Macroprudential Regulation of International Finance

Macroprudential Regulation of International Finance

Managing Capital Flows and Exchange Rates

KDI/EWC series on Economic Policy

Edited by Dongsoo Kang and Andrew Mason

Recent events, such as capital flow reversals and banking sector crises, have shaken faith in the widely held belief in the benefits of greater financial integration and financial deepening, which are typical in advanced economies. This book shows that emerging economies have often weathered the storm best despite the supposed burden of ‘weak institutions’. It demonstrates that a better policy framework requires reliable indicators of vulnerability to financial instability, as well as improved policy tools and automatic stabilizers that anticipate and limit the vulnerabilities to financial crises.

Chapter 10: The role of reserves in a small open economy: the case of New Zealand

Anella Munro and Michael Reddell

Subjects: asian studies, asian economics, economics and finance, asian economics, financial economics and regulation


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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