Last month the Reserve Bank released its half yearly Financial Stability Report. Its purpose is to report on the soundness and efficiency of New Zealand’s financial system and the measures undertaken by the Reserve Bank.
In amongst its 59 pages is some interesting information. The Reserve Bank reported our banking system is, “well capitalised, funding and liquidity buffers are above required minima, and non-performing loans continue to decline… each bank has the capacity to manage a range of significant negative events.”
The report went on to describe four key economic risks:
- Imbalances in the housing market (between demand and supply);
- High levels of indebtedness in the dairy sector;
- The potential effects of a slowdown in the Chinese economy; and
- The banking system’s reliance on offshore funding.
Reserve Bank Governor Graeme Wheeler commented the balance of these risks had shifted in the last six months: The housing risk had eased because of the loan-to-value ratio (LVR) measures, but risk within the dairy sector had increased.
The impact of the LVR limits has been obvious. In the year to September 2014:
- House prices inflation nationally declined from 9.4% to 5%.
- In Auckland house price inflation declined from 16.4% to 8.6%.
- New lending with a LVR ratio >80% went from 24.4% of lending down to just 7.3%, and now accounts for 16.5% of total lending against 20.5% last year.
That’s a dramatic turnaround and on that score the LVR policy has achieved its purpose.
On the future of the LVR policy, it reports; “The Reserve Bank intends to ease or remove the restriction when a sustained moderation in house price inflation is achieved, and when there is little risk of a resurgence in housing market activity.” While immigration remains strong, the LVR policy will remain in place.
In the media conference that followed, Reserve Bank Governor Graeme Wheeler commented on the possibility of regulations to curb buying by larger property investors (those owning more than five rentals).
The Stability Report itself made no mention of the need for such controls but the media made much of the Governor’s comment and as expected politicians jostled their way into the limelight with one-liners about home affordability. Unfortunately the home affordability debate has focused on property investors as the villain. It is therefore unsurprising that regulation remains the key area of concern for property investors. In a recent ANZ survey, 52% of property investors said it is their greatest concern, up from 48% last year. In 2010 just 12% rated this as the greatest risk. The main areas of concern are a proposed change to banking regulations by the Reserve Bank, and the introduction of the building warrant of fitness regime to private rental properties.
The Reserve Bank’s proposal would require banks to treat loans to residential property investors owning more than five properties as commercial lending. This is how the Reserve Bank describes it:
“…if the bank has recourse to, or is aware of, more than five properties owned and let by the borrower directly or through a company or any other ownership structure of the borrower, and the loan is predominantly [more than 50%] serviced from the rental income those properties generate, then the loan can no longer be classified as a residential mortgage loan but should be classified as either income producing real estate or SME [small and medium sized enterprise] retail lending. The bank is required to verify whether the customer has any other rental properties or residential mortgage loans with another lender or lenders as part of its credit origination process.”
SME bank lending is considered to be higher risk lending and is charged a higher interest rate. To target larger residential property investors is a truly absurd notion given the diversification of a large residential property portfolio actually lowers risk – larger investors should pay lower interest rates than the single property owner.
The true purpose of the regulation is obviously to put the brakes on house prices by targeting existing property investors, just as they targeted first home buyers when they changed the loan to value ratios last year. At this stage the Reserve Bank is still considering the proposal.
Not surprisingly a number of commentators and politicians are calling for the Reserve Bank to regulate property investors. They say these large investors are pushing up prices and elbowing out would-be first home buyers. That, of course, is untrue and ignores the fact that investors are not buying more homes than they did previously, they are simply buying a greater percentage of homes sold because fewer are selling to first home buyers due to the LVR regulations.
With respect to the banking system’s reliance on offshore funding, overseas lenders now provide 30.1% of bank funding, down from 38.3% in 2007. That is due to the slow down in the demand for credit and improved domestic savings, which is good news.
However the main consideration for the Reserve Bank may be the health of the economy and whether further controls are needed at all.
With respect to the dairy sector the Reserve Banks says; “The forecast dairy payout announced by Fonterra for the 2014–15 season of $5.30 per kilogram of milksolids (excluding dividends) is well below the payout for the previous season of $8.40. If realised, it would be the lowest payout in six years…Based on the recent outcomes of international dairy auctions, the payout could be lower than currently forecast some highly indebted farmers are expected to experience negative cash flow at the reduced milk payout.”
Today Fonterra has confirmed the lower payout and is now forecasting $4.70 per kg of milksolids. That reflects the 55% decline in international dairy prices since the start of the year. If that were a share market index the media would be reporting a market crash. The initial declines were moderate and in response to less demand from China, but the declines escalated in July after Russia banned the importation of some food groups (mostly dairy) from some western countries. Their action was in retaliation to EU sanctions on Russia for supporting pro-Russian separatists fighting in the Ukraine.
While the ban does not directly affect dairy imports from New Zealand, Brazil, and Argentina, the indirect effect has been to flood the market with product that would otherwise have been consumed by Russia. Russia was the second-largest global importer of dairy products and accounted for 12% to 15% of the total volume.
At $4.70 rural commentators believe a quarter of farmers will struggle to pay their bills.
Westpac is forecasting a payout of $6.20 for the 2015/16 season – and that is assuming that global milk prices rise rapidly over 2015. Ominously, the NZX Dairy Futures market indicates whole milk powder will not exceed US$3,000 per tonne at all during 2015. At the 2 December global auction the actual price declined 7.1% to US$2,229. The next dairy auction is on 16 December.
While the farming sector and the rural lending sector may be able to manage one season of low prices, the industry will be in serous trouble should that extend to two or three seasons. That will be of particular concern for provincial economies.
As a new year comes into view, all eyes will look to the horizon – to the politics of Europe and Russia and the economy of China – to see what 2015 will deliver and how our local economy will fare.