Sluggish credit growth not just a cyclical phenomenon
Speaking to parliament's finance select committee a couple of weeks ago, Bill English was once again talking down the economy, highlighting the possibility that 2010 ended with a double-dip recession. Along with weak consumer confidence and falling house prices, Mr English pointed to a lack of credit growth as one of the reasons for the economy's failure to keep improving throughout the last year.
At face value, the lack of credit growth is unsurprising. Growth in mortgage lending by banks is now at its weakest in at least 20 years due to falling house prices, very low sales volumes, and homeowners paying down their mortgages. Growth in agricultural lending has also not been weaker since the early 1990s, with farmers taking advantage of high international commodity prices to eliminate some of the debt they have accumulated over the last decade. Consumer debt has also contracted a long way since the global financial crisis hit in late 2008.
Given the hand-wringing over the last year about New Zealand's savings habits, and those of households in particular, the lack of new borrowing in each of these areas will be reassuring to many analysts. But more growth in business borrowing, which has contracted almost 10% over the last two years, wouldn't go amiss.
Businesses' willingness to borrow is being limited by their caution about committing to capital expenditure. Furthermore, even where firms are willing to invest, in the early stages of any economic recovery, that initial investment is likely to be funded out of cash reserves rather than taking on debt. These cyclical factors go some way to explaining the lack of growth in business borrowing.
But we believe that prudential regulations are also having an effect on where banks lend their money. In general, capital adequacy requirements introduced in 2008 for banks put a much lower risk weighting on mortgage lending than for most other lending types. For any business that doesn't have a reasonably good credit rating, or doesn't have a credit rating at all, banks are effectively forced to be reasonably tight-fisted with their funds to ensure that their lending portfolio fits within regulatory requirements.
This discrepancy in treatment is exemplified by disproportionately high business lending rates when compared with mortgage rates. Our graph shows the huge increase in the margin between 90-day bill rates and the business base lending rate since early 2008. Banks seem to be pricing business lending much higher to ensure that demand for funds does not push their capital adequacy ratios outside the regulated requirements.
One of the legacies of the global financial crisis is that central banks have been urged to take a more active role in prudential supervision. A lack of adequate oversight of financial institutions has been seen as an important contributor to the crisis and subsequent international economic struggles since 2008. The Reserve Bank is arguably ahead of the central bank pack when it comes to more closely monitoring the financial sector.
The irony of the current situation, though, is that these tighter controls are not necessarily hitting the appropriate targets. The worldwide surge in house prices over the last decade was a contributing factor to the global financial crisis. Concerns about the unaffordability of property and its amplifying effect on New Zealand's economic cycle are well documented. Yet the current regulations mean that banks are encouraged to favour mortgage lending over other types of lending.
There is a widespread perception in New Zealand that steps should be taken to reduce our preoccupation with housing and encourage more "productive" investment to boost our potential economic growth. Many advocates of changes in this area also believe that the financial sector should be more closely supervised following the global financial crisis and New Zealand's own finance company collapses. But the current policy direction makes those two aims incompatible.
We believe that the Reserve Bank's primary role in overseeing the financial sector should be monitoring and supervision, with the communication of transparent information to the public about any risks associated with investing in specific institutions. The complete absence of supervision for finance companies, some of the substandard practices that took place, and the lack of clear public information about the risks for investors, were a key factor in that sector's boom and subsequent collapse.
In limited cases where a systemic failure can be proved, there may be grounds for regulatory intervention to direct banks’ lending behaviour. But the evidence suggests that current regulations are resulting in businesses being harshly treated in their search for funds because of the housing market excesses over the last decade. Constraints on business investment will limit economic growth and have negative implications for medium-term job and income growth. In other words, ordinary New Zealanders could ultimately be the ones penalised by misguided restrictions imposed on the financial sector.