3.3 The connection between household/farm and offshore debts

Household/farm and offshore debts are connected through the property market, facilitated by the banking sector. The following sections of the paper explain how property market outcomes affect consumption and investment patterns.[9] These have financing and trade implications that mirror each other.[10]

3.3.1 Financing  

Households are a heterogeneous group with respect to debt and assets. Some households are savers, while others are dis-savers; some are buying assets while others are selling assets.[11] Rather than dealing directly with each other for their funding needs, households generally transact through banks (intermediation).

One household borrowing domestically to buy an existing house can be offset by a bank deposit from another household. Therefore, borrowing for this purpose does not impact on national saving or, by implication, the current account deficit.[12] The mortgage finance ends up with the vendor as cash who can then repay debt or deposit the money with a bank, substituting for other forms of bank borrowing. Therefore, buying an existing house is a financial transaction like a purchase of company shares with no implications necessarily on consumption or investment.

However, typically a vendor is unlikely to deposit the whole proceeds from sale. The way property transactions impact on the current account is to the extent that saving and investment decisions of property owners and/or vendors are changed. For example, a rapidly appreciating property market boosts wealth, which can stimulate further investment (gross fixed capital formation), and/or consumption through allowing and encouraging households to extract equity in the home (directly or passively).[13] This demand for funds by households is facilitated by the banking sector, as higher property prices can also encourage bank lending because the value of collateral is enhanced. If this demand for funds cannot be met domestically, it is met by banks borrowing offshore.

Work by the Reserve Bank of New Zealand (RBNZ) in 2008 estimated that a one dollar increase in housing wealth led to an annualised short-run increase in consumption of 0.9 cents to 2.4 cents, and a long-run effect of 5.4 cents to 7.5 cents (De Veirman, 2008). Other work in 2006 found that yearly home equity withdrawals averaged around $7 billion per annum from 2003 to 2005 ($14.5 billion if farms are included from March 2002), and 40% to 70% of equity withdrawals were consumed over the short term (Smith, 2006).

Active equity withdrawal has been an important driver of falling household saving, and according to some measures of saving, has led to significant household dis-saving. In addition, in response to rising wealth from higher house prices, some households may have chosen to passively reduce their saving rate rather than actively draw down on home equity. However, since 2009 it appears that the weak housing market has led households to save more by repaying mortgages, injecting more than $3 billion a year into housing equity (Treasury, 2010a).

It is this wealth effect from rising property prices that may have been a significant driver of national saving falling short of what is required to finance domestic investment.^[14] This shortfall in saving means banks borrow offshore to, in effect fund the current account deficit, which is adding to the net stock of New Zealand's offshore liabilities (Hunt, 2008). Figure 6 shows that, during the housing boom of 2002 to 2007, while investment lifted somewhat, lower national saving played a signficant role in the increased current account deficit. Since the GFC, the current account deficit has narrowed significantly, as national saving increased and investment decreased markedly. This has been amplified in the short term from the one-off gains from offshore reinsurance money and the Australian-owned banks' tax settlements, which has increased national saving.

An alternative hypothesis for the same set of observations from a financing perspective is that, for a time, the supply of relatively cheap offshore capital drove the current account deficit by lowering the domestic cost of capital, thereby encouraging investment, discouraging saving, and leading to inflation pressures and an appreciating exchange rate (Section 3.3.2).

However, irrespective of cause, because banks' funding of property lending is the primary vehicle for capital inflows, a chain of borrowing exists. This interconnects offshore creditors, New Zealand's banks and households. Since this offshore financing has been primarily used by banks to fund property lending (particularly houses and dairy farms), it suggests that offshore creditors are also ultimately secured against the soundness of New Zealand's property market. As at 31 December 2010, household mortgages and agricultural lending, most of which would be property-related, summed to 88% of gross offshore debt. However, property lending could have been used for purposes unrelated to property.[15]

Figure 6 - Gross saving and investment flows

Source: Statistics New Zealand