Update on the financial strain faced by households and businesses

The relatively quick transition to high interest rates after more than a decade of low interest rates has been a major development affecting global financial systems over the past 2 years. The impact of higher interest costs on indebted households and businesses has been a key focus for us given its implications for financial stability in New Zealand. An increase in defaults as borrowers fall behind on their debt repayments would result in losses to banks and, on a large enough scale, could lead to financial instability.

To date, the impacts of higher interest rates on the financial system have been more benign than generally expected. This is despite higher interest rates contributing to reduced economic activity, subdued credit growth across sectors, and house prices falling by around 15% between late 2021 and early 2023. This special topic provides an update on the financial strain facing households and businesses, and how this is expected to develop over the coming year.

Mortgage repricing is now well advanced and households continue to adapt

Most borrowers have moved off the low fixed mortgage rates that were locked in two to three years ago onto much higher rates. Only around 10% of mortgage lending remains on fixed rates below 4% (figure 2.1). As a result, the average rate across the stock of lending is about 85% of the way to its projected peak.  This rate has increased to 6% from a low of 2.8% in 2021. It will likely continue to increase to around 6.5% percent at around the end of this year based on the forward path of interest rates implied by market pricing.

Mortgage borrowers have had to adapt to the higher interest costs. Retail spending volumes have declined since early 2022 despite strong net immigration. This suggests that households have limited their discretionary spending. In addition, some borrowers have reduced principal repayments, which is an option available to borrowers who have paid off principal faster than required (figure 2.2).

Mortgage arrears continue to rise from recent lows

A small proportion of mortgage borrowers has not been able to manage higher interest costs. Difficulty in keeping up with payments has likely been made worse by cost-of-living pressures and other unforeseen events like job losses. As a result, an increasing share of mortgage lending has been categorised as non-performing (defined as those 90 or more days in arrears or impaired). This share has increased from 0.2% in 2022, a very low level, to around 0.5% currently (figure 2.3).  We also monitor the share of lending that is 30 days or more past due as a leading indicator of future non-performing loans. The share has also gradually increased to slightly above the 2020 peak. A similar trend can also be seen in the share of mortgage lending categorised as in hardship, where borrowers have suffered unforeseen circumstances that have needed them to change their debt repayments to be able to keep up with their obligations.

Data from the four largest banks show that the non-performing share is somewhat higher for lending already on higher mortgage rates, highlighting the link between debt servicing costs and borrower cash flow pressures (figure 2.4).

Households that borrowed heavily relative to their incomes are particularly strained by rising interest costs. Centrix data show that rates of financial hardship are highest amongst those between the ages of 30 and 50, who also tend to have larger loans. The share of new lending at high debt-to-income (DTI) ratios, i.e. above 6, was particularly elevated around 2021. This was when interest rates were particularly low and banks were using mortgage rates of around 6% in their affordability assessments for new lending. We recently consulted on the calibration of DTI restrictions, which aim to limit this vulnerability in the future. 

Banks are well positioned to manage further increases in mortgage arrears 

More borrowers are expected to fall behind on their mortgage payments. Banks have provided us with projections of the nonperforming share of their mortgage lending (figure 2.5). They expect this proportion to increase to 0.7% by around the end of this year, around half what it was during the Global Financial Crisis.

Arrears are expected to rise as some borrowers continue to roll onto even higher mortgage rates, albeit with the bulk of the transition already complete. The impact of higher debt servicing costs is also often only fully realised after some time, as a strained borrower exhausts savings and other buffers. However, banks have reported to us that on average borrowers still have capacity to handle high debt servicing costs, either through reducing principal repayments or drawing on savings buffers. As an example, an option for borrowers in financial stress is to pay only the interest costs and stop principal repayments. Over the past year, the share of interest-only mortgages has remained flat at historically low levels. Despite this, a small portion of borrowers will have few options available and are at risk of default. 

