Andrew Gawith: Prudent approach to boom and bust

Reserve Bank Governor Alan Bollard says both borrowers and lenders are far more cautious now. Photo / Mark Mitchell

Opinion

In 2008 the global financial crisis exposed the high levels of growth since 2000 as nothing more than a debt-fuelled binge.

While markets recover, some of the best international minds are still scratching their heads over how to safeguard the world's future financial security.

New Zealand was largely sheltered from the worst of the crisis, but it still provoked a rethink here too. In response, Alan Bollard has formulated some interesting changes aimed at forcing banks to be more prudent in future upswings.

These changes may have the happy side effect of dampening swings in the exchange rate.

Things are different now, argues Bollard. Overseas sources of funds are more cautious and less willing to lend freely.

House buyers and investors have had yet another reminder that house prices can fall, and it will take a while for many to forget it.

All in all, households will be more wary about repeating the mistakes that led to the financial crisis in the first place, well at least for a few years.

This appears to be true. New Zealanders have actually been paying down debt over the past year. Imports are down, and the current account is improving. So Bollard is probably right, things are different. At least for now.

New Zealand's somewhat unusual problem was that the Reserve Bank had to take extreme measures to curb the boom of the mid-2000s. This pushed up short-term interest rates, and attracted lots of foreign capital looking for short-term gains.

Meanwhile, the majority of house buyers avoided the higher cost of floating mortgages by turning to longer-term fixed interest rates, financed with cheap foreign money.

So the high short-term interest rates attracted overseas cash into the country, pushing the exchange rate up, which hurt exporters, but didn't really quell the boom.

Now that more people are back on floating mortgage rates, they will feel the sting of monetary policy changes much more readily.

This is all nice stuff, but none of it tells us that the same thing won't eventually happen again.

There have been enough booms and busts in recent decades for us to be sure of one thing - investors have a short memory, and in every boom they tend to convince themselves that this time is different.

However, the Reserve Bank has a new instrument in its armoury - the Core Funding Ratio - that could dampen the boom-bust cycle ... Put simply, this requires banks to source a certain chunk of their funding from "stable" sources - like domestic customer deposits or long-term funding.

The upshot of this is that unless banks can source enough of this kind of funding, they won't be able to make the next loan.

Initially this Core Funding Ratio was introduced as a minimum standard, and as a result hasn't made much difference to bank practices. However, the Reserve Bank is signalling the possibility that this ratio could move up and down according to economic cycles.

In the good years, banks would be required to build up a "war chest" of stable funding that they can rely on when times turn tough.

Conversely when the bottom falls out of the property market (which will happen again) and bad debts pile up, the restrictions can be reduced.

This change would force banks to rely more on domestic customer deposits - so in the next boom deposit rates should rise, and long term mortgage rates should rise to match them.

As a result more of our borrowing would be financed by domestic savings rather than international borrowing, which will reduce the pressure on the exchange rate.

This should eventually be good news for domestic bank deposit holders, and in the ideal world it might even encourage more Kiwis to save.

Unfortunately, even this potentially useful tool is unlikely to be enough to prevent New Zealanders returning to their borrowing ways.

The Reserve Bank has acknowledged that the Core Funding Ratio, as initially installed, has had little impact on bank practices. While the bank has signalled that the ratio could be cranked up over time, such changes are likely to be met with yelps from the banks.

The Reserve Bank is also concerned about encouraging people to circumvent the banking system and go through non-bank lending sources.

Ultimately the Reserve Bank is still charged with controlling inflation. It has no interest in single-handedly tackling New Zealand's economic imbalances.

It has made it clear that prudential tools are first and foremost about minimising the risk of bank lending, not about managing the wider economy.

So while this latest innovation could be another useful policy tool, we can't sit back and look to the Reserve Bank for everything.

So the financial crisis seems to have come and gone, at least for now.

While we wait to hear of possible reforms to the international financial system, New Zealand has developed a couple of useful innovations of its own.

Nothing really transformative, but it's a start.

* Andrew Gawith is a director of Gareth Morgan Investments.