Heading down a rocky road towards hard landing

Alan Bollard

New Zealand risks waking up with a dreadful hangover because of its debt-fuelled spending binge.

Reserve Bank Governor Alan Bollard said as much yesterday in a speech in Rotorua when delivering a stern warning on the country's spend-up which he will keep trying to curb with higher interest rates.

Bollard baldly stated the uptrend in house prices would not be sustained and an outright fall in prices was "likely".

He said the present levels of consumer spending, boosted by borrowing on the strength of higher house prices as well as higher incomes, were unsustainable.

Bollard estimated that households collectively were spending about $1.12 for every $1 of income - not something that could continue indefinitely.

The country's saving rate - or lack of - is among the worst of any developed country. While it is a slippery thing to measure exactly, economists say it is clear the savings rate is negative and has been getting worse.

Bollard said strong growth in spending showed up in inflation pressure and in the current account deficit. The deficit was nearly $12 billion in the year to June.

Inflation figures out on Monday are expected to show a jump of 1.2 per cent in the September quarter, pushing the annual rate to 3.5 per cent, well outside the 1 to 3 per cent band Bollard is required to maintain.

Some economists have taken the Governor's warning as reinforcing financial markets' expectations that he will raise the official cash rate by 25 basis points to 7 per cent on October 27, after a seven-month hiatus.

The financial markets had already come to regard a rate rise as close to a sure thing and the majority of market economists have too. Others, however, worry that an extra twist of the interest rate screw, on top of the seven Bollard has already made since the start of last year, could cause an economy which is already slowing to stall and trigger a "hard landing". New Zealand's interest rates are already the highest in the developed world.

The Institute of Economic Research, releasing its quarterly survey of business opinion on Tuesday, said that firms' responses unambiguously showed a slowing economy and the survey's findings did not justify another rate increase.

While firms reported steep rises in their costs - unsurprising in the light of the oil price - there was only a small increase in the proportion of firms saying they intended to raise their prices.

Instead, profits were taking the hit.

Firms, it seemed, have got the message the Reserve Bank has consistently repeated since the late 1980s: if too many people try to pass on higher costs to their customers, or employers, the bank will quell the risk of endemic inflation by engineering a business environment so bleak they don't dare to. Preventing a return to cost-plus thinking remains the bank's bottom line.

But it faces a period where confidence in the low inflation environment will be severely tested. The Reserve Bank's own forecasts have inflation hitting 4 per cent and staying above the top of its target band until the end of next year.

The unknown quantity is how long firms can sustain the squeeze to their profit margins from higher oil and wage costs without passing those costs on.

Westpac chief economist Brendan O'Donovan said a rate rise later this month seemed likely - the easy way out for a Reserve Bank nervous about inflation, given that the markets were now expecting it.

"But it also seems a hike too far." Domestic demand was already slowing and the impact of higher oil prices on the economy had still to flow through, O'Donovan said.

Higher interest rates are not only the prescription for inflation. They are also, along with a weaker exchange rate, what is needed to bring the current account deficit down from its present unsustainable 8 per cent of GDP.

Such deficits have to be funded by selling assets or, more often, running up debt. The cumulative legacy of decades of deficits is that New Zealand is a net debtor to the rest of the world to the tune of $124 billion or 81 per cent of GDP, "a much higher net liability position than in virtually any other developed country".

Deutsche Bank economist Darren Gibbs said Bollard would like the combination of higher interest rates, dampening demand in the economy, and a weaker kiwi dollar also dampening demand by making imports including oil more expensive.

"But he knows he cannot control the mix [of interest rates and exchange rate]," Gibbs said. "Hence the warning in the speech to potential foreign investors. In effect he is saying please go away and leave our currency alone."

Bollard said that as the current account deficit continued to widen "one would expect the foreign providers of capital to reassess the relative exchange rate risk attached to their investment in New Zealand dollar assets, increasingly recognising that the exchange rate cannot be sustained at current levels".

Bollard's problem is that one of the things keeping the dollar high is the relative attractiveness to foreign retail investors of debt securities denominated in kiwi dollars and paying New Zealand interest rates.

If he raises rates again on October 27, as now seems highly likely, he will make those securities even more attractive - at first sight at least.

That could create demand for New Zealand dollars, keeping the exchange rate high and imports cheap and eroding the competitiveness of exports.

It also partially frustrates his attempt to take heat out the housing market, as most mortgages are fixed-rate loans funded to a large extent by those international investors.

They take the risk that when their loans are repaid the exchange rate will have moved against them and they will get fewer Japanese yen or euros for their New Zealand dollars. Bollard was reminding them that that risk grows larger the wider the current account deficit becomes.

In his monetary policy statement last month, Bollard made it clear his finger was on the interest rate trigger and that one of the key risks was the prospect of significantly more stimulatory fiscal policy, irrespective of which major party led the next Government.

He repeated the warning yesterday.

"The likelihood of a more expansionary fiscal policy over the coming period has the potential to add inflation pressure in what remains a rather stretched economy. A growing fiscal surplus has clearly made higher levels of government expenditure affordable in the longer term," he said. "However in the short term a more expansionary fiscal stance also has the potential to aggravate the current account deficit as well as increasing the work monetary policy has to do to contain inflation. These pressures will need to be borne in mind as the incoming Government considers its fiscal options."