Our addiction to debt could bring New Zealand's so-called rock star economy to a sudden halt.
Thursday is an important date in this regard as Reserve Bank Governor Graeme Wheeler will announce his next interest rate decision. Inflation remains low but the central bank is concerned about the strong housing market and the huge amount of personal debt that is supporting it.
A further increase in the official cash rate (OCR) will inevitably flow through to mortgage rates and have a big impact on the spending power of highly leveraged residential property owners.
Reserve Bank figures show that individual bank borrowings passed $200 billion for the first time in May. The $200.6 billion of household bank borrowings at the end of the month is equal to 88.5 per cent of GDP compared with 68.8 per cent of GDP a decade ago and 57.3 per cent in mid-1999.
In addition, individuals have non-bank borrowings of $6 billion and student loans of $14 billion, giving total individual borrowings of $221 billion. Thus, New Zealand residents — including retirees and children — have average total borrowings of $49,000. The average debt for individuals in the workforce — excluding retirees, children and the unemployed —is $95,000.
There are a number of precedents, including Ireland, where a debt-fuelled residential property boom has had disastrous consequences for a country and its financial system.
Ireland's household debt surged from 43.5 per cent to 80.1 per cent of GDP in the five years ended March 2008 as the country experienced a massive residential property boom. House prices surged 70 per cent during this five-year period as the media carried a huge number of stories about surging prices, the hottest suburbs and the best places to buy.
The housing boom was sustained by high net migration inflows which were expected to continue.
The property bubble burst at the end of 2007. House prices plunged 50 per cent over the next five years, the three major domestic banks went bust or had to be bailed out by the Government, and the economy slumped. Substantial net migration inflows were replaced by large net migration outflows.
Many of these emigrants have settled here. Our Reserve Bank has been concerned about the highly leveraged residential property market for some time and in October 2013 it introduced restrictions on high loan-to-value (LVR) residential mortgage lending.
The bank introduced LVR restrictions because it was "concerned that risks in the New Zealand financial system were increasing, due to the escalation of house prices and a rise in residential mortgage lending with high LVRs, against a backdrop of high and rising household indebtedness. Current imbalances in the housing market could increase over time, resulting in a significant disorderly correction to the financial system in the event of a future economic or financial shock".
The housing market is extremely important in New Zealand because the bank estimates that our total residential housing stock is worth $725 billion, or 3.2 times GDP, compared with A$4832 billion, or 3.1 times GDP, in Australia. However, total bank assets and the domestic sharemarket are much bigger relative to GDP in Australia than New Zealand.
The LVR regulations have had an impact on house sales in New Zealand, particularly low-priced houses, but the $600,000 plus market remains relatively firm. The country's median price has risen 26 per cent over the past five years, still well below Ireland's 70 per cent price hike in a five-year period in the mid-2000s. Nevertheless, the bank believes that we have too much emphasis on housing, particularly as this addiction is being fuelled by more and more debt.
On March 13, Wheeler raised the OCR rate from 2.50 per cent to 2.75 per cent and made the following comments: "There has been some moderating in the housing market. Restrictions on high loan-to-value ratio mortgage lending are starting to ease pressure, and rising interest rates will have a further moderating influence. However, the increase in net immigration will remain an offsetting influence."
On April 24, Wheeler raised the OCR another 25 basis points to 3 per cent with almost the exact same comments.
On June 12, the OCR was increased a further 25 basis points to 3.25 per cent with the comments that the "housing market has moderated since late last year" but strong net migration flows "are adding to housing and household demand".
The key statement at the end of the June 12 release was: "By increasing the OCR as needed to keep future average inflation near the 2 per cent target mid-point, the bank is seeking to ensure that the economic expansion can be sustained."
There is a strong argument that these interest rate rises are contributing to an economic slowdown rather than sustaining the economic expansion. The reason for this is that higher interest rates have a big impact on consumer spending, especially when total household bank debt exceeds $200 billion. The higher interest rates will be immediately felt by those on floating mortgage rates, which represent 33 per cent of all mortgages in dollar terms.
On the positive side, fixed-rate mortgages have risen from 38 per cent to 67 per cent of total mortgages over the past two years although 89 per cent of these fixed-rate mortgages are for two years or less.
The flip side of the argument is that higher interest rates will benefit depositors and they will spend their higher interest income. This will counteract the reduction in spending by borrowers who face higher and higher interest payments as interest rates increase.
The problem with this argument is that a larger percentage of bank deposits are sourced from overseas, with the higher interest payments going to overseas investors, or are sourced from elderly investors who are not big spenders and often reinvest their interest income. Thus, rising interest rates have a negative impact on the economy even though depositors receive higher interest payments.
All eyes will be on Wheeler next Thursday because he will have more influence on the domestic economy over the next six to 12 months than any other individual.
A further increase in the OCR, which is anticipated, will put more and more pressure on borrowers and their ability to spend. This coincides with clear signs that domestic economic activity is moderating and commodity prices, particularly dairy and forestry, have fallen sharply in recent months. The clear beneficiaries of these interest rate rises are overseas investors because they receive higher income from their New Zealand dollar deposits, relative to most other currencies, and the kiwi is likely to remain elevated as long as our interest rates remain higher than most other countries.
The success of the LVR restrictions on residential mortgage lending shows that there are other ways to deal with our highly leveraged residential property obsession than more and more interest rate rises. The bank needs to become far more innovative and lateral-thinking in its war against household debt and a strong housing market because escalating interest rates could easily shatter our "rock star" economy. The bank will have a big influence on whether we are a one-hit wonder or develop into a Rolling Stones.
• Brian Gaynor is an executive director of Milford Asset Management.