Against the 10 reasons for Fitch downgrading NZ

Bernard Hickey posted on the 10 reasons why Fitch should downgrade New Zealand’s credit rating, it is an interesting post that you should run off and read before looking at this 🙂

Now that you have read that I am, for the sake of argument, going to counter each of these points. I cannot provide a “slamdunk” against anything, but I can raise the other side of the argument so that we can really think about the issues that little bit more.

Note that in many ways I agree with Bernard Hickey about our current situation being slightly precarious. However, I feel that going through these factors on the other side is a useful exercise for understand exactly what we need to look at.

1 and 2: High current account deficit/high debt position

Essentially these arguments are very similar. The current account deficit at its current level implies we are experiencing a large “inflow of net debt”, while the high stock of debt implies that we have a high stock of debt 🙂

There are two ways to view this as a problem:

  1. Net debt is a concern, as it is what we own in terms of assets – liabilities.
  2. Debt itself is a concern (absent of the asset level) as it implies that financial stability may be under threat.

Now, in terms of “sustainability” it is common to think of nominal GDP growth as some sort of maximum limit for the current account deficit as a % of GDP. Assuming inflation of 2.5% and long-run growth of 2.5% this implies our CA deficit should average 5% of GDP. It has blown this out of the water.

On the stability side it is an issue of the “concentration of debt” and the “risk associated with debt”. The higher the debt level to income the more likely it is that the debt is concentrated among specific people in the economy. Furthermore, the higher the debt is the more at risk we are from a correction in asset values etc.

My counter to these two points is:

  1. We KNOW that our net asset position is undervalued, as the assets associated with many small investors are not counted. This could easily account for 3% of GDP per year, implying that our CA deficit is sustainable. Furthermore, our net debt position will be significantly overstated as a result.
  2. If individuals know the risks associated with the debt it doesn’t really matter if the debt position is relatively high. Furthermore, we know that NZ’s banks are very safe at the moment – as they hold a lot of the debt, financial stability is not a major issue at present.

3: The fiscal balance going into deficit

The concern here is that rising government debt will simply make the debt position worse.

However, the counter here is something I use a lot:

  1. Ricardian equivalence: When government debt levels increase, households tend to increase savings levels. As a result, a moderate increase in government debt should translate into a moderate decrease in household debt. This will lead to a position where net debt will be unchanged (unless there are other structural factors).

4: Unbalanced economy

The issue here is that the share of GDP going to the non-tradable sector has increased. As we “make our income” as a nation through the tradable sector this might be concerning.

My counter is:

  1. We have had a rising terms of trade over this period. The income effect of this is not nicely captured by GDP figures. Essentially, an increase in the TOT allows us to buy more imports and the such with the same number of exports. As a result, the “non-tradable” sectors like retail have been able to increase activity with0ut us needing to actually increase export volumes. In such a case, the change in the relative shares doesn’t mean anything!

5: Fiscal position will worsen because of baby boomers
The wave of baby boomers will punish our fiscal position by going on super and using health care.

My main counters here are:

  1. The important thing is the “dependency ratio” – not just the old people but the very young (as they take up spending on health and education). It turns out this will increase, but not by as much as those over 65. In essence, just looking at older people exaggerates the fiscal hole.
  2. When the issue comes, the government will find ways to patch the hole. Ultimately, people are going to be pushed into working longer – making this less of an issue.

6: Productivity is terrible

Poor productivity growth implies that we haven’t been getting more “bang for our buck”. Without productivity growth we haven’t been able to fund debt.

Reply:

  1. The main issue isn’t productivity measures per see (as they are random averages that are difficult to look at independently of the state of the economy) but growth in our incomes – namely, productivity growth has been weak because employment growth (and capital expenditure) has been so strong, and on increasingly spending has been on “marginal” productivity projects. A rising TOT implies that income growth has been much better than the volume “productivity” measure.

