By Roger J Kerr
The RBNZ were cajoled (or bullied?) recently into reversing their previous stance of not cutting the OCR through April to June.
Could they now be convinced that as global FX markets have conspired against them at the wrong time with a weaker US dollar, they should not muck about and just slash the OCR by 0.50% to 1.75% on 11 August?
The money markets are already pricing-in two 0.25% cuts to the OCR by November, so why wait?
To make more of a splash on currency markets to drive the Kiwi dollar lower, a surprise is required that the markets are not expecting.
A 0.50% reduction in one fell swoop would do the trick to really get the NZ dollar down and inflation back above the 1.00% minimum level sooner.
Worries that OCR decreases will just fuel the housing market even more with lower mortgage lending interest rates are arguably not justified as the banks will not necessarily pass-through the full OCR reductions for two very good reasons:-
- Retail deposit rates being paid by the banks (70% of the banks’ cost of funds) are not being reduced as they attempt to hold retail money in their coffers that is otherwise being withdrawn in favour of higher yielding dividend shares or illiquid property syndicated investments.
- The credit spreads (borrowing margins) the banks are now paying on their wholesale debt issues continue to increase with investors around the world demanding higher margins to compensate for the ever decreasing underlying market interest rate. The Aussie-owned banks being on credit watch negative by the rating agencies due to Australia’s sovereign rating being reviewed does not help the banks’ borrowing margins.
Should the Reserve Bank of Australia move to cut their OCR again this week to a new low of 1.50%, the pressure will be intensified on the RBNZ to reduce the gap between the NZ and Australian interest rates, so as to relieve the upward pressure on the NZD/AUD cross-rate (currently back up to 0.9470).
The RBNZ slashed the OCR aggressively at this time 12 months ago when international dairy prices plummeted. The financial situation in the dairy industry is more acute today and the RBNZ highlighted the seriousness of the financial stresses at their recent special economic update.
Financial risks from trading existing assets (i.e. housing market) is not as direct and hard-hitting as financial risks from less cash income and falling asset values (i.e. the dairy industry). The RBNZ have belatedly recognised that the balance between to two has to be weighted more towards the productive heartland of the NZ economy.
Whilst very low interest rates do distort some economic and investment decisions in New Zealand, the benefits in terms of commencing major infrastructure build projects (transport, irrigation and civil) earlier than normal due to the massive reduction in the financing costs are massive. It is an opportunity in a lifetime for central government, local government and the private sector to advance such projects at a pace.
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Roger J Kerr contracts to PwC in the treasury advisory area. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com
47 Comments
Slash the OCR .......To what end ?
I don't see this working as you suggest , IMHO
It wont make one iota of difference to the Kiwi$ which is almost seen as a stable safe haven currency with more predictability that the Euro , the Pound or the US$ or even the Yen for that matter
It will add fuel to Auckland's housing market
It will make the banks lend more recklessly that they are doing already
And worst of all it will do more damage to older savers who live off their interest
Its hard to see any benefits unless you have a big position against the Kiwi$ that needs to be unwound
Cutting the yield on an asset (such as NZ dollar) will inevitably cut its price (the dollar exchange rate). Of course it may not happen instantly and if risk or other countries interest rates shift around at the same time the net effect might be dulled for a time. However, NZ needs to cut the exchange rate to give exporters and the real sectors of the economy a boost. Its very obvious from the current account deficit figures that NZ can not pay its way at these exchange rates. Unfortunately we have been living in an unsustainable world of ever cheaper imports and overseas holidays. Get ready for the new normal.
Logic won't work with a majority of the readers. They are baby boomers who have placed all their savings in term deposits so will squeal at the very mention of OCR cuts. Their predictions of rising interest rates and an imminent property bubble burst have been made since 2009 and they will stick with that mantra/prayer (a form of wishful thinking)...
I suppose one day the will be proven right (just like a broken clock is right two times a day:) but not in the next 10 years (my prediction).
Cutting the yield on an asset (such as NZ dollar) will inevitably cut its price (the dollar exchange rate). Of course it may not happen instantly and if risk or other countries interest rates shift around at the same time the net effect might be dulled for a time. However, NZ needs to cut the exchange rate to give exporters and the real sectors of the economy a boost. Its very obvious from the current account deficit figures that NZ can not pay its way at these exchange rates. Unfortunately we have been living in an unsustainable world of ever cheaper imports and overseas holidays. Get ready for the new normal.
