Month: May 2015

How much should we rely on stress tests?

Michael Reddell Financial stability

A commenter, Kelly, writes as follows:

Michael – is it necessarily true that the failure ( or lack thereof) of a bank stress test is the benchmark for assessing the worth and more specifically the legality ( in terms of consistency with the RBNZ’s act) of regulatory action? The relevant section of the Act says if I remember correctly that the Bank must use these powers for the purpose of ensuring the soundness and efficiency of the financial system. While the stress test results are one potential indicator they are not a necessary condition to justify regulatory action. Indeed I suspect that very little prudential regulation might be justified if this were the case. Stress tests are indicators of what might happen given a number of important assumptions any of which may not be true in real life. Also stress tests almost always are calibrated to ensure banks pass them ( or else additional capital should be added by failed institutions). History shows that stress tests have a poor record at predicting financial crisis. I think many reasonable people would consider a large fall in Auckland house prices might challenge the stability of the financial system in NZ. It’s true that in some circumstances it might not but would you expect the Bank to bank on being that lucky? The spillovers to the rest of the country would potentially be great.

The Bank’s actions in this area are in step with the generally successful international experience with regional LVR type measures. I think that this alone makes it difficult to argue the Bank is acting in an ultra vires manner. The IMF’s advice in this area is that macro prudential measures can be employed assuming key macro policy settings are also supportive. Your stance on monetary policy settings thus seem further supportive of the Bank’s stance. Although I am sure that the government could be doing more to help as you point out.

I’ve always enjoyed debates with Kelly, and I thought it might be worth addressing a few of the points he makes:

  • The Reserve Bank Act (sec 68) requires that the regulatory powers in Part V of the Act be used (by the Governor General, the Minister, and the Bank, but here the Bank’s discretionary action is in focus) “for promoting the maintenance of a sound and efficient financial system”.  Note that it is not about “ensuring” such an outcome, and neither has a “sound” financial system ever been regarded as one in which no bank failed.
  • Kelly suggests that very little prudential regulation might be justified if stress tests were to be used a key indicator.  I don’t think that is right.  After all, the risks that the Reserve Bank and APRA assessed last year were those that existed given the current panoply of regulatory controls, including the earlier LVR restrictions.  In other words, some mix of market disciplines and regulatory measures had produced loan books which appeared to be pretty robust to some pretty severe shocks.  The issue here now is whether a case can be made, in terms of the Reserve Bank Act, for further, quite intrusive and quite unconventional, controls.   That case would have seemed much easier to make if the stress tests had produced results which appeared more threatening to the soundness of the financial system.
  • Kelly alludes to widespread scepticism about the use of stress tests by some regulatory and supervisory agencies.  It is certainly true that one would not expect a regulator to publish stress test results, particularly those undertaken in the midst of a financial crisis, suggesting that the financial system was in great danger without having first taken remedial action.    But context matters.  Clearly New Zealand and Australian banks are not in crisis now.  Moreover, the timing of the recent NZ stress test was determined by APRA, not by the Reserve Bank of New Zealand, and occurred at a time last year when, if anything, the Reserve Bank seemed to be looking at the possibility of winding back, or lifting, the avowedly “temporary” LVR restrictions.  When the results of the stress tests were published in the November 2014 FSR there was no hint of any undue concern about risky lending practices or region-specific controls.  In other words, even from outside, I think we can acquit the Reserve Bank of any suggestion that it undertook the stress tests with a particular end in mind.  Instead, they really wanted to assess the health of the New Zealand system, posed some deliberately searching test scenarios, and were pleasantly surprised by the results.
  • Stress tests aren’t the only possible measure of financial strength.  Indeed, in the day-to-day activity of prudential supervision they play a much less important role than regulatory capital requirements.  In fact, it is unease about the use of not-very-transparent, hard to evaluate, internal ratings-based models for calculating capital requirements that has encouraged many to put more weight on stress tests in recent years.   But in any case recall that New Zealand banks have high capital ratios by international standards, and that is so even when higher risk weights are applied to housing exposures than in is done by banks in many other advanced countries.
  • Kelly notes that “many reasonable people would consider a large fall in Auckland house prices might challenge the stability of the financial system in NZ”.  As a matter of description that is certainly true, but that is why, for example, stress tests are done and why, for example, Parliament mandated the publication of Financial Stability Reports. Those reports are supposed to enable us to better understand, and to assess, the risks and the Bank’s regulatory activities.   And I’m certainly not suggesting that New Zealand should rely on luck to get through an eventual house price adjustment (rather, high capital ratios, and slow growing balance sheets are what suggest pretty moderate risks)   Indeed, I was one of those who was a bit surprised when we saw the first stress test results.  I pushed and prodded, and wondered if they were missing something important.  Sunny optimism is not in my nature, but in the end I was persuaded.  There are no doubt some things the stress tests don’t fully capture –  the possibility of sustained deflation is one of those risks, but that can’t be the concern the Bank is relying on (since the word does not even appear in the FSR).  And frankly nor would I expect it to be at this stage.    It seems likely that the Governor does not really believe the stress tests, or the capital ratios.  There might well be a good reason for his doubts, but he owes it to us, and to Parliament (through FEC), to explain the nature of those doubts, and allow them to be scrutinised and challenged.  It isn’t enough –  given his Act –  simply to worry that Auckland prices are too high and might come down one day.   We particularly need to be able to scrutinise the Bank’s analysis given that it is a unelected single individual  –  with, frankly, not that much experience or background in these policy areas –  who is making these regulatory calls.
  • Finally, Kelly notes that “the Bank’s actions in this area are in step with the generally successful international experience with regional LVR type measures. I think that this alone makes it difficult to argue the Bank is acting in an ultra vires manner.”   There are at least two separate points here.  First, as a matter of law I’m not arguing that the Bank’s proposed new controls would necessarily be ultra vires.  Some others might.  I would argue simply that they are using the legislation for purposes Parliament never envisaged, which is not good for the legitimacy of policymaking, and that – at present – they have not met any sort of burden of proof regarding why such arbitrary restrictions on investment property lending (of the sort never before used in New Zealand, even under the Nash to Muldoon years) are either necessary or desirable to further enhance the soundness of the financial system, especially in face of the inevitable efficiency costs.  It is important to remember that whatever the preferences of the Governor, the Reserve Bank has been given powers by Parliament for the promotion of the “soundness and efficiency of the financial system”.  That is different from the mandates regulatory agencies in many other countries have.    Whatever other countries have done, the Reserve Bank must look primarily to its own legislation.   Second, Kelly suggests that Auckland-specific restrictions are in step with “generally successful international experience”.  I think that is wrong, at least in the sort of countries, market-based economies, and systems of government we typically like to compare ourselves with.  I’m not aware of regional-based banking regulatory controls in any of the other Anglo countries for example, or in the Nordic countries.