7: Banks and consumers won’t change

Banks and consumers will continue to be an issue. Banks will take on too much risk and consumers will be willing to take on unsustainable debts.

Reply:

  1. I do not believe that the banks have taken on too much risk (hence why financial stability is not an issue) and I don’t think consumer debt is necessarily the core issue.

The household debt ratio has gone through the roof. But as we mentioned earlier, some household assets (and therefore the income flow from the assets) is missed in the statistics. Furthermore, household “debt” does not fully take into account some major assets, such as housing.

We know by looking at “nominal GDP” (to get an idea of relative prices) that consumer spending is at around historical averages. This convinces me that there is some issues with the debt statistics, not that there is a fundamental issue with households per see.

  1. Consumers HAVE reacted.

If we look at real GDP (where people point to in order to say households are spending too much) we know that households have responded rapidly to the worse economic conditions with March household consumption falling 1.4% on December (seasonally adjusted). In per capita terms Infometrics estimates (given assumptions on pop growth) that per person consumption could be around 3.2% lower than its peak in December 2007.

8: Commodity price collapse

Commodity prices and output have fallen, hitting income, and making our debt position even worse:

Reply:

  1. Import prices have also collapsed. Yes, the TOT will fall but it isn’t clear that they will fall to the historically low levels we normally see during a global recession. With commodity prices expected to recover (world prices for our goods are already rising), this may not be as large an issue.
  2. Some industries are already seeing this – with lamb prices now at their highest level ever (depending on what figures you look at of course). Yes dairy is struggling, and there are definite financial stability issues with some dairy farms, but ultimately this card is overplayed.
  3. On the volume side lets remember that export volume growth has actually been very strong lately, as we have come out of a drought. Sure volume growth in an agricultural industry is never going to be spectacular (but it will also not fall strongly either), but then neither are the inputs required for the industry. As we get more inputs, people will create other industries – hell isn’t tourism one of New Zealand’s biggest export industries now? We cannot ask the government to “create” export industries, they should come about from things where we have a comparative advantage.

9: Domestic inflation is too high

Domestic inflation will continue to cause a disjoint in incentives between types of investment etc keeping our economy unbalanced.

Reply:

Inflation is always an issue to be sure (discussion of it here). But we have just had a massive recession, and a whole lot of our “capacity” is now freely available.

The fact is that a recession has moderated this “non-tradable inflation” and lower inflation expectations. Now let us assume that the RBNZ will credibly keep inflation down in the future – and we have no underlying issue here.

10: We are not saving enough

Again see 1 and 2.

Reply:

  1. It is not clear we are not saving enough. Housing and small asset vehicles are not properly counted in our statistics.
  2. Furthermore, a country never needs to be a net saver. As long as we have positive nominal GDP growth we can sustain a growing stock of debt forever. With the statistics currently so unclear it is uncertain whether there is an underlying debt problem.

Conclusion

I personally think that there are issues with:

  1. Incentives to invest,
  2. Direction of government spending,
  3. Incentives to produce,
  4. Information.

Fundamentally, NZ faces a wedge between the private and social benefits of different investment (as a result of transfers, tax, poor information etc) and we have gradually built up a large debt position as a result.

However, the above discussion of the 10 points on why we need to be downgraded is enough to make me believe that the issue MAY be overcooked.

Ultimately, I hope the issue is overcooked, but I also hope that we can sort out appropriate policy before we really do face a credit downgrade.

  • I agree with reason nuber 1 .High current account deficit/high debt position is best reason for Fitch downgrading NZ

  • Miguel Sanchez

    To this, I’d add that there’s no reason to believe that a rating downgrade would make a blind bit of difference to the currency. Fitch is basing its view off public information that the market has already considered and rejected.

    And if higher interest rates are the answer to our problems then you have to ask where the central bank sits in all of this? Oh that’s right, they’re threatening to pump up the housing market even further in order to meet their outdated growth forecasts.

