Managing Capital Flows and Exchange Rates
KDI/EWC series on Economic Policy
Edited by Dongsoo Kang and Andrew Mason
Chapter 10: The role of reserves in a small open economy: the case of New Zealand
The role of reserves in New Zealand has evolved with the monetary policy framework. Prior to the floating of the New Zealand (NZ) dollar in 1985, foreign currency reserves played an important role in maintaining the fixed (but periodically adjusted) exchange rate. After the float, with the exchange rate playing a key role in the economy’s adjustment to shocks, foreign reserves were not needed to defend the exchange rate level. However, there is an important potential role for foreign currency intervention, to counter the small risk of extreme foreign exchange market dysfunction. This chapter also discusses a secondary motivation for foreign currency intervention associated with exchange rate “overshooting” and considers these roles in the New Zealand context. The chapter also considers New Zealand’s approach to financing foreign currency liquidity, which in turn reflects the role of reserves. The standard approach to generating intervention capacity is to hold outright an open (net long) foreign currency position. The approach chosen by New Zealand emphasizes longer-term foreign currency borrowing, and long-term hedging of domestic currency funding through foreign currency swap markets. This approach is unusual, but not unique among small advanced economies with floating exchange rates. This chapter describes the evolution of financing approaches in New Zealand and considers the insurance properties and relative costs of the approaches currently employed.
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