Perhaps all will become clear when the Reserve Bank releases its consultative document on the proposed new controls.  I certainly hope so.     But there is a lot to clarify.

The Reserve Bank stands by its stress tests

Michael Reddell Financial stability, Housing

Last Saturday I highlighted the Reserve Bank’s response, via Herald columnist Mary Holm, to a reader’s concern about the possible impact of a 50% fall in house prices.  A Bank spokeswoman, speaking prior to the release of the Financial Stability Report and of the Bank’s proposed restriction on banks lending to investor property borrowers in Auckland, had expressed confidence in the ability of the financial system to withstand such a shock.

While I was happy to highlight those comments, I had wondered (and had mentioned the possibility to a couple of people) if it was just a case of the left hand not knowing what the right hand was doing –  perhaps the Governor had not been aware of what someone in his PR department had been saying.   That doubt was reinforced after I was told that at the Finance and Expenditure Committee hearing on the FSR the Governor had refused to engage on, or respond directly to, a question about the stress tests.

However, in today’s Mary Holm column another Reserve Bank spokesman was commenting. He is quoted as saying:

“We repeat our comments from last week that the Reserve Bank was generally satisfied with how banks managed their way through the impacts of two adverse economic scenarios in the 2014 bank stress tests, which included a scenario similar to what your reader describes.

“We are comfortable that the New Zealand financial system is capable of withstanding a major adverse event, such as a collapse by up to 50 per cent of the Auckland housing market.”

That is good to know.  It is not just a statement about last year, when the stress tests were done, but about the risks banks have on their books now.

But it just reinforces the question as to what possible basis, under its Act, the Reserve Bank can have for proposing to ban banks from lending a singe cent to anyone, secured on an Auckland investment property, above 70 per cent of the value of that property.    The Bank is required to use its regulatory powers to promote the soundness and efficiency of the financial system.  Efficiency will inevitably be impaired by the proposed restriction, and the Reserve Bank has just told us today that the system can cope with a fall in house prices as large as has been seen anywhere.

The Reserve Bank told us its consultation document would be published later this month.  That now leaves only the coming week.  We should look forward, with considerable interest and some scepticism, to the case they will make.

More housing risks….in the US

Michael Reddell Housing

Last month I wrote about Peter Wallinson’s book Hidden in Plain Sight, about the role that Federal government interventions, and mandates, in the US housing finance market had played in the US housing credit boom of the late 90s and early 2000s.  Wallison argued, pretty persuasively to me, that it was these interventions that drove down credit quality and which meant that when house prices in the US fell, the losses to lenders were large – much larger than has typically been seen when house prices have fallen sharply in other countries.  Those losses in turn –  and the uncertainty around them –  was the catalyst for the US-centred financial crisis of 2007-09.

The US government has had a very large role in the housing finance market for decades now.  That has become quite unusual by the standards of advanced market economies.  Take New Zealand, by comparison.  In the early post-war decades, most first home buyers got a mortgage from the State Advances Corporation.  Indeed, the Monetary and Economic Council in their 1972 report on Monetary Policy and the Financial System reported that in 1965 just over 50 per cent of all outstanding mortgage debt advanced by financial institutions was held by the State Advances Corporation.

sac

That lending didn’t go bad for a variety of reasons –  overall debt levels were low (relative to GDP or household income), inflation increased, and credit rationing was pervasive (SAC dominated the market, but government policy was focused on administrative measures to restrain excess demand and so even SAC lending standards were not overly liberal).  By contrast, any government-provided or government-guaranteed mortgages in New Zealand now make up a derisory share of the market.  That has been the trend in most advanced economies in recent decades.  Housing debt is now initiated by private lenders, and while those lenders have at times made mistakes, or got over-exuberant, the losses on housing loans have not typically been large enough to threaten the health of the system.

The United States was different.  Not only did the government stay actively involved, but possibly in the worst possible way: mandating greater access to credit in a system where the private rewards from complying (and private costs from failing to comply) were very high.  State Advances Corporation managers did not have the sorts of bonuses and options at stake –  let alone the potential for merger approvals to be withheld –  that characterised the US.

But I’m not writing about this today simply to rake over history, but because in some respects the US government involvement in the housing finance market has just got worse since last decade’s crisis.  Around 80 per cent of all new residential mortgages initiated in the US now have a federal government guarantee.

This new short piece from Stephen Oliner, a former senior Fed official and now a fellow at the UCLA Ziman Center for Real Estate, outlines some of the facts and some of the risks.  (The FHA is the Federal Housing Administration, which accounts for a quarter of all government guaranteed mortgages.)   Oliner writes:

A few statistics about FHA loans are sufficient to dispel the myth that only pristine borrowers can get a mortgage. In recent months, the median credit score for borrowers who took out an FHA-guaranteed home purchase loan was 673. About two-thirds of all individuals in the U.S. have a higher credit score than that. FHA’s credit standards are loose as well for two other primary determinants of loan risk: the size of the down payment and the monthly payment burden. The median FHA borrower makes a down payment of less than five percent. If the borrower were to turn around and sell the home, the agent’s commission and other costs would exceed five percent. Hence, the median borrower is effectively underwater on day one. Second, many FHA-guaranteed loans have onerous monthly payments relative to the borrowers’ income. In fact, the payment-to-income ratio for more than four in ten FHA borrowers exceeds the ability-to-repay limit that was set in the recent Qualified Mortgage rule. This is a not a picture of tight credit.

