This provides a context for New Zealand which is a part of this crisis, but it is in a different situation. We may not be unique. It is quite likely that other economies on the international economic margins have similar difficulties quite different from the problems that the core economies – most notably the US – face.
In particular there do not seem to be any significant toxic assets in our banking system. Perhaps some of our finance companies had them, but they were largely eliminated by insolvency and bankruptcy, albeit at great cost to their depositors. Our banks seems sound and can advance credit if they have the reserves.
So our banking system – and therefore the New Zealand economy – faces a quite different challenge. About a third of the banking systems’ borrowings come from offshore – the rest are from New Zealanders, including the deposits (now guaranteed) you have with your bank. This offshore borrowing is around $90 billion – about six months of GDP; that’s a lot. Those borrowings have to be rolled over. Because of the international financial crisis, it is proving difficult to roll over old debt or to borrow new debt. This is not reflection on the New Zealand economy; other economies on the margins of the international system face the same problem.
The New Zealand government has decided – properly in my view – that this is not just the banks’ problem, it is all our problem. So it has taken a number of steps to share the burden. This includes the Treasury (that is the taxpayer) guaranteeing retail (our) deposits in the banks, and also wholesale deposits which will facilitate the offshore borrowing once the international financial credit markets start to flow again. As the lender of last resort, the Reserve Bank continues to support banks if they need liquidity, and it has extended its lending facilities to assets beyond the usual short-term government stock, such as good quality mortgages. The government has even said that if the banks are unable to supply the big corporates with sufficient credit, the public sector may advance it instead. Central banks have always accepted this possibility, but it is only in rare extreme circumstances that they use the option. These are such circumstances.
So our trading banking system is secure because the Reserve Bank has taken the textbook measures to underwrite it. Nevertheless there is a huge problem. That $90 billion of offshore borrowing requires repayment in US dollars. The Reserve Bank of New Zealand only issues New Zealand dollars. Somewhere, or how, the New Zealand economy has to obtain the equivalent of $90 billion in US dollars plus what we need for further borrowings. .
This is not overnight panic stuff. The previous government arranged for the RBNZ to increase its foreign currency reserve to $7 billion, and there has recently been arranged a swap facility with the Fed (the US central bank) which could provide us with a further $15 billion. Hopefully that would give us the required cover until the international markets free up.
But recall they have been gummed up now for almost eighteen months; credit markets will come unstuck only slowly. Not only would it be imprudent to rely on such a freeing up but many of the various options end up with the New Zealand government (that is us, the taxpayers) taking the exchange rate risk for possibly billions of dollars. We can be sure that the trading banks will be reluctant to do so, and the breakdown of the international financial system suggests it may be difficult to get offshore investors – Japanese housewives or hedge funds or whatever – to take the exchange rate risk from us. If they do, the margin for the cover is likely to be high, which means that the New Zealand economy – in practice, taxpayers, mortgage holders and businesses – will face high interest rates.
Before talking about the additional international borrowing requirements over the next few years, I need to say something about the Government’s fiscal stance, that is how much it has to borrow.
New Zealand went into recession at the beginning of last year (2008). It was a relatively mild recession. For instance across the year there was a job loss of 14,700 jobs. In 1991 there were 34,200 jobs lost, more than double last year’s loss. .
The 2008 recession was not caused by world economic conditions; rather it was a domestically induced downswing as a result of the interaction between our monetary, fiscal and exchange rate policies. It’s the third since the Rogernomics macroeconomics revolution of the 1980s. The first was the long recession from 1985 to 1993, and the second was the shorter Asian recession in 1997 and 1998. There is not a consensus on what causes these fluctuations; in my view it has been our tendency to run too high a real exchange rate, so instead of driving economic expansion the export sector falters and the economy contracts with it.
The New Zealand economy should have been coming out of the current recession about now. However, the world downswing is impacting on us so, instead of a recovery, the self-induced recession is being intensified by the world one. We do not know how intense the downswing will be. One cant help noticing that the forecasters keep revising their tracks down and pushing the bottom of the downswing further into the future.
The usual response to an internally induced recession is to increase the fiscal deficit. That happens automatically, because tax revenues fall and some social spending increases. But it is common to increase the deficit by further tax cuts and increases in spending. By how much and how is a matter for proper disagreement.
