NZ's credit rating may take another hit

Several nations, including New Zealand, have suffered recent credit downgrades. David Tripe explains what a credit rating is and how they are calculated

One of the topics of recent financial news from around the world and New Zealand has been credit ratings.

The US and countries in Europe have suffered downgrades, which have sometimes resulted in politicians alleging unfair treatment.

New Zealand has also had a downgrade from two of the three major agencies (Fitch and Standard & Poors) to AA, although the third (Moodys) has left our rating unchanged at Aaa. What are ratings, why do they matter, and what are the politics associated with them?

Credit ratings are opinions by ratings agencies on creditworthiness. In respect of countries, how sound is the economy? Will the country be able to repay its debts? Because it is an opinion, the judgment will sometimes be wrong, but when they rate corporations' debt issues and countries, their judgments are usually vindicated.

Particularly if you're in a different country to the one where you're lending, you will find the rating a useful signal.

Because credit ratings look at creditworthiness, or more specifically, at the probability of default (defined as failure to repay in full when it's due), they will also relate to interest rates. In general, the worse the credit rating, the higher the probability of default, and the higher the interest rate will be. Lenders identify a higher risk of not getting repaid, and want a higher interest rate to compensate for this.

So how risky is New Zealand, and is its credit rating appropriate? Could we be subject to fresh downgrades?

Government debt is not a major problem, despite the attention given to it by politicians (gross debt was $65 billion at June 30, 32.5 per cent of gross domestic product, while net debt was only just over 20 per cent of GDP).

However, if future governments do not reduce the current Budget deficit (which could be $15 billion or more in 2011-12), government debt could become more important.

The major risk in New Zealand is private debt. As at June 30, net foreign investment (debt plus equity) here exceeded foreign investment by New Zealanders by $140 billion, equivalent to 70 per cent of GDP. This is large by international standards, and much of it is debt requiring regular interest payments, putting a burden on the balance of payments current account.

The main reason for New Zealand's debt having grown to this extent has been our continuing balance of payments deficits on current account. We have absorbed foreign funds as debt and equity to pay for our spending being greater than our income, and this has resulted in the gradual buy-up of our banks, farms and other assets by foreigners.

The only way we can stop the buy-up of New Zealand is by increasing savings, so that we spend less internationally, and that we can then afford to finance the ownership of New Zealand ourselves. This is one of the reasons why the major parties are looking at extending KiwiSaver contributions.

A change to New Zealand's pattern of current account deficits is not going to happen quickly, and when it does occur, it will be likely to involve a downward shift in the value of the New Zealand dollar relative to all currencies, increasing the costs of imports (leading to petrol at $3 per litre?)

In the short run, the New Zealand economy is likely to face worse conditions, and we may easily face another credit-rating downgrade. These are some real challenges for the New Zealand economy.

Dr David Tripe is director of Banking Studies at Massey University's College of Business.