  • Matt,

    Many thanks for the link. Good stuff. Enjoying the debate, which I think needs to be right in the public’s face.
    Some counterpoints.
    1. Haven’t the small investor holdings always been there? If a current account deficit of 5% used to be too high, why would 8% be OK now? Also, are these small investor holdings as liquid as the big ones? Does that change the equation?
    2. You make a good point about the banks. They are strong and are the pressure point for any drama. But if we carry on like we are we risk becoming a basket case that the Australian government has to manage because of the risks to their banks. Instead of the IMF telling us to get our shit together, it will be Kevin Rudd and 4 grumpy bank CEOs (although at least one is a NZer at the moment). Equally bad I reckon.
    3. Is there any evidence to suggest New Zealanders actually save more (as opposed to doing less dis-saving)when the government saves less? Did it happen in the late 1980s and early 1990s?
    4. If the terms of trade improvement made it all OK, why has the current account deficit worsened in the last three years? Surely if justice prevailed it would be unchanged?
    5. Finding ways to patch the baby-boomers hole in our fiscal position is likely to mean rationing, lower health service levels and lower real pensions, as well as the ‘patchups’ of a later retirement age.
    6. Are you really saying we don’t have a productivity problem? Even if it’s only a relative problem vs Australia and elsewhere, it’s still a problem because our real per capita incomes drop in comparison. That causes us to die a slow death by outward migration of our best and brightest? How many of your colleagues at Uni now work overseas? And how many would you expect to come back?
    7. Isn’t the argument that household debt ratios don’t take into account the value of housing a circular argument? Everything’s fine as long as house prices keep rising, but when they don’t…watch out. It’s very handy for the banks that the RBNZ’s rules on capital adequacy say the banks can use the initial house valuations when they value their loans. ie The banks can get away with ignoring massive losses in home equity.
    8. Have import prices fallen as much as our commodity prices? I’m also not so sure about the volumes increasing. Fonterra has just cut its output forecast for this year because farmers have stopped spending on fertiliser and feed supplements.
    9.Yes, but is all that ‘spare capacity’ going to drive down prices in our mostly-publicly owned or monopoly type infrastructure and public sectors. I doubt it. They have to be opened up to competition to get that. Apart from retailing and some of the services sector, I’d bet most of our non-traded economy is inelastic when it comes to capacity and inflation.
    10. I understand the argument that says we may already save enough. It always depends on the value of our houses being real and sustainable. It’s a circular argument after a housing bubble (but not after the bubble has burst). It hasn’t burst yet…

    cheers Matt

    Owe you a beer/coffee for the link

  • Miguel Sanchez

    You make a good point about the forex markets ignoring Fitch too because they have all the information…
    But do the reef fish really have a clue that the shark is coming until someone gets eaten? I’m with David Lange on this stuff.
    The current account doesn’t matter until it matters. We will always be surprised at the little thing that means it matters. It may be as little as a credit rating downgrade from a second tier rating agency.
    I agree with you completely about the RBNZ complaining about consumers falling back into their old habits at the same time as promising to keep the OCR at 2.5% (or lower!) for 18 months. Beyond belief.
    cheers
    Bernard

  • @Bernard Hickey

    Hi Bernard, thanks for the replies. I will attempt to reply back:

    1) Indeed the small investors have always been there, but it matters insofar as figuring out:

    i) How high is our net liability position
    ii) How close are we to a sustainable current account deficit

    Yes our current account deficit is larger than it has been previously, but this mismeasurement makes it difficult to tell whether it is sustainable or not.

    In terms of looking at the flows, note that there is almost always a negative error in the BOP – this implies that either our capital account is in a higher surplus or the current account has a lower deficit. In December the error was several times larger than the CA deficit itself!!

    2) This ultimately matters on our view of households. If we think they have been excessive then there could be an issue. However, even this is unclear.

    3) There is a lot of evidence for other countries, I am unware of any NZ specific stuff.

