Economic uncertainty – time to get scared?

Today I noticed two very different stories about the outlook for the New Zealand economy. From Bernard Hickey (h.t. Kiwiblog) we have a dramatised version of what ANZ and BNZ are saying about economic conditions. From Berl we have a more moderate story which is closer in form to all the other analysts (such as RBNZ, Westpac, and Infometrics 😉 ).

Now don’t get me wrong – everyone is expecting a slowdown in economic growth. However, the question currently is, are we going to have a technical recession or not?

The main difference between those forecasting doom and those just forecasting gloom is the view of the credit market. The global credit market is relatively important for New Zealand economic growth as we have been consistently running a current account deficit – implying that we have had to borrow heavily from the rest of the world. No doubt this will need to correct at some point – however the doomsayers believe that it will correct sharply now, as investors becomes too scared, or too liquidity constrained to lend money to New Zealand – driving up domestic wholesale interest rates.

I feel that this view is exaggerated. Sure we are currently seeing a surge in the wholesale interest rate – however this is why we see the Fed pumping liquidity into the world economy, and cutting their cash rate.  Policy action in this case is focused on reducing the real wholesale rate, and as a result we can’t expect the world economy to give up without a fight.  Although people believe the Fed is running out of bullets, lets not forget that the European Central Bank has not cut rates yet – if things get desperate they can also get in on the act.

When people say that the 1 year fixed mortgage rate is going over 10% I believe them – I mean its nearly there now.  However, I am doubtful that credit conditions will continue to deteriorate at the rate they have been.

There is one point of agreement between all economists though – stagflation will occur, after all we are suffering from a combination of negative aggregate supply shocks (drought, high oil prices, global inflation, and lower global financial capital).  However, I don’t think it does us much good to get scared of it – we can’t help external shocks we just have to get through them.

Note:  I am not trying to say growth will not slow – it will.  I just feel like some commentators are being a bit melodramatic.  Unemployment is at record lows, household savings is improving, the governments fiscal position is healthy, and foreign lenders are still seem happy to lend to us.  I can’t see these positive factors deteriorating quickly enough to put us in a technical recession by late 2008.

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  • you are remarkably sanguine in the face of financial meltdown in UK & US. Your feelings are misplaced. The whole Northern Rock and mortgage collateralisation were based on very fragile business models. In the end it all comes tumbling down when the horses got spooked. Banks are too scared to lend to each other. New Zealand is utterly reliant on the Japanese carry trade.

    When, not if, some of them determine that the return is not worth the risk there will be an enormously destablising correction. Credit will disappear and the currency will finally tank. It might be for the long term good of the country but it will not be a pretty sight.

    I am reminded of 87 pre crash, except it is mortgage backed private spending on the basis of unsustainable house price inflation that has been fuelling the boom.

  • “Banks are too scared to lend to each other. ”

    Yes, they are, and have been for the past eight months (especially over the last four). However, this situation won’t last forever – it just depends on when the risk from the subprime mortgages gets washed out of the system.

    “New Zealand is utterly reliant on the Japanese carry trade.”

    To fund our current account deficit, indeed. However, as a small and robust economy I’m confident we will find it easier to secure credit than a large country. I agree that ultimately we will need a correction in our current account, hopefully this can be a gradual improvement instead of a sudden sharp correction. I think tax cuts will help.

    “When, not if, some of them determine that the return is not worth the risk there will be an enormously destablising correction”

    As long as the US remains weak our dollar is a reasonably strong bet to remain strong. WIth the high yields we provide to investors I don’t think the carry trade will dry up for that reason. We have to be more concerned about whether the global supply of credit remains elevated. I am confident that the large central banks will do everything in their power to prevent a complete stalling of the credit market – as a result we may face higher inflation and interest rates than we do now, but not economic collapse.

    “I am reminded of 87 pre crash”

    If my memory serves me correctly, the 87 crash was most potent in NZ, as speculation had been over the top here. Comparatively, NZ does not have the same level of subprime loans and negative gearing, so the impact on housing is likely to be weaker here. As a result, I do not expect NZ to slow as much as the US or UK

  • My comment is based on the confluence of an overstated exchange rate based on a growth killing interest rate together with housing prices that are well beyond ridiculous in terms of affordability.

    When credit dries up, and it will, the price of houses will be unsustainable.

    Either that or stagflation as wage pressure based on the need to afford somewhere to live forces a correction.

    UK & Australia are different. Australia has boomed off the back of commodity prices & exports to China. UK has boomed off financial services and Billionaires wealth transfers whether Russian or oil based. The US economy has boomed but housing affordability there is on a much more balanced level. The fact that lending practices are dodgy has not resulted in the same overpricing of housing so prices do not have so far to fall.

    New Zealand has had the benefit of dairy prices, which is small in comparison. Otherwise it has used the virtual wealth created by the property boom to add large numbers of bureaucrats, break productivity growth, spend up large on welfare and do a number of other value reducing activities.

    Equilibrium will come, and it will be painful for New Zealand. The 87 crash and the housing boom have similar attributes

  • cut all the rest of that and simply answer why New Zealand as an economy is any different from one of those Ninja households borrowing from shonky lenders who are only attracted by the high interest rates on offer. Both are borrowing beyond their means at a rate that is not sustainable

    Your post says that the dip will be shallow. 12 years ago mortage rates were up at 12.5% but house prices were much lower.

