KEY POINTS:
You only find out who is swimming naked, venerable investor Warren Buffett once said, when the tide goes out.
The tide of easy money and cheap credit that has run for most of the current decade is turning, with a vengeance.
This change is behind the turmoil that has rocked world financial markets in the past few weeks.
Fears of "contagion" from the collapse of the dodgy end of the United States mortgage market have seen the risk premium in interest rates rise, share prices tumble and the European, US and Japanese central banks step in yesterday to inject more cash into their banking systems.
All of this occurs in the context of a world economy that is going strong.
And so far, credit spreads - the margins different classes of borrowers have to pay over the interest rates that risk-free borrowers like the US Government can command - have moved from exceptionally low levels to more normal ones.
But the danger is if that trend carries on to become a full-blown credit crunch.
That would spill over from capital markets into the real economy.
Because of our high reliance on imported capital, New Zealand is vulnerable to a full-scale reversal of the global conditions of the past few years when credit was too easy, encouraging complacency, to one where credit is tight.
Our net international debt of $145 billion or 89 per cent of GDP is extremely high by international standards.
"We don't know whether these tremors in financial markets signal a more disruptive move to come or constitute a gradual release of pressure on interest rate spreads that have built up over some time," Bank of England Governor Mervyn King said on Wednesday.
"So it's impossible at this stage to judge just how large and how persistent this tightening of credit conditions is likely to be."
The US Federal Reserve left official interest rates on hold this week, indicating it is still more worried about inflation than growth.
The Fed noted the volatility of financial markets, tightening of credit conditions and the ongoing correction in the housing market.
"Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy," it said.
Most local economists would give a similar view of the New Zealand economy. This week's news recorded wages growing strongly, unemployment at record lows and further gains in export commodity prices.
The main impact of the international financial markets' turmoil so far has been to send the NZ dollar lower and keep upward pressure on mortgage rates.
The dollar's decline, albeit only to historically very high levels, reflects the unwinding of "carry trades" where international investors borrow in a country where interest rates are low, notably Japan, and invest short-term where rates are high like New Zealand.
They run the risk that the exchange rate will move against them and in a risk-averse environment such trades tend to dry up.
Rising global interest rates have pushed up longer-term fixed mortgage rates here, leaving borrowers with nowhere to hide as Reserve Bank Governor Alan Bollard has pushed up short-term rates as well. Housing market turnover and prices are both weaker as a result. But it is the US housing market's downturn that is rocking global financial markets.
Swiss-based global bank UBS estimates that about US$1.2 trillion of the United States' $10 trillion mortgage market is "sub-prime".
When money was cheap and house prices were climbing a lot of mortgages were written with little or no equity put up by the borrower and no questions asked about their incomes.
Many loans are structured to have a sweetheart period up-front when the interest rate is low, but with a reset to higher rates two years into the term of the loan.
A wave of such resets is due next year, leading to concerns that we have yet to see the worst of the fallout from the sub-prime mortgage market. At the same time there has been a lot of risk-taking at the funding end of the transactions.
About 60 per cent of the US mortgage book has been "securitised", allowing banks to lay off their bets to investors. Mortgage debt is repackaged into various products with varying degrees of risk.
Hedge funds have been major buyers of the riskiest of these.
"As the value of the underlying sub-prime mortgages has declined precipitously, hedge funds have suffered heavy losses from their positions in these instruments, prompting significant writedowns and closures at several funds," a report by Citibank says.
The hedge funds have encountered the problem that any highly geared investor who takes a position largely with borrowed money has.
Leverage is fine in a rising market; it amplifies your profits. But it works both ways: in a falling market it can wipe out your capital.
In an era of globalised financial markets the fallout is not confined to the United States, with French and Dutch investment banks among the more recent casualties.
"At the moment we are seeing some contagion but it is not spreading too far," said ANZ National Bank chief economist Cameron Bagrie.
Although credit spreads had widened they were still not wide by historical standards.
"They are not suggesting an imminent crash. We are going from an environment in which things were exceptionally easy to one which is more normal," Bagrie said.
"If you look at the global economy, outside the United States - in fact outside the US property market - everything's still pretty strong."
The International Monetary Fund has just revised up its forecast for global economic growth. China's annual growth rate is running at 11.9 per cent.
Even in the United States, growth picked up from a weak March quarter to an annualised 3.4 per cent in the June quarter.
Bagrie said that if the markets became concerned about global economic growth turning south, falling commodity prices would be the main transmission mechanism to New Zealand.
So far there is no sign of that. On the contrary, world prices for a standard basket of New Zealand's export commodities rose 4.7 per cent last month to be 35 per cent up on a year ago.
Citibank said that while recessions were typically associated with substantial widening of credit spreads, the latter could also arise from purely financial market events in the absence of a broad economic downturn, like the collapse of the hedge fund Long Term Capital Management in 1998 and the demise of Enron and WorldCom in 2002.
"In the corporate sector balance sheets and profitability are far healthier than was the case in prior economic downturns."
It also points to other sources of liquidity for the global system which remain in place.
High oil prices have left the Gulf states with about US$1.6 trillion in foreign assets. China has foreign reserves of around US$1.3 trillion.
Russia, India, Korea and Taiwan have a further US$1 trillion between them.
