Brian Gaynor: Blame interest rates on our borrowing

Brian Gaynor

The banks were under fire again this week after they raised long-term lending rates.

Reserve Bank Governor Alan Bollard pitched in with his statement: "We believe the rise in longer-term interest rates is unwarranted and inconsistent with the monetary policy outlook" and Finance Minister Bill English also issued a warning.

These attacks coincided with the release of the February banking statistics that allows us to assess the state of the sector.

The first point to note about the domestic banking industry is that it is huge, in relative and absolute terms, and has a massive influence on domestic economic activity.

For example:

* Total lending of $316.7 billion at the end of February represents 176 per cent of New Zealand's GDP, whereas total bank lending in Australia is only 121 per cent of that country's GDP.

* Total domestic bank lending is 7.5 times the value of the NZX, whereas bank lending across the Tasman is only 1.6 times the total market capitalisation of the ASX.

* New Zealand banks have a larger share of the total lending market than the Australian-based banks, partly because of the demise of our finance company sector.

* The banks account for well over 50 per cent of New Zealand's overseas debt.

* Bank lending has been a major contributor to economic growth as it now accounts for 176 per cent of New Zealand's GDP, compared with 116 per cent of GDP in June 1998.

The New Zealand banks fund their activities from domestic deposits and overseas borrowings.

As the accompanying table shows, overseas borrowings have become more and more important and now represent 41.2 per cent of total bank funding compared with only 25.5 per cent in June 1998 and just over 25 per cent in Australia at present.

Domestic individuals continue to supply a smaller and smaller percentage of total bank funding and the difference between their deposits and borrowings has escalated from a negative $16.9 billion in June 1998 to a negative $73.1 billion at present.

In other words New Zealanders are up to their eyeballs in debt.

The other problem with our banking funding is that it is predominantly short-term. Nearly 78 per cent of domestic funding is for 90 days or less and just over 73 per cent of offshore funding is for the same short-term period.

Most of the short-term funding is wholesale based, with New Zealand banks heavily dependent on commercial paper market at home and in the Northern Hemisphere. Domestic funding is relatively secure but there are uncertainties about overseas borrowings, particularly in the credit crisis.

The Crown Wholesale Guarantee Facility, which applies to maturities of up to five years, was introduced by the Government late last year to enable the banks to extend their funding maturities.

This has had some success as borrowings with maturities of one year or more have risen from $19.9 billion in mid-2008 to $32.7 billion at the end of February. Nevertheless these long-term borrowings still represent only 9.5 per cent of total bank funding compared with 6.5 per cent in June 2008.

The bank's lending maturity profile is quite different with 26.3 per cent of loans for one year or more but only 9.5 per cent of the funding for this period.

This isn't a concern under normal circumstances but with Northern Hemisphere wholesale markets under stress the banks find it more difficult to roll over borrowings when they mature.

Their problems are compounded by many borrowers wanting to switch from short-term to long-term loans.

The banks have not been in a great position to meet these demands and, as a result, a large number of companies have gone to the bond market and issued five-year or more securities to retail and individual investors.

The bond issuance market is nearing saturation and in the past few weeks a number of companies have turned to the sharemarket to raise new capital.

Nuplex, Fletcher Building and Kiwi Income Property Trust are the most obvious examples of this.

There is expected to be a large number of equity raisings over the next few months because long-term bank loans are difficult to obtain and the bond issuance market is running out of puff.

The banks have also been under pressure in recent weeks from house-owners converting their floating and maturing mortgages to long-term mortgages.

In June 2008 there was $19.6 billion of floating-rate mortgages and $50.5 billion of one-year term mortgages, a total of $71.1 billion.

At the end of February this had surged to $99.2 billion, comprising $35.5 billion of floating-rate and $63.7 billion of one- year fixed mortgages.

It appears that when mortgages matured over the past eight months borrowers moved to floating rates in anticipation that fixed rates would move lower. As soon as interest rates began to rise there was a rush to convert to long-term mortgages but the banks were short of long-term money to lend.

As interest rates are ultimately determined by supply and demand, there has been a sharp increase in long-term rates in response to the heightened demand.

These rate increases are probably justified because there is now more demand, than supply, of long-term bank loans.

Bollard, Bill English and the media have pointed the finger at the banks but the rise in long-term interest rates is mainly due to a number of long-term structural economic problems.

These include:

* New Zealand has too little savings and, as a result, our banks have become more and more reliant on offshore funding.

* This funding is mainly short-term, for 90 days or less.

* Banks, and their lending rates, come under pressure when borrowers want to switch from short-term to long-term loans.

* Too much has been lent to individuals to invest in residential property while the non-agriculture business sector now accounts for only 35 per cent of total loans compared with 44.1 per cent in mid-1998.

This creates major funding problems for businesses because the country is short of capital and our tiny sharemarket isn't a great source of new equity for growing companies.

The real issue we have to address is our woeful saving record and heavy reliance on overseas borrowings to fund our lifestyle.

The situation is getting worse as New Zealand now has $248 billion of overseas debt, equal to 137 per cent of GDP, compared with $188 billion or 115 per cent of GDP just two years ago.

Financial institutions, mainly banks, are responsible for nearly 65 per cent of New Zealand's foreign debt and a high percentage of this has gone into residential property.

These massive overseas borrowings could be a major problem when the world economy recovers.

The 1997 to 2007 economic boom was mainly due to an explosion in worldwide credit and New Zealand was a major participant because of our propensity to borrow.

The next economic upturn will probably be fuelled by saving and equity with credit playing a minor role. Countries that are dependent on the credit, and are short of savings and equity, are unlikely to fully participate in the recovery.

One of our major objectives must be to reduce our dependence on short-term overseas borrowings and ensure we have sufficient savings and equity to participate in the next upturn.

Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.

bgaynor@milfordasset.com