The default rate on these FHA loans, while relatively low in today’s benign environment of solid job growth and rising home prices, would increase substantially in an ordinary recession and would skyrocket if we have another financial meltdown. To gauge the vulnerability of recently originated mortgage loans, AEI’s International Center on Housing Risk publishes every month the results of a rigorous stress test, the National Mortgage Risk Index (NMRI). The NMRI uses the default experience of loans originated in 2007 to estimate how recent loans would perform if hit with a shock akin to the 2008-09 financial crisis. The index shows that nearly 25 percent of recent FHA loan borrowers would default in that scenario. This would be exceptionally harmful, not just to the borrowers, but also to the neighborhoods in which they live and to the taxpayers who would have to make good on the FHA’s loan guarantees.

Note that well: the median FHA borrower –  and typical FHA borrowers have low credit scores –  has a down payment of less than 5 per cent.

The US systemic risks are not nearly as great as those in 2007.  The total stock of mortgage debt is growing much less rapidly, and so far most US housing markets seem less overheated.  But it is a reminder both of how hugely distorted the US housing finance market is, and a contrast to the sorts of housing finance markets we see in New Zealand, Australia, or the UK.  In those latter countries, private lenders make their own assessment of the riskiness of the loans they are making, and of the wider market.  And those private lenders have their own shareholders’ money primarily at stake.  The risks here are simply very different from those in the United States –  both pre-crisis, and now.  For that, we should be very grateful.  But we also need to recognise that it is not primarily a matter of grace, but of superior policy.  When governments stay out of markets things are  – generally – much less likely to go spectacularly wrong.

Some bigger picture thoughts prompted by Budget day

Michael Reddell Fiscal policy

Some further, slightly scattered, thoughts prompted by the Budget.

I can’t get excited about the question of which year a surplus is finally recorded.  Apart from anything else, the government’s interest costs include an inflation-adjustment component (medium-term inflation expectations are still around 1.85 per cent per annum).  That is effectively a repayment of principal, not an operating cost.  A modest deficit is consistent with inflation-adjusted balance or surplus.  And if one is content to have a positive target level of debt –  as those on both sides of politics seem to be –  then a small deficit each year is still consistent with a stable or falling ratio of debt to GDP.  We probably should be a little more worried about the continuing structural deficits, especially once an adjustment is made for the above-average terms of trade New Zealand has been experiencing.  High terms of trade should have made it easier than otherwise to get back to balance.   Then again, the Treasury appears to be quite optimistic about the future path of the terms of trade – let’s hope they are right.

When I went to Treasury for a couple of years, one of their more sage observers counselled me to focus on the core Crown residual cash balance (just like analysing a set of corporate accounts – look for the cash). That measure includes all the gains from the buoyant terms of trade, and the cycle peaks, and still doesn’t get to balance for another three years.

residual cash

Perhaps the more important question is how much debt should governments aim to have.  We like to think of New Zealand government debt as quite low.  Debt is often quoted as a ratio to GDP, but if we take government gross debt as a percentage of government revenue, that ratio is now around 130 per cent – not so different from the ratio of household debt to disposable incomes that often seems to trouble observers.  Net debt is certainly lower, but a considerable chunk of the financial assets are in the highly volatile New Zealand Superannuation Fund (which I have been meaning to write about).

gross debt

Looking at the tables in the last OECD Economic Outlook, six OECD countries currently have positive net government financial liabilities (Estonia, Finland, Korea, Luxembourg, Norway and Sweden).  Some argue for the government to run net assets, to counter the effects of the welfare system in deterring private savings.  Others could construct a case for a positive net debt, because of the significant real assets governments own (some of which are, arguably, productive).  Those effects go in opposite directions.  Personally, I’m not convinced there is a case for governments holding large net assets, but perhaps we should be looking at reframing the local debate, and aiming to see net government debt at least fluctuate around zero.    Shakespeare’s “neither a borrower nor a lender be” has some appeal as a medium fiscal strategy.  It won’t be a textbook public finance strategy, but those particular textbooks don’t give much weight to the failures, and weaknesses, of governments.  Aiming for something around zero would also mean citizens just didn’t have to worry about government debt, one way or the other.

As a strategy for normal times, I also quite like the longstanding Swedish fiscal rule, of aiming for a 1 per cent of GDP structural surplus (although I see that the current Swedish government is looking at scrapping it).  No one can do structural adjustments particularly accurately in real time, but a 1 per cent structural surplus target is a cautious pragmatic second best approach.  If you get it right, debt will be low when crises hit – and they eventually will.  But often enough you will misjudge your how structural your surplus is.  But if you think you are running a 1 per cent surplus, and it later turns out that it was in fact a structural deficit (if, say, potential GDP turns out to have been lower than was thought) you are most unlikely to be in major fiscal problems.  Getting back to balance from a 2 per cent structural deficit isn’t likely to be that hard, or that urgent.

And, on the other hand, aiming for no more than a 1 per cent structural surplus deliberately foreswears the over-optimism of those who believe that very large swings in structural fiscal balances can act as effective macro-stabilisers in boom times (ZLB periods might be different).  In fact, running up large surpluses in boom times – when no one knows how long booms will last –  just tends to set up an electoral auction.

The previous government in many ways deserves a lot of credit for keeping spending in check for their first six years, but the structural surplus in 2006 peaked at 4.7 per cent of GDP (OECD estimate). Those huge surpluses just set up an electoral auction in the 2005 election campaign.  No political party will ever want to be in the position of allowing their opposition to spend the surplus their way –  those choices, about priorities, are a large part of what politics is about.  And the large surpluses built up in the early 2000s didn’t even do much to ease pressure on monetary policy, because they were run up well before the peak pressures on resources (2005 to 2008).  Quite possibly, overall macroeconomic management in New Zealand over the last 15 years would have been a little better if piecemeal adjustments had been made throughout.  We’d never have got into a position where we had highly stimulatory discretionary fiscal policy in the period (2005-2007) of greatest pressure on resources (and on the exchange rate).  And it would also have avoided a situation where Treasury, applying its best professional judgement, finally determined only just before the great recession of 2008/09 that the revenue increases looked permanent.  A high stakes judgement that turned out to be quite wrong.  Fiscal institutions, and ambitions, need to take more serious account of the severe limits of anyone’s knowledge.  A Fiscal Council, as the New Zealand Initiative and the former director of the IMF’s Fiscal Affairs Department have recently called for, might explore some of these issues.  Or a Macroeconomic Council might?  Then again, our academics and think tanks might lead such debates,

