In its just-released six-monthly Financial Stability Report, the Reserve Bank (RB) provides a comprehensive review of the New Zealand financial system and the problems besetting it from the global credit crisis. The picture emerging from the analysis confirms BERL’s concerns that the currently tight credit situation is unlikely to improve in the near future. In particular, it is likely that foreign funding of New Zealand credit expansion will remain scarce and expensive.

Another problem is the likely further decline in asset prices exacerbating the situation as further damage is done to financial sector balance sheets. While the RB is confident New Zealand will be less badly affected than most economies, it does not under-estimate the likelihood of significant further contraction before full recovery is achieved.

It may be for this reason that the RB not only reduced its OCR by 50 points to 2.50 percent at its review on April 30, but more importantly, it indicated a virtual ceiling at or below this level until the latter part of 2010. This action removed an element of upside risk of the RB returning to an inflation-fighting stance. This, in turn, should eventually have a downward influence on the TWI. However, the response was a gradual strengthening of the NZ$ to 59 on the TWI and 61 US cents, but as we go to press it has eased back to 57 on the TWI and about 59 US cents. Clearly, the all-knowing markets are having difficulty receiving the right message.

The main unknown in this situation now is the Budget on May 28. The Budget is expected to be fairly conservative, and as such likely to be welcomed in overseas financial circles, thereby ensuring continued availability of foreign funding for the banks. On the other hand, too tight a budget would lead to further contraction of the economy with consequential asset price declines and increases in debt default at a later date. Without doubt, it will be difficult to get the balance just right.

As to interest rates, the 90-day rate declined sharply to the 2.8 percent level but is now at 2.9 percent, apparently uncertain whether the next Statement on 11 June will contain a further OCR cut or not.

As the chart shows though, lower OCR and lower wholesale rates have only partially been passed on to those at the retail level. As widely reported, floating mortgage rates have declined slightly, but they remain on average close to 6.5 percent. Short-term fixed rates have fallen further, and are now at historically low levels. As is to be expected in a risk averse climate, longer-term fixed rates are now noticeably higher than floating rates. This is likely to remain the case for a while, with the primary issue being whether floating rates do actually heed the RB’s calls and decline further.

Of arguably more importance are the interest rates faced by small businesses. The relevant base lending rate has remained stuck in double-digits. While admittedly riskier lending, the growing premium being imposed on small businesses reinforces just how uninterested most banks are in participating in New Zealand’s small business sector.

 - reprinted from BERL Monthly Monitor, May 2009