Brian Fallow: NZ's savings chasm has to be bridged

New Zealand's dire deficit level went critical during the recession, highlighting the need to reduce the country's dependence on foreign savings. Photo / Kenny Rodger

As he launched the savings working group charged with coming up with options to address New Zealand's lousy savings performance, Finance Minister Bill English admitted he did not see any easy or obvious answers.

But they need to be found. The global financial crisis, and the recent travails of the more indebted members of the euro area, have highlighted how vulnerable we are, relying to the extent we do on foreigners' savings.

The current account deficit is a measure of how far New Zealanders' savings fall short of funding investment in the economy.

We have run deficits every year since 1973 and the cumulative effect is that the stock of foreign claims on the economy, net of New Zealand investment abroad, is equivalent to 89 per cent of the annual output of goods and services.

That is actually an improvement from nearly 95 per cent a year ago, but it only means that we have gone from being up to our collective nostrils in debt to the rest of world to up to our chins. But with the deficit forecast to widen again, that is probably as good as it gets.

This chronic problem turned acute during the global financial crisis, when offshore wholesale credit markets, upon which local banks rely for around 40 per cent of their funding, froze.

The Reserve Bank, as lender of last resort, had to provide liquidity in the short term and the Government had to stand guarantor for funding the banks sought in longer-term offshore markets.

Though the crisis has passed, we will live in the long, dark, cold shadow it has cast for years to come. And the underlying problem of seriously deficient national savings remains.

Westpac's economists have been reflecting in a recent series of research notes on the implications for interest rates of the crisis and regulatory changes the Reserve Bank has made in response to it.

No prizes for guessing that the implications are not borrower-friendly.

Before the crisis banks had access to a virtually limitless supply of short-term wholesale foreign credit. And it was cheap, in the sense of being available for a small premium to the official cash rate.

So at a time when demand for credit was growing faster than incomes, and hence the deposit base, a growing share of banks' funding came from short-term wholesale markets offshore.

With that as the marginal source of funding the banks had no incentive to pay more for retail deposits, so deposit interest rates closely tracked short-term wholesale rates and hence the OCR.

It also meant the OCR had to work harder - go higher to rein in borrowing - than it would have had to if the funding supply curve had been upwardly sloping (where the more you borrow the higher the rate you pay).

The problem, unheeded at the time, was rollover risk - the risk that when these short-term loans had to be repaid and replaced funding would dry up.

"Even though short-term money markets freed up relatively early and the cost is now comparable with pre-crisis levels, banks have voluntarily reduced their reliance on this potentially unstable market," says Westpac chief economist Brendan O'Donovan.

"Nobody wants to be seen as the next Northern Rock [the British bank brought down by relying predominantly on wholesale funding]. Instead banks have been willing to pay up for more stable sources of funding, namely retail deposits and long-term wholesale funding. This has driven up the price of these sources of funds, relative to pre-crisis conditions."

The Reserve Bank, as the banking sector's regulator, has moved to entrench that change by imposing a "core funding ratio". That is the minimum share of their funding that must come from retail deposits, long-term wholesale sources (defined as more than one year) and the banks' own capital. The ratio has been set at 65 per cent initially and is set to rise to 75 per cent over the next few years.

This has been good news for depositors, as deposit interest rates have been bid up until they approach the next cheapest source, which is now longer-term wholesale rates.

But the Westpac economists argue it does not necessarily do much to reduce our reliance on imported savings or to the periodic gusts of fear and alarm blowing through global financial markets.

It is very difficult to expand the total pool of local savings quickly, O'Donovan says. "For instance around half of term deposits come from retirees who draw on the interest for their regular income. Higher interest rates won't spur them to save substantially more."

The banks will remain exposed to the vagaries of global markets, he says, probably even more so since long-term interest rates are influenced less by central bank policy and more by expectations and sentiment.

"We are now finding that the more New Zealand borrows, the greater the premium it must pay because lenders have become wary of lending too much to any one country or bank."

Increased reluctance on the part of overseas lenders to lend to us, combined with regulatory restrictions on accessing their capital, amounts to a reduced supply of savings and means that over time lending and deposit rates will both be higher that they would otherwise have been, O'Donovan argues.

That is not to say higher than they were. With growth anaemic across developed countries, to say nothing of fears of a double-dip recession or even deflation, Westpac expects benchmark international interest rates will push up only slowly from their their current low levels.

But New Zealand's growth prospects are now driven less by how those countries do than by China, the rest of emerging Asia and Australia, whose outlook is happily rather brighter.

And it is worth remembering that the average mortgage rate borrowers are paying right now is the lowest it has been for many years and at 6.5 per cent is well below the average 7.7 per cent over the past 10 years.

That all suggests that the financial markets may be erring on the dovish side by pricing in only a one-in-three chance that the Reserve Bank will lift the OCR (to just 3.25 per cent) next month and seeing a rise of just 50 basis points in the OCR over the coming year.

Be that as it may, clearly it will take a lot more than regulatory changes aimed at strengthening the resilience of the banking system to lessen our abject reliance on imported savings.

But the Government has heavily curtailed the range of options the working group can consider.

In particular, it is not allowed to consider any changes to New Zealand Superannuation, even though it will be a powerful influence on the fiscal position and the extent to which the Government is adding to, or more likely subtracting from, national savings.

In light of that it is rather inconsistent that English made it clear on Tuesday that he expects the savings working group, like the tax working group it is modelled on, to come up with options that are broadly fiscally neutral. That limits the scope for taxpayer-funded incentives.

Making KiwiSaver compulsory presents its own difficulties: would it come at the expense of lifting take-home pay for those who live hand to mouth now and who can ill afford to save? And would it merely cannibalise other forms of savings, including bank deposits?