In passing, it is worth noting that the Reserve Bank is always curiously reluctant to analyse sovereign debt risk in their FSRs, even though the New Zealand government would be by far the largest single-name credit exposure of any of the banks.  And the New Zealand government last defaulted on its debts some decades more recently than the last time a New Zealand bank defaulted on any of its debts.  In a through the cycle sense, how robust are the risk weights on domestic sovereign debt exposures?  I’m not suggesting that the New Zealand government is in any near-term danger of defaulting, but then neither are the banks – apart from anything else, the Bank’s stress tests told us so.  The Reserve Bank tends to assume that governments can always just increase taxes to pay their debts, or inflate it away, but the historical track record is that they don’t always do so.  Sovereign debt defaults are simply not that uncommon.  We’ve done it.  The US and UK have, and Reinhart and Rogoff reminded us of the rather long list of others.

But to return to the Budget, perhaps the saddest aspect is that there is no sign of any serious effort to turn around New Zealand’s decades of relative economic decline, or indeed to materially alter the state of affairs that sees 10 per cent of the working age population on welfare benefits.  Another year, another wasted opportunity.  There is a line in the Bible, “to whom much is given, from much shall be required”.  I doubt history will look that kindly on Key, Joyce and English, or Clark, Anderton, and Cullen –  stewards of our country’s affairs for the last 16 years between them. .  It is not that the macroeconomic stewardship has been that bad, under either government, but both seem to have been content to preside over whatever direction the ship is taking, rather than exercising effective and persuasive leadership to make of this country what it once was, and again could be.  The common line is ‘ah, but at least we avoided a financial crisis”, but to what advantage when our overall economic performance in recent years has been as bad as that of the United States, the country at the heart of the crisis, despite having had the best terms of trade in decades.

nz vs us

Jordan Williams does this better, but…

Michael Reddell Fiscal policy

The government’s Budget was delivered yesterday.  I’ll post a few more analytical thoughts later, but this post is just a few scattered observations on individual measures:

  • Another $10m for the SuperGold card public transport subsidies.  Really?
  • A new tax on international travel.  I wonder if the government looked at the possibility of levying these costs on, for example, the apple and kiwifruit industries, for whose benefit most of the biosecurity apparatus seems to exist?  Are those industries really economic?
  • Scrapping the $1000 sign-on bonus for Kiwisaver is a good move, and perhaps next year they could scrap the $500 tax credit, and then abolish the scheme altogether (as a statutory provision).  At present, there is no evidence that Kiwisaver has raised the national savings rate at all and for people with both Kiwisaver accounts and mortgages the effective after-tax returns on funds held in Kiwisaver accounts must be pretty low (mortgages are repaid out of after-tax earnings, and tax is paid on earnings on Kiwisaver funds).   A more thoroughgoing review of capital income taxation, with a view to lowering it, would be a better step.
  • Radio New Zealand often doesn’t find very sympathetic people for its interviews.  As I was making lunches for my children this morning, I heard a benefit recipient complaining that the $25 benefit increase would only pay for buying a couple of school lunches for his kids.  That didn’t sound quite right:  On the one hand, if he really isn’t giving his kids lunches now, the increase must surely make a considerable difference.  And on the other hand, I’m pretty sure that the total cost of my three kids’ school lunches for a week, home baking included, is less than $25.  Incidentally, the Dom-Post reports that the benefit increases are around 8 per cent.  That is not small – real GDP per capita has increased by only that much since June 2005.
  • And does the government really have its priorities right when we still fritter money away on a Retirement Commissioner, a Children’s Commissioner, a Ministry for Women, a Ministry of Tourism, and a Ministry of Pacific Island Affairs.  I could go on: why are we funding a Reserve Bank museum (in what would be prime Wellington café space) or a “state of the nation” report answering the question “Who are NZ’s ethnic communities?”  And that is before we ask more serious questions about $400 million more to Kiwirail, and lots more to UFB (to which I have a jaundiced view after asking a senior minister at a forum some years ago why there had been no cost-benefit analysis of government spending in this area, to which he responded that one was not necessary because he knew the answer).
  • One hopes (surely?) that the reference in a press release to “up to $52 million” to replace a wharf on the Chatham Islands was a typo.  Then again, we are giving away money to a spa operator in Rotorua, so perhaps not.

Dairy debt

Michael Reddell Dairy, Financial stability

I’ve had a couple of questions about risks around the dairy debt, and since the sector intrigues me – and my wife’s family has quite a few present or former dairy farmers – I dug around a little more.

The Reserve Bank publishes agricultural debt data monthly, but debt by agricultural sub-sector is only available annually, as at the end of each June.  Last June there was $34.5 billion of dairy farm debt.  In the year to the end of March 2015, agricultural debt grew by 6 per cent.  If that was representative of dairy, there will be around $36.5 billion of dairy farm debt by the end of this June.

As I noted last week, the rate at which new dairy debt has been taken on (and made available by lenders) has slowed markedly since around 2009.  Dairy debt grew at an average annual rate of 17 per cent from 2003 to 2009, and by around 4 per cent per annum in the six years since then.   Last week I showed the chart of dairy debt to total nominal GDP –  it rose sharply until 2009/10, and since then has fallen back a bit.

A commenter reasonably pointed out that nominal GDP (incomes of everyone in the country) doesn’t service dairy debt.  That is quite true –  although any aggregate debt ratios (except perhaps those involving government debt) have somewhat similar problems.  My household’s income isn’t servicing any mortgage debt either, and yet charts of household debt to GDP or to disposable income are quite common. And people who have debt are different, in a variety of ways, from people who don’t have debt.  For some purposes, these sorts of ratios are useful, but sometimes they can mislead.   Micro data are great when they are available –  and I commend the work the Reserve Bank has done in using the data that are available for dairy.  As everyone recognises, dairy debt is very unevenly distributed: plenty of farmers have no material debt at all, while others –  often the most aggressive and optimistic industry participants –  have huge amounts of debt.  A net $25 billion has been taken on in only 12 years.  Unsurprisingly, there were some nasty loan losses in the 2008/09 recesssion.