    The governments sound fiscal position has been caused by overtaxation which has suppressed growth. High interest rates will continue to do the same.

    If New Zealand does get by without a recession it will only be at the cost of an extended period of stagflation. Which is preferable? A short sharp correction or steadily falling further behind the rest of the world?

  • Your comments above Matt are in line with my thinking.
    We will have a slowdown, but it will be mild, as Asia ,China and Australia continue to produce solid growth. UK and Europe is still hiding sub prime losses, but on the whole it remains a US story. Even that is beginning to look over the worst. NZ will escape the worst of it, with the protein boom only just getting started, and NZ in an excellent position. Offshore investors continue to invest in NZ and until our interest rates begin to point lower, that will remain the case. The NZD/USD could still see 0.8500 this year yet.

  • “Both are borrowing beyond their means at a rate that is not sustainable”

    If it was unsustainable no-one would lend to us. I agree that we will have to pay back our debt at some point. However, what is our current account deficit, 8.3% of GDP, so 8.3% of our income – thats handleable, its not yelling out for a sudden correction.

    “12 years ago mortage rates were up at 12.5% but house prices were much lower”

    Twelve years ago the houses that were on the market were smaller, the price of land was much lower (as the opportunity cost was lower) and our population was smaller. Ergo its a completely different situation.

    “The governments sound fiscal position has been caused by overtaxation which has suppressed growth”

    That does not change the fact that it is sound – the argument that growth has been ‘suppressed’ is separate to the argument that we are on the verge of an economic collapse.

    “If New Zealand does get by without a recession it will only be at the cost of an extended period of stagflation”

    Stagflation is for a year or so is likely, it is likely all across the world – especially as the price of imported manufactured goods increases. I’m confused here, didn’t we have a small period of stagflation in 2006 – isn’t stagflation just a couple of quarters of low growth (below 1% annualised) and inflation outside the target band.

    This type of stagflation is NOTHING compared to the old school type – I think we should probably define it to mean something a bit stronger.

  • “If it was unsustainable no-one would lend to us” – Oh please! Try telling that to Northern Rock Borrowers and US Ninjas. Just because the lender does not genuinely understand the risks does not mean a situation is sustainable.

    8.3% of income in 1 year is manageable. When it has persisted over many years there is an imbalance which must come back to equilibrium.

    What do you think would happen if Chinese manufacturers were no longer able to rely on China buying US Treasury bills to allow US consumers to purchase Chinese goods.

    What is going to happen when Japanese lenders realise they face a 50% loss in capital(exchange rate $0.80:$1 down to $.40:$1 when the Northern Rock of the South Pacific stops borrowing yet more money. For NZ borrowers 8% on a $200,000 mortgage is affordable on an income of $80,000. 12% on a $400,000 mortgage is still not affordable on an income that has only gone up 25% to $100,000.

    Some Japanese lenders WILL realise the merry go round has stopped and will try to get out first. Facing a prospective 50% capital loss within 12 months makes an interest rate of 10% not quite so attractive.

    The government has taken money out of the hands of taxpayers. As their gross incomes have risen the only way people have been able to spend some of that hard earned increase in gross income has been to borrow more to spend. Once that genie has been let out of the lamp it is very difficult to get it back in. Every other consumer is borrowing to spend so why not do it themselves. as an economist you dont like to deal with human behaviour but it is a very real impact on what has happened in the western world in general and new zealand in particular.

    The point being that it becomes unsustainable at some point. Northern Rock looked sustainable not so long ago.

    Old school stagflation is a very real risk for New Zealand.

  • “Oh please! Try telling that to Northern Rock Borrowers and US Ninjas”

    The risk associated with a country, (eg New Zealand) is sufficiently lower than a bank or non-bank financial institutions. The current account deficit in December was 7.9% of GDP – so our debt was 7.9% of our income, that sounds sustainable to me. I do agree that it would be good if it was lower – hopefully tax cuts will help with that.

    “exchange rate $0.80:$1 down to $.40:$1 when the Northern Rock of the South Pacific stops borrowing yet more money”

    If the exchange rate suddenly tumbled, it would be cheaper for people to invest in NZ. As the rate of return is the same this will attract investment and drive the dollar up. $0.40US is unrealistic, especially with the US dollar so weak.

    Also if we ‘stopped borrowing money’ then the supply of NZ dollars would fall, driving up the exchange rate – not driving it down!

    “The government has taken money out of the hands of taxpayers. As their gross incomes have risen the only way people have been able to spend some of that hard earned increase in gross income has been to borrow more to spend”

    Yes, its called Ricardian equivalence – that is why I expect a fair chunk of tax cuts to be saved or used for debt-servicing. Economists do realise this is going on, but the money is being saved by government (ergo surpluses) so its not too big a deal.

    “The point being that it becomes unsustainable at some point. Northern Rock looked sustainable not so long ago.”

    Again, why are you comparing a bank to a country. If our banking system was fragile and/or our government was running big deficits to go along with the current account deficit we should be concerned – however it is not like that so the analogy is misleading.

    “Old school stagflation is a very real risk for New Zealand.”

    As i’ve said we have had a drought and a spike in fuel prices, these are called aggregate supply shocks. Stagflation occurs following aggregate supply shocks – however stagflation for a year or two is not a huge deal if it is only mild (slow growth, above target inflation). If you are thinking of double digit inflation and a recession (what people tend to think of when hearing the word stagflation) then you are a bit over pessimestic.