You can see much more on my blog, and others for example Steve Keen at debt watch.

If you want to talk more about this I am happy to call and see you.

I will post this thread on my blog, you or others might wish to comment further.

tags: alasdair thompson, john walley, inflation, exchange rate
I am sorry but this comment section has been disabled due to spam. My contact details are easy to find, please contact me if you want to comment or discuss anything on this blog.