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Financial Stability Report for November 2005

New Zealand has experienced an extended period of economic expansion.

New Zealand has experienced an extended period of economic expansion. Growth in household and business incomes, low unemployment, and rising values for most asset classes, have resulted in a favourable environment for the New Zealand financial system.

Global influences have also been generally supportive. Prices for New Zealand’s principal exports have been at historic highs. And in an environment of stable international financial conditions, large amounts of global capital have been looking for good investment destinations. The New Zealand economy’s cyclical strength, and hence attractive returns, has created a set of conditions that have provided New Zealand banks with ready access to relatively low-cost funding in international markets.

Conditions as favourable as they have been over the past two to three years, however, cannot be expected to be sustained over the medium term. The Bank’s near-term economic outlook, as set out in the September Monetary Policy Statement, is for an orderly slowing of economic activity. But we also need to consider where the risks might lie.

In New Zealand imbalances have accumulated. The current account deficit – the amount by which our expenditure exceeds our income – has widened to a level that is not sustainable. The counterpart to the strength of spending has been increasing indebtedness, mainly among households. Much of the borrowing has been against houses, and house prices have become inflated relative to household incomes. There has also been a strong run-up in farm debt, and rural land prices are looking stretched. These developments increase our financial vulnerability. There is also the ever-present possibility of ‘shocks’, which could accentuate an adjustment to these imbalances. The unknown, but potentially very serious, consequences of a flu pandemic would be a case in point.

Adjustment to these imbalances could test the resilience of the financial system. For example, an increase in the risk premium charged by international markets in providing capital to New Zealand would result in higher domestic fixed-term interest rates. And at some stage the exchange rate will weaken. Financial markets appear capable of managing these adjustments, but strains may appear in some firms and households.

Higher interest costs, a slowing economy, and softer asset markets could cause strains for the most indebted, for example, among the one-in-ten of mortgaged households whose outgoings to service debt and other housing-related fixed commitments claim 50 per cent or more of their disposable income. A slower rate of economic growth than in recent years, and softer asset markets, would also make for less favourable credit conditions for lending institutions.

Overall, we assess the lending institutions – comprising banks and a large number of smaller non-bank lenders – to be well-placed to weather a period of higher lending risk. However, at the same time, institutions that have competed and grown rapidly in higher-risk lending markets during the last few years of benign conditions, will increasingly be tested. There is also a more general risk that, as growth opportunities in lending markets slow, lenders will be induced to take greater lending risk, to maintain or grow market share.

Alan Bollard