KEY POINTS:
The threat of further Reserve Bank interest-rate rises on March 8 and April 26 is causing considerable concern, particularly among exporters.
Additional rate rises would put upward pressure on the New Zealand dollar and create additional problems for farmers and other exporters.
Reserve Bank Governor Alan Bollard will
be in the firing line if he raises rates again because of the widespread belief that his approach is far too crude and his rises are having a negative impact on the economy's productive sector.
The Reserve Bank Governor will have to find new ways to fight the housing boom, buoyant consumer spending and inflation if he is to avoid being criticised this year.
One of the main objectives of the Reserve Bank is to curtail inflation through monetary policy. The Bank implements this policy through the official cash rate (OCR), which it reviews eight times a year.
Its current target, which was set in September 2002, is to keep inflation between 1 per cent and 3 per cent on average over the medium term. In order to achieve this objective, the Reserve Bank has raised the OCR, which has a strong influence on all other interest rates, from 5 per cent to 7.25 per cent since the beginning of 2004. This is the highest in the developed world.
These OCR rises have been a major contributor to the strong New Zealand dollar. Economists are predicting a further 0.25 per cent rise to 7.5 per cent on March 8 and the possibility that the OCR will go to 7.75 per cent on April 26.
These forecasts are hard to understand in light of the sharp drop in inflation from 4 per cent for the June 2006 year to 2.6 per cent for the December 2006 year (see table). The December quarter was a negative 0.2 per cent, the first negative quarter since the three months ended March 2001.
But Bollard is worried that the stronger-than-expected economy will boost inflation in the medium term. On January 25 he said that annual inflation "is projected to decrease considerably further through 2007" but "the medium-term outlook is less rosy, with annual rates of inflation projected to return to the upper part of our target range through 2008 and into 2009".
The problem with Bollard's approach, which is prescribed under law, is that the buoyant housing market and strong consumer demand are due to excessive credit growth and New Zealand borrowing trends are insensitive to interest-rate changes. For example:
* In 2004, when the OCR increased from 5 per cent to 6.5 per cent, the total amount of bank mortgage lending rose by $13.2 billion to $99.5 billion.
* The following year, when the OCR went from 6.5 per cent to 7.25 per cent, bank mortgage lending increased by $15.5 billion to $115 billion.
* In 2006, when the OCR was unchanged at 7.25 per cent, bank mortgage lending rose a further $14.6 billion to $129.6 billion.
Since the end of 2003 total bank mortgage lending has risen from 64 per cent to 82 per cent of GDP. By comparison, Australian bank mortgage lending represents 59 per cent of GDP at present.
The aggressive mortgage lending strategies of the banks have been strongly influenced by an international agreement called Basel I.
Under this agreement banks are required to have capital representing at least 8 per cent of the total value of their assets, mainly loans. In other words, banks have to hold at least $8 million of capital for every $100 million of assets.
But under Basel I, assets are adjusted for their perceived risk with 100 per cent of corporate loans being taken into account when calculating the capital requirement, 50 per cent of residential mortgages and 0 per cent of government securities.
This means that $100 million of residential mortgages is considered to be only $50 million as far as the capital calculation is concerned. Thus $100 million of residential mortgages requires only $4 million capital compared with $8 million capital for $100 million of corporate loans.
This is one of the main reasons why the Australian-owned banks usually require property security from the owners of small companies when lending to these companies. This allows them to have a lower capital requirement, make a higher return on their capital and remit more money back to Australia.
These residential property security requirements are a major deterrent to the development of small companies in New Zealand.
The ASB Bank, which is 100 per cent owned by the Commonwealth Bank of Australia, is a classic example of this.
At September 30 last year, ASB Bank had total assets of $46.3 billion, indicating that it should have minimum capital of $3.7 billion under the 8 per cent requirement. As 65 per cent of the bank's assets are in the form of residential mortgages - and only 50 per cent of these are taken into account when calculating its capital requirement - the bank's minimum capital requirement is $2.1 billion instead of $3.7 billion. (Its actual capital is $2.9 billion.)
Under Basel II, which will be introduced in New Zealand in January 2008, the risk-weighting on residential mortgages falls from 50 per cent to 35 per cent.
In other words, the capital requirement on $100 million of this loan type will fall from $4 million to $2.8 million.
On the surface this looks as if the banks will become even more aggressive as far as residential mortgages are concerned, but Basel II is less prescriptive - it gives each country the opportunity to adjust its risk-weightings.
The Reserve Bank of Australia has indicated that it will only apply the 35 per cent risk-weight to residential mortgages when the LVR (loan to value ratio) is 80 per cent or less and the mortgage is insured. It has also indicated that mortgages with an LVR of 100 per cent or more will be risk-weighted at 100 per cent under Basel II instead of 50 per cent at present.
The Reserve Bank of NZ is looking at its approach to Basel II. It has made no official announcement on the issue but Basel II gives Bollard another way to fight the housing boom.
For example, the Reserve Bank could determine that only residential mortgage loans with an LVR of 75 per cent or less, plus insurance, will be 35 per cent risk-weighted. Mortgages with an LVR of 75 per cent to 90 per cent, plus insurance, will be 50 per cent risk-weighted and all those with an LVR of 90 per cent or more will be 100 per cent risk-weighted.
This would have a big impact on bank lending policies. It would also be a more effective way to restrain the housing boom as the OCR is extremely crude, particularly as it has huge implications for the sectors of the economy that have no involvement in housing or consumer spending.
The OCR is also ineffective as only 15 per cent of residential mortgages, in dollar terms, have floating interest rates and any increase in the OCR takes a long time to flow through to borrowers' behaviour.
* Disclosure of interest: Brian Gaynor is an investment strategist and analyst at Milford Asset Management.
