KEY POINTS:
How would New Zealand cope with a perfect financial storm? It's an interesting conundrum, given the risks facing the economy. Not just the high household debt that Reserve Bank Governor Alan Bollard keeps warning us about, but also the risk that international investors might decide the "emperor has
no clothes" when they assess our credit-worthiness.
That risk could be exacerbated if corporate balance sheets become excessively leveraged as the private equity buy-up gathers pace.
The International Monetary Fund posed just such a question to major Australian banks when it asked them to explain the impact of a perfect storm on their balance sheets. The particular "what ifs" included: What if there was a sharp fall in residential and commercial property prices? Higher interest rates? A slide in the Aussie dollar? And a short recession caused by highly leveraged Australian householders deciding to chop up their credit cards and stop spending - ultimately doubling jobless numbers?
The answer that Westpac, National Australia Bank, ANZ and Commonwealth Bank gave was illuminating. Of course they would be pummelled. Profits would be slashed by 40 per cent within 18 months. Three years on they would still be down 25 per cent. But their balance sheets would remain relatively strong. Why? Because the Australian companies they've been lending to carry relatively low debt.
Glenn Stevens, the Reserve Bank of Australia's new governor, was not so sure. The big issue was just how much the banks' buffer zone would be stretched by a private equity boom and the debt-dominated funding packages used to buy some of Australia's key corporate assets.
Private equity deals in Australia for 2005 totalled US$4.2 billion ($6 billion). This jumped to US$22.2 billion last year.
Companies such as PBL (the Packer media empire), Kerry Stokes' Seven Network, Rebel Sports and maybe even Qantas - which now faces a $12.6 billion takeover from a Macquarie-led private equity consortium - have varying degrees of private equity involvement. Corporate debt levels could be a bigger risk to the Australian economic and financial system than has been seen for two decades, Stevens suggested.
Private equity firms have also been scouring New Zealand, scooping up Independent Liquor (reportedly for $200 million more than Lion Nathan would pay), grabbing control of companies such as Kathmandu and Healtheries. The biggest move - a bid by Stephen Tindall and Pacific Equity partners to buy The Warehouse - did not materialise.
But Stevens' timely warning about the extent of the debt involved as private equity accelerates has not been replicated by our own central bank.
The brainiacs at New Zealand's central bank, I am sure, engage in the same sorts of thought experiments as the IMF.
A perfect financial storm here could involve a sharp fall in residential and commercial property prices, higher interest rates (likely this month), a continued appreciation in the dollar, a balance of payments crisis caused by a changed perception of New Zealand's credit worthiness and a short recession if highly leveraged householders decided to chop up their credit cards.
Judging by the central bank's latest financial stability report, the major risk it sees is a damage to banks' balance sheets if the household sector faces increased strain to service mortgage debt.
Bollard's prime focus is, and should be, the amount of household debt. But reading between the lines of that report and recent speeches, he is increasingly concerned our own perfect storm may arrive.
That's why the bank's sanguine approach to the growth in corporate sector debt is surprising.
"Anecdotal evidence suggests that recent acquisitions by private equity financiers could also be increasing corporate sector leverage. Private equity finance involves taking control, usually of an ailing firm, and cutting costs to improve profitability," said the bank's November report.
"The restructured entity is typically sold within a three to five-year time period. Increasingly these investors are seeking control of healthy but low-debt firms. These firms are then re-leveraged before sale."
But the other perspective is that debt gets ramped up, taxes are minimised and the ability to monitor large segments of the corporate landscape is reduced as the takeover targets are delisted.
Two problems are apparent.
Firstly, the central bank has no direct means of measuring just how much debt is involved after private equity firms gear up companies upon acquisition. Unlike listed companies, there is no requirement for continuous financial disclosure.
Mounting corporate debt cannot be assessed directly through central bank monitoring of the major trading banks. The information, when it does flow via the Statistics Department enterprise surveys, is historical and generic at best. This reduces the available levers.
Secondly, ability to "get out of Dodge City alive" depends on the private equity investors' ability to sell leveraged companies, or refloat them at a later date.
With the Feltex failure looming large in investors' minds, what surety is there that New Zealanders will want a slice of such companies after private equity firms have taken their cut - particularly given the inflated values paid for some targets, as former Fletcher Building chief executive Ralph Waters has warned?
This is not to denigrate private equity, which has a useful role to play in ensuring efficiency.
In a broader sense, if the increasingly leveraged Australian corporate sector strikes trouble we will not be immune. The four Australian banks are now incorporated here.
If problems hit the Australian parent companies, banks here are likely to become increasingly risk-averse, which could make it more difficult for firms to get loans. If Australian companies get into strife there will be flow-ons to New Zealand subsidiaries.
Unfortunately, when I sought the perspective of Adrian Orr, the bank's deputy governor, who has structured the prudential management system, he was unable to comment.
Orr has just been appointed CEO of the New Zealand Superannuation Fund, a job which will see him (in future) focused on the potential high returns from private equity investments, rather than the systemic risks posed by increased corporate debt leverage.
