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Special Topic: Global financial developments

This special topic briefly discusses the main developments in the global financial crisis which intensified in September and their likely impact on the New Zealand economy.

Crisis of confidence in financial markets …

The background to the crisis lies in the sustained period of rapid credit growth, fuelling booms in housing and other asset prices, which occurred in the US and many other countries, including New Zealand, over the past decade. The trigger for the recent developments was a series of defaults on sub-prime mortgages in the US a year ago, but the crisis is now affecting a broader range of financial assets and has spread to a large number of other countries as the global housing boom begins to unwind.

The crisis is spreading because of a loss of confidence in the value of financial and other assets. Financial intermediaries are unwilling to lend to each other because they are not sure of the solvency of those they are dealing with. This has resulted in financial markets becoming dysfunctional, with limited or no funds available for borrowing and lending and central banks in many countries becoming a “lender of first resort”.

… led to higher market interest rates …

Although several central banks have lowered official interest rates, many market interest rates have actually increased to reflect the heightened risk of default. This is affecting all borrowers, including New Zealand banks seeking funding in global markets. At the same time, interest rates on government bonds (which carry a low probability of default) have fallen as investors have rushed to buy them and so the return which can be earned on funds is low. So far, exchange rates have not changed significantly, perhaps because all of the major currencies and economies are affected.

… and falls in equities and commodities

Share and commodity prices have been highly volatile and have fallen as the outlook for world growth is re-assessed. The Dow Jones index of the US share market lost 6% over the month (including experiencing its largest one-day fall and increase since September 2001) and other markets declined similarly. Share prices for financial institutions have been marked down most heavily.

Commodity prices have also fallen as the prospects for world growth have been revised downwards. Prices for West Texas Intermediate oil declined from around US$110 at the beginning of September to a low of US$91 mid-month; they spiked a couple of days later as traders scrambled to close out their positions before a contract was settled, but declined again to US$100 at the end of the month. Commodity prices declined generally, including international dairy prices.

In the past month, an increasing number of financial institutions have failed, both in the US and Europe, as falling asset values undermined investor confidence and made it difficult for those institutions to obtain funding, especially in wholesale markets.

Range of responses to financial failures …

Governments have adopted a range of responses to financial firms experiencing difficulties. In the US, investment bank Lehmans was allowed to fail. In other cases, governments have arranged takeovers by other financial institutions. In the US, Merrill Lynch was sold to Bank of America, Washington Mutual to JP Morgan, and Wachovia to Citigroup. In the UK, Lloyds has agreed to take over Halifax Bank of Scotland (HBOS).

A third response of governments was to directly re-capitalise threatened firms. This was the approach the US government adopted with the federal mortgage agencies, Fannie Mae and Freddie Mac, as well as for insurer AIG. This approach has also been widely adopted in Europe, for example Bradford & Bingley (a mortgage lender in the UK), Fortis (a financial services firm in northern Europe), Dexia (a French-Belgian bank) and a number of others. In Ireland, the government guaranteed the deposits of four banks and two building societies.

Central banks in the US and elsewhere have reacted to these developments by increasing liquidity and accepting a wider range of securities. In New Zealand, the Reserve Bank extended its liquidity arrangements and has lowered the Official Cash Rate (OCR) by 75 points to offset some of the higher finance costs for NZ banks.

… including a plan to support markets

The most significant response so far is the development of a plan by the US Treasury to purchase “troubled assets” in the residential and commercial mortgage sector. The plan aims to restore confidence and the functioning of credit markets. The purchase of such assets is intended to underpin financial markets by setting a price for them and bring confidence to both housing and financial markets, limiting further falls in house prices and removing some of the uncertainty in financial markets. The plan, which looks likely to be approved by the US legislature, may make a helpful contribution to gradually restoring confidence in these markets. However, it will take time to implement, is limited to the US and is unlikely to end the crisis on its own.

Implications for New Zealand

The most direct impact of the current financial crisis on the New Zealand economy is through access to and the cost of credit. Local banks are dependent upon overseas markets for around one third of their borrowing and much of this is relatively short term and has to be re-financed regularly. At present, markets for these funds are highly illiquid and when funds are available, their cost is higher. The pressures are likely to be greatest on institutions with high rates of household lending and extensive exposure to wholesale funding. Banks will pass on higher borrowing costs which will affect firms’ investment plans and households’ expenditure decisions. Borrowing rates facing NZ firms and households are now higher relative to wholesale rates than a year ago before the crisis began (Figure 5).

The effects of the crisis on local firms can already be seen with two companies postponing developments in primary processing at least partly because of the difficulty of raising funds and/or uncertainty about the state of global markets. With a high rate of foreign ownership of the NZ corporate sector, investment plans could be put on hold if foreign parents face credit constraints in their own markets.

In the medium term, the main impact of the crisis will be on world growth and demand for NZ’s exports, both goods and services. A weaker outlook for world growth is already being reflected in sharply lower prices for dairy products. It should be noted that there was rapid credit growth in the dairy industry in recent years to purchase land for conversions, much of it at values related to previous high prices.

Figure 5 – NZ interest rates
Figure 5 - NZ interest rates.
Source:  Reserve Bank of New Zealand

A key channel for the transmission of the financial crisis to New Zealand will be the Australian economy with which NZ is closely integrated. Lower demand for Australian resource exports, largely dependent on demand from Asia, would be reflected in lower demand from Australia for a range of NZ goods and services. In addition, New Zealand has strong links to Australia through Australian ownership of the four main NZ banks.

In the Pre-election Update, which was completed some weeks ago, it is assumed that world economic growth will be weaker than in the latest Consensus forecasts, but that the financial crisis will be resolved relatively quickly. The Pre-election Update includes an alternative scenario to capture the risk of even lower world growth and greater financial dislocation and its effects on the New Zealand economy. In that scenario, growth in real GDP would be 0.3 and 0.6 percentage points lower in the March 2009 and 2010 years respectively, commodity prices would decline further and the exchange rate would be lower.

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