Country Report New Zealand
New Zealand suffers from a persistent gap between savings and investment. Growth is currently gaining momentum, but this is mainly credit-driven. House prices are increasing fast and the necessary deleveraging process has been put into reverse.
Strengths (+) and weaknesses (-)
(+) Stable and reliable public institutions
Governance, rule of law and transparency indicators confirm the stability of the government. There is a strong motivation across all political parties to pursue fiscal consolidation. The central bank is highly credible in its inflation mandate and its supervisory role.
(+/-) Strong position as agricultural commodities producer
The primary sector is just 7% of GDP, but accounts for more than 50% of export earnings. Dairy and meat alone consists of 36% of export values. The dependence on primary exports makes the country subject to volatility in the global commodities market.
(-) Large external debt
New Zealand has a long history of current account deficits resulting in a large negative international investment position. This is mainly financed through debt, with net external debt at 78.8% of GDP in 2012. The persistent gap between private savings and investment induces higher domestic interest rates and thereby a persistently elevated exchange rate.
(-) Banking sector is highly concentrated and dependent on foreign funding
The four biggest banks together have a market share (loans) of 84%. The low private savings rate makes the banks reliant on foreign wholesale markets for funding, though tighter regulations have reduced the dependence to 32% of total funding, down from 39% in 2008.
1. The economy is gaining momentum
The economy is expected to grow by 2.7%-3% in 2013 and will likely pick up further in 2014 due to the ongoing reconstruction work in Christchurch. Domestic demand (private consumption and construction investment) will remain the main growth driver (figure 1). Although the terms of trade is still at a historically high level, net exports is expected to contribute negatively to GDP in both 2013 and 2014. Dairy exports profited from the high global dairy prices (figure 2), whereas other tradable producers were hurt by the strong kiwi dollar. The export outlook is not likely to improve, since it is widely expected by financial market participants that the New Zealand Reserve Bank (NZRB) will be the first central bank in a developed country to raise its policy rate. Whereas headline inflation is at the lower end of the target band (0.9% y-o-y in 13Q3), house price inflation is high (9% nationwide) and can probably not be curbed with only macro-prudential tools (RBNZ already indicated this in its last Monetary Policy Statement). Gross government debt increased strongly in the aftermath of the Global Financial Crisis and the Canterbury earthquakes (from 5.5% of GDP at the end of fiscal year 2007 to 26.3% of GDP at the end of the fiscal year 2012), but is projected to stabilize at the end of fiscal year 2014 at just below 29%. To reach this goal, the government pursues strong fiscal consolidation, which is backed by all major political parties.
2. Reconstruction leads to rising house price pressures
Both from an international and a historical perspective, house prices in New Zealand are overvalued (figure 3). The recent increase in house prices is primarily driven by a regional supply side problem in the Auckland- and the Christchurch regions, in which about half of the national population lives. In the former area, housing supply is restrained by land availability and council regulations. In the latter area, the Canterbury earthquakes caused considerable damage to the housing stock. Demand for housing increased over the last year due to an increase in immigration, lower mortgage rates and an easing in bank lending standards. The latter two increase the borrowing capacity of consumers. A key risk is that the surge in house prices can induce speculative demand. Another risk emerges when interest rates suddenly start to rise. Of the mortgages, 45% have a flexible interest rate, and another 45% have the rate fixed for a maximum of 2 years (figure 4). Therefore a rate increase could lead to pressures on the financial positions of households. The RBNZ tries to reduce growth in house prices by restricting the amount of high loan-to-value lending (LTV>80%) to a maximum of 10% of new mortgage production (down from an average 30% high LTV-lending in the year before). Since this measure makes it more difficult and expensive for first-homebuyers to enter, this will temporarily relieve the housing market.
3. Private sector is taking on more credit
In the past, in periods of rising house prices, private consumption increased, supported by drops in private savings (figure 3). The net household saving ratio (net saving as percentage of household income) has been negative for 16 out of the past 20 years. The deleveraging process seen in the last couple of years appears to have ended. Household debt once again increased faster than income, pushing household debt-to-disposable income up to 147.6% in 13Q3, which is close to its historical high (153.3%). Interest servicing costs are still low, but this is due to mortgage rates being at 50-year lows. Besides households, also the agricultural sector is highly indebted, specifically the dairy sector (figure 5). The agricultural debt-to-exports ratio is rising again, while also export prices are at an historical high. It indicates that the currently high milk prices induce farmers to take on more credit to increase production. Moreover, expectations about future high commodity prices might lead to rising farm land prices, and so again encourage more borrowing. Only when the current rise in commodity prices will be permanent, this buildup of debt can be justified. Currently, the non-performing loan ratio in the rural portfolio is decreasing (figure 6), due to the high export earnings and the low interest rates. Given the high percentage of loans with short-term fixed rates, a rise in interest rates will lead to higher debt servicing costs also in this sector. When at the same time a drought happens or commodity prices fall, this will sharply increase the vulnerability of the sector.
Since the Global Financial Crisis, the increased private savings is mirrored in an improvement in the current account deficit and the external debt position. The high financing needs of the government after the crisis and the earthquakes undid this progress (figure 8). Going forward, the ongoing fiscal consolidation is positive for the external debt position of New Zealand, but the increase in both household- and agricultural indebtedness leads to a renewed widening of the current account deficit. Given that the external lending was mainly used for consumption purposes in the past and that the country is already deeply indebted internationally, this makes the country vulnerable to a sudden stop of capital inflows. Note that this is still a tail-risk event.
4. New Zealand is becoming more reliant on China for its exports
New Zealand is the first developed country that entered into a free trade agreement with China (it came into force in 2008). Exports to China have more than tripled in the past 5 years, and in the first quarter of 2013, China took over the position of Australia as the most important export partner. Given the outlook of China moving towards a more consumption-based economy, this is positive for the position of New Zealand as exporter of high-value agricultural products. The exports though remains geographically concentrated, since it was already indirectly vulnerable to an economic shock in China through Australia. Also New Zealand’s export products are highly concentrated, making the country vulnerable to a trade ban on specific products (like the one on milk powder exported to China not so long ago).
The public institutions of New Zealand have a good reputation. The government ranks high on themes like democratic institutions, government transparency and lack of corruption. The central bank is independent and highly credible. GDP per capita (at PPP) is 88% of the OECD average or 73% of the Australian income level, reflecting below-average productivity, distance to export markets, and the small size of the economy which limits opportunities for scale advantages. Economic growth was and still is mainly based on private-sector borrowing and terms-of-trade gains. In the future, the economy needs to rebalance towards more sustainable growth, for which productivity increases are necessary. This structural challenge is reflected in the long history of current account deficits, which resulted in a large, negative net international investment position. The shortfall of private savings led to higher interest rates than in comparable countries, and therefore to an overvalued exchange rate. The exports of New Zealand are highly concentrated both in products (food & agri) and destinations (China and Australia).
The banking sector also is highly concentrated. The four biggest banks have a market share (loans) of 84%, making them all too-big-to-fail. These banks are subsidiaries of the biggest Australian banks, but in general do not get funding from their parents. Historically, the banking sector has been highly reliant on foreign wholesale markets, but tighter regulations have reduced this dependence. Higher than average capital ratios makes the banking sector more resilient to economic stress. According to the IMF, the banking sector can withstand a shock to their residential mortgages or their corporate lending. A combined shock, though, would pose problems to their capital position, of which the risks are ultimately borne by the government.