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The cuckoo's egg

Friday 6th October 2000

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Eurokiwi bonds are beyond New Zealand control yet can dictate the currency's value, writes NEVILLE BENNETT

The eurokiwi market is not widely understood. Yet it is huge. It is the main means of bank funding and it influences interest and exchange rates. It is also basically unregulated and almost anarchic: it is a means by which the banks avoid some of the effects of monetary policy.

It may be menacingly dangerous. It has beggared many European investors and may have caused resentment against New Zealand. Moreover, the rush of eurokiwi maturities (NBR, Sept 29) will depress the dollar and exert upward pressure on interest rates.

Eurokiwi are bonds, designated in New Zealand dollars, issued by a foreign organisation to overseas investors. They are listed on foreign stock exchanges and their total value is greater than the bonds issued by the New Zealand government.

The issuer tends to be prestigious with a high credit rating. The World Bank, for example, is a prominent issuer. Issuers are able to borrow at the cheapest rates and their reputation facilitates bond sales.

New Zealand banks have a vast appetite for funds yet little capacity to raise them domestically given the country's poor saving record. Only 30% of their funds come from deposits, with the remainder coming from their foreign masters (25%) and the largest part (45%) from "other institutions," which is shorthand for eurokiwi. The largest use of funds is in mortgages (38%).

Banks gain access to the funds by means of a simple swap. Issuers have no need of New Zealand dollars so they lend the proceeds of the bond issue to Kiwi banks. In return, a New Zealand bank raises and on-lends to the issuer the currency it really wants, perhaps US dollars or yen.

This means a local bank raises a loan of millions of dollars in US currency and lends it to the issuer for a fixed term, usually three years. The issuer lends New Zealand dollars to a New Zealand bank. The latter then typically offers three-year fixed-rate mortgages to Kiwi householders.

Retail investors, like the proverbial Belgian dentist, can buy the security in low values and at an attractive high yield. Incidentally, there may be a lot of pain in Belgian dental surgeries now because the New Zealand dollar has lost 44% in value since September, 1997, when many now-maturing eurokiwi were issued.

So eurokiwi bonds have made more capital available, and at a cheaper price, than New Zealanders could have raised for themselves. Perhaps they have not used it productively, apparently devoting most to housing (NBR, Sept 22).

Because the process has made large amounts of capital available, it created a feeling of optimism. This encouraged ordinary Kiwis to spend rather than save. Indeed, the value of net assets has been pretty stationary since the mid-1990.

The problem with eurokiwis is fundamental. Being a bond issued in New Zealand in New Zealand dollars by a foreign party for the purpose of being listed on a European stock market, it lies beyond the control of any New Zealand authority. It is a cuckoo's egg laid in a New Zealand nest by non-caring parents.

Bond issues cluster at certain times. There were massive issues in the 1990s but few occur now (see top chart). The maturities also cluster, particularly in the 2000/01 period. The sheer magnitude of these huge, sudden capital flows is destabilising and requires massive efforts to minimise the strains imposed on a small financial system.

For example, these capital flows have a large effect on interest and exchange rates. When issues were high, around 1996/97, the incoming capital lowered interest rates but drove the dollar above 70USc.

Conversely, when there are large net maturities as a present, involving some $5 billion a quarter, the broad effect is to deport capital, increase interest rates and depress the dollar.

When Kelly Eckhold, of the Reserve Bank, discussed these (NZRB Bulletin 61/2) his detached rhetoric was of shocks: "The smoothness of the adjustment to financial market prices will depend on the nature of the shocks to people's expectations of future issuance and the combination of shocks that occur."

Mr Eckhold first examined "a relatively benign shock" in the context of a slowing economy, lower interest rates and a lower demand for credit. He expected an "orderly" adjustment of "the foreign exchange rate to a lower level." (I am not privy to what young economists mean by "orderly;" perhaps it means an uninterrupted downward spiral.)

Mr Eckhold also examined a "faster-acting shock" that occurs when foreign interest rates are rising and investment is diverted into other markets. This reflects the current situation as the European Central Bank is in tightening mode.

He rightly predicts that issues drop off fast, "resulting in a more rapid fall of the exchange rate and a faster rise in interest rates." He warns a change in "offshore investors' perceptions of the risks associated with investing in New Zealand could also cause [an even] faster adjustment." In ordinary language, the dollar could collapse.

I have tried to estimate the effects of maturation. It helps to re-examine the process in concrete terms. When a Fannie Mae (US Federal National Mortgage Association) eurokiwi matured on September 26, a New Zealand bank got back its $US500 million loan and would return $NZ500 million. Both parties had kept their money on deposit, so no foreign exchange risk was involved. No effect was felt on the capital account, as the New Zealand bank wiped $500 million in US dollars at the 1997 exchange rate) off its assets and liabilities.

This is fortunate as bank operations generally are adding to overseas debt. The latest Statistics New Zealand data shows "other" foreign investments stood at $42.53 billion on March 31, a staggering increase of 43% in the year, comprising $12.2 billion in loans and $30.3 billion in currency and deposits. It is a system out of control.

Any New Zealand bank that dealt with maturing euro would have a problem replacing that funding. Remember, New Zealand banks have to get 65% of their funds from overseas Who, one wonders, will lend in New Zealand dollars when further depreciation is possible?

Chances are the banks will have to borrow in foreign currency and that is risky. We know they lost over $3 billion in the year to March on foreign exchange. And greater exposure to forex losses is undesirable. I suspect they will limit their funds and lending - bad news for business and homeowners.

For a few dollars less

When eurokiwi bonds are issued, the New Zealand dollar rises because the issuers have to buy dollars. The reverse happens when they mature.

The hypothetical Belgian dentist has a fistful of kiwi. What to do? He has Hamlet's dilemma. Is it nobler to hang on or cash in? Should he sell, hold or go on holiday to New Zealand?

Most will sell. A rash of maturities will, other things being equal, depress the kiwi.

On September 18, World Bank eurokiwi worth $1 billion matured and this was followed by a fall of nearly 2c. As my maths teacher would say, QED.

- Neville Bennett

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