3.3  Estimating liquidity risk

We use two rough indicators to examine New Zealand's potential liquidity risk:

• First, the projected stock and growth path of New Zealand debt (public and private) under different scenarios is compared to other countries that have recently experienced liquidity pressures in the recent crisis.
• Second, the size of adjustment in tax or spending necessary to stabilise debt over a five year period is compared to large historical contractions.

3.3.1  Cross country comparisons of government debt

The recent global financial crisis provides an unprecedented opportunity to undertake a cross-country comparison of how markets could react to differing levels of debt in similar market conditions. A range of economies have responded quite differently to an identical shock triggered by a correction in the US housing market. This cross-country dataset can be used to infer a rudimentary risk scale.

Figure 3 looks at the impact of public and private sector debt on a government's ability to borrow. All else equal, higher levels of government debt (shown on the vertical axis) imply a higher level of risk, although the structure of the Crown balance sheet, economic vulnerabilities in the private sector, as well as the duration, maturity profile, and denomination of debt also play a role. Thus, while the gross sovereign debt measure used in Figure 3 suggests an increase in rollover risk, it provides a partial picture at best.

In contrast, the net international investment position (shown on the horizontal axis) is used to measure economy-wide risk. Economy-wide risk, for the purposes of this paper, suggests a higher level of uncertainty or risk around estimates for economic growth. A net external debt figure provides information about the overall levels of leverage in the economy. Higher leverage leads to more volatile changes in income, which can lead to more significant changes in behaviour. For a government, these changes in behaviour can aggregate into significant changes in tax revenue.

The make-up and structure of bank borrowing provide a notable exception. Recapitalising domestic banks was a large cost for many governments. The NIIP provides a partial measure of risks, although the size of gross private sector liabilities or significant un-hedged foreign currency borrowing may be more important. In New Zealand's case, around 70% of the NIIP is made up of debt, largely intermediated through the four major banks, but only 5% of this debt is un-hedged. More recently, steps have been made to lengthen the maturity structure that characterised New Zealand bank funding before the crisis. Thus, while international debt is a concern, the risk associated with the debt structure of New Zealand banks now looks more moderate compared to some of the economies used as comparators in this study.

Figure 3: A cross-country comparison of debtfollowing the height of the financial crisis

Source: IMF 2009 BOP statistics, Statistics Ireland and New Zealand, OECD

Note: Graph includes all OECD countries except Iceland, which had already had a sovereign liquidity crisis and borrowed from the IMF. In 2008 Iceland had an NIIP of 369% of GDP. In 2006 prior to the crisis its NIIP was closer to 120% of GDP.

Markets have viewed an increase in private sector debt as a risk for the sovereign. The countries that experienced significant liquidity pressures (coloured red) are clustered on the left hand side of Figure 3. A higher percentage of countries with large negative NIIPs (beyond 60-80% of GDP) experienced liquidity pressures, compared to countries with more moderate NIIP positions, where liquidity pressures have been absent. Markets have been more reluctant to lend to sovereigns with highly-leveraged private sectors.

Low government debt has been a key factor setting New Zealand apart from other countries with large negative NIIPs. However, overseas experiences suggest that the reduced resilience associated with private sector debt can lead to rapid changes in government debt in a crisis. An indicative risk scale to interpret the scenario outcomes discussed later in the paper is included in Table 2. The risk scale takes into account the starting level of debt and rate at which debt grows.

The risk scale in Table 2 has been based on the experience of countries with comparative NIIPs. This illustrates that the New Zealand government could experience funding difficulties at lower levels of sovereign debt than many other OECD countries. For example, heavily indebted countries have experienced liquidity pressures at sovereign debt levels well below the average OECD level of debt - 62% of GDP in 2009. Under the framework used in this paper, sovereign debt beyond 40% of GDP is considered risky and sovereign debt above or beyond 80-90% is treated as unsustainable. The IMF (Ostry et al. 2010) suggest that New Zealand could not sustain debt beyond 90% of GDP as, beyond this threshold, unfavourable debt dynamics could start to set in. The IMF's threshold cannot be taken as an absolute measure or as a debt ceiling of how much New Zealand could borrow because the IMF analysis explicitly ignores liquidity risk. In practice markets would respond if New Zealand's projections merely suggested sovereign debt could rise as high as 90% of GDP. With this in mind, the IMF note that "prudence suggests that countries target a level of debt well below this limit".