It feels dangerous writing about the state of the world economy these days: just when you think you know what is going to happen in the next few days and weeks, some new and dramatic development comes along to make a nonsense of the situation.
Just a few short months ago, there were five huge independent investment banks in the United States. There were four as recently as 10 days ago. At time of writing, there are just two, and rumours surround one of those.
Only a month ago, the US government stepped in and bailed out Freddie Mac and Fannie Mae, between them funding or guaranteeing roughly half the US$11 trillion US mortgage market, and last week there was another rescue, this time of the world’s largest insurance company.
Now, the US government is planning to spend hundreds of billions of dollars buying the bad debts which are threatening the solvency of some of the biggest banks in the world.
What does all this mean for New Zealand?
Nobody can be dogmatic in answering this question, but in the short- to medium-term at least, the financial turmoil which is gripping world financial markets is bad news for us too.
We’ve already been knocked around by the impact of the drought, though in some parts of the country that now seems a distant memory and its effect is gradually waning.
We’ve also seen an extended period of weakness in the housing market, with the Reserve Bank at least projecting further weakness in the months ahead. This is good news for first home buyers, but clearly bad news not just for those who build houses, those who develop the land on which houses can be built, those who finance the developers, and those who lend to those finance companies but also to all those who have benefited by the feel-good effect of rising house prices – the retailers, and those who supply them.
The drought has nothing to do with the international financial turmoil of course, and even the weakness in the housing market hasn’t yet been much affected by it.
But there is no doubt that the fear gripping international financial markets will have an increasing effect on the housing market in the months ahead. New Zealanders are world champion borrowers – indeed, if borrowing were an Olympic sport, we would clearly take the gold in most categories of the event. We are not good savers. And the result of this mismatch is that the New Zealand banking sector has had to borrow the savings of non-New Zealanders on an enormous scale to bridge the gap.
It’s a large gap. Reserve Bank data show that, as at 30 September last year, the banking system had lent $273 billion to New Zealand-based borrowers – companies and individuals. As of the same date, New Zealanders had deposited just $175 billion with the banks, leaving the banks with a $98 billion gap to plug from offshore markets.
Well, if you are an international investor wondering where to invest your savings, and you have just seen some of the most respected institutions in the world go belly up, you might just decide you prefer to invest in US government bonds rather than take a risk on a small country a long way away. So it isn’t surprising that even our largest banks are having to pay a bigger margin above the rate paid by the US government than has been the case for a very long time.
In turn, this means that while reductions in the Reserve Bank’s Official Cash Rate will have some effect on borrowing costs in New Zealand, the high cost of covering the funding gap in international markets will mean that mortgage rates will be slower to come down than would otherwise be the case.
And of course, the turbulence in international markets will also have the effect of exacerbating the slowdown in major economies, such as the United States, the United Kingdom, Japan and Germany, with the result that demand for our exports will decline, or at least rise more slowly than would otherwise be the case.
Fortunately, we have four things which will help us weather the storm.
First, the exchange rate has declined over the last few months, and may well decline further. This is not good news for consumers looking for a reduction in the price of petrol, but it’s very good news for all those who export – farmers, orchardists, fishing companies, foresters, tourism operators, and manufacturers – as well as all those competing with imports.
Second, because the government has run Budget surpluses every year since Ruth Richardson’s Fiscal Responsibility Act was passed in 1994, and helped also by the funds raised by the privatisations of the late ‘eighties and ‘nineties, government debt is now at a very low level relative to the size of the economy – indeed, at a level which is one of the lowest in the developed world. This means that if the economic slowdown which now seems inevitable requires a bit of government pump priming, there is scope to do so without blowing government debt to uncomfortable levels.
Third, although of course I have no idea what my successor as Reserve Bank Governor will do in the months ahead, if the slowdown does threaten to become severe, and on the assumption such a slowdown would reduce inflation well below its current uncomfortably high level, there is clearly scope also to reduce the Official Cash Rate. In that respect, we are in a very different spot from that in which most other central banks find themselves, with official interest rates already at very low levels.
And finally, and unlike the situation in which many other countries find themselves, the banking system in New Zealand is in good shape. Yes, it needs to borrow large amounts offshore, and yes all banks are likely to find themselves having to write off more bad debts than has been the case in recent years. But it is certainly my very strong impression that none of the New Zealand banks is likely to incur even a small overall loss, let alone the kind of enormous losses which have brought some US institutions to their knees.
The slowdown which we are already experiencing, and which could easily last for an extended period, will be very uncomfortable for some people and some companies. Unemployment is already rising, and some companies are under pressure. But as long as policy-makers behave with common sense, we are not facing a serious crisis.
Copyright © 2024 Don Brash.