But sticking with aggregate measures, what about some other denominators?  This chart shows dairy debt as a percentage of annual dairy export receipts.

dairy2

The last observation is an estimate –  using the 6 per cent debt growth for the year to 2015, and assuming that the June quarter’s dairy export receipts bear the same relationship to the June quarter of 2014, as the March quarter of 2015 bore to the March quarter of 2014.  It will be wrong, but any error won’t materially affect the picture.  The stock of dairy debt this year will be just under 2.5 times the latest year’s dairy export receipts (industry sales, if you like).  Note that that is less than the average for the 12 years for which we have data.  That just reflects the fact that the fall in global commodity prices takes a while to feed into actual dairy export receipts.  On present trends –  including another fall in the GDT price yesterday – dairy receipts will fall a lot in the coming year, unless the exchange rate were to fall sharply.  But it is hard to envisage, at this stage, that the fall in dairy receipts will be enough to take the ratio of dairy debt to exports above the previous peak.  At a time when there was a lot of very new debt, reflecting exuberant attitudes among lenders and borrowers alike, that previous peak generated a nasty fall in rural land values, and some material losses for lenders, but no systemic threat.

Statistics New Zealand produces annual data on the GDP and gross output of the dairy sector.  Unfortunately, it is only available with a considerable lag.  Fortunately, dairy export data and dairy sector gross output data line up quite well.

dairy3

When the data are available, we will no doubt see that dairy sector gross output and GDP rose quite sharply over the last couple of years.  The year to March 2015 will no doubt be a record high (in as much as record levels of nominal variables mean very much).  And then it is likely to fall back.  But again, on international dairy prices as they stand now, and the exchange rate as it is, it seems unlikely that nominal gross output or GDP for the dairy sector will fall much below the previous peaks – $10 billion gross output, and $6 billion of GDP.  If so, again it is difficult to see where material banking system stresses could arise from –  even though it will no doubt see some more exits, and quite a bit of nervous hand-holding by the banks.

It is worth briefly reflecting on the $6 billion of dairy GDP.  That does mean that dairy farmers on average have $6 of debt for every $1 of GDP they generate –  and among the indebted farmers that ratio will be much much higher.   That would be much higher than the ratio of household sector debt to household sector income, but then much of the household debt is supporting consumption not production.

So what could go really wrong?  The usual story around dairy debt is that if New Zealand’s export commodity prices collapse then the exchange rate should also be expected to fall sharply, mitigating the adverse impact on New Zealand dollar prices, and probably on local rural land values too.  That hasn’t happened so far.  There are some obvious reasons, including the  Reserve Bank choice to hold policy interest rates above the level that was required to have kept inflation on target.  And weak as dairy prices are now, our overall terms of trade still don’t look likely to fall to any sort of historically low level this year.   But if global dairy prices don’t fall much further, and the exchange rate hangs around current levels, or falls, there isn’t likely to be any systemic threat arising from the dairy debt.  The nightmare scenario is one in which, for some reason, the exchange rate rises sharply from here, even as commodity prices stay weak.   One possible scenario we toyed with a couple of years ago was a very disruptive new euro-area crisis, in which somehow currencies like the NZD and AUD became seen as some sort of refuge in the storm.    It isn’t likely, but then tail risks matter.  The experience of 2008/09 also argues against it: then both the NZD and AUD fell very sharply as speculative risk appetite unwound, even though the crisis had nothing directly to do with our two economies. It would seem likely that, eg, a disorderly break-up of the euro would be at least as large a trigger for hunkering down, and a  quick flight to safety, that didn’t involve a surging NZD TWI.

I noted last week that deflation remained the biggest (if remote) medium-term threat to the stability of the New Zealand financial system, as its loan books are structured currently (debt ratios pretty flat, debt stocks growing slowly).   But the dairy sector debt should be relatively immune to that threat.  I think it is pretty common ground that if the OCR were ever cut to zero, or slightly negative, the NZD TWI would fall sharply,  The main attraction in holding NZD assets over the years has been yield pick-up, and when that vanished-  as it did in 2000, when the Fed funds rate briefly matched the OCR –  so does any strength in the NZ exchange rate.  Of course, during the Great Depression deflation did pose huge problems for New Zealand’s farm debt, but getting a downward adjustment in the exchange rate then was a much more difficult and political process.  The then Minister of Finance resigned in protest when the government finally imposed a devaluation –  these days if things went badly a sharp fall in the exchange rate would seem much more likely to be welcomed.

And, finally, one of the more sobering graphs I’ve seen in recent years ( there are many to choose from).  This is real agricultural sector GDP, which is available quarterly (albeit prone to considerable revisions), shown alongside total real GDP.

ag gdp

There is quite a bit of variability of course  – droughts etc  – and this is the whole agricultural sector, not just dairy, but over the 10 years or so that the terms of trade have been strong there has been almost no growth at all in real agricultural sector GDP.  Representatives of the manufacturing sector are prone to lament how manufacturing activity has been squeezed out, but actually even farm sector GDP has been tracking well below growth in total real GDP.   In some respects, things might be a little better than the picture suggests.  High dairy prices have encouraged greater use of more intensive production systems –  more irrigation and more supplementary feed.  Those inputs allow the production of more outputs, and the outputs can be sold for a higher price than previously.  In other words, more money might be being made in dairying, even if the real (constant price) value-added in the diary sector hasn’t changed much.  Ultimately it reflects the fact that there has not been much business investment taking place in recent years in response to the higher terms of trade – a very different picture from what was seen in Australia.  If commodity prices settle back at pre-boom levels that may be no bad thing[1] –  fewer wasted resources –  but if, as the optimists believe, the long-term prospects for global agriculture, and the sorts of products New Zealand produces in particular, are very good then it might end up looking like something of a last opportunity.   Daan Steenkamp wrote up some of this material at more length in a Reserve Bank Analytical Note last year.