    What I will point out is that if we looked at household savings vs government saving in NZ there is a negative relationship – household savings was positive in the early 90’s when governments were strongly dissaving, it went strongly negative during the time of collapsing government debt.

    4) If we believed the TOT would increase further a current account deficit makes sense.

    The way to think of a current account deficit is as NZ Inc borrowing. We borrowed during the drought, we borrowed when we expected our income to increase, and we borrowed to invest. We also borrowed because countries overseas were “subsidising” consumption goods for us by keeping their exchange rate down.

    All these types of borrowing are justifiable – unless we think there is a microeconomic issue throwing something out of whack (tax policy, poor institutions, inefficient transfers).

    However, I would actually need the data to try and figure out what magnitude these different impacts had on the GDP data. Ultimately, a higher TOT SHOULD lead to higher non-tradable GDP to tradable GDP. Why? As GDP measures what we produce FOR A FIXED PRICE, but the price of what we make has increased, allowing us to do more retailing and the such from the same level of output – our income is higher than GDP is telling us.

    5) And those are fine really. It would be better if we pointed these factors out – but ultimately this isn’t a reason for a currency downgrade.

    6) “Productivity” needs to be looked at appropriately. We can’t really target it, we just want to make an environment where things can be made efficiently. There are two big problems with the productivity measure.

    i) When we do decide to work more productivity falls, even though we will have more stuff.
    ii) A higher TOT (or change in the relative prices of goods generally) will probably create a situation where productivity looks lower, even though incomes are climbing.

    7) It is partially circular – but as long as we don’t expect house prices to go to zero we should still take a fundamental asset value into account.

    Say the rental equivalent?

    8) Input prices have not fallen by as much – but they have dropped like a stone.

    Think of it this way – overseas we have a problem of “overcapacity in manufacturing”. We import manufactured goods. Overcapacity means the price will drop and stay low. This is pretty nifty for us.

    On the volume side export volumes have risen – they won’t rise further – but they have risen.

    9) Yes some prices will not change in a willing way, and there are industries we need to sort out. However, this isn’t an “inflation” problem, this is a competition problem.

    The inflation problem is some endemic belief that prices will keep rising. My comment was that this appears to have been crushed by a global recession

    10) Even with house prices 30% lower it isn’t clear the household saving are unsustainable – as in essence this price fall is a gain to non-house owners. Ultimately, we have to ask exactly what is relevant for net wealth and what isn’t.

    There are things that are undermeasured, and compositional issues that should be included, and when these are taken into account I suspect the household savings picture would look a touch different.

    I believe the direction of the household savings stats, but I suspect the magnitude is misleading.

    My conclusion stuff: Personally I think the issue is to do with the composition of investment and resources. Net debt figures and the stuff can point to issues, but they are not sufficient to say that we have a problem.

    It is possible to make a case where we don’t deserve a downgrade is my point here – however as you have shown it is possible to make a case regarding why we should.

  • @Miguel Sanchez

    Currencies seem to move based on “focal points” – as they are a function of peoples expectations of the reaction to news. If Fitch saying something provides no new information but acts as a “focal point” to sell it could have a marked impact on the currency.

    Fundamentally this presumes that there are multiple “equilibrium” levels for the currency, each of which are a function of expectations.

  • Miguel Sanchez

    Bernard says: “We will always be surprised at the little thing that means it matters.”

    Exactly – so there’s no point in picking out a particular known factor and expecting it to have some mechanical relationship with the currency. It might matter, it might not – but if it doesn’t, what do we pin our hopes on next – divine intervention? No, if policymakers really think there’s a need for change they should focus on the things that are within their control.

    Matt: sorry, but “focal points” sounds like a convenient ex-post explanation, right up there with technical analysis – again, completely useless for forecasting.

  • @Miguel Sanchez

    It is completely useless to forecast the exchange rate though – it is a random walk. Over time we hope it steers around “fair value”.