Robust labour market conditions and strong nominal wage growth have supported borrowers over recent years. In general, if a mortgage holder still has a job, they can find ways to manage their repayments. However, with most economic forecasters expecting the unemployment rate to increase over the next year, a softer labour market is likely to lead to an increase in arrears.

With mortgages making up around 60% of bank lending, increased mortgage losses are likely to affect bank profitability. However, very few households are in a position of negative equity and banks would likely face relatively small losses in the event of an increase in borrowers defaulting. In addition, banks are in a strong financial position to continue to support their customers and maintain credit availability, owing to a combination of higher collective provisions and capital ratios, even if a significant deterioration in economic conditions eventuates (see Chapter 4). 

Business failures are also rising from low levels 

The business sector is facing subdued demand compared to the past few years, owing to the impact of high interest rates on domestic spending and below-trend global growth. High operating costs are accentuating lower demand, even as capacity pressure in the economy has eased somewhat. Growth in labour costs remains high, putting pressure on margins. Insurance costs and local authority rates have also increased considerably for businesses (Special Topic 2 covers the drivers of higher building insurance premiums, which affect both households and businesses). 

Read Special Topic 2 - Insurance availability and risk-based pricing

These developments have had varied impacts across sectors. Retail trade, manufacturing and construction face weak demand owing to the impact of higher interest rates, particularly on the housing market. Service-based sectors like restaurants and hospitality appear somewhat more resilient, benefiting from the rebound in net migration and international tourist arrivals following the removal of pandemic-related restrictions. 

The number of business failures has picked up over the past 2 years from very low levels (figure 2.6), particularly in the construction sector. The share of bank lending to businesses that is non-performing has increased over the past six months to around its 2020 level, and banks expect this share to remain broadly around current levels in the year ahead (figure 2.5). This projection is lower than what was expected 6 months ago, driven by a lower expected default rate among agricultural and general business lending. Cautious lending standards over recent years are helping to contain the increase in default rates. 

The revision also partly reflects the improved outlook for global inflation and lower expected path of interest rates, the fact that repricing of business lending rates occurs relatively quickly following interest rate changes, and the recent recovery in dairy prices and farm profitability. 

Reflecting recent challenges as well as higher interest rates, business lending has stopped growing. Banks’ responses to our Credit Conditions survey highlight that many businesses are delaying capital expenditure, which is reducing demand for credit, particularly from smaller businesses. Relative to GDP, business debt has declined noticeably since early 2020, suggesting lower leverage overall and greater financial resilience (see figure 1.3 in Chapter 1).

Near-term risks to the agriculture sector have eased with the recovery in dairy prices

Dairy prices are often volatile, and this has been the case again in the past year. In August 2023, the midpoint of Fonterra’s milk price forecast for the 2023/24 season was $6.75 per kilogram of milk solids (kgMS). Since then, international dairy prices have recovered and Fonterra’s milk price forecast has been revised higher to a midpoint of $7.80 per kgMS. Demand for dairy products has recovered in the major trading partners, while supply conditions have tightened in Europe and the United States. In addition to the rebound in milk prices, potential dry conditions related to El Niño have generally not occurred so far. Most dairy farms are likely to be profitable in the current season and the near-term risks to the sector have abated somewhat. 

While revenue continues to fluctuate, the sector has other ongoing challenges to manage. Operating costs remain high following strong cost inflation over the past few years. The average cost of producing a kgMS for the 2023/24 season is estimated to be around $7, including operating and interest costs. This is lower than the average cost in the previous season as farms have significantly cut a range of operating expenses to manage cash flows. Some of these cuts are likely to be temporary, for example those to repairs, maintenance and fertilizer. 

