Brian Fallow: Static OCR holds a sting in its tale

NZ banks have been paying about 4 per cent for new funding in the past year, 150 basis points above the OCR. Photo / Richard Robinson

At first blush it looks like good news for exporters: Governor Alan Bollard's expectation that he will not have to push the official cash rate so high over the next few years.

It is because there is a much wider margin than there used to be between the OCR and what banks have to pay for funding and it is the latter, plus the banks' net interest margin, which determines the rates borrowers pay.

A lower OCR should mean less upward pressure on the exchange rate from yield-chasing carry traders, right? Alas, no.

For one thing, New Zealand is hardly the only country to have its policy interest rate at a historic low and it is the yield gap that matters for the carry trade, which involves borrowing in one currency at a low rate to invest in another at a higher rate.

Which part of the yield curve you look at is important too.

It seems the interest rates which matter most for borrowers and the economy also have the most bearing on the exchange rate. The tightest link between the exchange rate and interest rates is not with the OCR, an overnight rate, but the three-year swap rate.

And that far out the interest rate curve there is a lot more factored into rates than just expectations of what the OCR will be then, including expectations of the demand for loans.

Right now we have a normal or positively sloping curve, where longer-term interest rates are higher than shorter-term ones, and quite steeply so.

It indicates the markets believe the recovery will continue and strengthen, the slack in the economy which has developed will eventually be taken up and, eventually, inflation will become a problem unless monetary policy is first normalised and then tightened.

Wholesale interest rates have fallen since the start of the year, but mortgage rates have held steady or increased. That is because, as the Reserve Bank notes in its March monetary policy statement, the banks' cost of funds remains high compared with before the global financial crisis.

Banks have been under pressure from regulators and ratings agencies to move to more stable funding from retail deposits and long-term wholesale sources instead of short-term wholesale funding which is cheaper but riskier - as was made brutally clear when the relevant markets froze at the height of the crisis.

The upshot has been that over the past year the banks have been paying about 4 per cent for new funding, 150 basis points above the OCR. By contrast, in the year before the collapse of Lehmans, that spread was 20 or 30 basis points.

It is not just a New Zealand phenomenon; the Reserve Bank of Australia makes the same point.

Bollard said last week that higher bank funding costs had reduced the level of stimulus that would normally be associated with any given level of the OCR. "We expect these costs to persist over the projection [the next three years] reducing the extent of future increases in the OCR."

By how much the bank won't say, of course. But market economists reckon the "neutral" level of the OCR, which is neither stimulatory nor restrictive, has moved from about 6 per cent before the crisis to 4.5 or 5 per cent now.

It is little comfort to borrowers, however, if the rate they have to pay embodies a lower OCR but, and only because, it also incorporates a higher risk premium. But at least exporting manufacturers have the benefit of the most favourable exchange rate with the Australian dollar for 10 years.

The Australian cash rate is 4 per cent, against New Zealand's 2.5 per cent, and market pricing implies it will rise to 5 per cent over the coming year while New Zealand's rises to 4 per cent.

Will that differential keep Australia the more attractive destination for carry trade inflows and the kiwi-aussie exchange rate helpfully weak?

Alas, no. Not indefinitely.

The 14 per cent depreciation of the NZ dollar against the aussie since late 2007 reflects the importance of relative economic performance in exchange rates. By whatever combination of good luck and good management Australia has managed to get through the global financial crisis without slipping into recession. But NZ suffered a peak-to-trough decline in output of 3.3 per cent - only about two-thirds of the OECD average but still a lot worse than across the ditch.

But while that means Australia is also further down the track in terms of the interest rate cycle, it would be unsafe to assume its rates will remain higher than New Zealand's.

New Zealand, as the smaller and weaker economy, is a riskier proposition to lend to. That is reflected in a lower credit rating and interest rate which in normal times are higher.

The Reserve Bank's projections have short-term interest rates rising more than 3 percentage points over the next three years. Ultimately how high rates go will depend on the quality of the recovery. There, at least, the picture looks brighter. At this point, fingers crossed, it looks as if we will avoid a repeat of the conditions in the last cycle which had Bollard standing on the brake pedal for an extended period, driving the OCR to an eye-watering 8.25 per cent and in the process inflicting via the exchange rate significant damage on exporters and firms competing with imports.

It was the combination of a world awash with cheap money and heedless of risk meeting the Kiwi mindset that the best way to accumulate wealth is not to save and invest in businesses but to borrow and buy houses. The resulting housing boom turbocharged consumption, stoking inflation and blowing out the trade balance.

This has done lasting damage. House prices may have doubled between 2002 and 2007 (and almost all of that increase has stuck) but incomes did not. The deterioration in housing affordability will take a long time to unwind. And in the meantime the legacy of household debt is liable to be a persistent headwind for firms chasing the consumer's dollar.

But at least with that starting point the dangers of another crisis are hopefully diminished.

And foreshadowed tax changes should reduce it further still. Scrapping the top 38 per cent tax rate will reduce the incentive to shelter income through rental property investments while other changes reduce the ability to do so.