Global and NZ Growth Prospects Deteriorate

Tuesday 21 October, 2008

In recent weeks we have warned that the surge in business and consumer confidence over September should not be extrapolated to an especially good outlook for the New Zealand economy over the coming year. Those warnings now need strengthening.

First we should note that there were certainly good reasons why pessimism should ease off.

• Interest rates falling with the Reserve Bank promising more reductions.
• The NZ dollar easing with further declines expected.
• Petrol prices easing back.
• Drought ending the period of its biggest negative impact on farm cash flows.
• Major Winter rain ending.

But we warned that growth will remain suppressed in the coming year by many factors.

• Near 88% of housing mortgage rates are fixed so a falling official cash rate will take a long time to affect the majority of household debt servicing costs.
• Business cash flows are severely constrained and most will spend the next 12 months reducing inventories, rationalising product lines, laying off spare staff, and delaying capital expenditure.
• Trading partner growth will be below average.

Now growth will be further suppressed by a potentially deep global recession bringing a pullback in commodity prices, reduced demand for our manufactured exports, and a potentially severe hit to our tourism sector. There is also the risk of the global credit crisis bringing decreased availability of credit to finance business expansion.

With regard to this latter point, until a couple of weeks ago it was valid to say New Zealand banks could still get the one third of funding needed from offshore but the cost would be relatively high. We have written in terms of the risk premium rising from about 0.1% just over a year ago to between 1.5% and 2.2% recently.

But as a result of the sharp worsening in the global credit crisis the availability of funds for banks has decreased. In other words it has become a quantity issue rather than just a pricing issue for banks looking to replace wholesale funds as they roll off around the world. Governments have reacted to this situation where not only investors shy away from banks but banks also have shied away from each other, with massive capital injections, capital guarantees, and various other measures aimed at getting the credit markets functioning again.

The New Zealand government has been forced to react over the weekend to the Australian government's capital guarantee scheme by introducing one here in New Zealand. Some changes have been made to address the initial perverse incentive provided to boost one’s mortgage and shift the funds to a finance company for a risk-free arbitrage profit. But at least one gap remains – the lack of a guarantee on wholesale funding.

Investors may distinguish between banks on the basis not just of the interest rate and credit rating they offer but whether they are guaranteed by their government. The Australian government for instance has guaranteed the international wholesale funding of Australian banks for the next three years. The New Zealand scheme does not contain this guarantee. That means investors overseas who might normally have invested in a New Zealand bank security have an incentive to purchase a capital guaranteed security from a bank in a different country.

At this point we could easily run through the negative impact on credit availability and the New Zealand economy if banks are unable to access wholesale funds here or offshore – even allowing for drawdowns of special lines with the RB and Australian parent banks. But that may be a redundant exercise because as the Finance Minister has noted the capital guarantee scheme is a work in process and it is probable that some changes will be made to remove this anomaly. Whether they are or not however, it seems fair to conclude that the recent indications of tightening credit availability will strengthen over coming months – not least because of the worsened economic outlook as the world goes into a potentially deep recession.

Source: Tony Alexander, Chief Economist of the Bank of New Zealand.