The last Labour Government both increased government spending and reduced tax levels. That was one of the reasons we expected there to be a recovery early this year. National argued that the measures were insufficient and have increased the deficit further. But the way I read their public statements is that despite the downturn being more severe than expected, there is a limit to how far they are prepared to do this.
The flip side of a bigger fiscal deficit is additional public borrowing; that borrowing depends on the willingness of counter-party lenders. Even were the international markets not gummed up, there are limitations on that willingness. If they think there is too much borrowing they will be reluctant, and will have to be induced with a higher interest rate. We were recently warned by one credit rating agency of this difficulty. In recent months three European governments have had their credit ratings downgraded, that is, their cost of borrowing increased.
Why not borrow from the central bank? In principle a government can do that, but in practice ours can only borrow NZ dollars from the Reserve Bank. Because ultimately we will, directly or indirectly, spend much of the increased fiscal deficit on imports, somewhere there has to be borrowing in US dollars or other foreign currencies. So any government borrowing intensifies the problem of the rolling over of the offshore debt.
How intense? The work-in-progress I am going to report suffers from two further limitations. First it reports net overseas liabilities, which includes foreign owned equity as well as debt. Currently I cannot forecast the items separately because, say, were the government to privatise a State Owned Enterprise – perhaps one of the electricity generators – foreign owned equities in New Zealand would increase, offset by a foreign supplied debt decrease. The balance between debt and equity is fluid, and difficult to forecast.
The second limitation is that I am using the last (December 2008) Treasury forecasts. It is widely acknowledged that even their lower (‘downside’) track is now too optimistic, and I also dont know the extent to which the government has stayed within the public spending assumptions of the December forecast. What this means is that the figures I am going to present are on the optimistic side of what we currently expect; even so they are deeply worrying.
In March 2008 net overseas liabilities (that is, what we owe to foreigners less what foreigners owe to New Zealand) amounted to 100 percent of annual GDP – to 52 weeks of production. That includes the $90 billion of debt owed by the trading banks, but it also includes equities owned overseas, corporate and personal debt, trade credit and host of other sorts of liabilities.
What the current forecasts suggest that New Zealand will have to raise $33 billion by debt and equity in a two years period. After that the net liabilities ratio would rise to 124 percent of annual GDP (65 weeks of production) by March 2010, just over a year off.
That is an enormous deterioration. The data series only goes back to 1992, and the level was never below 43 weeks of production (83 percent of annual GDP) so we are talking about a heavier offshore borrowing program than at any time in the last two decades.
The main source of the borrowing seems to be the public sector, with the private sector’s saving rising relative to investment so that it does not exacerbate the national debt burden. I cant be sure because I have not got forecast of the savings balances, but there can be no doubt that the major source of the external deterioration is the rising fiscal deficit.
Remember these forecasts of net overseas liabilities are not the Treasury forecasts, although they follow from them. What is incontestable is that New Zealand is engaged in a heavy offshore borrowing program stimulated by the government’s fiscal deficit.
I imagine that is the difficulty of too much borrowing which led to the government being cautious about a larger deficit by further reducing taxes and increasing spending above the commitments already made. To summarise the dilemmas it – and New Zealand – faces:
We have an immediate problem of rolling over the external (US dollar) debt of around $NZ90 billion. Let us hope that we (or, more likely, the world) can solve that, either by the financial markets opening up or by finding some bridging solutions, and that, whatever they are, the solution is not too costly. Even so, we need to be prudent. It is not certain that the world will soon solve the problem.
But even if it is solved, we face a second dilemma. Despite the big fiscal injection, unemployment is forecast (probably optimistically) to rise to only 7.5 percent of the labour force, or to over 150,000 New Zealanders. We can restrain the rise, by increasing the size of the fiscal injection, but we may not be able to fund the deficit, that is, find lenders – particularly offshore lenders – who will invest in the debt the government issues.
On the other hand if we do not increase the fiscal deficit, that is, put more demand in the economy, the rate of unemployment may rise to well above the 7.5 percent.
No one ever said economic management was easy, but we and the government face one of the toughest economic and financial challenges in the history of New Zealand. And, I am afraid, it is not obvious how to meet it.