Rocky Horror Show

Could New Zealand become a “Southern Rock”?

Listener: 11 July, 2009.

Keywords: Macroeconomics & Money;

Northern Rock, a British bank specialising in mortgages, nearly went bust a couple of years ago. It was getting a quarter of its funds from depositors, with the remaining three-quarters coming from the international money market – that is, from other financial institutions.

When the markets jammed up in September 2007, Northern Rock could not roll over its short-term borrowings and it went to the Bank of England for support. Its depositors rushed to withdraw their cash, fearing it could be locked up until the mortgages were paid off, the first “run” on a British bank since 1866.

In February 2008, the UK Government nationalised Northern Rock. Our trading banks also borrow from the international money markets. There were three main reasons a similar thing did not happen to them.

First, they rely on the money markets for only a third of their funds; two-thirds come from depositors. Second, they are better managed than Northern Rock, with “vanilla” rather than fancy borrowing. Third, the Reserve Bank handled the potential crisis effectively.

Today a run on a New Zealand bank is neither likely nor necessary. The retail deposit guarantee scheme means depositors will get their cash back even if something goes desperately wrong. The risk is borne by the New Zealand Government – that is, by us taxpayers.

Nevertheless, Northern Rock is a lesson. Could New Zealand, with its dependence on international borrowing, become a “Southern Rock” if the money markets jam again? Certainly, another jam could happen, and it might even happen during this financial crisis if things go wrong in the Northern Hemisphere.

You may be confident that the Reserve Bank and the Treasury have thought about this problem, and have backup reserves and lines of credit. But although using these could prevent a total meltdown, it would be costly. Better to take preventative measures – and that means “us”, since it is our over-borrowing that is causing the threat.

New Zealand trading banks have borrowed over $90 billion offshore, and foreign investments help fund New Zealand businesses. In total, our net international investment position (the difference between our external financial assets and liabilities) amounts to nearly our annual GDP. It is falling because we are continuing to borrow offshore – that is what a current account deficit means. Exports and other earnings are less than imports and other current payments; we borrow to cover the difference.

What’s more, we have been doing this for a long time. I estimate almost a quarter of our onshore assets are either owned offshore or have an offshore debt attached to them (like a third of your mortgage – probably). The chunk that is borrowed direct from the international money markets is the potentially most dangerous if there is another global financial crisis, or if this one prolongs and deepens.

There would be other benefits in having lower overseas borrowing, according to research by economist Dennis Rose*. The more we borrow, the higher our interest rate. Were we to have only half the net foreign liabilities we currently have, our annual interest rates could be 0.75 percentage points lower (more than $40 a week on a $300,000 mortgage).

The exchange rate might be 8% lower, resulting in a stronger export performance and more economic growth.

We cannot halve our liabilities overnight, but this is a target we might aim for. That means increasing the national savings rate, and ultimately that means households and the Government saving more.

Mind you, this may not seem the right time or place to start, although it never is. New Zealand needs more spending in the short term to prevent unemployment rising too far. It will not be easy to reconcile the contradictory policies. My advice is to behave prudently, which probably means cutting back your spending, leaving the Government to increase its spending to cover the gap. However, you must expect the Government to ease back its own spending – and/or raise taxation – as the New Zealand and international economies recover. The Southern Rock has to be based on a solid foundation of the nation saving to own itself.

* D. Rose (2009) ‘Overseas indebtedness country risk and interest rates’, Policy Quarterly, February 2009.