8 Conclusion
The main findings of this paper are that large imbalances arise from significant movements in factors of the economy away from long-term norms. Imbalances can impact on growth, but are not necessarily inconsistent with growth. Much depends on the causes of those imbalances and whether they are temporary or structural in nature. New Zealand's structural imbalances manifest mainly in the form of high and sustained household/farm debt. In turn, these debts are related to New Zealand's high and sustained offshore debt.
The recent devastating Canterbury earthquakes will have a significant medium-term impact on the economy. They have weakened the financial positions of both the private and public sectors. However, given the forecast recovery, these earthquakes are not expected to materially add to the long-term trend of structural increases in debt in the economy. It is the long-term propensity of the private sector to borrow that is the main issue.
While debt is not necessarily bad, it does carry risk if overly employed. In particular, between 2002 and 2007 domestic and offshore debts increased significantly and rapidly. That increase was driven primarily by banks borrowing offshore to fund property market activity of households and farmers, coincident with increases in private consumption and investment associated with the wealth effects from rising property prices.
Strong demand for resources led to inflation pressures, which resulted in tighter monetary conditions than would otherwise have been required to achieve price stability. While tempering private consumption and investment, the resulting elevated real exchange rate has been detrimental to the performance of the tradables sector.
These high private sector debts create risk for New Zealand's economy through the possibility of a sudden financial crisis or period of prolonged slow growth. Financial crises can arise when creditors act on solvency concerns about systemically important institutions like major financial intermediaries. This can lead to sustained and reduced economic activity as financial intermediaries work through bad debt and funding related difficulties, resulting in wider macroeconomic disruptions. Alternatively, should household/farm debtors collectively make the balance sheet adjustment before significant creditor concerns arise, the outcome could be a period of slower economic growth because of lower consumption.
While the private sector can generally be relied upon to exhibit rational borrowing behaviours (the so-called “consenting adults” view of the world), because of imperfect information and markets this cannot always be assured. Private decisions can be strongly influenced by government tax/transfer and spending policies, or regulatory settings that inadvertently encourage borrowing. In particular, the general willingness of the private sector to continue to borrow against property at prices at substantial multiples of disposable income suggests that it is unlikely that policy has had no part to play. High property-related leverage puts a spotlight on shocks that can impact on the property market. Such a shock would adversely impact on balance sheets throughout the economy, including New Zealand's banks. Because of banks' relatively high level of exposure to property-related debt, solvency is tied to the ability of property owners to service their debt. Ultimately the government's balance sheet would be affected, as economic activity and tax revenue is adversely impacted in this situation.
However, there are a number of favourable factors that add to New Zealand's resilience against shocks and reduce risk. Excluding finance companies that undertook very risky property-development financing, banking practices were generally prudent and limited to domestic operations, so reducing debt exposure to risky offshore assets. In particular, banks have avoided significant bad debts by largely only making loans to property owners that can generally afford them. This has been helped further by these borrowers being responsive to risk and financial circumstances having tempered debt use since the GFC. On the liabilities side, hedging of currency risk from offshore debt and using offshore parent banks as a reliable source of funding has helped with the financial stability of banks. Moreover, since the GFC, banks have reduced the proportion of their funding from relatively risky sources such as short-term wholesale debt. In addition, New Zealand's stable macroeconomic environment of relatively strong public finances and fiscal flexibility, credible monetary policy focussed on price stability, and flexible exchange rate provide considerable scope to respond to, and dampen, economic shocks.
The sum total of New Zealand's institutional arrangements acts to create robust macroeconomic buffers that generally work very well individually, but also combine well to provide higher resilience relative to many other countries that share similarly significant imbalances. This means, given New Zealand's present level of high but relatively stable private debt imbalances, the likelihood of imminent financial crisis is low.
Despite New Zealand's economic resilience to date, and short-term improvements in the current account deficit and property exposures, New Zealanders should not be complacent. Overseas experiences show how doing “nothing” has risks that could have long-term adverse implications for living standards through poor economic performance. In particular, debt resilience has its limits in a more risk averse world, which may see New Zealand close to the limits of prudence when current debt-related improvements in financial position may not be viewed as structural. This is especially the case given the recent emergence of significant structural fiscal deficits. The government's weaker post-GFC fiscal position would limit its ability to respond to a fresh crisis.
While the fiscal position is expected to improve, there is the possibility that household consumption accelerates quickly as the economy recovers, resulting in offshore liabilities continuing to grow in an unsustainable way. Moreover, a significant proportion of offshore debt is still short-term, and overall debt levels are still high and remain secured against elevated property prices. This means that any significant shock could cause an adverse self-reinforcing dynamic between asset values, economic activity, and financial stresses for households and banks.
Like the recent Canterbury earthquakes, the nature of potential macroeconomic shocks and the likelihood of them eventuating are difficult to identify with precision or confidence. The wakeup call from recent adverse experiences in the world economy shows there is a range of low probability, but high impact, scenarios that could have very significant long-term adverse implications for New Zealand's living standards. These could involve international creditors' unwillingness to lend to New Zealand institutions virtually at any price, a so-called “sudden stop” and/or a banking crisis that threatens banking solvency.
Accordingly, to the extent that it can, it would be desirable for government along with individuals to be vigilant and take actions that continue to build resilience, and so reduce the risk of costly economic adjustments from imbalances. These actions may carry some level of short-term costs to living standards, but they are likely to be less than in a crisis situation when debtors are forced quickly to live within their means. Moreover, if carefully designed, a policy response could aid in the transition to lower debt levels, while also avoiding slow economic growth (successful rebalancing). This is more likely if the policy prescriptions can be justified on their own merits as growth enhancing.
To maximise the chance of successful rebalancing, actions need to boost national saving relative to investment, as well as incomes. This would see debt ratios fall across the economy and incomes catch up with property prices. Higher saving would also likely help produce a deep and durable exchange rate adjustment through lower interest rates, as slower domestic demand growth would reduce inflationary pressures. This would enhance competiveness and facilitate resources shifting from consumption activities into tradables production and investment, which would be beneficial to maintaining economic activity levels. Moreover, a change in the composition of economic activity could provide an opportunity for higher sustainable growth provided the increased exports are associated with greater productivity.
To the extent that persistent excessive demand underpins the national saving problem, then specific solutions should involve examining the drivers of over-consumption as well as the impediments to saving. The government could first lead by reducing its own demands on economic resources through means that also encourage private saving (i.e. returning to surplus sooner through constraining spending). Other structural policy changes for consideration include: adjusting policy settings that have been encouraging private consumption relative to saving; considering new macroprudential tools that maybe able to temper long-run asset and credit cycles; and examining structural changes to the cost and availability of houses.
