Credit Rating Downgrade Highlights Need for Repairs

Gareth MorganUncategorized

New Zealand credit ratings downgrade signal time for repairsGareth Morgan and Susan Guthrie, Authors of  The Big Kahuna

The downgrade to New Zealand’s credit rating highlights something we are all prone to forget when World Cups, elections and the good times roll. Our economy is not structurally sound, we have spent over 20 years investing in one asset class to the detriment of developing a suite of sustainable income and employment-generating industries. Property speculation is the national pastime and with that obsession we have missed the opportunity to use the vast imports of overseas capital to develop a robust economic base. Instead we have run up a large external debt to fund this tit-for-tat escalation of each other’s house values. Building more and more houses as part of playing this game can hardly be regarded as a credible growth strategy.

This is precisely what the downgrade is about. The credit rating agencies, like many of us, are contemplating a second leg to the Great Financial Crisis of 2007-8, and in that scenario China does not get to carry on buoying commodity prices and hence the economies of the commodity producers New Zealand, Australia, Canada and Brazil. With Europe contracting and the US stuck in stagnation, China would have to keep building roads to nowhere, train tracks into its deserts, and surplus airports for the commodities demand to stay up. But nobody is using its new infrastructure, the productivity of the investment is terrible – and that’s inflationary. Incomes in China aren’t enhanced by such hollow investment and its households face the same high prices of basic commodities that we do – although on far lower incomes. The average household there spends 67 per cent of its income on food alone, the ratio of central and local government debt to GDP is 65 per cent now, hardly insignificant. And sure the country has foreign reserves – mainly in the high debt, weak currency areas of Europe and the US – hardly assets that are appreciating in value.

Meanwhile back in New Zealand the “sweet spot” of high commodity prices and a subdued domestic economy has seen our balance of trade swing mightily into surplus. Despite the highest terms of trade in a lifetime, our balance of payments deficit has reduced only to 3 per cent of GDP – thanks to the money we have to pay foreigners that own assets here and the cost of servicing the debts we owe them. What will that annual balance do now commodity prices are coming off and should the domestic economy stir from its slumber? Expand back out to over 6 per cent of GDP most likely, a debt-exacerbating number. One small mercy is that the NZ dollar at least can fall and partially correct our malaise.

This is what the credit rating agencies fear and why we’re becoming a greater credit risk for lenders. All that borrowing we’ve been doing over the past two decades has not rid us of the structural weakness in our economy. We remain highly indebted and even record export prices still see us borrowing. In a deleveraging world where lenders no longer want to lend bigger and bigger dollops we are a weak horse to back.

How can we have been so negligent and what remedial steps can we take? We all know property speculation has been our addiction. The scandal is that it arose because we’ve had a couple of weak Reserve Bank governors who on the one hand publicly bemoaned the rise in house prices but on the other specifically directed the banks to give mortgage lending priority over all other types of lending, all the while pondering whether asset price inflation was really inflation at all! Albeit that this was just our local version of weak central bank governance that has gripped the Western world since financial market deregulation. But in conjunction with a tax system that confers a total tax break for speculation on housing, we ended up with a toxic combination that has seen house prices here catapult to unsustainable heights. Today we are only part way into that adjustment.

But what a wasted two decades. Far from diversifying our income base the concentration of credit flows to property speculation has seen even greater concentration of income from (property-intensive) agricultural production. After all these decades we remain a one-trick pony – protein producers. Nothing wrong with that in moderation, but it’s not moderation – we now require record prices for the stuff to avoid debt-exacerbating balance of payments deficits. Ours is a morbid dependence on land-based production.

How do we reduce the chronic reliance on commodity prices? First, the central bank needs to understand that lending on property is not less risky than other forms of lending, that if it directs lenders to treat it as though it is, then they will lend and lend on property until that regulatory assumption is defeated. That’s how markets respond to arbitrary regulations. Second, we need an overhaul of our taxation regime that taxes all forms of income from capital in the same manner, whether its cash or imputed income. The holes in our taxation regime on capital have sponsored a misallocation of our most scarce resource.

Next we need to arrest the exponential growth in the administrative cost of delivering our targeted social welfare which sees families earning $100,000 a year qualifying for a needs-based benefit. As if bureaucrats could determine whose needs are the greatest anyway, and it certainly takes a lot of them even to try to implement the impossible. When the rich can access targeted assistance by virtue of a broken tax and transfer regime, we have the ingredients for the sort of social breakdown we are seeing in Europe. The only thing holding that back in New Zealand so far has been this “sweet spot” from buoyed commodity prices. Take that away and the festering sore of social disparity is well and truly exposed.

There is much to do. To see National trumpeting its benefit “reform”, that amounts to no more than the trivial pursuit of 2000 youths from dysfunctional families on the independent youth benefit, is more evidence of political paralysis on these issues of tax and distribution. Just as the Prime Minister has been wrong-footed by the credit downgrade, we have tax and transfer policy stuck in a hiatus lest it disturb the status quo of a comfortable election victory.

There is a naive single dimension to our economic policy – we either raise or reduce the budget deficit or we raise or reduce interest rates. That’s the sum total of the intellectual capital being applied to managing our economy. That it could be so bereft for so long has led to the persistence of our “structural imbalance”. There is a chronic need for policy enlightenment and a sweeping aside of a simplistic policy orthodoxy that has been rigidly paid homage to for 30 years now.

If we support innovation by flat but comprehensive rates of tax on income, if we underwrite social cohesion by giving effect to the right of everyone to live a dignified life and recognising that paid work is only one form of contribution to our society, and if we get some intellect into the central bank so its “prudential” policies stop distorting the capital markets, we have a chance to capitalise on the appeal of New Zealand as a place to live by the world’s most innovative and wealth-creating minds. Only then can we expect to break through the endemic structural weakness of being a spendthrift society – the very illness the credit rating agencies, at least, recognise we have.

Credit Rating Downgrade Highlights Need for Repairs was last modified: December 15th, 2015 by Gareth Morgan
About the Author

Gareth Morgan

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Gareth Morgan is a New Zealand economist and commentator on public policy who in previous lives has been in business as an economic consultant, funds manager, and professional company director. He is also a motorcycle adventurer and philanthropist. Gareth and his wife Joanne have a charitable foundation, the Morgan Foundation, which has three main stands of philanthropic endeavour – public interest research, conservation and social investment.