Nasty financial crises usually follow fairly hard on the heels of periods of exuberance –  surging asset prices, surging credit stocks, downward revisions in credit standards, and so on.  In respect of dairy, all of those things were present in 2008, but they haven’t been in the last couple of years.  That suggests that the systemic risks associated with the high level of dairy debt are low.  Yes, an overhang of high debt stocks could still cause severe problems if a particularly unusual set of circumstances were to arise –  there is always a hypothetical shock which could, in the extreme, prove too much for an indebted industry – but that is simply to say that all business, in a competitive market economy, involves taking risk.  As consumers, we should not want it any other way.

[1] And the dairy component of the ANZ Commodity Price Index (expressed in USD terms) is now only around 10% higher in real terms than it was when the series began in 1986.

A letter of expectation to the Reserve Bank

Michael Reddell Uncategorized

In recent years a practice has grown up of government ministers writing to agencies (Crown entities and the like) in a “letter of expectation”.  These are formal documents, but they are not legally binding.  They do not replace, or in any way either reduce or extend the obligations of the agency concerned under either its own legislation, or under any relevant provisions of other legislation (eg the Public Finance Act or the State Sector Act).  But they can still play a useful role in setting out things that are particular priorities for ministers, and particularly aspects around the engagement of the agency with the minister concerned and the minister’s office.

For some time, the Minister of Finance has been sending an annual letter of expectation to the Reserve Bank.  I asked for copies of those the current Governor had received from the Minister of Finance  and –  after pretty well the full extent of the lawfully available time had been used, including extending the deadline by transferring the request from the Reserve Bank to the Minister of Finance –  I received copies in the mail the other day (the technology was a little surprising in this age of e-government, but still….).

The first thing to note is that letters of expectation to the Reserve Bank Governor are not routinely published.  A quick search suggests that those to many other government agencies are.  There are pros and cons to routine pro-active publication.  Do so, and any really sensitive points won’t be included in the letter, unless the minister concerned particularly wants to make a public point.  Then again, these are public agencies, and letters like these can affect the emphasis that agencies put on various aspects of their statutory powers and responsibilities.

These documents can be a bit of a grab bag.  Sometimes the minister himself really does have a point to make, about something in the relationship that isn’t working that well.  Sometimes the contents might just reflect a hobbyhorse issue of people in the relevant policy ministry (when I was at Treasury I made a few comments on draft letters of expectation to the then Reserve Bank Governor).   And a letter of a couple of pages can’t capture everything about the dynamic of an ongoing relationship.  But the letters do go out under the signature of the minister, in this case a long-serving senior minister, and the contents should tell us something interesting about what Bill English is looking for from the Reserve Bank.  The Reserve Bank is an interesting mix – an institution with a very high degree of operational independence in most of its function, but with some key powers reserved to the Minister of Finance.

Graeme Wheeler has received three letters of expectation from Bill English since becoming Governor.  The most recent was sent on 2 March 2015.  A copy of it is here:

letter of expectations

A few things struck me as interesting:

  • The focus is almost entirely on the regulatory functions of the Reserve Bank.  One senses that these must be where the pressure points in the relationship have been  –  around advance consultation and around the analysis underpinning regulatory and legislative proposals.
  • No questions at all are raised about the way that inflation has consistently undershot the midpoint of the inflation target range, even though the target is a formal agreement between the Minister and the Governor, in which the Governor has the operational freedom to adjust policy to meet the target, but the Minister has the prime responsibility for setting the target, and holding the Governor to account for his performance in achieving it.  I was a bit surprised by this omission.  It may reflect some sense, whether in the Minister’s office or in Treasury, that the Minister should avoid being seen putting pressure on the Governor in respect of specific OCR decisions.  That is fine, but the Minister is responsible for how the Governor exercises his considerable powers in this area, and the surprisingly weak inflation has now been around for a long time.  And there was that curious comment in the newspaper a few weeks ago about the Minister’s apparent concerns.
  • The Minister is formally asking the Bank to supply him with advance information on any significant institution regulated by the Reserve Bank “that faces a material risk of financial difficulty”.  At one level, one can understand this request – ministers don’t like being surprised –  but the administration of prudential policy is typically put at arms-length from ministers for good reason.  In many countries (perhaps especially less developed ones), ministers (and their friends and donors) have been too close to major financial sector participants.  Knowing that an institution is at risk –  because sensitive information about its finances has been disclosed to the Minister – does not give the Minister power to intervene, but it does increase the risk of political pressure being brought to bear on the Bank in respect of how it handles an institution in difficulty.    There are no easy answers to where the line should be drawn, but this feels like one of those situations where what is written down goes a little far.
  • 2015 is the first time that the letter of expectation has been copied, formally at least, to the Chair of Reserve Bank’s Board of Directors.  The Board exists largely as the monitoring agent for the Minister of Finance, and it must be helpful for them to have formally the document recording the Minister’s expectations of the Governor.
  • In the last two letters the Minister has noted that “I also look forward to the Reserve Bank’s analytical contributions to deepen our understanding of New Zealand’s economic performance and macroeconomic imbalances”.  Perhaps this is now meant largely as a ritual incantation.   There has been little sign of such analysis in the last couple of years and given the Bank’s apparently much tighter funding constraints (in the forthcoming Funding Agreement) it may not be realistic to expect that they will have the resources to make much contribution in this area.
  • In each of the three letters, the Minister has highlighted his desire to reduce the contingent fiscal risks associated with the banking sector.  He notes the existence of the OBR tool but wants to better understand “opportunities to reduce these risks further”.  At one level, that prompts a reaction of “just say no”.  Ministers, not central banks, make the choices in which banking failures become direct fiscal risks.    But there is also a balance here.  Even under OBR, it is generally accepted that for the tool to work the non-written-down component of the failed bank’s liabilities will need to be government guaranteed.  Many (including me) would argue that, in most circumstances, when a major bank failed the liabilities of the other banks would also need to be guaranteed.  Eliminating fiscal risks associated with bank failure –  or even reducing them much further from the already very low levels (see the Bank’s work on the implications of Basle III) –  would require either a rock solid political determination to let a failed bank fail (and either close, or be taken over quickly)  –  unlikely ever to be a time-consistent strategy –  or even higher  minimum capital requirements.  I think that, at current capital levels, the Modigliani-Miller proposition would hold, and higher capital requirements would not raise overall bank cost of capital.  But I’m sure the banks wouldn’t see it that way.  The Reserve Bank itself can’t quite make up its mind what it believes on that score, but I can imagine a great deal of lobbying of ministers (here and in Australia) if the Reserve Bank were to respond by looking to materially raise required capital ratios.

