The tide is turning: Print 21 magazine article

Faced with deteriorating economic conditions, the Reserve Bank of New Zealand has finally taken its foot off the brake and cut interest rates for the first time in five years. Tony Alexander examines what it all means.

The Reserve Bank of New Zealand has just cut the official cash rate from 8.25 percent to 8 percent and signalled that there are likely to be further interest rate cuts soon. They have become more concerned about the state of New Zealand's domestic economy, the worrying news about offshore economies, and the increases in bank funding costs offshore which would probably have led to higher mortgage and business borrowing costs had they not in fact cut the official cash rate.

This latter point is quite important because what it means is that as the Reserve Bank keeps cutting interest rates, possibly at every six weekly review over the coming year, the feed through into New Zealand business and household borrowing costs will initially be quite small. To understand this, one has to realise that we New Zealand banks get about one third of the funding we need to lend in New Zealand from offshore. A year ago, the risk premium we would pay for borrowing offshore amounted to only about 0.1 percent. A few weeks ago that cost had increased to 1.5 percent and more recently 2.2 percent.

Our margins have been slashed to unsustainable levels. Hence, as the Reserve Bank cut the official cash rate, the old rule that this will automatically lead to the same reductions in bank lending rates definitely does not apply.

Still hard-pressed
This means New Zealand's domestic economy is still going to remain relatively hard-pressed over the next couple of years. Not only that but businesses are facing such tight margins and restricted cash flows that they are laying people off, delaying capital expenditure in some instances, and reducing inventories aggressively. Their actions will tend to depress the economy further over the next few months but also, of course, provide the continuing environment in which interest rates can decline.

And in the housing market, the fact that so many vendors are taking their properties off the market to rent out means that whenever the market shows some sign of life in response to tax cuts and slowly falling mortgage interest rates, prices will face new downward pressure as these vendors decide to place their properties back on the market.

But it is not all doom and gloom by any means. In fact possibly the best way to interpret what is happening at the moment is that we are getting a relatively brutal rebalancing of the economy that, in many ways, we have all been waiting for since 2004. The debt-driven surge in household spending in our country was clearly unsustainable and it has now come to a relatively shocking end. But the compression on our export sector from a high exchange rate from 2004 was also unsustainable. Now we can see the New Zealand dollar falling away and although it will take a while before the full benefits feed through to the majority of exporters, the power in our economy, as it were, is shifting to the more valuable sectors.

In fact we already have very well-known strength in the dairy sector but this is also spreading out into the sheep meat and beef industry with their prices internationally recovering 30 percent or so in the past year, and with the falling New Zealand dollar to provide more benefits. One has to keep in mind, however, their raw materials prices such as for fertiliser and fencing have risen substantially with further rises to come along due to this continuing strong growth in China's demand for raw materials plus the falling New Zealand dollar.

Opportunity knocks
Overall what it means is that our economy will be relatively constrained for another one to two years but with the export sector steadily improving over 2009 and 2010 and with that improvement eventually hitting generalised retailing and housing maybe from late 2010.

The key requirement for businesses in this environment is to get cash flows under control and then, when that is done, take advantage of the opportunities the rebalancing in our economy will present. This means not just long-term export growth prospects but also opportunities in the domestic sector as undercapitalised businesses come on the market, skilled and motivated employees become available, along with good premises. So keep an eye out for counter-cyclical asset acquisition opportunities.