The Economics of Money and Financial Markets in New Zealand

Table of contents

1. Financial Market Instruments for New Zealand
1.1 Crown Debt Instruments.
1.1.1 Government Stock
1.1.2 Treasury Bills
1.1.3 Reserve Bank Bills
1.1.4 Kiwi Bonds
1.1.5 Government Bond Coupons
1.1.6 Inflation-Indexed Bonds
1.2 Non-Crown Debt Instruments
1.2.1 Corporate and State Owned Enterprise Bonds
1.2.2 Bills of Exchange
1.2.3 Promissory Notes
1.2.4 Certificate of Deposit

2 Major Trends in the NZ Financial Market

3 Importance of a Financial System’s Stability
3.1 Introduction
3.2 The Importance of Financial Markets
3.3 Sources of Financial System Problems
3.4 Surveillance of Financial Instability
3.5 Conclusion

4 References

1 Financial Market Instruments for New Zealand

It is an aim of a financial market to provide a source of finance to particular target groups. This section deals largely with the financial instruments used by the market participants to raise funds, how these instruments are issued and how they are traded.

The participants in the money and bond market are investors and borrowers. To highlight financial instruments from the borrowers’ point of view it makes sense to divide the group of borrowers in two distinct categories:

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The ‘Crown’ market consists of the Reserve Bank and the central government whereas the borrowers in the ‘Non-Crown’ market are financial intermediaries such as banks, corporations, state owned enterprises, local authorities, etc. as you can see in the table above. (Potter, 2000 [A]; Potter, 2000 [B])

The financial instruments in these two markets will be analysed separately in the sections to come:

1.1 Crown Debt Instruments

The debt instruments of the borrowers in the Crown market (Reserve Bank and central government) are presented in the following graph with regards to their proportions of use:

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1.1.1 Government Stock

Government bonds (stock) are the Crown’s long-term debt instruments to obtain fund requirements. Due to the fact that revenue can be raised from collecting taxes the Crown is the most creditworthy entity in New Zealand. The Government bonds are the most commonly traded instruments in the market since their interest rates are much lower than similar securities issued by non-government institutions. Since 1983 this type of bonds are issued through competitive bidding tenders supporting the government to fund its fiscal deficits through borrowing, and increasing the liquidity of the government bond market. The government determines the quantity of bonds issued to borrowers by considering its fiscal position, its desired mix of domestic and foreign debt, the maturation of outstanding bonds, etc.. (Potter, 2000 [A])

1.1.2 Treasury Bills

Treasury bills count for the second largest share of government debt. In contrast to government stocks they are short-term instruments used for covering the government’s ongoing expenditures. They can be sold either by weekly tenders or by open market operations (seasonal treasury bills) conducted by the Reserve Bank. Depending on where the treasury bills

are issued its maturity ranges from one to three months when sold over the open market operations, otherwise either three, six or twelve months when issued in the weekly tenders. The quantity of bills issued is determined by the government by a forecast of its financing requirements on a particular day. (Potter, 2000 [A])

1.1.3 Reserve Bank Bills

Reserve Bank Bills and Treasury Bills are similar in terms of their structure and pricing. They are short-term discount securities which have a maturity of 28 days or less. There is the possibility to sell these bills back to its issuer, the Reserve Bank (‘discounted’) on demand of its holder. For this reason these securities provide banks a source of funds for transactions. Furthermore Reserve Bank bills act as a monetary policy instrument as well. (Potter, 2000 [A])

1.1.4 Kiwi Bonds

As a successor from the Kiwi Savings bonds the actual Kiwi bond provides a free retail instrument for attracting funds from smaller investors. This very popular tool as the development of the number of issues reveals, has maturities lasting six months, one, two or four years with the options of interest payments due quarterly or compounded quarterly whereas the interest rates are set below similar bonds issued by the government. (Potter, 2000 [A])

1.1.5 Government Bond Coupons

With the approval of the “stripping” of coupons on longer term government securities, government bond coupons appeared on the market. Stripping means the separation of the security into its principal and coupon interest

components, creating two new types of security. The new coupon security can be traded bundled or unbundled, meaning that either each individual coupon or only all coupons together can be transferred to more, hence one investor(s). The decision for whether or not bundling the stripped coupon has the holder of the original security. (Potter, 2000 [A])

1.1.6 Inflation-Indexed Bonds

This government bond was sold first in 1977 and consists of two components, the allotment and the indexed components. The sale of these securities is managed through tenders, similar to the government bonds. The intention of this bond is to protect investors against inflation. This instrument is supposed to attract mainly institutional investors such as superannuation funds and unit trusts. (Potter, 2000 [A])

1.2 Non-Crown Debt Instruments

The difference between securities issued by Crown and the non-Crown organisations is the yield margin. As already stated above the Crown is quite creditworthy due to its ability to obtain revenue through taxation; therefore investors in non-Crown securities demand a higher yields for their more risky investments. To the group of borrowers in the ‘Non-Crown’ market belong banks, corporations, state owned enterprises, local authorities, smaller organisations and individual borrowers. The instruments used in this market are described below:

1.2.1 Corporate and State Owned Enterprise Bonds

In order to meet funding requirements in the long run, larger corporates and state owned enterprises issue these type of bond. The issues are

quite similar to the structure of the bonds the government issues. The instrument’s maturity ranges from one to fifteen years, but commonly mature between three to seven years. The bonds are usually traded through tenders or by private placement, but some are sold through retail investors or brokers.

The secondary market in contrast to the Crown debt is relatively illiquid since there are only few market makers for that type of bonds. Hence, the credit risk is higher than the government bonds too. (Potter, 2000 [B])

1.2.2 Bills of Exchange

Bills of Exchange are the most frequently used short-term security used in the non-Crown market. This discount instrument is issued by organisations which want to raise funds in the short run. There are two types of bills, the commercial bills and the bank bills. The difference between those two is that the commercial bills have not been accepted or endorsed by a bank whereas the bank bills have. An accepted bill means that the bank will pay the bill’s holder the face value on maturity. In case the bank or an organisation that endorsed the bill cannot fulfil its payment on maturity, a repayment can be claimed from the bank or endorsers that signed the bill. Thus, the commercial bill, not having any institution to back up, bears a higher credit risks. Therefore they are traded at higher discount rates than bank bills. (Potter, 2000 [B])

1.2.3 Promissory Notes

Another short-term source of funds is the issue of promissory notes. Issued under the name of the borrower this discount security has got a similar legal standing as the bank bill. The repayment can be on demand but is often fixed by a maturity date in the promissory note. They are sold through either open market tenders, dealer issues or unsolicited private placements. The margin they are issued and traded at is over the treasury

bills and bank bills due to the lower credit ratings of the issuers and the illiquidity of the market. (Potter, 2000 [B])

1.2.4 Certificate of Deposit

Certificates of deposit are commonly issued by New Zealand banks as well as lower number of bonds as their main source of raising finance. The emphasis will be on the certificate of deposit: as a main source of short- term funding for banks, these certificates have a preset maturity date, but offer flexibility as well when investors can sell them to the secondary market prior to maturity. So, certificates of deposit can be divided into negotiable certificates and ownership-transferable certificates of deposit. The pricing is equivalent to the pricing of the treasury bills. The sale is through private placement or a tender system (market based bidding system). (Potter, 2000 [B])

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