It was interesting to have the material.  It does add a little to our ability to understand the Reserve Bank and its relationships with the Minister (and Treasury).  Perhaps they could at least consider routine publication in future, as part of enhancing the transparency of the Reserve Bank.

(If anyone does want the letters from 2013 and 2014 they can email me.)

Some overnight reading

Michael Reddell Earthquakes, Monetary policy, zero lower bound

Last week I wrote up some thoughts on negative nominal interest rates, and how important it is that finance ministers and central banks start treating as a matter of urgency the elimination of the regulatory constraints and practises that make it impossible for policy interest rates to go materially negative.  If they won’t, they need to raise inflation targets, but that would be a distinctly inferior option.

In that light, it was encouraging to read the blog of Miles Kimball –  one of key academic proponents of action in this area – and learn that he was talking overnight on exactly that topic at the annual central bank chief economists’ workshop hosted by the Bank of England.  The annual BOE meeting is an important and interesting forum (I got to go once) and typically John McDermott, chief economist at the Reserve Bank, attends.  The link to Kimball’s slides (“18 misconceptions about eliminating the zero lower bound”) is here.

I don’t agree with everything in Kimball’s presentation.  In particular I still think he puts too much weight on government providing the answer, rather than just getting out of the way and providing greater scope for market innovation. But then there is (or should be) a much greater urgency to addressing the issue in most of the rest of the advanced world, where policy interest rates have now been stuck at or near zero for a depressing number of years now.

The obstacles to negative nominal interest rates have been around as long as banknotes, but haven’t mattered very much in the past  –  after all, despite the occasional peripheral discussions and local experiments during the Great Depression, there was then a mechanism to generate recovery –  breaking the link to gold.  That option isn’t available this time.  Kimball rightly compares creating the ability to take nominal interest rates materially negative to breaking off gold in the 1930s.

In countries where interest rates have not yet hit zero, such as New Zealand and Australia, the Minister of Finance (who controls the gateway to taking legislation to Parliament), the Treasury (as chief economic adviser to the governments), and the Reserve Bank (as, in essence, implementation agents –  and to some extent the institution that benefits from the current system) need to be planning now to ensure that these old restrictions don’t impede the ability of our countries to cope with the next severe downturn.  This isn’t just something of academic or obscurantist interest – it is about unshackling one limb of macroeconomic policy so that it is ready when it is needed.  And as I’ve noted before, at 3.5 per cent our OCR is less high now than most of policy rates were in 2007 in those countries now stuck with the near-zero lower bound constraint.

And two other brief items:

I drew attention some weeks ago to the work Ian Harrison had been doing on earthquake strengthening requirements, an area of policy which appeared to have the makings of another government “blunder”.   A group Ian is associated with called EBSS (Evidence Based Seismic Strengthening) now has a website, and it includes a brief critique of the government’s revised proposals in this area announced earlier this month.  Those changes seem to amount to a step forward, in reducing the extremely heavy cost burden that the government had planned to impose on building owners, to mitigate extremely low probability and low cost risks.

However, as the EBSS paper notes, the new proposals still seem a long way short of ideal.  Now that I’m based at home I’m often down in the Island Bay shopping centre.  Many of the older buildings there –  including one housing the excellent and popular butcher –  are yellow-stickered, but I neither notice among other people, nor feel any myself,  any unease in using them.  Sometimes I wonder if that is just a short-sighted perspective, oblivious to the risks, but that is where numbers help.  This quote from the EBSS paper caught my eye.

As a point of comparison, flying has similar characteristics to earthquakes. There is a very small chance that there will be a catastrophic event that results in death. The chance of being killed, per hour, when flying is 4000 times greater than being in a typical Auckland ‘earthquake prone’ building. For New Plymouth buildings it is about 600 times greater, and for Wellington 20 times.

We fly because we know that flying is very safe. But the Auckland, New Plymouth and Wellington buildings will be shunned because they will be falsely identified as ‘high risk’ when there is overwhelming evidence that they are not.

And finally China. I must have missed the reports of the recent Chinese government instruction to banks that they must keep lending on local authority projects even if those local authorities can meet neither interest nor principal commitments on existing debt.  Christopher Balding has an excellent summary of what an edict like that seems to mean.  As he puts it “the Chinese bailout is starting to bail fast”.

High house prices: a blunder of our governments

Michael Reddell Uncategorized

That was the title of an address I did to a group of several hundred investment management professionals in Auckland this morning.  The organisers wanted snappy titles: mine was inspired by the book, The Blunders of our Governments that I wrote about a few weeks ago.

The essence of my story is in this summary I gave them for the programme.

High and rising house prices in Auckland hog the headlines.  The tax regime and bank lending practices are largely irrelevant to what has gone on.   Instead, increasingly unaffordable house and land prices result from the collision of two, no doubt individually well-intentioned, sets of policies.  Tight restrictions on land use crimp the supply of the sort of properties most people want to live in, while very high target levels of non-citizen inward migration persistently boost demand for housing.  One or other policy might make sense, but together they represent a blunder that is enormously costly to the younger generation of Aucklanders.

I only had 20 minutes to speak, but a fuller version of my story, with a few more of i’s dotted and t’s crossed, is here.

High house prices a blunder of our governments

In a slightly intimidating approach (at least for the speaker), each presentation was rated electronically by each member of the audience as soon as it ended.  93 per cent of the audience claimed to “largely agree” with my story.  I’m sure that won’t be the general reaction, and as ever I’m interested in thoughtful comments etc.

A new housing tax proposal

Michael Reddell Uncategorized

I’m a bit pushed for time today, so just a fairly quick post on the latest housing “patent remedy”.

