• Central bank says volatility up in short-term money markets
  • Fewer market participants in foreign exchange swap markets

New Zealand’s central bank has increased its financial market activity to help keep short-term interest rates in line with its benchmark, saying reduced liquidity poses a risk to monetary policy transmission.

Fewer market makers in the foreign-exchange swap markets and lower risk appetite among banks have led to increased volatility in short-term money markets, which can result in interest rates “deviating away from the official cash rate,” the Reserve Bank said in its Financial Stability Report published Wednesday in Wellington. The RBNZ “has responded to this by increasing its participation in the market through open market operations and foreign-exchange swaps, which have helped to keep key short-term interest rates in line with the OCR,” it said.

There is growing global concern that there may have been a structural change in the provision of market liquidity, an important ingredient for the smooth functioning of financial markets. Since the global financial crisis, reduced risk appetite and tighter regulation, such as increased capital requirements, have resulted in reduced market-making activity.

“It’s a global phenomenon whereby increased regulation has decreased the number of bank market makers in instruments like bonds, and as a result liquidity has suffered,” said Imre Speizer, markets strategist at Westpac Banking Corp in Auckland. “It’s causing excess volatility and it is a concern. I think this is an example of policies having unintended consequences.”

As an example of diminished liquidity in currency markets, the RBNZ cited a sharp drop in the New Zealand dollar against its U.S. counterpart on Aug. 25 this year. The kiwi fell more than 3 U.S. cents before quickly rebounding.

“The Reserve Bank will continue to closely monitor developments in liquidity and its effects on the New Zealand financial system,” it said.

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