    Focal points are important as currency holdings can be seen as an asset – we can’t use them to forecast because we can’t observe them, but it doesn’t stop them from being relevant. Especially when we are describing an event that is likely to have a disproportionate impact on the currency relative to strict fundamentals.

    One reason why I believe this theory is because it matches my observations when data has been released. Data can come in matching expectations exactly and there can be a huge swing in the currency. Only focal points can explain this to me.

  • Miguel Sanchez

    I’m specifically talking about forecasting the currency response in the event of a rating downgrade. If there was any connection between the two then surely as economists we could say something meaningful about this. But there isn’t, and we can’t.

    And thank you for demonstrating my point. Setting aside the issues of (1) whether your idea of a “huge swing” in the currency is the same as mine, and (2) whether you actually knew beforehand the expectations of the broader market, as opposed to just economists – you’re remembering the few occasions on which this appeared to happen, and spinning a story around it. But if I asked you, before a data release, what the currency would do if the data matched expectations, you’d have no reason to say anything other than “no change”.

  • @Miguel Sanchez

    Huh, I said that I believe a focal point can throw around the exchange rate in a way that is foreseeable – if you know they bias associated with it.

    If we get a credit downgrade on known information, market participants would cut the dollar – even if the actual information behind the dollar was completely known.

    Why? Because the price of the “asset” depends in part on expectations of what other people will do. In this situation, Fitch has moved and said that they don’t believe the dollar is worth as much. All this needs to do is change the expectations/beliefs of a small number of traders and the dollar will move, which will reinforce a belief for other traders to move and etc and etc until we reach a new equilibrium.

    With other news releases the adjustment is not observable – it is a random walk. However, in the case of a credit downgrade we know exactly where the bias is.

  • Selwyn

    It is so unlike me to support Bernards view of the world but he is spot on and for those that haven’t yet seen it, have a look and the debate that followed.

    http://www.interest.co.nz/ratesblog/index.php/2009/08/03/opinion-heres-10-reasons-why-fitch-should-downgrade-nzs-aa-rating/#comment-31588

  • Miguel Sanchez

    Matt Nolan :@Miguel Sanchez
    Huh, I said that I believe a focal point can throw around the exchange rate in a way that is foreseeable – if you know they bias associated with it.

    Um, no you didn’t:

    One reason why I believe this theory is because it matches my observations when data has been released. Data can come in matching expectations exactly and there can be a huge swing in the currency. Only focal points can explain this to me.

    The problem is that even if these focal points do exist, we don’t know about them beforehand. We might, after the fact, kid ourselves that we knew all along. But we don’t.

    If we could “know” these things, we would have “known” that the negative outlook by Fitch, and by S&P earlier this year, would have no impact of any consequence on the currency. But would you have dared say so before the fact?

    Oh, and since you raised it:

    Fitch has moved and said that they don’t believe the dollar is worth as much.

    Fitch say no such thing – they strongly argue that the macro adjustment has to come from within, not through the expediency of a temporarily weaker exchange rate.

  • “The problem is that even if these focal points do exist, we don’t know about them beforehand. We might, after the fact, kid ourselves that we knew all along. But we don’t.”

    I said that the idea of a focal point seemed applicable given experience. I then said that in the case of an observable bias we can use this to forecast some change – Fitch downgrade has a bias.

    “If we could “know” these things, we would have “known” that the negative outlook by Fitch, and by S&P earlier this year, would have no impact of any consequence on the currency. But would you have dared say so before the fact?”

    The S&P threat did influence the value of the currency – and given our lack of relative increase in the face of rising commodity prices and increasing risk aversion I would say that the Fitch announcement has had some impact on investor behaviour into NZ. And I would have said so before hand.

    I would not have picked the collapse in risk premiums in recent weeks, or the rising commodity prices though.

    “Fitch say no such thing – they strongly argue that the macro adjustment has to come from within, not through the expediency of a temporarily weaker exchange rate.”

