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Roger Bowden
22 January 2012

The Eurozone Meltdown

Part 2: New Zealand Exposures

Economists often talk about shocks, and in the next breath about impulse response functions[1], which is basically how an initial shock follows through over time to the rest of the economy. So this week’s article will describe how the Eurozone shock (last week) might be expected to flow through to the rest of the world and thence trickle down to us. I’ll conclude with a few general lessons for us, hopefully not too unctuous.

As a conscientious economist with the dismal reputation of our profession to uphold, I’ll start with the gloomy bit, which is the prospect of a Sino-mess. As with the Euro-mess, the Chinese version has its own generative forces, but causals are also involved from one to the other. For the Eurozone is a large market for Chinese exports, so any slowdown in the one will impact on the other.

However, the Chinese story really starts with a colossal real estate boom, as migrants flooded in from rural areas to find work in the factories that supplied the burgeoning export industries, and for the infrastructure construction that made it all possible. They had to live somewhere, and this needed apartments: acres upon acres of high rise towers, pushing back urban boundaries like cancerous growths of concrete and steel. Economists used to call it an acceleration effect, capital feeding into income and income on into more capital, and this indeed was the real Chinese boom, not exports as such.

The problems come when thing start slowing down, for the acceleration effect can just as easily go into reverse. Exports and manufacturing activity have indeed been slowing down, and migration even going into reverse as unemployed workers return to their roots. In some areas that has left an urban ghost land of newly constructed but vacant tower blocks.

Even more disturbing is the impact upon local body income and activity. A Chinese city council will derive 60-70% of its revenues from selling land to developers, or more precisely the right to occupy land, as the central government still technically owns it. A lease, if you like, but paid up front, capitalized into the price of the apartments. So if building stops, that’s going to be bad luck for an army of council workers and the economic demand that feeds off their needs. The Chinese government has recently begun to put local body finances on a firmer footing by allowing them to levy property taxes. A bit stiff for existing apartment owners, for they will already have paid their contribution upfront in the price of their apartment, but that’s life.

The results are already appearing in the form of retreating commodity prices for a number of industrial minerals such as iron ore and copper, as well as forestry products. Falling mineral prices won’t affect us directly here in NZ, but there will be a negative impact on important trade partners, of which Australia comes to mind, our number one export destination. And the flow of full fee paying Chinese students to NZ universities is slowing; though that’s partly a response to the inflated fees they’re being charged, for all the wrong reasons.

But on the bright side, our foodstuff commodity prices have held up very well, and to add a geopolitical ray of hope, there is a nascent resurgence in US economic activity, another major trade partner. So on the export front, the news is by no means all bad for NZ. Indeed if it were not for the Christchurch quakes, we’d be in pretty good shape, given also that the current government has taken some action to curb public sector expenditure. Good enough shape to weather an expected relatively minor downturn in our commodity prices.

But when you start talking about economic shocks, you keep coming back to earth in the Shaky Isles. The Christchurch quakes were (and are) a momentous economic shock. It cleaned out the EQC, for which the government has to raise new capital. International reinsurers have elevated us from a minor diversifiable risk to one big enough to want special pricing, if not the cold shoulder altogether. Home insurance is going through the roof, and that is something the Reserve Bank will have to consider in their inflation targeting.

However, I see the major impact as on government funding, the need to issue more government debt to cope, and the further need to preserve an equity buffer against further such geo-shocks. Wellingtonians are a jumpy lot right now, in spite of – or because of? – reassurances from GNS. If a big one hits there or somewhere else, folks, we’re right in it.

Last time I looked, the government debt to GDP ratio was about 40%. I would guess that figure will have to rise, based on the latest Ch-Ch quakes. Based on formula developed in a recent paper[2], I calculated that the sustainability level for NZ was 26.9% (spurious accuracy, but decimal points do look good). So we are already a bit north of the comfort zone. What if there’s another big shake? And even if there isn’t how do we reserve debt capability for the infrastructure we still need?

When companies borrow, they generally try to preserve a desired debt to equity ratio in their balance sheet. Should the same be true for governments? In the same paper, I suggested that this should be factored in to the sustainable debt to GDP ratio, lowering the latter a little. Curiously enough, that is just what the previous government did with the Cullen fund, though they had in mind its use to lessen the generational burden arising from baby boomer retirement, rather than to provide infrastructure equity or as a budget buffer against major natural or economic shocks.

The ‘economic problem’, as every student learns, is how to distribute resources in limited supply. In a political context one could add ‘amid the clamour of claimants’, and of course the silent claims of the generations to come. Here in NZ, MMP coalitional imperatives have reinforced the influence of pressure groups in public spending.  If there is a single lesson from the shocks and crises, it is the chaos that can result from insufficient attention to elementary economic prudence. There is nothing wrong with public debt. But it has to be backed by public equity in the form of financial reserves.

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