New Zealand: continuing stress in dairy and housing sector
The economic growth outlook has worsened due to less favorable global outlook, which keeps key commodity prices low. The risk of a sharp correction of house prices in Auckland has induced the government to implement additional macro-prudential measures.
Strengths (+) and weaknesses (-)
(+) Stable and reliable public institutions
Governance, rule of law and transparency indicators confirm the stability of the government. There is strong motivation across all political parties to pursue fiscal consolidation. The central bank is independent and highly credible in its inflation mandate and its supervisory role.
(+/-) Strong position as agricultural commodities producer
Dairy and meat alone consists of 41% of 2014 export revenues. 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, high interest rates and an overvalued exchange rate. Raising private savings remains one of the most important challenges in order to limit vulnerabilities arising from the large net external liability position.
(-) Banking sector is highly concentrated and dependent on foreign funding
The four biggest banks together have a 84% market share. Low levels of household savings make these banks reliant on global markets for funding, which poses a risk for banking system liquidity.
1. Growth outlook has weakened
Despite a pickup of GDP growth in the third quarter (1¼% q-o-q), the economic outlook has deteriorated. In 2015 economic growth has been moderate at best and the Treasury Department even foresees a slowdown this year to 2.2%; a downwards revision from forecast growth in May 2015 of 2.9% for 2015 and 2016. We expect economic growth in New Zealand to slow from 3.0% in 2014 to 2.5% in 2015 and 2.3% in 2016. There are three factors behind the weaker outlook. First, dairy prices have fallen more than 50% over the past 24 months. The drop in dairy prices is the result of sanctions on Russian imports, reduced Chinese demand following stock accumulation in 2013/2014, and, finally, increased global milk supply due to removed EU quotas in April 2015. Second, the two largest trading partners of New Zealand, China and Australia, are experiencing a slowdown in economic growth. China’s dairy consumption will be well below consumption growth experienced in the last couple of years and low milk prices will not substantially alter the more structural decline in volumes demanded (See BMI, Growth downgrade as agriculture and construction weaken, 12 December 2015). Third, New Zealand runs a persistent current account deficit and low commodity prices will probably amplify the deficit, as dairy and meat products cover roughly 40% of total exports (Figure 1). Household savings are chronically low, which increases reliance on external sources of finance. The negative savings-investment position could become more precarious in case of net capital outflows, triggered by slowing economic activity or a disruptive correction on the property market. On the upside, the depreciation of the NZD has resulted in booming tourism activity. Net migration inflow is also strong, driven by New Zealanders returning from Australia, as the Australian economy is shifting to lower gear. Total annual hours worked increased by almost 4% in 2014 vis-à-vis 2013 and expectations are that net migration will continue to contribute positively to labour supply, albeit somewhat less than in the last years.
2. Dairy sector stress seems manageable
The low dairy prices put farmers in a difficult position. Debt levels have been continuously rising (up to $38 billion in 2015) and debt-to-income levels well exceed 300%. Meanwhile, there is little to no improvement in the forecasted pay of milk production, which consequently restrict farmer cash flows, raise the need for budget cuts and, consequently, will lead to lower milk production. In addition, El Niño weather conditions are already causing low soil moisture levels in key dairying regions, such as Canterbury, Waikato and Taranaki (see footnote 1). This provides an additional risk for milk production. According to Rabobank Food & Agri Research the full impact of budget constraints will be felt in the first half of 2016 and milk production for this season is expected to decline by 7% to 10%. Based on unit record data, RBNZ recently provided an assessment of vulnerabilities in the dairy sector (See RNBZ, Bulletin 78(8), December 2015). They estimate that half of the sector was operating below breakeven in the 2014-15 season and about 80 percent of farmers, representing almost 90 percent of sectoral debt, are expected to have negative cash flow in the 2015-16 season. Banks have expanded their loans to the sector by more than 10% over the past year, based on the premise that the sector is viable and profitable over the mid-term. However, due to the increasing difficulties farmers are facing, the number of non-performing loans (NPL) is likely to increase. Stress tests conducted by RBNZ show that loss rates for the banking system are estimated to be 2% of the system’s dairy portfolio under a base scenario, and 14% under a severe scenario. Based on these results and the possible implications for the profit rates of the five largest dairy lenders, RBNZ concludes that losses are manageable for the banking system as a whole. Nevertheless, it also recommends banks to set aside provisions for the likely increase in NPLs.
3. Risks of a disruptive correction in real estate sector have grown
The house price-to-income ratio in Auckland has grown to a staggering 9.2 in September 2015 (Figure 2), partly driven by low interest rates, migration inflows and investor activity. Decreasing rental yield suggests that most investors are entering the market based on the expectation of capital gain. This implies that a possible sharp correction of prices on the Auckland property market could be amplified by investor sales dynamics. The government has taken additional policy measures to counteract the problems on the housing market. First, on the 1st of November, the loan-to-value ratio of property investments in Auckland can no longer exceed 70%. Furthermore, banks have to meet higher capital requirements for loans involving property investments vis-à-vis investments serving other purposes. Finally, increased housing supply is essential to absorb immigration and alleviate demand pressure on Auckland’s property prices.
The public institutions of New Zealand have a good reputation. The government ranks high on themes like democratic institutions, government transparency and absence of corruption. The central bank is independent and highly credible. GDP per capita (at PPP) is 91% of the OECD average and 78% 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 growth is necessary. This structural challenge is reflected in the long history of current account deficits, which has resulted in a large, negative net international investment position. The shortfall of private savings has generated relatively high interest and, consequently, led 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 is also highly concentrated. The four biggest banks have a market share (in loans) of 84%, making each of them 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. Above-average capital ratios make the banking sector more resilient to economic stress. According to the IMF, the banking sector can withstand an adverse shock related to China spillovers, dairy prices, and the housing market. However, a period of a low liquidity in financial markets or an excessive risk premium could trigger the necessity for additional monetary and fiscal support.