Credit crisis mark 2: How will it impact on New Zealand

I see that this is a popular topic at the moment, so I thought I would add my two cents.

Before doing so I’d like to point out that the Rates Blog has a good piece on it, and this Stuff article gives the opinion of most of the banks (BNZ’s currency strategist also gives a good breakdown on the Rates blog).

Now the way I see it, there are two channels that this crisis can and will impact on the New Zealand economy:

  1. Impact on export/import prices and volumes,
  2. Impact on domestic interest rates.
  3. Update: Impact on capital investment

Outside of these two channels global events will have no impact on New Zealand. This involves assuming that external factors don’t beat around our consumer and producer confidence for no reason, and that net migration does not change. Although these assumptions aren’t completely true, I think it is fair to assume that the impact of these factors is relatively minor.

As a result, lets talk about these channels.

Export and import, prices and volumes

Volumes of exports and imports

Now a typical argument here would be as follows:

Global growth is slowing, so people want to buy less New Zealand products – so volumes must fall right. Well not really.

Given that New Zealand is a small country, demand for our products is effectively “perfectly elastic” as the world price (as we make up such a small proportion of the total market for the goods we sell. As a result, what happens to volumes depends on New Zealand’s willingness to supply. As long as the world price does not change, this is fine.

The catch here is that, although we produce such a small amount of the worlds meat and dairy products, we produce a huge amount of the quantity of exported meat and dairy products! As a result, it may be possible that lower demand could have some impact on quantity – given that it is not costless to change where we export to.

On the import side there is no supply issue – we are such a small market that we will still get the goods at the world price. A drop in import volumes will only be as a result of lower demand by New Zealanders.

Prices for exports and imports – the terms of trade

This is the more important issue for a small open economy like New Zealand – the terms of trade.

If global demand falls off a cliff, the price of commodities will fall. Although this will lower some import prices, it will also lower our export prices (given that meat and dairy are commodities). The net impact of a general fall in commodity prices would be a reduction in the terms of trade – implying that our national income is lower. This would be a bad factor for NZ.

However, the thing to remember is that our terms of trade is at a record (34 year) high. Furthermore, there are structural reasons why meat and dairy prices should remain above trend – fundamentally implying that, as a nation, we are better off than we were a few years ago.

Domestic interest rates

Here is the kicker – we are a country that is currently a “net borrower”. Sure our borrowing is mainly the result of capital accumulation and an interest in smoothing consumption over time – but it still puts us at risk when we run into a global credit incident.

This lift in global interest rates will reduce consumption and it will reduce asset values in New Zealand, sure – but it will also increase savings.

The Reserve Bank is slashing interest rates in order to get a slight decline in the interest rate New Zealander’s pay. Surely this tells us that the Bank is working to counteract the interest rate impact on some parts of the financial market (namely the mortgage market) by cutting the OCR.

People always talk about credit being “tight”, and credit being “hard to get hold of” – for me this is an inappropriate way to view the issue. In the credit market there are two issues:

  1. Credit may be expensive because the interest rate is too high,
  2. The credit market may fail because of asymmetric information.

The RBNZ is covering off the first option. As a result, as long as credit rationing does not occur in NZ because of asymmetric information between lenders and borrowers there is NO ISSUE.

Well what about this asymmetric information

At the moment we do have some areas of the credit market which are “failing”. The Bank appears concerned about business lending – I can imagine one of the most concerning areas is lending to the property development and construction industry, which has dried up. Driving this is a high level of asymmetric information – banks fear that NZ might have the same oversupply problem that the US felt, even though given our population distribution we don’t.

Risks abound from the potential for further credit rationing sure – but I do not see it being as much of an issue in NZ as it will be (and has been) in the US.

Conclusion

Our terms of trade will fall – but not below the levels of early 2007.

Our interest rates will rise in some markets, but RBNZ action will actually see them fall in some other markets (mortgage rates).

Credit rationing will not be an economy wide problem – it should stay contained in areas of the economy that are well overdue for consolidation (construction).

Overall, this is hardly a 1929 style crisis. Early in the Depression central banks were lifting interest rates, Treasuries were cutting spending, and asymmetric information abounded (while nothing was done to improve the situation).

As long as the information transfer between market participants begins to improve again this crisis will be a historical point of interest in a years time – rather than the beginning of the end.

Update: As CPW says I should have also mentioned the asset price channel. Up until a couple months ago i was a strong proponent of the asset price channel having real effects in the economy – however, I have since been convinced otherwise. Fundamentally, the logic is that lower asset prices lower peoples lifetime wealth, and so leads to lower consumption, however:

  • Lower asset prices give people who do not own assets an increase in income – by lowering the relative price of assets.
  • Movements in asset prices are not the same as changes in expected wealth – expectations will be a lot more fixed, and are probably more closely related to fundamentals.

As a result, I am still of the opinion that the terms of trade and interest rate channels will be the most important for outcomes in New Zealand

Update 2: Don’t forget about the impact on capital investment – although I see this as akin to the interest rate channel, there is also the issue of technical expertise and the direct value associated with direct capital projects (eg a movie). I shouldn’t have been so quick to ignore it 😉

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  • CPW

    Presumably there’s also an asset price channel. And I’m not convinced this is an asymmetric information problem, banks aren’t lending to each other because they really might fail, not just because they can’t credibly signal that they’re not going to fail. Even if the Reserve Bank maintains real interest rates, it might still make sense for NZ banks to try and shore up their balance sheets as much as possible.

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  • “Presumably there’s also an asset price channel”

    The old wealth effect aye, good point. Fundamentally, we have to ask what peoples expectations of assets prices were, and what they are now – I suspect that the response would be a lot less volatile than the market price.

    However, if there has been a dip then that would be material – for those that own the assets. A countervailing factor would be the lower relative price of assets for those who do not own them – that comes with its own income effect 😉

    “And I’m not convinced this is an asymmetric information problem, banks aren’t lending to each other because they really might fail, not just because they can’t credibly signal that they’re not going to fail”

    But this only matters if the business that are going to fail will only do so because other banks aren’t loaning to them (so the projects they want to take on do have value) – which is an asymmetric information problem.

    If the bank was going to fail in the situation of full information – then they have to go anyway. But how many institutions are like that in NZ (now that most of the finance companies are gone).

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