KEY POINTS:
Exuberant borrowers need to understand the risks they are taking and that the easy money floating around the world won't last forever, Reserve Bank Governor Alan Bollard warned yesterday.
In a speech to the Wellington Regional Chamber of Commerce Bollard reflected on the very strong growth in the
flows of money around the world in recent years.
It has been driven by a glut of savings in East Asian and oil-exporting countries and persistent external deficits in countries like the United States, Australia and New Zealand.
The result in New Zealand's case is downward pressure on interest rates and upward pressure on the dollar, at a time when the opposite was required to put the economy back on an even keel.
Bollard acknowledged he had been more cautious about pushing up the official cash rate than he might otherwise have been, because he had not wanted to add to upward pressure on the exchange rate.
"Given our relatively high interest rates New Zealand has attracted a disproportionate share of global liquidity in recent years, putting upward pressure on the New Zealand dollar despite a relatively large current account deficit."
The result, he said, had been a "great deal" for New Zealand borrowers, though he wondered whether the Japanese and European retail investors who indirectly funded this borrowing fully recognised the exchange rate risk.
In New Zealand, too, borrowing households and lending banks should realise this period of cheap international money has been unusual - even if it has lasted for 10 years - and at some point the system would revert to more normal financial conditions.
Bollard noted the relatively close correlation between house prices and the New Zealand dollar over the past 15 years.
"Without claiming a direct relationship between the two, this goes some way to illustrate the extent to which persistent domestic inflation pressures have underpinned the outlook for interest rates, which in turn has maintained upward pressure on the New Zealand dollar," he said.
"Accordingly a sustained retracement in the New Zealand dollar from the highs seen in recent years could be contingent on our efforts to rein in domestic inflation pressures."
Bollard said that while the Reserve Bank's official cash rate was the dominant influence on short-term interest rates, for longer-term lending global interest rates and other factors like perception of the riskiness of lending to this country became the main influence on interest rates.
As borrowers have switched from floating to fixed-rate mortgages, and increasingly for longer terms, the effect of raising the official cash rate has been muted and delayed.
The effective or average mortgage rate - the main channel through which monetary policy works - has increased by only 1.1 percentage points since the start of 2004, even though Bollard has raised the OCR by 2.5 percentage points.
"But as household debt grows, the OCR becomes a more potent policy instrument," he said. And some of the distortions in the international environment would not necessarily last forever, he said, citing China's fixed exchange rate and Japan's very low interest rates in particular.
Global investors' appetite for risk in a period of strong world growth had encouraged "carry trades" where investors borrow cheaply in one country then invest in high-yielding sectors in another, pushing up the latter's exchange rate in the process.
"The upward pressure this has put on the New Zealand dollar and the downward pressure on interest rates have exacerbated the current problematic imbalance between traded and non-traded sectors in New Zealand."
