The RBNZ’s 50 points reduction in its Official Cash Rate (OCR) to 3.0% this month was at the lower end of expectations and in line with indications in its Review in January. It was not in line, however, with the indications in general that the credit crunch was worse than previously believed and not in line with the data contained in its own accompanying Monetary Policy Statement.

Not only have the Federal Reserve and the Bank of England reduced their benchmark rates to virtually zero but they have also emphasised that the credit crunch is so serious that “quantitative easing” – or “printing money” - is also required. Judging from the tone of a recent address by Prime Minister Kevin Rudd, Australian government authorities are likewise concerned, although maybe not the RBA.

In contrast, New Zealand’s Prime Minister John Key has indicated in an interview with the Wall Street Journal that his government’s intention is to help business improve efficiency and competitiveness. However, it is his government’s intention to intervene sparingly and concentrate on reducing the deficit left by its predecessor.

The equanimity of the RBNZ and the New Zealand government appears to be based on the twin beliefs that our financial system will be not much affected by the crunch and that the efforts of major economies to cure the international problem will bail us out. Hopefully they will be right.

However, we find little on which to base such hope. We note that in the five year run up to the commencement of the crunch, the New Zealand financial system engaged in credit expansion at nearly 50% above traditional rates, mostly in the form of mortgage debt. In the absence of such stimulus, expectations of quick capital gain no longer apply and property prices, interest rates and rentals must reach a new equilibrium. This new equilibrium will be where debt servicing and other ownership costs are more in line with cash flow returns. This requires a fall in prices of, maybe, another 20%. With banks’ capital ratios under 5% (as noted in our February Monthly Monitor), we believe such a fall in property values creates an asset impairment risk that cannot be ignored. Hence credit will be extremely tight for the foreseeable future.

Interest Rates

In line with the OCR having been reduced from 5% when we went to press last time to the current 3%, the 90 day wholesale rate has followed from 5.38% to 3.33%. Over the period, the 10 year bond rate has fluctuated considerably but as we go to press it is virtually unchanged at 4.8%. We now have a positive yield curve, the first time since the RBNZ, in April 2004, began raising its OCR in its futile attempt to reduce inflation by raising the cost of borrowing.

Retail interest rates have declined significantly in respect to deposits and floating mortgages but base lending rates and fixed rate mortgages have declined very little. This should not be surprising in view of a lack of competitiveness between major banks, they need to not only cover the costs associated with foreign funding but maintain profits at a time when their capital ratios, as discussed above, are in no condition to bear losses. It is disingenuous for RB officials to be upbraiding them for not following the OCR down, just as it was naïve to expect them to meekly follow it up when the RB was attempting to choke off excessive demand.

Looking ahead, we accept the RBNZ’s signal that there will be small cuts in the OCR to a floor of 2%, which means very little effective change in retail rates to business. We are sceptical of the hopes that retail rates will come down more rapidly in some form of catch-up process.

Exchange rates

During the past three months the NZ$ has fluctuated in the 51-59 range on the TWI and finished very little changed at 53 compared with 54 at the time we went to press last issue. Individual currency variations were pretty much within the random error range with the exception of the US$ which appreciated by about 6%.

Important determinants of rates at present are to do with international capital flows being much reduced or even reversed as previous purveyors now succumb to the credit crunch. Thus previous beneficiaries of the excessively liquid markets, notably New Zealand, Britain, Australia and South Korea, are now experiencing the suppliers of credit being short of funds or, even repatriating their investments in order to fill liquidity shortages at home.

While this situation persists, the NZ$ is likely to drift gently downwards until the BOP deficit is largely eliminated by a reduced level of imports and an increased level of exports. On past experience, the present rate looks about right for long-term equilibrium but we still expect “overshooting” and, of course, there are all the other factors, especially concerning the US$, that will be influencing the overall structure of rates.

We retain our previous forecasts of a trough of 45 on the TWI, returning to about 50 – but, with even more emphasis on the usual caveats.

- reprinted from BERL Forecasts March 2009