Bernard Hickey :Why Australian banks are crucial if NZ goes bankrupt

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What would happen if the world judged New Zealand Inc was unable to service its debts?

Unfortunately, these are not idle questions any more. Our net foreign debt is as high as Greece's and Ireland's, both of whom have just suffered the indignity of being 'bailed out' by the international powers-that-be after effectively being judged bankrupt as nations.

In their cases the International Monetary Fund and the European Union dictated massive cuts in public spending and new taxes. Their downfalls were preceded by credit rating downgrades.

Standard and Poor's put New Zealand's AA+ credit rating on negative outlook a few weeks ago. As recently as March last year Ireland had a credit rating that was one notch better than New Zealand's.

The former Celtic Tiger also once had public debt levels similar to ours relative to GDP, but now has a rating four notches below our rating.

New Zealand's growth rate has been the slowest in the OECD in the last 40 years and shows no signs of improving any time soon. Our government is borrowing up to NZ$300 million a week and is running a structural deficit running at about 4 per cent of GDP.

The government has just announced a slump in revenues leading to a cash deficit of NZ$15.7 billion or 7.7 per cent of GDP this year. It has also just increased its borrowing programme by NZ$10.5 billion over the next 3 years. That is almost all foreign borrowing.

In fact, it's somewhat strange that we haven't already been hauled over the coals by our creditors and the markets.

Our net foreign debt is set to widen past the 100 per cent of GDP danger point in the next four years, Treasury has forecast, although the government believes stronger commodity prices will help reduce that widening in coming years.

Our net foreign debt is in the Greek/Irish/Portugese/Spanish zone.

Understanding why we've gotten off so lightly helps explain what any bankruptcy might look like.

New Zealand's foreign debt problem is a household debt problem, rather than a government debt problem, like it was in Greece and Ireland. Actually, our foreign debt problem is a corporate or bank debt problem because the debt is owed via households through the big four Australian-owned banks.

This is the key point.

New Zealand's economic future is in the hands of the Australian banks and the Australian Government if we ever have trouble servicing those debts. The pivotal point in any future crisis will be the reaction of the four CEOs of those banks and the Australian government behind them.

In fact, we've been here before.

Back in October 2008 when the financial world was going to hell in a handbasket the Australian government stood behind those Australian banks by offering a retail deposit guarantee and a wholesale deposit guarantee. We immediately offered the same, although our guarantees have since been withdrawn faster than the Australian guarantee.

That pivotal decision was a pre-emptive one taken without much consulation with the New Zealand and it was disguised as a backstop for the banks in Australia.

The untold story is that those banks, their shareholders - and the Australian government indirectly - bailed out the New Zealand arms of the big four banks in late 2008 and early 2009. They were helped by some emergency loans from the Reserve Bank of New Zealand, but without around NZ$5 billion of fresh capital sent across the Tasman at short notice they would have struggled.

The 4 New Zealand arms of the four Australian banks weren't able to raise funds in their own right on international markets for many weeks. They relied on their parents for support.

At that time New Zealand couldn't be blamed for the freeze on international capital markets.

But what happens when or if we are targeted for something we've done or haven't done?

Can we simply expect the Australians to back us again? Is the Australian backstop something we can rely on? Should we just lie back and trust that they'll always be there?

What might happen if they aren't or want something more in return? What if they are in trouble themselves in the even of a Chinese slump or an Australian property crash.

Have they already asked for their pound of flesh?

The key trigger points

It's worth, therefore, wondering what might trigger another one of these pivotal moments and what we should do to reduce our risks.

Luckily for us, our government debt is relatively low at the moment, although it is growing fast. For Ireland and Greece, a sharp rise in Government bond yields was the symptom and trigger for their crises.

Bond markets essentially judged Ireland and Greece's public finances as unsustainable. The first canary in the mine was a rise in credit default swap spreads versus benchmarks, and then a rise in the bond yields themselves.

These rates set the basis for all interest rates, including the ones New Zealand's banks have to pay when servicing their corporate debts. If New Zealand were to be downgraded and our government bond yields were to diverge too much from Australian rates then it becomes painful for the banks.

As longer term interest rates rise, that puts more pressure on the economy and therefore on government finances. It becomes a vicious spiral.

Luckily, for New Zealand (and unlike Greece and Ireland), we have a flexible currency. In theory, a downgrade in our credit rating would force the New Zealand dollar lower, which would boost our export earnings and the economy more generally.

A debt spiral

But what if the economy doesn't improve much, particularly the domestic sector, which has been dependent on rising house prices and increased foreign borrowing in the past. Or America, Europe and Japan continue printing money aggressively to devalue their currencies, leaving ours high and dry?

What if the deleveraging that surprised everyone this year continued into next year, and the year after that? GST revenues, which the government is now relying on more heavily, would lag. Corporate profits would be weak.

Luckily for us (and unluckily for Ireland), the New Zealand government has not bailed out its largest banks and blown out public debt to fill a financial black hole opened up by a property collapse.

There has been some limited socialisation of financial losses, led by more than NZ$2 billion worth of payouts to holders of debentures in guaranteed finance companies.

Unlike in Australia, the bulk of the guarantees of deposits have now rolled off, although there is still a significant amount of guaranteed wholesale bank bonds. There is the non-trivial matter too of losses on leaky buildings, some of which may be borne by the government.

The real concern for the Australian banks starts when New Zealand customers start defaulting on their hefty household and farming debts, particularly if land and property values continue to fall.

The banks have had a sneak preview through the vineyard industry and parts of the dairy industry.

What if the CEOs of those big four banks believe that New Zealand's government is headed in the wrong direction and is keeping interest rates higher than is possible by running big deficits.

What pressure could they exert?

Covered bonds

One element of bank lobbying we have already seen is from those banks who wanted to be allowed to issue covered bonds overseas.

The Reserve Bank has been "very progressive" in supporting this push into covered bonds, which effectively push New Zealand depositers down the queue in the event of any problems and which were banned in Australia, at least until this week.

Back in 2005 the Reserve Bank had to fight a rear-guard action to keep control of regulation of the banks here in New Zealand. Then Australian Treasurer Peter Costello argued New Zealand had already ceded control over its banks when it sold them.

Governor Alan Bollard and his backers within the bank and Treasury successfully fought off that push.

Would they be able to fend off another set of demands when New Zealand is in a weaker position?

We should prepare

The best way to avoid this sort of risk is to have a much stronger economy and budget position. That means a much faster move to budget surplus. That is the fastest way to increase national savings and avoid building up more debts we may struggle to service.

We also need to use any prudential tools we have to stop the Australian banks borrowing more offshore. Are massive new issues of covered bonds a good idea? Particularly when they are being used to increase investment in property, rather than repaying short term borrowing.

The early signs are that these new foreign borrowings are being deployed into the housing market, helped along by the income tax cuts that are worsening the budget deficit.