I was quite critical last week of the Reserve Bank’s latest proposed regulatory intervention in the housing finance market.  I noted that

The Auckland housing situation (a social and political scandal, as I’ve said before) calls for careful diagnosis, informed by experience and insights from the rest of the country, and remedies that deal effectively with the underlying issues and causes.

The Government’s proposed new  tax measure –  a brightline test in which gains on (almost) any sale of a non-owner-occupied house held for less than two years will be liable for income tax at the seller’s usual marginal tax rate-  doesn’t seem to fit the bill much better than the Reserve Bank’s new intervention.  It is also unrelated to the basic causes of the problem – laws and regulatory practices that impede the responsiveness of new supply, while at the same time other policy instruments actively drive rapid population growth in Auckland.  (Taking a medium-term perspective, almost anything else is largely irrelevant.)  It will be interesting to see what Treasury’s advice on the proposal was –  they have long-favoured a capital gains tax, but it would be surprising if they thought this was either good tax policy, or something well-targeted at the housing market issues[1].

Last week’s Reserve Bank announcement drew editorials praising the fact that someone, anyone, was doing something, anything.  There doesn’t seem to be anything similar this morning, but perhaps that is the nature of politics.

In fact, relative to the Reserve Bank’s announcement, there are some things to be said for the government’s announcement.

  • Neither announcement has an electoral mandate – and it is only eight months since the General Election –  but at least the latest announcement was made by Ministers, who are elected members of Parliament.  The public can oust MPs, and as Australia illustrates leaders (and ministers) serve only at the pleasure of governing party caucuses.
  • Whereas it is virtually impossible to mount a credible argument that not a cent can safely be lent, at any interest rate, to Auckland investor property purchasers at LVRs over 70 per cent, at least the two year bright-line test can defended as reducing the weight the tax system places on establishing intent.  Taxes should be levied based on actions (or even assets), not on highly intrusive bureaucratic assessments of intent.
  • The government’s announcement yesterday will require legislation, and media report that there will be Select Committee scrutiny.   Elected representatives will scrutinise the proposal, and the media will report on the process.  Contrast that with the Reserve Bank’s proposal, which will be shoehorned in under legislative provisions that were never intended for the purpose.  Submissions will be invited, but (unlike Select Committee submissions) we will see those submissions only after the final decisions have been made, and the unelected Governor will be judge and jury in his own case.  Yes, it is probably lawful, but it lacks some legitimacy.

But in addition to being ill-targeted, yesterday’s announcement looks as though it will add to the pro-cyclicality of government revenue.  In other words, more revenue will flow into the government’s coffer at the peaks of booms (when it shouldn’t need extra revenue) only for that source to dry up when downturns happen.  Pro-cyclical discretionary fiscal policy is something to avoid as far as possible –  see, for example, Anne-Marie Brook’s work –  and this change will only (slightly) worsen the problem.  On a much larger scale, this issue was a major problem in Ireland.

I’m not close enough to tax administration to know quite how this will work if house prices ever fall sharply, but if people can offset losses on a house sale against other income, it would be quite an incentive to realise one’s loss quickly (inside the two year window when one can avoid the intent test), potentially exacerbating the speed of a correction.  So in a severe housing downturn, will the government be writing cheques to housing investors who’ve punted and lost?  Even if losses can only be carried forward to be offset against any future gains, the procyclicality of revenue will increase and the risk of more procylical discretionary policy will rise.

Capital income is generally overtaxed.  That said, I’m not resolutely opposed to a theoretically pure capital gains tax.  With efficient asset market pricing, there are no rationally expected real capital gains.  Any actual gains and losses (of which there will be many) are then just windfalls.  One can treat them as taxable income/losses or not, and it is mostly just a distributional issue with no very material efficiency implications.  But that assumes:

  • All assets are subject to tax (not some assets, held by some types of people)
  • Gains and losses are treated symmetrically
  • Only inflation-adjusted capital gains (losses) are taxed
  • The CGT applies based on changes in market values, not realisations

I’m not aware of a single capital gains tax anywhere, ever,  that has met those tests.  Real world CGTs are distortionary in a whole variety of ways, including discouraging turnover and encouraging assets to be held not by those who can most efficiently hold and manage them, but by those who are at least risk of having to trigger a transaction.  Big investment funds might never need to trade a property, but an individual small business operator (eg a family with a single investment property) can face many possible changes in life circumstances which could compel a sale – including, but not limited to, redundancy or job relocation.  The PIE regime already started to skew the ground against individual holders of investment properties, and this measure will skew it a bit further.

In the end, yesterday’s announcement looks a lot like political theatre.  As ministers, and the Reserve Bank, have rightly noted previously, CGTs don’t change the character of house price cycles, and attenuated ones like this are even less likely to.  Some will feel better that “something is being done”, but it will just divert attention, and policy and legislative time, away from measures that grapple with the real issues.  My first reaction yesterday when I heard the announcement was to think of the Third Labour Government’s Property Speculation Tax in 1973, introduced at the height of an earlier house price boom.   We had a look at it when we did the Supplementary Stabilisation Instruments Report in 2005/06.  It also made good political theatre, distracting from the real issues.   Every asset price boom is a little bit different.  But like this proposal the Property Speculation Tax attacked symptoms and was largely irrelevant to ending the 1970s house price boom (which was followed by a multi-year very deep fall in real house prices).  Marked changes in immigration policy, and a collapse in the terms of trade which helped prompt an exodus of New Zealanders to Australia, had much more to do with that.  House prices are influenced by a whole variety of factors, but Auckland prices are only likely to fall very much very sustainably if there is some combination of a far-reaching freeing up of restrictions that impede supply and an end to the policy-fuelled population pressures.

UPDATE:  This article is interesting in light of the Reserve Bank’s response to my OIA last week in which the Bank confirmed that it had done no substantive analysis of capital gains taxes, and had provided no advice on such issues to a variety of ministers or agencies.  Since I inadvertently omitted the Prime Minister from the list, it is possible they may have given such advice directly to him, but it would be surprising then that nothing had been provided to Treasury (or IRD).

[1] The brightline test idea has been around for a while.  I found that it was referred to in the Supplementary Stabilisation Instruments Report the Reserve Bank and Treasury prepared at the request of the then Minister of Finance in 2006.