Ohh, but it IS working Boatman. It's keeping those bubbles alive and well for now and that's all that seems to matter. Even Andrew Little has now made it quite clear that Labour do not want house prices to drop either. So...at election time the choice between red or blue means very little at all. Both just want to keep subsidising the growing problems with more tinkering and social benefits rather than deal to the root causes. Keeping a bubble inflated but stopping it growing does not translate into being no longer a bubble.
It will make one iota of difference Boatman. Talk to anyone involved at a professional level with currencies and they will tell you - its all about the carry trade. If the interest rate comes down the traders get paid less to park their money in NZ overnight. The guys I deal with in Asia love the kiwi dollar. They know Wheeler is a lapdog who muddles around doing what amounts to nothing, and achieving even less.. They cant believe how long this bonanza is lasting for them.
Roger Kerr does not know what he is talking about. Artificially lowering the NZ$ is not the way to go. Savers will now be looking towards investing in houses as the interest rate is very low and the capital gains is much much more than keeping in the banks. Hence house prices will continue to be out of reach for most people. RBNZ should now realise the damages it had done with the on-going reduction of the OCR. Better to reduce the inflation rate or remove the NZ$ from floating. NZ environment is different to other countries and following suit is just madness. Does our inflation accounts for other increases eg rates, insurances, house prices, utilities, etc?
The OCR is low enough for the effects to be non-linear. Sure the market has priced in the cuts but what will pass through to the bank's customers? At what point is the OCR completely irrelevant?
Any drop in interest rates will fuel the housing market. The drop will have other beneficial effects as some homeowners spend the money they don't pay in interest, but the OCR went up when it should have gone down. The high interest rates some are still paying probably won't disappear completely for another 18-24 months.
If as you say the banks will not pass the lowering to either borrowers or depositors, what is the point?
Would it not be better to force the banks to decrease their loan to capital ratio. IMHO this would force banks to lower deposit rates and hence the dollar without adding fuel to the housing inferno.
Yes, but we need to force them to retain this money in their NZ businesses rather than repatriating it to Australia or their shareholders. At least that way, if there is a crash, then there is more capital in the business to ensure that depositors get their money back.
This is exactly why capitalism is failing. Left to their own devices business take profit in the good times, and skip out in the bad.
We should not need to regulate everything to force them to do the right thing.
But it appears we have no choice. As a Tax payer I have already lost count of all the bailouts I have made so it is time to change.
The easiest way would be to scrap Ltd liability, make every business owner personally liable for their own screw ups. The original point was to encourage innovation, and mitigate the risk for starting a business. But the reality now is, most business owners hide behind it the second something goes wrong. Deliberate mismanagement is going without punishment.
If a company needs to publicly list then the directors and existing shareholders can't afford to fund expansion by themselves,perhaps they don't have the confidence in what they are trying to achieve, hence they draw on outside money. After all, it's not their money at risk any more is it?
OCR needs to be cut both to drop the dollar (or at least attempt it) and to boost some smidgen of inflation. Housing is it's own seperate issue that the RBNZ can't handle on its own anyway by trying to balance a higher OCR.
When Roger is not expecting inflation "around the corner" and is calling for cuts, we know the RBNZ better cut 1.0% at least...
I too still struggle with Roger's 'road to Damascus' conversion. I remember when he constantly inveighed against interest rate cuts,as it would inevitably lead to higher imported inflation but now he advocates for more and bigger cuts, with no concerns about inflation.
I am certain that the RB will do no such thing, but if it really wanted to do something dramatic, it would need to cut rates by more than 0.50%,perhaps even a full 1%.
The yield on the 10 year bond is down to 2.4%. If they cut interest rates further then it just means investors are more likely to put money into property.Is that a good thing?
The reason the NZD remains stubbornly strong is that the NZ economy is perceived as being in good shape. Debt to GDP is only around 25% compared to 100% for a lot of Western economies and the 250% that Japan has.
I don't think cutting interest rates will have much effect as NZ with its relatively low Govt Debt will still be perceived as a safe haven.
Believe it or not the NZ Economy has been well managed since the GFC.
Government debt to GDP is ~30% according to some.
Whereas, household debt, as a percentage of nominal disposable income is up there with the worst, ~+160%
Whilst very low interest rates do distort some economic and investment decisions in New Zealand, the benefits in terms of commencing major infrastructure build projects (transport, irrigation and civil) earlier than normal due to the massive reduction in the financing costs are massive. It is an opportunity in a lifetime for central government, local government and the private sector to advance such projects at a pace.
Is that so?
Transmission Gully costs estimated at 29July 2014.
