Brian Gaynor: Rate rise puts spotlight on kiwi dollar

Rises in the official cash rate will make New Zealand increasingly attractive to speculative investors, putting further pressure on the currency.

The New Zealand economy is on the up and Reserve Bank Governor Alan Bollard has begun to assert his authority again.

On Thursday he raised the Official Cash Rate (OCR) from 2.5 per cent to 2.75 per cent and signalled that the days of cheap credit are coming to an end.

This was the first OCR increase since July 2007 when it was raised from 8.0 per cent to 8.25 per cent.

The latest interest rate rise was fully anticipated but it does have some risks, particularly in terms of a higher New Zealand dollar and increased debt servicing costs for the highly geared household sector.

There has been plenty of good news on the economy lately, including:

* Unemployment fell to 6 per cent in the March quarter from 7.2 per cent in the previous quarter.

* The May ANZ Commodity Price Index was 54.5 per cent higher than 12 months previously, indicating rising prices for our main exports.

* The country had a merchandise trade surplus of $161 million for the April 2010 year, the first annual surplus since July 2002.

* Residential building consents for the January to April period were 33.9 per cent higher than for the same four months last year.

* The ANZ-Roy Morgan Consumer Confidence Index recorded its third successive rise in May and was considerably above year-earlier levels.

* The May NBNZ Business Confidence Survey showed a net 48.2 per cent of respondents had a positive outlook on the economy compared with a positive 1.9 per cent 12 months earlier.

The Reserve Bank's Monetary Statement, which accompanied this week's OCR announcement, maintains that "the economy has been expanding for more than a year [and] consistent with our previous forecasts, the pace of recovery has picked up in recent quarters".

The central bank believes that manufacturing and construction are leading the recovery with the export sector also making a strong contribution. North America and Europe are relatively subdued but the Asia-Pacific region is experiencing strong growth and exports to that region are expanding.

This is reflected in the export figures to our five main destinations for the three months ended April compared with the same period last year.

These figures are:

* Australia, plus 6.0 per cent.

* China, plus 22.9 per cent.

* United States, minus 15.8 per cent.

* Japan, plus 10.2 per cent.

* United Kingdom, minus 14.2 per cent.

Bollard raised the OCR this week because he believes that the economy will grow by 3.5 per cent in the March 2011 year and by 3.6 per cent in the following year.

He believes current interest rate levels are stimulatory and are no longer needed. If the economy continues to improve, particularly ahead of current forecasts, then further interest rate rises can be expected.

However, these interest rate rises could have a negative effect on the domestic economy for two reasons, namely, they could push up the New Zealand dollar and curtail household expenditure.

The value of the NZ dollar is impacted by the carry trade, which is where investors borrow money in countries with weak currencies and low interest rates and invest these funds in countries with strong currencies and high rates.

New Zealand will become more and more attractive to carry traders because our interest rates are higher than in Northern Hemisphere countries.

These are the major official central bank interest rates at present:

* Australia, 4.5 per cent.

* New Zealand, 2.75 per cent.

* European Union 1.0 per cent.

* United Kingdom, 0.5 per cent.

* Japan, 0.1 per cent.

* United States, 0 to 0.25 per cent.

The traditional carry trade is for investors to borrow in Japan, United States, United Kingdom or the European Union and invest in Australia and New Zealand. Investors are favouring the EU as a borrowing source at present because the euro is weak and its interest rates are relatively low.

If Bollard continues to raise the OCR then New Zealand will become more and more attractive as an investment destination for speculative funds and this could put further upside pressure on the New Zealand dollar.

A higher kiwi would have a negative impact on the export sector, which is a major driver of the economic recovery.

The other factor is household debt and the impact of higher interest rates on consumer spending.

One of the biggest problems facing New Zealand, and most other Western developed countries, is the huge increase in household or personal debt over the past two decades.

As the accompanying table shows, New Zealand household debt has surged from just $22 billion at the end of 1988 to $181 billion in December last year.

The 2009 year end figure does not include $10 billion of outstanding student loans. There was no student debt in 1988.

In other words household debt has increased 8.2 times since 1988, the country's GDP has risen only 2.7 times while the household debt-to-GDP ratio has surged from 32 per cent to 97 per cent.

Most of this additional debt has been invested in residential property where it has done little more than push up the price of existing houses and make them unaffordable for new buyers.

It has also raised New Zealand's overseas debt as a higher per cent of these household borrowings are sourced from overseas through the banks.

A one percentage increase in interest rates will raise the servicing costs on this $181 billion of household debt by $1.81 billion and a 3 per cent increase will raise servicing costs by $5.43 billion.

These additional interest costs will have a big impact on individuals as well as the economy as total retail sales in the past 12 months were around $66 billion.

The big constraint on the New Zealand economy, and most other Western economies, is the huge increase in household debt.

These debt levels are the Sword of Damocles hanging over our economic future.

With this in mind it is not surprising that developing countries, where household debt levels are low, are leading the global recovery while countries with high debt levels, particularly in Europe, are struggling.

However, Bollard doesn't really have to worry about overall economic conditions as his prime - and almost only - mandate is to ensure that New Zealand's inflation rate is within a 1 per cent to 3 per cent band over the medium term.

The Reserve Bank is forecasting inflation of 5.4 per cent for the June 2011 year but this will include two one-off items, the impact of the Emissions Trading Scheme from July 1 and the rise in GST from 12.5 per cent to 15 per cent on October 1.

These one-off items can be ignored by the Reserve Bank and without these inflation is expected to peak at 2.6 per cent in the June 2011 year.

But Bollard won't have to worry about inflation if his interest rate rise curtails household spending and reduces the cost of imported goods by pushing up the kiwi.

The New Zealand economy is finely balanced at present with strong export demand boosting confidence but the huge household debt levels will restrict the level of growth in the immediate future.

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

See the text of Governor Alan Bollard's statement here.
See the full Monetary Policy Statement here.