Against a backdrop of global volatility and geopolitical uncertainty, New Zealand's capital markets face two significant issues with potential impacts that need real focus.
First, there are the discussions underway on the proposals from Sir Michael Cullen's Tax Working Group. Second, there are the changes proposed by Reserve Bank governor Adrian Orr. Both have potential to impact the New Zealand markets in the short and long term.
These are structural issues that change capital formation — not just cyclical ones that impact short-term profits.
Both proposals have their origins in an economy where the housing market was going up and up. But given that house prices are cyclical — and the latest rising cycle appears to have faded — these proposals need to be carefully reconsidered.
Likewise, the timing of implementing not just one, but two such significant proposals — in an economic environment very different from when they were initially considered — should be enough to give pause.
Does the inherent problem we were originally trying to fix still remain once these two proposals take effect? What are their anticipated or unanticipated structural consequences, particularly in terms of capital formation?
We think each proposal may lead to a fundamental change in capital formation, structurally changing the cost of debt and equity.
Capital formation is the way an economy uses equity and debt in conjunction with ideas and people to grow. In turn, this determines tax revenue, the availability of new jobs, funding of new ideas and replacement of our infrastructure.
An entrepreneur borrowing against their house to start a business, a developer borrowing to subdivide, a company issuing new shares to fund an acquisition or a government issuing infrastructure bonds to fund light rail — these are all examples of capital formation in action.
Getting the combined cost of debt and equity as low as reasonably possible is the core purpose of a capital market. That combined cost is called a company's cost of capital because the less expensive it is to raise money, the easier it is for a company to invest, take risk, build factories, make acquisitions and grow.
The Reserve Bank's announcement that it would like to create a safer banking system is noble. But before we seek to make changes, the question must be asked: how unsafe is our current system?
By changing capital requirements and other rules, as the Reserve Bank proposes, banks will need to accept lower returns and less growth. Invariably this has two impacts: the cost of borrowing goes up while the availability of funding declines.
This affects every person and every business that uses capital because the suppliers of debt capital will have less to provide and it will be more expensive.
This directly increases the cost of capital in the New Zealand economy, lowers investment and ultimately reduces capital formation.
Given the rapidly changing housing market in Australia and the change beginning to be seen in ours, we need to seriously ask, are these outcomes the anticipated effects of the Reserve Bank's proposal?
Particularly in what could be a tough decade ahead, are we creating unnecessary pain for the economy by trying to do what we thought was the right thing in a previous cycle?
Perhaps the right thing to do now, instead of pushing ahead, is to retest the assumptions that led to the proposal in the first place.
If the kind of structural change proposed by the Reserve Bank was to happen in isolation, we would likely see people gradually shifting from debt to equity for funding.
But at the same time, on that side of the market, the Tax Working Group's suggestions are set to have a direct impact on the suppliers of equity capital.
By taxing small business owners, KiwiSaver providers, farmers and start-up investors on capital gains, it will lower the availability of capital and increase investors' return requirements. This directly increases the cost of equity capital — just as the cost of debt capital is increasing.
For a business today, the combined impact of these two changes is that debt will be harder to get and more expensive domestically, and equity capital is going to get more expensive domestically. Invariably, this lowers capital formation, which lowers growth in our country.
If the ultimate goal in our economic system is safety and fairness, we need to ask: on a global basis, how unsafe is our capital market? And we need to think seriously how these two proposals will impact the economy.
We believe strongly that our country should be a fair and financially secure place to do business. We would argue that the best way to do that is to grow the economy towards a common vision with clear rules of engagement. After all — no one has ever shrunk their way to greatness.
At face value today, we believe the combined impact of these proposals has the potential to reduce capital formation at the exact time the market they are aimed at is already slowing.
- James Lee is CEO of New Zealand investment and advisory group FNZC, which will change its name to Jarden in the middle of the year.