The Transmission Gully project’s net present cost is $850 million. This is the “whole of life” cost, for WGP to build and then operate the road for 25 years. Because the costs are spread over time, they are expressed in today’s terms.
This is $25m less than what the contract would be expected to cost through conventional procurement, and hence meets The Treasury’s value for money test for PPPs.
The cash payments will be around $125 million per year, starting only when the project is finished and open for use, and lasting for 25 years. This stream of cash payments brought back to today’s dollars is $850 million and is the “net present cost”. Read more
At the time of the above press release 10 year NZGSs were yielding ~4.5%. Currently they yield 2.165%.
In reality one would expect: This stream of cash payments brought back to today’s dollars is $850 million and is the “net present cost, to have risen considerably and possibly doubled if I could be bothered to undertake a full IRR analysis, and was in possession of the original discount factor and timing method.
I did the IRR analysis on Transmission Gulley a while ago. You need a discount rate of 15% per annum to make 25 years of $125 million equal $850 million. In other words the private partnership financing deal was laughably incompetently disastrous on behalf of NZ Treasury. That is not to say the road itself should not have been built; at your 2% financing, or even the 4% financing at the time, the say $1 billion total cost would have made eminent sense. By all means outsource the construction, and even the maintenance, but not the ownership and financing, if 15% is the best they can do.
I note since Transmission Gulley there has been little talk of such private partnerships on major infrastructure. I assume even English and Makhlouf are deeply embarrassed by the maths, and don't want any more such debacles.
Fair point. Somewhere I had simplistically understood the payments started when the project started.
Spreading the cost of the $850 million over the six years of construction, and then paying $125 million per annum, gives a discount rate of 12% to be equivalent to the $850 million construction cost.
Or using NPV, at the government cost of borrowing in 2014, the NPV would have been ~$1.6 billion; or at the 2.5% cost of funds now, the NPV would be ~$2.1 billion. So somewhere between double and treble the cost if directly funded. Unless there are other costs to the PPP. It is a bit unclear whether the $850 million tendered cost included maintenance costs for the 25 years, and who bears them. Are they included in the $125 million per annum? It would also not be a surprise to find some sort of inflation clause in the contract, where the $125 million per annum increases in nominal terms. So the PPP's likely 12% return could well be real after inflation return.
I remain very unconvinced that where there is effectively nil risk to the financing party, that PPPs make any economic sense at all.
Stephen L - my trusty HP 12C gives up a different result to your calculation for the Transmission Gully IRR.
Just for nothing but interest sake if you don't own such a machine could you try the HP 12C PC emulator using this procedure? You might consider this an irregular request, but all NZ bond dealing stock brokers used these machines in the eighties and when I arrived back from the UK in 1998 the IRD was using this same calculator in descriptive examples of taxation edicts.
If you cannot be bothered I fully understand.
Fascinating, thanks. I also seem now to have a different Chrome home page, so suspect I've pushed a couple of buttons too many. I had used both the IRR and NPV functions on Excel, getting the ~12% amount. Am not sure I've correctly used your HPC tool, but ended up with 11.25%, so not a long way off. The figure passes a sense check to me of paying $125 million a year for 25 years, (so paying 3.125 billion) starting in year 6, to fund an initial cost (or benefit to NZ) of $850 million spread over the 6 years.
It is long time since I have calculated IRRs. Mostly we used them to determine, from live price feeds, the cheapest to deliver (CTD) securitiy, from the eligible pool, for the relevant CBOT futures contracts to calculate hedging basis, given the latest repo costs. That is, before Bloomberg arrived on the scene.
In this instance I entered (850.00, CHS, g, CF0), thereafter (0, g, CFj), followed by (6, g, Nj). Then I entered (125.00, g, Cfj) followed by (25, g, Nj). Finally (f, IRR). I get 7.9235%. I am happy to be corrected.
Given our unemployment is already rather low, this would simply throw fuel on the fire.
There is already a huge shortage in the construction industry, lowering interest rates may allow for cheaper financing of construction projects , but , finance is irrelevant if you cannot get workers.
A bigger interest rate cut? Lets put in this way; If you are in a hot air balloon raising away then you see trouble ahead, do you:
1. Let all the hot air out at once, or
2. Let the hot air out slowly and gently let yourself down safely to the ground.
Some people would take 1 as a good solution.
Some people would take the "shock & awe" approach... take our sovereign bonds negative. If the Italian government can fund itself at 0.26% on the 5-year when it has a debt:GDP ratio >133%, we are being ripped off! Nevermind sound money in Today's world - unless you have some of the shiny stuff.
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