KEY POINTS:
The Government guarantee for their wholesale funding was not the only way out of the hole banks have dug for themselves over the past 10 years, argues Victoria University economist Geoff Bertram.
In a paper to an Institute of Policy Studies symposium on Saturday, Bertram said that of the current account deficits of the past decade (a cumulative $88 billion) the great bulk ($80 billion) had been funded by an increase in banks' net foreign liabilities.
It had created a major source of demand for New Zealand dollars, reducing the downward pressure on the exchange rate which might have driven a transfer of resources into the exporting and import-competing sectors of the economy.
That in turn had weakened the ability of the economy to trade its way out of trouble, now that the squeeze is on that external funding.
Instead, both the previous and new Governments accepted they had no option but to underwrite the banks as they seek to roll over their offshore funding.
"Yes, there are rigorous restrictions on the guarantee scheme that will undeniably reduce taxpayers' exposure very greatly. Rather than $150 billion, we may be faced with a worst-case contingent liability of, say, $30 billion," Bertram said.
"That is still a lot of money and it has been amazing to see how readily it was available to underwrite an offshore-owned banking system that was, and is, very far from insolvency and which is arguably perfectly capable of looking after itself in difficult times."
Just as an individual who spends more than he earns has to fund the difference by selling assets or borrowing, New Zealand's continual current account deficits ($15 billion in the year to June) have seen a relentless rise in net foreign claims on the economy to very high levels by international standards.
This has kept both exchange rates and interest rates higher than they would otherwise have been.
Banks' offshore debt represents just over half of the country's gross foreign liabilities. The annual interest bill it gives rise to now accounts for 70 per cent of the investment income deficit, which in turn is much the largest component of the current account deficit. We have in effect been borrowing to pay interest on our foreign debt.
Bertram points out there was a big surge in banks' foreign exchange liabilities, by way of transfers from their Australian parents, in the wake of the 1997 Asian crisis - some $22 billion by 2002. That allowed the banks to keep expanding their lending even though local deposits flatlined through that period.
It also meant that the cross-rate with the Australian dollar held up even as the trade-weighted exchange rate fell. It reduced the economy's overall currency adjustment, and it also reduced the negative impact on parent banks' reported earnings when they converted their New Zealand subsidiaries' profits to Australian dollars.
After a brief hiatus between 2002 and 2004, the banks resumed offshore borrowing to the point that by September 2008 there was a gap of nearly $100 billion between their kiwi dollar funding from New Zealand residents and their kiwi dollar claims on New Zealand residents.
"The banks had moved to offshore funding on a grand scale to finance domestic credit expansion within New Zealand, much of which went to fund speculative activity in the housingand property markets."
With a credit crunch and the onset of a global recession, the challenging question now is how to reduce and fund the current account deficit.
Bertram said the US banks' problem was on the assets side of their balance sheet (the quality of their loan books). New Zealand banks' problem, by contrast, is on the liabilities side - their reliance on imported credit for more than a third of their funding.
But the quality of their loan book allows them to progressively replace offshore funding by taking up - as they have begun to - the Reserve Bank's offer of loans secured by mortgage-backed securities.
"At a rough guess this mechanism has the potential to inject up to $100 billion into the banking system," Bertram said.
"The mortgage repo option provides, on the face of it, sufficient cover to ensure that banks could repay their offshore debts at the exchange rates stated in their hedge contracts."
But such a large-sale repatriation of foreign-currency debt would result in a much sharper depreciation of the exchange rate than anything seen in the past couple of decades, he said.
IN THE RED
* New Zealand's large current account deficits have been funded by banks importing credit, which is now in short supply.
* This has helped keep the dollar high, hobbling exports and making it harder now to trade our way out of trouble.
* And now the banks have sought, and been given, a Government guarantee to help them roll over those offshore debts.
