Brian Fallow on the economy

Brian Fallow is the Herald's Economics Editor

Brian Fallow: NZ safer than Greece but the risk is real

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Greece has to ensure austerity measures don't leave the economy in ruins. Photo / Bloomberg
Greece has to ensure austerity measures don't leave the economy in ruins. Photo / Bloomberg

Watching the Greek debt crisis unfold recalls the old story about the man who fell from the top of a tall building.

As he hurtled past people on the 20th floor balcony they heard him say: "o ... kay ... SO ... far ..."

An orderly resolution, that is, one which avoids default and a financial market panic, essentially requires a deal between three very different sets of parties, with very different interests.

First, of course, are the Greeks themselves. Not just the Greek Government but a durable majority of the people. "Democracy", after all, is a word we owe to the Greeks.

With gross government debt over 150 per cent of GDP and being shut out of capital markets, they are in no position to dictate terms.

But the years of dismal austerity they face cannot be so onerous that the economy crumples under its weight, especially in an era when labour and capital are mobile.

The second key group are the holders of more than €300 billion ($530.6 billion) of Greek government bonds, led by French and German banks. They have to agree to roll over the debt on terms which are, one way or another, concessionary.

And their agreement must be vol-untary. Any form of coercion risks the credit rating agencies calling it default.

The danger in that case would be that, as in the global financial crisis three years ago, everyone in the market starts looking sideways at their counterparts and worrying about how much they might be exposed.

It's not just the bonds themselves that are a problem, but derivatives like credit default swaps intended to diffuse the risk of default - at the expense of an opacity which can be paralysing.

The risk is contagion and a return to frozen credit markets.

Greek 10-year bonds have been selling on the secondary market - not, one imagines, especially deep at the minute - at yields around 18 per cent. Clearly, the sellers of these bonds are accepting deep discounts to their face value in order to be shot of them.

That ought to incentivise bondholders to be reasonable.

Finally, there are the international authorities - the European Union, the European Central Bank and the International Monetary Fund.

Their priority has to be the preservation of financial stability.

That cannot mean endlessly extending the overdraft of a fundamentally insolvent debtor. They also have a duty to the taxpayers of the many countries who fund them.

But their near-term challenge is to prevent the unthinkable from becoming the inevitable.

How many more times they can kick for touch to buy time is the question.

And the odds of securing a mutually tolerable agreement between those three sets of parties do not look particularly good.

Why should we care?

The first reason is that New Zealand - the country as distinct from the Government - is heavily in debt to the rest of the world.

As of March this year, New Zealand's net international liabilities were $148 billion, or around 76 per cent of GDP. But that number is flattered by $11 billion worth of reinsurance claims which, until they are settled, are treated as an asset in these accounts.

New Zealand's external debt, relative to the size of the economy, is in the same neighbourhood as Portugal, Ireland, Greece and Spain.

By contrast, gross government debt is at the prudent end of the league table with countries like Australia, Korea and Luxembourg.

The fiscal track outlined in the Budget has gross debt peaking at 38 per cent of GDP in 2014 before heading down again. That compares favourably with IMF projections for that year of 120 per cent for the G7 economies and 79 per cent for the G20.

But it doesn't mean we can afford to be relaxed about the high level of international debt.

Four-fifths of it is borrowing by banks and reflects the fact that for decades now New Zealanders have collectively wanted to borrow much more than other New Zealanders were able or willing to lend.

The problem, in the event the markets seize up again, is "rollover risk", posed by that portion of banks' offshore funding which is short-term and has to be refinanced within less than 90 days.

According to Reserve Bank figures, as of the end of last year a third of banks' overseas funding fell into that category.

That's an improvement from 45 per cent at the end of 2007 and reflects regulatory moves by the Reserve Bank post-crisis to reduce that risk.

But it has not been eliminated. So what happens if overseas credit markets freeze again?

Most likely the Reserve Bank would have to reopen its equivalent of a pawnbroker's window and lend banks money on the security of chunks of their mortgage books. No one involved liked that but it worked.

A greater danger posed by another financial crisis would be via the effect on global economic growth.

The last one saw commodity prices plunge.

A repeat would cut off the fuel supply to one of the twin engines of the economic recovery under way in this country, namely the boost to farm incomes from record-high export commodity prices.

There is also a more fundamental concern, trenchantly outlined in a recent paper by Treasury analyst Jean-Pierre Andre and the subject of a conference in Wellington over the next couple of days on New Zealand's macro-economic imbalances.

"Since this offshore financing has been primarily used by banks to fund property lending (particularly houses and dairy farms) it suggests that offshore creditors are ultimately secured against the soundness of New Zealand's property market," Andre writes.

But house prices and farm prices have substantially moved away from long-term historic and international norms, relative to incomes or earnings, and investor sentiment can change quickly.

He quotes economists Carmen Reinhart and Kenneth Rogoff in their widely cited paper "This time is different: Eight centuries of financial folly".

"Unfortunately a highly leveraged economy can unwittingly be sitting with its back at the edge of a financial cliff for many years before chance and circumstances provide a crisis of confidence that pushes it off."

Reduced to a slogan, the lesson of the last few years, which the Greeks may be about to teach us again, is that "debt = risk".

- NZ Herald

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