Debt servicing costs have increased considerably. Anonymised farm-level data from Figured (which operates a financial management platform for farmers) show the range of interest costs that farms incur (figure 2.7). While varying across farms, a majority of farms currently pay between $1.0 and $2.5 per kgMS. Around 7% of farms pay more than $3 per kgMS, and this proportion has been increasing. The reduction in debt held by the sector over the past 5 years has helped to contain these increasing costs. Farmers have also reduced principal repayments considerably to mitigate the rising cash flow pressure in the short term, which will slow any further debt reduction. 

Climate-related risk and regulatory changes continue to affect the dairy sector. Investment has been cut as farmers manage their short-term cash positions. This means progress towards more efficient production methods to help reduce emissions may be slower than otherwise expected. Our November 2023 Report delved further into climate-related risks for the agriculture sector using the results of a sensitivity analysis that we undertook with banks. The analysis showed there would be material impacts on farm lending from drought conditions and various levels of emissions pricing. 

Read the November 2023 Financial Stability Report

Despite these challenges, the share of banks’ dairy lending that is non-performing or potentially stressed remains low (figure 2.8). The higher expected milk payout compared to 6 months ago is supportive. Also, several profitable seasons have put farmers in a stronger position to manage the current challenges. A prolonged period of low payouts would see a material rise in loan losses for banks.

Around 40% of bank’s agriculture lending is outside the dairy sector, which is around 3% of their total lending. These other parts of the agriculture sector are struggling overall, with potentially stressed lending picking up over the past 6 months. For example, falls in international prices are impacting the profitability of sheep and beef farmers and the goat dairy industry. Meat prices have been temporarily dampened by additional supply from a drought-related surge in slaughter numbers in Australia. Like dairy, the meat sector faces higher debt servicing costs and climate change-related risks in the longer term, and many farms still require substantial investment to transition to a lower emission environment. These challenges could exacerbate the current financial strains. The horticulture sector is having a better season this year owing to generally good growing conditions, with parts of the sector still recovering from the devastating impacts of Cyclone Gabrielle last year. 

Commercial property risk remains a focus internationally and in New Zealand

Commercial property lending is a key source of risk to financial institutions in many developed economies, with some small and medium-sized banks in the United States particularly exposed. In New Zealand, commercial property makes up around 8% of bank lending. Structural trends such as increased remote working and online shopping, which were accelerated by the pandemic, have caused a rise in vacancies for office and retail properties. These trends vary across countries, with the United States seeing relatively more remote working. In addition, high interest rates mean debt servicing costs have increased and property valuations have declined.

These trends are evident in New Zealand as well but are generally less acute than those overseas. Remote working has increased by less than it has in other developed economies. Office vacancies have risen primarily for lower-quality spaces, while demand for higher-quality offices remains solid as firms prioritise locational advantage and collaborative spaces (figure 2.9). New Zealand cities tend to have lower office vacancy rates compared to Australian cities, except in the case of secondary office spaces in Auckland (figure 2.10). In general, the domestic market has been supported by strong migration-led population growth over the past decade and a relatively limited supply of new properties. Healthy market fundamentals have supported solid rent growth in recent years, which is helping owners to manage increased debt servicing costs and is underpinning capital values.

The ongoing slowing in the New Zealand economy is the key near-term risk to the commercial property sector. In addition, the proposed removal of depreciation from allowable tax deductions could add to existing cash flow pressures. Banks are generally willing to support stressed customers by providing interest-only lending and other options to mitigate cash flow pressures, while some borrowers are also able to draw on other income sources. Interest coverage covenants for existing borrowers have generally been eased where business models are assessed to be financially viable.

The capacity of banks to support their customers is partly a result of prudent lending standards over the past decade, which have reduced the vulnerability of banks’ loan portfolios to a downturn.

Some property owners may also look to reduce their debt through property sales, particularly if cash flow stress is severe. There have been fewer property sales in the market since 2021, pointing to a less liquid market that could make this deleveraging harder. A global commercial property slowdown could further exacerbate this as it could weaken foreign investors’ appetite for property in New Zealand. This would further reduce the pool of potential buyers.