It’s refreshing to hear a new perspective from the Reserve Bank on the aftermath of the Global Financial Crisis and the challenges it presents to the New Zealand economy. New Governor Graeme Wheeler is correct to say that Quantitative Easing cannot be seen as the silver bullet to restoring global prosperity.
One of the ironies of monetary policy however is that not only was it responsible for underwriting the credit explosion that led to the GFC, but also in order to mitigate the damage to the real economy imparted by the balance sheet restructuring that was needed on bursting of that bubble, loose monetary settings are at least a prerequisite. So loose money was the disease and is now at least part of the cure. While Mr Wheeler doesn’t accredit any of the quantitative easing that’s occurred in the major economies as having generated economic growth, he has avoided considering the counterfactual of what might have occurred without accommodating monetary conditions.
The logic of easy monetary policy settings being both the disease and part of the cure, tests most people until they appreciate the human cost of an austerity-driven correction to large imbalances. The downside of austerity was last widely seen in the Great Depression (although Greece is getting a taste right now), and despite that being a long time ago, the consequences of the dual of tight fiscal and monetary policy is etched permanently.
The new Governor points to New Zealand’s excessive debt as the home-made driver of our doldrums and postulates that until that corrects, the populist dream of an export-led, currency-supported expansion will remain elusive. A theory that holds indebtedness can be held responsible for over-valuation of the currency, is curious and worth exploring. You might be forgiven for believing excessive indebtedness to foreigners would actually deter further capital inflows and weaken the currency, albeit raising interest rates as a consequence. Certainly the Latin American debt crisis led to that outcome as has indebtedness of Spain, Ireland, Italy, and Portugal . So a theory that holds that on the contrary, high debt pushes the currency up, is novel and Mr Wheeler might like to explain the above exceptions.
Our strong currency is not a sign of international creditors and investors being in any significant way, deterred from New Zealand borrowers at present – indeed they’re loving it. If they’re so happy to fund these borrowing levels at the interest rates we’re happy to pay, where does that leave an argument that holds our borrowings are our downfall? Our creditors aren’t worried so perhaps Governor Wheeler knows something the markets don’t – like we aren’t using our borrowings wisely. I’ll come back to that theses.
Perhaps there is another reason for the “high” currency, coinciding with high external indebtedness? While the improved trade balance, on the back of strong terms of trade has certainly supported the “high” currency of recent years, that support is waning now. There may be another cause.
Isn’t it more likely that it’s our reserve Bank-set interest rates that are underpinning the currency? We have an official rate of 2.5%. In Europe, the US, Japan, and the UK the cash rates are all under 1%. Of our major trading partners, only the Australians have a rate above ours, at 3.25% – and we are relatively weak against the Aussie right now. Yet overall our TWI is, we agree, pretty high.
If we accept, heaven forbid, it is actually our official interest rates that are responsible for keeping the TWI up near the tops of the post-float range (gosh it’s been 28 years since we floated), the obvious question is whether our central bank’s approach to inflation control is seen by the markets at least, as just a little zealous for the current climes. In other words the interest rate carry we are paying (the gap over other central bank rates) is seen as a no risk, gift from the people of New Zealand to the world’s investors. They can’t get enough of this.
To confirm this as a possibility we need to examine whether the Reserve Bank is running a monetary policy that is regarded by foreign investors as simply too tight. In other words what is the capital market’s view of our inflation prospects? Certainly over the last six months our CPI inflation has been running between 1 and 1.5%, compared to US and Australian inflation running in the 1.5-2% zone, the UK and Euro zone in the 2.5-3% zone. So prima facie at least, there is evidence that our Reserve Bank is running relatively tight monetary policy – it has inflation lower than elsewhere and yet has got rates higher than elsewhere. And that, at least in the foreign investors’ mind, means it’s offering money for nothing.
So despite denial from Reserve Bank spokespeople, it’s absolutely the case that this might be a credible explanation for our “high dollar”.
Now let’s turn to this argument by Governor Wheeler that until we get our debt levels down the upward pressure cannot come off the currency. While I’ve suggested it’s not immediately clear why the market doesn’t agree with him that our borrowing levels are too high (otherwise they’d not be so keen to lend would they?) we can agree that our big external debt has to a large extent been raised by the banks and lent on to our housing market. We also know that house prices in New Zealand are at record levels compared to incomes, and that the previous two Governors bleated on about this in public ad nauseam but did nothing to address the one fundamental cause that was within their control. That of course was to reverse the RBNZ direction to the banks (who the Reserve Bank guarantees as we found out when push came to shove during the GFC) that they should attribute the lowest risk weighting to mortgage lending. With that directive from those last two Reserve Bank Governors, we ended up with lenders falling over themselves to send the funds they raised offshore into the property market – with unsurprising effects in terms of the misallocation of investment to that sector, high inflation in property prices and building costs. The handiwork of a poorly managed Reserve Bank has muct to atone for.
So the new Governor might express this as the debt level being too high. To the extent we have misallocated the capital we have raised, productivity is low, income generated is low, and GDP growth has been nobbled. So we have missed the economic growth bus, not because as he suggests the high borrowing has pushed the currency up, but rather because we have misallocated the capital raised to a low productivity endeavours. The new Governor then has it half-right – the high debt has caused trouble.
More importantly though the Reserve Bank has the power to reverse this self-fulfilling trend of rising external debt fuelling property values, fuelling more debt and so on – the well-known bubble that has yet to burst. It can do that simply by changing its prudential policy that currently asserts that mortgage lending is the lowest form of risk lending by the banks and they should give it priority. Given the RB guarantees lenders to the banks it can hardly, in the face of that policy, point the finger and credibly charge that there is too much debt dependency by New Zealanders. Who’s encouraging the banks to raise the debt and lend it out this way? The central bank prudential policy lies at the heart of the ailment. It has a choice – either remove the bank guarantees or change the risk weighting banks can ascribe to mortgages. The latter would raise the mortgage rate, lower the demand for that kind of borrowing and see the banks have to look to lend more to businesses in order to make a bob.
Looks to me like that outcome would see a quality of lending that would align more with sustainable economic growth. What I’ve wondered for years now is why the prudential policy the Reserve Bank applies to the banks isn’t conditioned by ensuring a level playing field for all types of borrowers? On what economic theory does it arise that mortgage lending is the least risky? We’ve had heaps of it and our economy is stuttering as a consequence.
So in conclusion there are a couple of things the new Governor needs to establish credibility on
(a) Why is the “high dollar” not due to our relatively high official cash rate/ low inflation duo?
(b) In light of the explosion in property prices, where is the justification for the Reserve Bank to instruct commercial banks to lend on mortgage in preference to all other lending?