The international situation has improved recently, firstly as a result of the announcement of the US Treasury package to remove toxic assets from the balance sheets of the largest American banks and, secondly by the G20 agreement to abstain from policies prejudicial to world trade. There is a growing sentiment that the world economy may be on the mend.

While we agree that progress has been made, our own view is that there is a lot further to go before conditions return to anything akin to normal. In the meantime businesses should adjust to a long subdued period; as financial system balance sheets are restored to health, as bankers recover from the traumatic experiences of doing so, and only then, return to a reasonable degree of optimism. Fortunately, authorities today have the thirties depression as a guide so it would be a mistake to assume it will take as long. Even so, it would equally be a mistake to assume the period will be short.

However, the straws in the wind in New Zealand are not good. Firstly, our authorities are too sanguine as to the seriousness of the problem. Secondly, the state of the banks’ balance sheets is not improving; the aggregate capital ratio remains under 5 percent, which is unheard of in post-war New Zealand. Thirdly, latest figures for private sector lending show it has contracted absolutely in each of the most recent months, December to February. This is also virtually unheard of.

The plus side of all this is that the causal factor, namely the tightness of foreign funding, has depreciated the NZ$ and established the pre-condition for restructuring economic activity away from the non-tradable and towards the tradable sector.

The situation can evolve in three ways. The first is that classic depression conditions will emerge as credit continues to be tight while official intervention remains minimal. The second is that official efforts to restore the inflow of bank funding will succeed, leading to a return to the previous, albeit unsustainable, situation. The third is that authorities stabilize the NZ$ at a rate consistent with growth and sustainable Balance of Payments (say 50 on the TWI), and intervene to maintain full employment during the transition period as market forces bring about the restructuring from non-tradable to tradable industries.

The second is probably the most palatable in the short run, but the third is what is needed to return NZ to sustainable growth. Probably we shall get a bit of all three but hopefully much of the third will be achieved.

As to the immediate future, the next event is the revision of the Reserve Bank’s OCR on April 30. The Reserve Bank of Australia reduced its OCR from 3.25 percent to 3.0 percent on April 7 and the question is whether the RBNZ will do likewise. Our view remains that it will move in line with previous hints of 25 point reductions on the way to an eventual floor of to 2.0 percent. Consequently, this month’s announcement is likely to take the OCR to 2.75 percent.

This expectation is consistent with a recent decline in the 90-day wholesale rate to about 3.0 percent. However, other market signals – namely a rising ten-year bond rate from 4 percent to 5.3 percent and a strengthening NZ$ from 50 to 58 on the TWI – could suggest otherwise. Or they could simply reflect that the long-term bond and foreign exchange markets are affected mostly by overseas, rather than local, factors.

- reprinted from BERL Monthly Monitor April 09