Stopping the Credit Crunch

Listener: 10 December, 2011.

Keywords: Macroeconomics & Money;

The confidence of those lending their international money is fragile. The tougher standards of security they now demand is one reason many debtors around the world are having their credit ratings downgraded.

Nowadays the lenders don’t look at just the state of a government’s books but at the nation’s as a whole. A country with sound public-sector accounts (ours are not too bad) but which is heavily borrowed overseas (as we are) may experience a credit downgrade (as we recently did).

That lenders are concerned with private-sector borrowing as well as that of the public sector was one of the harsh lessons learnt from the global financial crisis, when some countries – notably Iceland and Ireland, but don’t forget the UK, Germany and the US – suddenly found vast quantities of private debt dumped on the government. No longer could you pretend the two were independent.

This is particularly relevant to New Zealand, because before 2008 we explained to the credit-rating agencies that although we had a very high level of overseas borrowing by the private sector, the government accounts were in an excellent state (better than now) and they should give us a good credit rating. The agencies did, but that argument does not carry as much weight now. (The reasons our interest rates did not go up that much when the last downgrading was announced are that every-one expected it and lenders had already been raising their rates.)

Failing to appreciate this change led to a misinterpretation of the Treasury (Prefu) forecasts, released a month before the election. The Treasury expects we will grow around 3% annually over the next four years, while our trading partners grow closer to 4%, a figure based on the consensus forecasts of various international economic agencies.

That means the Treasury thinks we are growing slower than the rest of the world (despite the Canterbury earthquake rebuilding). If the international forecasts are optimistic (given subsequent events they probably are), then the New Zealand economy will grow more slowly, too.

Suppose the world forecasts are right. The Treasury thinks that over the next four years the whole country will borrow offshore a (net) total of more than $50 billion (or about $55 a person a week). It forecasts our net inter-national investment position – roughly how much we owe overseas – will deteriorate from 68.6% of GDP to 77.6% in four years’ time.

That makes a further credit downgrade more likely – especially if international financial confidence remains fragile – despite the reduced government borrowing. The forecasts expect the government to stop borrowing (net) in about three years’ time. The lenders will give us some credit for that but they will continue to worry about the ongoing offshore borrowing by the private sector. In any case, the Prefu is expecting interest rates to rise – by two percentage points in the next three years.

If this analysis is right – I hope it is not, but economic logic usually triumphs over hope – then the Government’s strategy is wrong, because it focuses only on the public-sector deficit, and ignores the private-sector’s borrowing. We should be addressing how to increase private savings, although we are unsure about what to do. Genial optimism is not a lot of help; you would be wise to be personally cautious.

How to prevent another downgrading and further interest rate hikes? If I were a Treasury economist dealing with a credit–rating agency, I would point out that around $20 billion of the (public and private) offshore borrowing of $50 billion is in effect the Canterbury earthquakes rebuilding programme, of which $13 billion is a cost to the Government. (It might help to have a mournful violin playing in the background.)

I’d deflect all questions about whether the Government can really keep to its spending reductions, and I’d highlight the Reserve Bank measures to prevent private debt ending up on the public balance sheet. The agencies are likely to say you can never predict how the next crisis might happen. I’d have my fingers crossed under the table.