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Friday, 27 February 2009

Bollard speech to Job Summit

Business is being much more cautious. There is no doubting the size of the shock that is at work in the global economy

Some are saying we are witnessing the biggest destruction of wealth we have ever seen.

A lot of public attention has been focused on the losses flowing out of the sub-prime crisis and flow-on disruption to the financial sector – the IMF estimate these will eventually amount to about $US 2.2 trillion. Some estimate the losses to be even bigger.

But this pales when put against the loss in wealth coming from declining equity and house prices, which already amount to many multiples of the direct losses coming out of the financial sector.

This destruction of wealth is having an inevitable impact on growth. The IMF’s January update estimates a cumulative loss of output relative to potential of about 5% of GDP – around $US 3 trillion.

In response to this shock we are also seeing massive government policy moves. There have been huge coordinated cuts in monetary policy, and a rise in government spending bigger than in any other previous crisis except World War II.

Comparisons of the present world recession to previous recessions, and even to the Great Depression of the 1930s, are rife. To be clear, the state of the global economy and the outlook are very serious, but we are nowhere near Depression-level economic condition.

In world growth terms we are somewhat below the early 1980s recession – that is, significantly worse than the growth troughs in the early 1990s and early 2000s. Unemployment rates will certainly continue to rise, but peak well short of the levels reached in the Depression. Then, unemployment rates rose well above 20 percent in many cases.

Global growth slowed very sharply at the end of last year, surprising governments and forecasters around the world. This is the sharpest contraction we have seen, as the financial crisis hit heavily into economic activity.

In trading partner terms, output contracted in the second half of 2008, and by much more than was experienced during the Asian Crisis or other previous downturns.
Our latest forecast is for trading partner growth to fall in the current quarter by nearly as much as it did in the December quarter. Taken together, this six month period will be the poorest period for the global economy in many decades.

In the medium term the world must adjust to a new global balance. In broad terms this means that Western Anglo economies are going to have to save more, reduce household deficits, build exports and improve their external balances.

Emerging market economies have seen a big challenge to their strategies of low currency – export-led growth with large reserve build-ups, and they will need to increase domestic consumption growth.

There are short-term pressures that will make this rebalancing even more difficult, particularly the build-up of government fiscal deficits. Some important factors count in New Zealand’s favour.

The economy grew strongly in the 10 years to 2007 - inflation was largely in 1 to 3% target band; giving rise to low unemployment, and a strong fiscal position. However, we had a housing boom over 2003-06 and very low household savings.

We have good institutions. We score highly on measures of ease of doing business, and measures of corruption/transparency. We have flexible labour markets and a a macro framework (notwithstanding the domestic debate we have experienced over recent years) that’s assessed as world best practice.

New Zealand’s freely floating exchange rate is an important buffer against the current, internationally sourced, shock. The downturn in international commodity prices, as well as international investor risk aversion and the contraction of liquidity in the global financial system, have led the value of the New Zealand dollar to fall against all the major currencies.

Not only does currency depreciation cushion the incomes of sectors exporting goods and services priced in foreign currency, it also acts powerfully and in the right direction to encourage the reduction of national debt and re-balancing of sectoral demand that is needed in New Zealand, as a deficit-running country. As a small, open economy with flexible product and labour markets, we should be better positioned than many others to re-orient production and income generation in response.

Also, our established track record for transparency in our regulatory institutions, sound management of the public accounts, and forward-looking monetary policy are well-regarded internationally.

Finally, our banking sector remains sound. The parts of the US and European capital markets that have been most damaged are investment banking, hedge funds, private equity, sovereign wealth funds, and stock, bond and derivatives markets. New Zealand’s direct exposure to these parts of the international capital markets, and to complex derivatives or structured credit products, is very light.

Our banking system is well-capitalised, plain vanilla, and mortgage lending is generally on good credit quality. The large Australian banking groups, of which the major New Zealand banks are a part, are now among the largest and highest-credit-quality banks in the world. Australian parents of the big 4 banks are some of the best-rated in the world (4 of the remaining 13 AAs and in the top 20 biggest).
Some of our trading partners GDP are forecast to fall around 5% in the current recession (but ours by rather less).

The shock varies a lot but is worse in countries with infected financial systems, steep housing falls and export-focused manufacturing sectors. However, the economy does have a number of imbalances that cannot go on forever and as a result there are challenges ahead.

Many of these stem from the very rapid increases in debt across household, farm and corporate sector that occurred over the past few years, financed from offshore.
House and farm prices are still at elevated levels, and the economy has a heavy dependence on bank-intermediated debt.

In aggregate we have built up a large external debt that does constrain some of our policy options going forward. This was illustrated only a few weeks ago when the rating agency Standard & Poors highlighted the constraints on fiscal policy.
While the New Zealand economy entered recession earlier than many countries, partly because of last year’s drought, to date it has been quite mild by both international and historical standards.

If the Treasury’s December Economic and Fiscal Update downside scenario were to eventuate we would be doing relatively well. This sees unemployment rise to around 7%, very unpleasant but not bad by international or historical standards.

Based on more recent data we think there are downside risks to the this picture over the short term and it is likely the economy did step down another notch in the December quarter. Bank lending as shown in these annual percent change credit growth data has slowed recently. This has been apparent for some time as far as households go, reflecting the end of the housing boom in 2007, and precautionary decisions by households.

The slowdown in business lending has been much more recent, while lending to agriculture is actually expanding. It would be wrong to attribute this recent slowing to credit supply. There has also been a fall-off in demand, despite falling interest rates.

Business is being much more cautious. They have scaled back their investment and employment plans. This is natural given some of the huge uncertainties that are present. However, we should also be watchful for the opportunities, and mindful of the risks of defeatism.

Within the Western world, New Zealand’s economy and financial system are relatively well-placed to weather the adjustment. Our challenge will be to remain well-positioned to take advantage of the economic recovery when it arrives – possibly suddenly and strongly, which has been New Zealand’s experience in the past. Households and firms should not pull down the shutters, and banks should continue to lend on sound business propositions.

We are in the middle of a major international shock that is spreading from financial institutions to economic recession. New Zealand does not have the banking or fiscal distortion that some major economics have. We have already put in place monetary and fiscal policies that, while they can’t insulate us, are ensuring the recession is felt much less than otherwise.

But a major shock exposes vulnerabilities: in our case the household dis-saving/current account imbalances/offshore bank funding vulnerabilities.
Australia and New Zealand have shown some resilience, but the international situation is now affecting us through credit and trade channels. Households have reacted conservatively, already increasing precautionary saving by reducing spending.
Businesses are impacted in different ways. Most are operating with caution, but have not put up the shutters. The RBNZ for its part will ensure that monetary policy is appropriately stimulatory, that there is appropriate domestic liquidity available to banks, that we remain ready further to changing financial circumstances, that our actions are co-ordinated with other government moves to promote stability for New Zealand.

The banks also have a key role in assisting the New Zealand economy. They face a big challenge operating at his time of fragile international markets, and it is completely appropriate that they should now be very conservative. However, they have profited from good times in this economy, and we expect them to be there for the tough times too.

That means they need to:

Keep seeking international funding (as has happened in Australia) and parent support
Use the support mechanisms put in place by the New Zealand government
Keep passing on wholesale interest rate cuts
Keep lending on sensible proposals
Avoid onerous conditions on lending that have the same effect as a credit crunch.
This summit is the opportunity for banks to restate their commitment to New Zealand’s economic health.

But governments and banks can only do so much. We now want to hear what ideas and actions you might have to offer.

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