fxmatters

One important section of the NZ dollar market is the funding of bank loans (see November 6 Issue for full overview, segment in discussion shown at bottom-right) . The lion’s share of the NZ banking sector is foreign-owned banks. This ownership, plus the fundamental strength of the NZ bank, enables ready access to global markets for funds. And the banks take advantage of this.

As at September, NZ$50 billion or 20% of funding was sourced from offshore markets, borrowed in various foreign currencies but almost all hedged back into NZ dollars.

The hedging process is tricky. Typically the banks will borrow short-term funds, say for 90-days and lets say in USD. At the margin, it is more likely to be 2-year NZD funds that the NZ public will want (albeit within a 15-year secured home loan). The banks switch their 90-day USDs into 2-year NZDs by way of two “swaps” (or some variation of this):

• the currency swap – the NZ Bank gives the USDs to another party (say the World Bank), who in turn gives the NZ bank NZDs, both contracting to swap the currencies back in 90 days, and in the process the World bank will pay the US 90-day interest rates and the NZ bank will pay the NZ 90-day interest rate;
• the interest rate swap – the NZ bank will further swap the NZ interest payments with another party (say the World Bank but not necessarily the same counterparty), this time contracting to pay the NZ 2-year interest rate in return for receiving the NZ 90-day rate (i.e. all that is swapped here are the interest payments).

The end result is that the NZ bank gets NZDs and pays a 2-year NZ interest rate plus/minus any rate mismatch within the process. The World Bank, in this case, gets USDs at a US 90-day interest rate. Both then go about their ’normal’ business.

Why go to all this trouble? It provides a slightly cheaper loan rate for both parties (that arises because the World Bank can borrow at lower rates in global markets).

The USDs came from the NZ bank’s offshore loan. Where did the NZDs come from?

This is where the Uridashi and Hedge Funds come in. The World Bank, for example, borrows NZDs in the global markets, paying a 2-year interest rate (or whatever the preferred term). It might be the Japanese householder buying these bonds through a Uridashi program. It might be the Belgium dentist via a wider Eurobond issue. It may be a Hedge Fund or a more traditional Investment Fund who buys the NZD bond to capture the higher yield. Or the Hedge Fund may even take the role described above for the World Bank.

Whoever the party is, they need to buy NZDs in the first place. It is this demand that has been instrumental in pushing the NZ dollar higher in recent years. Effectively the NZ public has tapped into global markets via the strength of, and confidence in, the NZ banking system, persuading foreign investors to take on the NZ dollar risk in the meantime.

What is apparent in this process is the relatively short-term nature of the investment into NZ dollars. If, say, after two years the NZ public repaid their loan then the whole process would reverse. The swaps would be completed. The NZ bank would repay the USD loan. The Japanese housewife or Belgium dentist or US hedge fund would sell the NZDs. The NZD would no doubt depreciate.

But the loan repayment that would initiate this reversal is not about to happen. What is happening is the fixed term on the NZ public’s loan is being rolled forward, typically for another 2 years. Around $15-20 billion Is going through this process between October and January. The flip side of this fixed rate rollover is the replacement of the funding and swap by the NZ bank. Around NZ$4 billion of Eurobonds and Uridashi mature Oct-Jan. Required is either a new foreign party to invest, or the initial investor to re-invest, in newly issued NZD bonds. The fixed rate home loan rollovers and the Uridashi maturities go hand in hand.

The debate has always what will be required to entice offshore investors either to rollover the NZD investment (or new investors come to the party). It seems not too much more than what is on offer. It is early days yet but the NZ$507 million Uridashi issue by the Dutch government’s Bank Nederlandse Gemeenten last week shows there are willing issuers. There are various reports that the Japanese public are still keen to invest (and why not when cash rates are 0.25% p.a.?). And, as one senior bank staff member in the midst of this process put it, the hedge funds are keen to pick up what the Japanese might not want.

The bottom line: the first large wave of foreign bond maturities is running smoothly. There is no strong NZD selling pressure from this source. There is a long tail of maturities to come, though. The next pressure point is August-October 2007 but any NZD sell-off would probably come sooner (i.e. maybe first half 2007).

The NZ dollar market is big. Very big. And it is dominated by offshore players (an apt term). There is a tendency to think of NZ exporters and importers as key. They are in the sense that over $40 billion traded annually is large. But that sum can also be turned over within a day in the fx market, most offshore.

The offshore players are many and varied. There are the international banks, where dealing rooms “pass the parcel”. There are the arrangers, issuers and ultimately Joe Public who are involved in the offshore NZD bond market. There are the traditional investment funds buying NZ stocks, bonds, property and forests. There are the corporates and their M&A activity. There are the hedge funds, the players with big pockets and a large appetite for risk. And now there are large numbers of at-home traders who buy and sell NZ dollars. All these interact with their NZ counterparts to determine the NZ dollar.

This market is depicted in the diagram below. The offshore names are by no means complete. The volatile parts – and hence more influential – are in red, the more stable in blue.

Click on the thumbnail to expand diagram (and scale diagram larger if necessary)