Former Economics Editor of the NZ Herald

Brian Fallow: Wave of debt poses serious threat


The Government made a rod for its own back by making the sovereign credit rating the hallmark of prudent fiscal and economic management, something to be preserved at all costs.

Now we have been downgraded, by two rating agencies, and the Government's reaction has been a somewhat comical combination of substantive relief and rhetorical embarrassment. Because the financial markets have responded to the downgrades with equanimity.

"Tell us something we don't know, and haven't priced in already," seems to be the reaction.

The needle on Government bond yields in the secondary market has barely flickered.

The 10-year bond was trading at a yield of 4.36 per cent yesterday, just 2 basis points higher than last Thursday, the day before the downgrades.

It compares to an average yield of just under 6 per cent over the past 10 years.

In the context of still falling international yields it means the margin against US and Australian bonds has widened a little, but who really cares?

The Government can borrow more cheaply than at any time in at least 25 years, which is convenient when the fiscal bottom line has sunk deep into the red.

The effect on the exchange rate seems to have been only to extend the fall already underway, which had seen the dollar decline 10 per cent over August and September on a trade-weighted basis.

What this illustrates is that there are bigger things to worry about than the credit rating: global forces at work which threaten to sideswipe the economy when it is still struggling to recover from recession and seismic calamity.

The recovery, such as it is, has been export-led, supported by the most favourable terms of trade - the mix of export and import prices - for 37 years.

But growth in the world economy is slowing and forecasts for our trading partners have been revised down steadily all year.

The OECD reports that growth among its members, which still count for more than half of world output, was a scant 0.2 per cent in the June quarter.

Then there is the tag-team sovereign debt crisis playing out on both sides of the Atlantic.

At the moment Europe is in the ring, but let's not forget the toxic partisan politics on display in Washington when it flirted with default. That issue is entirely unresolved. It has only been kicked to touch.

So the risk of GFC II, the sequel, remains.

The fact that international bond yields have fallen so much, pulling ours down with them, is not a good sign.

It means investors are taking an increasingly gloomy view of the prospects for growth.

And that they are so risk-averse that they are prepared to invest in US Treasuries for little or no real return, simply to preserve capital.

That fundamental shift in attitudes towards risk lies behind last Friday's credit rating downgrades.

Decades of running current account deficits, that is, spending more than we earn in our dealings with the rest of the world, has left us with net external debt of $140 billion, equivalent to 70 per cent of GDP.

But that includes some $12 billion of reinsurance claims, which are treated by the statisticians as New Zealand assets abroad until they are paid out, as they will be over the next year or two. Adjusting for that, the foreign debt to GDP ratio would be 76 per cent.

That is still an improvement on the 85 per cent recorded in March 2009, which is the sort of perilous level associated with Portugal, Ireland, Greece and Spain.

But it is still conspicuously high by international standards and international lenders no longer look upon such debt levels with the kindly and indulgent eye they once did.

Especially now that the Government's debt is climbing, albeit from low levels.

The unhappy experience of Ireland shows that private sector overseas debt can turn into government debt really fast, if the alternative is a collapse of the banking system.

As of the end of June, New Zealand banks' net overseas borrowing as recorded in Statistics New Zealand international investment position data was $112 billion, equivalent to 37 per cent of the banks' total lending at the time.

At the behest of their regulator, the Reserve Bank, they have reduced their reliance on overseas funding but clearly it remains high - too high for the rating agencies' comfort.

In its September 15 monetary policy statement the Reserve Bank focused on bank funding as one of the main channels through which the euro area's woes might impact on us.

So far the impact of tighter funding markets overseas has been minimal because the banks are relatively liquid and credit growth almost imperceptible - the combined bank debt of the household, farm and business sectors as at the end of August was less than 1 per cent higher than a year earlier.

However, the Reserve Bank noted that one indicator of the risk premium, credit default swap spreads on the big four Australian banks (parents, of course, of the big four New Zealand banks), had widened to levels seen at the height of the crisis in 2008.

Just why, it could not say. But it warned that "if conditions do not improve, these pressures will see monetary conditions tighten and banks would be likely to increase lending and deposit rates relative to the official cash rate".

In contrast to some of its counterparts, including the Federal Reserve, whose policy rates are up against the dreaded "zero bond", the Reserve Bank does have scope to cut the OCR if need be to counter a wider risk margin imposed on top of it by the markets.

But with the OCR at an all-time low of 2.5 per cent, it has much less ammunition in the belt than it did when the global financial crisis hit and it was able to cut the OCR by 5.75 percentage points.

The downgrades have usefully focused attention on the chronic problem of too much debt.

The danger is that it diverts attention it from the acute problem of too few jobs.

It is not debt in isolation that is the issue, but the ratio of debt to GDP, just as the same mortgage can be comfortable or a back-breaking burden depending on the borrower's income.

And there's the rub, the dilemma for policymakers.

You can't have your cake and eat it. Whether for households or the Government, the trade-off between spending and saving needs to be carefully balanced.

Simultaneous belt-tightening by the household and public sectors can be counter-productive if it leaves the economy starved of demand and firms with less incentive to hire and invest.

That is especially true if the outlook for the export sector is darkening.

It is the season for politicians to peddle their prescriptions for reducing government debt and/or increasing household savings.

The risk we face is that moves which are too aggressive in either of those directions will so hobble GDP growth as to be self-defeating.

- NZ Herald

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Former Economics Editor of the NZ Herald

Brian Fallow is a former economics editor for the New Zealand Herald. A Southlander happily transplanted to Wellington, he has been a journalist since 1984 and has covered the economy and related areas of public policy for the Herald since 1995. Why the economy? Because it is where we all live and because the forces at work in it can really mess up people's lives if we are not careful.

Read more by Brian Fallow

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