    But they did say that there is an imbalance in terms of our trade position – an imbalance that could be (paritially) corrected through a lower exchange rate.

    By saying that there was a greater risk associated with our currency than is priced in they are implicitly saying that the exchange rate should be lower!

    Note: In net terms my point is solely that a Fitch downgrade would lead to a lower dollar CP, I do believe that is justifiable. However, I agree with you that the magnitude of such movements is HEAVILY over-rated by the media and the such – any such impact is likely to be small.

  • Miguel Sanchez

    If you can discern any underperformance in the NZD in direct relation to Fitch’s announcement then you have much keener eyes than mine – from what I recall, it fell about half a cent and clawed it all back within 24 hours.

    “But they did say that there is an imbalance in terms of our trade position – an imbalance that could be (paritially) corrected through a lower exchange rate.”

    They said the first part, not the second. The upshot is that in order to return the outlook to stable, Fitch want to see evidence of a structural improvement in the current account deficit, beyond the cyclical improvement that we can expect as a result of the recession. The quick-fix of a weaker currency has no bearing on their view.

  • Miguel Sanchez

    By the way, I have their full report. Here’s a typical sample:

    “Fitch estimates that a sizable 4.5 percentage points of GDP turnaround in the CAD position is necessary to bring the deficit on NZ’s net international investment position (NIIP) back down below 100% by 2011. This could entail a severe and/or protracted economic contraction to correct the country’s structural savings-investment imbalance. Such a correction is not a certainty, however, with historically low real interest rates and the beginning of a housing recovery raising the risk that household borrowing and consumption, as well as net external borrowing, do not abate.”

    To me, that’s a pretty blatant argument for higher interest rates, not for a lower currency. Trying to engineer a weaker currency is just another way of saying “let’s inflate our way out of trouble”, and I’d be really concerned to see a ratings agency recommending that.

  • @Miguel Sanchez

    Hi Miguel,

    I don’t think we are disagreeing here at all – I think we might be slightly talking past each other.

    All I’m saying is that if Fitch did move it would increase the perceived risk associated with us for some investors. If this is the case then the exchange rate would fall – I am not asking for artificial depreciation of the currency (that is bull I agree), I am just saying that this is what would happen is nation specific risk expectations changed. Note that this would also lead to higher interest rates, irrespective of RBNZ policy.

    My focus with this specific mentioning of Fitch is on how the world drives our interest rates and exchange rate – not on domestic policy per see.

    I agree that a weaker currency is not a “quick-fix” to imbalances that are the result of domestic structural issues – in policy terms we should be focusing on these issues not the exchange rate.

    http://www.tvhe.co.nz/2009/07/29/high-dollar-is-a-symptom-not-a-cause/

    However, this discussion came about because I was replying to your comment that a downgrade wouldn’t impact on the currency. I believe it would – although I agree that the magnitude of the impact is highly exaggerated.

  • Miguel Sanchez

    “All I’m saying is that if Fitch did move it would increase the perceived risk associated with us for some investors.”

    And I think the only place where we disagree is that I don’t believe the above is a given – the minimal evidence we have locally would suggest it isn’t, and more broadly, there’s a huge Iceland-shaped hole in that theory (how high did their currency get between the rating downgrade in 2006 and the collapse of their banking system in 2008?). So if it’s not a given, there’s no point in hoping for a downgrade to force a change in our bad behaviour, as an alarming number of people seem to favour.

  • @Miguel Sanchez

    Fair point.

    “So if it’s not a given, there’s no point in hoping for a downgrade to force a change in our bad behaviour, as an alarming number of people seem to favour”

    Personally I do think it will influence the exchange rate – but I think the impact will be small, so I feel a similar way.

    Also I don’t like the idea of a crisis to “force us to change our behaviour”. Ultimately there are some structural issues in the economy that we should try and figure out at a micro level – waiting until the rest of the world calls us a risky proposition and punishes us isn’t really the best idea methinks