Cover story
What to watch out for in 2010
by Gareth Morgan
As the world struggles to shrug off the effects of the Great Recession, what does the year hold for New Zealand – and what’s likely to happen in the global economy?
New Zealanders have a higher proportion of their wealth in property than residents of any other economy. Property is the major business activity that characterises our economy.
At the height of the last house-price boom, Spain, Ireland and New Zealand topped the league tables for property-price escalation. Spain and Ireland now top the misery index tables courtesy of their high unemployment rates and budget deficits. Ireland recently cut social welfare by 4% and public sector pay by up to 15% after its economy collapsed last year.
New Zealand is outstanding in another regard: it has one of the highest rates of external debt in the OECD. And that’s despite enjoying record prices for our major exports and ultra-cheap prices for many of our most popular imports.
The poor allocation of capital that such an overindulgence in property has produced has taken New Zealand on a one-way trip down the OECD income tables, since – surprise, surprise – bidding against each other for the same stock of houses might result in a transfer of wealth but doesn’t actually generate income and jobs in any sustainable way.
The global credit orgy of the noughties has manifest itself in New Zealand in a specifically Kiwi way: a significant rise in the average house price compared with income, relative stagnation of incomes, and an abundance of offshore funding coming in either through the banks or directly for mortgage lending. The party has been wonderful.
So, what’s happening now?
In the wake of the credit crunch it appears our banks have moved from making the bulk of their lending on mortgages to nowadays doing mortgages exclusively. Brilliant! There should then be no excuse for us enjoying an early and grunty recovery in the property market, so long as borrowers regain confidence in their employment prospects. The latest house-price data confirms we’re back in business with a vengeance.
The New Zealand economy has long been lopsided. The obvious questions are: does this matter, and, if so, what are the main causes and remedies?
Over the medium term, it matters because the banks’ preference for mortgage lending means financial capital that could be invested in the production of goods and services for sale overseas is not happening. So, New Zealand earns a lower net international income while suffering from a permanent morbid dependency on foreign capital to maintain activity levels.
And with that capital inflow from offshore comes two things: a rising ratio of external debt to GDP and increasing foreign ownership of the economy. Despite record relative prices for our exports, we still haven’t been able to pay our way – our external deficit has been huge.
So, how do we solve the property problem?
There are two ways to address the property sector’s dependency on foreign capital: choke off the supply or reduce the demand for mortgages. The Reserve Bank, through its penchant for a core funding ratio, favours choking off the supply. By forcing the banks to raise more of their funding for on-lending from domestic sources, the Reserve Bank, on the face of it, would make mortgage finance more scarce and so more expensive.
But this won’t stop people offshore either lending directly to property folk here, rather than going through the banking sector, or lending to friendly finance companies that could then make the loans. And that type of borrowing comes at a price, so the Reserve Bank’s move would make all borrowing more expensive – not just that for mortgages.
This is a machine-gun approach – a single rifle shot would be much less harmful. At the core of the banks’ preference for mortgage lending lies the lower risk-weighting given to it by the Reserve Bank prudential rules (which are just our version of the central bankers’ club guidelines). The grounds central banks give for favouring mortgage lending are that defaults on mortgages in the past have proven less likely to lead to liquidity – or even solvency – problems for banks than other forms of lending, such as business lending.
But the past is not always a great indicator of the future. If the ratio of property prices to incomes rises far above its historical level, assumptions about how safe property lending is won’t always hold true. The Reserve Bank has reported on stress tests it has carried out on bank balance sheets and concluded that property prices in New Zealand are not high enough to threaten the solvency of the banking sector.
And herein lies the short-sightedness of the central bank’s approach. It is possible for the economic performance of the country to deteriorate (as already evidenced in OECD tables) – because of a misallocation of capital brought about by over-investment in property at the expense of business – without that necessarily, at least in the early stages, putting banks’ balance sheets at risk.
But this is still an economic problem, as it results in poor productivity and other imbalances, such higher inflation and external deficits. And even the advent of KiwiSaver is unlikely to take the heat out of the property market, if the Australian experience with compulsory superannuation and property speculation is anything to go by. According to the Economist, house prices in Australia – and Spain – are overvalued by 50%.
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