6 Scenarios (continued)

6.2 “Sudden stop”

Debt-raising activities by rational individuals should not pose a risk to the wider economy. However, a key risk for New Zealand arises if debt, even where driven by rational individuals, accumulates economy-wide to the point that it leads to global markets reassessing New Zealand's credit worthiness (i.e. national solvency risk).[35] In particular, investor attitude could reach some tipping point if offshore debts were to increase rapidly again, encouraged by some combination of government policy settings, property boom and high real exchange rates.

Such a tipping point may be preceded by warning signs pointing to international creditor unease. For example, because the majority of New Zealand's offshore debt is funded through the banking sector, a trigger could be associated with growing risk around a particular systemically-important intermediary.[36] Another trigger could initially manifest in the form of a lower sovereign credit rating, which would also lead to less favourable funding terms across the economy. Typically sovereign credit ratings represent the best credit rating in the country, and credit rating agencies take into account external indebtedness in assessing sovereign credit risk. This is because the sovereign is seen as the residual risk carrier in the economy.

Whatever the trigger, a global reassessment of New Zealand's risk profile or general fall in global risk appetite would likely raise the New Zealand's risk premium in the first instance. In the absence of a countervailing monetary policy response, this would lead to a significant increase in the cost of credit for new lending, and/or lead to severe credit restrictions (i.e. some sort of credit rationing).

In the extreme, this process could result in a “sudden stop” on New Zealand international funding, as international investors sought to reduce exposure to New Zealand-denominated investments. The impact of a “sudden stop” would be through two main channels, interrupted funding markets and a lower exchange rate.[37] These are discussed further in the Appendix to this paper.

Overall, the combination of interest rate and exchange rate effects in a “sudden stop” scenario could be expected to significantly reduce GDP in the short term. However, encouraged by a competitive exchange rate, eventually new exporters would come on stream in sufficient scale to offset domestic weakness, but this would take some time. Experience overseas shows that a financial crisis can depress an economy for many years (Reinhart and Reinhart, 2010).

Although the actual initial GDP fall would depend on financial conditions in the rest of the world, a 10% fall in actual GDP over a two-year period, or 15% relative to potential GDP, would certainly not be unprecedented looking at overseas experiences from country specific episodes. According to Okun's law there is a relationship between output and unemployment. For example, a 15% reduction in GDP from potential could imply an increase in the unemployment rate to around 12%, i.e. around 7.5% above the natural rate. A fall in GDP of that magnitude would have a significant impact on the fiscal position, which could lead to an aggravating fiscal policy contraction should fiscal sustainability come under threat (Fookes, 2011). Moreover, the large fall in domestic activity and rise in unemployment could well begin to raise serious issues about the soundness of the assets of the banking system itself, which would further exacerbate the downturn. In that sense, problems and risks can feed on themselves.

6.3 Combination crisis

A large enough banking crisis precipitated by internal events could also trigger a further aggravating “sudden stop”, as foreign creditors are likely to be concerned about their exposures. Similarly, a “sudden stop” could cause a banking crisis from falling economic activity and growing unemployment causing bad debts.

Crisis can, therefore, cascade down from offshore credit markets to New Zealand's banks and then individuals, or cascade up the debt chain from individuals. This interrelationship is not unexpected, as creditors no matter where they are located (offshore or domestic) have the same motivation to be repaid. Therefore, it is not surprising they can act in unison in response to pervasive threats. A quote from Martin Wolf, a journalist for the Financial Times, captures this sentiment well; “… bad things go together. In a boom, property prices jump, current account deficits explode, fiscal receipts soar and governments borrow easily; then, in the slump, property prices tumble, the financial system implodes, capital flows out, the currency falls, the fiscal deficit soars and inflation jumps” (Wolf, 2009).

A combined “sudden stop” and banking crisis would have severe consequences for the economy, as the ripple effects work through the economy and aggravate and reinforce each other. It was this combination of factors that ultimately required the Irish government to seek funds from the European Union and International Monetary Fund.