Brian Fallow: $162b in debt - time to cut up the cards

After years of spending and living beyond our means, the level of official debt brings a sobering reality check. Photo / Bloomberg

The Savings Working Group's interim report did not mince words.

New Zealand's credit, it said, "is about maxed out. It is time to get real".

The statisticians yesterday gave us an updated number on the extent to which we are collectively in debt to the rest of the world. It is $162 billion (net of New Zealand investment abroad), equivalent to 85 per cent of gross domestic product.

A ratio of net foreign liabilities to GDP above 60 per cent is considered risky, the Savings Working Group said, and to raise the likelihood of a sudden and destructive economic shock which would typically mean large job losses, constrained public services and falling asset values.

"The bottom line is we have had the fun, the big spend-up, bought over-priced houses and farms and a lot of bling," it said. "Now it is time to pay, and lay a foundation for a more secure foundation for future sustainable wealth."

The current account deficit has averaged more than 5 per cent of GDP over the past 30 years. That is the third highest among 25 OECD countries, after Greece and Portugal. The level of net foreign liabilities which are the cumulative effect of those decades of spending more than we earn put us by 2008 in the same neighbourhood as Portugal, Ireland, Greece and Spain. That is definitely the wrong side of the tracks.

There are some important differences from those countries which, hopefully, mitigate the risk of the kinds of travails Greece and Ireland are suffering.

They include relatively strong Government accounts (but so were Ireland's until its guarantee to its banks - and ours are deteriorating) and having our own exchange rate and very high levels of currency hedging by the banks. The banks are responsible for 60 per cent of the country's gross foreign debt and more than two-thirds of its net debt, 10 times as much as the Government.

Over 40 per cent of banks' lending is funded by borrowing offshore and a majority of their lending is to households, more than 90 per cent of it mortgages.

Ten years ago the annual current account deficit was the equivalent of 2.5 per cent of GDP. Six year later it had climbed to 8.3 per cent and it stayed there or thereabouts until early last year when the recession's impact on interest rates, foreign-owned companies' profits and our appetite for imports sent it back down again.

The steep rise in the current account deficit in the past decade was matched by steep rises in house prices and household debt.

At the start of the last decade, home buyers paid on average about three times their disposable (or after tax) income for a house. The ratio had crept up only very slowly from 2 per cent over the previous three decades. But by 2007 the ratio of house prices to incomes had almost doubled to 5.5 times, and it is still around 4.7 times.

The five years, 2003 to 2007, were notable for double-digit annual growth in household debt. But households' wealth was growing just as fast, reflecting rampant house price inflation - or as people preferred to think of it, capital gains.

If this was a bubble, it has not burst.

House prices, as measured by the Real Estate Institute's national index, are less than 5 per cent off their peak three years ago (though that means they have fallen 13 per cent in real terms).

Might it yet go pop?

A recent paper by IMF economists Patrizia Tumbarello and Shengzu Wang gives some grounds for comfort on that score.

True, they found that as of the middle of this year the ratio of house prices to disposable incomes was 28 per cent above its 10-year average and the house price to rent ratio 18 per cent above. But when they compare the ratios to their seven-year averages instead the overvaluation drops to 15 and 5 per cent respectively, indicating how sensitive they are to the period considered.

Such metrics do not take account of fundamentals like demographics, interest rates and the terms of trade, they argue.

More complex econometric analysis which takes account of those factors suggests that the system is getting back into balance, but at a relatively slow pace that would take about two-and-a-half years.

And they remind us that a decline in house prices is only one way for that adjustment to occur: "Sustainable levels can be achieved if incomes and rents grow faster than house prices, or other fundamentals such as migration and terms of trade change."

With any luck we will see a gradual and orderly correction of the overvaluation of house prices relative to incomes, driven more by income growth than house price falls.

When so much of the country's overseas liabilities consist of banks borrowing to fund mortgages a big sudden Irish-style plunge in the value of the securities for those loans would be calamitous. Households have been shedding debt with a determination that has caught policymakers by surprise and which makes life hard for businesses chasing the consumer's dollar.

Instead of the double-digit credit growth evident during the boom, household credit has been growing by around 2.5 per cent a year for the past two years.

Bankers report that people have taken advantage of lower mortgage rates to increase the rate at which they repay principal while keeping the amount they pay the same.

The big uncertainty is whether people will keep reducing debt when interest rates rise, as they inevitably will.

"Consumers may start to relax a little," says ANZ chief economist Cameron Bagrie. "They have cut back hard and may be getting tired of sausages for dinner."

Last week Statistics NZ provided more detailed and comprehensive numbers than it has before of savings (the difference between income and outlays) by sectors of the economy. It turns out the household sector has been less egregiously feckless and improvident than previous, cruder estimates indicated.

Households have spent on average over the past five years $1.06 for every dollar of income, rather than the $1.13 previously thought. In the year to March 2010 it was $1.02.

But that still means that households are "dis-saving" even in these debt-averse and cautious times. By contrast American households - not normally thought of as exemplars of thrift and providence - have a positive savings rate of around 6c in the dollar.

And the new statistics do not change the picture for national savings as a whole. They reallocate some expenditure from the household to the business sector; specifically, a lot of mortgage interest payments have been reassigned from owner occupiers to landlords, who are treated as businesses for these purposes.

They are no cause for complacency.