Brian Fallow: Debt falls, but we're not home & dry

NZ isn't as deep in overseas debt as it once was. Picture / 123RF

Over the past eight years, New Zealand has gone from being up to its neck in debt to the rest of the world, to up to its belly.

Net foreign liabilities have declined from nearly 85 per cent of gross domestic product in 2009, to 59 per cent now.

But in a speech this week reflecting on the reasons for this change, and its sustainability, Reserve Bank deputy governor Geoff Bascand sounded a cautionary note.

The level is still high by international standards, much of the improvement has been due to global factors beyond our control, and it is unsafe to assume that the domestic drivers - especially the behaviour of households - will persist.

Net foreign liabilities - or the net international investment position, as the statisticians call it - stood at $159 billion at the end of March 2017. It includes equity, but the overwhelming majority of it is net debt of $147b, equivalent to 55 per cent of GDP.

It largely reflects the cumulative effect of decades of current account deficits, as the country earned less from the rest of the word through trade and investment than the rest of the world earned from us, requiring us to import the savings of foreigners to cover the shortfall.

But it has also benefited in recent years from valuation gains, as the market value of New Zealand's holdings of offshore equities has been boosted by the strength of global sharemarkets. Those favourable revaluations account for nearly a third of the improvement in the ratio of net foreign liabilities to GDP since 2009, Bascand said.

The strength of equity markets has been underpinned by extraordinarily low world interest rates, which have also helped New Zealand's external accounts by reducing the cost of servicing foreign debt.

The trade balance, meanwhile, has benefited from the most favourable mix of export and import prices for decades - not enough to haul the balance of trade in goods into the black, but enough to be more than covered by a positive balance in services trade, especially tourism and export education.

These tailwinds have kept the current account deficit wobbling around the 3 per cent of GDP mark during the current expansion. By contrast, by the equivalent stage of the previous cycle it had widened to nearly 8 per cent of GDP.

That is not altogether a good thing, however. The current account deficit is also a measure of the gap between domestic investment and domestic saving, and that gap has narrowed from both sides.

One of the assumptions underlying the Reserve Bank's expectation that net foreign liabilities will remain around the current level, relative to the size of the economy, is that business investment remains low as a share of GDP, Bascand said. "[But] lower business investment as a share of the economy would likely lead to a deterioration in the capital stock and lower growth in productivity."

Another feature of the current expansion has been that for four or five years after the recession, household saving rates turned positive. But for the past three years households have collectively slipped back into spending more than their incomes; the Reserve Bank expects the saving rate to remain negative over the next three years.

Meanwhile, strong population growth has required the household sector to invest more in new residential building.

"If the housing demands associated with population pressure and existing shortages cannot be met by increased household sector or domestic saving more broadly, it will be reflected in a deterioration in our net foreign liabilities position," Bascand said.

The improvement since 2009 is nothing special by international standards, which may be why our credit ratings have not improved. They are about relative risk, after all.

New Zealand's net foreign liabilities position is similar to Australia's, relative to the size the economies, but the only developed countries which are worse by this measure are those casualties of European monetary union: Ireland, Greece, Portugal and Spain.

As of last March, New Zealand banks' gross foreign debt stood at $133b, which is just under a third of their combined loan book.

That is a source of vulnerability for the economy. The offshore funding markets, on which we depend so abjectly, froze for a while during the global financial crisis, requiring the government to stand behind the banks and the Reserve Bank to step up as lender of last resort.

Even during normal times, banks need to be able to peel off the currency risk of their offshore borrowing - the risk that when loans have to be repaid, the exchange rate will have moved against them. That means there have to be counterparties in arcane swaps markets willing to take on that risk, for a price.

Banks have accounted for much of the reduction in the ratio of net foreign liabilities to GDP since 2009, as credit growth was funded more by domestic deposits than was the case before the global financial crisis, Bascand said.

In part, that reflected regulatory changes as the Reserve Bank has since 2010 required the banks to fund more of their lending either from domestic deposits or from longer-term offshore borrowing.

But ANZ's chief economist Cameron Bagrie has been warning for some time about a widening and unsustainable gap between growth in banks' lending and growth in deposits. The result, since last September, has been higher interest rates for both deposits and mortgages (despite a lower official cash rate) and a tightening in banks' lending criteria.

Combined with the Reserve Bank's loan-to-value ratio restrictions, it has seen credit growth slow, the housing market cool and building consents plateau, he said.

"But timely measures now show that this finding gap has narrowed considerably." While there is still a wide gap between annual growth in household borrowing and deposits, over the past three months credit and deposit growth have run at a very similar pace, Bagrie said.

"It does suggest competition for deposits could ease a tad and there is a little more wriggle room on the lending side of the equation."