New Zealand Provides Taste of Things to Come

In a surprise move today, Standard & Poor’s (S&P) – the worlds leading credit rating agency – downgraded its outlook on New Zealand from AA+ stable to AA+ negative. In what should be a big warning call for Australia, here are some of the things that S&P had to say [note: most quotes come from an S&P email explaining its decision]:

The outlook revision on the foreign currency ratings reflect our recognition of the risks stemming from New Zealand’s projected widening external imbalances and the country’s weakened fiscal flexibility. New Zealand’s vulnerability to external shocks, arising from its open and relatively undiversified economy, also raises risks to the country’s economic recovery and credit quality…

Net external liabilities that predominately reflect dependence by households on foreign capital to fund consumption and property investments are expected to rise to 94.3% of GDP by 2014 from 82% in 2010. Moreover, New Zealand’s gross external financing needs (current account payments plus short-term liabilities to nonresidents, including nonresident bank deposits by remaining maturity) are expected to average 372% of current account receipts plus usable foreign exchange reserves over the next two years compared to 116% for the ‘AA’ median….

Australian banks own most of the New Zealand’s financial system [nearly 90% of bank assets]. Although we rate the four largest Australian banks ‘AA’, and while all of them consider New Zealand a core market, these banks themselves borrow heavily from offshore sources….

The main risk to the ratings would be a significant weakening in the credit quality of New Zealand’s banking sector, which is largely owned by the Australian banks. This vulnerability reflects the current account deficits and high private-sector external debt. A significant portion of this deficit has been financed by private-sector borrowings through the banking system [my emphasis].

As I said in my New Zealand Housing Bubble article, New Zealand and Australia have undertaken a similar approach to borrowing and lending in order to fuel their respective housing bubbles, namely:

1. an increased emphasis on housing lending relative to other forms of lending (such as lending to businesses); and, more importantly

2. an increased reliance on offshore funding (borrowing) via the international wholesale debt markets.

These two factors have been the key enablers of the surge in household debt that has fuelled both countries’ housing bubbles. Without these two developments, the banks would have had a significantly smaller pool of funds to lend to households, which would have ensured much slower house price growth; because if households are unable to borrow large sums of money, they can’t pay high prices.

On the second point, the below chart, which has been derived from RBNZ and RBA data, shows the extent of offshore funding (borrowing) by the banks:

As you can see, the level of offshore funding by New Zealand’s banks as a percentage of their total liabilities has increased from around 15% ($NZ11 billion) in 1990 to around 35% ($NZ132 billion) currently. Australia’s banks, by comparison, have seen a similar, albeit smaller proportional increase from 5% ($A12 billion) in January 1989 to 21% ($A515 billion) currently (click to see a detailed chart for Australia).

Furthermore, over half of New Zealand’s offshore funding by the banks is short-term, with a term-to-maturity of less than 12 months (see below RBNZ chart):

And it’s the banks’ heavy offshore borrowings to pump housing that has overwhelmingly created New Zealand’s net external debt that has S&P so worried (see below RBNZ chart).

Of course, it’s a similar story in Australia, where the banks’ heavy offshore borrowings for housing has also led to a large increase in net foreign liabilities (click to view chart).
Anyway, back to the S&P email.

The economy’s continued recovery depends mainly on the strength of global recovery and support from regional trading partners – particularly Australia and China.

A high level of household debt leaves growth prospects vulnerable to a sharp rise in either unemployment and/or interest rates. New Zealand’s savings rate of 15.7% of GDP in 2010 is low relative to its ‘AA+’ (34.4%) and ‘AAA’ (23.4%) rated peers, and explains the country’s sizeable current account deficits. Household liabilities to disposable income are 50% higher (at around 156%) than 10 years ago and leave the sector susceptible to weaker labour and property market conditions and higher borrowing costs. The corporate sector is also exposed to terms of trade.

Let’s not forget that Australia’s household debt to disposable income is slightly higher than New Zealand’s, and its housing market even more inflated (see below charts):

As I said previously, New Zealand is essentially a microcosm of Australia, minus the mineral resources. Given Australia shares essentially the same banking system, a ratings agency downgrade like this one handed out by S&P should ring alarm bells in Australia, since it provides a glimpse of what could happen if problems develop with the China growth story.

It also highlights the pressing need for a warts-and-all ‘Sons of Wallis’ financial system inquiry in order to identify the key risks in the financial system – such as the banks’ over-reliance on offshore funding and over-committment to housing lending – and provide the foundation for developing a safer and more efficient financial system going forward.  
Cheers Leith

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  1. Leith – an excellent article. Thank you.

    It does seem likely Australia will unfortunately follow New Zealand in this regard, because Governments in both countries have allowed unnecessary housing bubbles to form – and again – are failing to take the necessary constructive policy actions required to deal with them.

    The respective Governments are too interested in protecting the elites and banks – and ignoring the interests of the wider public.

    Hugh Pavletich
    Co author – Annual Demographia International Housing Affordability Survey
    New Zealand

  2. Leith

    great post once again.

    what are the chances of a review of Ireland, pre-bust, showing the correlation of rising external borrowings with the rising property prices they experienced?

    An article in the FT the other week noted these interesting stats about Ireland:
    -housing stock values quadrupled in the decade to 2006
    -construction rose to 1/8 of the economy (not sure what fraction it is in Australia)
    -the price of a house in Dublin rose fivefold (and has since halved)

    I am very interested in the peak size of their bubble and borrowings relative to where we are currently at in Australia… i.e. which is/was bigger?



  3. Perhaps this is all fueled by the "gimme gimme" attitude which seems to have been fostered by governments over the last decade or two. Public Good (hospitals, utilities, infrastructure) concepts have been gradually supplanted by "Welfare" (First home owners grants, increases in what is covered in free medical treatment) which encourages people to stick their hands out.

    Borrowing money to invest in something that requires no effort or attention and returns big sums of money is obviously attractive. We've gone so far past asking "if it seems too good to be true, then perhaps it is" to the point where we just expect the magic roundabout to go on and on and on.

    Wonder who's gonna have chairs when the music stops?

  4. Perhaps the situation developing over in NZ will become the BLACK SWAN event on our financial system.

    "The property market remained in decline during the month of October, according to the latest Mike Pero Mortgages-Infometrics Property Cycle Indicator (PCI). “The nationwide PCI has remained at its lowest possible figure of minus-10 for the second consecutive month and the second month in two years"