Price or Volume
Inflation is and will always be an issue. The control mechanisms for inflation can focus either on price (interest rates), volume (regulatory controls) or a combination of both. Price based controls seek to lower demand for borrowing and so reduce demand in the economy; regulatory controls seek to directly reduce the level of debt in the economy.
The problem is the price based approach is exposed to foreign pressure, high interest rates attracting money from offshore drive up exchange rates, lower returns from export activity and erode the competitiveness of domestic producers. Volume controls do not come with this exchange rate problem. Exchange rate impacts are often characterised as a side effect but really it has become the principle inflation control mechanism.
The Triennial Bank of International Settlements survey estimates the trade in New Zealand dollars to be around 46% of our annual GDP each day representing 1.6% of the total global currency trade when the New Zealand economy only represents 0.2% of global gross product. On this basis capital flows are far more significant than trade flows; our annual exports equate to about 12.5 hours’ worth of the currency trading and the annual total of imports and exports equate to the currency trading that takes place in a single day.
In today’s world, capital controls, and a focus on the current account deficit through firmer supply side regulatory measures, are more appropriate in the fight against inflation than total reliance on price control.
This point is starting to be recognised. A statement and a research paper from the International Monetary Fund (IMF) have argued that capital controls should be used. The IMF released a ‘Framework to Manage Capital Inflows’ that said:
“Surges in inflows can pose challenges such as rapid currency appreciation and a buildup in financial sector fragilities, such as those stemming from asset price bubbles or rapid credit growth, or the risk of a sudden stop or reversal of inflows.”
The paper called ‘Policies for Macrofinancial Stability: Options to Deal with Real Estate Booms’ from the International Monetary Fund recognised that:
“macroprudential tools (such as maximum loan-to-value ratios linked to the real estate cycle) appear to have the best chance to curb a boom. Their narrower focus reduces their costs. And, in the case of measures aimed at strengthening the banking system (such as dynamic provisioning), even when they fail to stop a boom, they may still help to cope with the bust.”
Problems with a variable and overvalued exchange rate and equity erosion have been much publicised since the economic downturn started in 2008. Price based monetary policy has, rightly, copped a lot of the flak.
Supply side regulatory solutions are possible, for example; the Core Funding Ratio (already in existence in New Zealand) and Loan to Value Ratios.
When the Reserve Bank Act was introduced in 1989 it was designed to control the inflation problems of the 1970s and 80s. The problem with using the Official Cash Rate (OCR) to curb inflationary pressures has been its ineffectiveness in preventing inflation in the non-traded sector. It is worth noting that trade flows, not capital flows, dominated international commerce at that time, and as mentioned above that is not the case today.
The price of credit has proven to be an ineffective regulator of domestic demand. An increase of say two percent in the price of mortgage credit is fairly insignificant if house prices are expected to increase between 10 and 20 percent. This has meant that the tradeable sector, which has caused little inflationary pressure, largely due to the exposure to global competition, has worn the brunt of OCR hikes via the exchange rate mechanism. Differentials between New Zealand’s OCR and the official interest rates elsewhere have largely driven currency volatility.
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Minimal banking regulation has seen the bank’s lending more to customers based on the expectation that capital appreciation would pay the bill as opposed to cash from the asset. Sadly the global financial crisis caused asset values to crash leaving many in negative equity, owing more than the asset is worth, and struggling to pay an interest bill from cash flows or wages.
In New Zealand housing and farms are badly exposed; to date there have been only limited mortgagee sales because New Zealand has not seen the rapid increase in unemployment of some countries, and rising commodity prices have shielded the agricultural sector, but the risk is still there. New Zealand’s high level of private debt has also become a serious concern – largely because the public-private debt divide has become pretty blurred after the global financial crisis as credit rating agencies are starting fear private debt.
Given that the price of credit has not been effective in reducing non-tradeable inflation we need to look at regulatory options.
Core Funding Ratio
The Core Funding Ratio (CFR) sets a percentage of funding that banks must attain from either domestic sources or on one year or longer terms from overseas. The rationale from the Reserve Bank was largely to do with ensuring financial stability by reducing the vulnerability to international shocks which could affect the supply of short-term credit. However, there is an added benefit that it could limit influxes of credit such as the one that caused New Zealand’s recent housing bubble.
A Reserve Bank of New Zealand (RBNZ) article on ‘The Reserve Bank’s new liquidity policy for banks’ sums up the benefits of the new rules well. It states:
“In addition to strengthening banks’ liquidity positions, the core funding ratio might also be expected to provide a degree of automatic stabilisation to the economy during periods of strong credit expansion. In recent years, banks have been able to fund cheaply in the offshore money markets and use derivatives to synthesise fixed-rate term funding at a cost cheaper than actually borrowing in term markets. The core funding ratio in the new prudential liquidity policy drives banks to either compete for more stable funding from nonfinancial customers, or borrow in wholesale markets for terms longer than one year. During periods of rapid credit expansion, banks will not have the same ability to borrow at short terms in the offshore money markets to supply domestic demand. To satisfy growing credit demand, banks will need to borrow from a variety of sources, with increased emphasis on customer deposits and longer-term markets. As a result, lending rates should automatically move higher without the Reserve Bank necessarily needing to move the official cash rate to the same extent. With short-term wholesale market rates not likely to rise as much, the attractiveness of the New Zealand dollar as a destination for ‘carry trade’ investors could be reduced. Through these channels, the policy has the potential to have a role in assisting monetary policy.”
Disappointingly the Reserve Bank slowed the implementation of the CFR in response to complaints from farmers who focused on holding up asset values. This slowed down the rate of adjustment. Any changes will have their losers, but with the rules both improving banking stability and playing a part in rebalancing the economy, it is difficult to understand the decision to delay these benefits.
The CFR would be more effective if it specified a percentage of funding that must come from domestic sources. This would prevent efforts from the banks to lower their borrowing costs using different instruments such as covered bonds. There is also the potential to vary the CFR across the business cycle to supplement the cash rate mechanism.
Loan to Value Ratios
Loan to Value Ratios (LVRs) regulate the equity required to back a particular loan. For example on residential property this could be set at 80 percent meaning that the remaining 20 percent would have to be saved as a deposit. Other asset types, say farms, might be set at a different level. This would reduce the supply of credit and consequently New Zealand’s demand for offshore borrowing. Asset prices would moderate and the exchange rate would better reflect trade flows.
Gearing loans to equity limits the ability of the bank to expand their balance sheets. It stops them lending more and more as inter-bank competition flairs, offering loans with little or no deposit fueling unsustainable asset bubbles that ultimately burst lowering equity values. Price is not enough; regulation is required.
A LVR approach is not a tax, it does not increase costs, it promotes saving and prudence, and it would help improve property and affordability, especially if the LVR was varied across the business cycle and asset and purchase type. For instance the LVR might require more equity for investment property than a family home.
LVRs have been used successfully in Texas and recently in Canada where an 80 percent ratio has helped to restrain their housing bubble and avoid the worst of the US subprime mess. According to the Case-Shiller Home Price Index, Dallas house prices went up 25 percent from 2000 to 2006 compared to the average of over double in the survey and they have hardly declined at all since.
The Reserve Bank’s implementation of the Core Funding Ratio demonstrated that these initiatives need not cause huge disturbance if introduced over a sensible period of time.
It is important to remember that the purpose of reforms is to force adjustments and these cannot come without pain. As long as changes are clearly signalled it is the responsibility of lenders and borrowers to change their behaviour.