Brian Fallow: Living off foreign aid

Should we worry that nearly a third of the money New Zealand banks lend comes from overseas savers?

Does the way fixed-rate mortgages in particular are funded represent a potential avalanche of selling for the New Zealand dollar?

Such questions are, to quote ex-All Black Grahame Thorne, a bit hard on the old brain.

They take us into the arcane world of eurokiwi and uridashi issuance and the cross-currency interest-rate swaps market.

But cutting out the middlemen, the essential flow of funds is to borrowers here from retail investors overseas who are attracted by our relatively high interest rates and are prepared to invest in securities denominated in New Zealand dollars.

Typically, they invest when the exchange rate is rising and disregard, or are prepared to take, the risk that when the loans mature and they get their kiwi dollars back, the exchange rate will have moved against them.

This is handy, because New Zealanders collectively want to borrow more, a lot more, than they collectively want to lend.

Borrowers benefit enormously from the fact that, as part of an open economy in good standing in the global financial market, they can access the savings of people overseas. Interest rates would be a lot higher if they had to balance credit supply and demand within New Zealand alone.

But such a high degree of reliance on the savings of foreigners inevitably impacts on the exchange rate, making it more of a roller-coaster ride than it might otherwise be. It also creates a high exposure to big shifts in the global supply of savings and demand for capital.

Right now the lion's share of mortgage lending is at fixed mortgage rates.

If the banks have a fixed rate of interest coming in, they naturally want a fixed rate going out.

The swaps market allows them to do that, as well as allowing them to access non-residents' savings.

The overseas institutions which issue eurokiwi and uridashi bonds and then swap the proceeds with New Zealand banks (for funds they have raised in other currencies) get cheaper funding than they otherwise could.

The latest housing boom has seen a steep rise in the amount of eurokiwi and uridashi bonds issued.

Westpac says $11 billion was issued last year and more than $5 billion so far this year.

The Reserve Bank puts the total outstanding at around $24 billion.

That has boosted demand for the NZ dollar and helped push the exchange rate to historic levels.

It helps explain why (until recently) the exchange rate has shrugged off worsening trade and balance of payments deficits and just kept climbing.

But a lot of this debt matures next year. Bondholders will want to turn their New Zealand dollars back into euros, yen or US dollars.

The risk is that the market will dump the kiwi dollar in anticipation. In the mid-1990s boom, eurobond issues tended to be for five or even seven-year terms. In 2003, they were often for three years but now they were for two-year terms, Westpac chief economist Brendan O'Donovan said.

The result is a bunching of maturities in 2006. About $600 million a month will roll off. Even if it is offset by perhaps $200 million a month of new issues, that would leave $400 million of net redemptions a month, putting selling pressure on the kiwi dollar. This could exacerbate any decline in the local dollar, he said.

 

World interest rates are expected to rise as the US Federal Reserve continues to tighten. But its New Zealand equivalent is at or near the end of its rate hikes. That will narrow the interest rate differential, the major attraction of eurobonds.

The current account goes from bad to worse - another signal to sell the dollar - and if the world economy slows, commodity prices should soften.

ANZ National Bank economists argue that the downward influence on the dollar from the maturing of eurokiwi and uridashi bonds may be overstated.

In the last cycle when redemptions started to impact on the dollar in 1999 as investors contemplated currency-related losses, the exchange rate was being driven lower by some exceptional factors, they said.

For one thing, and most unusually, two-year bond yields were briefly lower in New Zealand than in the US. This time round, though, the differential has contracted; in recent months, at 2.7 per cent, it is still positive. In 1999, the dotcom boom was fuelling demand for US dollars. This time, it is out of favour, weighed down by external and fiscal deficits.

ANZ National said the danger was that the market read too much into the potential impact of eurokiwi and uridashi maturities and ignored the brass tacks that would justify continued issuance for some time, leaving the dollar to fall sharply.

O'Donovan points to a "happy coincidence" between the factors which fuel demand for this kind of funding and circumstances which make it attractive for Belgian dentists and Japanese housewives to provide it.

"When you have a housing boom going on, domestic inflation tends to be stronger. Interest rates are higher and eurobond issuance increases.

"This provides capital to banks to on-lend and keep the boom going."

The exchange rate follows the housing cycle quite closely, O'Donovan says. When the property market levels off, interest rates tend to fall. And when the dollar falls as well, eurobond issuance dries up.

It is all very convenient.

Borrowers get the fixed rates they want and lower interest rates because they can access a greater pool of savings. Their banks can lay off interest rate risk and exchange rate risk.

But it all depends on retail investors being prepared to take on the risk that the others in the chain don't want, most particularly the risk of being caught by an exchange rate correction.

A nagging concern emerges at this point.

Western Europe and Japan are sources of this kind of money because they have ageing populations and high savings rates. But the demographic underpinning of that appetite for eurobonds may not be there next time around. People save for their old age with the view to drawing those savings down. The tide could run in the opposite direction.

Other features of international capital flows may change too. We now have the intrinsically absurd situation where people in China are exporting their savings to the US via the mechanisms authorities use to keep a fixed exchange rate with a devalued US dollar. The capital flow should be in the other direction.

At some point, one would expect the Chinese to want to spend more of their incomes or invest more of it in their own economy instead.

Every other borrower in the world has to stand in line behind Uncle Sam. Will President George W. Bush halve the Federal deficit? The record of his first term suggests not.

When 31c in every dollar your local banks have to lend comes from non-residents, the shifting dynamics of global capital markets cannot be a matter of indifference.