4.2  Crisis

Irrespective of cause or rationality, high household/farm and offshore debts create risk that creditors are sensitive to. Creditors, offshore or domestic, are particularly concerned about debt reaching levels that raises the possibility of widespread default through insolvency. While individuals can face financial pressures with few wider ramifications, it is only when many individuals are under financial stress that there are risks to the economy as a whole and so to creditors.

Insolvency can occur for a number of reasons. Some can be New Zealand-specific problems due to imprudent intermediation. Alternatively, insolvency can be due to global developments. Unhedged offshore creditors would also be concerned about the level of the exchange rate, which would likely fall as insolvency threatens and thus reducing their investment returns.

Indeed, significant creditor concern could precipitate financial crisis, if it were to lead to a rapid withdrawal of financial support. Given the highly bank-intermediated nature of New Zealand's debt markets, creditor concerns about default would therefore mainly reflect a judgement about the solvency of New Zealand's banking system, and its ability to continue to access funding in an uncertain global funding environment. Because the solvency of the banking system is so integrated with the property market, this judgement is in essence then a view about the prospects for New Zealand's property market, and ultimately the ability of property owners to service property debt.

4.2.1  Factors contributing to resilience

While New Zealand has high offshore debt and high household/farm indebtedness, there are a number of factors that diminish the risk of financial crisis. This may help explain why New Zealand did not suffer the same degree of difficulties that other countries faced with similar imbalances during the GFC.

First, there is no obvious limit or “target” for the net international investment position. It depends on the quality of investment opportunities, the prudence of intermediation to fund them. Together, these factors impact on economic growth prospects and so future incomes to service debt. In addition, it depends on the saving decisions by New Zealanders, and the attitude of creditors to continue to support debtors in the belief that liabilities will be serviced at face value over the long run. All this suggests that a judgement about whether New Zealand's debt position is too high is not straightforward.

Quality of intermediation

Private sector borrowing intermediated by banks accounts for around 76% of New Zealand's net offshore debt. Apart from finance companies, which are relatively small in the overall context of New Zealand's intermediation activities, New Zealand's main financial lenders appear to have been relatively prudent. Evidence for this includes that bad debt provisions, while rising during the GFC, have remained relatively low compared to bank operating profits, and are now falling again. This is consistent with the “consenting adults” view.

New Zealand's banks have largely avoided uninsured high loan-to-value ratio lending to customers who have limited abilities to service the debt (RBNZ, 2006b). In contrast, lending has generally been in the nature of well diversified recourse loans that were relatively small (compared with asset values), which customers could service comfortably.[19] Therefore, banks are not relying overly on the value of collateral to recoup loans, which can be questionable in generalised property downturns.

In support of this view about the soundness of New Zealand's bank lending, at the peak of the GFC the International Monetary Fund (IMF) stress-tested the balance sheets of New Zealand's banks against a range of plausible shocks (including property) without raising any significant concerns (IMF, 2009). This view has been sustained by the IMF in subsequent analysis (IMF, 2011), and the RBNZ's Financial Stability Report (RBNZ, 2011a). Supporting factors for the property market include continuing positive net immigration inflows, the extended period of low forecast interest rates, and the fall over the last three years in residential property building. This fall in building activity is despite there being no obvious excess of supply. Instead, recent weakness in the housing market to date has tended to be characterised by falling turnover rates and a relatively slow fall in real prices, with nominal prices showing only a mild decline (Section 4.2.2). Moreover, in the short term, the Treasury is forecasting a stable-to-rising property market (Section 6).

The prudence of the banking sector can also be seen in bank capital, which provides banks with a buffer against downturns. This has been maintained well above regulatory minimums over time, thus helping to keep down leverage ratios. As a result, bank credit ratings still remain strong, helping with liquidity. In addition, bank prudence has been encouraged by the vigilance of prudential supervisors and regulatory controls in both New Zealand and Australia. This is important given the Australasian integration of banks.[20] Nevertheless, prudence is a relative concept based on outcomes conforming to expectations. The scenarios set out in Section 6 of this paper consider what could happen, should intermediaries be subject to extreme levels of duress beyond expectations.

On the liabilities side, for the year ended 31 March 2010, around 93% of offshore bank debt was hedged or raised in domestic currency to avoid currency risk (Statistics New Zealand, 2010). This means that the value of this debt is largely unaffected by currency movements. This is important in times of crisis as the currency would likely depreciate.[21] In the absence of hedging, this would increase the value of bank's foreign liabilities, putting solvency at risk.

Moreover, a significant proportion of offshore liabilities (equity and debt) is to Australia, through ownership of New Zealand's major corporations including the major banks. Edwards (2006) has argued that this is relevant to assessing New Zealand's risk. This could be because parent funding is likely to exhibit some equity-type characteristics irrespective of form. This high Australian ownership means a significant proportion of the current account deficit is also attributable to Australia. Australian net investment in New Zealand for the year ended 31 March 2010 was around $64 billion (33% of GDP) (Statistics New Zealand, 2010). Assuming that net Australian investment in New Zealand has not materially changed as at 31 December 2010, if Australian investment in New Zealand is excluded, New Zealand's net international investment position would be around -49% of GDP.

In particular, assuming that Australian banks retain their current financial strength, it could reduce the magnitude of risks involved with New Zealand's high bank-related net offshore debt. This is because, while debt owed to an Australian parent bank is still offshore debt, it may have a different risk profile to offshore debt owed to portfolio investors, as it may be less prone to refinancing risk and so is a more stable portion of net offshore debt. In addition, the current strength of Australian banks means that New Zealand subsidiaries have access to a significant and reliable source of funding. However, this does assume that Australian banks do not face their own major risks peculiar to themselves, or regulatory constraints that adversely impact on their ability to manage and support their New Zealand's bank investments. The risks facing Australian banks are beyond the scope of the paper, but by definition a global shock could be expected to impact on New Zealand's banks as well as their Australian parents.

Strong macroeconomic institutions and other economic factors  

New Zealand has strong macroeconomic institutions[22] in place that can help mitigate shocks like the GFC. Despite the emergence of a significant structural fiscal deficit from 2008, New Zealand still has relatively strong and transparent fiscal policy with low sovereign debt and plans to maintain this (Mears et al, 2010). This position allows the government to borrow on reasonable terms, albeit at higher rates than many other OECD countries. A strong fiscal position enables a government to let fiscal stabilisers operate more fully in response to a shock, as well as taking discretionary fiscal policy actions that can help to further cushion the economy in times of weakness. A strong fiscal position also allows the government to provide credible guarantees, should it be necessary to support bank funding activities again in the face of severely interrupted funding markets.[23]

Monetary policy credibility also helps through anchoring inflation expectations in New Zealand (RBNZ, 2007). This allows policy interest rates to fall considerably when needed to stimulate domestic demand without risking raising inflation expectations. In combination with a floating exchange rate, lower interest rates can also be expected to have an exchange-rate effect that will enhance competitiveness, especially if commodity prices are under pressure. The capacity for a lower dollar, in combination with widespread hedging or swapping by banks of their offshore exposures into New Zealand dollars, also helps to spread the burden of adjustment from a shock with offshore creditors.

While these macroeconomic institutional arrangements added up to provide resilience during the GFC, New Zealand's industrial structure also helped prevent the GFC from disproportionately impacting on GDP compared with other OECD countries.[24] New Zealand's flexible labour markets responded to the downturn more with lower hours worked and wage restraint, and less with higher jobs losses. This was further aided by New Zealand's export volumes generally not being too adversely affected by the immediate impact of the GFC before growing again.^[25]