Bollard warns of risks to NZ recovery

Alan Bollard says there there is a danger of a sovereign debt crisis. Photo / Mark Mitchell

Reserve Bank Governor Alan Bollard expects the economic recovery to pick up this year and gradually become more secure.

But in his annual speech to the Canterbury Employers' Chamber of Commerce yesterday he highlighted some of the risks around that forecast.

One is a sovereign debt crisis.

Financial markets had been merciless in their treatment of the weaker members of the eurozone, he said.

"Managed sovereign defaults could still occur and these could impact the banking systems of core European countries," he said.

A scenario of renewed capital market fragility would also make life much tougher for Australian and New Zealand banks, which would be extremely damaging to the recovery.

And if the markets became more allergic to indebted small countries generally, New Zealand might see its credit rating downgraded and debt-servicing costs rise.

"If the market were to form the view that the Government deficit was increasingly structural and hard to correct, and if the New Zealand Government were forced to consolidate faster, this could generate a contractionary effect on consumption, which would be difficult to counter with monetary policy."

Another real risk was overheating in Asian economies, including China, Bollard said. Chinese policymakers might need to apply the brakes in response to rising consumer prices.

"This could be very disruptive, risking loan defaults, poor bank balance sheets, capital controls, exchange rate tensions, import protection and a regional slowdown,"he said.

"A disruption of this magnitude would have another undesirable effect: knocking Australia's terms of trade and exposing rising imbalances in that country. New Zealand would lose the advantage of the China/Australia growth locomotive that has helped drive our own export demand over the past 12 months."

On the other hand the commodity boom could intensify.

"New Zealand farmers are still recovering from the last commodity boom when some over-committed, and are still looking to reduce the debt they built up. A more measured reaction this time is important."

And as oil prices rose it would put pressure on inflation, not just in New Zealand but globally, risking a bursting of the commodity boom just as in 2007-08, Bollard said.

A purely domestic risk is that the caution households displayed last year turns out to be a structural change in behaviour rather than a cyclical response to a major recession.

House prices could be forced to drop much further to reach true economic values, he said, casting a pall of gloom over the market and the construction and retail sectors.

"Under this scenario, the Reserve Bank might have to reconsider some further monetary policy stimulus."

As it is, while turnover in the housing market has firmed over the past couple of months, "we believe the current level of house sales is consistent with continued softness in house prices this year".

On the outlook for the world's largest economy, the United States, Bollard sketched two possible scenarios. One highlighted its high unemployment, "moribund" housing market and the constraints facing both monetary and fiscal policy.

"If this US domestic gloom continues or worsens, it is difficult to see American consumers playing any part in driving world recovery.

"Further, it could impact equity markets, and start to focus financial markets on the size of US state and federal debt," he said.

"But just as possible, the US may surprise us with economic strength over 2011."

Businesses which had hoarded cash would be able to ramp up investment quickly and then demand for labour could increase almost as rapidly as labour was shed going into the crisis.

"Under this scenario, US consumers would start to spend again, acting as an engine of growth for trans-Pacific trade ... The US dollar would presumably appreciate, taking some pressure off the New Zealand dollar and providing an improved opportunity to rebalance our economy towards export growth."