KEY POINTS:
Over recent years New Zealand has been hit by a credit tsunami. The wave is now rapidly receding. The most obvious sign of this is the plummeting New Zealand dollar.
The financial sector has always been the Achilles heel of modern capitalism. The different schools of economic thought, from Keynes to Monetarism, have vigorously debated the impact of money and credit on the economy. Can banks, finance companies, mortgage brokers and various other sellers of credit be trusted to act prudently, particularly when an economy is booming and the collateral they are lending against is increasing in value?
A key factor in the 1930s Depression was imprudent bank lending. The conundrum is that as an asset increases in value, this increases the amount that can be borrowed against the collateral, further inflating the price of the underlying asset and allowing further borrowing. The current global financial situation has big implications for New Zealand. It is worth examining the background to the crisis.
The late 1990s was a boom time for the United States economy and share market. The emergence of technology stocks suggested the economy was moving into a new stage of the industrial revolution where the old rules of business valuations no longer applied. By 2000 it was apparent that the rules of the old economy were still relevant. What goes up will eventually come down, and the bubble had burst.
To make matters worse, a group of fanatics from the Middle East flew planes into the financial heart of America. The United States Federal Reserve quickly lowered interest rates to ensure that confidence was maintained and the economy would not slide into a recession. So began the great real estate splurge of the new millennium.
As real estate values throughout much of the Western world soared, banks and various other lenders became more aggressive in their lending practices and their sourcing of funds. In the United States, a large sub-prime mortgage industry emerged, catering to the risky end of the lending market. When the United States and many other countries lowered their interest rates in the early years of this decade to stimulate their economies, New Zealand did likewise but still had interest rates way above most other OECD countries. This was due to our stringent anti-inflation policy, and it made us a very attractive target to lend to.
By this stage, our banks and other financial institutions had realised they could borrow New Zealand dollars cheaply overseas and lend them to the New Zealand public at higher rates. Japanese housewives or Belgian dentists could buy New Zealand dollars on the foreign exchange market to lend back to us, and get the higher interest rates on offer in New Zealand. Although the actual process is a little more complex than this, the basic transaction still holds.
The effect of this process was to drive the value of the New Zealand dollar up against most other currencies. The New Zealand dollars that were being loaned back to us were then pumped into our lending market and particularly mortgage finance.
Our banking system is very risk-averse, preferring bricks and mortar as collateral as opposed to balance sheets and profit and loss statements. This process is now starting to unravel in spectacular fashion.
The collapse of the sub-prime mortgage market in the United States has spooked lenders. The Japanese housewives and Belgian dentists now want their money back pronto. While the New Zealand dollar was appreciating, they were getting our higher interest rates plus the gains in currency when they received their New Zealand dollars back. Now they risk taking a major hit as the New Zealand dollars they receive back are worth less in terms of their own currency. It's as though someone has just yelled "fire" in a crowded cinema.
The implications for New Zealand are varied but not good. As our exchange rate plunges, imports become more expensive. The oil companies have very quickly announced petrol price rises.
The falling dollar will also raise the price of cars, electronics and most other goods in our tradable sector. The prices of export goods such as dairy products, beef and lamb and various other produce will also increase as exporters can get higher prices overseas in New Zealand dollar terms. Interest rates will also remain high. The price increases in imports and exports will cause inflationary pressure which the Reserve Bank is required to contain. The drying up of loanable funds from overseas will mean that long-term interest rates will remain high.
The implications for our housing market are not pleasant. Simple statistics reveal some interesting truths. Over the past decade, average household incomes in New Zealand have risen by about 56 per cent and the population has increased by 12 per cent, whereas median national house prices have increased by 115 per cent. This suggests a credit-driven splurge has been the main driver of house prices.
A plateau in house prices could quickly lead to a slump. Current rental yields in many centres are sickly compared to bank interest rates. If capital gains evaporate many investors will sell out. The market could turn quickly, as is occurring in the United States.
There is an irony in all this. Since Britain joined the European Union in 1973, New Zealand has strived to diversify its industries. In recent years, even with the high New Zealand dollar, our dairy industry has boomed due to massive world demand, particularly from the Chinese. Our agricultural sector may prove to still be the backbone of the New Zealand economy in terms of generating real wealth.
* Peter Lyons teaches Economics at St Peters College, Epsom, and has authored several economics textbooks.
