RBNZ tells it straight by Leith van Onselen

The Reserve Bank of New Zealand (RBNZ) today released its biannual Financial Stability Report (FSR). For years, I have been a keen reader of the FSR as it provides an alternate view to the biannual Financial Stability Review released by the Reserve Bank of Australia in March and September.

I also follow events closely in New Zealand, as I believe that events there can provide important insights and lessons for Australia, particularly given the similarities between the two countries and the fact that we share essentially the same banking system [New Zealand’s Big Four banks – comprising around 90% of the New Zealand banking system – are owned by Australia’s Big Four].

Below is a summary of some of the key themes arising from today’s FSR, along with some charts and commentary.

The global economic outlook:

The RBNZ notes that the global economic recovery has broadened over the past year and it expects strong Asian growth to remain supportive of commodity producing economies such as Australia and New Zealand (see below chart).

However, the RBNZ notes a number of risks to the growth outlook:

The strong increase in prices for New Zealand’s export commodities has provided a large boost to the terms of trade and economy. However, any material slowing in Asian growth would likely result in large falls in commodity prices, which would have large effects on the New Zealand economy, both directly and indirectly through its dampening effect on the Australian economy [New Zealand’s largest export market]…

There are signs of overheating in some Asian property markets, with central banks in Asia increasingly tightening policy to slow asset and consumer price inflation. A hard landing in the region would pose significant risks to New Zealand’s export demand…

[Other] risks to the outlook…include the possibility of renewed turbulence in global credit markets from which New Zealand [Australian] banks secure funding…

Household sector:

New Zealand households are deleveraging after a prolonged period of excessive credit-fuelled consumption and asset growth. And this deleveraging is weighing heavily on aggregate demand, growth, and incomes. The RBNZ does not expect a return to pre-GFC levels of borrowing, consumption and asset growth any time soon.

Economic activity has remained sluggish, with GDP per capita still well below the peaks seen prior to the global financial crisis. This reflects weak private demand, with households increasing savings and firms responding to weak demand by curtailing investment plans…

While much of this adjustment is likely to be cyclical and a reflection of more difficult economic conditions, it is also likely that a degree of structural change is occurring with households and businesses wanting to run lower debt levels over the longer term. This ‘rebalancing’ has probably been an important driver of the severity of the post-2007 downturn. As consumers and firms spend less, other firms face reduced demand and household incomes weaken. This feedback can limit declines in the economy’s debt-to-income and leverage ratios, as the reduction of debt has a tendency to act as a drag on income and asset values…

Across the whole economy credit growth has slowed from double digit rates to essentially zero, a phenomenon also seen in many other countries. Double digit credit growth was a product of households and firms that were prepared to borrow increasing amounts against rising collateral values, and banks that had no difficulty funding that rapid growth. Bank funding of rapid balance sheet growth will be more challenging in the future. Furthermore, the borrowing decisions of households and firms are likely to be coloured for some time by the recent weakness in property prices and asset markets…

Indicators show that non-performing household loans held by banks remain elevated relative to recent history, suggesting some households are struggling to make debt repayments, even with lower interest rates. However, compared to some other countries, both non-performing loans and mortgagee sales remain modest.

Household debt has fallen in New Zealand relative to household income. [Although], the fall has been sharper in some other countries.

The RBNZ also notes that discretionary retailers are suffering financial difficulty, most likely due to lower spending by New Zealand households.

Housing market still overvalued:

The RBNZ believes that New Zealand home prices remain elevated relative to incomes and rents, and has warned that it is monitoring banks as they increase loan-to-value ratios (LVRs) in the face of elevated prices.

Nominal house prices have only fallen about 5 percent from their peak, or about 13 percent in real (inflation adjusted) terms. While prices have not fallen far, housing market activity has been particularly weak over the past 18 months. Tax changes, low confidence, low net migration, and sellers’ unwillingness to accept lower prices have all contributed to slow housing market activity…

Given that prices appear elevated relative to historical relationships with incomes and rents, prices may yet drift lower, particularly in real terms, for example if enough buyers are unwilling to pay current prices and prefer to rent while sellers’ expectations adjust. Any further negative news could cause a sharper downturn in the housing market, particularly if the labour market were to weaken sharply, or interest rates were to rise rapidly…

Some banks have also increased maximum loan-to-value ratio requirements for home buyers. The Reserve Bank will continue to monitor this lending, especially since house prices seem to remain elevated.

The below chart of New Zealand’s house price-to-income ratio has been compiled from RBNZ data, and suggests that home prices remain overvalued by 57% relative to their long-run average. Obviously, lower nominal interest rates acounts for some of this overvaluation.