Post-crunch deficits may require fresh NZ thinking

The challenge of raising billions of dollars to fund fiscal deficits in the competitive post-credit-crunch environment will require some fresh thinking from the Government, says Tony Hildyard, the New Zealand representative of giant US bond-fund manager Pimco.

Pimco has released its 2009 Secular Outlook, in which it identifies what it sees as the crucial factors influencing investment markets over the next three to five years. This year's document, entitled A New Normal, suggests that when the dust settles from last year's financial shocks, the new status quo will be one of slow growth in developed economies.

The report predicts the government intervention that was required to stabilise the financial system during the crisis "overstay" will act as an additional brake on growth, along with higher taxes and more regulation.

It picks short-term deflation and long-term inflation, as the collapse of demand caused by the crisis is superseded by policymakers' struggle to withdraw massive levels of monetary and fiscal stimulus introduced to counter it.

The environment would see the continued erosion of the US dollar as the world's reserve currency if "US policy makers lack the commitment or the skill to drain the system of emergency liquidity at the appropriate time".

Banking and Finance is also tipped to keep shrinking, with greater regulation and further consolidation.

In this environment the New Zealand Government would be seeking to raise up to $15 billion a year in debt, at a time when other governments also sought to raise large sums.

The prospect of governments competing for funds on international markets has already been a big factor in the rise in long-term interest rates that have seen longer-dated fixed mortgage rates increase in New Zealand.

Hildyard says one of the primary headaches for government debt issuers is the amount of government-guaranteed bank paper available already. "The likes of us, the Pimcos of the world, are going 'we're underweight [in] government stock; we'd prefer to buy the stuff they're guaranteeing and collect an extra 100 to 120 points on top of it'."

Even if guarantees are removed soon, as ANZ Banking Group chief executive Mike Smith called for last week, Hildyard believes there is still sufficient supply to satisfy demand for some time.

However, New Zealand's relatively undeveloped government debt market also presents some issues.

"In New Zealand - and I've talked to the Debt Management Office about this - when Pimco goes into a market, we want the ability to manage risk. You don't just buy and hold forever."

As yet, however, with no real bond futures market, there is no effective hedging mechanism for New Zealand Government stock.

Hildyard says there has been some talk of setting up a "primary dealer" structure, which is common overseas, where banks are contracted to make prices and purchase government issues.

"We think that's probably a good idea for the Government. Ultimately it should lower their cost of borrowing because you should get more participation from people because it improves liquidity. Banks are keen, as it is a source of revenue. [The] key thing for us - [it] means we can sell government debt holdings if we need to."